Financial Basic

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EV
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Financial Management:
Basic
Instructors Edition
NOT FOR PRINTING OR INSTRUCTIONAL USE
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ILT Series
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Trademarks
ILT Series is a trademark of Axzo Press.
Disclaimer
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Some of the product names and company names used in this book have been used for identification purposes only and
may be trademarks or registered trademarks of their respective manufacturers and sellers.
PR
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We reserve the right to revise this publication and make changes from time to time in its content without notice.
Introduction
Topic A:
Topic B:
Topic C:
Topic D:
Contents
iii
About the manual............................................................................... iv

Setting student expectations ............................................................. viii
Classroom setup..................................................................................x
Support...............................................................................................xii
Basics of accounting
1-1
IE
Topic A: Accounting........................................................................................ 1-2

Topic B: Key accounting terms ....................................................................... 1-4
Unit summary: Basics of accounting............................................................... 1-18
Accounting cycle
2-1
Topic A: Basics of the accounting cycle.......................................................... 2-2

Topic B: Analyze, record, and post transactions ............................................. 2-5
Topic C: Trial Balance.................................................................................... 2-12
Unit summary: Accounting cycle.................................................................... 2-22
Income Statement
3-1
EV
Topic A: Income Statement basics................................................................... 3-2

Topic B: Prepare and interpret an Income Statement ...................................... 3-7
Unit summary: Income Statement................................................................... 3-18
Balance Sheet
4-1
Topic A: Balance Sheet basics......................................................................... 4-2

Topic B: Prepare Balance Sheets..................................................................... 4-5
Topic C: Interpret Balance Sheets .................................................................. 4-19
Unit summary: Balance Sheet ......................................................................... 4-23
Other financial statements
5-1
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Topic A: Cash Flow Statement ........................................................................ 5-2

Topic B: Statement of Stockholders Equity .................................................. 5-15
Unit summary: Other financial statements ...................................................... 5-24
Budgeting
6-1
Topic A: Fundamentals of budgeting............................................................... 6-2

Topic B: Analyze financial statements ............................................................ 6-5
Topic C: Set objectives................................................................................... 6-19
Topic D: Monitor performance ....................................................................... 6-27
Unit summary: Budgeting ............................................................................... 6-36
Course summary
S-1
Topic A: Course summary ............................................................................... S-2

Topic B: Continued learning after class .......................................................... S-4
Glossary
G-1
Index
I-1
Unit 1
11
Unit time: 60 minutes
Complete this unit, and youll know how to:
IE
A Define accounting.
PR
EV
B Identify the key accounting terms.
12
Financial Management: Basic
Topic A: Accounting
Explanation
Accounting is defined by The American Institute of Certified Public Accountants as the

art of recording, classifying, and summarizing in a significant manner and in terms of
money, transactions and events which are of a financial character, and interpreting the
results.
To put it in simpler terms, accounting records and reveals the financial strengths and
weaknesses of an individual or business. All businesses, large or small, must have a
complete and accurate system of record keeping.
The need for accounting
IE
All organizations must show the operations of their businesses in financial terms for
various reasons: when applying for credit, figuring costs, keeping within their budgets,
or paying their employees. Also, businesses are responsible for furnishing this
information to government agencies for taxation and other regulatory purposes.
Keep in mind that more than one quarter of a million new bankruptcy cases are filed
each year. Many of these cases are the result of faulty accounting practices.
Individuals who use financial information
There are several individuals who might use financial information in an organization,
but who they are will depend on the size of the company. A large organization with
many employees will have an accounting department that is solely involved in preparing
and analyzing financial records. In addition, that same organization will have members
of upper-management and a board of directors who will be highly interested in the
companys financial status.
EV
Tell students that

another group that often
uses financial
information is
prospective investors.
Conversely, if a business consists of one individual who is self-employed, this person

will consult their accounting records almost daily. Accounting information is used by
every aspect of our economic society, including churches, clubs, school districts, nonprofit organizations, and city, state, and federal governments.
Benefits of understanding basic accounting concepts
PR
Anyone can benefit from having a basic understanding of accounting concepts. Youll
be able to understand how the strength of your company is related to its productivity
and the revenues these efforts generate. In addition, youll gain a better understanding
of the reasoning behind decisions made by your organization.
Do it!
A-1:
1 3
Identifying the need for accounting
Exercises
1 What kinds of businesses should have a system of record keeping?

A
All businesses
Fortune 500 businesses
Privately owned businesses
Publicly owned businesses
2 An organization must show the operations of its businesses in financial terms so

that it can:
B
Increase profits
Apply for credit
Surpass the competition
IE
Improve employee morale
3 Why would city, state, and federal

governments be interested in the
financial accounts of an
organization?
The probable answer could be:
To reveal trends within the economy as a

whole
To assess the profit on which the companys
tax liability is to be computed
PR
EV
Tell students to discuss

among themselves and
answer.
14
Topic B: Key accounting terms

To understand accounting, you need to be familiar with fundamental accounting terms,
such as:
Accounting equation
Transactions and accounts
T account
Revenue and expenses
Capital and withdrawals
Temporary and permanent accounts
Fixed cost and variable cost
IE
Explanation
Accounting equation
The accounting equation is the fundamental formula on which the books of accounting
are based. It establishes the relationship among assets, liabilities, and owners equity.
Asset
EV
Everything of value owned and used in a business is considered an asset, such as cash,
sales, supplies, and office equipment. For example, the computers, copier machines, and
office furniture owned by a company are its assets. Assets even include any money
owed to a business, known as Accounts Receivable.
Liability
The amount of money a business owes a person or company for goods or services
rendered is considered a liability. For example, when a company buys office supplies
and charges them to an account with an oral or implied promise to pay, the charges are
considered a liability and are often classified as Accounts Payable. In addition, when
a company borrows money from a bank, the loan is a liability and is often classified as
Notes Payable.
Owners equity
PR
The part of a business that belongs to the owner is the owners equity. Owners equity
can be determined by finding the difference between a companys assets and liabilities;
this difference is what a business is worth to the owner.
For example, if a companys total assets are worth $350,000, and its liabilities are worth
$75,000, then the owners equity would be the difference between these two figures:
$275,000.
In a business owned by an individual, the owners equity account will usually have the
owners name followed by the word Capital, such as, Terry Brown, Capital.
1 5
The accounting equation is expressed in the following manner:

Assets = Liabilities + Owners Equity (often abbreviated as: A = L + OE).
IE
It is important to learn and remember this equation, since it the basic element of
accounting, regardless of the size of the business. Youll use the accounting equation, as
shown in Exhibit 1-1, whenever recording business transactions.
Exhibit 1-1: The accounting equation
EV
Accounting period
An accounting period is also known as a fiscal period. It is the length of time that a
business analyzes its financial activities, and will vary in length from business to
business. Some businesses might use a one-month accounting period, while others
might use a three-month, six-month, or one-year accounting period.
Do it!
B-1:
Understanding the accounting equation
Exercises
The assets can differ from

the ones given here
according to the setting of
the classroom.
1 List at least three assets that you

can see around you.
Chair
Desk
Study material
PR
Ask students to share

their answers and discuss.
Pen
2 Which of the following is the definition of a liability?

A
Everything of value owned and used in a business
The amount of money a business owes a person or a company for goods or

services rendered
The part of a business that belongs to the owner
Any amount owed by a customer to your business
16

3 List at least three liabilities that

you can think of.
Loan payable to a bank

Salary payable to employees
Outstanding telephone bills
4 Which of the following is the basic accounting equation?

A
Liabilities/ Assets = Owners Equity
Owners Equity x Assets = Liabilities
Assets = Liabilities + Owners Equity
Assets + Liabilities = Owners Equity
$40,000
$25,000
$10,000
$15,000
6 A company has cash in hand worth $10,000; cash in the bank worth $25,000;
machinery worth $12,000; accounts payable worth $23,000; and a bank loan
worth $5,000.
EV
Tell students to read this

case and then answer the
questions that follow.
IE
5 Financial Internationals combined assets equal $25,000, and its liabilities are
worth $15,000. What is the owners equity?
What is the total amount of assets?

$47,000
Total assets ($47,000) = cash in hand ($10,000) + cash at bank ($25,000) + machinery
($12,000).
What is the total amount of liabilities?

$28,000
PR
Total liabilities ($28,000) = accounts payable ($23,000) + bank loan ($5,000)
What is the owners equity?

$19,000
Owners equity ($19,000) = Total assets ($47,000) - Total liabilities ($28,000)
7 The instructor will divide the class into two groups. Each group should review
Icons Balance sheet, shown below. As a group, identify assets and liabilities and
then calculate the owners equity.
Once the activity is

complete, ask a student
from one group to list the
assets and liabilities on
the whiteboard, and a
student from the other
group to write the owners
equity with its calculation.
1 7
Assets
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Have students verify the

answers are correct.
Cash = $620,000
EV
Marketable Securities = $200,000

Accounts and Notes Receivable = $1,190,000
Inventories = $2,410,000
Real Estate = $8,400,000
Leasehold Improvements = $200,000
Machinery Equipment = $1,900,000
Total Assets = $14,920,000
Liabilities
Accounts Payable = $500,000

Notes Payable = $180,000
PR
Dividends Payable = $110,000
Owners Equity
Mortgage Bonds = $1,000,000

Sinking Fund Debentures = $900,000
Total Liabilities = $2,690,000

Total Assets ($14,920,000) Total Liabilities
($2,690,000) = Owners Equity ($12,230,000)
18
Transactions and accounts

A business transaction is any business event or activity that involves monetary value. In
other words, it is any activity that changes assets, liabilities, or owners equity. For
example, when a company buys office supplies on credit, they exchange the value of the
office supplies for a debt or liability.
Explanation
Transactions can be both internal and external. For example, if a business moves money
from the marketing departments budget to another budget, it is an internal transaction.
However, if the same business sells 10,000 units of its product to an outside client, this
movement of resources is an external transaction.
When you record business transactions, you fill in the accounting equation (A = L +
OE).
IE
An account is a form used for recording and summarizing business transactions.

Basically, accounts are broken into the three categories of assets, liabilities, and owners
equity, the same three elements of the accounting equation.
These three account categories, or classes of accounts, are made up of smaller
individual accounts. For example, some liability accounts are Accounts Payable,
Notes Payable, and Wages Payable.
Do it!
B-2:
Identifying transactions and accounts
Exercises
EV
1 Icon moves $10,000 from the marketing budget into the human resource budget.
What type of transaction has taken place?
A
Internal
External
2 Define a business transaction?
PR
Any business event or activity that involves monetary value and which changes assets,
liabilities, or owners equity of a company.
1 9
T account
A T account is a simplified form used to record a transaction that results in the

increase or decrease of various accounts. It gets its name from its resemblance to the
letter T and is used to divide an account into two sides, debits and credits, as shown in
Exhibit 1-2. The left side of any account is called the debit side and is abbreviated Dr.
The right side of any account is called the credit side, abbreviated Cr. The name of
the specific account, such as Accounts Payable or Office Supplies, is listed at the top of
the T structure.
EV
IE
In order to understand debits and credits, you must understand how they increase or
decrease assets, liabilities, and owners equity.
Exhibit 1-2: The T account
Debits and credits
PR
Debits increase assets and decrease liabilities and owners equity. Conversely, credits
decrease assets and increase liabilities and owners equity, as shown in Exhibit 1-3.
Exhibit 1-3: Debits and Credits
110
EV
IE
For example, imagine that your business purchased $18,000 worth of new
teleconferencing equipment from Enson Corporation and charged it with the promise to
pay over the next six months. An asset account, such as Teleconferencing Equipment,
would be established to record the equipment purchased. Since you now own more
equipment, you would increase the balance of this account by entering $18,000 on the
left, or debit, side of the account, as shown in Exhibit 1-4. A liability account, Accounts
Payable, would be established to record the amount your company owes to Enson. Since
the $18,000 represents an increase in the amount of money you owe Enson, the $18,000
would be listed on the right, or credit, side of the T account for Accounts Payable.
Exhibit 1-4: Recording debits and credits in the T account
PR
For another example of a business transaction, imagine your business received $500
from Chelsea Insurance, a client who owed you for consultation services you provided
last month. This transaction would affect your Cash account and the Accounts
Receivable account, which are both asset accounts. Since your company is receiving
money or payment on this account, you are increasing the balance of the Cash account
and decreasing the balance of the Accounts Receivable account. Thus, you would list
the $500 on the left, or debit, side of the T account for Cash to increase its balance as
an asset. You would also list the $500 on the right, or credit, side of the T account for
Accounts Receivable to decrease its balance as an asset.
The Golden Rule for debits and credits

The Golden Rule for debits and credits is that every transaction affects and is recorded
in two or more accounts and that debits must always equal credits in every transaction.
In other words, for every debit that occurs during a transaction, there must be an
offsetting credit, and vice versa.
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This principle is also called double-entry bookkeeping. Double-entry bookkeeping is a

method of recording transactions in which each transaction must have at least two
entriesat least one debit and one credit. However, while some transactions might
have just one debit and one credit, other transactions might have numerous debits and
credits. No matter how many entries you make, the total dollar amount of debits must
equal the total dollar amount of credits.
EV
IE
For example, imagine that your business paid $4,500 to Enson Corporation for the
teleconferencing equipment they provided, as shown in Exhibit 1-5. The debit entry
would be $4,500 on the Accounts Payable account, since it would be a decrease to this
liability account. The offsetting credit entry would be $4,500 on the credit side of the
Cash account, since you would be decreasing the amount of cash available by paying
the debt.
Exhibit 1-5: Example of double-entry bookkeeping
Do it!
B-3:
Understanding the T account
Exercises
1 The left side of any T account is

called the debit side. True or
False?
True
PR
2 The Golden Rule for debits and credits states that in every transaction:
A
For every debit, there are two credits
Debits must be greater than credits
Debits must equal credits
Credits must be greater than debits
112

3 The definition for double-entry bookkeeping states that:
Every transaction must have at least two entriesone debit and one credit
No transaction can have more than two entries
Maintain two copies of every account in two locations
Record every transaction as a debit twice, but only once as a credit
Revenue and expenses
Revenue and expenses are two categories included in owners equity.
Tell students that the

other two categories
included in the owners
equity are capital and
withdrawals.
Revenues are monies that a business earns for selling goods or services to another firm
or individual. The terms Income and Fees Earned are often used when referring to
revenue accounts. For example, the revenue account for a movie theater might include
Ticket Revenue (or Ticket Income) and Concession Revenue (or Concession Income).
IE
Explanation
Expenses are the costs of any goods or services that a business buys and uses to help
earn revenues. Examples of an expense account might include Rent Expense, Utilities
Expense, and Insurance Expense.
EV
Simply stated, revenue increases owners equity and represents its credit side; expenses
decrease owners equity and represent its debit side, as shown in Exhibit 1-6.
Since the fundamental accounting equation is Assets = Liabilities + Owners Equity, the
expanded accounting equation incorporates revenue and expenses in the following
method:
PR
Assets = Liabilities + Owners Equity + Revenue Expenses
Exhibit 1-6: The effect of revenue and expenses on owners equity
113
How revenue and expenses relate to profit and loss
Do it!
B-4:
Revenue and expense transactions tell whether a business is making a profit (increasing
in value) or incurring a loss (decreasing in value) from its operations. If the revenue
total is larger than the expense total, then there is a net profit. If the expenses are larger
than the revenues, there is a net loss.
Identifying revenue and expenses
Exercises
1 Icon sells $10,000 worth of products to a local government agency. The cash
received represents:
Revenue
Expense
Assets
Liabilities
IE
2 While reading the financial statements of Icon International, you come across an
item that states Fees Earned: $5.8 million. Which section of the financial
statements would you find this account?
Assets
Liabilities
Expenses
Revenue
EV
3 Which of the following will show a net profit?

Revenues of $640,000 and expenses of $600,000
PR
114
Revenues
IE
4 Using the following excerpt from Icons Income Statement, list the revenues and
expenses.
Sales
Dividends and interest
Expenses
General and administrative expenses
EV
Depreciation and depletion

Cost of sales
Selling expenses
Capital and withdrawals
Explanation
The owners equity is calculated by taking into account the capital and withdrawals.
Capital is used to record an owners investments in a business. A withdrawal account,

also called a Drawing account, is used to record when an owner withdraws assets, such
as cash or equipment, from the business for personal use.
PR
Capital increases owners equity, so it is recorded on the right, or credit, side of the
account. Since withdrawals reduce owners equity, they are recorded on the left, or
debit, side of an owners equity account. Both capital and withdrawal accounts usually
include the name of the owner, such as, Terry Brown, Withdrawals.
Do it!
B-5:
115
Identifying capital and withdrawals
Exercises
1 Which of the following statements about capital is true?

A
It is recorded on the debit side of an owners equity account
It decreases the owners equity
It is used to record an owners investments in a business
2 Which of the following are recorded in the Drawing account?

Owners investment in a business
Cash withdrawn from the business for personal use
Cash paid to a business supplier
Equipment withdrawn from the business for official use
IE
Discuss why this

statement is false.
3 Withdrawals are recorded on the

right side of an owners equity
account. True or False?
False, as withdrawals reduce owners equity, they

are recorded on the left, or debit, side of an
owners equity account.
EV
Temporary and permanent accounts
A temporary account is an account that begins and ends an accounting period with a $0
balance. The temporary accounts in a companys books include the owners equity
accounts of withdrawals, revenues, and expenses. Reducing an accounts balance to $0
so it is ready to start a new period is called closing an account. Revenue and expense
accounts are temporary accounts, since their balances are reduced to $0, or closed, at the
end of each accounting period (usually the end of the fiscal year).
Accounts that are not closed or reduced to a $0 balance are permanent accounts. Assets,
liabilities, and the owners equity capital account are permanent accounts, since their
balances are carried over from one accounting period to the next.
A transaction involving a temporary account and a permanent account
PR
It is important that you understand the difference between transactions that involve
temporary and permanent accounts.
116
Imagine that your business purchased $60,000 worth of personal computers from Acme
Corporation on credit. This purchase would involve two permanent accounts: an asset
and a liability. Since office equipment was purchased, this asset account will reflect the
ownership of this equipment for several years. In addition, the Accounts Payable
account would reflect the balance owed to Acme Corporation until full payment is made
to them. Thus, this transaction involves two permanent accounts with balances that
would carry over on the companys books to a new fiscal year. If you were to treat these
two accounts as temporary accounts and close them at the end of the fiscal year, you
would reflect that you own no office equipment and that you had paid off all debts
without really having done so.
Do it!
B-6:
Identifying temporary and permanent accounts
Exercises
1 Permanent accounts are closed at

the end of each accounting period.
True or False?
False. The temporary accounts are closed at the

end of the accounting period. The balances of
permanent accounts are carried over from one
accounting period to the next.
EV
Discuss why this

statement is false.
IE
When your company pays rent on the building you lease, the transaction involves a
permanent account, Cash, and a temporary account, Rent Expense. Cash will be reduced
with a credit and Rent Expense will be increased with a debit. Cash is a permanent
account that represents the balance in the company checking account. If the Cash
account were treated as a temporary account and closed at the end of the fiscal year, the
company would start the new fiscal year with no cash with which to operate. Rent
Expense is a temporary account that is closed at the end of each fiscal year because the
rent you pay this year should not impact the financial statements for next year.
2 Which of the following describes a temporary account?

Opening Balance $500, Closing Balance $0
PR
117
Fixed cost and variable cost

Explanation
Costs are categorized based on the level of activity within a company.
Fixed costs remain the same, or fixed, regardless of the amount of activity within the
business. For example, the property taxes a business pays are fixed costs, since they stay
the same, regardless of how many units the company produces.
Fixed costs can increase or decrease, but they do not fluctuate in relation to the level of
activity within the business. For example, property taxes might increase due to increases
in property values in an area.
Unlike fixed costs, variable costs will change in relation to the level of activity within a
company. Variable costs can be directly associated with the number of units produced
by a business.
Do it!
B-7:
IE
For example, the cost of materials needed to produce units is a variable cost; since it
will increase or decrease in relation to how many units the company produces. In
addition, the packaging material used to package units has a variable cost, since it will
fluctuate according to how many units are produced and packed.
Identifying fixed cost and variable cost
Multiple-choice questions
1 Which of the following expenses is a variable cost?

Office rent
Raw materials
Property taxes
Building insurance
EV
2 Which of the following expenses will remain fixed, regardless of the amount of
activity within Icon International?
Discounts allowed
Depreciation on machinery
Direct expenses
Manufacturing wages
PR
118
Unit summary: Basics of accounting

In this unit, you learned what accounting is, how accounting is defined, and who uses
financial information in an organization.
Topic B
Finally, you learned how to identify the fundamental accounting terms, such as the
accounting equation, transactions and accounts, T account, and revenue and
expenses. You also learned how to identify capital and withdrawals, temporary and
permanent accounts, and fixed cost and variable cost.
Independent practice activity

1 Define accounting.
Topic A
IE
Accounting is the art of recording, classifying, and summarizing in a significant manner and in
terms of money, the transactions and events, which are of a financial character, and interpreting
the results.
2 Who uses financial information in an organization?
Departments involved in preparing records
Upper-management who reviews the information
Those who are self-employed will consult their accounting records almost daily.
EV
3 How will understanding basic accounting concepts benefit you?

They will help you to:
Understand how strengths relate to productivity and revenue
Understand the reasoning behind decisions
4 Why is it important to use sound accounting practices?

It helps in maintaining legal financial records.
You need to show operations in financial terms to:

Apply for credit
Figure costs
Pay employees
Pay taxes
Keep within established budget
PR
5 What does A, L, and OE stand for in the accounting equation: A = L + OE?

Assets, Liabilities, and Owners Equity
119
6 Identify the asset(s) from the following list:

A Icons Notes Payable to a bank
Money owed to Icon, such as accounts receivable
C Outstanding rent that Icon needs to pay for office space

D
Icons computers, copiers, and fax machines
7 Icons combined assets equal $175,000, and its liabilities are $135,000. Based on that
information, what is the owners equity?
A $175,000
B $310,000
$40,000
IE
D $135,000
8 Icon sells $10,000 worth of product to another company. Is this an internal or external
transaction?
External
9 Which of the following is incorrect?
EV
A Debits increase assets and decrease liabilities

B
Debits decrease assets and increase liabilities
C Credits decrease assets and increase liabilities

D Credits decrease assets and increase the owners equity
10 You invite an external consulting firm to familiarize employees with a new policy
for preventing sexual harassment. Will your organization incur revenue or an
expense?
A Revenue
B
Expense
PR
11 At the end of the fiscal year, Lawson Development reviews its accounting statements
and determines that it had revenues of $1.2 million and expenses of $1.5 million.
Did they show a net profit or a net loss?
A Net profit
B
Net loss
12 Which of the following represents a variable cost to Icon International?

A Property taxes paid by Icon each year
B Office rent paid each month
C
Amount of raw materials used by Icon for its products
D Insurance of the warehouse
120

13 Use the following clues to complete the crossword.
ACROSS:
1. A form used for recording and summarizing business transactions
5. Costs such as property taxes paid by the business that remain the same regardless
of the amount of activity within the business
6. Anything owned by a business that has a monetary value, for instance, cash,
office equipment, etc.
7. A time period in which a business analyzes its financial activities, and that varies
in length from one business to another
8. The amount of money a business owes a person or a company for goods and
services rendered
DOWN:
IE
9. The amount of money a business earns by selling goods or services to another

firm or individual
2. An owners investment in a business
3. Any business event or activity that involves monetary value
4. Part of a transaction that must always have an offsetting credit

1
EV
C
T
PR
Unit 2
Accounting cycle
21

A Identify the phases of the accounting cycle
IE
and the types of accounting records.
B Analyze and post transactions, balance a
General Ledger, and identify the cash and

accrual bases of accounting.
C Identify the concept and method of Trial
PR
EV
Balance preparation.
22
Topic A: Basics of the accounting cycle

Explanation
The accounting cycle can be divided into nine phases that use accounting records to
analyze, record, post, and journalize transactions.
Phases of the accounting cycle
You can divide the accounting cycle into nine phases. They are:
1 Analyze transactions
2 Record transactions in a General Journal
3 Post transactions from the General Journal to the General Ledger
4 Prepare a Trial Balance
5 Prepare a worksheet with adjusting entry data
6 Prepare financial statements
7 Journalize and post adjusting entries
8 Journalize and post closing entries
9 Prepare a Post-Closing Trial Balance
IE
Tell student that this unit

will focus on the first four
steps of the accounting
cycle.
Accounting records
EV
The books used to record accounts are:

Chart of Accounts
General Journal
General Ledger
Chart of Accounts
A Chart of Accounts is a detailed listing of all accounts that a business uses for
recording transactions. Every account, from Cash and Office Supplies to Accounts
Payable and Common Stock, is listed. The Chart of Accounts is unique for each
organization.
PR
Each account can be assigned a number, which is related to the class of accounts it
represents, as shown in Exhibit 2-1. For example, asset accounts can be labeled starting
with a 1, liability accounts with a 2, owners equity accounts with a 3, revenue accounts
with a 4, and expense accounts with a 5. This numbering system helps you to easily
identify the individual accounts.
2 3
IE
Accounting cycle
EV
Exhibit 2-1: Chart of Accounts

General Journal
The General Journal s a book of business transactions and is the accounting record
where transactions are first recorded. The entries in the General Journal are recorded in
chronological order, and each transaction has a brief description of its purpose, as well
as its account number. All of the transactions listed in the General Journal are then
posted into the General Ledger.
General Ledger
Once you have recorded transactions in the General Journal, you must post them in the
General Ledger. The General Ledger is the book that contains all of the business
accounts, listed in numerical order. Each account in the General Ledger lists all the
activity or transactions for that accounting period.
PR
When you post a transaction from the General Journal to the General Ledger, it means
that you have entered the transaction recorded in the General Journal in the appropriate
accounts on the General Ledger. Unless you post transactions, the individual account
balances will not be accurate.
24
Do it!
A-1:
Understanding the basics of an accounting cycle
Exercises
1 Put the following phases of the accounting cycle in the correct order:
Prepare financial statements.
Analyze transactions.
Post transactions from the General

Journal to the General Ledger.
Record transactions in a General Journal.
Analyze transactions.
Prepare a Trial Balance.
Prepare a worksheet with adjusting entry data.
IE
Journalize and post adjusting

entries.
Post transactions from the General Journal to the

General Ledger.
Record transactions in a General

Journal.
Prepare a Trial Balance.
Prepare financial statements.
Journalize and post adjusting entries.

Journalize and post closing entries.
Journalize and post closing

entries.
Prepare a Post-Closing Trial Balance.
EV
Prepare a Post-Closing Trial

Balance.
Prepare a worksheet with
adjusting entry data.
2 You first record a transaction in the ________________.

A
General Ledger
Chart of Accounts
General Journal
General Balance
PR
3 Which of the following is a commonly used numbering system for entries in a

Chart of Accounts?
A
Liabilities (1), Assets (2), Owners Equity (3), Revenue (4), and Expenses (5)
Owners Equity (1), Assets (2), Liabilities (3), Expenses (4), and Revenue (5)
Assets (1), Liabilities (2), Owners Equity (3), Revenue (4), and Expenses (5)
Assets (1), Liabilities (2), Owners Equity (3), Expenses (4), and Revenue (5)
Accounting cycle
2 5
Topic B: Analyze, record, and post transactions

The first three phases of the accounting cycle are analyzing, recording, and posting
transactions to the account books according to specific bases of accounting which is
being used, either cash or accrual.
Analyze transactions
Explanation
IE
You must be able to analyze a transaction in order to record it in the General Journal
and post it to the General Ledger. Analyzing a transaction is what you do when you
determine what type of account is affected by a financial activity, and how the event
translates into debits and credits. There are three questions you should ask yourself
when analyzing a transaction:
1 What account(s) will change?
2 What account classification does each account belong to?
3 How will the transaction change each account balance?
PR
EV
Assume that your business paid a bill of $700 to Access Systems, Inc. You then answer
the three questions to analyze the transaction, as shown in Exhibit 2-2:
1 The accounts that will be changed are the Cash and Accounts Payable accounts.
2 Cash belongs to the asset account classification, and Accounts Payable belongs
to the liability account classification.
3 Your Cash account will be decreased, and your Accounts Payable account would
be decreased. Therefore, $700 would be credited to the Cash account, and $700
would be debited to the Accounts Payable account.
Exhibit 2-2: Example of analyzing a transaction
26
Post transactions to the General Ledger

There are three steps you can follow when posting transactions from the General
Journal into the General Ledger:
1 Start with the first debit entry. Record the entry and its date in the corresponding
account in the General Ledger. Then, record all entries for that transaction. For
example, you might have a $500 debit in your Accounts Payable account. After
recording this entry, you would then record the $500 credit entry for Cash.
2 In the Post Reference column of the General Ledger, record the page number of
the General Journal where the transaction was entered. This referencing provides
a trail for anyone who needs to retrace the steps taken in posting transactions.
This column is often labeled Post Ref.
3 Enter the General Ledger account number where the entry was recorded in the
Post Ref. Column of the General Journal. This referencing will also help
establish a trail that can be retraced later if necessary.
Do it!
B-1:
IE
Explanation
Analyzing and posting a transaction
Exercises
1 What is the first question that you must ask when analyzing a transaction?
What account or accounts will be changed?
EV
2 Icon collects $100,000 from Epic Financial. What accounts will be affected by the
transaction?
A
Icons Sales account and its Accounts Receivable account
Icons Sales account and its Accounts Payable account
Icons Accounts Payable account and its Accounts Receivable account
Icons Accounts Receivable account and its Cash account
3 After Icon collects $100,000 from Epic Financial, you will post the transaction in
Cash , which belongs to the ________ account, and Accounts Receivable, which
belongs to the _________ account.
AssetLiability
AssetAsset
LiabilityLiability
LiabilityAsset
PR
Accounting cycle
2 7
4 When posting a transaction from the General Journal to the General Ledger, what
is the first step?
Enter the General Ledger account number where the entry was recorded in
the post reference column of the General Journal
Record the debit entry and its date in the corresponding account in the
General Ledger and record all of the entries for that transaction
In the post reference column of the General Ledger, record the page number
on the General Journal
Record the credit entry and its date in the corresponding account in the
General Ledger and record all of the entries for that transaction
IE
5 While posting transactions, why do you need to record the respective General
Journal and General Ledger page numbers in the post reference columns?
This referencing provides a trail for anyone who needs to retrace the steps taken while
posting transactions.
Balance a General Ledger
At the end of an accounting period, when the months financial activities have been
posted to the General Ledger, some accounts will have amounts posted to their debit
side as well as their credit side. Therefore, after you have posted all transactions to the
accounts, you must balance the General Ledger accounts. There can be only one balance
to each account at the end of the accounting period.
EV
Explanation
PR
Balancing a General Ledger requires balancing each of the accounts listed in the ledger.
Follow these four steps in order to balance an account:
1 Draw a single line under the last figures in each column, as shown in
Exhibit 2-3.
2 Write the totals, or footings, of each column just below the line, as shown in
Exhibit 2-3. In accounting, one line means more to come; a double line means
the end.
Exhibit 2-3: Steps 1 and 2 of balancing a General Ledger
28
IE
3 If the two footings are equal, as shown in Exhibit 2-4, the account is in
balance.
4 If the two footings are different, you can write the difference on the side of the
account that has the larger amount and circle the figure. If the debit side has the
larger amount, this account is considered to have a debit balance, as shown in
Exhibit 2-4. If the credit side has a larger amount, then the account has a credit
balance.
EV
Exhibit 2-4: Steps 3 and 4 of balancing a General Ledger
You might wonder why some accounts have footings that are not equal, since debits are
always supposed to equal credits. Individual accounts might have different debit and
credit totals because when you post a transaction from the journal, you post part of that
transaction to one ledger account and part of it to another ledger account. Therefore, the
debit side will equal the credit side if you add up all of the balances of all the accounts
in the ledger.
A normal balance
PR
The balance of an account is considered normal if it is on the same side of the account
(debit or credit) as it is shown in the accounting equation (A = L + OE), or if the
increase side of the account is larger than the decrease side. For example, since assets
are normally on the debit, or left, side of the accounting equation, an account that is
classified as an asset will have a normal balance if it has a debit balance. Conversely,
liability accounts will have a normal balance if they have a credit balance, as will
owners equity accounts.
Since revenue represents the credit side of owners equity, revenue accounts have a
normal balance if they have a credit balance. Expenses represent the debit side of
owners equity, so for expenses, a debit balance is a normal balance.
2 9
IE
Accounting cycle
Exhibit 2-5: Icons General Ledger
Do it!
B-2:
Balancing a General Ledger
Exercises
EV
1 In accounting, a double line means:

A
more to come
out of balance
in balance
the end
2 Which of the following is an example of a normal balance?

Debit balance of an Accounts Payable account
Credit balance of a Debentures account
Credit balance of an Accounts Receivables account
Debit balance of a Notes Payable account
PR
Discuss with students.

Explain why the account is
not in balance.
3 Review Icons General Ledger account shown in Exhibit 2-5. Is it in balance?

A
Yes
No
The account is not in balance because the debit and credit footings are different.
210
Debit balance of $1,000
Credit balance of $1,000
Debit balance of $1,400
Credit balance of $2,400
4 Review Icons General Ledger shown in Exhibit 2-5. What is the balance?
5 Review Icons General Ledger shown in Exhibit 2-5. What is the next step to
balance the General Ledger?
Circle the credit side since it has the larger amount
Write the difference between the two footings on the credit side and circle the
figure
Write the difference between the two footings on the debit side and circle the
figure
Add the difference between the two footings onto the next account and
continue balancing
IE
The cash and accrual bases of accounting
When using the cash basis of accounting, you record revenues only when the money is
received and record expenses only when they are paid. With the cash basis, there are
occasions when revenue is earned in one period, but the transaction is not recorded until
the money is received in a future period. Therefore, the cash basis does not accurately
and completely reflect a businesss true profitability.
EV
Explanation
PR
The accrual basis of accounting presents a true and uniform picture of profitability
because it records revenue when it is earned and expenses when they are incurred, not
strictly when money has changed hands. In other words, accrual accounting records
transactions when they occur, regardless of whether or not money has been received or
expenses have been paid.
Accounting cycle
Do it!
B-3:
211
Identifying cash and accrual bases of accounting
Exercises
1 Select the transaction(s) that will not be recorded under cash basis of accounting.
A
Interest paid
Outstanding rent
Equipment purchased on cash
Payment of dividend
IE
2 A business receives a rental income of $2000 in cash on June 30th. On December

31st, there is another $1500 of rental income due, which is not yet received. What
is the total of the Rental income account on December 31st if your company uses
the following basis of accounting:
Cash basis of accounting
$2000
Accrual basis of accounting
$3500
PR
EV
$3500 = $2000 + $1500
212
Topic C: Trial Balance

A Trial Balance is a report that lists all the account balances as of a certain date, usually
at the end of an accounting period, such as at the end of the month. The Trial Balance
serves two purposes:
It makes sure that the total debits equal the total credits in the recording of
transactions. Financial statements cannot be prepared unless the total debits
equal the total credits on the Trial Balance.
It ensures that each account has a normal balance.
Explanation
IE
If you find that a Trial Balance does not balance, there is a strong possibility that an
error was made in recording the transaction, posting to the General Ledger, computing
the account balances, copying balances to the Trial Balance, or in adding the Trial
Balance columns.
Prepare a Trial Balance
EV
In order to prepare a Trial Balance, you can follow these five steps:
1 Create a heading by centering the name of your company, the name of the
accounting statement (Trial Balance), and the date, as shown in Exhibit 2-6.
PR
Exhibit 2-6: Step 1 of preparing a Trial Balance
2 List all accounts found in the General Ledger, their account numbers, and their
corresponding balances. List the debit balances in one column and the credit
balances in a separate column, as shown in Exhibit 2-7.
3 Draw a single line under the last figure in each column, as shown in Exhibit 2-7.
213
IE
Accounting cycle
Exhibit 2-7: Steps 2 and 3 of preparing a Trial Balance
EV
4 Total the debit balances and credit balances and write these footings under the
line, as shown in Exhibit 2-8.
5 If the totals are the same, draw a double line just below them to show that the
Trial Balance is complete, as shown in Exhibit 2-8.
PR
Exhibit 2-8: Steps 4 and 5 of preparing a Trial Balance
The books are in balance

The books are in balance if the debit balances and credit balances are equal on a Trial
Balance. If the debits and credits are not the same, youll need to go back and determine
where an error occurred during the recording of transactions.
When looking for these errors the referencing that was done when the accounts were
posted to the General Ledger is quite helpful and makes it easier to find the mistake.
214
Do it!
C-1:
Preparing a Trial Balance
Exercises
1 The primary purpose of a Trial Balance is to determine that:

A
All transactions have been entered in journals
The General Ledger totals are in balance
The amounts in a Journal are correct
2 The books are in balance means that:
The Trial Balance has a larger credit balance
The Trial Balance has a larger debit balance
The debits and credits are equal on a Trial Balance
Every account in the Trial Balance has a debit balance
IE
3 When preparing a Trial Balance, what would you need to do after creating a
heading?
Draw a single line under the last figure in each column
Total the debit and credit balances and write these footings under the single
line that you have drawn
Draw a double line below the footings to show that the totals are equal
List all of the accounts found in the General Ledger, their account numbers,
and their corresponding balances
EV
4 When preparing a Trial Balance, what would you need to do before you draw a
double line below the footings?
Draw a single line under the last figure in each column
Create a heading to include the companys name, the accounting statements

name, and the date
Total the debit and credit balances and write these footings under the single
line that you have drawn
List all of the accounts found in the General Ledger, their account numbers,
and their corresponding balances
PR
Accounting cycle
5 Review the Trial Balance shown below. Is it in balance? Discuss with the class.
IE
Ask two or three students

to give reason to support
their answer.
215
EV
The Trial Balance is not in balance because the debit balance is more than the credit balance.
Common errors found in a Trial Balance

There are several common errors that can prevent your Trial Balance from being in
balance:
Computing the amount columns in the Trial Balance incorrectly
Copying the wrong account balance from the General Ledger to the Trial
Balance
Transferring a debit balance from a General Ledger to the credit column in the
Trial Balance, or transferring a credit balance from a General Ledger to the debit
column in the Trial Balance
Computing the account balance in the General Ledger account incorrectly
Posting an incorrect amount from the General Journal to the General Ledger
PR
Explanation
The general rule to follow when looking for errors in the Trial Balance is to retrace, in
reverse order, the steps you followed to get your Trial Balance figures. Go back, one
step at a time, and check each figure with your original figures. First check the Trial
Balance figures with the General Ledger, and then check the General Ledger figures
with the General Journal.
216

A transposition error
A transposition error is an error in which the numbers are transposed or reversed,

such as 76 written as 67 or 36 written as 63. There is a common feature among
transposition errors that will help you locate these types of errors: the difference
between numbers that have been transposed is always a number that adds up to 9 or
is evenly divided by 9.
IE
Consider these examples of a transposition error:

Transposing 76 and 67 leaves a difference of 9, which of course adds up to 9,
and is divisible by 9 (9 x 0 = 9)
Transposing 63 and 36 is 27, which adds up to 9 (2 + 7 = 9), and is divisible by
9 (9 x 3 = 27).
Transposing 725 and 275 is 450, which adds up to 9 (4 + 5 + 0 = 9), and is
divisible by 9 (9 x 50 = 450).
Once you know this trick of recognizing a transposition, youll save a lot of time by
knowing where to look for the error.
Do it!
C-2:
Identifying common errors found in a Trial Balance
EV
1 The difference between numbers that have been transposed is always a number
that adds up to:
A
2 Which of the following would prevent your Trial Balance from being in
balance?
A debit balance of $75 on the Salaries account has been incorrectly posted in
the trial balance as $750 debit
Sale of goods for $1000 to Epson Inc. on credit has been completely omitted
from the books of accounts
PR
A debit balance of $10000 in the Cash account has been posted to the trial
balance as a debit balance of $10000 in the Machinery account
A debit balance of $10000 in the Cash account has been posted to the credit
column of the trial balance. At the same time, a credit balance of $10000 in
the Mortgage bonds account has been posted to the debit column of the trial
balance
Accounting cycle
3 Review the following Trial Balance. What common errors prevent the books from
being in balance?
EV
IE
If necessary, help
students identify the
errors.
217
Transposition error
Computation error
Incorrect posting to the Ledger from the Journal
Transferring a debit to the credit column in the Trial Balance
PR
The computation error is that the debit column total of the Trial Balance is shown as
$3,122.00, whereas it is $3,100.00.
The other error is that all values entered in the Trial Balance are in the wrong columns. The
values shown in the debit column should have been written in the credit column and all
values shown in the credit column should have been written in the debit column.
218

4 Review the following Trial Balance. What common error prevents the books from
being in balance?
EV
IE
If necessary, help
errors.
Transposition error
Computation error
Incorrect posting to the Trial Balance from the Ledger
PR
The Sales account balance of $120,237.00 is incorrectly written in the Trial Balance as
$120,273.00.
Accounting cycle
219
Financial statements
Completing a Trial Balance will enable you to create two of the most important
financial statements in accounting: the Income Statement and the Balance Sheet. Then,
by using the Income Statement and the Balance Sheet, you can prepare the Cash Flow
Statement and the Statement of Stockholders equity.
Income Statement
Explanation
IE
An Income Statement, also known as a Statement of Operations, is a financial report that

provides information regarding the profit or loss for the last accounting period. It is only
concerned with revenue and expense accounts. This statement is important, as a
business owner or manager must know how the business is doing, assuming profit is the
reason a company is in business. All the information you need to complete an Income
Statement is found on the Trial Balance.
Balance Sheet
A Balance Sheet, also known as a Statement of Financial Position, is a financial report

prepared at the end of an accounting period that gives a detailed picture of the financial
condition, or position, of a business as of a specific date. It can almost be thought of as a
snap-shot in time of a businesss financial status. It shows what a company owns and
owes, and how much capital it has at a particular point in time. The Balance Sheet
summarizes the first three classifications listed on the Chart of Accounts: assets,
liabilities, and owners equity.
EV
Like an Income Statement, all the information you need to complete a Balance Sheet is
found on the Trial Balance.
Cash Flow Statement
A Cash Flow Statement, also known as the Statement of Cash Flows, provides
information about a companys cash inflows and outflows during an accounting period.
Specifically, it reports the impact of a companys operating, investing, and financing
activities on the cash flows during an accounting period.
Statement of Stockholders Equity
PR
The Statement of Stockholders Equity, also known as the Statement of Owners Equity,
reports the changes that have occurred in the owners, or stockholders, equity during an
accounting period. It is prepared after the Income Statement is prepared, since the net
profit or net loss must first be determined.
Since retained earnings and capital stock are the two main components of owners
equity, these are the two categories of accounts that are included in the Statement of
Stockholders Equity.
Importance of financial statements

Just as a barometer helps a meteorologist determine what the weather might be in the
future, financial statements tell you what business might be like tomorrow, next week,
and even next month. Simply, they show trends. Financial statements tell you how the
business is currently performing at a certain point in time or over a period of time, as
well as show current trends.
220
Do it!
C-3:
In the business world, each step forward is based on what has happened in the past.
Planning for future expansion, changing manufacturing procedures, changing packaging
specifications, and even changing the size of products are all decisions based on the
results of past information and on future expectations. Financial statements reflect the
results of changes that occurred during the last accounting period. Knowing such results
helps management make informed business decisions and plan intelligently.
Identifying financial statements
Exercises
1 Which financial statement is a snap-shot in time of a business financial status?

Balance Sheet
Cash Flow Statement
Income Statement
IE
2 The Income Statement is only

concerned with revenue and
expense accounts. True or False?
True
EV
3 A Report that shows how a company generated and used cash during an
accounting period is a:
A
Balance Sheet
Income Statement
Cash Flow Statement
4 A financial report that provides information regarding the profit or loss for the last
accounting period is a:
Balance Sheet
Income Statement
PR
Cash Flow Statement
5 Retained Earnings is one of the two categories of accounts that are included in the
Statement of Stockholders Equity. What is the other category?
A
Capital Stock
Operating expenses
Working capital
Operating activities
Accounting cycle
221
6 That Balance Sheet summaries what three classifications on the Chart of

Accounts?
Assets, Liabilities, and Interest expenses
Liabilities, Owners Equity, and Interest expenses
Assets, Liabilities, and Owners Equity
Assets, Cost of Goods Sold, and Owners Equity
7 Financial statements report the financial performance of an organization, and

provide data on:
Projections for the future
Business trends
Environmental changes
Availability of cash
PR
EV
IE
222
Unit summary: Accounting cycle

In this unit, you learned about the phases of the accounting cycle. You also learned to
identify the three types of accounting records: Chart of Accounts, General Journal, and
General Ledger.
Topic B
Then, you learned how to analyze, record, and post transactions. You also learned
how to balance a General Ledger and identify the cash and accrual bases of
accounting.
Topic C
Finally, you learned the concept and preparation of a Trial Balance, how to solve
common errors found in the Trial Balance, and also identified various types of
financial statements that you can create by using the Trial Balance.
IE
Topic A
1 What are the first four phases of the accounting cycle?

Analyzing transactions
Completing a General Journal
Completing a General Ledger
Preparing a Trial Balance
EV
2 Complete the table below by writing General Ledger, General Journal, or Trial
Balance next to the correct description.
Accounting
record
A book of business transactions where the entries are

recorded in a chronological order
General Journal
A book that contains all accounts of a business, listing

all transactions for an accounting period
General Ledger
A detailed listing of all the accounts that a business uses

for recording transactions. Each account has a number
assigned to it, which is related to the broad class of
accounts it represents
Chart of Accounts
PR
Description
Accounting cycle
223
3 Icon pays $200,000 to Epic Financial for consulting services. How will this affect
Icons Cash account and its Accounts Payable account?
A Icon will credit $200,000 to both Cash and Accounts Payable
Icon will debit $200,000 from its Cash and credit $200,000 to its Accounts
Payable
Icon will credit $200,000 from its Cash and debit $200,000 from its Accounts
Payable
4 Review Icons General Ledger account shown in Exhibit 2-9. Is the account in
balance?
EV
IE
No, because the debit side is larger than the credit side.
Exhibit 2-9: Icons General Ledger
5 Review Icons General Ledger account shown in Exhibit 2-9. What is the next step
to balance the General Ledger?
A Circle the credit side since it has the larger amount
PR
B Write the difference between the two footings on the credit side and circle the
figure
C
Write the difference between the two footings on the debit side and circle the
figure
D Add the difference between the two footings onto the next account and continue
balancing
224

6 What is the first step when preparing a Trial Balance?
A Draw a single line under the last figure in each column
Create a heading to include the companys name, the accounting statements
name, and the date
C Total the debit and credit balances and write these footings under the line
D Draw a double line below the footings to show that the totals are equal
E List all of the accounts found in the General Ledger, their account numbers, and
their corresponding balances
7 Which financial statements provide a picture of a companys operations and
financial position?
IE
The Balance Sheet, the Income Statement, the Cash Flow Statement, and the Statement of
Stockholders Equity
8 What is a Balance Sheet?
It is a financial report prepared at the end of an accounting period that gives a detailed picture of
the financial condition, or position, of a business as of a specific date.
9 What does a Cash Flow Statement show?

How a business earned and spent cash
Organizations cash position
Report on operating, investing, and financing activities
EV
10 Complete the following table by writing Balance Sheet, Cash Flow Statement, or
Statement of Stockholders Equity next to the correct description.
Financial
Statement
Report that explains the changes in the owners equity

accounts during an accounting period
Statement of
Stockholders Equity
Financial report that gives a detailed picture of an

organizations financial condition
Balance Sheet
Report that summarizes the changes in an organizations

cash position by reporting on three types of activities:
operating, investing, and financing
Cash Flow Statement
Summarizes the first three classifications listed on the Chart

of Accounts: assets, liabilities, and owners equity
Balance Sheet
PR
Description
Accounting cycle
225
11 Review the Trial Balance shown in Exhibit 2-10. What common errors prevent the
books from being in balance?
B Computation error
A Transposition error
C Incorrect posting to the Trial Balance from the Ledger
PR
EV
IE
Exhibit 2-10: Icons Trial Balance and General Ledger
226

12 Review the Trial Balance shown in Exhibit 2-11. What common error prevents the
books from being in balance?
Transposition error
B Computation error
C Incorrect posting to the Ledger from the Journal
PR
EV
IE
D Transferring a debit to the credit column in the Trial Balance
Exhibit 2-11: Icons Trial Balance and General Ledger
Accounting cycle
227

ACROSS:
1. If the two footings of an account are equal, the account is in _______.
3. The ________ basis of accounting records revenue when it is earned and

expenses when they are incurred, and not strictly when money has changed
hands.
4. Liability accounts will have a normal balance if they have a ________ balance.
8. ________ a transaction from the General Journal to the General Ledger
involves three steps.
9. All transactions are first recorded in a General _________.
IE
DOWN:
2. A _______ of accounts is a detailed listing of all the accounts that a business

uses for recording transactions.
5. Assets are normally on the ________ side of an accounting equation.
6. The General ________ is a book that contains all the accounts of a business,
listed in ascending numerical order.
EV
7. The balance of an account is considered ____________ if it is on the same side

of the account (debit or credit) as it is shown in the accounting equation (A = L
+ OE), or if the increase side of the account is larger than the decrease side.
1
PR
PR
EV
IE
228
Unit 3
Income Statement
31

A Identify the key terms of an Income
IE
Statement.
PR
EV
B Create and interpret an Income Statement.
32
Topic A: Income Statement basics

To prepare an Income Statement, you need to know some key terms associated with this
concept:
Types of revenues and expenses
Profit and Loss
Explanation
Types of revenues and expenses
IE
Revenues are amounts of money that a business earns for selling goods or services to
another firm or individual. Sales- and service-based incomes are the two main types of
revenue a company earns. In addition, fees income is another type of revenue that might
be generated.
A company might also gain revenue through dividends and interest, which is income
received from an investment in stocks and bonds. Often, these types of revenue are
classified as Other revenue or Non-operating revenue on an Income Statement.
Expenses are the costs of any goods or services a business buys and uses to help it earn
revenues.
EV
There are four categories of expenses youll find on an Income Statement:

Cost of goods sold
Operating expenses
Interest expenses
Income tax
Cost of goods sold
The cost of goods sold represents the costs of the products sold during an accounting
period. This cost can be determined by adding the beginning inventory with any
purchases made to the inventory, and then subtracting the ending inventory:
Beginning Inventory + Purchases to Inventory - Ending Inventory = Cost of Goods Sold
PR
Beginning inventory is the cost of merchandise on hand at the beginning of an

accounting period. Purchases to inventory are any additions made to inventory, less
returned merchandise and any discounts allowed by suppliers. Ending inventory is the
cost of merchandise that remains unsold at the end of an accounting period. In a
manufacturing unit, the cost of material, labor overheads, and manufacturing overheads
are also included in the cost of goods sold.
Income Statement
3 3
Operating expenses
Operating expenses are expenditures that are necessary for the daily operations of a
business. They are not directly tied to the costs of goods a business sells. Marketing,
administrative, and other general expenses, such as rent and office supplies, are
included in this category. In addition, depreciation and depletion are included in the
operating expenses.
Depreciation is the process of allocating the cost of a tangible asset over its useful life.
Long-term assets, which are assets that have a life longer than one year, are often
depreciated, such as a building, computers, or equipment. Depreciation occurs when an
assets decline in usefulness is estimated, and the allocation of costs to pay for the asset
is divided in a manner consistent with the decline.
IE
For example, imagine that your company purchased a piece of equipment that cost
$12,000 and was estimated to have a useful life of 10 years. Using depreciation, you
would break up the $12,000 into separate amounts that would be charged off over the
life of the equipment. That means the $12,000 would be split up equally over the next
10 years and the yearly depreciation amount would be $1,200.
Depletion is the process of recording the exhaustion of natural resources as an expense.
Oil wells, coalmines, and timberlands are all natural resources that are consumed as
they are used. Depletion is similar to depreciation in that the expense that is recorded
each accounting period reflects the portion of natural resource that was used up during
the current year.
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Interest expenses
Interest expenses are a result of the financial structure of a business. Specifically, a

company incurs interest expenses if it has taken out a loan to support its asset
investment. If a company has instead used stockholders equity to support its asset
investment, they will not have interest expenses.
Income tax
PR
Income tax is an unavoidable expense for any business. However, since it does not serve
to increase sales or improve operating efficiency, it stands alone as its own expense
category.
34
Do it!
A-1:
Identifying types of revenues and expenses
Exercises
A
Inventory expenses
Revenue-driven expenses
Interest expenses
Profit expenses
1 Which of the following is a category of expenses found on an Income Statement?
2 What is the Cost of Goods Sold in the following situation?
IE
Beginning inventory = $10,000

Ending inventory = $12,000
Purchases = $8,000
$14,000
$6,000
$10,000
$30,000
EV
3 What is the Cost of Goods Sold in the following situation?
If necessary, help
correct answer.
Opening Stock-in-trade = $15,000
$195,000
Purchases = $220,000
Cost of Goods Sold = Opening Stock-in-trade +

Net Purchases - Closing Stock-in-trade
Purchases Returns = $20,000
Closing Stock-in-trade = $20,000
Here, Net Purchases = Purchases - Purchases

Returns
4 _______ is the process of recording the exhaustion of natural resources as an

expense.
Depletion
Depreciation
Allocation
Amortization
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Income Statement
3 5
5 Which expense category represents Building rent and Office supplies?

Depletion expenses
Operating expenses
Additions to inventory
Income tax
6 Icon International purchases a piece of equipment for $50,000. This piece of

equipment would have a useful life of 10 years. How much should be written off
as depreciation?
$500 in the first year
$50,000 in the last year
$500,000 over ten years
$5,000 per year
IE
Profit and loss
A manufacturing business makes money by selling goods at a higher price than was
paid for them.
EV
Explanation
Gross profit on sales
The gross profit on sales is determined by subtracting the cost of goods sold from the
companys sales, or total revenue.
For example, if a company earns $400,000 in sales and their cost of goods sold is
$250,000, then their gross profit on sales is $150,000.
Operating profit
The operating profit is the amount of revenue remaining after you subtract the operating
expenses from the gross profit on sales. This profit is sometimes referred to as the
operating income.
PR
Earnings before interest and taxes and income before taxes

Earnings before interest and taxes (EBIT) are calculated by adding the operating profit
and the other revenue, which consists of dividends and interest.
Income before taxes is calculated by subtracting the interest expenses from the earnings
before interest and taxes. It is also often referred to as EBT, or earnings before taxes.
Net profit and net loss

Determining the net profit or net loss is the ultimate goal when producing an Income
Statement. The net profit or net loss is determined by subtracting any provisions made
for income tax from the income before taxes. If the amount is positive, it is a net profit.
Net profit indicates that a company generated more revenue than the amount of
expenses it incurred during the period of time that the Income Statement covers.
36

If the amount is negative, it is a net loss, which indicates that a company incurred more
expenses than the amount of revenue it generated during the period covered by the
Income Statement.
Calculating profit and loss
Exercises
A-2:
Do it!
1 During an accounting period, Enson Corporation earns $900,000 in sales and its
cost of goods sold is $550,000. What is its gross profit on sales?
A
$900,000
$1,450,000
$50,000 per year
$350,000
IE
Gross profit = Companys sales Cost of goods

sold
2 During an accounting period, Enson Corporations gross profit on sales is

$350,000 and its operating expense is $100,000. What is its operating profit?
$450,000
$250,000
$350,000
$100,000
Operating profit = Gross profit from sales

Operating expense
EV
3 During an accounting period, Enson Corporations operating profit is $500,000,

other revenue is $100,000, interest paid is $135,000, and income tax is $150,000.
What is Ensons net profit or net loss?
If necessary, help
correct answer.
Operating profit ($500,000) + Other revenue ($100,000) Interest paid ($135,000) Income tax
($150,000) = $315,000
4 The instructor will divide the class into two groups and give both groups a set of
cards. Use the cards to construct the appropriate formula. Note that the cards
might contain more than what is required to create the formula.
PR
Ensure the index

cards are prepared before
the class. Give one set to
Group A and the other set
to the Group B.
Net loss = $315,000
Group A: Use the cards to

construct the formula for Net
Profit or Net Loss
Net Profit or Net Loss = Operating Profit + Other

Revenue Interest Expenses Income Tax
Group B: Use the cards to

construct the formula for Earnings
Before Interest and Taxes
Earnings Before Interest and Taxes = Sales Cost

of Goods Sold Operating Expenses + Dividends
+ Interest
Income Statement
3 7
Explanation
Topic B: Prepare and interpret an Income

Statement
The Income Statement records a companys revenue and expense details and provides
information regarding the profit or loss for the last accounting period. By using this
information, you can determine if a company is operating satisfactorily.
Steps to prepare the Income Statement
IE
There are five steps that you can follow when preparing an Income Statement:
1 Create the heading
2 Enter the revenue account balances
3 Enter the operating expense account balances
4 Enter the other revenue
5 Enter the interest expenses and income tax
Create the heading
EV
There are three items you must center at the top of the page, as shown in Exhibit 3-1
when creating an Income Statement:
The name of the company
The name of the accounting statement (in this case, Income Statement)
The date or period of time covered by the statement, such as For the Year
Ending June 30, 2000
PR
Exhibit 3-1: Heading of the Income Statement
Enter the revenue account balances

Most companies have one major revenue accountSales. However, there are six steps
that you can follow when entering the revenue account balances into an Income
Statement:
1 Write a revenue account title, such as Sales, on the first line, as shown in
Exhibit 3-2.
2 Write the amount of the accounts balance in the right amount column on the
same line as the accounts title, as shown in Exhibit 3-2. Repeat this process for
all of the revenue accounts.
38
Exhibit 3-2: Steps 1 and 2 of entering the revenue account balances
EV
IE
3 If there is more than one revenue account, draw a single line under the amount
of the last revenue account balance, as shown in Exhibit 3-3. A single line in
accounting means more to come.
4 Write Total Revenue on the line just below the last revenue account title. Total
the revenue amounts and enter the balance on the line just under the last revenue
amount, as shown in Exhibit 3-3.
PR
5 Some Income Statements show the calculations for the cost of goods sold at this
place in the Income Statement. Do the preliminary calculations in the left
amount column, and enter the cost of goods sold in the right amount column.
Draw a line under this amount, as shown in Exhibit 3-4.
6 Subtract the cost of goods sold from the total revenue amount, and write it under
the line you drew, as shown in Exhibit 3-4. This amount is the gross profit on
sales.
3 9
Income Statement
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Enter the operating expense account balances
PR
EV
There are six steps that you can follow when entering the operating expense account
balances into an Income Statement. These steps are almost identical to the steps that you
follow when entering revenue account balances:
1 Write the heading Operating expenses on the line following the gross profit
on sales title, as shown in Exhibit 3-5.
2 Write the operating expense account title, such as Rent or Office Supplies,
starting on the next line, as shown in Exhibit 3-5.
Exhibit 3-5: Steps 1 and 2 of entering the operating expense account balances
3 Write the amount of the accounts balance in the left amount column on the
same line as the accounts title, as shown in Exhibit 3-6.
4 If there is more than one operating expense account, draw a single line under the
amount of the last account balance, as shown in Exhibit 3-6.
310
IE
EV
5 Write Total Operating expenses on the line just below the last operating
expense account title. Total the list of operating expenses and write the balance
in the right amount column, as shown in Exhibit 3-7. Draw a line under this
amount.
6 Subtract the total operating expenses from the gross profit on sales, enter the
amount below the line you drew (as shown in Exhibit 3-7), and label it as
Operating profit.
PR
Enter the other revenue
There are four steps that you can follow when entering the other revenue into an
Income Statement:
1 Write the heading Other revenue on the line following the Operating profit
title, as shown in Exhibit 3-8.
2 Write Dividends and interest on the line following the Other revenue title,
as shown in Exhibit 3-8.
311
Income Statement
Exhibit 3-8: Steps 1 and 2 of entering the other revenue
EV
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3 Enter the amount of revenue generated from dividends and interest on the same
line as the Dividends and interest title, in the right amount column. Draw a
line under this amount, as shown in Exhibit 3-9.
4 Add the dividends and interest amount to the operating profit amount, enter the
figure under the line you drew (as shown in Exhibit 3-9), and label it as
Earnings before interest and tax.
Exhibit 3-9: Steps 3 and 4 of entering the other revenue
Enter the interest expenses and income tax
PR
There are six steps that you can follow when entering the interest expenses and income
tax into an Income Statement:
1 Write the heading Other expense on the line following Earnings before
interest and tax, as shown in Exhibit 3-10.
2 Write Interest expenses on the line following Other expense, as shown in
Exhibit 3-10.
Exhibit 3-10: Steps 1 and 2 of entering the interest expenses and income tax
312
IE
3 Enter the amount of interest expenses in the right amount column and draw a
line under the amount, as shown in Exhibit 3-11.
4 Subtract the interest expenses from the total income, write the amount under the
line you drew, and label it as Income before taxes as shown in Exhibit 3-11.
EV
5 On the line following Income before taxes, write Provision for Federal and
State Income Taxes and enter the amount of income tax expenses in the right
amount column. Draw a line under the amount, as shown in Exhibit 3-12.
6 Subtract the provision for income tax from the income before taxes and write the
amount under the line you drew. If this amount is positive, it is a net profit. If
this amount is negative, it is a net loss. Draw a double line (meaning the
end) below the net profit or net loss to indicate that the Income Statement is
complete, as shown in Exhibit 3-12.
PR
313
EV
IE
Income Statement
Exhibit 3-13: Icons Income Statement
Do it!
B-1:
Preparing an Income Statement
Exercises
1 Review Icons Income Statement, as shown in Exhibit 3-13, and notice that each
line is numbered. How should Line 4 and Line 10 be labeled?
Sales
Line 10
Cost of goods sold
PR
Line 4
2 Study the Income Statement, as shown in Exhibit 3-13. What is the gross profit on
sales?
A
$4,000,000
$18,300,000
$3,700,000
$3,800,000
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($2,950,000)
$990,000
$1,850,000
($990,000)
Interpret Income Statements
There are two ratios that you can compute from the information an Income Statement
provides. Both of these ratios will help you determine if a company is operating
satisfactorily:
The net operating margin
The profit margin on sales
IE
Explanation
3 Study the Income Statement, as shown in Exhibit 3-13. What is the net profit or
loss for the year?
The net operating margin
EV
In order to determine if a company is operating at a satisfactory level of efficiency, you

must calculate the net operating margin. In order to calculate the net operating margin,
divide the operating profit by the total sales figure: Operating Profit / Sales = Net
Operating Margin.
The net operating margin is expressed as a percentage. For example, if a company
earned $2,040,000 in operating profit and $11,000,000 in sales, the net operating margin
is 18.55%. This implies that for each dollar of sales, approximately 18.5 cents was the
income from operations, as shown in Exhibit 3-14.
PR
The net operating margin is compared to a companys previous net operating margins in
order to determine its financial health. For example, if a companys net operating
margin drops from 18.55% to 10% in one year, then the companys financial strength
has obviously weakened. In addition, a company will often compare its net operating
margin to those of similar businesses, particularly competitors.
Exhibit 3-14: The net operating margin
Income Statement
315
The profit margin on sales
For example, if a companys net profit is $990,000 and its sales are $11,000,000, the
profit margin on sales is 9%. Therefore, for each dollar of sales, nine cents in profit
went to the company.
Like the net operating margin, the profit margin on sales is most effective when
compared with a companys profit margin on sales of previous years and with other
companies with similar types of business. By doing so, youll be able to reach accurate
conclusions on profit progress and prospects for the future, as shown in Exhibit 3-15.
EV
IE
Tell students that if sales

decline to $8,000,000
and net profit declines to
$400,000, the profit
margin on sales would
reduce to 5%. Discuss
the calculation as
(400,000 /8,000,000) x
100 = 5%.
The profit margin on sales will indicate the status of business activities. It is determined
by dividing the net profit for the year by the total sales figure: Net Profit / Sales = Profit
Margin on Sales.
Exhibit 3-15: The profit margin on sales
Analyzing an inadequate level of gross profit on sales
PR
There are three areas that should be investigated if the gross profit on sales is too low to
cover a companys operating and interest expenses:
1 Product volume The product volume is a factor if the number of units
produced is significantly higher than the rate at which sales can sell the units.
2 Price structure The price of a unit might be too low to generate the profits
needed to cover other expenses.
3 Product costs The cost of producing a unit might be too high.
Analyzing an inadequate level of operating profit

If a companys gross profit is adequate, but its operating profit is inadequate,
management must reduce the operating expenses. If reducing the operating expenses is
not possible, then the company might not be able to succeed as a viable financial
operation.
Analyzing the income before taxes total

The income before taxes total is an important indicator of how well a company will
endure a financial setback, such as a drop in profits or an increase in expenses.
316

Specifically, any drop in gross profit or increase in operating or interest expenses that
exceeds the income before taxes total will result in a net loss for the company.
EV
IE
Therefore, a company will be able to endure a financial crisis better as their income
before taxes total increases.
Do it!
B-2:
Interpreting an Income Statement
Exercises
PR
1 A net operating margin of 13%

means that for each dollar of
sales, 13 cents was the income
from operations. True or False?
True
2 Which of the following does not need to be investigated if a company has an

inadequate level of gross profit on sales?
A
Product costs
Sales commission
Price structure
Product volume
Income Statement
317
5.39%
33.63%
18.55%
18.86%
3 Review the Income Statement, as shown in Exhibit 3-16. What is the net operating
margin?
Operating Profit / Sales = Net Operating Margin

Assuming that the previous years net operating margin for Icon was 12%, what
does the current years net operating margin indicate?
IE
The net operating margin has increased from 12% to 18.55%. This implies that Icons
financial strength has improved.
4 Review the Income Statement, as shown in Exhibit 3-16. What is the profit
margin on sales?
11%
5.39%
7.21%
9%
EV
Net Profit / Sales = Profit Margin on Sales.
Assuming that the previous years profit margin on sales for Icon was 2%, what
does the current years net operating margin indicate?
PR
The profit margin on sales has increased from 2% to 9%, which implies that for each dollar of
sales, Icon is now earning 9 cents of profit as compared to the previous years two cents.
Therefore, Icon is operating at an improved level of efficiency.
318
Unit summary: Income Statement

In this unit, you learned about the key terms associated with an Income Statement. You
learned how to calculate the four categories of expenses listed in an Income Statement.
You also learned how to calculate the different types of profit and loss, such as gross
profit on sales, operating profit, earnings before interest and taxes, income before
taxes, net profit, and net loss.
Topic B
Finally, you learned how to prepare an Income Statement. You also learned how to
interpret an Income Statement by calculating the net operating margin and the
profit margin on sales, and analyzing the different types of profits.
IE
Topic A
1 What are the characteristics of an Income Statement?
Documents profit or loss
Tracks revenue and expense accounts
Helps businesses know how they are doing
2 What is revenue?
EV
Money earned by selling goods or services to others
3 What are the different types of revenue?
There are four types of revenue: sales-based, service-based, fees income, and dividends and
interest.
4 What does the term expense mean?
Expenses are the costs of goods or services bought to earn revenue.
5 List the four different categories of expenses.
Cost of goods sold, operating expenses, interest expenses, and income tax.
6 What expense category represents salaries paid to employees?

A Costs of Goods Sold
Operating Expenses
PR
C Interest Expenses
D Income Tax
7 What expense category represents the costs of products sold during an accounting
period?
A
Costs of Goods Sold
B Operating Expenses
C Additions to inventory
D Depreciation expenses
Income Statement
319
8 Icon purchases a building for $1,000,000. This building would have a useful life of
50 years. How much should be set aside as depreciation each year?
$20,000 per year
B $1,000,000 per year

C $50,000 per year
D $500,000 per year
9 What are the steps used to prepare an Income Statement?

Create the heading
Enter the revenue accounts
Enter the operating expense accounts
Enter the other revenue
Enter the interest expenses and income tax
IE
10 Review the Income Statement, as shown in Exhibit 3-17. What is the operating
profit?
A $2,000,000
EV
B $5,360,000
C
$2,040,000
PR
D $5,000,000
EV
IE
320
11 Review the Income Statement, as shown in Exhibit 3-17. What label would you use
for Line 19?
A
Earnings before interest and taxes
B Depletion
C Gross profit on sales
PR
D Sales
Income Statement
321
12 Use the following clues to complete the crossword:

ACROSS:
1. It is the process of recording the exhaustion of natural resources as an expense.
3. Operating ______ is the amount of revenue remaining after you subtract the
operating expenses from the gross profit on sales.
4. Beginning Inventory + Purchases to Inventory - Ending Inventory = ________
of Goods Sold.
5. The _______ profit indicates that a company generated more revenue than the
amount of expenses it incurred during the period of time covered by the Income
Statement.
IE
7. To determine whether a company is operating at a satisfactory level of

efficiency, you must calculate the net operating ________. You can calculate it
by dividing the operating profit by the total sales figure.
8. If a companys gross profit is adequate, but its operating profit is inadequate,
management must reduce the operating _______.
DOWN:
1. You _________ an asset when you estimate an assets decline in usefulness and
allocate the costs to pay for the asset in a manner consistent with the decline.
EV
2. They are the expenditures that are necessary for the daily operations of a
business.
6. The ___________ profit on sales is determined by subtracting the cost of goods
sold from the companys sales or total revenue.
PR
PR
EV
IE
322
Unit 4
Balance Sheet
41
IE
A Identify a Balance Sheet.

B Prepare a Balance Sheet.
C Identify and calculate the liquidity and the
PR
EV
debt-to-total-assets ratio.
42
Topic A: Balance Sheet basics

A Balance Sheet shows what a company owns and owes, and how much capital it has at
a particular point in time. It is always prepared after the Income Statement because you
cannot complete the balance sheet until you compute the net profit or net loss on the
Income Statement.
Explanation
Components of a Balance Sheet
The Balance Sheet summarizes the first three classifications listed on the chart of
accounts: Assets, Liabilities, and Owners Equity.
Assets
IE
Current assets are those which might be turned into cash in the reasonably near future,
usually within 12 months from the date of the Balance Sheet. Some examples of current
assets include cash, marketable securities held for the short term, accounts and notes
receivable, and prepaid expenses such as rent, insurance, and office supplies.
Fixed assets are those assets not intended for resale. They are tangible, long-lived assets
used in the operation of the business to produce, distribute, and promote the product or
service. Real estate, buildings, machinery, furniture, computers, and other equipment
are all fixed assets.
EV
Liabilities
Current liabilities are debts and obligations that a company expects to pay within 12
months from the date of the Balance Sheet. Accounts and notes payable, federal and
other taxes payable, and accrued liabilities such as wages, salaries, and commissions are
all current liabilities.
Long-term liabilities are those debts and obligations owed by a business that it expects
to pay beyond 12 months from the date of the Balance Sheet. Examples of long-term
liabilities are mortgage bonds and lease obligations.
Owners Equity
PR
Since owners equity represents the part of a business that belongs to the owner, it
includes any investments that the owner or owners of a business have made. These
investments are called capital stock, and they can be broken into two categories:
preferred stock and common stock. (Keep in mind that owners equity is also comprised
of revenue and expenses.)
Preferred stock is the form of capital stock that, as the name implies, has certain
preferences. A company must pay dividends on preferred stocks before paying
dividends on common stock. A dividend is an allocation of a companys net income
used for payment to the owners. Preferred stockholders are also given priority over
common stockholders in the distribution of a companys assets in case of a liquidation.
Balance Sheet
4 3
Common stock is the most basic form of ownership in a business. Dividends are paid to
common stockholders after all payments have been made on debts and to preferred
stockholders.
Do it!
A-1:
Retained earnings are another component of owners equity. It represents all earnings
that a business has accumulated since its inception less any dividends it has paid. In
other words, retained earnings are the portion of a companys earnings that has been
saved instead of paid out as dividends.
Identifying components of a Balance Sheet
Exercises
1 Dividends are paid on _____ stock before they are paid on any other kind of
stock.
Shared
Common
Capital
Preferred
IE
EV
2 Machinery owned by a business is an example of a fixed asset. Which

characteristic must be met for an item to be included in the category of a fixed
asset?
The item is held for resale
The item is tangible
The item is not used in business operations
Benefits from the sale of the item do not extend beyond one year
PR
44
Current Assets
IE
3 Review the following list of Icons accounts. Identify the asset and liability types.
Cash
Marketable Securities
Accounts and Notes Receivable
EV
Inventories
Fixed Assets
Real Estate
Leasehold Improvements
Machinery Equipment
Current Liabilities
Accounts Payable
Notes Payable
PR
Dividends Payable
Long-term Liabilities
Mortgage Bonds
Sinking Fund Debentures
Balance Sheet
4 5
Topic B: Prepare Balance Sheets

There are eight steps you can follow when preparing a Balance Sheet:
2 Enter the current asset accounts
3 Enter the fixed asset accounts
4 Enter the other asset accounts
5 Enter the current liability accounts
6 Enter the long-term liability accounts
7 Enter the owners equity accounts
8 Complete the Balance Sheet
IE
Explanation
Create the heading
Three items are included in the heading of a Balance Sheet, as shown in Exhibit 4-1.
Each item should be centered at the top of the sheet:
The name of the accounting statement (in this case, Balance Sheet)
The date of the Balance Sheet
EV
Make sure you include the specific date, since Balance Sheets show the financial
condition of a business at one point in time.
Exhibit 4-1: Heading of a Balance Sheet
Enter the current asset accounts
PR
You can follow nine steps to enter the current asset accounts into a Balance Sheet:
1 Center the word Assets on the first line of the larger column on the left side of
the Balance Sheet, as shown in Exhibit 4-2.
2 Write Current Assets on the line just below the Asset title, as shown in
Exhibit 4-2.
46
IE
Exhibit 4-2: Steps 1 and 2 of entering the current asset accounts
EV
3 List each current asset account title starting on the line just below the Current
Assets title, as shown in Exhibit 4-3.
4 Enter the amount for each current asset account in the right amount column on
the left side of the report, as shown in Exhibit 4-3.
PR
5 When you list the Accounts and Notes Receivable account, enter its amount in
the left amount column. Then, write Less Allowance for Bad Debt under the
Account and Notes Receivable title, as shown in Exhibit 4-4. This amount is a
provision for bad debts, since some customers will fail to pay their bills.
6 Enter the provision amount for bad debt in the left amount column, directly
below the Accounts and Notes Receivable amount. Draw a line under this
figure, as shown in Exhibit 4-4.
7 Subtract the provision for bad debt from the accounts and notes receivable
amount, and enter this figure in the right amount column, as shown in
Exhibit 4-4. Write Inventories on the next line and enter the value of
inventories.
4 7
Balance Sheet
IE
Exhibit 4-4: Steps 5, 6, and 7 of entering the current asset accounts
EV
8 Write Total Current Assets on the line just below the last current asset
account, as shown in Exhibit 4-5.
9 Draw a line under the last current asset amount. Total all of the current assets
and enter the amount on the same line as the Total Current Assets title in the
right amount column on the left side of the report, as shown in Exhibit 4-5.
PR
Enter the fixed asset accounts
You can follow eight steps in order to enter the fixed asset accounts into a Balance
Sheet:
1 Write Fixed Assets on the line just below the Total Current Assets title, as
shown in Exhibit 4-6.
2 List each fixed asset account title starting on the line just below the Fixed
Assets title, as shown in Exhibit 4-6.
IE
48
Exhibit 4-6: Steps 1 and 2 of entering the fixed asset accounts
PR
EV
3 Enter the amount for each fixed asset account in the left amount column on the
left side of the report, as shown in Exhibit 4-7.
4 Draw a line under the last fixed asset amount. Total all of the fixed assets and
enter the amount below the line, as shown in Exhibit 4-7.

5 Write Less Accumulated Depreciation on the next line, as shown in
Exhibit 4-8. This amount represents the value of depreciation that has accrued
during the accounting period and from previous accounting periods.
6 Enter the amount of accumulated depreciation on the left side of the report,
directly below the total of all the fixed assets. Draw a line under this amount, as
4 9
IE
Balance Sheet
PR
EV
7 On the next line, write Total Fixed Assets, aligned with the left side of the
column, as shown in Exhibit 4-9.
8 Subtract the less accumulated depreciation from the total fixed assets and enter
the amount on the same line as the Total Fixed Assets title in the right amount
Enter the other asset accounts

Many companies have other asset accounts that are listed on the Balance Sheet. These
assets include prepayments, which are goods or services that have been purchased in
advance of their use and from which the company has not yet received the benefits. For
example, if a company has prepaid insurance, the insurance premiums might have been
paid for a number of years in advance of the time when they would be charged off as an
expense.
410

In addition, a company might have intangibles, which are non-physical items such as
patents, trademarks, and copyrights. They are valued conservatively and often have no
more than a nominal value, such as $1.00. Many businesses list intangibles on a Balance
Sheet with no value attached, simply to show that these assets do exist.
EV
IE
In order to list prepayments and intangibles on your Balance Sheet, there are five steps
you can follow:
1 Under Total Fixed Assets, write Other Assets and then write
Prepayments, as shown in Exhibit 4-10.
2 Enter the amount of prepayments on the same line as the Prepayments title in
the right amount column on the left side of the report, as shown in Exhibit 4-10.
Exhibit 4-10: Steps 1 and 2 of entering the other asset accounts
PR
3 Write Intangibles under the Prepayments heading, as shown in Exhibit 4-11.

4 Enter the amount of intangibles on the same line as the Intangibles title, in the
right amount column, on the left side of the report. This amount is often $0.00.
Draw a single line under this amount, as shown in Exhibit 4-11.
5 Total the prepayments and intangibles and enter this amount directly below the
single line you drew, as shown in Exhibit 4-11.
411
IE
Balance Sheet
Exhibit 4-11: Steps 3, 4, and 5 of entering the other asset accounts

Enter the current liability accounts
PR
EV
There are six steps you can follow in order to enter the current liability accounts into a
Balance Sheet:
1 Center the word Liabilities on the first line of the larger column on the right
side of the Balance Sheet, as shown in Exhibit 4-12.
2 Write Current Liabilities on the line just below the Liabilities title, as shown
in Exhibit 4-12.
Exhibit 4-12: Steps 1 and 2 of entering the current liability accounts

3 List each current liability account title starting on the line just below the
Current Liabilities title, as shown in Exhibit 4-13.
4 Enter the amount for each current liability account in the left amount column on
the right side of the report, as shown in Exhibit 4-13.
412
IE
EV
5 Write Total Current Liabilities on the line just below the last current liability
6 Draw a line under the last current liability amount. Total all of the current
liabilities and enter the amount on the same line as the Total Current
Liabilities title in the right amount column on the right side of the report, as
PR
Enter the long-term liability accounts
There are five steps you can follow in order to enter the long-term liability accounts into
a Balance Sheet:
1 Write Long-term Liabilities on the line just below the Total Current
Liabilities title, as shown in Exhibit 4-15.
2 List each long-term liability account title starting on the line directly below the
Long-term Liabilities title, as shown in Exhibit 4-15.
3 Enter the amount for each long-term liability in the right amount column on the
right side of the report, as shown in Exhibit 4-15.
413
IE
Balance Sheet
Exhibit 4-15: Steps 1, 2, and 3 of entering the long-term liability accounts
PR
EV
4 Write Total Liabilities on the line just below the last long-term liability
5 Draw a line under the last long-term liability amount. Total all of the long-term
and current liabilities and enter the amount below the line, which will be the
same line on which the Total Liabilities title is listed, as shown in
Exhibit 4-16.
Exhibit 4-16: Steps 4 and 5 of entering the long-term liability accounts
Enter the owners equity accounts

You can follow eleven steps in order to enter the owners equity accounts into a Balance
Sheet:
1 Skip one blank line below the Total Liabilities title and center the words
Owners Equity, as shown in Exhibit 4-17.
2 Write Capital Stock on the line just below the Owners Equity title, as
IE
414
Exhibit 4-17: Steps 1 and 2 of entering the owners equity accounts
PR
EV
3 Write Preferred Stock on the next line, as shown in Exhibit 4-18.

4 Enter the amount of preferred stock on the same line as the Preferred Stock
title in the left amount column on the right side of the report, as shown in
Exhibit 4-18.
5 Write Common Stock on the next line, as shown in Exhibit 4-18.
6 Enter the amount of common stock on the same line as the Common Stock
title in the left amount column on the right side of the report, as shown in
Exhibit 4-18.
Exhibit 4-18: Steps 3 to 6 of entering the owners equity accounts
Balance Sheet
415
EV
IE
7 Draw a line under the common stock amount and add the preferred and common
stock amounts. Write this amount under the line, as shown in Exhibit 4-19.
8 Write Additional Paid-in Capital on the next line, aligned with the left side of
the column. Additional paid-in capital is the amount paid by shareholders over
and above the par or legal value of each share of stock. Enter this amount on the
same line, in the left amount column, as shown in Exhibit 4-19.
9 Write Retained Earnings on the next line. Enter the amount of retained
earnings on the same line in the left amount column, as shown in Exhibit 4-19.
Exhibit 4-19: Steps 7, 8, and 9 of entering the owners equity accounts
PR
10 Write Total Owners Equity on the line just below the retained earnings
11 Draw a line under the retained earnings amount. Add the combined preferred
and common stock amount with the additional paid-in capital and retained
earnings amounts. Enter this amount in the right amount column, on the same
line as the Total Owners Equity title, as shown in Exhibit 4-20.
Exhibit 4-20: Steps 10 and 11 of entering the owners equity accounts
416

Complete the Balance Sheet
IE
There are seven steps you can follow in order to complete the Balance Sheet:
1 Directly below the amount of the total owners equity, draw a single line, as
2 On the left side of the Balance Sheet, draw a single line across the amount
column on the same line as the line you drew on the right side of the Balance
Sheet, as shown in Exhibit 4-21.
EV
Exhibit 4-21: Steps 1 and 2 of completing the Balance Sheet
PR
3 Add the amounts on the left side of the Balance Sheet, and then add the amounts
on the right side to make sure the two sides are equal, as shown in Exhibit 4-22.
If they are not equal, there is an error, and you must correct it before completing
the Balance Sheet.
4 If the total assets equal the total liabilities plus owners equity, write the totals
under both single ruled lines you drew, as shown in Exhibit 4-22.
Exhibit 4-22: Steps 3 and 4 of completing the Balance Sheet
Balance Sheet
417
IE
5 Write the words Total Assets in the larger column on the left side of the
Balance Sheet on the same line as the left side total, as shown in Exhibit 4-23.
6 Write the words Total Liabilities and Owners Equity in the larger column on
the right side of the Balance Sheet on the same line as the Total Assets, as
7 Draw a double ruled line just below the totals for both the left and the right
amount columns, as shown in Exhibit 4-23. The double ruled line shows that the
work is done and the Balance Sheet is in balance.
PR
EV
Exhibit 4-23: Steps 5, 6, and 7 of completing the Balance Sheet
Exhibit 4-24: Icons Balance Sheet
418
Do it!
B-1:
Preparing a Balance Sheet
Exercises
1 Review Exhibit 4-24. From the following list, identify the values that should be
included in the specified lines of the Balance Sheet.
Real Estate, Accounts Payable, Cash, Mortgage Bonds, Federal and other taxes
payable, Depletion, Less accumulated depreciation, Preferred Stock
Cash
Line 13
Real Estate
Line 16
Less accumulated depreciation
Line 36
IE
Line 6
Preferred Stock
2 Review the Balance Sheet, as shown in Exhibit 4-24. What are the total assets?
$22,050,000
$10,850,000
$21,030,000
$10,180,000
EV
PR
Total Assets ($10,180,000) = Total Current Assets ($4,380,000) + Total Fixed Assets
($5,700,000) + Prepayments ($50,000) + Intangibles ($50,000)
Balance Sheet
419
Topic C: Interpret Balance Sheets

A Balance Sheet helps you identify a companys liquidity and the debt-to-total-assets
ratio.
Liquidity
Explanation
Liquidity refers to a businesss ability to generate adequate amounts of cash to meet an

obligation. For example, the liquidity of an asset refers to how quickly and easily the
asset is converted to cash. Obviously, creditors are interested in knowing the liquidity of
a company before agreeing to lend them money.
IE
A Balance Sheet will enable you to compute two figures that will help you identify and
compare a companys liquidity:
Working capital
Current ratio
Working capital
The working capital is a basic comparison between current assets and current liabilities.
It is calculated by simply finding the difference between these two amounts: Current
Assets - Current Liabilities = Working Capital. If current liabilities exceed current
assets, a negative working capital exists and a company might be perceived as not being
able to meet their current obligations.
EV
Discuss an example with

students. If total current
assets are worth
$30,000 and current
liabilities are $16,000,
the working capital
would be $14,000.
Explain the calculation
as $30,000 $16,000 =
$14,000.
The important thing to keep in mind when managing working capital is that it should be
balanced. For example, too little working capital might indicate that a business is not
able to pay its debts in a timely manner. Conversely, an excess of working capital could
mean that the company is not investing enough of its available funds in productive
resources, such as new computers or other equipment.
Current ratio
The current ratio allows the liquidity of a company to be compared with other
companies in its industry. In particular, it reflects if a company has sufficient current
resources to meet company obligations in the event of a sudden emergency. You
calculate the current ratio by dividing current assets by current liabilities: Current Assets
/ Current Liabilities = Current Ratio. The current ratio is expressed as a decimal.
PR
Discuss an example with

students. If current
assets = $30,000,
current liabilities =
$16,000, then current
ratio = 1.875. (30000 /
16000 = 1.875)
Generally, a current ratio of 2:1 is considered acceptable for a company. This is because
in such a situation, a company would be able to meet its current obligations even if the
value of its current assets reduces by 50%. A current ratio below one indicates that a
company is not able to pay off its current liabilities, and a current ratio above two
indicates that a company is able to pay off its current liabilities and have extra money
left.
IE
420
Do it!
EV
C-1:
Identifying liquidity
Exercises
1 Working capital is equal to:

A
Current Assets - Current Liabilities
Current Assets + Current Liabilities
Current Assets / Current Liabilities
Current Liabilities / Current Assets
2 Review the Balance Sheet, as shown in Exhibit 4-25. What is the working capital?
$1,840,000
$0
-$520,000
$2,420,000
PR
Working Capital ($2,420,000) = Current Assets ($4,380,000) Current Liabilities ($1,960,000)
Balance Sheet
421
Ask Students to share

their answers to the
following questions, and
discuss with the class.
0.75
0.48
2.23
1.48
3 Review the Balance Sheet, as shown in Exhibit 4-25. What is the current ratio?
What does this current ratio value imply?
Icons current ratio, 2.23, reflects a company that is generally able to pay off its current
liabilities.
IE
Discuss what possible methods could be used to improve the current ratio.
Anything that increases current assets and/or reduces current liabilities will improve the
current ratio. For instance, if you sell a fixed asset for cash, it increases the current assets as
cash increases in value. This will improve the current ratio. Similarly, if an accounts payable
is settled by issuing debentures to the creditor, it leads to a decline in current liabilities
without a change in the current assets. This, in turn, leads to an improvement in the current
ratio.
Is it possible that a change in either current assets or current liabilities or both

could result in no change to the current ratio? Discuss with the class.
EV
Yes, if the current assets or the current liabilities increase or decrease by the same amount,
the total current assets or current liabilities (as the case may be) will remain the same.
Therefore, there will be no change in the current ratio. For instance, cash and accounts
receivable are current assets. When you receive cash from an accounts receivable account,
though cash increases by a fixed amount, the accounts receivable account decreases by the
same amount.
Debt-to-total-assets ratio
Explanation
A Balance Sheet provides the information you need to compute a debt-to-total-assets

ratio. The debt-to-total-assets ratio is calculated by dividing total liabilities by total
assets: Total Liabilities / Total Assets = Debt-to-Total-Assets ratio.
PR
The debt-to-total-assets ratio indicates how many liabilities a company has per $1 of
assets. For example, imagine your companys total liabilities are $130,000 and its total
assets are $543,000. Therefore, your companys debt-to-total-assets ratio is .24. In other
words, for every $1 of assets, your company has $.24 of debt. Another way this figure
can be interpreted is that 24 percent of your companys assets are funded by liabilities,
or creditors.
The debt-to-total-assets ratio is important because it indicates a companys ability to
absorb a reduction in assets without hindering its ability to pay creditors. Generally,
creditors are more willing to loan funding to a company that has a low ratio; a company
that is less dependent on creditors for the funding of assets will be better able to pay
creditors in the event of a liquidation.
IE
422
Do it!
EV
C-2:
Identifying the debt-to-total-assets ratio
1 If a companys debt-to-total-assets ratio is .35, it means that:

A
For every dollar of liabilities, 35 cents is converted to stock
For every dollar of assets, the company has 35 cents of debt
For every dollar of debt, the company has 35 cents of assets
35% of the companys assets are used to reduce debt
PR
2 Review the Balance Sheet, as shown in Exhibit 4-26. What is the debt-to-totalassets ratio?
A
.38
2.64
.68
Debt-to-Total-Assets ratio (.38) = Total Liabilities ($3,860,000) / Total Assets ($10,180,000)
Balance Sheet
423
Unit summary: Balance Sheet

In this unit, you learned about the key terms associated with the Balance Sheet. You
learned that the two types of assets are current assets and fixed assets. You also
learned that there are two types of liabilities, current liabilities and long-term
liabilities. Then, you learned that owners equity includes retained earnings and
capital stock, which can be broken into two categories, preferred stock and common
stock.
Topic B
Then, you learned how to prepare a Balance Sheet.
Topic C
Finally, you learned how to interpret a Balance Sheet. You learned how to identify a
companys liquidity by computing the working capital and the current ratio. You
also learned how to assess a companys financial health by calculating the debt-tototal-assets ratio.
IE
Topic A
1 When is a Balance Sheet generally prepared?
Always after the Income Statement
When you want to see the state of affairs of the company as on a particular date.
EV
2 What asset type represents prepaid expenses, such as rent, insurance, and office
supplies?
A
Current asset
B Fixed asset
3 What liability type represents mortgage bonds?

A Current liability
Long-term liability
4 What are the steps used to prepare a Balance Sheet?

Create the heading
Enter the current, fixed, and other asset accounts
PR
Enter the current and long-term liability accounts
Enter the owners equity accounts
Complete the Balance Sheet
5 Review the Balance Sheet, as shown in Exhibit 4-27. What label should be located
on Line 24?
A Mortgage bonds
B
Accounts payable
C Preferred stock
D Total current liabilities
IE
424
EV
6 Review the Balance Sheet, as shown in Exhibit 4-27. What is the total liabilities and
stockholders equity?
A
$10,180,000
B $22,050,000
C $10,850,000
D $21,030,000
7 Liquidity refers to:
A A businesss ability to convert revenue into stock holdings

A businesss ability to generate adequate amounts of cash to meet a current
obligation
PR
C A businesss ability to convert revenues into expenses

D A businesss ability to convert expenses into revenues
51
Unit 5

A Identify and prepare a Cash Flow
IE
Statement.
B Identify and prepare a Statement of
PR
EV
Stockholders Equity.
52
Topic A: Cash Flow Statement

A Cash Flow Statement reports the impact of a companys operating, investing, and
financing activities on cash flow during an accounting period. It is prepared at the end
of an accounting period to provide information about a companys cash inflows and
outflows during that period.
Explanation
Accounts on a Cash Flow Statement
IE
There are three categories of accounts that are included on a Cash Flow Statement:
Investing activities
Financing activities
EV
Operating activities are the cash inflows and outflows that relate to the daily operations
of the company. Cash flows from operating activities are generally the result of the
purchase and sale of a product or service. For example, the following transactions are all
considered operating activities:
Collecting from customers
Collecting interest and dividends
Paying suppliers
Paying employees
Paying interest and tax
Cash flows from operating activities are reported on a Cash Flow Statement using either
the direct approach or indirect approach.
The direct approach shows operating activities listed out by natural category, such as
payments to employees, payments to suppliers, or collections from customers. In other
words, using the direct approach, cash receipts and cash disbursements from operating
activities are determined.
Using the indirect approach, cash flows from operating activities are reported by
adjusting net income for revenues and expenses that appear on the Income Statement
but do not affect cash.
PR
Tell students that

depreciation is an
example of a non-cash
expense.
For example, net income as reported on the Income Statement is adjusted for all noncash transactions, such as depreciation, as well as all changes in current assets and
liabilities on the Balance Sheet during the period. However, only current assets and
liabilities are reported in the operating section of the Cash Flow Statement. Other
changes to the Balance Sheet items are reported in the investing and financing sections.
Since this approach complements the accrual basis of accounting, it is the preferred
method of preparing Cash Flow Statements.
In both methods, investing and financing activities are identical.
5 3
Investing activities involve the acquisition and sale of long-term, or fixed, assets. For
example, the following transactions are investing activities:
Collecting on loans
Selling fixed assets
Selling debt or stocks
Loaning money
Purchasing stocks
Purchasing fixed assets
A-1:
Identifying accounts on a Cash Flow Statement
EV
Do it!
IE
Financing activities are the result of the issuance and repayment, or retirement, of longterm liabilities and capital stock. The following transactions are financing activities:
Issuing loans
Issuing stock certificates
Buying back your own stock
Making loan payments
Payment of dividends
Exercises
1 The three main sections of a Cash Flow Statement are:

A
Cash from operating activities, cash from sales, and cash from administrative
activities
Cash from operating activities, cash from investing activities, and cash from
financing activities
Cash from assets, cash from liabilities, and cash from equity
Cash from sales, cash from operations, and cash from depreciation and
amortization
PR
2 Which of the following activities is not an operating activity?

A
Collecting from customers
Paying interest and tax
Selling fixed assets
54
Buying stock
Paying dividends
3 Which of the following activities is an investing activity?
4 Classify the following transactions as operating, investing, or financing activities.

Investing
Payment to suppliers
Operating
Revenue from customers
Operating
Financing
IE
Collection of loans
5 While using the indirect approach, cash flows from ____________ activities are
reported by adjusting the net income for revenues and expenses that appear on the
Income Statement but do not affect cash.
EV
A
C
Collecting activities
Benefits of the Cash Flow Statement
Explanation
There are two main questions that a Cash Flow Statement can answer:
1 Is the company earning enough cash to purchase the additional assets needed for
growth?
2 Is the company earning extra cash that can be used to repay debt or invest in new
products?
PR
The first question relates to the operating activities on a Cash Flow Statement. Perhaps
it is clear from studying the statement that more assets are needed in order to increase
the amount of cash inflow from operating activities. Likewise, the second question
regards a companys financing and investing activities, respectfully. Not only does the
Cash Flow Statement show whether or not the extra cash is available, but it indicates
which area of the company would benefit from the cash the most.

Do it!
A-2:
5 5
Identifying benefits
Exercises
True
1 The Cash Flow Statement can

identify the areas of a company
that are in greatest need of cash.
True or False?
2 Read the following questions and identify what activity it relates to.
Is the company earning enough cash to purchase the additional assets needed for
growth?
IE
Is the company earning extra cash that can be used to repay debt or invest in new
products?
Financing and investing activities
Prepare Cash Flow Statements
To create a Cash Flow Statement, youll need information from both a Balance Sheet
and an Income Statement. There are six steps that you can follow to obtain correct
information from a Balance Sheet and Income Statement and enter it into a Cash Flow
Statement.
1 Calculate the year-end difference for each item on a Balance Sheet
2 Create the heading of the Cash Flow Statement
3 Enter the cash flows from operating activities
4 Enter the cash flows from investing activities
5 Enter the cash flows from financing activities
6 Total the Cash Flow Statement
EV
Explanation
Calculate the year-end difference for each item on a Balance Sheet
PR
For each item on a Balance Sheet, get the balance at the end of the current year and the
beginning of the current year. For asset accounts, subtract the beginning balance from
the ending balance. For liability and owners equity accounts, subtract the ending
balance from the beginning balance.
Once you have found these differences, these amounts will be used to indicate the cash
flows for operating, investing, and financing activities on the Cash Flow Statement.
56

Create the heading of the Cash Flow Statement
IE
Three items, as shown in Exhibit 5-1, are included in the heading of a Cash Flow
Statement and should be centered at the top of the sheet.
The name of the accounting statement (in this case, Cash Flow Statement)
The date the cash flow statement covers, such as For the Year Ending
December 31, 2001.
EV
Exhibit 5-1: Create the heading
Enter the cash flows from operating activities
PR
You can follow six steps to enter the cash flows from operating activities into a Cash
Flow Statement:
1 Write Cash Flows from Operating Activities on the first line under the
heading, as shown in Exhibit 5-2.
2 Write Net income or Net profit on the next line, as shown in Exhibit 5-2,
and enter the net income amount in the left amount column. Youll get this
amount from the Income Statement.
Exhibit 5-2: Steps 1 and 2 of entering the cash flows from operating activities
5 7
IE
3 On the next line, write Adjustments to reconcile net income to net cash
directly below the Net income or Net profit title, as shown in Exhibit 5-3.
This heading indicates that you are using the indirect approach to prepare your
Cash Flow Statement.
Exhibit 5-3: Step 3 of entering the cash flows from operating activities
PR
EV
4 One-by-one, list each source and use of cash that fall into the operating activities
category, and enter the amount of each in the left amount column, as shown in
Exhibit 5-4. These amounts are the differences you calculated on the Balance
Sheet in step one, as well as any non-cash transactions reported on the Income
Statement, such as depreciation. If an amount indicates cash that your business
paid, put parentheses around the figure, so youll know to subtract this amount.
Draw a line under the last amount.
Exhibit 5-4: Step 4 of entering the cash flows from operating activities
58
IE
5 After you list each of the operating activities, write, Net cash provided by
operating activities on the line after the last operating activity, as shown in
Exhibit 5-5.
6 Total the net income and all of the operating activities. Enter the amount under
the line you drew under the last operating activity amount, but in the right
column, as shown in Exhibit 5-5. This amount is the Net cash provided by
operating activities. However, if this amount is negative, this number represents
the Net cash used by operating activities, and should be labeled as such.
EV
Exhibit 5-5: Steps 5 and 6 of entering the cash flows from operating activities
Enter the cash flows from investing activities
PR
The following four steps will help you enter the cash flows from investing activities into
a Cash Flow Statement:
1 Write Cash Flows from Investing Activities on the first line under the Net
cash provided by operating activities or Net cash used by operating activities
2 One-by-one, list each source and use of cash that fall into the investing activities
Exhibit 5-6. These amounts will come by analyzing the differences you
calculated on the Balance Sheet. Each account involving cash receipts and cash
payments from investing activities is examined individually. The cash outflows
and inflows are not netted off, but are presented separately. Draw a line under
the last amount.
5 9
IE
Exhibit 5-6: Steps 1 and 2 of entering the cash flows from investing activities
PR
EV
3 After you list each of the investing activities, write Net cash provided by
investing activities on the line after the last investing activity, as shown in
Exhibit 5-7.
4 Total all of the investing activities. Enter the amount under the line you drew
under the last investing activity amount, but in the right column, as shown in
Exhibit 5-7. This amount is the Net cash provided by investing activities. If
this amount is negative, this number represents the Net cash used by investing
activities and should be labeled as such.
Exhibit 5-7: Steps 3 and 4 of entering the cash flows from investing activities
510

Enter the cash flows from financing activities
EV
IE
The following four steps will help you to enter the cash flows from financing activities
into a Cash Flow Statement:
1 Write Cash Flows from Financing Activities on the first line under the Net
cash from investing activities or Net cash used by investing activities title, as
2 One-by-one, list each source and use of cash that fall into the financing activities
Exhibit 5-8. Again, these amounts will come from the differences you calculated
on the Balance Sheet. As with investing activities, cash outflows and cash
inflows for financing activities are also presented separately. Draw a line under
the last amount.
Exhibit 5-8: Steps 1 and 2 of entering the cash flows from financing activities
PR
3 After you list each of the financing activities, write, Net cash provided by
financing activities on the line after the last financing activity, as shown in
Exhibit 5-9.
4 Total all of the financing activities. Enter the amount under the line you drew
under the last financing activity amount, but in the right amount column, as
shown in Exhibit 5-9. This amount is the Net cash provided by financing
activities. If this amount is negative, this number represents the Net cash used
by financing activities and should be labeled as such. Draw a line under the
amount.
511
IE
Exhibit 5-9: Steps 3 and 4 of entering the cash flows from financing activities
Total the Cash Flow Statement
PR
EV
The following five steps will help you to total and complete a Cash Flow Statement:
1 Add up the net cash amounts provided by or used by operating, investing, and
financing activities and enter the amount under the line you drew below the Net
cash provided by financing activities or Net cash used by financing activities,
as shown in Exhibit 5-10.
2 If the amount is positive, write Net increase in cash on the same line, under
the Net cash provided by financing activities or Net cash used by financing
activities title, as shown in Exhibit 5-10. If the amount is negative, write Net
decrease in cash instead.
Exhibit 5-10: Steps 1 and 2 of totaling the Cash Flow Statement
512
IE
3 On the next line, write Cash at beginning of year. Youll get this amount from
the Balance Sheets Cash amount for the previous year. Enter the amount in
the right column, and draw a line under the amount, as shown in Exhibit 5-11.
4 Add the amount of cash at the beginning of the year to the net increase in cash,
or subtract it from the net decrease in cash, whatever the case might be. Enter
the amount under the line you drew below Cash at beginning of year. Draw a
double line under the amount, as shown in Exhibit 5-11, indicating that this is
the end amount.
EV
Exhibit 5-11: Steps 3 and 4 of totaling the Cash Flow Statement
PR
5 This amount is the total amount of cash your company has at the end of the year,
so label it as Cash at end of year, as shown in Exhibit 5-12. This amount
should equal the Cash amount for the current year listed on your Balance
Sheet. If these two amounts are not equal, an error has been made and will need
to be corrected.
Exhibit 5-12: Step 5 of totaling the Cash Flow Statement
513
EV
IE
Exhibit 5-13: Icons Cash Flow Statement
Do it!
A-3:
Preparing a Cash Flow Statement
1 The Cash at end of year amount on the Cash Flow Statement should correspond
to which of the following?
The Cash amount for the current year on the Balance Sheet
The Total assets amount for the previous year on the Balance Sheet
The Net Income amount on the Income Statement
The Gross Profit on Sales amount on the Income Statement
PR
If these two amounts are not equal, an error has been made and will need to be corrected.
514

2 When calculating the differences for each asset on a Balance Sheet, you should:
Subtract the ending balance from the beginning balance
Subtract the beginning balance from the ending balance
Add the beginning and ending balances
Add the beginning and ending balances, then divide by 2
Once you have found these differences, these amounts will be used to indicate the cash
flows for operating, investing, and financing activities on the Cash Flow Statement.
$3,029,000
$39,000
$2,850,000
$29,000
IE
3 Review the Cash Flow Statement, as shown in Exhibit 5-13. What is the net
increase in cash?
4 Review the Cash Flow Statement, as shown in Exhibit 5-13. Using the value of
net increase in cash that you calculated, what is the Cash at the end of the year?
$29,000
$68,000
$10,000
$39,000
PR
EV
515
Topic B: Statement of Stockholders Equity

The Statement of Stockholders Equity provides an important link to the Income
Statement and to the Balance Sheet. The net profit or net loss at the bottom of an
Income Statement does not reflect any dividends paid to stockholders; dividends are a
distribution of net profit to stockholders, not an expense that is deducted to arrive at the
net profit or net loss.
Explanation
The Balance Sheet does not show what changes affected the stockholders section. The
Statement of Stockholders Equity shows all the changes in capital stock and retained
earnings for the period of the statement.
IE
Changes occur in the Statement of Stockholders Equity because the stockholders allow
the company to reinvest the funds that otherwise could be distributed as dividends.
Prepare a Statement of Stockholders Equity
EV
There are four steps that you can follow when preparing a Statement of Stockholders
Equity:
2 Enter the capital stock
3 Enter the retained earnings
4 Total the capital stock and retained earnings
Create the heading
PR
Three items are included in the heading of a Statement of Stockholders Equity, as

shown in Exhibit 5-14. Each item should be centered at the top of the sheet:
The name of the accounting statement (in this case, Statement of Stockholders
Equity)
The date
IE
516
Exhibit 5-14: Heading of a Statement of Stockholders Equity

Enter the capital stock
PR
EV
You can follow seven steps to enter the capital stock into a Statement of Stockholders
Equity:
1 Write Capital Stock on the first line under the heading, aligned with the left
side of the statement, as shown in Exhibit 5-15.
2 List the price per share of stock on the next line. $80 Per Share is an example
of this formatting, as shown in Exhibit 5-15.
Exhibit 5-15: Steps 1 and 2 of entering the capital stock

3 On the next line, list the balance of the issued shares as of the beginning of the
year by writing the month, date, and year, followed by the number of issued
shares. July 1, 2000: 2000 Shares Issued is an example of this formatting, as
4 On the same line, enter the balance of issued shares in the middle amount
517
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PR
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5 On the next line, write Issued during, followed by the specific year and the
number of shares issued. Issued during 2000, 3000 shares issued is an example
of this formatting, as shown in Exhibit 5-17.
6 Enter the value of the shares issued during the current year on the same line, in
the middle amount column. Draw a line under the amount, and total the
beginning balance with the value of shares issued. Write this amount in the right
amount column, as shown in Exhibit 5-17.

7 Write Balance, followed by the date of the statement on the same line as the
totaled amount, as shown in Exhibit 5-18.
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518
Exhibit 5-18: Step 7 of entering the capital stock

Enter the retained earnings
PR
EV
You can follow ten steps to enter the retained earnings into a Statement of Stockholders
Equity:
1 On the next line after the capital stock balance, write Retained Earnings,
aligned with the left side of the statement, as shown in Exhibit 5-19.
2 On the next line, write the date of the last prepared Statement of Stockholders
Equity, such as July 1, 2000, as shown in Exhibit 5-19.
Exhibit 5-19: Steps 1 and 2 of entering the retained earnings

3 Enter the amount of retained earnings in the middle amount column, as shown in
Exhibit 5-20. This amount is carried over from the previous years Statement of
Retained Earnings.
4 Write Net income or Net profit on the next line, as shown in Exhibit 5-20.
519
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5 On the same line, enter the net income in the left amount column, as shown in
Exhibit 5-21. You can find this information on your Income Statement.
6 Write Less Dividends Declared on the line directly below the Net income
PR

7 On the same line, in the left amount column, enter the value of the total
dividends your company had to pay. Draw a line under this amount, and subtract
the dividends from the net income. Write the amount, which represents the net
increase, under the line, but in the middle amount column, as shown in Exhibit
5-22.
8 Write Net Increase on the same line as the amount you just calculated, directly
below the Less Dividends Declared title, as shown in Exhibit 5-22.
IE
520
PR
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9 On the next line, write Balance, followed by the date of the statement, as
10 Draw a line under the Net Increase amount, and add this amount to the
retained earnings carried over from the previous year. Write the total on the
same line as the Balance title, in the right amount column, as shown in Exhibit
5-23.
Total the capital stock and retained earnings

You can follow four steps to total the capital stock and retained earnings on a Statement
of Stockholders Equity:
1 Write Total Stockholders Equity on the line directly below the Balance
title, aligned with the left side of the statement, as shown in Exhibit 5-24.
2 In the right amount column, draw a line under the retained earnings balance, as
521
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Exhibit 5-24: Steps 1 and 2 of totaling the capital stock and retained earnings
EV
3 Add the capital stock balance and the retained earnings balance and enter the
amount under the line, in the right column, on the same line as the Total
Stockholders Equity title, as shown in Exhibit 5-25.
4 Draw a double line, meaning the end, under the total stockholders equity
PR
Exhibit 5-25: Steps 3 and 4 of totaling the capital stock and retained earnings
522
Do it!
B-1:
Preparing a Statement of Stockholders Equity
Exercises
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1 Review the statement below. Which column should display the specified values?
Column 2
Retained earnings from the

previous year
Column 2
Net income for 2000
Column 1
Dividends declared during 2000
Column 1
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EV
Shares issued during 2000
523
2 By using the following data, calculate Icons net increase in retained earnings.
$1,090,000
$2,090,000
$890,000
$840,000
Retained earnings as on January 1, 2000 = $1,000,000; Net Income after Tax for
2000 = $990,000; Dividends declared during 2000 = $100,000
Net increase in retained earnings = Net Income after tax Dividends declared
IE
3 By using the following data, calculate Icons current balance of retained earnings.
Retained earnings as on January 1, 2000 = $1,000,000; Net Income after Tax for
2000 = $990,000; Dividends declared during 2000 = $100,000
A
$1,890,000
$110,000
$1,100,000
$3,890,000
EV
Current balance of retained earnings = Retained earnings as on January 1, 2000 + Net

increase in retained earnings
4 Changes occur in the Statement of Stockholders Equity because:

A
Business managers determine how profits can be increased
Shareholders determine how profits can be increased
Stockholders allow a company to reinvest the funds that could otherwise be

distributed as dividends
Business managers fail to achieve their business targets
5 The Statement of Stockholders Equity is linked to the Income Statement and

which of the following financial statements?
The Cash Flow Statement
The Trial Balance
The Balance Sheet
The General Ledger
PR
524
Unit summary: Other financial statements

In this unit, you learned about the Cash Flow Statement. You also learned that the
three categories of accounts that are included on a Cash Flow Statement are operating
activities, investing activities, and financing activities. Then, you learned about the
benefits of and how to prepare a Cash Flow Statement.
Topic B
Finally, you learned about the importance and method of preparation of the Statement
of Stockholders Equity.
Topic A
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1 Icon sells a percentage of its fixed assets, and it purchases stocks. What account
category will this fall into?
A Operating activity
B
Investing activity
C Financing activity
2 Icon pays dividends to stockholders. What account category will this fall into?
A Operating activity
EV
B Investing activity
C
Financing activity
3 List the questions that the Cash Flow Statement answers.
Is the company earning enough cash to purchase the additional assets needed for
growth?
Is the company earning extra cash that can be used to repay debt or invest in new
products?
4 What are the steps used to prepare a Cash Flow Statement?

Create the heading
Enter the cash flows from operating activities
PR
Enter the cash flows from investing activities
Enter the cash flows from financing activities
Total the statement
525
5 What approach was used to prepare the statement shown in Exhibit 5-26?
A
Indirect approach
C Direct approach
D Common approach
B Managed approach
EV
IE
By using the indirect approach, cash flows from operating activities are reported by adjusting net
income for revenues and expenses that appear on the Income Statement but do not affect cash.
PR
Exhibit 5-26: Icons Cash Flow Statement
6 What are the steps used to prepare a Statement of Stockholders Equity?

1
Create the heading
Enter the capital stock
Enter the retained earnings
Total the capital stock and retained earnings
526

7 Review the statement, as shown in Exhibit 5-27. What is the correct column for
Icons total balance of capital stock?
A Column 1
Column 3
EV
IE
B Column 2
Exhibit 5-27: Icons Statement of Stockholders Equity
8 Review the statement, as shown in Exhibit 5-28. What is Icons total stockholders
equity?
A $3,000,000
B $1,890,000
C $1,110,000
$4,890,000
PR
527
IE
Exhibit 5-28: Icons Statement of Stockholders Equity
9 Use the following clues to complete the crossword:
EV
ACROSS:
1. If you want to know whether your company is earning enough cash to purchase
the additional assets needed for growth, you need to look at the ____________
statement.
3. The __________ approach for reporting cash flows from operating activities
shows operating activities listed out by natural category (which is generally the
result of the purchase and sale of a product or service).
6. ______ activities involve the acquisition and sale of long-term or fixed assets.
DOWN:
1. _________ Stock is entered on the first line under the heading, aligned with the
left side of the Statement of Stockholders Equity.
PR
2. ____________ activities are the result of the issuance and repayment or

retirement of long-term liabilities and capital stock.
3. _______ are a distribution of the net profit to stockholders and not an expense
that is deducted to arrive at the net profit or the net loss.
4. Capital Stock and ______ earnings are the two main components of the
Owners Equity.
5. Owners ________ represents the part of a business that belongs to the owner.
528
F
I
N
D
C
I
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N
A
61
Unit 6
Budgeting

A Identify the importance and process of
IE
budgeting.
B Analyze financial statements by using ratio
analysis and the break-even point.
C Set objectives and identify common
budgeting problems.
D Monitor performance by using a pro
PR
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forma financial statement.
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Topic A: Fundamentals of budgeting

Budgeting is the process of planning financial activities for an upcoming accounting
period, usually a year. It requires analyzing how a business is currently performing and
setting objectives for improving its future financial health. Specific revenue and expense
expectations are identified with the intention of increasing a businesss profits while
keeping expenses in check.
Importance of budgeting
Explanation
IE
In order to strengthen a businesss financial health, budgeting is necessary. Since the

financial activities of a business can become quite complex, a budget is needed to
outline a plan that managers and employees can follow. Budgeting provides the
structure that is required in order to implement effective pricing and spending efforts.
Budgeting offers five main benefits:
Facilitates planning
Enhances communication
Reinforces accountability
Identifies problems
Motivates employees
EV
Budgeting facilitates planning
Planning is the main key to budgeting. A business that plans its future financial
activities is one that will have a vision for success. Budget planning requires a business
to articulate its vision for the future and how it will accomplish it. Strategies are
developed, and deadlines are identified to accomplish the established budget.
The planning aspect of budgeting also helps a business establish benchmarks that it can
use to measure its progress toward achieving its financial objectives.
Budgeting enhances communication
PR
Budgets communicate the spending and sales expectations of the managers and
employees within an organization. Communication is enhanced when the individuals
responsible for enforcing and meeting financial expectations can find these guidelines in
a budget. Managers and employees know what their boundaries are for the upcoming
accounting period and can adjust their spending and sales activities accordingly.
Budgeting reinforces accountability

Since budgets are communicated to those individuals responsible for implementing
them, accountability is reinforced. The responsible managers and employees can be
consulted if any deviations from the budget occur. Budgets enable accountable
individuals to make wise financial decisions by giving them the information they need.
Budgeting
6 3
Budgeting identifies problems
Budget planning requires a business to identify any financial problems that are
developing. Since a budgeted financial statement is broken into months or quarters,
deviations from the budget can alert members of management to potential problems.
Assigning specific numbers to financial expectations helps draw attention to situations
the business needs to investigate.
Budgeting motivates employees
IE
The clear guidelines that are outlined in a budget provide a method by which managers
and employees can be rewarded for their efforts. It is easy to evaluate managers and
employees performance by identifying whether the financial objectives articulated in
the budget are met. The compensation that individuals will receive if they meet the
financial expectations in the budget will motivate them to adhere to it.
Budgeting process
Explanation
There are three steps you can complete in order to create and enforce a budget:
1 Analyze financial statements
2 Set objectives
3 Monitor performance
EV
By following these three steps, youll be able to create an effective budget that can be
enforced throughout your organization.
Do it!
A-1:
Understanding budgeting
Exercises
1 Which of the following is a benefit that budgeting offers?

A
Budgeting enhances communication
Budgeting increases sales
Budgeting enhances an organizations public relations
Budgeting attracts highly skilled recruits
PR
2 How does budgeting reinforce accountability?

Communicated to responsible individuals
Establish who is responsible for variations
64

3 How can budgeting help identify problems?
Provides monthly and quarterly reports
Highlights budget deviations

Puts specific numbers to financial expectations
4 What is the first step used to create and enforce a budget?

Analyze financial statements
Set objectives
Monitor performance
Meet with management
PR
EV
IE
Budgeting
6 5
Topic B: Analyze financial statements

In order to set objectives for the upcoming accounting period, you must first study and
analyze your businesss current and past financial performances by using specific
methods to determine where improvements need and can be made. Financial statements
represent a companys monetary activities. To set sound objectives, you need to
investigate these activities by using methods such as ratio analysis and calculating the
break-even point.
Explanation
Methods of analyzing financial statements
IE
The methods of analyzing financial statements can be broken down into the following
categories:
Horizontal analysis
Trend analysis
Vertical analysis
Ratio analysis
Horizontal analysis
EV
The purpose of horizontal analysis is to determine how each item changed, why it
changed, and whether the change is favorable or unfavorable. This method of analysis
involves analyzing month-to-month or year-to-year changes for each line item on a
financial statement.
Trend analysis
PR
Trend analysis is similar to horizontal analysis, but it analyzes changes for three or
more years, as shown in Exhibit 6-1. Trends can be shown in both dollar amount and
percentage by designating the first year in the sequence as the base year. The amounts in
subsequent years are then shown as a percentage of the base year amount.
IE
66
Exhibit 6-1: Trend Analysis

Vertical analysis
Vertical analysis concentrates on the relationships between various items in the same
period by converting each element of the information into a percentage of the total
statement amount. In contrast, horizontal and trend analyses focus on the relationship
between the amounts of each financial item across time.
EV
For example, on a balance sheet, each item might be expressed as a percentage of total
assets. On an income statement, each item might be expressed as a percentage of sales.
Setting budgets through use of vertical analysis is often called top-down budgeting.
Ratio analysis
Ratio analysis will enable you to study the relationships between two or more items on
financial statements. Through the use of ratio analysis, youll be able to determine
which areas of financial activity need improvement. Ratios are particularly effective
tools for comparing your businesss operations to the operations of other companies
within the same industry. In addition, many industries have ratio norms that you can use
as a benchmark for gauging your companys financial health.
PR
However, business decisions should never be made based on one ratio alone. It is
important to remember that decisions should be made after thoroughly analyzing all of
the relevant ratios and information that pertains to the business.
Ratios are calculated to provide you with information about four aspects of a businesss
operations: liquidity, activity, leverage, and profitability.
Liquidity ratios help you determine your companys ability to generate adequate
amounts of cash to meet any current or short-term obligation.
Activity ratios enable you to evaluate how effectively your company uses its
assets.
Budgeting
6 7
Do it!
B-1:
Leverage ratios provide information about a businesss ability to meet its longterm obligations.
Profitability ratios determine if returns will be generated for those individuals
who provide capital to a company.
Identifying methods of analyzing financial

statements
Exercises
1 Which of the following methods is used to analyze financial changes that take
place over three or more years?
Vertical analysis
Horizontal analysis
Ratio analysis
Trend analysis
IE
2 If you need to study the change in your fixed assets over the previous year, what
method of analysis will you use?
Vertical analysis
Horizontal analysis
EV
A
C
Ratio analysis
Trend analysis
3 Which of the following statements about Ratio analysis is not true?

A
Helps you determine the areas of financial activity that require improvement
Helps you compare your businesss operations to those of other companies
Helps you analyze month-to-month or year-to-year changes for each line item
Serves as a benchmark for gauging your companys financial health
4 What method of analysis is being described in the following statement?
PR
Also known as top-down budgeting, this method looks at the relationship between
items in the same period.
A
Ratio analysis
Vertical analysis
Trend analysis
Horizontal analysis
68

5 What method of analysis is being described in the following statement?

Ratio analysis
Vertical analysis
Trend analysis
Horizontal analysis
This method enables you to study the relationship between two or more items on
financial statements.
6 What types of analysis can you perform by studying a Balance Sheet? Give
reasons for your answer.
IE
You can perform only the Vertical and Ratio analyses because these analyses concentrate on
relationships between the various items of a single organization in the same time period. In
contrast, to perform Trend or Horizontal analyses, you would need year-to-year or month-tomonth data, which cannot be provided by a single Balance Sheet.
7 What ratios are being described in the following statements?

Activity
EV
They allow you to analyze how

well your company is using its
assets.
Leverage
They indicate if returns will be

generated for those individuals
who provide capital to a company.
Profitability
PR
They provide information about a

businesss ability to meet its longterm obligations.
Budgeting
6 9
Ratios used for budgeting

Some important ratios that can be used to obtain the information needed to make
budgeting decisions are:
Current ratio
Inventory turnover ratio
Days sales outstanding
Total assets turnover ratio
Times-interest-earned ratio
Profit margin on sales
IE
Current ratio
Explanation
The current ratio allows the liquidity of a company to be compared with other
companies in the industry. In particular, it reflects if a company has sufficient current
resources to meet companys current obligations in the event of a sudden emergency.
You calculate the current ratio by dividing current assets by current liabilities: Current
Assets / Current Liabilities = Current Ratio. The current ratio is expressed as a decimal.
EV
Generally, a current ratio of 2:1 is considered satisfactory for a company. This is

because in such a situation, a company would be able to meet its current obligations
even if the value of its current assets reduces by 50%. A current ratio below one
indicates that a company is not able to pay off its current liabilities, and a current ratio
above two indicates that a company is able to pay off its current liabilities and has extra
money left.
The inventory turnover ratio will help you evaluate your inventory activity.
Specifically, the inventory turnover ratio tells you how many times your inventory is
turned over, or sold out and restocked, per year. For example, if a business has a 4.9
inventory turnover ratio, this figure means that the business sells out and has to restock
its inventory almost five times per year.
PR
The inventory turnover ratio is calculated by dividing Cost of goods sold by the average
inventory over the year: Cost of Goods Sold / Average Inventory = Inventory Turnover
Ratio. Average inventory is calculated by adding the beginning and ending inventory
balances and then dividing this amount by two.
For example, imagine that your business had $4,000,000 in cost of goods sold, $340,000
in beginning inventory, and $200,000 in ending inventory. You would first add
$340,000 and $200,000 and then divide this amount by two, which would give you
$270,000. Then, you would divide $4,000,000 by $270,000 and get an inventory
turnover ratio of 14.8. This ratio tells you that on average your business turned over
inventory almost 15 times last year.
610

IE
An activity ratio, the days sales outstanding indicates the length of time a business must
wait after making a sale before receiving cash from a client. It is calculated by dividing
the accounts receivable amount by the average sales per day amount: Accounts
Receivable / Average Sales Per Day = Days Sales Outstanding. The average sales per
day figure are calculated by dividing annual sales by 360, as shown in Exhibit 6-2.
Exhibit 6-2: Days sales outstanding
PR
EV
For example, if your company had an accounts receivable amount of $1,300,000, and its
annual sales were $14,000,000, you would divide $14,000,000 by 360, giving you a
figure of $38,889. Then, you would divide $1,300,000 by $38,889 and get a days sales
outstanding of 33 days. In other words, your company would wait on average 33 days
after making a sale before receiving cash from the customer, as shown in Exhibit 6-3.
Exhibit 6-3: Example of days sales outstanding
Budgeting
611
The total assets turnover ratio provides an indication of a businesss ability to generate
sales in relation to its total assets. As an activity ratio, it determines how many times a
companys assets turn over per year. You determine the total assets turnover ratio by
dividing annual sales by total assets: Sales / Total Assets = Total Assets Turnover Ratio.
For example, if your company had $14,000,000 in annual sales and $8,000,000 in total
assets, you would have a 1.75 total assets turnover ratio. Typically, the higher the
number, the better.
IE
As a measure of leverage, the debt-to-total-assets ratio indicates how many liabilities a

company has per $1 of assets. The debt-to-total-assets ratio is calculated by dividing
total liabilities by total assets: Total Liabilities / Total Assets = Debt-to-Total-Assets
Ratio.
For example, imagine your companys total liabilities are $130,000 and its total assets
are $543,000. Therefore, your companys debt-to-total-assets ratio is .24. In other
words, for every $1 of assets, your company has $.24 of debt. Another way this figure
can be interpreted is that 24 percent of your companys assets are funded by liabilities,
or creditors.
EV
The debt-to-total-assets ratio is important because it indicates a companys ability to

absorb a reduction in assets without hindering its ability to pay creditors. Generally,
creditors are more willing to loan funding to a company that has a low ratio; a company
that is less-dependent on creditors for the funding of assets will be better able to pay
creditors in the event of a liquidation.
PR
The times-interest-earned ratio measures a companys ability to meet its annual interest
payments. It is a leverage ratio and is calculated by dividing the operating profit, or
earnings before interest and tax (EBIT), by the interest charges: Operating Profit /
Interest Charges = Times-Interest-Earned Ratio, as shown in Exhibit 6-4.
Exhibit 6-4: Times-interest-earned ratio
612
IE
For example, if your businesss operating profit was $1,000,000, and its interest charges
were $200,000, then your times-interest-earned ratio would be five, as shown in Exhibit
6-5. In other words, your companys interest charges are covered five times by the
operating profit. This ratio is important to consider since failure to pay interest charges
can bring legal action from creditors.
Exhibit 6-5: Example of times-interest-earned ratio

The profit margin on sales will indicate how satisfactory business activities have been.
A profitability ratio, the profit margin on sales is calculated by dividing the net profit for
the year by the total sales figure: Net Profit / Sales = Profit Margin on Sales.
PR
EV
For example, if a companys net profit is $990,000 and its sales are $11,000,000, the
profit margin on sales is 9%. Therefore, for each dollar of sales, nine cents in profit
went to the company.
613
PR
EV
IE
Budgeting
Exhibit 6-6: Icons Balance Sheet and Income Statement
614
Do it!
B-2:
Identifying ratios used for budgeting
Exercises
Operating profit
Total expenses
Total liabilities
Cost of Goods Sold
1 The inventory turnover ratio is calculated by dividing _____ by average

inventory.
2 The total assets turnover ratio is calculated by dividing _____ by total assets.
Sales
Total expenses
Average inventory
Accounts receivable
IE
3 Review the Balance Sheet, as shown in Exhibit 6-6. What is the current ratio?
2.29
2.10
EV
A
C
2.23
2.08
4 If Icon has a current ratio that is over 2.0, that means:
The company is able to pay off its current liabilities and have extra money
left
The company is not able to pay off current liabilities
The company is able to pay off current liabilities without extra revenue
The company is not able to pay off external debts
PR
Budgeting
615
0.97
1.08
1.18
1.26
5 Review the Balance Sheet and the Income Statement, as shown in Exhibit 6-6.
What is the total assets turnover ratio?
6 Review the Balance Sheet, as shown in Exhibit 6-6. What is the debt-to-totalassets ratio?
0.25
0.10
0.52
0.38
IE
7 Icons profit margin on sales is 0.09. What does this indicate?
For every $1 of revenue Icon makes, it owes 9 cents to its creditors
Icon is losing 9% of its net profit to its creditors
Icon is making 9 cents in profit for each dollar of sales
For every $1 of profit, Icon is spending 9 cents on its debts
PR
EV
Ask one student from

each group to share the
groups answers.
Have the group validate
the other groups answers.
Help students if both
groups are unable to give
the correct answer.
8 The instructor will divide the class into two groups. Each group will be assigned
three of the following six ratios. For each assigned ratio, your group will need to
determine what ratio value is bettereither higher or lowerand provide reasons
for the answer.
616
Higher
A higher value would imply that the business is

doing well and its products or services are much
in demand. Therefore, the products sell quickly
and the company has to restock its inventory
more frequently.
Lower
IE
A lower value would imply that a companys

customers pay cash on time or within a shorter
period. In other words, a company would have to
wait for a fewer number of days after making a
sale before receiving cash from the customer.
Higher
EV
It determines how many times a companys

assets turn over per year. A higher value would
imply more usage of assets thereby making better
sales. Therefore, it is generating higher sales in
relation to its total assets.
Debts-to-total-assets ratio
Lower
It indicates a companys ability to absorb

reduction in assets without hindering its ability to
pay creditors. Generally, creditors are more
willing to fund loans to a company that has a low
ratio. A lower value would imply that a company
is in debt to a lesser extent and would be easily
able to pay its creditors in the event of liquidation.
PR
Higher
A higher value would imply that a company is

making more profit than the interest it needs to
pay. Therefore, the companys interest charges
are well covered by the operating profit and its
creditors would not need to use legal methods to
retrieve their interest.
Higher
A higher value implies that the business activities
of the company have been quite satisfactory and
for each dollar of sale made, it has earned ample
amount of net profit.
Budgeting
9 The instructor will draw a table with four columns on the whiteboard and label the
columns as Liquidity ratios, Activity ratios, Leverage ratios, and Profitability
ratios. The instructor will then divide the class into four groups, which represent
the four ratios, called Liquidity, Activity, Leverage, and Profitability.
Tell students to keep the

discussion short.
617
Discuss the following questions within your group in context of your ratio and
record the answers. Then, one student from your group will write the answers on
the whiteboard.
What information does the ratio
provide?
Liquidity: Determines a companys ability to

generate adequate amounts of cash to meet a
current obligation
IE
Activity: Evaluates how effectively a company

uses its assets
Leverage: Provides information about a
businesss ability to meet its long-term
obligations
Profitability: Determines whether returns will
be generated for individuals who provide
capital to a company
Liquidity: Current ratio
Activity: Inventory turnover ratio, Days sales

outstanding, and Total assets turnover ratio
EV
Which of the following belong to

your ratio?
Current, Inventory turnover, Days

sales outstanding, Total assets
turnover, Debt-to-total-assets,
Times-interest-earned, and Profit
margin on sales.
Write the formula for your ratio.
Leverage: Debt-to-total-assets ratio, Timesinterest-earned ratio

Profitability: Profit margin on sales
Current ratio = Current Assets / Current

Liabilities
PR
Inventory turnover ratio = Cost of Goods Sold

/ Average Inventory
Days sales outstanding = Accounts
Receivable / Average Sales Per Day
Total assets turnover ratio = Sales / Total
Assets
Debt-to-total-assets ratio = Total Liabilities /
Total Assets
Times-interest-earned ratio = Operating Profit /
Interest Charges
Profit margin on sales = Net Profit / Sales
618
The break-even point

The break-even point occurs when total sales equal total expenses, with nothing left
over for profit. In other words, the operating income, or EBIT, is equal to zero. Any
revenue generated that is below the break-even point is used to pay for expenses
incurred to create and sell your product. Any revenue generated that is above the breakeven point will generate profit for the business.
Explanation
PR
EV
IE
The break-even point is calculated by dividing the total fixed operating expenses by the
contribution profit margin per unit, which gives you the number of units you need to sell
in order to break even. Youll use your Income Statement to calculate the break-even
point, and there are five steps you can follow in order to do so:
1 Separate fixed costs from the variable costs. Youll find these figures under the
Operating Expenses section of your Income Statement. The variable costs will
include any selling expenses under this section, and the fixed costs are the
general and administrative costs, as well as depreciation and depletion.
2 Subtract the variable costs from the gross profit on sales. This figure is the
contribution profit margin.
3 Divide the contribution profit margin by the number of units that were sold,
which will give you the contribution profit margin per unit. You might have to
divide the Sales amount by the selling price per unit to determine how many
units were sold.
4 In order to determine the total fixed operating expenses, add the fixed costs
amount and the interest expenses, since interest expenses are considered a fixed
cost.
5 Divide the total fixed operating expenses by the contribution profit margin per
unit. This figure is the number of units you must sell in order to break even.
Budgeting
Do it!
B-3:
619
Calculating the break-even point
Exercises
1 Classify the following as either fixed costs or variable costs:

General and administrative
expenses
Fixed
Depreciation of machinery
Fixed
Expense of raw material
Variable
2 Contribution profit margin is:

Total sales Fixed cost
Total sales Variable cost
Gross profit Variable cost
Gross profit Fixed cost
IE
3 The break-even point occurs when:
Total sales are less than total expenses
Total sales are equal to total expenses
EV
Total expenses are less than total sales
Total sales and total expenses together are greater than one
PR
620
Topic C: Set objectives

Objectives provide the direction you need when establishing a budget. The guidance
objectives provide will ensure that your budgeting decisions relate back to promoting
the overall financial health of your business. Without objectives, you risk making
budgeting decisions that are misguided or simply not as effective as they could be.
Explanation
Steps required to establish effective objectives
IE
In order to set effective objectives, you can follow four steps:

1 Review previous accounting periods to determine the strengths and weaknesses
2 Set objectives that address strengths and weaknesses
3 Decide what resources are needed to achieve objectives
4 Make adjustments to objectives if necessary
Review previous accounting periods
EV
Since the first step of creating a budget is to analyze financial statements from previous
accounting periods, you have already identified the strengths and weaknesses of your
businesss financial operations. Use the figures provided from the ratio analysis to
determine which financial activities are in need of improvement and which ones are
healthy.
Address strengths and weaknesses
Once you have determined which financial activities are inadequate, create objectives
that address these weaknesses. Since you also identified which financial activities are
strong, you can use this information to direct your efforts toward the areas that truly
need attention.
For example, if your days sales outstanding is poor, you might decide to set a somewhat
ambitious objective that decreases the amount of time it takes after making a sale to
collect money from a customer. Conversely, if your debt-to-total-assets ratio is strong,
you could set an objective that was less ambitious for decreasing the amount of debt
your business owes.
What resources are needed
PR
It is important that you examine your objectives to determine if you have the resources
necessary to achieve them. If the resources are unavailable, it will be impossible to meet
your objectives.
For example, imagine that one of your objectives for the upcoming accounting period is
to improve your total assets turnover ratio by increasing the number of sales your
company makes. You would have to determine whether or not you have the manpower
available to accomplish this objective. Specifically, you would have to decide if you
have enough sales people to handle the increase in projected sales.
Budgeting
621
Make adjustments to objectives
If you discover that you do not have sufficient resources to meet your objectives, you
must adjust your objectives appropriately. Slight modifications might be all that are
necessary to make your objectives achievable. However, a more creative strategy might
be required to adjust your objectives.
For example, imagine that you do not have enough sales people to generate an increase
in sales by a certain percentage. Youll have to adjust your objective to reflect a lower,
more reasonable figure and look for another financial activity that could be used to
accommodate this adjustment, such as increasing your sales price or lowering sales
commissions.
Characteristics of objectives
Any objective you set for your budget should possess three characteristics:
Relevant
Measurable
Realistic
Relevant
IE
Explanation
EV
Your objectives must be relevant to your businesss vision. They must directly relate to
improving your companys financial health. Objectives are sometimes set purely for the
sake of setting them, without fully considering how they contribute to achieving the
businesss overall goal.
Measurable
Effective objectives are measurable. You must specifically articulate what needs to be
achieved. Immeasurable objectives will not allow you to gauge your progress toward
achievement.
For example, if you want to lower the percentage of your businesss assets that are
funded by creditors, choose a specific number by which to gauge your progress.
Realistic
PR
In order to ensure successful achievement, your objectives must be realistic. Objectives

can be challenging, but should never be impossible. Avoid the desire to set lofty
objectives, regardless of the potential payoffs. Goals that are impossible to achieve will
frustrate managers and employees and often lead to detrimental financial outcomes.
622
Do it!
C-1:
Setting effective objectives
Exercise
1 Put the following steps in the correct order required to establish effective
objectives:
Determine the strengths and weaknesses of

previous accounting periods.
Make adjustments to objectives, if

necessary.
Set objectives that address strengths and

weaknesses.
Determine the strengths and

weaknesses of previous
accounting periods.
Decide the resources that are needed to achieve

objectives.
IE
Decide the resources that are

needed to achieve objectives.
Make adjustments to objectives, if necessary.
Set objectives that address

strengths and weaknesses.
2 Effective objectives should be relevant, measurable, and ______.

Aggressive
Flexible
Quickly attained
Realistic
PR
EV
Budgeting
3 You have a monthly salary of $1,500 and need to create budget. List the
objectives you would use and evaluate those objectives based on the three
characteristics of effective objectives.
Objectives
Ask four students to read

their objectives. Tell the
class to evaluate and
discuss the objectives
based on whether or not
they are relevant,
measurable, and realistic.
623
Are they
effective?
What do they lack?

.
.
.
IE
.
.
.
Common budgeting problems
There are several common problems that individuals encounter when establishing a
budget. By being aware of these problems, you can avoid letting them affect your
objectives.
Losing sight of your objectives
Failing to keep objectives realistic
Practicing historical-base budgeting
Accepting arbitrary changes
Believing that sales have to increase
EV
Explanation
Losing sight of your objectives
PR
Sometimes the process of putting together a budget seems so daunting that the
individuals responsible for creating it focus more on the process involved than the
objectives. For this reason, it is important that you focus every decision toward your
objectives. In addition, regularly monitor your progress toward achieving your
objectives in order to emphasize their validity and role as the focus of your efforts.
Failing to keep objectives realistic

There is a common tendency for individuals to get rich on paper and then become
disappointed when the numbers on the budget do not match actual performance.
Therefore, it is crucial that you compare all objectives for the upcoming accounting
period with actual performances from previous periods.
In addition, carefully examine all assumptions made about the financial activity for the
upcoming accounting period. Base your objectives on solid facts, not on word-of-mouth
speculations.
624

Practicing historical-base budgeting
Historical-base budgeting is the process of basing your objectives for the upcoming
accounting period on the previous ones actual performance. Some individuals
automatically use the previous accounting periods performance as the budgeted amount
for the upcoming period.
The problem with this budgeting method is that consideration is often not given to
whether the previous accounting periods performance was good or poor. If the
financial activities from the previous accounting period were inadequate, using these
figures as a guideline for the upcoming accounting period will simply prolong poor
performance.
Accepting arbitrary changes
IE
Objectives are set for a reason: to guide positively the financial activities for an
upcoming accounting period. Therefore, any deviations from the plan for achieving an
objective should be questioned and, if necessary, stopped. Accepting arbitrary changes
undermines the validity of your objectives. If a change to the budget is requested, it
should be closely studied before being implemented.
Believing that sales have to increase
EV
It is often believed that sales have to increase with each new accounting period. In fact,
some individuals think that if sales do not significantly increase each accounting period,
the companys efforts have been a failure. However, this viewpoint is incorrect. There
might be accounting periods in which an increase in sales could create negative effects
for the company.
PR
For example, imagine that your company recently expanded its consumer base with the
opening of new stores. As a result, sales increased significantly. However, to repeat the
same strategy for the upcoming accounting period could be a serious error, since
concentrating efforts on new stores could result in neglected customer support service
for the stores recently opened. Therefore, the objectives for the new accounting period
would not include an increase in sales, but a steady hold on current sales numbers while
customer service efforts are refined.
Budgeting
Do it!
C-2:
625
Identifying common budgeting problems
Exercises
1 An effective way to budget is to
use the actual performance of the
previous accounting period as
your budget goals for the
upcoming accounting period. True
or False?
False. The problem with this budgeting method is

that consideration is often not given to whether
the previous accounting periods performance
was good or poor.
2 It is acceptable to adjust your

budget objectives to accommodate
resource availability. True or
False?
True
IE
3 Define historical-base budgeting.
It is the process of basing your objectives for the upcoming accounting period on the
previous ones actual performance.
4 Should you accept arbitrary changes to your plan? Why?
No, you should question any deviations from the plan and, if necessary, stop them.
EV
Accepting arbitrary changes undermines the validity of your objectives. If a change to the
budget is requested, it should be closely studied before being implemented.
5 You are in a meeting with Robin Carlson (Product Manager), Chala Merino
(Assistant Controller) and Drew Canfield (Director of Finance). The four of you
are responsible for determining new objectives for the Icons SK-200 product line.
Chala has recently reviewed the manufacturing budget and has found a problem
with the SK-200 line. She wants to modify the products current budgeting
objectives to provide a clear direction.
What do you think should be done first? Select the correct answer and provide
reasons to support it.
Focus on how the SK-200 product line has performed in the past few years
Review the planning that went into the SK-200 product line when it was first
developed
Analyze how the marketing strategy was first developed
PR
The first step in setting effective objectives is to determine the strengths and weaknesses of
previous accounting periods.
626

6 After reviewing the budgeting statements, Chala finds that the company is losing
money on maintaining the product. Though last years operating expenses were
set at $300,000, the actual expenses were $425,000.
What would benefit the company in such a situation? Select the correct answer
and provide reasons to support it.
A
Evaluate whether the quality of the product was worth the money spent
Calculate the actual profit earned as compared to the estimated profit
Review the advertising budget
7 Chala discloses that though clients seemed to be happy with the products
performance, the product has suffered a loss of $70,000. Chala, Drew, and Robin
give the following suggestions. Who do you think is correct and why?
A
Chala: I dont think its worth keeping the line open because cutting costs
would reduce our quality
Robin: As sales must increase in each accounting period, we should

concentrate on increasing sales and attracting new customers
Drew: We should reduce the operating expenses and retain the present
customers
EV
Encourage students to
discuss the answer. After
the discussion, explain the
answer that is given here.
IE
By doing this, the management is determining the strengths and weaknesses of the past
performances and enabling the team to keep the discussion focused.
By following Drews suggestion, you could make profit and still provide a quality product. By
cutting marketing costs, you would reduce operating expenses but it would not affect sales.
This is because the companies that would buy SK-200 are already doing so.
PR
By supporting Drew, you are acknowledging that sales do not have to increase with the new
accounting period. In addition, you are setting objectives that are easily measurable,
realistic, and relevant to the organizations goals.
Budgeting
627
Topic D: Monitor performance

The key to monitoring your businesss actual performance during an accounting period
is to record it regularly on paper, so it can be compared to the budgeted amount.
Businesses use pro forma financial statements to accomplish this task.
Explanation
Pro forma financial statements
IE
A pro forma financial statement is a forward-looking document; pro forma means

provided in advance. Unlike most financial statements that are created at the end of an
accounting period, pro forma statements are created when setting a budget, before an
accounting period. Pro forma financial statements are used to establish the projected
financial activity for an upcoming accounting period. Pro forma financial statements
are also often called estimates.
It is important to keep in mind that the financial statements that are created at the end of
an accounting period are included in a businesss annual report and, therefore, visible to
external parties. However, pro forma financial statements are only used for internal
purposes and are not viewed by parties outside of the company.
EV
Since pro forma financial statements are for internal use only, the number of these
documents will vary from business to business. In fact, the ways in which a company
can customize its pro forma statements to fit its specific needs are almost limitless.
However, many large businesses use pro forma Income Statements, Balance Sheets,
and Cash Flow Statements. Out of these statements, the pro forma Income Statement
is most common and widely used among businesses.
Some businesses also create pro forma financial statements based on the different
segments of their company that contain financial activity. For example, a company
might create pro forma financial statements that are specific to sales, production,
manufacturing, and labor, among other areas.
Do it!
D-1:
Identifying a pro forma financial statement
Exercises
1 Pro forma means:
Provided for analysis
Provided post performance
Provided in advance
Provided for departmental use
PR
2 The pro forma Balance Sheet is

the most widely used pro forma
financial statement. True or False?
False. The pro forma Income Statement is most

common and is widely used among businesses.
628

3 What are some common
characteristics of pro forma
financial statements?
Characteristics:
For internal use only

Easily customized
4 What are the types of pro forma

financial statements?
Number created will vary between

organizations
Types:
Income Statements
Balance Sheets
IE
Cash Flow Statements
Create a pro forma financial statement
There are seven steps that will help you prepare a pro forma financial statement:
1 List the line items
2 List historical performance
3 List the percentage of sales
4 List the upcoming accounting periods budgeted amount
5 Create a column for the month or quarter
6 Create a year-to-date column
7 Create a deviation column
EV
Explanation
List the line items
Along the left margin of the sheet, list one-by-one the line items that you wish to
budget, as shown in Exhibit 6-7. Most companies prefer to use a top-down method of
budgeting, which means that sales is the first line item listed, followed by all the various
expenses the business incurs, and all other budgeted financial activities are based on the
total amount of sales being generated. This method is sensible, since the amount of
revenue that your business generates drives the budgeting decisions made for all other
financial activities.
PR
Divide the rest of the sheet into several columns.
629
IE
Budgeting
Exhibit 6-7: List the line items

List historical performance
Youll find it helpful to have a historical base from which to compare your budgeted
amounts. Therefore, youll need to create a column for a previous years, quarters, or
months performance.
EV
At the top of the first column, write the period you want to use as a historical reference.
For example, you might write 1st quarter 2000 or January 2000.
PR
Next, fill in the amounts for each of the line items for the specified time period, as
Exhibit 6-8: List historical performance
List the percentage of sales

Many individuals find it useful to have a breakdown of performance based on the
percentage of sales for which each line item accounted. In other words, each of the line
items listed below sales is measured by calculating its amount as a percentage of the
total sales amount.
630

Youll use the next column for listing the percentage of sales for the historical
performance. Label any column used for listing the percentage of sales figures with a
simple percentage sign (%), followed by the words of sales, as shown in Exhibit 6-9.
IE
The percentage of sales is simple to calculate. Your sales amount will be the first line
item on the statement, and the percentage of sales for this item clearly will always be
100, as shown in Exhibit 6-9. Then, divide the amount of each of the other line items on
the statement by the sales amount to calculate and complete the percentage of sales
column.
EV
Exhibit 6-9: The percentage of sales
PR
For example, if your total sales amount was $12,000,000, and your cost of goods sold
was $8,000,000, you divide $8,000,000 by $12,000,000 in order to calculate the
percentage of sales for the cost of goods sold. In this case, percentage of sales for the
cost of goods sold would be 67 percent, as shown in Exhibit 6-10.
Exhibit 6-10: In this case, percentage of sales for the cost of goods sold is 67 percent
Budgeting
631
List the upcoming accounting periods budgeted amount
At the top of the next column, write the heading Budget, followed by the accounting
period for which the budget represents. For example, if you are creating an annual
budget, you should write the specific year. If the budget is for a specific month, you
should indicate which month: Budget January 2001, as shown in Exhibit 6-11.
IE
Under this heading, you then fill in the budgeted amounts for each of the line items.
Follow this column with another percentage of sales column, based on the budgeted
figures, as shown in Exhibit 6-11.
EV
Exhibit 6-11: Listing the upcoming accounting periods budgeted amount
Create a column for the month or quarter
Write Actual as the heading of the next column. This column will be used to record
your actual financial performance. Youll next need to determine how often you are
going to monitor your financial activities. You can monitor your performance monthly
or quarterly. Generally, the more frequently you monitor your activities, the better able
youll be to meet your budgeted amounts.
Once you have decided how frequently youll measure your actual performance, write
the first time period under Actual. For example, if you decide to monitor performance
on a monthly basis, you would write Actual January 2001 as the complete heading, as
PR
Once again, follow this column with a percentage of sales column to be filled in after
the actual performance is recorded, as shown in Exhibit 6-12.
IE
632
Exhibit 6-12: Creating a column for the month or quarter

Create a year-to-date column
EV
In the next column, write YTD, which stands for year-to-date, as shown in
Exhibit 6-13. This column is important because it will allow you to study your
cumulative performance with each new accounting period.
PR
Exhibit 6-13: In the next column, write YTD
Budgeting
633
Create a deviation column
IE
The next column will be used to record the amount that actual performance deviates
from the budget. Write +/- at the top of the column, to represent the degree to which
actual performance is over or under the budgeted amount, as shown in Exhibit 6-14.
Exhibit 6-14: Write +/- at the top of the column
PR
EV
For example, imagine that you had budgeted sales to be $12,500,000 for the month of
January, but your businesss actual performance was $12,550,000. You enter $50,000
in the deviation column, as shown in Exhibit 6-15, since this is the amount of deviation
from $12,500,000. If your actual performance is $12,480,000, you enter ($20,000) in
the deviation column. As a general rule in accounting, parentheses are used to indicate a
negative amount.
Exhibit 6-15: Enter the deviation in the deviation column

From this point on, youll repeat steps two through seven for each of the accounting
periods of which youll be measuring actual performance. For example, if you monitor
performance monthly for an entire year, you would have 11 more months to add to your
sheet, with accompanying percentage of sales, year-to-date, and deviation columns.
634
Remember that although the budget should be enforced, it is a guideline, and negative
deviations from the budgeted amounts can occur. Therefore, do not treat minor
deviations as a cause for alarm and reason for complete restructuring of the budget.
Instead, youll need to determine the reasons for and the severity of the negative
deviation and whether or not it is significant enough to warrant a new allocation of the
budget.
Remember, budgeting reinforces accountability, so consult the manager or employee
responsible for the negative deviation and work with them to take corrective action.
D-2:
Do it!
Creating a pro forma financial statement
Exercises
IE
1 As a general rule, parentheses are used in accounting to indicate which of the

following?
A
A negative amount
A positive deviation
A deviation of more than 10 percent
A percentage of sales
True
3 Any negative deviation from the

budgeted amount requires a
comprehensive restructuring of
the budget. True or False?
False. You do not need to treat minor deviations

as a cause for alarm and reason for complete
restructuring of the budget. Instead, you need to
determine the reasons for and the severity of the
negative deviation and whether or not it is
significant enough to warrant a new allocation of
the budget.
EV
2 To calculate the percentage of

sales, divide each line items
amount by the sales amount. True
or False?
PR
Budgeting
635
4 Review the following statement and answer the questions:
What is the year-to-date figure for Januarys Cost of Goods Sold?
IE
$730
What is the sales percentage for the sales expenses for the month of January?
6%
Sales percentage for January 2001 = Actual Selling Expenses for January 2001 ($70) / Actual
Sales for January 2001 ($1200) x 100
What is the percentage of sales for Februarys cost of goods sold?
PR
EV
55%
636
Unit summary: Budgeting

In this unit, you learned about the concept of budgeting and the five main benefits it
offers: facilitates planning, enhances communication, reinforces accountability,
identifies problems, and motivates employees. You also learned that the steps to
create and enforce a budget are analyzing financial statements, setting objectives, and
monitoring performance.
Topic B
Next, you learned that the methods of analyzing financial statements are horizontal
analysis, trend analysis, vertical analysis, and ratio analysis. Then, you learned that the
ratios that can be used for budgeting are current ratio, inventory turnover ratio, days
sales outstanding, total assets turnover ratio, debt-to-total-assets ratio, timesinterest-earned ratio, and profit margin on sales. You also learned how to calculate
the break-even point.
Topic C
Then, you learned about the importance, characteristics, and steps to create effective
objectives. You also learned how to identify common budgeting problems.
Topic D
Finally, you learned how to monitor performance by using a pro forma financial
statement. You also learned how to create a pro forma financial statement.
IE
Topic A

1 What is budgeting?
EV
Budgeting is the process of planning financial activities. It involves analyzing current performance
and setting objectives for future improvement.
2 Why is budgeting important?
It simplifies financial activities
It outlines a plan that managers and employees can follow
It provides structure for pricing and spending decisions
3 Why does budgeting require planning?

Enables articulation of vision
Develops strategies
Identifies deadlines
Establishes benchmarks to measure progress
PR
4 What are the benefits of budgeting?
Facilitates planning
Enhanced communication
Reinforced accountability
Identification of problems
Motivated employees
Budgeting
637
5 How does budgeting enhance communication?

Budgeting communicates spending and pricing expectations that are found in the budget.
6 In what ways does budgeting motivate employees?
Budgeting provides methods to reward employees and enhances performance evaluations.
7 What is the process for creating and enforcing a budget?
Analyze financial statements
Set budgeting objectives
Monitor performance
8 Which method of analysis is being described in the following statement?
IE
This method is very effective for comparing your businesss operations to the
operations of other companies within the same industry.
Ratio analysis
B Vertical analysis
C Trend analysis
D Horizontal analysis
EV
9 Which type of ratio is being explained in the following statement?

This ratio helps you determine your companys ability to generate adequate
amounts of cash to meet any current obligation.
Liquidity ratios
B Activity ratios
C Leverage ratios
D Profitability ratios
10 What does it mean if Icon has a debt-to-total-assets ratio of .38?
PR
A Icon has to wait an average of 38 days after making a sale before receiving cash
from a client
B Icon must withhold 38% of all its generated revenue in order to pay off its debts
For every $1 of assets, Icon has 38 cents of debt
D For every $1 of debt, Icon has 38 cents of assets
638

11 Review the Income Statement, as shown in Exhibit 6-16. What is the profit margin
on sales?
A
0.09
B 0.48
C 1.09
EV
IE
D 1.48
PR
12 How can you monitor actual performance against a budget?
Record information regularly
Compare to the budget
Use pro forma financial statements
13 What is a pro forma financial statement?

A pro forma financial statement is a forward-looking document that is created when setting a
budget, before an accounting period. It is used to establish the projected financial activity for an
upcoming accounting period. Pro forma financial statements are also called estimates.
Budgeting
639
14 What should be done if actual performance negatively deviates from the budget?
Budgets are only a guideline and minor deviations from the budget are no cause for alarm. You
first need to determine the deviation severity and then, determine the possibility for budgeting reallocation.
15 Review the statement, as shown in Exhibit 6-17. What is the year-to-date figure for
Februarys gross profit on sales?
A
$1065
B $420
C $370
IE
D $690
EV
Exhibit 6-17: Icons pro forma statement
16 What does it mean if selling expenses are 6% of sales?

A
Six percent of the sales revenue is used to pay for the selling expenses
B Six percent of the years budget is used to pay for the selling expenses
C Six percent of the sales revenue comes from the selling expense budget
17 Review the statement, as shown in Exhibit 6-17. What is the deviation for Januarys
gross profit on sales?
A $110
PR
B $130
($110)
D ($130)
640

ACROSS:
1. _________ is the process of planning the financial activities for an upcoming

accounting period.
3. The Total ________ Turnover ratio provides an indication of a businesss
ability to generate sales in relation to its total assets.
6. _________ analysis concentrates on the relationship between various items in

the same period.
8. _________ ratios help you determine your companys ability to generate
adequate amounts of cash to meet a current obligation.
DOWN:
IE
1. It is the point when total sales equal total expenses with nothing left over for
profit.
2. ________ analysis is similar to horizontal analysis but analyzes changes for
three or more years.
4. The ratios that enable you to evaluate how effectively your company uses its
assets are called _______ ratios.
5. The profit margin on ______(s) indicates how satisfactory business activities

have been.
EV
7. ________ analysis enables you to study the relationship between two or more
items on financial statements.
E
V
PR

Financial Basic

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NOT FOR PRINTING OR INSTRUCTIONAL USE

COPYRIGHT Axzo Press. All rights reserved.

NOT FOR PRINTING OR INSTRUCTIONAL USE

About the manual............................................................................... iv

Topic A: Accounting........................................................................................ 1-2

Topic A: Basics of the accounting cycle.......................................................... 2-2

Topic A: Income Statement basics................................................................... 3-2

Topic A: Balance Sheet basics......................................................................... 4-2

Other financial statements

Topic A: Cash Flow Statement ........................................................................ 5-2

Topic A: Fundamentals of budgeting............................................................... 6-2

Topic A: Course summary ............................................................................... S-2

NOT FOR PRINTING OR INSTRUCTIONAL USE

Unit time: 60 minutes

Complete this unit, and youll know how to:

B Identify the key accounting terms.

NOT FOR PRINTING OR INSTRUCTIONAL USE

Financial Management: Basic

Accounting is defined by The American Institute of Certified Public Accountants as the

The need for accounting

Tell students that

Conversely, if a business consists of one individual who is self-employed, this person

Benefits of understanding basic accounting concepts

NOT FOR PRINTING OR INSTRUCTIONAL USE

Identifying the need for accounting

1 What kinds of businesses should have a system of record keeping?

Fortune 500 businesses

Privately owned businesses

Publicly owned businesses

2 An organization must show the operations of its businesses in financial terms so

Apply for credit

Surpass the competition

Improve employee morale

3 Why would city, state, and federal

The probable answer could be:

To reveal trends within the economy as a

Tell students to discuss

NOT FOR PRINTING OR INSTRUCTIONAL USE

Financial Management: Basic

Topic B: Key accounting terms

NOT FOR PRINTING OR INSTRUCTIONAL USE

The accounting equation is expressed in the following manner:

Exhibit 1-1: The accounting equation

Understanding the accounting equation

The assets can differ from

1 List at least three assets that you

Ask students to share

2 Which of the following is the definition of a liability?

Everything of value owned and used in a business

The amount of money a business owes a person or a company for goods or

The part of a business that belongs to the owner

Any amount owed by a customer to your business

NOT FOR PRINTING OR INSTRUCTIONAL USE

Financial Management: Basic

Ask students to share

3 List at least three liabilities that

Loan payable to a bank

Outstanding telephone bills

4 Which of the following is the basic accounting equation?

Liabilities/ Assets = Owners Equity

Owners Equity x Assets = Liabilities

Assets = Liabilities + Owners Equity

Assets + Liabilities = Owners Equity