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Accounting for Non-Accountants

Dr. Joyce S. Wendam Lecturer

I - Basic Accounting: Concepts, Techniques and Conventions

Definition of Accounting
Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof.

Functions of Accounting
Functions of accounting: 1. Recording of data 2. Classifying of data 3. Summarizing of data 4. Interpreting the results

Major users of accounting information


1. 2. 3. 4. 5. 6. 7. 8. owners of the business management of the business banks or creditors of the business the government or its agencies prospective investors consumers employees of the business the general public

2 The Elements of Accounting

The Accounting Elements


Assets Owners Equity Liabilities Revenue Expenses

Assets
Assets are items of worth owned by the business organization in conducting its operations. Examples: cash, receivables, stock, land

Types of Assets

1. Current assets those assets which are readily converted into cash within a twelve-month period or within the normal operating cycle of a business. As a guide non-monetary assets that are convertible to cash within a year or the normal operating cycle of a business are categorized as current assets.

2. Non-current assets - those which are not readily convertible into cash within a twelvemonth period or within the normal operating cycle of a business and, thus, it has a longterm nature. Also known as long-term assets. These assets are mostly not intended to be sold by the business entity. Ex. - land, building, machinery, motor vehicles, equipment and furniture.

Liabilities
Amounts owed by the business entity to outside parties other than its owner and as such these are seen as debts and obligations of the business. Examples accounts payable, notes payable, loans, salaries payable

a. Current Liabilities
Current Liabilities - debts and obligations which should be paid within a twelve-month period or within the normal operating cycle of a business. Examples are creditors, accounts payable, salaries payable.

b. Non-current Liabilities
Non-current Liabilities debts and obligations which will be paid over more than a twelve-month period and, thus, it has a long-term nature. Also known as long-term liabilities. Examples mortgage loan or long-term notes payable

Owners Equity
Also known as owners contribution, investment, proprietorship, net worth or capital to the business. Outstanding claim of the owners in the assets of a business after satisfying the claims of the creditors.

Revenue & Expenses


Revenue - amount made or earned by the business entity as a result of its operations. Expenses expenditures associated with earning revenue. These are generally utilized in the period in which they incurred.

Profit/Loss calculation
The primary objective of most business organizations is to make earnings or profits. To calculate a profit or loss, we only need to subtract expenses from revenues. If revenue is greater than expenses, a profit is made and consequently, a loss is made when revenue is less than expenses. In Accounting, a loss is generally shown with parentheses around it ( a negative numerical figure).

Accounting Equation
The Fundamental Accounting Equation:

Assets = Liabilities + Owners Equity


The accounting equation may also be expressed in two other forms:
(1) OWNERS EQUITY = ASSETS LIABILITIES (2) LIABILITIES = ASSETS OWNERS EQUITY

Expanded Accounting Equation


A = L + OE (C + R E D)
Where:

A = assets L = liabilities OE = Owners Equity C = Capital R = Revenue E = Expenses D = Drawings

DOUBLE-ENTRY BOOKKEEPING
Phases of Accounting Recording Phase Classifying Phase Summarizing Phase Interpreting Phase

Recording Phase refers to the procedure of methodically and chronologically documenting business transactions in the appropriate accounting books.
Classifying Phase refers to the procedure of sorting accounting entries and grouping them into same type such as asset accounts, liability accounts, owners equity accounts, revenue accounts and expense accounts.

Summarizing Phase refers to the procedure of abridging or summing up of accounting entries that were classified in the classifying phase into more useful financial statements. Interpreting Phase refers to the procedure of analyzing the financial statements done in the summarizing phase to provide answers to major users of financial information.

Principles of Double-Entry Bookkeeping System


(1) Each business transaction involves a worth received and a worth given away; (2) The balance of the accounting equation should always be conserved, that is, the accounting equation should still be balance after each business transaction.

Debit and Credit Entry


Double-entry bookkeeping system always records a transaction using two entries: Debit entry deals with the worth received (things-of-value received) by the business entity. Credit entry deals with the worth given away (things-of-value given away) by the business entity.

For you to understand further the double-entry bookkeeping system, study the following business transactions: 1. The business purchase a motor vehicle for P500,000 from David Car Sales paid in cash. worth received: motor vehicle worth P500,000 worth given away: cash of P500,000 What is the accounting entry? Debit entry transportation equipment worth P500,000 Credit entry cash-on-hand of P500,000

Rules of Debit and Credit


Rule 1: An asset is increased by a debit entry. Rule 2: An asset is decreased by a credit entry. Rule 3: A liability is increased by a credit entry. Rule 4: A liability is decreased by a debit entry. Rule 5: An owners equity is increased by a credit entry.

Rule 6: An owners equity is decreased by a debit entry. Rule 7: A revenue is increased by a credit entry. Rule 8: A revenue is decreased by a debit entry. Rule 9: An expense is increased by a debit entry. Rule 10: An expense is decreased by a credit entry.

3. FINANCIAL ACCOUNTING REPORTS

Financial Statements
Summarized reports of accounting transactions Two-fold purpose: to communicate to users: - the effect of operating activities during a specified period of time; and, - the business financial position at the end of the period Types of financial statements: Income Statement Balance Sheet Statement of Cash Flow

Balance Sheet
Reports the financial position of a business at a specific point in time Often called the statement of financial position Equation: Assets = Liabilities + Owners Equity

Balance Sheet
Assets economic resources that are expected to benefit future activities Equities claims against, or interests in, the assets Liabilities entitys economic obligations to non-owners Owners equity excess of the assets over the liabilities For a corporation, the owners equity is called the stockholders equity.

Pro Forma Balance Sheet


XYZ Co. Balance Sheet December 31, 20xx ASSETS Current Assets Cash Marketable Securities Accounts Receivable Merchandise Inventory Other Current Assets Total Current Assets Fixed Assets Land Building xxx xxx xxx xxx xxx . xxx

xxx xxx

Furniture & Fixture Office Equipment Total Less: Accumulated Depreciation Total Fixed Assets TOTAL ASSETS

xxx xxx . xxx xxx . xxx . xxx .

LIABILITIES & STOCKHOLDERS EQUITY LIABILITIES Current Liabilities: Notes and Accounts Payable Taxes Payable Other Current Liabilities Total Current Liabilities Long-term Liabilities Total Liabilities

xxx xxx xxx . xxx xxx . xxx .

STOCKHOLDERS EQUITY Capital Stock Retained Earnings Total Stockholders Equity TOTAL LIABILITIES & STOCKHOLDERS EQUITY

xxx xxx . xxx . xxx .

Income Statement
Measures the operating performance of the corporation by matching its accomplishments (revenue from customers, which is usually called sales) and its efforts (cost of goods sold and expenses). Measures performance for a span of time Also known as Profit and Loss Statement

Revenues - inflows of assets either from the sale of goods or the performance of services Expenses - outflows or other uses of assets to produce revenues over expenses Net income (sometimes referred to as earnings or profit) is the excess of revenues over expenses, including tax expense

ABC Corporation

Income Statements For Year Ended December 31, 2008 (in thousands of pesos) Sales Less: Cost of Sales Gross Income Less: Operating Expenses Selling Administrative Total Operating Expenses Income from Operations Less: Interest Expense Income before tax Less: Income Tax Net Income 3,280 2,120 1,160 350 420 770 390 30 360 126 234 ====

Statement of Cash Flows


Prepared by analyzing changes in balance sheet amounts and the data in the income and retained earnings statements. The financing (i.e. obtaining financial resources) and investing (i.e. using financial resources) activities of a company are of considerable interest to users of financial information because those activities change the financial position of the business

C.

Pro forma Cash Flow Statement


XYZ Enterprise Cash Flow Projections For the Period Ending _________

Opening Balance Cash Receipts Collection of Receivables Cash Sales Sale of Temporary Investments Sale of Equity Short-Term Borrowing Long-Term Borrowing Investments Total Receipts xxx xxx xxx xxx xxx xxx xxx xxx .

xxx

xxx

Cash Disbursements Payments for Raw Materials Purchases Payments for Labor Manufacturing Overhead and Expenses Selling Expenses General and Administrative Expense Payment for Fixed Assets Interest Payments Loan Repayments Payments on Real Estate Mortgage Payment on Income Taxes Other Taxes and Assessments Total Disbursements End Balance xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx . (xxx) . xxx =======

MANAGEMENT ACCOUNTING

II - INTRODUCTION
Management Accounting Management Accounting the application of appropriate techniques and concepts in processing the historical and projected economic data of an entity to assist management in establishing a plan for reasonable economic objectives and in the making of rational decisions with a view towards achieving these objectives. Management Accounting defies attempts at comprehensive, concise definition; it changes constantly to adapt to technological changes, changes in managers needs, and new approaches to other functional areas of business marketing, production, finance, organizational behavior, and corporate strategy. An indispensable part of the system that provides information to managers the people whose decisions and actions determine the success or failure of an organization.

Definition of Management Accounting


Management Accounting includes the methods and concepts necessary for effective planning, for choosing alternative business actions and for control through the valuation and interpretation of performance (The American Accounting Association). The essential aim of management accountant is to assist management in decision making and control (Brown and Howard).

Financial Accounting and Managerial Accounting

Major Differences:

1.

They serve different audiences - Financial Accounting serves persons outside the firm such as creditors, customers, government units and investors. - Managerial - insiders
Differ in source and nature - Financial Accounting reports are developed from the basic accounting system , which captures data about completed transactions.

2.

Financial Accounting and Managerial Accounting


Managerial - reports incorporate information that is not found in the financial accounting system; such information might relate to expected future transactions (such as budgeted sales and costs) or alternatives to past transactions (such as showing what income would have been if we had sold more units at a lower price) As to purpose Financial accounting reports are general purpose. Managerial accounting reports are specifically designed for a particular user or a particular decision.

3. -

Financial Accounting and Managerial Accounting

4.

Financial accounting reports concentrate on the results of past decisions.


Managerial accounting reports often concentrate on what is likely to happen in the future.

5. Managerial accounting has no external restrictions such as the generally accepted accounting principles (GAAP) while financial accounting has to adhere to GAAP.

Managerial Functions and their Relationship to Accounting

1. planning setting goals and developing strategies and tactics to achieve them 2. decision making - use of analytical techniques 3. control - determining whether goals are being met, and if not, what can be done.

4. performance evaluation - how well operations are being controlled

Objectives of Management Accounting


Main objective to supply the required data to perform the internal management functions. The ff. are some of the functions: - Collection of data for preparation of plans - Evaluation of plans ascertaining the defects if any and brought to the notice of the managers immediately. - Observing the performance comparing the actual with the standards - Observing the reports analyzing the uses of various types of statements in the organization and suggesting for their improvement. - Coordination among persons showing organizational relaitons among people - Financial analysis - Timely decisions - Peaceful atmosphere - Coordination - Submission of reports for performance evaluation

Role of Managerial Accounting within an Organization Boeing Less transactional and more decision-support type of work. More analytical, more . . . option analysis US West From a historical role to a much more collaborative business partner, doing a lot more analysis, saying heres what we need to do in the business. A business partner. Its how do we run the business and what are the financial impacts of doing that. Caterpillar - Accountants evolve to become more of a team player and being involved in major projects and being looked to as a business advisor or consultant to help leverage our expertise on profitability of certain products or outsourcing decisions and then helping the team develop strategy and focus the team all the way through recommendation and implementation.
Source: Counting More , Counting Less: Transformation in the Mangament Accosunting Profession, Institute of Managmeent Accosutning, 1999.

Activities of Managerial Accountants

Assist in the design of the organizations information system Ensuring that the system performs adequately Periodically reporting information to interested managers Undertaking special analyses

III - Profit Planning


Cost-Volume-Profit Analysis a systematic examination of the relationships among costs, activity levels or volume, and profit. Cost refers to amount of resources given up in exchange for some goods or services Classification of cost 1. fixed remain the same in total over a wide range of volume 2. variable change in total in direct proportion to changes in volume

Profit Planning

Example: Exeter Company Selling price of backpacks Cost of backpacks from manufacturers Variable cost to pack and ship Sales commission at 5% of P20.00 Total Variable Cost Fixed Costs (rent, salaries, insurance, etc.) P20.00 P10.00 1.00 1.00 P12.00 P40,000

Contribution Margin Contribution Margin the difference between selling price per unit and variable cost per unit Contribution margin percentage per-unit contribution margin divided by selling price CM/unit CM percentage = ___________ Selling Price a) In our example, how much is the contribution margin per unit and what is the contribution margin percentage?

b)

What is the total cost?

Total costs = fixed costs + (variable cost per unit x unit volume) (Assume units sold, 6000 units) c) Determine profit:

Profit = (selling price x unit sales) - total variable costs total fixed costs

Achieving Target Profits

Break-Even Point
the point at which profits are zero because total revenues equal total costs BEP = Total sales = Total costs = 0 Profit

Finding the BEP

A. In units Total Fixed Costs Q (break even sales, in units) = -------------------------CM per unit = P40,000 ----------------P20 12 = P 40,000 --------------8 = 5,000 backpacks

Finding the BEP

B.

In Pesos

Total Fixed Costs + P 0 Break-even sales = ------------------------------CM % = P40,000 ----------------40% P100,000

Target Profit

At the BEP, total contribution margin equals total fixed costs. We can therefore find the volume required to achieve a target profit by finding the sales required to earn total contribution margin equal to the sum of total fixed costs and the target profit. Formula: Fixed costs + target profit Sales in units to achieve target profit = --------------------------------------Contribution margin per unit Problem: Suppose Exeter wishes to earn a profit of P5,000 per month. How many backpacks must it sell?

P40,000 + 5,000 ------------------------20 12 = 45,000 -----------8 5,625 units

B.

Sales, in pesos, to achieve target profit

total fixed costs + target profit Sales, in pesos, to achieve = -----------------------------------------------target profit contribution margin percentage P40,000 + 5,000 --------------------------40% P112,500

Target Return on Sales (ROS)

Formula: Sales, in pesos to achieve target ROS fixed costs = __________________________ CM percentage target ROS

Problem: Suppose that Exeter wishes to earn a 15% ROS. P40,000 = _________________ 40% - 15%
P40,000 _______________ = 25%

P160,000

To check:

Pesos Sales Variable costs (60% of sales) CM Fixed costs Income 160,000 96,000 64,000 40,000 24,000 ======

Percentages 100% 60% 40% 25% 15% ======

Target Selling Prices

Formula: total fixed costs + target profit Price = ___________________________ + unit variable cost unit volume Problem: Exeters target is P10,000 per month and it expects to sell 6,000 backpacks per month. Remember that Exeters variable costs are P10.00 to purchase a backpack and P1.00 for packing and shipping and a 5% sales commission. Thus, per unit variable cost is P11.00 plus 5% of selling price.

Target Selling Prices

Price

P40,000 + P10,000 = _____________________ + P11.00 + (5% x price) 6,000 = P8.33 + P11.00 + 5%Price P8.33 + P11.00 P19.33/.95 P20.35 rounded

95% Price

= =

Price

Target Costing

Some companies use a planning technique called target costing to help decide whether to enter a new market or bring out a new product. The essence of target costing is to determine how much the company can spend to manufacture and market a product, given a target profit The price and volume are estimated first, then the costs Target costing is useful especially in deciding whether to enter an established market where selling prices are relatively stable.

Target Costing

For instance, if the managers agree on a target profit of P300,000 and that unit volume of 100,000 is achievable at a P20.00 price, the total allowable cost is: Revenue (100,000 x P20 ) P2,000,000 Target profit 300,000 Total allowable cost P1,700,000 If managers expect total fixed costs to be P1,200,000, total variable costs can be P500,000 or P5.00 per unit. The P5.00 along with the P1,200,000 fixed cost, becomes an objective for the managers responsible for designing and manufacturing the product.

Uses of Target Costing

To illustrate, consider Cruz Co. Its managers decide to introduce a new product. They expect to sell 20,000 units at P10.00. They can make the product in either two manufacturing processes:
Process A uses a great deal of labor and has variable cost of P7.00 per unit and annual fixed costs of P40,000.00. Process B uses more machinery, with unit variable costs of P4.00 and annual fixed costs of P95,000.00.

Income Statement

Process A

Process B

Sales (20,000 x 10) P200,000 Variable cost at P7 & P4 140,000 Contribution margin at P3 and P6 60,000 Fixed costs 40,000 Profit 20,000 ========

P200,000 80,000 120,000 95,000 25,000 ========

Given the above income statements, what will you choose? Process A or Process B? Why?

1. Finding the BEP

BEP = Fixed Costs/CM per unit


Process A = P40,000/3 = 13,333 units Process B = P40,000/6 = 15,833 units The higher the break-even, the riskier. Managers often express risk by referring to the Margin of Safety (MOS).

2. Margin of Safety

= the decline in volume from the expected level of sales to the break-even point is called the margin of safety (MOS).
Formula: MOS = Expected level of sales - BE (units)

Finding the MOS

Process A MOS = 20,000 units (expected) 13,333 units (BE) = 6,667 units or P66,670 (6,667 x P10.00) or 33.33% (6,667/20,000)
Process B MOS = 20,000 units (expected) 15,833 units (BE) = 4,167 units or P41,670 (4,167 x P10.00) or 20.8% (4,167/20,000) Generally the higher the MOS, the lower the risk.

3. Indifference Point

= the level of volume at which total costs and, hence profits, are the same under both structures.
= at unit volumes below the indifference point, the alternative with the lower fixed cost gives higher profits; at volumes above the indifference point, the alternative with the higher fixed cost is more profitable.

Formula for Indifference Point


Total Cost for Process A = Total Cost for Process B Fixed Cost + Variable Cost = Fixed Cost + Variable Cost P40,000 + P7Q = P95,000 + P4Q P3Q = P55,000 Q = 18,333 rounded
At volume below 18,333 units, Process A gives lower total costs (and higher profits); above 18,333 units, Process B gives higher profits.

Cruzs managers have no correct answer in their choice of cost structure. Analytical tools such as the indifference point, margin of safety, and CVP graph help them evaluate alternatives, but the decision depends of their attitudes about risk and return. If they want to avoid risk, they will choose Process A foregoing the potential for higher profits from Process B. If they are venturesome, they probably will be willing to take some risk for the potentially higher returns and choose Process B.

Assumptions and Limitations of CVP Analysis

Assumptions: First: The company sells only one product or The sales of each product in a multiproduct company are a constant percentage of total sales. Second: Relevant only to manufacturing companies,not to merchandising and service companies.

Assumptions and Limitations Underlying CVP Analysis

All costs are classifiable as either fixed or variable. Fixed costs remain constant within the relevant range. The behavior of total revenues and total costs will be linear over the relevant range i.e. will appear as a straight line on the BE chart. In case of multiple-product companies, the selling prices, costs and proportion of units, (sales mix) sold will not change. There is no significant change in the inventory levels during the period under review. Unit selling prices will remain constant Unit variable cost will not change There will be no change inefficiency and productivity The design of the product will not change

Uses of Cost-Volume-Profit Analysis

- Planning CVP Analysis is useful tool for planning future operations.


- Control CVP Analysis may be used to control operations. Actual results are studied, analyzed and compared with the projected or planned data. - Analysis both projected and actual data may be analyzed using CVP relationships.

IV - Short-Term Decisions and Accounting Information


Making decisions is choosing among alternatives. Should we raise the price of our product, lower it, or leave it alone? Should we drop a product (or product line) or keep it? Should we add a new product? Should we make a component of our product in our factory or buy it from another company? Managers continually evaluate such sets of alternatives.

The Criterion for Short-Term Decisions

The economic criterion for making a short-term decision is simple. Take the action that you expect will give the organization the highest income (or lowest loss). Two subrules are often helpful: 1. The only revenues and costs that are relevant in making decisions are the expected future revenues and costs that will differ among the available choices (differential revenues and costs) 2. Revenues and costs that have already been earned or incurred are irrelevant in making decisions.

Sunk cost one that has already been incurred and therefore will be the same no matter which alternative a manager selects.
Opportunity cost the benefit lost by taking one action as opposed to another.

Example:

Compu Sales recently manufactured 100 specialized workstation monitors for a customer that has since gone bankrupt. A rival company has offered to buy the monitors for P12,000. The cost to manufacture the monitors was P17,000. The President says hed rather throw them away than sell them at a loss of P5,000. Is his reasoning sound?

Make or Buy Decisions

Suppose XYZ Co now makes a component for its major product. A manager has prepared the following estimates of costs at the normal volume of 20,000 units. Materials at P2/unit P40,000 Direct labor at P5/unit 100,000 Variable overhead at P3/unit 60,000 Allocated indirect fixed costs (building depreciation, heat and light, etc. 120,000 Total cost P320,000 An outside supplier offers to supply the component at P14/unit or P280,000 for 20,000 units. Should XYZ accept the offer?

Make or Buy Decision

Decisions Make Buy


Materials Direct labor Variable overhead Purchase price Total 40,000 100,000 60,000 -0200,000 ======= -0-0-0280,000 280,000 ======

Temporary Shut Down

Mr Rene Yap operates a snack counter selling sandwiches and softdrinks. Each unit sale is composed of a sandwich and a cup of softdrinks which is sold at a lot price of P15.00. Variable cost amounts to P8.00 per unit. Under normal conditions, Mr. Yap sells an average of 3,000 units per month, during which he incurs the following fixed costs: Rent P3,000 Allocated cost of utilities 2,000 Salary of sales clerk 1,500 Janitors salary 1,000 Security agencys billing 2,500 Total P10,000

A joint strike of teachers and students decreased the sales of Mr. Yap to only 800 units. Accordingly the strike would last for a month. Mr. Yap is considering of shutting down his business for a month to avoid incurring losses due to the reduced sales volume. He noted that if he shut down his operations, cost of allocated utilities would be reduced to P500.00 and he could avoid incurring salary of the sales clerk who would be asked to take a forced leave without pay while the snack counter is closed. All the other fixed costs would be incurred despite of the discontinuance of operations. Should the snack counter be shut down for one month?

Solutions: Continue: Unit sales price Less Variable cost CM /unit X Sales in units Total CM Less: Fixed Costs Loss under continued operations

P15.00 8.00 7.00 800.00 5,600.00 10,000.00 P 4,400.00

Shut Down: CM P Less: Shut down costs: Rent P3,000 Cost of utilities 500 Janitors salary 1,000 Security agencys billing 2,500 7,000 Loss if operations were shut down P7,000

V - Budgeting
Budget - a plan, expressed in quantitative terms, on how to acquire and use the resources of an entity during a certain future period of time. Uses/Advantages of Budgeting Budgeting compels periodic planning. Budgeting enhances coordination, cooperation, and communication. Forces quantification of plans and proposals Provides a framework for performance evaluation Enables members of the organization to be aware of business costs Satisfies some legal and contractual requirements Directs the firms activities toward the achievement of organizational goals.

Comprehensive Budgets

A comprehensive budget or a master budget is a set of financial statements and other schedules showing budgeted, expected, or pro forma results for a future period. Represents the overall plan of the organization for a given budget period.
Normally contains an income statement, a balance sheet, a cash budget (statement of cash receipts and disbursements), and schedules of production, purchases, and fixed-asset acquisitions.

Two Major Parts of the Master Budget

Operating Budget budgeted income statement for a certain budget period


Financial budget includes the budgeted balance sheet as of the end of a certain budget period, budgeted statement of changes in financial position, capital expenditure budget, and all other budgets required in financial management.

Sales Forecasting

Sales forecast is the foundation for the comprehensive budget. Factors Considered in Making a Sales Forecast - companys past sales volume - economic and political conditions - conditions in the industry to which the company belongs - competition - market research studies - pricing policies of the firm as well as those of the competitors - government control and regulations affecting the company - companys own sales force and its planned advertising and promotional activities - companys productive capacity and other limitations affecting production - change in demand for the product due to seasonal variations

Expense Budget

Each manager in an organization is responsible for specific tasks and their costs. So managers should have budget allowances, or expense budgets, stating the limits for costs they may incur in accomplishing their tasks.

Budgeting in Not-For-Profit Entities

Not-for-profit (NFP) entities, especially governmental units, use budgets in different ways from profit-seeking companies. - NFPs are likely to budget only for cash flows (receipts and expenditures), not for revenues and expenses - the process is more likely to begin with expenditures rather than receipts

Zero-Based Budgeting
Zero-based budgeting starts with the assumption that zero will be spent on each activity.
Tries to help management answer the question, Supposing we are to start our business from scratch, on what activities would we spend our money and to what activities would we give the highest priority?

1. 2. 3. 4. 5. 6.

Advantages of Zero Base Budgeting: Not based on incremental approach, so it promotes operational efficiency because it requires managers to review and justify their activities or the funds requested. Most appropriate for the staff and support areas Considers alternative ways of performing the same job Focuses management process on analysis and decision making Helpful to the management in making optimum allocation of scarce resources

Program Budgeting

Program budgeting requires that a budget indicate not only how the requested funds are to be spent, but also why the funds are to be spent in those ways.

VI - Analysis of Financial Statements

Horizontal Analysis

- Involves comparing figures shown in the financial statements of two or more consecutive periods. The difference between the figures of the two periods is calculated, and the percentage change from one period to the next is computed, using the earlier period as the base.

Horizontal Analysis
Compare Corporation

Income Statements For Years Ended December 31 (in thousands of pesos) 2008 Sales Less: Cost of Sales Gross Income Less: Operating Expenses Selling Administrative Total Operating Expenses Income from Operations Less: Interest Expense Income before tax Less: Income Tax Net Income 3,280 2,120 1,160 350 420 770 390 30 360 126 234 ==== 2007 2,950 1,917 1,033 100 480 580 453 25 428 149.8 278.2 ===== Increase (Decrease) Amount Percent 330 11% 203 11 127 12 250 ( 60) 190 (63) 5 (68) (23.8) (44.20) ====== 250 (13) 33 (14) 20 (16) (16) (16) ====

Horizontal Analysis
Formula for Percentage Change:
Percentage = Most Recent Value - Base Period Value Change Base Period Value = 3,280 2950 2,950 = .11 or 11%

Vertical Analysis
- process of comparing figures in the financial statements of a single period. - involves converting the figures in the statements to a common base. - accomplished by expressing all the figures in the statements as a percentage of an important item, such as total assets (in the balance sheet) and total or net sales (in the income statement). - all the figures in the statements would be expressed not in peso but in percentage terms. - these converted statements are called common-size statements, 100 percent statements or component statements.

Compare Corporation Income Statements For Years Ended December 31 (in thousands of pesos) 2008 Sales Less: Cost of Sales Gross Income Less: Operating Expenses Selling Administrative Total Operating Expenses Income from Operations Less: Interest Expense Income before tax Less: Income Tax Net Income 3,280 2,120 1,160 350 420 770 390 30 360 126 234 ==== Percent 100.0% 64.6% 35.4% 10.7% 12.8% 23.5% 11.9 1.0 10.9% 3.8% 7.1 2007 2,950 1,917 1,033 100 480 580 453 25 428 149.8 278.2 =====

Ratio Analysis
Ratios are categorized based on their uses: 1. Tests of liquidity - Current ratio - Acid test ratio - Turnovers 2. Tests of Solvency - Number of times interest earned ratio - Debt-equity ratio - Debt ratio - Equity ratio

Ratio Analysis
3. Tests of Profitability - Return on sales - Return on total assets - Return on owners equity - Earnings per share 4. Market Tests - Price-earnings ratio - Dividend yield - Dividend payout

Tests of Liquidity
1. Current Ratio also called the working capital ratio or bankers ratio, measures the number of times that the current liabilities could be paid with the available current assets. Current Assets CURRENT RATIO = Current Liabilities Standard 1.5:1 - the higher, the better

2. Acid Test Ratio


- Also called as quick ratio; only those assets that are cash or near cash (or assets that can be converted to cash quickly) are included so that the resulting ratio can indicate the firms paying liability in the very, very near term. - Similar to the current ratio except that the inventories and prepayments are excluded from the numerator.

Acid test ratio


Quick Assets Current Liabilities

Quick Ratio or

= Cash + Marketable Securities+ Receivables Current Liabilities

Standard = 1:1 - the higher, the better

Illustration:
Let us first compute Compare Corporations quick or liquid assets: 1989 1990 Cash 120 150 Marketable securities 45 15 Accounts receivable (net) 210 180 Total Quick Assets 375 345 === ===

Current Liabilities:
1989 1990 Notes & Accounts Payable - P125 169 Taxes Payable 85 107 Other Current Liabilities 82 Total CL P292 276 ===== ====

Solution:
Acid Test Ratio = Quick Assets Current Liabilities 2007 = 375 292 = 1.28 to 1 2008 = 345 276 = 1.25 to 1

Working Capital Activity Ratios


Both the current ratio and acid test ratio fail to provide answers to the following questions: 1. How long can the firm expect to realize cash from its receivables and inventories? 2. When should the firm pay its various current liabilities? To answer these 2 important questions, analysts can use the 3 working capital activity ratios: accounts receivable turnover, inventory turnover and accounts payable turnover.

Receivables Turnover
- the time required to complete one collection cycle from the time receivables are recorded, then collected, to the time new receivables are recorded again; the faster the cycle is completed, the more quickly receivables are converted into cash.

Formula for Receivables Turnover


Receivables Turnover = Net Sales Average Receivables

Average Receivables = Beg. Balance + Ending Balance 2 Standard: 20 60 days - the lower, the better

Inventory Turnover
Measures the number of times that inventory is replaced during the period.
Inventory = Turnover Cost of Goods Sold Ave. Merchandise Inventory Ave Mdse Invty - Beg Bal + Ending Bal 2 Standard 180 days - the lower the better

Net Working Capital

Net Working Capital = Current Assets - Current Liabilities


Standard = Positive Remarks = Positive

Tests of Solvency
Solvency refers to the companys ability to pay all its debts, whether such liabilities are current or noncurrent.
Net Income before Interest Expense

Times Interest Earned = ----------------------Interest Expense Standard - 2x - the higher, the better

Debt Ratio
- indicates the percentage of total assets provided by creditors. Total Liabilities Debt Ratio = --------------------- x 100 Total Assets Standard - 50% - the lower, the better

Debt-Equity Ratio
Debt-Equity = Total Liabilities Equity
Standard = 4:1 - the lower, the better

Tests of Profitability

Gross Profit Margin


Gross Profit Margin = Gross Profit Net Sales Standard = 10 15% The higher, the better

Net Profit Margin


Net Profit Margin = Net Profit Net Sales Standard = 2 20% The higher, the better

Return on Equity
Return on Equity = Net Profit Equity Standard = 5 25% The higher, the better

Return on Total Assets


Return on Total Assets = Net Profit Total Assets
Standard = 10% The higher, the better

Return on Investment
Rate of Return or Return on Investment

Income Investment

= Higher than interest rate

Payback Period
Payback Period = Total Project Cost Net Income = shall not exceed term of loan

Chapter VII Management Audit

Definition
Management Audit systematic and dispassionate examination, analysis and appraisal of management overall performance. Signifies critical assessment of management of the enterprise from the broadest possible point of view Thrust of this audit is on evaluation with appropriate analysis for improvement on contribution towards industrial development.

References
Manual on Project Evaluation, Seminar Workshop of Field Personnel on Credit Evaluation, Loan Documentation and Collection, 2003. Matz, Adolph, Milton, Usry F., Macuja, Estela F., Cost Accounting, Planning and Control, 1984 Mejorada, Nenita D., Management Services Part II, 1985 Reddy, Jayaprakash R., Management Accounting, 2004.

Happy Schooling!