Financial Accounting University of New York Prague - Martin Kolmhofer

FINANCIAL ACCOUNTING

University of New York PragueMartin Kolmhofer

Course Objectives

• Terminology and definitions used in the accounting language. • Identify why accounting is a necessary skill. • Summarize the history of accounting. • Identify and describe assets, liabilities and owners' equity. • Demonstrate the effects of business transactions on the accounting

equation• Recognize and compare the major financial reports. • Describe and create a company's Income Statement. • Compare and contrast a company's revenue, expenses, income, and

retained earnings. • Identify the key elements of a Balance Sheet. • Balance the accounting equation and properly chart debits and credits. • Describe the accounting cycle. • Define key terms: inventory, FIFO, LIFO, Cost of Goods Sold. • Summarize cash flow, identify fixed assets, and describe depreciation. • Know what to expect in an audit.

Bean Counting vs. Big Picture…

Overview Day 1

Accounting Introduction

History - What is accounting?

Why do we need accounting?

The role of monetary calculation in society

Inherent Limitations of financial accounting

What is accounting? Definition

• The systematic recording, reporting, and analysis of

financial transactions of a business.

History of Accounting Luca Pacioli (1445 – 1514)

1494:

"Summa de Arithmetica, Geometria, Proportioni et Proportionalita" ("Everything About Arithmetic, Geometry and Proportion“).

Double-entry bookkeeping:For every credit entered into a ledger there must be a debit

• Merchants of Venice• Accounting was created in response to the development of trade and commerce during the medieval times• Trading voyages needed to be financed• The system that was in use by these Venetian merchants was nearly the same as we use today

History of Accounting)

"Double-entry bookkeeping is one of the most beautiful discoveries of the human spirit… “ (Johann Wolfgang Von Goethe 1796)

Accountant vs. BookkeeperWhat’s the difference?

WHY STUDY ACCOUNTING ?

• Growing field due to increased regulation (Sarbanes -Oxley)

• Many different areas to spezialize in (AP, AR...)

• Lots of job growth opportunity

in all industries • Gives opportunity to move to

other areas of business

What is accounting? Functions of Money

Money as:

• Store of Value (enables saving, lending, borrowing…)

• Medium of Exchange (Alternative: Barter)

• Unit of Account (common measurement in which values are expressed)

Money as a Unit of Account

But if everybody charges in the same item, that is money, it becomes very clear who has the lowest price.

What if one supplier wants to be paid in babysitting, another one in computer help and another in petsitting and so on…

“Standard unit of measurement” = “Language of business”


Why do we need accounting

What is finance all about?



It´s all about people…

Why do we need accounting?Unlimited Wants vs. Limited Resources

Unlimited Wants: Only perfect beings want nothing…

Limited Resources: Time, Energy, Money…


Choices must be made…

Why do we need accounting?Economic (calculation) problem

ECONOMICS is the study of how people chose to use their scarce resources in an attempt to satisfy their unlimited wants


SCARCITY exists when there is not enough of something (product/service/resource)

to satisfy everyone’s wants AT A ZERO PRICE

The Price Mechanism

How to distribute resources rationally in the economy? Capitalist solution is the Price Mechanism

Those who are willing to pay the price will get the goods and services

Price Mechanism

• How does the Price Mechanism work?

• 3 Magic Words: Supply and Demand

• Example: Pencil vs. Watch

• Common misconceptions about how prices are determined (by suppliers, by cost of production…)

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Equilibrium Price Subjective preference rankings interact to yield objective money prices

Equilibrium occurs when quantity supplied equals quantity demanded

Market price will be stable, that is it won’t tend to change, when you reach the point at which willingness to buy coincides with

willingness to sell in the market


At 3 dollars every seller can find a willing buyer…


•No other price would be stable•All other prices would have a tendency to change

Example:

At a price of 1 dollar there would be a SHORTAGE(quantity demanded is greater than the quantity supplied)Result:Upward pressure on price

Equilibrium Price - Shortage Subjective preference rankings interact to yield objective money prices

Buyers start to compete to get the available units


Price goes up and consequently quantity demanded drops and quantity supplied rises until we get to equilibrium again


What about a higher price, like 5 dollars?

Equilibrium Price - Surplus Subjective preference rankings interact to yield objective money prices

When the quantity demanded is less than the quantity supplied we have a surplus and the price will drop.

At 5 dollars sellers are happy providing 5 units but buyers are unhappy, they only want one unit.

3 Dollars = “MARKET CLEARING PRICE” (clears the market of all surpluses and shortages)

Equilibrium Price - Surplus Subjective preference rankings interact to yield objective money prices

.

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Disadvantages of the Price Mechanism

In our market economy it´s the market that determines price and price serves as the rationing mechanism to determine who gets the scarce product or service and who does not.

Alternative Rationing Mechanisms

• Queuing (Waiting in line as a means of distributing goods and services )

• Ration Coupons (Tickets or coupons that entitle individuals to purchase a certain amount of a given product per month )

• Favored Customers (Those who receive special treatment from dealers during situations of excess demand. )

• Problem: EXCESS DEMAND is created but not eliminated

Alternative Rationing Mechanisms

Price Mechanism – Rationing, Price Ceilings

What would happen if you force a price that is not the equilibrium price?

Example: Government imposes price ceiling on gasoline

At the imposed price of 2,50 the quantity demanded is greater than quantity supplied. This means that not everyone is going to get the gasoline that they want, because there is a shortage.

WHAT WILL HAPPEN?

Price Mechanism – Rationing, Price Ceilings

•Would you rather KNOW that you are going to get gas as long as you are willing to pay 4 USD/gallon, or HOPE that you can get gas at the price ceiling of 2,50 USD?

•CONCLUSION: Price mechanism is usually a good and effective way to allocate resources

Market Failures

Market Failures: 3 examples where the price mechanism may not work - may not allocate scarce resources efficiently

• Public Goods (“Free Rider” Problem – Non Excludability, Examples: Street lighting, national defence…) – People will not pay for it – Solution: goods are provided collectively by the government and then financed through taxationCAN YOU THINK OF EXAMPLES?

• Externalities (Environmental Pollution etc…Example CO2 Certificates) – factories are not calculating certain costs

• Market Power (Monopolists - Price is higher and output is lower under monopoly than in a competitive market )

Video – Price Mechanism in Action

VIDEO – Price Mechanism in Action

• Example: Supply of a big city. Who coordinates? NOBODY• Process of impersonal social interaction is coordinated

through prices• Prices are signals that tell us what we have to do in order

to be useful for other people - This is how it was possible to create a society based on the division of labour

• Millions of people in society coordinate their plans through markets

“The Invisible Hand” – Adam Smith

Adam Smith was the first economist who investigated how this process of social coordination works.

Rational, self-interested behaviour does not produce chaos, but usually produces social coordination

Market Phenomena – Laws of Social Cooperation

“It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest. We address ourselves, not to their

humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”(Adam Smith, The Wealth of Nations 1776)

• Market phenomena• Laws of social cooperation

Division of LabourCoordination through money prices

Supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced.

EXAMPLES OF “CREATIVE DESTRUCTION”: Polaroid Cameras, Typewriter, SteamTrains....

CONSUMER

LABOUR – LAND - CAPITAL

Division of Labour – Cost and Profit to the Firm

All social phenomena result from interactions among the choices that individuals make after calculating the

expected benefits and costs to themselves


Social coordination through money prices…. Therefore it is important to calculate “Profit” correctly

Accounting Profit = is total revenue minus explicit cost.

Economic Profit = total revenue minus opportunity cost

Accountants do not include implicit costs because they are difficult to measure.


Opportunity Cost:“How much does it cost to go to university for a

year?”

Explicit costs: tuition, books, school supplies, etc.

Implicit cost: The amount that the student could have earned if she had worked rather than attended university

Implicit costs are costs that do not require a money payment. The opportunity cost includes both explicit and implicit costs.


• The opportunity cost of any decision is what is given up as a result of that decision.

• Opportunity cost includes both explicit costs and implicit costs. The firm’s economic profits are calculated using opportunity costs. Accounting profits are calculated using only explicit costs. Therefore, accounting profits are higher than economic profits.


Method of reasoning - Ability to identify true opportunity cost!


Identify true opportunity cost:

Story: The businessman and the fisherman

Conclusion: Does your profit cover all your „costs“?


“When there is no profit the loss is obvious”

(Old Chinese Merchant´s Proverb)

Summary Day 1

• Money as Unit of Account• Unlimited Wants/Limited Resources • Scarcity • Price Mechanism • Equilibrium Price • Disadvantages of the Price Mechanism – Market Failures • Alternative Rationing Mechanisms (Price Ceilings)• Division of Labour• Opportunity Cost

Summary Day 1

Questions?

Overview Day 2

• Users of Accounting Information• Accounting Principles• Financial Reports• Accounting Equation / Balance Sheet• How Transactions impact the Accounting Equation• Four basic types of transactions• The four core financial statements• Accounts, Debits and Credits• The Journal – The General Ledger • Posting• Chart of Accounts• Financial Statements from the Trial Balance• Accrual Accounting• Revenue Recognition / Expense Recognition• Adusting Entries

Users of accounting information

Internal• Shareholders / Investors• Staff / Employees• Trade Unions• Managers

External• Customers• Government (Taxation)• Lenders (Banks, Analysts)• Suppliers• The Public• Competitors

The preparation of information for external users is called Financial Accounting. (vs. Management Accounting)

Users of accounting informationInternal: Shareholders / Investors

• Company’s shareholders are the real owners of a business and need information from those who manage the business on their behalf

• They need information to help them determine whether they should buy, hold or sell (increase or decrease their holding). Shareholders are also interested in information which enables them to assess the ability of the enterprise to pay dividends.

• Question: How does stock price affect a company?

• No direct impact. Once the shares are sold into the market, the company is no longer affected directly by the share price. However, some indirect effects:

Low Price: Danger of Hostile Takeovers, hard to raise future capital

Users of accounting informationShareholders / Investors

ANALYST COVERAGE:

Financial Analyst: A financial professional who studies various industries and companies, providing research and valuation reports, and making buy, sell, and hold recommendations.

Users of accounting informationShareholders / Investors

Users of accounting informationInternal: Staff / Employees

Interested in information about:

•Stability and profitability of their employers

•Ability of the enterprise to provide remuneration, retirement benefits, employment prospects

•Pay and benefits obtained by senior management

Users of accounting informationInternal: Trade Unions

Knowing what a company is making will give them an insight on how much they can demand

Users of accounting informationInternal: Managers

• Management is also interested in the information contained in the financial statements even though it has access to additional management and financial information

• This is because the highly summarised nature of financial accounts allows management to assess whether the company's strategic and tactical objectives are being met.

Users of accounting informationExternal: Customers

• Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise. They will look at the companies finances to make sure the company is not in trouble and that their supplies are not about to dry up.

• Example: Strategic Suppliers – regular financial check-up!

Users of accounting informationExternal: Government

• Tax (Corporate Tax, Capital Gains, VAT…)

• Regulation (Compliance)

• National Statistics (GDP, Intrastat…)

• GDP: Total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports.

• Intrastat:Statitics on the trade in goods between countries of the European Union. (Balance of Payments)

Users of accounting informationExternal: Lenders (Banks)

•They need to make sure a company is in a healthy financial situation before they start to lend money.

•Concerned with debt repayment

•Prefer to deal with a financially strong company with a healthy cash flow

CREDIT BUREAUS (for individuals)CREDIT RATING AGENCIES (for corporations + sovereign debt):

•Baa1, Baa2, Baa3, Ba1, Ba2, Ba3 •A1, A2, A3 •B++, B+, B, B-, C++, C+, C, C-, •A.M. Best, Dun & Bradstreet, Standard & Poor's, Moody's, Fitch Ratings…

Users of accounting informationExternal: Lenders (Banks)

Examples of Sovereign Credit Ratings:

•Credit rating determines how much interest you have to pay for your debt•Important to INSTITUTIONAL INVESTORS (pension funds, Insurance companies

Users of accounting informationExternal: Suppliers

Suppliers – will look at a company’s balance sheet and profit and loss account to see if and how much credit they are willing to give:

METHODS OF PAYMENT IN INTERNATIONAL TRADE:

Rule (especially for international trade):

NEVER sell on open account to a new customer

(only against credit card or advance payment)

Users of accounting informationExternal: The Public

• Contribution to the local economy (number of people they employed)

• Patronage of local suppliers

• Although not everyone in the public might understand financial accounts…financial statemens also include written outlook:

Users of accounting informationExternal: Competitors

• Benchmarking (Best Practice, Peer Group, Ratio Analysis…)

• Mergers, Takeovers, Synergies…?

• Benchmarking is the process of comparing one's business processes and performance metrics to industry bests and/or best practices from other industries.

• Peer Group: Community in which most or all members have roughly the same characteristics



Can you distinguish between management accounting and financial accounting?

Overview Day 2


Accounting Principles

Question: Why have rules?

So that everyone plays the game the same wayWhat if owners and managers could prepare their business's

financial statements the way they felt like ?

• If a business was wanting a loan or credit, they would have a tendency to overstate the value of their assets and the value of their business. If it came to taxes (we don't like to have to pay them), let's expense and write off everything.

• As for measuring performance (profitability) and comparing businesses in the same industry, you'd have no idea as to who was actually doing well and who wasn't.

• You couldn't even compare your own business from year to year

Accounting Principles

• Rule making and standards setting organizations:

• FASB: Financial Accounting Standards Board = private sector organization in the United States that establishes financial accounting and reporting standards.Responsible for developing US GAAP : Generally Accepted Accounting Principles IASB: International Accounting Standards Board= is an independent, privately-funded accounting standard-setter based in London. Responsible for developing IFRS: International Financial Reporting Standards

• Harmonization Discussion: US - special accounting standards for special industries…

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Generally Accepted Accounting Principles - GAAP

The most important accounting concepts are:

• Economic Entity Assumption• Monetary Unit Assumption• Historical Cost Principle• Accruals – Time Period Assumption• Dual Aspects• Matching Principle• Materiality• Going concern• Consistency• Substance over form• Prudence

Accounting Principles - Business Entity

Definition• The activities of the entity

are to be kept separate from the activities of its owner and all other economic entities

Example• Pharmacist records the

purchase of two boxes of Listerine to be sold in the shop.

• On the other hand, she cannot record 1kg of beef she buys for Sunday lunch as it is her and only her private expense.

• PROBLEMS?

The income tax authorities have thousands of rules as to what may and may not be included as a deduction from revenue

Accounting Principles - Monetary Unit Assumption

Assumptions:

1) Stable currency is the unit of record:Dollar's purchasing power has not changed over time. Accountants ignore the effect of inflationFor example, dollars from a 1960 transaction are combined with dollars from a 2010 transaction – Example LANDRealistic Assumption? USD-Gold Exchange Rate vs. Consumer Price Index (= official inflation rate)

2) Record only transactions that can be expressed in terms of moneyIf an asset cannot be expressed as a dollar amount, it cannot be entered in the general ledger:

• Skills of the management team EXAMPLES?

Accounting Principles - Monetary Unit Assumption

Accounting Principles – Historical Cost Principle

• You record items at what you paid for them.

Accounting Principles – Historical Cost Principle

Historical Cost vs. Fair Value• From an accountant's point of view, the term "cost" refers to the amount

spent when an item was originally obtained, whether that purchase happened last year or thirty years ago = historical cost

• For example, land is initially recorded in the accounting records at its purchase price. That historical cost will not be adjusted even if the fair value is perceived as increasing. Difference to Monetary Unit Assumption?

• While this enhances the "reliability" of reported data, it can also pose a limitation on its "relevance.“

• An exception is certain investments in stocks and bonds that are actively traded on a stock exchange (“Mark-to-market valuation”)

• If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements—you need to look elsewhere, perhaps to a third-party appraiser.

Accounting Principles – Time Period Principle

• The Time-period principle implies that the economic activities of an enterprise can be divided into artificial time periods

Accounting Principles - Dual Aspects

Assets = Liabilities + Equity

• All accounting transactions must keep this equation balanced.

• When there is an increase on one side there must be an equal increase on the other side or an equal decrease on the same side.

Accounting Principles - Matching

Definition• Revenue for a given period

is matched against the costs incurred in the same period when generating this revenue.

• This concept enables for a true and fair view of profit for the given period.

Examples:• Accrued Expenses• Deferred Expenses• Depreciation

ACCRUAL ACCOUNTINGvs.

CASH BASED ACCOUNTING

Example Deferred Expense: You hold a CONFERENCE that you prepaid for in January, but the conference actually happens in March, you should recognize the expense for it in March as well as the revenue for the attendees.Example Depreciation: If a machine is bought for $100,000, has a life span of 10 years, and can produce the same amount of goods each year, then $10,000 of the cost of the machine is matched to each year, rather than charging $100,000 in the first year and nothing in the next 9 years. So, the cost of the machine is offset against the sales in that year.

Accounting Principles - Materiality

Definition• Unless the item is significant in

value when compared to the entity’s size, it may be excluded from the decision making.

• $5,000 might be immaterial for a large, profitable corporation (say General Motors), but it will be material or significant for a small company that has very little profit

Example• A classic example of the materiality

concept or the materiality principle is the immediate expensing of a $10 wastebasket that has a useful life of 10 years. The matching principle directs you to record the wastebasket as an asset and then depreciate its cost over its useful life of 10 years. The materiality principle allows you to expense the entire $10 in the year it is acquired instead of recording depreciation expense of $1 per year for 10 years. The reason is that no investor, creditor, or other interested party would be misled by not depreciating the wastebasket over a 10-year period.

Accounting Principles - Going Concern

Definition• The business entity will

continue in operations for the foreseeable future (rule of thumb – 12 months).

• Allows for the accruals principle to be reasonable

• Book values vs liquidation values

• EXAMPLES?

Example• With previous matching /

accruals principle it would not make sense to record the rent prepayment as a cost of the next period if the entity were not going to continue in operation.

Accounting Principles - Consistency

Definition• The accounting policies

should be consistent over time.

• I.e. similar items should be treated in a similar manner within one as well as over several accounting periods.

• This allows for reasonable comparison over time.

Example• If the entity changes the

accounting currency every month, the month-to-month comparison would be impossible.

• Examples:• Valuation of Inventory (FIFO,

LIFO…)• Depreciation Methods

Accounting PrinciplesSubstance over form

Definition• The financial statements of

the entity should reflect the business reality rather than the legal form of the events or transactions.

Example• A group of employees is sent for

one week trip to Africa. They spend one day in training and for the remaining time they go for safari.

• The whole trip could be expensed as seminar.

• In fact and in accordance with the Principle, it is an additional benefit for the employees and should be taxed accordingly

“When it is a cat but it was disguised in a legal form to look like a dog, then you would still treat it as a cat.” Example: Sale-and-Lease-Back contracts

Accounting Principles - Prudence

• One should not try to make things look prettier than they are. Typically, a revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable.

– Revenues should be recognized when they are to be realized with certainty (100% sure about the revenue).EXAMPLE: If there is a dispute about sales, the company is encouraged not to report the disputed revenue.

– Expenses should be recognized when they are probable to be incurred (more than 50% chance that the cost will be incurred). EXAMPLE: if there is a lawsuit that may require the company to pay fines/fees, it has to be reported (at least in the notes).

Accounting Principles - Prudence

Accounting Principles - Conflict of the Principles

• If the conflict arises, there is no right or wrong answer, the accountant needs to use his/her own judgment

• In conflicts between the prudence convention and any of the others, the prudence principle should be considered as the dominant one = “OVERRIDING PRICIPLE”

Accounting Principles - Conflict of the Principles

QUESTIONS?

Overview Day 2


Financial Reports

4 MAIN TYPES:

• Balance sheet (BS)• Income statement (IS) or Profit & Loss S. (P&L)• Statement of Retained Earnings • Cash Flow Statement (CF)

Financial Reports – 5 Types of Accounts

Balance Sheet Accounts• Assets• Liabilities• Owner’s Equity (Stockholders’ Equity for a corporation)

Profit and Loss Accounts (= Income Statement Accounts)• Revenues• Expenses

Double-entry accounting uses five — and only five — account types to record all the transactions that can possibly be recorded in an accounting system. There are sub-types of the following list, but all financial transactions can be recorded using these five types of accounts.

The profit and loss accounts are temporary accounts which track revenues and expenses for a yearlong fiscal period and are then closed, with balances transferred to an equity account.

Financial Reports

• The Balance Sheet lists the balances in all Asset, Liability and Owner’s Equity accounts

• The Income Statement lists the balances in all Revenue and Expense accounts

Overview Day 2


Accounting EquationWhy is Balance Sheet in “Balance”?

ASSETS = LIABILITIES + EQUITY

What exists? = Who owns it?

• There cannot be anything that does not belong to anybody Example: Money does not simply appear in the company:

1. You either earn it via a sale, then it is Equity2. ...or you borrow it from the bank...then it would be a Liability

Accounting Equation


• Everything we own = who provided the financing• Assets = Claims against those assets• Property = Property Rights

The double entry system based on the AccountingEquation allows us to track:

• What we got and what went = from whom and to whom

Accounting Equation

ASSETS = LIABILITIES + EQUITY + Revenues - Expenses + Gains

- Losses + Contributions - Withdrawals

The additional items under Equity are tracked in temporary accounts until the end of the accounting period, at which time they are closed to Equity. Example:

What is special about these accounts?

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Accounting EquationSome Definitions…

• Revenues: Increases to owner´s equity resulting from main business operations

(such as selling merchandise or providing services…) • Expenses: Decreases to owner´s equity resulting from main business operations

• Gains: Increases to owner´s equity resulting from non-business operations (such as selling the old delivery truck, a storage building…)

• Losses: Decreases to owner´s equity resulting from non-business operations

• Contributions: Increases to owner´s equity resulting from owner contributions

• Withdrawals: Decreases to owner´s equity resulting from owner withdrawals

Balance SheetASSETS = LIABILITES + EQUITY

Balance sheet of Bakery & Co. Balance sheet as at 1 January 2010

Assets Liabilities & EquityCurrent Assets Current Liabilities Cash and Cash Equivalents 250 Accounts Payable 350Inventories 300 Short-term Loan 200Accounts Receivable 700 Current Tax Liabilities 100Prepaid Expenses 50 Accrued Liabilities 100

Total Current Assets 1300 Total Current Liabilities 750 Fixed Assets Non-Current Liabilities Property, Plant, and Equipment 1550 Bank Loans 600

Total Fixed Assets 1550 Issued Debt Securities 1100 Deferred Tax Liability 100Intangible Assets and Goodwill

Total Non-Current Liabilities 1800

Intangible Assets 300 Goodwill 0

Total IA and Goodwill 300 Equity Common Stock 400Other Assets Retained earnings 100Investments 0 Reserves 50

Total Other Assets 0 Net Income 50 Equity 600 Total Assets 3150 Total Liabilities & Equity 3150

Declining order of liquidity

For the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short to long-term borrowings and other obligations.

Balance Sheet

• Gives an overview of what the company owns and owes

• Provides a snapshot of the entity at one particular moment

• Summarizes the entity’s assets, liabilities and equity

• Indicates how much a company is worth "on the books.“

• Portrays financial position (or condition)

Assets

DefinitionAn item which is owned by the entity and used in business operations to generate

revenues.

Informal Definition: All the good stuff a business has (anything with value). The goodies.

Additional Explanation: The good stuff includes tangible and intangible stuff. Tangible stuff you can physical see and touch such as vehicles, equipment and buildings. Intangible stuff is like pieces of paper (sales invoices) representing loans to your customers where they promise to pay you later for your services or product.

Examples?

Cash, Accounts receivable(Definition = amounts owed to a firm by its customers)

inventorylandequipment

Liabilities and Equity

• Definition. An amount owed to an external party

• Informal Definition: Other's claims to the business's good stuff. Amounts the business owes to others.

• Additional Explanation: Usually one of a business's biggest liabilities is to suppliers where a business has bought goods and services and charged them.

• Examples?• For a family, bank overdraft, credit card, or loan from parents would be considered as

liability that finances a purchase of a new washing machine. Family’s savings used for the same purpose would be considered as equity.

• Money borrowed from a bank• Rent for use of a building• Money owed to suppliers for materials• Payroll a company owes to its employees• Taxes owed to the government

Owner´s Equity

• Definition:The owner's rights to the property (assets) of the business; also called proprietorship and net worth.

• Informal Definition: What the business owes the owner. The good stuff left for the owner assuming all liabilities (amounts owed) have been paid.

• Sub-categories:

• Who are the “owners?” The answer to this question depends on the legal form of the entity…

Balance Sheet

Balance sheet of Bakery & Co. Balance sheet as at 1 January 2010

Assets Liabilities & EquityCurrent Assets Current Liabilities Cash and Cash Equivalents 250 Accounts Payable 350Inventories 300 Short-term Loan 200Accounts Receivable 700 Current Tax Liabilities 100Prepaid Expenses 50 Accrued Liabilities 100

Total Current Assets 1300 Total Current Liabilities 750 Fixed Assets Non-Current Liabilities Property, Plant, and Equipment 1550 Bank Loans 600

Total Fixed Assets 1550 Issued Debt Securities 1100 Deferred Tax Liability 100Intangible Assets and Goodwill Total Non-Current Liabilities 1800Intangible Assets 300 Goodwill 0

Total IA and Goodwill 300 Equity Common Stock 400Other Assets Retained earnings 100Investments 0 Reserves 50

Total Other Assets 0 Net Income 50 Equity 600 Total Assets 3150 Total Liabilities & Equity 3150

Balance Sheet - Equity

• Types Of Business Organization

• Sole Proprietorship• Partnership (General vs. Limited)• Corporation


• Types Of Business Organization

• Sole Proprietorship…is a business owned by one person. The owner receives all of the income from the business but is also responsible for all for the liabilities that the business incurs. Most small businesses are started as this form of business. This is the easiest of all of the types of businesses to open.

• Examples?

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• Types Of Business Organization• Partnership (General vs. Limited)…

is a business owned by more than one person, with its equity consisting of separate capital accounts for each partner. The income is split between the partners, usually based on the amount of money or assets that each partner invests in the business and each must report his share of the income on his personal income tax form.

• A limited partnership is similar to the general partnership. All of the general partners have an unlimited liability for the business debts. However, a limited partners liability, as the name implies, is limited to the amount of the contribution that he has made to the business.

• Examples? • Dentist office where two licensed dentists

partner together to open a dentistry office.


• Types Of Business Organization• Corporation…

is a very common entity form, with its ownership interest being represented by divisible units of ownership called shares of stock. These shares are easily transferable, with the current holder(s) of the stock being the owners. The total owners’ equity (i.e., “stockholders’ equity”) of a corporation usually consists of several amounts, generally corresponding to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends (dividends are distributions to shareholders as a return on their investment). Earnings give rise to increases in retained earnings, while dividends (and losses) cause decreases.

• Examples?



• Types of Business organization - Factors to consider:

• Tax consequences• Degree of control• Liability• Ability to raise money• Type of business (license required ?)




Questions?

Overview Day 2


How Transactions impact the Accounting Equation


Let's use our accounting equation and get an overview of the types of transactions that can occur and their effects on our equation:



Examples…

Remember: 1. Every transaction affects at least two different parts of the equation

in equal and offsetting manners

2. This will lead us later on to the concept of DOUBLE ENTRY ACCOUNTING

Did you note regularities? Yes? Because there are…4 Basic Types of Transactions


Transactions may increase both sides of the equation (left and right side both increase - transaction type (a), decrease both sides of the equation (left and right side both decrease - transaction type (b), or increase and decreases on the same side of the equation (increase and decrease on the left side - transaction type (c) or an increase and decrease on the right side transaction (d), the equation always balances.


· · Transactions

Assets = Liabilities + Owner's Equity

Left Side Right Side Right Side

Increase Decrease Decrease Increase Decrease Increase

1. ABC mows a client's yard and receives a check from the customer for $50 for the service provided.

2. ABC purchases $100 worth of office supplies and stores them in their storage room. The office supply store gives them an invoice that allows them to pay for them in 15 days (on account).

3. ABC places an ad in the local newspaper receives the invoice from the supplier and writes a check for $25 to the newspaper.

4. ABC purchases five mowers for $10,000 and finances them with a loan from the local bank.

5. ABC mows another customer's yard and sends the customer a $75 bill (invoice) for the service they performed. They allow their customer ten (10) days to pay them for this service (on account).

6. The owner of ABC needs a little money to pay some personal bills and writes himself a check for $500.

7. ABC pays the office supply company $100 with a check for the office supplies that they charged (promised to pay).

8. ABC receives a check from the customer who they billed (invoiced) $75 for services and allowed 10 days to pay.

9. ABC purchased some mulch for $60 and received an invoice from their supplier who allows them 15 days to pay. The mulch was used on a customer's yard.

10. ABC bills (prepares an invoice) the customer $80 for the mulch and mowing his yard and receives a check for $80 from the customer.

Totals $10,380 $700 $100 $10,160 $585 $205

Net Change $9,680 Increase $10,060 Increase $380 Decrease

Total Net Changes $9,680 Increase $9,680 Increase


• What do these transactions have in common?

2) You buy an asset against credit 4) You buy an asset with a bank loan 7) You pay your debts 8) You collect an existing account receivable

Answer: They do not make you richer or poorer


• When do you get richer / poorer?

1) Richer: You receive $50 for work done on your bank account = REVENUE(Revenues are enhancements resulting from providing goods and services to customers)

2) Poorer: You spend money on advertisement…= EXPENSE(Expenses can generally be regarded as costs of doing business)


Distinguishing Between the Terms Revenue and Income:

REVENUE – EXPENSE = INCOME


• All the transactions that make you richer or poorer affect your EQUITY account.

• It would be very impractical to post all the Revenues and Expenses directly into the Equity Account. (Important information gets lost!)

• Therefore you use temporary (Profit and Loss) accounts. They will tell you HOW the earnings / losses were achieved.

Equity’s “Kids”

• Instead of recording transactions directly to “Capital" (Owner's Equity), proper bookkeeping actually uses Revenue, Expense, and Withdrawals to record the increases and decreases to "Capital" (Owner's Equity) in order to provide us with the answers to the how and why the owner's claim to the business's property increased or decreased.

• These accounts are TEMPORARY (only exist during the year)

• Revenues, Expenses, and Withdrawals eventually are all merged together and become a part of the Ending Owner's Equity Balance.

• = “CLOSING THE BOOKS”

Equity’s “Kids”

• Revenue (Income): Amounts a business earns by selling services and products. Amounts billed to customers for services and/or products

• Expenses: Costs of doing business. The stuff we used and had to pay for or charge to run our business

• Contributions (Investments): Additional amounts, either cash or other property, that the owner puts in his business

• Withdrawals: Amounts the owner withdraws from his business for living and personal expenses.


Proper Recording Actually Uses Revenue, Expense & Draws Instead Of Owner's Equity Original Recording Proper Recording Uses

Transactions

Owner's Equity

Revenue Expense WithdrawalRight Side

Decrease Increase

Revenue Increases Resulting In an Increase to Equity

Expenses Increase Resulting In a Decrease to Equity

Withdrawals Increase Resulting in a Decrease to Equity

1. ABC mows a client's yard and receives a check from the customer for $50 for the service provided. 50

3. ABC places an ad in the local newspaper receives the invoice from the supplier and writes a check for $25 to the newspaper. 25

5. ABC mows another customer's yard and sends the customer a $75 bill (invoice) for the service they performed. They allow their customer ten (10) days to pay them for this service (on account). 75

6. The owner of ABC needs a little money to pay some personal bills and writes himself a check for $500. 500

9. ABC purchased some mulch for $60 and received an invoice from their supplier who allows them 15 days to pay. The mulch was used on a customer's yard. 60

10. ABC bills (prepares an invoice) the customer $80 for the mulch and mowing his yard and receives a check for $80 from the customer. 80


CONCLUSION:

• There are countless transactions, and each can be described by its impact on assets, liabilities, and equity. Importantly, no transaction will upset the balance of the accounting equation.

• The accounting equation holds at all times over the life of a business. When a transaction occurs, the total assets of a business may change, but the equation will remain in balance…

The Four Core Financial Statements

• Balance Sheet• Income Statement• Statement of Retained Earnings• Statement of Cash Flow

Income Statement

• A summary of the revenues and expenses for a specific period of time

• Indicates how much a company “can make” in a given time frame

• Reflects results of operations

Income Statement

• A single-step income statement is one of two commonly used formats for the income statement or profit and loss statement. It uses only one subtraction to arrive at net income.

• REVENUE – EXPENSES = NET INCOME

• An extremely condensed income statement in the single-step format would look like this:

Income Statement

• A multiple-step income statement uses multiple subtractions in computing the net income shown on the bottom line.

• The multiple-step profit and loss statement segregates the operating revenues and operating expenses from the nonoperating revenues, nonoperating expenses, gains, and losses. The multiple-step income statement also shows the gross profit (net sales minus the cost of goods sold).

Income Statement “Multiple Step”


Cost of goods sold:

• All of the expenses a company incurs to make the product or provide the services offered. (raw materials, expenses associated with running the factory such as electricity, and labor used to manufacture a product or provide a service.)

• EXAMPLE: A book shop buys a book for $25 and sells it for $32 - The cost of goods sold in $25

• GROSS MARGIN

= VARIABLE COSTS


Operating Expenses (OPEX):

Bills that must be paid in order for the business to continue operating

• Advertising, Marketing, Rent, Sales Comission, Depreciation, Licenses, Local taxes, and Legal and Accounting Fees. …

• G&A = General and Administrative Expenses

• SG&A = Selling, General and Administrative Expenses


Non-Operating Items:

• Expenses that do NOT relate to primary operation.

• Example: Interest Expenses, Gains & Losses of the Sale of Equipment…

NET INCOME goes to the owners of the company

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Gross Profit Rate:

= Gross Profit / Sales revenue

• a measure of the ability to pay overhead cost

• Larger gross margins are generally good for companies, with the exception of discount retailers. They need to show that operations efficiency and financing allows them to operate with tiny margins.


Profit Margin Ratio:

= Net Income / Sales• …measures how much out of every

dollar of sales a company actually keeps in earnings.

• Increased sales are good, but an increase does not mean that the profit margin of a company is improving

• is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.


Return on Assets Ratio:

= Net Profit / Average Total Assets

• An indicator of how profitable a company is relative to its total assets.

• Useful number for comparing competing companies in the same industry

• Companies that require large initial investments will generally have lower return on assets

Income Statement

Statement of Retained Earnings(Statement of Equity)

The statement of retained earnings reports how net income and dividends affected a company´s financial position during the period.

Note that the Income Statement must be prepared before the Statement of Retained Earnings

Example: Statement of Equity

Many companies provide an expanded statement of stockholders’ equity instead of the required statement of retained earnings. The statement of stockholders’ equity portrays not only the changes in retained earnings, but also changes in other equity accounts. These other equity accounts include capital stock and potentially a lot of other amounts related to topics like par value, preferred stock, treasury stock, and the like…

Statement of Retained Earning

• Gerald had beginning total Retained Earnings of $160,000. During the year, total assets increased by $240,000 and total liabilities increased by $120,000. Gerald's net income was $180,000. No additional investments were made; however, dividends did occur during the year. How much were the dividends?

• $ 20.000• $ 60.000• $ 140.000• $ 220.000

Statement of Retained Earning

• Retained earnings will change over time because of several factors. Which of the following factors would explain an increase in retained earnings?

• a. Net loss.b. Net income.c. Dividends.d. Investments by stockholders.

http://www.principlesofaccounting.com/correct.htm

http://www.principlesofaccounting.com/incorrect.htm

http://www.principlesofaccounting.com/incorrect.htm

Statement of Cash Flows… cannot be manipulated with accounting tricks

Statement of Cash Flows… cannot be manipulated with accounting tricks

• If a company reports earnings of $1 billion, does this mean it has this amount of cash in the bank?

• Not necessarily. Financial statements are based on accrual accounting, which takes into account non-cash items.

Financial Statements – Connection:

Quick Test: Financial Statements

Overview Day 2


Accounts, debits and creditsACCOUNTS

• TRANSACTIONS AFFECT THE ACCOUNTING EQUATION

• HOW DO YOU TRACK CHANGES ?

• A SYSTEM IS NEEDED!

Accounts, debits and creditsACCOUNTS

The records that are kept for the individual asset, liability, equity, revenue, expense, and dividend components are known as accounts.

Accounts, debits and creditsDEBITS AND CREDITS

The next basic accounting concept…

For every transaction

DEBITS = CREDITS

The Double entry system requires that the same dollar amount of the transaction must be entered on both the left side of one account, and

on the right side of another account. Instead of the word left, accountants use the word debit; and instead of the word right,

accountants use the word credit.



ASSETS = LIABILITES + STOCKHOLDERS’ (or OWNER’S) EQUITY

• Just as assets are on the left side (or debit side) of the accounting equation, the asset accounts have their balances on the left side. To increase an asset account's balance, you put more on the left side of the asset account. In accounting jargon, you debit the asset account. To decrease an asset account balance you credit the account, that is, you enter the amount on the right side.

• Just as liabilities and stockholders' equity are on the right side (or credit side) of the accounting equation, the liability and equity accounts have their balances on the right side. To increase the balance in a liability or stockholders' equity account, you put more on the right side of the account. In accounting jargon, you credit the liability or the equity account. To decrease a liability or equity, you debit the account, that is, you enter the amount on the left side of the account.


• DEBIT CREDIT• SOLL HABEN

• DEBITO CREDITO• . . • . .

• LEFT RIGHT

Accounts, debits and creditsDETERMINING AN ACCOUNTS BALANCE

Accounts, Debits & Credits

• T-Account

Accounts, Debits and Credits

QUICK TEST: Accounts, Debits and Credits

Overview Day 2


THE JOURNAL

•Chronological listing of a company’s transactions and events•Shows the accounts involved, and whether each is debited or credited•Also called the book of original entry (Source documents are interpreted)

Balance in each specific account?GENERAL LEDGER

THE GENERAL LEDGER

The journal contains page after page of detailed accounting transactions. In contrast, the general ledger contains a page for each and every account in use by a company.

POSTING

To “POST” means:

• to copy the entries listed in the journal into their respective ledger accounts.

• recording amounts as credits, (right side), and amounts as debits, (left side), in the pages of the general ledger

POSTING

To “post” means to copy the entries listed in the journal into their respective ledger accounts.

POSTING – Computerized Processing

Source Documents

No Posting without Source Document!

• Source document is the original record of a transaction• Supports the underlying transaction

Examples:

Sale – InvoiceExpense – ReceiptCollection of accounts receivables - Bank Statement

Source Documents

A receipt is a written acknowledgement that a specified article or sum of money has been received as an exchange for goods or services. = Source document for expenses

CHART OF ACCOUNTS

Listing of all accounts in use by a particular company:

For example, all assets may begin with “1” (e.g., 101 for Cash, 102 for Accounts Receivable, etc.), liabilities with “2,” and so forth.

Many computerized systems allow rapid entry of accounts by reference number rather than by entering a full account description. Another benefit is that each account can be further subdivided in subsets. For instance, if Accounts Receivable bears the account number 102, one would expect to find that individual customers might be numbered as 102.001, 102.002, 102.003, etc.

THE TRIAL BALANCE

After all transactions have been posted from the journal to the ledger, it is a good practice to prepare a trial balance. A trial balance is simply a listing of the ledger accounts along with their respective debit or credit balances:

THE TRIAL BALANCE

Since each transaction was journalized in a way that insured that debits equaled credits, one would expect that this equality would be maintained throughout the ledger and trial balance. If the trial balance fails to balance, an error has occurred and must be located.

THE TRIAL BALANCE

However, “balanced” trial balance is no guarantee of correctness:

•Transaction omission•Transaction duplication•Posting to the wrong accounts

THE TRIAL BALANCE

THE TRIAL BALANCE

• TIPP:

If the difference on the trial balance is divisible evenly by nine, you have transposed figures somewhere. For example, you have used 910 EUR in one place and 901 in another.

This can help you to find differences a little more quickly.

QUICK TEST: Journal, General Ledger and Posting

Overview Day 2


FINANCIAL STATEMENTS FROM THE TRIAL BALANCE

So to summarize…

The basic process is to transfer amounts from the general ledger to the trial balance, then into the financial statements

FINANCIAL STATEMENTS FROM THE TRIAL BALANCE

Accounting Terminology

Quick Test: Accounting Terminology

Overview Day 2


FINANCIAL STATEMENTS FROM THE TRIAL BALANCEEXAMPLE PROBLEM

• This example illustrates how to prepare three basic financial statements

• The Income Statement• The Statement of Retained Earnings• The Balance Sheet


REVIEW 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.


STEP 1: Classify the accounts as assets, liabilities, equity, revenue or expenses.

STEP 1: Classify the accounts as assets, liabilities, equity, revenue or expenses:

• ASSETS


ASSETS, LIABILITES


ASSETS, LIABILITES, EQUITY


• ASSETS, LIABILITES, EQUITY, REVENUES, EXPENSES

STEP 2: Prepare the Income Statement





REMEMBER: Financial Statements – Connection:

STEP 3: Prepare the Statement of Retained Earning

STEP 3: Prepare the Statement of Retained Earning

STEP 4: Prepare the Balance Sheet






FINANCIAL STATEMENTS FROM THE TRIAL BALANCENow try yourself…


The End

Accounting Humour

“The left side of the balance sheet has nothingright and the right side of the balance sheet hasnothing left. But they are equal to each other. Soaccounting-wise we are fine"

(AIG Vice Chairman Jacob Frenkel, Oct 11 2008 )

Overview Day 2


The periodicity assumption and its accounting implications

• Business activity is fluid. Revenue and expense generating activities are in constant motion. Just because it is time to turn a page on a calendar does not mean that all business activity ceases. But, for purposes of measuring performance, it is necessary to draw a line in the sand of time.

• Problem: Accountants have to record the things in balance sheet or income statement in the correct time period

• Examples: • Your customer prepays an annual magazine subscription• How should an accountant report the cost of equipment expected to last five

years?

The periodicity assumption and its accounting implications• Do you remember?

1. All the transactions that make us richer or poorer, affect the Equity on our balance sheet

2. We post these Revenues & Expenses via the (temporary) accounts which we use to create our Income Statement

• Question: When are we allowed to use these Income Statement accounts? When are we allowed to post an entry that makes us “richer” or “poorer”? (ACCRUAL BASED ACCOUNTING)

• Answer: See the rules for REVENUE RECOGNITION and EXPENSE RECOGNITION

Overview Day 2


The periodicity assumption and its accounting implications

• Under the accrual basis of accounting, revenues are reported on the income statement when they are earned. (not when the cash is received.)

• Under the accrual basis of accounting, expenses are matched with the related revenues and/or are reported when the expense occurs, not when the cash is paid. The result of accrual accounting is an income statement that better measures the profitability of a company during a specific time period.

REVENUE RECOGNITION

• REVENUE RECOGNITION

• Under the accrual basis of accounting (as opposed to the cash basis of accounting), REVENUES are recognized when they are EARNED (=as soon as a product has been sold or a service has been performed), regardless of when the money is actually received.

• Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.

EXPENSE RECOGNITION – 3 TYPES

• Expense recognition: The matching principle means when revenues are generated, the expenses incurred to generate those revenues should be reported in the same accounting period (the same income statement).

• Matching: Expenses can be allocated to corresponding revenuesExample: Cost of Goods Sold

• Systematic & Rational Allocation: If there is no clear link between cost and revenue Example: Depreciation, Allocation of prepaid expenses such as rent and insurance

• Immediate Recognition: costs for which there is no clear or certain future benefitExample: General Administrative Cost…

•

Overview Day 2


The adjusting process and related entries

• The accountant’s task is to apply the various rules and procedures of generally accepted accounting principles (GAAP) to assign revenues and expenses to the reporting period

• Adjusting entries are journal entries usually made at the end of an accounting period to allocate revenue and expenses to the period in which they actually occurred.


A common characteristic of an adjusting entry is that it will involve one income statement account and one balance sheet account. (The purpose of each adjusting entry is to get both the income statement and the balance sheet to be accurate.)

Sometimes an adjusting entry is needed because:

1. Revenue has been earned, but it has not yet been recorded. 2. An expense may have been incurred, but it hasn’t yet been

recorded. 3. A company may have paid for six-months of insurance coverage,

but the accounting period is only one month. (This means that five months of insurance expense is prepaid and should not be reported as an expense on the current income statement.)

4. A customer paid a company in advance of receiving goods or services. Until the goods or services are delivered, the amount is reported as a liability. After the goods or services are delivered, an entry is needed to reduce the liability and to report the revenues.


Deferrals Accruals

Deferrals: Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods.Accruals: Nothing has been entered in the accounting records for certain expenses or revenues, but those expenses and/or revenues did occur and must be included in the current period's income statement and balance sheet.


Deferrals Accruals

Deferred (=Prepaid) expense: Expense is recognized after cash is paid.Deferred (=Unearned) revenue: Revenue is recognized after cash is received.

Accrued (=unrecorded) expense: Expense is recognized before cash is paid. Accrued (=unrecorded) revenue: Revenue is recognized before cash is received.

The adjusting process and related entriesExample: Prepaid insurance

A three-year insurance policy was purchases on January 1, 20x1, for $9,000. The following entry would be needed to record the transaction on January 1:

The adjusting process and related entriesExample: Prepaid Rent

Assume a two-month rent is entered and rent paid in advance on March 1, 20X1, for $3,000. By March 31, 20X1, half of the rental period has lapsed, and financial statements are to be prepared. The following entries would be needed to record the transaction on March 1, and adjust rent expense and prepaid rent on March 31:

The adjusting process and related entriesHow often are adjustments needed?

Adjustments should be made every time financial statements are prepared

The adjusting process and related entriesExample: Supplies

Supplies purchased totaled $900. By year end, only $200 of supplies remained

…since $900 of supplies were purchased, but only $200 were left over, then $700 must have been used. (Matching Principle)

•In a periodic inventory system, this adjusting entry is used to determine the cost of goods sold expense. This entry is not necessary for a company using perpetual inventory.

The adjusting process and related entriesDepreciation

• FIXED ASSETS: Buildings, machinery, equipment, furniture, computers, parking lots, cars, and trucks are examples of assets that will last for more than one year.

• During each accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up. The portion being used up is reported as Depreciation Expense on the income statement.

• In effect depreciation is the transfer of a portion of the asset's cost from the balance sheet to the income statement during each year of the asset's life = ADJUSTING ENTRYDepreciation Expense 100

Asset(or Contra Account Accumulated Depreciation)

100

The adjusting process and related entriesDepreciation

The adjusting process and related entriesUnearned revenueOften, a business will collect monies in advance of providing goods or services. For example, you sell a one-year software licence and collect the full payment at the beginning of the subscription period:

EXAMPLES?

The adjusting process and related entriesACCRUALS

• Accruals are expenses and revenues that gradually accumulate throughout an accounting period (salaries, interest, rent, utilities…)

The adjusting process and related entriesACCRUALS – Accrued salaries

Few, if any, businesses have daily payroll. Typically, businesses will pay employees once or twice per month. Therefore, salary obligations gradually accumulate…

• When creating financial statements you have to ESTABLISH A LIABILITY for the accumulated obligations:

The journal entry on the actual payday needs to extinguish the previously established liability (Liabilities decrease, Cash decreases):

Salaries Payable 3,000

Cash 3,000

The adjusting process and related entriesACCRUALS – Accrued interest

• For example, if $100,000 is borrowed at 6% per year for 18 months, the total interest will amount to $9,000 ($100,000 X 6% X 1.5 years).

However, even if the interest is not payable until the end of the loan, it is still logical and appropriate to accrue the interest as time passes. This is necessary to assign the correct interest cost to each accounting period.

• Assume that an 18-month loan was taken out on July 1, 20X1, and was due on December 31, 20X2. The accounting for the loan on the various dates (assume a December year end, with an appropriate year-end adjusting entry for the accrued interest) would be as follows:

The adjusting process and related entriesACCRUALS – Accrued interest

The adjusting process and related entriesACCRUALS – Accrued rentAccrued rent = opposite of prepaid rent

•Accrued rent relates to rent that has not yet been paid, even though utilization of the asset has already occurred. For example, assume that office space is leased, and the terms of the agreement stipulate that rent will be paid within 10 days after the end of each month at the rate of $400 per month.

•During December of 20X1, Cabul Company occupied the lease space, and the appropriate adjusting entry for December follows:

The adjusting process and related entriesACCRUALS – Accrued revenue

Many businesses provide services to clients under an understanding that they will be periodically billed for the hours (or other units) of service provided. As a result, money has been earned during a month, even though it won’t be billed until the following month. Accrual accounting concepts dictate that such revenues be recorded when earned. The following entry would be needed at the end of December to accrue revenue for services rendered to date (even though the physical billing of the client may not occur until January):

EXAMPLES?

The adjusting process and related entriesACCRUALS – Questions

• QUESTIONS?


QUICK TEST ADJUSTING ENTRIES




Summary


EXAMPLE: Financial Statements from the adjusted trial balance

EXAMPLE: Post Entries to the LedgerFinancial Statements from the adjusted trial balance

Prepare Adjusted Trial Balance from LedgerFinancial Statements from the adjusted trial balance

Prepare Income Statement / Statement of Retained EarningsFinancial Statements from the adjusted trial balance

Prepare Balance SheetFinancial Statements from the adjusted trial balance

Overview Day 3

• Classified Balance Sheets• Current Assets• Inventory• Accounts Receivable• Fixed Assets• Depreciation Methods• Intangibles & Goodwill• Current Liabilites• Accounts Payable• Ratio Analysis• Compliance• Internal Controls• VAT• What to expect in an Audit

Classified Balance Sheets

To facilitate proper analysis, accountants will often divide the balance sheet into categories or classifications. The result is that important groups of accounts can be identified and subtotaled. Such balance sheets are called “classified balance sheets.”

Classified Balance Sheets

The asset side of the balance sheet may be divided into the following SUB-CATEGORIES: Current assets; Fixed Assets; Intangible assets; Other assets.

Classified Balance SheetsCurrent Assets

Current Assets include cash and those assets that will be converted into cash or consumed in a relatively short period of time; specifically, those assets that will be converted into cash or consumed within one year or the operating cycle, whichever is longer.

Classified Balance SheetsCurrent AssetsThe operating cycle for a particular company is the period of time it takes to convert cash back into cash (i.e., purchase inventory, sell the inventory on account, and collect the receivable); this is usually less than one year.

It is determined by adding the number of days inventory is held and the collection period for accounts receivable

Overview Day 3


Inventory

• Investors want as little money as possible tied up in inventory. It is fine to have a lot of inventory on the balance sheet if it is being sold at a fast enough rate there is little risk of becoming obsolete or spoiled.

• “Just -in-time” Delivery

INVENTORY – Inventory Valuation

• You don’t write: 7000 bottles of wine

…but rather:Wine 30.000 EUR

• Therefore you have to assign a value to your inventory…

• Ending inventory = Beginning inventory + Purchases during the period - Cost of goods sold

• How much is Cost of Goods Sold / Value of Ending Inventory?(different purchases are stored together / get mixed up…)

• Different inventory valuation methods (FIFO, LIFO, HIFO…)

INVENTORY – Perpetual Inventory System



Scanners scan the products and automatically update the sales and inventory records


PERPETUAL vs. PERIODICAL INVENTORY

Which dealer would you rather deal with ? The one who can call it up on their computer and determine immediately if they have any and give you the price or the dealer that puts you on hold and has to look around his store and try to physically locate the item and determine the price? BUT: Also Perpetual Inventory Systems need to have a physical count – WHY?

Perpetual Inventory Systems are only as good as the people who maintain it - verify that they actually do have the part…


INVENTORY – Perpetual vs. Periodic

INVENTORY – Physical Count

• Approved inventory count procedures / schedule

• Blindness of counts• Invitation of external auditors to the count• Second count should be performed by

different counter than the first counter

INVENTORY

• Quick Test Inventory Methods

INVENTORY –Inventory Valuation

• First-In, First-Out (FIFO)

• Valuation method in which the assets acquired first are sold first.


• Last-In, First-Out (LIFO)

Valuation method that assumes that assets acquired last are the ones that are sold first.

• Reduces income taxes in times of inflation


• Average Cost Method

• …values inventory costs as the average unit cost between the assets in the beginning inventory and the newly acquired assets.

INVENTORY – Cost of Goods sold

An inventory count on October 30 showed 500 units in the warehouse.

1) What is the cost of goods sold for October under the FIFO method?2) What is the cost of goods sold for October under the LIFO method?3) What is the cost of goods sold for October under the weighted average method?

INVENTORY

• Quick Test Costing Methods

INVENTORY - RATIOS

Inventory Turnover Ratio

• Shows how many times a company's inventory is sold and replaced over a period.

• A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying.

• FMCG vs. CAR DEALER

Days in Inventory = 365 / Inventory Turnover Ratio• Measures the average number of days the company holds its inventory

before selling it.

INVENTORY - RATIOS

Overview Day 3


Current Assets – Accounts Receivable

Current Assets – Accounts ReceivableA typical invoice contains:

• Invoice Requirements:

• The word “INVOICE”• Unique identification number• Company Name, Adress• Product Description• Date• Amount• Currency• VAT amount (if applicable)• Rate of VAT per Item (if applicable)• VAT registration number (if applicable)

Current Assets – Accounts Receivableec.europa.eu/taxation_customs/vies/vieshome.do


Receivables Turnover Ratio= Net Sales / Average Accounts Receivable• This ratio measures the number of times, on average, receivables are

collected during the period.• By maintaining accounts receivable, firms are indirectly extending

interest-free loans to their clients.• A low ratio implies the company should re-assess its credit policies in

order to ensure the timely collection of imparted credit that is not earning interest for the firm.

Average Collection Period= 365 / Receivables Turnover Ratio




• How to improve Cash Flow?

• Factoring = financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor at a discount in exchange for immediate money

• Invoice discounting= borrowing where the receivable is used as collateral

• Cash discounts

The sooner a seller receives the cash, the earlier he can put the money back into the business to buy more supplies and/or grow the company further.


• How do you estimate the amount of uncollectible accounts receivable?

• Aging Analysis, Percentage of Credit Sales based on experience…

• Prudence Principle: Create „Allowance for Doubtful Debt“


Bad Debt

• is an amount that is written off by the business as a loss to the business and classified as an expense because the debt owed to the business is unable to be collected, and all reasonable efforts have been exhausted to collect the amount owed. This usually occurs when the debtor has declared bankruptcy or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself

Doubtful Debt

• Doubtful debts are those debts which a business or individual is unlikely to be able to collect. The reasons for potential non payment can include disputes over supply, delivery, and conditions of goods, the appearance of financial stress within customers operation. When such a dispute occurs it is prudent s add this debt or portion thereof to the doubtful debt reserve When there is no longer any doubt that a debt in uncollectable the debt becomes bad.


Allowance for Doubtful Accounts = „CONTRA ASSET ACCOUNT“

• An asset account which is expected to have a credit balance (which is contrary to the normal debit balance of an asset account). The contra asset account is related to another asset account. For example, the contra asset account Allowance for Doubtful Accounts is related to Accounts Receivable. The contra asset account Accumulated Depreciation is related to a constructed asset(s)

• The net of the asset and its related contra asset account is referred to as the asset's book value.

Allowance for Doubtful AccountsJournal Postings

1. The allowance for doubtful accounts is normally recorded at the beginning of the company’s fiscal year after the estimated calculation is made. The following is the general journal entry at the beginning of the fiscal year.

- Bad Debts Expense – Debit (expense increase) - Allowance for Doubtful Accounts – Credit (asset decrease)

2. Once an account becomes delinquent (bad), a journal entry needs to be made to decrease accounts receivable for that specific customer = WRITE OFF

- Allowance for Doubtful Accounts – Debit (asset increase) - Accounts Receivable – Credit (asset decrease)



Overview Day 3


Balance Sheet Details: Fixed Assets

• Assets intended to be in use for periodlonger than one year

Property, Plant & Equipment Land, buildings, cars, furniture, computers, etc...

• Characteristics?• Cannot easily be converted into cash

Are not directly sold to a firm's consumers


• How to determine the cost of asset?: The cost of property, plant, and equipment includes the purchase price of the asset and all expenditures necessary to prepare the asset for its intended use.

Example “COST OF LAND”:• Land purchases often involve real estate commissions, legal fees, bank

fees, title search fees, and similar expenses. To be prepared for use, land may need to be cleared of trees, drained and filled, graded to remove small hills and depressions, and landscaped. In addition, old buildings may need to be demolished before the company can use the land. Such demolition expenses are considered part of the land's cost.


Example:

“Cost of land”: Land is not depreciated because

it does not have an expected useful life

“Land improvement”: Separate asset on the balance sheet, with definite live Example: Parking lot…


Balance Sheet Details: Fixed AssetsRepetition: Capitalization vs. Expense

• CAPEX (Capital Expenditure)

• …are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life that extends beyond the taxable year. In accounting, a capital expenditure is added to an ASSET account („CAPITALIZED")

• For tax purposes, capital expenditures are costs that cannot be deducted in the year in which they are paid or incurred and must be capitalized (= recorded as an asset).

• Depreciation is then periodically booked as an expense

Balance Sheet Details: Fixed AssetsRepetition: Capitalization vs. Expense

• OPEX (Operational Expenditure)

• …is an ongoing cost for running a product, business, or system.

• …are immediately treated as an EXPENSE

• Example:

The purchase of a photocopier is the CAPEX, and the annual paper, toner, power and maintenance cost is the OPEX.

Balance Sheet Details: Fixed AssetsSteps to follow when Capitalizing an Asset

1. Estimate Useful Life

2. Chose Rate of Depreciation

Overview Day 3


Fixed Assets - Depreciation MethodsExample EXCEL

• When a company buys a large asset such as a piece of machinery, accounting rules specify how the asset should be expensed each year. This is called depreciation. EXCEL offers four common methods for calculating depreciation:

• Straight-line (SLN)• Declining-balance (DB)• Double-declining-balance (DDB)• Sum-of-years-digits (SYD)

Fixed Assets - Depreciation Methods

• By selecting the depreciation time, method, companies can manage the effects on profit over time – most companies prefer to “write off” as fast as possible:

Reason: Less profits now = less taxes nowMore profits later = more taxes later

Fixed Assets - Depreciation MethodsCzech Republic – Depreciation on Fixed Assets

Fixed Assets - Depreciation MethodsDepreciation as a Policy Instrument

Fixed Assets - Depreciation MethodsDepreciation as a Policy Instrument


• Cost = This is the initial cost of the asset. For example the machinery might cost $120.000

• Useful life = This is how long you expect to use the asset. If you think the machinery will be used for 10 years before being replaced, the useful life is 10 years

• Salvage value = This is the value of the asset at the end of the useful life. Perhaps after 10 years you can sell the machine to a scrap dealer for $1.000. This is the salvage value.


Accumulated Depreciation = „CONTRA ASSET ACCOUNT“

• An asset account which is expected to have a credit balance (which is contrary to the normal debit balance of an asset account). The contra asset account is related to another asset account. For example, the contra asset account Allowance for Doubtful Accounts is related to Accounts Receivable. The contra asset account Accumulated Depreciation is related to a constructed asset(s)

• Journal Posting

• The net of the asset and its related contra asset account is referred to as the asset's book value or carrying value.

• Balance Sheet View

• Reason: You don´t want to lose the information for how much the asset was purchased in the first place

Fixed Assets – Fixed Asset Schedule

• Because businesses usually have several fixed assets purchased at different times, with different useful lives and different depreciation methods, it is necessary to keep a separate schedule of these assets called a fixed asset schedule.

• An example of a portion of a fixed asset schedule is:•


Exkurs: Present Value

• If you received $100 today and deposited it into a savings account, it would grow over time to be worth more than $100. This fact of financial life is a result of the time value of money, a concept which says it's more valuable to receive $100 now rather than a year from now. To put it another way, the present value of receiving $100 one year from now is less than $100.

• DISCOUNTED CASH FLOW ANALYSIS – Standard method to analyze long-term projects

• Example: You invest in 2010 in a project that returns from 2011 to 2016 every year 200 EUR. Discount rate = 10%. How much would you spend to invest in this project?

•

Overview Day 3


Balance Sheet Details: Intangibles and Goodwill

• Assets that cannot be seen, touched, nor physically measured

Intangible assets• Patents, Copyright, Trademark etc.• The process of expense recognition for this category of assets is called

amortization.

Goodwill• The difference between the acquisition price and book asset value of

purchased business entity• „Premium" for buying a business


What are Patents, Trademarks and Copyrights?Example: You invent a time machine

•You would have a PATENT on the technique•You would have a COPYRIGHT on the design•If you call it „TIMINATOR“ you would have a TRADEMARK on the name

Licenses are the contractual rights to use another's property, whether it be a patent, trademark or copyright


• Patents

• Has to be registerd - gets checked

• The right to exclude others from making, using, offering for sale, selling or importing an invention

• Granted for a limited period of time in exchange for a public disclosure of an invention

• Question: WHY?


Trademarks

• A Trademark is the means by which a business makes itself visible in the marketplace.

• The essential function of a trademark is to exclusively identify the commercial source or origin of products or services

• A trademark is typically a name, word, phrase, logo, symbol, design, image, or a combination of these elements

• Trademark rights may be used to prevent others from using a confusingly similar mark, but not to prevent others from making the same goods or from selling the same goods or services under a clearly different mark.

• Office for Harmonization in the Internal Market (OHIM) oami.europa.eu

International Trademark Classes


• Copyrights:

• a set of exclusive rights granted to the author or creator of an original work, including the right to copy, distribute and adapt the work.

• For example, a description of a machine could be copyrighted, but this would only prevent others from copying the description; it would not prevent others from writing a description of their own or from making and using the machine.

Can be sold - payments are often made dependent on the actual use of the work, and are then referred to as ROYALTIES


Overview Day 3


Balance Sheet Details: Current Liabilities

• Liabilities payable within one year

Accounts payable• Amount owed to vendors• Payables to employees

Short-term loan• Loans with banks, overdrafts

Current tax liabilities• Taxes owed to the public authorities

Accrued Liabilities• Accrued accounts payable, etc

Balance Sheet Details: Current Liabilities

• Liabilities payable within one year

Overview Day 3


Balance Sheet Detail: Accounts PayableCASH DISCOUNTS

Terms of Payment / Discounts:Example: 2/10 net 30

• Customer has the choice of paying the full amount of an invoice in 30 days or paying it in 10 days and taking 2 percent discount.

• For example, if the amount due is $100, the buyer may pay $98 within 10 days or $100 within 30 days.

• This translates into an effective annual rate of 36 percent, which is why companies will go great length to earn their early payment discounts



Balance Sheet Detail: Accounts PayableWHEN TO TAKE CASH DISCOUNTS

1) Cash Flow2) Company Policy3) Turnaround Time

Three factors that can influence the decision to take a discount:

Balance Sheet Detail: Accounts Payable

Strategies during periods of tight cash flow

1)Stretch vendor payments2)Place smaller orders3)Talk to vendors

Balance Sheet Detail: Non-Current Liabilities

• Liabilities payable in more thana year

Bank loans• Long-term bank loans, mortgage loans,

Equity

• Entity’s own financial resources

Common stock• Entity’s own issued capital

Retained earnings• Profits that were not distributed among shareholders but kept

with the entity

Quick Test: Classified Balance Sheets

Overview Day 3


RATIO ANALYSIS

Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. The level and historical trends of these ratios can be used to make judgements about a company's financial condition, its operations and attractiveness as an investment.

RATIO ANALYSIS

• Three Types

1. Liquidity Ratios2. Solvency Ratios3. Profitability Ratios

• Single ratio by itself is not very meaningful:Gross Profit Margin 25% ?

RATIO ANALYSIS

Liquidity Ratios

• Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash

WHO CARES?• Short-term creditors such as bankers and suppliers

RATIO ANALYSIS

Liquidity Ratios

• Working Capital• Current Ratio• Inventory turnover ratio• Days in inventory• Receivables turnover ratio• Average collection periodDo we have liquid cash, that will allow us to meet our obligations?

RATIO ANALYSIS

Solvency Ratios

• Measure the ability of an enterprise to survive over a long period of time

WHO CARES?• Long-term creditors and stockholders

RATIO ANALYSIS

Solvency Ratios

• Debt to total assets ratio• Cash debt coverage ratio• Times interest earned ratio

• Do we have the assets to cover our debt?

RATIO ANALYSIS

Profitability RatiosMeasure the income or operating success of an enterprise for a given period of time

• WHO CARES? • Everybody

• WHY? A company´s income affects:• Its ability to obtain debt and equity financing• Its liquidity position• Its ability to grow

RATIO ANALYSIS

Profitability Ratios

• Gross Profit Rate• Profit Margin Ratio• Return on Assets Ratio

RATIO ANALYSIS

RATIO ANALYSIS

RATIO ANALYSISCommon Size Balance Sheet

• A common-size balance sheet is a balance sheet where every dollar amount has been restated to be a percentage of total assets.

• Advantage: Items can be compared to a similar item of another company regardless of the size of the companies

Working CapitalCurrent Assets & Current Liabilities

Working Capital - Current Assets & Current Liabilities – Current Ratio

Current Ratio = Current assets /Current Liabilities

The current ratio is used to express the relative amount of working capital.

Working Capital - Current Assets & Current Liabilities – Current Ratio

Working Capital – Quick Ratio

• Quick Ratio = (Cash + Accounts Receivable)/Current Liabilities

• Provides a better test of debt-paying ability by dividing only a firm's quick assets (cash, short-term investments, and accounts receivable) by current liabilities

• Excludes inventory (because inventory is sometimes not easily sold)

Working Capital - Current Assets & Current Liabilities – Quick Ratio

• For more details see:

• Principles of Managerial Finance, Gitman • Chapter Two - Financial Statements and Analysis

RATIO ANALYSIS

Quick Test Ratio Analysis

RATIO ANALYSIS

Repetition: Accounting Cycle I

• Transactions are recorded as they occur through out the year – e.g. journal entries as per previous examples

• At the end of the period, the transactions need to be analyzed to ensure that the revenue and expenses are correctly matched

• To correct for mismatches adjusting entries are carried out– e.g. accruals

Repetition: Accounting Cycle II

• The trial balance is run to ensure that the debit and credit side sum up to zero and everything has been properly booked through out the period

• The financial statements are prepared and analyzed

• The income statement accounts’ balances are transferred to a temporary summary account where the net income for period is calculated

• The resulting net income is either distributed among the shareholders in dividends or kept in retained earnings

Repetition: Accounting Cycle III

• The balance sheet accounts are closed and the ending balances are transferred to the corresponding accounts for the next period

Overview Day 3


COMPLIANCE - Overview

What is “Compliance”?

–making sure that a company's financial matters are being handled in accordance with federal laws and regulations.

COMPLIANCE – Example WORLDCOM

The Sarbanes-Oxley act of 2002

Corporate scandals during the 1980’s and 1990’s lead to:

• Loss of public trust in accounting and reporting practices• Decrease of Dollar value• Threat of financial crisis

Therefore, the two senators Paul Sarbanes and Michael Oxley prepared a law, which:

– Requires all US based publicly-traded companies to have a proper Financial Internal controls system

– Makes management responsible for company finances (criminal penalties)

The Sarbanes-Oxley act (known as SOX) was enacted on July 30th 2002

Overview Day 3


Internal Controls

Objectives of an Internal Control System:

• Safeguard assets • Enhance the accuracy and reliability of accounting records • Reduce the risk of errors

Internal Controls

Types of internal controls:

– Detective Control: designed to detect errors and irregularities which have already occurred and to assure their prompt correction.

– Corrective Control: Designed to correct errors or irregularities after they have occured

– Preventive Control: Designed to prevent the recurrence of errors

Internal Control System

Key elements in a good internal control system:

Segregation (separation) of duties: No person should have control over a transaction from beginning to end

Authorization: Transactions should be authorized and executed by persons acting within the range of their authority

Documentation: Transactions should be clearly and thoroughly documented and available for review

Reconciliation: The process of comparing entries in the general ledger to supporting documentation

Internal Controls:Segregation of Duties Matrix

Segregation of Duties

What does “Segregation of Duties” (SoD) mean?

– No employee has access to perform all tasks in the end-to-end process– For instance, an AP Clerk can not create a new supplier– Or an Master Data Clerk can not authorize a payment

– Segregation of Duties is one of the core foundations of SOX

– Creates supplier

– Posts Invoice – Releases payment

MD Clerk AP Clerk Payments Clerk

INTERNAL CONTROLS

Quick Test Internal Controls

Overview Day 3


Value Added Tax

Value Added Tax

VAT = Value added tax

• A general tax that applies, in principle, to all commercial activities involving the production and

distribution of goods and the provision of services

• Consumer tax because it is borne ultimately by the final consumer. It is not a charge on businesses

• Is an indirect tax - in that the tax is collected from someone other than the person who actually

bears the cost of the tax.

• Is a neutral tax - with respect to the number of passages that there are between the producer and

the final consumer

• VAT that is generally charged by a business and paid by its customers is known as "output VAT"

(that is, VAT on its output supplies). VAT that is paid by a business to other businesses on the

supplies that it receives is known as "input VAT" (that is, VAT on its input supplies).

• Total tax liability/credit is residual between output VAT and input VAT

Value Added Tax

Value Added Tax

• Once a business is registered for VAT it will pay VAT on its purchases (‘input tax’) and charge VAT on its sales (‘output tax’).

The cost to the business is ultimately neutral because if your business receives more output tax from sales than it pays in input tax on purchases, it must pay the difference to the tax authorities. If more input tax has been paid than output tax charged, the tax authorities will refund the difference to the business.

Value Added Tax

The big four countries that provide the greatest returns for the least amount of work are:

• Germany• The Netherlands• Sweden• UK

Overview Day 3


What to expect in an Audit:

• What is a financial audit?

• A financial audit, or more accurately, an audit of financial statements, is the review of the financial statements of a company or any other legal entity (including governments), resulting in the publication of an independent opinion on whether those financial statements are relevant, accurate, complete, and fairly presented.

What to expect in an Audit:

• Purpose of a financial audit?

• Obligatory? (“Statutory Audit”)• Criteria: Total Assets – Sales Revenue – Number of Employees

• Voluntary?• to add credibility• to confirm the validity and reliability of information • To obtain more desirable loan terms from a financial institution or trade accounts with

customers

What to expect in an Audit:Auditing Firms – “Big Four”


Stages of a typical audit:

1) Planning and risk assessment 2) Internal Controls testing3) Substantive Procedures4) Finalization (Management report, Audit

Opinion)


Financial Statement Assertions:

1) Rights & Obligations2) Existence / Occurence: Recorded transactions exist3) Valuation: Recorded transactions are stated at the

correct amounts4) Completeness: Existing transactions are recorded5) Presentation & Disclosure: proper accounts?


Audit Opinion:

…indicates whether or not the auditor believes that the financial records inspected accurately represent the company's financial situation. Because auditors can be legally liable for false representations and misstatements, they are very careful when it comes to issuing a final opinion.


Unqualified Audit Opinion:Auditor has fully inspected all of the available information, was able to verify it, and endorses it

Qualified Audit Opinion:Some reservations. It is not necessarily negative, but the auditor may have had difficulty verifying information.

Disclaimer:Auditor does not have enough information to make an audit opinion.

Adverse Audit Opinion:Financial records do not accurately reflect a company's financial position



• Commercial relationships versus objectivity?

• Audited company pays the auditing firm for the service

Recommended Reading

INCOTERMS

• Incoterms or International Commercial Terms are a series of international sales terms, published by the International Chamber of Commerce (ICC) and widely used in international commercial transactions. They are used to specify the transaction costs (cost of Freight and Insurance) and responsibilities (including risks) between the buyer and the seller.

INCOTERMS – Four Main Groups

INCOTERMS – Summary

Financial Reports

• Balance sheet• Income statement• Cash Flow Statement

Cash Flow Statement I

• Shows the flow of cash in and cash out of the business for a given period

• A financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents

• Broken down into operating, investing, and financing activities

Cash Flow Statement II

Cash Flow Statement Bakery & CoFor year 2009

Items Debit – cash in /(Credit – cash out)Net Income 2,000Operating Activities:Depreciation and amortization 700Decrease (increase) in accounts receivable (500)Increase (decrease) in current liabilities (A/P, taxes payable) (1,500)

Decrease (increase) in inventories 1,000A. Net cash flow from operating activities (300)Investing Activities: Capital expenditures (2,000)Investments (200)Dividends received 100B. Net cash flow from investment activities (2,100)Financing Activities: Dividends paid (200) Sale (repurchase) of stock 1,000 Increase (decrease) in debt 2,000 C. Net cash flow from financing activities 2,800Net increase (decrease) in cash and cash equivalents = A + B + C 400

Cash Flow Simple Cash Flow Formula

When we begin to build a cash flow statement we want to keep the following in mind:

• We have a starting balance of cash at the beginning of our fiscal year.

• We might have increased cash via operations - we made money on the products or services we sell.

• We used cash throughout the year to pay for things - new assets and expenses.

• We might have raised cash throughout the year.

Cash Flow Simple Cash Flow FormulaUsing the above four pieces of information we can calculate

a fifth value - the cash we have at the end of the year. These building blocks of a cash flow statement are typically labeled as follows:

• Cash and Cash Equivalents (Beginning)+ Cash from Operations- Cash Flows from Investing Activities+ Cash Flows from Financing Activities= Cash and Cash Equivalents (Ending)

So in order to build a cash flow statement, we only need to be concerned with five concepts.

Cash Flow Cash and Cash Equivalents (Beginning)

• Cash and cash equivalents are a current asset of a company and most times can be found simply by looking at the company's balance sheet for the prior year. If you need to calculate this value, then cash and cash equivalents generally include cash itself, money market funds, certificates of deposit, savings accounts, and similar types of deposits.

• In general, this is a current asset that can be readily exchanged for goods and services on short notice. In our example, we're going to start our company off with $6,000,000 at the beginning of the year.

Cash Flow Cash from Operations

• Next up we're going to look for cash generated by the operations of the company. This is sometimes referred to as cash provided by operating activities. To calculate the cash provided by operations we need a starting point - and the starting point is net income

• One of the advantages of evaluating a company on a cash basis is that it's not subject to accounting concepts that prevent us from getting a clear picture of a company's financial health. Net income does include some of those accounting concepts so to truly understand the cash generated from operations we need to remove from the net income value what are called "non-cash transactions."

Cash Flow Items not Affecting Cash

• The most common example of a non-cash transaction that does not affect cash flow is depreciation. But there are two common classes of adjustments we need to make to net income to calculate cash from operations:

1. Depreciation / Amortization of Assets 2. Net Changes in Current Assets and Liabilities

• So if a company claimed a depreciation expense in their income statement, we need to add that value back in. Likewise, if a company had an increase in accounts receivable, we need to subtract that value from net income. What we're trying to figure out is how much cash exchanged hands throughout the year. A company might have sold more goods and had a rise in accounts receivable, but until that money is received it's not considered cash.

Cash Flow Cash from Operations Example

• Let's see how the above concepts would be used in practice. In this example, our company had net income of $8,000,000. The depreciation expense was $4,000,000, while accounts receivables went up by $2,000,000 and accounts payable went up by $1,000,000.

• In the above example we see that deprecation - which is a non-cash expense - would be added back to net income since money never really left the company's cash accounts. While a rise in accounts receivables (money not yet received) needs to be subtracted from net income (the company did not get the money yet).

Cash Flow Cash Flow from Investing Activities

• The next step in building our cash flow statement is to look at money a company spent on new capital investments. If a company capitalizes an investment then that outflow of money does not show up on the income statement. That's because accounting rules allow the company to depreciate (expense) the cost of the investment over time.

• From a practical standpoint if a company purchases a new asset - such a new plant equipment or machinery - then they most likely paid for that asset with cash. And when money leaves a company we've got an outflow of cash we need to show on our statement.

Cash Flow Cash Flow from Investing Activities Example

• In this example let's say our company purchased a new computer system for $1,500,000 along with an assembly line machine for $2,000,000. These were the only two capital investments made by the company for the year we're examining. In this example, the company was also required to set aside $500,000 into a special decommissioning fund.

• Normally a company might show one line item for the capital investments and label that line item as Additions to Plant. In this example we're going to show these items separately.

• So in this part of the cash flow statement we're seeing money that left the company to pay for assets. They don't show up on the income statement because they are considered "investments." These investments will be depleted over time either via depreciation or other accounting adjustments and at that point they show up as expenses on the income statement.

Cash Flow Cash Flow from Financing Activities

• The final category of adjustments we need to address on a statement of cash flows is money raised via financing activities. As was the case with cash from operations, we can have both positive and negative adjustments to cash flow depending on the financing activities the company engaged in during the year.

• Typical adjustments appearing here include changes in long and short term debt (issuing and redemption), issuing of preferred stock, issuing of common stock, retirement of stock and stock dividends paid in cash.

Cash Flow Cash Flow from Financing Activities Example

• In our example our company decided to raise $250,000 by issuing common stock. They also issued around $500,000 in short term debt and redeemed around $3,000,000 in long term debt. Finally, they paid a cash dividend on common stock of $2,000,000.

• In this example our company used more money in their financing activities than they generated during the year.

Cash Flow Cash and Cash Equivalents (Ending)

• Our final task is to calculate the ending cash balance for the company. This involves simply adding up all of the adjustments to find out if there was a net increase or decrease to cash. This value (either positive or negative) is then added to our starting balance to derive the ending balance.

• Early on in this example we stated that our company started with a $6,000,000 balance of cash. If you were to add up all of the adjustments you'd find we had a net increase of $2,750,000 to cash. Therefore our ending balance stands at $8,750,000.

THANK YOU

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Financial Accounting University of New York Prague - Martin Kolmhofer

Economy & Finance