Accounting for Non-Accountants PDF

by Dean Violeta V. Vicente Accounting for Non-Accountants by Dean Violeta V. Vicente Day One Accounting for Non-Accountants by Dean Violeta V. Vicente What is ACCOUNTING? Accounting is the process of identifying, measuring, and communicating economic information to permit informed judgments and...

by Dean Violeta V. Vicente Accounting for Non-Accountants by Dean Violeta V. Vicente Day One Accounting for Non-Accountants by Dean Violeta V. Vicente What is ACCOUNTING? Accounting is the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information. Accounting for Non-Accountants by Dean Violeta V. Vicente Parties Interested  Owners  Creditors  Government Agencies  Employees  Suppliers/Sellers  Others Accounting for Non-Accountants by Dean Violeta V. Vicente Flow of Information transaction documents journals and ledgers trial balance adjusting the books financial statements Accounting for Non-Accountants by Dean Violeta V. Vicente   Recording 4 Phases  Classifying of  Summarizing Accounting  Interpreting Accounting for Non-Accountants by Dean Violeta V. Vicente Accounting Cycle  Journalizing  Posting  Trial Balance  Adjustment/Adjusting Entries  Financial Statements (Balance Sheet , Income Statement and Cash Flow Statement)  Closing Entries  Post-Closing Trial Balance  Reversing Entries Accounting for Non-Accountants by Dean Violeta V. Vicente ACCOUNTING EQUATION Assets = Liabilities + Proprietorship/ Capital/Equity Accounting for Non-Accountants by Dean Violeta V. Vicente ASSETS  things of value owned by the business  are resources received which have future benefits. Typical assets for a business include:  Cash  Prepaid  Accounts insurance receivable  Office building  Office supplies  Office equipment Accounting for Non-Accountants by Dean Violeta V. Vicente   coins Cash  currency  checking accounts Accounting for Non-Accountants by Dean Violeta V. Vicente Accounts receivable are promises received from customers to pay for goods and services later. Credit. Cash or I’ll pay you later. Credit? Accounting for Non-Accountants by Dean Violeta V. Vicente   paper Office  pens supplies  floppy disks, etc Prepaid insurance is an asset because it has future benefit. Insurance benefits expire with the passage of time. Accounting for Non-Accountants by Dean Violeta V. Vicente An office building is an asset with future benefit because it will be used in the future. Office  desks furniture  chairs  copiers Office  computers equipment  fax machines Accounting for Non-Accountants by Dean Violeta V. Vicente ! Assets have future benefit. Does it have future benefit?  Cash it can be spent  Accounts future collections receivable  Office supplies use of supplies in the future Accounting for Non-Accountants by Dean Violeta V. Vicente LIABILITIES  amounts owed by the business to others  are obligations or promises given to others Typical liabilities for a business include:  Accounts payable  Notes payable  Mortgage payable Accounting for Non-Accountants by Dean Violeta V. Vicente Accounts payable are obligations or promises to pay later for goods and services that the company has purchased on credit. Notes payable are written promises (promissory notes) to repay a debt. Accounting for Non-Accountants by Dean Violeta V. Vicente Mortgage payable results when a company borrows money from a bank to buy real estate. The bank will take a mortgage on the real estate which means the bank can foreclose and seize the property should the borrower be unable to make the mortgage payments. Note: Liability accounts often include ! “payable” in the account title. Accounting for Non-Accountants by Dean Violeta V. Vicente TYPES OF BUSINESS ENTITIES  Sole Proprietorship  Partnership  Corporation Accounting for Non-Accountants by Dean Violeta V. Vicente PROPRIETORSHIP/CAPITAL/ EQUITY  the financial interest/s of the owner/s of the business if the ASSETS are GREATER than the LIABILITIES Accounting for Non-Accountants by Dean Violeta V. Vicente Stockholders’ equity is the claims by owners of stock on the resources of the organization. Stockholders’ equity is divided into 2 parts:  Common stock  Retained earnings Common stock represents the amount invested by owners of the business in exchange for stock in the company. Accounting for Non-Accountants by Dean Violeta V. Vicente Common stockholders:  vote for the board of directors Stockholders Board of Directors Chief Executive Officer Vice President of Finance Vice President of Marketing Vice President of Technology Accounting for Non-Accountants by Dean Violeta V. Vicente  receive dividends (if declared by the board of directors)  receive any residual assets left after creditors are paid if the company is liquidated Creditors Stockholders Accounting for Non-Accountants by Dean Violeta V. Vicente Retained earnings represent the amount of net income from all prior years that has been retained in the business and not distributed to stockholders as dividends. N N N e e e t t t I I I n n n c c c o o o m m m Stockholders e Retained e e earnings Dividends Accounting for Non-Accountants by Dean Violeta V. Vicente Retained Earnings is calculated: Retained Earnings, Beg. + Net Income - Dividends Retained Earnings, End. Accounting for Non-Accountants by Dean Violeta V. Vicente  Revenues are goods and services ! given by the business to customers. Accounting for Non-Accountants by Dean Violeta V. Vicente 2 types of Sales:  Cash sales. The company receives cash from the customer. The company gives the customer goods and services.  Credit sales. The company receives a customer’s promise to pay in the future (account receivable). The company gives the customer goods or services. Accounting for Non-Accountants by Dean Violeta V. Vicente  Expenses are goods and services ! received by the business (debit). Accounting for Non-Accountants by Dean Violeta V. Vicente ENTITY CONCEPT The BUSINESS has a juridical personality separate and distinct from the OWNER(s). Accounting for Non-Accountants by Dean Violeta V. Vicente The ASSETS, LIABILITIES and PROPRIETORSHIP or EQUITY of the BUSINESS must be TREATED SEPARATELY from those of the OWNER. Accounting for Non-Accountants by Dean Violeta V. Vicente DRAWING  WITHDRAWAL of the OWNER of the ASSETS (cash, goods, fixed assets, etc.) from the BUSINESS for his PERSONAL USE (only for sole proprietor- ships & Accounting for Non-Accountants by Dean Violeta V. Vicente JOURNALIZING  Recording the increases and decreases in the assets, liabilities and proprietorship/equity in the original book of account called the JOURNAL. Accounting for Non-Accountants by Dean Violeta V. Vicente The Concept: Each party to a transaction RECEIVES something and GIVES or PARTS WITH something. Accounting for Non-Accountants by Dean Violeta V. Vicente A scale or balance was used to measure what was received and what was given or parted with. Even before the birth of Christ, evidence showed the existence of accounting system in Greece. Not until 1494, that an Italian monk wrote on the rules of double-entry bookkeeping (for every item received, another item is given or parted with. Accounting for Non-Accountants by Dean Violeta V. Vicente left hand right hand is used is used to to give or to receive part with. Accounting for Non-Accountants by Dean Violeta V. Vicente The T-account represents the scale. T-ACCOUNT RECEIVE GIVE The left side The right side of the of the account account records what is records what given or parted is received. with. Paid Earned Accounting for Non-Accountants by Dean Violeta V. Vicente Debit records what is received on the left side of the account. Credit records what is given or parted with on the right side of the account. Accounting for Non-Accountants by Dean Violeta V. Vicente  T-ACCOUNT DEBIT CREDIT left side right side RECEIVE GIVE Accounting for Non-Accountants by Dean Violeta V. Vicente If your company purchased a new computer for P50,000, your company would receive a computer COMPUTER DEBIT (RECEIVE) P50,000 Accounting for Non-Accountants by Dean Violeta V. Vicente  COMPUTER DEBIT (RECEIVE) P50,000 CASH CREDIT (GIVE) P50,000 Accounting for Non-Accountants by Dean Violeta V. Vicente  DEBIT Balance AssetsReceive Sheet resources Accounts with future benefit Income Expenses Receive Statement goods and Accounts services from suppliers and employees Accounting for Non-Accountants by Dean Violeta V. Vicente  CREDIT Balance Liabilities Give promise to Sheet pay in future Accounts Balance Stockholders’ Give common Sheet Equity stock to owners Accounts Income Revenue Give goods and Statement services to customers Account Accounting for Non-Accountants by Dean Violeta V. Vicente ACCOUNTING EQUATION Assets = Liabilities + Proprietorship/ Capital/Equity Accounting for Non-Accountants by Dean Violeta V. Vicente RULES OF DEBIT and CREDIT  DEBIT : increase in ASSET decrease in LIABILITY decrease in PROPRIETORSHIP  CREDIT: decrease in ASSET increase in LIABILITY increase in PROPRIETORSHIP Accounting for Non-Accountants by Dean Violeta V. Vicente USING DOUBLE-ENTRY ACCOUNTING TO RECORD TRANSACTONS  Source Documents Analyze business transactions by reviewing source documents. These include checks, invoices, and contracts Accounting for Non-Accountants by Dean Violeta V. Vicente APPLICATION of the RULES of DEBIT and CREDIT  INCREASE in ASSET & DECREASE in another ASSET  INCREASE in ASSET & INCREASE in LIABILITY  INCREASE in ASSET & INCREASE in PROPRIETORSHIP Accounting for Non-Accountants by Dean Violeta V. Vicente APPLICATION of the RULES of DEBIT and CREDIT  DECREASE in LIABILITY & DECREASE in ASSET  DECREASE in LIABILITY & INCREASE in another LIABILITY  DECREASE in PROPRIETORSHIP & DECREASE in ASSET (DRAWING) Accounting for Non-Accountants by Dean Violeta V. Vicente SAMPLE JOURNAL ENTRY  General Journal Record business transactions in the general journal. DATE ACCOUNT DEBIT CREDIT 20X4 Nov. 1 Cash 2,000 Common Stock 2,000 Accounting for Non-Accountants by Dean Violeta V. Vicente Accrual accounting attempts to measure economic consequences of operating activities during the period in which they occur. Accrual accounting records revenues when earned. Thus, revenue is generally recorded when the goods or services are provided to the customer. Accounting for Non-Accountants by Dean Violeta V. Vicente  Note: Cash may not be received at the ! same time that revenue is earned. Cash may be received:  before revenue is earned (unearned revenue). Unearned revenue is a liability because the business has an obligation to provided goods or services in the future. Accounting for Non-Accountants by Dean Violeta V. Vicente  Note: Cash may not be received at the ! same time that revenue is earned. Cash may be received:  at the same time revenue is earned (cash sale).  after revenue is earned (collection of accounts receivable) Accounting for Non-Accountants by Dean Violeta V. Vicente Revenue Revenue is recorded Recorded when revenue is earned (usually when goods or services are provided). Cash The company has a When goods are Received liability (obligation) later provided, Before to provide goods and revenue is then Goods are services in the recorded and the Provided future. liability removed. Liability  Revenue Accounting for Non-Accountants by Dean Violeta V. Vicente Cash Cash received at Received at the same time the Same Time good or service is Goods are provided is a Provided cash sale Cash Goods and Cash is received Received services are after goods or After Goods provided on services are are credit. provided. Provided Collection of Credit Sale Accounts Receivable Accounting for Non-Accountants by Dean Violeta V. Vicente Expenses are costs of providing goods or services to customers. Typical expenses for a business include:  advertising expense  salaries expense  utilities expense Accounting for Non-Accountants by Dean Violeta V. Vicente  Note: Cash may not be paid at the same time that an expense is incurred and ! recorded. Cash may be paid:  before an expense is incurred (an asset or prepaid item is recorded).  at the same time an expense is incurred.  after an expense is incurred (payment of accounts payable). Accounting for Non-Accountants by Dean Violeta V. Vicente Expense Expenses are expired costs Recorded of the period, matched with revenues of the period, regardless of when an actual cash payment is made. Accounting for Non-Accountants by Dean Violeta V. Vicente Cash Paid Cash paid before When the Before the expense is asset’s benefits Expense incurred is a expire, an is prepaid item. expense is Incurred Prepaid items, such recorded and as prepaid the asset insurance and reduced. office supplies, are Asset assets because  they have future Expense benefit Accounting for Non-Accountants by Dean Violeta V. Vicente Cash Paid at Cash paid at the same Same Time time the expense is Expense is incurred. Incurred Accounting for Non-Accountants by Dean Violeta V. Vicente Cash Paid Goods and Cash is Paid After services are after the Expense purchased on expense is is credit. incurred. Incurred Payment of The company Accounts has an obligation Payable to pay later. A liability, such as Accounts Payable, is recorded. Accounting for Non-Accountants by Dean Violeta V. Vicente Posting  The process of summarizing by entering the journalized transactions and events from the Journal to the ledger.  Every item/account in the Balance Sheet and in the Income Statement has its own ledger account. Accounting for Non-Accountants by Dean Violeta V. Vicente Posting  The debit entries in the Journal are posted on the debit side of the particular account in the ledger.  Likewise, the credit entries in the Journal are posted on the credit side of the particular account in the ledger. Accounting for Non-Accountants by Dean Violeta V. Vicente 5 Classifications of Accounts  Assets  Liabilities  Stockholders’ equity  Revenues  Expenses Accounting for Non-Accountants by Dean Violeta V. Vicente An account is a summary device in Accounting. It is a detailed record of increases, decreases, balances of each element in financial statements. Accounting for Non-Accountants by Dean Violeta V. Vicente Case 1. Owner invested cash, P70,000; supplies, P60,000; delivery van, P120,000; and equipment and furniture, P35,000. Services rendered: for cash, P15,000; on account, P20,000. Accounting for Non-Accountants by Dean Violeta V. Vicente Case2. Common shares sold for cash, P70,000; inventory, P60,000; delivery van, P120,000 and furniture, P35,000 received from investors. Sold goods: cash, P15,000; on account, P20,000. Accounting for Non-Accountants by Dean Violeta V. Vicente Chart of Accounts Assets 101 Cash 105 Accounts Receivable 113 Office Supplies 114 Prepaid Insurance 121 Office Building 122 Accumulated Depreciation: Building 123 Office Equipment 124 Accumulated Depreciation: Office Equipment Accounting for Non-Accountants by Dean Violeta V. Vicente Liabilities 205 Accounts Payable 210 Interest Payable 211 Salaries Payable 220 Notes Payable 230 Mortgage Payable Accounting for Non-Accountants by Dean Violeta V. Vicente Stockholders’ Equity 301 Common Stock 310 Retained Earnings Revenue 410 Travel Revenue Accounting for Non-Accountants by Dean Violeta V. Vicente Expenses 510 Airline Expense 511 Hotel Expense 513 Office Supplies Expense 514 Insurance Expense 522 Depreciation Expense: Building 524 Depreciation Expense: Office Equipment 533 Salaries Expense 534 Utilities Expense 535 Advertising Expense 540 Interest Expense Accounting for Non-Accountants by Dean Violeta V. Vicente Case 3. Based on the chart of accounts given, a) what is the order of listing of account titles to be used by the business? b) what are the first few assets listed in the chart of accounts? c) what do you think is the type of business this enterprise is in? d) how will the ledger of the business be opened? One ledger for all assets? Accounting for Non-Accountants by Dean Violeta V. Vicente TRIAL BALANCE The trial balance is a list of accounts and the account balances at a particular date. What is the source of this trial balance? Accounting for Non-Accountants by Dean Violeta V. Vicente TRIAL BALANCE ACCOUNT DEBIT CREDIT Cash P 2,000 Accounts Receivable 3,000 Supplies 1,000 Prepaid Insurance 1,000 Computer 2,000 Accounts Payable P 1,000 Common Stock 4,000 Revenue 5,000 Salaries Expense 1,000 Total P 10,000 P 10,000 Accounting for Non-Accountants by Dean Violeta V. Vicente Case 4 Based on the trial balance answer the following questions. A) how much is total current assets & total noncurrent assets? B) how much is total current & total noncurrent liabilities? C) how much is net income? Prepare the balance sheet. Accounting for Non-Accountants by Dean Violeta V. Vicente Adjusting entries  journal entries made at the end of the accounting period  to show the appropriate amounts in the accounts Accounting for Non-Accountants by Dean Violeta V. Vicente Types of adjusting entries: Depreciation Prepaid items Accrued expenses Accounting for Non-Accountants by Dean Violeta V. Vicente  Depreciation: allocation of long lived asset’s cost to the periods when used.  Methods of Depreciation DATE ACCOUNT DEBIT CREDIT 20X4 Dep’n Expense ? Accum. Dep’n ? Accounting for Non-Accountants by Dean Violeta V. Vicente  Prepaid items: asset with future benefit  Prepaid Insurance and Office Supplies DATE ACCOUNT DEBIT CREDIT 20X4 Insurance Expense ? Prepaid Insurance ? Accounting for Non-Accountants by Dean Violeta V. Vicente  Accrued expenses: expenses incurred, but not yet recorded or paid  Interest and Salaries DATE ACCOUNT DEBIT CREDIT 20X4 Salaries ? Salaries Payable ? Accounting for Non-Accountants by Dean Violeta V. Vicente HOMEWORK... Given the additional information below, adjust the previously shown trial balance. See the exercise materials for the forms Additional information…  Estimated uncollectible accounts, 1% of accounts receivable  P750 of supplies remain unused.  80% of prepaid insurance has expired Accounting for Non-Accountants by Dean Violeta V. Vicente  Additional information…  Estimated useful life of computer is 4 years without salvage value  P100 of revenue collected will be earned next year.  Accrued salaries P200  Prepare the adjusted trial balance. Accounting for Non-Accountants by Dean Violeta V. Vicente DAY ONE EXERCISES Refer to your materials for the exercises and the forms for the homework Accounting for Non-Accountants by Dean Violeta V. Vicente Day Two Accounting for Non-Accountants by Dean Violeta V. Vicente ADJUSTED TRIAL BALANCE  Includes year-end adjustments  List of accounts and account balances after adjusting entries have been posted to the accounts Accounting for Non-Accountants by Dean Violeta V. Vicente WORKSHEET The adjusting entries are first shown in a worksheet before they are formally recorded in the journal. A portion of the worksheet, showing the adjusted trial balance, will appear as follows: Accounting for Non-Accountants by Dean Violeta V. Vicente  Trial Balance (TB) Adjust. Adjusted Trial Balance ACCOUNT Dr. Cr. Dr. (Cr.) Dr. Cr. P 2,000 Cash P 2,000 Accts. Rec’l 3,000 3,000 Supplies 1,000 750 (2) (250) Prep. Ins. 200 1,000 (3) (800) Computer 2,000 2,000 Accts. Pay’l P 1,000 P 1,000 Com. Stock 4,000 4,000 5,000 (5) 100 Revenue 4,900 (6) 200 Sal. Exp. 1,000 1,200 Total P 10,000 P 10,000 (1) 30 Loss on Bad Debts 30 Allowance for Bad Debts Expense (1) (30) 30 Supplies Expense (2) 250 250 800 (3) 800 Insurance Expense Accounting for Non-Accountants by Dean Violeta V. Vicente  Trial Balance (TB) Adjust. Adjusted Trial Balance ACCOUNT Dr. Cr. Dr. (Cr.) Dr. Cr. (4) 500 Depreciation Expense 500 Accumulated Depreciation (4) (500) 500 Unearned Revenue (5) (100) 100 (6) (200) Salaries Payable 200 Total P 10,730 P 10,730 From the worksheet where the accounts already show adjusted balances, the income statement and the balance sheet can be prepared. Accounting for Non-Accountants by Dean Violeta V. Vicente Adjusted accounts were: Supplies Prepaid insurance Revenue Salary expense New accounts added were: Loss on Bad Debts Allowance for Bad Debts Supplies Expense Insurance Expense Accounting for Non-Accountants by Dean Violeta V. Vicente  Balance Sheet Assets: Cash 2,000 Accounts Receivable 3,000 Less: Allowance for Bad Debts 30 2,970 Supplies 750 Prepaid Insurance 200 Total Current 5,920 Assets Computer 2,000 Less:Accumulated Depreciation 500 1,500 Total Assets 7,420 Accounting for Non-Accountants by Dean Violeta V. Vicente  Balance Sheet Liabilities: Accounts Payable 1,000 Unearned Revenue 100 Salaries Payable 200 Total Liabilities 1,300 Stockholders’ Equity: Common Stock 4,000 Retained earnings 2,120 Total Stockholders’ Equity 6,120 Total Liabilities and Stockholders’ Equity 7,420 Accounting for Non-Accountants by Dean Violeta V. Vicente  Income Statement Revenues 4,900 Expenses: Salaries Expense 1,200 Supplies Expense 250 Insurance Expense 800 Depreciation Expense: Computer 500 Loss on Bad Debts 30 Total Expenses 2,780 Income 2,120 Accounting for Non-Accountants by Dean Violeta V. Vicente Financial statements are financial reports that list accounts and the balances. These reports are given to stockholders, creditors, and managers.  balance sheet  income 3 Financial statements statement  statement of cash flows Accounting for Non-Accountants by Dean Violeta V. Vicente The balance sheet lists:  Assets  Liabilities  Stockholders’ equity Accounting for Non-Accountants by Dean Violeta V. Vicente The accounting equation expresses the relationship of these 3 types of accounts: Assets = Liabilities + Stockholders’ Equity The accounting equation must balance, thus the name—balance sheet. Accounting for Non-Accountants by Dean Violeta V. Vicente A BALANCE SHEET may be in an account form or report from. An ACCOUNT FORM shows ASSETS on the left side and LIABILITIES and CAPITAL/STOCKHOLDERS’ EQUITY on the right side. Assets Liabilities Capital/ Stockholders’ Equity Accounting for Non-Accountants by Dean Violeta V. Vicente A REPORT FORM shows ASSETS first followed by LIABILITIES and CAPITAL/STOCKHOLDERS’ EQUITY in one listing. Assets Liabilities Capital/Stockholders’ Equity Accounting for Non-Accountants by Dean Violeta V. Vicente The income statement lists:  revenues  expenses Cash Flow Statement shows 3 items:  from operating activities  from investing activities  from financing activities Accounting for Non-Accountants by Dean Violeta V. Vicente Complete Set of Financial Statements Balance Sheet reflects as of a given date, the assets, liabilities, and equity of the business enterprise. Accounting for Non-Accountants by Dean Violeta V. Vicente Income Statement reports the results of operations or performance of an entity for a given period of time - one year. The results of various economic events in the owner’s equity: increases – revenues; decreases - expenses. Accounting for Non-Accountants by Dean Violeta V. Vicente Net Income = Revenue - Expenses This is the base in determining the performance of the business entity. Accounting for Non-Accountants by Dean Violeta V. Vicente  Statement of Cash Flows reports for a certain interval the amount of cash generated or consumed. 3 types of business activities:  Operating NO ESTIMATES  Financing EVERYTHING  Investing FACTUAL Accounting for Non-Accountants by Dean Violeta V. Vicente Statements of Changes in Equity reports changes in stockholders’ equity. Factors for Changes:  Issuance of additional shares of stock;  Net income earned during the period; Accounting for Non-Accountants by Dean Violeta V. Vicente Factors for Changes (Cont’d):  Dividends declared by the board of directors; and  Other increases from appraisal of depreciable assets and unrealized gain or loss on equity securities. Accounting for Non-Accountants by Dean Violeta V. Vicente Notes to Financial Statements Outline the accounting policies, estimates, and judgments as well as details about the items found in the body of the financial statements. Accounting for Non-Accountants by Dean Violeta V. Vicente ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY Current: Current: Cash Accounts Common Credit Card Payable Stock Receivable Accrued Retained Accounts Expenses Earnings Receivable Notes Payable Marketable Securities Inventories Prepaid Expenses Accounting for Non-Accountants by Dean Violeta V. Vicente ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY Non-current: Non-current: Land and Mortgage Building Payable Machinery and Equipment China, Glass , Silver, Linen and Uniform Accounting for Non-Accountants by Dean Violeta V. Vicente Annual Report Contents:  Four basic financial statements  Notes to the financial statements  Summary of accounting methods  Management’s discussion and analysis of financial statements  Auditor’s report  Comparative financial data for a series of years Accounting for Non-Accountants by Dean Violeta V. Vicente Common-size Statements  Shows all items as percentages of the key or base amount  Facilitates financial statement comparison among companies of different sizes  Improves user’s ability to assess company performance against industry averages as well as performance over time Accounting for Non-Accountants by Dean Violeta V. Vicente DAY TWO EXERCISES Refer to your materials for the exercises Accounting for Non-Accountants by Dean Violeta V. Vicente UNDERSTANDING FINANCIAL STATEMENTS Accounting for Non-Accountants by Dean Violeta V. Vicente Financial performance analysis can be useful for many purposes. 7 Purposes by Sollenberger and Schneider :  to set goals and targets  to compare the firm’s performance to others  to measure financial strength for credit granting purposes Accounting for Non-Accountants by Dean Violeta V. Vicente 7 Purposes (Cont’d):  to measure profitability  to spot trends, weaknesses, and potential problem areas  to evaluate alternative courses of action  to understand interactions that financial changes have on a firm’s financial position Accounting for Non-Accountants by Dean Violeta V. Vicente Financial statement analysis  grouped into 4 categories: 1. Comparative statements 2. Percentage composition statements 3. Base year comparison 4. Ratio analysis. Accounting for Non-Accountants by Dean Violeta V. Vicente Techniques and Tools in Analyzing Financial Statements: Horizontal analysis determines how each item in the balance sheet or income statement has changed by comparing the current year’s balance with that of the preceding year or base year. Accounting for Non-Accountants by Dean Violeta V. Vicente When financial data for year 20X2 are compared with those of year 20X1, horizontal analysis takes place. Increases and decreases in pesos and percentages could be computed and therefore 20X1 data are used as base to arrive at percentage increase or decrease. Accounting for Non-Accountants by Dean Violeta V. Vicente 20X2 data may also be compared with those of other firms belonging to the same industry or with industry averages. Industry averages could be obtained from industry bodies or statistical data compiled by trade organizations. Accounting for Non-Accountants by Dean Violeta V. Vicente  M odel C om pany C o m p a r a tiv e C o n d e n s e d B a la n c e S h e e t D ecem ber 31, 20X2 and 20X1 In c r e a s e (D e c re a s e ) 20X 2 20X 1 Am ount % A s s e ts : C u rre n t a s s e ts P 6 0 0 ,0 0 0 P 4 5 0 ,0 0 0 P 1 5 0 ,0 0 0 33% N o n -c u rre n t a s s e ts 7 0 0 ,0 0 0 5 5 0 ,0 0 0 1 5 0 ,0 0 0 27% T o ta l A s s e ts P 1 ,3 0 0 ,0 0 0 P 1 ,0 0 0 ,0 0 0 P 3 0 0 ,0 0 0 30% L ia b ilitie s a n d S to c k h o ld e r s ’ E q u ity C u r r e n t lia b ilitie s P 2 5 0 ,0 0 0 P 2 0 0 ,0 0 0 P 5 0 ,0 0 0 25% N o n -c u r r e n t lia b ilitie s 2 0 0 ,0 0 0 2 5 0 ,0 0 0 (5 0 ,0 0 0 ) 20% T o t a l lia b ilitie s P 4 5 0 ,0 0 0 P 4 5 0 ,0 0 0 P - - C o m m o n s to c k P 5 0 0 ,0 0 0 P 5 0 0 ,0 0 0 P - - R e t a in e d e a r n in g s 3 5 0 ,0 0 0 5 0 ,0 0 0 3 0 0 ,0 0 0 600% T o t a l s to c k h o ld e r s ’ e q u ity P 8 5 0 ,0 0 0 P 5 5 0 ,0 0 0 P 3 0 0 ,0 0 0 54% T o t a l L ia b ilitie s a n d S to c k h o ld e r s ’ E q u ity P 1 ,3 0 0 ,0 0 0 P 1 ,0 0 0 ,0 0 0 P 3 0 0 ,0 0 0 30% Accounting for Non-Accountants by Dean Violeta V. Vicente  M odel C om pany C o m p a ra tiv e S c h e d u le o f C u r re n t A s s e ts D ecem ber 31, 20X2 and 20X1 In c re a s e (D e c re a s e ) 20X2 20X1 Am ount P e rc e n t C ash P 9 0 ,0 0 0 P 5 0 ,0 0 0 P 4 0 ,0 0 0 80% A c c o u n ts re c e iv a b le , n e t o f a llo w a n c e 2 2 0 ,0 0 0 1 1 0 ,0 0 0 1 1 0 ,0 0 0 100% M e rc h a n d is e in v e n to ry 2 8 0 ,0 0 0 2 8 2 ,0 0 0 (2 ,0 0 0 ) (1 % ) P re p a id e x p e n s e s 1 0 ,0 0 0 8 ,0 0 0 2 ,0 0 0 25% T o ta l C u rre n t A s s e ts P 6 0 0 ,0 0 0 P 4 5 0 ,0 0 0 P 1 5 0 ,0 0 0 33% Accounting for Non-Accountants by Dean Violeta V. Vicente  M odel C om pany C o m p a r a t i v e In c o m e S t a t e m e n t F o r th e Y e a rs E n d e d , D e c e m b e r 3 1 , 2 0 X 2 a n d 2 0 X 1 In c r e a s e ( D e c r e a s e ) 20X2 20X1 Am ount % S a le s P 1 , 5 0 0 ,0 0 0 P 1 , 2 0 0 ,0 0 0 P 3 0 0 , 0 0 0 20% S a l e s r e t u r n s a n d a ll o w a n c e s 3 0 ,0 0 0 3 5 ,0 0 0 ( 5 ,0 0 0 ) (1 4 % ) N e t S a le s P 1 , 4 7 0 ,0 0 0 P 1 , 1 6 5 ,0 0 0 P 3 0 5 , 0 0 0 26% C o s t o f g o o d s s o ld P 1 , 0 0 0 ,0 0 0 P 8 5 0 ,0 0 0 P 1 5 0 ,0 0 0 17% G r o s s p r o fi t o n s a le s 4 7 0 ,0 0 0 3 1 5 ,0 0 0 1 5 5 ,0 0 0 49% M a rk e tin g e x p e n s e s P 1 2 0 ,0 0 0 P 1 0 0 ,0 0 0 P 2 0 ,0 0 0 20% A d m in is tr a tiv e e x p e n s e s 1 8 0 ,0 0 0 1 5 0 ,0 0 0 3 0 ,0 0 0 20% T o ta l o p e ra tin g e x p e n s e s P 3 0 0 ,0 0 0 P 2 5 0 ,0 0 0 P 5 0 ,0 0 0 20% O p e r a tin g In c o m e P 1 7 0 ,0 0 0 P 6 5 ,0 0 0 P 1 0 5 ,0 0 0 162% R e n t a l in c o m e 2 0 ,0 0 0 5 ,0 0 0 1 5 ,0 0 0 300% In te re s t e x p e n s e 1 0 ,0 0 0 2 0 ,0 0 0 ( 1 0 ,0 0 0 ) 50% N e t In c o m e P 1 8 0 ,0 0 0 P 5 0 ,0 0 0 P 1 3 0 ,0 0 0 260% Accounting for Non-Accountants by Dean Violeta V. Vicente  M odel C om pany C o m p a r a t iv e S t a t e m e n t o f C o s t o f G o o d s S o l d F o r th e Y e a r E n d e d , D e c e m b e r 3 1 , 2 0 X 2 a n d 2 0 X 1 In c r e a s e ( D e c r e a s e ) 20X 2 20X 1 A m o u n t P ercen t M e r c h a n d is e in v e n t o r y , Jan u ary 1 P 2 8 2 ,0 0 0 P 2 3 2 ,0 0 0 P 5 0 ,0 0 0 2 1.6 % P u rch ases 9 9 8 ,0 0 0 9 0 0 ,0 0 0 9 8 ,0 0 0 1 0.9 % M e r c h a n d is e a v a ila b le f o r s a le P 1 ,2 8 0 , 0 0 0 P 1 ,1 3 2 , 0 0 0 P 1 4 8 ,0 0 0 1 3.0 7 % M e r c h a n d is e in v e n t o r y , D ecem ber 31 2 8 0 ,0 0 0 2 8 2 ,0 0 0 ( 2 ,0 0 0 ).0 1 % C o s t o f G o o d s S o ld P 1 ,0 0 0 , 0 0 0 P 8 5 0 ,0 0 0 P 1 5 0 ,0 0 0 1 7.6 5 % Accounting for Non-Accountants by Dean Violeta V. Vicente Trend Percentages:  Specialized form of horizontal analysis  shows trend of financial statement items over longer time periods such as 5 - 10 yrs.  Base year (earliest year in the time series) is set at 100%  All other years expressed as % of base year Using Aboitiz I/S compute the trend % Accounting for Non-Accountants by Dean Violeta V. Vicente Vertical analysis: relationship of component parts to the total in a single statement Examples: cash to total current assets or current assets to total assets shown as percentages, the total figure being the denominator. Accounting for Non-Accountants by Dean Violeta V. Vicente Vertical Analysis:  Compares each item on the F/S to a key or base item, the peso amount always set 100%  I/S: Net sales = 100%;B/S: Total assets = 100%  Once the statement items are converted into % of the base item (common-size statements), comparison of 1 company against another can be done Accounting for Non-Accountants by Dean Violeta V. Vicente Financial Statements = condensed NOTES TO F/S :  give details in schedules  support the main or principal figure Forms: statement of cost of goods sold, schedule of current assets and non-current assets, current liabilities and non-current liabilities, and operating expenses. Accounting for Non-Accountants by Dean Violeta V. Vicente Horizontal and Vertical analyses illustrated starting with the comparative balance sheet followed by the schedule of current assets, after which same analysis is made on the comparative income statement and the statement of cost of goods sold of the Model Company for years 20X2 and 20X1. Accounting for Non-Accountants by Dean Violeta V. Vicente  M odel C om pany C o m p a r a tiv e B a la n c e S h e e t D ecem ber 31, 20X2 and 20X1 P e rc e n ta g e s 20X 2 20X 1 20X 2 20X 1 A s s e ts C u rre n t a s s e ts P 6 0 0 ,0 0 0 P 4 5 0 ,0 0 0 4 6.2 % 45% N o n -c u rre n t a s s e ts 7 0 0 ,0 0 0 5 5 0 ,0 0 0 5 3.8 % 55% T o ta l A s s e ts P 1 ,3 0 0 ,0 0 0 P 1 ,0 0 0 ,0 0 0 100% 100% L ia b ilitie s a n d S to c k h o ld e r s ’ E q u ity C u r r e n t lia b ilitie s P 2 5 0 ,0 0 0 P 2 0 0 ,0 0 0 1 9.2 3 % 20% N o n -c u r r e n t lia b ilitie s 2 0 0 ,0 0 0 2 5 0 ,0 0 0 1 5.3 9 % 25% T o t a l lia b ilitie s P 4 5 0 ,0 0 0 P 4 5 0 ,0 0 0 3 4.6 2 % 45% C o m m o n s to c k P 5 0 0 ,0 0 0 P 5 0 0 ,0 0 0 3 8.4 6 % 50% R e t a in e d e a r n in g s 3 5 0 ,0 0 0 5 0 ,0 0 0 2 6.9 2 % 5% T o t a l s to c k h o ld e r s ’ e q u ity P 8 5 0 ,0 0 0 P 5 5 0 ,0 0 0 6 5.3 8 % 55% T o t a l L ia b ilitie s a n d S t o c k h o ld e r s ’ e q u ity P 1 ,3 0 0 ,0 0 0 P 1 ,0 0 0 ,0 0 0 100% 100% Accounting for Non-Accountants by Dean Violeta V. Vicente  M odel C om pany C o m p a r a tiv e S c h e d u le o f C u r r e n t A s s e ts D ecem ber 31, 20X2 and 20X1 P e rc e n ta g e s 20X 2 20X 1 20X 2 20X 1 C ash P 9 0 ,0 0 0 P 5 0 ,0 0 0 1 5.0 0 % 1 1.1 1 % A c c o u n ts r e c e iv a b le , n e t o f a llo w a n c e 2 2 0 ,0 0 0 1 1 0 ,0 0 0 3 6.6 7 % 2 4.4 4 % M e r c h a n d is e in v e n t o r y 2 8 0 ,0 0 0 2 8 2 ,0 0 0 4 6.6 7 % 6 2.6 7 % P re p a id e x p e n s e s 1 0 ,0 0 0 8 ,0 0 0 1.6 6 % 1.7 8 % T o ta l c u rre n t a s s e ts P 6 0 0 ,0 0 0 P 4 5 0 ,0 0 0 100% 100% Accounting for Non-Accountants by Dean Violeta V. Vicente  M odel C om pany C o m p a r a tiv e In c o m e S t a te m e n t F o r th e Y e a r E n d e d , D e c e m b e r 3 1 , 2 0 X 2 a n d 2 0 X 1 20X 2 20X 1 20X 2 20X 1 S a le s P 1 ,5 0 0 ,0 0 0 P 1 ,2 0 0 ,0 0 0 102% 103% S a le s r e tu r n s a n d a llo w a n c e s 3 0 ,0 0 0 3 5 ,0 0 0 2% 3% N e t s a le s P 1 ,4 7 0 ,0 0 0 P 1 ,1 6 5 ,0 0 0 100% 100% N e t s a le s P 1 ,4 7 0 ,0 0 0 P 1 ,1 6 5 ,0 0 0 100% 100% C o s t o f m e r c h a n d is e s o ld 1 ,0 0 0 ,0 0 0 8 5 0 ,0 0 0 68% 73% G r o s s p r o fi t o n s a l e s P 4 7 0 ,0 0 0 P 3 1 5 ,0 0 0 32% 27% M a r k e tin g e x p e n s e s 1 2 0 ,0 0 0 1 0 0 ,0 0 0 8.1 6 % 8.6 % A d m in is tr a tiv e e x p e n s e s 1 8 0 ,0 0 0 1 5 0 ,0 0 0 1 2.2 4 % 1 2.8 % T o t a l o p e r a tin g e x p e n s e s P 3 0 0 ,0 0 0 P 2 5 0 ,0 0 0 2 0.4 % 2 1.4 % O p e r a tin g in c o m e P 1 7 0 ,0 0 0 P 6 5 ,0 0 0 1 1.6 % 5.6 % R e n ta l in c o m e 2 0 ,0 0 0 5 ,0 0 0 1.3 %.4 % In te r e s t e x p e n s e 1 0 ,0 0 0 2 0 ,0 0 0.7 % 1.7 % N e t In c o m e P 1 8 0 ,0 0 0 P 5 0 ,0 0 0 1 2.2 % 4.3 % Accounting for Non-Accountants by Dean Violeta V. Vicente  M odel C om pany C o m p a r a tiv e S ta te m e n t o f C o s t o f M e r c h a n d is e S o ld F o r th e Y e a r E n d e d , D e c e m b e r 3 1 , 2 0 X 2 a n d 2 0 X 1 P e r c e n ta g e 20X 2 20X 1 20X 2 20X 1 M e r c h a n d is e in v e n t o r y , P 2 8 2 ,0 0 0 P 2 3 2 ,0 0 0 2 8.2 % 2 7.3 % Jan u ary 1 P u rch ases 9 9 8 ,0 0 0 9 0 0 ,0 0 0 9 9.8 % 1 0 5.9 % M e r c h a n d is e a v a ila b le fo r s a le P 1 ,2 8 0 ,0 0 0 P 1 ,1 3 2 ,0 0 0 1 2 8 % 1 3 3.2 % M e r c h a n d is e in v e n t o r y , D ecem ber 31 8 0 ,0 0 0 2 8 2 ,0 0 0 28% 3 3.2 % C o s t o f M e r c h a n d is e S o ld P 1 ,0 0 0 ,0 0 0 P 8 5 0 ,0 0 0 100% 100% Accounting for Non-Accountants by Dean Violeta V. Vicente  Base year comparison base period at 100% and expresses amounts in other periods as percentages of the base year. In income statement analysis, three years (20X0, 20X1, 20X2) may be compared, where 20X0 data are used as base figures. Accounting for Non-Accountants by Dean Violeta V. Vicente Benchmarking against industry average:  Benchmarking - the process of comparing a company’s activities to a standard of excellence achieved by industry leaders  Using common-size statements compare with industry leader’s statements to determine difference  Design and implement business processes to bring financial results in line with benchmark entities Accounting for Non-Accountants by Dean Violeta V. Vicente CFS in decision making:  Cash flow statements summarizes sources and uses of entity’s cash flows - esp. from operating activities  Company cannot stay in business for long if it cannot generate enough cash from operations to cover operating expenses  While borrowing and investing activities provide cash for business use, long-term reliance on these for sources of cash is not advised Accounting for Non-Accountants by Dean Violeta V. Vicente Ratio analysis  one variable is selected to be the numerator and another variable as the denominator. It is a relationship of two values. Accounting for Non-Accountants by Dean Violeta V. Vicente Ratios for decision making:  Ratios permit users to calculate a variety of financial comparisons - vs. prior year’s financial results; industry ave.; benchmark entities’ ratios  Ratios measure the ability to:  pay current liabilities  sell inventory & collect receivables  pay long-term debt  generate profits from operations  sustain shareholder wealth Accounting for Non-Accountants by Dean Violeta V. Vicente Ratios  expressed in terms of percentage (10%), ratio (2:1) or merely a number 38, numerator from income statement and denominator from the balance sheet of the same period. Accounting for Non-Accountants by Dean Violeta V. Vicente Rules to remember: balance sheet is for a point in time (as of) and the income statement is for a time period (for period ended) Accounting for Non-Accountants by Dean Violeta V. Vicente Rules: 1.Should be from the same balance sheet. 2.When balance sheet data and income statement data are used in a ratio, the balance sheet data should be an average for a time period similar to the income statement data. Accounting for Non-Accountants by Dean Violeta V. Vicente 3.Generally, days in a year is 360; weeks in a year = 52 or 12 months; days in a month = 30. 4.Analysts should be consistent in the use of definitions and accounting rules. Price level changes from year to year is considered insignificant unless the contrary exists. Accounting for Non-Accountants by Dean Violeta V. Vicente Commonly used ratios:  Liquidity ratios  Profitability ratios  Activity ratios  Debt ratios  Market ratios Accounting for Non-Accountants by Dean Violeta V. Vicente Liquidity ratios  current ratio or banker’s ratio and quick ratio or acid test ratio. current assets or quick assets current liabilities Accounting for Non-Accountants by Dean Violeta V. Vicente Quick assets: current assets in the form of cash, receivables, and marketable securities. DO NOT INCLUDE: inventory and prepaid expenses Accounting for Non-Accountants by Dean Violeta V. Vicente Inventories  have to be sold or will pass accounts receivable before they are converted into cash. Prepaid expenses  will be used during the next accounting period and not converted into cash. Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis a. current ratio ability to cover at least 2:1 short-term debt as should not it becomes due be above 4 b. quick ratio expresses degree at least 1:1 to which a firm’s current debts are covered by the most liquid current assets Accounting for Non-Accountants by Dean Violeta V. Vicente Measuring PROFITABILITY  Analysts, creditors and investors pay close attention to ratios that assess the ability to generate profit and operate efficiently  Commonly used profitability ratios:  Return on sales  Return on assets (investment)  Return on equity (investment)  Earnings per share Accounting for Non-Accountants by Dean Violeta V. Vicente Return on sales:  Relationship between net income and net sales; the % of each net sale earned as net income  measures management’s efficiency and effectiveness in company operations  high rate shows that more net sales peso goes to net income instead of covering expenses Accounting for Non-Accountants by Dean Violeta V. Vicente Return on assets:  Measures the company’s success in generating income from its available resources  ratio of the return to the creditors and investors that provide financing to the company  assets are financed by 2 sources:  Investors (equity)  Creditors (debt)  Interest expense is added back to NI Accounting for Non-Accountants by Dean Violeta V. Vicente Return on equity:  Relationship between NI available to common stockholders and the equity they provide  measures the success in using stockholders’ investment to generate NI  Deduct preferred dividends from NI (numerator) and use common contributed capital and retained earnings as denominator Accounting for Non-Accountants by Dean Violeta V. Vicente Profitability ratios  gross profit margin, net operating profit margin, and net profit margin: Denominator = year’s net sales from the income statement  return on assets and return on equity: Numerator = Net Profit Accounting for Non-Accountants by Dean Violeta V. Vicente Denominator = Average Assets or Average Equity Average assets for the year: assets, beg. + assets,end 2 Average equity: equity, beg. + equity, end 2 Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis a. gross profit amount of gross industry margin profit generated per average peso of sales b. operating amount of profit industry profit margin from operations average generated from peso of sales c. net profit amount of after tax industry margin profit per peso of average sales Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis d.return on measure of = or higher investment management’s overall than market performance in return on “T” generating profit bills e.return on rate of return on higher than equity stockholders’ ROI investment in the firm. This is a measure of management’s performance in generating profit for the owners Accounting for Non-Accountants by Dean Violeta V. Vicente Activity ratios  total asset turnover or fixed asset turnover, net sales as numerator, and averages of total assets or fixed assets as denominator.  Inventory turnover : cost of goods sold average inventory Accounting for Non-Accountants by Dean Violeta V. Vicente  Average collection period: average accounts receivable (net sales/360)  Average payment period: accounts payable (cost of goods sold/360) Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis a. average average collection = to or less collection period for accounts than credit period receivable period b. average average payment = to credit payment period for accounts period period payable c. inventory indicates liquidity industry turnover or activity of average inventory Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis d. total asset indicates how industry turnover efficiently the firm average is utilizing its assets to generate sales e. fixed asset extent to which high value turnover fixed assets are means used in productive generating sales use Accounting for Non-Accountants by Dean Violeta V. Vicente Debt ratios  based on the balance sheet data.  total liabilities / total assets  long-term debt / stockholders’ equity  total liabilities / capital  short-term liabilities / total debt Accounting for Non-Accountants by Dean Violeta V. Vicente Times interest earned  shows that results of operations are enough to pay interest expense.  net income before interest and taxes / interest expense. Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis a.debt to extent to which funds are industry assets provided by creditors average b.long-term extent to which funds are 40:60 debt to provided on a long-term historical equity basis by creditors versus norm owners c.debt to percent of firm’s industry capital capitalization package average that is made up of long- term debt Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis d.short-term percentage of total debt industry liabilities to borrowed from short- average total debt term creditors e.times extent to which earnings at least 2:1 interest can decline without the earned firm becoming unable to meet its interest expense; provides a measure of the degree of security afforded bondholders. Accounting for Non-Accountants by Dean Violeta V. Vicente Analyzing COMPANY STOCK as investment:  Investors expect to receive 2 types of returns on their investment in a corporation’s common stock: gains earned upon sale of co. stock periodic dividends paid by the co. to its stockholders Accounting for Non-Accountants by Dean Violeta V. Vicente Market ratios  performance compared to other firms in same industry or industry averages. Earnings per share: net income outstanding shares Dividend yield: dividend per share average market price per share Accounting for Non-Accountants by Dean Violeta V. Vicente Price earnings ratio: market price earnings per share Book value per share: stockholders’ equity allocated to the class of stock outstanding shares of such class of stock Accounting for Non-Accountants by Dean Violeta V. Vicente Dividend payout: dividends per share net income Price to book value: price per share book value per share. Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis a. earnings per net income per industry share share available to average common stockholders b. dividend percentage of net growth firms payout earnings paid out have low to common payout ratios stockholders Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis c. dividend yield shows rate of industry return. average Stockholders will receive from their investment in the short run d. price/earning a measure of high value if ratio current price of firm is stock to earnings growing or per share stable Accounting for Non-Accountants by Dean Violeta V. Vicente  Interpretations Basis e. book value indicates amount per none per share common share available to stockholders if firm’s assets are sold and liabilities are paid off f. price to amount stockholders are none book value willing to pay for each peso of common stock book value Accounting for Non-Accountants by Dean Violeta V. Vicente LIMITATIONS  No one ratio or year’s worth of financial information should be relied upon to provide a complete assessment of a corporation’s financial condition  Analyst should:  examine trends over time  benchmark to industry & key competitors  seek answers about why ratios are different Accounting for Non-Accountants by Dean Violeta V. Vicente Complexity in Business Decisions... Business environment is complicated by numerous local, regional, national, and global issues which must all be considered when evaluating current financial condition or forecasting future potential for income Accounting for Non-Accountants by Dean Violeta V. Vicente Cost Volume Profit Analysis  systematic examination of the relationship among costs, activity levels or volume, and profit. Classification of cost depends on management’s need for cost information. Accounting for Non-Accountants by Dean Violeta V. Vicente Costs classification: a. By function - (e.g. manufacturing)  Materials  Labor  Factory overhead Accounting for Non-Accountants by Dean Violeta V. Vicente b.By behavior  changes based on activity level, such as production or sales, volume, labor or machine hours. Example:  Fixed costs  Semi-variable costs  Variable costs  Semi-fixed costs  Mixed costs Accounting for Non-Accountants by Dean Violeta V. Vicente Break-even Analysis  focuses on break-even sales, which is that point of activity level (sales volume) where total revenues equal total costs (or expenses), there is neither profit nor loss. Accounting for Non-Accountants by Dean Violeta V. Vicente Break even point can be computed using 3 methods: 1.Algebraic method 2.Contribution margin method 3.Graphic approach Accounting for Non-Accountants by Dean Violeta V. Vicente Algebraic Method Example: Sample Co. produces and sells toothpaste. The variable costs to produce and sell one 50 mg. tube of toothpaste is P4.00, while the total fixed manufacturing, selling and administrative costs per period is P12,000.00. The 50 mg. of toothpaste is sold at P10.00. Determine the break-even sales in units and in pesos. Accounting for Non-Accountants by Dean Violeta V. Vicente Since the variable costing income statement is expressed as : Sales (10/tube) P 30,000 Less: variable costs (P4) 12,000 Contribution margin (P6) P 18,000 Less: fixed costs 12,000 Profit P 6,000 or Profit = Sales - Variable costs - Fixed costs Accounting for Non-Accountants by Dean Violeta V. Vicente To transpose variable costs and fixed cost to other side, the equation will appear as follows: Sales = Variable Costs + Fixed Costs + Profit Accounting for Non-Accountants by Dean Violeta V. Vicente Let x = the number of units to be sold to break-even, when profit = 0 Given: Variable costs = P 4.00 Fixed costs = P 12,000.00 Selling Price = P 10.00 Profit = P 0.00 Accounting for Non-Accountants by Dean Violeta V. Vicente  P10x = P4x + P12,000 + 0 P10x- P4x = P12,000 + 0 P6x = P12,000 + 0 x = P12,000 + 0 P6 x = 2000 tubes Thus, Break-even sales = Fixed Costs + Profit Contribution margin Accounting for Non-Accountants by Dean Violeta V. Vicente 1. Break-even sales (in units) = 2000 tubes 2. Break even sales (in pesos) = P20,000.00 (2000 tubes x P10.00 per tubes) Accounting for Non-Accountants by Dean Violeta V. Vicente Contribution Margin Method Going back to the variable income statement. Sales P xx Less: Variable costs xx Contribution margin P xx Less: Fixed costs xx Profit P xx Accounting for Non-Accountants by Dean Violeta V. Vicente From the I/S, we can derive the following formula:  Profit = Contribution Margin – Fixed Costs  Contribution Margin = Fixed Costs + Profit Accounting for Non-Accountants by Dean Violeta V. Vicente  Contribution Margin = Sales – Variable Costs  Sales = Variable Costs + Contribution Margin Accounting for Non-Accountants by Dean Violeta V. Vicente Considering sales as the base representing 100%, ratios can be developed to express both the variable costs and contribution margin as a percentage of sales, expressed as follows: Variable Cost = Variable Cost/Sales Ratio Contribution Contribution Margin = Margin Ratio Sales Accounting for Non-Accountants by Dean Violeta V. Vicente Based on the formula, sales can be determined: Sales = Variable costs Variable costs ratio Sales = Contribution margin Contribution margin ratio Accounting for Non-Accountants by Dean Violeta V. Vicente Break-even Chart or CVP Graph Approach 45,000 40,000 35,000 30,000 Total sales 25,000 Break-even Point Total cost 20,000 (2,000, P20,00) Variable cost 15,000 Fixed costs 10,000 5,000 0 1,000 2,000 3,000 4,000 tubes tubes tubes tubes Accounting for Non-Accountants by Dean Violeta V. Vicente Profit Planning and Break- even Sales Profit planning  sales with desired profit can be determined using beak- even sales formulas. Accounting for Non-Accountants by Dean Violeta V. Vicente Desired Profit Example: Assume that Sample Co. wants to know the required sales volume in units and in pesos to earn P12,000.00 Accounting for Non-Accountants by Dean Violeta V. Vicente 1. Sales in units = Fixed Costs + Profit Contribution Margin/unit = P12,000 + P12,000 P6.00 = 4,000 tubes Accounting for Non-Accountants by Dean Violeta V. Vicente 2. Sales in pesos: = Fixed costs + Profit Contribution ratio = P12,000 + P12,000 60% = P40,000.00 Accounting for Non-Accountants by Dean Violeta V. Vicente Desired Profit After Tax Example: Sample Co. pays corporate income tax rate of 32%. What should be the sales volume in units and in pesos to earn after- tax-profit of P12,000.00 Accounting for Non-Accountants by Dean Violeta V. Vicente 1. Sales in units = Fixed Costs + Profit after tax/(100%-Tax rate) Contribution Margin/unit = P12,000 + P12,000 100%-32% P6 = 4,941 tubes Accounting for Non-Accountants by Dean Violeta V. Vicente 2. Sales in pesos = Fixed Costs + Profit after tax/(100%-Tax rate) Contribution Margin ratio = P12,000 + P 12,000 100%-32% 60% = P49,411.76 Accounting for Non-Accountants by Dean Violeta V. Vicente