ACCOUNTING AND FINANCIAL

CONSIDERATIONS
• PRINCIPLES OF ACCOUNTING
 Accounting has been defined as the art of recording
business transactions in a systematic manner.
 It is the language of business and is used to
communicate financial
 In simplest terms, assets that are the economic
resources of a company are balanced against equities
that are claims against the firm. In equation form,
– Assets = Equities or
– Assets = Liabilities + Owners’ Equity
 This dual aspect has led to the double-entry
bookkeeping system in use today.
Any transaction that takes place causes changes
in the accounting equation.
An increase in assets must be accompanied by
one of the following:
 An increase in liabilities
 An increase in stockholders’ equity
 An increase in assets

A change in one part of the equation due to an economic transaction

must be accompanied by an equal change in another place therefore,
the term double-entry bookkeeping
 FINANCIAL STATEMENTS
A basic knowledge of accounting and financial
statements is necessary for a chemical
professional to be able to analyze a firm’s
operation and to communicate with accountants
financial personnel and
managers.
• Financial reports of a company are important
sources of information used by
• management
• Owners
• Creditors
• investment bankers, and
• financial analysts.
• A financial report contains two important
documents
– the balance sheet and
– the income statement.
• Two other documents that appear in the financial
reports are:
– the accumulated retained earnings and
– the changes in working capital
 Balance Sheet
• The balance sheet represents an accounting view
of the financial status of a company on a particular
date.
• The balance sheet consists of two parts:
– assets are the items that the company owns, and
– liabilities and stockholders’ equity are what the company
owes to creditors and stockholders.
• The balance sheet is not an account but a
statement of claims against company assets on the
date of the reporting period.
• The claims are the creditors and the stockholders.
• Therefore, the total assets must equal the total
liabilities plus the stockholders’ equity
 Assets
• Assets are classified as
• Current
• fixed, or
• intangibles.
• Current assets include:
– cash,
– cash equivalents
– marketable securities
– accounts receivable
– inventories, and
– prepaid expenses.
 Cash and cash equivalents are those items that can be
easily converted to cash.
 Marketable securities are securities that a company holds
that also may be converted to cash.
 Accounts receivable are the amounts due a company
from customers from material that has been delivered but
has not been collected as yet.
 Customers are given 30, 60, or 90 days in which to pay;
however, some customers fail to pay bills on time or may
not be able to pay at all.
• An allowance is made for doubtful accounts.
• The amount is deducted from the accounts
receivables.

• Inventories include the cost of:

– raw materials
– goods in process and
– product on hand.
• Prepaid expenses include
 insurance premiums paid
 charges for leased equipment and
 charges for advertising that are paid prior to the receipt of the
benefit from these items.

• The sum of all the above items is the total

current assets.
• The term current refers to the fact that these
assets are easily converted within a year, or more
likely in a shorter time, say, 90 days.
 Fixed assets
• Fixed assets are items that have a relatively
long life such as
– land, buildings, and
– manufacturing equipment.

• The sum of these items is the total property,

plant, and equipment.
• From this total, accumulated depreciation is
subtracted and the result is net property and
equipment.
 Intangibles
• an item referred to as intangibles includes a
variety of items such as
• patents, licenses, intellectual capital, and goodwill.
• Intangibles are difficult to evaluate since they
have no physical existence; e.g., goodwill is the
value of the company’s name and reputation.
• The sum of the total current assets, net
property, and intangibles is the total assets.
 Liabilities
 are the obligations that the company owes to
creditors and stockholders.
• Current liabilities are obligations that come due within
a year and includes:
– accounts payable (money owed to creditors for goods and
services)
– notes payable (money owed to banks, corporations, or
other lenders)
– accrued expenses (salaries and wages to employees,
interest on borrowed funds fees due to professionals, etc.)
– income taxes payable
– current part of long-term debt, and
– other current liabilities due within the year.
 Long-term liabilities
Long-term liabilities are the amounts due after 1
year from date of the financial report.
Includes deferred income taxes that a company is
permitted to postpone due to accelerated
depreciation to encourage investment, (but they
must be paid sometime in the future) and
bonds and notes that do not have to be paid within
the year but at some later date.
• The sum of the current and long-term liabilities is
the total liabilities.
 Stockholders’ equity
is the interest that all stockholders have in a
company and is a liability with respect to the
company. Includes
 preferred
 common stock as well as additional paid-in capital (the
amount that stockholders paid above the par value of
the stock) and retained earnings.
• These are earnings from accumulated profit that a
company earns and are used for reinvestment in
the company.
• The sum of these items is the stockholders’ equity.
On a balance sheet
 the sum of the total liabilities and
 the stockholders’ equity must equal the total assets,
hence the term balance sheet.

Comparing balance sheets for successive years,

in various items that will indicate how well the
company manages
 its assets and
meets its obligations.
 Income Statement
 An income statement shows
 the revenue and
 the corresponding expenses for the year and
serves as a guide for how the company may do in the
future.
 Often income statements may show how the company
performed for the last two or three years.
Net sales are the primary source of revenue
from goods and services.
 includes the amount reported after
 returned goods
discounts, and
allowances for price reductions are taken into account.
Cost of sales represents all the expenses to
convert raw materials to finished products.
The major components of these expenses are
direct material
direct labor and
overhead.
 If the cost of sales is subtracted from net sales,
the result is the gross margin.
– One of the most important items on the income statement is
depreciation and amortization.
Depreciation is an allowance the federal
government permits for
 the wear and tear
 the obsolescence of plant and equipment and is treated as
an expense.
 Amortization
 The decline in value of intangible assets such as
 Patents
 Franchises and goodwill.

 Selling, general and administrative expenses include

 The marketing salaries
 Advertising expenses
 travel
 executive salaries
 Office and payroll expenses.

 Operating income: When depreciation, amortization, and the

sales and administrative expenses are subtracted from the gross
margin.

 Dividends and interest income received by the company are then

added.
 Next interest expense earned by the stockholders
and income taxes are subtracted, yielding the
term income before extraordinary loss.
• It is the expenses a company may incur for
unusual and infrequent occasions.
• When all the above items are added or
subtracted from the operating income, net
income (or loss)is obtained.
• This latter term is the “bottom line” often
referred to in various reports.
 Accumulated Retained Earnings(ARE)
 It shows how much money has been retained for:
growth and
how much has been paid as dividends to stockholders.
 When the accumulated retained earnings increase,
the company has greater value.
 The calculation of this value of the retained
earnings begins with the previous year’s balance.
add the Net profit after taxes for the year.
Dividends paid to stockholders are then deducted and
the result is the accumulated retained earnings for the
year.
ARE = Net profit - Dividends paid to stockholders
 FINANCIAL RATIOS
Liquidity ratios are a measure of a company’s
ability to pay its short term debts.
Current ratio is obtained by dividing the current
assets by the current liabilities.
– Depending on the economic climate, this ratio is 1.5
to 2.0 for the chemical process industries.
– but some companies operate closer to 1.0.
The quick ratio is cash plus marketable securities
divided by the current liabilities and
– slightly greater than 1.0
Leverage ratios are an indication of the
company’s overall debt burden.
The debt/total assets ratio is determined by
dividing the total debt By total assets expressed
as a percentage.
– The chemical industry average is 35 %.
Debt/equity ratio is another such ratio.
The higher these ratios, the greater the
financial risk since if an economic downturn did
occur, it might be difficult for a company to
meet the creditors’ demands.
 The times interest earned is a measure of the extent to
which profit could decline before a company is unable to
pay interest charges.

 The ratio is calculated by dividing the earnings before

interest and taxes (EBIT) by interest charges.

 The fixed-charge coverage is obtained by dividing the

income available for meeting fixed charges by the fixed
charges
• Activity ratios are a measure of how effectively a
firm manages its assets.
• The two inventory/turnover ratios in common
use today.
1. The inventory/sales ratio is found by dividing the
inventory by the sales.
2. Divide the cost of sales by inventory.
The average collection period measures the
number of days that customers’ invoices remain
unpaid.
 Fixed assets and total assets turnover indicate
how well the fixed and total assets of the firm are
being used.
• Profitability ratios are used to determine how
well income is being managed.
• The gross profit margin is found by dividing the
gross profits by the net sales, expressed as a
percentage.
• The net operating margin is equal to the
earnings before interest and taxes divided by
net sales.
• Another measure, the profit margin on sales, is
calculated by dividing the net profit after taxes
by net sales.
• The return on total assets ratio is the net profit
after taxes divided by the total assets expressed
as a percentage.
• The return on equity ratio is the net income after
taxes and interest divided by stockholders’ equity
 BASIC RELATIONSHIPS IN
ACCOUNTING
• an asset may be defined as anything of value, such as
• cash, land, equipment, raw materials, finished products, or any type
of property.
• At any given instant, a business concern has a certain monetary
value because of
• its assets. At the same instant, many different persons may have a
just claim, or
• equity, to ownership of the concern’s assets. Certainly, any creditors
would have
• a just claim to partial ownership, and the owners of the business
would have
• some claim to ownership. Under these conditions, a fundamental
relationship in
• accounting can be written as
• Assets = equities
• Equities can be divided into two general classes
as follows: (1) Proprietorship- the claims of the
concern or person who owns the asset; and (2)
liabilities -the claims of anyone other than the
owner. The term proprietorship is often
• referred to as net worth or simply as ownership or
capital. Thus, Eq. (1) can be
• written as?
• Assets = liabilities + proprietorship (2)
• The meaning of this basic equation can be illustrated by the following
• simple example. Five students have gone together and purchased a secondhand
• automobile worth $1000. Because they did not have the necessary $1000 they
• borrowed $400 from one of their parents. Therefore, as far as the students are
• concerned, the value of their asset is $1000, their proprietorship is $600, and
• their liability is $400.
• Equation (2) is the basis for balancing assets against equities at any given
• instant. A similar equation can be presented for balancing costs and profits over
• any given time period. The total income must be equal to the sum of all costs
• and profits, or
• Total income = costs + profits (3)
• THEBALANCESHEET
• A balance sheet for an industrial concern is based on Eq. (1) or (2) and shows
• the financial condition at any given date. The amount of detail included varies
• depending on the purpose. Consolidated balance sheets based on the last day of
• the fiscal year are included in the annual report of a corporation. These reports
• are intended for distribution to stockholders, and the balance sheets present the
• pertinent information without listing each individual asset and equity in detail.
• Assets are commonly divided into the classifications of current, fixed, and
• miscellaneous. Current assets, in principle, represent capital which can readily be
• converted into cash. Examples would be accounts receivable, inventories, cash,
• and marketable securities. These are liquid assets. On the other hand, jhd
• ussets, such as land, buildings, and equipment, cannot be converted into
immediate
• cash. Deferred charges, other investments, notes and accounts due after
• 1 year, and similar items are ordinarily listed as miscellaneous assets under
• separate headings.
• Modern balance sheets often use the general term liabilities in place of
• equities. Current liabilities are grouped together and include all liabilities
such as
• accounts payable, debts, and tax accruals due within 12 months of the
balancesheet
• date. The net working capital of a company can be obtained directly from
• the balance sheet as the difference between current assets and current
liabilities.
• Other liabilities, such as long-term debts, deferred credits, and reserves
are
• listed under separate headings. Proprietorship, stockholders’ equity, or
capital
• stock and surplus complete the record on the equity (or liability) side of
the
• balance sheet.
• Consolidated balance sheets are ordinarily presented with assets listed on
• the left and liabilities, including proprietorship, listed on the right. As indicated
• in Eq. (11, the total value of the assets must equal the total value of the equities.
• A typical balance sheet of this type is presented in Fig. 5-2.
• The value of property items, such as land, buildings, and equipment, is
• usualIy reported as the value of the asset at the time of purchase. Depreciation
• reserves are also indicated, and the difference between the original property
• cost and the depreciation reserve represents the book value of the property.
• Thus, in depreciation accounting, separate records showing accumulation in the
• depreciation reserve must be maintained. In the customary account, reserve for
• depreciation is not actually a separate fund but is merely a bookkeeping method
• for recording the decline in property value.
• The ratio of total current assets to total current
liabilities is called the
• current ratio. The ratio of immediately available
cash (i.e., cash plus U.S.
• Government and other marketable securities) to
total current liabilities is
• known as the cash ratio. The current and cash
ratios are valuable for determining
• the ability to meet the financial obligations, and
these ratios are examined
THE INCOME STATEMENT