Accounting Functions. The various financial statements are- Income Statement Balance Sheet

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1 Accounting Functions The accounting system provides a structure of maintaining details of business transactions that represent the finances of the organization. The various financial statements are- Income Statement Balance Sheet

2 INCOME STATEMENT It is also known as Profit & Loss Account or Statement of Income and Expenditure It shows revenues, expenses, gains and losses but does not include cash inflows and cash outflows. It is a statement of daily financial transactions of the organization with reference to a period of time (generally 1 year) and at one point of time. The entries are flow variables and not stock variables. Income statement is a post-facto statement that is it records what has already happened and not what is expected to happen Some of the expenses shown in income statement are not realistic, like depreciation is charged on original cost of asset which does not consider inflationary change in its price.

3 Concepts of Income Statement A major issue with income statement is the accounting period that records the receipts and payments differs from the their time due (accrual basis of accounting). Hence a choice has to be made between accrual basis and realization basis of accounting There are 6 sub-sections in the income statement- (1) Revenue from primary activities (operating revenues) (2) Revenue from secondary activities (non-operating revenues) (3) Gains (4) Expenses involved in primary activities (operating expenses) (5) Expenses involved in secondary activities (non-operating activities) (6) Losses

4 XYZ Co. Income Statement for the year ended December 31, 2012

5 Details Amount (Rs) Amount (Rs) Total Revenue 10.00,000 + Cost of Goods Sold (COGS) 2,00,000 GROSS PROFIT 8,00,000 Operating Expenses:- Salaries 1,00,000 + Rent 1,00,000 + Utilities 50,000 + Depreciation 50,000 Total Operating Expenses 3,00,000 OPERATING PROFIT or Earning before interest and tax (EBIT) 8,00,000 3,00,000 5,00,000 Interest Expenses 1,00,000 INCOME BEFORE TAXES (EBT) 5,00,000 1,00,000 4,00,000 Taxes 1,00,000 NET INCOME 4,00,000 1,00,000 3,00,000 # of outstanding shares (units) 30,000 shares EARNING PER SHARE (EPS) 3,00,000 / 30,000 10

6 BALANCE SHEET It is also known as Statement of financial position. It is one of the major financial statement used by accountants and business owners of an organization The items are listed based on the convenience of the users like stockholders, creditors, loan officers, financers, investors who interpret financial results to meet their requirements Conventionally those assets which have a term life of 1 year or less is considered short term There are some virtual assets like patents, trademarks, intellectual property rights which are termed as intangible assets

7 Features of Balance Sheet Every Balance Sheet has 2 parts Assets and liabilities : Every asset generates equivalent liability and vise versa Several payments are made in advance or revenues received earlier or later There are frequent divergence between original cost and market value of assets and liabilities. Assets are written down through their lifetime. Hence asset values usually decrease due to depreciation charged on them. This is known as Matching Principle Depreciation is charged based on Matching Principle. It is also allocated for tax purposes. Balance sheet may suffer from various deficiencies- under reported, currently reported assets. Long term liabilities are like notes and accounts payable after 1 year.

8 Difference between Assets and Liabilities Assets An ASSET is what a company owns The company may owe Assets are resources of a company that are valuable and marketable items owned by the company Liabilities LIABILITY is what a company owes to outsiders (creditors) and stockholders It is a debt that can be discharged only by liquidating equivalent asset

9 ABC Company Sample Balance Sheet As of December 31, 2012

10 Current Asset Amount (Rs) Current Liabilities Amount (Rs) Cash 32,000 Notes Payable 7,000 Petty Cash 1,000 Accounts Payable 40,000 Temporary Investments 20,000 Wages Payable 9,000 Accounts Receivable (net A/R) 42,500 Interest Payable 4,000 Inventory 65,000 Taxes Payable Supplies 2,00,000 Warranty Payable 1,500 Prepaid Insurance 3,500 Unearned Revenue 2,500 TOTAL CURRENT ASSETS 3,65,000 TOTAL CURRENT LIABILITIES 4,30,500 Investments 45,500 Long Term Liabilities Property Plant & Equipment (PPE): Note Payable 20,000 Land 5,500 Bonds Payable 50,000 Land improvement 6,500 Other Long Term liabilities 70,000 Building 2,23,000 TOTAL LIABILITIES 5,00,500 Equipment 2,96,000 Stockholder s Equity: (-)accumulated depreciation (81,000) Common Stock 2,00,000

11 Financial Ratios FR are useful indicators to measure a company s performance and financial situation. They are used to analyze trends and compare a firm s financial figures to those of competitors or those of the business sector in which it belongs.

12 Main Financial Ratios Profitability ratio Efficiency ratio Liquidity ratio Stability ratio Investor ratio

13 Profitability Ratios Ratio Calculation Comments Gross Profit Margin Gross Profit _ X 100 Revenue or net sales Operating profit margin Operating profit X 100 Revenue Expressed as % A change in sales and production volume may not affect Profit Margin. Change in profit margin causes substantial change in overall profits Tells about company s ability to control operating costs Return on capital employed (ROCE) Net Profit before tax and interest (EBIT) (Total assets - current liabilities ) It is also called primary ratio It indicates what return the management has made on available resources before distributing them.

14 Liquidity Ratio Ratio Calculation Comments Current Ratio Current Assets Current liabilities A measure to check if the company can pay debts and convert assets into cash within a year If the ratio <1 is a cause of concern Quick ratio or Acid test ratio [Cash + short term investments + Accounts Receivable Stock ] / Current liabilities Not all assets are immediately turned into cash. Raw materials are first converted into final products and then sold to recover cash from debtors. This ratio deals with near -cash items This ratio <1 can be of concern

15 Turnover Ratios Ratio Calculation Comments Accounts Receivable (AR) Turnover (T/O) Ratio Days Sales in AR for the year Inventory T/O Days Sales in inventory Net credit sales for the year Average Accounts Receivable for the year 365 days AR T/O in a year Cost of Goods Sold for the year Average inventory for the year 365 days Inventory T/O in a year It estimates the number of times per year the company is able to collect its dues from debtors created from credit sales Faster receipts increase the ratio It however ignores cash sales that yield better results It gives the average number of days needed to collect the average amount of AR in a year A higher ratio means a smaller inventory and savings in costs Less days means the efficient inventory usage and cost savings

16 Other important ratios Ratio Calculation Comments Debt to Equity Ratio Total liabilities Total Stockholder s equity All assets of a company are finally converted / translated into liabilities or used for paying creditors and owners or stockholders It shows which part of the whole is used to pay creditors and the part used to pay owners Earning per Share (EPS) _Net income after tax _X 100 Weighted average number of outstanding common shares It expresses after tax net income of the company on per share of common stock basis. If company has preferred stock then preferred dividends are deducted from net income

17 Ratios Calculation Comments Times interest earned EBIT Interest expense for the year It is the measure of the company s capacity to meet interest payments on debts from its earnings. The ratio should not be <1 and should be as high as possible Return on Stockholder s Equity (after tax) Net Income for the year after taxes x 100 Average stockholder s equity for the year It shows profit after income tax earned by the company as a % of its average common stockholders balances for the year. If the company has preferred stock then preferred dividend is to be deducted