1. selling stock
2. borrowing money
3. receiving orders
4. shipping goods
5. invoicing customers
6. receiving payments
7. paying sales commissions
8. writing off bad debts
9. prepaying expenses
10. ordering equipment
11. paying deposits
12. receiving raw materials
13. scrapping damaged product
14. paying suppliers
15. booking manufacturing variances
16. depreciating fixed assets
17. valuing inventory
18. hiring staff and paying salary, wages and payroll taxes
19. computing profit
20. paying income taxes
21. issuing dividends
22. acquiring a business
23. and more

• How an enterprise can be rapidly growing, highly profitable and out of money all at the same time…and why this state of affairs is fairly common.
• Why working capital is so very important and which management actions lead to more, which lead to less.
• The difference between cash in the bank and profit on the bottom line, and how the two are interrelated.
• When in the course of business affairs a negative cash flow is a sign of good things happening… and when it’s a sign of impending catastrophe.
• Limits of common product costing systems and when to apply (and, more importantly, when to ignore) the accountant’s definition of cost.
• Why a development investment made today must return a much greater sum to the coffers of the company in later years.
• How discounts drop right to the bottom line as lost profits and why they are so very dangerous to a company’s financial health.
• How risk is different than uncertainty, and which is worse.
• Why a dollar in your pocket today can be worth a lot more than a dollar received tomorrow.
• The necessity (and limitation) of forecasting cash flows over time when making capital investment decisions.
• When to use NPV analysis and when to use IRR, and why it is important in capital investment decision-making.

• 1. accounting entity
• 2. going concern
• 3. measurement
• 4. units of measure
• 5. historical cost
• 6. materiality
• 7. estimates and judgments
• 8. consistency
• 9. conservatism
• 10. periodicity
• 11. substance over form
• 12. accrual basis of presentation

• The Income Statement gives one important perspective on the health of a business—its profitability.

• Note: The Income Statement does not tell the whole picture about a company’s financial health.

• Also note: The Income Statement says nothing about when the company receives cash or how much cash it has on hand.

Net Sales

Sales vs. Orders

 

• A sale is made when the company actually ships a product to a customer. Orders, however, are something different.

• Orders become sales only when the products ordered have left the company’s loading dock and are en route to the customer.

• When a sale is made, income is generated on the Income Statement. Orders only increase the “backlog” of products to be shipped and do not have an impact on the Income Statement in any way. Simply receiving an order does not result in income.

Costs

 

• Costs are expenditures for raw materials, workers’ wages, manufacturing overhead and so forth. Costs are what you spend when you buy (or make) products for inventory.

• When this inventory is sold, that is, shipped to customers, its total cost is taken out of inventory and entered in the Income Statement as a special type of expense called cost of goods sold.

• Costs lower cash and increase inventory values on the Balance Sheet. Only when inventory is sold does its value move from the Balance Sheet to the Income Statement as cost of goods sold.

 

Income Statement Format

for the period x through y

 

Cost of Goods Sold

 

• When a product is shipped and a sale is booked, the company records the total cost of manufacturing the product as cost of goods sold on the Income Statement.

• Remember: When the company made the product, it took all the product’s costs and added them to the value of inventory.

• The costs to manufacture products are accumulated in inventory until the products are sold. Then these costs are “expensed” through the Income Statement as cost of goods sold.

 

Income Statement Format

for the period x through y

 

Gross Margin

 

• Gross margin is the amount left over from sales after product manufacturing costs (cost of goods sold) are subtracted. Gross margin is sometimes called gross profit or the company’s manufacturing margin.

 

Cost vs. Expense

 

• Two different terms, cost and expense, are used to describe how the company spends its money:

Manufacturing expenditures to build inventories are called costs.

All other business expenditures are called expenses.

 

• Note: Using the terms cost and expense correctly will make it easier to understand how the Income Statement and Balance Sheet work together.

• Also note: An expenditure can be either a cost or an expense. Expenditure simply means the use of cash to pay for an item purchased.

Expenses

 

• Expenses pay for developing and selling products and for running the “general and administrative” aspects of the business.

• Examples of expenses are paying legal fees and a sales person’s salary, buying chemicals for the R&D laboratory and so forth.

• Expenses directly lower income on the Income Statement.

• Note: The words profit and income mean the same thing; that is, what’s left over from sales after you have subtracted all the costs and expenses.

 

Income Statement Format

for the period x through y

 

Operating Expenses

 

• Operating expenses are those expenditures (that is, cash out) that a company makes to generate income.

• Common groupings of operating expense are:

1. Sales & Marketing expense.

2. Research & Development (“R&D”) expenses.

3. General & Administrative (“G&A”) expenses.

 

• Operating expenses are also called SG&A expenses, meaning “sales, general and administrative expenses.”

Income or (Loss)

 

• If sales exceed costs plus expenses (as reported on the Income Statement), the business has earned income. If costs plus expenses exceed sales, then a loss has occurred.

• The terms income and profit and earnings all have the same meaning—what’s left over when you subtract expenses and costs from sales.

Note: The Income Statement is often referred to as the Profit & Loss Statement, the Earnings Statement, or simply the P&L.

• Remember: Income is the difference between two very large numbers: sales less costs and expenses. Slightly lower sales and/or slightly higher costs and expenses can eliminate any expected profit and result in a loss.

 

 

 

Income Statement Format

for the period x through y

 

Income From Operations

 

• A manufacturing company’s operations are all its actions taken in making and selling products, resulting in both expenses and costs. The term income from operations refers to what is left over after expenses and costs are subtracted from sales.

• Note: Companies can also generate income and have expenses from financial (non-operating) activities. For example, a manufacturing company selling a piece of real estate for a profit.

 

Income Statement Format

for the period x through y

 

 

Non-operating Income & Expense

 

• Paying interest on a loan is a so-called non-operating expense. Likewise, receiving interest on cash balances in the company’s bank account is non-operating income.

• Because it is from non-operating sources, interest income (or expense) is reported on the Income Statement just below the Income from Operations line. Likewise taxes.

• Note: A company’s operations can be producing income, but the company as a whole can still show an overall loss. This sad state of affairs comes about when non-operating expenses (such as very high interest expenses) exceed the total operating income.

 

Income Statement Format

for the period x through y

 

Net Income

 

• Income is the difference between two large numbers: (1) sales and (2) costs plus expenses. More costs plus expenses than sales and the company will show a loss. Less costs plus expenses than sales and the company will show a profit.

• Remember: Income is not cash. In fact, a very profitable company with lots of net income can also be insolvent; that is, with no cash left to pay its bills.

• Often rapidly growing companies are short of cash—even though they are highly profitable. They simply cannot supply out of earnings the capital required for such rapid growth.

 

Income Statement Format

for the period x through y

 

 

Income (Profits) vs. Sales (Revenue)

 

• The words income and revenue are often confused. They mean very different things:

Profit and income do mean the same thing.

Sales and revenue do mean the same thing.

 

• Income (also called profits) is at the BOTTOM of the Income Statement. Sales (also called revenue) is at the TOP of the Income Statement.

• Income is often referred to as the bottom line because it is the last line of the Income Statement.

• Sales are often referred to as the top line because it is at the top of the Income Statement.

 

Income Statement Format

for the period x through y

 

Income Statement Summary

 

• The Income Statement summarizes and displays the financial impact of:

movement of goods to customers (sales)
minus
efforts to make and sell those goods (costs and expenses)
equals
any value created in the process (income)

 

• All business activities that generate income or result in a loss for a company—that is, all transactions that change the value of shareholders’ equity—are recorded on the Income Statement.

Accrual Basis vs. Cash Basis

 

• The two major ways of running a company’s books—cash basis or accrual basis—differ on when the company records expenses and income.

• If income is measured when cash is received and expenses are measured when cash is spent, the business is said to be operating on a cash basis—just like your checkbook.

• If income and expenses are measured when the transactions occur—regardless of the physical flow of cash—the business is said to be operating on an accrual basis. More later.

Cash Basis

 

• Cash basis books are the simplest…functioning just like the proverbial cookie jar. When the books are on a cash basis, accounting transactions are triggered only by the movement of cash.

• With the books on a cash basis, the Income Statement and the Cash Flow Statement are the same.

• In general, people run their lives on a cash basis, but most businesses run their books on an accrual basis. All businesses that maintain inventories of product for sale must use accrual accounting to report income—so says the IRS.

Accrual Basis

 

• In accrual basis accounting, the Income Statement does not reflect the movement of cash, but rather, the generation of obligations (payables) to pay cash in the future.

• With accrual basis accounting, expenses occur when the company incurs the obligation to pay, not when it actually parts with the cash. In accrual basis accounting, sales and costs are recorded when the goods are shipped and customers incur the obligation to pay, not when they actually pay.

• For example, under accrual basis accounting you would lower your net worth when you use your charge card rather than when you ultimately paid the bill.

Income Statement & Balance Sheet

 

• The enterprise’s Income Statement and Balance Sheet are inexorably linked:

If the enterprise’s Income Statement shows income, then retained earnings are increased on the Balance Sheet.

Then, also, either the enterprise’s assets must increase or its liabilities decrease for the Balance Sheet to remain in balance.

• Thus, the Income Statement shows for a period all the actions taken by the enterprise to either increase assets or decrease liabilities on the Balance Sheet.

 

• The Cash Flow Statement tracks the movement of cash through the business over a period of time.

• A company’s Cash Flow Statement is just like a check register…recording all the company’s transactions that use cash (checks) or supply cash (deposits).

• The Cash Flow Statement shows:

1. The Income Statement shows the manufacturing and selling actions of the enterprise that results in profit or loss.

2. The Cash Flow Statement details the movements of cash into and out of the coffers of the enterprise.

3. The Balance Sheet records what the company owns and what it owes, including the owner’s stake.

1. Watch the flow of cash money.

2. Watch the flow of goods and services.

1. The first numeric column shows all prior account values as of the last transaction.

2. The second numeric column (with small shadowboxs) shows account values posted for the transaction as described on the right-hand page. 

3. The third numeric column shows the account values after the transaction has been posted, that is, after the second column numbers are added to the first.

T4. Pay $1.5 million for a building to be used for office, manufacturing and warehouse space. Set up a depreciation schedule.

 

 

T5. Hire administrative and sales staff. Pay first month’s salaries and book fringe benefits and taxes.

 

AppleSeed will soon be in production; you had better figure out how to sell applesauce! You will also need help with administrative tasks.

Hire some SG&A employees. SG&A stands for “sales, general and administrative.” SG&A is a catchall for all expenses not involved in manufacturing; that is, not added to inventory. More on this topic later.

Add to AppleSeed’s SG&A payroll a secretary at the wage of \$13 per hour (\$2,250 per month), a bookkeeper at a salary of \$3,000 per month, salesperson at \$4,000 per month and a salesclerk at \$10 per hour (\$1,750 per month).

The table below computes SG&A take-home pay and fringe benefit costs.

 

SG&A Payroll-Related Expenses

 

 

Transaction: Book this month’s payroll-associated expenses of \$14,790 (that is, \$7,680 for Sales & Marketing and \$7,110 for G&A). These expenses include salaries, wages, insurance and other fringe benefits. Issue payroll checks totaling \$7,960 to SG&A employees.

 

 

(1A) On the Income Statement add total monthly payroll expense of \$7,680 for the salesperson and clerk to SALES & MARKETING expense. (1B) Also add the payroll expense of \$7,110 for the secretary and the bookkeeper to GENERAL & ADMINISTRATIVE expenses.

 

Decrease RETAINED EARNINGS in the Balance Sheet by the total SG&A payroll of $14,790.

 

(3A) Issue payroll checks totaling $7,960 and list under CASH DISBURSEMENTS in the Cash Flow Statement. (3B) Decrease CASH in the Balance Sheet by the same amount.

 

The $6,830 due to others is owed, but not yet paid. Place this amount as ACCRUED EXPENSES in the liability section of the Balance Sheet.

 

 

Income Statement

 

 

 

Cash Flow Statement

 

 

 

Balance Sheet

 

 

 

T6. Pay employee health, life and disability insurance premiums plus unemployment, FICA, and withholding taxes.

 

When you put yourself on AppleSeed’s payroll in Transaction 2 and then hired an SG&A staff in Transaction 5, you issued payroll checks to all new AppleSeed employees.

However, you did not at that time pay all the payroll-associated expenses for fringe benefits such as health and life insurance or the withholding taxes and the FICA that you deducted from all employees’ paychecks.

These expenses were booked in the Income Statement at the time they were incurred, but since they were not at that time actually paid, they became accrued expenses.

If an expense is booked in the Income Statement but you do not “satisfy the obligation” by paying it immediately, then you must record the expense as “accrued” on the Balance Sheet.

 

 

 

Transaction: Pay all the payroll-associated expenses that were accrued in Transaction 2 and Transaction 5, including FICA, withholding tax and unemployment insurance due the government. Also pay to private insurance companies the workmen’s compensation and health and life insurance premiums.

 

 

Write checks totaling $9,690—$2,860 from Transaction 2 plus $6,830 from Transaction 5 for these accrued expenses. Show payments in CASH DISBURSEMENTS in the Cash Flow Statement.

 

Lower CASH in the asset section of the Balance Sheet by the same amount paid above.

 

Lower ACCRUED EXPENSES in the liabilities section of the Balance Sheet by the $9,690 paid above. Payment of these expenses had been deferred (accrued). Now that you have paid them you can, in effect, reverse the original deferring entry.

Note: Actually paying these accrued expenses does not affect the Income Statement now. The Income Statement was already charged when the expenses were incurred.

T9. Hire production workers. Expense first month’s salary and wages.

 

 

Let’s compute AppleSeed’s manufacturing overhead. From Transaction 9, we see that the supervisor’s total payroll cost is \$4,880 per month. From computations on the prior page, we see that depreciation is \$7,143 per month. Let’s assume that all other elements of overhead (heat, power, etc.) will cost \$8,677 per month. Thus, AppleSeed’s total manufacturing overhead is \$20,700 each and every month as shown below:

 

 

 

T13. Book depreciation and other manufacturing overhead costs for the month.

 

 

T14. Pay for labels received in Transaction 10.

 

We received our applesauce jar labels over a month ago and the printer is very anxious to get paid. When we received the jar labels we created an accounts payable. When we pay this vendor with cash we will “reverse” the payable at the same time we lower cash.

Note, paying for this raw material in no way affects the values in our Inventory Valuation Worksheet. The inventory was increased by the cost of the labels when we received them and created an accounts payable.

 

 

 

Transaction: Pay for 1 million labels received in Transaction 10. Issue a check to our vendor for $20,000 as payment in full.

 

 

Cut a check for $20,000 to pay the label printer. Increase CASH DISBURSEMENTS by that amount in the Cash Flow Statement.

 

Lower cash by $20,000 in the assets section of the Balance Sheet since we wrote the check.

 

Lower ACCOUNTS PAYABLE in the liabilities section of the Balance Sheet by the $20,000 that we no longer owe (since we just paid as described above).

 

 

Income Statement

 

 

 

Cash Flow Statement

 

 

 

Balance Sheet

 

 

T15. Finish Manufacturing 19,500 cases of our applesauce and move them from work-in-process (WIP) into finished goods inventory.

 

Manufacturing our product is a continuous flow of raw material and labor into work-in-process inventory and then on to finished goods.

When we have finally boxed our finished jars of applesauce and they are ready for shipping, we place them in our finished goods warehouse. We will value this inventory at “standard cost,” ready to become a COST OF GOODS SOLD amount when we ship.

On our Inventory Valuation Worksheet we will decrease work-in-process inventory and also increase finished goods inventory by the same amount, the value of goods we moved from work-in-process to finished goods.

Remember, we started out to make 20,000 cases. But somewhere in the process we lost some product and only ended up with 19,500 cases. We will “move” these 19,500 cases into finished goods inventory. In the next transaction we will deal with what happened and how to account for the remaining 500 cases.

The inventory value of the 19,500 cases to be transferred is \$198,900—a \$10.20 standard cost times 19,500 cases. Note that while accounting entries (see below) are made in our Inventory Valuation Worksheet as we move work-in-process inventory into finished goods, no change is made in the company’s Income Statement, Balance Sheet or Cash Flow Statement.

Inventory values will become COST OF GOODS SOLD only when we ship product to customers.

 

 

 

Transaction: This movement of inventory into a different class is really just an internal management control transaction as far as the financial statements are concerned. There is no effect on the three major financial statements of AppleSeed. INVENTORIES on the Balance Sheet remains the same. Our Inventory Valuation Worksheet, as shown below, reflects the change in inventory status.

 

 

Income Statement

 

 

 

Cash Flow Statement

 

 

 

Balance Sheet

 

 

T16. Scrap 500 cases’ worth of work-in-process inventory.

 

After we moved all the product that we could find (19,500 cases) into finished goods, we looked around for the remaining 500 cases we had expected to make.

We started out with enough material to make 20,000 cases but seem to have produced only 19,500 cases. The material and labor expenditures for these remaining 500 cases still remain in work-in-process inventory—but where is the product?

Our production supervisor comes up with the answer. It seems that our workers had some trouble starting up some of the new machines. Everything is fixed now, but for the first month of production every 40th jar of applesauce got smashed in the innards of the conveyor belts!

Thus, our output was only 19,500 cases and we spoiled 500 cases. We still expended the labor to produce 20,000 cases and we used all the material required to produce 20,000 cases, but at the end we only produced 19,500 cases.

Oh well, no use crying over spilled applesauce. But how should we account for the loss? Scrap the value of 500 cases of applesauce. Lower the value of work-in-process inventory, and take a corresponding loss on the Income Statement.

 

 

 

Transaction: Scrap the value of 500 cases of applesauce from the work-in-process inventory. Take a loss on the Income Statement for this amount.

 

 

Reduce INVENTORIES on the Balance Sheet by the \$5,100 value of the inventory to be scrapped (that is 500 cases times the standard cost of \$10.20 each).

 

Charge $5,100 to COST OF GOODS SOLD for the loss in value of the inventory due to scrapping 500 cases of work-in-process inventory.

 

Remember that the resulting loss in the Income Statement must be reflected as a decrease in RETAINED EARNINGS in the Balance Sheet.

 

Manufacturing Variances

The most efficient type of cost accounting is one that makes use of predetermined costs—referred to as standard costs. This procedure consists of setting, in advance of production, what the unit cost should be, and upon completion of production, comparing the actual costs with these standard costs. Any differences (either positive or negative) are then applied to the financial statements as a “variance” in order to reflect reality.

 

Standard Costs

 

We at AppleSeed Enterprises use a standard costing system to value our inventory. It is a convenient and accurate way to run the books and to account for what our products cost.

But, remember, the standard cost is what we expect our product to cost if all goes according to plan. That is, all must go exactly as expected (or excess money spent in one area must be saved in another) if our actual cost is to equal our standard cost.

In using a standard costing system, the various costs for materials, labor and overhead are booked into inventory at their actual amounts. But when product is placed in finished goods and then is sold, the transaction is performed “at standard.”

The difference between the actual and the standard cost is then booked in the accounting records. These differences, if any, are called manufacturing variances.

Types of Variances. For AppleSeed’s product and production costs to be “at standard,” that is, for no manufacturing cost variances to have occurred:

• We must produce 20,000 cases in a month—no more, no less. Otherwise we will have a volume variance.

• Our raw material must cost just what we have estimated them to be—no more, no less. Otherwise we will have a purchase variance.

• The amount of raw material used must be just as planned. Otherwise we will have a yield variance.

• We need no more or less direct labor and no overtime to produce our 20,000 cases. Otherwise we will have a labor variance.

• We don’t have excess scrap produced in the production process. Otherwise we will have a scrap variance.

 

 

For AppleSeed’s product and production costs to be at standard, that is, for no variances to have occurred:

1. We must produce exactly 20,000 cases in a month.

2. Our raw material must cost exactly what we have estimated.

3. The amount of raw material used must be just as planned.

4. We need no more or less direct labor and no overtime to produce our 20,000 cases.

5. We don’t have excess scrap produced in the production process.

 

Most often, everything does not come out perfectly. We will then have to apply variances to our books. Remember, our production cost accounting relied upon standard cost. We used this standard cost to apply costs to inventory and to cost of goods sold. If actual costs were different—and they always are, hopefully by just a little bit—we will have to adjust the books by entering variance amounts.

Note that while it does not apply to AppleSeed, there is one other kind of manufacturing variance, the mix variance. A multi-product company can make more (or less) of one product than planned. This production difference can result in more (or less) overhead “absorption” depending on the relative overhead contribution of the products actually produced. This “under” or “over absorption” is accounted for as a product mix variance.

In summary, volume variances occur when we make more or less product than we had planned. Thus we must spread our fixed costs and overhead over less product (resulting in a higher cost) or over more product (resulting in a lower cost).

Spending variances can occur when raw materials cost more or less than planned. Actual product cost reflects these differences.

Labor variances are very easy to understand. If it takes more man-hours to make our product than expected by the standard, then our product must cost more than planned.

If AppleSeed continuously books large manufacturing variances each month, we should modify our standard costs to make them conform more closely to reality.

If AppleSeed continuously books large manufacturing variances each month, we should modify our standard costs to make them conform more closely to reality.

 

 

 

Income Statement

 

 

 

Cash Flow Statement

 

 

 

Balance Sheet

 

 

T17. Pay for some of the raw materials received in Transaction 11.

 

With our first month’s production successfully placed in our finished goods warehouse, we throw a company picnic in celebration.

Halfway through the first hot dog, an important telephone call comes in. The president of Acme Apple and Jar Supply Incorporated, our apple and jar supplier, is on the line. He is calling to see how we are doing and when we plan to pay our bill for apples and jars. He suggests $150,000 or so would be appreciated.

Because we want to remain on good terms with this important supplier, we tell him, “The check is in the mail,” and rush back to our offices to put it there.

Looking at our listing of current accounts payable, we note that we owe Acme: \$79,200 for apples, \$184,000 for jars, and \$33,200 for jar caps—a total of \$296,400 outstanding.

Take out the checkbook and write the check.

 

 

 

Transaction: Pay a major supplier a portion of what is due for apples and jars. Cut a check for $150,000 in partial payment.

 

 

Cut a check for $150,000 to pay the supplier. Increase CASH DISBURSEMENTS by that amount in the Cash Flow Statement.

 

Lower CASH by $150,000 in the assets section of the Balance Sheet.

 

Lower ACCOUNTS PAYABLE in the liabilities section of the Balance Sheet by $150,000 that we not longer owe…since we just paid as described above.

Note: Actually paying for raw materials does not affect our inventory value in any way. Inventory value increased when we received the raw material and we created an accounts payable.

 

 

 

Income Statement

 

 

 

Cash Flow Statement

 

 

 

Balance Sheet

 

 

 

T18. Manufacture another month’s supply of our wonderful applesauce.

 

Things are progressing at our enterprise. With this multiple transaction we will make another month’s worth of applesauce and pay a few bills. Soon we will be ready to ship applesauce to our valued customers!

Shown at the bottom of the page are the series (K through Q) of Inventory Valuation Worksheet entries for the rest of the month. The table below translates these actions into transactions to post to AppleSeed’s financial statements.

 

 

 

Transactions: Make entries in the Income Statement, Cash Flow Statement and Balance Sheet as shown in the total column at below right. Note that for each worksheet entry (K through Q below), the change in Assets equals the change in Liabilities.

 

Inventory Valuation Worksheet

 

 

 

T21. Take an order (on credit) for 15,000 cases at $15.66 per case.

T22. Ship and invoice customer for 15,000 cases of applesauce ordered in Transaction 21.

Although we did lower our price to get this large order, our costs will remain the same. Thus we will garner a lower profit in this transaction than if we had sold at full list price.

AppleSeed’s net sales amount will be \$234,900 versus the \$238,500 if we had sold at list price—a difference of \$3,600 in lower sales.

Our gross margin (that is, sales less cost of goods sold) will be \$81,900 versus \$85,500—again, a difference of \$3,600 less margin.

In fact, this $3,600 difference in the original selling price will drop all the way to the bottom line as a lower profit. Discounts are dangerous profit-gobblers. Try to use them sparingly.

Transaction: Ship 15,000 cases of applesauce and send a $234,900 invoice to the customer.

  

 

(1A) Book sale of $234,900 as NET SALES on AppleSeed’s Income Statement. (1B) Make a corresponding entry as ACCOUNTS RECEIVABLE on the Balance Sheet.

 

(2A) On the Income Statement book COST OF GOODS SOLD for this sale of \$153,000, equaling a \$10.20 standard cost per case times 15,000 cases shipped. (2B) Reduce INVENTORIES on the Balance Sheet by this same amount.

 

(3A) Book on the Income Statement a SALES & MARKETING expense of $4,698 as the 2% selling commission for our broker. (3B) Also book this expense in ACCRUED EXPENSES on the Balance Sheet.

 

Increase RETAINED EARNINGS on the Balance Sheet by $77,202—the sale amount less cost of goods sold less the selling commission.

Income Statement

Cash Flow Statement

Balance Sheet

T23. Receive payment of $234,900 for shipment made in Transaction 22 and pay the broker’s commission.

Our big customer is very happy with our applesauce. He says that our brightly colored jars are “walking off the shelves.” We’re extremely happy that we decided to spend so much money on very fancy packaging.

Although it is true that “all you really need to be in business is a customer,” what you really need is a customer who pays. With this transaction we will collect our first accounts receivable and turn it into cash.

Transaction: Receive payment of \$234,900 for shipment that was made in Transaction 22. Pay the broker his \$4,698 selling commission.

 

 

(1A) Book $234,900 in CASH RECEIPTS in the Cash Flow Statement. (1B) Decrease ACCOUNTS RECEIVABLE on the Balance Sheet by the same amount.

 

(2A) Issue a $4,698 check to our broker and record in CASH DISBURSEMENTS in the Cash Flow Statement. (2B) Lower ACCRUED EXPENSES by the amount paid the broker.

 

Increase CASH by \$230,202 on the Balance Sheet (that is, \$234,900 received less \$4,698 disbursed).

Note: A customer’s cash payment for goods in no way changes the Income Statement. The Income Statement recorded a sale when first, we shipped the goods, and second, the customer incurred the obligation to pay (our accounts receivable).

 

Income Statement

Cash Flow Statement

 

Balance Sheet

T24. Oops! Customer goes bankrupt. Write off cost of 1,000 cases as a bad debt.

Remember back in Transaction 20 we shipped 1,000 cases of applesauce to your brother-in-law’s company? You’ll never guess what happened. They went bankrupt! Now he even wants a job.

We will never get paid. And because the goods have already been distributed and sold to applesauce lovers around the northwest, we will never get our product back, either.

Transaction: Write off the $15,900 accounts receivable that was entered when you made the 1,000 case shipment. Also, reduce the amount payable to our broker by what would have been his commission on the sale. If we don’t get paid, he doesn’t either!

 

 

(1A) Book the bad-debt expense of $15,900 against GENERAL & ADMINISTRATIVE expense on the Income Statement. (1B) Reduce ACCOUNTS RECEIVABLE on the Balance Sheet by the $15,900 we will never collect. These entries reverse the sale we had made.

 

Book a “negative expense” of minus $318 in SALES & MARKETING expense on the Income Statement. (2B) Decrease ACCRUED EXPENSE on the Balance Sheet by the same amount. These entries reverse the commission that had been due our broker.

 

Reduce RETAINED EARNINGS on the Balance Sheet by $15,582, the sale amount we wrote off less the commission no longer due.

Note: Our out-of-pocket loss is really just the $10,200 inventory value of the goods shipped.

Remember that in Transaction 20 we booked a profit from this sale of \$5,382—the \$15,900 sale minus the \$10,200 cost of goods sold minus the \$318 selling commission. Thus, if you combine the \$15,582 drop in RETAINED EARNINGS booked in this transaction plus the \$5,382 increase in RETAINED EARNINGS from Transaction 20, you are left with our loss of \$10,200 from this bad debt.

T27. Pay payroll-associated taxes and insurance benefit premiums.

 

 

T28. Pay some suppliers…especially the mean and hungry ones.

 

Several of our raw material suppliers have telephoned recently and asked how we are doing…and, by the way, when are we planning to pay their bills?

Because we are in a check-writing mood (and because we will shortly be asking them to send us more apples), we pay a chunk of supplier bills

 

 

 

Transaction: Pay suppliers a portion of what is due for apples and jars. Cut a check for $150,000 in partial payment.

 

 

Write a check for $150,000 to pay suppliers. Increase CASH DISBURSEMENTS by that amount in the Cash Flow Statement.

 

Lower CASH by $150,000 in the assets section of the Balance Sheet.

 

Lower ACCOUNTS PAYABLE in the liabilities section of the Balance Sheet by the $150,000 that we no longer owe, since we just paid as described above.

 

 

 

T31. Declare a $0.375 per share dividend and pay to the common shareholders.

 

Cash Flow Statement vs. Changes in Financial Position

 

The Cash Flow Statement format that we’ve been using for AppleSeed Enterprises’s financial statements is a very simple-to-understand representation of cash movement. We have likened it to a check register, with the “sources of cash” being deposits and the “uses of cash” being checks.

However, most accountants would prefer to use another format for cash flow. This format (shown on the next page), dubbed Statement of Changes in Financial Position is better likened to a “bridge” between the Balance Sheet at the start of a period and the Balance Sheet at the end of a period. This bridging format specifically shows the asset, liability and equity accounts that change to provide cash, and the accounts that change using cash.

Most of the time when you look at financial statements you will see a statement like the one on the facing page (except the statement will only show the “Cash Flow for the Period” column, not the computational columns we have included as a tutorial).

Both formats allow you to get to the same answer, Ending Cash Balance, but in different ways. The format introduced here focuses on cash movements divided into three major categories of interest to anyone reviewing the cash performance of a business:

1. Cash Flows from Operations.

Cash sources (uses) from activities such as making and selling products.

2. Cash Flows from Investing.

Cash uses (sources) from increases (decreases) in the productive assets of the company such as property, plant and equipment.

3. Cash Flows from Financing.

Cash sources (uses) from selling stock to investors, borrowing money from a bank and paying dividends.

 

The Statement of Changes in Financial Position shown on the facing page summarizes the movements of cash for AppleSeed Enterprises between Transaction 19 and Transaction 31. We have selected the period between these two trans-actions because it provides an informative example; we could have used the period between any two transactions.

If we look on page 146 at AppleSeed’s Cash Flow Statement for Transaction 19, we see $588,220 as an ending cash balance. Looking at AppleSeed’s Cash Flow Statement for Transaction 31 on page 178, we see \$488,462 as an ending cash balance. Subtracting the earlier from the later cash balance, we see that in the time between these two transactions, cash has dropped by \$99,762.

Refer to the statement on the facing page and review the following notes to see how this “bridging” cash flow description is constructed.

 

Statement of Changes in Financial Position

 

 

AppleSeed
Enterprises,
Inc.

Annual Report

 

 

Income Statement

 

 

 

 

Cash Flow Statement

 

 

 

Balance Sheet

 

 

To Our Shareholders:

 

I am happy to have this opportunity to report to you the results of AppleSeed Enterprises, Inc.’s first year of operation. Your company, in a very short time, has achieved its initial goal of becoming a recognized supplier of very high-quality applesauce.

 

Important Events

 

At the beginning of the year, AppleSeed raised $1 million through a successful offering of its common stock. This capitalization has allowed us to purchase high-volume production machinery and to maintain sufficient inventory to break into the highly competitive applesauce industry.

Our production continues at over 20 thousand cases per month. As demand increases, we project that the current manufacturing facility can be operated at over twice these levels. Depending, however, on the weather conditions in the Northeast, raw material supply may limit our ability to reach increased levels of production.

 

Financial Results

 

In AppleSeed’s first year of operation, revenues exceeded \$3 million. AppleSeed’s net income for the year was over \$250,000, or \$1.26 per share with 200,000 shares outstanding.

Our return on sales of 8% exceeds industry averages, as does our 15% return on shareholders’ equity. Return on assets was 8%. Our Balance Sheet remains strong. We end the year with $488,000 in cash and cash equivalents.

 

 

AppleSeed continues to spend heavily in marketing and sales. We believe these investments will pay off handsomely in the future in significantly improved market position, especially in specialty segments of the applesauce industry.

 

AppleSeed’s New Factory

During the coming year, we plan to introduce several new jar sizes and packaging configurations into the gift market. Product testing continues on specialty flavored and colored versions of our basic applesauce. A bright green sauce packaged in a shamrock-shaped jar will be introduced prior to St. Patrick’s Day this year. We expect our new products to be well-received in the marketplace.

 

 

I thank our customers for their continuing confidence in our products and in our ability to serve their applesauce needs. I thank our shareholders for their continuing support and our employees for their productive efforts throughout AppleSeed’s first year of operation.

 

Sincerely,

 

President and CEO

1. We know with reasonable certainty the amount of money involved.

2. We know the timing of the event.

3. An actual exchange between the parties of cash, goods or some formal representation of value (such as stock) has occurred.

• Cash available relative to the level of payables is a good indicator of how easily the company will be able to pay its bills in the future.

• Asset levels relative to sales volume indicates just how efficiently the company’s investments in productive assets (machinery and inventory) generate revenue.

• Gross margin as a percentage of sales determines how much the company is able to spend on various selling development and administrative activities and still make a profit.

• Liquidity

• Asset management

• Profitability

• Leverage

1. An order has been received.

2. The actual product has been shipped.

3. There is little risk the customer will not accept the product.

4. No significant additional actions are required by the company.

5. Title has transferred and the purchaser recognizes his responsibility to pay.

Strategic Planning Terms

1. Inflation Inflation does reduce purchasing power (value) over time. With a 5% per year inflation, a dollar received a year from today will only buy 95¢ worth of goods.

2. Risk There is always the chance that the promise of a dollar in the future will not be met and you will be out of luck. The risk could be low with a CD at an FDIC insured bank; or the risk could be high if it is your brother-in-law who is promising to repay a personal loan.

3. Opportunity Cost If you loan your dollar to someone else, you have lost the opportunity to use it yourself. That opportunity has a value to you today that makes today’s dollar worth more than tomorrow’s.

• The most commonly applied model of the “time value of money” is compound interest. Compounding is the process of computing the future value of money you have today given a certain interest rate.

• Now, if you want to compute the present value PV of a future value FV to be received in y years using the discount rate of d per year, then you would rearrange the equation above as:

• Note, discounting is the process of computing the present value of money to be received in the future. Discounting future project cash flows (future values) into present values will be important when we financially evaluate alternative capital projects. More later.

Discounting and Discount Rates

To see how this present value table was constructed, solve the present value equation on page 249:

 

 

then,

 

solved,

PV = $0.452

 

Internal Rate of Return (IRR)

NPV vs. IRR?

 

• NPV and IRR measure two different, but complementary, aspects of capital use. The two methods of evaluating capital investments each have inherent advantages and disadvantages. See the table below.

 

 

Net Present Value vs. Internal Rate of Return

 

 

Cash Flow Forecasting

 

Accurately estimating the amounts and timing of all the project cash inflows and outflows can be tricky. Forecasting cash flows requires a detailed understanding of the business and the project being analyzed, its input variables and expected outcomes.

We must estimate the amount and timing of original investments, changes in working capital and in ongoing costs and expenses. We must understand customers’ needs, wants, and market conditions to properly forecast revenues. In addition, the current and future financial environment, expected rates of inflation, project risk and tax considerations each play a part in NPV computations. Moreover, each of these elements of cash flow must be sequenced so that the NPV analysis will properly account for the time value of money. It is a lot to ask. See the box on this page for more on cash flow forecasting.

 

Selecting a Discount Rate

 

Selecting the appropriate discount rate is also difficult. The minimum discount rate would be equal to the company’s weighted average cost of capital. Any project must return that amount or it will dilute the value of the company. Then a “risk premium” should be added if there is increased risk in the project relative to the inherent risk associated with the company.

Cash Flow Forecasting The total cash flows used in an NPV analysis should come from well-prepared proforma financial statements developed for the project. Total project cash flows for a period can be computed as:

 

Income from operations equals revenue minus costs and expenses and is the major source of cash. (See page 53 for more details.) However, we must make two adjustments to get to actual cash inflow: (1) Income from operations is before taxes are deducted, so we need to subtract taxes here to get a corrected cash flow. (2) Also, depreciation charges are included in income from operations but do not lower cash in the period, so we must add depreciation back to get a correct cash flow. (See page 27 for more details.) Finally, only changes (up or down) to the components of working capital (inventory, receivables, payables, etc.) in the period are part of computing cash flow. If working capital has increased, cash is required and we will need to subtract that amount from total cash flow. (See page 36 for more details.)

 

Venture capitalists add a risk premium of 30% or more to startup company projects. A more modest risk premium of 5% to 15% might be more appropriate for an expansion project for an established company. Developing an NPV versus discount rate graph may be helpful. See page 252.

 

Sensitivity Analysis

 

Not all of the input variables in a capital budgeting analysis are equally important. For example, sales forecasts are almost always critical variables. Costs +/-10 % for a high gross profit product may not be all that important.

Performing a “sensitivity” analysis can help identify the key variables in a capital budgeting analysis. In a sensitivity analysis, variables are systematically changed to see how the resultant NPV or IRR is affected. If changing an assumption results in a big change in the computed project value, then it is an important variable to get right. If changing an assumption results in just a small change, then it is less important.

In “scenario analysis,” you might want to look at all your financial assumptions from a conservative perspective and see how cash flows are affected. For example, assume that everything will cost more and take longer to accomplish than your original projections. Often it is useful to prepare three sets of proforma statements: one with conservative (pessimistic) assumptions, one with realistic assumptions (most probable), and one with optimistic assumptions.

 

NPV Guidelines

 

Here are some operating guidelines for cash flow forecasting and NPV analysis:

1. Count ALL incremental cash flows. Incremental cash flows are those that arise from the project, from sales, costs, expenses, capital investment, increase in working capital or other sources.

Opportunity costs count too. If an existing asset or employee will be part of the project, then these costs should be included in the project’s cash flow.

2. Count ONLY incremental cash flows. Don’t include sunk costs. We have already spent that money and they should not be a part of the forward-looking decision process.

Accounting conventions used in balance sheet and income statement construction can mask the value of a project. Cash flow and profits are not the same. Being profitable does not necessarily mean the project has a positive cash flow.

3. Use nominal dollars in cash flow projections. A portion of the selected discount rate used in NPV calculations accounts for inflation. We must use nominal dollars in our forecasts so as not to double-count.

See Appendix B. Nominal vs. Real Dollars on page 277.

4. Account for time. Capital budgets often show initial cash outflow (the investment) and then a future cash inflow (the return). When analyzing cash flow, take into account that a dollar spent today is worth more than a dollar received in the distant future.

The discounted value of a future cash flow is determined by reducing its value by the appropriate discount rate for each unit of time (period) between when the cash flow is to be valued and the actual time of the cash flow in the future.

5. Don’t include costs of financing. In capital budgeting, the costs of financing should not be in the cash flow projections. Remember: Part of the discount rate used in NPV computations includes a cost of capital estimate.

6. Account for risk. Not all projects have the same risk. A project that is riskier should generate a higher expected return. A portion of the discount rate used in the NPV computation deals with risk degree.

7. Understand assumptions. Numeric tools used to evaluate capital projects often can provide valuable insights, but misapplied, they are worthless. Understand the assumptions upon which these calculations rest.

 

Microsoft Excel makes the computation part of NPV and IRR analysis easy. However, estimating cash flows and NPV discount rates can still be problematic. Nevertheless, using spreadsheet functions to perform sensitivity analyses quickly on key variables can greatly add to the value of analyses.

 

Using Spreadsheets

 

To compute NPV or IRR, the cash flow inputs are entered as an array (a sequence of spreadsheet cells) and the financial functions are computed using the formulas shown here. Be sure to review all the “help” screens available for each function to understand its application.

NPV(rate,value1,value2,…) Rate means the selected discount rate over one period. Value represents the array of each cash outflow or cash inflow equally spaced at the end of each period.

IRR(values,guess) Values represents an array of cells that contain the numbers for which you want to calculate the IRR. Guess input is an estimate of the resultant IRR. The spreadsheet uses an iterative technique starting with the guess to calculate the IRR.

Other spreadsheet functions are available for modified internal rate of return (MIRR) calculations using a lower discount rate for cash inflows and also for calculations to be used with projects with irregular cash flows (XNPV and XIRR).

 

Other Measures

 

Finance types regard NPV as the all-around best measure of value-added from a capital project, but there is a place for IRR in determining how efficiently capital is employed. NPV and IRR measure two different, complementary aspects of capital use. NPV and IRR can be used together in making capital budgeting decisions.

What follows are other common capital budgeting techniques—some with flaws, others helpful but complex.

 

Return on Investment (ROI) There is no standard way of computing ROI. Many organizations use ROI to mean a number of different analytical techniques. Thus, ROI measurement is flexible but also subject to confusion. Use the well defined NPV and IRR instead.

 

Payback Period Payback period refers to the period of time required for the return on an investment to repay the sum of the original investment. Shorter payback periods are obviously preferable to longer payback periods (assuming all else being equal).

Payback period as a measurement is easy to compute and is intuitively understandable. However, payback period computations ignore the time value of money and ignore any cash flows occurring after the payback period ends. As a method of capital budgeting analysis though, payback period has serious limitations. Don’t use it for that purpose.

“Our advice: Beware of geeks bearing formulas.”

 

 

Waren Buffett
commenting on financial models and the financial collapse of 2008

 

Real Option Analysis Real option analysis allows for go/no-go decisions during a project. The flexibility to slow down, or to even stop a project if necessary, lowers risk to the company. This lowered risk adds initial value to the project over a project that could not be stopped. Real option analysis can be quite complex but is very useful for large capital projects.

 

Monte Carlo Analysis A Monte Carlo analysis is a complex multivariable NPV calculation that first assigns various probability values to capital project variables and then simulates outcomes using brute force of computing power. The Monte Carlo analysis output is a probability distribution histogram showing the volatility and sensitivity in a project’s NPV. It is a very powerful technique, but requires sophistication to apply.

 

Summary

 

Different projects require different amounts and varying timing of investment, and they will generate different returns over time.

The NPV of a proposed project is the sum of all the project’s projected cash flows, each discounted by an appropriate rate to bring them to a comparable present value. Generally, when comparing projects, the project with the highest NPV should be accepted.

The IRR of the project is the discount rate where the NPV equals zero and discounted costs of the project equal discounted returns. Generally, if a project’s IRR is greater than the company’s hurdle rate, it should be accepted.

Capital budgeting using NPV and IRR measures allows management to select rationally from alternative project proposals with very different initial costs and future cash flows.

In the last section of this book, we will apply what we have learned about capital budgeting to help AppleSeed Enterprises choose between alternative expansion plans: (1) building a factory from scratch, or (2) buying an existing business. Decisions, decisions.

 

• That accrual has nothing to do with the Wicked Witch of the West. (pages 58-59)

• When negative cash flow is a sign of good things happening and when it is a sign of impending catastrophe. (page 195)

• Why discounts “drop” directly to the bottom line. (page 157)

• The important difference between liquidity and profitably. (pages 194-195)

• Those expenditures that are costs and those that are expenses. (page 50)

• Depreciation’s differing effect on income and on cash. (pages 118-119)

• Why product cost always depends on volume. (pages 148-151)

• Three common—and different—definitions of what a business is worth. (page 184)

• Why assets must always equal liabilities plus shareholders’ equity (worth) on the Balance Sheet. (page 16-17)

• Why working capital is so important and what business actions leads to more and what actions lead to less. (page 36)

• The difference between cash in the bank and profit on the bottom line and how they are related. (page 181)

• How many sets of books a company actually keeps. (page 213)

• Why some qualitative business analysis tools are as important as the numbers (pages 221-229)

• The difference between risk and uncertainty and which is worse when you try to plan. (pages 225-226)

• The difference between pre-money and post-money company valuations when you sell stock. (pages 231-232)

• Which business financing is more expensive, equity or debt? (page 233)

• How to compute today’s value of a dollar received tomorrow. (page 243)

• When to use NPV analysis and when to use IRR and why. (page 253)

• and more…