A Refresher in Financial Accounting

Financial Accounting
and Auditing Collection

Mark S. Bettner and Michael Coyne, Editors
A Refresher
in Financial
Accounting
Faisal Sheikh
A Refresher in Financial
Accounting
A Refresher in Financial
Accounting
Faisal Sheikh BSc (Hons) FCCA FHEA FFA FIPA

A Refresher in Financial Accounting
Copyright © Business Expert Press, LLC, 2018
All rights reserved. No part of this publication may be reproduced, stored

in a retrieval system, or transmitted in any form or by any means—
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First published in 2018 by

Business Expert Press, LLC
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ISBN-13: 978-1-94744-149-1 (paperback)

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Business Expert Press Financial Accounting and Auditing Collection
Collection ISSN: 2151-2795 (print)

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First edition: 2018
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Printed in the United States of America.

Dedication
Dedicated to the BEST ACCOUNTANTS I KNOW
MUM & DAD
FRA LUCA PACIOLI
BRIAN LEIGH
Zahra, Maryam and baby Halimah remember:

“Every generation inherits a world that it never made; and,
as it does so, it automatically becomes the trustee of that world
for those who come after. In due course, each generation
makes its own accounting to its children.”—Robert Kennedy
Abstract
This fresher guide is designed for students who took accounting in their
freshman year but struggled with double-entry bookkeeping or have for-
gotten it and need a quick revision of key accounting adjustments such
as accrued expenses, prepaid expenses, bad debt expense, depreciation
techniques, inventory valuation, and unearned revenue. In addition, the
preparation and interpretation of financial statements including the in-
come statement, statement of retained earnings, balance sheet, and cash
flow statement are also covered. Corporate accounting is also introduced,
especially the impact of tax, dividends, and the changes to the income
statement, statement of retained earnings, and balance sheet. The book is
packed with worked examples and four comprehensive case studies that
apply the aforementioned accounting concepts. After working through
this book, the student should be better prepared for intermediate finan-
cial reporting classes.
Keywords
Accounting, accounting adjustments, case studies, corporation, financial
statements, ratio analysis.
Contents
Acknowledgments....................................................................................xi
Introduction.........................................................................................xiii
Chapter 1 Fundamentals of Accounting..............................................1
Chapter 2 Financial Statements..........................................................9
Chapter 3 Major Adjustments..........................................................27
Chapter 4 Case Study 1—Applying the Major Adjustments.............41
Chapter 5 The Corporation..............................................................43
Chapter 6 Case Study 2—Corporation Accounting..........................51
Chapter 7 Interpretation of Financial Statements..............................53
Chapter 8 Case Study 3—Ratio Analysis..........................................69
Appendix 1 Applying the Major Adjustments.....................................71
Appendix 2 Corporation Accounting..................................................79
Appendix 3 Solution of Case Study 3—Ratio Analysis........................85
Appendix 4 Glossary of Key Financial Accounting Terms....................87
Index��93
Acknowledgments
I always dreamed of writing a textbook for accounting students that
would demystify the subject. Thus, a big thank you to the folks at Business
Expert Press especially Scott Isenberg, Nigel Wyatt, and Project Manager
Kiruthigadevi.
I remain indebted to my wife and little girls for giving me the time
and space to write this book. A special thank you to my accountant
Dad who made me follow his footsteps; Slade & Cooper in Manchester,
England, who helped me qualify and my Mom who took care of my spiri-
tual welfare on my journey to achieving Fellowship of the Association of
Chartered Certified Accountants.
This work is a culmination of eight years’ teaching undergraduate stu-
dents and watching them struggle with accounting. I sincerely hope that
American students will benefit from this guide, and I encourage them to
explore the ever-expanding universe of accounting.
Introduction
This refresher in financial accounting has been written for college stu-
dents who studied financial accounting in their Freshman year but strug-
gled with double-entry bookkeeping which is the basis of accounting.
The good news is that I assume no knowledge of double entry, but it
is supposed that you would like to refresh your knowledge on the four
financial statements, namely income statement, balance sheet, statement
of retained earnings, and the cash flow statement.
Initially I discuss the fundamentals of accounting based on U.S.
GAAP. In Chapter 2, I clearly explain the financial statements and cru-
cially how they are linked or articulated through Case Study 1. This is
very important as it gives an overview or an “accounting bird’s eye view”
of what is going on and how the financial statements fit together.
In Chapter 3, I describe the major adjustments and demonstrate those
using basic examples and timelines rather than journals or double entry.
It is important to recognize that any adjustment will have an effect on the
income statement and the balance sheet. Think of it like pulling a lever
on the income statement that must be compensated for by pulling a lever
on the balance sheet as well. With practice and patience, your knowledge
of accounting will improve, and if you complete further courses, this will
deepen your appreciation and understanding.
In Chapter 5, I introduce the Corporation and how it differs from
owner-managed businesses. This chapter is completed with a mini case
study where an income statement, statement of retained earnings, and
balance sheet for a Corporation are prepared. Chapter 6 is an extended
case study using a Corporation as an example.
Chapter 7 is about the interpretation of financial statements and is
illustrated through a comprehensive example that covers profitability, li-
quidity, activity, and financial leverage ratios. Chapter 8 is an unusual case
study as there are very few numbers and asks the reader to comment using
ratio analysis, thus enhancing higher-order cognition.
xiv INTRODUCTION
The case studies should not be attempted until you have a full un-
derstanding of all the other chapters, and I have also included a basic
financial accounting glossary in Appendix 4.
Best of Luck! And do get in touch if you have any suggestions for
improvements.
Faisal Sheikh
F.M.Sheikh@salford.ac.uk
July 2017
CHAPTER 1
Fundamentals of Accounting
The practice of accounting goes back thousands of years. It started

because people needed to record business transactions and to know if
their businesses were financially viable. Invoices (each of which h
ighlights
the details of a transaction) and receipts (each of which verifies that a
payment has been made) were kept and then given to an accountant to
calculate the net income or loss of the business up to some point in time.
The accountant would convert the financial transaction data (i.e., the
data recorded on invoices and receipts) into accounting information.
More often than not it would be the owner of the business who e xecuted
all the accounting tasks or an employee would be given the task of
maintaining the accounting records.
The fundamental principles of accounting as outlined by the Father
of Accounting, namely, Fra Luca Pacioli in his seminal—“Summa de
arithmetica, geometria. Proportionietproportionalita” (Summary of
Arithmetic, Geometry, Proportions and Proportionality) —have not
changed in essence since 1494, and these rules still form the basis of
modern accounting.
As businesses grew in size, it became less common for the owner of
the business to maintain the accounting records and were delegated to
an employee known as an accounts clerk. Companies began to dominate
the business environment; managers became separated from owners—the
owners of companies (stockholders or shareholders) often have no involve-
ment in the day-to-day running of the business. This required monitoring
of the manager, and auditing of the financial records by accountants
became established and laid the foundation of the accounting profession.
2 A REFRESHER IN FINANCIAL ACCOUNTING
Portrait of Luca Pacioli (c.1445–c.1514), mathematician and friend

of Leonardo da Vinci, 1495 by Jacopo de’Barbari (1440/50–c.l515),
Museo e Gallerie Nazianale di Capodimonte, Naples, Italy/Bridgeman
Art Gallery
The accounting profession is now highly regulated and controlled,

and there are established techniques and conventions for all the tradi-
tional accounting tasks. The environment within which accounting exists
is formally known as the accounting information system.
1.1 Accounting Information System

A system is a group of elements that are formed and interact to achieve
objectives. It can be observed that human beings spend their lives within
systems, for example, in the home or workplace. An organization is a
system in which a group of people work together to achieve common
objectives such as profit maximization.
Within each system, there are sub- or smaller systems. Within a com-
pany, there are subsystems called departments that can be broken down
into smaller systems to individual employees.
All systems are located in an environment. An input enters a system
from something located in its environment. A system administers its
Fundamentals of Accounting 3
input and then transmits its output to its environment. Thus, a business
receives inputs to its system in the shape of raw materials from suppli-
ers, payments from customers, etc. The business converts the inputs into
goods and services and sends its outputs (goods and services) into its envi-
ronment (to its customers). It records these input and output activities in
its accounting. The following figure is an example of a simple accounting
information system.
INPUTS: PROCESSES: OUTPUTS
Transaction Accounting Financial

data Information Statements
System
Changes to Management
data Information
To make a decision, a manager needs information, which is provided

to the manager from an information system. It will be an item of output
from the information system. For example, a manager who is in charge
of ordering inventory will be told by the information system how much
inventory is currently held by the business and how much will be needed.
The manager then decides how much inventory to order and from which
supplier. This decision is entered into the information system by the man-
ager; the order is then sent to the supplier by the information system and
is updated to show that an order has been placed.
A company will usually have multiple systems such as purchasing and
marketing, all of which must operate in an effective and efficient manner.
The accounting system is one of the systems within an organization. The
accounting information system will be part of the organization’s informa-
tion system. Whereas the information system will process a combination
of quantitative and qualitative data, the accounting information system
focuses on processing quantitative data.
The accounting information system will produce various outputs.

Some of the output will be for internal stakeholders such as monthly
variance reports and created according to the desires of the management.
Other output will be for external stakeholders such as lenders and follow
statutory formats such as financial statements. The former is known as
management accounting, while the latter is called financial accounting,
which is the focus of this book.
1.2 Ethics in Accounting

At the heart of Accounting is Ethics, which are the beliefs that distinguish
right from wrong; these are accepted standards of good and bad behavior.
The role of accounting is to provide useful and timely information for
decision-making. Therefore, there should be ethics in accounting, and as
the old adage states, “good ethics are good business”. Being providers of
accounting information, professional accountants usually e ncounter e thical
choices as they prepare financial statements. For example, these choices can
affect the price a customer pays and the bonus paid to employees.
1.3 Accounting Principles

These principles are the common rules that must be followed when pro-
ducing financial statements, especially for external stakeholders, such as
lenders or stockholders.
Generally Accepted Accounting Principles (GAAP) are rules that
indicate acceptable accounting practices. GAAP aims to make informa-
tion in financial statements relevant, reliable, and comparable. The two
major bodies that establish GAAP in the United States are:
• Financial Accounting Standards Board (FASB): a private group

that sets both broad and specific principles.
• Securities and Exchange Commission (SEC): a government
entity that determines reporting requirements for companies that
issue stock to the public.
The International Accounting Standards Board (IASB) issues International

Financial Reporting Standards (IFRS) that identify preferred a ccounting
practices, used, for example, when companies wish to raise money from
investors in different countries. There is much academic and practical
work being undertaken to facilitate the convergence of U.S. GAAP (and
other countries’ GAAP) to IFRS; however, this topic is outside the scope
of this work and will be covered in advanced financial reporting courses
or books.
Cost Principle. According to this principle, accounting information is

based on actual cost, which is measured on a cash or “equal-to-cash” basis.
For example, you pay $20 cash for a service and thus the cost is measured
as the amount of cash paid.
If something besides cash is exchanged (i.e., a car), the cost is measured

as the cash value of what is given up or received, such as the car. The cost
principle stresses reliability and verifiability, and information based in
cost is considered objective.
Objectivity Principle. Under this principle, information is backed by

independent, unbiased evidence and is more than a person’s opinion.
Revenue Recognition Principle. Revenue (sales) is the figure received

from selling services and products. Revenue is only recognized or recorded:
1. when it has been earned
2. and proceeds from selling services and products can be cash or
credit
3. and when it is measured by the cash value of any other items
received.
Matching Principle. A company must recognize its expenses incurred to

generate the revenue reported.
Full Disclosure Principle. This principle demands that a company must

report the details behind financial statements that would influence users’
decisions.
As stated earlier in the United States, accounting principles also include

the many complex detailed rules that are established and maintained by
the FASB. The combination of the basic underlying guidelines and the
complex detailed accounting rules are referred to as U.S. GAAP.
1.4 Accounting Assumptions

Key accounting assumptions state how a business is structured and func-
tions. They provide the structure as to how business transactions are
recognized. If any of these assumptions are false, it may be necessary to
change the financial statements. The significant assumptions are:
Accrual Assumption—Transactions are recorded using the accrual

basis of accounting, where the recognition of revenues and expenses
arises when earned or used, respectively. If this a ssumption is false, a
business should instead use the cash basis of accounting to develop
financial statements that are based on cash flows.
Conservatism Assumption—Revenues and expenses should be re-
corded when earned; profits should not be overstated; and losses
should not be understated.
Consistency Assumption—The same method of accounting will be
used from period to period, unless it can be replaced by a more
relevant method. If this assumption is false, the financial s tatements
produced over multiple periods are not comparable.
Economic Entity Assumption—The transactions of a business and
those of its owners must be separate. If this assumption is false, it is
impossible to develop accurate financial statements.
Going Concern Assumption—A business will continue to run for
the foreseeable future. If this assumption is false due to impending
bankruptcy, deferred expenses should be recorded immediately.
Reliability Assumption—Only those transactions that can be suffi-
ciently proven should be recognized. If this assumption is false,
a business is probably manipulating the recording of revenue to
enhance its short-term results.
Monetary Unit Assumption—Transactions should be expressed
in monetary or money units such as dollars ($). This ensures
consistent and comparable financial statements.
Time Period Assumption—The financial results reported by a busi-
ness should cover a uniform and consistent period of time, such
as a year. If this is not the case, financial statements will not be
comparable across accounting periods.
Although the aforementioned assumptions appear obvious, they can

easily be violated and lead to the production of financial statements that
are fundamentally flawed.
When a company’s financial statements are audited, the auditors will
be looking for breaches of these accounting assumptions and will refuse to
submit an unmodified opinion on the statements unless any issues found
are corrected. This may require new financial statements being produced
that use the corrected assumptions.
CHAPTER 2
Financial Statements
Financial statements represent a prescribed record of the financial conduct

of an entity, see below. These are written reports that measure the financial
performance, strength, and liquidity of a company. Financial statements
also highlight the financial effects of business transactions and events on
the entity.
Corresponding financial
Key measurement statement
Financial performance The income statement
Changes in retained earnings Statement of retained earnings
Strength and liquidity The balance sheet
Changes in cash Cash flow statement
Financial statements provide useful information to a variety of

stakeholders:
Managers require financial statements to manage the company by

considering its financial performance and position and to make
important business decisions.
Stockholders use financial statements to measure the risk and return
of their investment in the company and take investment decisions
accordingly. They also assess the feasibility of investing in a com-
pany. Investors may predict future dividends based on the profits
shown in the financial statements. Furthermore, risks associated
with the investment may be determined from the financial state-
ments. For example, volatile profits indicate higher risk. Therefore,
financial statements provide a foundation for the investment deci-
sions of potential investors.
Financial Lenders (e.g., Banks) use financial statements to decide

whether to issue short- or long-term loans to a business. Financial
institutions gauge the financial health of a business that allows
them to determine the probability of loan turning bad. Any deci-
sion to lend should be supported by a satisfactory asset base and
liquidity.
Suppliers need financial statements to assess the credit worthi-
ness of a business and decide whether to supply goods on credit.
Suppliers need to know if they will be paid. Thus, terms of credit
are established according to the assessment of their customers’
financial health.
Customers use financial statements to assess whether a supplier has
the resources to guarantee the supply of goods in the future. This
is very important where a customer is dependent on a supplier for
specialized parts (e.g., monopoly supplier).
Employees use financial statements for assessing the company’s prof-
itability and its consequence on their future pay and job security.
Competitors compare their performance with rival companies to
learn and develop strategies to improve their competitiveness and
gain competitive advantage.
General Public may be interested in the effects of a company on the
economy, environment, and the local community, i.e., Corporate
Social Responsibility.
Governments require financial statements to ascertain the validity of
tax declarations and quantification of tax receipts. Governments
also monitor economic progress through analysis of financial state-
ments of businesses from different sectors of the economy, which
will inform government policy.
2.1 Income Statement

An income statement is a report that highlights how much revenue a
company earned over a specific time (usually for a year or some portion
of a year). An income statement also indicates the costs and expenses that
were incurred with earning that revenue. The “bottom line” of the state-
ment usually shows the company’s net income (or profit) or losses. This
Financial Statements 11
informs how much the company generated or lost over the period. Thus
in summary:
TOTAL REVENUE − TOTAL EXPENSES = NET INCOME
The following figure presents a typical profit report (meaning an income

statement) for a medium-sized manufacturing business:
ABC Inc
Income Statement
For Year Ended December 31, 2017
$000
Sales Revenue 28,500
Cost of Goods sold (expense) 13,500
Gross Margin 15,000
Selling, general & admin expenses 11,500
Operating earnings 3,500
Interest expense 1,500
Earnings before income tax 2,000
Income Tax expense 550
Net Income 1,450
To understand the income statement, referring to ABC Inc., think of

it as a set of ladders. You start at the top with the total amount of Revenue
generated during the accounting period i.e., $28,500,000. This top line is
often called revenue or sales. It is called “gross” because expenses have not
been deducted from it yet. Thus, the number is “gross” or unrefined and
goes down, one step at a time.
At each step, you make a subtraction for certain costs beginning with
Cost of Goods Sold expense i.e., $13,500,000. This number tells you
the amount the company spent to produce the goods or services it sold
during the accounting period. Resulting in “Gross Profit” or “Gross Mar-
gin” i.e., $15,000,000. It is regarded as “gross” because there are certain
expenses that have not as yet been deducted from it.
The next section of the income statement deals with operating

expenses. These are “Selling, general, & admin’” expenses that support
a company’s operations for a given period, i.e., $11,500.000. Operating
expenses are different from “Cost of Goods Sold expense,” which were
deducted above, because operating expenses cannot be correlated directly
to the production of the products or services being sold.
Another important operating expense is depreciation which takes into
account the wear and tear on some assets, such as machinery, tools, and
furniture, which are used over the long term. Companies spread the cost
of these assets over the periods they are used. This process of spreading
this cost is called depreciation or amortization.
After all operating expenses have been deducted from gross profit, you
arrive at Operating earnings, i.e., $3,500,000, before interest and income
tax expenses. This is usually referred as “income from operations.”
Next, companies must account for interest income and interest e xpense.
Interest income is the money companies earn from holding their cash in
interest-bearing savings accounts, e.g., money market funds. The interest
expense is the money companies pay in interest for the money they b orrow.
Some income statements show interest income and interest expense sepa-
rately. Some income statements net off the two numbers. The interest
income and expense are then added or subtracted from the operating profits,
i.e., $1,500,000, to arrive at Earnings before income tax i.e., $2,000,000.
Finally, at the bottom of the ladder, income tax is deducted,
i.e., $550,000, and you discover how much the company actually earned
or lost during the accounting period. People often call this “the bottom
line,” i.e., $1,450,000.
2.2 Statement of Retained Earnings

A company, or a corporation, at the discretion of its board of directors,
can pay some of its income, usually after a profitable period, to stockhold-
ers, as dividends and keep the remainder as retained earnings. These are
added to the company’s accumulated retained earnings, which appear on
the balance sheet under owners’ equity.
After each reporting period, companies produce a statement of
retained earnings. This statement emphasizes, firstly, how net income from
the current period adds onto retained earnings to the firm’s total retained
earnings. This total appears on both the balance sheet and the statement
of retained earnings. Secondly, the portion of the period’s Net income the
firm pays as dividends to owners of preferred and common stock is shown.
The following is a statement of retained earnings, for ABC Inc.; this
includes the earnings of $1,450,000 and cash dividends of $210,000.
ABC Inc
Retained Earnings Statement
$000
Retained Earnings January 1 1,080
Add: Net Income 1,450
Less: Cash Dividends 210
Retained Earnings, December 31 2,320
Sometimes there may be a situation that causes a company to restrict

the distribution of retained earnings. A percentage is set aside that cannot be
used as a basis for declaring dividends. This generally occurs when a lender
stipulates in a contract that a company does not pay out an exorbitant
amount of its retained earnings, to ensure that debt obligations are covered.
2.3 Balance Sheet

The balance sheet is considered as a summary of the firm’s financial
position at one point in time. In fact, some firms and most government
organizations publish their balance sheets under the alternate name state-
ment of financial position.
In theory, a firm could produce a new and updated balance sheet
every day. In practice, they normally do so only periodically, at the end of
fiscal quarters and years. The balance sheet heading names a date a sserting
that “. . . at 31 December 2017.” It is thus a “snapshot” of the firm’s finan-
cial position as at that date. The balance sheet therefore differs from other
statements, which report activity over a specified time.
In fact, the balance sheet indicates end-of-period balances in the

company’s assets, liabilities, and owners’ equity accounts. However, it is
important to note its name includes “balance” for another reason. Since,
the balance sheets’ three main sections represent the accounting equation:
Assets = Liabilities + Owners’ equity
Thus, the term balance applies because the total of the company’s
assets must equal (balance) the sum of its liabilities and owner’s equities.
This balance is always maintained whether the company’s financial posi-
tion is good, or indifferent. Double entry principles in accrual accounting
guarantee that every change to the total on one side results in an equal,
offsetting change on the other side. The balance sheet must balance and
will always do so if accounting is carried out correctly.
Assets are what a company uses to operate its business, while its
liabilities and equity are two sources that finance these assets. Owners’
equity, also known as stockholders’ or shareholders’ equity in a publicly
traded company, is the amount of finance initially invested into the com-
pany, including any retained earnings, and it is a source of funding for
the business.
The following is a balance sheet for, ABC Inc.
ABC, Inc.
Balance Sheet
at December 31, 2017
Assets $000
Cash 7,875
Accounts Receivable 1,250
Inventory 690
Prepaid expenses 195
Current assets 10,010
Property, plant & equipment 5,750
Accumulated depreciation (1,875)
Net of depreciation 3,875
Total Assets 13,885
Liabilities and Owners’ Equity

Accounts payable 1,025
Accrued expenses payable 250
Income tax payable 550
Short-term notes payable 1.125
Current Liabilities 2,950
Long-term notes payable 2,880
Owners equity:
Invested Capital 5,735
Retained earnings 2,320
Total owners’ equity 8,055
Total liabilities and owners’ equity 13,855
ABC Inc.’s balance sheet is made up of two distinct sections. Assets

are stated at the top, and below them are the company’s liabilities and
owners’ equity. The assets and liabilities sections of ABC’s balance sheet
are ordered by how current the account is. Therefore, in the asset side, the
accounts are classified from generally liquid to least liquid. On the liabili-
ties side, the accounts are organized from short to long-term borrowings
and other obligations. We will delve deeper into the assets and liabilities.
Types of Assets
Current assets have a useful economic life of one year or less and can
be converted easily into cash. Such assets in this class include cash and
cash equivalents, accounts receivable, and inventory. Cash, probably
the most important current assets, also includes non-restricted bank
accounts. Cash equivalents are secure assets that can be readily converted
into cash, for example U.S. Treasury Bonds. Accounts receivables consist
of the short-term obligations owed to the company by its clients. Com-
panies often sell products or services to customers on credit, thus these
obligations are shown in the current assets account until they are honored
by the customers. Prepaid expenses are amounts that are paid in advance
for future expenses, and as they are used or expire, an expense is increased
and prepaid expense is decreased.
Lastly, inventory is the sum of the raw materials, work-in-progress

goods, and the company’s finished goods. Depending on the company,
the constituency of the inventory account will vary but will typically
consist of goods purchased from manufacturers and wholesalers. For ex-
ample, a manufacturing firm will carry a large amount of raw materials,
while a retail firm carries little or none.
Noncurrent assets are assets that cannot be turned into cash easily. They
also have an expected life span of more than a year. This can refer to tangible
assets such as plant and machinery, buildings, and land. Noncurrent as-
sets can include intangible assets such as goodwill, patents, or copyrights.
Intangible assets are not physical in nature, are usually not capitalized, and can
make or destroy a company, for example, the value of a brand name, should
not be underestimated. Depreciation is calculated and subtracted from tan-
gible assets, which represents the economic cost of the asset over its useful life.
Liabilities
On the bottom of the balance sheet are the liabilities. These are
the financial commitments a company owes to external parties. Just
like assets, they can be both current and long-term. Current liabilities are
the company’s liabilities that will come due, or must be honored, within
one year. This includes both shorter-term borrowings, such as accounts
payables, together with the current portion of longer-term borrowing,
such as the latest interest payment on a multi-year loan. Long-term
liabilities are debts and other non-debt financial obligations, which are
due more than at least one year from the date of the balance sheet.
Stockholders’ Equity
Shareholders’ equity is the amount of money that was initially invested

into a business. If a company decides to reinvest its net earnings into the
company (after taxes), these retained earnings will be moved from the
income statement onto the balance sheet and into the stockholders or
shareholder’s equity account. This account shows a company’s total net
worth. As stated earlier for the balance sheet to balance, total assets on one
side must to equal total liabilities plus shareholders’ equity on the other.
2.4 Cash Flow Statement

Complementing the income statement and balance sheet is the cash flow
statement, that is a mandatory part of a company’s financial reports since
1987 for publically listed companies. It records the amount of cash and
cash equivalents entering and outgoing a company. The cash flow state-
ment allows external stakeholders to understand how a company’s opera-
tions are being financed, where its money is coming from and crucially
how it is being spent.
The cash flow statement is unique when compared to the income
statement and balance sheet as it does not contain the amount of future
incoming and outgoing cash that has been recognized on credit. Thus
cash is not the same as net income or profit, in the income statement and
balance sheet, includes both cash and credit sales.
There are two acceptable methods for reporting a statement of cash
flows: the direct and the indirect method. The difference between the
two methods is seen in the operating section of the statement of cash
flows. Although the total cash provided (used by) operating activi-
ties will be the same, the line items used to report the cash flows will be
different.
Using the direct method necessitates cash-related daily business
operations to be identified by type of activity. For example, cash collected
from customers, cash paid to employees, cash paid to suppliers (or paid
for merchandize), cash paid for building operations, cash paid for inter-
est, and cash paid for taxes. These types of headings make it easy for users
of the cash flow statement to understand where cash came from and on
what it was spent.
The FASB prefers the direct method for preparing the statement of
cash flows because it gives a better picture of the financial state of the
business. However, most companies do not use the direct method, choos-
ing instead the indirect method since it is easier to produce and gives less
detailed information to competitors. The indirect method begins with
the assumption that net income or profit equals cash and adjusts net
income for major non-cash income statement items such as depreciation,
amortization, and gains and losses from sales and for net changes in cur-
rent asset, current liability, and income tax accounts.
The following figures show what the statement of cash flows looks like
when both the direct and indirect methods of preparation are used. The
following figure is the statement of cash flows using the direct method.
Statement of Cash Flows For ABC, Inc

DIRECT METHOD
For the Year EndingDecember 31, 2017
Cash Flows from Operating Activities $
Collections from Customers 24,500
Payments to Suppliers (7,884)
Wages (1,975)
Other Operating Costs (8,500)
Interest Paid (575)
Tax Paid (870)
Cash Flow Used by Operating Activities 4,696
Cash Flows from Investing Activities
Proceeds from the sale of equipment 3,500
Purchase of Machinery (2,000)
Cash Flow Used for Investing Activities 1,500
Cash Flows from Financing Activities
Additional long-term loan notes 450
Payment of loan notes (100)
Purchase of Treasury Stock (150)
Dividends paid (75)
Cash Flow Used for Financing Activities 125
Increase/Decrease in Cash 6,321
Beginning Cash, January 1,2017 1,554
Ending Cash, December 31, 2017 7,875
Reconciliation of Net Income and Cash Flow Used provided by Operating
Activities:
Net Income 1,450
Add (Minus) not affecting cash:
Depreciation Expense 1,275
Gain on the sale of Equipment (1,875)
Decrease in Accounts Receivable 5,750
Decrease in Accounts Payable (1,904)
Using the Direct Method
The direct method of preparing the statement of cash flows shows the
net cash from operating activities. This section shows all operating cash
receipts and payments. Some examples of cash receipts used for by the di-
rect method are cash collected from customers, as well as interest and divi-
dends received by the company. Examples of cash payments are cash paid
to workers, other suppliers and interest paid on notes payable and loans.
• Cash received and paid are shown as compared to net income or

loss as shown on the income statement.
• Any differences between the direct and indirect method are
located in the operating section of the statement of cash flows.
The financing and investing sections are the same regardless of
which method you use.
Using the Indirect Method
The indirect method starts the operating section with net income
(before interest and tax) from the income statement. You then modify
net income for any non-cash items such as depreciation from the income
statement, see figure follows. Other common items requiring adjustment
are gains and losses from the sale of assets. This is because the gains or losses
shown on the income statement from the sale will usually not equal the
cash a company receives, because the gain or loss is based on the d ifference
between the asset’s net book value, that is cost less accumulated depreciation
and the amount the item sold for—not how much cash the buyer hands
over to the seller. The following example will demonstrate this further:
Assume a business has a piece of plant it no longer uses because
it no longer needs it. The business sells it to another company for
$2,500 and the cash received is $2,500, but what is the gain or loss on
this disposal? Consider these additional facts:
• The company originally paid $4,000 to purchase the plant.

• The total amount depreciated over time (accumulated deprecia-
tion) was $3,000.
• Net book value for the plant on the date of sale was $1,000 ($4,000
cost—$3,000 accumulated depreciation).
The gain (or loss) on disposal is: $

Proceeds 2,500
Net book value 1,000
Gain on disposal 1,500
The cash received ($2,500) differs from the gain on disposal ($1,500).
These are the types of transactions that are reconciled in the statement of
cash flows.
Statement of Cash Flows

INDIRECT METHOD
For the Year Ending December 31, 2017
Cash Flows from Operating Activities $
Net Income 1,450
Add (Minus) not affecting cash:
Depreciation Expense 1,275
Gain on the sale of Equipment (1,875)
Decrease in Accounts Receivable 5,750
Decrease in Accounts Payable (1,904)
Cash Flows from Investing Activities
Proceeds from the sale of equipment 3,500
Purchase of Machinery (2,000)
Cash Flow Used for Investing Activities 1,500
Cash Flows from Financing Activities
Additional long-term loan notes 450
Payment of loan notes (100)
Purchase of Treasury Stock (150)
Dividends paid (75)
Cash Flow Used for Financing Activities 125
Increase/Decrease in Cash 6,321
Beginning Cash, January 1,2017 1,554
Ending Cash, December 31, 2017 7,875
The following table summarizes how to account for changes in work-

ing capital on the balance sheet in comparison with last year, in the cash
flow statement:
Increases Decreases
Closing inventories Minus Add
Receivables and prepaid Minus Add
expenses
Payables and accrued Add Minus
expenses
Whether using the direct or indirect method, the cash generated

from operations in the statement of cash flows should have exactly the
same answer. i.e. the ending cash balance should be the same.
2.5 Limitations of Financial Accounting

As discussed earlier, accounting helps users of financial statements to
make more informed financial decisions. However, it is important to
realize the limitations of accounting and financial reporting when forming
those decisions.
Different Accounting Policies and Frameworks
Accounting frameworks such as IFRS allow the preparers of financial

statements to utilize accounting policies that most suitably reflect the
conditions of their entities.
Whereas a degree of flexibility is important in order to present reliable
information of a particular entity, the use of varying accounting policies
amongst different entities weakens the extent of comparability between
financial statements.
The use of different accounting frameworks (e.g., IFRS, U.S. GAAP)
by entities operating in different geographic locations presents challenges
when comparing their financial statements. The problem is being
addressed by the rising use of IFRS and the convergence process b etween
leading accounting bodies to create a single set of coherent global
standards.
Accounting Estimates
Accounting requires the use of estimates in the preparation of financial

statements where accurate amounts cannot be established. By their very
nature, estimates are intrinsically subjective and thus lack accuracy as they
involve the use of management’s insight in establishing values included in
the financial statements. Where estimates are not founded on objective
and verifiable information, they can dampen the reliability of accounting
information.
Professional Judgment
The use of professional judgment by the preparers of financial statements

is necessary in applying accounting policies in a way that is coherent with
the economic reality of an entity’s transactions. However, differences
in the interpretation of the demands of accounting standards and their
application to real-life scenarios will always be inevitable. Therefore, the
greater the use of judgment involved, the more subjective financial state-
ments will be.
Verifiability
Audit is the major mechanism that allows users to place trust in financial
statements. However, audit only offers reasonable but not absolute assur-
ance on the truth and fairness of the financial statements. Consequently
undertaking an audit according to acceptable audit standards still means
that certain material misstatements in financial statements may yet re-
main undetected due to the inherent limitations of the audit.
Use of Historical Cost
Historical cost or the Historical Cost Convention is the most widely

used basis for the measurement of assets. On the other hand, the use
of historical cost poses various problems for the users of financial state-
ments as it does not account for the change in price levels of assets over a
period of time. This diminishes the relevance of accounting information
by presenting assets at amounts that may be far less or more than their
realizable value and also fails to account for the opportunity cost of using
those assets.
The effect of the use of the historical cost basis is demonstrated by the
following example.
Company ONE purchased plant for $100,000 on January 1, 2013

which had a useful life of 10 years.
Company TWO purchased similar plant for $200,000 on
December 31, 2017.
Depreciation is charged on a straight-line basis.
At the end of the reporting period at December 31, 2017, the balance
sheet of Company TWO would show a fixed asset of $200,000 whilst
Company ONE’s financial statement would show an asset of $50,000
($100,000 − $100,000/10 x 5 years) (net of depreciation).
The above example presents an accounting inconsistency. Even though
the plant presented in company ONE’s financial statements is competent
of producing economic benefits worth 50% ($100,000/$200,000) of
Company TWO’s asset, it is carried at a historical cost equivalent of just
25% ($50,000/$200,000) of its value.
In addition, the depreciation charged in Company ONE’s financial
statements (i.e., $10,000 ($100,000/10) p.a.) does not reflect the opportu-
nity cost of the plant’s use (i.e., $20,000 ($200,000/10) p.a.). Therefore, over
the asset’s life, an amount of $100,000 would be charged as depreciation in
Company ONE’s financial statements even though the cost of maintain-
ing the productive capacity of its asset would have significantly increased. If
Company ONE were to distribute all profits as dividends, it would not have
enough funds to replace its existing plant at the end of its useful life. There-
fore, the use of historical cost may potentially result in reporting u
nderstated
profits, which means that the business is not sustainable in the long-run.
Due to the problems inherent with the use of historical cost, some
preparers of financial statements use the “revaluation model” to account
for long-term assets. However, due to the restricted market of various
assets and the cost of periodic valuations required under revaluation
model, it is not widely used in practice.
An important development in accounting is the use of “capital main-

tenance” in the determination of profit that is sustainable after taking
into account the resources that would be required to “maintain” the pro-
ductivity of operations. However, this accounting basis is still in its early
stages of development.
Measurability
Accounting only takes into account transactions that are capable of being
measured in monetary terms. Therefore, financial statements do not ac-
count for those resources and transactions whose value cannot be reason-
ably assigned such as the dedication of the workforce.
Limited Predictive Value
Financial statements are based on the Historical Cost Convention con-

sequently they present an account of the past performance of an entity.
They offer little insight into the future of an entity and subsequently lack
any predictive value which is vital from the point of view of investors.
Fraud and Error
Financial statements are highly at risk to fraud and errors which can
undermine the overall credibility and reliability of information con-
tained in them. Intentional manipulation of financial statements
that gravitate toward achieving predetermined results (also known
as “window dressing”) has been a regrettable reality in the recent past as
has been p
opularized by major accounting debacles such as the Enron or
WorldCom scandal.
Cost–Benefit Compromise
Reliability of accounting information is related to the cost of its pro-

duction. Hence, there may be times when the cost of producing reliable
information offsets the benefit expected to be gained which suggests why,
in some cases, the quality of accounting information might be flawed.
Having briefly discussed the limitations of financial accounting, it is

important to note that standard setters do their best to issue guidance in
the form of accounting standards to dampen these problems. Advanced
accounting courses cover accounting standards in depth. Finally, it is
important to remember that all human endeavors are flawed but it is nec-
essary to remain vigilant and ethical at all times during your accounting
studies and career.
CHAPTER 3
Major Adjustments
The starting point for calculating or understanding any adjustments is the

trial balance, which is a summary of “T” accounts that are underpinned
by double entry bookkeeping. You will have studied double entry, but
for most accounting students it is difficult to remember as they are not
practicing accountants. Instead, in the following examples and in the case
studies, we begin from the trial balance and examine the impact of the
adjustments on the financial statements.
Before the financial statements for the year end can be prepared, some
year-end adjustments will need to be made. These year-end adjustments
are required in order to satisfy the accruals concept in the preparation of
financial statements. The accruals concept requires that:
• All income and expenditure must be MATCHED to the relevant

accounting period.
• Going concern—that is the business will operate into the
foreseeable future.
There are two broad categories of adjustments:
• When we pay or receive cash BEFORE the expense or revenue

is recorded: this category includes prepaid or deferred expenses
(including depreciation), and unearned revenues or deferred

revenues.
• When cash is paid or received AFTER the expense or revenue
is recorded: this category includes accrued expenses and accrued
revenues.
3.1 Accrued Expenses

Accrued expenses occur when a business had the benefit of something
such as heat and light in one accounting period but will not account for
it until the next period.
Accruals have the following impact:
A) Increase the expense or purchases which are shown on the income

statement.
B) The change/increase in expenses or purchases is shown as a current
liability in the liabilities and owners’ equity section of the balance
sheet.
Calculation of Accruals
1. “Full Accrual”
This usually occurs when the business has not received an invoice for the
service such as legal by the time the financial statements are drawn up,
and that expense has not been included in the trial balance.
For Example:
Cool Cupcakes has called on the services of its business lawyers several
times during the year just ended. The trial balance includes a balance
of $27,000 in the Legal Fees account.
At the year end, the management of the store tells their accountant
that they have not yet received a bill of costs for some work done by
the lawyers a month ago. They estimate the bill to be $5,000.
Therefore, The Accrual Is $5,000.
A figure of $32,000 ($27,000 + $5,000) will appear on the income

statement, and the accrual of $5,000 will appear in the liabilities and
owners’ equity section of the balance sheet.
Major Adjustments 29
2. “Partial Accrual”
Again this occurs due to late invoices usually after the year end; however,
they stagger the year end and will have to be calculated.
For Example:
The year end for Cool Cupcakes is the 31 March 2017 and they
receive an electricity bill for $600 for the quarter-ended/3 month pe-
riod—30 April 2017:
Start year end quarter end

1 February 2017 31 March 2017 30 April 2017
Electricity was used in February and March 2017 of the 3-month

quarter but was not paid because the invoice was received after the
yearend probably in May 2017 so is an accrued expense. We do not
need to worry about April 2017 because the electricity that was used
in April 2017 will be paid during the year.
Two months accrued and one month (ignore – into new a ccounting
period)
Thus, we will apportion the 3-month period and the accrual will be:
2/3 x $600 = $400
This $400 will be treated just the same as before—see full accrual.
3.2 Prepaid (Deferred) Expenses

Prepaid expenses occur when a business has accounted for a good or
service in advance during one accounting period but does not get the
benefit of all or some of what it has accounted for until the next period.
Prepayments have the following impact:
A) The relevant expense accounted, for example, rent is reduced, so

that it records the correct amount of “benefit” used in the accounting
period. This is shown in the income statement.
B) An asset account is created on the balance sheet in current assets
because the business has accounted for certain sums in advance and
can look forward to receiving the benefit in the next accounting
period.
For Example:
SHU Clubbing has paid $30,000 rent for its business premises. The rent
was accounted for on the 1 October, 2017 for 12 months in advance.
SHU Clubbing has an accounting year end of 31 December 2017.
The trial balance shows that SHU Clubbing has paid $30,000 of
rent in the accounting year. However, SHU Clubbing should only be
paying rent in the present accounting period for the 3 months of Oc-
tober, November, and December 2017. The remaining nine months
should be accounted for in the next accounting period.
Thus:
9/12 × $30,000 = $22,500 is the prepayment.
A figure of $7,500 ($30,000 − $22,500) will appear on the in-

come statement and the prepayment of $22,500 will be recorded as
a current asset on the balance sheet.
3.3 Accounts Receivable and Bad Debt Expense

Accounts receivable are customers who owe money to the business as they
purchase goods or services on credit, and the total of these amounts is
shown in the “receivables” account. This is an asset account.
Some receivables will never pay monies owed to the business. When
this is known with certainty, this is known as a bad debt expense which
may be written off during the accounting year. If this is the case, there will
already be a bad debts expense accounted for in the trial balance, and no
a djustment is required. However, the business may also need to carry out
further year-end adjustments as a review is made of the debts owed to the
business. The two methods for calculating the amount of bad debts expense:
• Direct write-off method

• Allowance method
Direct Write-Off Method:
A) Additional bad debts will be shown as an expense on the income

statement.
B) The total in part a will be deducted from the receivables figure in
current assets on the balance sheet.
For Example:
Loreto Inc. has a balance on its receivables account of $7,000. At
the year end, it is discovered that one of its trade customers has been
declared bankrupt, owing $360.
The trial balance will show that $7,000 is owing to Lotto Inc. but
the company knows $360 of that will never be paid.
The receivables asset account on the balance sheet must be reduced
to $6,640 (i.e., $7,000 − $360)
The bad debt expense itself will be shown as an expense account on
the income statement.
Allowance Method:
A doubtful debt occurs when a business is cautiously providing for the

possibility that a debt or debts may not be paid. A doubtful debt differs
from a bad debt in that the business is not writing off the debt completely.
There are two ways of “being doubtful” about debts:
A) Specific doubtful debts: A business may know that a particular

receivable is in trouble financially and make the necessary provision
B) General doubtful debts: Experience tells them that a business may

not have any information on a specific receivable but knows that the
market generally is not doing well and wants to make a general provi-
sion for a certain percentage of its receivables who are not expected
to pay. For example, it is estimated that 5% of its receivables may not
pay.
A business may choose to make specific or general or both provisions.

The impact on the financial statements is:
1. The provision for doubtful debts will appear as an expense and is

adjusted accordingly.
2. The provision for doubtful debts is a liability and will be deducted from
the receivables figure in the current assets section of the balance sheet.
For Example:
Chill Fashion Inc. is a new business. Chill’s first accounting period is
“Year 1.”
Year 1: At the end of Year 1, Chill Fashion’s receivables amount
to $101,000. It believes that Rude Boy Inc., one of its customers, is
on the brink of insolvency. It is unlikely that Rude Boy will pay its
outstanding invoice of $1,000. Thus, Chill will make a SPECIFIC
provision for doubtful debts for this $1,000.
In addition, Chill Fashion decides that it is likely that 1.5%
of the remaining debts may never be paid (i.e., ($101,000 −
$1,000 = $100,000 x 1.5% = $1,500). Chill therefore wishes to
create a GENERAL provision of $1,500 for doubtful debts.
The total provision for doubtful debts at the end of Year 1 is $2,500
($1,500 + $1,000).
As Chill Fashion is a new business, there has been an increase of $2,500

from $0 which must be shown as an expense on the income statement
and $2,500 will be deducted from receivables on the balance sheet.
Year 2: It is decided that the provision should now be $3,000. There

has been an increase of $500 and will be shown as an expense on the
income statement and added to the bad and doubtful debts expense and
$500 will be taken away from receivables.
Year 3: It is felt that business conditions are improving and the
provision should be reduced by $2000. Thus the bad and doubtful
debts expense will be reduced by $2,000 and it shows as $1,000, and
$2,000 will added back to receivables on the balance sheet.
3.4 Depreciation
A fixed asset may have a useful life for several years, after which it may be
of little or no value. Depreciation is the mechanism used in the accounts
to deal with this decline in value and this cost is spread over the useful
life of the asset.
There are other methods for calculating depreciation but two
most common are straight-line or declining balance. Either method is
acceptable but must be used consistently over the life of the asset unless a
change improves the quality of the financial statements.
The annual depreciation expense will be shown in the income
statement and the accumulated depreciation on the balance sheet.
PLEASE NOTE! LAND IS NEVER DEPRECIATED
Straight-Line Method
A) Spreads the depreciation charge evenly over the life of the asset and
gives rise to the same charge for depreciation each year.
Formula for annual depreciation charge:
A) Cost—Residual value/No. of years of useful economic life

(Residual Value is the value at the end of the useful economic life of the
asset which can be 0/zero)
B) Or a percentage will be given, say 25%; therefore, take 25% of the
cost of the asset and apply accordingly.
Example:
Cost $6,000
Net realizable value $0
Useful economic life 5 Years
Annual depreciation charge:
($6,000 – $0) = $1,200 or 20% annually – (6,000 x 0.20 = 1,200)
see the table that follows:
Year 1 Year 2 Year 3 Year 4 Year 5

Cost (1) 6,000 6,000 6,000 6,000 6,000
Total 6,000 6,000 6,000 6,000 6,000
Depreciation
Bfd (2) 0 1,200 2,400 3,600 4,800
Expense (3) 1,200 1,200 1,200 1,200 1,200
Cfd (4) 1,200 2,400 3,600 4,800 6,000
Net book 4,800 3,600 2,400 1,200 0

value (5)
Notes:
1. This figure will be picked up from the trial balance—it is the original
cost of the asset.
2. During the first year, the bfd/brought forward accumulated
depreciation is always zero/0. It can also be found on the trial balance.
3. This is the depreciation expense and will appear on the income
statement.
4. The cfd/carry forwards are calculated by adding the bfd and charge
for the year and will become the bfd in the subsequent year. This cfd
will appear on the balance sheet.
5. The net book value/NBV is calculated by deducting the total cost of
the asset from the cfd accumulated depreciation and will also appear
on the balance sheet.
Declining Balance Method
The depreciation charge each year is expressed as a percentage of the

declining balance i.e., The NBV of the asset.
Example:
Cost $ 6,000
20% declining balance per annum—see the table that follows.

Cost 6,000 6,000 6,000 6,000 6,000
Total 6,000 6,000 6,000 6,000 6,000
Depreciation
Bfd 0 1,200 2,160 2,928 3,542
Expense 1,200 (1) 960 (2) 768 (3) 614 (4) 492 (5)
Cfd 1,200 2,160 2,928 3,542 4,034
Net book 4,800 3,840 3,072 2,458 1,966

value
Notes:
1. As this is the first year, the charge will be 6,000 x 0.20 = $1,200
2. 4,800 x 0.20 or (6,000−1,200) x 0.20
3. 3,840 x 0.20 or (6,000−2,160) x 0.20
4. 3,072 x 0.20 or (6,000−2,928) x 0.20
5. 2,458 x 0.20 or (6,000−3,542) x 0.20
Just as before, the cost/cfd/nbv appears on the balance sheet and the
expense is disclosed on the income statement.
Since the declining balance method results in bigger depreciation ex-
penses near the beginning of an fixed asset’s life and smaller depreciation
expenses later on, it makes sense to use this method with assets that lose
value quickly.
Addition and Disposal of Fixed Assets
Regardless of which ever method we use for calculating depreciation,

additions and disposals are calculated in the same manner. When an
addition to fixed assets is made, it will lead to an increase in cost and
accumulated depreciation. Similarly a disposal of a fixed asset will cause
a reduction in the cost and accumulated depreciation and will result in a
gain or loss on disposal.
Example:
Cost $6,000
Net realizable value $500
Useful economic life 4 years
There was an addition in Year 2 of an asset costing $1,000, $0
residual value, and was depreciated at 25% per annum.
The original asset was disposed of in Year 3 for $3,000 and
depreciation was not charged in the year of disposal. Straight-line
depreciation is used.
See the table that follows

Cost 6,000 6,000 7,000 1,000 1,000
Addition 1,000
Disposal 6,000
Total 6,000 7,000 (2) 1,000 (4) 1,000 1,000
Depreciation
Bfd 0 1,375 3,000 500 750
Expense 1,375 (1) 1,625 (3) 250 250 250
Disposal 2,750 (5)
Cfd 1,375 3,000 500 (6) 750 1,000
Net book 4,625 4,000 500 250 0

value
Notes:
1. Original asset depreciated at 6,000 − 500 = 5,500/4 = 1,375 per

annum
2. Addition 6,000 + 1,000 = 7,000
3. New asset depreciation 1,000 x 0.25 = 250
Original asset depreciation = 1,375
Total = 1,625
4. Original asset disposed 7,000 − 6,000 = 1,000
5. Original accumulated depreciation to date must be removed
1,375 x 2 = 2,750
6. 3,000 + 250 − 2,750 = 500
NB gain or loss on disposal − proceeds − NBV of original asset

Proceeds 3,000
NBV 6,000 − 2,750 (accumulated depreciation to date) = 3,250
Loss on disposal 3,000 − 3,250 = 250 and will be treated as an expense
on the income statement, and if it had been a gain, it would be shown as
an addition on the balance sheet under owners’ equity.
3.5 Closing Inventory

This is the business’s remaining inventory as at the year end. It includes
raw materials, work-in-progress, or finished goods and is deducted from
the cost of sales on the income statement and shown as a current asset
on the balance sheet.
At the end of each period (month or year), a company should do
a physical inventory count to determine the amount of inventory on
hand. Then the company needs to place a value on the goods. There are
three methods for inventory valuation: weighted-average cost method;
First-In-First-Out, or FIFO; and Last-In-First-Out, or LIFO. U.S.
GAAP allows all three methods to be used, and the following example
will demonstrate all three methods.
Example:
Jody runs a candy shop. She enters into the following transactions
during August:
August 1: Purchases 1,200 candy bars at $1 each.

August 14: Purchases 500 candy bars at $1.20 each.
August 17: Sells 700 candy bars at $2 each.
How many candy bars does she have at the end of the month?
1,200 + 500 – 700 = 1,000 candy bars.
Jody must value her closing inventory of candy bars.
First-In-First-Out or FIFO
This method assumes that the first inventories bought are the first ones to
be sold, and that inventories bought later are sold later.
Date Details Number Unit $ $Value

August 1 Purchase 1,200 1 1,200
August 14 Purchase 500 1.20 600
Sub total 1,700 1,800
August 17 Sell (700) 2 1,400

1,000
August 1 1,200 − 700 500 1 500
Total valuation 1,000 1,100
Using the First-In-First-Out method, our closing inventory comes to

$1,100. This equates to a cost of $1.10 per candy bar ($1,100/1,000
candy bars).
Food companies or those that trade in other goods that have a limited
shelf life use FIFO because the earlier goods need to be sold before they
pass their sell-by date.
Last-In-First-Out, or LIFO
This method assumes that last inventories bought are the first to be sold
and that inventories bought first are sold last.

Sub Total 1,700 1,800
August 17 Sell (700) 2 1,400

1,000
August 14 500 sold 0 0 0
August 1 1,200 − 200 1000 1 1,000
(700 − 500)
Total valuation 1,000 1,000
Using the Last-In-First-Out method, our closing inventory comes to

$1,000. This equates to a cost of $1.00 per candy bar ($1,000/1,000
candy bars).
Weighted-Average Cost Method
This method assumes the company will sell all their inventories
simultaneously. The weighted-average cost method is mostly used in
manufacturing businesses, where inventories are piled or mixed together
and cannot be differentiated, such as chemicals and oils. For example,
chemicals bought three months ago cannot be differentiated from those
bought yesterday, as they are all mixed together. Thus we work out an
average cost for all chemicals that the company possesses. The method
specifically involves working out an average cost per unit at each point in
time after a purchase.

Sub Total 1,700 1,800
Average cost 1.06
(1)
August 17 Sell (700) 2 1,400

Total valuation (1,700 − 700) 1,000 1.06 1,060
Notes (1) 1,800/1,700 = 1.06 (2dp)
3.6 Unearned (Deferred) Revenue

Deferred revenue, or unearned revenue, is advance invoicing for products
or services that are to be delivered in the future. The beneficiary of such
prepayment recognizes unearned revenue as a liability on a balance sheet,
because it refers to revenue that has not yet been earned, but represents
products or services that are owed to a customer. As the product or service
is delivered over time, it is recorded as revenue on the income statement.
Unearned revenue is recorded as an obligation on the balance sheet of
a company that receives advance payment, because it owes its customers
services or products. Examples of unearned revenue are rent payments
made in advance, prepayment for newspapers subscriptions, annual
prepayment for the use of software, and prepaid insurance.
Example:
Consider an IT company that receives $3,000 in advance payment at
the beginning of its fiscal year from a customer for annual IT Support.
Upon receipt of the payment, the company’s bank will increase by
$3,000, and $3,000 recorded as deferred revenue. As the fiscal year
progresses, the company invoices the customer $250 per month. By
the end of the fiscal year, the entire deferred revenue balance of $3,000
is reversed and is booked as revenue on the income statement.
CHAPTER 4
Case Study 1—Applying

the Major Adjustments
The following is a balance sheet for Tango Inc. at the end of its first year
of trading:
Tango Inc.
Balance Sheet
at December 31, 2015
Assets $
Cash 1,500
Accounts receivable 39,200
Inventory 130,000
Prepaid expenses 10,600
Plant & equipment 24,000
Total Assets 200,300
Accrued expenses payable 2,500
Owners’ equity:
Equity 100,000
Total owners’ equity 153,800
During 2016, the following transactions took place:
1. The owners withdrew equity in the form of cash of $40,000.

2. Premises continued to be rented at an annual rental of $40,000.
During the year, rent of $30,000 was paid.
3. Insurance on the premises was paid during the year as follows: for
the period April 1, 2016 to March 31, 2017 for $2,600
4. A second piece of plant and equipment was bought on January 1,
2016 for $26,000. This is expected to be used in the business for four
years and then be sold for $6,000.
5. Wages totaling $73,400 were paid during the year. At the end of the
year, the business owed $1,720 of wages for the last week of the year.
6. Electricity bills for the first three quarters of the current year and
$1,240 (for the last quarter) of the previous year were paid, total-
ing $3,640. After December 31, 2016 but before the financial state-
ments had been finalized for the year, the bill for the last quarter of
the current year arrived showing a charge for $1,380.
7. The prepaid expenses of $10,600 consisted of Insurance ($600) and
rent ($10,000).
8. The accrued expenses of $2,500 comprised of Wages ($1,260) and
electricity ($1,240).
9. Inventories totaling $134,000 were bought on credit.
10. Inventories totaling $16,000 were bought for cash.
11. Sales revenue on credit totaled $358,000 (cost $178,000).
12. Cash sales revenue totaled $108,000 (cost $50,000).
13. Receipts from receivables account totaled $356,000.
14. Payments to payables account totaled $142,000
15. Machine running expenses paid totaled $32,400.
The business uses the straight-line method for depreciating plant &
equipment. Ignore taxation.
Required:
Prepare an income statement, statement of retained earnings,
balance sheet, and cash flow statement (both direct and indirect
method) for December 31, 2016. Also comment as to how the financial
statements are inter-related.
CHAPTER 5
The Corporation
A corporation is a legal entity which means that it is a separate and

distinct entity from its owners namely the stockholders (In some U.S.
states, stockholders are called shareholders). A corporation is regarded
as a legal “person” with majority of the rights and obligations of a real
person. However, a corporation is not allowed to hold public office or
vote, but it does pay income taxes. It may be recognized as a profit making
or nonprofit making organization and may be publicly or privately held.
The stock of a quoted or listed company such as Coca Cola is traded on
a stock exchange namely NYSE. Stock of a privately held company is
not traded on an exchange, and there are usually only a small n umber
of stockholders in comparison to a public company which may have
millions of stockholders.
Two of the main factors affecting companies: TAX and DIVIDENDS.
Owner-managed businesses and partnerships are not liable for busi-
ness tax. The income statement of a corporation therefore includes a state-
ment of the business tax the company should pay on its profits. This
business tax will affect the profitability of the company and is usually
shown as a tax accrual.
The owners of companies are stockholders or shareholders.
Stockholders’ return on their investment is the dividend that they may
receive, as opposed to drawings that partners or sole traders take from the
partnership or business, respectively.
Dividends will usually appear in an additional financial statement
called the statement of changes in equity or statement of retained earnings.
5.1 Dividends
Dividends are paid or payable out of profits generated in the current or
previous accounting periods. Any company can make a distribution (e.g.,
a dividend) provided that it has “profits available for the purpose.”
Types of Dividend
a. Common Stock
There are two types of dividend that can be paid on common stock:
INTERIM OR FINAL. Interim is paid during the year, and final divi-
dend is declared after the year end and paid some time thereafter.
b. Preference Stock
Preference dividends are usually paid in two installments each year.

Because of the nature of preference shares, the amount of dividend will
already be known each year.
Paid-in capital tells the reader the aggregate amount that has been
“paid-in” on each class of issued shares. Paid-in capital is that element of
the nominal value called for upon issue—i.e., NOT INCLUDING ANY
CAPITAL SURPLUS.
Example:
A newly incorporated company has issued 200,000 common stock of
$1, and has paid-in 75 cents per stock.
The value of the paid-in capital in the corporation’s balance
sheet will therefore be $150,000 (0.75 x 200,000).
5.2 Reserves
Reserves are profits that are retained in the business and not distributed
to the owners by way of a dividend. These can be profits made by the
business, sometimes referred to as retained earnings and capital reserves,
The Corporation 45
which represent a perceived increase in the value of some fixed assets such
as land or buildings.
5.3 Capital Surplus Account

The capital surplus account represents the difference between the par or
nominal value of the shares and the amount that the stockholders actually
paid for the stock to the company.
The difference between cash received by the company and the par
value of the new shares issued is transferred to the capital account. For
example, if X Co. issues 1,000 $1 ordinary shares at $2.60. Then, the
cash will increase by $2,600 and the equity section of the balance
sheet will include:
Ordinary shares $1,000
Capital surplus account $1,600
The capital surplus Account only comes into being when a company
issues shares at a price in excess of their par value. The market price of the
shares, once they have been issued, has no bearing at all on the company’s
accounts, and so if their market price goes up or down, the capital surplus
account remains unaltered.
5.4 Statement of Retained Earnings

for Corporations
Statement of retained earnings under U.S. GAAP details the change in
owners’ equity over an accounting period by presenting the change in
reserves covering the stockholders’ equity.
Changes in stockholders’ equity over an accounting period usually
comprise the following essentials:
• Net Income or loss during the accounting period attributable to

stockholders
• Increase or decrease in reserves
• Dividend payments to stockholders
• Gains and losses recognized directly in equity
• Effect of changes in accounting policies
• Effect of correction of prior period error
5.5 Worked Example

The following items were taken from the accounting records of Maddot
Inc. The income statement and balance sheet account balances are for
December 31, 2016 except for the retained earnings balance which is the
balance at 1/1/2016:
$
Equipment 264,000
Advertising expense 52,400
Cash 109,000
Common stock 10,000
Administrative expense 24,600
Dividends 4,400
Insurance expense 6,000
Notes payable (long-term) 140,000
Prepaid insurance 13,100
Rent expense 34,000
Retained earnings (beg) 32,620
Salaries expense 76,720
Service revenue 235,400
Office supplies 8,000
Supplies expense 12,000
Salaries payable 6,200
Accumulated depreciation 40,000
Additional paid in Capital 40,000
Income tax rate 30%
Prepare an income statement, a statement of retained earnings, and a balance sheet

for Maddot Inc. for the Year 2016.
The Corporation 47
Solution
$ $
Trial Balance:
Debit Credit
Accounts payable (B/S) 122,000
(B/S)
Equipment (B/S) 264,000
Advertising expense (I/S) 52,400
Cash (B/S) 109,000
Common stock (B/S) 10,000
Administrative 24,600
expense (I/S)
Dividends (RE) 4,400
Insurance expense (I/S) 6,000
Notes payable (long- 140,000
term) (B/S)
Prepaid insurance (B/S) 13,100
Rent expense (I/S) 34,000
(beg) (RE)
Salaries expense (I/S) 76,720
Service revenue (I/S) 235,400
Inventory (B/S) 8,000
Supplies expense (I/S) 12,000
Salaries payable (B/S) 6,200
Accumulated 40,000
depreciation (B/S)
Additional paid in 40,000
Capital (B/S)
626,220 626,220
KEY: Balance sheet: B/S; Income statement: I/S; Statement of retained

earnings: RE.
Maddot Inc.
Income Statement
For The Year Ending December 31, 2016
$
Service revenues 235,400
Expenses:
Administrative expense 24,600
Insurance expense 6,000
Supplies expense 12,000
Advertising expense 52,400
Rent expense 34,000
Salaries expense 76,720
Total expenses 205,720
Net Income before taxes 29,680
Income tax expense (29,680 x 30%) 8,904
Net Income 20,776
Maddot Inc.
Statement of Retained Earnings
For The Year Ending December 31, 2016
$
Retained earnings, January 1, 2016 32,620
Net income 20,776
Dividends (4,400)
Retained Earnings, December 31, 48,996
2016
The Corporation 49
Maddot Inc.
Balance Sheet
At December 31, 2016
$
Assets
Cash 109,000
Inventory 8,000
Prepaid expenses 13,100
Property, plant & equipment 264,000
Accumulated depreciation 40,000
Total Assets 376,100
Accrued expenses payable 6,200
Income tax payable 8,904
Short-term notes payable -
Long-term notes payable 140,000
Shareholders’ equity:
Common stock 10,000
Additional paid in capital 40,000
Total shareholders’ equity 98,996
Total liabilities and shareholders’ 376,100
equity
CHAPTER 6
Case Study 2—Corporation

Accounting
The CFO of Leggo Inc. has prepared the following trial balance as at
December 31, 2016.
$’000
50c Common Stock (fully paid) 350
7% $1 Preference stock (fully paid) 100
10% Loan notes 200
Retained earnings (beginning) 242
General reserve (beginning) 171
Land and buildings 430
Plant and machinery 830
Accumulated depreciation:
Buildings20
Plant and machinery 222
Inventory190
Sales revenues 2,695
Purchases2,152
Preference dividend 7
Common dividend (interim) 8
Loan interest 10
Wages and salaries 254
Light and heat 31
Sundry expenses 113
Suspense account 135
Trade accounts receivable 179
Trade accounts payable 195
Cash126
Notes
1. Sundry expenses include $9,000 paid in respect of insurance for the
year ending September 1, 2017. Light and heat does not include an
invoice of $3,000 for electricity for the 3 months ending January 2,
2017, which was paid in February 2017. Light and heat also includes
$20,000 relating to sales people’s commission.
2. The suspense account is in respect of the following items.
$’000
Proceeds from the issue of 100,000 common stock 120
Proceeds from the sale of plant 300
420
Less: consideration for the acquisition of Toyy Inc. 285
135
3. The net assets of Toyy Inc. were purchased on March 3, 2016. Assets
were valued as follows.
$’000
Investments 231
Inventory 34
265
All inventories acquired were sold during 2016. The investments were
still held by Leggo Inc. at December 31, 2016.
4. The property was acquired some years ago. The buildings element
cost was estimated at $100,000, and the estimated useful life of the
assets was 50 years at the time of purchase.
5. The plant which was sold had cost $350,000 and had a carrying
amount of $274,000 as at January 1, 2016, and $36,000 deprecia-
tion is to be charged on plant and machinery for 2017.
6. The loan notes have been in issue for some years. The 50c common
stock all rank for dividends at the end of the year.
7. The management wishes to provide for:
i) Loan stock interest due
ii) A transfer to general reserve of $16,000
iii) Audit fees of $4,000
8. Inventory as at December 31, 2016 was valued at $220,000 (cost).
9. Taxation is at 25%.
Required:
Prepare the income statement and balance sheet for Leggo Inc. as at
December 31, 2016, including the statement of retained earnings. No
other notes are required.
CHAPTER 7
Interpretation of Financial
Statements
Financial statements highlight more about a company than what it

earned, what it owes, and the historical value of its assets. Thus to demon-
strate the economics of a company, you need to study and deeply analyze
its financial statements.
It is important to note that no individual figures on a financial state-
ment are useful in isolation. Let us assume that Company A1’s income
statement indicates a net income of $100,000 and Company B2’s a net
income of $300,000. It is apparent that Company B2 made twice the
profit of Company A1.
However, does that really mean that Company B2 is twice as profitable?
Is it operated more efficiently? Would you want to invest in C ompany B2
rather than Company A1? What if we know that Company A1 had assets
of $400,000 and Company B2 had assets of $3,000,000?
We can clearly see that Company A1 had a return on assets (ROA) of
25 percent ($100,000 ÷ $400,000 = 0.25) and Company B2 a return
of only 10 percent ($300,000 ÷ $3,000,000 = 0.10). This basic analysis
changes the entire picture of the company’s performances noticeably and sug-
gests a difference between profit and profitability, see the table that follows.
Company A1 Company B2
Net Income $100,000 $300,000
ROA 25% 10%
Company B2 made twice the profit but it was less than half as profit-
able as measured by ROA. Why? The ratio suggests that it used its assets less
efficiently than in comparison to Company A1. This simple ratio was use-
ful in providing us with a deeper understanding of these two companies.
7.1 Ratio Analysis

Ratios express a relationship between items in the financial statements
that can be quantified, although we are still not in a position to under-
take informed judgments about the operation or financial wellbeing of a
company. To further our analysis and understanding of the company, we
need to compare the results of our computations with a series of bench-
marks. Commonly we will use four benchmarks: past performance of the
company (i.e., horizontal/trend analysis), performance of leading or star
companies in the same industry, industry averages, and a pre-set targets or
Key Performance Indicators (KPIs), i.e., we are comparing.
Trend analysis compares the current year’s results with past years’ results
and is useful in highlighting the direction, rate, and extent of trends. It allows
us to compare trends in related items in the financial statements. For exam-
ple, we can compare the rate of change in purchases with the rate of change in
accounts payable which would normally change at approximately the same
rate. If the rate of change in accounts payable is significantly greater than
the rate of change in purchases, we should ask why. Perhaps the company
is experiencing a cash flow problem and is taking longer to pay its suppliers
or it has found new suppliers who are offering more favorable credit terms.
If we are comparing current results with those of the past several years,
it is important that we exclude those years where there were abnormal
events such as a workers’ strike or severe weather conditions which badly
affected the company. Otherwise, the data are likely to be distorted and
comparisons will be worthless if not disingenuous.
When we compare the results of one company with others, they
should be in the same industry and be similar in size. The local company
with 12 employees that makes computer hardware and Dell are in the
same industry but not comparable. The difference in their size makes
their financial statements too disparate for comparison.
Ideally we would want comparable companies to use similar account-
ing methods which can be gauged by reviewing the notes to their financial
statements. Hence, if both companies have large closing inventory balances
Interpretation of Financial Statements 55
and one company uses FIFO and the other LIFO to value their closing
inventory, they may not be comparable without initially making changes.
If we benchmark our results against KPIs, we need to understand
how they were established and ensure that they are specific, measureable,
achievable, realistic, and timely (SMART).
To further illustrate liquidity, financial leverage, activity, and profit-
ability ratios, we will use the financial statements of Lyte Inc:
Lyte Inc.
Income Statement
For the Year Ended December 31
2017 2016
$000 $000
Revenues 25,000 23,600
Less Cost of Goods Sold 16,600 15,600
Gross Margin 8,400 8,000
Less: Selling, General and Admin. Expenses:
Rent 1,260 1,340
Utilities 1,000 980
Insurance 800 760
Advertising 360 350
Depreciation 300 280
Research and 880 800
Development
Operating Income 3,800 3,490
Other Income/Expense: 1,240 1,300
Interest Expense
Earnings before Tax 2,560 2,190
Income Tax 754 658
Earnings before 1,806 1,532
Extraordinary Items
Extraordinary Items (net 240 0
of tax)
Net Income 1,566 1,532
(Dividends paid, $400,000)
Common Stock Price $58 $50
Lyte Inc
Balance Sheet
For the Year Ended December 31
2017 2016
$000 $000
Assets
Current Assets: Cash 1,042 596
Accounts Receivable 2,748 2,560
Inventory 4,472 4,620
Prepaid Items 300 240
Total Current Assets 8,562 8,016
Property, Plant and Equipment
Buildings, Machinery and 7,200 7,000
Trucks
Less Accumulated (2,400) (2,100)
Depreciation
Net Property, Plant and 4,800 4,900
Equipment
Other Assets
Long-Term Investments 3,000 2,800
Total Assets 16,362 15,716
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts Payable 1,840 1,900
Wages Payable 1,700 1,610
Short-Term Notes 690 640
Payable
Total Current Liabilities 4,230 4,150
Long-Term Debt 2,400 2,600
Owners’ Equity
Preferred Stock ($50 par, 100 100
6%, 1,000 sh. issued)
Common Stock ($8 par, 4,000 4,000
500,000 sh. issued)
Paid-in Capital in Excess 1,000 1,000
of Par
Retained Earnings 4,632 3,866
Total Liabilities and 16,362 15,716
Stockholders’ Equity
7.2 Liquidity Ratios

Liquidity ratios are designed to measure a company’s ability to honor its
current and ongoing financial commitments such as paying short-term
creditors, meeting pay-roll, and maintaining sufficient inventory.
Current ratio = current assets ÷ current liabilities
Current assets can be usually converted into cash or are consumed during
a company’s normal accounting cycle. Current liabilities are obligations
that are expected to be fulfilled with the use of current assets within one
year or the firm’s normal accounting cycle. As a firm normally finances its
current liabilities from current assets, there is an important relationship
between the two. Thus, the higher the current ratio, the more liquid the
company, i.e., the easier it will be for the company to honor its current
financial commitments.
On the other hand being too, liquid namely having too much cash,
a growing accounts receivable balance and too much inventory are not
necessarily sound business. A large cash/bank balance suggests that it is
not earning a very good return. A large accounts receivable indicates that
a firm is owed a lot of money, some of which may go bad, and a large
closing inventory may mean slow moving or obsolete inventory that is
not being turned into cash.
A “good” current ratio is dependent on the nature of the company.
So a ratio of 1.5:1 means a company has 1.5 times more current assets
than its current liabilities. If a company can consistently forecast cash
inflows and outflows, it may not need a high current ratio. Thus, it is
not surprising that a company’s suppliers and short-term lenders are
especially interested in its liquidity. If a company does not have satisfac-
tory liquidity, it will probably have trouble paying for inventory and find
that suppliers are not willing to extend credit and only conduct business
on a cash-on-delivery (C.O.D.) basis. The current ratio for Lyte Inc. in
2017 and 2016 is detailed in the table that follows:
Current ratio Working (Two decimal places)

2017 8,562/4,230 2.02
2016 8,016/4,150 1.93
The current ratio has improved because Lyte Inc. has more cash,
less inventory, but higher accounts receivable and prepaid expenses
in comparison with 2016.
Quick ratio = “quick assets” ÷ current liabilities
This ratio is also known as the acid–test ratio, since it is the acid–test
of a company’s liquidity. Quick assets include cash, accounts receivable,
and short-term marketable securities, i.e., those assets that can quickly
be turned into cash and used to pay current liabilities. Inventory and
prepaid expenses (e.g., prepaid rent) are excluded from the numerator
because they are not necessarily liquid. For example, to raise cash quickly
by selling inventory may require a significant reduction in prices, and rent
paid in advance will not usually be refunded.
According to most analysts, a quick ratio of 1:1 is adequate for most
companies. The quick ratio for Lyte Inc. in 2017 and 2016 is detailed in
the table that follows:
Quick ratio Working (Two decimal places)

2017 8,562 − 4,472 −300/4,230 0.90
2016 8,016 − 4,620 − 240/4,150 0.76
The quick ratio has improved because Lyte Inc. has more cash, in
comparison with 2016 and is closer to the 1:1 target.
Another measure of liquidity is not a ratio and is known as working

capital. Working capital = current assets − current liabilities. Working
capital is the surplus of current assets over current liabilities, and the
excess is considered as a cushion. This cushion is vital for a company to
giving it, enough current assets to satisfy its current obligations and to
cover potential contingencies and uncertainties.
The working capital for Lyte Inc. in 2017 and 2016 is detailed in the
table that follows:
Working capital Working $000

2017 8,562 − 4,230 4,332
2016 8,016 − 4,150 3,866
The working capital has improved because Lyte Inc. has enjoyed
higher sales albeit on credit and thus more cash, in comparison
with 2016.
7.3 Financial Leverage Ratios

Financial leverage ratios represent the use of debt rather than owners’
equity in financing a company’s assets. Significant debt in relation to
owners’ equity results in a much higher degree of financial leverage but
involves a risk–reward trade-off. Thus increased leverage presents the like-
lihood of a greater return, but at the price of greater risk. The level of risk
depends on the attitude of the board of directors or owners of the business.
Some owners will be risk averse, while others are risk neutral, and gamblers
tend to be risk-seekers. However, investors and long-term lenders are risk
averse and interested in the amount of leverage a company holds. It is
also important to remember that extra debt results in higher fixed costs in
the shape of interest. Thus a struggling company will still have to make
principal and interest payments on existing and on any new debt. Also
creditors are interested in a company’s leverage. Hence, the greater the
degree of leverage a company has, the less protection its creditors will have.
The debt to equity ratio ((current liabilities + Long-term debt) ÷
equity)) for Lyte Inc. in 2017 and 2016 is detailed in the table that follows:
Debt to equity ratio Working (Two decimal places)

2017 (4,230 + 2,400)/(100 + 0.68
4,000 + 1,000 + 4,632)
2016 (4,150 + 2,600)/(100 + 0.75
4,000 + 1,000 + 3,866)
In 2016, the debt to equity ratio for Lyte Inc. was 0.75 or 75% of
owners’ equity. So for every $1 of financing provided by the com-
pany’s owners, creditors supplied approximately 75 cents.
The debt to equity ratio for Lyte Inc. has improved because
long-term debt has fallen and net income has risen.
Another method of measuring a company’s leverage is to calculate the

debt to total assets ratio ((current liabilities + long-term debt) debt/
total assets)). The debt to total assets ratio for Lyte Inc. in 2017 and
2016 is detailed in the table that follows:
Debt to total assets

ratio Working (Two decimal places)
2017 (4,230 + 2,400)/16,362 0.41
2016 (4,150 + 2,600)/15,716 0.43
In 2016, Lyte Inc. financed 43 percent of its assets through debt.

Creditors are very interested in a firm’s leverage.
The debt to total assets ratio for Lyte Inc. has improved because
long-term debt has fallen and total assets have increased.
Although times interest earned is not considered a leverage ratio, it

is important to lenders. This ratio measures the number of times that net
income before interest expense and income taxes exceeds interest expense.
It is calculated as operating income ÷ interest expense. The times
interest earned ratio for Lyte Inc. in 2017 and 2016:
Times interest earned Working Times

2017 3,800/1,240 3.06
2016 3,490/1,300 2.68
The times interest earned ratio for Lyte Inc. has improved because
operating income has increased and interest expense has fallen.
7.4 Activity Ratios

Activity ratios determine the extent to which a company uses various
assets. The correct level of assets is difficult if not impossible to state.
The answer depends on environmental factors such as the industry in
which the company operates and internal factors such as the company’s
business strategy. For example, there is a “right” level of cash to have
on hand, and if a company has too much cash on hand, it may be
foregoing profitable investment opportunities. On the other hand, if
it has too little, the company will struggle to honor short-term obliga-
tions such as payroll. The inventory turnover of a tractor dealer will
be slower than a toy store. Also, some manufacturing companies may
operate a just-in-time inventory policy, while others prefer to carry
large inventories.
Inventory Turnover
This ratio is calculated as cost of goods sold divided by inventory (cost of

goods sold ÷ inventory). The inventory turnover ratio for Lyte Inc. in
2017 and 2016:
Inventory turnover Working Times (2dp)

2017 16,600/4,472 3.71
2016 15,600/4,620 3.38
The inventory turnover has improved as Lyte Inc. is selling more.
A related ratio is the number of days’ sales in inventory and is cal-

culated as 365 ÷ inventory turnover. The number of days’ sales in
inventory for Lyte Inc. in 2017 and 2016:
Number of days’
sales in inventory Working Days
2017 365/3.71 98
2016 365/3.38 108
In 2016, Lyte Inc. had 108 days or approximately three months’

worth of inventory on hand. In 2017, Lyte Inc. is holding less
inventory and selling more, consequently the ratio has improved.
Accounts Receivable Turnover
This is calculated as sales divided by accounts receivable (sales ÷

accounts receivable). The accounts receivable turnover for Lyte Inc. in
2017 and 2016:
Accounts receivable
turnover Working Times (2dp)
2017 25,000/2,748 9.10
2016 23,600/2,560 9.22
The accounts receivable turnover has improved as Lyte Inc. is sell-

ing more.
A related ratio is the accounts receivable days as 365 ÷ accounts

receivable turnover. The number of days’ sales in inventory for Lyte
Inc. in 2017 and 2016:
Accounts receivable
days Working Days (to nearest day)
2017 365/9.10 40
2016 365/9.22 40
In 2016, it took approximately 40 days to collect monies from

receivables, and it is virtually the same in 2017.
Ideally receivables should be constant or falling but there are other fac-
tors such as credit terms, the efficiency of collecting receivables, and what the
industry average is to consider. If a company has a credit policy that is too
tight then it will lose business to competitors, and if the credit terms are too
generous, this can cause problems. If Lyte Inc. offers a 2% discount for full
payment within 10 days and the balance of receivables pay within 30 days,
then it clearly has a challenge and has to work hard to collect old receivables.
Accounts Payable Turnover
This is calculated as purchases divided by accounts payables ( purchases ÷

accounts payable). (If purchases are not given then the cost of goods sold
figure can be used). The accounts payable turnover for Lyte Inc. in 2017
and 2016:
Accounts payable
turnover Working Times (2dp)
2017 16,600/1,840 9.02
2016 15,600/1,900 8.21
The accounts payable turnover has improved as Lyte Inc. is settling

payables quicker.
A related ratio is the accounts payables days as 365 ÷ accounts

turnover. The number of days’ sales in inventory for Lyte Inc. in 2017
and 2016:
Accounts payable
days Working Days (to nearest day)
2017 365/9.02 41
2016 365/8.21 45
In 2016, it took approximately 45 days to pay suppliers but it has

improved in 2017 as Lyte Inc. is selling more and pays quicker to
ensure a regular supply that meets demand.
Cash Conversion Cycle (CCC)
The CCC measures the number of days a company’s cash is tied up in the
production and sales process of its normal operations and the advantage
it obtains from credit terms from its payables. The shorter the CCC, the
more liquid the company’s working capital position is. The CCC is also
known as the “cash” or “operating” cycle and is calculated: [(number of
days’ sales in inventory + accounts receivable days) − accounts pay-
able days]
The CCC is an important indicator of the company’s efficiency in

managing its working capital assets and its ability to honor its current
liabilities. It also examines how quickly the company changes its inven-
tory into revenues, and its revenues into cash, which is then used to
finance its payables. The CCC for Lyte Inc. in 2017 and 2016:
CCC Working Days

2017 (98 + 40) − 41 97
2016 (108 + 40) − 45 103
The CCC has improved by 10 days in 2017 indicating a better

liquidity position, which should enable the owners of Lyte Inc. to
borrow less, greater opportunities to achieve trade discounts when
purchasing raw materials, and more power to fund the growth of
the company.
7.5 Profitability Ratios

Profitability ratios are used to assess a company’s ability to generate earn-
ings compared to its expenses and other relevant costs incurred during a
specific period. Return on Assets (ROA)
ROA compares net income to total assets and calculated as net
income divided by total assets (net income ÷ total assets). It is
important to note that different analysts use different measures of net
income and total assets. Some analysts use net income minus interest
(net of taxes) in the numerator; some use operating income and many
use average assets in the denominator. Irrespective of how the numerator
and denominator are defined, the ROA should be calculated consistently
and ultimately relates the income earned during a period of time to the
assets that were invested to generate those earnings. ROA for Lyte Inc.
in 2017 and 2016:
ROA Working % (2dp)

2017 1,566/ 16,362 x 100 9.57
2016 1,532/15,716 x 100 9.75
In 2016, for every $1 of profit produced approximately $10

(100/9.75) was invested in its assets as was the case in 2017.
Return on Equity (ROE)
ROE measures the amount of net income returned as a percentage of com-

mon stockholder’s equity. ROE highlights how much profit a company
generates with the money stockholders or shareholders have invested.
It is calculated net income minus preferred dividends to common
stockholders’ equity [(net income − preferred stock dividends) ÷
common stockholders’ equity].
ROE for Lyte Inc. in 2017 and 2016
ROE Working % (2dp)

2017 ((1,566 – (100 × 0.06))/ 16.20
(4,000 + 1,000+ 4,632)
× 100
2016 ((1,532 – (100 x 0.06))/ 17.21
(4,000 +1,000 + 3,866)
x 100
In 2016, every $1 invested in Lyte Inc. resulted in approximately

17 cents return. There was a marginal decline in 2017; however,
any figure between 15 and 20% is considered a sound investment.
ROA v ROE for Lyte Inc. in 2017 and 2016
Debt to asset
ROA ROE Ratio
2017 9.57 16.20 0.41
2016 9.75 17.21 0.43
The difference in ROA and ROE is due to leverage and this is sup-
ported by the debt to asset ratio, see previous table. It appears that
Lyte Inc. has used debt wisely and to the benefit of stockholders.
Profit Margin
This ratio relates net income to sales (net income ÷ sales). It highlights
the percentage of each sales dollar that causes net income. Profit margin
for Lyte Inc. in 2017 and 2016:
Profit margin Working % (2dp)

2017 1,566/25,000 × 100 6.26
2016 1,532/23,600 × 100 6.50
The profit margin has worsened although revenues were higher

in 2017, because there was an extraordinary item in 2017 that
resulted in lower net income.
Earnings per Share (EPS)
EPS (net income − preferred dividends ÷ average number of com-

mon shares outstanding including Paid-in-Capital) determines the
market value of a share of common stock. Consequently EPS is of specific
interest to stockholders and potential investors.
The basic EPS is simple. However, if the company’s capital structure or
how the company finances its assets is complex (for example, the structure
may have issues of preferred stock and stock warrants and long-term bonds),
then the calculation of fully diluted EPS becomes necessary. It is calcu-
lated [(net income − preferred dividend) ÷ weighted average number
of shares outstanding − impact of convertible securities − impact of
options, warrants and other dilutive securities]. As Lyte Inc. has a simple
capital structure, we will only calculate a basic EPS. (NB: Lyte’s preferred
dividends were $6,000 for both 2017 and 2016 ($100 × 1,000 × 0.06)
EPS Working $
2017 (1,566 − 6)/500 3.12
2016 (1,532 − 6)/500 3.05
EPS means every share of the common stock earned 3.05 dollars
(2016) and 3.12 dollars (2017) of net income. The higher EPS for
2017 is the sign of higher earnings, strong financial position, and
potentially a sound company to invest money in.
Price/Earnings Ratio (P/E Ratio)
The P/E ratio compares the price of a company’s common stock on any
given day with its EPS for the recent year (current market price ÷ EPS).
The P/E ratio is also known as a company’s earnings multiple.
The major driver of the price of a company’s stock is investors’
expectations about the future profit of the company. If investors believe
a company’s future earnings are positive, then both the price of the stock
and P/E ratio will increase and vice versa. Investors can pay more than
30 times earnings for the stock of some companies and less than 10 times
for others. Therefore, investors collectively can be more buoyant about
the future of some companies rather than others. PE ratio for Lyte Inc. in
2017 and 2016:
P/E Ratio Working (2 dp)

2017 58/3.12 18.59
2016 50/3.05 16.39
In 2016, an investor was willing to pay $16.39 for $1 of current

earnings. The 2017 P/E ratio was higher as Lyte’s revenues and net
income continue to increase.
7.6 Limitations of Ratio Analysis

Ratio analysis is widely used in business, and its major strength is that
it advances a systematic approach to analyzing company performance.
However, it is also important to note some of the deficiencies of ratio
analysis:
• Ratios function with numbers but do not address qualitative issues

such as customer service which has an important impact on the
financial performance.
• Ratios are historic in nature but investment analysts will make as-
sumptions about future performance using ratios.
• Ratios are very useful when they are used to compare performance
over a number of successive periods and\or against comparable
businesses and industry standards but this information is not al-

ways available.
• Accounting information can be manipulated in many ways to
make the figures used for ratios more attractive. For example, busi-
nesses can delay payments to payables at the end of the financial
year to make the cash balance stronger than normal and thus im-
prove working capital.
CHAPTER 8
Case Study 3—Ratio

Analysis
Cuthbert & Co is an established menswear retailer that also offers

bespoke tailoring services. The company runs its operations from down-
town Manhattan premises and offers an extremely high level of customer
service. Cuthbert & Co have discerning customers who are willing to pay
premium prices and take advantage of exceptional credit terms (60 days)
that are available only after $75,000 of purchases have been made in one
transaction or over a 12-month period.
Clothes NOW! is a recent start up created by two friends from a
leading New York business school. The company specializes in low cost
but fashionable menswear and has a limited range which is updated every
quarter. Clothes NOW! operates from a self-service store on the edge of
the city and has only 10 workers. Customers pay immediately for their
clothes; however, regular customers who have spent at least $5,000 over a
quarter can take advantage of a 30-day credit facility.
Required:
Explain how the accounting ratios of Cuthbert & Co and Clothes
NOW! reflect their difference in business operations.
APPENDIX 1
Applying the Major

Adjustments
Solution (NB: I/S: Income statement; B/S:
Balance sheet)
Workings
The 2016 workings will be discussed:
1. The owners withdrew equity in the form of cash of $40,000:

Minus bank $40,000
Minus equity $40,000
2. Premises continued to be rented at an annual rental of $40,000.
During the year, rent of $30,000 was paid:
$ Impact on financial
statements
BFD 10,000
Add: Paid 30,000 Minus Cash

Less: CFD prepayment -
Total 40,000 Expense on I/S
3. Insurance on the premises were paid during the year as follows: for
the period April 1, 2016 to March 31, 2017 of $2,600:
statements
BFD 600
Add: Paid 2,600 Minus cash

Less: CFD prepayment 650 (w) Prepaid expense on B/S
(w) 2,600 x 3/12 = 650 - Paid $2,600 on April 1 2016 for 12 months in advance, yearend
December 31 2016 so 3 months prepaid
72 APPENDIX 1
4. A second piece of plant and equipment was bought on January 1,

2016 for $26,000. This is expected to be used in the business for four
years and then be sold for $6,000:
Property, plant, & Impact on financial

equipment statements
$
Cost 24,000
Addition 26,000 Minus bank

Disposal
Total 50,000 Shown on B/S

Depreciation
Bfd 5,000
Expense 10,000 (w) Expense on I/S

Disposal
Cfd 15,000 Shown on B/S

Net Book Value 35,000 Shown on B/S
(w) First Plant and machinery $5,000 in second year. Depreciation on second piece of plant -
$26,000 - $6,000/4 = $5,000. So $5,000 + $5,000 = $10,000.
5. Wages totaling $73,400 were paid during the year. At the end of the
year, the business owed $1,720 of wages for the last week of the year.
$ Impact on Financial
Statements
BFD: Deducted because 1,260
$1,260 has been paid
which is included in
$73,400
Add: CFD Accrued 1,720 Accrued expense on B/S
expenses
6. Electricity bills for the first three quarters of the year and $1,240
(for the last quarter) of the previous year were paid, totaling $3,640.
After December 31, 2016 but before the financial statements had
been finalized for the year, the bill for the last quarter arrived show-
ing a charge of $1,380.
APPENDIX 1 73
statements
BFD: Deducted because 1,240
$1,240 has been paid which
is included in $3,640
Add: CFD 1,380 Accrued expense on B/B
Accrued expense
7. The prepaid expenses of $10,600 consisted of insurance ($600) and

rent ($10,000) are BFD balances.
8. The accrued expenses of $2,500 comprised of wages ($1,260) and
electricity ($1,240) are BFD balances.
9. Inventories totaling $134,000 were bought on credit:
Credit purchases of $134,000 — Add to payables on B/S and add to
inventory on B/S
10. Inventories totaling $16,000 were bought on cash:
Cash purchases of $16,000 — Deduct from cash B/S and add to in-
ventory on B/S
11. Sales revenue on credit totaled $358,000 (cost $178,000):
statements
Credit sales 358,000 Add to receivables on B/S
& revenue on I/S
Cost 178,000 Minus cost of goods sold
expense on I/S
Profit 180,000
12. Cash sales revenue totaled $108,000 (cost $50,000)
statements
Cash sales 108,000 Add to bank on B/S &
revenue on I/S
Cost 50,000 Minus cost of goods sold
expense on I/S
Profit 58,000
74 APPENDIX 1
13. Receipts from receivables account totaled $356,000:

Receipt of $356,000 — Add to bank on B/S and minus receivables
on B/S
14. Payments to payables account totaled $142,000:
Payment of $142,000 —Minus bank on B/S and minus payables on
B/S
15. Machine running expenses paid totaled $32,400.
Payment of $32,400 — Minus bank on B/S and show on I/S
INCOME STATEMENT:
Tango Inc.
Income Statement
$
Sales revenue (358,000 + 108,000) 466,000
Cost of goods sold expense (178,000 + 228,000

50,000)
Gross margin 238,000
Rent (10,000 + 30,000) (40,000)
Insurance (600+ 1,950) (2,550)
Wages (−1,260 + 73,400 + 1,720) (73,860)
Electricity (−1,240 + 3,640+ 1,380) (3,780)
Depreciation expense (5,000 + 5,000) (10,000)

Machine running expenses (32,400)
Net income 75,410
STATEMENT OF RETAINED EARNINGS:
Tango, Inc.
Retained Earnings Statement
$
Retained earnings January 1 53,800
Add: Net income 75,410
Retained earnings, December 31 129,210
APPENDIX 1 75
BALANCE SHEET:
Tango, Inc.
Balance Sheet
$
Assets
Cash (1,500 − 40,000 − 30,000 − 2,600 99,460
− 26,000 −73,400 − 3,640− 16,000 +
108,000 + 356,000 − 142,000 −32,400)
Accounts receivable (39,200 +358,000 41,200
- 356,000)
Inventory (130,000 + 134,000 + 16,000 52,000
− 178,000 − 50,000)
Prepaid expenses (650) 650
Plant & equipment 50,000
Total assets 228,310
Liabilities and owners’ equity
Accounts payable (44,000 + 134,000 36,000
−142,000)
Accrued expenses payable (1,720 + 3,100
1,380)
Current liabilities 39,100
Owners’ equity:
Equity (100,000 − 40,000) 60,000
Total owner’ equity 189,210
76 APPENDIX 1
CASHFLOW STATEMENT (DIRECT METHOD):
Cash Flows from Operating Activities

$
Collections from customers (108,000 + 464,000
356,000)
Payments to suppliers (16,000 + 142,000) (158,000)
Operating costs:
Rent (30,000)
Insurance (2,600)
Wages (73,400)
Electricity (3,640)
Machine running expenses (32,400)
Cash flow used by operating activities 163,960
Cash flows from investing activities
Purchase of machinery (26,000)
Cash flows from financing activities
Withdrawal by Owner (40,000)
Net increase in cash 97,960
Beginning cash, January 1 1,500
Ending cash, December 31 99,460
CASHFLOW STATEMENT (INDIRECT METHOD):

Cash Flows from Operating Activities:
$
Net income 75,410
Add (deduct items) not affecting cash:
Depreciation expense 10,000
Increase in accounts receivable (41,200 − 39,200) (2,000)
Decrease in prepaid expenses (10,600 − 650) 9,950
Decrease in inventory (130,000 − 52,000) 78,000
Decrease in accounts payable (44,000 − 36,000) (8,000)
Increase in accrued expenses (2,500 − 3,100) 600

Cash flow used by operating activities 163,960
Cash flows from investing activities
Purchase of machinery (26,000)
Cash flows from financing activities
Withdrawal by owner (40,000)
Net increase in Cash 97,960
Beginning cash, January 1 1,500
Ending cash, December 31 99,460
APPENDIX 1 77
How the financial statements are inter-related:
We have just calculated the following balances based on the aforemen-

tioned financial statements:
A: Balance sheet December 31, 2015

Cash $1,500
Retained earnings $53,800
Prepaid expenses $10,600 consisted of insurance ($600) and
Rent ($10,000)
Accrued expenses $2,500 comprised of wages ($1,260) and
electricity ($1,240)
The beginning cash balance feeds into the cash flow statement
including the opening retained earnings figure that appears on the state-
ment of retained earnings. The brought forward prepaid and a ccrued
expenses will flow into the income statement as they will affect the fig-
ures shown on the income statement.
B: Cash flow statement December 31, 2016

Closing cash of $99,460 flows into the balance sheet at December
31, 2016.
C: Statement of retained earnings December 31, 2016

Closing retained earnings of $129,210 flows into the balance
sheet at December 31, 2016.
D: Income statement December 31, 2016

Prepaid expense insurance ($600)
Accrued expenses of $3,100 comprised of wages ($1,720) and
electricity ($1,380)
The carry forward prepaid and accrued expenses used to adjust the
income statement figures will be shown on the balance sheet.
Net income of $75,410 flows into the statement of retained
earnings.
The aforesaid has been summarized in following diagram which
will be replicated when the new accounting year begins, in this case
January 1, 2017:
78 APPENDIX 1
Cash Flow
Statement
B
Balance
Balance
Sheet Income Sheet
December Statement
D December
31, 2015
31, 2016
A
Statement
of
Retained
Earnings
C
APPENDIX 2
Corporation Accounting
Solution
Trial Balance:
$’000 $’000
Debit Credit
50c Common stock (fully paid) B/S 350
7% $1 Preference stock (fully paid) 100
B/S
10% Loan notes B/S 200
Retained earnings (beginning) RE 242
General reserve (beginning) 171
Land and buildings B/S 430
Plant and machinery B/S 830
Accumulated depreciation:
Buildings B/S 20
Plant and machinery B/S 222
Opening inventory I/S 190
Sales revenues I/S 2,695
Purchases I/S 2,152
Preference dividend RE 7
Common dividend (interim) RE 8
Loan interest I/S 10
Wages and salaries I/S 254
Light and heat I/S 31
Sundry expenses I/S 113
Suspense account 135
Trade accounts receivable B/S 179
Trade accounts payable B/S 195
Cash B/S 126 -
4,330 4,330
Balance sheet: B/S; income statement: I/S; statement of retained earnings: RE
Workings for Income Statement:
80
Cost of goods sold Selling & distribution Administration Finance/interest

$000 $000 $000 $000
From Trial Balance:
Opening inventory 190
APPENDIX 2
Purchases 2,152
Extra inventory—Toyy Inc. 34
Wages & salaries & commission 254
Light & Heat 31
Interest paid 10
Sundry expenses 113
Adjustments:
Closing inventory −220
Bad debt expense
Increase in allowance
Interest accrual: 10
(200 x 10%) − 10
Audit fee accrual 4
Light and Heat accrual 3

Cost of goods sold Selling & distribution Administration Finance/interest

$000 $000 $000 $000
Prepaid insurance −6
(9 x 8 /12)
Journal for commission −20 20
Depreciation: land & buildings 2
Depreciation: plant & machinery 36
TOTAL 2,156 14 423 20
Total accrued expenses (10 + 4 + 3) = 17

Total prepaid expenses = 6
APPENDIX 2
81
82 APPENDIX 2
Working for depreciation

Land & buildings Plant & machinery
$000 $000
Cost 430 830
Less: Disposal 350
Total 430 480
Depreciation
Bfd 20 222
Expense 2 (i) 36 (ii)
Less: Disposal 76 (iii)
Cfd 22 182
Net book value 408 298

(i) 100/50
(ii) Given in trial balance
(iii) 350 − 274
Gain/loss of disposal of fixed asset

$000
Proceeds 300
Net book value (350 − 76) 274
Gain on disposal 26
Goodwill arising on purchase of Toyy Inc.

$000
Consideration paid 285
Asset valuation at date of purchase 265
20
Capital surplus account

$000
Proceeds 120
Less: Nominal value (100 x 0.50) 50
70
APPENDIX 2 83
Leggo Inc.
Income Statement
FOR THE YEAR ENDING December 31, 2016
$000
Sales revenue 2,695
Cost of goods sold expense 2,156
Gross margin 539
Gain on disposal 26
Selling, general, & admin expenses 437
Operating earnings 128
Interest expense 20
Earnings before income tax 108
Income tax expense (108 x 0.25%) 27
Net income 81
Leggo Inc.
Statement of Retained Earnings
FOR THE YEAR ENDING December 31, 2016
$000 $000 $000 $000 $000
Stock Capital General Retained Total
surplus reserve earnings
Balance as 450 171 242 863
at 1.1.2016
(common +
preference
stock = 350
+ 100)
Net income 81 81
Issue of 50 70 120
common
stock
Dividend (15) (15)
paid
(7 + 8)
Transfer 16 (16) -
to general
reserve
Total 500 70 187 292 1,049
84 APPENDIX 2
Leggo Inc.
Balance Sheet
$000
Assets
Cash 126
Accounts receivable 179
Inventory 220
Prepaid expenses 6
Current assets 531
Long-term investment 231
Property, plant, & equipment 706
Goodwill 20
Total assets 1,488
Liabilities and owners’ equity
Accounts payable 195
Accrued expenses payable 17
Income tax payable 27

Short-term notes payable -
Current liabilities 239
Long-term notes payable 200
Shareholders’ equity:
Common stock 400
Preference stock 100
Capital surplus 70
General reserve 187

Retained earnings 292
Total shareholders’ equity 1,049
Total liabilities and shareholders’ 1,488
equity
APPENDIX 3
Solution of Case Study

3—Ratio Analysis
Cuthbert & Co
This company will enjoy a high gross margin but the majority of the gross
profit will be utilized by overhead expenses so that the profit margin will
be low.
The inventory holding period and receivables collection period will
be lengthy.
The company may suffer liquidity problems as it attempts to replenish
inventory especially from those suppliers who do not offer credit terms in
excess of 30 days.
The company will probably need short- and long-term finance which
will be shown in a high debt/equity ratio and low return on equity.
Clothes NOW!
Conversely this company will have a much lower gross margin, but due to
lower overhead expenses a superior profit.
The inventory holding period and receivables collection period will be
very short in comparison.
Liquidity, especially cash, will be high.
If the company continues enjoying high levels of profits coupled with
high levels of cash flow, it will be able to grow organically and easily
source credit.
APPENDIX 4
Glossary of Key Financial

Accounting Terms
10-K. The annual report submitted by publicly held companies.

Account. An account is an instrument for gathering additions and deletions of
a single asset, liability, or owners’ equity item, including revenues and expenses.
Accountant. An accountant is a professional who undertakes accounting func-
tions such as preparation of financial statements. Accountants can work in public
practice, industry, government departments, and nongovernmental organiza-
tions. Accountants can distinguish themselves from nonqualified accountants by
achieving certifications by national professional associations such as the American
Institute of Certified Public Accountants (AICPA), after meeting state-specific
requirements and prescribed work experience.
Accounting. A system of identifying, recording, analyzing, and communicat-
ing transactions. According to the AICPA, accounting is a service activity whose
“function is to provide quantitative information, primarily financial in nature,
about economic entities that is intended to be useful in making economic
decisions.”
Accounting entity. A person, partnership, corporation, or other organization op-
erating as an economic entity.
Accounting Equation. Assets = liabilities + owners’ equity
Accounts payable. A liability owed to a creditor due to the purchase of materials
and supplies recorded as a current liability.
Accounting period. This is an established range of time in which accounting
functions are executed, consolidated, and analyzed in a calendar year or fiscal year.
Accounts receivable. An asset owing by a receivable due to the sale of materials
and supplies recorded as a current asset.
Accrual basis of accounting. The method of realizing revenues when a company
sells goods or services and recognizing expenses when they occur.
Accruals. Accruals are accounting adjustments for revenues that have been earned
but have not been recorded in the accounts and expenses that have been incurred
but have not been recognized in the accounts as well. These accruals need to be
added through adjusting entries so that the financial statements also report these
amounts as well.
Accumulated depreciation. An account showing the total depreciation charges
on an asset since its initial purchase.
88 APPENDIX 4
Acid–test ratio. Quick assets divided by total current liabilities.

Additional paid-in capital. This is found on the balance sheet under shareholders’
equity. It is the value of common stock above what it was issued at. The calcula-
tion is: (Issue Price minus Par Value) multiplied by Basic Shares.
Allowance for uncollectibles (accounts receivable). A contra account that high-
lights the estimated accounts receivable amount that the company will not be
able to collect.
Asset. A resource which gives a future economic benefit to its owner.
Balance sheet. It is based on Total Assets = Total Liabilities + Owners’ Equity.
Balance sheet account. An account that is shown on a Balance Sheet.
Basic earnings per share. Net income minus preferred dividends divided by the
number of common stock including any additional paid-in capital.
Board of directors. The body that operates the corporation on behalf of the share-
holders and is elected by them.
Bond. A debt instrument showing the interest rate, maturity date, and face
amount of the debt. Bonds are usually subject to semi-annual payments.
Book value. The figure shown in accounts for an asset, liability, or owners’ equity
item. For depreciable assets such as cars, book value is the initial cost less accu-
mulated depreciation.
Capital. The owners’ equity in a business.
Capitalize. When expenditure is recognized as an asset rather than an expense.
Cash. All notes and coins, negotiable checks, and balances in bank accounts.
For the purposes of the statement of cash flows, “cash” also includes marketable
securities held as current assets.
Cash basis of accounting. A technique of accounting in which a company records
revenues when it receives cash and recognizes expenses when it makes a payment.
Cash provided by operations. A section of the cash flow statement.
Common stock or shares. After a company has honored all debt obligations and
paid preferred stockholders, any residual earnings and assets of a corporation are
subject to the rights of common stock holders.
Conservatism. The accounting principle where expenses and liabilities are re-
corded, even if they are uncertain and only recognizing revenue and assets when
they are assured of being received.
Consistency. The accounting principle where transactions are treated exactly in
the same way in consecutive periods thereby ensuring the consistency of financial
statements.
Contributed capital. The owners’ equity account which is where a company’s
capital paid in by the owners is shown.
Corporation. A legal entity that is distinct from the owner and is authorized by a
state under the rules of the entity’s charter.
Cost. The monetary value of assets or liabilities suffered in order to purchase
some good or service.
APPENDIX 4 89
Credit. A credit is when a transaction is “given” and appears on the right-hand

side of an account.
Cost of goods sold expense. The cost of opening inventory plus cost of goods
purchased minus closing inventory, during a period of time.
Current assets. Assets that a company expects to turn into cash, sell, or exchange
in an accounting cycle or in one year.
Current liabilities. Financial obligations that must be honored within an
accounting cycle by using current assets.
Current ratio. Current assets divided by current liabilities.
Debit. A debit is when a transaction is “accepted” and appears on the left-hand
side of an account.
Debt. This is a short- or long-term liability, owed by a company and includes
notes, bonds, and mortgages that have definite payment dates.
Debt/equity ratio. Total liabilities divided by total equities.
Declining-balance depreciation. An accounting technique where the deprecia-
tion charge each year is expressed as a percentage of the declining balance, i.e.,
The net book value of the asset
Depreciable cost or expense. The loss in value of an asset that the company
will charge over the useful economic life of the asset through the process of
depreciation.
Depreciation. The process of assigning the cost of an asset over the useful eco-
nomic life of an asset.
Dividend. A dividend is an allocation of a share of a company’s earnings, decided
by the board of directors and paid to both preferred and common stock holders.
Dividends are usually cash payments or shares of stock.
Earnings per share. Net income attributable to common stockholders (net
income minus preferred dividends) divided by common stock.
EBIT. Earnings before interest and income taxes also known as operating profit.
Expense. The payment of operating costs such as wages or non-operating costs
such as interest or supplier payables or long-term commitments like loans.
Extraordinary item. A major or material expense or revenue item that is unusual
and not frequent.
Financial Accounting Standards Board (FASB). A bipartisan board that is
responsible for determining generally accepted accounting principles.
First-In-First-Out (FIFO). An inventory valuation technique that companies use
to calculate closing inventory cost. FIFO assumes sales are made from the oldest
purchases.
Financial accounting. Specializes in the preparation, interpretation, and report-
ing to external stakeholders such as lenders.
Financial statements. These are the final product of financial accounting namely
the income statement, balance sheet, statement of retained earnings, and cash
flow statement.
90 APPENDIX 4
GAAP. Generally accepted accounting principles.

General ledger. The name for the ledger that includes all financial statement
accounts.
Going concern assumption. The assumption that a company will operate into
the foreseeable future.
Goodwill. This is the excess amount that a company pays for the current fair
market value of a company’s net assets.
Gross Margin. Net sales less cost of goods sold.
Historical cost. This is the initial cost of assets. The preparation of financial state-
ments is based on the historical cost convention.
Income. This is when revenues are earned from the sale of goods or services.
Income statement. The financial statement of revenues, expenses, gains, and
losses for an accounting period.
Insolvency. When a company cannot honor its debts.
Inventory turnover. Number of times the company sells the inventory during an
accounting period; it is calculated by taking cost of goods for a period and divid-
ing by closing inventory.
Liability. A commitment to forward assets or provide services to another entity.
Last-In-First-Out (LIFO). An inventory valuation technique that companies use
to calculate closing inventory cost. LIFO assumes sales are made from the newest
purchases.
Liquid assets. Assets such as cash, marketable securities, and current receivables
that can easily be transformed into hard cash.
Liquidity. The capacity of a company to meet short-term commitments.
Net assets. Total assets less total liabilities which also equates to owners’ equity.
Net current assets. Current assets less current liabilities.
Net Income. This is total income less total expenses.
Objectivity. The accounting convention of not recognizing a transaction until it
can be quantified with reasonable accuracy and verified independently.
Prepaid expense. A prepaid expense is an asset that appears on a balance sheet
due to a company accounting for goods and services to be received in the next
accounting period.
Price/earnings ratio. The market value of a share of a corporation’s common
stock or shares, divided by the earnings per share.
Quick assets. Cash plus marketable securities and receivables.
Quick ratio. Also known as the acid–test ratio. It is calculated by taking the quick
assets and dividing by the current liabilities.
Retained Earnings. Net income over the life of a corporation less dividends.
Revenue. This is the inflow of cash, increases in other assets or payment of li-
abilities due to the sale of goods and services that are the norm for the company.
APPENDIX 4 91
Securities and Exchange Commission (SEC). This is the government agency that
is responsible for the financial reporting practices of public corporations. The
SEC allows the FASB to set accounting principles.
Stakeholder. Internal and external entities that have an interest in an organiza-
tion’s activities and outcomes.
Statement of cash flows. A schedule of cash receipts and payments for an ac-
counting period that categorizes sources and uses of cash from operating, invest-
ing, and financing activities.
Straight-line depreciation. An accounting technique in which periodic deprecia-
tion charges are all the same.
Total assets turnover. Revenue divided by total assets.
Uncollectible account. A receivable that will not be able to be collected and has
gone bad. It will be shown as a bad debt expense in the income statement.
Working capital. Current assets less current liabilities.
Write off. To charge an asset to expense or loss.
Index
ABC Inc. Acid–test ratio. See Quick ratio
balance sheet for, 14–15 Activity ratios
cash flow statement accounts payable turnover, 63
direct method for, 18 accounts receivable turnover, 62
indirect method for, 20 cash conversion cycle, 63–64
income statement for, 11–12 inventory turnover, 61–62
statement of retained earnings Allowance method, 31–33
for, 13 Assets, 14–15. See also specific assets
Accounting account, 30
accounting information system, 2–4 types of, 15–16
assumptions, 6–7 Assumption, accounting. See specific
corporation, 51–52, 79–84 assumptions
estimates, 22 Audit, 22
ethics in, 4
policies and frameworks, 21 Bad debt expense, 30–33
principles, 4–5 allowance method for, 31–33
Accounting adjustments, 27 direct write-off method for, 31
accounts receivable and bad debt Balance sheet, 13–16
expense, 30–31 for Leggo Inc., 84
allowance method for, 31–33 for Lyte Inc., 56
direct write-off method for, 31 for Maddot Inc., 49
accrued expenses, 28–29 for Tango Inc., 41–42, 75
application of, 41–42, 71–78 unearned revenue as liability on, 40
closing inventory, 37–40 Brought forward, 34, 35
depreciation, 33–37
addition and disposal of fixed Capital account, 45
assets, 36–37 Capital maintenance, 24
declining balance method for, 35 Capital surplus account, 45
straight-line method for, 33–34 Carry forwards, 34, 35
prepaid (deferred) expenses, 29–30 Cash, 15
unearned (deferred) revenue, 40 equivalents, 15
Accounting information system, 2–4 or operating cycle. See Cash
Accounts clerk, 1 conversion cycle (CCC)
Accounts payable turnover, 63 Cash conversion cycle (CCC), 63–64
Accounts receivable, 15, 30–33 Cash flow statement
turnover, 62 direct method for, 17–21
Accruals, 27 indirect method for, 17–21
assumption, 6 for Tango Inc., 76
calculation of, 28–29 Cash-on-delivery (C.O.D.), 57
Accrued expenses, 27, 28–29 Chill Fashion Inc., 32–33
94 INDEX
Closing inventory, 37–40 straight-line method for, 33–34

First-In-First-Out method for, working for, 82
37, 38 Direct method, for cash flow
Last-In-First-Out method for, statement, 17–21
37, 39 Direct write-off method, 31
weighted-average cost method for, Dividends, 43
37, 39–40 types of, 44
Clothes NOW!, 69, 85 Double-declining balance method, 35
Coca Cola, 43 Doubtful debt, 31–32
Common stock, 44
Competitors, financial statements Earnings per share (EPS), 66
and, 10 Economic entity assumption, 6
Conservatism assumption, 6 Employees, financial statements
Consistency assumption, 6 and, 10
Cool Cupcakes, 28–29 Enron, 24
Corporation Equity, 14–16
accounting, 51–52, 79–84 Ethics, in accounting, 4
capital surplus account, 45
definition of, 43 Final dividend, 44
dividends, 44 Financial accounting, 4
Maddot Inc., 46–47 limitations of
balance sheet, 49 accounting estimates, 22
income statement, 48 accounting policies and
statement of retained earnings, 48 frameworks, 21
reserves, 44–45 cost–benefit compromise, 24
statement of retained earnings fraud and error, 24
for, 45 historical cost, use of, 22–24
Cost principle, of accounting, 5 limited predictive value, 24
Cost–benefit compromise, 24 measurability, 24
Current assets, 15, 57 professional judgment, 22
Current liabilities, 16, 57 verifiability, 22
Current ratio, 57–58 Financial Accounting Standards Board
Customers, financial statements (FASB), 4, 17
and, 10 Financial lenders, financial statements
Cuthbert & Co, 69, 85 and, 10
Financial leverage ratios
Debt, doubtful, 31–32 debt to equity ratio, 59–60
Debt to equity ratio, 59–60 debt to total assets ratio, 60
Debt to total assets ratio, 60 times interest earned ratio, 60
Declining balance method, 35 Financial position, 13
Deferred expenses. See Prepaid Financial statements
expenses balance sheet, 13–15
Deferred revenue. See Unearned assets, types of, 15–16
revenue liabilities, 16
Depreciation, 16, 33–37 stockholders’ equity, 16
addition and disposal of fixed assets, cash flow statement
36–37 direct method for, 17–21
declining balance method for, 35 indirect method for, 17–21
INDEX
95
financial accounting, limitations of Governments, financial statements

accounting estimates, 22 and, 10
accounting policies and
frameworks, 21 Historical Cost Convention, 22, 24
cost–benefit compromise, 24 Historical cost, use of, 22–24
fraud and error, 24
historical cost, use of, 22–24 Income statement, 10–12
limited predictive value, 24 for Leggo Inc., 83
measurability, 24 for Lyte Inc., 55
professional judgment, 22 for Maddot Inc., 48
verifiability, 22 for Tango Inc., 74
income statement, 10–12 unearned revenue as revenue on, 40
inter-relation of, 77–78 workings for, 80–81
interpretation of, 53–54 Indirect method, for cash flow
providing information for statement, 17–21
competitors, 10 Intangible assets, 16
customers, 10 Interest expense, 60
employees, 10 Interim dividends, 44
financial lenders, 10 International Accounting Standards
general public, 10 Board (IASB), 4
governments, 10 International Financial Reporting
stockholders, 9 Standards (IFRS), 4, 5, 21
suppliers, 10 Inventory, 15, 16
ratio analysis, 54–56, 67–68 turnover, 61–62
activity ratios, 61–64 Invoices, 1
financial leverage ratios,
59–60 Key Performance Indicators (KPIs),
liquidity ratios, 57–59 54, 55
profitability ratios, 64–67
of retained earnings, 12–13 Last-In-First-Out (LIFO) method,
Financial transaction data, 1 37, 39, 55
First-In-First-Out (FIFO) method, Leggo Inc., 51–52
37, 38, 55 balance sheet for, 84
Fixed assets, addition and disposal of, income statement for, 83
36–37 statement of retained earnings
Fraud and error, financial statements for, 83
and, 24 Liabilities, 14–16
Full accrual, 28 Limited predictive value, 24
Full disclosure principle, 5 Liquidity ratios
current ratio, 57–58
General doubtful debts, 32 quick ratio, 58
General public, financial statements working capital, 58–59
and, 10 Long-term liabilities, 16
Generally Accepted Accounting Loreto Inc., 31
Principles (GAAP), 4–5 Lyte Inc.
statement of retained earnings accounts payable turnover for, 63
under, 45 accounts receivable turnover for, 62
Going concern assumption, 6 balance sheet for, 56
96 INDEX
cash conversion cycle for, 63–64 price/earnings ratio, 67

current ratio for, 57–58 profit margin, 66
debt to equity ratio for, 59–60 return on assets, 64–65
debt to total assets ratio for, 60 return on equity, 65
earnings per share for, 66
income statement for, 55 Quick assets, 58
inventory turnover for, 61–62 Quick ratio, 58
price/earnings ratio for, 67
profit margin for, 66 Ratio analysis, 54–56, 69, 85
quick ratio for, 58 activity ratios
return on assets for, 64–65 accounts payable turnover, 63
return on equity for, 65 accounts receivable turnover, 62
times interest earned ratio for, 60 cash conversion cycle, 63–64
working capital for, 59 inventory turnover, 61–62
financial leverage ratios
Maddot Inc., 46–47 debt to equity ratio, 59–60
balance sheet for, 49 debt to total assets ratio, 60
income statement for, 48 times interest earned ratio, 60
statement of retained earnings limitations of, 67–68
for, 48 liquidity ratios
Management accounting, 4 current ratio, 57–58
Managers, financial statements and, 9 quick ratio, 58
Matching principle, of accounting, 5 working capital, 58–59
Measurability, 24 profitability ratios
Monetary unit assumption, 6 earnings per share, 66
price/earnings ratio, 67
Net book value (NBV), 34, 35 profit margin, 66
Net income, 17 return on assets, 64–65
Noncurrent assets, 16 return on equity, 65
NYSE, 43 Receipts, 1
Reliability assumption, 6
Objectivity principle, of accounting, 5 Reliability of accounting
Operating activities, 17, 19 information, 24
Operating income, 60 Reserves, 44–45
Owners’ equity, 14–16 Retained earnings, 12–13
changes in, 45 Return on assets (ROA), 64–65
Return on equity (ROE), 65
Pacioli, Fra Luca, 1, 2 Revaluation model, 23
Paid-in capital, 44 Revenue recognition principle, 5
Partial accrual, 29
Preference stock, 44 Securities and Exchange Commission
Prepaid expenses, 15, 29–30 (SEC), 4
Price/earnings ratio (P/E ratio), 67 Shareholders, 43
Professional judgment, use of, 22 equity. See Owners’ equity
Profit equals cash, 17 SHU Clubbing, 30
Profit margin, 66 Specific doubtful debts, 31
Profitability ratios Statement of financial position, 13.
earnings per share, 66 See also Balance sheet
INDEX
97
Statement of retained earnings, 12–13 Tax accrual, 43

for corporations, 45 Time period assumption, 6
for Leggo Inc., 83 Times interest earned ratio, 60
for Maddot Inc., 48 Trend analysis, 54
for Tango Inc., 74 Trial balance
Stockholders adjustments in. See Accounting
equity. See Owners’ equity adjustments
financial statements and, 9 for corporation accounting, 79, 81
Straight-line method, 33–34, 42 for Leggo Inc., 51–52
Suppliers, financial statements and, 10
System, defined, 2 Unearned revenue, 40
U.S. Treasury Bonds, 15
Tangible assets, 16
Tango Inc. Verifiability, 22
balance sheet for, 41–42
balance sheet for, 75 Weighted-average cost method, 37,
cashflow statement, 76 39–40
income statement for, 74 Window dressing, 24
statement of retained earnings Working capital, 58–59
for, 74 WorldCom scandal, 24
OTHER TITLES IN OUR FINANCIAL ACCOUNTING
AND AUDITING COLLECTION
Scott Showalter, North Carolina State University and
Jan Williams, Dean Emeritus of the College of Business and
Professor Emeritus of the University of Tennessee, Editors
• Executive Compensation: Accounting and Economic Issues by Gary Giroux

• Using Accounting and Financial Information: Analyzing, Forecasting, and
Decision-Making by Mark Bettner
• Pick a Number: Internationalizing U.S. Accounting by Roger Hussey and Audra Ong
• International Auditing Standards in the United States: Comparing and Understanding
Standards for ISA and PCAOB by Asokan Anandarajan and Gary Kleinman
• Accounting for People Who Think They Hate Accounting by Anurag Singal
• Accounting for Fun and Profit: A Guide to Understanding Financial Statements
by Lawrence Weiss
• Audit Committee Formation in the Aftermath of 2007-2009 Global Financial Crisis,
Volume I: Structure and Roles by Zabihollah Rezaee
• Audit Committee Formation in the Aftermath of 2007-2009 Global Financial Crisis,
Volume II: Responsibilities and Sustainability by Zabihollah Rezaee
• Audit Committee Formation in the Aftermath of the 2007-2009 Global Financial Crisis,
Volume III: Emerging Issues by Zabihollah Rezaee
• Accounting for Fun and Profit: A Guide to Understanding Advanced Topics in Accounting
by Lawrence A. Weiss
• Accounting History and the Rise of Civilization, Volume I by Gary Giroux
• Accounting History and the Rise of Civilization, Volume II by Gary Giroux
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Financial Accounting

and Auditing Collection

Faisal Sheikh BSc (Hons) FCCA FHEA FFA FIPA

All rights reserved. No part of this publication may be reproduced, stored

First published in 2018 by

ISBN-13: 978-1-94744-149-1 (paperback)

Business Expert Press Financial Accounting and Auditing Collection

Collection ISSN: 2151-2795 (print)

Cover and interior design by S4Carlisle Publishing Services

First edition: 2018

Printed in the United States of America.

Zahra, Maryam and baby Halimah remember:

The practice of accounting goes back thousands of years. It started

Portrait of Luca Pacioli (c.1445–c.1514), mathematician and friend

The accounting profession is now highly regulated and controlled,

1.1 Accounting Information System

INPUTS: PROCESSES: OUTPUTS

Transaction Accounting Financial

To make a decision, a manager needs information, which is provided

The accounting information system will produce various outputs.

1.2 Ethics in Accounting

1.3 Accounting Principles

• Financial Accounting Standards Board (FASB): a private group

The International Accounting Standards Board (IASB) issues International

Cost Principle. According to this principle, accounting information is

If something besides cash is exchanged (i.e., a car), the cost is ­measured

Objectivity Principle. Under this principle, information is backed by

Revenue Recognition Principle. Revenue (sales) is the figure ­received

Matching Principle. A company must recognize its expenses incurred to

Full Disclosure Principle. This principle demands that a company must

As stated earlier in the United States, accounting principles also include

1.4 Accounting Assumptions

Accrual Assumption—Transactions are recorded using the ­accrual

Although the aforementioned assumptions appear obvious, they can

Financial statements represent a prescribed record of the financial ­conduct

Financial statements provide useful information to a variety of

Managers require financial statements to manage the company by

Financial Lenders (e.g., Banks) use financial statements to decide

2.1 Income Statement

TOTAL REVENUE − TOTAL EXPENSES = NET INCOME

The following figure presents a typical profit report (meaning an ­income

To understand the income statement, referring to ABC Inc., think of

The next section of the income statement deals with operating

2.2 Statement of Retained Earnings

Sometimes there may be a situation that causes a company to restrict

2.3 Balance Sheet

In fact, the balance sheet indicates end-of-period balances in the

Assets = Liabilities + Owners’ equity

Liabilities and Owners’ Equity

ABC Inc.’s balance sheet is made up of two distinct sections. Assets

Lastly, inventory is the sum of the raw materials, work-in-progress

Shareholders’ equity is the amount of money that was initially invested

2.4 Cash Flow Statement

Statement of Cash Flows For ABC, Inc

Using the Direct Method

• Cash received and paid are shown as compared to net income or

Using the Indirect Method

• The company originally paid $4,000 to purchase the plant.

If something besides cash is exchanged (i.e., a car), the cost is measured

Revenue Recognition Principle. Revenue (sales) is the figure received

Accrual Assumption—Transactions are recorded using the accrual

Financial statements represent a prescribed record of the financial conduct

The following figure presents a typical profit report (meaning an income