ACCOUNTING FOR NON- ACCOUNTANTS UNDERSTANDING THE BASICS OF ACCOUNTING

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1 ACCOUNTING FOR NON- ACCOUNTANTS UNDERSTANDING THE BASICS OF ACCOUNTING

2 LEARNING OBJECTIVE To guide and assist you in your decision making processes, To allow you to participate actively in the financial matters of your business and, To let you appreciate the various accounting terminologies and methodologies applied in your on-going undertakings.

3 WHY DO YOU NEED TO STUDY ACCOUNTING WHEN YOU ARE NOT AN ACCOUNTANT? Accounting is an activity you will do even if you are not an accountant, simply because it is necessary especially so if you engage in a profit-oriented undertaking, called business. Many small businesses do not survive to see their third birthday. This is a sad but true fact. One of the main reasons this happens is that people who set up their own business lack the necessary skills needed to successfully run a business. Often they are very skilled at what they do for a living, however, being skilled at what you do is only part of the story. You need to add more skills to your skill set if your business is to reach its full potential: skills such as marketing, human resources management, finance, strategic planning and, hence this module, accounting.

4 WHAT IS A BUSINESS? A business is an organization in which basic resources (inputs), such as materials and labor, are assembled and processed to provide goods or services (outputs) to customers. Business activities are meant to generate economic activity. Business transforms good and services in forms that on the other hand, people whose needs and wants are to be satisfied would also be willing to exchange their goods and services whose value equals the value of what they receive. This is the essence of a business transaction, the exchange of values; values received equal the values parted with.

5 WHAT IS A BUSINESS? The objective of most businesses is to earn a profit. Profit is the difference between the amounts received from customers for goods or services and the amounts paid for the inputs used to provide the goods or services.

6 WHAT IS ACCOUNTING? Accounting can be defined as an information system that provides reports to users about the economic activities and condition of a business. is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities, that is intended to be useful in making economic decision. 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.

7 1. Recording of data 2. Classifying of data 3. Summarizing of data 4. Interpreting the results WHAT ARE THE FUNCTIONS OF ACCOUNTING?

8 FIRST ACCOUNTING FUNCTION: RECORDING involves putting into record the various transactions in a step-by-step procedure and in order of occurrence or when the transaction happens or occurs. A transaction is said to have occurred or happened, once a document to its effect has been made, and as such the transaction is recorded.

9 SECOND ACCOUNTING FUNCTION: CLASSIFYING involves the grouping together of similar names and items of the various resources of the business that were already transformed (finished goods, products, services, loans, etc) or are still in the process of transformation (raw materials, inventory, etc). By classifying and grouping together of similar resources of the enterprise, analysis is facilitated, communication is facilitated, and ambiguity is avoided.

10 Assets Liabilities Capital Revenue Expenses Equities Drawing BUSINESS RESOURCES ARE CLASSIFIED AS FOLLOWS:

11 BUSINESS RESOURCES ARE CLASSIFIED AS FOLLOWS: Asset - refers to anything that has money equivalent possessed by the enterprise or business and is used in the operation of the enterprise, which in its absence, will greatly hamper the operation of the business. The assets are needed by the business in order that it can produce the goods and the services that it intended to do. Ex. Cash, account receivables, land, equipment, supplies, etc.

12 BUSINESS RESOURCES ARE CLASSIFIED AS FOLLOWS: Liabilities -refer to the monetary values of anything that the business has loaned out, borrowed or taken from outside of the business itself. The business incurs liabilities in order that it can pay for its operation as well as to create its initial asset base. Ex. Loans from Metro Bank, accounts payable, tax payable, notes payable, etc.

13 BUSINESS RESOURCES ARE CLASSIFIED AS FOLLOWS: Capital refers to the monetary values or the rights of the owner or owners to a claim on the properties or possessions of the business. When a capital gets into a business, it is transformed into a number of forms of which it will become part of the assets of the business. Income refers to the sales the business makes either in cash or on account. It also refers to professional or consultancy fees, service income, sales from the farm products. Expenses refer to costs or expenditures, used up supplies and materials incurred in operating the business. Ex. Salary expense, Electric bill, Maintenance expense, Supplies used, etc.

14 BUSINESS RESOURCES ARE CLASSIFIED AS FOLLOWS: Equities refer to the rights or claims of both the creditors and the owners of the business to what the enterprise is owning or possessing with equivalent monetary values. In case the business goes bankrupt, and when the project decides to sell out all that it owns, the first to be paid are the creditors and the money that will be left after settling all the outside obligations will be divided among the owners or partners of the enterprise. Drawing refer to the personal withdrawal of the owner or owners against capital they put in the business. The result of such withdrawal is a decrease on the capital of the enterprise.

15 THIRD ACCOUNTING FUNCTION: SUMMARIZING Since a business is conducting a lot of transactions in the course of its life, the information that was recorded in its books of accounts becomes numerous. If the business accounting system was properly in place then summarizing the information in its books is facilitated by their classifications. Distilling all of this information into forms. Summarizing the business transactions is founded on the Accounting Equation.

16 THE ACCOUNTING EQUATION ASSETS = LIABILITIES + EQUITY The resources owned by a business The rights of creditors are the debts of the business The rights of the owners

17 THE ACCOUNTING EQUATION The accounting equation may also be expressed in two other forms: (1) OWNER S EQUITY = ASSETS LIABILITIES (2) LIABILITIES = ASSETS OWNER S EQUITY A = L + OE (C + R E D) Where: A = assets L = liabilities OE = Owner s Equity C = Capital R = Revenue E = Expenses D = Drawings

ACCRUAL GOING CONCERN CONCEPT BUSINESS ENTITY CONCEPT ACCOUNTING CONCEPTS: UNDERLYING ASSUMPTIONS Income is recognized when earned regardless of when received Expense is recognized when incurred

18 ACCRUAL GOING CONCERN CONCEPT BUSINESS ENTITY CONCEPT ACCOUNTING CONCEPTS: UNDERLYING ASSUMPTIONS Income is recognized when earned regardless of when received Expense is recognized when incurred regardless of when paid The effects of transactions are recognized when they occur The business will continue in operational existence for the foreseeable future Financial statements should be prepared on a going concern basis unless management either intends to liquidate the enterprise or to cease trading, The business and its owner(s) are two separate entities Any private and personal incomes and expenses of the owner(s) should not be treated as the incomes and expenses of the business

ACCOUNTING CONCEPTS: UNDERLYING ASSUMPTIONS TIME PERIOD The life of an entity is subdivided into time periods which are of equal length for the purpose of making financial reports Usually

19 ACCOUNTING CONCEPTS: UNDERLYING ASSUMPTIONS TIME PERIOD The life of an entity is subdivided into time periods which are of equal length for the purpose of making financial reports Usually twelve months MONETARY UNIT Assets, liabilities, capital, income and expenses should be stated in terms of a unit of measure (Philippine Peso) The purchasing power of the Peso is stable/constant

ACCOUNTING CONCEPTS: QUALITATIVE CHARACTERISTICS Relevance Reliability Faithful Representation Substance over Form The capacity of information to influence a

users that the information is free from bias and error and faithfully represents what it purports to represent The actual effects of the transaction should be

20 ACCOUNTING CONCEPTS: QUALITATIVE CHARACTERISTICS Relevance Reliability Faithful Representation Substance over Form The capacity of information to influence a decision The degree of confidence users place upon the truthfulness of the representations in the financial statements The quality of information that assures users that the information is free from bias and error and faithfully represents what it purports to represent The actual effects of the transaction should be properly accounted for and reported in the financial statements Transactions should be accounted in accordance with their substance in reality and not merely their legal form

21 ACCOUNTING CONCEPTS: QUALITATIVE CHARACTERISTICS Neutrality Conservatism or Prudence Completeness Information in the Financial Statements must be free from bias fairness Care and caution must be exercised when dealing with uncertainties in the measurement process The Revenues and profits are not anticipated. Only realized profits with reasonable certainty are recognized in the profit and loss account Relevant information must be presented in a way that facilitates understanding and avoids erroneous implication

22 ACCOUNTING CONCEPTS: QUALITATIVE CHARACTERISTICS Understandability Financial information must be comprehensible or intelligible if it is to be useful Comparability Information must be comparable with similar information of previous periods or with information of another entity

23 TIMELINESS ACCOUNTING CONCEPTS: ACCOUNTING CONSTRAINTS Information must be available or communicated early enough when a decision is to be made COST-BENEFIT The benefit derived from the information should exceed the cost incurred in obtaining the information MATERIALITY RELEVANCE vs RELIABILITY An item is material if knowledge of it would affect or influence the decision of the informed users of the financial statements There is a tradeoff between relevance (reporting information in a relevant manner) and reliability (ensuring that the information is reliable)

24 ACCOUNTING METHODS Accounting methods dictate how the company's transactions are recorded in the company's financial books Cash-basis accounting companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash Accrual accounting companies record revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when they receive the cash. Companies record any expenses when they're incurred, even if they have not paid for the supplies yet

25 Accounting Process

26 3. FINANCIAL ACCOUNTING REPORTS

27 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

28 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

29 BALANCE SHEET Assets economic resources that are expected to benefit future activities Equities claims against, or interests in, the assets Liabilities entity s 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.

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

31 Furniture & Fixture xxx Office Equipment xxx. Total xxx Less: Accumulated Depreciation xxx. Total Fixed Assets xxx. TOTAL ASSETS xxx. LIABILITIES & STOCKHOLDERS EQUITY LIABILITIES Current Liabilities: Notes and Accounts Payable xxx Taxes Payable xxx Other Current Liabilities xxx. Total Current Liabilities xxx Long-term Liabilities xxx. Total Liabilities xxx.

32 OWNER S EQUITY Capital xxx Profit (Loss) for the period xxx Drawing (xxx). Total Owner s Equity xxx. TOTAL LIABILITIES & OWNER S EQUITY xxx.

33 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

34 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

35 XYZ Co. Income Statements For Year Ended December 31, 2017 (in thousands of pesos) Sales 3,280 Less: Cost of Sales 2,120 Gross Income 1,160 Less: Operating Expenses Selling 350 Administrative 420 Total Operating Expenses 770 Income from Operations 390 Less: Interest Expense 30 Income before tax 360 Less: Income Tax 126 Net Income 234 ====

36 STATEMENT OF CASH FLOWS is a statement showing all the cash inflows and cash outflows of the business. It shows how much money there is at the beginning and at the end of the business period. Cash Inflow- refers to cash receipts made from the disposals of farm products to the customers, as well as beginning cash to start the business. Cash Outflow- refers to expenses incurred during the operation period. It includes payments of cash for various materials and supplies used in the projects or enterprises.

37 STATEMENT OF CASH FLOWS Cash balance ending refers to the cash generated after all expenses have been deducted from cash inflows of the business. However, if cash inflows are greater than cash outflows, the business has enough cash to continue with the operation of the business; if it is not, then it is an indication that the manager should now look for additional financing from outside sources to continue funding the day to day activities of the business.

38 PRO FORMA CASH FLOW STATEMENT XYZ Co. Cash Flow Projections For the Period Ending Cash Inflows (Receipts) Collection of Receivables Cash Sales Sale of Marketable Securities Short-Term Borrowing Long-Term Borrowing Additional Investments Total Cash Inflows xxx xxx xxx xxx xxx xxx xxx

39 Cash Outflows (Disbursements) Payments for Merchandise Inventory xxx Selling Expenses xxx General and Administrative Expense xxx Payment for Fixed Assets xxx Interest Payments xxx Loan Repayments xxx Payments on Real Estate Mortgage xxx Payment on Income Taxes xxx Other Taxes and Assessments xxx. Total Cash Outflows (xxx). Net Cash Flow xxx Add: Cash Balance, Beginning xxx Cash Balance, Ending xxx =======

40 FOURTH ACCOUNTING FUNCTION: INTERPRETING Use the different reports to look critically at your business. Does it perform well? What can you do better? There are two main subjects in the report: Income Statement Balance Statement

41 INCOME STATEMENT The Income Statement tells about the earnings and spending of the company during the year. This means how much income has the company had from the daily running of activities and how much has the company spent on the same activities. This part of the report tells whether the activities have been running as a profitable business in the period or not. It is called the Income Statement.

42 BALANCE SHEET The Balance Sheet / Statement of Financial Position, on the other hand, shows the actual value of the company as such. This means, how much money is present in the company in total when the value of buildings, tools, stock, money in the bank account and in the cash box etc. is added. It also shows how much the company owes to others. A company normally owes money to suppliers, the bank and to the owner of the company.

43 WRITE OFF FIXED ASSETS/ DEPRECIATION Fixed Assets like vehicles would usually encounter wear and tear as it is continuously used in the operation of the business. In the law, it is allowed that owners will depreciate the value of the machine yearly up to its estimated life span, and such depreciation will be reflected as part of the operating cost of the project although there is no actual cash incurrence, however, the amount of money deducted from the income as depreciation cost can be kept by the business that in the event that the machine can no longer function efficiently, there is already accumulated cash which can be used to replace the old machine. The accumulated amount might not be sufficient to buy a new machine, yet, it can be used as down payment for the purchased machine and the remaining balance can be paid in an instalment basis from the income that can be generated by the use of the machine.

44 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.

45 XYZ Corporation Income Statements For Years Ended December 31 (in thousands of pesos) Increase (Decrease) Amount Percent Sales 3,280 2, % Less: Cost of Sales 2,120 1, Gross Income 1,160 1, Less: Operating Expenses Selling Administrative ( 60) (13) Total Operating Expenses Income from Operations (63) (14) Less: Interest Expense Income before tax (68) (16) Less: Income Tax (23.8) (16) Net Income (44.20) (16) ==== ===== ====== ====

46 HORIZONTAL ANALYSIS Formula for Percentage Change: Percentage = Most Recent Value - Base Period Value Change Base Period Value = 3, ,950 =.11 or 11%

47 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.

48 XYZ Corporation Income Statements For Years Ended December 31 (in thousands of pesos) 2017 Percent 2016 Sales 3, % 2,950 Less: Cost of Sales 2, % 1,917 Gross Income 1, % 1,033 Less: Operating Expenses Selling % 100 Administrative % 480 Total Operating Expenses % 580 Income from Operations Less: Interest Expense Income before tax % 428 Less: Income Tax % Net Income ==== =====

49 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

50 3. Tests of Profitability - Return on sales - Return on total assets - Return on owner s equity - Earnings per share 4. Market Tests - Price-earnings ratio - Dividend yield - Dividend payout RATIO ANALYSIS

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

52 TESTS OF LIQUIDITY: 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 firm s paying liability in the very, very near term. - Similar to the current ratio except that the inventories and prepayments are excluded from the numerator.

53 TESTS OF LIQUIDITY: ACID TEST RATIO Quick Assets Quick Ratio = Current Liabilities or = Cash + Marketable Securities+ Receivables Current Liabilities Standard = 1:1 - the higher, the better

54 ILLUSTRATION: Let us first compute XYZ Corporation s quick or liquid assets: Cash Marketable securities Accounts receivable (net) Total Quick Assets === === Current Liabilities: Notes & Accounts Payable P Taxes Payable Other Current Liabilities 82 - Total CL P ===== ====

55 Acid Test Ratio = Quick Assets Current Liabilities 2016 = = 1.28 to = = 1.25 to 1 SOLUTION:

56 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.

57 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.

58 FORMULA FOR RECEIVABLES TURNOVER Receivables = Net Sales Turnover Average Receivables Average Receivables = Beg. Balance + Ending Balance 2 Standard: days - the lower, the better

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

60 Net Working Capital = Current Assets - Current Liabilities NET WORKING CAPITAL Standard = Positive Remarks = Positive

61 TESTS OF SOLVENCY Solvency refers to the company s ability to pay all its debts, whether such liabilities are current or noncurrent. Net Income before Interest Expense Times Interest Earned = Standard - Interest Expense 2x - the higher, the better

62 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

63 DEBT-EQUITY RATIO Debt-Equity = Total Liabilities Equity Standard = 4:1 - the lower, the better

64 TESTS OF PROFITABILITY

65 Gross Profit Margin = Gross Profit Net Sales Standard = 10 15% The higher, the better GROSS PROFIT MARGIN

66 Net Profit Margin = Net Profit Net Sales Standard = 2 20% The higher, the better NET PROFIT MARGIN

67 Return on Equity = Net Profit Equity Standard = 5 25% The higher, the better RETURN ON EQUITY

68 Return on Total Assets = Net Profit Total Assets RETURN ON TOTAL ASSETS Standard = 10% The higher, the better

69 RETURN ON INVESTMENT Rate of Return or = Income Return on Investment Investment = Higher than interest rate

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

71 HAPPY LEARNING!!!

" Annual report: the main method that management uses to report the results of the company s activities during the year.

Annual report: the main method that management uses to report the results of the company s activities during the year. Chapter 1 Overview of Corporate Financial Reporting What is Business? " Business plan to profit from selling a product or service. " Can be an individual or thousands of owners (investors). What is Accounting?