Basic Accounting

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1 Basic Accounting

In this note, we are going to introduce the basics of financial accounting. By the end, you will
be able to understand and interpret simple financial statements.

Accounting is the language of business, used by managers to report financial information. It


is essential for business decision-making. It is a system meant for:

1. Identifying and measuring business activities.

2. Recording information into reports.

3. Communicating this information to decision-makers.

The graph below shows how an accounting system operates in business and how the flow of
information occurs.

3) Accountants
prepare reports to 1) People make
show the results of decision
business operations

2) Business transactions occur

When accounting information is produced for internal purposes, we refer to it as managerial


accounting. Managers use accounting information to make economic decisions to run the firm
efficiently.

In contrast, when accounting information is used to report the firm’s financial performance to
outsiders, we refer to this activity as financial accounting.

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1.1 Information Conveyed in Financial Statements

Recall that accounting focuses on communicating information to users. That information is


disclosed using financial statements. Managers are responsible for preparing the annual report,
which is a booklet that contains the financial statements of the firm, explanatory notes, and a
detailed discussion and analysis of the results.

The annual report is made public periodically. It is used by people outside the firm to assess
its performance and to evaluate management.

The three important financial statements are:

1. Balance Sheet

 It shows a firm’s value on a particular date.

2. Income Statement

 It summarizes a firm’s performance over a period of time.

3. Cash Flow Statement

 It summarizes the amount of cash and cash equivalents entering and leaving a firm.

1.2 The Balance Sheet

The balance sheet is a snapshot of the firm. It summarizes what a firm owns (the assets) and
what a firm owes (the liabilities), and the difference between the two (the equity).

A simplified balance sheet:

Balance Sheet
Assets Liabilities
Equity

In business, we look at a company as a bundle of resources whose purpose is to generate income.


These resources are bought with funds from two sources – money from lenders and owners –
who in turn demand a “rent” from the company for the use of their money.

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This insight can be visualized in the balance sheet of the company.

Balance Sheet
Assets Liabilities
A business needs assets to carry on business (1) funds which come from lenders
and generate a return.
Equity
This bundle of resources is financed by: (2) funds which are provided by the
company’ owners

In summary, the balance sheet is represented by the accounting equation:

Assets = Liabilities + Equity

This identity describes the notion that the balance sheet must balance. That is, the left-side
total is equal to the right-side sum. If an asset increases, the amount of its increase must be
matched by (a) a decrease of the same amount in other assets; (b) an increase of an equal
amount in liabilities; (c) an increase of an equal amount in equity; or, (d) some combination of
the above. At the end of the process, the two sides of the equation must remain equal (their
overall totals may change, however).

Example 1.1

Sophie starts a business “Sophie’s Cake Shop” and on day one she:

 (a) Puts $500,000 of her own money into the business.


 (b) Arranges a business loan of $400,000 from HSBC.

We can represent this information in terms of the accounting equation as follows:

Assets = Liabilities + Equity


(a) + 500,000 Cash (a) + 500,000 Capital
(b) + 400,000 Cash (b) + 400,000 Bank Loan
900,000 400,000 500,000

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Here is the balance sheet:

Sophie’s Cake Shop


Balance Sheet at the End of Day One
Assets Liabilities
Cash 900,000 Bank Loan 400,000

Equity
Contributed Capital 500,000
900,000 900,000

This statement gives Sophie the state of affairs at the end of day one. It shows her:

Liabilities
Assets What does she owe?
What does she own? Equity
What is her worth?

1.2.1 Elements of the Balance Sheet

Let us look at a detailed balance sheet. The heading of the balance sheet indicates the name of
the entity, the name of the statement, and the date. We will now look at the key elements on
both sides of the balance sheet.

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1.2.1.1 Assets

An asset is a resource controlled by the corporation as a result of past events and from which
future economic benefits are expected to flow to the corporation.

The criteria for recognizing an asset are:

 Resources are owned or controlled by the firm.


 Resources are expected to provide future economic benefits sufficient to recover
their cost.
 The future economic benefits are measurable with a reasonable degree of certainty.

Assets are listed by their ease of conversion into cash. They can be classified into current and
fixed (non-current).

 A current asset is an asset where the benefit is expected to be fully utilized within
one year; for example, cash, accounts receivable, and inventory.
 A fixed asset is an asset where the benefit is expected to be utilized over a
relatively long life; for example, land and building.

Example 1.2

Do the following pass the definition of an asset?

(a) $1 million cash held by Marks & Spencer.

(b) Marks & Spencer sold a pair of shoes for $1,000 to a customer who purchased the shoes
using a credit card.

(c) Caterpillar purchased new equipment it will use in producing engines. The new
equipment substitutes a robotically controlled machining process for a labour-intensive
process. Caterpillar agreed to give the equipment vendor 200,000 shares of its common
stock in payment for the equipment. At the time of the transaction, Caterpillar’s stock
price was $123 per share.

(d) Caterpillar sold 16 trucks to a customer for a total of $10 million. The customer agreed
to pay Caterpillar $2 million at the time Caterpillar delivered the trucks and the rest in
four equal instalments at the end of each of the next four years. At the time of the final
payment, Caterpillar will transfer the legal title of the trucks to the customer.

(e) IBM spends $8,000,000 on tuition-assistance programs for its middle-level managers
to obtain MBAs. Historically, 80% of the managers who received the MBA remain
with the firm five years or more.

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Identifying whether resources satisfy the definition of an asset is often straightforward. In
practice, implementing the criteria for recognition and valuation of assets is conceptually
challenging when:

 Ownership or control of a resource is uncertain.


 The economic benefits of outlays are uncertain or difficult to quantify.
 Resource values have changed.

1.2.1.2 Liabilities

A liability is a present obligation of the entity to transfer an economic resource as a result of


past events.

Liability for existing, three criteria must all be satisfied:

 The entity has an obligation.


 The obligation is to transfer an economic resource.
 The obligation is a present obligation that exists as a result of past events.

Liabilities can also be classified into current and long-term.

 Current liability reflects the sacrifice that is expected to be settled within one year;
for example, accounts payable and notes payable.
 A long-term liability is a sacrifice that is expected to be settled in more than one
year; for example, long-term debt.

Example 1.3

Do the following pass the definition of a liability?

(a) Marks & Spencer purchased merchandise inventory and agreed to pay its supplier
$800,000 within 30 days.

(b) IBM borrowed $10 million by issuing long-term bonds whose terms require that on
December 31 of each year, IBM make a payment of 10% of the amount borrowed.

(c) Cathay Pacific signs an agreement with its employees’ labour union, promising to
increase wages by 6% and to increase housing benefits.

(d) A customer files a suit claiming damages of $1 million from faulty engines that Ford
manufactured. The case has not yet gone to trial, so no court has yet rendered a decision
or verdict.

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1.2.1.3 Equity

Shareholders’ equity is the total equity interest that all shareholders have in a corporation. It
is the residual value remained to the shareholders after repaying all debts by selling its assets.

Equity can be separated into contributed capital and retained earnings.

 Contributed capital is the owners’ initial investment in the firm.


 Retained earnings represent the accumulated total of after-tax earnings and losses
from operations over the life of the firm that has been retained in the corporation.

To demonstrate the significance of the two quantities, “contributed capital” and “retained
earnings”, consider the following two corporations of similar size. Let us assume that both
companies are of the same age.

Company X
Balance Sheet in $ millions
Assets 100 Liabilities 40

Equity
Contributed Capital 10
Retained Earnings 50
100 100

Company Y
Balance Sheet in $ millions
Assets 100 Liabilities 40

Equity
Contributed Capital 55
Retained Earnings 5
100 100

The only difference between the two balance sheets is in the amounts of contributed capital
and retained earnings. Company X was started with an initial capital of $10 million and
Company Y with $55 million. Company X proved to be very successful and managed to
reinvest $50 million of its profits to help finance its asset growth. Company Y struggled during
its existence and only managed to reinvest $5 million of its profits.

Of course, other explanations and scenarios could account for the differences. Dividend policy,
for example, impacts the level of retained earnings.

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1.2.1.4 Managerial Issues

1. Net Working Capital

 Net working capital is the difference between a firm’s current assets and its current
liabilities.
 The level of working capital naturally expands and contracts with sales activities.
 Too little working capital can put a firm in a bad position since the firm may be
unable to pay its bills or to take advantage of profitable opportunities.
 Too much working capital reduces profitability since that capital has a carrying
cost.

2. Inventory

 Having too many inventories can fill customer orders without delay and provides
a buffer against potential production stoppages.
 The flip side of plentiful inventory is the risk of deterioration in the market value
of inventory itself.
 Inventory can be valued using either the FIFO, LIFO, or average cost valuation
method.

Example 1.4

A new company in its first year of operations purchases five products for sale in the order and
at the prices shown:

Item Purchase Price


#1 $5
#2 $7
#3 $8
#4 $9
#5 $11

The company sells three of these items, all at the end of the year. The cash flow assumptions
would be:

Accounting Method Goods Sold Goods Remaining in Inventory


FIFO #1, #2, #3 #4, #5
LIFO #5, #4, #3 #2, #1
Average Cost (Total Cost / 5) × 3 (Total Cost / 5) × 2

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The effect would be:

Accounting Method Cost of Good Sold Inventory Valuation


(Income Statement) (Balance Sheet)
FIFO $20 $20
LIFO $28 $12
Average Cost $24 $16

It can be seen that during a period of inflation, with product prices increasing, the LIFO method
produces the highest cost of goods sold and the lowest ending valuation in inventory.

3. Financial Leverage

 Financial leverage refers to the use of debt in acquiring an asset. The more debt a
firm has, the higher is its degree of financial leverage.
 Financial leverage creates an opportunity for a firm to gain a higher return on the
capital invested.

Test Yourself 1.1

1. Do the following pass the definition of an asset?

(a) A firm issues a $1.2 million cheque to an insurance company for liability insurance
over the next year.

(b) A firm issues a cheque for $500,000 as a deposit on a custom-built machine.

(c) A firm buys stock in another firm for $325,000.

(d) A firm acquires chemicals to be used as raw materials for $800,000.

(e) A well-known scientist is hired to manage the R&D function for $1.8 million a year.
Employment starts next month.

(f) The firm receives an order for $150,000 in products.

(g) The firm writes a cheque for $1 million to obtain an option to purchase a tract of land.

(h) A firm receives notice from a supplier that it has shipped raw materials of $200,000.
The firm has title to the goods while in transit.

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2. Do the following pass the definition of a liability?

(a) The firm owes its attorneys $500,000 in legal expenses.

(b) The firm provides warranties on its products.

(c) The firm borrows $6 million from the bank for 90 days.

1.3 Income Statement

The income statement indicates the results of operations over a specified period. Unlike the
balance sheet, which is a snapshot of the firm’s position at a point in time, the income statement
indicates cumulative business results within a defined time frame.

The simple income statement equation is:

Revenue – Expenses = Net Income

For this reason, the income statement is also called the profit and loss statement (P&L). Net
income is an important figure because it reveals whether the firm is making money or not. It
is a summary figure for the performance of the firm.

What exactly are income and expenses?

 Income refers to increases in economic benefits during an accounting period that


results in an increase in equity, other than those related to a transaction with
shareholders.
 Expenses are decreases in economic benefits during an accounting period that
result in a decrease in equity, other than those related to transactions with
shareholders.

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1.3.1 Typical Layout of Income Statement

While each company may adapt categorization of revenues and expenses as appropriate, the
general format of an income statement is as follow:

Income Statement
Sales Revenue
– Cost of Good Sold
Gross Profit
– Marketing and Selling Expenses
– Administration Expenses
– Research and Development Expenses
– Other Operating Expenses
Earnings before Interest and Tax (EBIT)
+ Interest Income
– Interest Expenses
Profit before Tax
– Taxes
Net Income

1.3.1.1 Revenue

An income statement starts with the firm’s revenues. The recognition of revenues is a key
event in the life of any firm. Accounting standards contain specific rules on revenue
recognition.

A firm recognizes revenues when the transaction fulfills the following conditions:

 The earnings process is substantially complete. The firm has done all that it has
promised to do for the customer: the firm has delivered the products or performed
the services it has agreed to provide. This means that the firm has earned the
revenues.
 The amount to be collected is reasonably determinable. The firm has received
cash or some other asset. If the asset is not cash, the firm must be reasonably
certain of converting it into cash. This means that the firm can reliably measure
the revenues.

If the firm has not performed all its obligations, it must adjust the amount of revenue recognized
to reflect those unperformed obligations.

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Example 1.5

During a busy Christmas season, DisneyToy Inc., a manufacturer of doll clothing, furniture,
and accessories, receives an email from one of its best longtime customers requesting
immediate shipment of 100,000 doll dresses for next-day delivery, with payment later.
DisneyToy ships the order as instructed. As is customary in the industry, the customer is
expected to pay for the goods 30 days after shipment.

There are many points when revenue may be recognized as a result of the sale of goods or
services to customers. Five of the most common are:

 The point at which an order is obtained from a customer.


 The point at which an order is accepted and the terms of the sale are finalized.
 The point at which goods are delivered to a customer.
 The point at which the customer is billed.
 The point at which payment is received from the customer.

When should revenue be recognized?

1.3.1.2 Expenses

Expenses shown on the income statement are based on the matching principle. The basic idea
is first to determine revenues and then match those revenues with the costs associated with
producing them.

A firm recognizes an expense when either of the following conditions holds:

 The consumption of asset results from a transaction that leads to the recognition
of revenue. The expense is recognized in the period when the firm recognizes the
revenue. This is known as the matching principle.
 The consumption of asset results from the passage of time.

As a result of the way revenues and expenses are reported, the figures reported in the statements
may not be at all representative of the actual cash inflows and outflows that occurred during a
particular period.

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1.3.1.3 Depreciation

Depreciation is counted on the income statement as an expense, even though it involves no


cash outflows. Depreciation is a way of estimating the consumption of an asset over time. For
example, if a computer loses about a third of its value each year, the firm would not expense
the full value of the computer in the first year of its purchase, but deduct one-third each year
as an expense.

An income statement for U.S. Corporation is shown below. It reports revenues and expenses
for the period.

1.4 Accounting for Business Transactions

To illustrate the accounting for transactions, we consider eleven events and analyze each in
terms of its effect on CU Car Wash Inc.

Gary opened CU Car Wash Inc. in April 2019. The details of transactions:

1. Gary and a few friends invest $50,000 to open CU Car Wash, and the business issues
ordinary share capital to the shareholders.

2. CU Car Wash purchases a parcel of land and pays cash of $40,000.

3. The business buys supplies on account, agreeing to pay $3,700 within 30 days.

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4. CU Car Wash earns $7,000 of service revenue by providing services for customers.
The business collects the cash.

5. CU Car Wash cleans a fleet of UPS delivery trucks, and UPS promises to pay CU Car
Wash $3,000 within one month.

6. During the month, CU Car Wash pays $2,700 for the following expenses: equipment
rental, $1,100; employee salaries, $1,200; and utilities $400.

7. CU Car Wash pays $1,900 on account, which means to pay off an account payable.

8. Gary, the major shareholder of CU Car Wash, paid $30,000 to remodel his home.

9. In transaction 5, CU Car Wash performed services for UPS on account. The business
now collects $1,000 from UPS.

10. CU Car Wash sells some half of the land it bought for $22,000. CU Car Wash receives
$22,000 cash and makes a $2,000 gain on the sale of the land.

11. CU Car Wash declares a dividend and pays the shareholders $2,100 cash.

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1.4.1 Transactions and Financial Statements

Assets = Liabilities + Equity


Share Retained
Cash A/R Supplies Land A/P
Capital Earnings
1 +50,000 +50,000 Issued share capital
2 –40,000 +40,000 Paid cash for land
3 +3,700 +3,700 Bought supplies on account
4 +7,000 +7,000 Service revenue
5 +3,000 +3,000 Service revenue
6 –1,100 –1,100 Rent expense
6 –1,200 –1,200 Salary expense
6 –400 –400 Utility expense
7 –1,900 –1,900 Paid A/P
8 Not a transaction of the business
9 +1,000 –1,000 Received A/R
10 +22,000 –20,000 +2,000 Gain from sale
11 –2,100 –2,100 Dividends
33,300 2,000 3,700 20,000 1,800 50,000 7,200

Note that every transaction maintains the equality of the accounting equation: Assets = Liabilities + Equity.

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From the above information, we can generate financial statements.

CU Car Wash Inc.


Income Statement for the Month ended 30 April 2019
Income
Service revenue (7,000 + 3,000) 10,000
Gain from sale of land 2,000
12,000
Expenses
Salary expense 1,200
Rent expense 1,100
Utility expense 400
2,700

Net Income 9,300


Dividend 2,100
Retained Earnings 7,200

CU Car Wash Inc.


Balance Sheet as at 30 April 2019
Assets Liabilities
Cash 33,300 A/P 1,800
A/R 2,000
Supplies 3,700 Equity
Land 20,000 Contributed Capital 50,000
Retained Earnings 7,200
59,000 59,000

The worksheet approach to recording transactions is fine in concept, but it would never work
in practice due to the volume and variety of transactions occurring in the ordinary business
environment.

To overcome this problem, accountants record business transactions using accounts, journals,
and ledgers.

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Test Yourself 1.2

Shelly opens a research service near a college campus. She names the corporation Herzog
Researchers Ltd. During the first month of operations, July 2019, the business engages in the
following transactions:

(a) Herzog Researchers Ltd issues its ordinary shares to Shelly, who invests $25,000 to
open the business.

(b) The company purchases on account office supply costing $350.

(c) Herzog Researchers pays cash of $20,000 to acquire a lot next to the campus. The
company intends to use the land as a building site for a business office.

(d) Herzog Researchers performs research for clients and receives cash of $1,900.

(e) Herzog Researchers pays $100 on the account payable it created in the transaction (b).

(f) Herzog pays $2,000 of personal funds for a vacation.

(g) Herzog Researchers pays cash expenses for office rent $400 and utilities $100.

(h) The business sells a quarter of its land parcel for $6,000.

(i) The business declares and pays a cash dividend of $1,200.

1. Analyze the preceding transactions in terms of their effects on the accounting equation
of Herzog Researchers Ltd.

2. Prepare the income statement and the balance sheet of Herzog Researchers Ltd after
recording the transactions.

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Test Yourself 1.2

Assets = Liabilities + Equity


Share Retained
Cash Supplies Land A/P
Capital Earnings
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(g)
(h)
(i)

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Herzog Researchers. Ltd
Income Statement for the Month ended 31 July 2019
Income
Service revenue
Gain from sale of land

Expenses
Rent expense
Utility expense

Net Income
Dividend
Retained Earnings

Herzog Researchers. Ltd


Balance Sheet as at 31 July 2019
Assets Liabilities
Cash A/P
Supplies
Land Equity
Contributed Capital
Retained Earnings

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1.5 Double-Entry Accounting

In the previous section, we understand all business transactions include, at least, two effects on
an entity’s financial statement elements. We have seen how every transaction affects at least
two accounts.

Accounting, therefore, based on a double-entry system, which records the dual effects on the
entity. Each transaction affects at least two accounts. An increase or decrease in one account
must be matched by a corresponding increase or decrease in another account or accounts.

1.5.1 The T-Account

The most straightforward representation of an account is by the letter “T”. We call them T-
accounts. The vertical line in the letter divides the account into its two sides: left and right.
The account title appears at the top of the T-account.

 The left side of each account is called the debit (Dr) side.
 The right side is called the credit (Cr) side.

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1.5.2 The Rules of Debits and Credits

Balance Sheet Accounts

Assets Liabilities and Equity


Dr Cr Dr Cr
(+ Increase) (– Decrease) (– Decrease) (+ Increase)

Income Statement Accounts


Debit for decreases in Equity Credit for increases in Equity

Expenses and Withdrawals Revenues


Dr Cr Dr Cr
(+ Increase) (– Decrease) (– Decrease) (+ Increase)

The type of account determines how we record increases and decreases. The rules of debit and
credit are:

 Increases in assets, dividends, or expenses are recorded on the debit side of the
account.
 Decreases in assets, dividends, or expenses are recorded on the credit side.
 Increases in liabilities and equity or revenue are recorded by credits.
 Decreases in liabilities and equity or revenue are recorded by debits.

The following summary shows how debits and credits are used to record increases and
decreases in various types of accounts.

Assets = Liabilities + Equity


Increases  are recorded as: Dr Cr Cr
Decreases  are recorded as: Cr Dr Dr

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1.5.3 Recording Transactions

Now, let us revisit the CU Car Wash business and record the same eleven transactions we
illustrated earlier using debits and credits.

Gary opened CU Car Wash Inc. in April 2019. The details of transactions:

1. Gary and a few friends invest $50,000 to open CU Car Wash, and the business issues
ordinary share capital to the shareholders.

Accounting equation:

Assets = Liabilities + Equity


+50,000 = 0 + +50,000

In real life, accountants first enter transactions into the accounting system as they occur by
using journal entries. A journal entry is a standardized way of indicating which accounts are
debited and credited and the amounts.

Journal entry:

Dr Cr
Cash 50,000
Share Capital 50,000
Issued share capital.

Once the transactions have been recorded, the accounting system automatically posts the
journal entries to the appropriate T-accounts.

Cash Share Capital


(1) 50,000 (1) 50,000

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2. CU Car Wash purchases a parcel of land and pays cash of $40,000.

Assets = Liabilities + Equity


+40,000 = 0 + 0
–40,000

Dr Cr
Land 40,000
Cash 40,000
Paid cash for land.

Cash Land
(1) 50,000 (2) 40,000 (2) 40,000

3. The business buys supplies on account, agreeing to pay $3,700 within 30 days.

Assets = Liabilities + Equity


+3,700 = +3,700 + 0

Dr Cr
Supplies 3,700
A/P 3,700
Purchase office supplies on account.

Supplies A/P
(3) 3,700 (3) 3,700

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4. CU Car Wash earns $7,000 of service revenue by providing services for customers.
The business collects the cash.

Assets = Liabilities + Equity


+7,000 = 0 +7,000

Dr Cr
Cash 7,000
Service Revenue 7,000
Performed services for cash.

Cash Service Revenue


(1) 50,000 (2) 40,000 (4) 7,000
(4) 7,000

5. CU Car Wash cleans a fleet of UPS delivery trucks, and UPS promises to pay CU Car
Wash $3,000 within one month.

Assets = Liabilities + Equity


+3,000 = 0 + +3,000

Dr Cr
A/R 3,000
Service Revenue 3,000
Performed services on account.

A/R Service Revenue


(5) 3,000 (4) 7,000
(5) 3,000

6. During the month, CU Car Wash pays $2,700 for the following expenses: equipment
rental, $1,100; employee salaries, $1,200; and utilities $400.

Assets = Liabilities + Equity


–2,700 = 0 + –2,700

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Dr Cr
Rent Expense 1,100
Salary Expense 1,200
Utility Expense 400
Cash 2,700
Paid expenses.

Cash Rent Expense


(1) 50,000 (2) 40,000 (6) 1,100
(4) 7,000 (6) 2,700

Salary Expense Utility Expense


(6) 1,200 (6) 400

7. CU Car Wash pays $1,900 on account, which means to pay off an account payable.

Assets = Liabilities + Equity


–1,900 = –1,900 + 0

Dr Cr
A/P 1,900
Cash 1,900
Paid cash on account.

Cash A/P
(1) 50,000 (2) 40,000 (7) 1,900 (3) 3,700
(4) 7,000 (6) 2,700
(7) 1,900

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8. Gary, the major shareholder of CU Car Wash, paid $30,000 to remodel his home.

This is not a transaction of the car-wash business, so the business does not record the
transaction.

9. In transaction 5, CU Car Wash performed services for UPS on account. The business
now collects $1,000 from UPS.

Assets = Liabilities + Equity


+1,000 = 0 + 0
–1,000

Dr Cr
Cash 1,000
A/R 1,000
Collected cash on account.

Cash A/R
(1) 50,000 (2) 40,000 (5) 3,000 (9) 1,000
(4) 7,000 (6) 2,700
(9) 1,000 (7) 1,900

10. CU Car Wash sells some half of the land it bought for $22,000. CU Car Wash receives
$22,000 cash and makes a $2,000 gain on the sale of the land.

Assets = Liabilities + Equity


+22,000 = 0 + +2,000
–20,000

Dr Cr
Cash 22,000
Land 20,000
Gain on Sale of Land 2,000
Sold land costing $20,000 for $22,000.

Cash Land
(1) 50,000 (2) 40,000 (2) 40,000 (10) 20,000
(4) 7,000 (6) 2,700
(9) 1,000 (7) 1,900
(10) 22,000 Gain on Sale of Land
(10) 2,000

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11. CU Car Wash declares a dividend and pays the shareholders $2,100 cash.

Assets = Liabilities + Equity


–2,100 = 0 + –2,100

Dr Cr
Dividends 2,100
Cash 2,100
Declared and paid dividends.

Cash Dividends
(1) 50,000 (2) 40,000 (11) 2,100
(4) 7,000 (6) 2,700
(9) 1,000 (7) 1,900
(10) 22,000 (11) 2,100

1.5.4 Balancing of an Account

When the posting is completed, most of the accounts have entries on both sides of the accounts.
The process of finding out the difference between the totals of the two sides of a ledger account
is known as balancing. The difference in the total debits and the total credits of accounts is
known as balance.

Assets:

Cash A/R
(1) 50,000 (2) 40,000 (5) 3,000 (9) 1,000
(4) 7,000 (6) 2,700 Bal c/f 2,000
(9) 1,000 (7) 1,900 Bal b/f 2,000
(10) 22,000 (11) 2,100
Bal c/f 33,000
Bal b/f 33,000

Supplies Land
(3) 3,700 Bal c/f 3,700 (2) 40,000 (10) 20,000
Bal b/f 3,700 Bal c/f 20,000
Bal b/f 20,000

27
Liabilities:

A/P
(7) 1,900 (3) 3,700
Bal c/f 1,800
Bal b/f 1,800

Equity:

Dividends Share Capital


(11) 2,100 Bal c/f 2,100 Bal c/f 50,000 (1) 50,000
Bal b/f 2,100 Bal b/f 50,000

Service Revenue Gain on Sale of Land


Bal c/f 10,000 (4) 7,000 Bal c/f 2,000 (10) 2,000
(5) 3,000 Bal b/f 2,000
Bal b/f 10,000

Rent Expense Utility Expense


(6) 1,100 Bal c/f 1,100 (6) 400 Bal c/f 400
Bal b/f 1,100 Bal b/f 400

Salary Expense
(6) 1,200 Bal c/f 1,200
Bal b/f 1,200

Each account has a balance. If an account’s debits exceed its total credits, that account has a
debit balance. If the sum of the credits is greater, the account has a credit balance.

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1.5.5 The Trial Balance

A trial balance lists all accounts with their balances – assets first, then liabilities and equity.
The trial balance summarizes all the account balances for the financial statements and shows
whether total debits equal total credits.

CU Car Wash Inc.


Trial Balance
30 April 2019
Balance
Account Title Debit Credit

Cash 33,300
A/R 2,000
Supplies 3,700
Land 20,000
A/P 1,800
Share Capital 50,000
Dividends 2,100
Service Revenue 10,000
Gain on Sale of Land 2,000
Rent Expense 1,100
Salary Expense 1,200
Utility Expense 400
63,800 63,800

The trial balance ensures that the debits equal the credits. Once the trial balance is prepared
and the debits and credits balance, the next step is to prepare the financial statements.

29
CU Car Wash Inc.
Income Statement for the Month ended 30 April 2019
Income
Service revenue (7,000 + 3,000) 10,000
Gain from sale of land 2,000
12,000
Expenses
Salary expense 1,200
Rent expense 1,100
Utility expense 400
2,700

Net Income 9,300


Dividend 2,100
Retained Earnings 7,200

CU Car Wash Inc.


Balance Sheet as at 30 April 2019
Assets Liabilities
Cash 33,300 A/P 1,800
A/R 2,000
Supplies 3,700 Equity
Land 20,000 Contributed Capital 50,000
Retained Earnings 7,200
59,000 59,000

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Test Yourself 1.3

On September 1, 2018, Michael Moe incorporated Moe’s Mowing, Inc., a company that
provides mowing and landscaping services. During the month of September, the business
incurred the following transactions:

(a) To begin operations, Michael deposited $10,000 cash in the business’s bank account.
The business received the cash and issued shares to Michael.

(b) The business purchased equipment for $3,500 on account.

(c) The business purchased office supplies for $800 cash.

(d) The business provided $2,600 of landscaping works to a customer on account.

(e) The business paid $500 cash toward the equipment previously purchased on account in
transaction (b).

(f) The business received $2,000 in cash for services provided to a new customer.

(g) The business paid $200 cash to repair equipment.

(h) The business paid $900 cash for September’s salary expense.

(i) The business received a utilities bill amounting to $150; it has not paid this bill.

(j) The business received $2,100 cash from a customer on account.

(k) The business paid cash dividends of $1,500.

1. Journalize the transactions and then post to the T-accounts.

2. Total each T-account to determine its balance at the end of the month.

3. Prepare the trial balance of Moe’s Mowing, Inc., at September 30, 2018.

31
Test Yourself 1.3

Dr Cr
(a)

(b)

(c)

(d)

(e)

(f)

(g)

(h)

(i)

(j)

(k)

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Assets:

Cash A/R

Supplies Equipment

Liabilities:

A/P Utilities Payable

Equity:

Dividends Share Capital

Service Revenue Repair Expense

Salary Expense Utility Expense

33
Moe’s Mowing, Inc.
Trial Balance
September 30, 2018
Balance
Account Title Debit Credit

Cash
A/R
Supplies
Equipment
A/P
Utilities Payable
Share Capital
Dividends
Service Revenue
Repair Expense
Salary Expense
Utility Expense

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1.6 Financial Ratio Analysis

Next, we are going to analyze the financial statements in a meaningful manner. Quantitatively,
we can compute financial ratios to interpret the financial results.

Financial ratios can help us to examine the financial health of a corporation. The ratios fall
into five classes:

 Liquidity
 Solvency
 Asset Management
 Profitability
 Market Value

Let us look at the financial statements of City Corporation and calculate some common
financial ratios.

City Corporation
2018 Income Statement
($ in thousands)

Sales 1,506
Less: Cost of goods sold 1,004
Gross profit 502

Depreciation 10
Lease rental costs 30
Other operating expenses 360
EBIT 102

Interest 5
Taxable income 97
Tax 47
Net income 50
Less: Dividends
- Preferred 1
- Common 29
Change in retained earnings 20

35
City Corporation
Balance Sheet as of 31 December, 2017 2018
($ in thousands)
2018 2017
Current assets:
Cash 20 30
Accounts receivable 95 95
Inventory 130 110
Total current assets 245 235

Fixed assets:
Land 10 10
Building and equipment 120 100
Total fixed assets 130 110

Other assets:
Goodwill 10 10

TOTAL ASSETS 385 355

Current liabilities:
Accounts payable 50 40
Estimated income taxes payable 10 10
Total current liabilities 60 50

Fixed liabilities:
Mortgage bonds, 10% 50 50

TOTAL LIABILITIES 110 100

Shareholders’ equity:
Convertible preferred stock, 5% 20 20
Common stock (10,000 shares) 50 50
Retained earnings 205 185
Total shareholders’ equity 275 255

TOTAL LIABILITIES AND


385 355
SHAREHOLDERS’ EQUITY

36
1.6.1 Liquidity Ratios

A corporation’s liquidity is measured by its ability to raise cash to meet its current obligations.

1. Current Ratio

Current Assets

Current Liabilities
245
 The current ratio in 2018   4.1 times
60
 The higher the ratio, the more protection the firm has against liquidity problems.
 However, the ratio may be distorted by seasonal influences, slow-moving
inventories built up out of proportion to market opportunities, or abnormal
payment of accounts payable just prior to the balance sheet date.

2. Quick Ratio (Acid-Test Ratio)

Current Assets - Inventory



Current Liabilities
245  130
 The quick ratio in 2018   1.9 times
60
 The quick ratio measures the ability of a firm to use its “near-cash” assets to
immediately extinguish its current liabilities.

3. Cash Ratio

Cash

Current Liabilities
20
 The cash ratio in 2018   0.3 times
60
 A very short-term creditor might be interested in this ratio.

37
1.6.2 Solvency Ratios

Solvency ratios generate insight into a firm’s ability to meet long-term debt payment.

1. Total Debt Ratio

Total Liabilities

Total Assets
110
 The total debt ratio in 2018   0.29
385
 Total debt ratio indicates the proportion of a firm’s total assets financed by short-
and long-term credit sources.

Another variation of this ratio is to measure the relative mix of funds provided by the owners
and the creditors.

2. Debt-equity Ratio

Total Liabilities

Shareholders' Equity
110
 The debt-equity ratio in 2018   0.4
275

3. Times Interest Earned Ratio

EBIT

Interest
102
 Times interest earned in 2018   20.4 times
5
 This ratio indicates the extent to which operating profits can decline without
impairing the firm’s ability to pay interest on its long-term debt.

4. Cash Coverage Ratio

EBIT  Depreciation

Interest
102  10
 Cash coverage in 2018   22.4 times
5
 This ratio uses EBIT plus non-cash charges as the numerator. The modification
indicates the ability of the firm to cover its cash outflow for interest from its funds
from operations.

38
1.6.3 Asset Management Ratios

Asset management ratios measure how a firm manages its investment and fixed assets. The
focus of these ratios is on the efficiency of the uses of the assets. That is, how good a firm
utilizes its assets.

1. Inventory Turnover

Cost of Goods Sold



Inventory
1,004
 The inventory turnover in 2018   7.7 times
130
 The inventory turnover ratio indicates how fast inventory items move through a
business.

2. Days’ Sales in Inventory

365 days

Inventory Turnover
365
 The average days’ sales in inventory in 2018   47 days
7.7
 This ratio estimates the average length of time items spent in inventory.

3. Receivables Turnover

Sales

Accounts Receivable
1,506
 The receivable turnover in 2018   15.9 times
95
 Only credit sales should be used.
 This ratio shows a firm’s credit policy. It looks at how fast the firm collects on
credit sales.

4. Average Collection Period

365 days

Receivables Turnover
365
 The average collection period in 2018   23 days
15.9

39
5. Asset Turnover

Sales

Total Assets
1,506
 The asset turnover in 2018   3.9 times
385
 This ratio is an indicator of how efficiently management is using its investment in
total assets to generate sales.
 High turnover rates suggest efficient asset management.

1.6.4 Profitability Ratios

We look at profits in two ways. First, as a percentage of net sales; second, as a return on the
funds invested in the business.

1. Profit Margin

Net Income

Sales
50
 The profit margin in 2018   3.3%
1,506
 It measures the total operating and financial ability of management.

2. Return on Assets (ROA)

Net Income

Total Assets
50
 The ROA in 2018   13%
385
 This ratio measures the return on total assets after recognition of taxes and
financing costs.

3. Return on Equity (ROE)

Net Income

Total Equity
50
 The ROE in 2018   18%
275
 The fact that ROE exceeds ROA reflects the firm’s use of financial leverage.

40
1.6.5 Market Value Ratios

The market value ratios are based on information on the market price of the stocks. These
measures can be calculated directly for publicly traded companies.

1. Earnings Per Share (EPS)

Net Income

Shares Outstanding
50
 The EPS in 2018   $5 per share
10
 This EPS figure is known as “basic earnings per share”.

2. Price-Earnings Ratio (PE)

Price Per Share



Earnings Per Share
 Assume the price for the stock of City Corporation is $40, the PE ratio
40
  8 times
5
 PE ratio measures how much investors are willing to pay per dollar of current
earnings.
 Higher PEs are often taken to mean that the firm has significant prospects for
future growth.

3. Price-Sales Ratio

Price Per Share



Sales Per Share
 Assume the price for the stock of City Corporation is $40, the price-sales ratio
40
  0.27 times
150.6
 Price-Sales ratio can be used when the firm reported negative earnings for the
period.

41
4. Market-to-Book Ratio (MB)

Market Value Per Share



Book Value Per Share
40
 The MB ratio in 2018   1.45 times
27.5
 Note that book value per share is total equity divided by the number of shares
outstanding.
 A value of less than 1 could mean that the firm has not been successful overall in
creating value for its shareholders.

5. Enterprise Value (EV)

 Enterprise Value = Market Value of Equity + Debt – Cash


 The enterprise value of a firm assesses the value of the underlying business assets,
unencumbered by debt and separate from any cash and marketable securities.

1.6.6 Linking Ratios

We can gain more significant insights into a firm’s ROA and ROE by linking together selected
financial ratios.

1. ROA

 Profit Margin  Asset Turnover = ROA


Net Income Sales Net Income
 
 Sales Total Assets Total Assets
3.3%  3.9  13%
 This formula indicates that the return on assets is closely related to profitability
and turnover.

2. ROE (Du Pont Identity)

 Profit Margin  Asset Turnover  Equity Multiplier = ROE


Net Income Sales Total Assets Net Income
  
 Sales Total Assets Total Equity Total Equity
3.3%  3.9 1.4  18%
 Du Pont identity is a popular expression breaking ROE into three parts: operating
efficiency, asset use efficiency, and financial leverage.

42
In financial strategy, we are trying to maximize the ROE in the long-run. To achieve this, we
pursue various courses of action that enable us to raise one or two of the three ratios without
too severe a decline in the others. This is easier said than done. Usually, the attempt to raise
one of the three ratios brings about a drop in the others. A successful financial strategy creates
a favourable trade-off, whereby a 10% increase in asset turnover, for instance, is “bought” at
the cost of only a 3% drop in sales profitability, resulting in a higher ROE.

1.6.7 Managerial Implications

So far, we have looked at the five major types of financial ratios. You would probably ask,
“How can we interpret all the ratios together?”

A simple way to analyze the overall picture is to group the ratios into a matrix. For example:

Liquidity / Solvency Profitability Implications


Liquid / Solvent High Low Risk but High Return
Illiquid / Insolvent High High Risk and High Return
Liquid / Solvent Low Low Risk and Low Return
Illiquid / Insolvent Low High Risk but Low Return

Some caveats when you are using financial ratios:

 Ratio analysis deals only with quantitative data. It does not look at qualitative
factors such as the quality of management.
 Management can take short-run actions to influence the ratios.
 Comparison of ratios between companies must be on a comparable accounting
basis. Differences in accounting practices in such areas as depreciation, income
recognition, and intangible assets can make the comparisons misleading.
 Accounting records are maintained in historical dollars. In periods of inflation the
ratios may be biased upwards.
 Ratios must be evaluated in the correct business context.
 Past data does not necessarily reflect the current situation or future expectations.

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1.7 Cash Flow Statement

Now, we introduce the third of the three financial statements, namely, the cash flow statement.

Cash is extremely important, and maintaining liquidity is essential to guaranteeing the survival
of any firm. The vast majority of business failures occur because firms run out of cash. Users
of financial information want to know how cash is generated and how cash is used every period.

To satisfy this informational need on the part of investors, firms prepare the cash flow statement,
which shows how cash is generated and used during every period and classifies the different
cash flows into three categories:

1. Cash flow from operating activities

 Operating activities typically involve transactions related to providing goods and


services to customers.
 They reflect the cash flow effects of the typical and recurring transactions that
appear on the income statement.
 Examples of operating cash inflows are receipts from customers and the receipt of
interest and dividends from investments.
 Operating cash outflows include payments to employees and suppliers and
payments for interest and taxes.

2. Cash flow from investing activities

 Investing activities usually involve cash flows from the acquisition and disposal
of fixed assets.
 Cash outflows arise from purchasing (investing in) property, plant, and equipment,
making loans, and acquiring investments in other corporations.
 Cash inflows result from disposing of property, plant, and equipment; collecting
loans (other than the interest), and selling investments.

3. Cash flow from financing activities

 Financing activities include cash flows from obtaining and repaying the financing.
 Cash inflows result from contributions by owners (issuing stock to shareholders
in exchange for cash) and from loans.
 Cash outflows arise from payments to shareholders (as dividends or payments to
repurchase their shares) and the repayment of loans (but not the associated interest).

To understand the preparation of the cash flow statement, we are going to use an example.
Below you are given a summary of the movements in the cash account of CU Company.

44
Cash
Bal b/f 72 Payments to suppliers (O) 782
Collections from customers (O) 1,191 Salaries paid (O) 280
Sale of PPE (I) 5 Interest paid (O) 14
New share capital (F) 15 Taxes paid (O) 22
PPE purchase (I) 72
Land purchase (I) 2
Loan repayment (F) 31
Dividends paid (F) 10
Bal c/f 70
1,283 1,283
Bal b/f 70

We need to group the different cash flows into the three categories. We have written its nature
using the letters O, I, or F to indicate operations, investing, or financing, respectively.

Cash Flow Statement for Year 2


Operating activities:
Collections from customers 1,191
Payments to suppliers –782
Payment to employees –280
Payments for interest –14
Payments for taxes –22
Cash flow from operating activities (CFO) 93

Investment activities:
Land purchase –2
Purchase of PPE –72
Sale of PPE 5
Cash flow from (used in) investing activities (CFI) –69

Financing activities:
Loan payment –31
New share capital 15
Dividends paid –10
Cash flow from (used in) financing activities (CFF) –26

Change in cash (CFO + CFI + CFF) –2


Cash, beginning balance 72
Change in cash during Year 2 –2
Cash, ending balance 70

45
Some companies’ cash flow items may not being categorized in the same way we have done it
above. IAS 7 allows for alternative classifications. IAS 7 provides guidance on some of these
alternatives:

 Interest paid, usually categorized as an operating cash flow item, may be classified
as financing cash flow items or investing cash flows.
 Interest and dividend received, usually categorized as an operating cash flow item,
may be classified as investing cash flows.
 Dividend paid, usually categorized as a financing cash flow item, may be classified
as cash flows from operations.
 Taxes paid, usually categorized as an operating cash flow item, may be classified
as financing or investing activities.

For the purposes of learning cash flow items, we will use the “usual” classifications of cash
flow items. But remember that when you look at companies’ real financial statements, you
may see alternative placements of these items.

In summary, a cash flow statement summarizes the sources and uses of cash. Operating cash
flows are needed for the long-term survival of a corporation. Future investments are paid for
through operating cash flows in the long-run.

In the initial stages of a firm’s life, financing cash flows are positive, and investing cash flows
are negative.

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