FINANCIAL and MANAGERIAL

ACCOUNTING

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 Financial and Managerial Accounting

TABLE OF CONTENTS
FINANCIAL ACCOUNTING
CHAPTER ONE INFORMATION FOR DECISION MAKING
CHAPTER TWO BASIC FINANCIAL STATEMENTS
CHAPTER THREE THE ACCOUNTING CYCLE
CHAPTER FOUR FINANCIAL ASSETS
CHAPTER FIVE FINANCIAL STATEMENT ANALYSIS
MANAGEMENT ACCOUNTING,
CHAPTER SIX MANAGEMENT ACCOUNTING BASIC
FRAMEWORK
CHAPTER SEVEN COST – VOLUME – PROFIT /CVP/
ANALYSIS
CHAPTER EIGHT INCREMENTAL ANALYSIS
 Part I Financial Accounting

CHAPTER ONE INFORMATION FOR

DECISION MAKING
CHAPTER TWO BASIC FINANCIAL
STATEMENTS
CHAPTER THREE THE ACCOUNTING CYCLE
CHAPTER FOUR FINANCIAL ASSETS
CHAPTER FIVE FINANCIAL STATEMENT
ANALYSIS
CHAPTER – 1 CHAPTER ONE INFORMATION FOR DECISION MAKING

INTRODUCTION TO FINANCIAL ACCOUNTING

Contents
What is Accounting
Objectives of Accounting
Types of Accounting Information
Accounting Systems
Basic Functions of Accounting
Conceptual Framework for Financial Reporting
Basic Concepts of Financial Accounting and
Reporting
 Accounting is the language of
business!

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 What is Accounting?
• Is a composite activity of:
 identifying,
 recording, and
 communicating

the economic events of an organization to

interested users.

• Accounting is often called the “language of

business”

Accounting is the art of analyzing,

recording, summarizing, evaluating and reporting,
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if necessary, interpreting information about
 What is Accounting?

Three Activities

The accounting process includes

the bookkeeping function.

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Financial Accounting and Management
7
Accounting
• Accounting can be defined as an
information system that provides
reports to users about the economic
activities and condition of a business.

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 The accounting
process

Accounting “links”
decision makers with
economic activities Accounting
Economic
and with the results
activities information
of their decisions.

Actions
(decisions)
Decision makers
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 Information
Information System
System

Cost
Cost&&Revenue
Revenue
Determination
Determination
Information
Information  Job
Jobcosting
costing Decision
DecisionSupport
Support
Users  Process  CVP
CVPanalysis
Users Processcosting
costing analysis
 Investors
Investors  ABC  Performance
Performance
ABC
 Creditors
Creditors  Sales evaluation
evaluation
Sales
 Managers
Managers Assets  Incremental
Incremental
 Owners Assets&&Liabilities
Liabilities
Owners  Plant analysis
analysis
 Customers Plantand
and  Budgeting
Customers equipment Budgeting
 Employees equipment  Capital
Employees  Loans Capital
 Regulatory Loans&&equity
equity allocation
Regulatory  Receivables, allocation
agencies Receivables,  Earnings
agencies payables Earningsper
per
payables&&cash
cash share
Cash share
CashFlows
Flows  Ratio
Ratioanalysis
analysis
 From
Fromoperations
operations
 From
Fromfinancing
financing
 From
Frominvesting
investing
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 Who Uses Accounting Data
Internal Users
Management Revenue
Offices
Human Resources Investors

There are two broad groups of users of

financial information: internal users Labor Unions
and external users.
Finance

Creditors
Marketing
Securities
Customers controlling bodies
External Users

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 Who Uses Accounting Data
Common Questions Asked User

1. Can we afford to give our

employees a pay raise?
Human Resources

2. Did the company earn a

satisfactory income?
Investors

3. Should any product lines be

eliminated?
Management
4. Is cash sufficient to pay dividends to
stockholders?
Finance

5. What price for our product will

maximize net income?
Marketing

6. Will the company be able to pay its

debts as they become due?
Creditors
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 Its purpose is to communicate or report the results
of business operations and its various aspects.
 It is the process of identifying, measuring and
communicating economic information to permit
informed judgments and decisions by users of the
information.
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 AICPA has defined accounting as“ is the art of recording, classifying
and summarizing in a significant manner and in terms of money
transactions and events which are, in part at least, of a financial
character and interpreting the results thereof.”
 AAA has defined accounting as “the process of identifying,
measuring and communicating economic information to permit
informed judgments and decisions by users of the information.”

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 Objectives of Accounting

1. To record the business transactions in a systematic manner.

2. To determine the gross profit and net profit earned by a
firm during a specific period.
3. To know the financial position of a firm at the close of the
financial year by way of preparing the balance sheet.
4. To facilitate management control.
5. To assess the taxable income and the sales tax liability.
6. To provide requisite information to different parties, i.e.,
owners, creditors, employees, management, government,
investors, financial institutions, banks etc.
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 Accounting Information(AI): A Means to an End

 Accounting was developed as a system for reporting

information to the owners including shareholders & other
investors of the business
 Accounting information is not an end , but is a means to an
end i.e. its final product is decision which is ultimately
enhanced by the use of accounting information, whether
that decision made by owners, management, creditors,
government bodies, labor unions ,etc.

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 Accounting from a User’s Perspective
 Many people think of accounting as simply a highly
technical field practiced only by professional accountants.
 In reality, nearly every one uses accounting information
daily to measure & communicate economic events.
 Whether you manage a business , make investments ,or
monitor how you receive & use your money, you are
working with accounting concepts & accounting
information.
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 Types of Accounting Information
 Financial, Managerial & Tax Accounting, are the 3 types of Accounting
Information used widely in the business community

1.Financial Accounting: financial accounting information appears in financial

statements that are intended for external use.
 Describes the financial resources, obligations,& activities of an economic
entity.
 It is designed to primarily to assist investors & creditors in deciding where to
place their scarce investment resources.
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2. Management Accounting: management accounting
information is for internal use & provides special
information for managers.
 Information managers use may range from broad, long-
range planning data to detailed explanations of why
actual costs varied from cost estimates.
 Management accounting generates information that
managers can use to make sound decisions such as
financial, resource allocation, production & marketing
decisions.
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3.Tax Accounting- preparation of income tax returns
is a specialized field in accounting.
 Tax returns are based on financial accounting
information.
 However, the information is adjusted/ reorganized
to conform with income tax reporting requirements.
 Income tax planning is the most challenging task of
tax accounting.

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 Accounting Systems (AS)

 Accounting system consists of the personnel, procedures,

devices & records used by an organization:
 to develop accounting information &
 to communicate this information to decision makers.
 The design & capabilities of these systems vary greatly
from very small business to large business organizations.
 But, the basic purpose of accounting system remains the
same to meet the organization’s needs for accounting
information as efficient as possible.
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Factors affect the structure of accounting system in an
organization are:
the co.’s need for accounting information, &
the resources available for the operation of the system.

Determining the Information Needs

Information needs of an organization are affected by:
size of the organization,
ownership,(public or private), &
the philosophy of management.
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 The Cost of Producing Accounting Information
Accounting system should be cost effective i.e. the
value of the information produced should exceed
the cost of producing it.
Development and installation of computer based
accounting system have increased greatly the types
and amount of accounting information that can be
produced in a cost effective way.

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 Basic Functions of Accounting

 Recording: Accounting records business transactions in terms of money. It is

essentially concerned with ensuring that all business transactions of financial

nature are properly recorded. Recording is done in journal, which is further
subdivided into subsidiary books from the point of view of convenience.
 Classifying: Accounting also facilitates classification of all business

transactions recorded in journal. Items of similar nature are classified under

appropriate heads. The work of classification is done in a book called the
ledger.

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 Summarizing: Accounting summarizes the classified information. It is
done in a manner, which is useful to the internal and external users.
Internal users interested in this information are the persons who manage
the business. External users of information are the investors, creditors,
tax authorities, labor unions, trade associations, shareholders, etc.
 Interpreting: It implies analyzing and interpreting the financial data
embodied in final accounts. Interpretation of the data helps the
management, outsiders and shareholders in decision making.

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 Financial Accounting Information

 Financial accounting information provides information about the financial

resources, obligations, & activities of an enterprise that is intended for use
primarily by external decision makers i.e. investors and creditors.
 External Users of Accounting Information
 Investors
 Creditors
 Customers
 Government Agencies
 Labor Unions
 Suppliers
 Trade Associations
 General Public
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 Objectives of Financial Reporting

 To provide information useful in making investment & credit

decisions.( General)
 To provide information useful in assessing amount, timing, &
uncertainty of future cash flows. ( Specific)
 To provide information about economic resources, claims to
resources & changes in resources & claims.( Specific)
=met in large part by a set of financial statements
( balance sheet, income statement & statements of cash flow).

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 Characteristics of Externally Reported Information

• Financial Reporting-A Means- it is a means to an end-ultimate

outcome is to improve the quality of decision making by external parties.
• Financial Reporting vs. Financial Statements
 Financial reporting is broader than financial statements

 Financial reporting includes press release, articles in a journal,

communication via internet
 Financial statements includes balance sheet, income statement and
statements of cash flow
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• Historical in nature: looks back in time & reports the results
of events & transactions that already happened.
• Inexact & approximate measure: have a great look of
precision but in fact much of it is based on estimates, judgment
& assumptions that must be made about both the past &
future.
e.g. allocation of depreciation expenses
• General purpose assumptions: for multiple users ( “ one size
fits all).
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 Management Accounting Information

 Management accounting is the design & use of accounting information system to

achieve the orgn’s objectives by supporting decision makers inside the enterprise.
 Internal Users of Accounting Information
 BODs, CEO, CFO
 Business unit managers
 Plant mangers
 Store managers
 Line supervisors
 Other employees and any level of management

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 Objectives of Management Accounting

 To provide information useful to help the enterprise achieve its goals,

objectives & mission.( General)
 To provide information useful in assessing both the past performance
& future directions of the enterprise & information from internal &
external sources. ( Specific)
 To provide information about decision making authority, for decision
making support, & for evaluating & rewarding decision making
performance. ( Specific)
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Characteristics of Management Accounting Information

 Importance of timeliness- should occur at good time without

delay.
 Identity of decision makers-for those who have decision making
authority.
 Oriented towards the future-to motivate management to make
future decisions that are in the best interest of the enterprise,
consistent with its goals, objectives & missions.
 Measures of efficiency and effectiveness of resource utilization.
 Management accounting information a means-not an end in and
of it self.

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 Financial Accounting Vs Management
Accounting
Financial Accounting Managerial Accounting

 It describes the performance It is used to help management

of the business over a record, plan and control the
specific period. This specific activities of a business and to
period referred to as assist in the decision making
“accounting period”. It has process. It can be prepared for
one year long. any period (for daily, quarterly or
annually).

It is required by law to prepare There is no legal requirement

and publish financial statements. to prepare management reports.

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The format of published There is no pre-determined
financial statement is format for managerial
determined by several accounting. It can be as
different regulatory bodies: detailed or brief as
Company Law, Accounting management wish.
standards, Stock exchange etc.
Financial accounting Management Accounting
concentrate on the business as can focus on specific areas of a
a whole rather than analyzing business activities.
the component parts of the
business. For example, it can provide
For example, sales are insight into performance of
aggregated to provide a figure products, departments,
for total sales rather than markets etc.
published product wise.

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 Financial accounting Managerial accounting
includes information that usually include a wide variety
can only be expressed in of financial and non-financial
monetary terms. information.
Example, number and
productivity of employees,
sales volumes (units sold) etc.

Its focus is on reporting Its focus is on reporting to

to external users of internal users (Management).
accounting information.

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It provides financial It is not guided by
statements based on Generally Accepted
Generally Accepted Accounting Principles
Accounting Principle (GAAP).
(GAAP).

Financial accounting Managerial accounting

presents a historic perspective emphasis on the future, e.g.,
on the financial performance sales budget and on
of the business. influencing the behavior of
managers.

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 Conceptual Framework for Financial Reporting

Conceptual Framework sets out the concepts that

underlie IFRS financial statements.
Purpose of the Conceptual Framework
1. To assist IASB in setting and revising standards
2. To assist preparers to make the judgements that are
necessary to apply IFRSs
3. To assist auditors and regulators assess judgments of
preparers
4. To assist users to consider those judgments when using
IFRS financial information to inform their decisions
5. To assist in understanding of standard-setting by IFRS
6. To reduce conflicts between Framework and Standards
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• Conceptual Framework comprises of:
1. the objective of general purpose
financial reporting
2. qualitative characteristics
3. elements of financial statements
4. recognition
5. measurement
6. presentation and disclosure
7. Other concepts all flow from the
objective.
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 1. Objective of General Purpose
Financial Reporting

“Provide financial information about the

reporting entity that is useful to existing and
potential investors, lenders and other
creditors in making decisions about
providing resources to the entity”

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 • To provide information about
 Economic resources and claims (SFP)
 Changes in economic resources and claims
(SPLOCI)
 Financial performance reflected by past cash
flows (SCF)
 Changes in economic resources and claims
not resulting from financial performance
(SCE)

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 2. Qualitative Characteristics of Useful Financial
Information

• Fundamental
Relevance
Faithful representation
• Enhancing
Comparability
Verifiability
Timeliness
Understandability

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• Relevance: Capable of making a difference
in users’ decisions
predictive value
confirmatory value
materiality (entity-specific)
• Faithful representation: Faithfully
represents the phenomena it purports to
represent
completeness (depiction including
numbers and words)
neutrality (unbiased)
free from error (ideally)
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• Comparability: like things look alike;
different things look different
• Verifiability: knowledgeable and
independent observers could reach
consensus, but not necessarily complete
agreement, that a depiction is a faithful
representation
• Timeliness: having information available to
decision-makers in time to be capable of
influencing their decisions
• Understandability: Classify, characterize,
and present information clearly and
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concisely
 3. Elements of financial statements
Asset Income
• resource controlled by • recognised increase in
the entity asset/decrease in liability
in current reporting period
• result of past event
• that result in increased
• expected inflow of equity except
economic benefits contributions from owners
Liability Expense
• recognised decrease in
• present obligation
asset/increase in liability
• arising from past event in current reporting period
• expected outflow of • that result in decreased
economic benefits equity except distributions
to owners
Equity = assets less
liabilities

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 4. Recognition
• Accrual basis of accounting used
• Recognise element when:
– The element satisfies definition
– probable that benefits will flow to/from
the entity
– has cost or value that can be measured
reliably

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– What does probable mean?
It means “more likely than not”
The meaning of probable is determined
at the standards level. Therefore,
inconsistent use across IFRSs (usually
more than 50%)

– What does measure reliably mean?

 To a large extent, financial reports are
based on estimates, judgements and
models rather than exact depictions.
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 5. Measurement

• Measurement is the process of

determining monetary amounts at which
elements are recognised and carried.
• To a large extent, financial reports are
based on estimates, judgements and
models rather than exact depictions.

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 Measurement methods include

1. Historical cost: cash paid or fair value

of consideration given
2. Current cost: Cash that would be paid if
acquired now
3. Realisable (settlement) value: cash that
could be obtained by selling the asset
now
4. Present value: present discounted value
of future net cash inflows that the item is
expected to generate

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 6. Constraints
– Cost vs. benefit: cost of information is
justified by the benefits of reporting that
information.
 Benefits include more efficient
functioning of capital markets and a
lower cost of capital for the economy.
 Costs include collecting, processing,
verifying and disseminating financial
information and the costs of analysing
and interpreting the information
provided.
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7. Underlying assumptions of financial
reporting:
Going concern, and
Accruals accounting

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 Financial Statements

• A statement of financial position as at the

end of the period
• A statement of profit or loss and other
comprehensive income for the period
• A statement of changes in equity for the
period
• A statement of cash flows for the period
• Notes, comprising
– A summary of significant accounting
policies
– Other explanatory information
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 Basic Concepts of Financial
Accounting and Reporting
 Generally Accepted Accounting
Principles(GAAP)
 The Accounting Equation

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 GAAP
• Generally Accepted Accounting
Principles
– Rules that govern accounting
– Based on a conceptual framework
• Goal:
– To provide useful information to those
making investment and lending
decisions

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1. GAAP…

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1.1 Assumptions
Economic entity
• A business is separate from its owners

Going concern
• A company continues in business indefinitely.

Monetary Unit
• Money is the common denominator of economic
activity

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1.1 Assumptions…

Periodicity
• A company can divide its economic
activities into artificial time periods.

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1.2 Principles
Measurement Principle
• Historical cost-requires that companies account for and
report many assets and liabilities on the basis of acquisition
price.
• Fair Value- the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction
between market participants at the measurement date

Revenue Recognition Principle

• Revenue is recognized when realized and when earned.

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1.2 Principles…
Expense Recognition Principle
• Expenses are recognized when they are incurred-when
assets are consumed in the process of generating revenue.
• Period costs Vs Product costs.

Full Disclosure Principle

• Requires that firms supply information that is of sufficient
importance to influence the judgment and decisions of an
informed user.
• Information is disclosed through (1) main body of financial
statements (2) notes to FS ,and (3)
Supplementary information.
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Matching Principle
• Deducting expenses from revenues arrives at accounting
profit.
• However, accountants carry forward expenses until they
can be identified with the revenue of particular accounting
year and carry forward receipts until they can be regarded
as revenue of the particular year.
• Thus, this principle is very important for correct
determination of profit, which is also a measure of
performance.
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• All expenses that generate revenue in the current
accounting period are recognized as expenses of the
current period.
• Cost of goods sold and operating expenses incurred
during the current period are recognized as expenses of
the current period and will be matched with the revenue
of the current period. Incomes received in advance or
relating to earlier periods must not be taken into account.
• Similarly, expenses paid in advance are also to be
ignored while computing the income of current
accounting period.
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 The Materiality Principle
• According to this principle, financial statements
should disclose all material items, i.e., items the
knowledge of which might influence the decisions of
the user of the financial statements.

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• Materiality can be defined as ‘the characteristic
attaching to a statement, fact or item whereby its
disclosure or the method of giving it expression
would be likely to influence the judgment of a
reasonable person”.
• Thus when the event is material, it should be
disclosed.
• But if the item or event is immaterial, it may not be
disclosed.
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• It is on the basis of materiality concept that items of
stationery are considered to have been used up
either at the time of purchase or at the time of their
issue from stores.
The Consistency Principle
• States that, a firm should follow same accounting
methods & procedures from year to year.
• However, it is permitted to change them if it has a
sound reason to do so.
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• But the effect of such a change must be disclosed
in the financial statements of the year in which
change took place to enable the users to be aware
of the lack of consistency.
The Conservatism (Prudence) Principle
• The traditional approach of playing safe or being
cautious in recognizing all the possible losses but
ignoring all probable profits.

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• This is also known as prudence concept implying
the common & accepted behavior of accounting or
providing for future losses.
• Though this approach leads to creation of secret
reserves & understatement of income; it also of
safeguards the interest of outsiders by preventing
the management from recognizing unrealized
profits & providing for all future losses.

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Duality Principle
• Every transaction entered into by a firm has two
aspects, viz., debit & credit.
• Debit represents creation of or addition to an asset or
an expense or the reduction or elimination of a liability.
• Credit means reduction or elimination of an asset or an
expense or the creation of or addition of a liability.
• Therefore, according to dual aspect concept, at any
time, the total assets of a business are equal to its total
liabilities.
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• The system of accounting, which records both the
aspects of a transaction ever, is based on Double
Entry System .

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1.3 Constraints

Cost
• Firms should weigh the costs of
providing information against the
benefits that can be derived from using
it.

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2. The Accounting Equation

Assets = Liabilities + Stockholders’ equity

Economic Claims to
Resources Economic
Resources

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2.1 Assets
• Economic resources that have a
future benefit
• Examples:
– Cash
– Accounts receivable
– Merchandise inventory
– Furniture
– Land

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2.2 Claims to Assets
• Liabilities • Owners’ equity
– Debts payable to – Owners’ claims to
outsiders the assets of the
– Examples: business
• Accounts payable – In a corporation,
• Bank loans stockholders’ equity

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The Accounting Equation

Assets = Liabilities + Stockholders’ equity

Paid-in Retained
capital earnings

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 The Accounting Equation
Stockholders’ equity

Paid-in capital Retained earnings

Common stock + Net income

- Dividends
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 The Accounting Equation

Retained earnings Revenues

+ Net income
- Expenses
- Dividends

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 The End
Of 1

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 CHAPTER - 2

BASIC FINANCIAL
STATEMENTS
•Forms of business
organizations
•Basic financial
statements
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 Forms of Business Organizations

 Accountants frequently refer to a business

organization as an accounting entity or a business
entity.
 For accounting purpose, each business
organization or entity has an existence separate
from its owner(s), creditors, employees, customers
& other business
 This separate existence of business organization is
called business entity concept.

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 Thus , in the accounting records of the business entity, the
activities of each business should be kept separate from
the activities of other businesses & from the personal &
financial activities of the owner(s).

 In modern business world, most business enterprises are

organized as:
1. Sole proprietorships,
2. Partnerships,&
3. Corporations
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1. Sole proprietorship
 Is unincorporated business owned by an individual & often managed
by that same person.
 No legal formalities are necessary to organize such businesses, &
usually business operations can begin with only a limited investment.
 From an accounting view point, a sole proprietorship is a business
entity separate from the other affairs of its owner.
 From the legal point of view, however, the business& its owner are
not regarded as separate entities.
 Thus, the owner is personally liable for the debts of the business.

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2. Partnership
 Is an unincorporated business owned by two or more persons
associated as partners.
 As in case of the sole proprietorship, the owners of a
partnership are personally responsible for all debts of the
business.
 From an accounting stand point, a partnership is viewed as a
business entity separate from the personal affairs of its owners.
 A benefit of partnership form over sole proprietorship form is the
ability to bring together large amount of capital investment
from multiple owners.
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3. Corporation
 A corporation is a business incorporated under the law of a
state and owned by a few stockholders or thousands of
stockholders.
 It is unique in that it is a separate legal business entity.
 The owners of the corporation are stockholders or
shareholders.
 The corporate form of business protects the personal
assets of the owners from the creditors of the corporation.

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 Introduction to Financial Statements

 Business entities may have many objectives & goals.

 The two primary objectives of every business are profitability and

solvency.

 Profitability is the ability to generate income.

 Solvency is the ability to pay debts as they become due.

 Unless a business can produce satisfactory income & pay its debts
as they become due , the business can’t survive to realize its other
objectives.
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 The financial statement that reflects a co.’s profitability is the
income statement.

 The statement of retained earnings shows the change in

retained earnings between the beginning and end of a period.

 The balance sheet reflects the company’s solvency.

 The statement of cash flows shows the cash inflows and

outflows for a co. over a period of time
12/18/2024 86
 A Starting Point: Statement of Financial Position (Balance Sheet)

• Is a list of balances in the assets, liability & owners’ ( stockholders’) equity

accounts.

• This “list depicts the position of assets , liabilities,& owners’

( stockholders’) equity of a specific business at a specific point of time.”

• It is prepared on a specified date because the figure shown in the

balance sheet is true on that date only.

• The totals of the assets should be equal to the totals of liabilities &
owners’ ( stockholders’) equity. If it is not so, it means that there is
some error.

12/18/2024 87
 Objective of Balance Sheet

 Principal Objective: The main purpose of preparing balance sheet

is to know the financial position of the business at a particular date.

 Subsidiary Objectives: Though the main aim is to know the exact

financial position of the firm at a particular date, yet it serves other
purpose as well such as:
1. It gives information about the actual and real
owner’s( stockholders’) equity.
2. It helps the firm to make provisions against possible future
losses. A provision is made in the form of the Reserves.

12/18/2024 88
 Characteristics of Balance Sheet:
 It is a statement and not an account.
 It is always prepared on a particular date, & thus shows the
position at that date & not for a period.
 It has no debit side & credit side.
 It shows the financial position of the business concern.
 It shows what the firm owes to others & also what others owe
to the firm
 The totals of assets always are equal with the totals of
liabilities & owners’(SH) equity.
12/18/2024 89
 Uses of balance Sheet
 The balance sheet is described as a snapshot/photograph/picture of the financial position of a
business entity.

 The various groups interested in the company can draw useful inferences from an analysis of
the information contained in the balance sheet.

 It proves that the accounting equation (Assets = Liabilities + Owner's Equity) is in

balance.

 It shows the nature & value of the assets.

 It shows what the firm owes to others and also what others owe to the firm.

12/18/2024 90
 Elements of the Balance Sheet
1. Assets: An asset is something of value the company owns such
as cash, marketable securities, accounts receivable, inventory,
prepaid expenses, property, plant, equipment, long-term
investments, patents, copyrights, trademarks, & franchise licenses.
2. Liabilities: Liabilities are the company's existing debts owed to
third parties.
 Examples include amounts owed to suppliers for goods or services
received (accounts payable), to employees for work performed
(wages payable), and to banks for principal & interest on loans
(notes payable & interest payable).

12/18/2024 91
3. Owner's equity (OE): represents the amount owed to the owner or
owners by the company.

 In a corporation, ownership is represented by shares of stock, so the

owner’s equity is called stockholders' equity or shareholders' equity
(SHE).

 Because creditors’ claim have legal priority over those of owners,

OE/SHE is a residual amount.

 Therefore, OE/SHE is always equal to total assets minus total liabilities.

12/18/2024 92
 The Accounting Equation
Assets = Liabilities+ Owners’ Equity/SHE
 Assets: things of value owned by the business or the economic resources of the
business.
 Liabilities: are debts owed by the business.
 Equities: are claims to, or interests in assets.
Assets –Liabilities= Owners Equity/SHE
Owners’ Equity/SHE= Net Assets
 Example
A = L + OE/ SHE
a) $300,000 = 150,000 + 150,000
b) ? = 562,500 + 375,000
c) 307,500 = ? + 142,500
12/18/2024 93
 Effects of Business Transactions(BT) on Accounting Equation

 Business transactions/economic events are any events that directly

affects the financial position of an organization.

 BT can be classified as external & internal

 External business transaction involve an exchange between the co. &

other external separate business entity.

 Internal transaction directly affect the financial position of a co. but don’t
involve an exchange transaction with an other entity.
12/18/2024 94
 These events must be recorded to
properly reflect a co.’s financial
position & results of operations.

 Each transaction affecting the

accounting equation will have a dual
effect because resources always
must equal claims to those
resources.
12/18/2024 95
12/18/2024 96
 Example
1.Mr. X invested $50,000 to open a law office.
A = L + OE
+50,000 (cash) - + 50,000 (investment)
2. $40,000 was borrowed from a bank & a note payable was signed.
A = L + OE
+40,000(cash) +40,000 (Notes Payable) -
3. Supplies Costing $3,000 were purchased on account.
A = L + OE
+3,000( supplies) +3,000(Accounts Payable) -
4.Services were performed on account $10,000.
A = L + OE
+10,000 (A/R) - +10,000 (Revenue)
5.Salaries of $ 5,000 were paid to employees.
A = L + OE
-5,000 (Cash) - - 5,000( salary exp.)
6. $ 500 of supplies were used:
A = L + OE
- 500 (supplies) - -500 (supplies exp.)
7. $ 1,000 was paid on account to supplies vendor.
A = L + OE
12/18/2024 97
-1000(cash) -1,000 (A/p) -
 X Co.
Balance Sheet
On December 31,2009
Assets Liabilities & Owner’s Equity
Cash 84,000 Liabilities:
Supplies 2,500 A/P 2,000
A/R 10,000 N/P 40,000
Total L. 42,000
Owner’s E quity :
X Capital 54,500
Total Assets 96,500 Total L & OE $ 96,500
12/18/2024 98
 The Greener Landscape Group
Balance Sheet
December 31,2010
ASSETS
Current Assets
Cash $ 6,355
Accounts Receivable 200
Supplies 25
Prepaid Insurance 1,100
Total Current Assets 7,680
Property, Plant, and Equipment
Equipment $18,000
Less: Accumulated Depreciation (235) 17,765
Total Assets $25,445
12/18/2024 99
LIABILITIES AND OWNER'S EQUITY
Current Liabilities
Accounts Payable $ 50
Wages Payable 80
Interest Payable 79
Unearned Revenue 225
Total Current Liabilities 434
Long-Term Liabilities
Notes Payable 10,000
Total Liabilities 10,434
Owner's Equity
J. Green, Capital 15,011
Total Liabilities & Owner's Equity $25,445
12/18/2024 100
 Income Statement
 It lists revenues & expenses & calculates the company's net
income or net loss for a period of time.
 Net income means total revenues are greater than total
expenses.
 Net loss means total expenses are greater than total
revenues.
Greener Landscape Group
Income Statement
For the Year Ended on Dec.31,2009
Revenues:
Lawn Cutting Revenue $845
Expenses:
Wages Expense $280
Depreciation Expense 235
Insurance Expense 100
Interest Expense 79
Advertising Expense 35
Gas Expense 30
Supplies Expense 25
Total Expenses
12/18/2024
(784) 101
Net Income $ 61
 Greener Landscape Group
Income Statement
For the Year Ended on Dec.31,2009
Revenues:
Lawn Cutting Revenue $845
Expenses:
Wages Expense $280
Depreciation Expense 235
Insurance Expense 100
Interest Expense 79
Advertising Expense 35
Gas Expense 30
Supplies Expense 25
Total Expenses (784)
Net Income $ 61

12/18/2024 102
 Statement of Owner's
Equity
 The statement of owner's equity is prepared after the
income statement.
 It shows the beginning & ending owner's equity balances
& the items affecting owner's equity during the period.
 These items include investments, the net income or loss
from the income statement, & withdrawals/drawings.
 Because the specific revenue & expense categories that
determine net income or loss appear on the income
statement, the statement of owner's equity shows only
the total net income or loss.

12/18/2024 103
 Greener Landscape Group
Statement of Owner’s Equity
For the Year Ended on Dec.31,2009
J. Green, Capital, Jan.1 $ 0
Additional Investments 15,000
Net Income 61
Increase in OE 15,061
Withdrawals (50)
J. Green, Capital, Dece.31,2009 $ 15,011

12/18/2024 104
 Statement of Retained Earnings

 It explains the changes in retained earnings between

two balance sheets.

 These changes usually consists of the addition of NI

( or deduction of NL) & the deduction of dividends.

 Dividends are the means by which a corporation

rewards its shareholders (owners) for providing it with
the investment funds.

 A dividend is a distribution of income to owners

rather than an expense of doing business.

12/18/2024 105
 XYZ Corporation
Statement of Retained Earnings Format
For the Year Ended on December 31,2009
RE, Jan.1, 2009 $ xx
Add/Less: NI/NL of the year xx
Less: Dividend (xx)
Increase /decrease in RE xx
RE , Dec.31,2009 $ xxx

12/18/2024 106
 Statement of Cash Flows

 The statement of cash flows tracks the

movement of cash during a specific accounting
period.

 It assigns all cash exchanges to one of three

categories operating, investing, or financing to
calculate the net change in cash and then
reconciles the accounting period's beginning &
ending cash balances.

 As its name implies, the statement of cash flows

includes items that affect cash.
12/18/2024 107
 Statement of cash flows has 3 sections
1. Cash flows from the operating activities are the
cash effects revenues & expense transactions
that are included in the income statements.

2. Cash flows from the investing activities are the

cash effects of purchasing & selling assets.

3. Cash flows from financing activities are the cash

effects of
– Owners investing in the company,
– Owners withdrawal from the company &
– Creditors loaning money to the co. &
–
12/18/2024 Repayment of either or both. 108
 Greener Landscape Group
Statement of Cash Flows
For the Year Ended on Dec.31,2009
Cash Flows from Operating Activities:
Cash from Customers $ 870
Cash to Employees (200)
Cash to Suppliers (1,265)
Cash Flow Used by Operating Activities (595)
Cash Flows from Investing Activities:
Purchases of Equipment (8,000)
Cash Flows from Financing Activities:
Investment by Owner 15,000
Withdrawal by Owner (50)
Cash Flow Provided by Financing Activities 14,950
Net Increase in Cash 6,355
Beginning Cash, Jan.1 0
Ending Cash, Dece.31,2009 $6,355

12/18/2024 109
 Presentations of Owner’s Equity in Balance Sheet
 Sole proprietorship
 Owner’s Equity:
Mr. X, Capital…………………………….. xx
 Partnership
 Partners’ Capital:
Partner A, Capital…………………….xx
Partner B, Capital……………………..xx
Total partners’ equity xxx
 Corporation
 Stockholders’ Equity:
Capital Stock……………………………………xx
Retained Earnings…………………………….xx
Total Stockholders’ Equity xxx
12/18/2024 110
Relationships among Financial Statements
____________________TIME_________________
B/Sheet Income St’t B/S
St’t of CF

 At the beginning & ending point in time, a co. prepare

a st’t of financial position (B/S) that gives a static look
in financial terms of where the co. stands.

 The other 2 FSs of IS & SCF cover the intervening

period of time b/n the two B/Ss & explain the
important changes that occurred during the period.

12/18/2024 111
 Illustration
1. United communications was organized on December 1 of
the current year and had the following account balances at
December 31, listed in tabular form.
Assets = liabilities + Owners Equity
Cash + Land + Building + office equipment = Notes Payable + Accounts Payable + Capital Stock
Balances $37000 95000 125000 51250 80000 28250 200000

12/18/2024 112
 Early in January, the following transactions were carried out by United
Communications;
1. Sold capital stock to owners for 35000
2. Purchased land and a small office building for a total price of 90,000, of
which 35000 was the value of the land and 55000 was the value of the
building . Paid 22500 in cash and signed a note payable for the remaining
67500
3. Brought several computer systems on credit for 9500(30 day open account)
4. Obtained a loan from Capital bank in the amount of 20000. signed a note
payable
5. Paid the 28,250 account payable as of December 31.
Instructions
a. Record the effects of each of the five transactions in the format given above
and show the totals for all columns after each transaction.
b. Prepare a balance sheet at the end of the five transactions(January 31)
12/18/2024 113
 The End
Of Chapter 2

12/18/2024 114
 CHAPTER THREE
ACCOUNTING CYCLE
Contents
– Capturing Economic Events
– Basis of Accounting
– Adjustments
– Reporting Financial
Statements
. Capturing Economic Events

Accounting cycle is a series of steps

performed during the accounting period
( some throughout the period & some at
the end )
• to analyze
• record,
• classify,
• summarize,&
• report useful financial information for the
purpose of preparing financial statement.
 Steps Involved in the Accounting Cycle

1. Obtain & analyze business

transactions by examining the
source documents.( through the
accounting period)
2. Journalize transactions in the
journal. (through the accounting
period)
3. Post journal entries to the accounts
in the ledger.( throughout the
accounting period)
12/18/2024 117
4. Prepare an unadjusted trial balance.( period end only)
5. Record adjusting entries. .( period end only)

6. Post the adjusting entries. ( period end only)

7.Prepare an adjusted trial balance. ( period end only)

7.Prepare financial statements. ( period end only)

8. Close the temporary accounts. ( period end only)

9. Post the closing entries.( period end only)

10.Prepare a post closing trial balance .( period end only)

12/18/2024 118
The Account

 Record of increases and decreases

Account in a specific asset, liability, equity,
revenue, or expense item.
 Debit = “Left”
 Credit = “Right”

An account can be Account Name

illustrated in a T- Debit / Dr. Credit / Cr.
account form.
Debits and Credits

Double-entry system
► Each transaction must affect two or more accounts to
keep the basic accounting equation in balance.
► Recording done by debiting at least one account and
crediting another.
► DEBITS must equal CREDITS.
 If Debit amounts are greater than Credit amounts, the
account will have a debit balance.

Account Name
Debit / Dr. Credit / Cr.

Transaction #1 $10,000 $3,000 Transaction #2

Transaction #3 8,000

Balance $15,000
 If Debit amounts are less than Credit amounts, the
account will have a credit balance.

Account Name
Debit / Dr. Credit / Cr.

Transaction #1 $10,000 $3,000 Transaction #2

8,000 Transaction #3

Balance $1,000
Debits and Credits
Assets  Assets - Debits should exceed
Debit / Dr. Credit / Cr.
credits.
 Liabilities – Credits should
Normal Balance
exceed debits.
Chapter
3-23

 Normal balance is on the

Liabilities increase side.
Debit / Dr. Credit / Cr.

Normal Balance

Chapter
3-24
 Debits and Credits

Owner’s Equity
 Owner’s investments and revenues
Debit / Dr. Credit / Cr.

increase owner’s equity (credit).

Normal Balance
 Owner’s drawings and expenses
Chapter
3-25
decrease owner’s equity (debit).

Owner’s Capital Owner’s Drawing Helpful Hint Because

Debit / Dr. Credit / Cr. Debit / Dr. Credit / Cr. revenues increase owner’s
equity, a revenue account
has the same debit/credit
rules as the Owner’s
Normal Balance Normal Balance Capital account. Expenses
have the opposite effect.
Chapter Chapter
3-25 3-23
Debits and Credits

Revenue
Debit / Dr. Credit / Cr.

 The purpose of earning revenues

is to benefit the owner(s).
Normal Balance
 The effect of debits and credits on
Chapter

revenue accounts is the same as

3-26

their effect on Owner’s Capital.

Expense
Debit / Dr. Credit / Cr.  Expenses have the opposite
effect: expenses decrease owner’s
Normal Balance
equity.

Chapter
3-27
 Debits/Credits Rules

Balance Sheet Income Statement

Asset = Liability + Equity Revenue - Expense

Debit

Credit
 Summary of Debits/Credits Rules
Relationship among the assets, liabilities and owner’s equity
of a business:
Basic
Assets = Liabilities + Owner’s Equity
Equation

Expanded
Basic
Equation

The equation must be in balance after every transaction.

For every Debit there must be a Credit.
Steps in the Recording Process

Analyze each transaction Enter transaction in a journal Transfer journal information to

ledger accounts

Business documents, such as a sales slip, a check, a bill, or

a cash register tape, provide evidence of the transaction.
The Journal
 Book of original entry.
 Transactions recorded in chronological order.
 Contributions to the recording process:
1. Discloses the complete effects of a transaction.

2. Provides a chronological record of transactions.

3. Helps to prevent or locate errors because the debit and

credit amounts can be easily compared.
Journalizing - Entering transaction data in the journal.
Illustration: On September 1, Ray Neal invested $15,000 cash in
the business; softbyte, and Softbyte purchased computer
equipment for $7,000 cash.

General Journal

Date Account Title Ref. Debit Credit

Sept. 1 Cash 15,000
Owner’s Capital 15,000

Equipment 7,000
Cash 7,000
Simple and Compound Entries
Illustration: On July 1, Butler Company purchases a delivery truck
costing $14,000. It pays $8,000 cash now and agrees to pay the
remaining $6,000 on account.

General Journal

Date Account Title Ref. Debit Credit

July 1 Equipment 14,000
Cash 8,000
Accounts payable 6,000
The Ledger
 General Ledger contains the entire group of accounts
maintained by a company.
Standard Form of Account
 Posting
process of
transferring
amounts from
the journal to
the ledger
accounts.
Chart of Accounts
Accounts and account numbers arranged in sequence in which
they are presented in the financial statements.
 The Recording Process Illustrated

Follow these steps:

1. Determine what
type of account is
involved.
2. Determine what
items increased or
decreased and by
how much.
3. Translate the
increases and
decreases into
debits and credits.
Summary of Journalizing and Posting
Trial Balance
Limitations of a Trial Balance

The trial balance may balance even when

1. a transaction is not journalized,
2. a correct journal entry is not posted,
3. a journal entry is posted twice,
4. incorrect accounts are used in journalizing or posting, or
5. offsetting errors are made in recording the amount of a
transaction.
.Basis of Accounting
Accrual- versus Cash-Basis Accounting

Accrual-Basis Accounting
 Transactions recorded in the periods in which the
events occur.
 Companies recognize revenues when they perform
services (rather than when cash is received).
 Expenses are recognized when incurred (rather than
when paid).
Accrual- vs. Cash-Basis Accounting

Cash-Basis Accounting
 Revenues recognized when cash is received.
 Expenses recognized when cash is paid.
 Cash-basis accounting is not in accordance with
generally accepted accounting principles (GAAP).
Recognizing Revenues and Expenses

REVENUE RECOGNITION PRINCIPLE

Recognize revenue in the
accounting period in which the
performance obligation is
satisfied.
Recognizing Revenues and Expenses

EXPENSE RECOGNITION PRINCIPLE

Match expenses with revenues
in the period when the expense
makes its contribution to revenue.
“Let the expenses follow the
revenues.”
GAAP relationships in revenue
and expense recognition
.Adjustments
The Basics of Adjusting Entries

Adjusting Entries
 Ensure that the revenue recognition and expense
recognition principles are followed.
 Necessary because the trial balance may not contain
up-to-date and complete data.
 Required every time a company prepares financial
statements.
 Will include one income statement account and one
balance sheet account.
 Types of Adjusting Entries
Categories of adjusting entries

Deferrals Accruals

1. Prepaid Expenses. Expenses 1. Accrued Revenues.

paid in cash before they are Revenues for services
used or consumed. performed but not yet received
in cash or recorded.

2. Unearned Revenues. 2. Accrued Expenses.

Cash received before services Expenses incurred but not yet
are performed. paid in cash or recorded.
 Types of Adjusting Entries

Trial Balance –
Each account is
analyzed to
determine whether
it is complete and
up-to-date.
Adjusting Entries for Deferrals

Deferrals are expenses or revenues that are

recognized at a date later than the point when cash
was originally exchanged. There are two types:
 Prepaid expenses and
 Unearned revenues.
 PREPAID EXPENSES
Payment of cash, that is recorded as an asset because service or
benefit will be received in the future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

 insurance  rent
 supplies  equipment
 advertising  buildings
PREPAID EXPENSES
 Expire either with the passage of time or through use.
 Adjusting entry:
► Increase (debit) to an expense account and
► Decrease (credit) to an asset account.
Illustration: Pioneer Advertising Agency
purchased supplies costing $2,500 on
October 5. Pioneer recorded the payment by
increasing (debiting) the asset Supplies. This
account shows a balance of $2,500 in the
October 31 trial balance. An inventory count
at the close of business on October 31
reveals that $1,000 of supplies are still on
hand.
Oct. 31 Supplies expense 1,500
Supplies 1,500
Illustration: On October 4, Pioneer
Advertising Agency paid $600 for a one-year
fire insurance policy. Coverage began on
October 1. Pioneer recorded the payment by
increasing (debiting) Prepaid Insurance. This
account shows a balance of $600 in the
October 31 trial balance. Insurance of $50
($600 ÷ 12) expires each month.

Oct. 31 Insurance expense 50

Prepaid insurance 50
Depreciation
 Buildings, equipment, and motor vehicles (assets that
provide service for many years) are recorded as assets,
rather than an expense, in the year acquired.
 Depreciation is the process of allocating the cost of an
asset to expense over its useful life.
 Depreciation does not attempt to report the actual change
in the value of the asset.
Illustration: For Pioneer Advertising, assume
that depreciation on the equipment is $480 a
year, or $40 per month.
Oct. 31
Depreciation expense 40
Accumulated depreciation 40

Accumulated Depreciation is called a

contra asset account.
Statement Presentation
 Accumulated Depreciation is a contra asset account
(credit).
 Appears just after the account it offsets (Equipment) on
the balance sheet.
 Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation.
 UNEARNED REVENUES

Receipt of cash that is recorded as a liability because the service has

not been performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

 Rent  Magazine subscriptions
 Airline tickets  Customer deposits
UNEARNED REVENUES

 Adjusting entry is made to record the revenue for

services performed during the period and to show the
liability that remains at the end of the period.
 Results in a decrease (debit) to a liability account and
an increase (credit) to a revenue account.
Illustration: Pioneer Advertising Agency received $1,200 on
October 2 from R. Knox for advertising services expected to be
completed by December 31. Unearned Service Revenue shows a
balance of $1,200 in the October 31 trial balance. Analysis reveals
that the company performed $400 of services in October.
Oct. 31 Unearned service revenue 400
Service revenue 400
Adjusting Entries for Accruals

Accruals are made to record

 Revenues for services performed
OR
 Expenses incurred
in the current accounting period that have not been
recognized through daily entries.
 ACCRUED REVENUES

Revenues for services performed but not yet received in cash or

recorded.

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

 Rent  Services performed
 Interest
ACCRUED REVENUES

 Adjusting entry shows the receivable that exists and records

the revenues for services performed.
 Adjusting entry:
► Increases (debits) an asset account and
► Increases (credits) a revenue account.
Illustration: In October Pioneer Advertising
Agency earned $200 for advertising services
that had not been recorded.
Oct. 31
Accounts receivable 200
Service revenue 200

200
200
 ACCRUED EXPENSES

Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

 Rent  Taxes
 Interest  Salaries
ACCRUED EXPENSES

 Adjusting entry records the obligation and recognizes the

expense.
 Adjusting entry:
► Increase (debit) an expense account and
► Increase (credit) a liability account.
Illustration: Pioneer Advertising Agency signed a three-month
note payable in the amount of $5,000 on October 1. The note
requires Pioneer to pay interest at an annual rate of 12%.

Oct. 31 Interest expense 50

Interest payable 50
Illustration: Pioneer Advertising Agency last paid salaries on
October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of $2,000 for a
five-day work week, or $400 per day. Thus, accrued salaries at
October 31 are $1,200 ($400 x 3 days).
Summary of Basic Relationships
The Adjusted Trial Balance
Adjusted Trial Balance
 Prepared after all adjusting entries are journalized and
posted.
 Purpose is to prove the equality of debit balances and
credit balances in the ledger.
 Is the primary basis for the preparation of financial
statements.
. The Financial Statements

Financial
FinancialStatements
Statementsare
areprepared
prepareddirectly
directlyfrom
fromthe
theAdjusted
Adjusted
Trial
TrialBalance.
Balance.

Owner’s
Income Balance
Equity
Statement Sheet
Statement
Preparation of the income statement and owner’s
equity statement from the adjusted trial balance
Preparation of the balance sheet from
the adjusted trial balance
Using a Worksheet

Steps in Preparing a Worksheet

 Multiple-column form used in preparing financial
statements.
 Not a permanent accounting record.
 Five step process.
 Use of worksheet is optional.
Steps in Preparing a Worksheet
 1. Prepare a Trial Balance on the Worksheet
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200
Supplies 2,500
Prepaid Insurance 600
Office Equipment 5,000
Notes Payable 5,000
Accounts Payable 2,500
Unearned Revenue 1,200
Owner's Capital 10,000
Owner's Drawing 500
Service Revenue 10,000

Salaries Expense 4,000

Rent Expense 900
Totals 28,700 28,700

Trial balance amounts come

directly from ledger accounts.
Include all accounts
with balances.
General journal
showing adjusting
entries

Adjusting
Journal
Entries
 2. Enter the Adjustments in the Adjustments Columns
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200
Supplies 2,500 1,500
Prepaid Insurance 600 50
(a)
Office Equipment 5,000
(b)
Notes Payable 5,000
Adjustments Key:
Accounts Payable 2,500
Unearned Revenue 1,200 400 (a) Supplies Used.
Owner's Capital 10,000 (b) Insurance Expired.
(d)
Owner's Drawing 500
Service Revenue 10,000 400 (c) Depreciation Expensed.
(d) 200 (d) Service Revenue Earned.
Salaries Expense 4,000 1,200 (e)
Rent Expense 900 (g) (e) Service Revenue Accrued.
Totals 28,700 28,700 (f) Interest Accrued.
Supplies Expense 1,500
Insurance Expense (a) 50
(g) Salaries Accrued.
(b)
Accumulated Depreciation (c)
40
Depreciation Expense (c)
40
Accounts Receivable (e) 200
Interest Expense (f) 50 Enter adjustment amounts, total
Interest Payable (f) 50 adjustments columns,
Salaries Payable (g) 1,200
and check for equality.
Totals 3,440 3,440

Add additional accounts as needed.

 3. Complete the Adjusted Trial Balance Columns
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200 15,200
Supplies 2,500 (a) 1,500 1,000
Prepaid Insurance 600 (b) 50 550
Office Equipment 5,000 5,000
Notes Payable 5,000 5,000
Accounts Payable 2,500 2,500
Unearned Revenue 1,200 (d) 400 800
Owner's Capital 10,000 10,000
Owner's Drawing 500 500
Service Revenue 10,000 (d) 400 10,600
(e) 200
Salaries Expense 4,000 (g) 1,200 5,200
Rent Expense 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500
Insurance Expense (b) 50 50
Accumulated Depreciation (c) 40 40
Depreciation Expense (c) 40 40
Accounts Receivable (e) 200 200
(f)
Interest Expense 50 50
Interest Payable (f) 50 50
Salaries Payable (g) 1,200 1,200
Totals 3,440 3,440 30,190 30,190

Total the adjusted trial balance

columns and check for equality.
 4. Extend Amounts to Financial Statement Columns
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200 15,200
Supplies 2,500 (a) 1,500 1,000
Prepaid Insurance 600 (b) 50 550
Office Equipment 5,000 5,000
Notes Payable 5,000 5,000
Accounts Payable 2,500 2,500
Unearned Revenue 1,200 (d) 400 800
Owner's Capital 10,000 10,000
Owner's Drawing 500 500
Service Revenue 10,000 (d) 400 10,600 10,600
(e) 200
Salaries Expense 4,000 (g) 1,200 5,200 5,200
Rent Expense 900 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500 1,500
Insurance Expense (b) 50 50 50
Accumulated Depreciation (c) 40 40
Depreciation Expense (c) 40 40 40
Accounts Receivable (e) 200 200
(f)
Interest Expense 50 50 50
Interest Payable (f) 50 50
Salaries Payable (g) 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600

Extend all revenue and expense account

balances to the income statement columns.
 5. Total Columns, Compute Net Income (Loss)
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200 15,200 15,200
Supplies 2,500 (a) 1,500 1,000 1,000
Prepaid Insurance 600 (b) 50 550 550
Office Equipment 5,000 5,000 5,000
Notes Payable 5,000 5,000 5,000
Accounts Payable 2,500 2,500 2,500
Unearned Revenue 1,200 (d) 400 800 800
Owner's Capital 10,000 10,000 10,000
Owner's Drawing 500 500 500
Service Revenue 10,000 (d) 400 10,600 10,600
(e) 200
Salaries Expense 4,000 (g) 1,200 5,200 5,200
Rent Expense 900 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500 1,500
Insurance Expense (b) 50 50 50
Accumulated Depreciation (c) 40 40 40
Depreciation Expense (c) 40 40 40
Accounts Receivable (e) 200 200 200
(f)
Interest Expense 50 50 50
Interest Payable (f) 50 50 50
Salaries Payable (g) 1,200 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590
Net Income 2,860 2,860
Totals 10,600 10,600 22,450 22,450
Compute Net Income or Net Loss.
Preparing Statements from a Worksheet
 Income statement is prepared from the income
statement columns.
 Balance sheet and owner’s equity statement are
prepared from the balance sheet columns.
 Companies journalize and post adjusting entries.
Preparing Statements from a Worksheet
Preparing Adjusting Entries from a Worksheet

 Adjusting entries are prepared from the adjustments

columns of the worksheet.
 Journalizing and posting of adjusting entries follows the
preparation of financial statements when a worksheet is
used.
Closing the Books

At the end of the accounting period, the company makes

the accounts ready for the next period.
Preparing Closing Entries

Closing entries formally recognize, in the general ledger, the

transfer of
 net income (or net loss) and
 owner’s drawing
to owner’s capital.

Closing entries are only made at the end of the annual

accounting period.
 Closing the Books

Note:
Owner’s Drawing is closed
directly to Capital and not to
Income Summary because
Owner’s Capital is a
Owner’s Drawing is not an permanent account; all
other accounts are
expense. temporary accounts.
Closing entries
journalized
Posting
Closing
Entries
Preparing a Post-Closing Trial Balance
Purpose is to prove the equality of the permanent account
balances after journalizing and posting of closing entries.
Summary of the Accounting Cycle

1.
1. Analyze
Analyze business
business transactions
transactions

9.
9. Prepare
Prepare aa post-closing
post-closing trial
trial 2.
2. Journalize
Journalize the
the transactions
transactions
balance
balance

8.
8. Journalize
Journalize and
and post
post closing
closing 3.
3. Post
Post to
to ledger
ledger accounts
accounts
entries
entries

7.
7. Prepare
Prepare financial
financial statements
statements 4.
4. Prepare
Prepare aa trial
trial balance
balance

6.
6. Prepare
Prepare an
an adjusted
adjusted trial
trial 5.
5. Journalize
Journalize and
and post
post adjusting
adjusting
balance
balance entries
entries
 Illustration
1. Each transaction during NetSolutions’ first month
of operations is described in the following paragraphs.

1. Nov. 1, 2009 Chris Clark deposits $25,000 in a bank account in the

name of NetSolutions.
2. Nov. 5, 2009 NetSolutions paid $20,000 for the purchase of land as a
future building site.
3. Nov. 10, 2009 NetSolutions purchased supplies for $1,350 and agreed
to pay the supplier in the near future.
4. Nov. 18, 2009 NetSolutions received cash of $7,500 for providing
services to customers.
5. Nov. 30, 2009 NetSolutions paid the following expenses during the
month: wages, $2,125; rent, $800; utilities, $450; and miscellaneous,
$275.
6. Nov. 30, 2009 NetSolutions paid creditors on account, $950.
7. Nov. 30, 2009 Chris Clark determined that the cost of supplies on
hand at the end of the month was $550.
8. Nov. 30, 2009 Chris Clark withdrew $2,000 from NetSolutions for
personal use. 215
 Illustration
Record the following transactions in the general
journal.
Jan. 20,2005: owners invested $80,000 in exchange for capital stock.
Jan. 21, 2005: purchased the land for 52,000
Jan.22,2005: purchased building from Co. M for 36,000; 6000 cash made
down payment and issued a 90 day, non interest bearing note payable for
the remaining 30,000.
Jan. 23, purchsed tools and equipments on account from Snappy tools. The
purchase price was $13,800, due in 60 days.

12/18/2024 216
Jan 24, 2005: The company sold the excess tools on
account to co. AC at a price of 1,800. the tools were
sold at a price equal to their cost.
Jan 26, 2005: the company received 600 in partial
collection of the account receivable from company
AC.
Jan. 27, 2005: The company made 6,800 partial
payment of its accounts payable to Snappy tools.
Jan. 31, 2006: revenue of 2,200 is earned, all of which
was received in cash.
12/18/2024 217
Jan.31 Paid employees wages in January, $1,200.
Jan.31. paid for utilities used in January, $200
Feb. 1. Paid 360 cash news advertising for February.
Feb. 1. Purchased radio advertising for February at a cost of 470,
payable within 30 days .
Feb.4. Purchased various shop supplies ; cost 1,400, due in 30
days.
Feb.15: collected 4980 cash fro repairs made to
vehicles.

12/18/2024 218
Feb. 28 Billed Co. H, 5400 for maintenance and repair services
provided in Feb. The agreements with co. H calls for payment
to be received by March 10.
Feb. 28 paid employees wages earned in Feb, 4900.
Feb. 28: recorded 1,600 utility bill for Feb. The entire amount is
due March 15.
Feb. 28: The co. declares and pays dividend of 40 cents per share
to the owners of its 8000 shares of capital stock – a total of
3,200.

12/18/2024 219
 Illustration 2: Adjusting Entries
Given the following information, prepare necessary
adjusting entries at the end of the period (December
31).

1. On December 1, the company signed a new rental

agreement and paid three months’ rent in advance
at a rate of 2100 per month. This advance payment
was debited to the prepaid office rent account.

12/18/2024 220
2. An estimate of supplies on hand was made
December 31; the estimated cost of the unused
supplies was 450. the amount of supplies presented
in the adjusted trial balance was 600.
3. The useful life of the equipment has been estimated
at five years from date of acquisition.(assume that
the historical cost is 36,000 with no selvage value at
the end of the useful life)

12/18/2024 221
4. Accrued interest on notes payable to amounted
100 at year end. (set up accounts for interest
expense and interest payable).
5. Consulting services valued at 2850 were rendered
during December to clients who had made payment
in advance.
6. At December 31, consulting services valued at 11,000
had been rendered to clients but not yet billed. No
advance payment had been received from these
clients
12/18/2024 222
7. Salaries earned by employees but not paid as of
December 31 amounted to 1700.
9. Income taxes expense for the year estimated at
56000. of this amount, 51000 had been recognized
as expense in prior months , and 39,000 had been
paid to tax authorities. The company plans to pay the
17,000 remainder of its income tax liability on
January 15.

12/18/2024 223
THE END
Chapter 4

Financial Statement
Analysis
What is Financial Statement Analysis?
FSA is the process of identifying financial
strengths & weaknesses of the firm by properly
establishing relationship b/n the items of the
balance sheet & the income statement.
There are various methods or techniques that
are used in analyzing financial statements, such
as comparative statements, schedule of
changes in working capital, common size
percentages, funds analysis, trend analysis, &
ratios analysis.
 Financial statements are prepared to meet external
reporting obligations & also for decision making
purposes.
 They play a dominant role in setting the framework of
managerial decisions.
 But the information provided in the financial
statements is not an end in itself as no
meaningful conclusions can be drawn from these
statements alone.
 However, the information provided in the financial
statements is of immense use in making decisions
through analysis & interpretation of financial
statements.
 Sources of Financial Statement Analysis

Annual reports a company usually contains:

1. Financial statements.
2. Notes to the financial statements.
3. A summary of accounting methods used.
4. Management discussion and analysis of
the financial statements.
5. An auditor’s report.
6. Comparative financial data for 5 to 10
years.
 All these documents can be the source of
financial statement analysis.
Tools and Techniques of Financial Statement Analysis

• Following are the most important tools

and techniques of financial statement
analysis:
1.Horizantal and Vertical Analysis
2. Ratio Analysis
 1.Horizontal and Vertical Analysis

 Horizontal (Trend) Analysis

• Comparison of two or more year's
financial data is known as horizontal
analysis, or trend analysis.
• Horizontal analysis is facilitated by
showing changes between years in both
dollar and percentage form
• Horizontal analysis of financial
statements can also be carried out by
computing trend percentages.
Trend percentage states several years' financial
data in terms of a base year.
The base year equals 100%, with all other years
stated in some percentage of this base.
Therefore, the changes in financial statements from
a base year to following years are expressed as a
trend percentage to show the extent & direction of
changes.
1st , a base year is selected & each item in the FSs
for the base year is given a weight of 100%.
2nd is to express each item in the FSs for following
years as a percentage of its base-year amount.
 Horizontal Analysis-Example

Increase/
2005 2004 Amount Per
$41,500 $37,850 $3,650 9.6%
s 40,000 36,900 3,100 8.4%
me 1,500 950 550 57.9%
 Horizontal Analysis-Example

2005 2004 Diff

Sales $41,500 $37,850 $3,6

$3,650 ÷ $37,850 = .0964, or 9.6%

 Trend Percentages - Example

…are computed by selecting a base

year whose amounts are set equal to
100%.
• The amounts of each following year
are expressed as a percentage of
the base amount.

Trend % = Any year $ ÷ Base year $

 Trend Percentages - Example
Year 2005
2004 2003
Revenues $27,611
$24,215 $21,718
Cost of sales 15,318 14,709
13,049
Gross profit $12,293 $
9,506What are the$ trend
8,669percentages?
2003 is the base year.
 Trend Percentages - Example
Year 2005
2004 2003
Revenues 127% 111%
100%
Cost of sales 117% 113% 100%
Gross profit 142% 110%
100%These percentages were calculated by
dividing each item by the base year.
 Vertical Analysis
• Vertical analysis is the procedure of
preparing & presenting common size
statements.
• Common size statement is one that shows the
items appearing on it in percentage form as
well as in dollar form.
• Each item is stated as a percentage of some
total of which that item is a part.
• Key financial changes & trends can be
highlighted by the use of common size
statements.
 Vertical Analysis...

…compares each item in a financial

statement to a base number set to
100%.
• Every item on the financial
statement is then reported as a
percentage of that base.
 Vertical Analysis

2005
$38,303 100
es 19,688
fit $18,615
ating expenses 13,209 34.5
income $ 5,406 14.1
me 2,187
fore taxes $ 7,593 19.8
xes 2,827
e $ 4,766
 Vertical Analysis

Assets 2005
sets:
$ 1,816
s net 10,438
s 6,151
penses 3,526 9.1
nt assets $21,931 56.6
equipment, net 6,847 17.7
ts 9,997
s $38,775
 Common-size Statements

• On the income statement, each

item is expressed as a percentage of
net sales.
• On the balance sheet, the common
size is the total on each side of the
accounting equation.
• Common-size statements are used to
compare one company to other
companies, and to the industry
average.
Common-size Statements-example
Percent of Net Sales

Lucent12.4%
Technologies 10.8%

8.0%
MCI
7.4%
43.0%

51.4%

38.2%
28.8%

 Cost of goods sold  Operating expenses

 Income tax  Net income
 2. Ratio Analysis

The ratios analysis is the most powerful tool of

financial statement analysis.
Ratios simply means one number expressed in
terms of another.
A ratio is a statistical yardstick by means of
which relationship between two or various
figures can be compared or measured.
Ratios can be found out by dividing one
number by another number.
Ratios show how one number is related to
another
 Ratio Classifications

1 Measuring ability to pay current liabilities

(Liquidity Ratios)
2 Measuring ability to sell inventory and
collect receivables (Activity Ratios)
3 Measuring ability to pay short-term and
long-term debt (Leverage Ratios)
4 Measuring profitability (Profitability
Ratios)
5 Analyzing stock as an investment (Market
Value Ratios).
 1.Measuring ability to pay current liabilities (Liquidity Ratios)

• Liquidity ratios measure the short term

solvency of financial position of a firm.
• These ratios are calculated to comment
upon the short term paying capacity of a
concern or the firm's ability to meet its
current obligations.
• Following are the most important liquidity
ratios:
» Current Ratio
» Liquid/Acid Test/Quick Ratio
 Stylistic Furniture Example
Net sales (Year 2005)
$858,000
Cost of goods sold
513,000
Gross profit
$345,000
Total operating expenses
244,000
Operating income
$101,000
Interest revenue
4,000
 Stylistic Furniture Example

Assets 2005
nt assets:
$ 29,000 $ 32,0
ables net 114,000 85,000
ories 113,000 111,000
d expenses 6,000 8,000
urrent assets $262,000 $236,000
erm investments 18,000 9,000
and equipment, net 507,000 399,000
ssets $787,000 $644,000
 Stylistic Furniture Example

Liabilities 2005 20
urrent liabilities:
otes payable $ 42,000 $ 27,000
ccounts payable 73,000 68,000
ccrued liabilities 27,000 31,000
tal current liabilities $142,000 $126,000
ng-term debt 289,000 198,000
tal liabilities $431,000 $324,000
 Stylistic Furniture Example

holders’ Equity 2005

mon stock, no par $186,000 $186,000
ned earnings 170,000 134,0
stockholders’ equity $356,000 $320,000
liabilities and
holders’ equity $787,000 $644,0
Measuring Ability to Pay Current
Liabilities

1.The current ratio measures the company’s

ability to pay current liabilities with current
assets.

Current ratio =
Total current assets ÷ Total current liabilities
 Measuring Ability to Pay Current
Liabilities

Stylistic current ratio: CA/CL

2004: $236,000 ÷ $126,000 = 1.87
2005: $262,000 ÷ $142,000 = 1.85
The industry average is 1.50.
The current ratio decreased slightly
during 2005.
 Measuring Ability to
Pay Current Liabilities

2.The acid-test ratio shows the company’s

ability to pay all current liabilities
if they come due immediately.
•Quick Assets = Current Assets –
(Inventories & Prepaid Assets)

Acid-test ratio =(Cash + STIs+ Net current

receivables)
÷ Total current liabilities
 Measuring Ability to Pay Current Liabilities

Stylistic’ acid-test ratio: QA/CL

2004
($32,000 + $85,000) ÷ $126,000 = .93
2005
($29,000 + $114,000) ÷ $142,000 =
1.01
The industry average is .40.
The company’s acid-test ratio improved
considerably during 2005.
2.Measuring ability to sell inventory & collect receivables.
(Activity Ratios)

Activity ratios are calculated to measure

the efficiency with which the resources of a
firm have been employed.
These ratios are also called turnover ratios
b/c they indicate the speed with which
assets are being turned over into sales.
Following are the most important activity
ratios: -Inventory turnover ratio
-Receivables turnover ratio
-Average Collection period
 Measuring Ability to Sell Inventory

1.Inventory turnover ratio is a measure of the

number of times the average level of inventory
is sold during a year.

Inventory turnover = CGS÷ Average invento

•Average Inventories = (Beginning Inventori
+ Ending Inventories) / 2
 Measuring Ability to Sell Inventory

Stylistics' inventory turnover:

• 2005: $513,000 ÷ $112,000 = 4.58
• The industry average is 3.4.
• A high number indicates an ability
to quickly sell inventory.
 Measuring Ability to Collect Receivables

2.Accounts receivable turnover measures a

company’s ability to collect cash from credit
customers.

Accounts receivable turnover =

Net credit sales ÷ Average accounts receiva
 Measuring Ability to Collect Receivables

Stylistics' A/R Turnover:

2005: $858,000 ÷ $99,500 = 8.62
times
The industry average is 51 times.
Stylistics’ receivable turnover is much
lower than the industry average.
The company is a home-town store that
sells to local people who tend to pay
their bills over a lengthy period of time.
 Measuring Ability to
Collect Receivables

3.Days’ sales in receivable ratio measures how

many day’s sales remain in Accounts Receivable.

One day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =

Average net Accounts Receivable ÷ One day’
sales
 Measuring Ability to
Collect Receivables

Stylistics’ days’ sales in Accounts

Receivable for 2005:
One day’s sales:
$858,000 ÷ 365 = $2,351
Days’ sales in Accounts Receivable:
$99,500 ÷ $2,351 = 42 days
The industry average is 7 days.
3.Measuring ability to pay short-term and
long-term debt (Leverage Ratios)
• Long term solvency or leverage
ratios convey a firm's ability to meet the
interest costs & payment schedules of its
long term obligations.
• Following are some of the most important
long term solvency or leverage ratios
Debt Ratio
Times-Interest-Earned2(Coverage Ratio)
 Measuring Ability to
Pay Debt

1.The debt ratio indicates the proportion

of assets financed with debt.

Total liabilities ÷ Total assets

 Measuring Ability to
Pay Debt

Stylistics’ debt ratio: TL/TA

2004
$324,000 ÷ $644,000 = 0.50
2005
$431,000 ÷ $787,000 = 0.55
The industry average is 0.64.
Stylistic Furniture expanded operations
during 2005 by financing through
borrowing.
 Measuring Ability to Pay Debt

2.Interest Coverage Ratio(Times-Interest-

Ratio) measures the number of times
operating income can cover interest expe

Interest Coverage Ratio(Times-Interest-Earned)

= Income from operations÷ Interest expense
 Measuring Ability to Pay Debt

Stylistics’ Times-Interest-Earned Ratio:

2004
$ 57,000 ÷ $14,000 = 4.07
2005
$101,000 ÷ $24,000 = 4.21
The industry average is 2.80.
The company’s times-interest-earned
ratio increased in 2005.
This is a favorable sign.
 4. Measuring profitability (Profitability Ratios)

Profitability ratios measure the results of

business operations or overall performance
& effectiveness of the firm.
 Some of the most popular profitability
ratios are as under:
- Rate of return on net sales (ROS)
- Rate of return on total assets (ROA)
-Rate of return on common SHE
-Earnings per share of common stock
 Measuring Profitability

1.Rate of return on net sales shows the

percentage of each sales dollar earned as
net income.

Rate of return on net sales =Net income

÷ Net sales
 Measuring Profitability

Stylistics’ rate of return on sales:

2004
• $26,000 ÷ $803,000 = 0.032
2005
• $48,000 ÷ $858,000 = 0.056
• The industry average is 0.008.
• The increase is significant in itself & also b/c it
is much better than the industry average.
 Measuring Profitability

2.Rate of return on total assets measures

how profitably a company uses its assets.

Rate of return on total assets =

(Net income+ interest expense)
÷ Average total assets
i.e., operating income to average total a
Usually used to compute return on tota
 Measuring Profitability

Stylistics’ rate of return on total assets for

2005:
($48,000 + $24,000) ÷ $715,500 = 0.101
The industry average is 0.078.
How does Stylistics’ compare to the industry?
Very favorably.
 Measuring Profitability
•Common equity includes additional paid-in
capital on common stock & retained earnings.

3.Rate of return on common stockholders’ equity

= (Net income – preferred dividends)
÷ Average common stockholders’ equity
 Measuring Profitability

Stylistics’ rate of return on

common stockholders’ equity for
2005:
($48,000 – $0) ÷ $338,000 = 0.142
The industry average is 0.121.
Q. Why is this ratio larger than the return on
total assets (.101)?
 Measuring Profitability

4. Earnings per share of common stock

= (Net income – Preferred dividends)
÷ Number of shares of common stock
outstanding
 Measuring Profitability
Stylistics’ earnings per share:
2004
• ($26,000 – $0) ÷ 10,000 = $2.60
2005
• ($48,000 – $0) ÷ 10,000 = $4.80
• This large increase in EPS is considered very
unusual.
 5. Analyzing stock as an investment( Capital Market Ratios)

• Relate investors’ expectations about the

company’s performance and financial conditions.
• Following are the most important market value of
investment ratios:
- Price/earning ratio
- Dividend yield
- Dividend per share of common
(preferred) stock
-Book value per share of common stock
1. Price- Earning Ratio
• PER= Current Market Price per Share of Common Stock

Earning Per Share

• The investors might have a specific multiple
in mind that indicates whether the stock is
underpriced or overpriced.
 Analyzing Stock as an Investment

Price/earning ratio is the ratio of market price

per share to earnings per share.
2004
$35 ÷ $2.60 = 13.5
2005
$60 ÷ $4.80 = 12.5
Given Stylistic Furniture’s 2005 P/E ratio of 12.5,
we would say that the company’s stock is selling
at 12.5 times earnings.
 Analyzing Stock as an Investment

2.Dividend yield shows the percentage of a

stock’s market value returned as dividends to
stockholders each period.

Dividend per share of common

(or preferred) stock ÷ Market price per shar
of common (or preferred) stock
 Analyzing Stock as an Investment

Dividend yield on Stylistics’ common

stock:
2004
$1.00 ÷ $35.00 = .029 (2.9%)
2005
$1.20 ÷ $60.00 = .020 (2%)
An investor who buys Stylistics’ Furniture
common stock for $60 can expect to
receive 2% of the investment annually in
the form of cash dividends.
Analyzing Stock as an Investment

3. Book value per share of common stock

= (Total stockholders’ equity – Preferred equity)
÷ Number of shares of common stock
outstanding
 Analyzing Stock as an Investment

Book value per share of Stylistics’ common

stock:
2004
• ($320,000 – $0) ÷ 10,000 = $32.00
2005
• ($356,000 – $0) ÷ 10,000 = $35.60
 Advantages of Financial Statement Analysis

 There are various advantages of financial statements

analysis.
 The major benefit is that the investors get enough
idea to decide about the investments of their funds in
the specific company.
 Financial statements analysis can help the
government agencies to analyze the taxation due to
the company.
 Moreover, company can analyze its own performance
over the period of time through financial statement
analysis.
Illustrations
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Current Ratio

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has
$2.96 of current assets.
 Acid-Test Ratio
• The quick, or acid test, ratio is calculated by
deducting inventories and other prepaid
expenses from current assets and then
dividing the remainder by current liabilities.
Acid-Test Ratio
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Balance Sheet (partial)
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
 Accounts receivable turnover ratio

• It measures the number of times, on average, the

company collects receivables during the period.
 QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
QUALITY DEPARTMENT STORE INC.
For the Years Ended December 31
Balance Sheet (partial)
For the Years Ended December 31
Accounts Receivable Turnover

Assume the beginning receivable for 2010 is $200,000.

 Accounts Receivable Turnover

$2,097,000
= 10.2 times
($180,000 + $230,000) / 2
A variant of the accounts receivable turnover ratio is to convert it to an
average collection period in terms of days.

365 days / 10.2 times = every 35.78 days

Accounts receivable are collected on average every 36 days.

Inventory Turnover
• Measures the number of times, on average, the inventory is
sold during the period
• It is defined as cost of goods sold divided by average
inventories (beginning plus ending divided by two).
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial) Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Inventory Turnover

.
Inventory Turnover

$1,281,000
= 2.3 times
($500,000 + $620,000) / 2

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

 Profitability Ratios

Measure the income or operating success of a company for a given

period of time.
 Income, or the lack of it, affects the company’s ability to obtain debt
and equity financing, liquidity position, and the ability to grow.
 Ratios include the profit margin, asset turnover, return on assets,
return on common stockholders’ equity, earnings per share,
price-earnings, and payout ratio.
Profit Margin
• Measures the percentage of each dollar of
sales that results in net income.
• It is calculated by dividing net income by
sales.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31
Profit Margin
 Asset Turnover
• Measures how efficiently a company uses its
assets to generate sales.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Asset Turnover
Return on Asset
• The ratio of net income to total assets
measures the return on total assets (ROA)
after interest and taxes
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Return on Asset
Return on Common Stockholders’ Equity
• Shows how many dollars of net income the company earned
for each dollar invested by the owners.
• ROE is a comprehensive indicator of a firm’s performance
because it provides an indication of how well managers are
employing the funds invested by the firm’s shareholders to
generate returns
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Return on Common Stockholders’ Equity
Earnings Per Share (EPS)
• A measure of the net income earned on each share of common stock.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Earnings Per Share (EPS)
Price-Earnings Ratio

• Calculated market price of the share/earning per

share
• Assume the market price of the share is $12 in
2011 and $8 in 2010
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Price-Earnings Ratio
 Payout Ratio
• Measures the percentage of earnings distributed in the form of cash
dividends.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Payout Ratio
 Solvency Ratios

Solvency ratios measure the ability of a company to survive over a

long period of time.
 Debt to Assets and
 Times Interest Earned

are two ratios that provide information about debt-paying ability.

QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Debt to Total Assets Ratio

Measures the percentage of the total assets that creditors provide.

QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12
Times Interest Earned

Provides an indication of the company’s ability to meet interest payments as

they come due.
Summary of Ratios
Summary of Ratios
End of Chapter 4
 Chapter V
Introduction to Management Accounting

CONTENTS
• Meaning

• Financial Accounting vs Management Accounting

• Classification of Manufacturing Costs

• Cost Accumulation Systems

• Statement of Cost of Goods Manufactured

•
 Management Accounting
• Management accounting is not merely the application of
accounting to management; rather it is a study of analytical
techniques that result from the combining of accounting
fundamentals with the fundamental concepts of
management.
• Certain concepts of management are essential to a study of
management accounting.
– Planning
– Organizing,
– Controlling
– Standards
– Strategies, etc
 Management Accounting
• Management accounting as a body of technical knowledge is, in fact, a
synthesis of various disciplines. Many of the techniques such as capital
budgeting models and EOQ models have been borrowed from other
disciplines.
• The conceptual framework of management accounting, then, has building
blocks in its foundation from:
– Management theory ( planning, control, organization)
– Financial accounting (financial statements)
– Finance theory (capital budgeting, working capital)
– Economic theory (pricing, forecasting, supply, demand, cost behavior)
– Marketing theory (order getting, order processing, order delivery)
– Mathematics (algebra, calculus)
 Financial Accounting Vs Management Accounting
Financial Accounting-view point Management Accounting-view point
1. CASH 1. CASH
What is the balance? How much cash should be on hand?
Emphasis is on: Emphasis is on:
General journal entries, bank Cash budgeting, cash flow, alternative
reconciliations, petty cash uses of cash.

2. ACCOUNTS RECEIVABLE 2. ACCOUNTS RECEIVABLE

What is the amount that is collectible? What should the credit terms be?
Emphasis is on: Emphasis is on:
Estimation of bad debts, factoring, Effect of different credit terms, bad
recording of collections debt factors, analysis of credit revenue
and expenses.

3. INVENTORY 3. INVENTORY
What is the historical dollar amount that What is the optimum level of inventory?
should be assigned to inventory? Emphasis is on:
Emphasis is on: EOQ models, safety stock, quantity
Inventory cost methods, methods of discounts
estimating inventory
 Financial Accounting Vs Management Accounting
Financial Accounting-view point Management Accounting-view point
4. FIXED ASSETS 4. FIXED ASSETS
What is the unamortized amount? How much plant and equipment is
Emphasis is on: needed?
Depreciation methods, journal entries or Emphasis is on: Capacity requirements,
trades and retirements capital budgeting, replacement of
equipment.

5. SHORT-TERM DEBT 5. SHORT-TERM DEBT

What amount is owed? How much short-term debt is needed?
Emphasis is on: Recording accrued liabilities Emphasis is on: Cost of capital, debt/equity
and interest expense ratios, cash budgeting, and risk

6. LONG-TERM DEBT 6. LONG-TERM DEBT

What amount is owed? How much long-term debt should be
Emphasis is on: Amortization of bond issued?
premium and discount, accrued interest, and Emphasis is on: Cost of capital, debt/equity
bond refunding ratio, cash budgeting, issuance of different
types of securities.
 Financial Accounting Vs Management Accounting
Financial Accounting-view point Management Accounting-view point
7. STOCKHOLDERS’ EQUITY 7. STOCKHOLDERS’ EQUITY
What is the amount of stock issued? How much stock should be issued?
How should different types of stock What kind of stock security should be
transactions be recorded? issued?
Emphasis is on: Recording different types of Emphasis is on: Cost of capital, debt/equity
stock transactions, recording of different ratio, cash flow, and amount of dividends.
types of dividends
8. SALES 8. SALES
How much were sales? What will the amount of sales be?
Emphasis is on: Recording of sales and Emphasis is on: Sales forecasting, pricing,
purchases Transactions cash budgeting, methods of increasing Sales

9. EXPENSES 9. EXPENSES
How much were expenses? What should the amount expenses be?
Emphasis is on: Journal entries, accrued Emphasis is on: Budgeting, flexible
expenses, depreciation, bad debts. budgeting cost-volume-profit analysis
Classification of
Costs
• Classification of Manufacturing Costs
 What is Cost?
 An amount that has to be paid or given up in order to get something.
 In business, cost is usually a monetary valuation of: effort, material,
resources, time and utilities consumed, risks incurred, and opportunity
forgone in production and delivery of a good or service.

 COST OBJECTS (CO)

A Cost Object is any activity for which a separate measurement of costs is
desired.
E.g. - the cost of a product,
- the cost of rendering a service to a bank customer or
hospital patient,
- the cost of operating a particular department or sales
territory.
Association with - Direct
cost object - Indirect

Classification Bases
Reaction to
- Variable - Fixed
changesTypes
in of costs included
- Mixed - Step
activity

Classification - Unexpired - Expired

on the - Period - Product
- Prime
Financial - Conversion
Statements
• Direct and Indirect Costs
– Direct Costs: Refer those costs which are easily traceable
to a particular cost object.
• E.g. Direct Material and Direct labor costs (in a manufacturing
enterprise)
– Indirect Costs: Refer those costs which are assigned to a
particular cost object.
• E.g. Indirect Material, Indirect labor and other factory costs
Note:
The sum of direct material and direct labor costs is called prime cost
while the sum of direct labor and other factor costs (manufacturing
overhead costs) is called conversion costs.
• Cost Behavior in relation to change in volume of activity
– Variable Cost: variable costs vary in direct proportion to the volume
of activity. Consequently, total variable costs are linear and unit
variable cost is constant.
– Fixed Costs: remain constant over wide ranges of activity for a
specified time period. They are not affected by changes in activity

vc FC
• Mixed Cost: A mixed cost has both a variable and a fixed
component. On a per-unit basis, a mixed cost does not
fluctuate proportionately with changes in activity nor does
it remain constant with changes in activity.
• E.g. Electricity Bill or land line telephone bill

Total Cost
Variable component
-------------------------------
Fixed Component
• Step-fixed costs: also known as semi-fixed costs are costs
that remain fixed within specified activity levels for a given
amount of time but which eventually increase or decrease
by a constant amount at critical activity levels.
Total
FC

Activity Level
• Classification on the financial statements

• Product costs are those costs that are identified with goods
purchased or produced for resale. In a manufacturing
organization they are costs that are attached to the product
and that are included in the inventory valuation for finished
goods, or for partly completed goods (work in progress),until
they are sold; they are then recorded as expenses and matched
against sales for calculating profit. Product costs are also called
inventoriable costs

• Period costs are those costs that are not included in the
inventory valuation and as a result are treated as expenses in
the period in which they are incurred. Hence no attempt is
made to attach period costs to products for inventory valuation
purposes.
Cost Accumulation
Systems
 Cost Accumulation System - Defined
• Cost accumulation system specifies how we can
determine the cost of a cost object. Hence, it:
• defines
– cost object
– method of assigning costs to production
• specifies
– how product costs will be measured:
• Job Costing System and
• Process Costing System
 Cost Flow in a Manufacturing Firm
Work-in-Process Inventory Finished Goods Inventory
Direct material cost Product cost transferred
Direct labor cost
Manufacturing overhead when product is finished

Cost of Goods Sold Income Summary

Expense closed into

Income Summary at end

of accounting period
Job Costing
 A. Job Costing System
• Is used for production of large, unique, high-cost items

• Built to order rather than mass produced.

• Costs are accumulated for each job

• There is a subsidiary ledger for each job

• Often found in small or medium firms that produce

customized products
• E.g. typical application
 Job Costing System
• WIP Subsidiary Ledger

Job 1 Job 2 Job 3 WIP- Control

100 200 500 = Job 1 100
Job 2 200
Job 3 500

Job 1 + Job 2 + Job 3 = WIP Control

 Job Costing

• Contains all financial information about a job

– direct material (from material requisition)
– direct labor (from time sheets or labor tickets)
– applied overhead
 Material Requisition Form
• Tracks who is responsible for materials
• Verifies flow of materials from warehouse to department (to
a job)
• Journal entry
Work in Process Inventory (direct material) xxx
Manufacturing Overhead (indirect material) xxx
Raw Material Inventory xxx
 Employee Time Sheet
• Time worked on each job
• Journal entry

Work in Process Inventory (direct labor) xxx

Manufacturing Overhead (indirect labor) xxx
Salaries and Wages Payable xxx
 Manufacturing Overhead
Overhead Account
Actual Overhead Applied Overhead

Journal Entry:
Work-in-process Inv. xxx
Manufacturing Overhead (applied) xxx
 Completion of a Job
• Move job cost sheet from WIP subsidiary to Finished Goods
subsidiary
• Journal entry
Finished Goods Inventory xxx
Work in Process Inventory xxx
Process
Costing
 2. Process Costing System

• Process costing is a costing system in which the product or service

cost is obtained by assigning costs to masses of like units

• Conversion costs are costs that are applied uniformly in a

department

• Materials costs are assumed to be applied at discrete points in the

production process

• Transferred costs are costs transferred from one department to

another department
Features of Process Costing System
 Used for production of small, identical, low unit cost items.

 Mass produced in automated continuous production

process.

 Costs cannot be directly traced to each unit of product.

 Typical process cost applications:

 Petrochemical refinery

 Paint manufacturer

 Paper mill
 Process Costing System Diagram
Material Costs Material Costs

Assembly Transferred Testing Finished

Department Department
Costs Goods

Conversion Conversion
Costs Costs
 Process Costing Steps
• Equivalent units is a measure of the output of a process
costing system
• 60 units 25% complete = 15 equivalent whole units

Five Steps in Process Costing

1. Track the physical units of output
2. Determine the number of equivalent whole units
3. Compute the cost per equivalent unit
4. Measure total costs to account for
5. Assign costs to units completed and transferred out of the
department and units in ending inventory
Statement of Cost of Goods Manufactured
• Statement of cost of goods manufactured is calculated as:
Direct Materials used* xxx
Labor cost incurred xxx
Manufacturing overhead cost xxx
Total Manufacturing Costs xxx
Add: Beginning WIP Inv. xxx
Total Manufacturing costs incurred todate xxx
less: Ending WIP, Inventory xxx
Cost of Goods Manufactured xxx

*Direct Materials Used = BI + Purchases - EI

 Exercise
Inventories January 1 December 31
Materials Br. 165,000 Br. 210,000
WIP Br. 306000 Br. 290,000
Finished Goods Br. 298,000 Br. 284,000
Additional Information:
Advertising Exp Br. 148,000
Depr. Expe-Office Equip. 41,900 (50% of which is factory dep)
Direct Labor 360,000
Heat, Light, and Power-Factory 8,500
Materials Purchased 325,000 (60% on credit)
Salaries Exp. 195,000 (24% of which is office exp)
Property Taxes 24,800 (70% of which is factory exp)
Sales 1,630,000
Miscellaneous Exp. 4,200 (20% of which is office exp)
• Required:
– Prepare the statement of cost of goods
manufactured
– Determine the cost of goods sold
– Compute Net income/net loss
 Chapter 6

Cost Volume Profit Analysis

Contents
1.Meaning
2.Purpose
3.Assumptions
4.techniques
12/18/2024 360
 CVP Analysis- Overview
 Cost-Volume-Profit (CVP) analysis is a technique
that examines the change of profits in response
to changes in sales volume, costs and prices.
Similarly, it can be defined as the study of the
effects of changes in cost and volume on a
company’s profits.
 Cost-Volume-Profit (CVP) analysis examines the
behavior of total revenues, total costs and
operating income as changes occur in the
output level, selling price per unit, the variable
cost per unit and/or the fixed costs of the
product.
12/18/2024 361
  CVP analysis is important to profit planning.
 CVP analysis is critical in management
decisions such as:
1. The volume of sales needed to achieve a
targeted level of profit
2. The amount of revenue required to avoid
losses
3. determining product mix: Which products
or services to emphasis
4. Whether to increase fixed costs
5. What profit can be expected on a given
sales volume
6. maximizing use of production facilities,
12/18/2024 7. setting selling prices 362
 • Because CVP is so important, management
often wants the information reported in a
special format income statement.
• The CVP income statement is for internal use
only, classifies costs and expenses as fixed or
variable, reports a contribution margin in the
body of the statement.
– Contribution margin – amount of revenue
remaining after deducting all variable
costs
• The contribution margin is often reported as a
total amount and on a per unit basis.
12/18/2024 363
Assumptions of Cost-Volume-Profit
Analysis
CVP analysis is based on the following general assumptions:
1. Changes in level of activity are the only factors that affect
costs and revenue.
2. Total costs can be separated in to variable and fixed
components.
3. When represented graphically, the behavior of total revenues
and total costs are linear (straight line) in relation to output
level.
4. Selling price per unit, variable cost per unit and fixed costs
are known and constant.
5. When more than one type of product is sold, the sales mix will
remain constant.
6. All revenues and costs can be added and compared without taking
into account the time value of money.
7. All units produced are sold.


12/18/2024Whenthe above assumptions are not valid, the results of CVP
364
analysis may be inaccurate.
 TECHNIQUES OF CVP ANALYSIS
CVP analysis could be studied using
1. Equation,
2. contribution approach and
3. Graphical Methods.

1. EQUATION METHOD
 CVP analysis begins with the basic profit equation.
Net Income = Total Revenue – Total Costs
 Separating costs in to variable and fixed
categories, we express profit as:
Net Income = Total Revenue – Total Variable costs – Total Fixed costs

 Contribution Margin refers to the excess of selling

price over the variable cost.
12/18/2024 365
• Similarly, it represents the amount of
revenues minus variable costs that
contributes to recovering fixed costs.
• Once fixed cost is fully recovered, the
remaining contribution margin
increases operating income.

Total Contribution Margin = Total Revenues(sales) –

Total Variable Costs

12/18/2024 366
 2. Contribution Margin
Approach Ratio
Contribution Margin Ratio
• Some managers prefer to use a contribution margin
ratio in CVP analysis. The contribution margin ratio is
the contribution margin per unit divided by the unit-
selling price.

• Contribution Margin Ratio = Contribution Margin per unit

Selling Price Per Unit

• Example: Assume, the contribution margin per unit is Br

60 and the selling price per unit is Br 120, the
contribution margin ratio will be 50% (Br 60 ÷ Br 120).

12/18/2024 367
  The contribution margin ratio of 50% implies
that Br 0.5 of each sales dollar is available to
apply to fixed costs and to contribute to net
income.
 This expression of contribution margin is very
helpful in determining the effect of changes in
sales on net income.
 For example, net income will increase Br 2,000
(50%  Br 4,000) if sales increase Br 4,000.
 Thus, by using the contribution margin ratio,
managers can quickly determine increases in
net income from any change in sales.
12/18/2024 368
 Break-Even Point Analysis

• The Break-Even Point is that quantity of

output sold at which total revenues equal
total costs- that is, the quantity of output
sold at which the net income is zero.
• The process of finding out the point is BEP
Analysis.
• The Break Even Point can be computed
through:
1. Mathematical Equation Method
2. Contribution Margin Method
3. Graphical Method
12/18/2024 369
 1. Equation Method

• To use the equation method to

determine break even, the income
statement is expressed as the
following equation.
• Net Income = Sales – total Variable cost – total Fixed
costs

• Net income = SPU(Q) – VCU(Q) - FC

12/18/2024 370
• At the Break Even Point, the net income equals
to zero or all sales equals with all costs.
• This equation provides the most general and
easiest to remember approach to any CVP
situation.
• Refer the previous illustration. The Break
Even Point in terms of units sold and dollar
sales is:
• Net Income = (Quantity × selling price per
unit) – (Quantity × Variable cost per unit) –
Fixed cost
12/18/2024 371
 Example
 At Break Even Point Net Income is zero.
(Quantity  Br 120) – (Quantity  Br 60) – Br
10,500=0
Quantity (Br 120 – Br 60) =Br 10,500
Quantity at BEP = Br 10,500  (Br 120 – Br 60)
Quantity at BEP = Br 10,500  Br 60 = 175 Units
Dollar Sales at BEP = Unit selling price 
Quantity
Dollar sales at BEP = Br 120  175 units = Br
21,000
• At 175 units Sold and revenue of Br 21,000, the
net income becomes zero.
12/18/2024 372
  Therefore, if the sell is less than 175 units, there
will be a loss, if it is 175 units, net income will
become zero and if the sell is greater than 175
units, there will be a profit.
2. Contribution Margin Method
• The contribution method simply rearranges the
terms in Equation method.
Net Income = TR – TVC – TFC
Net Income = (SPU  Q) - (VCPU  Q) – Fixed Costs
Net Income = Q(SPU –VCPU) – Fixed Costs
Net Income + Fixed Costs = Q  CMPU
At BEP net income is zero. Therefore;
Q = Fixed Cost  Contribution Margin Per
unit
12/18/2024 373
 The formula:

• BEP in units = Total Fixed Costs

Contribution Margin
Per unit

• BEP in Birr = Total Fixed Costs

Contribution Margin
Ratio

12/18/2024 374
• The calculation in the equation
method and the calculation in the
contribution margin method appear
similar because one equation is
merely a restatement of the other.
• In our example, fixed costs are Br
10,500 and the contribution margin
per unit is Br 60 (Br 120 – Br 60).
Therefore;
• BEP in Units = Br 10,500  Br 60 =
12/18/2024 375
• To calculate the break even in terms of
dollars/ revenue, in our example, CM% is
Br 60  Br 120 = 0.50 or 50% , that is
50% of each dollar of sales/revenue or 50
cents, is contribution margin.
• To break even, contribution margin must
equal fixed cost of Br 10,500.
• Therefore, to earn Br 10,500 of
contribution margin, revenue/sales must
equal to Br 10,500  0.50 = Br 21,000.
• BEP in Dollars = Br 10,500  0.50 = Br 21,000.
12/18/2024 376
 3. Graphical Method
• The effective way to find the break-
even point is to prepare a break-even
graph.
• Because this graph shows costs,
volumes and profits, it is referred to as
a cost-volume-profit graph.
• In the graph, sales volume is recorded
along the horizontal axis, and both
total revenues and total costs (FC +
VC) are recorded on the vertical axis.
12/18/2024 377
  The construction of the graph using the previous
example data is as follows:
1. Plot the total revenue line, starting at the zero
activity level. For every unit sold, the total revenue
increases by Br 120.
2. Plot the total fixed costs using a horizontal line. This
line is plotted at Br 10,500.
3. Plot the total cost line. This starts at the fixed cost
line at zero level of activity. It increases by the
variable cost at each level of activity.
4. Determine the Break-Even-Point from the intersection
of the total cost line and the total revenue line. The
BEP in dollars is found by drawing a horizontal line
from BEP to the vertical axis. The BEP in units is
found by drawing a vertical line from BEP to the
horizontal axis.
12/18/2024 378
 Illustration: CVP Income
Statement -
The CVP income statement for
Vargo Video Company is illustrated
below:

12/18/2024 379
 Break-Even Analysis
• Vargo Company’s contribution margin per unit
is $200 (sales price $500 - $300 variable costs)
• It was also shown that Vargo Company’s
contribution margin ratio was:

12/18/2024 380
 Break Even Analysis
• Vargo Company’s break-even point in units or
in dollars (using contribution margin ratio) is:

In its early stages of operation, a company’s

primary goal is to break-even.
Failure to break-even will eventually lead to
financial failure

12/18/2024 381
 Target Net Income
 Management usually sets an income
objective for individual product lines.
 The objective is called Target Net
Income.
 The target net income indicates the sales
necessary to achieve a specified level of
income.
 The sales necessary to achieve target net
income can be determined from each of
the approaches used to determine Break-
Even sales.
12/18/2024 382
 Target Net income
• Once a company achieves break-even sales, a
sales goal can be set that will result in a target
net income
• Assuming Vargo’s target net income is
$250,000, required sales in units and dollars to
achieve this are:

12/18/2024 383
 Margin of Safety

• The margin of safety tells us how far sales can

drop before the company will operate at a loss
• The margin of safety can be expressed in
dollars or as a ratio
• Assuming Vargo’s sales are $800,000:

12/18/2024 384
 CVP and Changes in the Business Environment

• To better understand CVP analysis, three

independent cases involving Vargo company
will be examined.
• Each case will use the original data for Vargo
Company:

12/18/2024 385
 When Vargo Company match a competitor’s 10%
discount and reduce selling price to $450 per unit,
what will be the new break even point?
With variable costs per unit unchanged, a 10%
discount in selling price will decrease the
contribution margin to $150 and increase break-
even sales to 1,333 units

Management must decide how likely it is that

Vargo can achieve the increase in sales as well as
the likelihood of lost sales if the discount is not
12/18/2024matched. 386
 • Use of new equipment is being considered that will
increase fixed costs by 30% and lower variable
costs by 30%. What effect will the new equipment
have on the sales required to break-even?
• Fixed costs will increase $60,000 and variable costs
will decrease $90,000 (variable cost per unit
=$210).

The change appears positive as break-even point is

reduced by approximately 10%
12/18/2024 387
• Vargo’s supplier of raw materials has increased
the cost of raw materials which will increase the
variable cost per unit by $25.
• Management will not change the selling price of
the DVDs.
• Management intends to cut fixed costs by
$17,500
• Vargo currently has a net income of $80,000 on
sales of 1,400 DVDs
• How many more units will need to be sold to
maintain the $80,000 net income?
12/18/2024 388
 • Variable cost per unit increases to $325 as a
result of the $25 increase in raw materials cost

• Fixed costs decrease to $182,500

• Contribution margin per unit is now $175

• If Vargo cannot sell an additional 100 units,

management must further reduce costs,
increase the selling price of the DVDs, or
accept a lower net income.
12/18/2024 389
 Example 1
• Assume a firm has Br. 1,000,000 invested in its plant and
sets a goal of 15% annual return on investment. Fixed
costs in the factory presently amount to Br. 400,000 per
year and variable costs amount to Br. 15 per unit
produced. In the past year the firm produced and sold
50,000 units at Br. 25 each and earned a profit of Br.
100,000.
Required: what will be the value of the following factors to achieve
the target profit level
1. What will be the fixed cost to achieve the target profit
level.
2. What would be the variable cost per unit
3. What would be the quantity to be sold
4. What would be the amount of selling price per unit
12/18/2024 390
 sales – variable cost – fc = profit
Sales – varaible cost = profit + FC
50,000.25-50,000V = 550,000
-50,000v = - 700,000
V = 700/50
= 14 per unit

12/18/2024 391
• PQ – VQ –FC = Profit
• PQ – VQ = Profit + FC
• Q(P-V) = Profit + FC
• Q = Profit + FC
P- V
55,000

12/18/2024 392
• PQ – VQ = Profit + FC
• PQ = VQ + Profit + FC
• P = V Q + Profit + FC
Q
= 26

12/18/2024 393
 Example 2
2. A factory manufacturing sewing
machines has the capacity to
produce 500 machines per annum.
The marginal ( variable cost) of each
machine is Br. 200 and each
machine is sold for 250. Fixed
overheads are Br. 12,000 per annum.
Calculate the break even points for
out put and sales and show what
profit will result if output is 90% of
12/18/2024 394
 Limitations of CVP
Analysis
1. Cost classification as variable and fixed.
Mixed costs or semi variable costs?
2. Selling price remain constant and linear.
3. Variable cost remain constant and linear.
4. Fixed costs remain constant.
Changes with the change of the level of
activity?
5. Sales mix remain constant. Changes in
sales mix?

END OF CHAPTER 6
12/18/2024 395
 Financial and Managerial
Accounting
MBA

Chapter 7
Relevant Costs for Decision
Making – Incremental Analysis
396
 Contents
INTRODUCTION
-1 The Challenge of changing markets
-2 The concept of relevant information
-3 Incremental Analysis in common business decisions
- Special order decisions
- Make-or-buy decisions
- Add or Drop decision
- Production constraint decision
- Joint product decisions

397
 Introduction
Use differential analysis to analyze decisions.

Differential Analysis
The process of estimating revenues and costs
of alternative actions available to decision makers
and of comparing these estimates to the status quo

Short Run
The period of time over which capacity will be
unchanged, usually one year

398
 Differential Costs

Are costs that change in response to an alternative

course of action

Differential costs differ between actions.

Alternative A Alternative B

399
Differential Costs versus Total Costs
Information presented to management can show the
detailed costs that are included for making a
decision, or it can show just the differences between
alternatives, as follows.
Status Quo Alternative Difference

Sales revenue Br.750 Br.900 Br.150

Less: Variable costs 250 300 50
Contribution margin Br.500 Br.600 Br.100
Less: Fixed costs 350 350 -0-
Operating profit Br.150 Br.250 Br.100

400
 Sunk Costs
Costs incurred in the past that cannot be
changed by present or future decisions

A sunk cost is NOT relevant for making decisions.

401
The Challenge of Changing
Markets

402
• Product markets can change quickly due to competitor
price cuts, changing customers preferences, and
introduction of new products by competitors.
• Managers must make short-run decisions with fixed set
of resources, to react to the changing market place.

Special Production Decisions:

• Make or buy
• Add or drop

Order • Product Choices

Joint product
Others 403
The Concept of Relevant
Information

404
 Some cost concepts
• Common costs:
– Are costs which will be identical for all alternatives. e.g.
rent or rates on a factory.
• Sunk costs:
– Also called past costs. e.g. dedicated fixed assets,
development costs already incurred.
• Committed costs:
– Is a future cash outflow that will be incurred anyway,
whatever decision is taken now. e.g. contracts already
entered into which cannot be altered.
• Which of these costs are relevant costs?

405
What makes information relevant to a
decision problem?
• Two/three criteria are important:
– Bearing on the future:
• The consequence of the decisions are born in
the future, not in the past.
– Different under competing alternatives
• Must involve costs or benefits that differ among
the alternatives
– Cash Flow
• Must be a cash expense.
406
Incremental Analysis to Common
Business Decisions

407
 Short-Run Vs Long-Run Pricing Decisions

Year 0 Year 1

Short-run Long-run
pricing decision: pricing decision:
Less than one year Longer than one year

Pricing a one-time
Pricing a new product.
special order.

408
 Special Orders Decisions:
• XYZ Co. has received a one-time offer for 500 prints
at a special price of Br. 0.40 per print (Br.200).

• The regular price is Br. 0.50. should the offer be accepted

or rejected.

Sales for the week (5,000 prints at Br. 0.50) Br.2,500

Less: Variable costs, including paper, maintenance,
and etc (5,000 copies at Br. 0.20) 1
Total contribution margin
Less: Fixed costs (supplies, plus allocated costs
of the print shop)
Operating profit for the week
409
 Special Orders Decisions
Condition I: Analysis of Special Order: Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special
Offer) Offer) Difference
Comparison of Totals
Sales revenue Br.2,500 Br.2,700 Br.200
Variable costs (1,000) (1,100) (100)
Total contribution Br.1,500 Br.1,600 Br.100
Fixed costs (1,200) (1,200) -0-
Operating profit Br. 300 Br. 400 Br.100

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. 0.40 Br. 200
Less: Differential costs, 500 at Br. 0.20 100
Differential operating profit (before taxes) Br. 100

410
The special order should be accepted
 Special Orders Decisions
Condition II: Analysis of Special Order: No Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special
Offer) Offer) Difference
Comparison of Totals
Sales revenue Br.2,500 Br.2,450 Br.(50)
Less: Variable costs 1,000 1,000 -0-
Total contribution Br.1,500 Br.1,450 Br.(50)
Less: Fixed costs 1,200 1,200 -0-
Operating profit Br. 300 Br. 250 Br.(50)

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. (0.10) Br. (50)
Less: Differential costs, -0-
Differential operating profit (before taxes) Br. (50)

411
The special order should be rejected
 Use of Differential Analysis for Production
Decision
Understand how to apply differential analysis to production
decisions.

Decision to make goods or services

Make or buy
internally or purchase them externally

Add or drop Decision to add or drop a product

a segment line or close a business unit

Product Decision on what products or

choice services to offer (product mix)

412
 Make-or-Buy Decisions
XYZ company’s current costs of developing prints:

100,000
Per unit prints
Costs directly traceable:
Direct materials Br.0.05 Br. 5,000
Direct labor 0.12 12,000
Variable manufacturing overhead 0.03 3,000
Fixed manufacturing overhead 4,000
Common costs allocated to this product line 10,000
Total costs Br.34,000

This year’s expected volume is 100,000 prints, so the full cost of processing a
print is:
Br. 34,000 ÷ 100,000 = Br. 0.34
413
 Make-or-Buy Decisions
The Co. has received an offer from an outside developer to
process any number of prints for Br. 0.25 each.

Should XYZ Co. accept this offer?

The accounting department prepared

cost analyses at volume levels of 50,000
and 100,000 prints per year.

414
 Condition I
Make-or-Buy Decisions 100,000
100,000 Process Outsource
prints
prints prints processing Difference

Direct costs:
Direct materials Br. 5,000 Br.25,000a Br.20,000 higher
Labor 12,000 -0- 12,000 lower
Variable overhead 3,000 -0- 3,000 lower
Fixed overhead 4,000 -0- 4,000 lower
Common costs 10,000b 10,000b -0-
Total costs Br.34,000 Br.35,000 Br. 1,000 higher
a
100,000 units purchased at Br.0.25 = Br.25,000
b
These common costs remain unchanged for these volumes.
Because they do not change, they could be omitted from the analysis.

Differential costs increase by Br.1,000, so reject

alternative to buy.
415
 Make-or-Buy Decisions
Condition II
50,000 prints
50,000 Process Outsource
prints prints processing Difference

Direct costs:
Direct materials Br. 2,500 Br.12,500a Br.10,000 higher
Labor 6,000 -0- 6,000 lower
Variable overhead 1,500 -0- 1,500 lower
Fixed overhead 4,000 -0- 4,000 lower
Common costs 10,000b 10,000b -0-
Total costs Br.24,000 Br.22,500 Br. 1,500 lower
a
50,000 units purchased at Br.0.25 = Br.12,500
b
These common costs remain unchanged for these volumes.
Because they do not change, they could be omitted from the analysis.

Differential costs decrease by Br.1,500, so accept

alternative to buy.
416
Add or Drop a product/service

417
 Add or Drop Decisions
XYZ Co.
Product Line Income Statement

Total Prints Cameras Frames

Sales revenue Br.80,000 Br.10,000 Br.50,000 Br.20,000

Cost of sales (all variable) 53,000 8,000 30,000 15,000
Contribution margin Br.27,000 Br. 2,000 Br.20,000 Br. 5,000
Less fixed costs:
Rent 4,000 1,000 2,000 1,000
Salaries 5,000 1,000 2,500 1,500
Marketing and administrative* 3,000 500 1,500 1,000
Operating profit (loss) Br.15,000 Br. (500) Br.14,000 Br. 1,500

*Half of the Marketing and Administrative cost is fixed. 418

 Add or Drop Decisions
XYZ Co.
Differential Analysis
Status quo: Alternative:
Keep prints Drop prints Difference

Sales revenue Br.80,000 Br.70,000 Br.10,000 decrease

Cost of sales (all variable) 53,000 45,000 8,000 decrease
Contribution margin Br.27,000 Br.25,000 Br. 2,000 decrease
Less fixed costs:
Rent 4,000 4,000 -0-
Salaries 5,000 4,000 1,000 decrease
Marketing and administrative3,000 2,750 250 decrease
Operating profit (loss) Br. 15,000 Br. 14,250 Br. 750 decrease

Profits decrease Br.750, so keep prints.

419
Product Choice Decisions

420
 Product Choice Decisions
Constraints
Activities, resources, or policies that limit the
attainment of an objective are called constraints.

Contribution Margin per Unit of Scarce Resource

Contribution margin per unit of a particular input with
limited availability.

421
 Product Choice Decisions
XYZ Co
Revenue and Cost Information
Metal Wood
frames frames
Price
Less: Variable costs per unit Br.50 Br.80
Material 8 22
Labor 8 24
Overhead 4 4
Contribution margin per unit Br.30 Br.30
Fixed costs
Manufacturing Br.3,000
Marketing and administrative 1,500
Total Br.4,500
422
 Product Choice Decisions
XYZ Co.
Revenue and Cost Information
Metal Wood
frames frames

Per unit:
Contribution margin Br. 30 Br. 30
Machine hours required ÷ 0.5 ÷ 1.0
Contribution margin per machine hour Br. 60 Br. 30

Metal Frames have a higher contribution margin

per machine hour.

423
 Product Choice Decisions
Suppose XYZ Co. has 200 machine hours per month
available.
Metal Wood
frames frames
Capacity 400 200
Contribution margin per unit × Br.30× Br.30
Total contribution margin Br.12,000 Br.6,000
Less: Fixed manufacturing costs 3,000 3,000
Less: Fixed marketing and admin. costs 1,500 1,500
Operating profit Br. 7,500 Br.1,500

Selling metal frames will result in higher profits than selling

wooden frames.
424
Joint Product Decisions

425
 Joint Product Decisions
Two
Two or
or more
more products
products produced
produced from
from aa
common
common input
input are
are called
called joint
joint products.
products.

Product A
Joint
Jointcosts
costsare
are
the
thecosts
costsofof
Joint Costs Product B processing
processingprior
priorto
to
the
thesplit-off
split-offpoint.
point.
Product C
The
Thesplit-off
split-offpoint
pointisisthe
thepoint
pointin
inaaprocess
processwhere
where
joint
jointproducts
productscancanbe
berecognized
recognizedasasseparate
separateproducts.
products.
426
 Joint Product Decisions
Firms are often faced with the decision to
sell partially completed products at the
split-off point or to process them to
completion.

General rule:
Process further only if
incremental revenues > incremental costs

427
 Joint Product Decisions
Addis Mfg Co. produces two products, X and Y, from this process.

Final
X Revenue
Br. 80,000
Further
Processing Sale
Br. 50,000 Br.120,000

Joint Common
Cost Production
Br. 120,000
Process

Y Revenue Further
Processing
Final
Sale
Br. 70,000
Br. 40,000 Br.115,000
Split-Off
Point

Should the products be sold at split-off or processed further?

428
 Joint Product Decisions
Incremental Incremental
Product Revenue Cost Difference
X Br. 40,000 Br. 50,000 Br.(10,000)
Y 45,000 40,000 5,000

Product X incremental revenue = Br. 120,000 - 80,000

Product Y incremental revenue = Br. 115,000 - 70,000

Decision:
Process product Y, but sell product X at the split-off
point. Note that the Br.120,000 joint cost is irrelevant to
the processing decision.
429
Joint Product Decisions
Joint costs are really
common costs incurred to
simultaneously produce a
variety of end products.

Joint costs are commonly

allocated to end products on
the basis of the relative sales
value of each product or on
some other basis.
430
 Joint Product Decisions
Joint costs are not relevant
in decisions regarding what to do with
a product after the split-off point.
As a general rule . . .
It is always profitable to continue processing a joint
product after the split-off point so long as the
incremental revenue exceeds the incremental
processing costs.

431
 End of Chapter 7

Wish You Good Work and

Luck!!

432