Basic Accounting and Finance

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Basic Accounting and Finance

Donald N. Merino
Stevens Institute of Technology

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14.1 Introduction
14.1.1 Importance of Accounting to Engineers
Why is accounting important to engineers? One reason was that engineers needed to know the cost and
profitability of the products they design. For example, look at the ever-changing technology of your PC.
What drives these changes? The continual increase in the cost performance of new chips, printed circuit
boards, disc drives, etc. all result in new and improved products being offered every year.
For companies and governments involved in research and engineering, Design for Cost (DFC) and
Cost as an Independent Variable (Systems Engineering, Concurrent Engineering) are the most recent con-
cepts that help define the synergy between economics and engineering. Knowledge of basic accounting
and finance are essential to understand this concept.

14.1.2 Accounting and Engineering Economics

Economic studies for capital project selection depend on estimates of cash flows. You do not have to be a
professional accountant or estimator to make an economic analysis. A practitioner of engineering eco-
nomics is expected to understand the fundamentals of both disciplines. The data on which such forecasts
are based come from many sources, but the most important source is accounting records.

14.1.3 What is Accounting?

Accounting in its simplest form is scorekeeping—it is observing, measuring, recording, classifying, and
summarizing the financial data associated with the multitude of transactions occurring in the operation of
a business. As such, the accounting function is historical, not predictive. Other non-accounting instru-
ments are predictive, such as sales forecasts, production plans, expense budgets, and cash flows. However,
they are usually based, at least in part, on solid historical accounting data. If that is the only purpose, one
might ask why keep score? In reality, the main purpose of maintaining good accounting data is to have it
available for use in decision-making.

14.1.4 Users of Accounting Information

Many people use accounting information in order to make financial decisions. The following are some
examples:
• Individuals: You and I use accounting information to manage bank accounts, to make investments,
and to make decisions concerning many different types of purchases.
• Business: In corporations, the managers of the organization use accounting information to determine
accountability for past activities and as a basis of decision-making for future events.
• Investors and Creditors: These are people who may decide invest money in the organization. They
use accounting information to evaluate risk and return on a prospective investment, i.e., as an aid in
making the decision to invest or not.
• Regulators: Examples of regulators include the Securities Exchange Commission (SEC), Internal
Revenue Services (IRS), and other Tax Collectors. These organizations use accounting information
to evaluate managers’ adherence to proper, prescribed procedures and their overall managerial perfor-
mance.

14.2 Basic Accounting

14.2.1 Introduction
The following tutorial will help you get a better understanding of the concepts and principles of basic
accounting. You should fully understand this tutorial before moving on to the next one. These ideas will
be critical to fully grasping the information that is presented later.
This section presents information on the various types of accounting entities, accounting transactions,
basic accounting terminology, and financial statement terminology, including the well-known “accounting
equation.” This basic section will not only help you better understand financial accounting and engineer-
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ing economics, but also give you insights and knowledge to help you read and interpret financial reports,
such as SEC filings and personal or corporate tax information.

14.2.2 Financial Accounting

Accounting is the management discipline that deals with the financial condition and the financial
performance of economic entities by recording, analyzing, and reporting the transactions in which they
engage in order to assess their current performance and to forecast their future performance.

Entities
Entities are the bounded systems whose financial records may be examined to determine their state of
financial health. There are two types of entities, for-profit and not-for-profit. A convenient classification
follows:
• For-profit (business) entities
• Sole proprietorships
• Partnerships
• Corporations
• Not-for-profit entities
• Private-sector organizations (usually charitable or religious)
• Public-sector organizations (government)

The above classification does not include you, the individual consumer, but when an accountant helps
you prepare your income tax return, you are an economic entity.
The capital selection process applies to both for-profit and not-for-profit entities. Business entities
are found in the private sector of the economy. However, there are public sector entities that compete and
function much like their private counterparts. Utility companies which are owned by national or local
governments are one of many examples. For these and other not-for-profit entities, the terms “profit” and
“loss” are replaced with “surplus” and “deficit” respectively.
For profit economic entities include sole proprietorships, which are owned by one individual; part-
nerships, which are owned by two or more individuals; and corporations, which are owned by a few or
many shareholders. The sole proprietorship is the most common form of business entity, but corporations
are dominant in terms of revenues and profits. Table 14.1 compares the three forms for the year 2000.

Table 14.1. Comparison of Types of Business Entities

Business Annual Receipts

Number Dollars
    (Millions) Percentage   (Billions) Percentage

Proprietorships (non-farm) 20.6 77.1% 1,139 4.94%

Partnerships 1.00 3.74% 2,316 10.04%
Corporations 5.10 19.1%   19,593 85.01%
26.70 100% 23,048 100%

Ref: U.S. Bureau of the Census, Statistical Abstract of the United States, 2004

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Proprietorships and partnerships are not “legal entities” in the eyes of the law. That is, they do not
have an independent identity under the law. Therefore, their owners are fully responsible for their acts and
obligations, and creditors can, if necessary, go beyond the assets of the business to seek the personal assets
of the owners in order to satisfy their claims.
Corporations, on the other hand, are “legal entities.” Their shareholders have limited liability, which
means that corporations are responsible for their own acts and obligations. Creditors can rely only on
corporate assets for the satisfaction of their claims, not those of shareholders, employees or members of
the board of directors.
Proprietorships and partnerships are generally managed by their owners; corporations are not. The
shareholders elect a board of directors, which appoints executives to serve as managers. In short, owner-
ship and management are divorced (and, as a result, the interests of the managers may conflict with those
of the shareholders!).
Examples of not-for-profit entities in the private sector include universities, schools, hospitals, muse-
ums, and charitable organizations. Examples are also found in the public sector, but these function under
the aegis of federal, state, and local governments, which are economic entities, along with school districts,
water sanitary districts, public utility and transit authorities, and all other governmental bodies subject to
financial review.
Thus, economic entities can be as large as a global corporation or as small as the corner newsstand.
They can be an entire organization or one of its parts, and, as mentioned, they can also include you and
the author of this tutorial.
Next, our attention will be focused on corporations and governmental entities because these are the
major disbursers of money for capital outlays.

14.2.3 Transactions
A transaction is a piece of business—a sale, a purchase, a borrowing, the repayment of a loan, the pay-
ment for a service, the issuance of stock, the repurchase of stock, and so on. Transactions allow entities
to function. Transactions, when properly recorded, analyzed, and reported give us the financial condition
and the financial performance of economic entities.

14.2.4 Financial Condition

The “financial condition” of an entity is its financial state of health or well-being at any given point in
time. It is an assessment based on information reported in the firm’s financial statements. One critically
important financial statement (report) is called the “balance sheet” or, more formally, “the statement of
financial condition.” This statement is a “snapshot” or an instantaneous view of the balances of the firm’s
accounts at the time that the statement is prepared. (Note: while the Balance Sheet represents the bal-
ance of accounts at one specific point in time, the Income Statement and Statement of Cash Flow show
the sum effect of all transactions entered into by the firm over a stated period of time.) The points of time
usually selected for publication of the financial statements are at the end of (1) each month, of (2) each
quarter, and of (3) each year. Monthly issues of the balance sheet are primarily for use by management
and might not be disseminated to the public. Quarterly and annual issues are generally published for use
by those stakeholders who need to know or wish to know an entity’s current financial condition; stake-
holders include lenders, suppliers, creditors, and shareholders.

14.2.5 Financial Statement Terminology

Account
The “account” is the basic unit for recording information of a firm’s financial database. Accounts are
grouped into three basic types—assets, liabilities and owner’s equity. An account is a detailed record of
the transactions affecting one or more of these three types. Under the present, widely-used system, each
transaction affects at least two accounts, hence the name “double entry accounting system.”
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Asset
An asset is a resource that an entity owns or controls in order to achieve a future benefit (profit, share of
market, and competitive advantage). Some examples of assets are cash, inventory, accounts receivable,
equipment, furniture, land, and buildings.
• Cash: This account shows the amount of money that a company holds in currency or in its bank
account.
• Inventory: This account reflects the cost (and possibly the quantity) of goods, held for use or
intended for sale, that a company owns. Merchandise (goods intended for sale to customers) is
recorded as an asset when it is purchased or when it is produced. In addition, raw materials (in-
tended for use in production) are also considered to be inventory. The inventory account increases
when inventory is purchased or produced and, conversely, decreases when the goods are sold or the
materials are used.
• Accounts Receivable: This account shows the amount of credit sales the firm has made, that is deliv-
ery of goods or services to customers who then say “Charge it!” or “Bill me…I’ll pay you later.” It is
the amount of money that customers owe to the company and have promised to pay in the future for
goods and services that they have already received. When the customers do pay, accounts receivable
decreases and cash increases.
• Notes Receivable: A promissory note that says that the customer is going to pay an agreed upon
amount in the future.
• Equipment and Furniture: The original (historical) cost of each item of equipment and furniture
is entered (written into, keyed into) an asset account. This account, then, shows the original cost of
individual items and the total cost (investment) for all of the items.
• Land: This account records the cost of the land that is owned by a business.
• Buildings: This account records the initial cost of buildings owned by the business. Some examples
are factories, office buildings, distribution centers, etc.

Land and buildings deliberately purchased for resale are entered into a different account called an
“investment account.”

Liability
A liability is an obligation or debt that is payable to a creditor. Some examples of liabilities include ac-
counts payable and notes payable.
• Accounts Payable: This account is the opposite of accounts receivable; it is the amount that the busi-
ness owes to its suppliers as a result of credit purchases.
• Notes Payable: This account is the opposite of notes receivable. It is a promissory note stating that
the business will pay in the future for goods or services (previously) acquired on credit.

Owner’s Equity
Imagine that all of the assets of a firm were sold and the cash received was used to pay all of the firm’s
liabilities. The remaining cash (value) is called “owner’s equity.” Equity represents the value of the invest-
ment in a business by its owners. Following are accounts that affect owner’s equity:
• Revenues: For proprietorships, partnerships and corporations, revenue is the total of prices for goods
and services that customers agree to pay; revenue is earned through the sale of goods or services. Rev-
enues increase equity.
• Expenses: For proprietorships, partnerships and corporations, expenses are the cost of resources used
for producing and delivering goods or services to customers, e.g., rent, salaries, electricity, gas, etc.
Expenses decrease equity.
• Retained Earnings: For corporations the retained earnings account holds the value of the accumu-
lative profits and losses of the firm since its inception. These retained earnings (profits) are a major
source of the firm’s investment capital.
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• Capital: For proprietorships, partnerships and corporations, capital is the amount of the owner’s
investments over the lifetime of the business. Usually this investment takes the form of cash payments
for shares of the firm’s stock.
• Dividends and Withdrawals: For a proprietorship or partnership, cash amounts withdrawn (for-
mally) by the owner from the business to be used to pay personal expenses is called “withdrawals”
or “draw.” After making a withdrawal, the asset cash and the owner’s equity both decrease. For a
corporation, cash amounts paid to stockholders (not all corporations do this) is called “dividends.”
Interestingly, corporations cannot deduct dividends paid for income tax purposes. However, as with
withdrawals, dividends paid reduce both the cash account and equity.

Equity = Capital (initial and subsequent investments by owners)

+ Retained Earnings (through last year)
+ Revenue for this year
Expenses for this year
– Dividends/Withdrawals made this year

14.2.6 Financial Performance

An entity can be in good financial health and still perform badly—although not for long—by living off what
it has accumulated in the way of past profits. It can be in poor financial health and perform well; indicating
that its health is improving and, if good performance continues, then it will eventually “get well.” Financial
performance over a period of time—a month, a quarter, a year—is recorded, analyzed, and reported in the
“income statement” and in two additional statements that together constitute the key financial reports for an
economic entity—the “balance sheet” (see above), and the “statement of cash flows.”
Not-for-profit entities use similar statements with somewhat different names. The income statement,
for example, is often called the “statement of receipts and expenditures.” The owner’s equity statement is
the “statement of fund balances.” For many such entities, it is not possible to prepare balance sheets, be-
cause there is no way of determining the value of certain of their assets. This is particularly true for federal,
state, and local governments. How, for example, do you estimate the value of Yellowstone National Park?

14.2.7 Accounting Equation

The fundamental equation of accounting is the following:

Assets = Liabilities + Owner’s Equity

If the accounting statements do not result in the above equation being in balance, an accounting error has
taken place (or a fraud in as occurred!). CPA firms catch errors like unbalanced balance sheets.

14.3 Income Statement

14.3.1 Introduction
Income statements are read by managers, the SEC (Securities and Exchange Commission, a federal agen-
cy) and anyone who either owns stock or is interested in buying stock in a particular firm. The income
statement can give the reader a fair idea of management’s overall performance as measured in terms of
profitability revenue and revenue growth, costs, and changes in costs from year to year. The information
in the income statement is the basis for important ratios that can provide additional insights into the
efficiency and effectiveness with which the firm is being operated. It is important to note that the perfor-
mance portrayed in an income statement can differ substantially from one firm to another, depending in
large part on the industry in which the organization competes. For example, a natural resource company
(e.g., Phelps-Dodge) would likely have a different percentage of its revenue going to research and develop-
ment than would a pharmaceutical company (e.g., Merck).

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14.3.2 The Income Statement

When a product is sold to a customer “ready, willing, and able” to buy, the seller can immediately re-
cord the transaction as earned revenue. Because there are very few cash transactions in business these
days, it is quite common for the customer to ask the seller to put the amount of the sale
“on account” or to “bill me” for the price of the transactions. Therefore, even though no cash
changes hands at the time of the transaction, the seller must reflect in the income statement not
only the revenue (as noted above) but also the expenses incurred in earning the revenue. (This is in
accord with what is called the “Matching Principle,” an important concept within the “Generally
Accepted Accounting Principles” (GAAP) that govern accounting in the United States.) (Note: In
the Balance Sheet the effect of this type of transaction would be as follows: recognition of the reve-
nue would increase the value of the firm’s Equity; the customer’s promise to pay later would increase
Accounts Receivable, with the two aspect of the transaction not only keeping the Balance Sheet in
balance, but also exemplifies the “double entry” nature of the accounting system, because the trans-
action affected both of the two accounts “equity” and “accounts receivable.” In the unlikely event
that a customer does pay in cash, the only difference between that and the cashless example de-
scribed above is that the Cash account, not Accounts Receivable would be affected on the asset side
of the Balance Sheet.)
The expenses involved in producing goods or services that have been sold, matched as described
above in the Income Statement with the Revenue earned, are also amounts owed to their respective
suppliers. Once again, the Balance Sheet would be affected depending on how the suppliers are paid,
i.e., in cash (very unusual) or later when an invoice is received. If the suppliers are paid in cash, the
Balance Sheet would see a decrease in Equity by the amount of the expense incurred, and an increase in
(the Liability) Accounts Payable. If paid in cash, the (Asset account) cash would decrease and Accounts
Payable would not be affected. Either way, the balance sheet remains in balance and the equity accounts
accurately reflect the difference between the assets and the liabilities that belong to the owners.
If revenues exceed expenses during any given period, the earnings for the period are positive (that is, a
Profit is earned). If the difference is substantial (or, occasionally, even if it is not), management may decide
to distribute some of the earnings to the owners. These distributions, which are called “dividends” for
corporations and withdrawals (“draw”) for proprietorship and partnerships, reduce the equity of the firm
as well as (usually) the Cash account.
The portion of the earnings that is not distributed to owners accrues to the firm’s benefit as an in-
crease in Equity; the firm’s Retained Earnings and is a source of investment capital.
The statement of income equation for any given accounting period can be expressed as follows:

Revenues – Total Costs and Taxes = Earnings=Net Income

Letting R stand for revenue, C for costs and expenses and ∆E for increase in equity over the period (be-
fore any distribution to owners) gives us
R-C=∆E

The above equation is the model for statements of income. A typical example is given in Table 14.2

For our example, the revenues for the period are $800,000 (1). The total expenses before taxes are $
710,000 (CoGS of $500,000 (2) + G&A of $200,000 (4) + interest of $10,000 (6)), and the earnings be-
fore taxes, often referred to as the net income before taxes, would be the difference, or $ 90,000 (7). The
“net earnings” or income after taxes would be $75,000 (9). The total expenses of $710,000 are broken
down into three categories: the cost of goods and services sold (CoGS), which total $500,000 (2); the
Operating Expenses (includes General and Administrative expenses (G&A)), which total $200,000 (4);
and the miscellaneous expenses, such as interest payments on borrowed funds which total $10,000 (6).

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Table 14.2. A Typical Income Statement

XYZ Company
Income Statement for the Year Ending December 31, 200X
(1) Revenues   $800,000
(2) Less cost of goods and services   $500,000
(3) Gross profit   $300,000
Less operating expenses    
(4.1) Sales and marketing expenses $100,000  
(4.2) General and administrative expenses $100,000  
(4) Total operating expenses   $200,000
(5) Income before taxes   $100,000
(6) Less: Miscellaneous revenue and expenses (interest)   $10,000
(7) Net income before income taxes (NIBT)   $90,000
(8) Less: Income taxes   $15,000
(9) Net income after income taxes (NIAT)   $75,000

Earnings Before (After) Income Taxes are synonymous with Net Income Before (After) Income
Taxes. There may be depreciation expenses included in either or both cost of goods sold (for production
facilities and equipment) and operating expenses (for administrative facilities and equipment).
In general, Income Statements cover a one-year period, with the period or “fiscal year” ending at a
specified date, often December 31 of the corresponding calendar year. Many firms for various reasons
operate on a fiscal year that ends at a time other than December 31. Annual reports for public firms must
be audited by a certified public accounting (CPA) firm, and, if approved, carry the certification of the
auditors as well as of the firm’s top managers.

14.4 Balance Sheet

14.4.1 Introduction
The Balance Sheet represents the information related to the fundamental accounting equation outlined
in the prior chapters. Please review that section and any definitions of the accounts classified as Assets,
Liabilities, and Equity before continuing with this section. Companies report this information in annual
reports to shareholders and to the SEC, as this is a document that is required to be published annually.
The balance sheet will always be in balance unless there is an accounting error (or fraud).

14.4.2 The Balance Sheet

The financial condition of an entity is given by its assets (what it owns) and its liabilities (what it owes).
The difference between the two is ‘’owner’s equity,” which is also referred to as “net worth,” “net assets”
or just “equity”. As we have seen, the Balance Sheet summarizes and exhibits the account balances of the
firm in the categories: Assets, Liabilities and Equity. The Balance Sheet is sometimes called the “Statement
of Financial Condition.”
An important distinction is made between current assets and long-term assets, and current liabilities
and long-term liabilities. Assets, Liabilities, and Owner’s Equity are tied together by the fundamental
equation of accounting, which is as basic to accounting as the law of conservation of energy is to the natu-
ral sciences. The equation is:
Assets - Liabilities = Owner Equity

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Or, as it is usually written,

Assets= Liabilities + Owner Equity

Rewritten in equation form:

A= L + E
Where A = Assets, L = Liabilities, and E = Owners’ Equity

You can see and touch tangible assets. You can see and touch the pieces of paper that document
liabilities. However, you can’t touch equity, because it is nothing more than the difference that brings
balance sheets into balance. (That occurs when the two sides of the fundamental equation are, in fact,
equal.) Consider the house that you might have bought for $200,000 with a $175,000 mortgage. The
house is an asset; the mortgage is a liability. Your equity is the difference: $25,000. You can’t see, hear,
smell, or touch this difference, but you can see the house and you can touch the mortgage note in your
desk drawer.
Assets may be broken down into three categories, current, fixed and other. Current assets consist of
cash and items that can be quickly (usually within a year) converted into cash. Fixed assets (often called
“non-current” or “long term”) consist of land (property, which cannot be depreciated), plant (buildings)
and equipment (which are depreciable, if owned). Other assets include such intangibles as patents, copy-
rights and any other asset that is not classified as current or fixed. Sometimes these intangible assets are
considered long term because they have long expected useful lives.
Usually assets are listed beginning with the most liquid asset at the top and the least liquid at the
bottom. Therefore, current assets would precede fixed assets. Marketable securities such as U.S. Treasury
bills or certificates of deposit represent very liquid and short-term investments. Hence, they are frequently
viewed as a form of cash. Accounts receivable represent the total money owed to the firm by its customers.
Inventories include raw materials, work in process (partially finished goods), and finished goods held by
the firm. All of these would be considered to be current assets.
All assets are entered into the financial data base at their actual (“historical”) cost, which includes
transportation and installation costs, if applicable. The term “Net Fixed” means that the value displayed is
the difference between total fixed asset costs and the accumulated depreciation related to those assets. The
net value of fixed assets is called their “Book Value.”
Liabilities are broken down into two major categories, current and long-term (non-current). Current
liabilities are amounts due in one year or less. Long-term liabilities are due more than one year into the
future. Like assets, the liabilities and equity accounts are listed on the balance sheet from short-term to
long-term. Current liabilities include Accounts Payable (amounts owed for credit purchases by the firm),
Notes Payable, outstanding short-term loans (typically from commercial banks) and accruals, amounts
not yet paid, but owed for which a bill may not yet have been received. (Examples of accruals include tax-
es due to the government and wages due to employees.) Long-term debt represents that part of any debt
for which payment is not due in the next twelve months.
One important Balance Sheet term you should be familiar with is “Working Capital.” This is tech-
nically the difference between the values of the current assets and the current liabilities. Estimates of the
investment required for (the “infusion of ”) working capital enter into the capital project selection process.
A General Ledger is a summary of all of the organization’s accounts. An adjusted Trial Balance is pre-
pared from the General Ledger. It is used to organize the information from the general ledger to create the
Balance Sheet and Income Statement.
Equity is usually broken down into at least two major accounts. The first, paid-in capital (also called
Capital, Common Stock) is that portion of the difference between the assets and liabilities that was
contributed by owners both initially and whenever additional capital was needed. The second, retained
earnings, is that portion of the difference between assets and liabilities coming from Net Income, earned
from the production and sale of goods and services, that is, from earnings that were retained in the
business and not distributed as dividends to shareholders or as withdrawals to sole proprietors or partners.
Managers strive to make the difference between the assets and liabilities at the end of an account-
ing period larger than it was at the beginning of the accounting period by increasing retained earnings
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by earning profits for the firm. When achieved, this means that the value of the firm for the owners has
increased. We can formulate this objective very simply, as follows:
Let A1, L1 and E1 be the assets, liabilities, and equity at the beginning of the period and A2, L2 and
E2, the assets, liabilities and equity at the end of the period. By the balance sheet equation,

A1 –L1 = E1 and A2 – L2 = E2

Subtracting the first equation from the second gives

(A2-A1) – (L2 –L1) = (E2 – E1) or ∆ A - ∆ L = ∆ E

If ∆ E is positive, management has succeeded in increasing the difference between assets and liabilities
over the time period under study.
The assets total $ 550,000 (9) and the liabilities $200,000(14). The difference of $350,000((9)-(14))
is the equity. As shown in Table 14.3, ASEM LLC had the following items on its December 31, 200X
balance sheet:

Table 14.3. Assets, Liabilities, and Equity for ASEM LLC

    Dates 200X
Cash and equivalents $73,000 31-Dec
Notes payable $33,000 31-Dec
Long-term debt $175,000 31-Dec
Accounts receivable, net $55,600 31-Dec
Non-depreciable assets $196,000 31-Dec
Deferred income tax liability $19,500 31-Dec
Accumulated retained earnings $180,000 1-Jan
Income taxes payable $23,000 31-Dec
Inventories $24,000 31-Dec
Prepaid expenses $9,000 31-Dec
Accumulated Net Worth $35,600 1-Jan
Property, plant and equipment, at initial cost $418,000 31-Dec
Accounts payable $33,700 31-Dec
Goodwill, patents and trademarks $12,300 31-Dec
Short-term Debt $21,200 31-Dec
Accumulated depreciation $178,000 31-Dec
Retained Earnings $19,900 31-Dec
Additional paid-in capital $69,000 31-Dec

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Table 14.4 contains the Balance Sheet for ASEM LLC, as of Dec 31, 200X.

Table 14.4. Balance Sheet for ASEM LLC

BALANCE SHEET (as of Dec. 31, 200X)

ASSETS LIABILITIES
Current Assets (<= 1 yr)   Current Liabilities (<= 1 yr)  
Cash and equivalents $73,000 Accounts payable $33,700
Accounts receivable, net $55,600 Short-term debt $21,200
Inventories $24,000 Income taxes payable $23,000
Prepaid expenses $9,000 Notes payable $33,000
       
Total Current Assets $161,600 Total Current Liabilities $110,900
 
Fixed Assets (>= 1 yr)   Long Term Liabilities (>= 1 yr)  
Non-depreciable assets $196,000 Long-term debt $175,000
Depreciable assets:   Deferred income tax liability $19,500
Property, plant and equipment, at initial
$418,000    
cost
(Less) Accumulated depreciation $178,000    
Net depreciable asset, at book value $240,000    
    Total Long Term Liabilities $194,500
Total Fixed Assets $436,000 Total Liabilities $305,400
       
Intangible Assets   STOCKHOLDER’S EQUITY
Goodwill, patents and trademarks $12,300 Accumulated retained earnings $180,000
(Add) Retained earnings carried over from
    $19,900
Income Statement
    Accumulated Net Worth $35,600
    Additional paid-in capital $69,000
Total Intangible Assets $12,300    
    Total Stockholder’s Equity $304,500
Total Liabilities &
Total Assets $609,900 $609,900
Stockholder’s Equity

14.5 Stockholder’s (Owner’s) Equity

14.5.1 Introduction
The stockholder’s equity was chosen to be expanded upon because it is often the most confusing aspect
of the balance sheet and the basic accounting equation. Assets and liabilities are more easily understood,
whereas stockholder’s equity is a more abstract concept. It is always important to note that if the accoun-
tant knows the value of assets and liabilities, he or she can easily calculate stockholder’s equity.

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14.5.2 Stockholder’s Equity

This tutorial is an extension of section 4—the Balance Sheet. While there are multiple sources of equity,
the two primary sources of equity are:
• The amount provided directly by equity investors, which is called the total Paid-In Capital.
• The amount retained from profits (or earnings)—that is, the amount of net income that has not been
paid to owners in the form of dividends—which is called Retained Earnings.

Creditors can sue the entity if the amounts due to them are not paid. Owners (Equity Investors)
have only a residual claim; that is, if the entity is dissolved, they are entitled to whatever is left after the
liabilities have been paid. Therefore, liabilities are the primary claim against the assets and equity is the
secondary claim.
We can describe the right-hand side of the balance sheet in two distinct, but correct ways:
1. As the amount of funds supplied by creditors and owners
2. As the claims of these parties against the firm’s assets

The equity section is often labeled “Shareholder’s Equity” or “Owner’s Equity.” Equity consists of
capital obtained from sources that are not liabilities. Table 14.3 shows the two sources of equity capital:
1. $275,000, which is labeled “Paid-in Capital”; and
2. $75,000, which is labeled “Retained Earnings”

Table 14.5. Two Sources of Equity Capital for Shareholder’s Equity

Dec. 31, 200X

Paid-in Capital* $ 275,000
Retained Earnings** $ 75,000
Total Stockholder’s Equity $ 350,000

Assume that a company’s retained earnings in the fiscal year 200X + 1 is $100,000 (Paid-In Capital is
held constant). Then, the Stockholder’s equity for the following year is shown in Table 14.6:

Table 14.6. Stockholder’s Equity Based Upon Two Sources of Equity Capital

Dec. 31, 200X + 1

Paid-in Capital* $ 275,000
Retained Earnings** $ 175,000
Total Stockholder’s Equity $ 450,000

* Paid-in capital amount comes from previous year’s balance sheet.

** Retained earnings are computed as follows

Retained Earnings for 200X + 1 = Retained Earnings for 200X + Net Income after Taxes (less dividends, if any)
for 200X + 1.

14.5.3 Paid-In Capital

Paid-In Capital is the amount of capital supplied by equity investors. They own the corresponding equity
(shares of stock representing the value to the owners of the firm). The details of how this item is report-
ed depend on the type of organization. XYZ Company is a corporation, and its owners receive shares
of common stock as evidence of their ownership. Therefore, they are called Shareholders (or Stockhold-
ers). Individual shareholders may sell their stock to another person, but this has no effect on the balance
sheet of the corporation. The market price of shares of Microsoft changes practically every day, but the
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amount of Paid-In Capital reported on the Microsoft balance sheet is not affected by these changes. This
is consistent with the entity concept: that is, transactions between individual shareholders do not affect
the Balance Sheet of the entity (the economic entity “Microsoft” is distinct from the economic entities
“individual stockholders”).

14.5.4 Retained Earnings

The other equity item, $75,000, shows the amount of equity that has been earned by the profitable opera-
tions of the company and that has been retained in the entity; hence the name, Retained Earnings.
Retained Earnings represents those amounts that have been retained in the entity after some part (or
none, for some firms) of the company’s earnings (i.e., profits) has been paid to shareholders in the form of
dividends. In the form of an equation:

Retained Earnings = Earnings – Dividends

Retained Earnings are additions to equity that have accumulated since the entity began, not those of a
single year. The amount of Retained Earnings shows the amount of capital generated by operating activi-
ties and retained in the entity. It is important to note that retained earnings are not cash. Cash is an asset.

14.5.5 Example of Retained Earnings

ASEM Corp. had the following items on its December 31, 200X Stockholder’s Equity Statement as
shown in Table 14.7.

Table 14.7. ASEM Corporations Stockholder’s Equity Statement on December 31, 200X

    Dates 200X
Accumulated Retained Earnings $273,500 1-Jan
Retained Earnings ($29,600) Jan 1 - Dec 31
Accumulated Net Worth $320,000 1-Jan
Additional Paid-In Capital $71,000 31-Dec

Using the given data, prepare the Stockholder’s Equity Statement for ASEM Corp., as of December 31,
200X is shown in Table 14.8.

Table 14.8. Stockholders’ Equity Statement for ASEM Corp as of December 31, 200X

TOTAL STOCKHOLDER’S EQUITY (as of Dec. 31, 200X)

Accumulated retained earnings $273,500
(Add) Retained earnings carried over from Income Statement ($29,600)
Accumulated retained earnings $243,900
Accumulated net worth $320,000
Additional paid-in capital $71,000
Total Stockholder’s Equity $634,900

14.6 Cash Flow Statement

14.6.1 Introduction
You have already become familiar with the Income Statement and Balance Sheet. The Cash Flow Statement
is the last of the major financial statements that would be taught in an introductory course in accounting.

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The Cash Flow Statement essentially converts the accrual basis of accounting that is used to create the
Income Statement and Balance Sheet into a cash basis. Although the accrual style is helpful in analyzing
revenues and expenses, organizations also find it useful to have an understanding about the amount of
cash the organization has at its disposal.

14.6.2 The Cash Flow Statement

Financial management probably spends more time recording, analyzing, and forecasting cash flow than any
other financial matter. The reporting is summarized in a statement of cash flows (cash flow statement) in
which the analysis starts at the beginning of the period Table 14.9 shows an example. The difference, which
is either positive or negative (or possibly zero), is analyzed by breaking down the cash flow into three parts:
• Cash flow from operating activities, that is, running the business on a daily basis (i.e., cash received
from selling a product/service and paying the related expenses)
• Cash flow from investing activities (i.e., cash flows related to buying and selling the facilities in which
the firm operates and from purchasing/selling businesses—mergers and acquisitions)
• Cash flow from financing activities (i.e., cash related to taking out and repaying loans, buying and
selling stocks/bonds and paying dividends).
• Or economic studies on project selection, estimates of future cash inflows and outflows from operat-
ing activities are prepared with the help of pro forma income statements (forecasts of income).

Table 14.9 contains an example of cash flow reporting.

Table 14.9. Cash Flow Statement

XYZ Company
Statement of Cash Flows, 200X
Cash Flow from Operating Activities
Net Income………………………………………………………………$75,000
Adjustments:
Depreciation Expense… …………………$100,000
Changes in working capital accounts:
Decrease in accounts receivable……..…$20,000
Increase in Inventory……………………..$(40,000)*
Decrease in accounts payable…………..$(30,000)*
Increase in accrued wages………..…… $40,000
Change in working capital……………………..$(10,000)*
Total adjustments to net income……………................................$90,000

Total cash flow from operations………………………….…….…..$165,000

Cash Flow from Investing Activities

Purchase of plant………………………………$(60,000)*
Total cash flow from Investing Activities....................................$(60,000)*

Cash Flow from Financing Activities

Issuance of long-term debt………………………. $10,000
Dividends paid…………………………………… $(12,000)*
Total cash flow from Investing Activities.....................................$(2,000)*

Net increase in cash and cash equivalents……….………………$103,000

* Parentheses indicate decreases in cash

Note: Cash Flow statements can be prepared using two different methods, each of which determines the same, correct end-
ing balance of cash; the methods are the direct method and the indirect method. Differences in the two methods lie only in the
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Operating Activities section. The description below uses the indirect method to prepare the Cash Flow statement.
The first section of the cash flow statement (Table 9.4) reports how much cash was generated by the
operating activities of the period; that is, from the day-to-day activities that bring cash in from customers
and pay cash out to employees and suppliers. To do this, we must first convert net income—the bottom
line of the net income statement—from an accrual basis to a cash basis. “Cash flow from operating activ-
ities” is the difference between operating cash inflows and operating cash outflows.
The second part of the cash flow statement reports cash flows from investing activities: acquisition
of new fixed assets and cash inflows from sale of existing assets. The acquisition amount may not be an
immediate net decrease in cash because the payment of cash may have been partially or completely offset
by borrowing an equal amount (loans). Nevertheless, whatever amount of cash was paid is recorded as a
cash outflow, and the amount of the borrowing is recorded separately as a financing activity.
Companies may obtain cash by issuing debt securities, such as bonds or stock. These are called
financing activities. Cash flows from financing activities include cash receipts or disbursements from
one or all of the following: the sale of stock by a corporation to provide paid-in capital, entering into a
long-term loan, repaying the loan, and distributing dividends or drawings. However, Interest payments on
borrowed funds are not treated as financial activities but as operating activities.
In the selection process, we usually start with the assumption that the first cost and the working cap-
ital (the funds needed to “set up shop” before cash flows in from sales) for a new venture are supplied by
equity financing, that is, by investors rather than creditors. If the results are favorable, we then examine a
mixture of equity and creditor financing or even consider leasing to conserve cash.
The three groups of activities that affect cash flow—operating, financing, and investing—are all
involved in the cash flow patterns to help analyze capital investment opportunities. The above discussion
shows the cash flow statement for a company.

14.6.3 Example of Cash Flow Statement

Table 14.10 and 14.11 contains for Merino Realty had the following items on its December 31, 200X
Income Statement and the associated Cash Flow Statement. Note that the income tax bracket for the
company is 35%.

Table 14.10. Revenue and Expenses for Merino Realty

    Dates 200X
Revenues $334,000 Jan 1 - Dec 31
Interest expense $14,600 Jan 1 - Dec 31
Cost of sales (Cost of Goods Sold) $197,400 Jan 1 - Dec 31
Administrative Salary Expense $23,400 Jan 1 - Dec 31
Insurance Expense $12,300 Jan 1 - Dec 31
Depreciation Expense $27,700 Jan 1 - Dec 31
Dividends paid $3,200 Jan 1 - Dec 31
Interest income $6,500 Jan 1 - Dec 31
Selling and administrative expenses $58,000 Jan 1 - Dec 31

The income tax bracket for the company is 35%.

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Using previously given information, Table 14.11 is the Cash Flow from the Income Statement.

Table 14.11. Cash Flow from Merino Reality Income Statement

CASH FLOW FROM INCOME STATEMENT (Jan. 1 - Dec. 31, 200X)

Revenues $334,000
(Less) Cost of sales (Cost of Goods Sold) $197,400
Gross Margin $136,600
(Less) Selling and administrative expenses $58,000
(Less) Administrative Salary Expense $23,400
Operating Income $55,200
(Add) Interest income $6,500
(Less) Interest expense $14,600
(Less) Insurance Expense $12,300
(Less) Depreciation $27,700
Income Before Taxes $7,100
(Less) Provision for income taxes $2,485
Net Income $4,615
Dividend Paid $3,200
Net Income after Dividend $1,415
Add back Depreciation $27,700
Cash Flow from Income Statement $29,115

14.7 Depreciation
14.7.1 Introduction
Depreciation is a methodology used by organizations to distribute the cost of a capital asset over a long
period of time. For example, if a company invests in an expensive super computer, the company is
required by tax law in the U.S. to allocate the cost of that computer over a span of a few years, using the
depreciation technique. If the company did not do this, the year in which the company bought the super-
computer would probably result in financial statements that are significantly worse than the year before. It
is important to note that depreciation is considered a non-cash expense.
Depreciation is often a difficult subject to grasp for students. You may need to review this tutorial
two or more times before you fully grasp the concept, or you can review the textbook.

14.7.2 Depreciation
Depreciation is the expense associated with allocating the cost of a capital asset (except land) over its
useful life. Land, being appreciable, is not depreciated. All other capital assets that a company buys are
depreciated. The portion of the first cost of an asset that is consumed through use over a period of time is
called depreciation (depreciation expense).

14.7.3 Depreciation Terminology

First Cost (Historical Cost)

It is the original price paid for an asset, i.e., the price at which the asset was acquired, including transpor-
tation and installation.

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Estimated Useful Life

It is the length of service the business expects to get from an asset. Some define useful life as the length of
time that a “prudent manager” would decide to use the asset.

Accumulated Depreciation
This account is used to show the cumulative sum of all depreciation expense for an asset from the date
on which the asset is acquired. The balance of this account increases over the life of the asset that is being
depreciated.

Book Value
It is the first cost of a depreciable asset, less its accumulated depreciation.

Book Value = First Cost - Accumulated Depreciation

Depreciable Cost
Depreciable cost can be defined as:

Depreciable Cost = First Cost of the Asset – Estimated Salvage Value

Estimated Salvage Value

It is also known as estimated residual value, or scrap value. It is the expected cash value of an asset if sold
at the end of its useful life.

Plant Assets Disposal

Plant assets have a useful life. When these plant assets cease to be productive, they are usually disposed of.
They can be sold, exchanged or scrapped. When they are sold, a gain or loss on the transaction may be
incurred. It is a gain (technically called a “depreciation recovery”) if the asset is sold for more than its book
value and it is a loss if the asset is sold for less than its book value. We will explain how to calculate the
after tax amounts in section 14.8.3.

14.7.4 Depreciation Methods

The depreciable cost of eligible capital assets is expensed over its estimated useful life. Tax authorities allow
various depreciation methods to be used, and so there are a number of methods for calculating depreci-
ation. We will discuss (1) the straight-line method, (2) MACRS, and (3) the double-declining balance
method.

Straight-Line Method
Straight Line Depreciation Per Year = First Cost - Salvage Value
Useful Life in Years

An equal amount of depreciation expense is assigned to each year of the asset’s useful life. The depre-
ciable cost is divided by the useful life in years to determine the annual depreciation expense.

SL Example: A computer is purchased for $2,200 on January 2001. The salvage value of the comput-
er is $200 and its useful life is four years.
Calculate, using Straight Line method,
• Depreciation expense
• Accumulated depreciation at end of each year
• Book value at the end of the year for each year of useful life of the asset
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SL Depreciation = Cost – Salvage

No.Years

SL Depr. = 2200 – 200 = 500

4
SL Depr Rate = 1 = 1 = 0.25 = 25%
Useful life 4

Table 14.12 presents depreciation schedule for this example.

Table 14.12. SL Depreciation Example

Initial Asset Depreciation Depreciable Depreciation Accumulated Asset Book

Year Cost Rate Cost Amount Depreciation Value
$2,200 $2,200
1 0.25 $2,000 $500 $500 $1,700
2 0.25 $2,000 $500 $1,000 $1,200
3 0.25 $2,000 $500 $1,500 $700
4 0.25 $2,000 $500 $2,000 $200

Thus, Annual Depreciation Amount = Depreciation Rate X Depreciable Cost = (.25 X 2000) = $500 / yr

Depreciable Cost = Cost - Salvage Value = $2200 -$200 = $2000

Note that at the end of amortization, the Book Value must equal the estimated Salvage Value.

MACRS: Modified Accelerated Cost Recovery System

MACRS is mandatory for the federal tax returns under Tax Reform Act of 1986. An accelerated method
similar to the double-declining balance method, it allows deducting larger amounts during the first years
of the asset’s life. The depreciation of a particular asset depends on the classification of that asset. MACRS
defines eight property classes (3 years, 5 years, 7 years, 10 years, 15 years, 20 years, and two real proper-
ty classes). These property classes and the applicable MACRS rates can be referred from Chapter 16 of
Lang/Merino text. To determine the annual depreciation expense for an asset using MACRS, first locate
the asset in the appropriate property class table. In the table, find the year of ownership for the asset and
multiply the first cost of the asset by the percentage given in the table for that year of ownership.

MACRS Example
Stevens acquired, for an installed cost of $40,000, a machine having a recovery period of five years. Using
the applicable MACRS rates, the depreciation expense each year is shown in Table 14.13.

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Table 14.13. MACRS Depreciation Example

Year Cost (in $) (1) Percentages (%) (2) Depreciation (in $) (1 * 2 = 3)

1 40,000 20 8,000
2 40,000 32 12,800
3 40,000 19 7,600
4 40,000 12 4,800
5 40,000 12 4,800
6 40,000 5 2,000
TOTAL 100% 40,000

Double-Declining Balance Method

This method is an accelerated depreciation method as MACRS is. This method calculates depreciation
by allocating larger amounts to the depreciation expense account in the earlier periods of the useful life
compared with the later periods.
It computes annual depreciation by multiplying the asset’s book value by a constant rate, which is two
times the straight-line depreciation rate.
There is much more on depreciation. However, at this time you should be aware that the depreciable
life of an asset (the period of time over which its cost is prorated) does not have to be, and often is not,
the same as its useful life. Accelerated depreciation and inflation often bring the book value of an asset far
below its market value, which is why the discussion that follows on gains and losses from the disposal of
assets is important.1

14.7.5 Gains and Losses from the Disposal of Assets

Gains and losses from the disposal of assets result from the differences between market value and book value.
If market value exceeds book value, there is a gain; if it is less, there is a loss. Consider the following example:

Fair Market Value = FMV; Book Value = BV

Tax Rate = TR; FMV – BV = Taxable Gain/ Loss
Taxable Gain/ Loss * TR = Taxes; After Tax Entry = FMV – Taxes

Example: (Gains and Losses)—The car bought for $30,000 is sold for a cash payment of $20,000 at
the end of two years, at which time its book value is $18,000 ($30,000 less two years of accumulated de-
preciation at $6,000 per year). Its market value on the day of sales is therefore $2,000 more than its book
value. The tax rate is 40%.

FMV-BV = Taxable
Capital Gains: $20,000 – $18,000 = $2,000
Taxes: $2,000 * 0.4 = $800
After Tax Cash Flow: $20,000 - $800 = $19,200

This completes our overview of accounting. The concepts presented here can be understood by one
more example given later in the tutorial. We hope you have found this discipline a more conceptual and
stimulating subject than its image as “bookkeeping” usually conveys.

14.8 After Tax Analysis

14.8.1 Introduction
The section is related to prior chapters on the Income Statement, Balance Sheet, Cash Flow Statement
and Depreciation. You may wish to review those topics before continuing with this section.
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The tax code is very complicated for individuals and corporation in the United States. You probably,
at some point in your life, have filled a tax return with the Internal Revenue Service (IRS). Organizations
have an even more daunting task with more complicated rules.

14.8.2 After Tax Analysis and Cash Flow

The taxes paid and tax related items like depreciation and investment tax credits have a significant impact
on the economics of all aspects of corporate activity, but particularly on Capital Investment.
Economic decision-making is based on Cash Flows (not accounting profit). If you take a course in
Corporate/Managerial Finance you will find that corporations are managed on the Cash Flow.
In Section 14.6 (Cash Flow) you saw that Cash Flows can be generated as part of:
• Operating Activities
• Capital/Finance Activities

Operating cash flows can be determined from the Income Statement. Note that an operating cash
flow is Net Income after Tax plus depreciation. Remember that depreciation is a non-cash (accrual) ex-
pense. Operating cash flows are periodic over a number of years.
Capital Cash Flows can be determined from the Balance Sheet. There are a number of activities that
impact the Capital Cash Flows. Change in inventory levels, financing activities and capital expenditure
are some of these activities. For engineering economics we are interested in investments for depreciable
(plant, equipment, etc.) and non-depreciable (land) capital. For capital projects we are also interested in
loans (to finance capital) and the after tax sale/disposal of capital at the end of the project.
In the following sections we will provide the calculations and format for
• Net Cash Flow from Operating Activity
• Net Cash Flow from Capital Activity

as well as the After Tax Cash flows for

• Depreciation
• Loans/Borrowings
• Salvage/Disposal of Capital Items

14.8.3 After Tax Cash Flow from Depreciation Charges

Section 14.7 described various depreciation methods and how to calculate them. Note that depreciation
is a non-cash (accrual) entry and as such is added back to the Net Income after tax to yield the cash flow
from operating activities.

14.8.4 After Tax Cash Flow from Investment Tax Credit

From time to time government/agencies (U.S., State and sometime local) give incentives for business to
make capital Investments. This is usually during a recession or natural disaster (like Hurricane Katrina)
and is designed to increase capital spending.
Why Capital Spending? The concept is that for every dollar spent on capital goods, the Gross Na-
tional Product (GNP and GDP) will increase many fold (6 to 8 times). In Macro-economics this is called
the “Multiplier Effect.” The Investment Tax Credit (ITC) allows a company to subtract some part of the
Capital purchase price from the Income Tax it pays.
For example, if the ITC is 10% and the company makes a $200,000 capital investment then the
company can deduct $20,000 from its taxes (usually in year 0 or 1). It is assumed that the company
will keep the Capital asset in service for a certain number of years. If it does not, it may have to give
back some of the ITC. This is called re-capture. You need to seek Tax Counsel on this matter because
the rules are complex. ITC for solar panels or energy saving items like Hybrids cars are examples that
apply to consumers.

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14.8.5 After Tax Cash Flows from Loans

The after tax analysis with loan repayment includes are the steps in Table 14.13 plus interest expenses. In-
terest is subtracted from the net cash flow before income taxes are calculated since interest is tax deduct-
ible, requiring it to be eliminated from the taxable income.
Interest charges benefit the organization because it reduces the taxable income and, hence, the income
taxes. The principal payments are being subtracted in Table 14.5 since principal is NOT tax deductible.
When dealing with loans, we need to understand the difference between interest and principal. Principal
is the actual amount you have borrowed or the remaining, unpaid balance owed to the lender. Interest is
most easily described as the fee charged by the lender for lending you the principal. It is usually expressed
in as annual percentage of the principal. Interest is generally tax deductible, meaning it REDUCES tax-
able income.
Table 14.14 provides an example on how to “amortize” a loan. The example assumes that the interest
rate is 10% and the loan is repaid in four years. The amount of the loan is $80,000. Annual payment is
calculated using the time value of money equation:
A = P (A/P, I, N) = $80,000(A/P, 10, 4)
A = $80,000 x .3155 = $25,240/year

Table 14.14. Loan Balance / Amortization Table

Beginning-of- year Annual Principal

Year Annual payment* Annual Interest End-of-Year Balance
balance Repayment
(1) (2) (3) (4) (5) (6)
10% of (2) (3) - (4) (2) – (5)
01 $80,000 $25,240 $8,000 $17,240 $62,760
02 $62,760 $25,240 $6,276 $18,964 $43,796
03 $43,796 $25,240 $4,380 $20,860 $22,936
04 $22,936 $25,240 $2,294 $22,936 0
Total 80,000

14.9 Accounting Process

14.9.1 Introduction
The accounting process is governed by laws to prevent fraud, insider trading, and unfair practices. This tu-
torial does not introduce these laws; however, you should note that if there is any doubt as to the ethics of
the accounting process in your organization, you should consult references available on the subject. Most
references guide you to practice methods introduced below.

14.9.2 The Accounting Process

The accounting process is a systematic and logical methodology for processing a myriad of transactions to
produce the financial statements on which managers, bankers, creditors, suppliers, and shareholders rely.
We highlight this process below but suggest that you also go to one or more of the suggested references
provided by your professor.

14.9.3 Double Entry Accounting

Double entry system of accounting means that each business transaction influences at least two accounts.
The accounting equation needs to balance, so if there is a change on one side of the equation, some
item(s) on the other side need to be changed to maintain the balance.

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The process begins with the journal or daily record of transactions. We know that every transaction
must be recorded in at least two accounts; otherwise, balance sheets would not balance. One of these ac-
counts is debited (entered on the left or “debit” side of the T-account), and the other is credited (entered
on the right of “credit” side of the T-account).
The words debit and credit refer to the left and right side of the T-account respectively for the purpos-
es below. Their abbreviations are dr. (debit) and cr. (credit). Each “simple” journal entry (a simple entry is
one that affects just two accounts) is therefore recorded as shown in Table 14.15.

Table 14.15. T-account Method of Recording Debits and Credits

Debit Credit

Name of first account $ XXXXXXX

Name of second account $ XXXXXXX

Note that accounting requires that the sum of all the debits pertaining to a transaction must equal the
sum of all the credit for those same transactions. Not shown, but part of the journal record of the transac-
tion, are the date, the amounts to be “posted” in the affected accounts and, if needed, a brief description
of the transaction.
Table 14.16 shows how assets, liabilities, and equity should be recorded.

Table 14.16. Location of Typical Items That are Posted

Increase in assets Debits

Decrease in assets Credits
Increase in liabilities Credits
Decrease in liabilities Debits
Increase in equity Credits
Decrease in equity Debits

14.10 Financial and Managerial Accounting

141.10.1 Introduction
This section covers cost-volume-profit (CVP) analysis. CVP analysis is the study of effects of output
volume on revenue (sales), expenses (costs) and net income (net profit). The most basic CVP analysis
computes the monthly break-even point in number of units and in dollar sales. To apply this analysis,
some simplifications must be assumed. The costs have to be simplified into fixed and variable costs.
Total Sales Revenue - Total Costs = Profits
Sales - Costs = Profits
Sales = Costs + Profits
Sales = Fixed Costs + Variable Costs + Profits

Therefore, the CVP equation can be written as:

Units sold * Selling Price per Unit = Fixed Costs + (Variable Cost per Unit * Units Sold) + Profits

14.10.2 Breakeven Analysis

The breakeven point is the point where the sales revenue equals the total costs and is demonstrated in
Figure 14.1. The breakeven point is the point where the sales revenue equals the total costs.

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Figure 14.1. Concept of Breakeven Analysis

Units Total Revenue

Total Cost

Profit

Breakeven Sales
(In Units)
Variable Cost

Fixed Cost

Loss

Dollars

As you can see, the net income is zero at the breakeven point.

14.10.3 Contribution Margin

It is the amount that covers fixed costs first and then provides profits for the period. When the contribu-
tion margin is higher than the fixed costs we have a profit, and when the contribution margin is lower
than the fixed costs, we have a loss. If the contribution margin is equal to the fixed costs, the profit is zero
and this point is called breakeven point.

Contribution Margin = Sales Revenue - Variable Costs

14.10.4 Contribution Margin Ratio

Contribution Margin Ratio is the proportion of each sales dollar available to cover fixed costs and provide
profits. It is the ratio of contribution margin to sales.

Contribution Margin Ratio = Contribution Margin

Sales

14.10.5 Breakeven Sales in Dollars

We get this equation in terms of the contribution margin ratio.

Sales = Fixed Costs + Variable Costs + Profits

Sales - Variable Costs = Fixed Costs + Profits

This equation can be rewritten in terms of the Contribution Margin if the equation is divided by
Sales on both sides.

Contribution Margin Ratio = Contribution Margin

Sales

Hence, Contribution
Margin Ratio = Fixed Costs + Profits
Sales

To calculate the breakeven sales, the profits are set at zero, and it gives us the following equation:

Contribution Margin Ratio = Fixed Costs

Breakeven Sales
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From this equation we get the Breakeven Sales,

Breakeven Sales = Fixed Cost
Contribution Margin Ratio

Breakeven Sales in Units = Fixed Costs

(Unit Selling Price – Variable Unit Cost)

14.10.6 Target Net Profit

To achieve the target net profit, the minimum amount of units that must be sold can be calculated as follows:

Selling Price per Unit * Units Sold = Fixed Costs + (Variable Cost per Unit*Units Sold) +
Target Net Profit

Units * (Selling price per unit - Variable Cost per Unit) = Fixed costs + Target Net Profit
Units * Unit Contribution Margin = Fixed Costs + Target Net Profit
Units to Earn Target Net Profit = (Fixed Costs + Target Net Profit) / Unit Contribution Margin

14.10.7 Sales to Achieve Target Return on Sales

Return on Sales, also known as Income percentage of revenue, helps you determine if the organization is
generating enough returns on the sales effort. Following is the formula used to calculate Return on Sales:

Return on Sales = Income / Revenue

14.10.8 Degree of Operating Leverage

Operating leverage ratio is the ratio of fixed to variable costs. A company has less leverage when the fixed
costs are lower than the variable costs. When the proportion of fixed costs in relation to variable costs is high,
the operating leverage is high, and the profits are more sensitive to changes in sales volume. The degree is a
measure of how changes in sales volume affect the profits. The lower the costs are for manufacturing a unit,
the higher the contribution margin per unit. This is why it is important to manage a good cost structure.

14.11 Advanced and Other Topics

This chapter covered the fundamentals of accounting, basic financial accounting, and some of the ad-
vanced topics in cost costing and cost estimation. Section 14.13 provides a mapping of all of the topics to
two standard references in the field.
The topics not covered in this chapter are as follows:

I. Basic Accounting—Fundamentals
A. Asset & Inventory: LIFO; FIFO
II. Basic Financial Accounting
A. Financial Ratios
B. Capital Structure of Firm
C. Stocks, Bonds and Financial Instruments
III. Advanced Cost Accounting—Fundamentals
G. Activity Based Costing (ABC)
H. Flexible & Master Budgets
I. Performance Assessments
J. Ethical Considerations—SoX
IV. Advanced Cost Estimation
A. Statistical Cost Estimation
B. Use of Cost Indices and Cost Factors
C. Design for Cost / Affordability / Target Costing

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 Basic Accounting and Finance

14.12 Summary
One chapter can hardly cover the basics of accounting and finance other than a cursory presentation of
the subject matter. Yet, few subjects are more important in modern business than the understanding of
the finances of a corporation or an individual project. Engineering managers must understand the financ-
es of a business to provide value.

14.13 References
The following are two standard references in this field. The following table maps the topics in this chapter
to these references.

Merino, Donald N., Accounting for Engineers, Engineering Management Body of Knowledge, American
Society of Engineering Management, vol 1.1, Nov. 2007.
Riggs, Henry E., Financial and Cost Analysis for Engineering and Technology Management, John Wiley
& Sons, Inc., 1994, ISBN: 0-471-57415-5; ISBN (13): 978-0471574156.
Easton, Peter, Halsey, Robert, McAnally, Mary, and Hartgraves, Al, Financial & Managerial Accounting for
MBAs, 1st edition, Cambridge Business Publishers, 2008, ISBN: 0-9787279-1-6.

Topics Referenced to Standard Texts in the Field

References 1 2
Authors Riggs Easton, ..
I. Basic Accounting—Fundamentals
A Debits and Credits 3 1
B. Assets, Liabilities 3 1
C. Income, Expenses 3, 4 1,2
D. Equity Definitions 2 1-3
E. Income Statement 4 1-3
F. Balance Sheet 3 1-3
G. Cash Flow Statement 11 1-3
Integration of Income Statement; Balance Sheet and Cash Flow
H. 2, 3
Statement
I. Asset & Inventory 1, 6 6
II. Basic Financial Accounting
A. Financial Ratios 10 4–6
B. Capital Structure of Firm 10 7–9
C. Stocks, Bonds and Financial Instruments 10 part 12, 13
III. Advanced Cost Accounting—Fundamentals
A. Fixed and Variable Costs 13 15
B. Break-even Analysis 13 16
C. Job, Process and Standard Costs 17 18
D. Direct and Indirect Costs 16 19
E. Cost of Goods Sold; Overhead Costs 16 19
F. Contribution Analysis—Profit and Loss Calculations 18 20
G. Activity Based Costing 16 19
H. Flexible & Master Budgets 12 20, 21
I. Performance Assessments 10 part 22
J. Ethical Considerations—SoX Readings Readings
IV. Advanced Cost Estimation
A. Statistical Cost Estimation NA 15
B. Use of Cost Indices and Cost Factors NA 16
C. Design for Cost / Affordability / Target Costing NA 23

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