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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.
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
History of Accounting
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)
Money as: Store of Value (enables saving, lending, borrowing ) Medium of Exchange (Alternative: Barter) Unit of Account (common measurement in which values
are expressed)
But if everybody charges in the same item, that is money, it becomes very clear who has the lowest price.
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 )
Equilibrium Price
Subjective preference rankings interact to yield objective money prices
Market price will be stable, that is it wont tend to change, when you reach the point at which willingness to buy coincides with willingness to sell in the market
Equilibrium Price
Subjective preference rankings interact to yield objective money prices
Equilibrium Price
Subjective preference rankings interact to yield objective money prices
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
Subjective preference rankings interact to yield objective money prices
Price goes up and consequently quantity demanded drops and quantity supplied rises until we get to equilibrium again
Equilibrium Price
Subjective preference rankings interact to yield objective money prices
At 5 dollars sellers are happy providing 5 units but buyers are unhappy, they only want one unit. When the quantity demanded is less than the quantity supplied we have a surplus and the price will drop.
3 Dollars = MARKET CLEARING PRICE (clears the market of all surpluses and shortages)
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
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?
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 taxation CAN 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 )
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
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)
Supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced.
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.
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.
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
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)
Financial Analyst: A financial professional who studies various industries and companies, providing research and valuation reports, and making buy, sell, and hold recommendations.
Stability and profitability of their employers Ability of the enterprise to provide remuneration, retirement benefits, employment prospects Pay and benefits obtained by senior management
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.
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!
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)
Credit rating determines how much interest you have to pay for your debt Important to INSTITUTIONAL INVESTORS (pension funds, Insurance companies
Rule (especially for international trade): NEVER sell on open account to a new customer (only against credit card or advance payment)
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
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
Accounting Principles
Question: Why have rules?
The income tax authorities have thousands of rules as to what may and may not be included as a deduction from revenue
Assumptions:
1) Stable currency is the unit of record: Dollar's purchasing power has not changed over time. Accountants ignore the effect of inflation For example, dollars from a 1960 transaction are combined with dollars from a 2010 transaction Example LAND Realistic Assumption? USD-Gold Exchange Rate vs. Consumer Price Index (= official inflation rate) Record only transactions that can be expressed in terms of money If an asset cannot be expressed as a dollar amount, it cannot be entered in the general ledger: Skills of the management team EXAMPLES?
2)
The Time-period principle implies that the economic activities of an enterprise can be divided into artificial time periods
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.
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.
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.
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-tomonth comparison would be impossible.
Definition The financial statements of the entity should reflect the business reality rather than the legal form of the events or transactions.
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).
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
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
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)
Balance Sheet Accounts Assets Liabilities Owner s Equity (Stockholders Equity for a corporation) Profit and Loss Accounts (= Income Statement Accounts) Revenues Expenses
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
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
Accounting Equation
Accounting Equation
The double entry system based on the Accounting Equation allows us to track: What we got and what went = from whom and to whom
Accounting Equation
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:
Gains: Increases to owners equity resulting from non-business operations (such as selling the old delivery truck, a storage building ) Losses: Decreases to owners equity resulting from non-business operations
Contributions: Increases to owners equity resulting from owner contributions Withdrawals: Decreases to owners equity resulting from owner withdrawals
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.
300 0 300
0 0
Equity Common Stock Retained earnings Reserves Net Income Equity Total Liabilities & Equity
Total Assets
3150
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
Definition An 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) inventory land equipment
Owners 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 Current Assets Cash and Cash Equivalents Inventories Accounts Receivable Prepaid Expenses Total Current Assets Fixed Assets Property, Plant, and Equipment Total Fixed Assets Intangible Assets and Goodwill Intangible Assets Goodwill Total IA and Goodwill Other Assets Investments Total Other Assets 250 300 700 50 1300 Liabilities & Equity Current Liabilities Accounts Payable Short-term Loan Current Tax Liabilities Accrued Liabilities Total Current Liabilities Non-Current Liabilities Bank Loans Issued Debt Securities Deferred Tax Liability Total Non-Current Liabilities 350 200 100 100 750
1550 1550
300 0 300
0 0
Equity Common Stock Retained earnings Reserves Net Income Equity Total Liabilities & Equity
Total Assets
3150
Types Of Business Organization Sole Proprietorship Partnership (General vs. Limited) Corporation
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
Let's use our accounting equation and get an overview of the types of transactions that can occur and their effects on our equation:
Did you note regularities? Yes? Because there are 4 Basic Types of Transactions
ASSETS = LIABILITIES + EQUITY
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.
Assets = Left Side Transactions 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 Net Change Total Net Changes $10,380 $700 $100 Increase Decrease Decrease
$10,160
$205
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
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
Transactions 1. ABC mows a client's yard and receives a check from the customer for $50 for the service provided. 3. ABC places an ad in the local newspaper receives the invoice from the supplier and writes a check for $25 to the newspaper. 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. 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.
Decrease
Increase
50
25
75
500
60
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
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.
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).
= VARIABLE COSTS
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
Income Statement Multiple Step 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.
Income Statement Multiple Step 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
Note that the Income Statement must be prepared before the Statement of Retained Earnings
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
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.
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
A SYSTEM IS NEEDED!
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.
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
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)
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.
Source Documents No Posting without Source Document! Source document is the original record of a transaction Supports the underlying transaction Examples: Sale Invoice Expense Receipt Collection 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.
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.
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
So to summarize The basic process is to transfer amounts from the general ledger to the trial balance, then into the financial statements
Accounting Terminology
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
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
STEP 1:
Classify the accounts as assets, liabilities, equity, revenue or expenses:
ASSETS, LIABILITES
STEP 1:
Classify the accounts as assets, liabilities, equity, revenue or expenses:
STEP 1:
Classify the accounts as assets, liabilities, equity, revenue or expenses:
STEP 2:
Prepare the Income Statement
STEP 2:
Prepare the Income Statement
STEP 2:
Prepare the Income Statement
STEP 2:
Prepare the Income Statement
STEP 2:
Prepare the Income Statement
STEP 3:
Prepare the Statement of Retained Earning
STEP 3:
Prepare the Statement of Retained Earning
STEP 4:
Prepare the Balance Sheet
STEP 4:
Prepare the Balance Sheet
STEP 4:
Prepare the Balance Sheet
The End
Accounting Humour
The left side of the balance sheet has nothing right and the right side of the balance sheet has nothing left. But they are equal to each other. So accounting-wise we are fine" (AIG Vice Chairman Jacob Frenkel, Oct 11 2008 )
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
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?
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
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.
Matching: Expenses can be allocated to corresponding revenues Example: 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 benefit Example: General Administrative Cost
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
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.
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 entries How often are adjustments needed?
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.
EXAMPLES?
Accruals are expenses and revenues that gradually accumulate throughout an accounting period (salaries, interest, rent, utilities )
The journal entry on the actual payday needs to extinguish the previously established liability (Liabilities decrease, Cash decreases):
Salaries Payable Cash 3,000 3,000
EXAMPLES?
QUESTIONS?
Summary
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
EXAMPLE:
Financial 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
It is determined by adding the number of days inventory is held and the collection period for accounts receivable
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
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
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
Valuation method in which the assets acquired first are sold first.
Valuation method that assumes that assets acquired last are the ones that are sold first.
Reduces income taxes in times of inflation
values inventory costs as the average unit cost between the assets in the beginning inventory and the newly acquired assets.
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
INVENTORY - RATIOS
Days in Inventory
Measures the average number of days the company holds its inventory before selling it.
INVENTORY - RATIOS
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
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.
Invoice discounting
= borrowing where the receivable is used as collateral
Cash discounts
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.
The net of the asset and its related contra asset account is referred to as the asset's book value.
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
Balance Sheet Details: Fixed Assets Assets intended to be in use for period longer 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
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
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.
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
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 now More profits later = more taxes later
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.
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 dont want to lose the information for how much the asset was purchased in the first place
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
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
Goodwill The difference between the acquisition price and book asset value
of purchased business entity Premium" for buying a business
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
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
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
Short-term loan
Loans with banks, overdrafts
Accrued Liabilities
Accrued accounts payable, etc
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
Retained earnings
Profits that were not distributed among shareholders but kept with the entity
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
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
1. 2. 3.
Three Types
Liquidity Ratios Solvency Ratios 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 period
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 Ratios
Measure the income or operating success of an enterprise for a given period of time
WHO CARES?
Everybody 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
Advantage: Items can be compared to a similar item of another company regardless of the size of the companies
The current ratio is used to express the relative amount of working capital.
RATIO ANALYSIS
RATIO ANALYSIS
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
COMPLIANCE - Overview
What is Compliance ? making sure that a company's financial matters are being handled in accordance with federal laws and regulations.
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
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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
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.
Key elements in a good internal control system: Segregation (separation) of duties: No person should have
control over a transaction from beginning to end
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 MD Clerk AP Clerk Payments Clerk
Creates supplier
Posts Invoice
Releases payment
INTERNAL CONTROLS
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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
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.
The big four countries that provide the greatest returns for the least amount of work are:
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
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.
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
Stages of a typical audit: 1) 2) 3) 4) Planning and risk assessment Internal Controls testing Substantive Procedures Finalization (Management report, Audit Opinion)
What to expect in an Audit: Auditing Firms Big Four Financial Statement Assertions:
1) Rights & Obligations 2) Existence / Occurence: Recorded transactions exist 3) Valuation: Recorded transactions are stated at the correct amounts 4) Completeness: Existing transactions are recorded 5) 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.
Disclaimer:
Auditor does not have enough information to make an audit opinion.
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 Summary
Financial Reports
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
Net Income Operating Activities: Depreciation and amortization Decrease (increase) in accounts receivable Increase (decrease) in current liabilities (A/P, taxes payable)
Decrease (increase) in inventories A. Net cash flow from operating activities Investing Activities: Capital expenditures Investments Dividends received B. Net cash flow from investment activities Financing Activities: Dividends paid Sale (repurchase) of stock Increase (decrease) in debt C. Net cash flow from financing activities Net increase (decrease) in cash and cash equivalents = A + B + C
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.
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