GYAAN KOSH

TERM 1
Learning and
Development Council,
CAC

Financial Accounting in Decision Making

This document covers the basic concepts of Financial
accounting in Decision Making covered in Term 1. The
document only summarizes the main concepts and is not
intended to be an instructive material on the subject.

Gyaan Kosh Term 1

FADM

Learning & Development Council, CAC

1. Introduction to Financial Reporting

1. A. The Balance Sheet Equation
Assets = Liabilities + Owners Equity
Assets = Liabilities + (Shareholders Equity + Retained Earnings)
Retained Earnings = Revenues Expenses Dividends + Op. Retained Earnings

1. B. Financial Statements

Performance over a given period: Income Statement & Cash Flows

Financial Condition on a given day: Balance Sheet

2. The Accounting Process

2. A. Income Measurement
Matching Expenses

Expenses related to earning revenue must be matched so that income can be determined. Period costs are
added as the period finishes e.g. rent, depreciation
Recognition of expired assets e.g. inventory used for the sale. Product Cost

2. B. Basic Assumptions

Going concern
Accrual basis of accounting
Consistency

3. Accrual Process
3. A. Accrued Expenses (L)
Cash paid after services received. Expense comes first

3. B. Accrued Revenues (A)

Cash received after services rendered, revenue recognition comes first

3. C. Deferred Expenses (A)

Cash paid before services received. E.g. Prepaid insurance

3. D. Deferred Revenues (L)

Cash received before services are rendered. E.g. unearned revenue / advances

3. E. Expiration of unexpired costs

Part consumed during operations is converted to expense (comes in Income Statement). The unexpired portion
remains as an asset in the Balance Sheet.

Gyaan Kosh Term 1

FADM

Learning & Development Council, CAC

3. F. Earning of unearned revenues

Part earned is converted to income in Income Statement. Unearned portion remains as a liability in the Balance
Sheet.

3. G. Capitalizing versus Expensing

i.
ii.
iii.
iv.
v.

Firms capitalize expenses when the benefit incurred is across multiple years. Asset is created in the Balance
Sheet amortized/depreciated over years.
Expense implies that the benefit from expenditure expires within one year. Expense recorded in the Income
Statement
Development costs are capitalized however not research costs (Under IFRS).
If there is an uncertainty as to whether there are future benefits, expenditure is recorded as an expense.
Accumulated Depreciation is a contra-asset

Effects
Capitalizing
Income Statement Income increases
Balance Sheet

Assets increase

Expensing
Income Decreases
Shareholders Equity decreases

4. Revenue Recognition
4. A. Recognition Criterion

Persuasive evidence of an arrangement (Contract)

Delivery has occurred or services have been provided (earning process is complete)

Gyaan Kosh Term 1

FADM

Learning & Development Council, CAC

Sellers price to buyer is fixed

Collection is reasonably assured
Has nothing to do with cash collection
At Point of Sale costs are inventoried till delivery is made
Industry and Transaction specific

4. B. Expenses
Outflows or consumption of assets or incurrence of a liability from activities that constitute the major operations

Product Costs
o Directly related to goods or services
o Raw materials
o Labor
o Recognized when related revenue is recognized
Period Costs
o Not directly related to production
o Recognized over the period they are expensed.

5. Accounts Receivables
5. A. Working Capital
Current Assets less Current Liabilities (also known as Net worth)

5. B. Estimating Bad Debts

Percent of Credit Sales use historical data to determine ratio.

Aging Method A/R is likely to differ as a function of how long the accounts have been outstanding. Older
have higher %.

6. Stock Re-purchases

Increases Earnings per Share

Provides stock for reissuance in employee stock option schemes
Profit / Loss while dealing with own stock does not come in the income statement

7. Cash Flow Statements

7. A. Cash Flow from Operating Activities

(+) Receipts from Customers

(-) Payments to Suppliers
(-) Payments to Employees
(-) Payments for Rent, Utilities, Insurance
(-) Taxes Paid
(+) Interest and Dividends Received
(-) Interest Paid

7. B. Cash Flow from Investing Activities

(-) Purchases of Tangible Fixed Assets

(+) Sales of Tangible Fixed Assets
(-) Purchases of Intangible Assets

Gyaan Kosh Term 1

FADM

Learning & Development Council, CAC

(+) Sales of Intangible Assets

(-) Purchases of Securities, incl. M&A
(+) Sales of Securities
(-) Loans made to other companies
(+) Repayments of loans made to other companies

7. C. Cash Flows from Financing Activities

(+) Proceeds from New Borrowing

(-) Retirement of Debt
(+) Proceeds from New Issues of Stock
(-) Repurchases of Stock
(-) Dividends Paid to Shareholders

7. D. Indirect Method of Cash Flow

Start with Net Income

Subtract any non-cash and non-operating transactions

8. Inventory Accounting

Total Inventory = Balance of (Raw material + WIP + Finished Goods)

9. Leasing vs. Buying

Balance Sheet & Income Statement Effects:
Borrowing / Buying

Leasing

Substantially Greater Debt reported in BS

Higher Leverage ratios:

Lower Leverage ratios

L+New Borrowing/E

L/E

L+New Borrowing/A

L/A

Lower returns on assets as assets increase in BS

Gyaan Kosh Term 1

FADM

Learning & Development Council, CAC

Borrowing / Buying

Leasing

Income decreases in first year due to depreciation In subsequent years as depreciation becomes less
than rent the decrease in income also becomes less

Income decreases by a constant

amount (rent)

Taxed as an asset depreciation

Reduction in Taxes as rent is an

expense

9. A. Capital Lease
Treats leases as a debt-financed purchase of the asset.
Criteria to trigger Capital Lease:

Ownership transfer at end of lease term

Bargain purchase option
Lease term exceeds 75% of asset life
Present value of lease payments exceed 90% of assets fair value

10. Employee Stock Options

The Intrinsic Value Method: No action was taken at the stock options grant date if the options exercise price
was greater than or equal to the firms stock price on the grant date. Companies recognized no compensation
expense at any time.
Expense over the vesting period: At the grant date, the company computes the economic value of the options
using the Black-Scholes model, or equivalent. This value is systematically recognized as an expense over the options
vesting period.

11. Financial Ratios

Profitability Ratios

Gyaan Kosh Term 1

FADM

Liquidity Ratios

Leverage Ratios

Activity Ratios
Inventory turnover = Cost of Goods Sold / Average Inventory
Accounts receivable turnover = Sales on credit/ Average Accounts receivable
Accounts payable turnover = Cost of Goods Sold/ Average Accounts payable
Number of Days Inventory = 365/ Inventory Turnover
Number of Days Receivables = 365/ Receivables Turnover
Number of Days Payable = 365/ Payables Turnover

Learning & Development Council, CAC

Gyaan Kosh Term 1

FADM

Learning & Development Council, CAC

Operating Cycle (Also known as Cash Conversion Cycle)

= Number of Days Receivables + Number of Days Inventory - Number of Days payables

DuPont Analysis
ROE (Net Income/Equity) = (Profit margin)*(Asset turnover)*(Equity multiplier)
= (Net Income/Sales)*(Sales/Assets)*(Assets/Equity)

Operating efficiency (measured by profit margin)

Asset use efficiency (measured by asset turnover)

Financial leverage (measured by equity multiplier)

DuPont 5 Part decomposition

The company's tax burden is (Net profit pretax profit). This is the proportion of the company's profits retained
after paying income taxes. [NI/EBT]
The company's interest burden is (Pretax profit EBIT). This will be 1.00 for a firm with no debt or financial
leverage. [EBT/EBIT]
The company's operating profit margin or return on sales (ROS) is (EBIT Sales). This is the operating profit per
dollar of sales. [EBIT/Sales]
The company's asset turnover ratio is (Sales Assets).
The company's leverage ratio is (Assets Equity), which is equal to the firm's debt to equity ratio + 1. This is a
measure of financial leverage.