Introduction to Accounting

There are 3 important documents

1. Balance Sheet
2. Income Statement aka Profit and Loss
3. Cash flow statement

Balance Sheet: gives point is time snapshot reflects what the company owns, owes and what the shareholders put in as equity.

Assets (own) = Liability (owe) + Equity (shareholders contributed)

Expanded Accounting Equation

Assets = Liabilities + Equity + Revenues - Expenses

Equity = Owners money [remember each shareholder is also owns part of business]       

DEA LER mnemonic is useful to remember 
The rule of debit and credit can be summarized as follows:
- Debit increases Expenses and Assets while decreasing Liabilities, Equity, and Revenues.
- Credit increases liabilities, equity, and revenues while decreasing assets and expenses.

There is a link between the income statement and the balance sheet. The connection is that at the end of the year the Profit of the year is transferred to the Equity portion of the balance sheet.

Net income from the income statement is not the Cash on the balance sheet.

Since accountants know that not all Accounts Receivable will be collected, the accountants: set up an “Allowance for Doubtful Accounts" account

Account Receivable -  Allowance for Doubtful Accounts = Net Receivable

Inventory is an asset that the company plans to sell as a regular part of their business.

Current assets = Cash + AR + Inventory

Inventory valuation is 4 types LIFO, FIFO, Average, Identification

Identification for large like Aircraft, Yacht etc

current assets are things we plan to sell or move through our company within 1 year.

Long Term Assets - You do not plan to sell or liquidate, that is Property, Plant , Equipment. we plant to use them to make money.

Property, Plant and Equipment are often summarized into a total called fixed assets on the Balance Sheet

Fixed assets on the Balance Sheet are sometimes referred to as capital assets .

In accounting language chairs in a restaurant could be considered Long Term Assets and it is not inventory. Whereas chairs in a furniture store could be considered inventory.

Amortization or depreciation is used, to make sure fixed asset values are not overstated on the Balance Sheet

Intangible Assets are trademarks, Patents, buying out somebody else's rights.

Intangible assets are tremendously important to technology firms.

Goodwill when companies buys another company  example

If a company buys another company that has total assets at $750,000 and they pay $950,000 for that company, the accountants would record $200,000 as Goodwill

Amortization is an expense that is always a non-cash item.

One method of calculating amortization is called straight-line. Under this method the cost (purchase price) of the asset is divided by the estimated life, in years, of the asset to determine the amount to be charged to each year.

If you have an asset such as a delivery truck the best amortization approach is to consider the life of the truck in terms of kilometres travelled. This is called the “units of production” methodology.

Liabilities:

Current liabilities = Wages payable + Interest payable + Dividend payable

Accounts payable represent amounts that a company owes and that is typically due within in one year

Long Term Liability = Bank loan + Bond

Bonds are a type of long-term debt and bonds create interest charges. On the Balance Sheet these two items are categorized in this manner

interest is recorded as a current liability and the bond as a long-term debt.

Long Term Debt is the most significant part in Liabilities.

There is a very strong connection between bankruptcies and the level of long -term debt in a given corporation. It is not common to file for bankruptcy if you have no long-term debt and if your current liabilities are at a reasonable level.

Equity:
A = L + EQ

EQ Equity = Common stock + Retained Earnings + Dividends

Common Stock is the cash given by people who bought the stock directly from the company like IPO, stock issuance

Issuing shares, equity financing, is very common when you start a business because, banks will not lend you money.

All items on the balance sheet are cumulative by nature, whereas all figures on the income statement are for a period of time and then begin at zero when the next period commences.

retained earning is not CASH

Dividends for a given year get deducted from the retained earnings balance and thus dividends can reduce the value of retained earnings.

liquidity is measure of how quickly an asset can be converted to cash

In balance sheet most liquid assets start at top

Liquidity or current Ratio = Current Assets / Current Liability ideally should be between 1 or 2,

too much liquidity is also not optimal as it indicates you have lot of assets

Quick Ratio is exactly the same as the current ratio with the adjustment being that we remove the inventory from the numerator as Inventory is less liquid and harder to convert to cash.

‘Income Statement’

It has top line (Revenue/ Sales) and bottom line. Income statement  is over period of time, created for 1 year.

Revenue – [Cost or Expense] = Profit or Net Income

We use brackets to denote subtraction
Income statement is used for period of time. Companies need to report quarterly Income statement if it is listed on Stock exchange. It has start and end. At the end of period all accounts are closed out and next year start afresh. we can consider the balance sheet analogy as a photo and the income statement analogy as a video.

Sales or Revenue

<Cost of Goods Sold COGS> or <Cost of Revenue>

------------------

Gross Margin

<Selling and Admin>

----------------
Net Income

Gross Margin divided by sales gives gross margin ratio percent. This is useful as we can compare the ratio for one firm to that of another firm.

Sales or Revenue is Top Line

Net Income is Bottom Line.

When transaction for example buy of Truck is occurs, it is added in Sales of Income Statement and Assets section's Acccount Receivables of Balance Sheet and Inventory in balance sheet is reduced and final net income is flows to Equity section of Balance sheet.

Account Receivables, when it gets collected it transfers to CASH

Normal business to business transactions extend credit for 20-30 days.

SALES are recorded, triggered when it is EARNED (Revenue Recognition)

EXPENSES are recorded, triggered when it is CONSUMED

Revenue recognition is accounting language to explain that if work is complete and transaction physically done accountants will call it revenue

Inventory sold in Balance sheet becomes COGS on the income statement.

When you build inventory, the only costs included in the inventory total are Direct materials, Direct Labor and Manufacturing overhead.

Cash Flow statement:

Cash flow is over period of time of 1 year

cash flow statement highlights where cash is generated and where cash is consumed.

CASH is like the oxygen of the company and fundamentally very important to company and it has its own statement.

The three main categories on the Cash Flow Statement are operations, investing and financing.

Managing cash levels is a fundamental role of the finance department or CFO, but does not equate to a strategy

Investing can be thought of buying Fixed Assets. A negative number under investing may mean the company may bought assets such as Property, Plant and Equipment and positive means company might have sold either of PPE

If we had two balance sheets, from the same company, exactly one year apart in time, we could determine the change in cash for that year by comparing the two cash totals, with the difference equaling the net change in cash for that year.

A realistic reason as to why financing might be a negative number for Toyota is that they may have used cash to "pay down" debt.

The financing section of the Cash Flow Statement records the cash that comes into the company from the outside market and is split into two types: debt financing example Bonds and equity financing example common stock, Dividends

Essentially every accounting category in the Cash Flow Statement could be a source or use of funds except dividends. Dividends are always a use or consumption of funds as they decrease the equity account.

RATIOS:

A/R Turnover Rate:

Sales / AR

Accounts receivable turnover rate is: Sales / average accounts receivable.

A higher turnover rate indicates that a firm is "good" at collecting its receivables.

If a company always maintains a balance of about $100,000 in accounts receivable and has sales of $200,000 in a year, the number of days it takes to collect the receivables is about: 180 days

200,000/ 100,000 = 2

365/2 = 182.5 days

Inventory Turnover Rate:

COGS/ Inventory

Inventory turnover rate measures how quickly a company produces and sells inventory

Companies want to move inventory since it is an asset that does not by its sheer presence generate income, like a bank loan, until the inventory is sold.

purpose of calculating the Gross Margin ratio is profitability

Debt to equity is calculated as debt/equity and it is used to measure how much, in comparison, did owners put in relative to creditors.

Return on Equity

ROE :  Net Income / Equity

Return is another description for both net income and profit.

The investor would have trouble determining EPS since the number of shares outstanding changes frequently throughout the year.

When looking at the EPS you must be careful, since the number of total shares outstanding may have changed and this can distort what you thought was a trend upwards or downwards in the EPS.

Reference:
https://www.edx.org/course/introduction-accounting-ubcx-busacct1x
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AccPrimer/accstate.htm