Financial Accounting University of New York Prague - Martin Kolmhofer

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Course Objectives:

Terminology and definitions used in the accounting language.
Identify why accounting is a necessary skill.
Summarize the history of accounting.
Identify and describe assets, liabilities and owners' equity.
Demonstrate the effects of business transactions on the accounting equation
Recognize and compare the major financial reports.
Describe and create a company's Income Statement.
Compare and contrast a company's revenue, expenses, income, and retained earnings.
Identify the key elements of a Balance Sheet.
Balance the accounting equation and properly chart debits and credits.
Describe the accounting cycle.
Define key terms: inventory, FIFO, LIFO, Cost of Goods Sold.
Summarize cash flow, identify fixed assets, and describe depreciation.
Know what to expect in an audit.

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  • 06/01/12
  • Financial Accounting University of New York Prague - Martin Kolmhofer

    1. 1. FINANCIAL ACCOUNTING University of New York Prague Martin Kolmhofer
    2. 2. Course Objectives <ul><li>Terminology and definitions used in the accounting language. </li></ul><ul><li>Identify why accounting is a necessary skill. </li></ul><ul><li>Summarize the history of accounting. </li></ul><ul><li>Identify and describe assets, liabilities and owners' equity. </li></ul><ul><li>Demonstrate the effects of business transactions on the accounting equation </li></ul><ul><li>Recognize and compare the major financial reports. </li></ul><ul><li>Describe and create a company's Income Statement. </li></ul><ul><li>Compare and contrast a company's revenue, expenses, income, and retained earnings. </li></ul><ul><li>Identify the key elements of a Balance Sheet. </li></ul><ul><li>Balance the accounting equation and properly chart debits and credits. </li></ul><ul><li>Describe the accounting cycle. </li></ul><ul><li>Define key terms: inventory, FIFO, LIFO, Cost of Goods Sold. </li></ul><ul><li>Summarize cash flow, identify fixed assets, and describe depreciation. </li></ul><ul><li>Know what to expect in an audit. </li></ul>
    3. 4. Bean Counting vs. Big Picture…
    4. 5. Overview Day 1 <ul><li>Accounting Introduction </li></ul><ul><ul><li>History - What is accounting? </li></ul></ul><ul><ul><li>Why do we need accounting? </li></ul></ul><ul><ul><li>The role of monetary calculation in society </li></ul></ul><ul><ul><li>Inherent Limitations of financial accounting </li></ul></ul>
    5. 6. What is accounting? Definition <ul><li>The systematic recording, reporting, and analysis of financial transactions of a business. </li></ul>
    6. 7. History of Accounting Luca Pacioli (1445 – 1514) 1494: &quot;Summa de Arithmetica, Geometria, Proportioni et Proportionalita&quot; (&quot;Everything About Arithmetic, Geometry and Proportion“). Double-entry bookkeeping: For every credit entered into a ledger there must be a debit <ul><li>Merchants of Venice </li></ul><ul><li>Accounting was created in response to the development of trade and commerce during the medieval times </li></ul><ul><li>Trading voyages needed to be financed </li></ul><ul><li>The system that was in use by these Venetian merchants was nearly the same as we use today </li></ul>
    7. 8. History of Accounting ) &quot;Double-entry bookkeeping is one of the most beautiful discoveries of the human spirit… “ ( Johann Wolfgang Von Goethe 1796)
    8. 9. Accountant vs. Bookkeeper What’s the difference?
    9. 10. WHY STUDY ACCOUNTING ? <ul><li>Growing field due to increased regulation (Sarbanes -Oxley) </li></ul><ul><li>Many different areas to spezialize in (AP, AR...) </li></ul><ul><li>  </li></ul><ul><li>Lots of job growth opportunity in all industries </li></ul><ul><li>  </li></ul><ul><li>Gives opportunity to move to other areas of business </li></ul>
    10. 11. What is accounting? Functions of Money <ul><li>Money as: </li></ul><ul><li>Store of Value (enables saving, lending, borrowing…) </li></ul><ul><li>Medium of Exchange (Alternative: Barter) </li></ul><ul><li>Unit of Account (common measurement in which values are expressed) </li></ul>
    11. 12. Money as a Unit of Account But if everybody charges in the same item, that is money, it becomes very clear who has the lowest price. What if one supplier wants to be paid in babysitting, another one in computer help and another in petsitting and so on… “ Standard unit of measurement” = “Language of business”
    12. 13. Why do we need accounting?
    13. 14. Why do we need accounting What is finance all about?
    14. 15. Why do we need accounting?
    15. 16. Why do we need accounting? It´s all about people…
    16. 17. Why do we need accounting? Unlimited Wants vs. Limited Resources Unlimited Wants: Only perfect beings want nothing… Limited Resources: Time, Energy, Money…
    17. 18. Why do we need accounting? Choices must be made…
    18. 19. Why do we need accounting? Economic (calculation) problem <ul><li>ECONOMICS is the study of how people chose to use their scarce resources in an attempt to satisfy their unlimited wants </li></ul>
    19. 20. Why do we need accounting? <ul><li>SCARCITY exists when there is not enough of something (product/service/resource) to satisfy everyone’s wants AT A ZERO PRICE </li></ul>
    20. 21. The Price Mechanism How to distribute resources rationally in the economy? Capitalist solution is the Price Mechanism Those who are willing to pay the price will get the goods and services
    21. 22. Price Mechanism <ul><li>How does the Price Mechanism work? </li></ul><ul><li>3 Magic Words: Supply and Demand </li></ul><ul><li>Example: Pencil vs. Watch </li></ul><ul><li>Common misconceptions about how prices are determined (by suppliers, by cost of production…) </li></ul>
    22. 23. Equilibrium Price Subjective preference rankings interact to yield objective money prices Equilibrium occurs when quantity supplied equals quantity demanded Market price will be stable, that is it won’t tend to change, when you reach the point at which willingness to buy coincides with willingness to sell in the market
    23. 24. Equilibrium Price Subjective preference rankings interact to yield objective money prices At 3 dollars every seller can find a willing buyer…
    24. 25. Equilibrium Price Subjective preference rankings interact to yield objective money prices <ul><li>No other price would be stable </li></ul><ul><li>All other prices would have a tendency to change </li></ul>Example: At a price of 1 dollar there would be a SHORTAGE (quantity demanded is greater than the quantity supplied) Result: Upward pressure on price
    25. 26. Equilibrium Price - Shortage Subjective preference rankings interact to yield objective money prices Buyers start to compete to get the available units
    26. 27. Equilibrium Price Subjective preference rankings interact to yield objective money prices Price goes up and consequently quantity demanded drops and quantity supplied rises until we get to equilibrium again
    27. 28. Equilibrium Price Subjective preference rankings interact to yield objective money prices What about a higher price, like 5 dollars?
    28. 29. Equilibrium Price - Surplus Subjective preference rankings interact to yield objective money prices When the quantity demanded is less than the quantity supplied we have a surplus and the price will drop. At 5 dollars sellers are happy providing 5 units but buyers are unhappy, they only want one unit. 3 Dollars = “MARKET CLEARING PRICE” (clears the market of all surpluses and shortages)
    29. 30. Equilibrium Price - Surplus Subjective preference rankings interact to yield objective money prices .
    30. 31. Disadvantages of the Price Mechanism In our market economy it´s the market that determines price and price serves as the rationing mechanism to determine who gets the scarce product or service and who does not.
    31. 32. Alternative Rationing Mechanisms <ul><li>Queuing ( Waiting in line as a means of distributing goods and services ) </li></ul><ul><li>Ration Coupons ( Tickets or coupons that entitle individuals to purchase a certain amount of a given product per month ) </li></ul><ul><li>Favored Customers ( Those who receive special treatment from dealers during situations of excess demand. ) </li></ul><ul><li>Problem: EXCESS DEMAND is created but not eliminated </li></ul>
    32. 33. Alternative Rationing Mechanisms
    33. 34. Price Mechanism – Rationing, Price Ceilings What would happen if you force a price that is not the equilibrium price? Example: Government imposes price ceiling on gasoline At the imposed price of 2,50 the quantity demanded is greater than quantity supplied. This means that not everyone is going to get the gasoline that they want, because there is a shortage. WHAT WILL HAPPEN?
    34. 35. Price Mechanism – Rationing, Price Ceilings <ul><li>Would you rather KNOW that you are going to get gas as long as you are willing to pay 4 USD/gallon, or HOPE that you can get gas at the price ceiling of 2,50 USD? </li></ul><ul><li>CONCLUSION: Price mechanism is usually a good and effective way to allocate resources </li></ul>
    35. 36. Market Failures <ul><li>Market Failures: 3 examples where the price mechanism may not work - may not allocate scarce resources efficiently </li></ul><ul><li>Public Goods (“Free Rider” Problem – Non Excludability, Examples: Street lighting, national defence…) – People will not pay for it – Solution: goods are provided collectively by the government and then financed through taxation CAN YOU THINK OF EXAMPLES? </li></ul><ul><li>Externalities (Environmental Pollution etc…Example CO2 Certificates) – factories are not calculating certain costs </li></ul><ul><li>Market Power (Monopolists - Price is higher and output is lower under monopoly  than in a competitive market ) </li></ul>
    36. 37. Video – Price Mechanism in Action
    37. 38. VIDEO – Price Mechanism in Action <ul><li>Example: Supply of a big city. Who coordinates? NOBODY </li></ul><ul><li>Process of impersonal social interaction is coordinated through prices </li></ul><ul><li>Prices are signals that tell us what we have to do in order to be useful for other people - This is how it was possible to create a society based on the division of labour </li></ul><ul><li>Millions of people in society coordinate their plans through markets </li></ul>
    38. 39. “ The Invisible Hand” – Adam Smith Adam Smith was the first economist who investigated how this process of social coordination works. Rational, self-interested behaviour does not produce chaos, but usually produces social coordination
    39. 40. Market Phenomena – Laws of Social Cooperation <ul><li>“ It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own self interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” </li></ul><ul><li>(Adam Smith, The Wealth of Nations 1776) </li></ul><ul><li>Market phenomena </li></ul><ul><li>Laws of social cooperation </li></ul>
    40. 41. Division of Labour Coordination through money prices Supply, demand, and prices in input and output markets determine the allocation of resources and the ultimate combinations of things produced. EXAMPLES OF “CREATIVE DESTRUCTION”: Polaroid Cameras, Typewriter, SteamTrains.... CONSUMER LABOUR – LAND - CAPITAL
    41. 42. Division of Labour – Cost and Profit to the Firm <ul><li>All social phenomena result from interactions among the choices that individuals make after calculating the expected benefits and costs to themselves </li></ul>
    42. 43. Division of Labour – Cost and Profit to the Firm <ul><li>Social coordination through money prices…. </li></ul><ul><li>Therefore it is important to calculate “Profit” correctly </li></ul><ul><li>Accounting Profit = is total revenue minus explicit cost. </li></ul><ul><li>Economic Profit = total revenue minus opportunity cost </li></ul><ul><li>Accountants do not include implicit costs because they are difficult to measure. </li></ul>
    43. 44. Division of Labour – Cost and Profit to the Firm <ul><li>Opportunity Cost: </li></ul><ul><li>“ How much does it cost to go to university for a year?” </li></ul><ul><li>Explicit costs: tuition, books, school supplies, etc. </li></ul><ul><li>Implicit cost: The amount that the student could have earned if she had worked rather than attended university </li></ul><ul><li>Implicit costs are costs that do not require a money payment. The opportunity cost includes both explicit and implicit costs . </li></ul>
    44. 45. Division of Labour – Cost and Profit to the Firm <ul><li>The opportunity cost of any decision is what is given up as a result of that decision. </li></ul><ul><li>Opportunity cost includes both explicit costs and implicit costs. The firm’s economic profits are calculated using opportunity costs. Accounting profits are calculated using only explicit costs. Therefore, accounting profits are higher than economic profits. </li></ul>
    45. 46. Division of Labour – Cost and Profit to the Firm <ul><li>Method of reasoning - Ability to identify true opportunity cost! </li></ul>
    46. 47. Division of Labour – Cost and Profit to the Firm <ul><li>Identify true opportunity cost: </li></ul><ul><li>Story: The businessman and the fisherman </li></ul>Conclusion: Does your profit cover all your „costs“?
    47. 48. Division of Labour – Cost and Profit to the Firm <ul><li>“ When there is no profit the loss is obvious” </li></ul><ul><li>(Old Chinese Merchant´s Proverb) </li></ul>
    48. 49. Summary Day 1 <ul><li>Money as Unit of Account </li></ul><ul><li>Unlimited Wants/Limited Resources </li></ul><ul><li>Scarcity </li></ul><ul><li>Price Mechanism </li></ul><ul><li>Equilibrium Price </li></ul><ul><li>Disadvantages of the Price Mechanism – Market Failures </li></ul><ul><li>Alternative Rationing Mechanisms (Price Ceilings) </li></ul><ul><li>Division of Labour </li></ul><ul><li>Opportunity Cost </li></ul>
    49. 50. Summary Day 1 <ul><li>Questions? </li></ul>
    50. 51. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    51. 52. Users of accounting information <ul><li>Internal </li></ul><ul><li>Shareholders / Investors </li></ul><ul><li>Staff / Employees </li></ul><ul><li>Trade Unions </li></ul><ul><li>Managers </li></ul><ul><li>External </li></ul><ul><li>Customers </li></ul><ul><li>Government (Taxation) </li></ul><ul><li>Lenders (Banks, Analysts) </li></ul><ul><li>Suppliers </li></ul><ul><li>The Public </li></ul><ul><li>Competitors </li></ul>The preparation of information for external users is called Financial Accounting . (vs. Management Accounting )
    52. 53. Users of accounting information Internal: Shareholders / Investors <ul><li>Company’s shareholders are the real owners of a business and need information from those who manage the business on their behalf </li></ul><ul><li>T hey need information to help them determine whether they should buy, hold or sell (increase or decrease their holding). Shareholders are also interested in information which enables them to assess the ability of the enterprise to pay dividends . </li></ul><ul><li>Question: How does stock price affect a company? </li></ul><ul><li>No direct impact. Once the shares are sold into the market, the company is no longer affected directly by the share price. However, some indirect effects: Low Price: Danger of Hostile Takeovers, hard to raise future capital </li></ul>
    53. 54. Users of accounting information Shareholders / Investors ANALYST COVERAGE: Financial Analyst: A financial professional who studies various industries and companies, providing research and valuation reports, and making buy, sell, and hold recommendations.
    54. 55. Users of accounting information Shareholders / Investors
    55. 56. Users of accounting information Internal: Staff / Employees <ul><li>Interested in information about: </li></ul><ul><li>Stability and profitability of their employers </li></ul><ul><li>Ability of the enterprise to provide remuneration, retirement benefits, employment prospects </li></ul><ul><li>Pay and benefits obtained by senior management </li></ul>
    56. 57. Users of accounting information Internal: Trade Unions Knowing what a company is making will give them an insight on how much they can demand
    57. 58. Users of accounting information Internal: Managers <ul><li>Management is also interested in the information contained in the financial statements even though it has access to additional management and financial information </li></ul><ul><li>This is because the highly summarised nature of financial accounts allows management to assess whether the company's strategic and tactical objectives are being met. </li></ul>
    58. 59. Users of accounting information External: Customers <ul><li>Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise. They will look at the companies finances to make sure the company is not in trouble and that their supplies are not about to dry up. </li></ul><ul><li>Example: Strategic Suppliers – regular financial check-up! </li></ul>
    59. 60. Users of accounting information External: Government <ul><li>Tax (Corporate Tax, Capital Gains, VAT…) </li></ul><ul><li>Regulation (Compliance) </li></ul><ul><li>National Statistics (GDP, Intrastat…) </li></ul><ul><li>GDP: Total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. </li></ul><ul><li>Intrastat: Statitics on the trade in goods between countries of the European Union. (Balance of Payments) </li></ul>
    60. 61. Users of accounting information External: Lenders (Banks) <ul><li>They need to make sure a company is in a healthy financial situation before they start to lend money. </li></ul><ul><li>Concerned with debt repayment </li></ul><ul><li>Prefer to deal with a financially strong company with a healthy cash flow </li></ul><ul><li>CREDIT BUREAUS (for individuals) CREDIT RATING AGENCIES (for corporations + sovereign debt): </li></ul><ul><li>Baa1, Baa2, Baa3, Ba1, Ba2, Ba3 </li></ul><ul><li>A1, A2, A3 </li></ul><ul><li>B++, B+, B, B-, C++, C+, C, C-, </li></ul><ul><li>A.M. Best, Dun & Bradstreet, Standard & Poor's, Moody's, Fitch Ratings… </li></ul>
    61. 62. Users of accounting information External: Lenders (Banks) Examples of Sovereign Credit Ratings: <ul><li>Credit rating determines how much interest you have to pay for your debt </li></ul><ul><li>Important to INSTITUTIONAL INVESTORS (pension funds, Insurance companies </li></ul>
    62. 63. Users of accounting information External: Suppliers Suppliers – will look at a company’s balance sheet and profit and loss account to see if and how much credit they are willing to give: METHODS OF PAYMENT IN INTERNATIONAL TRADE: Rule (especially for international trade): NEVER sell on open account to a new customer (only against credit card or advance payment)
    63. 64. Users of accounting information External: The Public <ul><li>Contribution to the local economy (number of people they employed) </li></ul><ul><li>Patronage of local suppliers </li></ul><ul><li>Although not everyone in the public might understand financial accounts…financial statemens also include written outlook: </li></ul>
    64. 65. Users of accounting information External: Competitors <ul><li>Benchmarking (Best Practice, Peer Group, Ratio Analysis…) </li></ul><ul><li>Mergers, Takeovers, Synergies…? </li></ul><ul><li>Benchmarking is the process of comparing one's business processes and performance metrics to industry bests and/or best practices from other industries. </li></ul><ul><li>Peer Group: Community in which most or all members have roughly the same characteristics </li></ul>
    65. 66. Users of accounting information
    66. 67. Users of accounting information <ul><li>Can you distinguish between management accounting and financial accounting? </li></ul>
    67. 68. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    68. 69. Accounting Principles <ul><li>Question: Why have rules? </li></ul><ul><li>So that everyone plays the game the same way </li></ul><ul><li>What if owners and managers could prepare their business's financial statements the way they felt like ? </li></ul><ul><li>If a business was wanting a loan or credit , they would have a tendency to overstate the value of their assets and the value of their business. If it came to taxes (we don't like to have to pay them), let's expense and write off everything. </li></ul><ul><li>As for measuring performance (profitability) and comparing businesses in the same industry, you'd have no idea as to who was actually doing well and who wasn't. </li></ul><ul><li>You couldn't even compare your own business from year to year </li></ul>
    69. 70. Accounting Principles <ul><li>Rule making and standards setting organizations: </li></ul><ul><li>FASB: Financial Accounting Standards Board = private sector organization in the United States that establishes financial accounting and reporting standards. Responsible for developing US GAAP : Generally Accepted Accounting Principles IASB: International Accounting Standards Board = is an independent, privately-funded accounting standard-setter based in London. Responsible for developing IFRS: International Financial Reporting Standards </li></ul><ul><li>Harmonization Discussion: US - special accounting standards for special industries… </li></ul>
    70. 71. Generally Accepted Accounting Principles - GAAP <ul><li>The most important accounting concepts are: </li></ul><ul><li>Economic Entity Assumption </li></ul><ul><li>Monetary Unit Assumption </li></ul><ul><li>Historical Cost Principle </li></ul><ul><li>Accruals – Time Period Assumption </li></ul><ul><li>Dual Aspects </li></ul><ul><li>Matching Principle </li></ul><ul><li>Materiality </li></ul><ul><li>Going concern </li></ul><ul><li>Consistency </li></ul><ul><li>Substance over form </li></ul><ul><li>Prudence </li></ul>
    71. 72. Accounting Principles - Business Entity <ul><li>Definition </li></ul><ul><li>The activities of the entity are to be kept separate from the activities of its owner and all other economic entities </li></ul><ul><li>Example </li></ul><ul><li>Pharmacist records the purchase of two boxes of Listerine to be sold in the shop . </li></ul><ul><li>On the other hand, she cannot record 1kg of beef she buys for Sunday lunch as it is her and only her private expense. </li></ul><ul><li>PROBLEMS? </li></ul>The income tax authorities have thousands of rules as to what may and may not be included as a deduction from revenue
    72. 73. Accounting Principles - Monetary Unit Assumption <ul><li>Assumptions: </li></ul><ul><li>Stable currency is the unit of record: Dollar's purchasing power has not changed over time. Accountants ignore the effect of inflation For example, dollars from a 1960 transaction are combined with dollars from a 2010 transaction – Example LAND Realistic Assumption? USD-Gold Exchange Rate vs. Consumer Price Index (= official inflation rate) </li></ul><ul><li>Record only transactions that can be expressed in terms of money If an asset cannot be expressed as a dollar amount, it cannot be entered in the general ledger: </li></ul><ul><li>Skills of the management team EXAMPLES? </li></ul>
    73. 74. Accounting Principles - Monetary Unit Assumption
    74. 75. Accounting Principles – Historical Cost Principle <ul><li>You record items at what you paid for them. </li></ul>
    75. 76. Accounting Principles – Historical Cost Principle <ul><li>Historical Cost vs. Fair Value </li></ul><ul><li>From an accountant's point of view, the term &quot;cost&quot; refers to the amount spent when an item was originally obtained, whether that purchase happened last year or thirty years ago = historical cost </li></ul><ul><li>For example, land is initially recorded in the accounting records at its purchase price.  That historical cost will not be adjusted even if the fair value is perceived as increasing.  Difference to Monetary Unit Assumption? </li></ul><ul><li>While this enhances the &quot;reliability&quot; of reported data, it can also pose a limitation on its &quot;relevance.“ </li></ul><ul><li>An exception is certain investments in stocks and bonds that are actively traded on a stock exchange (“Mark-to-market valuation”) </li></ul><ul><li>If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements—you need to look elsewhere, perhaps to a third-party appraiser . </li></ul>
    76. 77. Accounting Principles – Time Period Principle <ul><li>The Time-period principle implies that the economic activities of an enterprise can be divided into artificial time periods </li></ul>
    77. 78. Accounting Principles - Dual Aspects <ul><li>Assets = Liabilities + Equity </li></ul><ul><li>All accounting transactions must keep this equation balanced. </li></ul><ul><li>When there is an increase on one side there must be an equal increase on the other side or an equal decrease on the same side.  </li></ul>
    78. 79. Accounting Principles - Matching <ul><li>Definition </li></ul><ul><li>Revenue for a given period is matched against the costs incurred in the same period when generating this revenue. </li></ul><ul><li>This concept enables for a true and fair view of profit for the given period. </li></ul><ul><li>Examples: </li></ul><ul><li>Accrued Expenses </li></ul><ul><li>Deferred Expenses </li></ul><ul><li>Depreciation </li></ul><ul><li>ACCRUAL ACCOUNTING </li></ul><ul><li>vs. </li></ul><ul><li>CASH BASED ACCOUNTING </li></ul>Example Deferred Expense: You hold a CONFERENCE that you prepaid for in January, but the conference actually happens in March, you should recognize the expense for it in March as well as the revenue for the attendees. Example Depreciation: If a machine is bought for $100,000, has a life span of 10 years, and can produce the same amount of goods each year, then $10,000 of the cost of the machine is matched to each year, rather than charging $100,000 in the first year and nothing in the next 9 years. So, the cost of the machine is offset against the sales in that year.
    79. 80. Accounting Principles - Materiality <ul><li>Definition </li></ul><ul><li>Unless the item is significant in value when compared to the entity’s size , it may be excluded from the decision making. </li></ul><ul><li>$5,000 might be immaterial for a large, profitable corporation (say General Motors ), but it will be material or significant for a small company that has very little profit </li></ul><ul><li>Example </li></ul><ul><li>A classic example of the materiality concept or the materiality principle is the immediate expensing of a $10 wastebasket that has a useful life of 10 years. The matching principle directs you to record the wastebasket as an asset and then depreciate its cost over its useful life of 10 years. The materiality principle allows you to expense the entire $10 in the year it is acquired instead of recording depreciation expense of $1 per year for 10 years. The reason is that no investor, creditor, or other interested party would be misled by not depreciating the wastebasket over a 10-year period. </li></ul>
    80. 81. Accounting Principles - Going Concern <ul><li>Definition </li></ul><ul><li>The business entity will continue in operations for the foreseeable future (rule of thumb – 12 months). </li></ul><ul><li>Allows for the accruals principle to be reasonable </li></ul><ul><li>Book values vs liquidation values </li></ul><ul><li>EXAMPLES? </li></ul><ul><li>Example </li></ul><ul><li>With previous matching / accruals principle it would not make sense to record the rent prepayment as a cost of the next period if the entity were not going to continue in operation. </li></ul>
    81. 82. Accounting Principles - Consistency <ul><li>Definition </li></ul><ul><li>The accounting policies should be consistent over time. </li></ul><ul><li>I.e. similar items should be treated in a similar manner within one as well as over several accounting periods. </li></ul><ul><li>This allows for reasonable comparison over time. </li></ul><ul><li>Example </li></ul><ul><li>If the entity changes the accounting currency every month , the month-to-month comparison would be impossible. </li></ul><ul><li>Examples: </li></ul><ul><li>Valuation of Inventory (FIFO, LIFO…) </li></ul><ul><li>Depreciation Methods </li></ul>
    82. 83. Accounting Principles Substance over form <ul><li>Definition </li></ul><ul><li>The financial statements of the entity should reflect the business reality rather than the legal form of the events or transactions. </li></ul><ul><li>Example </li></ul><ul><li>A group of employees is sent for one week trip to Africa. They spend one day in training and for the remaining time they go for safari. </li></ul><ul><li>The whole trip could be expensed as seminar. </li></ul><ul><li>In fact and in accordance with the Principle, it is an additional benefit for the employees and should be taxed accordingly </li></ul>“ When it is a cat but it was disguised in a legal form to look like a dog, then you would still treat it as a cat.” Example: Sale-and-Lease-Back contracts
    83. 84. Accounting Principles - Prudence <ul><li>One should not try to make things look prettier than they are. Typically, a revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable . </li></ul><ul><ul><li>Revenues should be recognized when they are to be realized with certainty (100% sure about the revenue). EXAMPLE: If there is a dispute about sales, the company is encouraged not to report the disputed revenue. </li></ul></ul><ul><ul><li>Expenses should be recognized when they are probable to be incurred (more than 50% chance that the cost will be incurred). EXAMPLE: if there is a lawsuit that may require the company to pay fines/fees, it has to be reported (at least in the notes). </li></ul></ul>
    84. 85. Accounting Principles - Prudence
    85. 86. Accounting Principles - Conflict of the Principles <ul><li>If the conflict arises, there is no right or wrong answer, the accountant needs to use his/her own judgment </li></ul><ul><li>In conflicts between the prudence convention and any of the others, the prudence principle should be considered as the dominant one = “ OVERRIDING PRICIPLE” </li></ul>
    86. 87. Accounting Principles - Conflict of the Principles <ul><ul><li>QUESTIONS? </li></ul></ul>
    87. 88. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    88. 89. Financial Reports <ul><li>4 MAIN TYPES: </li></ul><ul><li>Balance sheet (BS) </li></ul><ul><li>Income statement (IS) or Profit & Loss S. (P&L) </li></ul><ul><li>Statement of Retained Earnings </li></ul><ul><li>Cash Flow Statement (CF) </li></ul>
    89. 90. Financial Reports – 5 Types of Accounts <ul><li>Balance Sheet Accounts </li></ul><ul><li>Assets </li></ul><ul><li>Liabilities </li></ul><ul><li>Owner’s Equity (Stockholders’ Equity for a corporation) </li></ul><ul><li>Profit and Loss Accounts (= Income Statement Accounts) </li></ul><ul><li>Revenues </li></ul><ul><li>Expenses </li></ul>Double-entry accounting uses five — and only five — account types to record all the transactions that can possibly be recorded in an accounting system. There are sub-types of the following list, but all financial transactions can be recorded using these five types of accounts. The profit and loss accounts are temporary accounts which track revenues and expenses for a yearlong fiscal period and are then closed, with balances transferred to an equity account.
    90. 91. Financial Reports <ul><li>The Balance Sheet lists the balances in all A sset, L iability and O wner’s Equity accounts </li></ul><ul><li>The Income Statement lists the balances in all R evenue and E xpense accounts </li></ul>
    91. 92. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    92. 93. Accounting Equation <ul><li>Why is Balance Sheet in “Balance”? </li></ul><ul><li>ASSETS = LIABILITIES + EQUITY </li></ul><ul><li>What exists? = Who owns it? </li></ul><ul><li>There cannot be anything that does not belong to anybody Example: Money does not simply appear in the company: </li></ul><ul><li>You either earn it via a sale, then it is Equity </li></ul><ul><li>...or you borrow it from the bank...then it would be a Liability </li></ul>
    93. 94. Accounting Equation <ul><li>ASSETS = LIABILITIES + EQUITY </li></ul><ul><li>Everything we own = who provided the financing </li></ul><ul><li>Assets = Claims against those assets </li></ul><ul><li>Property = Property Rights </li></ul><ul><li>The double entry system based on the Accounting </li></ul><ul><li>Equation allows us to track: </li></ul><ul><li>What we got and what went = from whom and to whom </li></ul>
    94. 95. Accounting Equation <ul><li>ASSETS = LIABILITIES + EQUITY + Revenues - Expenses </li></ul><ul><li>+ Gains </li></ul><ul><li>- Losses + Contributions - Withdrawals </li></ul><ul><li>The additional items under Equity are tracked in temporary accounts until the end of the accounting period, at which time they are closed to Equity . Example: </li></ul>What is special about these accounts?
    95. 96. Accounting Equation Some Definitions… <ul><li>Revenues : Increases to owner´s equity resulting from main business operations ( such as selling merchandise or providing services…) </li></ul><ul><li>Expenses: Decreases to owner´s equity resulting from main business operations </li></ul><ul><li>Gains: Increases to owner´s equity resulting from non-business operations ( such as selling the old delivery truck, a storage building…) </li></ul><ul><li>Losses: Decreases to owner´s equity resulting from non-business operations </li></ul><ul><li>Contributions: Increases to owner´s equity resulting from owner contributions </li></ul><ul><li>Withdrawals: Decreases to owner´s equity resulting from owner withdrawals </li></ul>
    96. 97. Balance Sheet ASSETS = LIABILITES + EQUITY Declining order of liquidity For the asset side, the accounts are classified typically from most liquid to least liquid. For the liabilities side, the accounts are organized from short to long-term borrowings and other obligations. Balance sheet of Bakery & Co. Balance sheet as at 1 January 2010 Assets   Liabilities & Equity Current Assets     Current Liabilities   Cash and Cash Equivalents 250   Accounts Payable 350 Inventories 300   Short-term Loan 200 Accounts Receivable 700   Current Tax Liabilities 100 Prepaid Expenses 50   Accrued Liabilities 100 Total Current Assets 1300   Total Current Liabilities 750       Fixed Assets     Non-Current Liabilities   Property, Plant, and Equipment 1550   Bank Loans 600 Total Fixed Assets 1550   Issued Debt Securities 1100       Deferred Tax Liability 100 Intangible Assets and Goodwill     Total Non-Current Liabilities 1800 Intangible Assets 300       Goodwill 0       Total IA and Goodwill 300   Equity         Common Stock 400 Other Assets     Retained earnings 100 Investments 0   Reserves 50 Total Other Assets 0   Net Income 50       Equity 600           Total Assets 3150   Total Liabilities & Equity 3150
    97. 98. Balance Sheet <ul><li>Gives an overview of what the company owns and owes </li></ul><ul><li>Provides a snapshot of the entity at one particular moment </li></ul><ul><li>Summarizes the entity’s assets , liabilities and equity </li></ul><ul><li>Indicates how much a company is worth &quot;on the books.“ </li></ul><ul><li>Portrays financial position (or condition) </li></ul>
    98. 99. Assets <ul><li>Definition </li></ul><ul><li>An item which is owned by the entity and used in business operations to generate revenues. </li></ul><ul><li>Informal Definition: All the good stuff a business has (anything with value). The goodies. </li></ul><ul><li>Additional Explanation: The good stuff includes tangible and intangible stuff. Tangible stuff you can physical see and touch such as vehicles, equipment and buildings. Intangible stuff is like pieces of paper (sales invoices) representing loans to your customers where they promise to pay you later for your services or product. </li></ul><ul><li>Examples? </li></ul><ul><li>Cash, Accounts receivable </li></ul><ul><li>( Definition = amounts owed to a firm by its customers) inventory land equipment </li></ul>
    99. 100. Liabilities and Equity <ul><li>Definition. An amount owed to an external party </li></ul><ul><li>Informal Definition: Other's claims to the business's good stuff. Amounts the business owes to others. </li></ul><ul><li>Additional Explanation: Usually one of a business's biggest liabilities is to suppliers where a business has bought goods and services and charged them. </li></ul><ul><li>Examples? </li></ul><ul><li>For a family, bank overdraft, credit card, or loan from parents would be considered as liability that finances a purchase of a new washing machine. Family’s savings used for the same purpose would be considered as equity. </li></ul><ul><li>Money borrowed from a bank </li></ul><ul><li>Rent for use of a building </li></ul><ul><li>Money owed to suppliers for materials </li></ul><ul><li>Payroll a company owes to its employees </li></ul><ul><li>Taxes owed to the government </li></ul>
    100. 101. Owner´s Equity <ul><li>Definition: The owner's rights to the property (assets) of the business; also called proprietorship and net worth. </li></ul><ul><li>Informal Definition: What the business owes the owner. The good stuff left for the owner assuming all liabilities (amounts owed) have been paid. </li></ul><ul><li>Sub-categories: </li></ul><ul><li>Who are the “owners?” The answer to this question depends on the legal form of the entity… </li></ul>
    101. 102. Balance Sheet Balance sheet of Bakery & Co. Balance sheet as at 1 January 2010 Assets   Liabilities & Equity Current Assets     Current Liabilities   Cash and Cash Equivalents 250   Accounts Payable 350 Inventories 300   Short-term Loan 200 Accounts Receivable 700   Current Tax Liabilities 100 Prepaid Expenses 50   Accrued Liabilities 100 Total Current Assets 1300   Total Current Liabilities 750       Fixed Assets     Non-Current Liabilities   Property, Plant, and Equipment 1550   Bank Loans 600 Total Fixed Assets 1550   Issued Debt Securities 1100       Deferred Tax Liability 100 Intangible Assets and Goodwill     Total Non-Current Liabilities 1800 Intangible Assets 300       Goodwill 0       Total IA and Goodwill 300   Equity         Common Stock 400 Other Assets     Retained earnings 100 Investments 0   Reserves 50 Total Other Assets 0   Net Income 50       Equity 600           Total Assets 3150   Total Liabilities & Equity 3150
    102. 103. Balance Sheet - Equity <ul><li>Types Of Business Organization </li></ul><ul><li>Sole Proprietorship </li></ul><ul><li>Partnership (General vs. Limited) </li></ul><ul><li>Corporation </li></ul>
    103. 104. Balance Sheet - Equity <ul><li>Types Of Business Organization </li></ul><ul><li>Sole Proprietorship… is a business owned by one person. The owner receives all of the income from the business but is also responsible for all for the liabilities that the business incurs. Most small businesses are started as this form of business. This is the easiest of all of the types of businesses to open. </li></ul><ul><li>Examples? </li></ul>
    104. 105. Balance Sheet - Equity <ul><li>Types Of Business Organization </li></ul><ul><li>Partnership (General vs. Limited)… is a business owned by more than one person, with its equity consisting of separate capital accounts for each partner. The income is split between the partners, usually based on the amount of money or assets that each partner invests in the business and each must report his share of the income on his personal income tax form. </li></ul><ul><li>A limited partnership is similar to the general partnership. All of the general partners have an unlimited liability for the business debts. However, a limited partners liability, as the name implies, is limited to the amount of the contribution that he has made to the business. </li></ul><ul><li>Examples? </li></ul><ul><li>D entist office where two licensed dentists partner together to open a dentistry office. </li></ul>
    105. 106. Balance Sheet - Equity <ul><li>Types Of Business Organization </li></ul><ul><li>Corporation… is a very common entity form, with its ownership interest being represented by divisible units of ownership called shares of stock. These shares are easily transferable, with the current holder(s) of the stock being the owners. The total owners’ equity (i.e., “stockholders’ equity”) of a corporation usually consists of several amounts, generally corresponding to the owner investments in the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends ( dividends are distributions to shareholders as a return on their investment). Earnings give rise to increases in retained earnings , while dividends (and losses) cause decreases. </li></ul><ul><li>Examples? </li></ul>
    106. 107. Balance Sheet - Equity
    107. 108. Balance Sheet - Equity <ul><li>Types of Business organization - Factors to consider: </li></ul><ul><li>Tax consequences </li></ul><ul><li>Degree of control </li></ul><ul><li>Liability </li></ul><ul><li>Ability to raise money </li></ul><ul><li>Type of business (license required ?) </li></ul>
    108. 109. Balance Sheet - Equity
    109. 110. Balance Sheet - Equity
    110. 111. Balance Sheet - Equity
    111. 112. <ul><li>Questions? </li></ul>
    112. 114. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    113. 115. How Transactions impact the Accounting Equation <ul><li>ASSETS = LIABILITIES + EQUITY </li></ul>Let's use our accounting equation and get an overview of the types of transactions that can occur and their effects on our equation:
    114. 116. How Transactions impact the Accounting Equation <ul><li>ASSETS = LIABILITIES + EQUITY </li></ul><ul><li>Examples… </li></ul><ul><li>Remember: </li></ul><ul><li>Every transaction affects at least two different parts of the equation in equal and offsetting manners </li></ul><ul><li>This will lead us later on to the concept of DOUBLE ENTRY ACCOUNTING </li></ul>
    115. 117. Did you note regularities? Yes? Because there are… 4 Basic Types of Transactions ASSETS = LIABILITIES + EQUITY Transactions may increase both sides of the equation (left and right side both increase - transaction type (a) , decrease both sides of the equation (left and right side both decrease - transaction type (b) , or increase and decreases on the same side of the equation (increase and decrease on the left side - transaction type (c) or an increase and decrease on the right side transaction (d) , the equation always balances .
    116. 118. How Transactions impact the Accounting Equation · · Transactions Assets = Liabilities + Owner's Equity Left Side Right Side Right Side Increase Decrease Decrease Increase Decrease Increase 1. ABC mows a client's yard and receives a check from the customer for $50 for the service provided.             2. ABC purchases $100 worth of office supplies and stores them in their storage room. The office supply store gives them an invoice that allows them to pay for them in 15 days (on account).             3. ABC places an ad in the local newspaper receives the invoice from the supplier and writes a check for $25 to the newspaper.             4. ABC purchases five mowers for $10,000 and finances them with a loan from the local bank.             5. ABC mows another customer's yard and sends the customer a $75 bill (invoice) for the service they performed. They allow their customer ten (10) days to pay them for this service (on account).             6. The owner of ABC needs a little money to pay some personal bills and writes himself a check for $500.             7. ABC pays the office supply company $100 with a check for the office supplies that they charged (promised to pay).             8. ABC receives a check from the customer who they billed (invoiced) $75 for services and allowed 10 days to pay.             9. ABC purchased some mulch for $60 and received an invoice from their supplier who allows them 15 days to pay. The mulch was used on a customer's yard.             10. ABC bills (prepares an invoice) the customer $80 for the mulch and mowing his yard and receives a check for $80 from the customer.             Totals $10,380 $700 $100 $10,160 $585 $205 Net Change $9,680 Increase $10,060 Increase $380 Decrease Total Net Changes $9,680 Increase $9,680 Increase
    117. 119. How Transactions impact the Accounting Equation <ul><li>What do these transactions have in common? </li></ul><ul><li>2) You buy an asset against credit </li></ul><ul><li>4) You buy an asset with a bank loan </li></ul><ul><li>7) You pay your debts </li></ul><ul><li>8) You collect an existing account receivable </li></ul><ul><li>Answer: They do not make you richer or poorer </li></ul>
    118. 120. How Transactions impact the Accounting Equation <ul><li>When do you get richer / poorer? </li></ul><ul><li>Richer: You receive $50 for work done on your bank account = REVENUE ( Revenues are enhancements resulting from providing goods and services to customers) </li></ul><ul><li>Poorer: You spend money on advertisement… = EXPENSE ( Expenses can generally be regarded as costs of doing business) </li></ul>
    119. 121. How Transactions impact the Accounting Equation <ul><li>D istinguishing Between the Terms Revenue and Income: </li></ul><ul><li>REVENUE – EXPENSE = INCOME </li></ul>
    120. 122. How Transactions impact the Accounting Equation <ul><li>All the transactions that make you richer or poorer affect your EQUITY account. </li></ul><ul><li>It would be very impractical to post all the Revenues and Expenses directly into the Equity Account. (Important information gets lost!) </li></ul><ul><li>Therefore you use temporary (Profit and Loss) accounts. They will tell you HOW the earnings / losses were achieved. </li></ul>
    121. 123. Equity’s “Kids” <ul><li>Instead of recording transactions directly to “Capital&quot; (Owner's Equity), proper bookkeeping actually uses Revenue, Expense, and Withdrawals to record the increases and decreases to &quot;Capital&quot; (Owner's Equity) in order to provide us with the answers to the how and why the owner's claim to the business's property increased or decreased. </li></ul><ul><li>These accounts are TEMPORARY (only exist during the year) </li></ul><ul><li>Revenues, Expenses, and Withdrawals eventually are all merged together and become a part of the Ending Owner's Equity Balance. </li></ul><ul><li>= “CLOSING THE BOOKS” </li></ul>
    122. 124. Equity’s “Kids” <ul><li>Revenue (Income): Amounts a business earns by selling services and products. Amounts billed to customers for services and/or products </li></ul><ul><li>Expenses: Costs of doing business. The stuff we used and had to pay for or charge to run our business </li></ul><ul><li>Contributions (Investments): Additional amounts, either cash or other property, that the owner puts in his business </li></ul><ul><li>Withdrawals: Amounts the owner withdraws from his business for living and personal expenses. </li></ul>
    123. 125. How Transactions impact the Accounting Equation Proper Recording Actually Uses Revenue, Expense & Draws Instead Of Owner's Equity Original Recording Proper Recording Uses Transactions Owner's Equity Revenue Expense Withdrawal Right Side Decrease Increase Revenue Increases Resulting In an Increase to Equity Expenses Increase Resulting In a Decrease to Equity Withdrawals Increase Resulting in a Decrease to Equity 1. ABC mows a client's yard and receives a check from the customer for $50 for the service provided.   50       3. ABC places an ad in the local newspaper receives the invoice from the supplier and writes a check for $25 to the newspaper. 25         5. ABC mows another customer's yard and sends the customer a $75 bill (invoice) for the service they performed. They allow their customer ten (10) days to pay them for this service (on account).   75       6. The owner of ABC needs a little money to pay some personal bills and writes himself a check for $500. 500         9. ABC purchased some mulch for $60 and received an invoice from their supplier who allows them 15 days to pay. The mulch was used on a customer's yard. 60         10. ABC bills (prepares an invoice) the customer $80 for the mulch and mowing his yard and receives a check for $80 from the customer.   80      
    124. 126. How Transactions impact the Accounting Equation <ul><li>CONCLUSION: </li></ul><ul><li>There are countless transactions, and each can be described by its impact on assets, liabilities, and equity. Importantly, no transaction will upset the balance of the accounting equation. </li></ul><ul><li>The accounting equation holds at all times over the life of a business. When a transaction occurs, the total assets of a business may change, but the equation will remain in balance… </li></ul>
    125. 127. The Four Core Financial Statements <ul><li>Balance Sheet </li></ul><ul><li>Income Statement </li></ul><ul><li>Statement of Retained Earnings </li></ul><ul><li>Statement of Cash Flow </li></ul>
    126. 128. Income Statement <ul><li>A summary of the revenues and expenses for a specific period of time </li></ul><ul><li>Indicates how much a company “can make” in a given time frame </li></ul><ul><li>Reflects results of operations </li></ul>
    127. 129. Income Statement <ul><li>A single-step income statement is one of two commonly used formats for the income statement or profit and loss statement. It uses only one subtraction to arrive at net income. </li></ul><ul><li>REVENUE – EXPENSES = NET INCOME </li></ul><ul><li>An extremely condensed income statement in the single-step format would look like this: </li></ul>
    128. 130. Income Statement <ul><li>A multiple-step income statement uses multiple subtractions in computing the net income shown on the bottom line. </li></ul><ul><li>The multiple-step profit and loss statement segregates the operating revenues and operating expenses from the nonoperating revenues, nonoperating expenses, gains, and losses. The multiple-step income statement also shows the gross profit (net sales minus the cost of goods sold ). </li></ul>
    129. 131. Income Statement “Multiple Step”
    130. 132. Income Statement “Multiple Step” <ul><li>Cost of goods sold: </li></ul><ul><li>All of the expenses a company incurs to make the product or provide the services offered.  (raw materials, expenses associated with running the factory such as electricity, and labor used to manufacture a product or provide a service.) </li></ul><ul><li>EXAMPLE: A book shop buys a book for $25 and sells it for $32 - The cost of goods sold in $25 </li></ul><ul><li>GROSS MARGIN </li></ul>= VARIABLE COSTS
    131. 133. Income Statement “Multiple Step” <ul><li>Operating Expenses (OPEX): B ills that must be paid in order for the business to continue operating </li></ul><ul><li>Advertising, Marketing, Rent, Sales Comission, Depreciation , Licenses, Local taxes, and Legal and Accounting Fees.  … </li></ul><ul><li>G&A = General and Administrative Expenses </li></ul><ul><li>SG&A = Selling, General and Administrative Expenses </li></ul>
    132. 134. Income Statement “Multiple Step” <ul><li>Non-Operating Items: </li></ul><ul><li>Expenses that do NOT relate to primary operation. </li></ul><ul><li>Example: Interest Expenses, Gains & Losses of the Sale of Equipment… </li></ul>NET INCOME goes to the owners of the company
    133. 135. Income Statement “Multiple Step” <ul><li>Gross Profit Rate: </li></ul><ul><li>= Gross Profit / Sales revenue </li></ul><ul><li>a measure of the ability to pay overhead cost </li></ul><ul><li>Larger gross margins are generally good for companies, with the exception of discount retailers. They need to show that operations efficiency and financing allows them to operate with tiny margins. </li></ul>
    134. 136. Income Statement “Multiple Step” <ul><li>Profit Margin Ratio: = Net Income / Sales </li></ul><ul><li>… measures how much out of every dollar of sales a company actually keeps in earnings. </li></ul><ul><li>Increased sales are good, but an increase does not mean that the profit margin of a company is improving </li></ul><ul><li>is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales. </li></ul>
    135. 137. Income Statement “Multiple Step” <ul><li>Return on Assets Ratio: </li></ul><ul><li>= Net Profit / Average Total Assets </li></ul><ul><li>An indicator of how profitable a company is relative to its total assets. </li></ul><ul><li>Useful number for comparing competing companies in the same industry </li></ul><ul><li>Companies that require large initial investments will generally have lower return on assets </li></ul>
    136. 138. Income Statement
    137. 139. Statement of Retained Earnings (Statement of Equity) The statement of retained earnings reports how net income and dividends affected a company´s financial position during the period. Note that the Income Statement must be prepared before the Statement of Retained Earnings
    138. 140. Example: Statement of Equity Many companies provide an expanded statement of stockholders’ equity instead of the required statement of retained earnings. The statement of stockholders’ equity portrays not only the changes in retained earnings, but also changes in other equity accounts. These other equity accounts include capital stock and potentially a lot of other amounts related to topics like par value, preferred stock, treasury stock, and the like…
    139. 141. Statement of Retained Earning <ul><li>Gerald had beginning total Retained Earnings of $160,000. During the year, total assets increased by $240,000 and total liabilities increased by $120,000. Gerald's net income was $180,000. No additional investments were made; however, dividends did occur during the year. How much were the dividends? </li></ul><ul><li>$ 20.000 </li></ul><ul><li>$ 60.000 </li></ul><ul><li>$ 140.000 </li></ul><ul><li>$ 220.000 </li></ul>
    140. 142. Statement of Retained Earning <ul><li>Retained earnings will change over time because of several factors. Which of the following factors would explain an increase in retained earnings? </li></ul><ul><li>a. Net loss. b. Net income. c. Dividends. d. Investments by stockholders . </li></ul>
    141. 143. Statement of Cash Flows … cannot be manipulated with accounting tricks
    142. 144. Statement of Cash Flows … cannot be manipulated with accounting tricks <ul><li>If a company reports earnings of $1 billion, does this mean it has this amount of cash in the bank? </li></ul><ul><li>Not necessarily. Financial statements are based on accrual accounting , which takes into account non-cash items. </li></ul>
    143. 145. Financial Statements – Connection:
    144. 147. <ul><li>Quick Test: Financial Statements </li></ul>
    145. 148. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    146. 149. Accounts, debits and credits ACCOUNTS <ul><li>TRANSACTIONS AFFECT THE ACCOUNTING EQUATION </li></ul><ul><li>HOW DO YOU TRACK CHANGES ? </li></ul><ul><li>A SYSTEM IS NEEDED! </li></ul>
    147. 150. Accounts, debits and credits ACCOUNTS The records that are kept for the individual asset, liability, equity, revenue, expense, and dividend components are known as accounts .
    148. 151. Accounts, debits and credits DEBITS AND CREDITS <ul><li>The next basic accounting concept… </li></ul><ul><li>For every transaction DEBITS = CREDITS </li></ul><ul><li>The Double entry system requires that the same dollar amount of the transaction must be entered on both the left side of one account, and on the right side of another account. Instead of the word left , accountants use the word debit ; and instead of the word right , accountants use the word credit . </li></ul>
    149. 152. Accounts, debits and credits DEBITS AND CREDITS
    150. 153. Accounts, debits and credits DEBITS AND CREDITS <ul><li>ASSETS = LIABILITES + STOCKHOLDERS’ (or OWNER’S) EQUITY </li></ul><ul><li>Just as assets are on the left side (or debit side) of the accounting equation, the asset accounts have their balances on the left side. To increase an asset account's balance, you put more on the left side of the asset account. In accounting jargon, you debit the asset account . To decrease an asset account balance you credit the account, that is, you enter the amount on the right side. </li></ul><ul><li>Just as liabilities and stockholders' equity are on the right side (or credit side) of the accounting equation, the liability and equity accounts have their balances on the right side. To increase the balance in a liability or stockholders' equity account, you put more on the right side of the account. In accounting jargon, you credit the liability or the equity account. To decrease a liability or equity, you debit the account, that is, you enter the amount on the left side of the account. </li></ul>
    151. 154. Accounts, debits and credits DEBITS AND CREDITS <ul><li>DEBIT CREDIT </li></ul><ul><li>SOLL HABEN </li></ul><ul><li>DEBITO CREDITO </li></ul><ul><li>. . </li></ul><ul><li>. . </li></ul><ul><li>LEFT RIGHT </li></ul>
    152. 155. Accounts, debits and credits DETERMINING AN ACCOUNTS BALANCE
    153. 156. Accounts, Debits & Credits <ul><li>T-Account </li></ul>
    154. 157. Accounts, Debits and Credits <ul><li>QUICK TEST: Accounts, Debits and Credits </li></ul>
    155. 158. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    156. 159. THE JOURNAL <ul><li>Chronological listing of a company’s transactions and events </li></ul><ul><li>Shows the accounts involved, and whether each is debited or credited </li></ul><ul><li>Also called the book of original entry (Source documents are interpreted) </li></ul>Balance in each specific account? GENERAL LEDGER
    157. 160. THE GENERAL LEDGER The journal contains page after page of detailed accounting transactions. In contrast, the general ledger contains a page for each and every account in use by a company.
    158. 161. POSTING <ul><li>To “POST” means: </li></ul><ul><li>to copy the entries listed in the journal into their respective ledger accounts. </li></ul><ul><li>recording amounts as credits, (right side), and amounts as debits, (left side), in the pages of the general ledger </li></ul>
    159. 162. POSTING To “post” means to copy the entries listed in the journal into their respective ledger accounts.
    160. 163. POSTING – Computerized Processing
    161. 164. Source Documents <ul><li>No Posting without Source Document! </li></ul><ul><li>Source document is the original record of a transaction </li></ul><ul><li>Supports the underlying transaction </li></ul><ul><li>Examples: </li></ul><ul><li>Sale – Invoice </li></ul><ul><li>Expense – Receipt </li></ul><ul><li>Collection of accounts receivables - Bank Statement </li></ul>
    162. 165. Source Documents A receipt is a written acknowledgement that a specified article or sum of money has been received as an exchange for goods or services. = Source document for expenses
    163. 166. CHART OF ACCOUNTS <ul><li>Listing of all accounts in use by a particular company: </li></ul>For example, all assets may begin with “1” (e.g., 101 for Cash, 102 for Accounts Receivable, etc.), liabilities with “2,” and so forth. Many computerized systems allow rapid entry of accounts by reference number rather than by entering a full account description . Another benefit is that each account can be further subdivided in subsets. For instance, if Accounts Receivable bears the account number 102, one would expect to find that individual customers might be numbered as 102.001, 102.002, 102.003, etc.
    164. 167. THE TRIAL BALANCE After all transactions have been posted from the journal to the ledger, it is a good practice to prepare a trial balance. A trial balance is simply a listing of the ledger accounts along with their respective debit or credit balances:
    165. 168. THE TRIAL BALANCE Since each transaction was journalized in a way that insured that debits equaled credits, one would expect that this equality would be maintained throughout the ledger and trial balance. If the trial balance fails to balance, an error has occurred and must be located.
    166. 169. THE TRIAL BALANCE <ul><li>However, “balanced” trial balance is no guarantee of correctness: </li></ul><ul><li>Transaction omission </li></ul><ul><li>Transaction duplication </li></ul><ul><li>Posting to the wrong accounts </li></ul>
    167. 170. THE TRIAL BALANCE
    168. 171. THE TRIAL BALANCE <ul><li>TIPP: If the difference on the trial balance is divisible evenly by nine , you have transposed figures somewhere. For example, you have used 910 EUR in one place and 901 in another. This can help you to find differences a little more quickly. </li></ul>
    169. 172. <ul><li>QUICK TEST: Journal, General Ledger and Posting </li></ul>
    170. 173. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    171. 174. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE So to summarize… The basic process is to transfer amounts from the general ledger to the trial balance, then into the financial statements
    172. 175. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE
    173. 176. Accounting Terminology <ul><li>Quick Test: Accounting Terminology </li></ul>
    174. 177. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    175. 178. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE EXAMPLE PROBLEM <ul><li>This example illustrates how to prepare three basic financial statements </li></ul><ul><li>The Income Statement </li></ul><ul><li>The Statement of Retained Earnings </li></ul><ul><li>The Balance Sheet </li></ul>
    176. 179. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE EXAMPLE PROBLEM <ul><li>REVIEW </li></ul><ul><li>Income statement — A summary of the revenue and expenses for a specific period of time. </li></ul><ul><li>Statement of retained earnings – a summary of the changes in the retained earnings that have occurred during a specific period of time. </li></ul><ul><li>Balance sheet — A list of the assets, liabilities, and owner’s equity as of a specific date. </li></ul>
    177. 180. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE EXAMPLE PROBLEM
    178. 181. STEP 1: Classify the accounts as assets, liabilities, equity, revenue or expenses.
    179. 182. STEP 1: Classify the accounts as assets, liabilities, equity, revenue or expenses: <ul><li>ASSETS </li></ul>
    180. 183. STEP 1: Classify the accounts as assets, liabilities, equity, revenue or expenses: <ul><li>ASSETS, LIABILITES </li></ul>
    181. 184. STEP 1: Classify the accounts as assets, liabilities, equity, revenue or expenses: <ul><li>ASSETS, LIABILITES, EQUITY </li></ul>
    182. 185. STEP 1: Classify the accounts as assets, liabilities, equity, revenue or expenses: <ul><li>ASSETS, LIABILITES, EQUITY, REVENUES, EXPENSES </li></ul>
    183. 186. STEP 2: Prepare the Income Statement
    184. 187. STEP 2: Prepare the Income Statement
    185. 188. STEP 2: Prepare the Income Statement
    186. 189. STEP 2: Prepare the Income Statement
    187. 190. STEP 2: Prepare the Income Statement
    188. 191. REMEMBER: Financial Statements – Connection:
    189. 192. STEP 3: Prepare the Statement of Retained Earning
    190. 193. STEP 3: Prepare the Statement of Retained Earning
    191. 194. STEP 4: Prepare the Balance Sheet
    192. 195. STEP 4: Prepare the Balance Sheet
    193. 196. STEP 4: Prepare the Balance Sheet
    194. 197. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE EXAMPLE PROBLEM
    195. 198. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE EXAMPLE PROBLEM
    196. 199. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE EXAMPLE PROBLEM
    197. 200. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE Now try yourself…
    198. 201. FINANCIAL STATEMENTS FROM THE TRIAL BALANCE EXAMPLE PROBLEM <ul><li>The End </li></ul>
    199. 203. Accounting Humour <ul><li>“ The left side of the balance sheet has nothing </li></ul><ul><li>right and the right side of the balance sheet has </li></ul><ul><li>nothing left. But they are equal to each other. So </li></ul><ul><li>accounting-wise we are fine&quot; </li></ul><ul><li>(AIG Vice Chairman Jacob Frenkel, Oct 11 2008 ) </li></ul>
    200. 204. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    201. 205. The periodicity assumption and its accounting implications <ul><li>Business activity is fluid. Revenue and expense generating activities are in constant motion. Just because it is time to turn a page on a calendar does not mean that all business activity ceases. But, for purposes of measuring performance, it is necessary to draw a line in the sand of time. </li></ul><ul><li>Problem: Accountants have to record the things in balance sheet or income statement in the correct time period </li></ul><ul><li>Examples: </li></ul><ul><li>Your customer prepays an annual magazine subscription </li></ul><ul><li>How should an accountant report the cost of equipment expected to last five years? </li></ul><ul><li> </li></ul>
    202. 206. The periodicity assumption and its accounting implications <ul><li>Do you remember? </li></ul><ul><li>All the transactions that make us richer or poorer, affect the Equity on our balance sheet </li></ul><ul><li>We post these Revenues & Expenses via the (temporary) accounts which we use to create our Income Statement </li></ul><ul><li>Question: When are we allowed to use these Income Statement accounts? When are we allowed to post an entry that makes us “richer” or “poorer”? (ACCRUAL BASED ACCOUNTING) </li></ul><ul><li>Answer: See the rules for REVENUE RECOGNITION and EXPENSE RECOGNITION </li></ul>
    203. 207. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    204. 208. The periodicity assumption and its accounting implications <ul><li>Under the accrual basis of accounting, revenues are reported on the income statement when they are earned . (not when the cash is received.) </li></ul><ul><li>Under the accrual basis of accounting, expenses are matched with the related revenues and/or are reported when the expense occurs , not when the cash is paid. The result of accrual accounting is an income statement that better measures the profitability of a company during a specific time period. </li></ul>
    205. 209. REVENUE RECOGNITION <ul><li>REVENUE RECOGNITION </li></ul><ul><li>Under the accrual basis of accounting (as opposed to the cash basis of accounting), REVENUES are recognized when they are EARNED (=as soon as a product has been sold or a service has been performed), regardless of when the money is actually received. </li></ul><ul><li>Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month. </li></ul>
    206. 210. EXPENSE RECOGNITION – 3 TYPES <ul><li>Expense recognition: The matching principle means when revenues are generated, the expenses incurred to generate those revenues should be reported in the same accounting period (the same income statement). </li></ul><ul><li>Matching: Expenses can be allocated to corresponding revenues Example: Cost of Goods Sold </li></ul><ul><li>Systematic & Rational Allocation: If there is no clear link between cost and revenue Example: Depreciation, Allocation of prepaid expenses such as rent and insurance </li></ul><ul><li>Immediate Recognition: costs for which there is no clear or certain future benefit Example: General Administrative Cost… </li></ul>
    207. 211. Overview Day 2 <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    208. 212. The adjusting process and related entries <ul><li>The accountant’s task is to apply the various rules and procedures of generally accepted accounting principles (GAAP) to assign revenues and expenses to the reporting period </li></ul><ul><li>Adjusting entries are journal entries usually made at the end of an accounting period to allocate revenue and expenses to the period in which they actually occurred. </li></ul>
    209. 213. The adjusting process and related entries A common characteristic of an adjusting entry is that it will involve one income statement account and one balance sheet account. (The purpose of each adjusting entry is to get both the income statement and the balance sheet to be accurate.)
    210. 214. Sometimes an adjusting entry is needed because: <ul><li>Revenue has been earned, but it has not yet been recorded. </li></ul><ul><li>An expense may have been incurred, but it hasn’t yet been recorded. </li></ul><ul><li>A company may have paid for six-months of insurance coverage, but the accounting period is only one month. (This means that five months of insurance expense is prepaid and should not be reported as an expense on the current income statement.) </li></ul><ul><li>A customer paid a company in advance of receiving goods or services. Until the goods or services are delivered, the amount is reported as a liability. After the goods or services are delivered, an entry is needed to reduce the liability and to report the revenues. </li></ul>
    211. 215. The adjusting process and related entries <ul><li>Deferrals Accruals </li></ul>Deferrals: Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods. Accruals : Nothing has been entered in the accounting records for certain expenses or revenues, but those expenses and/or revenues did occur and must be included in the current period's income statement and balance sheet.
    212. 216. The adjusting process and related entries <ul><li>Deferrals Accruals </li></ul>Deferred (=Prepaid) expense: Expense is recognized after cash is paid. Deferred (=Unearned) revenue: Revenue is recognized after cash is received. Accrued (=unrecorded) expense: Expense is recognized before cash is paid. Accrued (=unrecorded) revenue: Revenue is recognized before cash is received.
    213. 217. The adjusting process and related entries Example: Prepaid insurance A three-year insurance policy was purchases on January 1, 20x1, for $9,000. The following entry would be needed to record the transaction on January 1:
    214. 218. The adjusting process and related entries Example: Prepaid Rent Assume a two-month rent is entered and rent paid in advance on March 1, 20X1, for $3,000. By March 31, 20X1, half of the rental period has lapsed, and financial statements are to be prepared. The following entries would be needed to record the transaction on March 1, and adjust rent expense and prepaid rent on March 31:
    215. 219. The adjusting process and related entries How often are adjustments needed? <ul><li>Adjustments should be made every time </li></ul><ul><li>financial statements are prepared </li></ul>
    216. 220. The adjusting process and related entries Example: Supplies Supplies purchased totaled $900. By year end, only $200 of supplies remained <ul><li>… since $900 of supplies were purchased, but only $200 were left over, then $700 must have been used. (Matching Principle) </li></ul><ul><li>In a periodic inventory system, this adjusting entry is used to determine the cost of goods sold expense. This entry is not necessary for a company using perpetual inventory. </li></ul>
    217. 221. The adjusting process and related entries Depreciation <ul><li>FIXED ASSETS: Buildings, machinery, equipment, furniture, computers, parking lots, cars, and trucks are examples of assets that will last for more than one year. </li></ul><ul><li>During each accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up. The portion being used up is reported as Depreciation Expense on the income statement . </li></ul><ul><li>In effect depreciation is the transfer of a portion of the asset's cost from the balance sheet to the income statement during each year of the asset's life = ADJUSTING ENTRY </li></ul>Depreciation Expense 100 Asset (or Contra Account Accumulated Depreciation) 100
    218. 222. The adjusting process and related entries Depreciation
    219. 223. The adjusting process and related entries Unearned revenue Often, a business will collect monies in advance of providing goods or services. For example, you sell a one-year software licence and collect the full payment at the beginning of the subscription period: EXAMPLES?
    220. 224. The adjusting process and related entries ACCRUALS <ul><li>Accruals are expenses and revenues that gradually accumulate throughout an accounting period (salaries, interest, rent, utilities…) </li></ul>
    221. 225. The adjusting process and related entries ACCRUALS – Accrued salaries <ul><li>Few, if any, businesses have daily payroll. Typically, businesses will pay employees once or twice per month. Therefore, salary obligations gradually accumulate… </li></ul><ul><li>When creating financial statements you have to ESTABLISH A LIABILITY for the accumulated obligations: </li></ul>The journal entry on the actual payday needs to extinguish the previously established liability (Liabilities decrease, Cash decreases): Salaries Payable 3,000 Cash 3,000
    222. 226. The adjusting process and related entries ACCRUALS – Accrued interest <ul><li>For example, if $100,000 is borrowed at 6% per year for 18 months, the total interest will amount to $9,000 ($100,000 X 6% X 1.5 years). </li></ul><ul><li>However, even if the interest is not payable until the end of the loan, it is still logical and appropriate to accrue the interest as time passes. This is necessary to assign the correct interest cost to each accounting period. </li></ul><ul><li>Assume that an 18-month loan was taken out on July 1, 20X1, and was due on December 31, 20X2. The accounting for the loan on the various dates (assume a December year end, with an appropriate year-end adjusting entry for the accrued interest) would be as follows: </li></ul>
    223. 227. The adjusting process and related entries ACCRUALS – Accrued interest
    224. 228. The adjusting process and related entries ACCRUALS – Accrued rent <ul><li>Accrued rent = opposite of prepaid rent </li></ul><ul><li>Accrued rent relates to rent that has not yet been paid, even though utilization of the asset has already occurred. For example, assume that office space is leased, and the terms of the agreement stipulate that rent will be paid within 10 days after the end of each month at the rate of $400 per month. </li></ul><ul><li>During December of 20X1, Cabul Company occupied the lease space, and the appropriate adjusting entry for December follows: </li></ul>
    225. 229. The adjusting process and related entries ACCRUALS – Accrued revenue Many businesses provide services to clients under an understanding that they will be periodically billed for the hours (or other units) of service provided. As a result, money has been earned during a month, even though it won’t be billed until the following month. Accrual accounting concepts dictate that such revenues be recorded when earned. The following entry would be needed at the end of December to accrue revenue for services rendered to date (even though the physical billing of the client may not occur until January): EXAMPLES?
    226. 230. The adjusting process and related entries ACCRUALS – Questions <ul><li>QUESTIONS? </li></ul>
    227. 231. The adjusting process and related entries <ul><li>QUICK TEST ADJUSTING ENTRIES </li></ul>
    228. 232. The adjusting process and related entries
    229. 233. The adjusting process and related entries
    230. 234. The adjusting process and related entries
    231. 235. Summary <ul><li>Users of Accounting Information </li></ul><ul><li>Accounting Principles </li></ul><ul><li>Financial Reports </li></ul><ul><li>Accounting Equation / Balance Sheet </li></ul><ul><li>How Transactions impact the Accounting Equation </li></ul><ul><li>Four basic types of transactions </li></ul><ul><li>The four core financial statements </li></ul><ul><li>Accounts, Debits and Credits </li></ul><ul><li>The Journal – The General Ledger </li></ul><ul><li>Posting </li></ul><ul><li>Chart of Accounts </li></ul><ul><li>Financial Statements from the Trial Balance </li></ul><ul><li>Accrual Accounting </li></ul><ul><li>Revenue Recognition / Expense Recognition </li></ul><ul><li>Adusting Entries </li></ul>
    232. 237. EXAMPLE: Financial Statements from the adjusted trial balance
    233. 238. EXAMPLE: Post Entries to the Ledger Financial Statements from the adjusted trial balance
    234. 239. Prepare Adjusted Trial Balance from Ledger Financial Statements from the adjusted trial balance
    235. 240. Prepare Income Statement / Statement of Retained Earnings Financial Statements from the adjusted trial balance
    236. 241. Prepare Balance Sheet Financial Statements from the adjusted trial balance
    237. 243. Overview Day 3 <ul><li>Classified Balance Sheets </li></ul><ul><li>Current Assets </li></ul><ul><li>Inventory </li></ul><ul><li>Accounts Receivable </li></ul><ul><li>Fixed Assets </li></ul><ul><li>Depreciation Methods </li></ul><ul><li>Intangibles & Goodwill </li></ul><ul><li>Current Liabilites </li></ul><ul><li>Accounts Payable </li></ul><ul><li>Ratio Analysis </li></ul><ul><li>Compliance </li></ul><ul><li>Internal Controls </li></ul><ul><li>VAT </li></ul><ul><li>What to expect in an Audit </li></ul>
    238. 244. Classified Balance Sheets To facilitate proper analysis, accountants will often divide the balance sheet into categories or classifications. The result is that important groups of accounts can be identified and subtotaled. Such balance sheets are called “classified balance sheets.”
    239. 245. Classified Balance Sheets The asset side of the balance sheet may be divided into the following SUB-CATEGORIES: Current assets; Fixed Assets; Intangible assets; Other assets.
    240. 246. Classified Balance Sheets Current Assets Current Assets include cash and those assets that will be converted into cash or consumed in a relatively short period of time; specifically, those assets that will be converted into cash or consumed within one year or the operating cycle, whichever is longer.
    241. 247. Classified Balance Sheets Current Assets The operating cycle for a particular company is the period of time it takes to convert cash back into cash (i.e., purchase inventory, sell the inventory on account, and collect the receivable); this is usually less than one year. It is determined by adding the number of days inventory is held and the collection period for accounts receivable
    242. 248. Overview Day 3 <ul><li>Classified Balance Sheets </li></ul><ul><li>Current Assets </li></ul><ul><li>Inventory </li></ul><ul><li>Accounts Receivable </li></ul><ul><li>Fixed Assets </li></ul><ul><li>Depreciation Methods </li></ul><ul><li>Intangibles & Goodwill </li></ul><ul><li>Current Liabilites </li></ul><ul><li>Accounts Payable </li></ul><ul><li>Ratio Analysis </li></ul><ul><li>Compliance </li></ul><ul><li>Internal Controls </li></ul><ul><li>VAT </li></ul><ul><li>What to expect in an Audit </li></ul>
    243. 249. Inventory <ul><li>Investors want as little money as possible tied up in inventory. It is fine to have a lot of inventory on the balance sheet if it is being sold at a fast enough rate there is little risk of becoming obsolete or spoiled. </li></ul><ul><li>“ Just -in-time” Delivery </li></ul>
    244. 250. INVENTORY – Inventory Valuation <ul><li>You don’t write: 7000 bottles of wine …but rather: Wine 30.000 EUR </li></ul><ul><li>Therefore you have to assign a value to your inventory… </li></ul><ul><li>Ending inventory        = Beginning inventory + Purchases during the period - Cost of goods sold </li></ul><ul><li>How much is Cost of Goods Sold / Value of Ending Inventory? (different purchases are stored together / get mixed up…) </li></ul><ul><li>Different inventory valuation methods (FIFO, LIFO, HIFO…) </li></ul>
    245. 251. INVENTORY – Perpetual Inventory System
    246. 252. INVENTORY – Perpetual Inventory System
    247. 253. INVENTORY – Perpetual Inventory System Scanners scan the products and automatically update the sales and inventory records
    248. 254. INVENTORY – Perpetual Inventory System PERPETUAL vs. PERIODICAL INVENTORY Which dealer would you rather deal with ? The one who can call it up on their computer and determine immediately if they have any and give you the price or the dealer that puts you on hold and has to look around his store and try to physically locate the item and determine the price? BUT: Also Perpetual Inventory Systems need to have a physical count – WHY? Perpetual Inventory Systems are only as good as the people who maintain it - verify that they actually do have the part…
    249. 255. INVENTORY – Perpetual Inventory System
    250. 256. INVENTORY – Perpetual vs. Periodic
    251. 257. INVENTORY – Physical Count <ul><li>Approved inventory count procedures / schedule </li></ul><ul><li>Blindness of counts </li></ul><ul><li>Invitation of external auditors to the count </li></ul><ul><li>Second count should be performed by different counter than the first counter </li></ul>
    252. 258. INVENTORY <ul><li>Quick Test Inventory Methods </li></ul>
    253. 259. INVENTORY –Inventory Valuation <ul><li>First-In, First-Out (FIFO) </li></ul><ul><li>Valuation method in which the assets acquired first are sold first. </li></ul>
    254. 260. INVENTORY –Inventory Valuation <ul><li>Last-In, First-Out (LIFO) Valuation method that assumes that assets acquired last are the ones that are sold first. </li></ul><ul><li>Reduces income taxes in times of inflation </li></ul>
    255. 261. INVENTORY –Inventory Valuation <ul><li>Average Cost Method </li></ul><ul><li>… values inventory costs as the average unit cost between the assets in the beginning inventory and the newly acquired assets. </li></ul>
    256. 262. INVENTORY – Cost of Goods sold An inventory count on October 30 showed 500 units in the warehouse. 1) What is the cost of goods sold for October under the FIFO method ? 2) What is the cost of goods sold for October under the LIFO method? 3) What is the cost of goods sold for October under the weighted average method?
    257. 263. INVENTORY <ul><li>Quick Test Costing Methods </li></ul>
    258. 264. INVENTORY - RATIOS <ul><li>Inventory Turnover Ratio </li></ul><ul><li>Shows how many times a company's inventory is sold and replaced over a period. </li></ul><ul><li>A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. </li></ul><ul><li>FMCG vs. CAR DEALER </li></ul><ul><li>Days in Inventory = 365 / Inventory Turnover Ratio </li></ul><ul><li>Measures the average number of days the company holds its inventory before selling it. </li></ul>
    259. 265. INVENTORY - RATIOS
    260. 266. Overview Day 3 <ul><li>Classified Balance Sheets </li></ul><ul><li>Current Assets </li></ul><ul><li>Inventory </li></ul><ul><li>Accounts Receivable </li></ul><ul><li>Fixed Assets </li></ul><ul><li>Depreciation Methods </li></ul><ul><li>Intangibles & Goodwill </li></ul><ul><li>Current Liabilites </li></ul><ul><li>Accounts Payable </li></ul><ul><li>Ratio Analysis </li></ul><ul><li>Compliance </li></ul><ul><li>Internal Controls </li></ul><ul><li>VAT </li></ul><ul><li>What to expect in an Audit </li></ul>
    261. 267. Current Assets – Accounts Receivable
    262. 268. Current Assets – Accounts Receivable A typical invoice contains: <ul><li>Invoice Requirements: </li></ul><ul><li>The word “INVOICE” </li></ul><ul><li>Unique identification number </li></ul><ul><li>Company Name, Adress </li></ul><ul><li>Product Description </li></ul><ul><li>Date </li></ul><ul><li>Amount </li></ul><ul><li>Currency </li></ul><ul><li>VAT amount (if applicable) </li></ul><ul><li>Rate of VAT per Item (if applicable) </li></ul><ul><li>VAT registration number (if applicable) </li></ul>
    263. 269. Current Assets – Accounts Receivable ec.europa.eu/taxation_customs/vies/vieshome.do
    264. 270. Current Assets – Accounts Receivable <ul><li>Receivables Turnover Ratio </li></ul><ul><li>= Net Sales / Average Accounts Receivable </li></ul><ul><li>This ratio measures the number of times, on average, receivables are collected during the period. </li></ul><ul><li>By maintaining accounts receivable, firms are indirectly extending interest-free loans to their clients. </li></ul><ul><li>A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm. </li></ul><ul><li>Average Collection Period </li></ul><ul><li>= 365 / Receivables Turnover Ratio </li></ul>
    265. 271. Current Assets – Accounts Receivable
    266. 272. Current Assets – Accounts Receivable
    267. 273. Current Assets – Accounts Receivable <ul><li>How to improve Cash Flow? </li></ul><ul><li>Factoring = financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor at a discount in exchange for immediate money </li></ul><ul><li>Invoice discounting = borrowing where the receivable is used as collateral </li></ul><ul><li>Cash discounts </li></ul>The sooner a seller receives the cash, the earlier he can put the money back into the business to buy more supplies and/or grow the company further.
    268. 274. Current Assets – Accounts Receivable <ul><li>How do you estimate the amount of uncollectible accounts receivable? </li></ul><ul><li>Aging Analysis, Percentage of Credit Sales based on experience… </li></ul><ul><li>Prudence Principle: Create „Allowance for Doubtful Debt“ </li></ul>
    269. 275. Current Assets – Accounts Receivable <ul><li>Bad Debt </li></ul><ul><li>is an amount that is written off by the business as a loss to the business and classified as an expense because the debt owed to the business is unable to be collected, and all reasonable efforts have been exhausted to collect the amount owed. This usually occurs when the debtor has declared bankruptcy or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself </li></ul><ul><li>Doubtful Debt </li></ul><ul><li>Doubtful debts are those debts which a business or individual is unlikely to be able to collect. The reasons for potential non payment can include disputes over supply, delivery, and conditions of goods, the appearance of financial stress within customers operation. When such a dispute occurs it is prudent s add this debt or portion thereof to the doubtful debt reserve When there is no longer any doubt that a debt in uncollectable the debt becomes bad. </li></ul>
    270. 276. Current Assets – Accounts Receivable <ul><li>Allowance for Doubtful Accounts = „CONTRA ASSET ACCOUNT“ </li></ul><ul><li>An asset account which is expected to have a credit balance (which is contrary to the normal debit balance of an asset account). The contra asset account is related to another asset account. For example, the contra asset account Allowance for Doubtful Accounts is related to Accounts Receivable. The contra asset account Accumulated Depreciation is related to a constructed asset(s) </li></ul><ul><li>The net of the asset and its related contra asset account is referred to as the asset's book value . </li></ul>
    271. 277. Allowance for Doubtful Accounts Journal Postings <ul><li>The allowance for doubtful accounts is normally recorded at the beginning of the company’s fiscal year after the estimated calculation is made. The following is the general journal entry at the beginning of the fiscal year. </li></ul><ul><li>- Bad Debts Expense – Debit (expense increase) </li></ul><ul><li>- Allowance for Doubtful Accounts – Credit (asset decrease) </li></ul><ul><li>2. Once an account becomes delinquent (bad), a journal entry needs to be made to decrease accounts receivable for that specific customer = WRITE OFF </li></ul><ul><li>- Allowance for Doubtful Accounts ­– Debit (asset increase) </li></ul><ul><li>- Accounts Receivable – Credit (asset decrease) </li></ul>
    272. 278. Current Assets – Accounts Receivable
    273. 279. Current Assets – Accounts Receivable
    274. 280. Overview Day 3 <ul><li>Classified Balance Sheets </li></ul><ul><li>Current Assets </li></ul><ul><li>Inventory </li></ul><ul><li>Accounts Receivable </li></ul><ul><li>Fixed Assets </li></ul><ul><li>Depreciation Methods </li></ul><ul><li>Intangibles & Goodwill </li></ul><ul><li>Current Liabilites </li></ul><ul><li>Accounts Payable </li></ul><ul><li>Ratio Analysis </li></ul><ul><li>Compliance </li></ul><ul><li>Internal Controls </li></ul><ul><li>VAT </li></ul><ul><li>What to expect in an Audit </li></ul>
    275. 281. Balance Sheet Details: Fixed Assets <ul><li>Assets intended to be in use for period longer than one year </li></ul><ul><li>Property, Plant & Equipment Land, buildings, cars, furniture, computers , etc... </li></ul><ul><li>Characteristics? </li></ul><ul><li>Cannot easily be converted into cash Are not directly sold to a firm's consumers </li></ul>
    276. 282. Balance Sheet Details: Fixed Assets <ul><li>How to determine the cost of asset?: The cost of property, plant, and equipment includes the purchase price of the asset and all expenditures necessary to prepare the asset for its intended use. </li></ul><ul><li>Example “COST OF LAND”: </li></ul><ul><li>Land purchases often involve real estate commissions, legal fees, bank fees, title search fees, and similar expenses. To be prepared for use, land may need to be cleared of trees, drained and filled, graded to remove small hills and depressions, and landscaped. In addition, old buildings may need to be demolished before the company can use the land. Such demolition expenses are considered part of the land's cost. </li></ul>
    277. 283. Balance Sheet Details: Fixed Assets <ul><li>Example: </li></ul><ul><li>“ Cost of land”: </li></ul><ul><li>Land is not depreciated because it does not have an expected useful life </li></ul><ul><li>“ Land improvement”: Separate asset on the balance sheet, with definite live Example: Parking lot… </li></ul>
    278. 284. Balance Sheet Details: Fixed Assets
    279. 285. Balance Sheet Details: Fixed Assets Repetition: Capitalization vs. Expense <ul><li>CAPEX (Capital Expenditure) </li></ul><ul><li>… are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life that extends beyond the taxable year. In accounting, a capital expenditure is added to an ASSET account („CAPITALIZED&quot;) </li></ul><ul><li>For tax purposes, capital expenditures are costs that cannot be deducted in the year in which they are paid or incurred and must be capitalized (= recorded as an asset). </li></ul><ul><li>Depreciation is then periodically booked as an expense </li></ul>
    280. 286. Balance Sheet Details: Fixed Assets Repetition: Capitalization vs. Expense <ul><li>OPEX (Operational Expenditure) </li></ul><ul><li>… is an ongoing cost for running a product, business, or system. </li></ul><ul><li>… are immediately treated as an EXPENSE </li></ul><ul><li>Example: The purchase of a photocopier is the CAPEX, and the annual paper, toner, power and maintenance cost is the OPEX. </li></ul>
    281. 287. Balance Sheet Details: Fixed Assets Steps to follow when Capitalizing an Asset <ul><li>Estimate Useful Life </li></ul><ul><li>Chose Rate of Depreciation </li></ul>
    282. 288. Overview Day 3 <ul><li>Classified Balance Sheets </li></ul><ul><li>Current Assets </li></ul><ul><li>Inventory </li></ul><ul><li>Accounts Receivable </li></ul><ul><li>Fixed Assets </li></ul><ul><li>Depreciation Methods </li></ul><ul><li>Intangibles & Goodwill </li></ul><ul><li>Current Liabilites </li></ul><ul><li>Accounts Payable </li></ul><ul><li>Ratio Analysis </li></ul><ul><li>Compliance </li></ul><ul><li>Internal Controls </li></ul><ul><li>VAT </li></ul><ul><li>What to expect in an Audit </li></ul>
    283. 289. Fixed Assets - Depreciation Methods Example EXCEL <ul><li>When a company buys a large asset such as a piece of machinery, accounting rules specify how the asset should be expensed each year. This is called depreciation. EXCEL offers four common methods for calculating depreciation: </li></ul><ul><li>Straight-line (SLN) </li></ul><ul><li>Declining-balance (DB) </li></ul><ul><li>Double-declining-balance (DDB) </li></ul><ul><li>Sum-of-years-digits (SYD) </li></ul>
    284. 290. Fixed Assets - Depreciation Methods <ul><li>By selecting the depreciation time, method, companies can manage the effects on profit over time – most companies prefer to “write off” as fast as possible: </li></ul><ul><li>Reason: Less profits now = less taxes now More profits later = more taxes later </li></ul>
    285. 291. Fixed Assets - Depreciation Methods Czech Republic – Depreciation on Fixed Assets
    286. 292. Fixed Assets - Depreciation Methods Depreciation as a Policy Instrument
    287. 293. Fixed Assets - Depreciation Methods Depreciation as a Policy Instrument
    288. 294. Fixed Assets - Depreciation Methods <ul><li>Cost = This is the initial cost of the asset. For example the machinery might cost $120.000 </li></ul><ul><li>Useful life = This is how long you expect to use the asset. If you think the machinery will be used for 10 years before being replaced, the useful life is 10 years </li></ul><ul><li>Salvage value = This is the value of the asset at the end of the useful life. Perhaps after 10 years you can sell the machine to a scrap dealer for $1.000. This is the salvage value. </li></ul>
    289. 295. Fixed Assets - Depreciation Methods <ul><li>Accumulated Depreciation = „CONTRA ASSET ACCOUNT“ </li></ul><ul><li>An asset account which is expected to have a credit balance (which is contrary to the normal debit balance of an asset account). The contra asset account is related to another asset account. For example, the contra asset account Allowance for Doubtful Accounts is related to Accounts Receivable. The contra asset account Accumulated Depreciation is related to a constructed asset(s) </li></ul><ul><li>Journal Posting </li></ul><ul><li>The net of the asset and its related contra asset account is referred to as the asset's book value or carrying value . </li></ul><ul><li>Balance Sheet View

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