Financial Statements and Budgeting Methods
Ch 1
Accounting equation (Ch 1):
The balance sheet shows the relationship between assets, liabilities, and stockholder’s equity at a particular date. In equation form, Assets = Liabilities + Stockholder’s Equity. This is referred to as the basic accounting equation.
Financial statements (Ch 1) Format/Content (which accounts belong on each financial statement):
Four types of financial statements:
Income Statement:
Summarizes all revenue and expenses for period (month, quarter, or year). If revenues exceed expenses, the result is a net income. If expenses exceed revenue, the result is a net loss.
- Revenues
- Service revenue
- Expenses
- Salaries and wages expense
- Supplies expense
- Rent expense
- Insurance expense
- Interest expense
- Depreciation expense
- Total Expenses
- Net Income
Retained Earnings Statement:
Indicates amount paid out in dividends and amount of net income or net loss for period. Shows changes in retained earnings balance during period covered by statement. Time period is the same as that covered by income statement.
- Retained earnings, October 1
- Add: Net income
- Less: Dividends
- Retained earnings, October 31
Balance Sheet:
Shows the relationship between assets, liabilities, and stockholders’ equity at a particular date.
- Assets
- Cash
- Accounts Receivable
- Supplies
- Prepaid Insurance
- Equipment
- Total Assets
- Liabilities and Stockholder’s Equity
- Liabilities
- Notes payable
- Accounts payable
- Salaries and wages payable
- Unearned service revenue
- Interest payable
- Total Liabilities
- Stockholders’ equity
- Common stock
- Retained earnings
- Total stockholders’ equity
- Total liabilities and Stockholders’ Equity
Statement of Cash Flows:
Reports cash inflows and outflows resulting from financing, investing, and operating activities during the period. Reports the cash effects of a company’s operations for a period of time. Shows cash increases and decreases from investing and financing activities. Indicates increase or decrease in cash balance as well as ending cash balance.
- Cash flows from operating activities
- Cash receipts from operating activities
- Cash payment for operating activities
- Net cash provided by operating activities
- Cash flows from investing activities
- Purchased equipment
- Net cash used by investing activities
- Cash flows from financing activities
- Issuance of common stock
- Issuance of note payable
- Payment of dividend
- Net cash provided by financing activities
- Net increase in cash
Cash at the beginning of period
Cash at the end of period
Transaction classification on Statement of Cash Flows (Operating, Investing, Financing activities) (Ch 1):
Operating Activities:
Comprise the primary activities for which the organization is in business. Include cash activities related to net income. For example, cash generated from the sale of goods (revenue) and cash paid for merchandise (expense) are operating activities because revenues and expenses are included in net income.
Investing Activities:
Investing activities involve the purchase of resources (assets) needed to operate the business. Typical assets include:
Land, Building, Equipment, Cash, Investments in debt or equity securities of another company
Financing Activities:
To start or expand a business the owner or owners quite often need cash from outside sources. The two primary sources are:
Borrowing from creditors
Liabilities are amounts owed to creditors
Note payable (bank loan)
Bonds payable (debt securities)
Selling shares of stock to investors
Common stock (total amount paid in by stockholders for the shares they purchased)
Dividends (payments to stockholders)
Net Income calculation (Ch1):
Net income results when revenues exceed expenses. To find net income, subtract total expenses from total revenues. If expenses exceed revenues, you have a net loss.
Ch 2
Profit Margin calculation (Ch2):
A profit margin is a figure representing the profitability of a company, expressed as a percentage on the company’s income statement. The stronger the percentage, the more money the company is earning, after all expenses are paid. Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales.
Current ratio – calculation and interpretation (Ch2):
The current ratio is used to measure a company’s short-term liquidity position and provides a quantitative relationship between current assets (CA) and current liabilities (CL). The Current Ratio = Current Assets/Current Liabilities
Interpretation:
If Current Assets > Current Liabilities, then Ratio is greater than 1.0 -> a desirable situation to be in.
If Current Assets = Current Liabilities, then Ratio is equal to 1.0 -> Current Assets are just enough to paydown the short term obligations.
If Current Assets Classified Balance Sheet (Current/PPE/Intangibles, Current/long-term liabilities) (Ch 2)
Retained earnings statement (Ch 2)
Ch 4
Revenue Recognition Principle and Expense Recognition Principle (Ch4)
Companies recognize revenue in the accounting period in which the performance obligation is satisfied.
Companies recognize expense in the period which efforts are made to generate revenue. Adjustments (Ch 4): Prepaid Expenses (all types)/Unearned Revenue/Accruals (Revenue and Expense)
Two Types of Adjustment:
Deferrals:
Prepaid Expenses:
- Insurance
- Rent
- Supplies
- Advertising
- Equipment
- Accumulated Depreciation-Equipment is a contra asset account.
- Buildings
- Equipment and buildings are recorded as assets, rather than an expense, in the year acquired.
- Expenses paid in cash before they are used or consumed. Costs that expire either with the passage of time or through use. An adjustment results in an increase to an expense account and a decrease to an asset account or increase to a contra-asset.
Unearned Revenues:
- Rent
- Magazine subscriptions
- Airline tickets
- Customer deposits
- Cash received before services are performed and recorded as a liability. Adjustment is made to record the revenue for services performed during the period and to show the liability that remains. Adjustment results in a decrease to a liability account and an increase to a revenue account.
Accruals:
- Accrued Revenues:
- Rent
- Interest
- Services performed
- Revenues for services performed but not yet received in cash or recorded. Shows the receivable that exists, and records the revenues for services performed. This adjustment: Increases an asset account and a revenue account.
Accrued Expenses:
- Interest
- Utilities
- Taxes
- Salaries
- Expenses incurred but not yet paid in cash or recorded. An adjustment records the obligations and recognizes the expenses. This type of adjustment increases an expense account and a liability account.
Accrual Accounting Definition (Ch 4):Transactions recorded in the periods in which the events occur. Revenues are recognized when services performed, even if cash was not received. Expenses are recognized when incurred, even if cash was not paid.
Ch 5
Internal control activities (Ch 5):
In internal control, methods and measures are adopted to:
- Safeguard assets.
- The use of a bank contributes significantly to good internal control over cash.
- Minimizes the amount of currency on hand.
- Creates a double record of bank transactions.
- Enhance accuracy and reliability of accounting records.
- Increase efficiency of operations.
- Ensure compliance with laws and regulations.
Internal Control Activities:
- Establishment of Responsibility
- Control is most effective when only one person is responsible for a given task.
- Establishing responsibility often requires limiting access only to authorized personnel, and then identifying those personnel.
- Segregation of Duties
- Different individuals should be responsible for related activities.
- The responsibility for record-keeping for an asset should be separate from the physical custody of that asset.
- Documentation Procedures
- Companies should use prenumbered documents, and all documents should be accounted for.
- Employees should promptly forward source documents for accounting entries to the accounting department.
- Physical Controls
- Vaults, alarms, time clocks, Biometric security.
- Independent Internal Verification
- Records periodically verified by an employee who is independent.
- Discrepancies reported to management.
- Human Resource Controls
- Bond employees who handle cash.
- Rotate employees’ duties and require vacations.
- Conduct background checks.
- Bank reconciliation preparation and related adjustments (Ch 5):
- In a bank reconciliation, cash balances must be balanced according to both the bank and the company.
- For Bank:
- Adjustments include those for deposits in transit, outstanding checks, and bank errors.
- Deposits in Transit:
- Deposits recorded by the depositor (company) that have not been added to the bank’s records. (Time lag)
- Are an increase(+)
- Outstanding Checks
- Checks issued and recorded by the company that have not been subtracted from the bank’s records. (Time lag)
- Are a decrease(-)
- Bank Errors
- Can increase or decrease(+/-)
- For Company:
- NSF
- A check written by a customer that is not paid by the bank because of insufficient funds in the customer’s bank account. “Bounced check”
- Are a decrease(-)
- EFT or interest earned
- Funds transferred electronically between locations. Can be receipts or payments.
- Are an increase(-)
- Bank service fees/fees
- Are a decrease(-)
- Book Errors
- Are an increase or decrease(+/-)
- Adjustments include those for EFT collections and other deposits, NSF (bounced) checks, service charges and other payments, and company errors.
Ch 6
Multi-step Income Statement (gross profit, operating income, other rev/exp) (Ch 6)
Multi-Step Income Statement:
Highlights the components of net income and includes three important line items, including gross profit, income from operations and net income.
Gross Profit calculation and ratio (Ch 6):
Gross Profit:
Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. It can be calculated by subtracting the cost of goods sold from revenue, or Revenue – Cost of Goods Sold = Gross Profit.
Gross Profit Ratio:
The gross profit ratio is a profitability ratio that shows the relationship between gross profit and total net sales revenue. It can be calculated by dividing gross profit by net sales multiplied by 100, or Gross Profit / Net Sales * 100 = Gross Profit Ratio
Bad Debt Expense – calculation and adjustments (Ch 6):
Bad Debt Expense can be calculated by multiplying the estimated percentage of sales that will remain uncollected by the amount of sales. Or Estimated % Sales Uncollectable * Sales.
Estimated % Sales Uncollectible can be calculated by dividing the amount of bad debt by the total accounts recievable for a period, and multiply by 100. Or Bad Debt / Total Accounts Receivable for Period * 100.
Adjustments:
Under the allowance method for uncollectible accounts:
Companies estimate uncollectible accounts receivable.
Increase Bad Debt Expense and increase Allowance for Doubtful Accounts(a contra account).
Companies decrease Allowance for Doubtful Accounts and decrease Accounts Receivable at the time the specific account is written off as uncollectible.
Write-off of bad debts – how impacts accounting equation (Ch 6):
A write-off affects only balance sheet accounts. Cash realizable value in the balance sheet, therefore, remains the same before and after the write-off.
Perpetual inventory – definition and entries (Ch 6):
In a perpetual inventory system, there are maintained detailed records of the cost of each inventory purchase and sale. Records continuously show inventory that should be on hand for every item. Company determines cost of goods sold each time a sale occurs.
In recording purchases in a perpetual inventory system, Increase Inventory and Decrease Cash /OR Increase Accounts Payable
Sales may be made on credit or for cash.
Sales revenue, like service revenue, is recorded when the performance obligation is satisfied.
Performance obligation is satisfied when the goods are transferred from the seller to the buyer.
There are two types of entries to be made:
Increase Revenue and Increase Cash /OR Accounts Receivable
Decrease Inventory and Increase Cost of Good Sold (expense)
When items purchased are later returned:
Sales Returns and Allowances is shown as a subtractive item under revenues (Contra-Revenue)
Accounts receivable also reduced.
If goods are returned, Inventory is increased and Cost of Goods Sold is decreased for the cost of the goods.
If the goods were defective, Inventory is reduced to reflect the decline in value.
LIFO/FIFO – COGS and Ending inventory calculations and entries (Ch 6):
LIFO:
Costs of the latest goods purchased are the first to be recognized in determining cost of goods sold.
A major shortcoming of the LIFO method is that in a period of inflation, the costs allocated to ending inventory may be significantly understated in terms of current cost.
FIFO:
Costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold.
A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending inventory will approximate their current cost.
Cost of Goods Sold:
LIFO: With LIFO, you use the last three units to calculate cost of goods sold expense.
FIFO: In short, you use the first three units to calculate cost of goods sold expense.
Ending Inventory:
Beginning Inventory + Net Purchases – Cost of Goods Sold (or COGS)
Ch 7
Acquisition cost of assets (what to include and entry) (Ch 7):
The Cost of Acquiring Assets:
Land:
All necessary costs incurred in making land ready for its intended use increase the Land account.
Included Costs:
cash purchase price
closing costs such as title and attorney’s fees
real estate brokers’ commissions
accrued property taxes and other liens on the land assumed by the purchaser.
Buildings:
Includes all costs related directly to purchase or construction.
Included Costs:
Purchase Costs
Purchase price, closing costs (attorney’s fees, title insurance, etc.) and real estate broker’s commission.
Remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing.
Construction Costs
Contract price plus payments for architects’ fees, building permits, and excavation costs.
Equipment:
Include all costs incurred in acquiring the equipment and preparing it for use.
Included Costs:
Cash purchase price.
Sales taxes.
Freight charges.
Insurance during transit paid by the purchaser.
Expenditures required in assembling, installing, and testing the unit.
Depreciation – definition, calculation and entry (straight-line only) (Ch 7):
Definition:
Process of allocating to expense the cost of a plant asset over its useful life in a rational and systematic manner.
Applies to land improvements, buildings, and equipment, not land.
Affected by three factors, including salvage value, cost, and useful life
Calculation:
Under the Straight-Line Method, the Depreciation expense can be calculated by dividing the Depreciable Cost by the Useful Life in Years. The Depreciable Cost can be calculated by subtracting salvage value from cost. In terms of a formula:
Depreciable Cost = Salvage Value – Cost
Depreciation Expense = Depreciable Cost / Useful Life in Years
Net Book Value – definition and calculation (Ch 7):Definition:
The book value is defined as the difference between the cost of any depreciable asset and its related accumulated depreciation.
Calculation: Cost of Depreciable Asset – Accumulated Depreciation for that Asset = Net Book Value
Sale of Assets – calculation of gain/loss and entry (Ch 7)Eliminate asset by (1) decreasing Accumulated Depreciation, and (2) decreasing the asset account.
To Start:
Compare the book value of the asset with the proceeds received from the sale.
Calculation of:
Gain: If proceeds exceed the book value, a gain on disposal occurs.
Loss: If proceeds are less than the book value, a loss on disposal occurs.
Ch 8
Current liabilities vs. long-term liabilities on the Balance Sheet (Ch 8)
Current Liabilities:
A debt that a company expects to pay from existing current assets or through the creation of other current liabilities, and within one year or the operating cycle, whichever is longer.
Current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest.
Interest on Notes = Face value x Annual Interest Rate x Fraction of the year
Long-Term Liabilities:
A long-term liability is a noncurrent liability. That is, a long-term liability is an obligation that is not due within one year of the date of the balance sheet (or not due within the company’s operating cycle if it is longer than one year).
Examples include:
bonds payable
long-term loans
deferred revenues
deferred income taxes
Treasury Stock – definition, journal entry, and how handled on Balance sheet (Ch 8)Definition:
Treasury stock is a corporation’s own stock that has been reacquired by the corporation and is being held for future use.
Purchase of Treasury Stock:
Generally accounted for by the cost method.
Increase Treasury Stock for the price paid.
Treasury stock is a contra stockholders’ equity account, not an asset.
Treasury Stock decreases by the same amount when the company later sells the shares.
Stockholders’ Equity section of balance sheet (Ch 8)Stockholders’ Equity:
BALANCE SHEET PRESENTATION OF STOCKHOLDERS’ EQUITY
Two classifications of paid-in capital:
Capital stock
Additional paid-in capital
Paid-in capital is the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock.
Other comprehensive income items include:
certain adjustments to pension plan assets,
types of foreign currency gains and losses, and
some gains and losses on investments.
Stock issuance entries (common and preferred stock) (Ch 8)
Stock Issuance for:
Common Stock:
Corporation can issue common stock directly to investors or indirectly through an investment banking firm.
Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation.
Preferred Stock:
Typically, preferred stockholders have a priority in relation to dividends and assets in the event of liquidation. However, they sometimes do not have voting rights.
Stock terms (authorized, issued, outstanding shares) (Ch 8)
Stock terms for:
Authorized Shares:
Authorized stock is the maximum number of shares that a corporation is legally permitted to issue, as specified in its articles of incorporation. It is also usually listed in the capital accounts section of the balance sheet.
Issued Shares:
Issued stock is a corporate stock which is issued and held in the corporation’s treasury or sold or distributed to shareholders. In other words, the total number of a company’s shares that was sold and held by shareholders. It is to be noted that issued stock can be held both by insiders and by the general public.
Outstanding Shares:
the number of shares the corporation has actually issued that are held by the public.
Dividend dates and related entries (Ch 8)
Dividend Dates:
A dividend is a distribution to stockholders on a pro rata (proportional to ownership) basis.
Types of Dividends:
Cash dividends.
Stock dividends.
Property dividends.
Scrip (promissory note)
Dividends are generally reported quarterly as a dollar amount per share.
Dividends require information concerning three dates:
Declaration Date:
Board authorizes dividends
Record Date:
Registered shareholders are eligible for dividend
Payment Date:
The company issues dividend checks
Retained earnings – calculation of ending balance (Chs 1 and 8)
Retained Earnings:
Retained earnings is net income that a corporation retains for future use in the business.
Calculation of Ending Balance:
RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
Ch 10
Manufacturing costs and Product versus Period costs (Ch10)
Manufacturing Costs:
Classified as either direct materials, direct labor, and manufacturing overhead.
Indirect Materials and Labor are also counted as part of manufacturing overhead
Manufacturing Overhead
Indirect materials
Indirect Labor
Depreciation on factory buildings and machines, insurance, taxes, and maintenance on factory facilities.
Product Costs:
Costs that are an integral part of producing the product. Recorded in “inventory” account. Not an expense (COGS) until the goods are sold.
Consist of:
Direct Materials
Direct labor
Manufacturing Overhead
Period Costs:
Charged to expense as incurred.
Non-manufacturing costs.
Includes all selling and administrative expenses.
Cost of good manufactured and Cost of goods sold calculations (Ch10)
Cost of Goods Manufactured:
Cost of Goods Manufactured = Beginning Work in Process Inventory + Total Manufacturing Costs(Sum of Direct Material Costs, Direct Labor Costs, and Manufacturing Overhead in the Current Year) – Ending Inventory Work in Progress
Cost of Goods Sold:
For Merchandiser:
Cost of Goods Sold = Beginning Merchandise Inventory + Cost of Goods Purchased – Ending Merchandise Inventory
For Manufacturer:
Cost of Goods Sold = Beginning Finished Goods Inventory + Cost of Goods Manufactured – Ending Finished Goods Inventory
Manufacturers’ financial statements and how they are difference from a merchandiser (Ch10)Under a Periodic Inventory System:
The income statements of a merchandiser and a manufacturer differ in the cost of goods sold section.
The balance sheet for a merchandiser shows only one category of Inventory. Inventory.
The balance sheet for a manufacturer shows three categories of inventory, including raw material inventory, work in process inventory, and finished goods inventory
Ch 11
Break-even point calculation (Ch11):
Break-even point is calculated as such, Fixed Costs/Contribution per unit.
Break-even point in dollars is calculated as such, Sales price per unit x Break-even point in units.
Sales to meet target profit calculation and margin of safety calcuation (Ch11)Required Sales to meet Target Profit:
Required sales may be expressed either in sales dollars or sales units. Required sales in dollars can be calculated as such, Required Sales = Variable Costs + Fixed Costs + Target Net Income
Required sales in units can be calculated as such, Fixed Costs + Target Net Income / Contribution Margin per Unit. Contribution Margin per unit = sales price per unit – variable expenses per unit.
Margin of Safety:
It is the difference between actual or expected sales and sales at the break-even point. It may be expressed in dollars or as a ratio.
Margin of safety in Dollars Calculation:
Actual Sales – Break-even point
Margin of Safety as a Percentage:
Margin of Safety in Dollars(Actual Sales – Break-even point) / Actual Sales
Use high/low method to determine variable and fixed components of a mixed cost (Ch11):The high/low method uses the total costs incurred at the high and the low levels of activity to classify mixed costs into fixed and variable components.
Calculation to Determine Variable and Fixed Cost Components of Mixed Cost:
Step 1: Calculate variable cost per unit using the identified high and low activity levels
Variable cost = (Total cost of high activity – Total cost low activity) / (Highest activity unit – Lowest activity unit)
Step 2: Solve for fixed costs
To calculate the total fixed costs, plug either the high or low cost, and the variable cost into the total cost formula.
Total cost = (Variable cost per unit x Units produced) + Total fixed cost
Step 3: Construct total cost equation based on high-low calculations above
Total cost = variableCostX + total fixed costs.
Identify variable/fixed/mixed costs (Ch11)
Variable Costs:
Costs that vary in total directly and proportionately with changes in the activity level.
Example: If the activity level increases 10 percent, total variable costs increase 10 percent.
Variable costs remain the same per unit at every level of activity.
Examples: raw materials, packaging, and labor directly involved in a company’s manufacturing process.
Fixed Costs:
Costs that remain the same in total regardless of changes in the activity level within a relevant range.
Fixed cost per unit cost varies inversely with activity: As volume increases, unit cost declines, and vice versa.
Examples: Property taxes, insurance, rent, depreciation on buildings and equipment.
Mixed Costs:
Costs that have both a variable element and a fixed element.
Change in total but not proportionately with changes in activity level.
Preparation of a CVP Income statement (Ch11)Assumptions:
1.Behavior of both costs and revenues is linear throughout the relevant range of the activity index.
2.Costs can be classified accurately as either variable or fixed.
3.Changes in activity are the only factors that affect costs.
4.All units produced are sold.
5.When more than one type of product is sold, the sales mix will remain constant.
CVP Income Statement:
A statement for internal use.
Classifies costs and expenses as fixed or variable.
Reports contribution margin in the body of the statement.
Contribution margin–amount of revenue remaining after deducting variable costs.
Reports the same net income as a traditional income statement.
Ch 13
Budgeting (Ch13)
Production budget/Cash budget/Components of operating and master budgetsProduction Budget:
Shows units that must be produced to meet anticipated sales.
Derived from sales budget plus the desired change in ending finished goods inventory.
Formula: Required Production Units = Budgeted Sales Units + Desired Ending Finished Goods Units – Beginning Finished Goods Units.
Cash Budget:
Shows anticipated cash flows.
Often considered to be the most important output in preparing financial budgets.
Ending cash balance of one period is the beginning cash balance for the next.
Contains three sections:
Cash Receipts
Expected receipts from the principal sources of revenue.
Expected interest and dividends receipts, proceeds from planned sales of investments, plant assets, and the company’s capital stock.
Cash Disbursements
Expected cash payments for direct materials, direct labor, manufacturing overhead, and selling and administrative expenses.
Financing
Expected borrowings and repayments of borrowed funds plus interest.
Shows beginning and ending cash balances.
Components of Operating Budgets:
Individual budgets that result in the preparation of the budgeted income statement and establish goals for sales and production personnel.
Sales Budget, Production Budget, Direct Materials Purchases Budget, Direct Labor Budget, Overhead Budget, Ending Finished Goods Inventory Budget, Cost of Goods Sold Budget, Selling and Administrative Expenses Budget, Budgeted Income Statement
Components of Master Budgets:
Set of interrelated budgets that constitutes a plan of action for a specified time period.
Contains two classes of budgets:
Operating Budgets
Financial Budgets
Ch 16
Use Cash payback method, Net present value method, and Annual rate of return method to evaluate capital
budget projects (Ch16)Cash Payback Method:
Cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash inflow produced by the investment.
Shorter payback period = More attractive the investment
Cash payback period = Cost of Capital Investment / Net Annual Cash Flow
Net Present Value Method:
Discounted cash flow technique.
Generally recognized as the best approach.
Considers both the estimated total cash inflows and the time value of money.
Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.
NPV = (Today’s value of the expected cash flows) – (Today’s value of invested cash)
Net Present Value Variables:
Dollar amount to be received (future amount).
Length of time until amount is received (number of periods).
Interest rate (the discount rate).
Net Present value for a Single Cash Flow:
Present Value = Cash Flow / (1 + i)^n
i = discount rate and n = period number
Annual Rate of Return Method:
Indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment.
Annual Rate of Return = Expected Annual Net Income / Average Investment
Average Investment = Original Investment + Value at end of Useful Life / 2