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Return on Assets | The return on assets indicates how profitably a company has used its assets. The calculation is the company’s net income for a year divided by the average amount of assets during the same year. If the corporation’s net income for the year was $100,000 and the average amount of assets was $1,000,000 the return on assets was 10%. Sometimes the return is after income tax expense and sometimes it is before income tax expense. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Return on Equity | Return on equity (with no preferred stock) is a corporation’s net income for a year divided by the average amount of stockholders’ equity during the year. If the corporation’s net income was $100,000 and its stockholders’ equity averaged $500,000 during the year, the return on equity was 20%. | This is a cheet sheet Question |
Asset Turnover Ratio | The calculation of the asset turnover ratio is: net sales for a year divided by the average amount of assets during the same year. If net sales were $800,000 and the average amount of assets was $1,000,000 the asset turnover ratio was 0.8:1 [$800,000/$1,000,000]. | This is a cheet sheet Question |
Evaluating Business Investments | When someone is deciding to invest in business assets that have a life of more than one year, it is important that the time value of money be considered. The time value of money means that the dollars (or other currency) invested or paid today are more valuable than the dollars that will be received in the future years. The process of evaluating and deciding which long-lived assets will be made is referred to as capital budgeting and the amounts actually invested are referred to as capital expenditures. We will discuss two models that consider the time value of money. They are: • Net present value • Internal rate of return Both of these models are also referred to as discounted cash flow (DCF) models. | This is a cheet sheet Question |
Discounting Future Cash Flows | To recognize the time value of money, the future cash flows are discounted to their “present value.” Discounting can be thought of as removing the interest or necessary earnings that is included in the future cash amounts. After the interest has been removed the resulting amount is the present value or the discounted cash amount. Depending on the purpose, the rate used for discounting the future cash amounts could be described as any of the following: • desired rate of return • target rate of return • time value of money • company’s cost of capital • incremental interest rate of the borrower • the inflation rate, etc. Example 1. If a company will be receiving a single amount of $1,000 at the end of 5 years, its present value is only $621 (if the $1,000 is discounted by a target rate of 10% per year for 5 years). If the $1,000 is discounted by 12%, the present value is $567. If the $1,000 is discounted by 8%, the present value is $681. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. Note that when the rate used for discounting increases, the present value of the future cash amounts will be smaller. In other words, if you need to earn a higher rate and the $1,000 is a fixed amount, you need to invest a smaller amount. | This is a cheet sheet Question |
Present Value Tables | In classrooms, textbooks, and in our explanation, the calculation of the present values will be done by using present value tables. If there is a stream of equal cash amounts occurring at equal time intervals, the present value of an annuity table can be used. When there is a single future amount, or when the future amounts are not uniform in amount or occur at various time intervals, the present value of 1 table is used. (However, using an online calculator or a financial calculator is more practical, precise and faster.) | This is a cheet sheet Question |
Net Present Value Model | Net present value (NPV) is one of the discounted cash flow models used to evaluate investments in long-lived assets. In the NPV model, the future cash flows are discounted to their present values and then all of the present values (including the investment outflow of cash) are summed into a single amount. That single amount is known as the net present value. Example 2. A company is deciding whether to pay out cash of $100,000 today in order to receive the following cash amounts at the end of each of the years 1 thru 5: $25,000 + $30,000 + $35,000 + $40,000 + $45,000. Since the $100,000 is occurring at the present time, its present value is $100,000. Next the 5 future amounts need to be discounted to their present value. The discounting of the future amounts by 10% per year is shown in the following table: When the present value of the $100,000 cash outflow is combined with the present value of the five cash inflows we arrive at the net present value of 29,055. This positive present value indicates that the investment is earning significantly more than the 10% rate to discount the cash flows. (A net present value of $0 would indicate that the corporation was earning exactly 10%.) | This is a cheet sheet Question |
Internal Rate of Return | The internal rate of return (IRR) is a discounted flow model that computes the exact rate of return earned on an investment. In other words, the internal rate of return tells you the rate that will discount all of the investment’s cash flows to a net present value of exactly $0. If a present value table is used, it requires a trial-and-error approach. If it is done online or with a financial calculator, the rate will appear with electronic speed. Example 3. To illustrate the internal rate of return, we will use the same cash flows that were used in Example 2. First, recall that the net present value showed a positive 29,055. This relatively large net present value indicates that the internal rate of return will be significantly greater than the 10% rate used to calculate the net present value. As a result, we decided to discount the cash flows by 20%. The present value factors of a single amount for 20% are used in the following table: For personal use by the original purchaser only. Copyright © AccountingCoach®.com. After discounting the cash flows by 20%, the net present value is (720). This relatively small amount indicates that the internal rate of return is very close to 20%. Since the amount is negative, the actual rate is less than 20% (as opposed to more than 20%). When an internal rate of return is calculated for each of the potential investments, the investments can be ranked from high to low. | This is a cheet sheet Question |
Recap of NPV and IRR | Both the net present value (NPV) and the internal rate of return (IRR) models are recommended because of the following: 1. Both use all of the cash flows that occur during the entire life of the investment 2. Both recognize the time value of money (future amounts are discounted) 3. Because the present value factors are very small in the future years, the estimated future amounts (which are difficult to predit) carry less weight than the more current amounts For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Payback Period | Another model that is often used when evaluating business investments is the payback period. The payback period simply indicates the number of years it takes for a company to recover its investment. The payback period is easy to understand, but it has two drawbacks: • The future cash amounts are not discounted to their present value. This means that the time value of money is ignored. • The payback calculation does not consider all of the cash inflows. It merely looks at the cash flows until the investment is recovered. Example 4. The following chart illustrates the payback period calculation. The amounts come from our earlier examples, except that the cash inflows are assumed to occur evenly throughout each of the five years. Cash In or (Cash Out) Cumulative Amount of Cash In Portion of the Year Cumulative Number of Years Day 1 of Year 1 ($100,000) Year 1 $25,000 $ 25,000 1.00 1.00 Year 2 $30,000 $ 55,000 1.00 2.00 Year 3 $35,000 $ 90,000 1.00 3.00 Year 4 $40,000 $ 100,000 0.25 3.25 Year 5 $45,000 As the chart indicates, the company will recover its $100,000 investment in 3.25 years. This is 3 full years plus $10,000 of the $40,000 in Year 4. Note that the payback period calculation ignored the following: • $30,000 of the $40,000 occurring in Year 4, and • $45,000 occurring in Year 5. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Financial Accounting | Financial accounting is a type or branch of accounting that begins with the recording, sorting and storing of a business’s transactions in accounts contained in its general ledger. After reviewing and adjusting the amounts to comply with generally accepted accounting principles, the amounts are summarized and presented in the form of financial statements. When the financial statements of a U.S. corporation are distributed to someone outside of the corporation, the financial statements should include the following: • Income statement • Statement of comprehensive income • Balance sheet • Cash flow statement • Statement of stockholders’ equity • Notes to the financial statements | This is a cheet sheet Question |
Double-Entry; Debit and Credit | It is the norm for a corporation to use the double-entry accounting system. Double-entry accounting means that every transaction will affect two or more accounts. It also uses the terms debit and credit, which had their origin five centuries ago. Today, you should associate debit with left side of an account, and associate the term credit with the right side of an account. As a result, every business transaction will have an amount recorded (as a debit) on the left side of an account and will have an amount recorded (as a credit) on the right side of an account. Example 1. If a corporation borrows $10,000 from its bank, the corporation will debit the account Cash and will credit the account Loans Payable. Example 2. When a corporation pays its June rent on June 1, the corporation will debit Rent Expense and will credit Cash. Today’s accounting software will assure that the double-entry system is adhered to. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Generally Accepted Accounting Principles (GAAP) | When a U.S. corporation’s financial statements are distributed to someone outside of the corporation, they must comply with generally accepted accounting principles (GAAP or US GAAP). GAAP includes underlying concepts such as the historical cost principle, matching principle, revenue recognition, full disclosure principle, plus many detailed rules or standards that are required by the Financial Accounting Standards Board (FASB). Some of the rules or standards include the accounting for hedging transactions, pensions, leases, foreign currency translation, and many more. | This is a cheet sheet Question |
Accrual Method of Accounting | US GAAP usually requires that a corporation’s financial statements be prepared using the accrual method (or basis) of accounting. (Individuals on the other hand are likely to use the cash method of accounting.) Under the accrual method, revenues are reported on the income statement and the related receivable will be reported on the balance sheet when the amount is earned (as opposed to when the cash is received). Similarly, expenses and losses are reported on the income statement and the related liability is reported on the balance sheet when they occur (as opposed to waiting until the amount is paid). | This is a cheet sheet Question |
Other Types or Branches of Accounting | As noted earlier financial accounting is just one type or branch of accounting. The others include cost accounting, management accounting, not-for-profit accounting, governmental accounting, income tax accounting, auditing, forensic accounting, accounting systems, auditing, and more. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Depreciation | In accounting, depreciation is the spreading (allocation) of an asset’s cost over the many accounting periods in which it is used. The assets that are depreciated include buildings, equipment, furnishings, vehicles, land improvements (but not the land), and similar long-term assets that are used in a business. The purpose of depreciation is to match the cost of the asset with the revenues that are earned from the use of the asset. Note that the purpose of depreciation is not to calculate the market value of an asset. Except for some manufacturing assets, the depreciation for the accounting period is recorded as a debit in the income statement account Depreciation Expense. The amount of depreciation is recorded as a credit in the balance sheet account Accumulated Depreciation, which is a contra-asset account. This is done instead of crediting an asset such as Equipment. The combination of the debit balance in the Equipment account and the credit balance in the account Accumulated Depreciation for Equipment is the book value (or the carrying value) of the equipment. Remember that this book value is not the fair market value of the equipment. It merely represents the cost which has not yet been depreciated. Example 1. A company purchases equipment at a cost of $100,000 and it is expected to be useful for 10 years. At the end of 10 years it will be scrapped for $0. A common depreciation method is to debit $10,000 per year to Depreciation Expense and to credit Accumulated Depreciation for $10,000. Depreciation on the Financial Statements Vs. | This is a cheet sheet Question |
Tax Return | The depreciation that we are discussing is the depreciation reported on the financial statements. This depreciation is almost always different from the depreciation reported on the corporation’s income tax returns. The reason is that the financial statement depreciation is based on the matching principle of accounting while the income tax depreciation is based on income tax regulations and tax strategies. However, the total amount of depreciation over the life of the asset will likely be the same: the asset’s cost. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Cost | An asset’s cost is the cash equivalent amount paid for the asset plus the necessary costs to get the asset in place and ready for use. The asset’s cost is the maximum total amount of depreciation expense over the years of the asset’s useful life. Once the asset’s cost is fully depreciated, the depreciation expense stops, even if the asset continues to be used in the business. | This is a cheet sheet Question |
Useful Life | An asset’s useful life is the estimated number of years (or units of output) that the asset will be economically useful. This estimate is made when the asset is placed into service. For example, if a company estimates that a machine with a cost of $100,000 will have a useful life of 10 years, its financial statements will report $10,000 per year. (The 10 years is used even if the income tax regulations specify a 7-year life or it allows the immediate expensing of the $100,000 in the year that it is placed into service.) Salvage Value (Scrap Value or Residual Value) An asset’s salvage value is an estimate of the amount that will be recovered at the end of an asset’s useful life. It is also known as the scrap value or residual value. This estimate is made at the time the asset is placed into service and the amount is subtracted from an asset’s cost in order to determine the total amount of depreciation over the life of the asset. Often the salvage value is estimated to be $0. | This is a cheet sheet Question |
Depreciable Cost | An asset’s depreciable cost is the asset’s cost minus the asset’s estimated salvage value at the end of its useful life. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Half-year Convention | The half-year convention assumes that a newly acquired asset was placed in service at the midpoint of a year. As a result, one-half of the annual depreciation is charged to depreciation expense in the first year (and in the final year) of the asset’s useful life. Example 2. If an asset has a cost of $100,000 and an estimated useful life of 10 years and an estimated salvage value of $0, the annual depreciation could be $10,000. Under the half-year convention, the company will report $5,000 of depreciation in the year the asset is placed into service, followed by 9 full years of $10,000 of depreciation, and then $5,000 in the 11th year…for a total of $100,000. | This is a cheet sheet Question |
Straight-Line Depreciation | Straight-line depreciation is the common method for computing the depreciation reported on the financial statements. Straight-line depreciation results in the same amount of annual depreciation in each year (except for partial years). The full-year, annual depreciation is computed by taking the asset’s depreciable cost and dividing it by the number of years of useful life. | This is a cheet sheet Question |
Accelerated Depreciation | Accelerated depreciation refers to the depreciation methods in which larger amounts of annual depreciation are taken in the early years of an asset’s life, and smaller amounts of annual depreciation are taken in the later years. (Over the entire useful life of the asset the total amount of depreciation is the same as the straight-line method.) Two of the accelerated depreciation methods are the double-declining-balance method, and the sum-of-the-years’-digits method. Double-Declining-Balance (DDB) Method Double-declining-balance (or DDB) method of depreciation is one of the accelerated methods of depreciation. “Double” means taking 200% of the straight-line depreciation rate. The “declining- balance” refers to the asset’s book value which is declining as the asset is depreciated. (Book value or carrying value is the asset’s cost minus its accumulated depreciation.) This means that an asset with a For personal use by the original purchaser only. Copyright © AccountingCoach®.com. useful life of 10 years will have a straight-line rate of 10% which will be doubled to 20%. This rate is multiplied times the asset’s book value as of the beginning of the year. Example 3. Assume that a corporation acquires an asset at the cost of $100,000. It estimates the asset will be useful for 10 years. This means the straight-line depreciation rate is 10%, which will become 20% for the double-declining-balance method. The asset’s book value at the beginning of the first year is $100,000 which is multiplied by 20% to arrive at $20,000 of depreciation in the first year of the asset’s life. For the second year of the asset’s life, the beginning book value will be $80,000 ($100,000 minus $20,000 of accumulated depreciation). That amount times 20% will mean $16,000 of depreciation during the second year of the asset’s life. The depreciation for the third year of the asset’s life will be $64,000 X 20% = $12,800. This continues until the asset’s book value is equal to the asset’s salvage value. (Over the life of the asset, the total amount of depreciation will be the same under any depreciation method. The differences involve the timing of the depreciation.) | This is a cheet sheet Question |
Sum-of-the-Years’-Digits (SYD) Method | Sum-of-the-years’-digits (SYD) method of depreciation is also an accelerated method of depreciation. Its name comes from summing all of the digits in the years of the asset’s useful life (see Example 4 below). This sum will become the denominator of the fraction that will be used. The numerator of the fraction is the years of depreciation remaining. Example 4. Assume that a corporation acquires a business asset and estimates its useful life is 10 years. The digits in the years of useful life are: 1+2+3+4+5+6+7+8+9+10 and the sum is 55. Since there are 10 years remaining in the first year of the asset’s life, the depreciation for the first year will be 10/55 of the depreciable cost. If the asset has a cost of $100,000 and the estimated salvage value is $0, the depreciation (rounded) for the first year of the asset’s life is $100,000 X 10/55 = $18,182. The depreciation for the second year of the asset’s life will be $100,000 X 9/55 = $16,364. In the final year of the asset’s life the depreciation will be $100,000 X 1/55 = $1,818. (Again, the total amount of depreciation expense during the years of useful life will be the same regardless of the method used.) For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Meaning of Debits and Credits | Debit and credit are related to the terms used in Italy 500 years ago to record business transactions using the double-entry system of accounting. Today, you should memorize the following meanings: • Debit means left or left side of an account • Credit means right or right side of an account An amount recorded on the left side of an account is said to have been debited to the account, or that the amount was a debit (or debit entry) in the account. An amount recorded on the right side of an account is said to be a credit entry, a credit, or that the account was credited. It is important that you do not think that a debit is “good” or “bad”. Similarly, you should not think of a credit as being “good” or “bad”. | This is a cheet sheet Question |
Account | An account is a record in which the amounts from a company’s transactions are posted (or recorded) in order to sort and store similar amounts. The following are common account titles: Cash, Accounts Receivable, Accounts Payable, Loans Payable, Sales, Advertising Expense, Rent Expense, Interest Expense, and perhaps hundreds more. When we use the term accounts, we are referring to the general ledger accounts. In the past, the general ledger was a ledger book with paper pages, but today it is likely to be a computer file or database. A simple listing of the general ledger account titles and account numbers that are available for use is the chart of accounts. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Double-Entry Accounting or Bookkeeping | The double-entry system requires that the amount(s) in a transaction must be entered in the general ledger accounts as a debit and as a credit in another account(s). In other words, every transaction will involve: • A minimum of two accounts • One or more of the accounts must have an amount entered as a debit, and • One or more of the accounts must have an amount entered as a credit • The total amount entered as a debit must be equal to the amount entered as a credit Example #1. When a company borrows $5,000 from its bank, the company will record a debit of $5,000 in the account entitled Cash and a credit of $5,000 in the account Loans Payable or Notes Payable. Example #2. When a company pays $1,000 for a loan payment consisting of $100 of interest and $900 of principal the company will record a debit of $100 in the account Interest Expense, a debit of $900 to Loans Payable, and a credit of $1,000 in the account Cash. It is common for inexpensive, yet sophisticated accounting software to use the double-entry system, however, it may prompt you for only one account name or number. For example, if the software prepares a check, it will automatically credit the account Cash when the check is written. Therefore, the software requires that you enter only the account or accounts to be debited. Accounting Equation May Help You | This is a cheet sheet Question |
Understand Debits and Credits | The accounting equation is: Assets = Liabilities + Stockholders’ (or Owner’s) Equity Asset accounts, which are on the left side of the equation, will usually have their balances on the left side of the general ledger account. Since debit means left side, an asset account will normally have a debit balance. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. Liability accounts, which appear on the right side of the accounting equation, will usually have their balances on the right side of the general ledger account. Since credit means right side, a liability account will normally have a credit balance. Stockholders’ equity accounts, which also appear on the right side of the accounting equation, will usually have their account balances on the right side. Asset Accounts Will Likely Have Debit | This is a cheet sheet Question |
Balances | Examples of asset accounts are: • Cash • Accounts Receivable • Inventory • Prepaid Expenses • Investments • Land • Buildings • Furniture and Fixtures • Vehicles, and more Generally, asset accounts will have debit balances and their account balances will be increased with a debit entry. Therefore, a credit entry will decrease the asset’s normal debit balance. There are a few asset accounts that are expected to have credit balances. These are known as contra-asset accounts. Two examples of contra-asset accounts include: • Allowance for Doubtful Accounts (which relates to the debit balance in Accounts Receivable) • Accumulated Depreciation (which relates to the debit balances in the accounts Buildings, Equipment, Vehicles, etc.) These contra-asset accounts will be credited instead of crediting the related asset accounts. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Liability Accounts Will Likely Have Credit Balances | Some examples of liability accounts include: • Accounts Payable • Loans Payable (or Notes Payable) • Interest Payable • Wages Payable • Income Taxes Payable • Accrued Expenses Payable (or Accrued Liabilities) • Deferred Revenues, and others Generally, liability accounts are expected to have credit balances and their account balances will be increased with a credit entry. To decrease a liability account’s balance a debit entry is needed. Stockholders’ (or Owner’s) Equity Accounts | This is a cheet sheet Question |
Will Have Credit Balances | Some examples of stockholders’ (or owner’s) equity accounts include: • Common Stock • Paid-in Capital in Excess of Par • Retained Earnings • Accumulated Other Comprehensive Income • Mary Smith, Capital Generally, these accounts are expected to have credit balances and their account balances will be increased with a credit entry. To decrease one of these accounts a debit entry is needed. Note: Treasury Stock and Mary Smith, Drawing are two contra-equity accounts that are expected to have debit balances. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. Revenue Accounts Will Have Credit Balances Examples of revenue accounts include: • Sales • Service Fees Earned • Fee Revenues • Interest Income Revenue accounts will have credit balances and their account balances will be increased with a credit entry. Revenue accounts have credit balances because revenues increase stockholders’ (or owner’s) equity. There are a few revenue accounts that will have debit balances. Two examples are: • Sales Discounts • Sales Returns and Allowances Revenue accounts that are expected to have debit balances are known as contra-revenue accounts. These accounts are debited because they cause a decrease in the expected credit balances of the stockholders’ (or owner’s) equity accounts. | This is a cheet sheet Question |
Expense Accounts Will Have Debit Balances | The following are just a few of the many general ledger accounts for expenses: • Salaries Expense • Rent Expense • Utilities Expense • Repairs and Maintenance Expense • Advertising Expense • Depreciation Expense • Interest Expense • Income Tax Expense For personal use by the original purchaser only. Copyright © AccountingCoach®.com. The accounts for expenses will have debit balances and will almost always be debited. Expenses have debit balances because they decrease the normal credit balances of stockholders’ (owner’s) equity. The Accounts for Revenues and Expenses are | This is a cheet sheet Question |
Temporary Accounts | At the end of each accounting year, the income statement accounts (revenues, expenses, gains, losses) are closed to a stockholders’ (owner’s) equity account. As a result, the income statement accounts will begin each accounting year with zero balances. This is the reason that the income statement accounts are known as temporary accounts. (The balance sheet accounts are known as permanent accounts, since their balances are not closed at the end of an accounting year. Instead, balances in the balance sheet accounts are carried forward to the next accounting year.) | This is a cheet sheet Question |
Learning Which Accounts to Debit and Credit | Since many business transactions involve cash, a good place to begin learning debits and credits is with the general ledger account Cash. Since Cash is an asset account: • Cash will be debited when cash is received. (Recall that a debit will increase an asset account’s balance.) • Cash will be credited when cash is paid out. (Recall that a credit will decrease an asset account’s balance.) In our earlier examples, a company borrowed money from its bank. The account Cash has to be debited because the company is receiving $5,000 of cash from its bank. Because of double-entry accounting, another account will be credited for $5,000. In this case, the company should credit Loans Payable or Notes Payable. This credit makes sense because the balance in a liability account needs to be increased. In our other example, when a company pays a bill, the asset account Cash needs to be credited for $1,000 in order to reduce this asset’s normal debit balance. Therefore, one or more accounts will need to be debited. Since $100 of the payment was for interest, the account Interest Expense will be debited. The $900 principal repayment will be debited to the liability account Loans Payable. (Recall that liability accounts are decreased with a debit entry.) For personal use by the original purchaser only. Copyright © AccountingCoach®.com. If a company makes a cash sale of $500, the company will debit Cash for $500 because the company is receiving cash and needs to increase the balance in the asset account Cash. The double-entry system requires that another account be credited. In this situation, the account to be credited is Sales. (Recall that revenue accounts are almost always credited. Also recall that revenue accounts are credited since they increase the normal credit balance in the equity accounts.) If a company buys a new machine at a cost of $20,000 by writing a check for $12,000 and promising to pay $8,000 in six months, the company will debit the asset Machinery for $20,000; credit Cash for $12,000; and credit Loans Payable or Notes Payable for $8,000. | This is a cheet sheet Question |
Additional Tips for Accounts to be Debited and Credited | You might think of the acronym DEAL when learning which accounts will be increased with a debit entry. Use the first letter from the following four types of accounts to spell D-E-A-L: Dividends Expenses Assets Losses You could think of the acronym GIRLS when learning which accounts will be increased with a credit entry. Use the first letter from the following five types of accounts to spell G-I-R-L-S: Gains Income Revenue Liabilities Stockholders’ (or owner’s Equity) | This is a cheet sheet Question |
Trial Balance | If each transaction is recorded with debits equal to credits, and there are no math errors in calculating the account balances, then the accounts will be in balance. A trial balance is an internal report that lists all of the account balances in the respective debit or credit column. The amounts in each column should sum to the same total. (Today’s popular accounting software is programmed For personal use by the original purchaser only. Copyright © AccountingCoach®.com. to require debits to be equal to credits and the account balances will be computed without error. Therefore, the trial balance should never indicate a difference.) However, a balanced trial balance does not guarantee that the records are free of errors. For example, an entry could be completely omitted or could be entered twice and the trial balance will be in balance. Also, the monthly rent payment could be coded incorrectly as a debit to an asset account instead of a debit to Rent Expense and the trial balance will be in balance. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Financial Ratios Including Limitations | Financial ratios are one component of financial analysis. Financial ratios are often calculated by using amounts from previously issued annual financial statements. In that case the resulting ratios are history and may not be indicative of the present and future situation. It is also wise to consider the financial ratios to be averages. For example, the sales are unlikely to have occured evenly throughout the year. Therefore, the resulting number of days’ sales in inventory may be 100, but it is an average of some months of 120 days and some months of 80 days. The turnover ratios and the “return on” ratios usually involve an annual income statement amount and a balance sheet amount. However, the balance sheet amount is valid only for the final moment of the accounting year and may not be indicative of the amounts within the accounting year. This is especially true when a corporation ends its accounting year at the low point of its business activity. To overcome this situation, it is best to use the average balance sheet amounts for the 12 months during the year. (Merely averaging the two lowest points of the year will not solve the problem.) It is also important to realize that companies within the same industry may apply accounting principles differently. Some companies may be conservative in their accounting, while another may be the complete opposite. For example, Company C values its inventory using LIFO and uses very short useful lives for depreciating its plant assets. Its competitor Company L values its inventory using FIFO and uses very long useful lives for depreciating its plant assets. In periods of inflation, the financial statements and financial ratios of these companies will have differences due to the way accounting principles are applied. Of course within a company where the accounting rules are consistantly applied, the current financial ratios can be compared with confidence to its financial ratios from the past and to those budgeted for the current year and future years. | This is a cheet sheet Question |
Working Capital | Working capital is actually an amount (rather than a ratio) which is an indicator of a company’s ability to meet its obligations. It is calculated as follows: current assets minus current liabilities. For example, if a business has $280,000 of current assets and $260,000 of current liabilities, its working capital is $20,000. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Current Ratio | The current ratio is also an indicator of a company’s ability to pay its current obligations. The calculation is: current assets divided by current liabilities. If a company has current assets of $300,000 and current liabilities of $150,000 the company’s current ratio is 2:1 [($300,000/$150,000):1]. | This is a cheet sheet Question |
Acid-Test Ratio or Quick Ratio | The acid-test ratio is also known as the quick ratio. It is a more conservative indicator of a company’s ability to pay its current obligations (than the current ratio) since inventory is excluded from the calculation. In other words, the calculation is: [cash + marketable securities + accounts receivable] divided by current liabilities. If a company had current assets of $300,000 (of which $180,000 was inventory) and current liabilities of $150,000, the acid-test ratio will be approximately 0.8:1 [$120,000/$150,000]. | This is a cheet sheet Question |
Receivables Turnover Ratio | The receivables turnover ratio is an indicator of how fast a company’s accounts receivable are (or were) collected. The calculation is: credit sales for a year divided by the average balance in accounts receivable during the same year. If credit sales for the year were $800,000 and the average amount of accounts receivable throughout the year was $100,000 the company’s receivables turnover ratio will be 8 times [$800,000/$100,000]. Of course, if only the two low end-of-the-year receivable amounts are averaged, the resulting ratio will be much different from the average based on the average throughout the year. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Average Collection Period or Days’ Sales in Receivables | The average collection period tells how many days (on average) it takes to collect a company’s accounts receivable. The calculation is: 360 or 365 days divided by the receivables turnover ratio. Using the information in our previous calculation, the receivables turnover ratio was 8. Therefore, the average collection period was 45 days [360 days/8]. A logical next step is to compare the average collection period to past ratios and also to the credit terms offered to customers. | This is a cheet sheet Question |
Inventory Turnover Ratio | The inventory turnover ratio indicates how many times a company’s inventory turns over in a year. The calculation is: cost of goods sold for a year divided by the average inventory during the same year. Since a company records inventory at cost, it is logical to use the cost of goods sold from the income statement. If the cost of goods sold for the year was $600,000 and the average cost of inventory during the year was $200,000 the company’s inventory turnover ratio is 3 times [$600,000/$200,000]. Again, if the average inventory is based on the two lowest points of the year, this turnover ratio will be greater than an average based on amounts throughout the year. | This is a cheet sheet Question |
Days’ Sales in Inventory or Days to Sell | The days’ sales in inventory indicates how many days of sales are in inventory. The calculation is: 360 or 365 days divided by the inventory turnover ratio. If the inventory turnover ratio is 3, the days’ sales in inventory will be 120 days [360 days/3]. | This is a cheet sheet Question |
Free Cash Flow | The calculation of free cash flow is: net cash flow from operating activities minus the necessary capital expenditures. (Sometimes a company’s dividend payments are deducted along with the capital expenditures.) If a corporation had cash from operating activities of $200,000 and necessary capital expenditures of $60,000 the amount of free cash flow was $140,000. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Times Interest Earned | Times interest earned indicates a company’s ability to pay the interest on its debt. The calculation is: income before interest expense and income tax expense divided by interest expense. If a company’s net income was $100,000 after interest expense of $40,000 and income tax expense of $20,000 the times interest earned is 4 times [$160,000/$40,000]. Gross Profit or Gross Margin (in dollars) Gross profit is the remainder of net sales minus cost of goods sold. Gross profit is the amount prior to deducting a company’s selling, general and administrative expenses and adding or subtracting the nonoperating items. If net sales (gross sales minus sales returns and allowances and sales discounts) were $800,000 and the cost of goods sold was $600,000 the gross profit was $200,000. Gross Profit Percentage or Gross Margin as a | This is a cheet sheet Question |
Percentage | The gross profit percentage is the dollars of gross profit divided by the dollars of net sales. If the gross profit was $200,000 and the net sales were $800,000 the gross profit percentage or gross margin was 25%. | This is a cheet sheet Question |
Return on Assets | The return on assets indicates how profitably a company has used its assets. The calculation is the company’s net income for a year divided by the average amount of assets during the same year. If the corporation’s net income for the year was $100,000 and the average amount of assets was $1,000,000 the return on assets was 10%. Sometimes the return is after income tax expense and sometimes it is before income tax expense. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Return on Equity | Return on equity (with no preferred stock) is a corporation’s net income for a year divided by the average amount of stockholders’ equity during the year. If the corporation’s net income was $100,000 and its stockholders’ equity averaged $500,000 during the year, the return on equity was 20%. | This is a cheet sheet Question |
Asset Turnover Ratio | The calculation of the asset turnover ratio is: net sales for a year divided by the average amount of assets during the same year. If net sales were $800,000 and the average amount of assets was $1,000,000 the asset turnover ratio was 0.8:1 [$800,000/$1,000,000]. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Financial Accounting | Financial accounting is a type or branch of accounting that begins with the recording, sorting and storing of a business’s transactions in accounts contained in its general ledger. After reviewing and adjusting the amounts to comply with generally accepted accounting principles, the amounts are summarized and presented in the form of financial statements. When the financial statements of a U.S. corporation are distributed to someone outside of the corporation, the financial statements should include the following: • Income statement • Statement of comprehensive income • Balance sheet • Cash flow statement • Statement of stockholders’ equity • Notes to the financial statements | This is a cheet sheet Question |
Double-Entry; Debit and Credit | It is the norm for a corporation to use the double-entry accounting system. Double-entry accounting means that every transaction will affect two or more accounts. It also uses the terms debit and credit, which had their origin five centuries ago. Today, you should associate debit with left side of an account, and associate the term credit with the right side of an account. As a result, every business transaction will have an amount recorded (as a debit) on the left side of an account and will have an amount recorded (as a credit) on the right side of an account. Example 1. If a corporation borrows $10,000 from its bank, the corporation will debit the account Cash and will credit the account Loans Payable. Example 2. When a corporation pays its June rent on June 1, the corporation will debit Rent Expense and will credit Cash. Today’s accounting software will assure that the double-entry system is adhered to. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Generally Accepted Accounting Principles (GAAP) | When a U.S. corporation’s financial statements are distributed to someone outside of the corporation, they must comply with generally accepted accounting principles (GAAP or US GAAP). GAAP includes underlying concepts such as the historical cost principle, matching principle, revenue recognition, full disclosure principle, plus many detailed rules or standards that are required by the Financial Accounting Standards Board (FASB). Some of the rules or standards include the accounting for hedging transactions, pensions, leases, foreign currency translation, and many more. | This is a cheet sheet Question |
Accrual Method of Accounting | US GAAP usually requires that a corporation’s financial statements be prepared using the accrual method (or basis) of accounting. (Individuals on the other hand are likely to use the cash method of accounting.) Under the accrual method, revenues are reported on the income statement and the related receivable will be reported on the balance sheet when the amount is earned (as opposed to when the cash is received). Similarly, expenses and losses are reported on the income statement and the related liability is reported on the balance sheet when they occur (as opposed to waiting until the amount is paid). | This is a cheet sheet Question |
Other Types or Branches of Accounting | As noted earlier financial accounting is just one type or branch of accounting. The others include cost accounting, management accounting, not-for-profit accounting, governmental accounting, income tax accounting, auditing, forensic accounting, accounting systems, auditing, and more. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Evaluating Business Investments | When someone is deciding to invest in business assets that have a life of more than one year, it is important that the time value of money be considered. The time value of money means that the dollars (or other currency) invested or paid today are more valuable than the dollars that will be received in the future years. The process of evaluating and deciding which long-lived assets will be made is referred to as capital budgeting and the amounts actually invested are referred to as capital expenditures. We will discuss two models that consider the time value of money. They are: • Net present value • Internal rate of return Both of these models are also referred to as discounted cash flow (DCF) models. | This is a cheet sheet Question |
Discounting Future Cash Flows | To recognize the time value of money, the future cash flows are discounted to their “present value.” Discounting can be thought of as removing the interest or necessary earnings that is included in the future cash amounts. After the interest has been removed the resulting amount is the present value or the discounted cash amount. Depending on the purpose, the rate used for discounting the future cash amounts could be described as any of the following: • desired rate of return • target rate of return • time value of money • company’s cost of capital • incremental interest rate of the borrower • the inflation rate, etc. Example 1. If a company will be receiving a single amount of $1,000 at the end of 5 years, its present value is only $621 (if the $1,000 is discounted by a target rate of 10% per year for 5 years). If the $1,000 is discounted by 12%, the present value is $567. If the $1,000 is discounted by 8%, the present value is $681. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. Note that when the rate used for discounting increases, the present value of the future cash amounts will be smaller. In other words, if you need to earn a higher rate and the $1,000 is a fixed amount, you need to invest a smaller amount. | This is a cheet sheet Question |
Present Value Tables | In classrooms, textbooks, and in our explanation, the calculation of the present values will be done by using present value tables. If there is a stream of equal cash amounts occurring at equal time intervals, the present value of an annuity table can be used. When there is a single future amount, or when the future amounts are not uniform in amount or occur at various time intervals, the present value of 1 table is used. (However, using an online calculator or a financial calculator is more practical, precise and faster.) | This is a cheet sheet Question |
Net Present Value Model | Net present value (NPV) is one of the discounted cash flow models used to evaluate investments in long-lived assets. In the NPV model, the future cash flows are discounted to their present values and then all of the present values (including the investment outflow of cash) are summed into a single amount. That single amount is known as the net present value. Example 2. A company is deciding whether to pay out cash of $100,000 today in order to receive the following cash amounts at the end of each of the years 1 thru 5: $25,000 + $30,000 + $35,000 + $40,000 + $45,000. Since the $100,000 is occurring at the present time, its present value is $100,000. Next the 5 future amounts need to be discounted to their present value. The discounting of the future amounts by 10% per year is shown in the following table: For personal use by the original purchaser only. Copyright © AccountingCoach®.com. Cash In or (Cash Out) Present Value of 1 Factors for 10% Present Value Amounts Day 1 of Year 1 ($100,000) 1.000 (100,000) Final Day of Year 1 $25,000 0.909 22,725 Final Day of Year 2 $30,000 0.826 24,780 Final Day of Year 3 $35,000 0.751 26,285 Final Day of Year 4 $40,000 0.683 27,320 Final Day of Year 5 $45,000 0.621 27,945 Net Present Value 29,055 When the present value of the $100,000 cash outflow is combined with the present value of the five cash inflows we arrive at the net present value of 29,055. This positive present value indicates that the investment is earning significantly more than the 10% rate to discount the cash flows. (A net present value of $0 would indicate that the corporation was earning exactly 10%.) | This is a cheet sheet Question |
Internal Rate of Return | The internal rate of return (IRR) is a discounted flow model that computes the exact rate of return earned on an investment. In other words, the internal rate of return tells you the rate that will discount all of the investment’s cash flows to a net present value of exactly $0. If a present value table is used, it requires a trial-and-error approach. If it is done online or with a financial calculator, the rate will appear with electronic speed. Example 3. To illustrate the internal rate of return, we will use the same cash flows that were used in Example 2. First, recall that the net present value showed a positive 29,055. This relatively large net present value indicates that the internal rate of return will be significantly greater than the 10% rate used to calculate the net present value. As a result, we decided to discount the cash flows by 20%. The present value factors of a single amount for 20% are used in the following table: For personal use by the original purchaser only. Copyright © AccountingCoach®.com. Cash In or (Cash Out) Present Value of 1 Factors for 20% Present Value Amounts Day 1 of Year 1 ($100,000) 1.000 (100,000) Final Day of Year 1 $25,000 0.833 20,825 Final Day of Year 2 $30,000 0.694 20,820 Final Day of Year 3 $35,000 0.579 20,265 Final Day of Year 4 $40,000 0.482 19,280 Final Day of Year 5 $45,000 0.402 18,090 Net Present Value ( 720) After discounting the cash flows by 20%, the net present value is (720). This relatively small amount indicates that the internal rate of return is very close to 20%. Since the amount is negative, the actual rate is less than 20% (as opposed to more than 20%). When an internal rate of return is calculated for each of the potential investments, the investments can be ranked from high to low. | This is a cheet sheet Question |
Recap of NPV and IRR | Both the net present value (NPV) and the internal rate of return (IRR) models are recommended because of the following: 1. Both use all of the cash flows that occur during the entire life of the investment 2. Both recognize the time value of money (future amounts are discounted) 3. Because the present value factors are very small in the future years, the estimated future amounts (which are difficult to predit) carry less weight than the more current amounts For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Payback Period | Another model that is often used when evaluating business investments is the payback period. The payback period simply indicates the number of years it takes for a company to recover its investment. The payback period is easy to understand, but it has two drawbacks: • The future cash amounts are not discounted to their present value. This means that the time value of money is ignored. • The payback calculation does not consider all of the cash inflows. It merely looks at the cash flows until the investment is recovered. Example 4. The following chart illustrates the payback period calculation. The amounts come from our earlier examples, except that the cash inflows are assumed to occur evenly throughout each of the five years. Cash In or (Cash Out) Cumulative Amount of Cash In Portion of the Year Cumulative Number of Years Day 1 of Year 1 ($100,000) Year 1 $25,000 $ 25,000 1.00 1.00 Year 2 $30,000 $ 55,000 1.00 2.00 Year 3 $35,000 $ 90,000 1.00 3.00 Year 4 $40,000 $ 100,000 0.25 3.25 Year 5 $45,000 As the chart indicates, the company will recover its $100,000 investment in 3.25 years. This is 3 full years plus $10,000 of the $40,000 in Year 4. Note that the payback period calculation ignored the following: • $30,000 of the $40,000 occurring in Year 4, and • $45,000 occurring in Year 5. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Depreciation | In accounting, depreciation is the spreading (allocation) of an asset’s cost over the many accounting periods in which it is used. The assets that are depreciated include buildings, equipment, furnishings, vehicles, land improvements (but not the land), and similar long-term assets that are used in a business. The purpose of depreciation is to match the cost of the asset with the revenues that are earned from the use of the asset. Note that the purpose of depreciation is not to calculate the market value of an asset. Except for some manufacturing assets, the depreciation for the accounting period is recorded as a debit in the income statement account Depreciation Expense. The amount of depreciation is recorded as a credit in the balance sheet account Accumulated Depreciation, which is a contra-asset account. This is done instead of crediting an asset such as Equipment. The combination of the debit balance in the Equipment account and the credit balance in the account Accumulated Depreciation for Equipment is the book value (or the carrying value) of the equipment. Remember that this book value is not the fair market value of the equipment. It merely represents the cost which has not yet been depreciated. Example 1. A company purchases equipment at a cost of $100,000 and it is expected to be useful for 10 years. At the end of 10 years it will be scrapped for $0. A common depreciation method is to debit $10,000 per year to Depreciation Expense and to credit Accumulated Depreciation for $10,000. Depreciation on the Financial Statements Vs. | This is a cheet sheet Question |
Tax Return | The depreciation that we are discussing is the depreciation reported on the financial statements. This depreciation is almost always different from the depreciation reported on the corporation’s income tax returns. The reason is that the financial statement depreciation is based on the matching principle of accounting while the income tax depreciation is based on income tax regulations and tax strategies. However, the total amount of depreciation over the life of the asset will likely be the same: the asset’s cost. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Cost | An asset’s cost is the cash equivalent amount paid for the asset plus the necessary costs to get the asset in place and ready for use. The asset’s cost is the maximum total amount of depreciation expense over the years of the asset’s useful life. Once the asset’s cost is fully depreciated, the depreciation expense stops, even if the asset continues to be used in the business. | This is a cheet sheet Question |
Useful Life | An asset’s useful life is the estimated number of years (or units of output) that the asset will be economically useful. This estimate is made when the asset is placed into service. For example, if a company estimates that a machine with a cost of $100,000 will have a useful life of 10 years, its financial statements will report $10,000 per year. (The 10 years is used even if the income tax regulations specify a 7-year life or it allows the immediate expensing of the $100,000 in the year that it is placed into service.) Salvage Value (Scrap Value or Residual Value) An asset’s salvage value is an estimate of the amount that will be recovered at the end of an asset’s useful life. It is also known as the scrap value or residual value. This estimate is made at the time the asset is placed into service and the amount is subtracted from an asset’s cost in order to determine the total amount of depreciation over the life of the asset. Often the salvage value is estimated to be $0. | This is a cheet sheet Question |
Depreciable Cost | An asset’s depreciable cost is the asset’s cost minus the asset’s estimated salvage value at the end of its useful life. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Half-year Convention | The half-year convention assumes that a newly acquired asset was placed in service at the midpoint of a year. As a result, one-half of the annual depreciation is charged to depreciation expense in the first year (and in the final year) of the asset’s useful life. Example 2. If an asset has a cost of $100,000 and an estimated useful life of 10 years and an estimated salvage value of $0, the annual depreciation could be $10,000. Under the half-year convention, the company will report $5,000 of depreciation in the year the asset is placed into service, followed by 9 full years of $10,000 of depreciation, and then $5,000 in the 11th year…for a total of $100,000. | This is a cheet sheet Question |
Straight-Line Depreciation | Straight-line depreciation is the common method for computing the depreciation reported on the financial statements. Straight-line depreciation results in the same amount of annual depreciation in each year (except for partial years). The full-year, annual depreciation is computed by taking the asset’s depreciable cost and dividing it by the number of years of useful life. | This is a cheet sheet Question |
Accelerated Depreciation | Accelerated depreciation refers to the depreciation methods in which larger amounts of annual depreciation are taken in the early years of an asset’s life, and smaller amounts of annual depreciation are taken in the later years. (Over the entire useful life of the asset the total amount of depreciation is the same as the straight-line method.) Two of the accelerated depreciation methods are the double-declining-balance method, and the sum-of-the-years’-digits method. Double-Declining-Balance (DDB) Method Double-declining-balance (or DDB) method of depreciation is one of the accelerated methods of depreciation. “Double” means taking 200% of the straight-line depreciation rate. The “declining- balance” refers to the asset’s book value which is declining as the asset is depreciated. (Book value or carrying value is the asset’s cost minus its accumulated depreciation.) This means that an asset with a For personal use by the original purchaser only. Copyright © AccountingCoach®.com. useful life of 10 years will have a straight-line rate of 10% which will be doubled to 20%. This rate is multiplied times the asset’s book value as of the beginning of the year. Example 3. Assume that a corporation acquires an asset at the cost of $100,000. It estimates the asset will be useful for 10 years. This means the straight-line depreciation rate is 10%, which will become 20% for the double-declining-balance method. The asset’s book value at the beginning of the first year is $100,000 which is multiplied by 20% to arrive at $20,000 of depreciation in the first year of the asset’s life. For the second year of the asset’s life, the beginning book value will be $80,000 ($100,000 minus $20,000 of accumulated depreciation). That amount times 20% will mean $16,000 of depreciation during the second year of the asset’s life. The depreciation for the third year of the asset’s life will be $64,000 X 20% = $12,800. This continues until the asset’s book value is equal to the asset’s salvage value. (Over the life of the asset, the total amount of depreciation will be the same under any depreciation method. The differences involve the timing of the depreciation.) | This is a cheet sheet Question |
Sum-of-the-Years’-Digits (SYD) Method | Sum-of-the-years’-digits (SYD) method of depreciation is also an accelerated method of depreciation. Its name comes from summing all of the digits in the years of the asset’s useful life (see Example 4 below). This sum will become the denominator of the fraction that will be used. The numerator of the fraction is the years of depreciation remaining. Example 4. Assume that a corporation acquires a business asset and estimates its useful life is 10 years. The digits in the years of useful life are: 1+2+3+4+5+6+7+8+9+10 and the sum is 55. Since there are 10 years remaining in the first year of the asset’s life, the depreciation for the first year will be 10/55 of the depreciable cost. If the asset has a cost of $100,000 and the estimated salvage value is $0, the depreciation (rounded) for the first year of the asset’s life is $100,000 X 10/55 = $18,182. The depreciation for the second year of the asset’s life will be $100,000 X 9/55 = $16,364. In the final year of the asset’s life the depreciation will be $100,000 X 1/55 = $1,818. (Again, the total amount of depreciation expense during the years of useful life will be the same regardless of the method used.) For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Chart of Accounts | A chart of accounts is a list of the general ledger accounts (and subaccounts) available for recording an organization’s transactions. The chart of accounts will likely include an account number and account title. However, there could also be a brief description of the transactions that should be recorded in each of the accounts. The chart of accounts can be expanded to accommodate new types of business transactions. The chart of accounts will not include the account balances or other amounts. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
How the Chart of Accounts Is Organized | The chart of accounts will have the accounts arranged in the same order as the general ledger. A common order for a business corporation is: Asset accounts Current assets Noncurrent assets Liability accounts Current liabilities Noncurrent liabilities Stockholders’ equity accounts Paid-in capital Retained earnings Accum other comprehensive income Treasury stock Common Stock, Paid-in Capital in Excess of Par Retained Earnings Accumulated Other Comprehensive Income Treasury Stock Cash, Accounts Receivable, Allowance for Doubtful Accounts, Inventory, Prepaid Expenses Investments, Land, Buildings, Equipment, Vehicles, Furnishings, Accumulated Depreciation Sales, Service Revenues, Fees Earned Salaries & Wages Expense, Rent Expense, Utilities Expense, Advertising Expense, Delivery Expense Interest Income, Gain on Sale of Delivery Truck Interest Expense, Loss from Lawsuit, Loss on Sale of Equipment Notes Payable, Accounts Payable, Accrued Expenses Payable Mortgage Loan Payable, Bonds Payable, Deferred Income Taxes Operating revenues Operating expenses Non-operating revenues & gains Non-operating expenses & losses Balance Sheet Accounts Income Statement Accounts Examples/Common Account Titles Examples/Common Account Titles For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Account Numbers | It is common for the first digit of each account number to indicate the type of account. For example, the first digit of an asset account number will usually begin with a “1”. The first digit of the liability accounts will begin with the digit “2”. Perhaps marketing expenses will begin with the digit “5” and administrative expenses will begin with the digit “6”. Non-operating or other income items may begin with the digit “9”. Very small companies might use 4-digit account numbers, while large companies may use 6 or more digits in their account numbers. | This is a cheet sheet Question |
Other Comments | The chart of accounts often reflects a company’s organization chart. With that arrangement, the internal financial statements can be prepared for each division, department, cost center, etc. This allows a company to give the person who is responsible for a specific department only the financial information for which they are responsible. Today’s accounting software may provide sample charts of accounts for a variety of businesses. However, you should plan on having to modify and expand the chart of accounts in order to accommodate your particular organization. In the accounting software that I had used many years ago, the chart of accounts included a field for coding the layout of the financial statements. For example, part of the code would cause the balances in several accounts to be “condensed” into a single amount. The financial statement would then display only the condensed total amount. It also prepared a separate page or schedule to show the detailed amounts. | This is a cheet sheet Question |
Cash Flow Statement | The cash flow statement is officially known as the statement of cash flows (SCF). It reports the major cash inflows and outflows that have occurred during the accounting period specified in its heading. Expressed another way, the SCF for the calendar year 2023 will list the major cash flows that caused the change in a corporation’s cash and cash equivalents from December 31, 2022 to December 31, 2023. The cash flow statement is especially useful because a corporation’s income statement is prepared under the accrual method of accounting. This means the income statement reports revenues earned (not cash receipts) and expenses incurred (not cash payments). Since many investors and financial analysts believe that “cash is king” the annual cash flow statement is one of the five required annual financial statements whenever financial statements are distributed to people outside of the corporation. (The other four required financial statements are: income statement, statement of comprehensive income, balance sheet, and statement of stockholders’ equity.) | This is a cheet sheet Question |
Format of SCF | The statement of cash flows has three major sections: • Cash flows from operating activities • Cash flows from investing activities • Cash flows from financing activities In addition, the SCF must disclose some supplemental or supplementary information, including significant noncash transactions (such as an exchange of shares of stock for land), income taxes paid, and interest paid. How Amounts Are Presented Each significant cash inflow and each significant cash outflow will be reported in one of the three sections noted above (operating, investing, financing). For personal use by the original purchaser only. Copyright © AccountingCoach®.com. A positive amount on the SCF means: • a cash inflow • cash was provided • it was good for the corporation’s cash • it had a positive or favorable effect on the corporation’s cash balance A negative amount on the SCF means: • a cash outflow • cash was used • it was not good for the corporation’s cash • it had a negative or unfavorable effect on the corporation’s cash balance | This is a cheet sheet Question |
How a Positive Amount is Determined | If a balance sheet asset (other than cash) has decreased it usually means that cash was provided. Therefore, the SCF will report the amount of the asset’s decrease as a positive amount. For instance, if the asset Accounts Receivable has decreased by $2,000, the SCF will report this as a positive $2,000 since decreasing Accounts Receivable is good for the corporation’s cash, there was a cash inflow, and it had a positive or favorable effect on the corporation’s cash balance. When a balance sheet liability has increased, it will mean that cash was provided. This means the amount of the increase will be shown on the SCF as a positive amount. For example, if Notes Payable has increased by $10,000 it will be reported on the SCF as a positive $10,000 since the increase in Notes Payable means there was a cash inflow, cash was provided, and this had a positive or favorable effect on the cash balance. When a stockholders’ equity account has increased, it will mean that cash was provided. Thus, the amount of the increase in stockholders’ equity will be reported on the SCF as a positive amount. For instance, if Common Stock has increased by $40,000, it will be reported on the SCF as a positive $40,000. It is positive since the increase in Common Stock means there was a cash inflow, cash was provided, and this had a positive or favorable effect on the cash balance. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
How a Negative Amount is Determined | If the asset Inventory has increased, the SCF will report this as a negative amount. The reasoning is that increasing Inventory likely meant a cash outflow, cash was used, and/or it was not good for the corporation’s cash balance. When a liability has decreased, it is also assumed that cash was used and it is presented on the SCF as a negative amount. For example, if Accounts Payable has decreased by $3,000, the amount will be reported on the SCF as (3,000). It is reported as a negative amount since reducing Accounts Payable meant there was a cash outflow, cash was used, and this had a negative or unfavorable effect on the corporation’s cash balance. When a stockholders’ equity account is decreased, it is assumed that cash was used. As a result, the amount of the decrease will appear on the SCF as a negative amount. For example, if Retained Earnings is decreased, it could be the result of declaring and paying a cash dividend. The payment of a cash dividend is reported on the SCF as a negative amount since the decrease in Retained Earnings means there was a cash outflow, cash was used, and it had a negative or unfavorable effect on the corporation’s cash balance. | This is a cheet sheet Question |
Indirect Method of Preparing SCF | The indirect method of preparing the statement of cash flows is used by nearly all large corporations. (The alternative is the direct method, which is actually preferred by the Financial Accounting Standards Board or FASB.) Under the indirect method the first section of the SCF (which is the cash flows from operating activities) begins with the corporation’s net income. Since the income statement reports revenues and expenses using the accrual method of accounting, the net income will have to be adjusted to cash amounts. A common adjustment involves depreciation expense. The reason is the depreciation expense had reduced the amount of net income, but depreciation did not require the use of cash. There will be additional adjustments to net income reporting in the operating activities section for the changes in the current assets and current liabilities. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Cash Flows from Operating Activities | The cash flows from operating activities is the heading of the first section of the cash flow statement. Under the indirect method, this section begins with a corporation’s net income and is then adjusted from the accrual accounting amounts to the cash amounts. For example, there will be a positive adjustment to net income for the depreciation expense taken on the income statement since it did not use cash. If Accounts Receivable increased, it indicates that the corporation did not collect cash for all of the Sales reported on the income statement. As a result, there will be a subtraction or negative adjustment to the net income for the amount of the increase in Accounts Receivable. There will be adjustments for most of the changes in current asset and current liability accounts, including inventory, prepaid expenses, accounts payable, deferred revenues, etc. (However, the change in a company’s short-term borrowings is reported under cash flows from financing activities.) Ideally, the net amount of cash flows from operating activities will be greater than the net income. If this is not the case, I suggest a close review of the negative adjustments within this section of the SCF. For instance, an increase in Accounts Receivable may indicate that customers are unable to pay the amounts they owe. An increase in Inventory may indicate sales have slowed unexpectedly. | This is a cheet sheet Question |
Cash Flows from Investing Activities | The cash flows from investing activities is the second section of the SCF. This section reports the amounts pertaining to the purchase and sale of a corporation’s noncurrent (or long-term) assets. For example, capital expenditures (amounts spent for property, plant and equipment used in the business) and the purchase of long-term investments are uses of cash and therefore will be reported as negative amounts. The proceeds from the sale of property, plant and equipment and the sale of a long-term investment will provide cash and are therefore reported as positive amounts. | This is a cheet sheet Question |
Cash Flows from Financing Activities | The third section of SCF is the cash flows from financing activities. The amounts reported in this section involve the increases and decreases in noncurrent liabilities, stockholders’ equity, and short- term loans. For example, if the corporation issues common stock or bonds, the amount received will be reported as a positive amount since this provides cash, which is positive for the corporation’s cash balance. If the corporation pays off some of its debt or pays a cash dividend to stockholders, those amounts will be listed as negative amounts, since cash was used and that has a negative effect on the corporation’s cash balance. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Total of Three Sections = Change in Cash and Cash Equivalents | After the three sections, the SCF will show the grand total of the three sections. The grand total is followed by a reconciliation with the change in the corporation’s cash and cash equivalents. | This is a cheet sheet Question |
Supplemental Information | In addition to the amounts reported in the three sections of the face of the cash flow statement, the statement must also disclose supplemental or supplementary information. One example is the acquisition of an asset in exchange for shares of stock. In this example, no cash was involved, but the transaction did involve a significant investing activity and a significant financing activity. Two other required disclosures are the amount of interest paid and the amount of income taxes paid. For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Break-even Point | The break-even point is the level of sales that result in a business having a net income of zero. In other words, its revenues will be exactly equal to its expenses. The break-even point calculation that is found in managerial accounting textbooks is based on knowing how a company’s costs or expenses will change as the volume of sales change. The break- even point calculation is based on the following amounts: • Total amount of fixed expenses • Variable expenses per unit or as a percentage of sales • Selling price or sales dollars • Contribution margin (which can be determined from the sales and variable expenses) | This is a cheet sheet Question |
Fixed Expenses | Fixed expenses are the expenses that will not change in total as the sales volume changes. For example, if a retail store’s rent is $30,000 per year and will not change within a reasonable range of sales, the rent is a fixed expense. Other examples are managers’ salaries, property insurance, property tax, etc. | This is a cheet sheet Question |
Variable Expenses | Variable expenses are the expenses that change in total as volume changes. For example, if a retailer purchases a product at a cost of $11 and sells it for $20, the $11 per unit is a variable expense. Another variable expense would be a sales commission of 5% that is given on every sale. In this example, the variable expenses would be $12 per unit ($11 + $1). The $12 of variable expenses can also be expressed as a percentage of selling price, such as 60% ($12 divided by $20). For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Selling Price | In the calculation of the break-even point, the selling price of a product is assumed to be a constant amount per unit. If the selling price is $20 per unit, the break-even calculation assumes that the selling price will remain $20 whether 50 units are sold or 50,000 are sold. | This is a cheet sheet Question |
Contribution Margin per Unit | Contribution margin per unit = selling price per unit minus the variable expenses per unit. If the selling price per unit is $20 and the variable expenses are $12, the resulting contribution margin per unit is $8. Contribution Margin Ratio (using the per unit amounts) Contribution margin ratio (using the per unit amounts) = contribution margin per unit divided by selling price per unit. If the selling price per unit is $20 and the variable expenses per unit are $12, the resulting contribution margin per unit is $8. This means that the contribution margin ratio is 40% ($8 contribution margin/$20 selling price). | This is a cheet sheet Question |
Total Contribution Margin | If a company has total sales of $200,000 and total variable expenses of $120,000 its total contribution margin is $80,000. Contribution Margin Ratio (using totals) The contribution margin ratio using totals = total contribution margin divided by total sales. If a company has a total contribution margin of $80,000 and its total sales were $200,000, the company’s contribution margin ratio is 40% ($80,000/$200,000). For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Break-even Calculations | Here’s a recap of the information we discussed above and some other information which we will use in the break-even calculations that follow: • The company had only one product and its selling price was $20 per unit • The total fixed expenses were $66,000 per year • The variable expenses were $12 per unit, which is 60% of the $20 selling price • The contribution margin was $8 per unit, which is 40% of the selling price Break-even Point in Units (for the year): = Total fixed expenses for the year divided by the contribution margin per unit = $66,000 divided by $8 per unit = 8,250 units Break-even Point in Sales Dollars (for the year): = Total fixed expenses for the year divided by the contribution margin ratio = $66,000 divided by 40% = $165,000 The break-even point in sales dollars for the year could also be calculated taking the break-even point in units of 8,250 and multiplying that amount by the $20 selling price = $165,000 per year. | This is a cheet sheet Question |
The Mix of Products Sold May Change | The break-even model has some limitations. For example, a company often sells many different products (and/or services) with a wide range of contribution margins (and a variety of contribution margin ratios). Therefore, the same total number of units sold could result in vastly different profits if the sales mix changes. (Sales mix is the varying proportions of high and low margin products that are sold.) For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Not All Variable Expenses Are Linear | Another limitation is that many variable expenses will not change in direct proportion to the change in volume. In other words, if the total variable expenses were graphed according to sales volume, the resulting line would not be a straight line. Perhaps the line will curve upward thereby revealing that some variable expenses may be increasing exponentially instead of increasing at a constant rate. | This is a cheet sheet Question |
Fixed Expenses Could Change | Some fixed expenses could increase when a very large change in volume occurs. That is why the definition of fixed expense has a qualifier: The total expense is fixed “within a relevant range of sales or volume.” For example, if the volume increases by such a large amount that another salaried supervisor is required, the fixed expense of supervisors will increase. If the increase in volume is so large that it necessitates renting an additional building, the fixed expense of rent will increase. | This is a cheet sheet Question |
Selling Prices May Have to Change | A company may find that in order to increase its sales, it will have to lower its selling prices. This in turn reduces the contribution margin per unit. Competitors may also enter the market and offer lower selling prices in order to attract customers. | This is a cheet sheet Question |
Electronic Worksheets | The simple break-even point models were developed prior to electronic worksheets and personal computers. Now that these inexpensive tools are available, it makes sense to develop electronic worksheets with more sophistication than the simple break-even models. With formulas in the electronic worksheet cells, accountants can easily change various assumptions and immediately see the results. In other words, electronic worksheets allow accountants to play “What if?” What if the selling price is increased by $1 per unit? What if the volume is decreased by 4,000 units? What if the fixed expenses are increased by $8,000 per year? For personal use by the original purchaser only. Copyright © AccountingCoach®.com. | This is a cheet sheet Question |
Bookkeeping in the Past | Historically, bookkeepers were responsible for the following steps in the accounting cycle: • Record all the company’s transactions in journals • Post the amounts from the journals to accounts in the general ledger and subsidiary ledgers • Calculate the balance in each of the accounts • Prepare a trial balance (a list of the balances in the general ledger accounts) • Identify and correct any errors that caused the trial balance to not balance (total debit balances did not equal total credit balances) After the bookkeeper completed these time-consuming tasks each month, an accountant prepared the necessary adjusting entries and the financial statements for the month and year-to-date. | This is a cheet sheet Question |
Bookkeeping Today | Thanks to computers and the discipline imposed by the accounting software, the accounts and trial balance will always be in balance. Further, the previously distinct steps in the accounting cycle now appear to happen simultaneously. For example, when a distributor sells goods on credit, the software prepares the sales invoice, credits the general ledger’s Sales account, debits the general ledger’s Accounts Receivable, updates the customer’s detailed account, reduces the Inventory account, increases the Cost of Goods Sold, updates all balances in the general ledger accounts, provides for a trial balance and financial statements on demand, and more. Of course, the bookkeeper must be certain that only legitimate business transactions are processed by the accounting software. | This is a cheet sheet Question |
Double-entry Accounting System | Behind the computer screens, most accounting software is based on the double-entry system of accounting which has been in existence for more than 500 years. The double-entry system means the following: For personal use by the original purchaser only. Copyright © AccountingCoach®.com. • Every transaction affects two (or more) general ledger accounts • Every transaction must have an amount recorded in at least one account as a debit (left side of the account), and an amount must be recorded in at least one account as a credit (right side of the account) • The amounts entered for each transaction must have the total debits equal to the total credits • At all times, the total of the amounts entered as debits must equal the total of the amounts entered as credits • At all times, the total of the debit balances in the accounts must be equal to the total of the credit balances in the accounts Here are a few examples of what will be occurring automatically when using accounting software: • Cash will be credited whenever a check is written • Cash will be debited when money is received • Accounts Receivable will be debited when a sales invoice is issued for a credit sale | This is a cheet sheet Question |