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Slide 1: CHAPTER 18 Understanding Principles of Accounting Leonardo Matarrese @MyPlick 18 - 1
Slide 2: Key Terms Accounting Comprehensive system for collecting, analyzing, and communicating financial information Bookkeeping Recording of accounting transactions Accounting System Organized means by which financial information is identified, measured, recorded, and retained Leonardo Matarrese @MyPlick for use in accounting statements 18 - 2
Slide 3: Users of Accounting Information      Business Managers Employees & Unions Investors & Creditors Tax Authorities Leonardo Matarrese @MyPlick Government Regulatory Agencies 18 - 3
Slide 4: Who Are Accountants & What Do They Do? Controller Person who manages all of a firm’s accounting activities (chief accounting officer) Leonardo Matarrese @MyPlick 18 - 4
Slide 5: Financial versus Managerial Accounting Financial Accounting System Field of accounting concerned with external users of a company’s financial information Managerial (or Management) Accounting System Leonardo Matarrese @MyPlick 18 - 5
Slide 6: Certified Public Accountant (CPA) Accountant licensed by the state and offering services to the public  Professional Practice and the Big 4 – Deloitte & Touche – Ernst & Young – KPMG LLP – PricewaterhouseCoopers  Leonardo Matarrese @MyPlick 18 - 6
Slide 7: CPA Services Audit Systematic examination of a company’s accounting system to determine whether its financial reports fairly represent its operations in accordance with GAAP Generally Accepted Accounting Principles (GAAP) Accepted rules and procedures governing the content and form of financial reports Tax Services Include assistance not only with tax return preparation but also with tax planning Conflict of Interest in Enron Management Advisory Services Specialized accounting services to help managers resolve a variety of business problems Leonardo Matarrese @MyPlick 18 - 7
Slide 8: Non-Certified Public Accountants Provide income tax preparation, payroll accounting, and financial planning services to many small businesses, individuals, and larger firms Leonardo Matarrese @MyPlick 18 - 8
Slide 9: Private Accountants Private Accountant Salaried accountant hired by a business to carry out its day-to-day financial activities Certified Management Accountant (CMA) Leonardo Matarrese specializing in Certified accountant@MyPlick 18 - 9
Slide 10: Journal Tools of The Accounting Trade Chronological record of a firm’s financial transactions, including a brief description of each This is what you will be doing in Introductory Accounting Ledger Record, divided into accounts and usually compiled on a monthly basis, containing summaries of all journal transactions Fiscal Year Leonardo Matarrese @MyPlick Twelve-month period designated for annual financial 18 - 10
Slide 11: Accounting & Recordkeeping Accounting is a comprehensive tool for: Collecting Analyzing & Communicating Initial Records entered into Intermediate Records entered into Final Records Forms basis for Financial Statements Financial Information Leonardo Matarrese @MyPlick 18 - 11
Slide 12: Entering a Check in the General Journal Leonardo Matarrese @MyPlick 18 - 12
Slide 13: Entering a Check in the General Ledger Leonardo Matarrese @MyPlick 18 - 13
Slide 14: The Accounting Equation Assets = Liabilities + Owners’ equity Asset: Any economic resource expected to benefit a firm or an individual who owns it Liability: Debt owed by a firm to an outside organization or individual Owners’ Equity: Amount of money that owners would receive if they sold all of a firm’s assets and paid all of its liabilities Assets = Liabilities + Owners’ equity Leonardo Matarrese @MyPlick 18 - 14
Slide 15: Double-Entry Accounting System A bookkeeping system that balances the accounting equation by recording the dual effects of every financial transaction Leonardo Matarrese @MyPlick 18 - 15
Slide 16: Financial Statements Any of several types of reports summarizing a company’s financial status to aid in managerial decision making – Balance Sheets – Income Statements – Statements of Cash Flows – Budget Leonardo Matarrese @MyPlick 18 - 16
Slide 17: Balance Sheets Financial statement detailing a firm’s assets, liabilities, and owners’ equity Matarrese @MyPlick Leonardo 18 - 17
Slide 18: Perfect Posters’ Balance Sheet Leonardo Matarrese @MyPlick 18 - 18
Slide 19: Four Types of Assets Current Asset – Asset that can or will be converted into cash within the following year – Liquidity — ease with which an asset can be converted into cash What are some Current Assets? Leonardo Matarrese @MyPlick 18 - 19
Slide 20: Investment Asset Moneys that are invested in other companies or land held for future use.  These could be invested in stocks or bonds or in land held for future use.  Perfect Posters did not have any of this asset.  Leonardo Matarrese @MyPlick 18 - 20
Slide 21: Fixed Asset – Asset with long-term use or value, such as land, buildings, and equipment – Depreciation — process of distributing the cost of an asset over its life – What are some fixed Assets. Leonardo Matarrese @MyPlick 18 - 21
Slide 22: Intangible Assets – Nonphysical asset, such as a patent or trademark, that has economic value in the form of expected benefit – Goodwill — Amount paid for an existing business above the value of its other assets  Other examples of Intangibles. Leonardo Matarrese @MyPlick 18 - 22
Slide 23: Depreciation Methods     Accountants differ on how it should be calculated. First have to decide life of the asset Then must look at salvage value Next decide whether to use Straight Line, Sum of the years digits, or Declining balance 18 - 23 Leonardo Matarrese @MyPlick
Slide 24: Lets look at an example  Machine had a cost of $35,000, given a 5 year life, and a $5,000 salvage value. Assume the machine was purchased on January 1, 2001, what is depreciation expense for,2001,2002 and 2003 using – a. – b. – c. The straight-line method The sum of the years digits method The double declining balance method Leonardo Matarrese @MyPlick 18 - 24
Slide 25: Depreciation CalculationsStraight Line Method  Straight Line method--amount of depreciation is the same each year – (Cost - Salvage value)/ life – 35,000-5,000/5= 6,000 per year • • • • • 2001 2002 2003 2004 2005 6,000 6,000 6,000 6,000 6,000 Leonardo Matarrese @MyPlick 18 - 25
Slide 26: Graph of the Straight Line Method 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2001 2002 2003 2004 2005 18 - 26 Leonardo Matarrese @MyPlick
Slide 27: Depreciation Calculations--Sum of the year’s digits First need the sum of years digits = 5+4+3+2+1=15  2001 = (35,000-5,000) X 5/15 = 10,000  2002 = 30,000 X 4/15 = 8,000  2003 = 30,000 X 3/15 = 6,000  2004 = 30,000 X 2/15 = 4,000  2005 = 30,000 X 1/15 = 2,000  Leonardo Matarrese @MyPlick 18 - 27
Slide 28: Graphical Comparison of Methods 12,000 10,000 8,000 6,000 4,000 2,000 0 2001 2002 2003 2004 2005 SL SYD Can you see why the sum of the years digits is called an Leonardo Matarrese @MyPlick accelerated method? 18 - 28
Slide 29: Depreciation Calculations-Double Declining Balance Under this method salvage value is initially ignored  Rate = (100%/n) X2 or 100%/5 X 2 = 40%       2001 35,000 X 40% = 14,000 2002 (35,000 - 14,000) = 21,000 X 40% = 8,400 2003 (21,000 - 8,400)=12,600 X 40% =5,040 2004 (12,600 - 5,040)=7,560 X 40% = 3,024 but limited to 2,560 Leonardo Matarrese @MyPlick 2005 None the asset is fully depreciated 18 - 29
Slide 30: Account Receivable Three Important Nonliquid Assets – Amount due from a customer who has purchased goods on credit Merchandise Inventory – Cost of merchandise that has been acquired for sale to customers and is still on hand Important to see how valued. – LIFO (last-in-first-out) method Method of valuing inventories that assumes that those received most recently (last in) are sold first – FIFO (first-in-first-out) method Method of valuing inventories that assumes that older inventories (first in) are sold first Prepaid Expense Leonardo Matarrese @MyPlick – Expense, such as prepaid rent, that is paid before the 18 - 30 upcoming period in which it is due
Slide 31: Now let’s take a look at inventory    Accountants cannot agree here either. First must count the inventory--many of you have already done this Then must price out the inventory--Let’s look at an example. Leonardo Matarrese @MyPlick 18 - 31
Slide 32: Inventory for Item IA       Beginning inventory-- 10 units at $10 each First Purchase 20 units at $11 each Second Purchase 20 units at $12 each Third Purchase 20 units at $15 each Last Purchase 20 units at $18 each Assume you counted 35 units--all identical how should we price these units? How would the 55 units sold be priced? Leonardo Matarrese @MyPlick 18 - 32
Slide 33:   FIFO Cost of Goods Sold = – – – – – 10 @ 10 = 100 20 @ 11 = 220 20 @ 12 = 240 5 @ 15 = 75 Total CGS = 635 Pricing Inventory   LIFO Cost of Goods Sold = – – – – 20 @ 18 = 360 20 @ 15 = 300 15 @ 12 = 180 Total CGS = 840 5 @ 12 = 60 20 @ 11= 220 10 @ 10 = 100 Total Inventory = 380  Inventory = – 15 @ 15 = 225 – 20 @ 18 = 360 – Total Inventory =585  Inventory = – – – – Why does the inventory Matarresematter? value @MyPlick Leonardo 18 - 33
Slide 34: Liabilities Current Liability Debt that must be paid within the year Accounts Payable Current liabilities consisting of bills owed to suppliers, plus wages and taxes due within the upcoming year Long-term Liability Debt that is not due for more than 1 Leonardo Matarrese @MyPlick 18 - 34
Slide 35: Owner’s Equity Paid-In Capital Additional money, above proceeds from stock sale, paid directly to a firm by its owners Retained Earnings Earnings retained by a firm for its use rather than paid as dividends Leonardo Matarrese @MyPlick 18 - 35
Slide 36:  Now see if you can prepare a balance sheet for Ralph’s AutoBody at December 31, 2001. Leonardo Matarrese @MyPlick 18 - 36
Slide 37: Income Statement (Profit-and-loss Statement) Financial statement listing a firm’s annual revenues and expenses so that a bottom line shows annual profit or loss Revenues – Expenses = Profit (or loss) Leonardo Matarrese @MyPlick 18 - 37
Slide 38: Perfect Posters’ Income Statement Leonardo Matarrese @MyPlick 18 - 38
Slide 39: Income Statements Revenues – Funds that flow into a business from the sale of goods or services Cost of Goods Sold – Total cost of obtaining materials for making the products sold by a firm during the year – Gross Profit (or Gross Margin) — Revenues obtained from goods sold minus cost of goods sold Operating Expenses – Costs, other than the cost of goods sold, incurred in producing a good or service – Operating Income — Gross profit minus operating expenses – Net Income (or Net Profit or Net Earnings) — Gross Leonardo Matarrese @MyPlick profit minus operating expenses and income taxes 18 - 39
Slide 40:  See if you can put together the income statement for Simmons Merchandising using the information given. This income statement is for the year ended December 31, 2000. Leonardo Matarrese @MyPlick 18 - 40
Slide 41: Statement of Cash Flows Financial statement describing a firm’s yearly cash receipts and cash payments $$ Cash flows from operations $$ Cash flows from investing $$ Cash flows from financing Leonardo Matarrese @MyPlick 18 - 41
Slide 42: Budget Detailed statement of estimated receipts and expenditures for a period of time in the future Leonardo Matarrese @MyPlick 18 - 42
Slide 43: Perfect Posters’ Sales Budget Leonardo Matarrese @MyPlick 18 - 43
Slide 44: Reporting Standards and Practices Revenue Recognition — formal recording and reporting of revenues in the financial statements Matching — net income is calculated by subtracting expenses from revenues. The matching principle states that expenses will be matched with revenues to determine net income for an accounting period. Leonardo Matarrese @MyPlick 18 - 44
Slide 45: Reporting Standards & Practices Full Disclosure — financial statements should include not just numbers, but also interpretations and explanations by management so that external users can better understand information contained in the statements Management’s Discussion & Analysis (MD&A) — provides an interpretation “as seen through the eyes of management.” Managers’ qualitative interpretations, together with their detailed knowledge of a firm’s activities, give them a valuable perspective on past events and probable future events. Leonardo Matarrese @MyPlick 18 - 45
Slide 46: Analyzing Financial Statements Solvency Ratio Financial ratio, either short- or longterm, for estimating the risk in investing in a firm Profitability Ratio Financial ratio for measuring a firm’s potential earnings Activity Ratio Leonardo Matarrese @MyPlick 18 - 46
Slide 47: Short-Term Solvency Ratios Liquidity Ratio Solvency ratio measuring a firm’s ability to pay its immediate debts Current Ratio Solvency ratio that determines a firm’s credit worthiness by measuring its ability to pay current liabilities Current assets $57,210 = = 2.61 Current liabilities $21,935 Leonardo Matarrese @MyPlick 18 - 47
Slide 48: Short-Term Solvency Ratios Working Capital Difference between a firm’s current assets and current liabilities Quick (or Acid-Test) Ratio Solvency ratio for determining a firm’s ability to meet emergency demands for cash Quick Asset Cash plus assets one step removed from cash (marketable securities and accounts receivable) Quick assets $7,050 + 2,300 + 26,210 − 650 = = 1.59 Current liabilities $21,935 Leonardo Matarrese @MyPlick 18 - 48
Slide 49: Long-Term Solvency Ratios Debt Ratio Solvency ratio measuring a firm’s ability to meet its longterm debts Debt-to-Owners’ Equity Ratio (or Debt-to-Equity Ratio) Solvency ratio describing the extent to which a firm is financed through borrowing Debt A firm’s total liabilities Debt $61,935 = = 0.56 Owners' equity $111,155 Leonardo Matarrese @MyPlick 18 - 49
Slide 50: Long-Term Solvency Ratios Leverage Ability to finance an investment through borrowed funds Leonardo Matarrese @MyPlick 18 - 50
Slide 51: Profitability Ratios Net Profit Margin (or Return on Sales) Profitability ratio indicating the percentage of its income that is a firm’s profit Net income $12,585 = = 0.049 = 4.9% Sales $256,425 Return on Equity Profitability ratio measuring income earned for each dollar invested Net income $12,585 = = 11.3% Total owners' equity $111,155 Leonardo Matarrese @MyPlick 18 - 51
Slide 52: Profitability Ratios Earnings Per Share Profitability ratio measuring the size of the dividend that a firm can pay shareholders Net income $12,585 = = $1.57 per share Number of common shares outstanding 8,000 Leonardo Matarrese @MyPlick 18 - 52
Slide 53: Activity Ratios Inventory Turnover Ratio Activity ratio measuring the average number of times that inventory is sold and restocked during the year Cost of goods sold Cost of goods sold = Average inventory (Beginning inventory + Ending inventory)/2 $104,765 = 4.8 times ($22,380 + $21,250)/2 Leonardo Matarrese @MyPlick 18 - 53
Slide 54: International Accounting Foreign Currency Exchange Rate Value of a nation’s currency as determined by market forces  International Transactions  International Accounting Standards Leonardo Matarrese @MyPlick 18 - 54