Financial Accounting - CTB-6008 Session 2 PDF

FINANCIAL ACCOUNTING Seventh Seventh Canadian Canadian Edition Edition...

FINANCIAL ACCOUNTING Seventh Seventh Canadian Canadian Edition Edition LIBBY, LIBBY, LIBBY, LIBBY, HODGE, HODGE, KANAAN, KANAAN, STERLING STERLING CTB-6008 SESSION 2 Alexandrine Baril, CPA, MBA, M.Fisc. PowerPoint Author: Shannon Butler, CPA, CA, MEd Carleton University, Sprott School of Business © 2020 McGraw-Hill Limited 3-1  FINANCIAL WHO IS YOUR TEACHER? ACCOUNTING Seventh Seventh Canadian Canadian Edition Edition LIBBY, LIBBY, LIBBY, LIBBY, HODGE, HODGE, KANAAN, KANAAN, STERLING STERLING PowerPoint Author: Shannon Butler, CPA, CA, MEd Carleton University, Sprott School of Business © 2020 McGraw-Hill Limited 3-2  OPERATING CYCLE / CASH-TO-CASH CYCLE Operating cycle / cash-to-cash cycle = the time it takes for a company to pay cash to suppliers, sell those goods and services to customers, and collect cash from customers © 2020 McGraw-Hill Limited 3-3  PERIODICITY ASSUMPTION To meet the needs of decision makers, we report financial information for relatively short time periods (monthly, quarterly, annually)→ the frequency depends on the size of your business! Two types of issues arise in reporting periodic net earnings to users: 1) Recognition issues: When should the transactions and their effects of operating activities be recognized, classified, and recorded? 2) Measurement issues: What amounts should be recognized and recorded for the transactions? © 2020 McGraw-Hill Limited 3-4  INCOME STATEMENT / STATEMENT OF EARNINGS Sales − Cost of sales = Gross profit − Operating expenses = Earnings from operations +/− Non-operating revenues/expenses and gains/losses = Earnings before income taxes − Income tax expense = Net earnings © 2020 McGraw-Hill Limited 3-5  INCOME STATEMENT / STATEMENT OF EARNINGS Revenues = Increases in assets or settlements of liabilities from ongoing operations of the business Operating revenues result from the sale of goods or services Expenses = Decreases in assets or increases in liabilities from ongoing operations They are incurred to generate revenues during the period © 2020 McGraw-Hill Limited 3-6  PRIMARY OPERATING EXPENSES Cost of sales = the cost of products sold to customers In companies with a manufacturing or merchandising focus, the cost of sales (also called cost of goods sold) is usually the most significant expense. The difference between sales—net of sales discounts, returns, and allowances—and cost of sales is known as gross profit (or gross margin) Operating expenses are the usual expenses, other than cost of sales, that are incurred in operating a business during a specific accounting period The expenses reported will depend on the nature of the company’s operations For a service company, salaries expense will be the biggest source of expense © 2020 McGraw-Hill Limited 3-7  NON-OPERATING ITEMS Not all activities affecting a statement of earnings are central to continuing operations Any revenues, expenses, gains, or losses that result from these other activities are not included as part of earnings from operations but instead categorized as other income or expenses These typically include: Interest income, financing costs, gains or losses on disposal of assets The non-operating items that are subject to income taxes are added to or subtracted from earnings from operations to obtain the earnings before income taxes (or pretax earnings) © 2020 McGraw-Hill Limited 3-8  INCOME TAX EXPENSE Income tax expense is the last expense listed on the statement of earnings All for-profit corporations are required to compute income taxes owed to federal, provincial, and foreign governments Income tax expense is calculated as a percentage of earnings before income taxes, reflecting the difference between income, which includes revenues and gains, and expenses and losses It is determined by using applicable tax rates © 2020 McGraw-Hill Limited 3-9  COMPUTING JOURNAL ENTRIES © 2020 McGraw-Hill Limited 3-10  TRANSACTION ANALYSIS RULES Every transaction / operation occurring during the year must be recorded in our accounting books Journal entries are recorded for every transaction, in the General Journal For every journal entry, we will use at least 2 accounts Accounts, depending on their nature, will increase on the debit (left) side OR the credit (right) side of the entry © 2020 McGraw-Hill Limited 3-11  INCREASES IN THE ACCOUNTS Transactions that INCREASE assets are listed on the LEFT, as a debit to the account Transactions that INCREASE liabilities and shareholder’s equity are listed on the RIGHT, as a credit to the account © 2020 McGraw-Hill Limited 3-12  DECREASES IN THE ACCOUNTS Transactions that DECREASE assets are listed on the RIGHT, as a credit to the account Transactions that decrease liabilities and shareholder’s equity are listed on the LEFT, as a debit to the account © 2020 McGraw-Hill Limited 3-13  RULES OF DEBIT AND CREDIT © 2020 McGraw-Hill Limited 3-14  EXPANDING THE RULES OF DEBIT AND CREDIT AND NORMAL BALANCE OF AN ACCOUNT An account’s normal balance appears on the side of the account – debit or credit- where increases are recorded © 2020 McGraw-Hill Limited 3-15  Example: An owner invested $ 1,000 in his business Assets Liabilitie s Owner’s Equity $ 1,000 $ 1,000 © 2020 McGraw-Hill Limited 3-16  Example: 3-17 Business borrowed $ 500 from the bank Assets Liabilitie s $ 500 Owner’s Equity $ 500 © 2020 McGraw-Hill Limited 3-17  EXAMPLE 2: BUSINESS PAID $ 600 TO OUR SUPPLIER Assets Liabilitie s $ 600 Owner’s Equity $ 600 © 2020 McGraw-Hill Limited 3-18  EXERCISE: LEE MANAGEMENT CONSULTING Use the file “Lee Management Consulting – Exercise and Template” on the portal Required: Journalize the transactions in the General Journal. © 2020 McGraw-Hill Limited 3-19  2 ACCOUNTING METHODS © 2020 McGraw-Hill Limited 3-20  1) CASH BASIS ACCOUNTING Under cash basis accounting, we record revenues when cash is received, no matter if the service was offered or if the merchandise was provided to the client The cash basis does not necessarily reflect all assets and liabilities of a company on a particular date Cash basis financial statements are not very useful to external decision makers © 2020 McGraw-Hill Limited 3-21  2) ACCRUAL ACCOUNTING In accrual basis accounting, revenues and expenses are recognized when the transaction that causes them occurs, not necessarily when cash is received or paid Revenues are recognized when they are earned and expenses when they are incurred The revenue recognition principle and the matching process determine when revenues and expenses are to be recorded under accrual basis accounting © 2020 McGraw-Hill Limited 3-22  REVENUE RECOGNITION PRINCIPLE The revenue recognition principle specifies both the timing and amount of revenue to be recognized during an accounting period It requires that a company recognize revenue when goods and services are transferred to customers in an amount it expects to receive Revenue is earned when the business delivers goods or services, although cash can be received from customers (1) in a period before delivery, (2) in the same period as delivery, or (3) in a period after delivery © 2020 McGraw-Hill Limited 3-23  RECORDING REVENUES VERSUS CASH RECEIPTS © 2020 McGraw-Hill Limited 3-24  REVENUE RECOGNITION – EXAMPLE 1 Let’s say a client makes a cash deposit of $1,000 for a service that we will offer next month… Cash is received before the services are rendered! On receipt of a $1,000 cash Debit Credit deposit: Cash (+A) 1,000 Unearned revenue (+L) 1,000 On the day we offer the service: Unearned revenue (−L) 1,000 Sales revenue (+R, +SE) 1,000 © 2020 McGraw-Hill Limited 3-25  REVENUE RECOGNITION – EXAMPLE 2 Let’s say we purchase goods for $300, and we pay cash on the same date. Cash is received in the same period as the goods or services are delivered. On delivery of purchased goods Debit Credit for $300 cash Cash (+A) 300 Sales revenue (+R) 300 © 2020 McGraw-Hill Limited 3-26  REVENUE RECOGNITION – EXAMPLE 3 Let’s say we sell goods for $500 ON ACCOUNT. Cash is received after the goods or services are delivered. On delivery of purchased goods for Debi Credit $500 on account t Accounts receivable (+A) 500 Sales revenue (+R) 500 On receipt of cash after delivery Cash (+A) 500 Accounts receivable (−A) 500 © 2020 McGraw-Hill Limited 3-27  MATCHING PROCESS The matching process requires that expenses be recorded when incurred in a hope of generating revenues for the same period Our expenses for a financial period will be all of the resources consumed in earning revenues during a specific period, so they must be recognized in that same period! In other words, we try matching of costs with benefits! © 2020 McGraw-Hill Limited 3-28  MATCHING PROCESS The costs of generating revenue include expenses incurred, such as: Salaries to employees who worked during the period (wages expense) Utilities for the electricity used during the period (utilities expense) Inventory items (e.g., T-shirts, legwear, pants and shorts) that are sold during the period (cost of sales) Facilities rented during the period (rent expense) Use of buildings and equipment for production purposes during the period (depreciation expense) © 2020 McGraw-Hill Limited 3-29  RECORDING EXPENSES VERSUS CASH PAYMENTS As with revenues and cash receipts, expenses are recorded as incurred, regardless of when cash is paid Cash may be paid before, during, or after an expense is incurred An entry is made on the date the expense is incurred and another one on the date of the cash payment, if at different times © 2020 McGraw-Hill Limited 3-30  MATCHING PROCESS – EXAMPLES Some expenses are incurred today, but we will benefit from them over more than one financial period Examples: A company will pay today for an insurance protection for future coverage over 1 year A company will pay rent for future use of space A company will purchase supplies and equipment for future use For these expenses and assets that will be used on a long-term period → we will expense the cost on the duration of the use of the asset © 2020 McGraw-Hill Limited 3-31  MATCHING PROCESS – EXAMPLE 1 Let’s say we buy supplies for $2,000 today, and we will use only half of them this year! On date of payment of $2,000 cash Debit Credit for office supplies Office supplies (+A) 2,000 Cash (−A) 2,000 On subsequent use of half of the supplies Supplies expense (+E, −SE) 1,000 Office supplies (−A) 1,000 © 2020 McGraw-Hill Limited 3-32  MATCHING PROCESS – EXAMPLE 2 Let’s say the company’s truck is broken, so we must pay for a repair expense of $500. Expenses are sometimes incurred and paid for in the period in which they arise → we will then expense the full amount right now On payment of $500 cash for using a repair service Repair expense (+E, −SE) 500 Cash (−A) 500 © 2020 McGraw-Hill Limited 3-33  THE MATCHING PROCESS – EXAMPLE 3 Let’s say we are at year-end, and our employees worked full-time for our last week before Christmas vacations. Sadly, they will only get paid in January! On the use of $4,000 employees’ services Credi Debit during the period t Salaries expense (+E, −SE) 4,000 Salaries payable (+L) 4,000 On payment of cash after using employees’ services Salaries payable (−L) 4,000 Cash (−A) 4,000 © 2020 McGraw-Hill Limited 3-34  KEY RATIO ANALYSIS TOTAL ASSET TURNOVER RATIO ANALYTICAL QUESTION → How effective is management at generating sales from assets (resources)? RATIO AND COMPARISONS → The total asset turnover ratio is useful in answering this question. It is computed as follows: ​​ Total Sales (or Operating) Asset = Revenues Turnover Ratio Average Total Assets* *Average total assets = (Beginning total assets + Ending total assets) ÷ 2. © 2020 McGraw-Hill Limited 3-35  KEY RATIO ANALYSIS INTERPRETATION  TOTAL ASSET TURNOVER RATIO INTERPRETATION  The total asset turnover ratio measures the sales generated per dollar of assets.  A high total asset turnover ratio signifies efficient management of assets; a low total asset turnover ratio signifies less-efficient management.  Stronger operating performance improves the total asset turnover ratio.  Creditors and security analysts use this ratio to assess a company’s effectiveness at controlling current and non-current assets. © 2020 McGraw-Hill Limited 3-36  KEY RATIO ANALYSIS RETURN ON ASSETS (ROA) ANALYTICAL QUESTION → How well has management used the total invested capital provided by debt holders and shareholders during the period? RATIO AND COMPARISONS → Analysts refer to the rate of return on assets (ROA) as a useful measure in addressing this issue. It is computed as follows: Return * on In complex calculations, interest expense (net of tax) and minority NettoEarnings* interest are added back net earnings. + Interest Expense Assets = (net of tax) ​ ​ (ROA) Ratio Average Total Assets © 2020 McGraw-Hill Limited 3-37  KEY RATIO ANALYSIS INTERPRETATION  RETURN ON ASSETS INTERPRETATION  ROA measures how much the firm earned from the use of its assets.  It is the broadest measure of profitability and management effectiveness, independent of financing strategy.  ROA allows investors to compare management’s investment performance against alternative investment options.  Firms with higher ROA are doing a better job of selecting new investments, all other things being equal. © 2020 McGraw-Hill Limited 3-38