Financial Accounting: Primarily meets needs of external users:
investors, lenders, prospective buyers etc.
Formally, accrual accounting occurs through the process of:
1. Revenue recognition: A firm can recognize revenue
provided that:
a. It has earned the revenue i.e. it has done what its
supposed to do (i.e. provide product or delivers
service)
b. The amount of revenue is realizable1, i.e., that the
amount collectible is reasonably assured and is
measurable with a reasonable degree of reliability
2. Matching costs to revenues:
a. Product costs, i.e. those that can be directly
associated with revenues, are recognized as expenses
in the period when the firm recognizes the revenue
b. Period costs, i.e. those that are not directly associated
with revenues are, recognized as expenses in the time
period benefitted.
ASSETS = LIABILITIES +
Common Retained
= + + +
Assets
Dr. Cr.
Liabilities
Dr. Cr.
Stock
Dr. Cr.
Earnings
Dr. Cr.
+ - - + - + - +
Adjusting entries are required to ensure that revenue recognition
and matching principle for expenses are followed. These
adjusting entries can broadly be classified as Accruals2 and
Deferrals. Typically adjusting entry will include one income
statement account and one balance sheet account.
Trial Balance A list of accounts and their balances at a given
time.
Financial statements are drawn from the trial balance.
Income (profit) Statement tells what the company earned during
a period. Important for gauging the firms profitability.
Tracking cash flows is very important for the following reasons:
While income tells about ability of firm to thrive in the long run
(solvency), only cash flow analysis tells us about firms ability to
pay its bills in the short run (liquidity). Profitable firms can go
bankrupt because of inability to pay bills in the short run.
Tells us about the Sources and Uses of cash, i.e., where cash has
come from and where it is being used. This is crucial for
understanding and evaluating a firms operations.
Statement of cash flow helps in determining the ability of a
company to pay its suppliers/employees, make interest and
dividend payments, repay loans, buy PP&E for
replacement/expansion, etc.
Compute net cash provided by operating activities by adjusting
each item in the income statement from the accrual basis to the
cash basis.
Cash received from CX: A/R T-Account: Dr. Beg, Sales, End;
Cr: Collections.
Cash paid to supplier: (1) Inventory: Dr. Beg, Purchases, End;
Cr: COGS. (2) A/P: Dr: Payments; Cr: Beg, Purchases, End
Salaries Paid: Dr: Paid; Cr: Beg, Accrued Salaries, End
Same for Interest and Tax
Dividends Paid: RE: Dr: Dividends; Cr: Beg, Net Income, End
Non-cash Depreciation expense
charges Patent amortization expense
Gains
and losses
Loss on disposal of plant assets
Gain on disposal of plant assets
Changes in Increase in current asset account
current assets Decrease in current asset account
and current liabilities Increase in current liability account
Decrease in current liability account
1 2
When assets received are readily convertible to cash or claims of cash
Comparative analysis: Evaluation of consecutive financial statements to
examine direction, speed, & extent of any trend(s)
Common size analysis: Evaluation of internal makeup of financial
statements, and/or financial statement accounts across companies
Common size income statement as a percentage of revenue
Common size balance sheet as a percentage of assets / liabilities
/ stockholders equity
Profitability Ratios
ROE = DuPont Analysis
Profit margin: Measures a firms ability to generate
income from a particular level of sales.
SHAREHOLDERS' EQUITY
Asset turnover: Measures a firms ability to generate sales
from a particular investment in assets.
- -
Revenues
Dr. Cr.
Expenses
Dr. Cr.
Dividends
Dr. Cr.
Leverage: equity multiplier Magnifying effect
- + + - + -
Gross profit margin = Gross profit / Sales;
High ratio indicates some combination of higher product pricing and low
product costs. This is determined by competitive advantage of the firm
Operating profit margin = Operating profit / Sales
An operating margin increasing faster than gross margin indicates
improvements in controlling operating costs (e.g. SG&A)
Pretax margin = EBT / Sales
Also reflects the effect of leverage and non-operating income / expenses.
Increase in pretax margin driven by non-operating income should be
scrutinized
Net profit margin = Net income / Sales
The bottom-line should be adjusted for non-recurring items to estimate
future earnings potential
Solvency Ratios
Debt/Equity Ratio: Measures how much the firm has borrowed for each
$ invested by the shareholders
Total Liabilities/Total Assets: Measures the proportion of total assets
financed by external funds (Rule of thumb ~0.5 or 50%)
Interest coverage ratio = EBIT / Interest expense
EBIT = Earnings (income) before Interest expense and income Taxes
Measures how many times a firms net income before interest expense and
income taxes exceeds its interest expense.
Interest coverage ratios less than 2.0 suggest a risky situation.
Fixed charge coverage = EBIT/(Interest payments + Current portion of
debt)
Liquidity Ratios
Current ratio = (Current Assets) / (Current Liabilities)
High current ratio indicates greater ability to meet short term obligations
Low current ratio indicates greater reliance on operating cash flows or
Adjustment Required to external financing to meet short term obligations
Convert Net Income to Net Cash
Provided by Operating Activities
Typically a ratio of 2:1 or better is considered good
Quick ratio = (Cash + ST marketable securities + AR ) / Current liabilities
Add More conservative that current ratio because it considers -
Add
Inventory may not be quickly converted into cash
Add
Deduct
Prepaid expenses, deferred taxes etc. cant be converted back
into cash
Deduct
Add Cash ratio = (Cash + ST marketable securities) / Current liabilities
Add Represents liquidity measure in crisis situation
Deduct
Only highly marketable short term securities should be considered
Prepaid Expenses, Unearned Revenues
Activity Ratios
Total asset turnover = Sales / Total assets
Measures a firms ability to generate sales from a particular
investment in assets.
Fixed asset turnover = Sales / Fixed assets
Decline in ratio the firm is not using its assets efficiently. However,
a low or decreasing rate of fixed asset turnover may be an indicator
of an expanding firm that is preparing for future growth.
Increase in ratio firm is using its assets efficiently (or a
technological innovation is introduced). However, a firm might cut
back its capital expenditures if the near-term outlook for its products
is poor. Such an action could lead to an increase in the fixed asset
turnover ratio.
LIFO Liquidation
When the quantity sold exceeds the quantity purchased under LIFO
Old inventory costs from the older cost layers are transferred to cost of
goods sold. Creates larger than normal profits because older layers
are usually less costly per unit when prices are rising
Disclosure of LIFO gain: The amount by which net income would be
increased if the liquidation had not occurred.
As the benefits PP&E are expected to extend beyond one year, the
acquisition cost is capitalized when the PP&E is bought. Capitalizing
means the entire amount of the cost is shown as an asset in the balance
sheet.
Asset (+A) Dr.
Cash or Payable (-A or +L) Cr.

Capitalized costs are eventually charged as an expense to income

through different processes:
Amortization
Impairment
Gains / losses on disposal of assets

Impairment
When market forces or nature may destroy substantial parts of the
assets value, we write down the value of the asset to its current fair
value (i.e., market value) through a process of impairment. The amount
of impairment is charged as an expense during the period when the value
destruction occurred.
Impairment Expense (+E,-SE) Dr.
Provision for impairment or Asset Cr. (+CA or A)
Note that amortization is a periodic charge that occurs every period
over the assets life. Impairment is a one-time event.

When Asset is sold:

Cash (+A) Dr. (Sale proceeds)
Loss on sale of asset (+E, -SE) Dr. (plug)
Asset (-A) Cr. (carrying value)

Asset acquisition cost

Include all costs required to bring the asset into serviceable or usable
condition and location taxes, transport, installation, transport
Categories of inventory
Merchandising company - finished goods Double Declining Depreciation Method
Manufacturing company - (i) raw material, (ii) work-in-progress The faster an asset is written off for tax purposes, the greater the tax
(WIP), and (iii) finished goods deferral to future periods and more funds are available for operations
immediately
Included in the inventory cost Conceptually, decreasing depreciation charges over time compensates
purchase cost including sales taxes for:
freight-in Increasing repair and maintenance costs
all other taxes and duties Decreasing revenue and operating efficiency
insurance for goods in transit Higher uncertainty of revenues in later years of aged assets
storage until good ready to sale (but not after)
(due to obsolescence)
Exclude:
selling costs
Impact of Product Lifecycle on Cash Flows:
freight-out (delivery to customers)
storage for ready-to-sell goods

Perpetual system This approach keeps a running (or perpetual)

record of the amount of inventory on hand. Typically used when
inventory volumes are high and per-unit costs are low.
Periodic System: Ending inventory and cost of goods sold must be
determined by physically counting the goods on hand at the end of
the period. Typically used for low volume, high unit cost items (e.g.,
automobiles) or when continuous monitoring of inventory levels is
essential.

If prices are increasing, then following are true (opposite if prices are
decreasing):
LIFO will show lower profit as more recent costs are
matched to sales
LIFO will show lower inventory values because it
reflects older market prices
FIFO Inventory - LIFO Inventory = LIFO reserve.
Companies using LIFO are required to disclose
LIFO reserve can be viewed as an unrealized holding
gain. A gain that results from holding inventory as
prices are rising