Presentation Part 1

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Table of Contents
Section
1 Basic Accounting Assumptions and Principles
2 Overall Considerations
3 Financial Statements
4 The Basic Equation of Accounting
5 The Balance Sheet
6 The Income Statement
7 The Statement of Cash Flows

8 Connections and Associations

Section 1
Basic Accounting Assumptions and Principles
Economic Entity Assumption
• Means that economic activity can be identified with a particular unit of accountability. In other words a
company keeps its activity separate and distinct from its owners and any other business units
Going Concern Assumption
• Unless there is evidence to the contrary, accountants assume that the life of the business entity is
infinitely long. The financial statements should be prepared on a going concern basis; unless
management intends to liquidate the company or cease trading
1 2 3 4
• History of profitable • Ready access to financial • Debt repayment schedule • Current and expected
operation resources profitability

(Continued)
Monetary Unit Assumption
• Means that the money is the common denominator of economic activity and provides an appropriate
basis for accounting measurement and analysis
Periodicity Assumption
• To measure the results of a company's activity accurately, we would not need to wait until it liquidates.
Decision makers however can not wait that long for such information. Users need to know a
company's performance and economic status on a timely basis so that they can evaluate and
compare firms and take appropriate actions. Accordingly, a company can divide its economic
activities into artificial time periods. These time periods vary, but the most common are monthly,
quarterly and yearly
Historical Cost Principle

• What a company owns and what it owes are recorded at their original (historical) cost with no
adjustment for inflation. A company can own a building valued at US$100 yet carry it on the records
at its original purchase of US$50 (less accumulated depreciation). This assumption can greatly
understate the value of some assets purchased in the past and depreciated to a very low amount on
the books

(Continued)
Revenue Recognition Principle
• In accrual accounting, a sale is recorded when all the necessary activities to provide the good or
service have been completed regardless of when cash changes hand
Accrual Accounting and Matching Principle
• If a business action in a period makes money, then all its product costs and its business expenses
should be reported in that period. Otherwise, profits and losses could flop; (such as: fixed assets and
depreciation, inventory and cost of goods sold and prepayment and administrative expenses)
Revenues Expenses
Cash Basis When Collected When Paid
Accrual Basis When Recognized When Incurred

Section 2
Overall Considerations
Introduction
Decision Makers
Benefit>Cost Materiality
Understandability
Decision Usefulness
Relevant Reliable
Predictive Feedback
Timeliness Verifiability RF Neutrality
Value Value
Comparability Consistency

Important Definitions
Decision Makers
• Providers of capital and their advisers

• Employees and their representatives
• Lenders
• Suppliers and other trade creditors
• Customers
• Government and other agencies
• Public
Understandability
• Users are assumed to have:

• A reasonable knowledge of business and economic activities and accounting
• A willingness to study information with reasonable diligence
• Information about complex matters should not be excluded on the grounds that it may be too difficult
for certain users to understand

Important Definitions (Continued)
Consistency of Presentation
• In general, the presentation and classification of items in the financial statements should be retained
from one period to the next
Materiality and Aggregation
• Omissions or misstatements of items are material if they could, individually or collectively,

influence the economic decisions of the users of the financial statements
• Materiality depends on both the size and the nature of the omission or the misstatement
Material Immaterial items

• Present separately • Aggregate with amounts of similar nature and function
• Need not present separately
Conservatism
• When in doubt, choose the solution that will be least likely to overstate net assets and net income

Section 3
Financial Statements
Financial Statements
 The components of the financial statements are set out below:
 Balance sheet
 Income statement
 Statement of cash flows
 Statement of changes in equity
 Significant accounting policies and other explanatory notes
 Entities are encouraged to present additional information, such as: financial review by management,
environmental reports or value added statements

Section 4
The Basic Equation of Accounting
The Basic Equation of Accounting
 The basic equation of accounting is set out below:
 What you have less what you owe is what you are worth
Assets Liabilities Worth

(have) (owe) (value to owners)
 Value to owners means the same thing as worth, net worth, equity, owners' equity and shareholders'
equity – the value of the enterprise to its owners


Section 5
The Balance Sheet
Introduction
 The balance sheet presents the basic equation of accounting in a slightly rearranged form:

 This equation must always be in balance with assets equaling the sum of liabilities and worth
 If an asset is added to the left side of the equation, the right side of the equation must also increase by
adding a liability or equity (including income statement components)

Introduction (Continued)
The Balance Sheet Format
Assets Liabilities and Equity
Cash Accounts Payable
Accounts Receivable Accrued Expenses
Inventory Current Portion of Long-Term Debt
Prepaid Expenses Income Taxes Payable
Total Current Assets Total Current Liabilities
Fixed Assets at Cost Long-Term Debt
Less: Accumulated Depreciation Capital Stock

Net Fixed Assets Retained Earnings
Other Assets Total Owners' Equity
Total Assets Total Liabilities and Equity

The Balance Sheet – A Snapshot in Time
 The balance sheet is a snapshot in time. It is reported as of a certain date
 The balance sheet presents:
 What the enterprise HAS today: Assets
 How much the enterprise OWES today: Liabilities
 What the enterprise IS WORTH today: Equity

(has today) (owes today) (worth today)

Assets
Balance Sheet Format  Assets
Assets  Assets are everything a company owns including but

not limited to: cash in the bank, inventory, machines
Most Liquid
Cash and buildings
Accounts Receivable  Assets have a monetary value such as the right to

collect cash from customers who owe the company
Inventory money; such as accounts receivable
Prepaid Expenses
 Assets are valuable and this value must be
quantifiable for an asset to be listed on the balance
Total Current Assets
sheet
Fixed Assets at Cost
 Amounts paid are recognized as assets when it is
Less: Accumulated Depreciation probable that future economic benefits associated
with the asset will flow to the company (this is

Net Fixed Assets satisfied when risks and rewards have passed to the
company)
Other Assets
Total Assets
Least Liquid

Assets (Continued)
Balance Sheet Format  Assets (Continued)
Assets  A company shall present current and non-current

assets, as separate classification on the face of its
Most Liquid
Cash balance sheet. It is also permitted to present some of
the assets using current and non-current
Accounts Receivable classification and others in order of liquidity when this
provides information that is reliable and is more
Inventory relevant
Prepaid Expenses
 An asset is classified as current when it is:
 Expected to be realized in, or is held for sale or
Fixed Assets at Cost consumption in, the normal course of the
company's operating cycle;
Less: Accumulated Depreciation
 Expected to be realized within 12 months after

Net Fixed Assets the reporting period; or
Other Assets
 A cash or cash equivalent which is not restricted
in its use
Total Assets
Least Liquid

Cash
Balance Sheet Format Cash
Assets  The ultimate liquid asset:
Most Liquid
Cash  Cash on hand including petty cash
Accounts Receivable  Cash at banks (demand deposits)
Inventory  Term deposits

Prepaid Expenses
 Checks for collection
Fixed Assets at Cost  Cash can be denominated in different currencies

(such as USD, EUR, GBP); however, all foreign
Less: Accumulated Depreciation currencies should be converted at the balance sheet
date into the currency in which the balance sheet is

Net Fixed Assets presented
Other Assets
 Post dated checks are prohibited
Total Assets
Least Liquid

Cash (Continued)
Cash at company Cash at bank
 The bank balance in the company's books may be different from the balance shown in the bank's
statement. This does not necessarily mean that one of the balances is the correct one
 In order to ensure which balance is the correct one, a bank reconciliation should be prepared

Cash (Continued)
Bank Reconciliation
Books Bank
Balance per books 1,000 Balance per bank 800
Add: Add:
- Bank collections 100 - Checks for collection 150
- Interest income 10 - Deposit in transit 200
Less: Less:
- Bank service charges (2) - Outstanding checks (48)
- NSF checks (6)

Reconciled balance 1,102 Reconciled balance 1,102
 Refer to exercise 1

Accounts Receivable
Balance Sheet Format

Accounts Receivable
 When a company ships a product or provides a

Assets
service to a customer on credit, it acquires a right to
Most Liquid collect money from that customer at a specified time
Cash
in the future. Accounts receivable should only reflect
Accounts Receivable what will eventually be collected after deducting an
allowance for bad debts (which is NRV). Allowances
Inventory will increase expenses and decrease receivables
Prepaid Expenses  Accounts receivable v/s notes receivable
Total Current Assets  Allowance for doubtful accounts can be determined

in three ways:
Less: Accumulated Depreciation  As a percentage of credit sales

Net Fixed Assets  As a percentage of accounts receivable
Other Assets  Aging of accounts receivable
Total Assets  Refer to exercises 2 and 3

Least Liquid

Inventory
Balance Sheet Format Inventory
Assets  The term inventory includes raw material,

work-in-progress, finished goods and goods for
Most Liquid
Cash sale
Accounts Receivable  Raw material inventory is used during the

manufacturing process
Inventory
Prepaid Expenses
 Work-in-progress inventory is partially
finished products in the process of being
Total Current Assets manufactured
Fixed Assets at Cost  Finished goods inventory is completed

products ready for sale
 Matching principle (sales v/s cost of goods sold)

Net Fixed Assets
Other Assets
 In general, as finished inventory is sold, it
becomes an "accounts receivable" and then
Total Assets cash when the customer pays
Least Liquid

Inventory (Continued)
Inventories are defined as:
Assets held for sale in

the ordinary course of
business
Materials or supplies to
be consumed in the
Assets in the process of
production process or in
production for such sale
the rendering of
services

 Inventories are measured at:
 Lower of cost; and
 NRV
 FMV
 Any cost to prepare the inventory for its intended sale should be capitalized

Inventories are measured at:
NRV FV
• Estimated selling price in the ordinary course of • Amount for which an asset could be exchanged or a
business liability settled between knowledgeable willing parties
• Less: Estimated costs to complete in an arm's length transaction
• Less: Estimated costs necessary to make the sale
• Is the amount that the company actually expects to

make from the selling of that particular inventory;
where fair value is not

 What may be included in cost of inventory?
 Cost of inventory comprises expenditure which has been incurred in the normal course of business in
bringing the product or service to its present location or condition
 Cost formula methods are set out below:
 Specific Identification
 FIFO
 Weighted Average
 LIFO

 Specific Identification
 Items that are not interchangeable

Specifically Identified
 Goods or services produced for specific projects
 Relatively unusual method of valuation
 Such as: antiques, jewelry and automobiles
 This method is inappropriate where there are large number of items that are interchangeable

 FIFO
 First in – First out: Gives the closest approximation to actual cost flows, since this method assumes
that when inventories are sold or used in a production process, the oldest ones are sold or used first.
Consequently, the balance of inventory on hand at any point in time represents the most recent
purchases or production
 Example: During its first year of operations, ABC has purchased all of its inventory in 3 separate
batches
- Batch 1: 4,000 units at US$4.25 per unit

4,000 units in total were sold, 3,000 units after the first purchase and 1,000 units after the second
purchase
Solution: COGS: US$17,000 and Ending Inventory: US$23,250

 Weighted Average
 Used for similar items that are utilized in production/sales without regards to when these items are
received
 Example: During its first year of operations, ABC has purchased all of its inventory in 3 separate
batches

4,000 units in total were sold, 3,000 units after the first purchase and 1,000 units after the second
purchase
Solution: COGS: US$17,889 and Ending Inventory: US$22,361


Prepaid Expenses
Prepaid Expenses
 Bills that the company has paid for services not
Assets yet received such as: prepaid rent or insurance
Most Liquid
Cash  Prepaid expenses are current assets not
because they can be turned into cash, but
Accounts Receivable
because the company will not have to use cash
Inventory
to pay them in the near future (they have been
paid already)
Prepaid Expenses
 Example: On 1 January 2010 ABC company paid
Total Current Assets a rental amount of US$24,000 in advance for a
period of 2 years. Compute the prepaid amount
Fixed Assets at Cost on 31 March 2011
Prepaid expense as at 31 March 2011 amounts
Net Fixed Assets

to US$9,000
Other Assets
Total Assets
Least Liquid

Current Asset Cycle
Cash buys inventory
Inventory when sold

becomes accounts receivable
Accounts receivable upon

collection becomes cash

Fixed Assets
Fixed Assets
 Fixed assets are held by a company for use in

Assets the production or supply of goods or services, or
Most Liquid for administrative purposes and are expected to
Cash
be used for more than one period
Accounts Receivable
 Fixed assets commonly include: land, buildings,
Inventory machinery, equipment, furniture, vehicle and
others
Prepaid Expenses
 Fixed assets are carried at historical cost and
Total Current Assets are subject to depreciation
 Fixed assets are reported in the balance sheet
at net book value which is equal to the cost
minus the accumulated depreciation
Net Fixed Assets

 Any cost to prepare the asset for its intended
Other Assets use should be capitalized; otherwise it should be
expensed; such as: reallocation costs and
Total Assets day-to-day operations
Least Liquid

Fixed Assets (Continued)
 The following expenditures should be included in the cost of fixed assets:
Equipment Building
• Purchase price less discounts • Architectural fee

• Non-refundable taxes • Permission cost
• Import charges and duties • Direct material, direct labor and overhead
• Custom charges • Interest on borrowings during construction
• Insurance while in transit
• Testing and assembling
• Handling delivery for the first time
Land
• Purchase price less discounts

• Broker commission
• Legal title and recording fees
• Draining, clearing and site development
• Cost of razing (net of proceeds)

 Repair and maintenance charges are considered as subsequent costs:
Description Criteria Expense Capitalize
Increase life x
Repair and Maintenance
Increase usefulness x
Cost of day-to-day servicing of the item x

Repair and Maintenance
Servicing costs (labor and
x
consumables) incurred

 Depreciation
 Depreciation amount should be allocated on a systematic basis over the useful life of an asset item
except for land
 The useful life of an asset can be demonstrated as follows:
 The period over which an asset is expected to be available for use by a company; or
 The number of production or similar units expected to be obtained from the asset
 The residual value and the useful life of an asset shall be reviewed at least at each financial
year-end
 Example: An asset which costs $1,000 was estimated to have a useful life of ten years. After two
years, the useful life was revised to four remaining years. Calculate the depreciation charge and the
carrying value (cost – accumulated) for years 1, 2 and 3
 The depreciation charge for each period should be recognized as an expense

 Depreciation is always recognized, even if the fair value exceeds the carrying amount
 Depreciation commences when an asset is available for use

 Depreciation (Continued)
 Depreciation ceases at the earlier of the date the asset is:
 Classified as held for sale; or
 Derecognized (e.g. scrapped or sold)
 Depreciation does not cease when an asset is idle or retired from use for sale (unless it is fully
depreciated)
 Land and buildings are separable assets and are accounted for separately, even when they are
acquired together
 Depreciation methods (to be reviewed annually and, if significant, the method should be changed to
reflect a change in the pattern of consumption of future benefits):
 Straight-line (a constant charge over the useful life of an asset item);

 Sum of the units (charged based on the estimated expected use or output); or
 Diminishing balance (a decreasing charge over the useful life of an asset item)

Exhibit 1: Example (Straight-Line): Cost US$500,000, Salvage Value US$50,000 and Useful
Life in Years 5
Annual
Depreciable Depreciation Accumulated Carrying
Year Depreciation
Cost Rate Depreciation Amount
Expense
1 450,000 20% 90,000 90,000 410,000
2 450,000 20% 90,000 180,000 320,000
3 450,000 20% 90,000 270,000 230,000
4 450,000 20% 90,000 360,000 140,000
5 450,000 20% 90,000 450,000 50,000


Exhibit 2: Example (Sum of the Units): Cost US$20,000, Salvage Value US$2,000 and Useful
Life in Units 10,000
Annual
Units of Activity Depreciation Accumulated Carrying
Year Depreciation
(Given) Rate Depreciation Amount
Expense
1 2,500 180% 4,500 4,500 15,500
2 2,800 180% 5,040 9,540 10,460
3 1,100 180% 1,980 11,520 8,480
4 1,900 180% 3,420 14,940 5,060
5 1,700 180% 3,060 18,000 2,000


Exhibit 3: Example (Diminishing Balance): Cost US$20,000, Salvage Value US$2,000 and
Useful Life in Years 5
Carrying Annual Carrying

Depreciation Accumulated
Year Amount Depreciation Amount
Rate Depreciation
(Beginning) Expense (Ending)
1 20,000 40% 8,000 8,000 12,000
2 12,000 40% 4,800 12,800 7,200
3 7,200 40% 2,880 15,680 4,320
4 4,320 40% 1,728 17,408 2,592
5 2,592 plug 592 18,000 2,000


 Fixed Assets Disposal
 When a fixed asset item is disposed, a gain on disposal might be recognized or a loss on disposal
might be incurred
 Gain or loss on disposal will be calculated as follows:
Gain or Loss on Net Book Value of an

Cash Received
Disposal Asset Item
 Example: ABC company sold an equipment on 31 December 2010 for an amount of US$50,000.
This asset had a cost of US$100,000 and a useful life of 10 years. The asset was acquired on 30
June 2007. Compute the gain or loss on disposal on this item

Other Assets

Other Assets
 The other assets category on the balance sheet

Assets
includes assets of the company that cannot be
Most Liquid properly classified
Cash
Accounts Receivable  It is worth mentioning that other assets may

include current items
Inventory
 Intangible assets can be considered as other
Prepaid Expenses assets unless they represent a significant
portion of the balance sheet
 Intangible assets are assets owned by the
company, that have value, but are not tangible in
Less: Accumulated Depreciation nature. Intangible assets include: patents,
copyrights, franchise, trademarks,…
Net Fixed Assets

 Intangible assets should be recorded in the
Other Assets balance sheet at net book value
Total Assets
Least Liquid

Other Assets (Continued)
 Other Assets (Continued)
 Net book value of intangible assets is cost less accumulated amortization
 Intangible assets are amortized using the straight-line method
 Other assets may include transitory accounts, due from employees, taxes receivable and others

Liabilities
Liabilities
 Economic obligations that a corporation owes to

Liabilities and Equity
lenders, suppliers, employees and others
Accounts Payable Most Liquid  Classified as current (due within the year) and
Accrued Expenses non-current
Current Portion of Long-Term  The cash generated from current assets is used
Debt to pay current liabilities as they become due
Income Taxes payable
 A liability is classified as current when it is:
Total Current Liabilities
 Expected to be settled in the normal course
Long-Term Debt of the company's operating cycle;
 Held primarily for trading purposes;
Capital Stock
 Expected to be settled within 12 months after

the reporting period; or
Retained Earnings
 The company does not have an
Total Owners' Equity unconditional right to defer settlement of the
liability for at least 12 months after the end of
Total Liabilities and Equity Least Liquid the reporting period

Accounts Payable
Accounts Payable
 Accounts payable are bills, generally to other
Liabilities and Equity companies for materials and equipment bought
or services rendered on credit that the company
Accounts Payable Most Liquid must pay soon
Accrued Expenses
 When it receives materials or services, the
Current Portion of Long-Term company can either pay for them immediately
Debt with cash or wait and let what is owed become
an accounts payable. Business to business
transactions are most often done on credit
 Unearned revenue: You can not recognize a
Long-Term Debt revenue unless the services are rendered or
completed. Unearned revenue is recognized
Capital Stock once substantial performance on future services
has occurred
Retained Earnings
 Accounts payable v/s notes payable
Total Owners' Equity
Total Liabilities and Equity Least Liquid


Accrued Expenses
Accrued Expenses
 Accrued expenses are monetary obligations
Liabilities and Equity similar to accounts payable
Accounts Payable Most Liquid  Accrued expenses are expenses incurred but not
yet paid (accrual basis)
Accrued Expenses
Current Portion of Long-Term  Accrued expenses are different from accounts

Debt payable, as accounts payable are used for debts
to regular suppliers
Total Current Liabilities  Accrued expenses comprise among others:

salaries earned by employees but not yet paid,
Long-Term Debt interest due but not yet paid, utilities and other
expenses (accounting, auditing, legal and other
Capital Stock
charges) incurred but not yet paid

Retained Earnings

Current Portion of Long-Term Debt
Balance Sheet Format Current Portion of Long-Term Debt
 A loan with an overall term of more than 12

months from the date of the balance sheet is
Accounts Payable called long-term debt
Most Liquid
Accrued Expenses  Current portion of long-term debt is the amount

due for payment within 12 months and is a
Current Portion of Long-Term current liability classified under current portion of
Debt
long-term debt

Year 1 Year 2 Year 3 Year 4 Year 5
Long-Term Debt
Current
Portion of
Capital Stock Long-Term Debt
Long-Term
Debt
Retained Earnings

Balance sheet date

Income Taxes Payable
Balance Sheet Format Income Taxes Payable

 Every time the company sells something and
makes a profit on the sale, a percentage of the
Accounts Payable profit will be owed to the government as income
Most Liquid
taxes
Accrued Expenses
 Income taxes payable are income taxes that the
Current Portion of Long-Term
company owes to the government but that the
Debt
company has not yet paid
Long-Term Debt
Capital Stock
Retained Earnings

Long-Term Debt
Balance Sheet Format Long-Term Debt
 Long-term debt represents liabilities due within a

period that exceeds the balance sheet date by
Accounts Payable
12 months or more
Most Liquid
Accrued Expenses  Refer to "Current Portion of Long-Term Debt"

section
Debt
Long-Term Debt
Capital Stock
Retained Earnings

Working Capital
 Working capital is the amount of money left over after subtracting current liabilities from current assets
Current Assets – Current Liabilities = Working Capital

(the good stuff) (the less good stuff) (the great stuff)
Cash Accounts Payable

The amount of money the company
Accounts Receivable Accrued Expenses has to "work with" in the short-term
Inventory Current Portion of Long-Term Debt Also called net current assets or
simply "Funds"
Prepaid Expenses Income Taxes Payable

Capital Stock
Balance Sheet Format Capital Stock (or "Common Stock")
 The amount of money the owners contributed to

start the business
Accounts Payable Most Liquid
 All companies issue common stock; but they can
Accrued Expenses issue other types of stocks, such as preferred
stocks
Debt
 Common stocks have voting rights
 Preferred stocks have certain preferences and
Total Current Liabilities rights over common stocks. These rights might
include specified dividend priority or a
Long-Term Debt preference in case the company is liquidated.
Preferred stocks do not have voting rights
Capital Stock
Retained Earnings

Retained Earnings
Balance Sheet Format Retained Earnings
Liabilities and Equity  Retained earnings: ∑ of all profits - ∑ of all

dividends
Accounts Payable Most Liquid
 All of the company's profits that have been
Accrued Expenses returned to the owners as dividends are called
retained earnings
Debt
 Dividends can not be paid to owners unless
Income Taxes payable sufficient retained earnings are available to pay
the dividends
 If the Company has not made a profit but rather
Long-Term Debt
has sustained losses, it has "negative retained
Capital Stock
earnings" that are called its accumulated deficit
Retained Earnings

Section 6
The Income Statement
Introduction
 The Income Statement

Income Statement Format
 This statement gives one important perspective
Net Sales on the health of a business – its profitability
Cost of Goods Sold
 Unlike the balance sheet, the income statement
Gross Margin does not show the company's financial health
Operating Expenses  Unlike the cash flow statement, the income

statement does not report cash movements
Income from Operations (EBIT)
 This statement says nothing about when the
Net Interest Income/(Expense) company receives cash or how much cash it has
on hand (accrual basis/matching principle v/s
Income Before Tax (EBT)
cash basis)
Income Tax Expense
 The income statement reports on making and

Net Income selling activities of a business over a period of
time

Introduction (Continued)
 The income statement equation is illustrated below:
What is sold in the period
What it costs to make the sale
Selling and general expenses for the period
Income for the period


Net Sales
 Net Sales
 Sales are recorded on the income statement when the
Net Sales company actually ships product or renders services to
customers; accordingly customers have an obligation to
Cost of Goods Sold
pay for the product or the service and the company has
Gross Margin
the right to collect. The company's right to collect, is an
accounts receivable and is recorded on the balance sheet
Operating Expenses
 Net sales = sales – sales discounts – sales returns and
Income from Operations (EBIT) allowances
Net Interest Income/(Expense)  Sales ≠ Gains

 Sales are recognized in the normal course of
Income Tax Expense
business
Net Income  Gains are reported at their net amounts (cash

received less net book value of an asset item sold)
and neither relate to an operation in the normal
course of business nor to the incurrence of an
expense

Net Sales (Continued)
 Sales v/s Orders
Sales v/s Orders
Sales Orders
• A sale is made when the company • Orders become sales only when the
actually ships a product or provides a products have left the company's
service to a customer – transfer of leading dock and are en route to the
risks and rewards customers or when the services are
rendered
When a sale is made, income is generated on the income statement. Accordingly receiving an order does not
result in income

 Types of Sales
Cash Sales
Credit Sales
Sale of Services (Sale on
Account)
Consignment
Secured Sales
(Sale?)

 Reduction of Sales
Bad Debt Expense

Cash Discounts Sales Returns and Allowances
(Uncollectible Sales)
• The discount is generally based • Sales of goods often result in • Refer to accounts receivable
on a percentage of the sales those goods being returned for section
price (2/10, n/30) a variety of reasons • When the company ensures
• Goods returned represent about the uncollectibility of a
deductions from accounts receivable, then it should
receivable and sales write-off the allowance for
doubtful debt account
 Example: ABC company estimates that 3% of accounts receivable valued at US$2,000 (end of
period) will be returned
Sales and accounts receivable will decrease by an amount of US$60 (US$2,000 x 3%)

Cost of Goods Sold
Cost of Goods Sold

 In general, costs are expenditures of raw material, direct
Net Sales labor and overhead. Moreover, costs are what you
spend when you buy (or make) products for inventory
Cost of Goods Sold
 When this inventory is sold (shipped to customers) and
Gross Margin
risks and rewards are transferred, its total cost is taken
Operating Expenses out of inventory and entered in the income statement as
a special type of expense called cost of goods sold
 Costs lower cash and increase inventory value on the
Net Interest Income/(Expense) balance sheet. Only when inventory is sold, its value
moves from the balance sheet to the income statement
Income Before Tax (EBT) as cost of goods sold
Income Tax Expense
 To comply with the matching principle, when a product is

Net Income shipped and a sale is recorded, the company incurs the
total cost of inventory as cost of goods sold on the
income statement

Cost of Goods Sold (Continued)
 Cost of goods sold is computed as follows:
Beginning inventory
+
Net purchases
=
Cost of goods available for sale
-
Ending inventory
=
Cost of goods sold
 Net purchases = purchases + freight in – purchase discounts – purchase returns and allowances
 Freight out is classified as selling expenses

Cost of Goods Sold (Continued)
 Costs v/s Expenses
 Two different terms (costs and expenses) are used to describe how the company spends its
money:
 Expenditures to prepare the inventory for its intended sale
 All other business expenditures are called expenses
 Expenses v/s Losses
 Expenses are incurred in the normal course of business
 Losses are reported at their net amounts (cash received less net book value of an asset item
sold) and do not relate to an operation in the normal course of business

Gross Margin

Gross Margin
 The amount left over from sales after cost of goods sold
Net Sales
is subtracted
Cost of Goods Sold
 Also called gross profit
Gross Margin
Operating Expenses
Net Interest Income/(Expense)
Income Tax Expense

Net Income

Operating Expenses
Operating Expenses
 Operating expenses are those expenditures that a
Net Sales company makes to generate income
Cost of Goods Sold
 In general, they include sales and marketing expenses,
Gross Margin research and development (R&D) expenses, and
general and administration (G&A) expenses
Operating Expenses
 Examples:
 Professional fees (legal, audit, …)
Net Interest Income/(Expense)  Insurance
 Rent
 Repair and maintenance
Income Tax Expense  Utilities
 Entertainment
Net Income  Depreciation
All the expenses mentioned above relate to the

administration and sales activities


 Income from operations represents the result of

Net Sales
revenues and expenses related directly to the core
Cost of Goods Sold business of the company
Gross Margin  All non-operating revenues and expenses should be

deducted from "Income from operations" to arrive to
Operating Expenses "Income before tax"; and they include the following:
Income from Operations (EBIT)  Gain or loss on disposal of fixed assets

 Gain or loss from foreign exchange
 Other revenues and gains
Income Tax Expense
 Other expenses and losses

Net Income

Income Statement Format Net Interest Income/(Expense)
Net Sales
 Includes finance income from term deposits and
investments
Cost of Goods Sold
 Includes finance cost from borrowings and overdrafts in
Gross Margin addition to bank charges and commissions
Operating Expenses
Income Tax Expense

Net Income

Income Tax Expense

Income Tax Expense
 Income tax expense is computed based on local laws

Net Sales
and regulations
Cost of Goods Sold
 It is worth mentioning that income tax is based on the
Gross Margin taxable income rather than income before tax.
Accordingly, a reconciliation should be prepared to show
Operating Expenses the difference between the taxable income and the
income before tax
Income Tax Expense

Net Income

Net Income
Net income
 Income is not cash. A profitable company can be
Net Sales insolvent with no cash left to pay its bills
Cost of Goods Sold
 Growing companies are often short of cash as they
Gross Margin require capital for growth and are unable to supply
capital out of their earnings
Operating Expenses
 If the company's income statement shows income, then
Income from Operations (EBIT) retained earning are increased on the balance sheet
Net Interest Income/(Expense)  The income statement summarizes and displays the
financial impact of:
Movement of goods to customers
Income Tax Expense
Net Income Efforts to make and sell those goods

=
Any value created in the process

Section 7
The Statement of Cash Flows
The Statement of Cash Flows
Statement of Cash Flows Format The Statement of Cash Flows
 It tracks the movement of cash through the

Cash flows from operating activities
business over a period of time
Net income  Cash flow statement includes three major

categories:
Adjustments to reconcile net income to net cash
provided by operating activities
 Operating activities
Net cash provided (used) by operating activities
 Investing activities
Net cash provided (used) by investing activities
 Financing activities
Net cash provided (used) by financing activities

Net increase (decrease) in cash
Cash at the beginning of period
Cash at the end of period

Operating Activities
Statement of Cash Flows Format Operating Activities
 Principal revenue-producing activities and

other activities that are not investing or
financing activities
Net income
 Include the day-to-day activities of a business
 Indirect method adjusts profit or loss before
Net cash provided (used) by operating activities tax for effects of:
 Non-cash transactions (including but not

limited to: depreciation, amortizations,
gains and losses from disposals and
Net cash provided (used) by financing activities provisions)
Net increase (decrease) in cash  Changes during the period in working

capital: inventories and operating
receivables and payables
 Items of income/expense associated with

investing/financing cash flows

Operating Activities (Continued)
Net Income
Additions Deductions
• Depreciation expense • Gain on sale of plant assets

• Amortization of intangible assets • Increase in receivables
• Loss on sale of plant assets • Increase in inventory
• Loss on impairment of assets • Increase in prepaid expenses
• Decrease in receivables • Decrease in accounts payable
• Decrease in inventory • Decrease in accrued liabilities
• Decrease in prepaid expenses
• Increase in accounts payable
• Increase in accrued liabilities

Investing Activities
Statement of Cash Flows Format Investing Activities
 Purchase of property plant and equipment or

long-term investments (not included in the
operating activities) which must represent
Net income actual amounts paid – be careful of any
payable balances
 Proceeds from sales of property plant and
equipment or long-term investments (not
included in the operating activities) – not
profit or loss on disposal (adjusted as a
Net cash provided (used) by investing activities non-cash item)
Net cash provided (used) by financing activities  Pay attention to non-cash transactions

Financing Activities
Statement of Cash Flows Format Financing Activities
 Result in changes in the size and composition

of equity capital and borrowings; such as:
Net income  Issuance of share capital

Adjustments to reconcile net income to net cash  Payment of cash dividends (not
declared – noncash transactions)
 Increase/(Decrease) in borrowings
Net cash provided (used) by financing activities


Section 8
Connections and Associations
Connections and Associations
 Connections and associations include the following cycles:
 Balance sheet associations
 Revenue cycle
 Expense cycle
 Inventory cycle
 Investment cycle
 Fixed asset cycle


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Remedial Workshop

Professional Training Services

1 Basic Accounting Assumptions and Principles

6 The Income Statement

7 The Statement of Cash Flows

8 Connections and Associations

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Economic Entity Assumption

Going Concern Assumption

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Monetary Unit Assumption

Historical Cost Principle

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Revenue Recognition Principle

Accrual Accounting and Matching Principle

Cash Basis When Collected When Paid

Accrual Basis When Recognized When Incurred

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• Providers of capital and their advisers

• Users are assumed to have:

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Materiality and Aggregation

• Omissions or misstatements of items are material if they could, individually or collectively,

Material Immaterial items

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 The components of the financial statements are set out below:

 Statement of cash flows

 Statement of changes in equity

 Significant accounting policies and other explanatory notes

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 The basic equation of accounting is set out below:

Assets Liabilities Worth

Assets Liabilities Worth

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Assets Liabilities Worth

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The Balance Sheet Format

Assets Liabilities and Equity

Cash Accounts Payable

Accounts Receivable Accrued Expenses

Inventory Current Portion of Long-Term Debt

Prepaid Expenses Income Taxes Payable

Total Current Assets Total Current Liabilities

Fixed Assets at Cost Long-Term Debt

Less: Accumulated Depreciation Capital Stock

Net Fixed Assets Retained Earnings

Other Assets Total Owners' Equity

Total Assets Total Liabilities and Equity

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 The balance sheet is a snapshot in time. It is reported as of a certain date

 The balance sheet presents:

 What the enterprise HAS today: Assets

 How much the enterprise OWES today: Liabilities

 What the enterprise IS WORTH today: Equity

Assets Liabilities Worth

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Balance Sheet Format  Assets

Assets  Assets are everything a company owns including but

Accounts Receivable  Assets have a monetary value such as the right to

with the asset will flow to the company (this is

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Balance Sheet Format  Assets (Continued)