Accounting 2 (Quick Study Business) [Lam Crds ed.] 1423216318, 9781423216315

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BarCharts, Inc.®

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Accounting Functions I. Accounting helps an organization to achieve its goals and objectives by gathering, organizing, and communicating information about its activities A. Two distinct accounting disciplines: Financial accounting and managerial accounting B. Accounting 2 focus: Managerial accounting 1. Financial accounting (a) Concerned with the preparation of financial statements for decision makers and stakeholders such as stockholders, suppliers, creditors and banks, employees, government agencies, and customers (1) Suppliers provide products and services (2) Creditors and banks provide loans, leasing and other services (3) Employees provide time and effort (4) Governments provide permission to operate, municipal services, regulation, and protection (5) Customers provide cash 2. Managerial accounting (a) Concerned with providing accounting information to managers within organizations, allowing them to manage, make decisions, and perform control functions (b) Concerned with providing strategic information, supporting performance management, and risk management (1) Strategic management: The management accountant is a strategic partner in the organization (2) Performance management: The management accountant is a partner in developing the practice of business decision making and managing the performance of the organization (3) Risk management: The management accountant contributes to frameworks and practices for identifying, measuring, managing, and reporting risks to the accomplishment of organizational objectives II. An accounting system uses three types of activities A. Score keeping to accumulate and classify data B. Attention directing to focus on problems and opportunities C. Problem solving to recommend the best course of action III. Accounting system design is guided by themes A. Cost/benefit criteria 1. The benefits of information should outweigh the cost to generate and distribute the information 2. Weighing costs against benefits is done in all decisions B. Behavioral implications; effects on the manager’s decision making IV. Accounting’s position in the organization can be both line and staff A. Line authority: Downward over subordinates B. Staff authority: Downward, laterally, or upward C. Controller: 1. Top accounting officer in an organization; measures and reports on operating performance 2. Responsible for accounting records, internal controls, preparation of financials, tax returns, and internal reports V. Accountants are expected to adhere to standards of ethical conduct A. American Institute of Certified Public Accountants (AICPA): CPAs must adhere to professional ethical standards (www.aicpa.org) B. Institute of Management Accountants: CMAs must adhere to ethical standards (www.imanet.org) 1. Ethical standards of Institute of Management Accountants: (a) Competence – maintain professional competence through professional development activities (b) Confidentiality – refrain from disclosing confidential information acquired in the course of work (c) Integrity – avoid conflicts of interest, disclose favorable and unfavorable information, and refrain from activities that would discredit the profession (d) Credibility – report results fairly and objectively VI. Sarbanes-Oxley Act 2002 (SOX) A. Law passed by U.S. Congress intended to reduce unethical behavior and strengthen the effectiveness of internal controls 1. Internal control is a process designed to provide reasonable assurance regarding the achievement of objectives in the following categories: (a) Effectiveness and efficiency of operations (b) Reliability of financial reporting (c) Compliance with laws and regulations (d) Safeguarding of assets

Management Accounting Basics I. Management accounting vs. financial accounting A. Primary users 1. Financial accounting: Investors, creditors, and regulators 2. Management accounting: Managers and other internal uses B. Primary purpose 1. Financial accounting: Help investors and creditors make investment and credit decisions 2. Management accounting: Help managers plan and control C. Types of reports 1. Financial accounting: Financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP) 2. Management accounting: Internal reports such as budgets and other analysis to aid management D. Scope of information 1. Financial accounting scope is on the company as a whole through summaries (financial statements) 2. Management accounting scope is on detailed reports on parts of the company such as products, customers, departments, and divisions E. Verification process 1. Financial accounting: Information is subject to an independent audit 2. Management accounting: No independent audit F. Focus and time dimension 1. Financial accounting focus is on relevance and reliability of information with focus on the past 2. Management accounting focus is on relevance for decision making and the future II. Types of companies and organizations A. Manufacturing firm: Uses labor, plant, and equipment to convert raw materials into finished goods B. Merchandising firm: Resells products that were previously purchased from suppliers C. Service firm: Provides services (sells intangibles as opposed to the tangible products of a manufacturer or merchandiser) D. Nonprofits and governments: Provide goods and services that meet the needs of society III. Manufacturing costs A. Materials 1. Raw materials, parts, and components used in the finished product 2. Can be direct or indirect costs B. Labor 1. Cost of employees associated with converting materials to a finished good 2. Can be direct or indirect costs C. Manufacturing overhead 1. Costs other than direct materials and direct labor associated with manufacture of finished goods 2. Manufacturing overhead is also called an indirect cost 3. Must be applied (estimated) to the cost of jobs 4. Can be over-applied or under-applied (a) Comparison of actual overhead to applied overhead (b) Over-applied means that the applied overhead is greater than the actual overhead IV. Product vs. period costs A. Product costs are necessary and integral to producing a product 1. Direct materials 2. Direct labor 3. Manufacturing overhead

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B. Product costs are also called inventoriable costs 1. Product costs are initially assets C. Period costs are immediately expensed 1. Include administrative and selling costs V. Costs in financial statements A. Income statement 1. Cost of goods manufactured is the manufacturing costs of the finished goods of a production process of a given period (a) Cost of goods manufactured Beginning work-in-process inventory + Current period manufacturing costs – Ending work-in-process inventory = Cost of goods manufactured 2. Cost of goods sold is the cost of the products sold during a particular period (a) Cost of goods sold for merchandiser Beginning merchandise inventory + Purchases – Ending merchandise inventory = Cost of goods sold (b) Cost of goods sold for manufacturer Beginning finished goods inventory + Cost of goods manufactured – Ending finished goods inventory = Cost of goods sold B. Balance sheet 1. Inventory costs such as raw materials, work-inprocess, and finished goods (or merchandise) (a) Raw material: Something that is acted upon or used by labor and equipment for use as the basis to create some product (b) Work-in-process: Goods that are partially completed (c) Finished goods: Completed products ready for sale VI. Costs in service companies A. Successful service companies need to know the cost of the services rendered B. Banks, law firms, and hospitals all utilize cost accounting C. No inventory costs for a service company D. No cost of goods sold in service companies VII. Costs in merchandising A. Cost of inventory is purchase price plus cost of shipping (also called freight-in) B. Cost of goods sold recognized when merchandise is sold VIII. Costs in manufacturing A. Inventory costs consist of cost of materials, labor, and overhead incurred to make the product B. Cost of goods sold (expense) is recognized when products are sold IX. Trends and developments A. Greater focus on the costs of the value chain 1. Research and development costs 2. Sales and marketing costs 3. Delivery costs 4. Customer relations 5. Cost of customers X. Technology A. Sophisticated software such as enterprise resource planning (ERP) helps managers manage the value chain 1. ERP provides comprehensive information via a centralized database B. Computer-integrated manufacturing (CIM) 1. Reduces the amount of direct labor C. Just-in-time inventory methods, total quality management, and activity-based costing all benefit from advances in technology XI. Types of management accountants A. Staff accountant B. Internal auditor C. Accounting manager D. Controller E. Chief financial officer F. Finance director G. Budget analyst H. Financial analyst I. Budget director

Cost Behavior Cost-Volume Relationships

I. Cost drivers: Activities that cause costs to be incurred A. Direct cause-and-effect relationship between factors and activities and consumed resources II. Variable costs vs. fixed costs A. Variable costs (VC) change in direct proportion to the cost driver 1. Examples (a) Sales commissions: The cost rises in proportion to items sold (b) The cost of paper for a printing company: More jobs printed means more paper used and, therefore, higher paper costs (c) Room supplies are a common variable cost in the hotel industry: Room supplies costs rise with the number of rooms occupied B. Fixed costs (FC) do not change immediately with the cost driver 1. Examples (a) Rent on a building (b) Salaries (c) Property taxes III. Cost-volume-profit analysis A. Break-even point: Level of sales at which revenues equal expenses B. Contribution margin (CM)/unit = Sales price/ unit – VC/unit 1. EX: The selling price of one unit is $40, while the variable cost per unit is $23; the contribution margin is $17 C. Sales – VC – FC = Net income 1. EX: Sales $120,000 Variable costs $70,000 Contribution margin $50,000 D. Break-even in units = FC/CM per unit 1. EX: If the fixed cost is $120,000, and the contribution margin per unit is $30, the break-even point is 4,000 units ($120,000/$30 = 4,000 units) E. Break-even in dollars is calculated as follows: FC/CM ratio 1. The contribution margin ratio = CM/Price 2. EX: If the contribution margin is $30 and the price is $50, the contribution margin ratio is 60% 3. EX: If the contribution margin is $50,000 and the sales are $120,000, the contribution margin ratio is 41.7% 4. EX: If the contribution margin ratio is 40% and fixed costs are $150,000, the break-even point in dollars is $375,000 ($150,000/.4) F. Target profit can be added to fixed costs (FC + Target profit/CM per unit = Sales volume needed to achieve the target profit) 1. EX: If the contribution margin is $30 per unit, fixed costs are $160,000, and the target profit is $20,000, the volume needed to achieve the target profit is 6,000 units ($160,000 + $20,000/$30) IV. Relevant range: Limit of cost-driver activity where FC and VC assumptions are valid A. Over the long term, all costs vary V. Margin of safety A. The difference between actual or expected sales and sales at the break-even point B. EX: If sales are 100,000 units and the breakeven point is 80,000, the margin of safety is 20,000 units C. EX: If sales in dollars are $750,000 and the break-even point in sales is $500,000, the margin of safety is $250,000 VI. Margin of safety ratio A. Margin of safety in dollars divided by actual (or expected) sales B. EX: If sales in dollars are $750,000 and the break-even point in sales is $500,000, the margin of safety is $250,000 and the margin of safety ratio is 33% ($250,000/$750,000) VII. Operating leverage A. The company’s relative use of fixed vs. variable cost

B. Degree of operating leverage 1. Contribution margin divided by net income 2. EX: A company’s net income is $120,000, while its contribution margin is $320,000; the degree of operating leverage (DOL) is 2.67 ($320,000/$120,000) 3. A high degree of operating leverage means that a firm’s net income is very sensitive to changes in sales

Variations of Cost Behavior

I. Cost drivers and cost behavior A. Cost behavior is assumed linear over some relevant range of activities or cost drivers B. Cost behaviors that combine characteristics of both fixed and variable cost behavior: 1. Step costs: Either fixed or variable, changed abruptly at interval of activity because the resources and their costs come in divisible chunks 2. Mixed costs: Contain elements of FC and VC II. Management’s influence on cost functions A. Through decisions about product or service attributes, capacity, technology, and policies to create incentives to control costs III. Cost behavior as a function of appropriate cost drivers A. Total cost = FC + (VC × Cost driver) 1. EX: The fixed costs of a delivery truck are $4,000 per year, while the variable costs are 60 cents per mile; the truck is driven 15,000 miles in a year; the total cost of the truck ownership for the year is $13,000 B. Apply activity analysis in choosing a cost driver C. If a cost function is accurate and useful, it must be plausible and reliable IV. Methods of measuring cost functions A. Cost = FC + (VC × # of units) B. Engineering analysis: What costs should be C. Accounting analysis: 1. Volume-related cost driver vs. what cost could have been 2. Classify each account as a VC or FC D. High-low, visual-fit, and least-squares methods: Separate fixed and variable past data to predict costs

Cost Accounting Systems

I. Cost accounting A. Accounting systems concerned with production costs; keeps track of material, labor, and overhead costs B. Types of cost systems: Job order cost, process cost, and ABC II. Job order cost system A. A cost system that accumulates and assigns costs to unique products or unique batches of products B. Job cost sheet (see example below) 1. Keeps track of materials and labor used on a particular job and the allocation of overhead to that job 2. “Open” job cost sheets represent work-in-process 3. “Closed” job cost sheets for a period represent finished goods or cost of goods sold A-1 Printers Job Cost Sheet Customer: KMT Software Job number: 4212 Address: 1234 Main Street Swansea, MA 02777 Job description: 2,500 Calendars Date started: 9/1/10 Date finished: 9/2/10 Cost Summary Materials $66.78 Labor $91.34 Overhead $89.51 Total cost

$247.63

Direct Materials Date Req. # Cost 9/1/10 26161 $33.78 9/2/10 26171 $33.00 Total

$66.78

Direct Labor Overhead Date Ticket Cost Date Rate Cost 9/1/10 T-110 $17.00 9/2/10 150% $89.51 9/1/10 T-111 $27.00 of DL$ 9/2/10 T-112 $15.67 Total

$59.67 Total

$89.51

III. Process cost system A. A cost system that accumulates and assigns costs to products that are identical and usually mass-produced B. Allocation of costs between partially (work-in-process) and fully completed units (finished goods) C. Cost of production report provides production cost allocation between work-in-process and finished goods D. Four-step process: 1. Summarize flow of physical units 2. Compute output in terms of equivalent units 3. Compute the cost per equivalent unit 4. Assign costs to units completed and to units in work-in-process inventory IV. Activity-based costing (ABC)

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A. A cost system that can be used with either job order costing or process costing that assigns cost based on cost drivers that reflect the consumption of resources B. Steps: 1. Identify each activity and estimate its cost 2. Identify the cost driver for each activity and estimate the total quantity of each driver’s allocation base 3. Compute the cost allocation rate for each activity: Cost allocation rate = Estimated total cost of activity ÷ Estimated total quantity of the allocation base V. Allocate indirect costs to the cost object Allocated activity cost = Cost allocation rate × Actual quantity of the allocation base A. ABC allows managers to practice activity-based management (ABM) B. ABM 1. Comprehensive management tool that focuses on reducing costs and improving processes by utilizing ABC information 2. Helps with pricing and product mix decisions and cost cutting 3. ABM aids value engineering 4. Reevaluates activities to increase efficiencies and reduce costs

Relevant Information & Decision Making

I. Criteria for relevant information A. Predicted future cost: Differ among alternatives 1. Only data that is different between alternatives is relevant to a decision (a) EX 1: If alternative 1 has annual fuel costs of $10,000 and alternative 2 also has fuel costs of $10,000, the fuel costs are not relevant to the decision (b) EX 2: If alternative 1 has fuel costs of $15,000 and alternative 2 has fuel costs of $10,000, then fuel costs are relevant to the decision because there could be savings if alternative 2 is adopted B. Past data: Irrelevant 1. A sunk cost (past expenditure) is not relevant to a decision because the investment has already been made and can’t be changed 2. EX: If you purchased a furnace 15 years ago for $100,000 and are now deciding to replace that furnace, the amount paid in the past has no bearing on the current decision to replace the old asset C. Cost or revenue that remains the same regardless of the alternative: Irrelevant 1. Only data that is different between the alternatives is relevant to a decision (a) EX 1: If alternative 1 has projected revenue of $150,000 and alternative 2 also has projected revenue of $150,000, the expected revenues are not relevant to the decision (b) EX 2: If alternative 1 has projected revenues of $150,000 and alternative 2 has projected revenues of $100,000, then revenue projections are relevant to the decision because there could be $50,000 more revenue if alternative 1 is adopted II. Special sales order A. Should accept when additional revenues exceed additional costs B. Fixed costs normally unaffected 1. Fixed costs are usually irrelevant III. Deletion or addition of products or departments A. Avoidable costs: Will not continue B. Unavoidable costs: Continue IV. Optimal use of limited resources A. Emphasize product with largest total profit contribution per unit of the limiting factor B. # of units/limiting factor × (CM)/unit = Total CM/ unit of limiting factor V. Role of costs in pricing decisions

A. Marginal cost: Additional cost for one more unit produced B. Marginal revenue: Additional revenue from one more unit sold C. Price elasticity: Effect of price changes on sales volume D. Cost-plus pricing 1. Cost + a markup 2. Product or service price is determined by adding a markup to a cost base 3. Markup is the amount added to cost to determine a price VI. Influences on pricing in practice A. Legal requirements: 1. Predatory pricing 2. Discriminatory pricing B. Competition C. Costs D. Customer demand E. Target costing: Design a product that can be produced at a low enough cost to provide an adequate profit margin

VII. Opportunity cost A. Max profit forgone by choosing an alternative B. Economic in nature VIII. Outlay cost A. Requires cash outlay B. Accounting in nature IX. Differential = incremental cost A. Difference in total cost between alternatives B. Used in differential analysis X. Make-or-buy decisions A. Identify quantitative and qualitative factors B. Focus on relevant costs XI. Joint product costs A. Occur when two or more products have relatively significant sales values B. Not separately identifiable until split-off point C. Identify separable costs beyond split-off point D. Identify joint costs prior to split-off point E. Decide whether to sell or process further 1. Differential analysis 2. Opportunity cost analysis 3. Joint costs are irrelevant

Budgeting Master Budget: Overall Plan

I. Budgeting over time A. Strategic plan: Overall goals and objectives B. Long-range planning: For 5–10 years C. Capital budget: Planned expenditures for facilities, equipment, etc. D. Master budget: Summarizes all subunits 1. Operating budget: Focuses on income statement and its schedules 2. Financial budget: Focuses on effects of operating and capital budgets on cash II. Advantages of budget A. Allows managers to plan and provides a direct link to the strategic plan B. Maintains control by comparing actual revenues and costs to budgeted revenues and costs C. Enhances communication and coordination 1. Distributed to managers and staff so that objectives are known D. Authorizes spending 1. Line items give managers the approval to spend certain amounts 2. In government, line items are appropriations that the voters have authorized

Introduction to Cost Systems

I. Classification of costs A. Cost accumulation and cost objectives 1. A cost is a sacrifice or giving up of resources for a purpose 2. A cost object is something that managers want to know the cost of (a) EX: Products, services, departments, functions, tasks, customers B. Direct and indirect costs 1. Direct costs can be identified specifically and exclusively with a given cost objective (a) Can be traced to the cost object accurately and in an economically feasible manner 2. Indirect costs cannot be identified with a given cost objective (a) Cannot be traced accurately to the cost object in an economically feasible manner C. Manufacturing costs 1. Direct material costs (DM): Costs of all materials that are physically identified as a part of the manufactured goods

E. Calculates variances 1. Variances are the difference between the budget items (revenues and costs) and actual revenues and costs (a) Favorable variances have a positive impact on profits (b) Unfavorable variances have a negative impact on profits F. Provides benchmarks – motivational tools that challenge staff to reach goals III. Preparation of master budget A. Operating budget 1. Prepare sales budget 2. Estimate cash collections 3. Prepare purchases budget 4. Estimate disbursements for purchases 5. Prepare operating expense budget 6. Prepare selling and administrative budgets 7. Estimate disbursements for operations B. Financial budget 1. Prepare detailed cash budget 2. Prepare budgeted balance sheet and budgeted income statement (also called pro formas) IV. Difficulties A. All budgets rely on sales budget B. Past patterns used 1. Managers look at trends to estimate future C. Estimates for sales are very difficult to generate D. Volatile economic environment makes stable estimates almost impossible

Management Control Systems I. Management control system (MCS) A. An integration of management accounting tools B. Organizational goals: #1 in designing MCS (broad) C. Organizational subgoals: Means of achieving organization’s overall goals (mid-range) D. Organizational objectives: Day-to-day guidance (specific) E. Balance of goals, subgoals, and objectives: Overemphasis on short term to the detriment of long range threatens achievement of organization’s basic goals II. Designing an MCS A. Working within constraints: MCS must fit organization’s structure (i.e., whether it is by function or division) B. Identification of responsibility centers 1. Cost center: Measures accumulated costs 2. Profit center: Measures revenue less costs 3. Investment center: Measures net income to invested capital

E. Budgetary slack is the amount by which a manager intentionally “pads” the budget to make it easier to achieve goals V. Participative budgeting A. Starts with inputs from lower-level managers and works upward so that managers participate at all levels VI. Sensitivity analysis A. Budgets at different sales levels B. Budgets at different expense levels C. Allows managers to play “what-if”

Flexible Budgets & Standards for Control

I. Static budget = master budget A. Performance report: Actual results vs. original plan B. Master budget variances 1. Favorable or unfavorable 2. Useful for management by exception II. Flexible budget = variable budget A. Adjust for changes in cost drivers B. Prepared for a range of activity C. Reflect fixed cost and variable cost behavior D. Flexible budget variances: Flexible budget vs. actual results E. Activity level variances: Flexible budget vs. master budget

C. Weighing costs and benefits: Maximum benefits at minimum costs D. Motivation of employees 1. Goal congruence: Individuals and groups aim at same goals 2. Managerial effort: Exertion toward goal or objective E. Design of internal controls: Prevent and detect errors and irregularities; promote operational efficiency 1. Accounting controls: Separation of duties, reconciliations and proofs, physical control, matching of documents and records (i.e., purchase order and invoice), and authorizations 2. Administrative controls: Budgets for planning, controlling, and evaluating F. Development of measures of performance: For both financial and nonfinancial performance measures III. Control and measurement of financial performance A. Uncontrollable costs: Cannot be affected by management within a given time span

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2. Direct labor costs (DL): The wages of all the labor that can be traced to manufactured goods 3. Manufacturing overhead costs (MO): All costs other than DM or DL D. Prime costs = DM + DL E. Conversion costs = DL + MO II. Cost management system A. Measures the resources used 1. Assesses the effects of costs of changes 2. Helps management meet objectives and budgets III. Two approaches to costs A. Absorption costing: All variable and fixed manufacturing costs are treated as product cost 1. Required by GAAP B. Contribution approach: Only variable manufacturing costs are treated as product cost

III. Isolation of variances and their causes A. Effectiveness: Degree to which a goal or target is met, measured by sales activity variance B. Efficiency: Inputs used in relation to outputs, measured by flexible budget variance C. Expected cost: Most likely to be attained D. Standard cost: Should be attained; budget for one unit IV. Flexible budget variances A. Variances from material and labor standards 1. Price (rate) variance: Difference between actual input price and standard price 2. Usage (quantity or efficiency) variance: Difference between quantity of input used and quantity allowed for actual output B. Provide feedback C. Overhead (OH) variances 1. Variable OH efficiency variance 2. Variable OH spending variance

B. Controllable costs: Influenced by management’s decisions C. Contribution margin D. Contribution by segment: Controllable by responsibility center managers E. Unallocated costs IV. Control and measurement of nonfinancial performance A. Quality control 1. Prevention: Costs to prevent defects/substandard service 2. Appraisal: Costs to identify defects/substandard service 3. Internal failure: Costs to scrap or rework 4. External failure: Customer dissatisfaction B. Control of time cycle C. Control of productivity V. Management by exception A. Review by management focused on variances only

Management Control in Decentralized Organizations I. Centralization vs. decentralization A. Cost/benefit criteria B. Profit centers and decentralization II. Transfer pricing A. At cost 1. Price based on costs incurred by division producing the goods or services B. Market-based 1. Based on existing market prices of competing goods or services C. Variable cost–based 1. Based on variable cost to produce the good or service D. Negotiated 1. Prices determined through agreement of division managers E. Use of incentives F. Need for many transfer prices G. Multinational transfer pricing III. Performance measures and management controls A. Motivation leads to performance, which can lead to rewards B. Agency theory → performance → rewards → risk

IV. Measures of profitability A. Return on investment (ROI) = income/investment 1. EX: A division’s net operating income is $120,000 on an investment of $1,000,000, which means the ROI is 12% ($120,000/$1,000,000) B. Residual income = Net income – Imputed interest 1. EX: A division earns $200,000 of operating income on invested capital of $1,000,000; the minimum required return that investors in the company expect is 12%; the residual income is $80,000 ($200,000 less [$1,000,000 × .12]) V. Invested capital can be defined as: A. Total assets B. Total assets employed C. Total assets: Current liabilities D. Stockholders’ equity VI. Keys to successful MCS A. Focus on controllability B. Management by objectives VII. Balanced scorecard A. Evaluates performance from a series of perspectives 1. Financial perspective: Employs financial measures

Capital Budgeting Analyzing Long-Range Decisions I. Capital budgeting A. The process of making capital expenditure decisions B. Requires large investments and affects operations for years to come II. Discounted cash flow models A. Net present value (NPV) method 1. The difference between the original outlay and the discounted cash flows of a project B. Discount rate is the interest rate used to calculate the present value of the future cash flows 1. Total project approach: Choose largest NPV 2. Differential approach: Choose if NPV is positive 3. NPV is the discounted cash flows less the initial investment 4. Excel® has the NPV function, as do financial calculators (a) EX: A project has the following cash flows and the company has a cost of capital of 12%; the cost of capital is used to calculate the present value of the years 1 through 10 cash flows Years Cash Flows The discounted cash flows are 0 -$100,000 $100,592.17 less the initial 1 12,000 investment (year 0) of $100,000, 2 13,000 a net present value $592.17; a 3 14,000 positive net present value means 4 15,000 5 16,000 that the cash flows are generating 6 17,000 a return that is greater than the 7 20,000 cost of capital (12%); if the net 8 22,000 present value was exactly zero, 9 23,000 then the project’s rate of return 10 50,000 would be exactly 12% NPV $102,000 C. Internal rate of return (IRR) method 1. The interest rate that causes the Years Cash Flows present value of the expected cash 0 -$100,000 flows to equal the initial outlay 1 12,000 2. Choose if IRR is greater than 2 13,000 desired rate of return 3 14,000 3. Excel® has an IRR function, as do 4 15,000 financial calculators 5 16,000 (a) EX: The desired rate of return 6 17,000 is 12%; a proposed project has 7 20,000 the following cash flows (see 8 22,000 9 23,000 table at right) 10 50,000 Accept the project as its IRR IRR 12.12% exceeds the minimum rate of return

D. Allows for assessment of risk and sensitivity (whatif) analysis E. Complicating factors in implementation of models: Income taxes, inflation, mutually exclusive projects, and unequal project lives III. Payback method A. Payback time = Initial investment/annual cash flow B. Assumes that investments with long payback periods are riskier than those with short payback periods C. Does not measure profitability D. Ignores time value of money E. Formula: Payback period = Amount invested ÷ Expected annual cash flow 1. EX: A project is expected to average $20,000 of cash flow each year; if the initial investment is $100,000, then the payback period is 5 years ($100,000/$20,000 = 5 years) IV. Accounting rate of return (ARR) A. Expected annual net income divided by average investment 1. Average investment = Original investment + Value at end of useful life 2. EX: A company invests in a machine that costs $135,000 with a salvage value of zero; the estimate annual net income is $14,000; the ARR is found as follows: $14,000/([$135,000 + $0]/2) = 21.5% B. Disadvantage: Ignores time value of money V. Profitability index A. A method of comparing capital expenditure alternatives B. Present value of cash flows/initial investment C. The proposal with the highest profitability index should be accepted VI. Performance evaluation A. Conflict: Evaluations based on accounting measures can deter from making major long-term decisions with large initial investments B. Reconciliations of conflict 1. Post audit: Monitor and evaluate projects (a) A thorough evaluation of how well a project’s actual performance compares to the original projections 2. Base management evaluations on different priorities

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(a) Return on assets (b) Net income (c) Share price (d) Earnings per share 2. Customer perspective: Measures how well the firm compares to competitors in terms of price, quality, innovation, and customer service (a) Customer retention (b) Response time (c) Brand recognition (d) Customer service expense per customer 3. Internal process perspective: Evaluates all aspects of the value chain, including product development, production, and delivery (a) Percentage of defect-free finished goods (b) Stockouts (c) Labor utilization rates (d) Throughput 4. Learning and growth perspective (a) Employee retention ratios (b) Training hours per employee (c) Number of ethics violations (d) Number of employee accidents

Taxes & Inflation I. Marginal income tax rate A. Tax rate paid on additional amounts of pretax income II. Recovery period A. Number of periods assets are depreciated for tax purposes III. Tax shields; deductions protect that amount of income from taxation IV. Accelerated depreciation A. Writes off assets quicker than straight-line method B. Tax avoidance (minimizing and delaying taxes) C. Double-declining-balance depreciation: (100%/# of years asset is to be depreciated) ×2 V. Depreciation and equipment replacement A. Initial investment 1. Cost of old equipment: Effect on tax cash flows 2. Cost of new equipment is relevant B. Do not double count: Equipment investment is a one-time outlay not to be double counted as an outlay in the form of depreciation C. Relation to income tax cash flow: Income tax cash effect relevant (not the book value or depreciation) VI. Gains or losses on disposal A. Losses produce tax savings, and gains produce tax expenditures B. Gains are still more desirable than losses VII. Capital budgeting and inflation A. Nominal rate: Quoted market interest rate 1. Includes an element of inflation 2. Use for minimum desired rate of return B. Depreciation deductions: No allowance for inflationary effects VIII. After-tax impact of operating cash inflows A. Inflow × (1 – tax rate) 1. EX: A firm in the 28% marginal tax bracket has a cash inflow of $10,000; the after-tax cash flow is $10,000 × (1 – .28) = $7,200

Cost Allocation Introduction

I. Assignment of each cost to the cost objective II. Purposes A. To predict the economic effects of decisions B. To obtain desired motivation C. To measure income and assets D. To justify cost or obtain reimbursement III. Types A. Allocation of costs to appropriate units B. Reallocation of costs from one unit to another C. Allocation of a particular unit to products or services IV. Allocation of costs to final products or services A. Allocate production-related costs to their operation, production, or revenue-producing department B. Select one or more cost drivers in each production department C. Allocate the total cost accumulated in Step A to products or services using cost drivers specified in Step B V. Allocation base A. A common denominator that links indirect costs to cost objects (anything for which you need to calculate a cost) B. Indirect cost is divided by the allocation base to derive an allocation rate

Overhead Application: Variable & Absorption Costing

I. Variable vs. absorption costing A. Accounting for fixed manufacturing overhead (FMO) 1. Variable costing method: FMO is excluded 2. Absorption costing method: FMO is included II. Variable method A. Apply all variable manufacturing costs to goods produced B. Expenses FMO is incurred C. Separates costs into categories of fixed and variable on the income statement III. Absorption method A. Applies all variable manufacturing costs plus part of fixed manufacturing to each product B. Separates costs into categories of manufacturing and nonmanufacturing on the income statement C. Uses two overhead rates 1. Fixed overhead rate = budgeted fixed overhead/expected cost driver activity 2. Production volume variance: Actual production deviates from the expected volume used IV. Fixed overhead and absorption costs of product A. Variable and fixed unit costs B. Production volume variance = Applied fixed overhead – Budgeted fixed overhead 1. Actual production volume does not coincide with expected volume C. Fixed overhead rate depends on expected activity level chosen

D. Actual costing: Actual materials, actual labor, and actual variable and fixed overhead E. Normal costing: Actual materials, actual labors, and budgeted rates for fixed overhead F. Standard costing: Budgeted rates

Statement of Cash Flows

I. Reports cash activity during the same period as the income statement A. Cash receipts B. Cash payments C. Net change in cash as a result of operating, investing, and financing activity II. Users of statement of cash flows can assess a number of factors A. Ability to generate future cash flows B. Ability to pay dividends and meet obligations C. Differences between net income and net cash provided by operations D. Cash investing and financing transactions III. Classification on cash flows A. Operating activities 1. Cash effects of revenue and expenses B. Investing activities 1. Cash flows from acquiring and disposing of investments and property, plant, and equipment; lending money; and collecting loans C. Financing activities 1. Obtaining cash from issuing debt and repaying amounts borrowed and obtaining cash from stockholders, repurchasing shares, and paying dividend IV. Two methods: Indirect and direct A. Indirect adjusts net income for items that do not affect cash B. Direct shows operating cash receipts and payments; Financial Accounting Standards Board (FASB) has a preference for direct method C. The table below provides examples of cash inflows and outflows: Inflows Outflows Payments to: Suppliers Sale of goods & services Operating Employees (wages & Interest & dividends activities salaries) received Governments for taxes Lenders for interest Sale of property, plant & Purchase of property, plant equipment & equipment Sale of investments in debt Purchase of investments in Investing or equity securities of debt or equity securities of activities other entities other entities Collection of loans to other Making loans to other entities entities Dividends paid to stockholders Sale of common stock Financing Redemption of long-term Issuance of long-term debt activities debt such as bonds & notes Purchase of own common stock (treasury stock) D. Example statement of cash flows:

Statement of Cash Flows - Indirect Method Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Loss on sale of machinery Increase in accounts receivable Decrease in inventories Increase in accounts payable Net cash provided by operating activities Cash from investing activities Sale of machinery Purchase of machinery Net cash used by investing activities Cash flows from financing activities Payments of cash dividends Net increase in cash Cash at beginning of period Cash at end of period

$450,000

$900,000 25,000 (170,000) 35,000 20,000

810,000 $1,260,000

270,000 (700,000)

(430,000) (200,000) $630,000 120,000 $750,000

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Financial Analysis I. Horizontal analysis A. Evaluation of financial statement data over period of time B. Increases or decreases of financial items are determined C. Changes are shown in dollars and by percentage 1. Find the difference between the most current period balance and the previous period balance for each item on the balance sheet 2. Calculate the percentage change as follows: Dollar change ÷ balance from previous period × 100 D. Example of a horizontal analysis of a balance sheet: Balance Sheet 2010

2009

Change Amount Percent

Assets Current assets $1,000,000 $970,000 $30,000 Plant assets (net) 825,000 675,000 150,000 Intangible assets 16,000 18,500 (2,500) Totals assets $1,841,000 $1,663,500 $177,500 Liabilities Current liabilities $350,000 $305,100 $44,900 Long-term liabilities 547,000 567,000 ($20,000) Total liabilities $897,000 $872,100 $24,900 Stockholders’ Equity Common stock 290,000 280,000 10,000 Retained earnings 654,000 511,400 142,600 Total stockholders’ equity 944,000 791,400 152,600 Total liabilities & stockholders’ equity $1,841,000 $1,663,500 $177,500

3.1% 22.2% -13.5% 11.8%

14.7% -3.5% 11%

3.6% 27.9% 31.5%

11%

E. Example of a horizontal analysis of an income statement: Income Statement

Sales Sales returns & allowances Net sales Cost of good sold Gross profit Selling expenses Administrative expenses Total operating expenses Income from operations Other revenues & gains Interest & dividends Other expenses & losses Interest expense Income before income taxes Income tax expense Net income

Change 2010 2009 Amount Percent $2,200,000 $1,970,000 $230,000 11.7% 100,000 125,000 $2,100,000 $1,845,000

(25,000) 255,000

-20.0% 13.8%

1,381,000 $719,000

1,150,000 $695,000

231,000 24,000

20.1% 3.5%

254,000

212,500

41,500

19.5%

106,000

109,000

(3,000)

-2.8%

360,000

321,500

38,500

12.0%

359,000

373,500

(14,500)

-3.9%

10,000

11,500

(1,500)

-13.0%

35,000

41,200

(6,200)

-15.0%

314,000

320,800

(6,800)

-2.1%

142,500 $171,500

168,000 $152,800

(25,500) $18,700

-15.2% 12.2%

II. Vertical analysis A. Evaluation of financial statement data that expresses each item as a percent of a base amount 1. Each item on the income statement is divided by net sales 2. Each item on the balance sheet is divided by total assets

Financial Analysis (continued)

B. Example of a vertical analysis of an income statement: Income Statement 2010 Amount Percent 2009 Percent Sales $2,200,000 104.8% $1,970,000 106.8% Sales returns & allowances 100,000 4.8% 125,000 6.8% Net sales $2,100,000 100.0% $1,845,000 100.0% Cost of good sold 1,381,000 65.8% 1,150,000 62.3% Gross profit $719,000 34.2% $695,000 37.7% Selling expenses 254,000 12.1% 212,500 11.5% Administrative expenses 106,000 5.0% 109,000 5.9% Total operating expenses 360,000 17.1% 321,500 17.4% Income from operations 359,000 17.1% 373,500 20.2% Other revenues & gains Interest & dividends 10,000 0.5% 11,500 0.6% Other expenses & losses Interest expense 35,000 1.7% 41,200 2.2% Income before income taxes 314,000 15.0% 320,800 17.4% Income tax expense 142,500 6.8% 168,000 9.1% Net income $171,500 8.2% $152,800 8.3% C. Example of a vertical analysis of a balance sheet: Balance Sheet 2010 2009 Amount Percent Amount Percent Assets Current assets $1,000,000 54.3% $970,000 58.3% Plant assets (net) 825,000 44.8% 675,000 40.6% Intangible assets 16,000 0.9% 18,500 1.1% Totals assets $1,841,000 100.0% $1,663,500 100.0% Liabilities Current liabilities $350,000 19.0% $305,100 18.3% Long-term liabilities 547,000 29.7% 567,000 34.1% Total liabilities $897,000 48.7% $872,100 52.4% Stockholders’ Equity Common stock 290,000 15.8% 280,000 16.8% Retained earnings 654,000 35.5% 511,400 30.7% Total stockholders’ equity 944,000 51.3% 791,400 47.6% Total liabilities & stockholders’ equity $1,841,000 100.0% $1,663,500 100.0% III. Ratio analysis A. Evaluation of financial statements by expressing relationships between financial statement items B. A ratio is one financial item divided by another financial item C. Ratios measure liquidity, profitability, and solvency

IV. Liquidity ratios: Measure of the ability of a firm to pay its short-term obligations A. Current ratio Formula: Current assets/Current liabilities Purpose: Measures ability to pay short-term debts EX: Current assets = $3,000,000 and current liabilities = $1,500,000; the current ratio is 2 ($3,000,000/$1,500,000, which means that current assets are 2 times the amount of current liabilities) B. Acid Test (quick ratio) Formula: Cash + Short-term investments + Receivables/ Current liabilities Purpose: Measures ability to pay short-term debts using a more conservative approach (doesn’t consider inventory) EX: Cash = $200,000; short-term investments = $400,000; receivables = $300,000; and current liabilities = $1,500,000; Acid Test (quick ratio) is .6 times C. Receivables turnover Formula: Net sales/Average receivables Purpose: Indicator of receivables management and a measure of the liquidity of receivables EX: Credit sales = $3,000,000; returns and allowances = $100,000; sales discounts = $50,000; beginning receivables = $300,000; and ending receivables = $600,000; the receivables turnover is 6.3 times; average receivables are calculated as follows: (Beginning receivables + Ending receivables)/2; Net sales = Credit sales – Returns and allowances – Sales discounts D. Inventory turnover Formula: Cost of goods sold/Average inventory Purpose: Indicator of inventory management and a measure of the liquidity of inventory EX: Cost of goods sold = $5,400,000; beginning inventory = $300,000; and ending inventory = $600,000; the inventory turnover is 12; the average inventory is calculated as follows: (Beginning inventory + Ending inventory)/2 V. Profitability ratios: Measure the operating success of a firm (net income) A. Profit margin Formula: Net income/Net sales Purpose: Measures the amount of net income (on average) generated by each dollar of sales EX: Net income = $1,200,000 and net sales = $24,000,000; profit margin is 5% B. Asset turnover Formula: Net sales/Average total assets Purpose: Measures how efficiently assets are used to generate sales EX: Net sales = $10,000,000; beginning assets = $3,000,000; and ending assets = $5,000,000; asset turnover is 2.5 times; average assets are calculated as follows: (Beginning total assets + Ending total assets)/2 C. Return on assets Formula: Net income/Average total assets Purpose: Measures overall profitability of assets EX: Net income = $1,200,000; beginning assets = $6,000,000; and ending assets = $10,000,000; the return on assets is 15%; average assets are calculated as follows: (Beginning total assets + Ending total assets)/2 D. Return on common equity Formula: Net income/Average common stockholders’ equity Purpose: Measures profitability of stockholders’ investment EX: Net income = $1,200,000 and common stockholders’ equity = $6,000,000; return on common equity is 20%

E. Payout ratio Formula: Cash dividends/Net income Purpose: Measures the percentage of earnings distributed in the form of cash dividends EX: Net income = $2,000,000 and cash dividends = $600,000; the payout ratio is 30% VI. Solvency ratios: Measure the ability of the company to survive and pay its long-term obligations over a long period of time A. Debt to total assets Formula: Total liabilities/Total assets Purpose: Measures the percentage of assets financed by creditors EX: Total liabilities = $800,000 and total assets = $4,000,000; the debt to assets ratio is 20% B. Times interest earned Formula: Income before income taxes and interest expense/Interest expense Purpose: Measures the ability to make interest payments when they come due EX: Income before income taxes and interest expense are deducted = $10,000,000 and interest expense = $2,000,000; the times interest earned ratio is 5 times VII. Quality of earnings A. Repeatable, controllable, and bankable B. Question: Are the earnings sustainable? C. Full and transparent information necessary for high quality of earnings

Time Value of Money

I. Time value of money formulas and concepts are used in many areas of accounting and finance II. Interest A. Payment for use of money B. Principal is the original amount paid III. Simple interest A. Interest = Principal × Rate × Time IV. Compound interest A. Future value 1. Growth of value based on rates of return and time 2. Future value = Present value + Interest earned 3. EX: $10,000 invested for 5 years at 6% interest is Future value: $13,383 = Present value (principal): $10,000 + Interest earned: $3,383 4. Excel® FV function or FV function of financial calculator makes the future value calculation easy B. Present value 1. Discounting of future value into present dollars by extracting returns (interest) 2. Discounting is reverse compounding 3. Present value = Future value – Interest earned 4. EX: $13,383 received in 5 years can be discounted to present value (today’s dollars) Present value: $10,000 = Future value (principal): $13,383 – Interest earned: $3,383 V. Annuities A. Stream of equal cash flows made at equal time intervals B. EX: $1,000 received every year for 10 years C. A fixed rate mortgage is a type of annuity D. Present value of an annuity 1. The discounted value of a stream of equal cash flows E. Future value of an annuity 1. The future worth of an equal stream of cash flows

U.S. $6.95

AUTHOR: Michael P. Griffin

NOTE TO STUDENT: This guide is intended for informational purposes only. Due to its condensed format, this guide cannot cover every aspect of the subject; rather, it is intended for use in conjunction with course work and assigned texts. BarCharts, Inc., its writers, editors, and design staff are not responsible or liable for the use or misuse of the information contained in this guide. Excel® is either a registered trademark or trademark of Microsoft Corporation in the United States and/or other countries. All rights reserved. No part of this publication may be reproduced or transmitted in any form, or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without written permission from the publisher. Made in the USA. © 2011 BarCharts, Inc. 1214

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