ADDIS ABABA UNIVERSITY

SCHOOL OF BUSINESS AND ECONOMICS

MBA PROGRAM
Course Title: Financial and Managerial Accounting
Module Code: ACFN 631
Credit Hours: 2
Course ECTS: 4.5

Course Description: This course deals with the conceptual and analytical issues for
understanding the techniques, nature and purpose of financial and managerial reporting. The
course will focus on the nature and role of accounting information, systems of information
processing, the processing and reporting framework, income measurement and asset
valuation and types and formats of corporate annual reports. Cost accumulation systems, cost
allocation, budgeting, standard costing, break-even analysis and consideration of relevant cost
for short-term decisions will also be covered.

Course Objectives: Financial Accounting: Generally, to provide students striving to become

effective managers/leaders with a practical understanding of the source, basis, common uses
and limitations of financial accounting.
Specifically:
 To develop a working knowledge of financial accounting statements (i.e. balance
sheet, income statement, and cash flow statement), accounting terminology,
Generally Accepted Accounting Principles (GAAP), IAS, IFRS, and accrual
accounting concepts, and the process used to record financial transactions and
generate those statements.
 To develop an understanding of limitations and problems caused by (1) a primary
focus of the business on attaining results and (2) using primarily accounting data to
make operating decisions
Managerial Accounting: Students in this part of the course shall:
 Gain an introduction to accounting techniques used by internal management to aid
in planning, directing, controlling, and decision making activities.
 Use accounting data to identify and analyze alternatives with the purpose of making
managerial choices to maximize economic benefits of a firm.
 Course Contents
Chapter 1: Introduction to Financial Accounting

Accounting Information: A Means to an End

Accounting from the users perspective
Types of accounting information
Accounting Systems
Determining information needs
The cost of producing accounting information
Basic functions of accounting information
Financial Accounting Information
External users of accounting information
Objectives of external financial reporting
Characteristics of externally reported information
Management Accounting Information
Users of internal accounting information
Objectives of management accounting
Characteristics of management accounting information
Conceptual Framework for financial accounting and reporting
Basic Concepts of financial accounting and reporting
Chapter 2: Basic Financial Statements
2.1.Introduction to Financial Statements
2.2. A Starting Point: Statement of Financial Position
2.3. The income statement
2.4. The statement of cash flow
2.5. Relationship among financial statements
2.6. Forms of business organizations
Chapter 3: The Accounting Cycle
3.1 Capturing Economic Events
3.1.1 Recording business transactions
3.1.2 Ledger accounts and posting
3.1.3 The unadjusted trial balance
3.2 Accruals and Deferrals
3.2.1 Adjusting entries
3.2.2 Accounting principles
3.2.3 Effects of the adjusted entries
3.3 Reporting Financial Results
3.3.1 Preparing financial statements
3.3.2 Closing the temporary accounts
3.3.3 Post closing trial balance
Chapter 4: Financial Statement Analysis
4.1 The need for Financial Analysis
4.2 Sources of Financial Data
4.3 Tools of Analysis
4.4 Measure of Liquidity and Credit Risk
Chapter 5: Introduction to Managerial Accounting
Brief introduction to cost and management accounting
Basic cost concepts and cost behavior
Job and Process Costing System
Activity costing — another way to measure costs
Financial Statements of Manufacturing Firms
Chapter 6: Cost-Volume-Profit (CVP) Relationships
6.1 Cost Behavior Analysis
6.2 Break-Even Point Analysis
Equation Method
Contribution Margin Method
Graphical Method
6.3 Decision Making Using CVP Analysis
6.4 Limitation of CVP Analysis
Chapter 7: Relevant Costs for Decision Making-Incremental
Analysis
7.1 Cost concepts for Decision Making
7.2 Common Types of Incremental Analysis
7.3 Other Considerations in Decision Making
Textbook

Williams, Haka and Bettner ,Financial and Managerial Accounting -the basis for business decisions; 13th edition, Tata McGraw-Hill
Edition

References
Horngren C. T., Datar S. M. & Foster G., (2003)."Cost Accounting a Managerial Emphasis" 11th Edition, Prentice Hall, Inc.,
New Delhi, India.
Horngren C. T., Sundem G.L. & Stratton W.O., (2001)."Introduction to Management Accounting" 11th Edition, Prentice Hall,
Inc., New Delhi, India.
Weygand J. J., Kieso D. E. & Kimmed P.D., (2002). "Managerial Accounting,Tools for Business Decision Making", 2nd Edition, John
Wiley & Sons, Inc., U.S.A.
Williams, Meigs, Haka and Bettner," Financial and Managerial Accounting, 14th Edition.
Any Financial Accounting Book
Any Managerial Accounting Book
Mode of Assessment
Your assessment will be done as per the following outlined methods of assessments

Assessment
Assessment item 1: Test and Worksheet (groups)… ….…...………….20%
Assessment item 2: Term paper with presentation selected from
list of topics to be provided by the instructor (group) …………….....….…30%
Final exam covering all the topics handled ………………….….…..……. 50%
 FINANCIAL and MANAGERIAL
ACCOUNTING

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

CHAPTER ONE INFORMATION FOR DECISION

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

INTRODUCTION TO FINANCIAL ACCOUNTING

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

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 What is Accounting?
• Is a composite activity of:

 identifying,

 recording, and

 communicating

the economic events of an organization to interested users.

• Accounting is often called the “language of business”

Accounting is the art of analyzing, recording, summarizing,

evaluating and reporting, if necessary, interpreting information
about business transactions.
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 What is Accounting?

Three Activities

The accounting process includes

the bookkeeping function.

5/14/2019 Financial Accounting and Management Accounting

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

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 The accounting
process

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

Actions
(decisions)
Decision makers
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 Information System

Cost & Revenue

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

There are two broad groups of users of

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

Creditors
Marketing
Securities
Customers controlling bodies
External Users

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 Who Uses Accounting Data
Common Questions Asked User

1. Can we afford to give our

employees a pay raise?
Human Resources

2. Did the company earn a

satisfactory income?
Investors

3. Should any product lines be

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

5. What price for our product will

maximize net income?
Marketing

6. Will the company be able to pay its

debts as they become due?
Creditors
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Its purpose is to communicate or report the results
of business operations and its various aspects.
It is the process of identifying, measuring and
communicating economic information to permit
informed judgments and decisions by users of the
information.

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 AICPA has defined accounting as“ is the art of recording, classifying
and summarizing in a significant manner and in terms of money
transactions and events which are, in part at least, of a financial
character and interpreting the results thereof.”
 AAA has defined accounting as “the process of identifying,
measuring and communicating economic information to permit
informed judgments and decisions by users of the information.”

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

Accounting was developed as a system for reporting

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

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

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 Types of Accounting Information
 Financial, Managerial & Tax Accounting, are the 3 types of Accounting
Information used widely in the business community
1.Financial Accounting: financial accounting information appears in financial
statements that are intended for external use.
 Describes the financial resources, obligations,& activities of an economic entity.
 It is designed to primarily to assist investors & creditors in deciding where to
place their scarce investment resources.

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2. Management Accounting: management accounting
information is for internal use & provides special
information for managers.
 Information managers use may range from broad, long-
range planning data to detailed explanations of why
actual costs varied from cost estimates.
 Management accounting generates information that
managers can use to make sound decisions such as
financial, resource allocation, production & marketing
decisions.
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3.Tax Accounting- preparation of income tax returns
is a specialized field in accounting.
Tax returns are based on financial accounting
information.
However, the information is adjusted/ reorganized to
conform with income tax reporting requirements.
Income tax planning is the most challenging task of
tax accounting.

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 Accounting Systems (AS)
Accounting system consists of the personnel, procedures,
devices & records used by an organization:
 to develop accounting information &
 to communicate this information to decision makers.
The design & capabilities of these systems vary greatly
from very small business to large business organizations.
But, the basic purpose of accounting system remains the
same to meet the organization’s needs for accounting
information as efficient as possible.

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Factors affect the structure of accounting system in an
organization are:
the co.’s need for accounting information, &
the resources available for the operation of the system.
Determining the Information Needs
Information needs of an organization are affected by:
size of the organization,
ownership,(public or private), &
the philosophy of management.

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 The Cost of Producing Accounting Information
Accounting system should be cost effective i.e. the
value of the information produced should exceed
the cost of producing it.
Development and installation of computer based
accounting system have increased greatly the types
and amount of accounting information that can be
produced in a cost effective way.

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 Basic Functions of Accounting

 Recording: Accounting records business transactions in terms

of money. It is essentially concerned with ensuring that all
business transactions of financial nature are properly recorded.
Recording is done in journal, which is further subdivided into
subsidiary books from the point of view of convenience.
 Classifying: Accounting also facilitates classification of all
business transactions recorded in journal. Items of similar
nature are classified under appropriate heads. The work of
classification is done in a book called the ledger.
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 Summarizing: Accounting summarizes the classified information. It is done
in a manner, which is useful to the internal and external users. Internal
users interested in this information are the persons who manage the
business. External users of information are the investors, creditors, tax
authorities, labor unions, trade associations, shareholders, etc.
 Interpreting: It implies analyzing and interpreting the financial data
embodied in final accounts. Interpretation of the data helps the
management, outsiders and shareholders in decision making.

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 Financial Accounting Information

 Financial accounting information provides information about the financial

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

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

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 Characteristics of Externally Reported Information

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

to improve the quality of decision making by external parties.
• Financial Reporting vs. Financial Statements
 Financial reporting is broader than financial statements
 Financial reporting includes press release, articles in a journal,
communication via internet
 Financial statements includes balance sheet, income statement and
statements of cash flow

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• Historical in nature: looks back in time & reports the
results of events & transactions that already happened.
• Inexact & approximate measure: have a great look of
precision but in fact much of it is based on estimates,
judgment & assumptions that must be made about both
the past & future.
e.g. allocation of depreciation expenses
• General purpose assumptions: for multiple users ( “
one size fits all).
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 Management Accounting Information
 Management accounting is the design & use of accounting information system to achieve
the orgn’s objectives by supporting decision makers inside the enterprise.
 Internal Users of Accounting Information
 BODs, CEO, CFO
 Business unit managers
 Plant mangers
 Store managers
 Line supervisors
 Other employees and any level of management

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

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Characteristics of Management Accounting Information

 Importance of timeliness- should occur at good time

without delay.
 Identity of decision makers-for those who have decision
making authority.
 Oriented towards the future-to motivate management to
make future decisions that are in the best interest of the
enterprise, consistent with its goals, objectives & missions.
 Measures of efficiency and effectiveness of resource
utilization.
 Management accounting information a means-not an end
in and of it self.

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 Financial Accounting Vs Management
Accounting
Financial Accounting Managerial Accounting

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

of the business over a record, plan and control the
specific period. This specific activities of a business and to
period referred to as assist in the decision making
“accounting period”. It has process. It can be prepared for
one year long. any period (for daily, quarterly or
annually).
It is required by law to prepare There is no legal requirement
and publish financial statements. to prepare management reports.

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The format of published There is no pre-determined
financial statement is format for managerial
determined by several different accounting. It can be as
regulatory bodies: Company detailed or brief as
Law, Accounting standards, management wish.
Stock exchange etc.
Financial accounting Management Accounting can
concentrate on the business as focus on specific areas of a
a whole rather than analyzing business activities.
the component parts of the
business. For example, it can provide
For example, sales are insight into performance of
aggregated to provide a figure products, departments,
for total sales rather than markets etc.
published product wise.
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 Financial accounting Managerial accounting
includes information that usually include a wide variety
can only be expressed in of financial and non-financial
monetary terms. information.
Example, number and
productivity of employees,
sales volumes (units sold) etc.

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

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

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

Financial accounting Managerial accounting

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

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

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 1. Objective of General Purpose Financial
Reporting

“Provide financial information about the reporting

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

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

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2. Qualitative Characteristics of Useful Financial Information

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

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• Relevance: Capable of making a difference in
users’ decisions
predictive value
confirmatory value
materiality (entity-specific)
• Faithful representation: Faithfully represents the
phenomena it purports to represent
completeness (depiction including numbers
and words)
neutrality (unbiased)
free from error (ideally)

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• Comparability: like things look alike; different
things look different
• Verifiability: knowledgeable and independent
observers could reach consensus, but not
necessarily complete agreement, that a
depiction is a faithful representation
• Timeliness: having information available to
decision-makers in time to be capable of
influencing their decisions
• Understandability: Classify, characterize, and
present information clearly and concisely
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 3. Elements of financial statements
Asset Income
• resource controlled by the • recognised increase in
entity asset/decrease in liability in
• result of past event current reporting period
• expected inflow of economic • that result in increased
benefits equity except contributions
from owners
Liability
Expense
• present obligation
• recognised decrease in
• arising from past event asset/increase in liability in
• expected outflow of current reporting period
economic benefits • that result in decreased
Equity = assets less liabilities equity except distributions
to owners

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

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

– What does measure reliably mean?

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

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 5. Measurement

• Measurement is the process of determining

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

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 Measurement methods include

1. Historical cost: cash paid or fair value of

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

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

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7. Underlying assumptions of financial reporting:
 Going concern, and
 Accruals accounting

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 Financial Statements

• A statement of financial position as at the end of

the period
• A statement of profit or loss and other
comprehensive income for the period
• A statement of changes in equity for the period
• A statement of cash flows for the period
• Notes, comprising
– A summary of significant accounting policies
– Other explanatory information

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 Basic Concepts of Financial
Accounting and Reporting
Generally Accepted Accounting
Principles(GAAP)
The Accounting Equation

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

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1. GAAP…

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

Going concern
• A company continues in business indefinitely.

Monetary Unit
• Money is the common denominator of economic
activity

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1.1 Assumptions…

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

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

Revenue Recognition Principle

• Revenue is recognized when realized and when earned.

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

Full Disclosure Principle

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

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

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

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

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1.3 Constraints

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

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2. The Accounting Equation

Assets = Liabilities + Stockholders’ equity

Economic Claims to
Resources Economic
Resources

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

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

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74
The Accounting Equation

Assets = Liabilities + Stockholders’ equity

Paid-in Retained
capital earnings

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 The Accounting Equation
Stockholders’ equity

Paid-in capital Retained earnings

Common stock + Net income

- Dividends
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 The Accounting Equation

Retained earnings Revenues

+ Net income
- Expenses
- Dividends

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 The End
Of 1

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 CHAPTER - 2

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

 Accountants frequently refer to a business

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

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

 In modern business world, most business enterprises

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

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2. Partnership
 Is an unincorporated business owned by two or more persons
associated as partners.
 As in case of the sole proprietorship, the owners of a
partnership are personally responsible for all debts of the
business.
 From an accounting stand point, a partnership is viewed as a
business entity separate from the personal affairs of its owners.
 A benefit of partnership form over sole proprietorship form is the
ability to bring together large amount of capital investment
from multiple owners.

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3. Corporation
 A corporation is a business incorporated under the law of a
state and owned by a few stockholders or thousands of
stockholders.
 It is unique in that it is a separate legal business entity.
 The owners of the corporation are stockholders or
shareholders.
 The corporate form of business protects the personal
assets of the owners from the creditors of the corporation.

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 Introduction to Financial Statements
 Business entities may have many objectives & goals.

 The two primary objectives of every business are profitability

and solvency.

 Profitability is the ability to generate income.

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

 Unless a business can produce satisfactory income & pay its

debts as they become due , the business can’t survive to
realize its other objectives.

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 The financial statement that reflects a co.’s profitability is the
income statement.

 The statement of retained earnings shows the change in

retained earnings between the beginning and end of a period.

 The balance sheet reflects the company’s solvency.

 The statement of cash flows shows the cash inflows and

outflows for a co. over a period of time

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 A Starting Point: Statement of Financial
Position (Balance Sheet)
• Is a list of balances in the assets, liability & owners’ (
stockholders’) equity accounts.

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

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

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

the balance sheet is true on that date only.

• The totals of the assets should be equal to the totals of

liabilities & owners’ ( stockholders’) equity. If it is not so, it
means that there is some error.
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 Objective of Balance Sheet
 Principal Objective: The main purpose of preparing balance
sheet is to know the financial position of the business at a
particular date.

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

exact financial position of the firm at a particular date, yet it
serves other purpose as well such as:
1. It gives information about the actual and real owner’s(
stockholders’) equity.
2. It helps the firm to make provisions against possible
future losses. A provision is made in the form of the
Reserves.
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Characteristics of Balance Sheet:
 It is a statement and not an account.
 It is always prepared on a particular date, & thus shows the
position at that date & not for a period.
 It has no debit side & credit side.
 It shows the financial position of the business concern.
 It shows what the firm owes to others & also what others
owe to the firm
 The totals of assets always are equal with the totals of
liabilities & owners’(SH) equity.
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 Uses of balance Sheet
 The balance sheet is described as a snapshot/photograph/picture of the financial
position of a business entity.

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

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

balance.

 It shows the nature & value of the assets.

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

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

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

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

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

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

OE/SHE is a residual amount.

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

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

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 Effects of Business Transactions(BT) on Accounting Equation

 Business transactions/economic events are any events that

directly affects the financial position of an organization.

 BT can be classified as external & internal

 External business transaction involve an exchange between the

co. & other external separate business entity.

 Internal transaction directly affect the financial position of a co. but

don’t involve an exchange transaction with an other entity.

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 These events must be recorded to properly reflect a co.’s
financial position & results of operations.

Each transaction affecting the accounting equation

will have a dual effect because resources always must equal
claims to those resources.

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5/14/2019 96
 Example
1.Mr. X invested $50,000 to open a law office.
A = L + OE
+50,000 (cash) - + 50,000 (investment)
2. $40,000 was borrowed from a bank & a note payable was signed.
A = L + OE
+40,000(cash) +40,000 (Notes Payable) -
3. Supplies Costing $3,000 were purchased on account.
A = L + OE
+3,000( supplies) +3,000(Accounts Payable) -
4.Services were performed on account $10,000.
A = L + OE
+10,000 (A/R) - +10,000 (Revenue)
5.Salaries of $ 5,000 were paid to employees.
A = L + OE
-5,000 (Cash) - - 5,000( salary exp.)
6. $ 500 of supplies were used:
A = L + OE
- 500 (supplies) - -500 (supplies exp.)
7. $ 1,000 was paid on account to supplies vendor.
A = L + OE
-1000(cash) -1,000 (A/p) -

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 X Co.
Balance Sheet
On December 31,2009
Assets Liabilities & Owner’s Equity
Cash 84,000 Liabilities:
Supplies 2,500 A/P 2,000
A/R 10,000 N/P 40,000
Total L. 42,000
Owner’s E quity :
X Capital 54,500
Total Assets 96,500 Total L & OE $ 96,500

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 The Greener Landscape Group
Balance Sheet
December 31,2010
ASSETS
Current Assets
Cash $ 6,355
Accounts Receivable 200
Supplies 25
Prepaid Insurance 1,100
Total Current Assets 7,680
Property, Plant, and Equipment
Equipment $18,000
Less: Accumulated Depreciation (235) 17,765
Total Assets $25,445

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LIABILITIES AND OWNER'S EQUITY
Current Liabilities
Accounts Payable $ 50
Wages Payable 80
Interest Payable 79
Unearned Revenue 225
Total Current Liabilities 434
Long-Term Liabilities
Notes Payable 10,000
Total Liabilities 10,434
Owner's Equity
J. Green, Capital 15,011
Total Liabilities & Owner's Equity $25,445

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 Income Statement
 It lists revenues & expenses & calculates the company's net income or
net loss for a period of time.
 Net income means total revenues are greater than total expenses.
 Net loss means total expenses are greater than total revenues.
Greener Landscape Group
Income Statement
For the Year Ended on Dec.31,2009
Revenues:
Lawn Cutting Revenue $845
Expenses:
Wages Expense $280
Depreciation Expense 235
Insurance Expense 100
Interest Expense 79
Advertising Expense 35
Gas Expense 30
Supplies Expense 25
Total Expenses (784)
Net Income
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 Greener Landscape Group
Income Statement
For the Year Ended on Dec.31,2009
Revenues:
Lawn Cutting Revenue $845
Expenses:
Wages Expense $280
Depreciation Expense 235
Insurance Expense 100
Interest Expense 79
Advertising Expense 35
Gas Expense 30
Supplies Expense 25
Total Expenses (784)
Net Income $ 61

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

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

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 Statement of Retained Earnings

 It explains the changes in retained earnings between two balance

sheets.

 These changes usually consists of the addition of NI ( or deduction of

NL) & the deduction of dividends.

 Dividends are the means by which a corporation rewards its

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

 A dividend is a distribution of income to owners rather than an

expense of doing business.

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

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 Statement of Cash Flows
 The statement of cash flows tracks the movement of
cash during a specific accounting period.

 It assigns all cash exchanges to one of three categories

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

 As its name implies, the statement of cash flows

includes items that affect cash.

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 Statement of cash flows has 3 sections
1. Cash flows from the operating activities are the cash
effects revenues & expense transactions that are included
in the income statements.

2. Cash flows from the investing activities are the cash effects
of purchasing & selling assets.

3. Cash flows from financing activities are the cash effects of

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

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 Presentations of Owner’s Equity in Balance Sheet
 Sole proprietorship
 Owner’s Equity:
Mr. X, Capital…………………………….. xx
 Partnership
 Partners’ Capital:
Partner A, Capital…………………….xx
Partner B, Capital……………………..xx
Total partners’ equity xxx
 Corporation
 Stockholders’ Equity:
Capital Stock……………………………………xx
Retained Earnings…………………………….xx
Total Stockholders’ Equity xxx

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Relationships among Financial Statements
____________________TIME_________________
B/Sheet Income St’t B/S
St’t of CF

 At the beginning & ending point in time, a co. prepare a st’t of

financial position (B/S) that gives a static look in financial terms of
where the co. stands.

 The other 2 FSs of IS & SCF cover the intervening period of time
b/n the two B/Ss & explain the important changes that occurred
during the period.

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 Illustration
1. United communications was organized on December 1 of
the current year and had the following account balances at
December 31, listed in tabular form.
Assets = liabilities + Owners Equity
Cash + Land + Building + office equipment = Notes Payable + Accounts Payable + Capital Stock

Balances $37000 95000 125000 51250 80000 28250 200000

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

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 The End
Of Chapter 2

5/14/2019 114
CHAPTER THREE
ACCOUNTING CYCLE
Contents
• Capturing Economic Events
• Basis of Accounting
• Adjustments
• Reporting Financial Statements
. Capturing Economic Events

Accounting cycle is a series of steps

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

1. Obtain & analyze business transactions

by examining the source documents.(
through the accounting period)
2. Journalize transactions in the journal.
(through the accounting period)
3. Post journal entries to the accounts in
the ledger.( throughout the accounting
period)
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4. Prepare an unadjusted trial balance.( period end only)
5. Record adjusting entries. .( period end only)
6. Post the adjusting entries. ( period end only)
7.Prepare an adjusted trial balance. ( period end only)
7.Prepare financial statements. ( period end only)
8. Close the temporary accounts. ( period end only)
9. Post the closing entries.( period end only)
10.Prepare a post closing trial balance .( period end only)

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The Account

 Record of increases and decreases

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

An account can be Account Name

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

Double-entry system
► Each transaction must affect two or more accounts to
keep the basic accounting equation in balance.

► Recording done by debiting at least one account and

crediting another.

► DEBITS must equal CREDITS.

 If Debit amounts are greater than Credit amounts, the
account will have a debit balance.

Account Name
Debit / Dr. Credit / Cr.

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

Transaction #3 8,000

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

Account Name
Debit / Dr. Credit / Cr.

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

8,000 Transaction #3

Balance $1,000
Debits and Credits
Assets  Assets - Debits should exceed
Credit / Cr.
credits.
Debit / Dr.

 Liabilities – Credits should

Normal Balance
exceed debits.
Chapter
3-23

 Normal balance is on the

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

Normal Balance

Chapter
3-24
Debits and Credits

 Owner’s investments and revenues

increase owner’s equity (credit).

 Owner’s drawings and expenses

decrease owner’s equity (debit).

Helpful Hint Because

revenues increase owner’s
equity, a revenue account
has the same debit/credit
rules as the Owner’s
Capital account. Expenses
have the opposite effect.
Debits and Credits

Revenue
Debit / Dr. Credit / Cr.

 The purpose of earning revenues

is to benefit the owner(s).
Normal Balance

 The effect of debits and credits on

revenue accounts is the same as
Chapter
3-26

their effect on Owner’s Capital.

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

Chapter
3-27
 Debits/Credits Rules

Balance Sheet Income Statement

Asset = Liability + Equity Revenue - Expense

Debit

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

Expanded
Basic
Equation

The equation must be in balance after every transaction.

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

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

ledger accounts

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

a cash register tape, provide evidence of the transaction.
The Journal
 Book of original entry.

 Transactions recorded in chronological order.

 Contributions to the recording process:

1. Discloses the complete effects of a transaction.

2. Provides a chronological record of transactions.

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

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

General Journal

Date Account Title Ref. Debit Credit

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

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

General Journal

Date Account Title Ref. Debit Credit

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

Follow these steps:

1. Determine what
type of account is
involved.
2. Determine what
items increased or
decreased and by
how much.
3. Translate the
increases and
decreases into
debits and credits.
Summary of Journalizing and Posting
Trial Balance
Limitations of a Trial Balance
The trial balance may balance even when
1. a transaction is not journalized,

2. a correct journal entry is not posted,

3. a journal entry is posted twice,

4. incorrect accounts are used in journalizing or posting, or

5. offsetting errors are made in recording the amount of a

transaction.
.Basis of Accounting
Accrual- versus Cash-Basis Accounting

Accrual-Basis Accounting
 Transactions recorded in the periods in which the
events occur.

 Companies recognize revenues when they perform

services (rather than when cash is received).

 Expenses are recognized when incurred (rather than

when paid).
Accrual- vs. Cash-Basis Accounting

Cash-Basis Accounting
 Revenues recognized when cash is received.

 Expenses recognized when cash is paid.

 Cash-basis accounting is not in accordance with

generally accepted accounting principles (GAAP).
Recognizing Revenues and Expenses

REVENUE RECOGNITION PRINCIPLE

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

EXPENSE RECOGNITION PRINCIPLE

Match expenses with revenues
in the period when the expense
makes its contribution to revenue.

“Let the expenses follow the

revenues.”
GAAP relationships in revenue
and expense recognition
.Adjustments
The Basics of Adjusting Entries

Adjusting Entries
 Ensure that the revenue recognition and expense
recognition principles are followed.

 Necessary because the trial balance may not contain

up-to-date and complete data.

 Required every time a company prepares financial

statements.

 Will include one income statement account and one

balance sheet account.
 Types of Adjusting Entries
Categories of adjusting entries

Deferrals Accruals

1. Prepaid Expenses. Expenses 1. Accrued Revenues.

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

2. Unearned Revenues. 2. Accrued Expenses.

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

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

Deferrals are expenses or revenues that are

recognized at a date later than the point when cash
was originally exchanged. There are two types:

 Prepaid expenses and

 Unearned revenues.
 PREPAID EXPENSES
Payment of cash, that is recorded as an asset because service
or benefit will be received in the future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

 insurance  rent
 supplies  equipment
 advertising  buildings
PREPAID EXPENSES

 Expire either with the passage of time or through use.

 Adjusting entry:
► Increase (debit) to an expense account and

► Decrease (credit) to an asset account.

Illustration: Pioneer Advertising Agency
purchased supplies costing $2,500 on
October 5. Pioneer recorded the payment by
increasing (debiting) the asset Supplies. This
account shows a balance of $2,500 in the
October 31 trial balance. An inventory count
at the close of business on October 31
reveals that $1,000 of supplies are still on
hand.
Oct. 31 Supplies expense 1,500
Supplies 1,500
Illustration: On October 4, Pioneer
Advertising Agency paid $600 for a one-year
fire insurance policy. Coverage began on
October 1. Pioneer recorded the payment by
increasing (debiting) Prepaid Insurance. This
account shows a balance of $600 in the
October 31 trial balance. Insurance of $50
($600 ÷ 12) expires each month.

Oct. 31 Insurance expense 50

Prepaid insurance 50
Depreciation
 Buildings, equipment, and motor vehicles (assets that
provide service for many years) are recorded as assets,
rather than an expense, in the year acquired.

 Depreciation is the process of allocating the cost of an

asset to expense over its useful life.

 Depreciation does not attempt to report the actual change

in the value of the asset.
Illustration: For Pioneer Advertising, assume
that depreciation on the equipment is $480 a
year, or $40 per month.
Oct. 31

Depreciation expense 40
Accumulated depreciation 40

Accumulated Depreciation is called a

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

Receipt of cash that is recorded as a liability because the

service has not been performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

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

 Adjusting entry is made to record the revenue for

services performed during the period and to show the
liability that remains at the end of the period.

 Results in a decrease (debit) to a liability account and

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

Accruals are made to record

 Revenues for services performed

OR

 Expenses incurred

in the current accounting period that have not been

recognized through daily entries.
 ACCRUED REVENUES

Revenues for services performed but not yet received in cash

or recorded.

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

 Rent  Services performed
 Interest
ACCRUED REVENUES

 Adjusting entry shows the receivable that exists and records

the revenues for services performed.

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

200
200
 ACCRUED EXPENSES

Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

 Rent  Taxes
 Interest  Salaries
ACCRUED EXPENSES

 Adjusting entry records the obligation and recognizes the

expense.

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

Oct. 31 Interest expense 50

Interest payable 50
Illustration: Pioneer Advertising Agency last paid salaries on
October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of $2,000 for a
five-day work week, or $400 per day. Thus, accrued salaries at
October 31 are $1,200 ($400 x 3 days).
Summary of Basic Relationships
The Adjusted Trial Balance
Adjusted Trial Balance
 Prepared after all adjusting entries are journalized and
posted.

 Purpose is to prove the equality of debit balances and

credit balances in the ledger.

 Is the primary basis for the preparation of financial

statements.
. The Financial Statements

Financial Statements are prepared directly from the

Adjusted Trial Balance.

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

Steps in Preparing a Worksheet

 Multiple-column form used in preparing financial
statements.

 Not a permanent accounting record.

 Five step process.

 Use of worksheet is optional.

Steps in Preparing a Worksheet
 1. Prepare a Trial Balance on the Worksheet
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200
Supplies 2,500
Prepaid Insurance 600
Office Equipment 5,000
Notes Payable 5,000
Accounts Payable 2,500
Unearned Revenue 1,200
Owner's Capital 10,000
Owner's Drawing 500
Service Revenue 10,000

Salaries Expense 4,000

Rent Expense 900
Totals 28,700 28,700

Trial balance amounts come

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

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

Add additional accounts as needed.

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

Total the adjusted trial balance

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

Extend all revenue and expense account

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

 Balance sheet and owner’s equity statement are

prepared from the balance sheet columns.

 Companies journalize and post adjusting entries.

Preparing Statements from a Worksheet
Preparing Adjusting Entries from a Worksheet

 Adjusting entries are prepared from the adjustments

columns of the worksheet.

 Journalizing and posting of adjusting entries follows the

preparation of financial statements when a worksheet is
used.
Closing the Books
At the end of the accounting period, the company makes
the accounts ready for the next period.
Preparing Closing Entries
Closing entries formally recognize, in the general ledger, the
transfer of
 net income (or net loss) and
 owner’s drawing
to owner’s capital.

Closing entries are only made at the end of the annual

accounting period.
 Closing the Books

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

1. Analyze business transactions

9. Prepare a post-closing 2. Journalize the

trial balance transactions

8. Journalize and post

3. Post to ledger accounts
closing entries

7. Prepare financial
4. Prepare a trial balance
statements

6. Prepare an adjusted trial 5. Journalize and post

balance adjusting entries
 Illustration
1. Each transaction during NetSolutions’ first month of
operations is described in the following paragraphs.

1. Nov. 1, 2009 Chris Clark deposits $25,000 in a bank account in the name of
NetSolutions.
2. Nov. 5, 2009 NetSolutions paid $20,000 for the purchase of land as a future building
site.
3. Nov. 10, 2009 NetSolutions purchased supplies for $1,350 and agreed to pay the supplier
in the near future.
4. Nov. 18, 2009 NetSolutions received cash of $7,500 for providing services to customers.
5. Nov. 30, 2009 NetSolutions paid the following expenses during the month: wages,
$2,125; rent, $800; utilities, $450; and miscellaneous, $275.
6. Nov. 30, 2009 NetSolutions paid creditors on account, $950.
7. Nov. 30, 2009 Chris Clark determined that the cost of supplies on hand at the end of the
month was $550.
8. Nov. 30, 2009 Chris Clark withdrew $2,000 from NetSolutions for personal use.

101
Illustration
Record the following transactions in the general
journal.
Jan. 20,2005: owners invested $80,000 in exchange for capital
stock.
Jan. 21, 2005: purchased the land for 52,000
Jan.22,2005: purchased building from Co. M for 36,000; 6000
cash made down payment and issued a 90 day, non interest
bearing note payable for the remaining 30,000.
Jan. 23, purchsed tools and equipments on account from Snappy
tools. The purchase price was $13,800, due in 60 days.

5/14/2019 102
Jan 24, 2005: The company sold the excess tools
on account to co. AC at a price of 1,800. the
tools were sold at a price equal to their cost.
Jan 26, 2005: the company received 600 in partial
collection of the account receivable from
company AC.
Jan. 27, 2005: The company made 6,800 partial
payment of its accounts payable to Snappy
tools.
Jan. 31, 2006: revenue of 2,200 is earned, all of
which was received in cash.

5/14/2019 103
Jan.31 Paid employees wages in January, $1,200.
Jan.31. paid for utilities used in January, $200
Feb. 1. Paid 360 cash news advertising for February.
Feb. 1. Purchased radio advertising for February at a
cost of 470, payable within 30 days .
Feb.4. Purchased various shop supplies ; cost 1,400,
due in 30 days.
Feb.15: collected 4980 cash fro repairs made
to vehicles.

5/14/2019 104
Feb. 28 Billed Co. H, 5400 for maintenance and repair
services provided in Feb. The agreements with co. H
calls for payment to be received by March 10.
Feb. 28 paid employees wages earned in Feb, 4900.
Feb. 28: recorded 1,600 utility bill for Feb. The entire
amount is due March 15.
Feb. 28: The co. declares and pays dividend of 40
cents per share to the owners of its 8000 shares of
capital stock – a total of 3,200.

5/14/2019 105
Illustration 2: Adjusting Entries
Given the following information, prepare
necessary adjusting entries at the end of the
period (December 31).

1. On December 1, the company signed a

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

5/14/2019 106
2. An estimate of supplies on hand was made
December 31; the estimated cost of the
unused supplies was 450. the amount of
supplies presented in the adjusted trial
balance was 600.
3. The useful life of the equipment has been
estimated at five years from date of
acquisition.(assume that the historical cost is
36,000 with no selvage value at the end of
the useful life)
5/14/2019 107
4. Accrued interest on notes payable to
amounted 100 at year end. (set up accounts for
interest expense and interest payable).
5. Consulting services valued at 2850 were
rendered during December to clients who had
made payment in advance.
6. At December 31, consulting services valued at
11,000 had been rendered to clients but not yet
billed. No advance payment had been received
from these clients

5/14/2019 108
7. Salaries earned by employees but not paid
as of December 31 amounted to 1700.
9. Income taxes expense for the year estimated
at 56000. of this amount, 51000 had been
recognized as expense in prior months , and
39,000 had been paid to tax authorities. The
company plans to pay the 17,000 remainder
of its income tax liability on January 15.

5/14/2019 109
THE END
Chapter 4

Financial Statement Analysis

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

 Annual reports a company usually contains:

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

 Following are the most important tools and techniques

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

 Horizontal (Trend) Analysis

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

Increase/(Decrease)
2005 2004 Amount Percent
Sales $41,500 $37,850 $3,650 9.6%
Expenses 40,000 36,900 3,100 8.4%
Net income 1,500 950 550 57.9%
Horizontal Analysis-Example

2005 2004 Difference

Sales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = .0964, or 9.6%

Trend Percentages - Example

…are computed by selecting a base year whose

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

Trend % = Any year $ ÷ Base year $

 Trend Percentages - Example
Year 2005 2004 2003
Revenues $27,611 $24,215 $21,718
Cost of sales 15,318 14,709 13,049
Gross profit $12,293 $ 9,506 $ 8,669
2003 is the base year.

What are the trend percentages?

 Trend Percentages - Example
Year 2005 2004 2003
Revenues 127% 111% 100%
Cost of sales 117% 113% 100%
Gross profit 142% 110% 100%

These percentages were calculated by

dividing each item by the base year.
Vertical Analysis
 Vertical analysis is the procedure of preparing &
presenting common size statements.
 Common size statement is one that shows the items
appearing on it in percentage form as well as in dollar
form.
 Each item is stated as a percentage of some total of
which that item is a part.
 Key financial changes & trends can be highlighted
by the use of common size statements.
Vertical Analysis...

…compares each item in a financial statement to a base

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

2005 %
Revenues $38,303 100.0
Cost of sales 19,688 51.4
Gross profit $18,615 48.6
Total operating expenses 13,209 34.5
Operating income $ 5,406 14.1
Other income 2,187 5.7
Income before taxes $ 7,593 19.8
Income taxes 2,827 7.4
Net income $ 4,766 12.4
Vertical Analysis

Assets 2005 %
Current assets:
Cash $ 1,816 4.7
Receivables net 10,438 26.9
Inventories 6,151 15.9
Prepaid expenses 3,526 9.1
Total current assets $21,931 56.6
Plant and equipment, net 6,847 17.7
Other assets 9,997 25.7
Total assets $38,775 100.0
Common-size Statements

 On the income statement, each item is expressed as

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

Lucent Technologies
10.8%
MCI
12.4%
8.0%
7.4%
43.0%

51.4%

38.2%
28.8%

 Cost of goods sold  Operating expenses

 Income tax  Net income
2. Ratio Analysis
 The ratios analysis is the most powerful tool of financial
statement analysis.
 Ratios simply means one number expressed in terms of
another.
 A ratio is a statistical yardstick by means of which
relationship between two or various figures can be
compared or measured.
 Ratios can be found out by dividing one number by
another number.
 Ratios show how one number is related to another
 Ratio Classifications

1 Measuring ability to pay current liabilities (Liquidity

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

 Liquidity ratios measure the short term solvency of

financial position of a firm.
 These ratios are calculated to comment upon the
short term paying capacity of a concern or the firm's
ability to meet its current obligations.
 Following are the most important liquidity ratios:
 CurrentRatio
 Liquid/Acid Test/Quick Ratio
Stylistic Furniture Example
Net sales (Year 2005) $858,000
Cost of goods sold 513,000
Gross profit $345,000
Total operating expenses 244,000
Operating income $101,000
Interest revenue 4,000
Interest expense (24,000)
Income before taxes $ 81,000
Income taxes 33,000
Net income $ 48,000
Stylistic Furniture Example

Assets 2005 2004

Current assets:
Cash $ 29,000 $ 32,000
Receivables net 114,000 85,000
Inventories 113,000 111,000
Prepaid expenses 6,000 8,000
Total current assets $262,000 $236,000
Long-term investments 18,000 9,000
Plant and equipment, net 507,000 399,000
Total assets $787,000 $644,000
Stylistic Furniture Example

Liabilities 2005 2004

Current liabilities:
Notes payable $ 42,000 $ 27,000
Accounts payable 73,000 68,000
Accrued liabilities 27,000 31,000
Total current liabilities $142,000 $126,000
Long-term debt 289,000 198,000
Total liabilities $431,000 $324,000
Stylistic Furniture Example

Stockholders’ Equity 2005 2004

Common stock, no par $186,000 $186,000
Retained earnings 170,000 134,000
Total stockholders’ equity $356,000 $320,000
Total liabilities and
stockholders’ equity $787,000 $644,000
Measuring Ability to Pay Current Liabilities

1.The current ratio measures the company’s

ability to pay current liabilities with current
assets.

Current ratio =
Total current assets ÷ Total current liabilities
Measuring Ability to Pay Current
Liabilities
 Stylistic current ratio: CA/CL
 2004: $236,000 ÷ $126,000 = 1.87

 2005: $262,000 ÷ $142,000 = 1.85

 The industry average is 1.50.

 The current ratio decreased slightly during 2005.
Measuring Ability to
Pay Current Liabilities
2.The acid-test ratio shows the company’s
ability to pay all current liabilities
if they come due immediately.
•Quick Assets = Current Assets –
(Inventories & Prepaid Assets)

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

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

 Stylistic’ acid-test ratio: QA/CL

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

 Activity ratios are calculated to measure the efficiency

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

1.Inventory turnover ratio is a measure of the

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

Inventory turnover = CGS÷ Average inventory

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

 Stylistics' inventory turnover:

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

2.Accounts receivable turnover measures a

company’s ability to collect cash from credit
customers.

Accounts receivable turnover =

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

 Stylistics' A/R Turnover:

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

3.Days’ sales in receivable ratio measures how

many day’s sales remain in Accounts Receivable.

One day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =

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

1.The debt ratio indicates the proportion

of assets financed with debt.

Total liabilities ÷ Total assets

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

2.Interest Coverage Ratio(Times-Interest-Earned

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

Interest Coverage Ratio(Times-Interest-Earned)

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

 Stylistics’ Times-Interest-Earned Ratio:

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

 Profitability ratios measure the results of business

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

1.Rate of return on net sales shows the

percentage of each sales dollar earned as
net income.

Rate of return on net sales =Net income

÷ Net sales
Measuring Profitability

 Stylistics’ rate of return on sales:

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

2.Rate of return on total assets measures

how profitably a company uses its assets.

Rate of return on total assets =

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

Stylistics’ rate of return on total assets for 2005:

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

3.Rate of return on common stockholders’ equity

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

 Stylistics’ rate of return on common stockholders’

equity for 2005:
 ($48,000 – $0) ÷ $338,000 = 0.142

 The industry average is 0.121.

Q. Why is this ratio larger than the return on total assets

(.101)?
Measuring Profitability

4. Earnings per share of common stock

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

 Relate investors’ expectations about the company’s

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

Earning Per Share

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

 Price/earning ratio is the ratio of market price per

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

2.Dividend yield shows the percentage of a

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

Dividend per share of common

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

 Dividend yield on Stylistics’ common stock:

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

3. Book value per share of common stock

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

 Book value per share of Stylistics’ common stock:

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

 There are various advantages of financial statements

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

Illustration 18-12
Current Ratio

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

Illustration 18-12
 Accounts receivable turnover ratio

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

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

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

 Accounts Receivable Turnover

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

365 days / 10.2 times = every 35.78 days

Accounts receivable are collected on average every 36 days.

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

Illustration 18-12
Inventory Turnover

.
Inventory Turnover

$1,281,000
= 2.3 times
($500,000 + $620,000) / 2
A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

 Profitability Ratios

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

period of time.

 Income, or the lack of it, affects the company’s ability to obtain debt
and equity financing, liquidity position, and the ability to grow.

 Ratios include the profit margin, asset turnover, return on assets,

return on common stockholders’ equity, earnings per share,
price-earnings, and payout ratio.
 Profit Margin
 Measures the percentage of each dollar of
sales that results in net income.
 It is calculated by dividing net income by sales.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31
Profit Margin
 Asset Turnover
 Measures how efficiently a company uses its
assets to generate sales.
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

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

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

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

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

 Calculated market price of the share/earning per

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

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

Illustration 18-12
Payout Ratio
 Solvency Ratios

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

long period of time.

 Debt to Assets and

 Times Interest Earned

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

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

Illustration 18-12
Debt to Total Assets Ratio

Measures the percentage of the total assets that creditors provide.

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

Illustration 18-12
Times Interest Earned

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

they come due.
Summary of Ratios
Summary of Ratios
End of Chapter 4
 ADDIS ABABA UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
MBA PROGRAM
DISTANCE EDUCATION DIVISION
ASSIGNMENT FOR FINANCIAL AND MANAGERIAL ACCOUNTING

Instructions
1. Answer the questions as per the requirement of each question.
2. It needs to be handwritten
3. Date of submission is On next tutorial period.
E mail Address: Abebaw.kassie@aau.edu.et

Assignment 2-1
1. On March 1, 2002, Tahir Muktar, a famous businessman in Addis, opened a business named
“Universal Garage” which is organized as a sole proprietorship. The business is established
to render car repair, maintenance and related services for fees. Below are chart of accounts
for and selected transactions completed by Universal Garage in March 2002.
a) Chart of accounts
Universal Garage
Chart of Accounts
100 ASSETS 300 OWNER'S EQUITY
110 CURRENT ASSETS 301 Tahir, Capital
111 Cash 302 Tahir, Drawings
112 Accounts Receivable 303 Incomes Summary
114 Supplies
116 Prepaid Rent 400 REVENUES
117 Prepaid Insurance 401 Fees Earned
120 PLANT ASSETS 410 Other Income
121 Land
123 Machinery 500 EXPENSES
123.1 Accumulated Depreciation-Machinery 501 Salary Expenses
125 Office Equipment 502 Supplies Expenses
125.1 Accumulated Depreciation-Office Equipment 503 Rent Expenses
200 LIABILITIES 504 Insurance Expenses
210 CURRENT LIABILITIES 505 Depreciation Expenses
211 Account Payable 506 Interest Expenses
213 Salaries Payable 510 Miscellaneous Expenses
216 Interest Payable
220 NON-CURRENT LIABILITIES
221 Long-term Bank Loan

1
b) Transactions
Mar 1 Received the following assets from its owner, Tahir:
Cash....................................... Br, 8,300
Supplies ................................. 2,000
Office Equipment................... 10,000
2 Borrowed Br 5,000 from Dashen Bank
3 Paid Br 1,800 for rent on a building leased for business purposes
3 Purchased welding and other repair machinery for Br 3,600 cash
4 Paid Br 200 for a radio advertisement
8 Sold for Br 200 cash an old office equipment with a recorded cost of Br 200
13 Paid weekly salary Br 1,200
16 Received Br 4,400 from services rendered on cash
20 Paid weekly salary Br 1,200 include transactions for other income
20 Delivered service on credit, Br 6,000
21 Purchased additional repair machinery on account for Br 2,000 from Sámi-Engineers
23 Received Br 5,000 additional cash investment from its owner
24 Repaid Br 1,000 bank loan and paid Br 100 interest on bank loan
26 Purchased supplies for Br 800 cash
27 Paid Br 100 for customer entertainment and other items
27 Paid weekly salary Br 1,200
31 Paid Br 500 for electricity and other utilities consumed during the month
31 Received Br 4,200 cash from credit customers
31 Paid Tahir Br 1,800 for personal uses

Required:
a) Journalize the above transactions in a two-column journal
b) Post the journal entries to “T” accounts
c) Prepare and complete a worksheet based on the following additional information
i. Cost of supplies remained unconsumed on Mar 31 is Br 900
ii. The amount paid on Mar 3 is for a three-month rent
iii. The amounts of depreciation for machinery and office equipment are estimated to be Br 560 and Br
1,900 respectively
iv. Universal Garage usually pays Br 1,200 for employee's salary every saturday for a six-day work
week ended on that day
v. Interest on bank loan accrued but not paid on March 31 total Br 100
d) Prepare financial statements for the month
e) Journalize and post adjusting entries
f) Journalize and post closing entries
g) Prepare post-closing trial balance

2
 2. Consider the following details of the income statement of Samson Company for the year just
ended December 31, 20 x 3.
Sales (1,000,000 units) Br. 20,000,000
Manufacturing cost of goods sold 15,000,000
Gross margin Br. 5,000,000
Selling and administrative expenses 4,000,000
Operating income Br. 1,000,000

Samson’s fixed manufacturing costs were Br. 3 million and its fixed selling and administrative costs
were Br. 2.9 million.
Near the end of the year, Ethio Company offered Samson Br. 13 per unit for 100,000 unit special

order. The special order would not affect Samson’s regular business in any way. Furthermore, the

special sales order would not affect total fixed costs and would not require any additional variable

selling and administrative expenses.

Instruction: Should Samson accept or reject the special order? By what percentage the operating
income decreases or increases if the order had been accepted? Assume that the company would
utilize its idle manufacturing capacity to accept the special order.

3. Lucy Company has the capacity to produce 15,000 units per month. Current regular
production and sales are 10,000 units per month at a selling price of Br. 15 each. Based on
the current production level, the following costs are to be incurred per unit:
Direct materials Br. 5.00
Direct labor 3.00
Variable factory overhead (FOH) 0.75
Fixed FOH 1.50
Variable selling expense 0.25
Fixed administrative expense 1.00
Lucy Company has received special order from a customer that wants to purchase 4,000 units at Br.

10 each. There would be no selling expense in connection with this special order.

3
 Instructions:
a. Should Lucy Company accepts or rejects the special order? Why or Why not? Assume that the
special order should not disturb regular business.
b. Suppose that the special order was for 8,000 units instead of 4,000 units. Thus, regular business
would be reduced by 3,000 units to accept the special order because production capacity cannot
be expanded in the short run. What would be the overall profit of the firm if it accepts this
order?
c. Refer the data given in requirement (b) above. At what selling price per unit from the customer
would the Lucy Company be economically indifferent between accepting and rejecting the offer?
4. ABC Company makes and sells 10,000 units of a certain product. The total manufacturing
cost of goods made is Br400, 000. Suppose XYZ Company offered Br38 per unit for 1,000
units special order that:
 Would not affect the regular business in any way
 Would not affect fixed costs
 Would not require any additional variable selling and administrative expenses
 Would use some other wise idle manufacturing capacity
Required
Should ABC Company accept the special order?
The income statement of the company for the most recent period is given below:
Sales-------------------------------------------------------------500,000
Variable costs
Manufacturing----------------------------360,000
Selling and admin-------------------------30,000-----------390,000
Contribution margin-----------------------------------------110,000
Fixed costs
Manufacturing------------------------------40,000
Selling and admin--------------------------50,000-----------90,000
Operating income----------------------------------------------20,000

4
 5. Wajo Company has two products: a plain cellular phone and a fancier cellular phone with
many special features. Unit data follow:
Plain Phone Fancy Phone
Selling price Br.80 Br.120
Variable costs 64 84
Contribution margin Br.16 Br.36
Contribution margin ratio 20% 30%

Instructions:
a. Which product is more profitable? On which should the firm spend its resources? Assume
that sales are restricted by demand for only a limited number of phones.
b. Now suppose that annual demand for phones of both types is more than the company can
produce in the next year and the major constraint is the availability of time on a processing
machine. Plain Phone requires one hour of processing on the machine, Fancy Phone
requires three hours of processing. Which product is more profitable? Assume that only 10,
000 machine hours of capacity are available.

6. Great Company manufactures 60, 000 units of part XL-40 each year for use on its
production line. The following are the costs of making part XL-40:
Total Costs Cost per
60, 000 units unit
Direct material Br. 480, 000 Br.8
Direct labor 360, 000 6
Variable factory overhead (FOH) 180, 000 3
Fixed FOH 360, 000 6
Total manufacturing costs Br. 1, 380, 000 Br.23
Another manufacturer has offered to sell the same part to Great for Br.21 each. The fixed overhead
consists of depreciation, property taxes, insurance, and supervisory salaries. The entire fixed
overhead would continue if the Great Company bought the component except that the cost of Br.
120, 000 pertaining to some supervisory and custodial personnel could be avoided.

Instructions:
a) Should the parts be made or bought? Assume that the capacity now used to make parts
internally will become idle if the pats are purchased?
b) Assume that the capacity now used to make parts will be either (i) be rented to near by
manufacturer for Br. 60, 000 for the year or (ii) be used to make another product that will

5
 yield a profit contribution of Br. 250,000 per year. Should the company purchase them from
the outside supplier?
7. Assume that a division of Leranso Company makes an electric component for its speakers.
The management is trying to decide whether the division of the company should
manufacture this component part or purchase it from another manufacturer.
The following are production costs for 100,000 units of the component for the forth-coming year.
Direct material Br.500, 000
Direct labor 200,000
Factory overhead
Indirect labor Br. 32,000
Supplies 90,000
Allocated occupancy costs 50,000 172,000
Total cost Br.872, 000
A small local company has offered to supply the components at a price of Br.7.80 each. If the
division discontinued the production of its components it would save two thirds of the supplies cost
and Br.22, 000 of indirect labor cost. All other overhead costs would continue regardless of the
decision made.

Instruction: Should the parts be made or bought? Assume that the capacity now used to make the
parts will become idle if they are purchased from outside.

8. Assume that the following data relate to Muna Company to make 10,000 units of product-X.
Total cost Unit costs
Direct material---------------------------------------40,000 4
Direct labor-------------------------------------------160,000 16
FOH-Variable----------------------------------------80,000 8
FOH-Fixed ----------------------------------------160,000 16
Total----------------------------------------------------440,000 44
 An other manufacturer offers to sell Muna Company the same part for Br40 per unit..
 Note that Br40, 000 of the fixed cost will be eliminated if the parts are bought instead of
made and released facilities will be left idle.
Required: Should the company make or buy the part?
 Assume that the released facilities can be used for other purposes say:
 In some activity to generate a contribution to profit of Br110, 000
 Renting out for Br70,000
Required: Which alternative is the best alternative?