Introduction to Accounting Foundations

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Learn basic accounting principles you need to successfully run your business. This deck covers the essentials, including financial statements like balance sheets, income statements, statements of cash flow, governance, and tax considerations.Taught by Brendan McCorry, Justin Vogel, and Sonal Shah of Ernst & Young

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Introduction to Accounting Foundations

  1. 1. presentsBrendan McCorry, Justin Vogel, Sonal Shah,Ernst & YoungIntroduction toAccounting Foundations
  2. 2. ► Welcome and Introductions► Accounting Foundations► Type of Entity – Tax considerationsAgenda
  3. 3. ► Brendan McCorryAudit Partnerbrendan.mccorry@ey.com(617) 585-3421► Justin VogelAudit Senior Managerjustin.vogel@ey.com(617) 585-0990► Sonal ShahTax Senior Managersonal.shah@ey.com(617) 585-6813Welcome
  4. 4. ► Objectives of financial reporting► Governance► Financial statement overview► Income statement► Balance sheet► Statement of cash flowsAccounting Foundations
  5. 5. ► To provide information that is useful to presentand potential investors and creditors► To help investors, creditors and other usersassess the amounts, timing and uncertainty ofprospective net cash inflows► To provide information about the economicresources of an enterprise, the claims to thoseresources and the effects of transactions,events and circumstances that changeresources, and claims to those resources.Objectives of Financial Reporting
  6. 6. ► Purpose of financial accounting system► To provide information in a standardized format thatallows financial stakeholders to understand a businessfrom an economic standpoint► Establish reporting requirements► Companies with publicly traded securities are governedby Regulatory authorities, which ensure compliancewith local jurisdiction reporting requirements► Privately owned companies may not have anyaccounting requirements at all, depending on theirfinancial stakeholdersGovernance
  7. 7. ► Established accounting standards► Auditors examine the financial statements toensure they are presented in accordance withgenerally accepted accounting principles(“GAAP”)► Many countries have adopted theInternational Financial Reporting Standards(“IFRS”), which seek convergence in globalfinancial reporting.Governance
  8. 8. ► U.S. GAAP► Accounting rules and guidance are established through various publications issued bygroups including the following:► Financial Accounting Standards Board (“FASB”),► American Institute of Certified Public Accountants (“AICPA”) and► Public Company Accounting Oversight Board (“PCAOB”).► GAAP is also influenced by the Securities and Exchange Commission (“SEC”).► Governance of Accounting Rules► State boards of accountancy► Federal regulation (Securities and Exchange Commission)► PCAOB► Companies have audits performed to show compliance with GAAPGovernance
  9. 9. Financial statements generally include:► Income statement► Balance sheet► Statement of cash flows► Statement of changes in stockholders’ equityFinancial Statement Overview
  10. 10. ► Income statements are generallypresented top-down (i.e., revenueslisted first followed by expenses)► Key components:► Revenue► Cost of sales► Gross profit► Operating expenses► Operating income► Tax expense► Net income► Sample summary income statementGross revenue 100Sales deductions (10)Net revenue 90Cost of sales 60Gross profit 30Operating expenses 20Operating income 10Tax expense 4Net income 6As a percentage of net sales:Gross margin 33.3Operating income 11.1Net income 6.7Income Statement
  11. 11. Revenue►Inflows of assets or settlements of liabilities from the sale of product,rendering of services, or other activities that constitute an entity’s ongoingmajor or central operationsRevenue is generally realizable and earned when the followingcriteria are met:►Persuasive evidence of an arrangement exists►Delivery has occurred or services have been rendered►Seller’s price to the buyer is fixed or determinable►Collectibility is reasonably assuredRevenue
  12. 12. Gross to net revenue:► Consideration offered by a vendor on a either a limited or a continuous basisto a customer such as discounts, coupons, rebates and free products orservices is generally required to be recorded as a reduction to gross revenue.► The following is an example:Gross to Net revenue
  13. 13. Expenses► Represent decreases in economic benefits during theaccounting period in the form of outflows or depletionsof assets or incurrence of liabilitiesMatching principle► Indicates that when it is reasonable to do so andallowed under the accounting standards, expensesshould be matched with revenues.► Only if no connection with revenue can be established,costs are charged as expenses to the current period(e.g. office salaries and other administrativeexpenses)Expenses
  14. 14. Cost of sales are:►Direct expenses incurred in producing a particular good for sale,including the actual cost of materials that comprise the good,and direct labor expense in putting the good in saleable conditionOperating expenses are:► Day-to-day expenses incurred in running a business, such assales and administration, or research & development► Operating expenses do not include direct production costs► In short, operating expenses include amounts spent bycompanies on matters such as selling, advertising, accountingand other costs that are required to sell their products andservices.Cost of Sales and Operating Expenses
  15. 15. Other income and expense► Generally includes items such as interestincome, interest expense, and non-operatingincome/expense► It is important to understand the composition ofother income and expense because there aresometimes operating expense/income itemsinappropriately included in the detail.Other Income and Expense
  16. 16. Objective:Shows assets (what a company owns), liabilities (what a companyowes) and stockholders’ equity (portion of assets owned byshareholders) at a particular date in timeGeneral characteristics► Assets = Liabilities plus stockholders’ equity► Assets and liabilities are generally listed in order of liquidity► In general, assets and liabilities are carried at cost(accounting convention of conservatism); however, there arecertain exceptions (i.e., lower of cost or market, fixed assetimpairments, investments, etc.)► Net assets = Assets – LiabilitiesBalance Sheet
  17. 17. Significant operating components generally include:► Cash► Accounts receivable► Other current assets► Fixed assets► Accounts payable► Accrued expenses► Debt or shareholder’s equityIn addition, fixed assets are often significant due to theuse of cash for capex requirements.Balance Sheet
  18. 18. ► Accounts receivable► Amounts that customers owe to a business► Since not all customer debts will be collected,businesses typically record an allowance for bad debtswhich is subtracted from gross accounts receivable► Other considerations – Credit terms► Collection periods often vary by company andindustry► Discounts offered are reserved at the time of sale► Certain allowances may be recorded in accruedexpensesAccounts Receivable
  19. 19. ► Prepaid expenses and other current assets► Services/ benefits to be received in the future which were paid in advance(e.g. future months of insurance coverage when annual premium is paid atthe beginning of the term)► Refundable items (lease deposits)► Inventory► Goods and/or materials (to be converted into goods) held for sale tocustomers► Inventory is usually classified into the following categories:► Raw materials► Work-in-process (WIP)► Finished goods► Generally reported net of reservesOther Current Assets
  20. 20. ► Fixed assets► Includes long-lived tangible assets used in the production of other goodsand services. Examples include land, buildings, machinery, furniture, andtools.Capex► Capex represents the amounts spent to acquire fixed assets and isgenerally broken up into the following components:► Growth capex (e.g., building expansion)► Recurring capex (e.g., periodic replacement of laptop computers)Other considerations► Repairs and maintenance expenseFixed Assets
  21. 21. ▶ Accounts payable▶ Amounts that are owed to suppliers and othervendors▶ Other considerations:▶ Cut-off▶ Stretching of payablesAccounts Payable
  22. 22. ▶ Accrued liabilities▶ Liabilities that have occurred (i.e., known obligation to pay for or provide services), but (i) havenot been paid (e.g., invoice) or performed (e.g., warranty) and (ii) not recorded as an obligationin accounts payable during an accounting period;▶ Examples include:▶ Obligations for goods and services provided for which invoices have not yet been received.▶ Accrued wages payable▶ Accrued sales tax▶ Accrued bonus▶ Accrued vacation▶ Accrued warranty▶ Accrued customer allowance▶ Deferred revenueAccrued Liabilities
  23. 23. ► Recording obligations► Liabilities are required to be recorded once theobligation is known► Liabilities should be accrued via a charge toincome if the liability is probable and the losscan be reasonably estimated.► Accrued liabilities are often subjective andrequire management estimates (e.g., accruedwarranty, bonus, etc.)Accrued Liabilities
  24. 24. ▶ Objective:▶ Provide financial users with cash receipt and payment informationFormat:▶ Most companies follow the indirect method – net income is the startingpoint and adjustments are made to remove non-cash components of netincome.▶ Three major sections:▶ Cash flows from operating activities▶ Cash flows from investing activities▶ Cash flows from financing activitiesStatement of Cash Flows
  25. 25. ▶ Footnotes to Financial Statements▶ Disclosure is required beyond the basic financialstatements▶ Provides an opportunity for management toexplain items which are not obvious from thestatements. May also provide additional detailon the components of accounts.Other Considerations
  26. 26. Type of Entity - Tax Considerations
  27. 27. ► The following are the three most common legal entities forconducting a business:► “C” corporation► A traditional statutory (state law) corporation where noelection has been made to treat as an “S” corporation► “S” corporation► A traditional statutory (state law) corporation that,subject to certain requirements and restrictions, makes aspecial tax election or “S” election► LLC/partnership► A joint venture of two or more parties entered into for profitTypes of Taxable Entities
  28. 28. ► The “C” corporation tax considerations:► The C corporation is a separate taxpaying entity► Corporate income is usually subject to two levels of incometax (i.e., “double taxation”)► Entity level income tax► Shareholder level tax (dividend distributions)► Losses and other tax attributes are retained at thecorporate level and do not flow through to shareholders► The treatment of these attributes to the corporation may besubject to limitation upon a purchase or “change inownership”Type of Entity – Tax Considerations
  29. 29. The “S” corporation tax considerations:► Generally, not subject to entity level income tax► Entity level income, gain or loss flows through tothe shareholders► Shareholders report S corporation income, gain,or loss in their personal income tax returns andadjust their tax basis in their stock accordingly► No second level of income tax on distributions ofpreviously taxed earningsType of Entity – Tax Considerations
  30. 30. ► The “S” corporation tax considerations (continued)► Eligibility requirements► Domestic corporation► Maximum number of shareholders is 100► Eligible shareholders are limited to US citizenor resident individuals, certain estates,certain trusts and ESOPs► One class of stockType of Entity – Tax Considerations
  31. 31. The LLC or Partnership tax considerations:► Generally, not subject to entity level income tax► Entity level income, gain or loss flows through to the member/partner and is taxed on member/partner tax return► Other considerations► Significant flexibility on the rights of equity interests and thetypes of equity holders. However, LLCs may be complex whencompared to C corporations► Management incentive benefits and complexities in the use ofprofits interests vs. traditional corporate stock options► Single-member LLCs are generally disregarded for US federalincome tax purposesType of Entity – Tax Considerations
  32. 32. Assurance | Tax | Transactions | AdvisoryAbout Ernst & YoungErnst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 152,000 peopleare united by our shared values and an unwavering commitment to quality. We make a difference by helping ourpeople, our clients and our wider communities achieve their potential.Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is aseparate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services toclients. For more information about our organization, please visit www.ey.com.Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US.About Ernst & Young’s Strategic Growth Markets NetworkErnst & Young’s worldwide Strategic Growth Markets Network is dedicated to serving the changing needs of rapid-growth companies. For more than 30 years, we’ve helped many of the world’s most dynamic and ambitious companiesgrow into market leaders. Whether working with international mid-cap companies or early stage venture-backedbusinesses, our professionals draw upon their extensive experience, insight and global resources to help yourbusiness achieve its potential.It’s how Ernst & Young makes a difference.© 2012 Ernst & Young LLP.All Rights Reserved.No. 1203-1343809 LAThis publication contains information in summary form and is therefore intended for general guidance only. It is notintended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young LLPnor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned toany person actingor refraining from action as a result of any material in thispublication. On any specific matter,reference should be made to the appropriate advisor.Ernst and Young
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