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CHAPTER 21: ACCOUNTING FUNDAMENTALS

Layout of Chapter: 1. 2. 3. 4. 5. 1. What is Accounting Types of Accountants The Accounting Cycle The Accounting Equation Analyzing Financial Statements WHAT IS ACCOUNTING

The process of identifying, measuring and communicating economic information to permit informed decisions by users of the information. 2. TYPES OF ACCOUNTANT

Based on the type of Certification: CPA (Certified Public Accountant) (i.e. chartered accountant of Bd) CMA (Certified Management Accountant) also classified as: Public Accountant Private Accountant 3. ACCOUNTING CYCLE

The steps - analyzing, recording, posting and preparing records - by which the results of the business transactions are communicated. Journal Account General Ledger Financial Statement 4. THE ACCOUNTING EQUATION Assets = Liabilities + Owners Equity This indicates a companys financial position at any point in time.

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East West University

INCOME STATEMENT
For the year ended December 31, 2003 Details Gross Sales Less: Sales discounts Sales returns Net Sales Less: Cost of Goods Sold (COGS) Gross profit Less: Selling and Administrative expenses (Advertising, salary, rent, utility, insurance, depreciation, transportation) EBIT (Earning Before Interest and Tax) Less: Interest expense EBT (Earning Before Tax) Less: Tax Net Income/ (Loss) (165) 430 ( 85) 345 (100) 245 25 35 ( 60) 940 (345) 595 $ $ 1000

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EAST WEST UNIVERSITY

BALANCE SHEET
As at December 31, 2003 Details ASSETS a) Currents Assets Cash Accounts Receivable Inventory Total current Assets b) Fixed Assets Land Building Machinery and Equipment Furniture and Fixtures Total Fixed Assets TOTAL ASSETS LIABILITIES a) Current Liabilities Accounts Payable Short-term bank loan Total Current Liabilities b) Long-term Liabilities Notes Payable Long-term bank loan Total Long-term liabilities TOTAL LIABILITIES OWNERS EQUITY Capital Stock Retained Earnings Add Current Years Profit TOTAL OWNERS EQUITY TOTAL LIABILITIES + EQUITY 5. ANALYZING FINANCIAL STATEMENTS $ $

495 150 175 820 500 250 100 100 950 1770

125 175 300 425 225 650 950 325 250 245 820 1770

Ratio Analysis: Methods of analyzing financial information by comparing logical relationships between various financial statement items. 1. Liquidity Ratio: Measure of a firms ability to pay its short-term debts as they come due.

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a) Current Ratio measures the firms ability to pay off current liabilities from its current assets.
Current Ratio = Current Current Assets Liabilitie s

b) Quick Ratio
Quick Ratio = Qucik Current Assets Liabilitie s

*Where quick asset = Total Current Assets Inventory {When Ratio is 1:1 then it is adequate} 2. Activity Ratio: Measure of how efficiently assets are being used to generate revenue. a) Accounts Receivable Turnover
Accounts Re ceivable Turnover = Net Net Sales Re ceivable

Accounts

b) Number of Days Sales in Receivable.

# Days Sales in Re ceivable = # of Days in Year Account Re ceivable Turnover

3. Profitability Ratio: Financial Performance a) Return on Sales Re turn on Sales = (Average is 5%) b) Return on Equity
Re turn on Equity = Net Income =% Equity

Net Income Net Sales

=%

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This Ratio measures the return company earns on every taka of shareholders (owners) investments. 4. Debt Ratio: Ability to pay long-term debts. a)

Debt to Total Assets Ratio Equity =

b)
Time Interest Earned = EBIT

Total Liabilitie s Total Assets

Interest Expense

EBIT = Earnings before Interest & Tax

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PRACTICE ACCOUNTING PROBLEM 1. Dhaka Ltd. exports CK shirts to USA. Use the following information to prepare a) b) An Income Statement for the year ended on 31 December 2001; A Balance Sheet as on 31 December 2001. (All figures are in Bangladeshi Taka) Advertising expense Utility Income Tax Accounts payable (A/P) Cost of goods sold Transportation Interest Expense Accounts receivable Land Machinery Long-term loan Answer: Net Income Total Assets Total Liabilities & Owners Equity Tk. 20,000 Tk.1,92,500 Tk.1,92,500 1,500 5,000 1,600 12,000 15,000 1,300 2,400 15,000 50,000 20,000 40,000 Building Capital stock Rent Salary Sales returns Insurance Wages Cash Inventory Notes payable Gross Sales Short-term loan 30,000 80,000 3,600 6,000 1,000 600 2,000 60,000 17,500 20,000 60,000 19,000

Retained Earnings (Dec. 31) 1,500

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Not all the information is required for various calculations. One has to identify which bit of information is required for what calculation. For Income Statement, only the information which is directly related to Revenue, Expenses, Interest and Tax is needed. For Balance Sheet, you need to isolate the data regarding Assets (Current & Fixed), Liabilities (Short-term & Long-term), and Equity Capital & Retained Earnings. (Figures needed in Income Statement) Gross Sales Sales returns Cost of goods sold Advertising expense Utility Rent Salary Insurance Transportation Wages Interest Expense Income Tax (Figures needed in Balance Sheet) Cash Accounts receivable Inventory Land Machinery Building Accounts payable (A/P) Short-term loan 60,000 15,000 17,500 50,000 20,000 30,000 12,000 19,000 60,000 1,000 15,000 1,500 5,000 3,600 6,000 600 1,300 2,000 2,400 1,600

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Notes payable Long-term loan Capital stock Retained Earnings (Dec. 31)

20,000 40,000 80,000 1,500

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Dhaka Ltd.

INCOME STATEMENT
For the year ended Dec. 31, 2003 Gross Sales Less: Sales returns Net Sales Cost of goods sold Gross Profit Less: Selling & Administrative Expenses Advertising expense Utility Rent Salary Insurance Transportation Wages EBIT (Earnings before Interest & Tax) Less: Interest Expense EBT (Earnings before Tax) Less: Income Tax Net Profit 1,500 5,000 3,600 6,000 600 1,300 2,000 (20,000) 24,000 (2,400) 21,600 (1,600) 20,000 60,000 (1,000) 59,000 (15,000) 44,000

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Dhaka Ltd.

BALANCE SHEET
At Dec. 31, 2003

ASSETS
Current Asset Cash Accounts receivable Inventory Total Current Asset Fixed Asset Land Machinery Building Total Fixed Asset Total Assets 50,000 20,000 30,000 100,000 192,500 60,000 15,000 17,500 92,500

LIABILITIES
Short-term Liability Accounts payable (A/P) Short-term loan Total Short-term Liability Long-term Liability Notes payable Long-term loan Total Long-term Liability Total Liabilities 20,000 40,000 60,000 91,000 12,000 19,000 31,000

OWNERS EQUITY
Capital stock Retained Earnings (Dec. 31) Add Net Profit Total Owners equity 1,500 20,000 21,500 101,500 80,000

Total Liabilities & Owners Equity

192,500

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Analyzing Financial Statement of Dhaka Ltd. 1. Current Ratio

Current Ratio = Current Current Assets Liabilitie s = 92,5000 = 2.98 31,000

2. Quick Ratio
Quick Ratio = Qucik Current Assets Liabilitie s = 75,000 = 2.41 31,000

*Where quick asset = Total Current Assets Inventory {When Ratio is 1:1 then it is adequate} 3. Return on Sales Re turn on Sales = Net Income Net Sales 4. Return on Equity
Re turn on Equity = Net Income 20,000 = = .1970 or 19.70 % Equity 101,500

20,000 = .3389 or 33.89% 59,000

This Ratio measures the return company earns on every taka of shareholders (owners) investments. 5. Debt to Assets Ratio

Debt to Total Assets Ratio Equity = = 91,000 = .4727 or 47.27% 192,500

Total Liabilities Total Assets

6. Time Interest Earned

Time Interest Earned = EBIT Interest Expense = 24,000 = 10 times 2,400

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