Financial Basic

F i n a n c i a l M a n a g e m e n t : B a s i c Instructor’s Edition

ILT Series™

COPYRIGHT © Axzo Press. All rights reserved.

No part of this work may be reproduced, transcribed, or used in any form or by any means⎯graphic, electronic, or mechanical, including photocopying, recording, taping, Web distribution, or information storage and retrieval systems⎯without the prior written permission of the publisher.

For more information, go to www.courseilt.com.

Trademarks ILT Series is a trademark of Axzo Press.

Some of the product names and company names used in this book have been used for identification purposes only and may be trademarks or registered trademarks of their respective manufacturers and sellers.

Disclaimer We reserve the right to revise this publication and make changes from time to time in its content without notice.

C o n t e n t s

Introduction iii Topic A: About the manual............................................................................... iv Topic B: Setting student expectations ............................................................. viii Topic C: Classroom setup..................................................................................x Topic D: Support...............................................................................................xii

Basics of accounting 1-1 Topic A: Accounting........................................................................................ 1-2 Topic B: Key accounting terms ....................................................................... 1-4 Unit summary: Basics of accounting............................................................... 1-18

Accounting cycle 2-1 Topic A: Basics of the accounting cycle.......................................................... 2-2 Topic B: Analyze, record, and post transactions ............................................. 2-5 Topic C: Trial Balance.................................................................................... 2-12 Unit summary: Accounting cycle.................................................................... 2-22

Income Statement 3-1 Topic A: Income Statement basics................................................................... 3-2 Topic B: Prepare and interpret an Income Statement ...................................... 3-7 Unit summary: Income Statement................................................................... 3-18

Balance Sheet 4-1 Topic A: Balance Sheet basics......................................................................... 4-2 Topic B: Prepare Balance Sheets..................................................................... 4-5 Topic C: Interpret Balance Sheets .................................................................. 4-19 Unit summary: Balance Sheet ......................................................................... 4-23

Other financial statements 5-1 Topic A: Cash Flow Statement ........................................................................ 5-2 Topic B: Statement of Stockholders’ Equity .................................................. 5-15 Unit summary: Other financial statements ...................................................... 5-24

Budgeting 6-1 Topic A: Fundamentals of budgeting............................................................... 6-2 Topic B: Analyze financial statements ............................................................ 6-5 Topic C: Set objectives................................................................................... 6-19 Topic D: Monitor performance ....................................................................... 6-27 Unit summary: Budgeting ............................................................................... 6-36

Course summary S-1 Topic A: Course summary ...............................................................................S-2 Topic B: Continued learning after class ..........................................................S-4

Glossary G-

Index I-1

1

1–1

U n i t 1 Basics of accounting

Unit time: 60 minutes

Complete this unit, and you’ll know how to:

A Define accounting.

B Identify the key accounting terms.

1–2 Financial Management: Basic

Topic A: Accounting Explanation Accounting is defined by The American Institute of Certified Public Accountants as the

art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are of a financial character, and interpreting the results.

To put it in simpler terms, accounting records and reveals the financial strengths and weaknesses of an individual or business. All businesses, large or small, must have a complete and accurate system of record keeping.

The need for accounting All organizations must show the operations of their businesses in financial terms for various reasons: when applying for credit, figuring costs, keeping within their budgets, or paying their employees. Also, businesses are responsible for furnishing this information to government agencies for taxation and other regulatory purposes.

Keep in mind that more than one quarter of a million new bankruptcy cases are filed each year. Many of these cases are the result of faulty accounting practices.

Individuals who use financial information

Tell students that another group that often uses financial information is prospective investors.

There are several individuals who might use financial information in an organization, but who they are will depend on the size of the company. A large organization with many employees will have an accounting department that is solely involved in preparing and analyzing financial records. In addition, that same organization will have members of upper-management and a board of directors who will be highly interested in the company’s financial status.

Conversely, if a business consists of one individual who is self-employed, this person will consult their accounting records almost daily. Accounting information is used by every aspect of our economic society, including churches, clubs, school districts, non-profit organizations, and city, state, and federal governments.

Benefits of understanding basic accounting concepts

Anyone can benefit from having a basic understanding of accounting concepts. You’ll be able to understand how the strength of your company is related to its productivity and the revenues these efforts generate. In addition, you’ll gain a better understanding of the reasoning behind decisions made by your organization.

Basics of accounting 1–3

Do it! A-1: Identifying the need for accounting

Exercises 1 What kinds of businesses should have a system of record keeping?

A All businesses

B Fortune 500 businesses

C Privately owned businesses

D Publicly owned businesses

2 An organization must show the operations of its businesses in financial terms so that it can:

A Improve employee morale

B Increase profits

C Apply for credit

D Surpass the competition

Tell students to discuss among themselves and answer.

3 Why would city, state, and federal governments be interested in the financial accounts of an organization?

The probable answer could be:

•••• To reveal trends within the economy as a whole

•••• To assess the profit on which the company’s tax liability is to be computed


Topic B: Key accounting terms Explanation To understand accounting, you need to be familiar with fundamental accounting terms,

such as:

• Accounting equation

• Transactions and accounts

• “T” account

• Revenue and expenses

• Capital and withdrawals

• Temporary and permanent accounts

• Fixed cost and variable cost

Accounting equation The accounting equation is the fundamental formula on which the books of accounting are based. It establishes the relationship among assets, liabilities, and owner’s equity.

Asset

Everything of value owned and used in a business is considered an asset, such as cash, sales, supplies, and office equipment. For example, the computers, copier machines, and office furniture owned by a company are its assets. Assets even include any money owed to a business, known as “Accounts Receivable.”

Liability

The amount of money a business owes a person or company for goods or services rendered is considered a liability. For example, when a company buys office supplies and charges them to an account with an oral or implied promise to pay, the charges are considered a liability and are often classified as “Accounts Payable.” In addition, when a company borrows money from a bank, the loan is a liability and is often classified as “Notes Payable.”

Owner’s equity

The part of a business that belongs to the owner is the owner’s equity. Owner’s equity can be determined by finding the difference between a company’s assets and liabilities; this difference is what a business is worth to the owner.

For example, if a company’s total assets are worth $350,000, and its liabilities are worth $75,000, then the owner’s equity would be the difference between these two figures: $275,000.

In a business owned by an individual, the owner’s equity account will usually have the owner’s name followed by the word “Capital,” such as, “Terry Brown, Capital.”


The accounting equation is expressed in the following manner:

Assets = Liabilities + Owner’s Equity (often abbreviated as: A = L + OE).

It is important to learn and remember this equation, since it the basic element of accounting, regardless of the size of the business. You’ll use the accounting equation, as shown in Exhibit 1-1, whenever recording business transactions.

Exhibit 1-1: The accounting equation

Accounting period

An accounting period is also known as a fiscal period. It is the length of time that a business analyzes its financial activities, and will vary in length from business to business. Some businesses might use a one-month accounting period, while others might use a three-month, six-month, or one-year accounting period.

Do it! B-1: Understanding the accounting equation

Exercises The assets can differ from the ones given here according to the setting of the classroom.

Ask students to share their answers and discuss.

1 List at least three assets that you can see around you.

•••• Chair

•••• Desk

•••• Study material

•••• Pen

2 Which of the following is the definition of a liability?

A Everything of value owned and used in a business

B The amount of money a business owes a person or a company for goods or services rendered

C The part of a business that belongs to the owner

D Any amount owed by a customer to your business



3 List at least three liabilities that you can think of.

•••• Loan payable to a bank

•••• Salary payable to employees

•••• Outstanding telephone bills

4 Which of the following is the basic accounting equation?

A Liabilities/ Assets = Owner’s Equity

B Owner’s Equity x Assets = Liabilities

C Assets = Liabilities + Owner’s Equity

D Assets + Liabilities = Owner’s Equity

5 Financial International’s combined assets equal $25,000, and its liabilities are worth $15,000. What is the owner’s equity?

A $40,000

B $25,000

C $10,000

D $15,000

Tell students to read this case and then answer the questions that follow.

6 A company has cash in hand worth $10,000; cash in the bank worth $25,000; machinery worth $12,000; accounts payable worth $23,000; and a bank loan worth $5,000.

What is the total amount of assets?

$47,000

Total assets ($47,000) = cash in hand ($10,000) + cash at bank ($25,000) + machinery ($12,000).

What is the total amount of liabilities?

$28,000

Total liabilities ($28,000) = accounts payable ($23,000) + bank loan ($5,000)

What is the owner’s equity?

$19,000

Owner’s equity ($19,000) = Total assets ($47,000) - Total liabilities ($28,000)


Once the activity is complete, ask a student from one group to list the assets and liabilities on the whiteboard, and a student from the other group to write the owner’s equity with its calculation.

Have students verify the answers are correct.

7 The instructor will divide the class into two groups. Each group should review Icon’s Balance sheet, shown below. As a group, identify assets and liabilities and then calculate the owner’s equity.

Assets •••• Cash = $620,000

•••• Marketable Securities = $200,000

•••• Accounts and Notes Receivable = $1,190,000

•••• Inventories = $2,410,000

•••• Real Estate = $8,400,000

•••• Leasehold Improvements = $200,000

•••• Machinery Equipment = $1,900,000

Total Assets = $14,920,000

Liabilities •••• Accounts Payable = $500,000

•••• Notes Payable = $180,000

•••• Dividends Payable = $110,000

•••• Mortgage Bonds = $1,000,000

•••• Sinking Fund Debentures = $900,000

Total Liabilities = $2,690,000

Owner’s Equity Total Assets ($14,920,000) – Total Liabilities ($2,690,000) = Owner’s Equity ($12,230,000)


Transactions and accounts Explanation A business transaction is any business event or activity that involves monetary value. In

other words, it is any activity that changes assets, liabilities, or owner’s equity. For example, when a company buys office supplies on credit, they exchange the value of the office supplies for a debt or liability.

Transactions can be both internal and external. For example, if a business moves money from the marketing department’s budget to another budget, it is an internal transaction. However, if the same business sells 10,000 units of its product to an outside client, this movement of resources is an external transaction.

When you record business transactions, you fill in the accounting equation (A = L + OE).

An account is a form used for recording and summarizing business transactions. Basically, accounts are broken into the three categories of assets, liabilities, and owner’s equity, the same three elements of the accounting equation.

These three account categories, or classes of accounts, are made up of smaller individual accounts. For example, some liability accounts are “Accounts Payable,” “Notes Payable,” and “Wages Payable.”

Do it! B-2: Identifying transactions and accounts

Exercises 1 Icon moves $10,000 from the marketing budget into the human resource budget.

What type of transaction has taken place?

A Internal

B External

2 Define a business transaction?

Any business event or activity that involves monetary value and which changes assets, liabilities, or owner’s equity of a company.


“T” account A “T” account is a simplified form used to record a transaction that results in the increase or decrease of various accounts. It gets its name from its resemblance to the letter “T” and is used to divide an account into two sides, debits and credits, as shown in Exhibit 1-2. The left side of any account is called the debit side and is abbreviated “Dr.” The right side of any account is called the credit side, abbreviated “Cr.” The name of the specific account, such as Accounts Payable or Office Supplies, is listed at the top of the “T” structure.

In order to understand debits and credits, you must understand how they increase or decrease assets, liabilities, and owner’s equity.

Exhibit 1-2: The “T” account

Debits and credits

Debits increase assets and decrease liabilities and owner’s equity. Conversely, credits decrease assets and increase liabilities and owner’s equity, as shown in Exhibit 1-3.

Exhibit 1-3: Debits and Credits


For example, imagine that your business purchased $18,000 worth of new teleconferencing equipment from Enson Corporation and charged it with the promise to pay over the next six months. An asset account, such as Teleconferencing Equipment, would be established to record the equipment purchased. Since you now own more equipment, you would increase the balance of this account by entering $18,000 on the left, or debit, side of the account, as shown in Exhibit 1-4. A liability account, Accounts Payable, would be established to record the amount your company owes to Enson. Since the $18,000 represents an increase in the amount of money you owe Enson, the $18,000 would be listed on the right, or credit, side of the “T” account for Accounts Payable.

Exhibit 1-4: Recording debits and credits in the “T” account

For another example of a business transaction, imagine your business received $500 from Chelsea Insurance, a client who owed you for consultation services you provided last month. This transaction would affect your Cash account and the Accounts Receivable account, which are both asset accounts. Since your company is receiving money or payment on this account, you are increasing the balance of the Cash account and decreasing the balance of the Accounts Receivable account. Thus, you would list the $500 on the left, or debit, side of the “T” account for Cash to increase its balance as an asset. You would also list the $500 on the right, or credit, side of the “T” account for Accounts Receivable to decrease its balance as an asset.

The Golden Rule for debits and credits

The Golden Rule for debits and credits is that every transaction affects and is recorded in two or more accounts and that debits must always equal credits in every transaction. In other words, for every debit that occurs during a transaction, there must be an offsetting credit, and vice versa.


This principle is also called double-entry bookkeeping. Double-entry bookkeeping is a method of recording transactions in which each transaction must have at least two entries—at least one debit and one credit. However, while some transactions might have just one debit and one credit, other transactions might have numerous debits and credits. No matter how many entries you make, the total dollar amount of debits must equal the total dollar amount of credits.

For example, imagine that your business paid $4,500 to Enson Corporation for the teleconferencing equipment they provided, as shown in Exhibit 1-5. The debit entry would be $4,500 on the Accounts Payable account, since it would be a decrease to this liability account. The offsetting credit entry would be $4,500 on the credit side of the Cash account, since you would be decreasing the amount of cash available by paying the debt.

Exhibit 1-5: Example of double-entry bookkeeping

Do it! B-3: Understanding the “T” account

Exercises 1 The left side of any “T” account is

called the debit side. True or False?

True

2 The Golden Rule for debits and credits states that in every transaction:

A For every debit, there are two credits

B Debits must be greater than credits

C Debits must equal credits

D Credits must be greater than debits


3 The definition for double-entry bookkeeping states that:

A Every transaction must have at least two entries—one debit and one credit

B No transaction can have more than two entries

C Maintain two copies of every account in two locations

D Record every transaction as a debit twice, but only once as a credit

Revenue and expenses Explanation Revenue and expenses are two categories included in owner’s equity.

Tell students that the other two categories included in the owner’s equity are capital and withdrawals.

Revenues are monies that a business earns for selling goods or services to another firm or individual. The terms Income and Fees Earned are often used when referring to revenue accounts. For example, the revenue account for a movie theater might include Ticket Revenue (or Ticket Income) and Concession Revenue (or Concession Income).

Expenses are the costs of any goods or services that a business buys and uses to help earn revenues. Examples of an expense account might include Rent Expense, Utilities Expense, and Insurance Expense.

Simply stated, revenue increases owner’s equity and represents its credit side; expenses decrease owner’s equity and represent its debit side, as shown in Exhibit 1-6.

Since the fundamental accounting equation is Assets = Liabilities + Owner’s Equity, the expanded accounting equation incorporates revenue and expenses in the following method:

Assets = Liabilities + Owner’s Equity + Revenue – Expenses

Exhibit 1-6: The effect of revenue and expenses on owner’s equity


How revenue and expenses relate to profit and loss

Revenue and expense transactions tell whether a business is making a profit (increasing in value) or incurring a loss (decreasing in value) from its operations. If the revenue total is larger than the expense total, then there is a net profit. If the expenses are larger than the revenues, there is a net loss.

Do it! B-4: Identifying revenue and expenses

Exercises 1 Icon sells $10,000 worth of products to a local government agency. The cash

received represents:

A Revenue

B Expense

C Assets

D Liabilities

2 While reading the financial statements of Icon International, you come across an item that states “Fees Earned: $5.8 million.” Which section of the financial statements would you find this account?

A Assets

B Liabilities

C Expenses

D Revenue

3 Which of the following will show a net profit?

A Revenues of $640,000 and expenses of $600,000

B Revenues of $600,000 and expenses of $640,000

C Revenues of $720,000 and expenses of $780,000

D Revenues of $720,000 and expenses of $720,000


4 Using the following excerpt from Icon’s Income Statement, list the revenues and expenses.

Revenues •••• Sales

•••• Dividends and interest

Expenses •••• General and administrative expenses

•••• Depreciation and depletion

•••• Cost of sales

•••• Selling expenses

Capital and withdrawals Explanation The owner’s equity is calculated by taking into account the capital and withdrawals.

Capital is used to record an owner’s investments in a business. A withdrawal account, also called a Drawing account, is used to record when an owner withdraws assets, such as cash or equipment, from the business for personal use.

Capital increases owner’s equity, so it is recorded on the right, or credit, side of the account. Since withdrawals reduce owner’s equity, they are recorded on the left, or debit, side of an owner’s equity account. Both capital and withdrawal accounts usually include the name of the owner, such as, “Terry Brown, Withdrawals.”


Do it! B-5: Identifying capital and withdrawals

Exercises 1 Which of the following statements about “capital” is true?

A It is recorded on the debit side of an owner’s equity account

B It decreases the owner’s equity

C It is used to record an owner’s investments in a business

2 Which of the following are recorded in the Drawing account?

A Owner’s investment in a business

B Cash withdrawn from the business for personal use

C Cash paid to a business supplier

D Equipment withdrawn from the business for official use

Discuss why this statement is false.

3 Withdrawals are recorded on the right side of an owner’s equity account. True or False?

False, as withdrawals reduce owner’s equity, they are recorded on the left, or debit, side of an owner’s equity account.

Temporary and permanent accounts A temporary account is an account that begins and ends an accounting period with a $0 balance. The temporary accounts in a company’s books include the owner’s equity accounts of withdrawals, revenues, and expenses. Reducing an account’s balance to $0 so it is ready to start a new period is called closing an account. Revenue and expense accounts are temporary accounts, since their balances are reduced to $0, or closed, at the end of each accounting period (usually the end of the fiscal year).

Accounts that are not closed or reduced to a $0 balance are permanent accounts. Assets, liabilities, and the owner’s equity capital account are permanent accounts, since their balances are carried over from one accounting period to the next.

A transaction involving a temporary account and a permanent account

It is important that you understand the difference between transactions that involve temporary and permanent accounts.


Imagine that your business purchased $60,000 worth of personal computers from Acme Corporation on credit. This purchase would involve two permanent accounts: an asset and a liability. Since office equipment was purchased, this asset account will reflect the ownership of this equipment for several years. In addition, the Accounts Payable account would reflect the balance owed to Acme Corporation until full payment is made to them. Thus, this transaction involves two permanent accounts with balances that would carry over on the company’s books to a new fiscal year. If you were to treat these two accounts as temporary accounts and close them at the end of the fiscal year, you would reflect that you own no office equipment and that you had paid off all debts without really having done so.

When your company pays rent on the building you lease, the transaction involves a permanent account, Cash, and a temporary account, Rent Expense. Cash will be reduced with a credit and Rent Expense will be increased with a debit. Cash is a permanent account that represents the balance in the company checking account. If the Cash account were treated as a temporary account and closed at the end of the fiscal year, the company would start the new fiscal year with no cash with which to operate. Rent Expense is a temporary account that is closed at the end of each fiscal year because the rent you pay this year should not impact the financial statements for next year.

Do it! B-6: Identifying temporary and permanent accounts

Exercises Discuss why this statement is false.

1 Permanent accounts are closed at the end of each accounting period. True or False?

False. The temporary accounts are closed at the end of the accounting period. The balances of permanent accounts are carried over from one accounting period to the next.

2 Which of the following describes a temporary account?

A Opening Balance $500, Closing Balance $0

B Opening Balance $0, Closing Balance $4500

C Opening Balance $500, Closing Balance $4300

D Opening Balance $0, Closing Balance $0


Fixed cost and variable cost Explanation Costs are categorized based on the level of activity within a company.

Fixed costs remain the same, or fixed, regardless of the amount of activity within the business. For example, the property taxes a business pays are fixed costs, since they stay the same, regardless of how many units the company produces.

Fixed costs can increase or decrease, but they do not fluctuate in relation to the level of activity within the business. For example, property taxes might increase due to increases in property values in an area.

Unlike fixed costs, variable costs will change in relation to the level of activity within a company. Variable costs can be directly associated with the number of units produced by a business.

For example, the cost of materials needed to produce units is a variable cost; since it will increase or decrease in relation to how many units the company produces. In addition, the packaging material used to package units has a variable cost, since it will fluctuate according to how many units are produced and packed.

Do it! B-7: Identifying fixed cost and variable cost

Multiple-choice questions 1 Which of the following expenses is a variable cost?

A Office rent

B Raw materials

C Property taxes

D Building insurance

2 Which of the following expenses will remain fixed, regardless of the amount of activity within Icon International?

A Discounts allowed

B Depreciation on machinery

C Direct expenses

D Manufacturing wages


Unit summary: Basics of accounting Topic A In this unit, you learned what accounting is, how accounting is defined, and who uses

financial information in an organization.

Topic B Finally, you learned how to identify the fundamental accounting terms, such as the accounting equation, transactions and accounts, “T” account, and revenue and expenses. You also learned how to identify capital and withdrawals, temporary and permanent accounts, and fixed cost and variable cost.

Independent practice activity 1 Define accounting.

Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, the transactions and events, which are of a financial character, and interpreting the results.

2 Who uses financial information in an organization?

• Departments involved in preparing records

• Upper-management who reviews the information

Those who are self-employed will consult their accounting records almost daily.

3 How will understanding basic accounting concepts benefit you?

They will help you to:

• Understand how strengths relate to productivity and revenue

• Understand the reasoning behind decisions

4 Why is it important to use sound accounting practices?

It helps in maintaining legal financial records.

You need to show operations in financial terms to:

• Apply for credit

• Figure costs

• Pay employees

• Pay taxes

• Keep within established budget

5 What does “A,” “L,” and “OE” stand for in the accounting equation: A = L + OE?

Assets, Liabilities, and Owner’s Equity


6 Identify the asset(s) from the following list:

A Icon’s Notes Payable to a bank

B Money owed to Icon, such as accounts receivable

C Outstanding rent that Icon needs to pay for office space

D Icon’s computers, copiers, and fax machines

7 Icon’s combined assets equal $175,000, and its liabilities are $135,000. Based on that information, what is the owner’s equity?

A $175,000

B $310,000

C $40,000

D $135,000

8 Icon sells $10,000 worth of product to another company. Is this an internal or external transaction?

External

9 Which of the following is incorrect?

A Debits increase assets and decrease liabilities

B Debits decrease assets and increase liabilities

C Credits decrease assets and increase liabilities

D Credits decrease assets and increase the owner’s equity

10 You invite an external consulting firm to familiarize employees with a new policy for preventing sexual harassment. Will your organization incur revenue or an expense?

A Revenue

B Expense

11 At the end of the fiscal year, Lawson Development reviews its accounting statements and determines that it had revenues of $1.2 million and expenses of $1.5 million. Did they show a net profit or a net loss?

A Net profit

B Net loss

12 Which of the following represents a variable cost to Icon International?

A Property taxes paid by Icon each year

B Office rent paid each month

C Amount of raw materials used by Icon for its products

D Insurance of the warehouse


13 Use the following clues to complete the crossword.

ACROSS:

1. A form used for recording and summarizing business transactions

5. Costs such as property taxes paid by the business that remain the same regardless of the amount of activity within the business

6. Anything owned by a business that has a monetary value, for instance, cash, office equipment, etc.

7. A time period in which a business analyzes its financial activities, and that varies in length from one business to another

8. The amount of money a business owes a person or a company for goods and services rendered

9. The amount of money a business earns by selling goods or services to another firm or individual

DOWN:

2. An owner’s investment in a business

3. Any business event or activity that involves monetary value

4. Part of a transaction that must always have an offsetting credit

1 2 3 4 A C C O U N T D

A R E

P A B

5 F I X E D N I

6 T A S S E T

A A

7 L F I S C A L

T

8 L I A B I L I T Y

O

9 R E V E N U E

2–1

U n i t 2 Accounting cycle



A Identify the phases of the accounting cycle and the types of accounting records.

B Analyze and post transactions, balance a General Ledger, and identify the cash and accrual bases of accounting.

C Identify the concept and method of Trial Balance preparation.


Topic A: Basics of the accounting cycle Explanation The accounting cycle can be divided into nine phases that use accounting records to

analyze, record, post, and journalize transactions.

Phases of the accounting cycle Tell student that this unit will focus on the first four steps of the accounting cycle.

You can divide the accounting cycle into nine phases. They are:

1 Analyze transactions

2 Record transactions in a General Journal

3 Post transactions from the General Journal to the General Ledger

4 Prepare a Trial Balance

5 Prepare a worksheet with adjusting entry data

6 Prepare financial statements

7 Journalize and post adjusting entries

8 Journalize and post closing entries

9 Prepare a Post-Closing Trial Balance

Accounting records The books used to record accounts are:

• Chart of Accounts

• General Journal

• General Ledger

Chart of Accounts

A Chart of Accounts is a detailed listing of all accounts that a business uses for recording transactions. Every account, from Cash and Office Supplies to Accounts Payable and Common Stock, is listed. The Chart of Accounts is unique for each organization.

Each account can be assigned a number, which is related to the class of accounts it represents, as shown in Exhibit 2-1. For example, asset accounts can be labeled starting with a 1, liability accounts with a 2, owner’s equity accounts with a 3, revenue accounts with a 4, and expense accounts with a 5. This numbering system helps you to easily identify the individual accounts.

Accounting cycle 2–3

Exhibit 2-1: Chart of Accounts

General Journal

The General Journal s a book of business transactions and is the accounting record where transactions are first recorded. The entries in the General Journal are recorded in chronological order, and each transaction has a brief description of its purpose, as well as its account number. All of the transactions listed in the General Journal are then posted into the General Ledger.

General Ledger

Once you have recorded transactions in the General Journal, you must post them in the General Ledger. The General Ledger is the book that contains all of the business’ accounts, listed in numerical order. Each account in the General Ledger lists all the activity or transactions for that accounting period.

When you post a transaction from the General Journal to the General Ledger, it means that you have entered the transaction recorded in the General Journal in the appropriate accounts on the General Ledger. Unless you post transactions, the individual account balances will not be accurate.


Do it! A-1: Understanding the basics of an accounting cycle

Exercises 1 Put the following phases of the accounting cycle in the correct order:

Prepare financial statements.

Post transactions from the General Journal to the General Ledger.

Analyze transactions.

Journalize and post adjusting entries.

Record transactions in a General Journal.

Prepare a Trial Balance.

Journalize and post closing entries.

Prepare a Post-Closing Trial Balance.

Prepare a worksheet with adjusting entry data.

Analyze transactions.

Record transactions in a General Journal.

Post transactions from the General Journal to the General Ledger.

Prepare a Trial Balance.

Prepare a worksheet with adjusting entry data.

Prepare financial statements.

Journalize and post adjusting entries.

Journalize and post closing entries.

Prepare a Post-Closing Trial Balance.

2 You first record a transaction in the ________________.

A General Ledger

B Chart of Accounts

C General Journal

D General Balance

3 Which of the following is a commonly used numbering system for entries in a Chart of Accounts?

A Liabilities (1), Assets (2), Owner’s Equity (3), Revenue (4), and Expenses (5)

B Owner’s Equity (1), Assets (2), Liabilities (3), Expenses (4), and Revenue (5)

C Assets (1), Liabilities (2), Owner’s Equity (3), Revenue (4), and Expenses (5)

D Assets (1), Liabilities (2), Owner’s Equity (3), Expenses (4), and Revenue (5)


Topic B: Analyze, record, and post transactions Explanation The first three phases of the accounting cycle are analyzing, recording, and posting

transactions to the account books according to specific bases of accounting which is being used, either cash or accrual.

Analyze transactions You must be able to analyze a transaction in order to record it in the General Journal and post it to the General Ledger. Analyzing a transaction is what you do when you determine what type of account is affected by a financial activity, and how the event translates into debits and credits. There are three questions you should ask yourself when analyzing a transaction:

1 What account(s) will change?

2 What account classification does each account belong to?

3 How will the transaction change each account balance?

Assume that your business paid a bill of $700 to Access Systems, Inc. You then answer the three questions to analyze the transaction, as shown in Exhibit 2-2:

1 The accounts that will be changed are the Cash and Accounts Payable accounts.

2 Cash belongs to the asset account classification, and Accounts Payable belongs to the liability account classification.

3 Your Cash account will be decreased, and your Accounts Payable account would be decreased. Therefore, $700 would be credited to the Cash account, and $700 would be debited to the Accounts Payable account.

Exhibit 2-2: Example of analyzing a transaction


Post transactions to the General Ledger Explanation There are three steps you can follow when posting transactions from the General

Journal into the General Ledger:

1 Start with the first debit entry. Record the entry and its date in the corresponding account in the General Ledger. Then, record all entries for that transaction. For example, you might have a $500 debit in your Accounts Payable account. After recording this entry, you would then record the $500 credit entry for Cash.

2 In the Post Reference column of the General Ledger, record the page number of the General Journal where the transaction was entered. This referencing provides a trail for anyone who needs to retrace the steps taken in posting transactions. This column is often labeled Post Ref.

3 Enter the General Ledger account number where the entry was recorded in the Post Ref. Column of the General Journal. This referencing will also help establish a trail that can be retraced later if necessary.

Do it! B-1: Analyzing and posting a transaction

Exercises 1 What is the first question that you must ask when analyzing a transaction?

What account or accounts will be changed?

2 Icon collects $100,000 from Epic Financial. What accounts will be affected by the transaction?

A Icon’s Sales account and its Accounts Receivable account

B Icon’s Sales account and its Accounts Payable account

C Icon’s Accounts Payable account and its Accounts Receivable account

D Icon’s Accounts Receivable account and its Cash account

3 After Icon collects $100,000 from Epic Financial, you will post the transaction in Cash , which belongs to the ________ account, and Accounts Receivable, which belongs to the _________ account.

A Asset…Liability

B Asset…Asset

C Liability…Liability

D Liability…Asset


4 When posting a transaction from the General Journal to the General Ledger, what is the first step?

A Enter the General Ledger account number where the entry was recorded in the post reference column of the General Journal

B Record the debit entry and its date in the corresponding account in the General Ledger and record all of the entries for that transaction

C In the post reference column of the General Ledger, record the page number on the General Journal

D Record the credit entry and its date in the corresponding account in the General Ledger and record all of the entries for that transaction

5 While posting transactions, why do you need to record the respective General Journal and General Ledger page numbers in the post reference columns?

This referencing provides a trail for anyone who needs to retrace the steps taken while posting transactions.

Balance a General Ledger Explanation At the end of an accounting period, when the month’s financial activities have been

posted to the General Ledger, some accounts will have amounts posted to their debit side as well as their credit side. Therefore, after you have posted all transactions to the accounts, you must balance the General Ledger accounts. There can be only one balance to each account at the end of the accounting period.

Balancing a General Ledger requires balancing each of the accounts listed in the ledger. Follow these four steps in order to balance an account:

1 Draw a single line under the last figures in each column, as shown in Exhibit 2-3.

2 Write the totals, or footings, of each column just below the line, as shown in Exhibit 2-3. In accounting, one line means “more to come;” a double line means “the end.”

Exhibit 2-3: Steps 1 and 2 of balancing a General Ledger


3 If the two footings are equal, as shown in Exhibit 2-4, the account is “in balance.”

4 If the two footings are different, you can write the difference on the side of the account that has the larger amount and circle the figure. If the debit side has the larger amount, this account is considered to have a debit balance, as shown in Exhibit 2-4. If the credit side has a larger amount, then the account has a credit balance.

Exhibit 2-4: Steps 3 and 4 of balancing a General Ledger

You might wonder why some accounts have footings that are not equal, since debits are always supposed to equal credits. Individual accounts might have different debit and credit totals because when you post a transaction from the journal, you post part of that transaction to one ledger account and part of it to another ledger account. Therefore, the debit side will equal the credit side if you add up all of the balances of all the accounts in the ledger.

A “normal” balance

The balance of an account is considered “normal” if it is on the same side of the account (debit or credit) as it is shown in the accounting equation (A = L + OE), or if the increase side of the account is larger than the decrease side. For example, since assets are normally on the debit, or left, side of the accounting equation, an account that is classified as an asset will have a normal balance if it has a debit balance. Conversely, liability accounts will have a normal balance if they have a credit balance, as will owner’s equity accounts.

Since revenue represents the credit side of owner’s equity, revenue accounts have a normal balance if they have a credit balance. Expenses represent the debit side of owner’s equity, so for expenses, a debit balance is a normal balance.


Exhibit 2-5: Icon’s General Ledger

Do it! B-2: Balancing a General Ledger

Exercises 1 In accounting, a double line means:

A “more to come”

B “out of balance”

C “in balance”

D “the end”

2 Which of the following is an example of a “normal” balance?

A Debit balance of an Accounts Payable account

B Credit balance of a Debentures account

C Credit balance of an Accounts Receivables account

D Debit balance of a Notes Payable account

Discuss with students. Explain why the account is not in balance.

3 Review Icon’s General Ledger account shown in Exhibit 2-5. Is it “in balance?”

A Yes

B No

The account is not in balance because the debit and credit footings are different.


4 Review Icon’s General Ledger shown in Exhibit 2-5. What is the balance?

A Debit balance of $1,000

B Credit balance of $1,000

C Debit balance of $1,400

D Credit balance of $2,400

5 Review Icon’s General Ledger shown in Exhibit 2-5. What is the next step to balance the General Ledger?

A Circle the credit side since it has the larger amount

B Write the difference between the two footings on the credit side and circle the figure

C Write the difference between the two footings on the debit side and circle the figure

D Add the difference between the two footings onto the next account and continue balancing

The cash and accrual bases of accounting Explanation When using the cash basis of accounting, you record revenues only when the money is

received and record expenses only when they are paid. With the cash basis, there are occasions when revenue is earned in one period, but the transaction is not recorded until the money is received in a future period. Therefore, the cash basis does not accurately and completely reflect a business’s true profitability.

The accrual basis of accounting presents a true and uniform picture of profitability because it records revenue when it is earned and expenses when they are incurred, not strictly when money has changed hands. In other words, accrual accounting records transactions when they occur, regardless of whether or not money has been received or expenses have been paid.


Do it! B-3: Identifying cash and accrual bases of accounting

Exercises 1 Select the transaction(s) that will not be recorded under cash basis of accounting.

A Interest paid

B Outstanding rent

C Equipment purchased on cash

D Payment of dividend

2 A business receives a rental income of $2000 in cash on June 30th. On December 31st, there is another $1500 of rental income due, which is not yet received. What is the total of the Rental income account on December 31st if your company uses the following basis of accounting:

Cash basis of accounting $2000

Accrual basis of accounting $3500

$3500 = $2000 + $1500


Topic C: Trial Balance Explanation A Trial Balance is a report that lists all the account balances as of a certain date, usually

at the end of an accounting period, such as at the end of the month. The Trial Balance serves two purposes:

• It makes sure that the total debits equal the total credits in the recording of transactions. Financial statements cannot be prepared unless the total debits equal the total credits on the Trial Balance.

• It ensures that each account has a normal balance.

If you find that a Trial Balance does not balance, there is a strong possibility that an error was made in recording the transaction, posting to the General Ledger, computing the account balances, copying balances to the Trial Balance, or in adding the Trial Balance columns.

Prepare a Trial Balance In order to prepare a Trial Balance, you can follow these five steps:

1 Create a heading by centering the name of your company, the name of the accounting statement (Trial Balance), and the date, as shown in Exhibit 2-6.

Exhibit 2-6: Step 1 of preparing a Trial Balance

2 List all accounts found in the General Ledger, their account numbers, and their corresponding balances. List the debit balances in one column and the credit balances in a separate column, as shown in Exhibit 2-7.

3 Draw a single line under the last figure in each column, as shown in Exhibit 2-7.


Exhibit 2-7: Steps 2 and 3 of preparing a Trial Balance

4 Total the debit balances and credit balances and write these footings under the line, as shown in Exhibit 2-8.

5 If the totals are the same, draw a double line just below them to show that the Trial Balance is complete, as shown in Exhibit 2-8.

Exhibit 2-8: Steps 4 and 5 of preparing a Trial Balance

“The books are in balance”

“The books are in balance” if the debit balances and credit balances are equal on a Trial Balance. If the debits and credits are not the same, you’ll need to go back and determine where an error occurred during the recording of transactions.

When looking for these errors the referencing that was done when the accounts were posted to the General Ledger is quite helpful and makes it easier to find the mistake.


Do it! C-1: Preparing a Trial Balance

Exercises 1 The primary purpose of a Trial Balance is to determine that:

A All transactions have been entered in journals

B The General Ledger totals are in balance

C The amounts in a Journal are correct

2 “The books are in balance” means that:

A The Trial Balance has a larger credit balance

B The Trial Balance has a larger debit balance

C The debits and credits are equal on a Trial Balance

D Every account in the Trial Balance has a debit balance

3 When preparing a Trial Balance, what would you need to do after creating a heading?

A Draw a single line under the last figure in each column

B Total the debit and credit balances and write these footings under the single line that you have drawn

C Draw a double line below the footings to show that the totals are equal

D List all of the accounts found in the General Ledger, their account numbers, and their corresponding balances

4 When preparing a Trial Balance, what would you need to do before you draw a double line below the footings?


B Create a heading to include the company’s name, the accounting statement’s name, and the date

C Total the debit and credit balances and write these footings under the single line that you have drawn

D List all of the accounts found in the General Ledger, their account numbers, and their corresponding balances


Ask two or three students to give reason to support their answer.

5 Review the Trial Balance shown below. Is it “in balance?” Discuss with the class.

The Trial Balance is not in balance because the debit balance is more than the credit balance.

Common errors found in a Trial Balance Explanation There are several common errors that can prevent your Trial Balance from being “in

balance:”

• Computing the amount columns in the Trial Balance incorrectly

• Copying the wrong account balance from the General Ledger to the Trial Balance

• Transferring a debit balance from a General Ledger to the credit column in the Trial Balance, or transferring a credit balance from a General Ledger to the debit column in the Trial Balance

• Computing the account balance in the General Ledger account incorrectly

• Posting an incorrect amount from the General Journal to the General Ledger

The general rule to follow when looking for errors in the Trial Balance is to retrace, in reverse order, the steps you followed to get your Trial Balance figures. Go back, one step at a time, and check each figure with your original figures. First check the Trial Balance figures with the General Ledger, and then check the General Ledger figures with the General Journal.


A transposition error

A transposition error is an error in which the numbers are transposed or reversed, such as 76 written as 67 or 36 written as 63. There is a common feature among transposition errors that will help you locate these types of errors: the difference between numbers that have been transposed is always a number that adds up to 9 or is evenly divided by 9.

Consider these examples of a transposition error:

• Transposing 76 and 67 leaves a difference of 9, which of course adds up to 9, and is divisible by 9 (9 x 0 = 9)

• Transposing 63 and 36 is 27, which adds up to 9 (2 + 7 = 9), and is divisible by 9 (9 x 3 = 27).

• Transposing 725 and 275 is 450, which adds up to 9 (4 + 5 + 0 = 9), and is divisible by 9 (9 x 50 = 450).

Once you know this trick of recognizing a transposition, you’ll save a lot of time by knowing where to look for the error.

Do it! C-2: Identifying common errors found in a Trial Balance

Multiple-choice questions 1 The difference between numbers that have been transposed is always a number

that adds up to:

A 6

B 7

C 8

D 9

2 Which of the following would prevent your Trial Balance from being “in balance?”

A A debit balance of $75 on the Salaries account has been incorrectly posted in the trial balance as $750 debit

B Sale of goods for $1000 to Epson Inc. on credit has been completely omitted from the books of accounts

C A debit balance of $10000 in the Cash account has been posted to the trial balance as a debit balance of $10000 in the Machinery account

D A debit balance of $10000 in the Cash account has been posted to the credit column of the trial balance. At the same time, a credit balance of $10000 in the Mortgage bonds account has been posted to the debit column of the trial balance


If necessary, help students identify the errors.

3 Review the following Trial Balance. What common errors prevent the books from being “in balance?”

A Transposition error

B Computation error

C Incorrect posting to the Ledger from the Journal

D Transferring a debit to the credit column in the Trial Balance

The computation error is that the debit column total of the Trial Balance is shown as $3,122.00, whereas it is $3,100.00.

The other error is that all values entered in the Trial Balance are in the wrong columns. The values shown in the debit column should have been written in the credit column and all values shown in the credit column should have been written in the debit column.


If necessary, help students identify the errors.

4 Review the following Trial Balance. What common error prevents the books from being “in balance?”


B Computation error

C Incorrect posting to the Trial Balance from the Ledger


The Sales account balance of $120,237.00 is incorrectly written in the Trial Balance as $120,273.00.


Financial statements Explanation Completing a Trial Balance will enable you to create two of the most important

financial statements in accounting: the Income Statement and the Balance Sheet. Then, by using the Income Statement and the Balance Sheet, you can prepare the Cash Flow Statement and the Statement of Stockholder’s equity.

Income Statement

An Income Statement, also known as a Statement of Operations, is a financial report that provides information regarding the profit or loss for the last accounting period. It is only concerned with revenue and expense accounts. This statement is important, as a business owner or manager must know how the business is doing, assuming profit is the reason a company is in business. All the information you need to complete an Income Statement is found on the Trial Balance.

Balance Sheet

A Balance Sheet, also known as a Statement of Financial Position, is a financial report prepared at the end of an accounting period that gives a detailed picture of the financial condition, or position, of a business as of a specific date. It can almost be thought of as a “snap-shot” in time of a business’s financial status. It shows what a company owns and owes, and how much capital it has at a particular point in time. The Balance Sheet summarizes the first three classifications listed on the Chart of Accounts: assets, liabilities, and owner’s equity.

Like an Income Statement, all the information you need to complete a Balance Sheet is found on the Trial Balance.

Cash Flow Statement

A Cash Flow Statement, also known as the Statement of Cash Flows, provides information about a company’s cash inflows and outflows during an accounting period. Specifically, it reports the impact of a company’s operating, investing, and financing activities on the cash flows during an accounting period.

Statement of Stockholders’ Equity

The Statement of Stockholders’ Equity, also known as the Statement of Owner’s Equity, reports the changes that have occurred in the owner’s, or stockholders’, equity during an accounting period. It is prepared after the Income Statement is prepared, since the net profit or net loss must first be determined.

Since retained earnings and capital stock are the two main components of owner’s equity, these are the two categories of accounts that are included in the Statement of Stockholders’ Equity.

Importance of financial statements

Just as a barometer helps a meteorologist determine what the weather might be in the future, financial statements tell you what business might be like tomorrow, next week, and even next month. Simply, they show trends. Financial statements tell you how the business is currently performing at a certain point in time or over a period of time, as well as show current trends.


In the business world, each step forward is based on what has happened in the past. Planning for future expansion, changing manufacturing procedures, changing packaging specifications, and even changing the size of products are all decisions based on the results of past information and on future expectations. Financial statements reflect the results of changes that occurred during the last accounting period. Knowing such results helps management make informed business decisions and plan intelligently.

Do it! C-3: Identifying financial statements

Exercises 1 Which financial statement is a “snap-shot” in time of a business’ financial status?

A Balance Sheet

B Statement of Stockholders’ Equity

C Cash Flow Statement

D Income Statement

2 The Income Statement is only concerned with revenue and expense accounts. True or False?

True

3 A Report that shows how a company generated and used cash during an accounting period is a:

A Balance Sheet

B Income Statement

C Statement of Stockholders’ Equity

D Cash Flow Statement

4 A financial report that provides information regarding the profit or loss for the last accounting period is a:

A Balance Sheet

B Income Statement

C Statement of Stockholders’ Equity

D Cash Flow Statement

5 Retained Earnings is one of the two categories of accounts that are included in the Statement of Stockholders’ Equity. What is the other category?

A Capital Stock

B Operating expenses

C Working capital

D Operating activities


6 That Balance Sheet summaries what three classifications on the Chart of Accounts?

A Assets, Liabilities, and Interest expenses

B Liabilities, Owners’ Equity, and Interest expenses

C Assets, Liabilities, and Owners’ Equity

D Assets, Cost of Goods Sold, and Owners’ Equity

7 Financial statements report the financial performance of an organization, and provide data on:

A Projections for the future

B Business trends

C Environmental changes

D Availability of cash


Unit summary: Accounting cycle Topic A In this unit, you learned about the phases of the accounting cycle. You also learned to

identify the three types of accounting records: Chart of Accounts, General Journal, and General Ledger.

Topic B Then, you learned how to analyze, record, and post transactions. You also learned how to balance a General Ledger and identify the cash and accrual bases of accounting.

Topic C Finally, you learned the concept and preparation of a Trial Balance, how to solve common errors found in the Trial Balance, and also identified various types of financial statements that you can create by using the Trial Balance.

Independent practice activity 1 What are the first four phases of the accounting cycle?

• Analyzing transactions

• Completing a General Journal

• Completing a General Ledger

• Preparing a Trial Balance

2 Complete the table below by writing General Ledger, General Journal, or Trial Balance next to the correct description.

Description Accounting record

A book of business transactions where the entries are recorded in a chronological order

General Journal

A book that contains all accounts of a business, listing all transactions for an accounting period

General Ledger

A detailed listing of all the accounts that a business uses for recording transactions. Each account has a number assigned to it, which is related to the broad class of accounts it represents

Chart of Accounts


3 Icon pays $200,000 to Epic Financial for consulting services. How will this affect Icon’s Cash account and its Accounts Payable account?

A Icon will credit $200,000 to both Cash and Accounts Payable

B Icon will debit $200,000 from its Cash and credit $200,000 to its Accounts Payable

C Icon will credit $200,000 from its Cash and debit $200,000 from its Accounts Payable

4 Review Icon’s General Ledger account shown in Exhibit 2-9. Is the account “in balance?”

No, because the debit side is larger than the credit side.

Exhibit 2-9: Icon’s General Ledger

5 Review Icon’s General Ledger account shown in Exhibit 2-9. What is the next step to balance the General Ledger?

A Circle the credit side since it has the larger amount

B Write the difference between the two footings on the credit side and circle the figure

C Write the difference between the two footings on the debit side and circle the figure

D Add the difference between the two footings onto the next account and continue balancing


6 What is the first step when preparing a Trial Balance?


B Create a heading to include the company’s name, the accounting statement’s name, and the date

C Total the debit and credit balances and write these footings under the line

D Draw a double line below the footings to show that the totals are equal

E List all of the accounts found in the General Ledger, their account numbers, and their corresponding balances

7 Which financial statements provide a picture of a company’s operations and financial position?

The Balance Sheet, the Income Statement, the Cash Flow Statement, and the Statement of Stockholders’ Equity

8 What is a Balance Sheet?

It is a financial report prepared at the end of an accounting period that gives a detailed picture of the financial condition, or position, of a business as of a specific date.

9 What does a Cash Flow Statement show?

• How a business earned and spent cash

• Organization’s cash position

• Report on operating, investing, and financing activities

10 Complete the following table by writing Balance Sheet, Cash Flow Statement, or Statement of Stockholder’s Equity next to the correct description.

Description Financial Statement

Report that explains the changes in the owner’s equity accounts during an accounting period

Statement of Stockholders’ Equity

Financial report that gives a detailed picture of an organization’s financial condition

Balance Sheet

Report that summarizes the changes in an organization’s cash position by reporting on three types of activities: operating, investing, and financing

Cash Flow Statement

Summarizes the first three classifications listed on the Chart of Accounts: assets, liabilities, and owner’s equity

Balance Sheet


11 Review the Trial Balance shown in Exhibit 2-10. What common errors prevent the books from being “in balance?”


B Computation error

C Incorrect posting to the Trial Balance from the Ledger


Exhibit 2-10: Icon’s Trial Balance and General Ledger


12 Review the Trial Balance shown in Exhibit 2-11. What common error prevents the books from being “in balance?”


B Computation error

C Incorrect posting to the Ledger from the Journal


Exhibit 2-11: Icon’s Trial Balance and General Ledger



ACROSS:

1. If the two footings of an account are equal, the account is in _______.

3. The ________ basis of accounting records revenue when it is earned and expenses when they are incurred, and not strictly when money has changed hands.

4. Liability accounts will have a normal balance if they have a ________ balance.

8. ________ a transaction from the General Journal to the General Ledger involves three steps.

9. All transactions are first recorded in a General _________.

DOWN:

2. A _______ of accounts is a detailed listing of all the accounts that a business uses for recording transactions.

5. Assets are normally on the ________ side of an accounting equation.

6. The General ________ is a book that contains all the accounts of a business, listed in ascending numerical order.

7. The balance of an account is considered ____________ if it is on the same side of the account (debit or credit) as it is shown in the accounting equation (A = L + OE), or if the increase side of the account is larger than the decrease side.

1 2

B A L A N C E

H 3

A C C R U A L

R 4 5 C R E D I T T

6 7 E L N

B E O

I D R

8 P O S T I N G M

E A

9 J O U R N A L

3–1

U n i t 3 Income Statement



A Identify the key terms of an Income Statement.

B Create and interpret an Income Statement.


Topic A: Income Statement basics Explanation To prepare an Income Statement, you need to know some key terms associated with this

concept:

• Types of revenues and expenses

• Profit and Loss

Types of revenues and expenses Revenues are amounts of money that a business earns for selling goods or services to another firm or individual. Sales- and service-based incomes are the two main types of revenue a company earns. In addition, fees income is another type of revenue that might be generated.

A company might also gain revenue through dividends and interest, which is income received from an investment in stocks and bonds. Often, these types of revenue are classified as Other revenue or Non-operating revenue on an Income Statement.

Expenses are the costs of any goods or services a business buys and uses to help it earn revenues.

There are four categories of expenses you’ll find on an Income Statement:

• Cost of goods sold

• Operating expenses

• Interest expenses

• Income tax

Cost of goods sold

The cost of goods sold represents the costs of the products sold during an accounting period. This cost can be determined by adding the beginning inventory with any purchases made to the inventory, and then subtracting the ending inventory:

Beginning Inventory + Purchases to Inventory - Ending Inventory = Cost of Goods Sold

Beginning inventory is the cost of merchandise on hand at the beginning of an accounting period. Purchases to inventory are any additions made to inventory, less returned merchandise and any discounts allowed by suppliers. Ending inventory is the cost of merchandise that remains unsold at the end of an accounting period. In a manufacturing unit, the cost of material, labor overheads, and manufacturing overheads are also included in the cost of goods sold.

Income Statement 3–3

Operating expenses

Operating expenses are expenditures that are necessary for the daily operations of a business. They are not directly tied to the costs of goods a business sells. Marketing, administrative, and other general expenses, such as rent and office supplies, are included in this category. In addition, depreciation and depletion are included in the operating expenses.

Depreciation is the process of allocating the cost of a tangible asset over its useful life. Long-term assets, which are assets that have a life longer than one year, are often depreciated, such as a building, computers, or equipment. Depreciation occurs when an asset’s decline in usefulness is estimated, and the allocation of costs to pay for the asset is divided in a manner consistent with the decline.

For example, imagine that your company purchased a piece of equipment that cost $12,000 and was estimated to have a useful life of 10 years. Using depreciation, you would break up the $12,000 into separate amounts that would be charged off over the life of the equipment. That means the $12,000 would be split up equally over the next 10 years and the yearly depreciation amount would be $1,200.

Depletion is the process of recording the exhaustion of natural resources as an expense. Oil wells, coalmines, and timberlands are all natural resources that are consumed as they are used. Depletion is similar to depreciation in that the expense that is recorded each accounting period reflects the portion of natural resource that was used up during the current year.

Interest expenses

Interest expenses are a result of the financial structure of a business. Specifically, a company incurs interest expenses if it has taken out a loan to support its asset investment. If a company has instead used stockholders’ equity to support its asset investment, they will not have interest expenses.

Income tax

Income tax is an unavoidable expense for any business. However, since it does not serve to increase sales or improve operating efficiency, it stands alone as its own expense category.


Do it! A-1: Identifying types of revenues and expenses

Exercises 1 Which of the following is a category of expenses found on an Income Statement?

A Inventory expenses

B Revenue-driven expenses

C Interest expenses

D Profit expenses

2 What is the Cost of Goods Sold in the following situation?

Beginning inventory = $10,000

Ending inventory = $12,000

Purchases = $8,000

A $14,000

B $6,000

C $10,000

D $30,000

3 What is the Cost of Goods Sold in the following situation?

If necessary, help students identify the correct answer.

Opening Stock-in-trade = $15,000

Purchases = $220,000

Purchases Returns = $20,000

Closing Stock-in-trade = $20,000

$195,000

Cost of Goods Sold = Opening Stock-in-trade + Net Purchases - Closing Stock-in-trade

Here, Net Purchases = Purchases - Purchases Returns

4 _______ is the process of recording the exhaustion of natural resources as an expense.

A Depletion

B Depreciation

C Allocation

D Amortization


5 Which expense category represents Building rent and Office supplies?

A Depletion expenses

B Operating expenses

C Additions to inventory

D Income tax

6 Icon International purchases a piece of equipment for $50,000. This piece of equipment would have a useful life of 10 years. How much should be written off as depreciation?

A $500 in the first year

B $50,000 in the last year

C $500,000 over ten years

D $5,000 per year

Profit and loss Explanation A manufacturing business makes money by selling goods at a higher price than was

paid for them.

Gross profit on sales

The gross profit on sales is determined by subtracting the cost of goods sold from the company’s sales, or total revenue.

For example, if a company earns $400,000 in sales and their cost of goods sold is $250,000, then their gross profit on sales is $150,000.

Operating profit

The operating profit is the amount of revenue remaining after you subtract the operating expenses from the gross profit on sales. This profit is sometimes referred to as the operating income.

Earnings before interest and taxes and income before taxes

Earnings before interest and taxes (EBIT) are calculated by adding the operating profit and the other revenue, which consists of dividends and interest.

Income before taxes is calculated by subtracting the interest expenses from the earnings before interest and taxes. It is also often referred to as EBT, or earnings before taxes.

Net profit and net loss

Determining the net profit or net loss is the ultimate goal when producing an Income Statement. The net profit or net loss is determined by subtracting any provisions made for income tax from the income before taxes. If the amount is positive, it is a net profit. Net profit indicates that a company generated more revenue than the amount of expenses it incurred during the period of time that the Income Statement covers.


If the amount is negative, it is a net loss, which indicates that a company incurred more expenses than the amount of revenue it generated during the period covered by the Income Statement.

Do it! A-2: Calculating profit and loss

Exercises 1 During an accounting period, Enson Corporation earns $900,000 in sales and its

cost of goods sold is $550,000. What is its gross profit on sales?

A $900,000

B $1,450,000

C $50,000 per year

D $350,000

Gross profit = Company’s sales – Cost of goods sold

2 During an accounting period, Enson Corporation’s gross profit on sales is $350,000 and its operating expense is $100,000. What is its operating profit?

A $450,000

B $250,000

C $350,000

D $100,000

Operating profit = Gross profit from sales – Operating expense

3 During an accounting period, Enson Corporation’s operating profit is $500,000, other revenue is $100,000, interest paid is $135,000, and income tax is $150,000. What is Enson’s net profit or net loss?

If necessary, help students identify the correct answer.

Net loss = $315,000

Operating profit ($500,000) + Other revenue ($100,000) – Interest paid ($135,000) – Income tax ($150,000) = – $315,000

Ensure the index cards are prepared before the class. Give one set to Group A and the other set to the Group B.

4 The instructor will divide the class into two groups and give both groups a set of cards. Use the cards to construct the appropriate formula. Note that the cards might contain more than what is required to create the formula.

Group A: Use the cards to construct the formula for Net Profit or Net Loss

Net Profit or Net Loss = Operating Profit + Other Revenue – Interest Expenses – Income Tax

Group B: Use the cards to construct the formula for Earnings Before Interest and Taxes

Earnings Before Interest and Taxes = Sales – Cost of Goods Sold – Operating Expenses + Dividends + Interest


Topic B: Prepare and interpret an Income Statement

Explanation The Income Statement records a company’s revenue and expense details and provides information regarding the profit or loss for the last accounting period. By using this information, you can determine if a company is operating satisfactorily.

Steps to prepare the Income Statement There are five steps that you can follow when preparing an Income Statement:

1 Create the heading

2 Enter the revenue account balances

3 Enter the operating expense account balances

4 Enter the “other revenue”

5 Enter the interest expenses and income tax

Create the heading

There are three items you must center at the top of the page, as shown in Exhibit 3-1 when creating an Income Statement:

• The name of the company

• The name of the accounting statement (in this case, Income Statement)

• The date or period of time covered by the statement, such as “For the Year Ending June 30, 2000”

Exhibit 3-1: Heading of the Income Statement

Enter the revenue account balances

Most companies have one major revenue account—Sales. However, there are six steps that you can follow when entering the revenue account balances into an Income Statement:

1 Write a revenue account title, such as “Sales,” on the first line, as shown in Exhibit 3-2.

2 Write the amount of the account’s balance in the right amount column on the same line as the account’s title, as shown in Exhibit 3-2. Repeat this process for all of the revenue accounts.


Exhibit 3-2: Steps 1 and 2 of entering the revenue account balances

3 If there is more than one revenue account, draw a single line under the amount of the last revenue account balance, as shown in Exhibit 3-3. A single line in accounting means “more to come.”

4 Write “Total Revenue” on the line just below the last revenue account title. Total the revenue amounts and enter the balance on the line just under the last revenue amount, as shown in Exhibit 3-3.


5 Some Income Statements show the calculations for the cost of goods sold at this place in the Income Statement. Do the preliminary calculations in the left amount column, and enter the cost of goods sold in the right amount column. Draw a line under this amount, as shown in Exhibit 3-4.

6 Subtract the cost of goods sold from the total revenue amount, and write it under the line you drew, as shown in Exhibit 3-4. This amount is the “gross profit on sales.”



Enter the operating expense account balances

There are six steps that you can follow when entering the operating expense account balances into an Income Statement. These steps are almost identical to the steps that you follow when entering revenue account balances:

1 Write the heading “Operating expenses” on the line following the “gross profit on sales” title, as shown in Exhibit 3-5.

2 Write the operating expense account title, such as “Rent” or “Office Supplies,” starting on the next line, as shown in Exhibit 3-5.

Exhibit 3-5: Steps 1 and 2 of entering the operating expense account balances

3 Write the amount of the account’s balance in the left amount column on the same line as the account’s title, as shown in Exhibit 3-6.

4 If there is more than one operating expense account, draw a single line under the amount of the last account balance, as shown in Exhibit 3-6.



5 Write “Total Operating expenses” on the line just below the last operating expense account title. Total the list of operating expenses and write the balance in the right amount column, as shown in Exhibit 3-7. Draw a line under this amount.

6 Subtract the total operating expenses from the gross profit on sales, enter the amount below the line you drew (as shown in Exhibit 3-7), and label it as “Operating profit.”


Enter the “other revenue”

There are four steps that you can follow when entering the “other revenue” into an Income Statement:

1 Write the heading “Other revenue” on the line following the “Operating profit” title, as shown in Exhibit 3-8.

2 Write “Dividends and interest” on the line following the “Other revenue” title, as shown in Exhibit 3-8.


Exhibit 3-8: Steps 1 and 2 of entering the “other revenue”

3 Enter the amount of revenue generated from dividends and interest on the same line as the “Dividends and interest” title, in the right amount column. Draw a line under this amount, as shown in Exhibit 3-9.

4 Add the dividends and interest amount to the operating profit amount, enter the figure under the line you drew (as shown in Exhibit 3-9), and label it as “Earnings before interest and tax.”

Exhibit 3-9: Steps 3 and 4 of entering the “other revenue”

Enter the interest expenses and income tax

There are six steps that you can follow when entering the interest expenses and income tax into an Income Statement:

1 Write the heading “Other expense” on the line following “Earnings before interest and tax,” as shown in Exhibit 3-10.

2 Write “Interest expenses” on the line following “Other expense,” as shown in Exhibit 3-10.

Exhibit 3-10: Steps 1 and 2 of entering the interest expenses and income tax


3 Enter the amount of interest expenses in the right amount column and draw a line under the amount, as shown in Exhibit 3-11.

4 Subtract the interest expenses from the total income, write the amount under the line you drew, and label it as “Income before taxes” as shown in Exhibit 3-11.


5 On the line following “Income before taxes”, write “Provision for Federal and State Income Taxes” and enter the amount of income tax expenses in the right amount column. Draw a line under the amount, as shown in Exhibit 3-12.

6 Subtract the provision for income tax from the income before taxes and write the amount under the line you drew. If this amount is positive, it is a “net profit.” If this amount is negative, it is a “net loss.” Draw a double line (meaning “the end”) below the net profit or net loss to indicate that the Income Statement is complete, as shown in Exhibit 3-12.



Exhibit 3-13: Icon’s Income Statement

Do it! B-1: Preparing an Income Statement

Exercises 1 Review Icon’s Income Statement, as shown in Exhibit 3-13, and notice that each

line is numbered. How should Line 4 and Line 10 be labeled?

Line 4 Sales

Line 10 Cost of goods sold

2 Study the Income Statement, as shown in Exhibit 3-13. What is the gross profit on sales?

A $4,000,000

B $18,300,000

C $3,700,000

D $3,800,000


3 Study the Income Statement, as shown in Exhibit 3-13. What is the net profit or loss for the year?

A ($2,950,000)

B $990,000

C $1,850,000

D ($990,000)

Interpret Income Statements Explanation There are two ratios that you can compute from the information an Income Statement

provides. Both of these ratios will help you determine if a company is operating satisfactorily:

• The net operating margin

• The profit margin on sales

The net operating margin

In order to determine if a company is operating at a satisfactory level of efficiency, you must calculate the net operating margin. In order to calculate the net operating margin, divide the operating profit by the total sales figure: Operating Profit / Sales = Net Operating Margin.

The net operating margin is expressed as a percentage. For example, if a company earned $2,040,000 in operating profit and $11,000,000 in sales, the net operating margin is 18.55%. This implies that for each dollar of sales, approximately 18.5 cents was the income from operations, as shown in Exhibit 3-14.

The net operating margin is compared to a company’s previous net operating margins in order to determine its financial health. For example, if a company’s net operating margin drops from 18.55% to 10% in one year, then the company’s financial strength has obviously weakened. In addition, a company will often compare its net operating margin to those of similar businesses, particularly competitors.

Exhibit 3-14: The net operating margin


The profit margin on sales

The profit margin on sales will indicate the status of business activities. It is determined by dividing the net profit for the year by the total sales figure: Net Profit / Sales = Profit Margin on Sales.

Tell students that if sales decline to $8,000,000 and net profit declines to $400,000, the profit margin on sales would reduce to 5%. Discuss the calculation as (400,000 /8,000,000) x 100 = 5%.

For example, if a company’s net profit is $990,000 and its sales are $11,000,000, the profit margin on sales is 9%. Therefore, for each dollar of sales, nine cents in profit went to the company.

Like the net operating margin, the profit margin on sales is most effective when compared with a company’s profit margin on sales of previous years and with other companies with similar types of business. By doing so, you’ll be able to reach accurate conclusions on profit progress and prospects for the future, as shown in Exhibit 3-15.

Exhibit 3-15: The profit margin on sales

Analyzing an inadequate level of gross profit on sales

There are three areas that should be investigated if the gross profit on sales is too low to cover a company’s operating and interest expenses:

1 Product volume The product volume is a factor if the number of units produced is significantly higher than the rate at which sales can sell the units.

2 Price structure The price of a unit might be too low to generate the profits needed to cover other expenses.

3 Product costs The cost of producing a unit might be too high.

Analyzing an inadequate level of operating profit

If a company’s gross profit is adequate, but its operating profit is inadequate, management must reduce the operating expenses. If reducing the operating expenses is not possible, then the company might not be able to succeed as a viable financial operation.

Analyzing the income before taxes total

The income before taxes total is an important indicator of how well a company will endure a financial setback, such as a drop in profits or an increase in expenses.


Specifically, any drop in gross profit or increase in operating or interest expenses that exceeds the income before taxes total will result in a net loss for the company.

Therefore, a company will be able to endure a financial crisis better as their income before taxes total increases.


Do it! B-2: Interpreting an Income Statement

Exercises 1 A net operating margin of 13%

means that for each dollar of sales, 13 cents was the income from operations. True or False?

True

2 Which of the following does not need to be investigated if a company has an inadequate level of gross profit on sales?

A Product costs

B Sales commission

C Price structure

D Product volume


3 Review the Income Statement, as shown in Exhibit 3-16. What is the net operating margin?

A 5.39%

B 33.63%

C 18.55%

D 18.86%

Operating Profit / Sales = Net Operating Margin

Discuss with students. Assuming that the previous year’s net operating margin for Icon was 12%, what does the current year’s net operating margin indicate?

The net operating margin has increased from 12% to 18.55%. This implies that Icon’s financial strength has improved.

4 Review the Income Statement, as shown in Exhibit 3-16. What is the profit margin on sales?

A 11%

B 5.39%

C 7.21%

D 9%

Net Profit / Sales = Profit Margin on Sales.

Discuss with students. Assuming that the previous year’s profit margin on sales for Icon was 2%, what does the current year’s net operating margin indicate?

The profit margin on sales has increased from 2% to 9%, which implies that for each dollar of sales, Icon is now earning 9 cents of profit as compared to the previous years’ two cents. Therefore, Icon is operating at an improved level of efficiency.


Unit summary: Income Statement Topic A In this unit, you learned about the key terms associated with an Income Statement. You

learned how to calculate the four categories of expenses listed in an Income Statement. You also learned how to calculate the different types of profit and loss, such as gross profit on sales, operating profit, earnings before interest and taxes, income before taxes, net profit, and net loss.

Topic B Finally, you learned how to prepare an Income Statement. You also learned how to interpret an Income Statement by calculating the net operating margin and the profit margin on sales, and analyzing the different types of profits.

Independent practice activity 1 What are the characteristics of an Income Statement?

• Documents profit or loss

• Tracks revenue and expense accounts

• Helps businesses know how they are doing

2 What is revenue?

Money earned by selling goods or services to others

3 What are the different types of revenue?

There are four types of revenue: sales-based, service-based, fees income, and dividends and interest.

4 What does the term expense mean?

Expenses are the costs of goods or services bought to earn revenue.

5 List the four different categories of expenses.

Cost of goods sold, operating expenses, interest expenses, and income tax.

6 What expense category represents salaries paid to employees?

A Costs of Goods Sold

B Operating Expenses

C Interest Expenses

D Income Tax

7 What expense category represents the costs of products sold during an accounting period?

A Costs of Goods Sold

B Operating Expenses

C Additions to inventory

D Depreciation expenses


8 Icon purchases a building for $1,000,000. This building would have a useful life of 50 years. How much should be set aside as depreciation each year?

A $20,000 per year

B $1,000,000 per year

C $50,000 per year

D $500,000 per year

9 What are the steps used to prepare an Income Statement?


2 Enter the revenue accounts

3 Enter the operating expense accounts

4 Enter the “other revenue”

5 Enter the interest expenses and income tax

10 Review the Income Statement, as shown in Exhibit 3-17. What is the operating profit?

A $2,000,000

B $5,360,000

C $2,040,000

D $5,000,000



11 Review the Income Statement, as shown in Exhibit 3-17. What label would you use for Line 19?

A Earnings before interest and taxes

B Depletion

C Gross profit on sales

D Sales


12 Use the following clues to complete the crossword:

ACROSS:

1. It is the process of recording the exhaustion of natural resources as an expense.

3. Operating ______ is the amount of revenue remaining after you subtract the operating expenses from the gross profit on sales.

4. Beginning Inventory + Purchases to Inventory - Ending Inventory = ________ of Goods Sold.

5. The _______ profit indicates that a company generated more revenue than the amount of expenses it incurred during the period of time covered by the Income Statement.

7. To determine whether a company is operating at a satisfactory level of efficiency, you must calculate the net operating ________. You can calculate it by dividing the operating profit by the total sales figure.

8. If a company’s gross profit is adequate, but its operating profit is inadequate, management must reduce the operating _______.

DOWN:

1. You _________ an asset when you estimate an asset’s decline in usefulness and allocate the costs to pay for the asset in a manner consistent with the decline.

2. They are the expenditures that are necessary for the daily operations of a business.

6. The ___________ profit on sales is determined by subtracting the cost of goods sold from the company’s sales or total revenue.

1 2 D E P L E T I O N

E P

3 P R O F I T E

R R

E A

4 5 C O S T N E T

6 I I G

7 A M A R G I N R

T G O

E S

8 E X P E N S E S

4–1

U n i t 4 Balance Sheet



A Identify a Balance Sheet.

B Prepare a Balance Sheet.

C Identify and calculate the liquidity and the debt-to-total-assets ratio.


Topic A: Balance Sheet basics Explanation A Balance Sheet shows what a company owns and owes, and how much capital it has at

a particular point in time. It is always prepared after the Income Statement because you cannot complete the balance sheet until you compute the net profit or net loss on the Income Statement.

Components of a Balance Sheet The Balance Sheet summarizes the first three classifications listed on the chart of accounts: Assets, Liabilities, and Owner’s Equity.

Assets

Current assets are those which might be turned into cash in the reasonably near future, usually within 12 months from the date of the Balance Sheet. Some examples of current assets include cash, marketable securities held for the short term, accounts and notes receivable, and prepaid expenses such as rent, insurance, and office supplies.

Fixed assets are those assets not intended for resale. They are tangible, long-lived assets used in the operation of the business to produce, distribute, and promote the product or service. Real estate, buildings, machinery, furniture, computers, and other equipment are all fixed assets.

Liabilities

Current liabilities are debts and obligations that a company expects to pay within 12 months from the date of the Balance Sheet. Accounts and notes payable, federal and other taxes payable, and accrued liabilities such as wages, salaries, and commissions are all current liabilities.

Long-term liabilities are those debts and obligations owed by a business that it expects to pay beyond 12 months from the date of the Balance Sheet. Examples of long-term liabilities are mortgage bonds and lease obligations.

Owner’s Equity

Since owner’s equity represents the part of a business that belongs to the owner, it includes any investments that the owner or owners of a business have made. These investments are called capital stock, and they can be broken into two categories: preferred stock and common stock. (Keep in mind that owner’s equity is also comprised of revenue and expenses.)

Preferred stock is the form of capital stock that, as the name implies, has certain preferences. A company must pay dividends on preferred stocks before paying dividends on common stock. A dividend is an allocation of a company’s net income used for payment to the owners. Preferred stockholders are also given priority over common stockholders in the distribution of a company’s assets in case of a liquidation.

Balance Sheet 4–3

Common stock is the most basic form of ownership in a business. Dividends are paid to common stockholders after all payments have been made on debts and to preferred stockholders.

Retained earnings are another component of owner’s equity. It represents all earnings that a business has accumulated since its inception less any dividends it has paid. In other words, retained earnings are the portion of a company’s earnings that has been saved instead of paid out as dividends.

Do it! A-1: Identifying components of a Balance Sheet

Exercises 1 Dividends are paid on _____ stock before they are paid on any other kind of

stock.

A Shared

B Common

C Capital

D Preferred

2 Machinery owned by a business is an example of a fixed asset. Which characteristic must be met for an item to be included in the category of a fixed asset?

A The item is held for resale

B The item is tangible

C The item is not used in business operations

D Benefits from the sale of the item do not extend beyond one year


3 Review the following list of Icon’s accounts. Identify the asset and liability types.

Current Assets •••• Cash

•••• Marketable Securities

•••• Accounts and Notes Receivable

•••• Inventories

Fixed Assets •••• Real Estate

•••• Leasehold Improvements

•••• Machinery Equipment

Current Liabilities •••• Accounts Payable

•••• Notes Payable

•••• Dividends Payable

Long-term Liabilities •••• Mortgage Bonds

•••• Sinking Fund Debentures

Balance Sheet 4–5

Topic B: Prepare Balance Sheets Explanation There are eight steps you can follow when preparing a Balance Sheet:


2 Enter the current asset accounts

3 Enter the fixed asset accounts

4 Enter the other asset accounts

5 Enter the current liability accounts

6 Enter the long-term liability accounts

7 Enter the owner’s equity accounts

8 Complete the Balance Sheet

Create the heading

Three items are included in the heading of a Balance Sheet, as shown in Exhibit 4-1. Each item should be centered at the top of the sheet:


• The name of the accounting statement (in this case, Balance Sheet)

• The date of the Balance Sheet

Make sure you include the specific date, since Balance Sheets show the financial condition of a business at one point in time.

Exhibit 4-1: Heading of a Balance Sheet

Enter the current asset accounts

You can follow nine steps to enter the current asset accounts into a Balance Sheet:

1 Center the word “Assets” on the first line of the larger column on the left side of the Balance Sheet, as shown in Exhibit 4-2.

2 Write “Current Assets” on the line just below the “Asset” title, as shown in Exhibit 4-2.


Exhibit 4-2: Steps 1 and 2 of entering the current asset accounts

3 List each current asset account title starting on the line just below the “Current Assets” title, as shown in Exhibit 4-3.

4 Enter the amount for each current asset account in the right amount column on the left side of the report, as shown in Exhibit 4-3.


5 When you list the “Accounts and Notes Receivable” account, enter its amount in the left amount column. Then, write “Less Allowance for Bad Debt” under the “Account and Notes Receivable” title, as shown in Exhibit 4-4. This amount is a provision for bad debts, since some customers will fail to pay their bills.

6 Enter the provision amount for bad debt in the left amount column, directly below the “Accounts and Notes Receivable” amount. Draw a line under this figure, as shown in Exhibit 4-4.

7 Subtract the provision for bad debt from the accounts and notes receivable amount, and enter this figure in the right amount column, as shown in Exhibit 4-4. Write “Inventories” on the next line and enter the value of inventories.

Balance Sheet 4–7

Exhibit 4-4: Steps 5, 6, and 7 of entering the current asset accounts

8 Write “Total Current Assets” on the line just below the last current asset account, as shown in Exhibit 4-5.

9 Draw a line under the last current asset amount. Total all of the current assets and enter the amount on the same line as the “Total Current Assets” title in the right amount column on the left side of the report, as shown in Exhibit 4-5.


Enter the fixed asset accounts

You can follow eight steps in order to enter the fixed asset accounts into a Balance Sheet:

1 Write “Fixed Assets” on the line just below the “Total Current Assets” title, as shown in Exhibit 4-6.

2 List each fixed asset account title starting on the line just below the “Fixed Assets” title, as shown in Exhibit 4-6.


Exhibit 4-6: Steps 1 and 2 of entering the fixed asset accounts

3 Enter the amount for each fixed asset account in the left amount column on the left side of the report, as shown in Exhibit 4-7.

4 Draw a line under the last fixed asset amount. Total all of the fixed assets and enter the amount below the line, as shown in Exhibit 4-7.


5 Write “Less Accumulated Depreciation” on the next line, as shown in Exhibit 4-8. This amount represents the value of depreciation that has accrued during the accounting period and from previous accounting periods.

6 Enter the amount of accumulated depreciation on the left side of the report, directly below the total of all the fixed assets. Draw a line under this amount, as shown in Exhibit 4-8.

Balance Sheet 4–9


7 On the next line, write “Total Fixed Assets,” aligned with the left side of the column, as shown in Exhibit 4-9.

8 Subtract the less accumulated depreciation from the total fixed assets and enter the amount on the same line as the “Total Fixed Assets” title in the right amount column, as shown in Exhibit 4-9.


Enter the other asset accounts

Many companies have other asset accounts that are listed on the Balance Sheet. These assets include prepayments, which are goods or services that have been purchased in advance of their use and from which the company has not yet received the benefits. For example, if a company has prepaid insurance, the insurance premiums might have been paid for a number of years in advance of the time when they would be charged off as an expense.


In addition, a company might have intangibles, which are non-physical items such as patents, trademarks, and copyrights. They are valued conservatively and often have no more than a nominal value, such as $1.00. Many businesses list intangibles on a Balance Sheet with no value attached, simply to show that these assets do exist.

In order to list prepayments and intangibles on your Balance Sheet, there are five steps you can follow:

1 Under “Total Fixed Assets,” write “Other Assets” and then write “Prepayments,” as shown in Exhibit 4-10.

2 Enter the amount of prepayments on the same line as the “Prepayments” title in the right amount column on the left side of the report, as shown in Exhibit 4-10.

Exhibit 4-10: Steps 1 and 2 of entering the other asset accounts

3 Write “Intangibles” under the “Prepayments” heading, as shown in Exhibit 4-11.

4 Enter the amount of intangibles on the same line as the “Intangibles” title, in the right amount column, on the left side of the report. This amount is often “$0.00.” Draw a single line under this amount, as shown in Exhibit 4-11.

5 Total the prepayments and intangibles and enter this amount directly below the single line you drew, as shown in Exhibit 4-11.

Balance Sheet 4–11

Exhibit 4-11: Steps 3, 4, and 5 of entering the other asset accounts

Enter the current liability accounts

There are six steps you can follow in order to enter the current liability accounts into a Balance Sheet:

1 Center the word “Liabilities” on the first line of the larger column on the right side of the Balance Sheet, as shown in Exhibit 4-12.

2 Write “Current Liabilities” on the line just below the “Liabilities” title, as shown in Exhibit 4-12.

Exhibit 4-12: Steps 1 and 2 of entering the current liability accounts

3 List each current liability account title starting on the line just below the “Current Liabilities” title, as shown in Exhibit 4-13.

4 Enter the amount for each current liability account in the left amount column on the right side of the report, as shown in Exhibit 4-13.



5 Write “Total Current Liabilities” on the line just below the last current liability account, as shown in Exhibit 4-14.

6 Draw a line under the last current liability amount. Total all of the current liabilities and enter the amount on the same line as the “Total Current Liabilities” title in the right amount column on the right side of the report, as shown in Exhibit 4-14.


Enter the long-term liability accounts

There are five steps you can follow in order to enter the long-term liability accounts into a Balance Sheet:

1 Write “Long-term Liabilities” on the line just below the “Total Current Liabilities” title, as shown in Exhibit 4-15.

2 List each long-term liability account title starting on the line directly below the “Long-term Liabilities” title, as shown in Exhibit 4-15.

3 Enter the amount for each long-term liability in the right amount column on the right side of the report, as shown in Exhibit 4-15.


Exhibit 4-15: Steps 1, 2, and 3 of entering the long-term liability accounts

4 Write “Total Liabilities” on the line just below the last long-term liability account, as shown in Exhibit 4-16.

5 Draw a line under the last long-term liability amount. Total all of the long-term and current liabilities and enter the amount below the line, which will be the same line on which the “Total Liabilities” title is listed, as shown in Exhibit 4-16.

Exhibit 4-16: Steps 4 and 5 of entering the long-term liability accounts

Enter the owner’s equity accounts

You can follow eleven steps in order to enter the owner’s equity accounts into a Balance Sheet:

1 Skip one blank line below the “Total Liabilities” title and center the words “Owner’s Equity,” as shown in Exhibit 4-17.

2 Write “Capital Stock” on the line just below the “Owner’s Equity” title, as shown in Exhibit 4-17.


Exhibit 4-17: Steps 1 and 2 of entering the owner’s equity accounts

3 Write “Preferred Stock” on the next line, as shown in Exhibit 4-18.

4 Enter the amount of preferred stock on the same line as the “Preferred Stock” title in the left amount column on the right side of the report, as shown in Exhibit 4-18.

5 Write “Common Stock” on the next line, as shown in Exhibit 4-18.

6 Enter the amount of common stock on the same line as the “Common Stock” title in the left amount column on the right side of the report, as shown in Exhibit 4-18.

Exhibit 4-18: Steps 3 to 6 of entering the owner’s equity accounts


7 Draw a line under the common stock amount and add the preferred and common stock amounts. Write this amount under the line, as shown in Exhibit 4-19.

8 Write “Additional Paid-in Capital” on the next line, aligned with the left side of the column. Additional paid-in capital is the amount paid by shareholders over and above the par or legal value of each share of stock. Enter this amount on the same line, in the left amount column, as shown in Exhibit 4-19.

9 Write “Retained Earnings” on the next line. Enter the amount of retained earnings on the same line in the left amount column, as shown in Exhibit 4-19.

Exhibit 4-19: Steps 7, 8, and 9 of entering the owner’s equity accounts

10 Write “Total Owner’s Equity” on the line just below the retained earnings amount, as shown in Exhibit 4-20.

11 Draw a line under the retained earnings amount. Add the combined preferred and common stock amount with the additional paid-in capital and retained earnings amounts. Enter this amount in the right amount column, on the same line as the “Total Owner’s Equity” title, as shown in Exhibit 4-20.

Exhibit 4-20: Steps 10 and 11 of entering the owner’s equity accounts


Complete the Balance Sheet

There are seven steps you can follow in order to complete the Balance Sheet:

1 Directly below the amount of the total owner’s equity, draw a single line, as shown in Exhibit 4-21.

2 On the left side of the Balance Sheet, draw a single line across the amount column on the same line as the line you drew on the right side of the Balance Sheet, as shown in Exhibit 4-21.

Exhibit 4-21: Steps 1 and 2 of completing the Balance Sheet

3 Add the amounts on the left side of the Balance Sheet, and then add the amounts on the right side to make sure the two sides are equal, as shown in Exhibit 4-22. If they are not equal, there is an error, and you must correct it before completing the Balance Sheet.

4 If the total assets equal the total liabilities plus owner’s equity, write the totals under both single ruled lines you drew, as shown in Exhibit 4-22.

Exhibit 4-22: Steps 3 and 4 of completing the Balance Sheet


5 Write the words “Total Assets” in the larger column on the left side of the Balance Sheet on the same line as the left side total, as shown in Exhibit 4-23.

6 Write the words “Total Liabilities and Owner’s Equity” in the larger column on the right side of the Balance Sheet on the same line as the “Total Assets,” as shown in Exhibit 4-23.

7 Draw a double ruled line just below the totals for both the left and the right amount columns, as shown in Exhibit 4-23. The double ruled line shows that the work is done and the Balance Sheet is “in balance.”

Exhibit 4-23: Steps 5, 6, and 7 of completing the Balance Sheet

Exhibit 4-24: Icon’s Balance Sheet


Do it! B-1: Preparing a Balance Sheet

Exercises 1 Review Exhibit 4-24. From the following list, identify the values that should be

included in the specified lines of the Balance Sheet.

Real Estate, Accounts Payable, Cash, Mortgage Bonds, Federal and other taxes payable, Depletion, Less accumulated depreciation, Preferred Stock

Line 6 Cash

Line 13 Real Estate

Line 16 Less accumulated depreciation

Line 36 Preferred Stock

2 Review the Balance Sheet, as shown in Exhibit 4-24. What are the total assets?

A $22,050,000

B $10,850,000

C $21,030,000

D $10,180,000

Total Assets ($10,180,000) = Total Current Assets ($4,380,000) + Total Fixed Assets ($5,700,000) + Prepayments ($50,000) + Intangibles ($50,000)


Topic C: Interpret Balance Sheets Explanation A Balance Sheet helps you identify a company’s liquidity and the debt-to-total-assets

ratio.

Liquidity Liquidity refers to a business’s ability to generate adequate amounts of cash to meet an obligation. For example, the “liquidity” of an asset refers to how quickly and easily the asset is converted to cash. Obviously, creditors are interested in knowing the liquidity of a company before agreeing to lend them money.

A Balance Sheet will enable you to compute two figures that will help you identify and compare a company’s liquidity:

• Working capital

• Current ratio

Working capital

Discuss an example with students. If total current assets are worth $30,000 and current liabilities are $16,000, the working capital would be $14,000. Explain the calculation as $30,000 – $16,000 = $14,000.

The working capital is a basic comparison between current assets and current liabilities. It is calculated by simply finding the difference between these two amounts: Current Assets - Current Liabilities = Working Capital. If current liabilities exceed current assets, a negative working capital exists and a company might be perceived as not being able to meet their current obligations.

The important thing to keep in mind when managing working capital is that it should be balanced. For example, too little working capital might indicate that a business is not able to pay its debts in a timely manner. Conversely, an excess of working capital could mean that the company is not investing enough of its available funds in productive resources, such as new computers or other equipment.

Current ratio

Discuss an example with students. If current assets = $30,000, current liabilities = $16,000, then current ratio = 1.875. (30000 / 16000 = 1.875)

The current ratio allows the liquidity of a company to be compared with other companies in its industry. In particular, it reflects if a company has sufficient current resources to meet company obligations in the event of a sudden emergency. You calculate the current ratio by dividing current assets by current liabilities: Current Assets / Current Liabilities = Current Ratio. The current ratio is expressed as a decimal.

Generally, a current ratio of 2:1 is considered acceptable for a company. This is because in such a situation, a company would be able to meet its current obligations even if the value of its current assets reduces by 50%. A current ratio below one indicates that a company is not able to pay off its current liabilities, and a current ratio above two indicates that a company is able to pay off its current liabilities and have extra money left.



Do it! C-1: Identifying liquidity

Exercises 1 Working capital is equal to:

A Current Assets - Current Liabilities

B Current Assets + Current Liabilities

C Current Assets / Current Liabilities

D Current Liabilities / Current Assets

2 Review the Balance Sheet, as shown in Exhibit 4-25. What is the working capital?

A $1,840,000

B $0

C -$520,000

D $2,420,000

Working Capital ($2,420,000) = Current Assets ($4,380,000) – Current Liabilities ($1,960,000)


3 Review the Balance Sheet, as shown in Exhibit 4-25. What is the current ratio?

A 0.75

B 0.48

C 2.23

D 1.48

What does this current ratio value imply? Ask Students to share their answers to the following questions, and discuss with the class.

Icon’s current ratio, 2.23, reflects a company that is generally able to pay off its current liabilities.

Discuss what possible methods could be used to improve the current ratio.

Anything that increases current assets and/or reduces current liabilities will improve the current ratio. For instance, if you sell a fixed asset for cash, it increases the current assets as cash increases in value. This will improve the current ratio. Similarly, if an accounts payable is settled by issuing debentures to the creditor, it leads to a decline in current liabilities without a change in the current assets. This, in turn, leads to an improvement in the current ratio.

Is it possible that a change in either current assets or current liabilities or both could result in no change to the current ratio? Discuss with the class.

Yes, if the current assets or the current liabilities increase or decrease by the same amount, the total current assets or current liabilities (as the case may be) will remain the same. Therefore, there will be no change in the current ratio. For instance, cash and accounts receivable are current assets. When you receive cash from an accounts receivable account, though cash increases by a fixed amount, the accounts receivable account decreases by the same amount.

Debt-to-total-assets ratio Explanation A Balance Sheet provides the information you need to compute a debt-to-total-assets

ratio. The debt-to-total-assets ratio is calculated by dividing total liabilities by total assets: Total Liabilities / Total Assets = Debt-to-Total-Assets ratio.

The debt-to-total-assets ratio indicates how many liabilities a company has per $1 of assets. For example, imagine your company’s total liabilities are $130,000 and its total assets are $543,000. Therefore, your company’s debt-to-total-assets ratio is .24. In other words, for every $1 of assets, your company has $.24 of debt. Another way this figure can be interpreted is that 24 percent of your company’s assets are funded by liabilities, or creditors.

The debt-to-total-assets ratio is important because it indicates a company’s ability to absorb a reduction in assets without hindering its ability to pay creditors. Generally, creditors are more willing to loan funding to a company that has a low ratio; a company that is less dependent on creditors for the funding of assets will be better able to pay creditors in the event of a liquidation.



Do it! C-2: Identifying the debt-to-total-assets ratio

Multiple-choice questions 1 If a company’s debt-to-total-assets ratio is .35, it means that:

A For every dollar of liabilities, 35 cents is converted to stock

B For every dollar of assets, the company has 35 cents of debt

C For every dollar of debt, the company has 35 cents of assets

D 35% of the company’s assets are used to reduce debt

2 Review the Balance Sheet, as shown in Exhibit 4-26. What is the debt-to-total-assets ratio?

A .38

B 2.64

C 0

D .68

Debt-to-Total-Assets ratio (.38) = Total Liabilities ($3,860,000) / Total Assets ($10,180,000)


Unit summary: Balance Sheet Topic A In this unit, you learned about the key terms associated with the Balance Sheet. You

learned that the two types of assets are current assets and fixed assets. You also learned that there are two types of liabilities, current liabilities and long-term liabilities. Then, you learned that owner’s equity includes retained earnings and capital stock, which can be broken into two categories, preferred stock and common stock.

Topic B Then, you learned how to prepare a Balance Sheet.

Topic C Finally, you learned how to interpret a Balance Sheet. You learned how to identify a company’s liquidity by computing the working capital and the current ratio. You also learned how to assess a company’s financial health by calculating the debt-to-total-assets ratio.

Independent practice activity 1 When is a Balance Sheet generally prepared?

• Always after the Income Statement

• When you want to see the state of affairs of the company as on a particular date.

2 What asset type represents prepaid expenses, such as rent, insurance, and office supplies?

A Current asset

B Fixed asset

3 What liability type represents mortgage bonds?

A Current liability

B Long-term liability

4 What are the steps used to prepare a Balance Sheet?


2 Enter the current, fixed, and other asset accounts

3 Enter the current and long-term liability accounts

4 Enter the owner’s equity accounts

5 Complete the Balance Sheet

5 Review the Balance Sheet, as shown in Exhibit 4-27. What label should be located on Line 24?

A Mortgage bonds

B Accounts payable

C Preferred stock

D Total current liabilities



6 Review the Balance Sheet, as shown in Exhibit 4-27. What is the total liabilities and stockholders’ equity?

A $10,180,000

B $22,050,000

C $10,850,000

D $21,030,000

7 Liquidity refers to:

A A business’s ability to convert revenue into stock holdings

B A business’s ability to generate adequate amounts of cash to meet a current obligation

C A business’s ability to convert revenues into expenses

D A business’s ability to convert expenses into revenues

5–1

U n i t 5 Other financial statements



A Identify and prepare a Cash Flow Statement.

B Identify and prepare a Statement of Stockholders’ Equity.


Topic A: Cash Flow Statement Explanation A Cash Flow Statement reports the impact of a company’s operating, investing, and

financing activities on cash flow during an accounting period. It is prepared at the end of an accounting period to provide information about a company’s cash inflows and outflows during that period.

Accounts on a Cash Flow Statement There are three categories of accounts that are included on a Cash Flow Statement:

• Operating activities

• Investing activities

• Financing activities

Operating activities

Operating activities are the cash inflows and outflows that relate to the daily operations of the company. Cash flows from operating activities are generally the result of the purchase and sale of a product or service. For example, the following transactions are all considered operating activities:

• Collecting from customers

• Collecting interest and dividends

• Paying suppliers

• Paying employees

• Paying interest and tax

Cash flows from operating activities are reported on a Cash Flow Statement using either the direct approach or indirect approach.

The direct approach shows operating activities listed out by natural category, such as payments to employees, payments to suppliers, or collections from customers. In other words, using the direct approach, cash receipts and cash disbursements from operating activities are determined.

Tell students that depreciation is an example of a non-cash expense.

Using the indirect approach, cash flows from operating activities are reported by adjusting net income for revenues and expenses that appear on the Income Statement but do not affect cash.

For example, net income as reported on the Income Statement is adjusted for all non-cash transactions, such as depreciation, as well as all changes in current assets and liabilities on the Balance Sheet during the period. However, only current assets and liabilities are reported in the operating section of the Cash Flow Statement. Other changes to the Balance Sheet items are reported in the investing and financing sections. Since this approach complements the accrual basis of accounting, it is the preferred method of preparing Cash Flow Statements.

In both methods, investing and financing activities are identical.

Other financial statements 5–3

Investing activities

Investing activities involve the acquisition and sale of long-term, or fixed, assets. For example, the following transactions are investing activities:

• Collecting on loans

• Selling fixed assets

• Selling debt or stocks

• Loaning money

• Purchasing stocks

• Purchasing fixed assets

Financing activities

Financing activities are the result of the issuance and repayment, or retirement, of long-term liabilities and capital stock. The following transactions are financing activities:

• Issuing loans

• Issuing stock certificates

• Buying back your own stock

• Making loan payments

• Payment of dividends

Do it! A-1: Identifying accounts on a Cash Flow Statement

Exercises 1 The three main sections of a Cash Flow Statement are:

A Cash from operating activities, cash from sales, and cash from administrative activities

B Cash from operating activities, cash from investing activities, and cash from financing activities

C Cash from assets, cash from liabilities, and cash from equity

D Cash from sales, cash from operations, and cash from depreciation and amortization

2 Which of the following activities is not an operating activity?

A Collecting from customers

B Paying interest and tax

C Selling fixed assets

D Collecting interest and dividends


3 Which of the following activities is an investing activity?

A Buying stock

B Making loan payments

C Collecting interest and dividends

D Paying dividends

4 Classify the following transactions as operating, investing, or financing activities.

Collection of loans Investing

Payment to suppliers Operating

Revenue from customers Operating

Making loan payments Financing

5 While using the indirect approach, cash flows from ____________ activities are reported by adjusting the net income for revenues and expenses that appear on the Income Statement but do not affect cash.

A Investing activities

B Operating activities

C Financing activities

D Collecting activities

Benefits of the Cash Flow Statement Explanation There are two main questions that a Cash Flow Statement can answer:

1 Is the company earning enough cash to purchase the additional assets needed for growth?

2 Is the company earning extra cash that can be used to repay debt or invest in new products?

The first question relates to the operating activities on a Cash Flow Statement. Perhaps it is clear from studying the statement that more assets are needed in order to increase the amount of cash inflow from operating activities. Likewise, the second question regards a company’s financing and investing activities, respectfully. Not only does the Cash Flow Statement show whether or not the extra cash is available, but it indicates which area of the company would benefit from the cash the most.


Do it! A-2: Identifying benefits

Exercises 1 The Cash Flow Statement can

identify the areas of a company that are in greatest need of cash. True or False?

True

2 Read the following questions and identify what activity it relates to.

Is the company earning enough cash to purchase the additional assets needed for growth?

Operating activities

Is the company earning extra cash that can be used to repay debt or invest in new products?

Financing and investing activities

Prepare Cash Flow Statements Explanation To create a Cash Flow Statement, you’ll need information from both a Balance Sheet

and an Income Statement. There are six steps that you can follow to obtain correct information from a Balance Sheet and Income Statement and enter it into a Cash Flow Statement.

1 Calculate the year-end difference for each item on a Balance Sheet

2 Create the heading of the Cash Flow Statement

3 Enter the cash flows from operating activities

4 Enter the cash flows from investing activities

5 Enter the cash flows from financing activities

6 Total the Cash Flow Statement

Calculate the year-end difference for each item on a Balance Sheet

For each item on a Balance Sheet, get the balance at the end of the current year and the beginning of the current year. For asset accounts, subtract the beginning balance from the ending balance. For liability and owner’s equity accounts, subtract the ending balance from the beginning balance.

Once you have found these differences, these amounts will be used to indicate the cash flows for operating, investing, and financing activities on the Cash Flow Statement.


Create the heading of the Cash Flow Statement

Three items, as shown in Exhibit 5-1, are included in the heading of a Cash Flow Statement and should be centered at the top of the sheet.


• The name of the accounting statement (in this case, Cash Flow Statement)

• The date the cash flow statement covers, such as “For the Year Ending December 31, 2001.”

Exhibit 5-1: Create the heading

Enter the cash flows from operating activities

You can follow six steps to enter the cash flows from operating activities into a Cash Flow Statement:

1 Write “Cash Flows from Operating Activities” on the first line under the heading, as shown in Exhibit 5-2.

2 Write “Net income” or “Net profit” on the next line, as shown in Exhibit 5-2, and enter the net income amount in the left amount column. You’ll get this amount from the Income Statement.

Exhibit 5-2: Steps 1 and 2 of entering the cash flows from operating activities


3 On the next line, write “Adjustments to reconcile net income to net cash” directly below the “Net income” or “Net profit” title, as shown in Exhibit 5-3. This heading indicates that you are using the indirect approach to prepare your Cash Flow Statement.

Exhibit 5-3: Step 3 of entering the cash flows from operating activities

4 One-by-one, list each source and use of cash that fall into the operating activities category, and enter the amount of each in the left amount column, as shown in Exhibit 5-4. These amounts are the differences you calculated on the Balance Sheet in step one, as well as any non-cash transactions reported on the Income Statement, such as depreciation. If an amount indicates cash that your business paid, put parentheses around the figure, so you’ll know to subtract this amount. Draw a line under the last amount.

Exhibit 5-4: Step 4 of entering the cash flows from operating activities


5 After you list each of the operating activities, write, “Net cash provided by operating activities” on the line after the last operating activity, as shown in Exhibit 5-5.

6 Total the net income and all of the operating activities. Enter the amount under the line you drew under the last operating activity amount, but in the right column, as shown in Exhibit 5-5. This amount is the “Net cash provided by operating activities.” However, if this amount is negative, this number represents the “Net cash used by operating activities,” and should be labeled as such.

Exhibit 5-5: Steps 5 and 6 of entering the cash flows from operating activities

Enter the cash flows from investing activities

The following four steps will help you enter the cash flows from investing activities into a Cash Flow Statement:

1 Write “Cash Flows from Investing Activities” on the first line under the “Net cash provided by operating activities” or “Net cash used by operating activities” title, as shown in Exhibit 5-6.

2 One-by-one, list each source and use of cash that fall into the investing activities category, and enter the amount of each in the left amount column, as shown in Exhibit 5-6. These amounts will come by analyzing the differences you calculated on the Balance Sheet. Each account involving cash receipts and cash payments from investing activities is examined individually. The cash outflows and inflows are not netted off, but are presented separately. Draw a line under the last amount.


Exhibit 5-6: Steps 1 and 2 of entering the cash flows from investing activities

3 After you list each of the investing activities, write “Net cash provided by investing activities” on the line after the last investing activity, as shown in Exhibit 5-7.

4 Total all of the investing activities. Enter the amount under the line you drew under the last investing activity amount, but in the right column, as shown in Exhibit 5-7. This amount is the “Net cash provided by investing activities.” If this amount is negative, this number represents the “Net cash used by investing activities” and should be labeled as such.

Exhibit 5-7: Steps 3 and 4 of entering the cash flows from investing activities


Enter the cash flows from financing activities

The following four steps will help you to enter the cash flows from financing activities into a Cash Flow Statement:

1 Write “Cash Flows from Financing Activities” on the first line under the “Net cash from investing activities” or “Net cash used by investing activities” title, as shown in Exhibit 5-8.

2 One-by-one, list each source and use of cash that fall into the financing activities category, and enter the amount of each in the left amount column, as shown in Exhibit 5-8. Again, these amounts will come from the differences you calculated on the Balance Sheet. As with investing activities, cash outflows and cash inflows for financing activities are also presented separately. Draw a line under the last amount.

Exhibit 5-8: Steps 1 and 2 of entering the cash flows from financing activities

3 After you list each of the financing activities, write, “Net cash provided by financing activities” on the line after the last financing activity, as shown in Exhibit 5-9.

4 Total all of the financing activities. Enter the amount under the line you drew under the last financing activity amount, but in the right amount column, as shown in Exhibit 5-9. This amount is the “Net cash provided by financing activities.” If this amount is negative, this number represents the “Net cash used by financing activities” and should be labeled as such. Draw a line under the amount.


Exhibit 5-9: Steps 3 and 4 of entering the cash flows from financing activities

Total the Cash Flow Statement

The following five steps will help you to total and complete a Cash Flow Statement:

1 Add up the net cash amounts provided by or used by operating, investing, and financing activities and enter the amount under the line you drew below the “Net cash provided by financing activities” or “Net cash used by financing activities,” as shown in Exhibit 5-10.

2 If the amount is positive, write “Net increase in cash” on the same line, under the “Net cash provided by financing activities” or “Net cash used by financing activities” title, as shown in Exhibit 5-10. If the amount is negative, write “Net decrease in cash” instead.

Exhibit 5-10: Steps 1 and 2 of totaling the Cash Flow Statement


3 On the next line, write “Cash at beginning of year.” You’ll get this amount from the Balance Sheet’s “Cash” amount for the previous year. Enter the amount in the right column, and draw a line under the amount, as shown in Exhibit 5-11.

4 Add the amount of cash at the beginning of the year to the net increase in cash, or subtract it from the net decrease in cash, whatever the case might be. Enter the amount under the line you drew below “Cash at beginning of year.” Draw a double line under the amount, as shown in Exhibit 5-11, indicating that this is “the end” amount.

Exhibit 5-11: Steps 3 and 4 of totaling the Cash Flow Statement

5 This amount is the total amount of cash your company has at the end of the year, so label it as “Cash at end of year,” as shown in Exhibit 5-12. This amount should equal the “Cash” amount for the current year listed on your Balance Sheet. If these two amounts are not equal, an error has been made and will need to be corrected.

Exhibit 5-12: Step 5 of totaling the Cash Flow Statement


Exhibit 5-13: Icon’s Cash Flow Statement

Do it! A-3: Preparing a Cash Flow Statement

Multiple-choice questions 1 The “Cash at end of year” amount on the Cash Flow Statement should correspond

to which of the following?

A The “Cash” amount for the current year on the Balance Sheet

B The “Total assets” amount for the previous year on the Balance Sheet

C The “Net Income” amount on the Income Statement

D The “Gross Profit on Sales” amount on the Income Statement

If these two amounts are not equal, an error has been made and will need to be corrected.


2 When calculating the differences for each asset on a Balance Sheet, you should:

A Subtract the ending balance from the beginning balance

B Subtract the beginning balance from the ending balance

C Add the beginning and ending balances

D Add the beginning and ending balances, then divide by 2

Once you have found these differences, these amounts will be used to indicate the cash flows for operating, investing, and financing activities on the Cash Flow Statement.

3 Review the Cash Flow Statement, as shown in Exhibit 5-13. What is the net increase in cash?

A $3,029,000

B $39,000

C $2,850,000

D $29,000

4 Review the Cash Flow Statement, as shown in Exhibit 5-13. Using the value of net increase in cash that you calculated, what is the “Cash at the end of the year?”

A $29,000

B $68,000

C $10,000

D $39,000


Topic B: Statement of Stockholders’ Equity Explanation The Statement of Stockholders’ Equity provides an important link to the Income

Statement and to the Balance Sheet. The net profit or net loss at the bottom of an Income Statement does not reflect any dividends paid to stockholders; dividends are a distribution of net profit to stockholders, not an expense that is deducted to arrive at the net profit or net loss.

The Balance Sheet does not show what changes affected the stockholder’s section. The Statement of Stockholders’ Equity shows all the changes in capital stock and retained earnings for the period of the statement.

Changes occur in the Statement of Stockholders’ Equity because the stockholders allow the company to reinvest the funds that otherwise could be distributed as dividends.

Prepare a Statement of Stockholders’ Equity There are four steps that you can follow when preparing a Statement of Stockholders’ Equity:


2 Enter the capital stock

3 Enter the retained earnings

4 Total the capital stock and retained earnings

Create the heading

Three items are included in the heading of a Statement of Stockholders’ Equity, as shown in Exhibit 5-14. Each item should be centered at the top of the sheet:


• The name of the accounting statement (in this case, Statement of Stockholders’ Equity)

• The date


Exhibit 5-14: Heading of a Statement of Stockholders’ Equity

Enter the capital stock

You can follow seven steps to enter the capital stock into a Statement of Stockholders’ Equity:

1 Write “Capital Stock” on the first line under the heading, aligned with the left side of the statement, as shown in Exhibit 5-15.

2 List the price per share of stock on the next line. “$80 Per Share” is an example of this formatting, as shown in Exhibit 5-15.

Exhibit 5-15: Steps 1 and 2 of entering the capital stock

3 On the next line, list the balance of the issued shares as of the beginning of the year by writing the month, date, and year, followed by the number of issued shares. “ July 1, 2000: 2000 Shares Issued “ is an example of this formatting, as shown in Exhibit 5-16.

4 On the same line, enter the balance of issued shares in the middle amount column, as shown in Exhibit 5-16.



5 On the next line, write “Issued during,” followed by the specific year and the number of shares issued. “Issued during 2000, 3000 shares issued” is an example of this formatting, as shown in Exhibit 5-17.

6 Enter the value of the shares issued during the current year on the same line, in the middle amount column. Draw a line under the amount, and total the beginning balance with the value of shares issued. Write this amount in the right amount column, as shown in Exhibit 5-17.


7 Write “Balance,” followed by the date of the statement on the same line as the totaled amount, as shown in Exhibit 5-18.


Exhibit 5-18: Step 7 of entering the capital stock

Enter the retained earnings

You can follow ten steps to enter the retained earnings into a Statement of Stockholders’ Equity:

1 On the next line after the capital stock balance, write “Retained Earnings,” aligned with the left side of the statement, as shown in Exhibit 5-19.

2 On the next line, write the date of the last prepared Statement of Stockholders’ Equity, such as “ July 1, 2000,” as shown in Exhibit 5-19.

Exhibit 5-19: Steps 1 and 2 of entering the retained earnings

3 Enter the amount of retained earnings in the middle amount column, as shown in Exhibit 5-20. This amount is carried over from the previous year’s Statement of Retained Earnings.

4 Write “Net income” or “Net profit” on the next line, as shown in Exhibit 5-20.



5 On the same line, enter the net income in the left amount column, as shown in Exhibit 5-21. You can find this information on your Income Statement.

6 Write “Less Dividends Declared” on the line directly below the “Net income” title, as shown in Exhibit 5-21.


7 On the same line, in the left amount column, enter the value of the total dividends your company had to pay. Draw a line under this amount, and subtract the dividends from the net income. Write the amount, which represents the net increase, under the line, but in the middle amount column, as shown in Exhibit 5-22.

8 Write “Net Increase” on the same line as the amount you just calculated, directly below the “Less Dividends Declared” title, as shown in Exhibit 5-22.



9 On the next line, write “Balance,” followed by the date of the statement, as shown in Exhibit 5-23.

10 Draw a line under the “Net Increase” amount, and add this amount to the retained earnings carried over from the previous year. Write the total on the same line as the “Balance” title, in the right amount column, as shown in Exhibit 5-23.


Total the capital stock and retained earnings

You can follow four steps to total the capital stock and retained earnings on a Statement of Stockholders’ Equity:

1 Write “Total Stockholders’ Equity” on the line directly below the “Balance” title, aligned with the left side of the statement, as shown in Exhibit 5-24.

2 In the right amount column, draw a line under the retained earnings balance, as shown in Exhibit 5-24.


Exhibit 5-24: Steps 1 and 2 of totaling the capital stock and retained earnings

3 Add the capital stock balance and the retained earnings balance and enter the amount under the line, in the right column, on the same line as the “Total Stockholders’ Equity” title, as shown in Exhibit 5-25.

4 Draw a double line, meaning “the end,” under the total stockholders’ equity amount, as shown in Exhibit 5-25.

Exhibit 5-25: Steps 3 and 4 of totaling the capital stock and retained earnings


Do it! B-1: Preparing a Statement of Stockholders’ Equity

Exercises 1 Review the statement below. Which column should display the specified values?

Shares issued during 2000 Column 2

Retained earnings from the previous year

Column 2

Net income for 2000 Column 1

Dividends declared during 2000 Column 1


2 By using the following data, calculate Icon’s net increase in retained earnings.

Retained earnings as on January 1, 2000 = $1,000,000; Net Income after Tax for 2000 = $990,000; Dividends declared during 2000 = $100,000

A $1,090,000

B $2,090,000

C $890,000

D $840,000

Net increase in retained earnings = Net Income after tax – Dividends declared

3 By using the following data, calculate Icon’s current balance of retained earnings.

Retained earnings as on January 1, 2000 = $1,000,000; Net Income after Tax for 2000 = $990,000; Dividends declared during 2000 = $100,000

A $1,890,000

B $110,000

C $1,100,000

D $3,890,000

Current balance of retained earnings = Retained earnings as on January 1, 2000 + Net increase in retained earnings

4 Changes occur in the Statement of Stockholders’ Equity because:

A Business managers determine how profits can be increased

B Shareholders determine how profits can be increased

C Stockholders allow a company to reinvest the funds that could otherwise be distributed as dividends

D Business managers fail to achieve their business targets

5 The Statement of Stockholders’ Equity is linked to the Income Statement and which of the following financial statements?

A The Cash Flow Statement

B The Trial Balance

C The Balance Sheet

D The General Ledger


Unit summary: Other financial statements Topic A In this unit, you learned about the Cash Flow Statement. You also learned that the

three categories of accounts that are included on a Cash Flow Statement are operating activities, investing activities, and financing activities. Then, you learned about the benefits of and how to prepare a Cash Flow Statement.

Topic B Finally, you learned about the importance and method of preparation of the Statement of Stockholders’ Equity.

Independent practice activity 1 Icon sells a percentage of its fixed assets, and it purchases stocks. What account

category will this fall into?

A Operating activity

B Investing activity

C Financing activity

2 Icon pays dividends to stockholders. What account category will this fall into?

A Operating activity

B Investing activity

C Financing activity

3 List the questions that the Cash Flow Statement answers.

• Is the company earning enough cash to purchase the additional assets needed for growth?

• Is the company earning extra cash that can be used to repay debt or invest in new products?

4 What are the steps used to prepare a Cash Flow Statement?


2 Enter the cash flows from operating activities

3 Enter the cash flows from investing activities

4 Enter the cash flows from financing activities

5 Total the statement


5 What approach was used to prepare the statement shown in Exhibit 5-26?

A Indirect approach

B Managed approach

C Direct approach

D Common approach

By using the indirect approach, cash flows from operating activities are reported by adjusting net income for revenues and expenses that appear on the Income Statement but do not affect cash.

Exhibit 5-26: Icon’s Cash Flow Statement

6 What are the steps used to prepare a Statement of Stockholders’ Equity?


2 Enter the capital stock

3 Enter the retained earnings

4 Total the capital stock and retained earnings


7 Review the statement, as shown in Exhibit 5-27. What is the correct column for Icon’s total balance of capital stock?

A Column 1

B Column 2

C Column 3

Exhibit 5-27: Icon’s Statement of Stockholders’ Equity

8 Review the statement, as shown in Exhibit 5-28. What is Icon’s total stockholders’ equity?

A $3,000,000

B $1,890,000

C $1,110,000

D $4,890,000


Exhibit 5-28: Icon’s Statement of Stockholders’ Equity

9 Use the following clues to complete the crossword:

ACROSS:

1. If you want to know whether your company is earning enough cash to purchase the additional assets needed for growth, you need to look at the ____________ statement.

3. The __________ approach for reporting cash flows from operating activities shows operating activities listed out by natural category (which is generally the result of the purchase and sale of a product or service).

6. ______ activities involve the acquisition and sale of long-term or fixed assets.

DOWN:

1. _________ Stock is entered on the first line under the heading, aligned with the left side of the Statement of Stockholders’ Equity.

2. ____________ activities are the result of the issuance and repayment or retirement of long-term liabilities and capital stock.

3. _______ are a distribution of the net profit to stockholders and not an expense that is deducted to arrive at the net profit or the net loss.

4. Capital Stock and ______ earnings are the two main components of the Owner’s Equity.

5. Owner’s ________ represents the part of a business that belongs to the owner.


1 2 C A S H F L O W F

A I

3 4 P D I R E C T N

I I E A

5 T V T E N

A I A Q C

L D I U I

E N I N

6 I N V E S T I N G

D D Y

S

6–1

U n i t 6 Budgeting



A Identify the importance and process of budgeting.

B Analyze financial statements by using ratio analysis and the break-even point.

C Set objectives and identify common budgeting problems.

D Monitor performance by using a “pro forma” financial statement.


Topic A: Fundamentals of budgeting Explanation Budgeting is the process of planning financial activities for an upcoming accounting

period, usually a year. It requires analyzing how a business is currently performing and setting objectives for improving its future financial health. Specific revenue and expense expectations are identified with the intention of increasing a business’s profits while keeping expenses in check.

Importance of budgeting In order to strengthen a business’s financial health, budgeting is necessary. Since the financial activities of a business can become quite complex, a budget is needed to outline a plan that managers and employees can follow. Budgeting provides the structure that is required in order to implement effective pricing and spending efforts.

Budgeting offers five main benefits:

• Facilitates planning

• Enhances communication

• Reinforces accountability

• Identifies problems

• Motivates employees

Budgeting facilitates planning

Planning is the main key to budgeting. A business that plans its future financial activities is one that will have a vision for success. Budget planning requires a business to articulate its vision for the future and how it will accomplish it. Strategies are developed, and deadlines are identified to accomplish the established budget.

The planning aspect of budgeting also helps a business establish benchmarks that it can use to measure its progress toward achieving its financial objectives.

Budgeting enhances communication

Budgets communicate the spending and sales expectations of the managers and employees within an organization. Communication is enhanced when the individuals responsible for enforcing and meeting financial expectations can find these guidelines in a budget. Managers and employees know what their boundaries are for the upcoming accounting period and can adjust their spending and sales activities accordingly.

Budgeting reinforces accountability

Since budgets are communicated to those individuals responsible for implementing them, accountability is reinforced. The responsible managers and employees can be consulted if any deviations from the budget occur. Budgets enable accountable individuals to make wise financial decisions by giving them the information they need.

Budgeting 6–3

Budgeting identifies problems

Budget planning requires a business to identify any financial problems that are developing. Since a budgeted financial statement is broken into months or quarters, deviations from the budget can alert members of management to potential problems. Assigning specific numbers to financial expectations helps draw attention to situations the business needs to investigate.

Budgeting motivates employees

The clear guidelines that are outlined in a budget provide a method by which managers and employees can be rewarded for their efforts. It is easy to evaluate managers’ and employees’ performance by identifying whether the financial objectives articulated in the budget are met. The compensation that individuals will receive if they meet the financial expectations in the budget will motivate them to adhere to it.

Budgeting process Explanation There are three steps you can complete in order to create and enforce a budget:

1 Analyze financial statements

2 Set objectives

3 Monitor performance

By following these three steps, you’ll be able to create an effective budget that can be enforced throughout your organization.

Do it! A-1: Understanding budgeting

Exercises 1 Which of the following is a benefit that budgeting offers?

A Budgeting enhances communication

B Budgeting increases sales

C Budgeting enhances an organization’s public relations

D Budgeting attracts highly skilled recruits

2 How does budgeting reinforce accountability?

•••• Communicated to responsible individuals

•••• Establish who is responsible for variations


3 How can budgeting help identify problems?

•••• Provides monthly and quarterly reports

•••• Highlights budget deviations

•••• Puts specific numbers to financial expectations

4 What is the first step used to create and enforce a budget?

A Analyze financial statements

B Set objectives

C Monitor performance

D Meet with management

Budgeting 6–5

Topic B: Analyze financial statements Explanation In order to set objectives for the upcoming accounting period, you must first study and

analyze your business’s current and past financial performances by using specific methods to determine where improvements need and can be made. Financial statements represent a company’s monetary activities. To set sound objectives, you need to investigate these activities by using methods such as ratio analysis and calculating the break-even point.

Methods of analyzing financial statements The methods of analyzing financial statements can be broken down into the following categories:

• Horizontal analysis

• Trend analysis

• Vertical analysis

• Ratio analysis

Horizontal analysis

The purpose of horizontal analysis is to determine how each item changed, why it changed, and whether the change is favorable or unfavorable. This method of analysis involves analyzing month-to-month or year-to-year changes for each line item on a financial statement.

Trend analysis

Trend analysis is similar to horizontal analysis, but it analyzes changes for three or more years, as shown in Exhibit 6-1. Trends can be shown in both dollar amount and percentage by designating the first year in the sequence as the base year. The amounts in subsequent years are then shown as a percentage of the base year amount.


Exhibit 6-1: Trend Analysis

Vertical analysis

Vertical analysis concentrates on the relationships between various items in the same period by converting each element of the information into a percentage of the total statement amount. In contrast, horizontal and trend analyses focus on the relationship between the amounts of each financial item across time.

For example, on a balance sheet, each item might be expressed as a percentage of total assets. On an income statement, each item might be expressed as a percentage of sales. Setting budgets through use of vertical analysis is often called top-down budgeting.

Ratio analysis

Ratio analysis will enable you to study the relationships between two or more items on financial statements. Through the use of ratio analysis, you’ll be able to determine which areas of financial activity need improvement. Ratios are particularly effective tools for comparing your business’s operations to the operations of other companies within the same industry. In addition, many industries have ratio norms that you can use as a benchmark for gauging your company’s financial health.

However, business decisions should never be made based on one ratio alone. It is important to remember that decisions should be made after thoroughly analyzing all of the relevant ratios and information that pertains to the business.

Ratios are calculated to provide you with information about four aspects of a business’s operations: liquidity, activity, leverage, and profitability.

• Liquidity ratios help you determine your company’s ability to generate adequate amounts of cash to meet any current or short-term obligation.

• Activity ratios enable you to evaluate how effectively your company uses its assets.

Budgeting 6–7

• Leverage ratios provide information about a business’s ability to meet its long-term obligations.

• Profitability ratios determine if returns will be generated for those individuals who provide capital to a company.

Do it! B-1: Identifying methods of analyzing financial statements

Exercises 1 Which of the following methods is used to analyze financial changes that take

place over three or more years?

A Vertical analysis

B Horizontal analysis

C Ratio analysis

D Trend analysis

2 If you need to study the change in your fixed assets over the previous year, what method of analysis will you use?

A Vertical analysis

B Horizontal analysis

C Ratio analysis

D Trend analysis

3 Which of the following statements about Ratio analysis is not true?

A Helps you determine the areas of financial activity that require improvement

B Helps you compare your business’s operations to those of other companies

C Helps you analyze month-to-month or year-to-year changes for each line item

D Serves as a benchmark for gauging your company’s financial health

4 What method of analysis is being described in the following statement?

Also known as top-down budgeting, this method looks at the relationship between items in the same period.

A Ratio analysis

B Vertical analysis

C Trend analysis

D Horizontal analysis


5 What method of analysis is being described in the following statement?

This method enables you to study the relationship between two or more items on financial statements.

A Ratio analysis

B Vertical analysis

C Trend analysis



6 What types of analysis can you perform by studying a Balance Sheet? Give reasons for your answer.

You can perform only the Vertical and Ratio analyses because these analyses concentrate on relationships between the various items of a single organization in the same time period. In contrast, to perform Trend or Horizontal analyses, you would need year-to-year or month-to-month data, which cannot be provided by a single Balance Sheet.

7 What ratios are being described in the following statements?

They allow you to analyze how well your company is using its assets.

Activity

They provide information about a business’s ability to meet its long-term obligations.

Leverage

They indicate if returns will be generated for those individuals who provide capital to a company.

Profitability

Budgeting 6–9

Ratios used for budgeting Explanation Some important ratios that can be used to obtain the information needed to make

budgeting decisions are:

• Current ratio

• Inventory turnover ratio

• Days sales outstanding

• Total assets turnover ratio

• Debt-to-total-assets ratio

• Times-interest-earned ratio

• Profit margin on sales

Current ratio

The current ratio allows the liquidity of a company to be compared with other companies in the industry. In particular, it reflects if a company has sufficient current resources to meet company’s current obligations in the event of a sudden emergency. You calculate the current ratio by dividing current assets by current liabilities: Current Assets / Current Liabilities = Current Ratio. The current ratio is expressed as a decimal.

Generally, a current ratio of 2:1 is considered satisfactory for a company. This is because in such a situation, a company would be able to meet its current obligations even if the value of its current assets reduces by 50%. A current ratio below one indicates that a company is not able to pay off its current liabilities, and a current ratio above two indicates that a company is able to pay off its current liabilities and has extra money left.

Inventory turnover ratio

The inventory turnover ratio will help you evaluate your inventory activity. Specifically, the inventory turnover ratio tells you how many times your inventory is “turned over,” or sold out and restocked, per year. For example, if a business has a 4.9 inventory turnover ratio, this figure means that the business sells out and has to restock its inventory almost five times per year.

The inventory turnover ratio is calculated by dividing Cost of goods sold by the average inventory over the year: Cost of Goods Sold / Average Inventory = Inventory Turnover Ratio. Average inventory is calculated by adding the beginning and ending inventory balances and then dividing this amount by two.

For example, imagine that your business had $4,000,000 in cost of goods sold, $340,000 in beginning inventory, and $200,000 in ending inventory. You would first add $340,000 and $200,000 and then divide this amount by two, which would give you $270,000. Then, you would divide $4,000,000 by $270,000 and get an inventory turnover ratio of 14.8. This ratio tells you that on average your business turned over inventory almost 15 times last year.


Days sales outstanding

An activity ratio, the days sales outstanding indicates the length of time a business must wait after making a sale before receiving cash from a client. It is calculated by dividing the accounts receivable amount by the average sales per day amount: Accounts Receivable / Average Sales Per Day = Days Sales Outstanding. The average sales per day figure are calculated by dividing annual sales by 360, as shown in Exhibit 6-2.

Exhibit 6-2: Days sales outstanding

For example, if your company had an accounts receivable amount of $1,300,000, and its annual sales were $14,000,000, you would divide $14,000,000 by 360, giving you a figure of $38,889. Then, you would divide $1,300,000 by $38,889 and get a days sales outstanding of 33 days. In other words, your company would wait on average 33 days after making a sale before receiving cash from the customer, as shown in Exhibit 6-3.

Exhibit 6-3: Example of day’s sales outstanding

Budgeting 6–11

Total assets turnover ratio

The total assets turnover ratio provides an indication of a business’s ability to generate sales in relation to its total assets. As an activity ratio, it determines how many times a company’s assets turn over per year. You determine the total assets turnover ratio by dividing annual sales by total assets: Sales / Total Assets = Total Assets Turnover Ratio.

For example, if your company had $14,000,000 in annual sales and $8,000,000 in total assets, you would have a 1.75 total assets turnover ratio. Typically, the higher the number, the better.

Debt-to-total-assets ratio

As a measure of leverage, the debt-to-total-assets ratio indicates how many liabilities a company has per $1 of assets. The debt-to-total-assets ratio is calculated by dividing total liabilities by total assets: Total Liabilities / Total Assets = Debt-to-Total-Assets Ratio.

For example, imagine your company’s total liabilities are $130,000 and its total assets are $543,000. Therefore, your company’s debt-to-total-assets ratio is .24. In other words, for every $1 of assets, your company has $.24 of debt. Another way this figure can be interpreted is that 24 percent of your company’s assets are funded by liabilities, or creditors.

The debt-to-total-assets ratio is important because it indicates a company’s ability to absorb a reduction in assets without hindering its ability to pay creditors. Generally, creditors are more willing to loan funding to a company that has a low ratio; a company that is less-dependent on creditors for the funding of assets will be better able to pay creditors in the event of a liquidation.

Times-interest-earned ratio

The times-interest-earned ratio measures a company’s ability to meet its annual interest payments. It is a leverage ratio and is calculated by dividing the operating profit, or earnings before interest and tax (EBIT), by the interest charges: Operating Profit / Interest Charges = Times-Interest-Earned Ratio, as shown in Exhibit 6-4.

Exhibit 6-4: Times-interest-earned ratio


For example, if your business’s operating profit was $1,000,000, and its interest charges were $200,000, then your times-interest-earned ratio would be five, as shown in Exhibit 6-5. In other words, your company’s interest charges are covered five times by the operating profit. This ratio is important to consider since failure to pay interest charges can bring legal action from creditors.

Exhibit 6-5: Example of times-interest-earned ratio

Profit margin on sales

The profit margin on sales will indicate how satisfactory business activities have been. A profitability ratio, the profit margin on sales is calculated by dividing the net profit for the year by the total sales figure: Net Profit / Sales = Profit Margin on Sales.

For example, if a company’s net profit is $990,000 and its sales are $11,000,000, the profit margin on sales is 9%. Therefore, for each dollar of sales, nine cents in profit went to the company.

Budgeting 6–13

Exhibit 6-6: Icon’s Balance Sheet and Income Statement


Do it! B-2: Identifying ratios used for budgeting

Exercises 1 The inventory turnover ratio is calculated by dividing _____ by average

inventory.

A Operating profit

B Total expenses

C Total liabilities

D Cost of Goods Sold

2 The total assets turnover ratio is calculated by dividing _____ by total assets.

A Sales

B Total expenses

C Average inventory

D Accounts receivable

3 Review the Balance Sheet, as shown in Exhibit 6-6. What is the current ratio?

A 2.29

B 2.10

C 2.23

D 2.08

4 If Icon has a current ratio that is over 2.0, that means:

A The company is able to pay off its current liabilities and have extra money left

B The company is not able to pay off current liabilities

C The company is able to pay off current liabilities without extra revenue

D The company is not able to pay off external debts

Budgeting 6–15

5 Review the Balance Sheet and the Income Statement, as shown in Exhibit 6-6. What is the total assets turnover ratio?

A 0.97

B 1.08

C 1.18

D 1.26

6 Review the Balance Sheet, as shown in Exhibit 6-6. What is the debt-to-total-assets ratio?

A 0.25

B 0.10

C 0.52

D 0.38

7 Icon’s profit margin on sales is 0.09. What does this indicate?

A For every $1 of revenue Icon makes, it owes 9 cents to its creditors

B Icon is losing 9% of its net profit to its creditors

C Icon is making 9 cents in profit for each dollar of sales

D For every $1 of profit, Icon is spending 9 cents on its debts


8 The instructor will divide the class into two groups. Each group will be assigned three of the following six ratios. For each assigned ratio, your group will need to determine what ratio value is better—either higher or lower—and provide reasons for the answer.

Ask one student from each group to share the group’s answers.

Have the group validate the other group’s answers.

Help students if both groups are unable to give the correct answer.

Inventory turnover ratio Higher

A higher value would imply that the business is doing well and its products or services are much in demand. Therefore, the products sell quickly and the company has to restock its inventory more frequently.

Days sales outstanding Lower

A lower value would imply that a company’s customers pay cash on time or within a shorter period. In other words, a company would have to wait for a fewer number of days after making a sale before receiving cash from the customer.

Total assets turnover ratio Higher

It determines how many times a company’s assets turn over per year. A higher value would imply more usage of assets thereby making better sales. Therefore, it is generating higher sales in relation to its total assets.

Debts-to-total-assets ratio Lower

It indicates a company’s ability to absorb reduction in assets without hindering its ability to pay creditors. Generally, creditors are more willing to fund loans to a company that has a low ratio. A lower value would imply that a company is in debt to a lesser extent and would be easily able to pay its creditors in the event of liquidation.

Times-interest-earned ratio Higher

A higher value would imply that a company is making more profit than the interest it needs to pay. Therefore, the company’s interest charges are well covered by the operating profit and its creditors would not need to use legal methods to retrieve their interest.

Profit margin on sales Higher

A higher value implies that the business activities of the company have been quite satisfactory and for each dollar of sale made, it has earned ample amount of net profit.

Budgeting 6–17

Tell students to keep the discussion short.

9 The instructor will draw a table with four columns on the whiteboard and label the columns as Liquidity ratios, Activity ratios, Leverage ratios, and Profitability ratios. The instructor will then divide the class into four groups, which represent the four ratios, called Liquidity, Activity, Leverage, and Profitability.

Discuss the following questions within your group in context of your ratio and record the answers. Then, one student from your group will write the answers on the whiteboard.

What information does the ratio provide?

•••• Liquidity: Determines a company’s ability to generate adequate amounts of cash to meet a current obligation

•••• Activity: Evaluates how effectively a company uses its assets

•••• Leverage: Provides information about a business’s ability to meet its long-term obligations

•••• Profitability: Determines whether returns will be generated for individuals who provide capital to a company

Which of the following belong to your ratio?

Current, Inventory turnover, Days sales outstanding, Total assets turnover, Debt-to-total-assets, Times-interest-earned, and Profit margin on sales.

•••• Liquidity: Current ratio

•••• Activity: Inventory turnover ratio, Days sales outstanding, and Total assets turnover ratio

•••• Leverage: Debt-to-total-assets ratio, Times-interest-earned ratio

•••• Profitability: Profit margin on sales

Write the formula for your ratio. •••• Current ratio = Current Assets / Current Liabilities

•••• Inventory turnover ratio = Cost of Goods Sold / Average Inventory

•••• Days sales outstanding = Accounts Receivable / Average Sales Per Day

•••• Total assets turnover ratio = Sales / Total Assets

•••• Debt-to-total-assets ratio = Total Liabilities / Total Assets

•••• Times-interest-earned ratio = Operating Profit / Interest Charges

•••• Profit margin on sales = Net Profit / Sales


The break-even point Explanation The break-even point occurs when total sales equal total expenses, with nothing left

over for profit. In other words, the operating income, or EBIT, is equal to zero. Any revenue generated that is below the break-even point is used to pay for expenses incurred to create and sell your product. Any revenue generated that is above the break-even point will generate profit for the business.

The break-even point is calculated by dividing the total fixed operating expenses by the contribution profit margin per unit, which gives you the number of units you need to sell in order to break even. You’ll use your Income Statement to calculate the break-even point, and there are five steps you can follow in order to do so:

1 Separate fixed costs from the variable costs. You’ll find these figures under the Operating Expenses section of your Income Statement. The variable costs will include any selling expenses under this section, and the fixed costs are the general and administrative costs, as well as depreciation and depletion.

2 Subtract the variable costs from the gross profit on sales. This figure is the contribution profit margin.

3 Divide the contribution profit margin by the number of units that were sold, which will give you the contribution profit margin per unit. You might have to divide the Sales amount by the selling price per unit to determine how many units were sold.

4 In order to determine the total fixed operating expenses, add the fixed costs amount and the interest expenses, since interest expenses are considered a fixed cost.

5 Divide the total fixed operating expenses by the contribution profit margin per unit. This figure is the number of units you must sell in order to break even.

Budgeting 6–19

Do it! B-3: Calculating the break-even point

Exercises 1 Classify the following as either fixed costs or variable costs:

General and administrative expenses

Fixed

Depreciation of machinery Fixed

Expense of raw material Variable

2 Contribution profit margin is:

A Total sales – Fixed cost

B Total sales – Variable cost

C Gross profit – Variable cost

D Gross profit – Fixed cost

3 The break-even point occurs when:

A Total sales are less than total expenses

B Total sales are equal to total expenses

C Total expenses are less than total sales

D Total sales and total expenses together are greater than one


Topic C: Set objectives Explanation Objectives provide the direction you need when establishing a budget. The guidance

objectives provide will ensure that your budgeting decisions relate back to promoting the overall financial health of your business. Without objectives, you risk making budgeting decisions that are misguided or simply not as effective as they could be.

Steps required to establish effective objectives In order to set effective objectives, you can follow four steps:

1 Review previous accounting periods to determine the strengths and weaknesses

2 Set objectives that address strengths and weaknesses

3 Decide what resources are needed to achieve objectives

4 Make adjustments to objectives if necessary

Review previous accounting periods

Since the first step of creating a budget is to analyze financial statements from previous accounting periods, you have already identified the strengths and weaknesses of your business’s financial operations. Use the figures provided from the ratio analysis to determine which financial activities are in need of improvement and which ones are healthy.

Address strengths and weaknesses

Once you have determined which financial activities are inadequate, create objectives that address these weaknesses. Since you also identified which financial activities are strong, you can use this information to direct your efforts toward the areas that truly need attention.

For example, if your days sales outstanding is poor, you might decide to set a somewhat ambitious objective that decreases the amount of time it takes after making a sale to collect money from a customer. Conversely, if your debt-to-total-assets ratio is strong, you could set an objective that was less ambitious for decreasing the amount of debt your business owes.

What resources are needed

It is important that you examine your objectives to determine if you have the resources necessary to achieve them. If the resources are unavailable, it will be impossible to meet your objectives.

For example, imagine that one of your objectives for the upcoming accounting period is to improve your total assets turnover ratio by increasing the number of sales your company makes. You would have to determine whether or not you have the manpower available to accomplish this objective. Specifically, you would have to decide if you have enough sales people to handle the increase in projected sales.

Budgeting 6–21

Make adjustments to objectives

If you discover that you do not have sufficient resources to meet your objectives, you must adjust your objectives appropriately. Slight modifications might be all that are necessary to make your objectives achievable. However, a more creative strategy might be required to adjust your objectives.

For example, imagine that you do not have enough sales people to generate an increase in sales by a certain percentage. You’ll have to adjust your objective to reflect a lower, more reasonable figure and look for another financial activity that could be used to accommodate this adjustment, such as increasing your sales price or lowering sales commissions.

Characteristics of objectives Explanation Any objective you set for your budget should possess three characteristics:

• Relevant

• Measurable

• Realistic

Relevant

Your objectives must be relevant to your business’s vision. They must directly relate to improving your company’s financial health. Objectives are sometimes set purely for the sake of setting them, without fully considering how they contribute to achieving the business’s overall goal.

Measurable

Effective objectives are measurable. You must specifically articulate what needs to be achieved. Immeasurable objectives will not allow you to gauge your progress toward achievement.

For example, if you want to lower the percentage of your business’s assets that are funded by creditors, choose a specific number by which to gauge your progress.

Realistic

In order to ensure successful achievement, your objectives must be realistic. Objectives can be challenging, but should never be impossible. Avoid the desire to set lofty objectives, regardless of the potential payoffs. Goals that are impossible to achieve will frustrate managers and employees and often lead to detrimental financial outcomes.


Do it! C-1: Setting effective objectives

Exercise 1 Put the following steps in the correct order required to establish effective

objectives:

Decide the resources that are needed to achieve objectives.

Make adjustments to objectives, if necessary.

Determine the strengths and weaknesses of previous accounting periods.

Set objectives that address strengths and weaknesses.

Determine the strengths and weaknesses of previous accounting periods.

Set objectives that address strengths and weaknesses.

Decide the resources that are needed to achieve objectives.

Make adjustments to objectives, if necessary.

2 Effective objectives should be relevant, measurable, and ______.

A Aggressive

B Flexible

C Quickly attained

D Realistic

Budgeting 6–23

Ask four students to read their objectives. Tell the class to evaluate and discuss the objectives based on whether or not they are relevant, measurable, and realistic.

3 You have a monthly salary of $1,500 and need to create budget. List the objectives you would use and evaluate those objectives based on the three characteristics of effective objectives.

Objectives Are they effective?

What do they lack?

.

.

.

.

.

.

Common budgeting problems Explanation There are several common problems that individuals encounter when establishing a

budget. By being aware of these problems, you can avoid letting them affect your objectives.

• Losing sight of your objectives

• Failing to keep objectives realistic

• Practicing historical-base budgeting

• Accepting arbitrary changes

• Believing that sales have to increase

Losing sight of your objectives

Sometimes the process of putting together a budget seems so daunting that the individuals responsible for creating it focus more on the process involved than the objectives. For this reason, it is important that you focus every decision toward your objectives. In addition, regularly monitor your progress toward achieving your objectives in order to emphasize their validity and role as the focus of your efforts.

Failing to keep objectives realistic

There is a common tendency for individuals to get rich on paper and then become disappointed when the numbers on the budget do not match actual performance. Therefore, it is crucial that you compare all objectives for the upcoming accounting period with actual performances from previous periods.

In addition, carefully examine all assumptions made about the financial activity for the upcoming accounting period. Base your objectives on solid facts, not on word-of-mouth speculations.


Practicing historical-base budgeting

Historical-base budgeting is the process of basing your objectives for the upcoming accounting period on the previous one’s actual performance. Some individuals automatically use the previous accounting period’s performance as the budgeted amount for the upcoming period.

The problem with this budgeting method is that consideration is often not given to whether the previous accounting period’s performance was good or poor. If the financial activities from the previous accounting period were inadequate, using these figures as a guideline for the upcoming accounting period will simply prolong poor performance.

Accepting arbitrary changes

Objectives are set for a reason: to guide positively the financial activities for an upcoming accounting period. Therefore, any deviations from the plan for achieving an objective should be questioned and, if necessary, stopped. Accepting arbitrary changes undermines the validity of your objectives. If a change to the budget is requested, it should be closely studied before being implemented.

Believing that sales have to increase

It is often believed that sales have to increase with each new accounting period. In fact, some individuals think that if sales do not significantly increase each accounting period, the company’s efforts have been a failure. However, this viewpoint is incorrect. There might be accounting periods in which an increase in sales could create negative effects for the company.

For example, imagine that your company recently expanded its consumer base with the opening of new stores. As a result, sales increased significantly. However, to repeat the same strategy for the upcoming accounting period could be a serious error, since concentrating efforts on new stores could result in neglected customer support service for the stores recently opened. Therefore, the objectives for the new accounting period would not include an increase in sales, but a steady hold on current sales numbers while customer service efforts are refined.

Budgeting 6–25

Do it! C-2: Identifying common budgeting problems

Exercises Discuss with students. 1 An effective way to budget is to

use the actual performance of the previous accounting period as your budget goals for the upcoming accounting period. True or False?

False. The problem with this budgeting method is that consideration is often not given to whether the previous accounting period’s performance was good or poor.

2 It is acceptable to adjust your budget objectives to accommodate resource availability. True or False?

True

3 Define historical-base budgeting.

It is the process of basing your objectives for the upcoming accounting period on the previous one’s actual performance.

4 Should you accept arbitrary changes to your plan? Why?

No, you should question any deviations from the plan and, if necessary, stop them.

Accepting arbitrary changes undermines the validity of your objectives. If a change to the budget is requested, it should be closely studied before being implemented.

5 You are in a meeting with Robin Carlson (Product Manager), Chala Merino (Assistant Controller) and Drew Canfield (Director of Finance). The four of you are responsible for determining new objectives for the Icon’s SK-200 product line. Chala has recently reviewed the manufacturing budget and has found a problem with the SK-200 line. She wants to modify the product’s current budgeting objectives to provide a clear direction.

What do you think should be done first? Select the correct answer and provide reasons to support it.

A Focus on how the SK-200 product line has performed in the past few years

B Review the planning that went into the SK-200 product line when it was first developed

C Analyze how the marketing strategy was first developed

The first step in setting effective objectives is to determine the strengths and weaknesses of previous accounting periods.


6 After reviewing the budgeting statements, Chala finds that the company is losing money on maintaining the product. Though last year’s operating expenses were set at $300,000, the actual expenses were $425,000.

What would benefit the company in such a situation? Select the correct answer and provide reasons to support it.

A Evaluate whether the quality of the product was worth the money spent

B Calculate the actual profit earned as compared to the estimated profit

C Review the advertising budget

By doing this, the management is determining the strengths and weaknesses of the past performances and enabling the team to keep the discussion focused.

Encourage students to discuss the answer. After the discussion, explain the answer that is given here.

7 Chala discloses that though clients seemed to be happy with the product’s performance, the product has suffered a loss of $70,000. Chala, Drew, and Robin give the following suggestions. Who do you think is correct and why?

A Chala: “I don’t think it’s worth keeping the line open because cutting costs would reduce our quality”

B Robin: “As sales must increase in each accounting period, we should concentrate on increasing sales and attracting new customers”

C Drew: “ We should reduce the operating expenses and retain the present customers”

By following Drew’s suggestion, you could make profit and still provide a quality product. By cutting marketing costs, you would reduce operating expenses but it would not affect sales. This is because the companies that would buy SK-200 are already doing so.

By supporting Drew, you are acknowledging that sales do not have to increase with the new accounting period. In addition, you are setting objectives that are easily measurable, realistic, and relevant to the organization’s goals.

Budgeting 6–27

Topic D: Monitor performance Explanation The key to monitoring your business’s actual performance during an accounting period

is to record it regularly on paper, so it can be compared to the budgeted amount. Businesses use “pro forma” financial statements to accomplish this task.

“Pro forma” financial statements A “pro forma” financial statement is a forward-looking document; “pro forma” means “provided in advance.” Unlike most financial statements that are created at the end of an accounting period, “pro forma” statements are created when setting a budget, before an accounting period. “Pro forma” financial statements are used to establish the projected financial activity for an upcoming accounting period. “Pro forma” financial statements are also often called estimates.

It is important to keep in mind that the financial statements that are created at the end of an accounting period are included in a business’s annual report and, therefore, visible to external parties. However, “pro forma” financial statements are only used for internal purposes and are not viewed by parties outside of the company.

Since “pro forma” financial statements are for internal use only, the number of these documents will vary from business to business. In fact, the ways in which a company can customize its “pro forma” statements to fit its specific needs are almost limitless. However, many large businesses use “pro forma” Income Statements, Balance Sheets, and Cash Flow Statements. Out of these statements, the “pro forma” Income Statement is most common and widely used among businesses.

Some businesses also create “pro forma” financial statements based on the different segments of their company that contain financial activity. For example, a company might create “pro forma” financial statements that are specific to sales, production, manufacturing, and labor, among other areas.

Do it! D-1: Identifying a “pro forma” financial statement

Exercises 1 “Pro forma” means:

A Provided for analysis

B Provided post performance

C Provided in advance

D Provided for departmental use

2 The “pro forma” Balance Sheet is the most widely used “pro forma” financial statement. True or False?

False. The “pro forma” Income Statement is most common and is widely used among businesses.


3 What are some common characteristics of “pro forma” financial statements?

Characteristics:

•••• For internal use only

•••• Easily customized

•••• Number created will vary between organizations

4 What are the types of “pro forma” financial statements?

Types:

•••• Income Statements

•••• Balance Sheets

•••• Cash Flow Statements

Create a “pro forma” financial statement Explanation There are seven steps that will help you prepare a “pro forma” financial statement:

1 List the line items

2 List historical performance

3 List the percentage of sales

4 List the upcoming accounting period’s budgeted amount

5 Create a column for the month or quarter

6 Create a “year-to-date” column

7 Create a deviation column

List the line items

Along the left margin of the sheet, list one-by-one the line items that you wish to budget, as shown in Exhibit 6-7. Most companies prefer to use a top-down method of budgeting, which means that sales is the first line item listed, followed by all the various expenses the business incurs, and all other budgeted financial activities are based on the total amount of sales being generated. This method is sensible, since the amount of revenue that your business generates drives the budgeting decisions made for all other financial activities.

Divide the rest of the sheet into several columns.

Budgeting 6–29

Exhibit 6-7: List the line items

List historical performance

You’ll find it helpful to have a historical base from which to compare your budgeted amounts. Therefore, you’ll need to create a column for a previous year’s, quarter’s, or month’s performance.

At the top of the first column, write the period you want to use as a historical reference. For example, you might write “1st quarter 2000” or “January 2000.”

Next, fill in the amounts for each of the line items for the specified time period, as shown in Exhibit 6-8.

Exhibit 6-8: List historical performance

List the percentage of sales

Many individuals find it useful to have a breakdown of performance based on the percentage of sales for which each line item accounted. In other words, each of the line items listed below sales is measured by calculating its amount as a percentage of the total sales amount.


You’ll use the next column for listing the percentage of sales for the historical performance. Label any column used for listing the percentage of sales figures with a simple percentage sign (%), followed by the words “of sales,” as shown in Exhibit 6-9.

The percentage of sales is simple to calculate. Your sales amount will be the first line item on the statement, and the percentage of sales for this item clearly will always be 100, as shown in Exhibit 6-9. Then, divide the amount of each of the other line items on the statement by the sales amount to calculate and complete the percentage of sales column.

Exhibit 6-9: The percentage of sales

For example, if your total sales amount was $12,000,000, and your cost of goods sold was $8,000,000, you divide $8,000,000 by $12,000,000 in order to calculate the percentage of sales for the cost of goods sold. In this case, percentage of sales for the cost of goods sold would be 67 percent, as shown in Exhibit 6-10.

Exhibit 6-10: In this case, percentage of sales for the cost of goods sold is 67 percent

Budgeting 6–31

List the upcoming accounting period’s budgeted amount

At the top of the next column, write the heading “Budget,” followed by the accounting period for which the budget represents. For example, if you are creating an annual budget, you should write the specific year. If the budget is for a specific month, you should indicate which month: “Budget January 2001,” as shown in Exhibit 6-11.

Under this heading, you then fill in the budgeted amounts for each of the line items. Follow this column with another percentage of sales column, based on the budgeted figures, as shown in Exhibit 6-11.

Exhibit 6-11: Listing the upcoming accounting period’s budgeted amount

Create a column for the month or quarter

Write “Actual” as the heading of the next column. This column will be used to record your actual financial performance. You’ll next need to determine how often you are going to monitor your financial activities. You can monitor your performance monthly or quarterly. Generally, the more frequently you monitor your activities, the better able you’ll be to meet your budgeted amounts.

Once you have decided how frequently you’ll measure your actual performance, write the first time period under “Actual.” For example, if you decide to monitor performance on a monthly basis, you would write “Actual January 2001” as the complete heading, as shown in Exhibit 6-12.

Once again, follow this column with a percentage of sales column to be filled in after the actual performance is recorded, as shown in Exhibit 6-12.


Exhibit 6-12: Creating a column for the month or quarter

Create a “year-to-date” column

In the next column, write “YTD,” which stands for “year-to-date,” as shown in Exhibit 6-13. This column is important because it will allow you to study your cumulative performance with each new accounting period.

Exhibit 6-13: In the next column, write “YTD”

Budgeting 6–33

Create a deviation column

The next column will be used to record the amount that actual performance deviates from the budget. Write “+/-” at the top of the column, to represent the degree to which actual performance is over or under the budgeted amount, as shown in Exhibit 6-14.

Exhibit 6-14: Write “+/-” at the top of the column

For example, imagine that you had budgeted sales to be $12,500,000 for the month of January, but your business’s actual performance was $12,550,000. You enter “$50,000” in the deviation column, as shown in Exhibit 6-15, since this is the amount of deviation from $12,500,000. If your actual performance is $12,480,000, you enter “($20,000)” in the deviation column. As a general rule in accounting, parentheses are used to indicate a negative amount.

Exhibit 6-15: Enter the deviation in the deviation column

From this point on, you’ll repeat steps two through seven for each of the accounting periods of which you’ll be measuring actual performance. For example, if you monitor performance monthly for an entire year, you would have 11 more months to add to your sheet, with accompanying percentage of sales, year-to-date, and deviation columns.


Remember that although the budget should be enforced, it is a guideline, and negative deviations from the budgeted amounts can occur. Therefore, do not treat minor deviations as a cause for alarm and reason for complete restructuring of the budget. Instead, you’ll need to determine the reasons for and the severity of the negative deviation and whether or not it is significant enough to warrant a new allocation of the budget.

Remember, budgeting reinforces accountability, so consult the manager or employee responsible for the negative deviation and work with them to take corrective action.

Do it! D-2: Creating a “pro forma” financial statement

Exercises 1 As a general rule, parentheses are used in accounting to indicate which of the

following?

A A negative amount

B A positive deviation

C A deviation of more than 10 percent

D A percentage of sales

2 To calculate the percentage of sales, divide each line item’s amount by the sales amount. True or False?

True

Discuss with students. 3 Any negative deviation from the budgeted amount requires a comprehensive restructuring of the budget. True or False?

False. You do not need to treat minor deviations as a cause for alarm and reason for complete restructuring of the budget. Instead, you need to determine the reasons for and the severity of the negative deviation and whether or not it is significant enough to warrant a new allocation of the budget.

Budgeting 6–35

4 Review the following statement and answer the questions:

What is the year-to-date figure for January’s Cost of Goods Sold?

$730

What is the sales percentage for the sales expenses for the month of January?

6%

Sales percentage for January 2001 = Actual Selling Expenses for January 2001 ($70) / Actual Sales for January 2001 ($1200) x 100

What is the percentage of sales for February’s cost of goods sold?

55%


Unit summary: Budgeting Topic A In this unit, you learned about the concept of budgeting and the five main benefits it

offers: facilitates planning, enhances communication, reinforces accountability, identifies problems, and motivates employees. You also learned that the steps to create and enforce a budget are analyzing financial statements, setting objectives, and monitoring performance.

Topic B Next, you learned that the methods of analyzing financial statements are horizontal analysis, trend analysis, vertical analysis, and ratio analysis. Then, you learned that the ratios that can be used for budgeting are current ratio, inventory turnover ratio, days sales outstanding, total assets turnover ratio, debt-to-total-assets ratio, times-interest-earned ratio, and profit margin on sales. You also learned how to calculate the break-even point.

Topic C Then, you learned about the importance, characteristics, and steps to create effective objectives. You also learned how to identify common budgeting problems.

Topic D Finally, you learned how to monitor performance by using a “pro forma” financial statement. You also learned how to create a “pro forma” financial statement.

Independent practice activity 1 What is budgeting?

Budgeting is the process of planning financial activities. It involves analyzing current performance and setting objectives for future improvement.

2 Why is budgeting important?

• It simplifies financial activities

• It outlines a plan that managers and employees can follow

• It provides structure for pricing and spending decisions

3 Why does budgeting require planning?

• Enables articulation of vision

• Develops strategies

• Identifies deadlines

• Establishes benchmarks to measure progress

4 What are the benefits of budgeting?

• Facilitates planning

• Enhanced communication

• Reinforced accountability

• Identification of problems

• Motivated employees

Budgeting 6–37

5 How does budgeting enhance communication?

Budgeting communicates spending and pricing expectations that are found in the budget.

6 In what ways does budgeting motivate employees?

Budgeting provides methods to reward employees and enhances performance evaluations.

7 What is the process for creating and enforcing a budget?

• Analyze financial statements

• Set budgeting objectives

• Monitor performance

8 Which method of analysis is being described in the following statement?

This method is very effective for comparing your business’s operations to the operations of other companies within the same industry.

A Ratio analysis

B Vertical analysis

C Trend analysis


9 Which type of ratio is being explained in the following statement?

This ratio helps you determine your company’s ability to generate adequate amounts of cash to meet any current obligation.

A Liquidity ratios

B Activity ratios

C Leverage ratios

D Profitability ratios

10 What does it mean if Icon has a debt-to-total-assets ratio of .38?

A Icon has to wait an average of 38 days after making a sale before receiving cash from a client

B Icon must withhold 38% of all its generated revenue in order to pay off its debts

C For every $1 of assets, Icon has 38 cents of debt

D For every $1 of debt, Icon has 38 cents of assets


11 Review the Income Statement, as shown in Exhibit 6-16. What is the profit margin on sales?

A 0.09

B 0.48

C 1.09

D 1.48


12 How can you monitor actual performance against a budget?

• Record information regularly

• Compare to the budget

• Use “pro forma” financial statements

13 What is a “pro forma” financial statement?

A “pro forma” financial statement is a forward-looking document that is created when setting a budget, before an accounting period. It is used to establish the projected financial activity for an upcoming accounting period. “Pro forma” financial statements are also called estimates.

Budgeting 6–39

14 What should be done if actual performance negatively deviates from the budget?

Budgets are only a guideline and minor deviations from the budget are no cause for alarm. You first need to determine the deviation severity and then, determine the possibility for budgeting re-allocation.

15 Review the statement, as shown in Exhibit 6-17. What is the year-to-date figure for February’s gross profit on sales?

A $1065

B $420

C $370

D $690

Exhibit 6-17: Icon’s pro forma statement

16 What does it mean if selling expenses are 6% of sales?

A Six percent of the sales revenue is used to pay for the selling expenses

B Six percent of the year’s budget is used to pay for the selling expenses

C Six percent of the sales revenue comes from the selling expense budget

17 Review the statement, as shown in Exhibit 6-17. What is the deviation for January’s gross profit on sales?

A $110

B $130

C ($110)

D ($130)



ACROSS:

1. _________ is the process of planning the financial activities for an upcoming accounting period.

3. The Total ________ Turnover ratio provides an indication of a business’s ability to generate sales in relation to its total assets.

6. _________ analysis concentrates on the relationship between various items in the same period.

8. _________ ratios help you determine your company’s ability to generate adequate amounts of cash to meet a current obligation.

DOWN:

1. It is the point when total sales equal total expenses with nothing left over for profit.

2. ________ analysis is similar to horizontal analysis but analyzes changes for three or more years.

4. The ratios that enable you to evaluate how effectively your company uses its assets are called _______ ratios.

5. The profit margin on ______(s) indicates how satisfactory business activities have been.

7. ________ analysis enables you to study the relationship between two or more items on financial statements.

1 2 B U D G E T I N G

R R

3 4 E A S S E T S A

A N C

5 K D S T

E A I

6 7 V E R T I C A L V

E A E I

N T T

8 L I Q U I D I T Y

O

Financial Basic

Documents

Transcript of Financial Basic