EXIT EXAM REVIEW: ACCOUNTING

Accounting Concepts
Characteristics
Relevance – the quality of information that indicates the information makes a difference in a decision.
Reliability – the quality of information that gives assurance that it is free of error and bias. Accounting records
must be based on the most reliable data available (verifiable by independent source).
Comparability – Ability to compare the accounting information of different companies because they use the
same accounting principles.
Consistency – Use of the same accounting principles and methods from year to year within a company.
Assumptions
Monetary Unit – Only items that can be expressed in money are included in the accounting records.
Economic Entity – Every economic entity can be separately identified and accounted for. An organization
stands apart from other organizations as a separate economic unit. Economic events can be identified with a
particular unit of accountability.
Time Period – The life of a business can be divided into artificial time periods so businesses can report
information at regular intervals.
Going Concern – Entity will continue to operate long enough to recover cost of its assets (business will remain
in operation for the foreseeable future).
Principles
Revenue Recognition – Revenue should be recognized (recorded) in the period in which it is earned. Revenue
is earned when the business has completed rendering services and/or ownership of products has transferred.
Amount to record as revenue is equal to the cash value of services and/or goods.
Matching – expenses are matched with related revenues in same accounting period (Let the expenses follow the
revenue).
Full Disclosure Principle – all circumstance and events that would make a difference to financial statement
users will be disclosed (included in financial statements and notes).
Cost Principle – Assets/services acquired are recorded at actual, historical cost.
Constraints
Materiality – whether an item is large enough to likely influence the decision of an investor or creditor.
Conservatism – the approach of choosing an accounting method that will least likely overstate assets and net
income.

Accrual accounting – transactions are recorded in the periods in which the events occur rather than in the
periods in which the entity receives or pays cash. Accrual accounting is required for financial statements that
are prepared using generally accepted accounting principles.

Basic financial statements

There are four basic financial statements:
Balance Sheet
Income Statement (also known as Statement of Earnings or Statement of Operations)
Statement of Retained Earnings or Statement of Stockholders’ Equity
Statement of Cash Flows

Balance sheet – reports the assets, liabilities and equity at a specific point in time.
Assets = Liabilities + Equity

The balance sheet may also be referred to as the statement of financial position. It is a snapshot of a company's financial
position at a point in time.

Assets – Resources owned by a business.

Current assets are assets that are expected to be converted to cash or used up by the business within in one year or
operating cycle.
Long-term investments are generally investments in stocks and bonds of other corporations that are normally held for
many years. It also includes investments in long-term assets such as land or buildings that are not currently being used in
the company's operating activities.
Property, plant, and equipment are assets with relatively long useful lives that are currently being used in operating
the business. The category includes land, buildings, machinery and equipment, delivery equipment and furniture.
Intangible assets are assets that do not have physical substance yet often are very valuable. Examples of intangible
assets include: patents, copyrights, and trademarks.

Liabilities – Debts and obligations of a business.

Current liabilities are obligations that are to be paid within the coming year.
Long-term liabilities are obligations expected to be paid after one year.

Equity – Owners’ claim on total assets. Equity represents the difference between assets and liabilities.
Stockholders' equity is divided into two parts: common stock and retained earnings.
Common stock - Investment of assets into the business by the stockholders – recorded at the amount paid in by
stockholders. “Common stock” is reported at the par or stated value of the stock and any excess paid in is reported in
“Paid In Capital In Excess Of Par” (also may be called “Additional Paid In Capital”).
Retained earnings - income retained for use in the business – is the sum of all net income from inception of the
company less dividends (distributions) paid to the stockholders.

Note: Total assets on the balance sheet must equal total liabilities and stockholders’ equity.
Also, retained earnings on the balance sheet must equal retained earnings end of period on the statement
of retained earnings.
Balance Sheet Example

DSU Corporation
Balance sheet
As of December 31, 2006

ASSETS
Current assets
Cash $ 6,600
Short-term investments 2,000
Account Receivable 7,000
Inventories 4,000
Supplies 2,100
Prepaid Insurance 400
Total current assets $ 22,100

Long-term investments
Investment in stock of Wall Corp. 5,200
Investment in stock of Fancy Corp 2,000
7,200

Property, plant and equipment

Land 10,000
Office equipment $ 24,000
Less: accumulated depreciation 5,000 19,000 29,000

Intangible assets
Patents 3,100

Total assets $ 61,400

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current Liabilities
Accounts payable $ 13,100
Salaries payable 1,600
Unearned revenue 900
Interest payable 450
Total current liabilities $ 16,050

Long-term liabilities
Mortgage payable 10,000
Notes payable 1,300
Total long-term liabilities 11,300

Total liabilities 27,350

Stockholders' equity
Common Stock 14,000
Retained earnings 20,050
Total stockholders' equity 34,050

Total liabilities and stockholders' equity $ 61,400

Income Statement – reports the revenues and expenses of an entity for a period of time.
Income Statement Example
DSU Corporation
Income Statement
For the year ended December 31, 2006

Net Sales $ 500,000

Less COGS* 350,000
Gross profit $ 150,000

Operating Expenses
Selling 80,000
Adminstrative 30,000
Total Operating Expenses 110,000
Income from operations 40,000

Other Revenues
Gain on sale of investment in XYZ 20,000

Other Expenses
Loss on sale of investment in ABC 10,000 10,000
Income from continuing operations before taxes 50,000
Income tax expense 5,000

Income from continuing operations 45,000

Extraordinary gain, net of $1,200 applicable taxes 7,000

Net Income $ 52,000

* Cost of Goods Sold Calculation

Beginning inventory
plus Purchases
equals Cost of Goods Available For Sale
minus Ending Inventory
equals Cost of Goods Sold

Statement of Retained Earnings – reports the changes in retained earnings for a period of time.
Example:
DSU Corporation
Statement of Retained Earnings
For the year ended December 31, 2006

Retained Earnings, beginning of period $ 1,050

Add: Net Income (or deduct Net Loss) 52,000
53,050
Deduct: Dividends 33,000
Retained Earnings, end of period $ 20,050

Note: Net income (loss) presented on the statement of retained earnings must equal the net income (loss)
presented on the income statement.

Statement of Cash Flows – provides information about the receipts (sources) and disbursements (uses) of a
company’s cash.
Reported based on the three primary business activities: operating, investing and financing. Noncash investing
and financing activities must be reported in a separate schedule.
DSU Corporation
Statement of Cash Flows
For the year ended December 31, 2006

Cash flows provided by operating activities

Cash receipts from operating activities $ 26,000
Cash payments for operating activities 20,000
Net cash provided (used) by operations $ 6,000

Cash flows provided by investing activities

Increase (decrease) in property and plant (3,500)
Other cash inflow (outflow) (6,200)
Net cash provided (used) by investing (9,700)

Cash flows provided by financing activities

Issue of equity securities 4,100
Increase (decrease) in borrowing 3,200
Dividends, other distributions -
Net cash provided (used) by financing 7,300

Net increase (decrease) in cash and equivalents 3,600

Cash and equivalents at start of year 3,000

Cash and equivalents at year-end $ 6,600

Note: Cash and equivalents at year-end on the statement of cash flows must equal cash presented on the
balance sheet.

FINANCIAL STATEMENT ANALYSIS

Three basic tools:
Horizontal Analysis (trend analysis) – technique for evaluating a series of financial statement data over
a period of time. Its purpose is to determine the increase or decrease that has taken place, expressed as
either an amount or a percentage.
Vertical Analysis (common-size analysis) – technique for evaluating financial statement data that
expresses each item in a financial statement as a percent of a base amount. Generally, the base for the
balance sheet analysis is total assets and for the income statement is net sales.
Ratio Analysis – expresses the relationship among selected items of financial statement data. Ratio
analysis is used to analyze a company’s liquidity, solvency and profitability.
Liquidity Ratios – measure the short-term ability of the enterprise to pay its maturing obligations and to meet
unexpected needs for cash. Short-term creditors (such as bankers and suppliers) are interested in assessing
liquidity.
Working Capital = Current Assets – Current Liabilities
The greater the amount of working capital, the greater the cushion of protection available to short-term
creditors, and the greater assurance that short-term debts will be paid when due.

Current Ratio Current Assets

Current Liabilities
 When the current ratio exceeds 1.0, an equal increase in current assets and current liabilities decreases
the ratio. When the current ratio is less than 1.0, an equal increase in current assets and current liabilities
increases the ratio.

Acid Test or Quick Ratio Cash + Marketable securities + Net Receivables

Current Liabilities

This ratio provides a more severe test of immediate solvency by eliminating inventories and prepaid
expenses (current assets that are not more quickly converted into cash).

Inventory Turnover Cost of Goods Sold

Average Inventory

Indicates the number of times inventory was acquired and sold (or used in production) during the period.
It can be used to detect inventory obsolescence or pricing problems. Average inventory is generally
determined by adding the beginning and ending inventories and dividing by two.

Number of Days’ Supply in Average Inventory (Days in Inventory)

360 (365) Average (Ending) Inventory
Inventory Turnover or Average Daily Cost of Goods Sold

Indicates the number of days inventory is held before it is sold. Average daily cost of goods sold is
determined by dividing cost of goods sold by the number of business days in the year.

Receivables Turnover Net Credit Sales

Average Net Receivables

This ratio provides an indication of the efficiency of credit policies and collection procedures, and of the
quality of the receivables. Average net receivables include trade notes receivable. Average net
receivables is generally determined by adding the beginning and ending net receivables balances and
dividing by two.

Number of Days’ Sales in Average Receivables (Average Collection Period)

360 (365)
Receivables Turnover

Tests the average number of days required to collect receivables.

Solvency Ratios – measures the ability of the enterprise to survive over a long period of time. Long-term
creditors and stockholders are interested in a company’s long-run solvency.

Debt to Total Assets Ratio Total Liabilities

Total Assets

Measures total assets provided by creditors. The higher the percentage, the greater the risk the company
may not be able to meet maturing obligations.

Debt to Equity Total Liabilities

Owners’ Equity
 Provides a measure of the relative amounts of resources provided by creditors and owners.

Times Interest Earned Net Income + Income Taxes + Interest Expense

Interest Expense

Measures the ability of the company to meet its interest payments. Income taxes are added back to net
income because the ability to pay interest is not dependent on the amount of income taxes to be paid
since interest is tax deductible.

Free Cash Flow

Cash provided by operations minus Capital Expenditures minus Cash Dividends

Capital expenditures = Property, Plant & Equipment acquisitions

Note: All information obtained from Statement of Cash Flows.
Provides an indication of the company’s ability to pay dividends and/or expand operations.

Profitability Ratios – measures the income or operating success of an enterprise for a given period of time.

Earnings Per Share (EPS) Net Income - Preferred Dividends

Average Common Shares Outstanding

Measures the ability to pay dividends to common stockholders by measuring profit earned per share of
common stock.

Price-Earnings Ratio Market Price Per Common Share

Earnings Per Share (EPS)

A measure of whether a stock is relatively cheap or relatively expensive based on its present earnings.

Gross Profit Rate Gross Profit

Net sales

Profit Margin Ratio Net income

Net sales

Return on Assets Ratio Net Income .

Average Total Assets

This ratio provides a measure of the degree of efficiency with which resources (total assets) are used to
generate earnings.

Asset Turnover Ratio Net Sales .

Average Total Assets

Measures how efficiently a company uses its assets to generate sales.

Payout Ratio Cash Dividend Per Common Share

Earnings Per Share (EPS)
 This ratio represents the percentage of earnings per share distributed to common stockholders in cash
dividends. A low ratio would probably indicate the reinvestment by a growth-oriented firm.

Return on Common Stockholders’ Equity

Net Income - Preferred Dividends
Average Common Stockholders’ Equity

Measures the rate of earnings on resources provided by common stockholders. (In other words, shows
how many dollars of net income were earned for each dollar invested by owners). Average common
stockholders’ equity is generally determined by adding beginning and ending common stockholders’
equity and dividing by two.

Financial leverage – assessment of cost of money borrowed to rate of return earned on assets acquired
with borrowed funds. Successful use of leverage is where a company earns more by the use of
borrowed money than it costs to use the borrowed funds. When compared to the return on total assets,
the return on common stockholders’ equity measures the extent to which leverage is being employed for
or against the common stockholders. When the return on common stockholders’ equity is greater than
the return on total assets, leverage is positive and common stockholders benefit.

Cost of capital – Rate of return that management expects to pay on all borrowed and equity funds.

Cash Budgeting
Cash budget shows anticipated cash flows, usually over a one- to two-year period. The cash budget contributes
to more effective cash management. It contains three sections: cash receipts, cash disbursements, and
financing. Also contains beginning and ending cash balances.

Example Cash Budget

DSU Corporation
Cash Budget
For the year ended December 31, 2006

Beginning Cash Balance $ 38,000

Add: Cash Receipts
Collections from customers 168,000
Sale of securities 2,000
Total Receipts 170,000
Total Available Cash 208,000
Less: Cash Disbursements
Materials 23,200
Salaries 62,000
Selling and administrative expenses (exclude depreciation) 94,300
Purchase of truck 10,000
Income tax expense 3,000
Total Disbursements 192,500
Excess (deficiency) of available cash over disbursements 15,500
Financing
Borrowings -
Repayments - .
Ending Cash Balance $ 15,500

Depreciation – Process of allocating asset’s cost over period asset used.

Straight-line Cost – Salvage Value
Useful Life (in years)
 Results in an equal amount of depreciation each year.

Declining-balance – accelerated, results in larger amounts of depreciation in beginning

Book Value at beginning of year times (1 divided by useful life in years times %)
Examples of percentages - 100%, 150%, 200% (double declining balance)

Units-of-Activity – Amount of depreciation depends on units of output.

Cost – Salvage Value
Useful Life (in years) times Units of Activity during year

Managerial and Cost Accounting

Product Cost – identified with goods purchased or produced for resale and become expenses (cost of goods
sold) when inventory is sold.
Period Cost – expensed during the current period – not inventory cost.

Direct Materials – Raw materials directly associated with finished product.

Direct Labor – Work of employees directly associated with turning raw materials into finished product.
Manufacturing Overhead – Costs indirectly associated with manufacture of finished product.
Prime Costs – Direct materials and direct labor.
Conversion Costs – Direct labor and manufacturing overhead.

Variable Costs – vary in total directly and proportionately with changes in activity level (ex. Direct Materials)
Fixed Costs – remain the same in total regardless of change in activity level (ex. Rent)

Contribution margin is the amount of revenue remaining after deducting variable costs.
Contribution Margin Per Unit = Unit Selling Price – Unit Variable Price

Break-Even Point – net profits at breakeven point are equal to zero. Profits = costs.
Break-even point in units = fixed costs divided by contribution margin per unit

Costing Systems – Methods to allocate overhead.

Job Order Costing – costs are assigned to a particular job (each unit or each batch of goods).
Process costing – Costs are assigned to a mass of similar products. Costs per unit are computed as an average
of total cost.
Activity-Based Costing (ABC) – approach used in determining costs used in job and process costing systems –
considers activities rather than products as the cost objects. Accumulate overhead costs for each activity and
assign the costs to cost objects.

Standard Cost Variances

A variance is the difference between actual performance and best level of performance that can be attained.
Favorable variance – increase in operating income relative to budget.
Unfavorable variance – decrease in operating income relative to budget.
Standard = budget
Materials price variance = (AQ x AP) – (AQ x SP)
Materials quantity (efficiency) variance = (AQ x SP) – (SQ x SP)
Total materials variance = materials price variance + materials quantity variance
AQ = Actual Quantity
SQ = Standard Quantity
AP = Actual Price
SP = Standard Price
Labor Price Variance = (AH x AR) – (AH x SR)
Labor Quantity (efficiency) Variance = (AH x SR) – (SH x SR)
Total labor variance = labor price variance + labor quantity variance
AH = Actual Hours
SH = Standard Hours
AR = Actual Rate
SR = Standard Rate

Overhead controllable variance = Actual overhead – Overhead budgeted

Overhead volume variance = Actual Overhead – (Normal capacity – standard hours allowed)
Total overhead variance = overhead controllable variance + overhead volume variance