Cost Accounts Handouts

HAND OUTS ON ACCOUNTING Financial accounting is focused on four general-purpose, external financial statements: 1. 2. 3. 4.

balance sheet income statement statement of cash flows statement of stockholders' equity

Because these financial statements will be used by many different individuals outside of the company, the financial statements must follow generally accepted accounting principles (GAAP). These common rules or standards are developed by the Financial Accounting Standards Board (FASB). All of the rules are based on basic accounting principles and concepts such as cost, matching, full disclosure, going concern, consistency, and more. GAAP also requires that large corporations follow the accrual basis of accounting. This means that revenues are reported when they are earned (not when the money is received), and expenses are reported when they are incurred (not when paid). If a corporation's stock is publicly-traded, it is also required to follow the reporting requirements of the Securities and Exchange Commission (SEC), an agency of the U.S. government. This means the corporation's financial statements must be audited by an independent registered public accounting firm. The corporation must also provide additional financial reporting such as annual reports to stockholders and to the SEC (Form 10-K), proxy statements, and other financial information The three main financial statements are: 1. The balance sheet—which reports a corporation's assets, liabilities, and stockholders' equity as of a point in time (e.g., as of midnight of December 31, 2006). 2. The income statement—which reports a corporation's revenues and expenses for a period of time, such as a year, quarter, month, 52 weeks, 13 weeks, etc. 3. The statement of cash flows (or cash flow statement)—which provides information on the change in a corporation's cash and cash equivalents during the same period of time as the income statement. The financial statements that are distributed outside of a company need to be prepared in accordance with generally accepted accounting principles (GAAP). For example, the cost principle generally requires that the balance sheet should report long-lived assets at cost minus accumulated depreciation. The matching principle requires that the cost of long-lived assets used in the business be allocated to various accounting periods in which they generate revenues or are used up. Some costs are deferred to the balance sheet as assets and are expensed in subsequent periods

because of the going concern principle and the matching principle. The financial statements are to reflect these basic accounting principles as well as the detailed accounting pronouncements of the Financial Accounting Standards Board (FASB). When a corporation's stock is publicly traded, its financial statements must be audited by independent certified public accountants. These CPAs issue an audit report stating that the financial statements have been prepared in accordance with GAAP. The financial statements of some companies whose stock is not publicly traded might also be audited for the comfort of the owners and/or lenders. Always keep in mind that financial statements report the results of past transactions. There is no assurance that the future transactions will be similar to the past transactions. Financial Statements 1) The cost flow assumption that results in less net income when the cost of the inventory items is increasing. 2) The income statement format that reports the amount of gross profit as a line item is the _____________-step format. 3) A corporation's own stock that has been purchased by the corporation but is not retired is ___________ stock. 4) When an accountant is faced with two possible alternatives for reporting a situation, this accounting guideline directs the accountant to select the alternative that will result in less net income and less asset amount (or a greater liability amount). 5) When a long-term asset is sold for less than its book value, the difference is reported on the income statement as a ______. 6) An accounting year ending with a date other than December 31 is a _________year company. 7) A long-term asset used in a business that does not get depreciated. 8) The cumulative earnings of a corporation minus the cumulative dividends declared by the corporation is generally the amount reported on the balance sheet as ____________ Earnings. 9) The __________ of the financial statements includes the company name and the name of the financial statement. 10) Dividends that a corporation declares and pays are reported under this activity on the statement of cash flows. Break-even Point & Cost Estimation Knowing how costs change as volume or activities change is helpful when making some business decisions. For example, if most of a product's costs are fixed, then a company's total costs will increase only slightly when more units are produced and sold. Understanding this cost behavior might lead to special promotions that will increase profits and sales.

Costs and expenses that do not increase with reasonable increases in volume are known as fixed costs. Examples of fixed costs are the salaries of managers, property tax and depreciation. Costs and expenses that increase in total as volume increases are variable costs and expenses. A product's direct material, direct labor, and some overhead costs are variable costs. Two examples of variable overhead costs might be the electricity to power the equipment in the manufacturing process and factory supplies. Some costs are mixed costs-partly fixed and partly variable. An example might be the maintenance costs. You can determine how much of a mixed cost is fixed and how much is variable by using several techniques. One technique is to plot the costs on a graph where the y-axis is the total cost and the x-axis is the amount of volume or activity. If the plotted points form a straight line, you can extend the line through the y-axis. The point where the line intersects the y-axis is the fixed cost. Another technique is the high-low method. With this method, you compare the total cost at the highest level of activity to the total cost at the lowest level of activity. The variable cost rate is the difference in total cost divided by the difference in the volume of activity. A more sophisticated technique for separating the fixed and variable costs in a mixed cost is regression analysis. This technique computes the best fitting line through the plotted points by utilizing the least-squares method. Breakeven analysis utilizes the concept known as contribution margin. Contribution margin is sales dollars minus variable costs and variable expenses. If a product sells for $10 and its variable costs and variable expenses are $6, the contribution margin is $4 per unit. The formula for the breakeven point in units of product is the total fixed costs divided by the contribution margin per unit. For example, if the total fixed costs are $40,000 and the contribution margin per unit is $4, the breakeven point is 10,000 units ($40,000 divided by $4). Cash flow statement The cash flow statement (or statement of cash flows) is one of the main financial statements. The cash flow statement explains how a company's cash and cash equivalents have changed during a specified period of time. The cash flow statement is organized into three sections: 1. Cash provided and used in operating activities, 2. Cash provided and used in investing activities, 3. Cash provided and used in financing activities. Under the indirect method of preparing and presenting the cash flow statement, the operating activities section begins with the net income during the period of the statement. Since the company's net income was calculated and reported under the accrual basis of accounting, the amount of net income needs to be adjusted to a cash amount. The first adjustment is to add back the amount of depreciation, depletion, and amortization expenses, since these expenses had reduced net income but did not

reduce the company's cash. Next, any gains or losses on the sale of long-term assets used in the business are listed, since the entire amount received from the sale is reported as investing activities. Lastly, the changes in the current assets (other than cash) and the changes in current liabilities are listed. For example, if inventory has increased, the amount of the increase in inventory is subtracted because additional cash would have been used to increase the amount of inventory. The amount by which a current liability decreased is also subtracted, since it is assumed that cash was used to decrease the current liability. All of the items reported in the operating activities section are combined into a final number: the net amount of cash provided by operating activities. The second section of the cash flow statement reports the investing activities. The changes in the long-term asset account balances are reported in this section. For example, if a company's long-term investment in another company has increased during the period, the amount of the increase is reported as a negative amount in the investing activities section—an indication that cash was used. The same is true for the purchase of property, plant and equipment for use in the business—an increase in the equipment account indicates that cash was used to purchase equipment. If a long-term investment or plant asset is sold, the entire proceeds from the sale are reported as a positive amount in the investing activities section. This indicates that cash was provided or increased from the sale. (Any gain or loss on the sale is an adjustment to the net income reported in the operating activities section of the statement.) The third section of the cash flow statement contains the company's financing activities. This section lists the changes in long-term liabilities and stockholders' equity. For example, if Bonds Payable has increased by $1,000,000, it is assumed that cash of $1,000,000 was provided. The $1,000,000 will appear as a positive amount in the financing activities section of the statement. If Bonds Payable decreased, then the amount of the decrease will be reported as a negative amount— indicating that cash was used to retire the bonds. The amount of dividends declared and paid will also appear as a negative amount, since cash was used. If the company sells some of its shares of stock, the amount received will be reported as a positive amount since it provided cash. If the company purchases some of its shares of stock, the amount will appear as a negative amount in the financing activities section because cash was used. In addition to the three main sections of the cash flow statement, it is also necessary to disclose significant non-cash transactions (e.g. exchanging stock for land) and other items required by generally accepted accounting principles. Cash Flow Statement 1) The conversion of bonds into common stock is an example of _____________________ information that is reported outside of the three major sections of the statement of cash flows.

2) Companies using the indirect method must also disclose the amount paid for ___________ and income taxes. 3) Cash __________ (plural) from financing activities occur when a corporation issues equity securities, bonds, and long-term notes. 4) The purchase of _____________ stock will be reported as a decrease in the cash provided by financing activities. 5) The ________ (gain, loss) on the sale of an asset used in a company's business will be a deduction to the cash provided by operating activities under the indirect method. 6) The _________________ (similar to repurchase or retirement) of bonds payable will decrease the cash provided by financing activities. 7) The 2006 statement of cash flows of ABC Corp. explains the change in the cash and ________ equivalents from December 31, 2005 through December 31, 2006. 8) The entire____________ from the sale of an asset used in the business will be reported as an increase in the cash provided by investing activities. 9) An increase in Accounts __________ would be an increase in the cash provided by operating activities under the indirect method. 10) Cash _________ (opposite of inflows) from investing activities occur when a corporation purchases equipment to be used in the business and when it makes a long-term investment in another corporation What is the difference between cash flow and free cash flow? A corporation’s cash flow from operations is available from the first section of the statement of cash flows. Usually the calculation begins with the accrual accounting net income followed by adding back depreciation expense and then adjusting for the changes in the balances of current assets and current liabilities. Free cash flow is often defined as the cash flow from operations (or net cash flows from operating activities) minus the cash necessary for capital expenditures. Occasionally, dividends to stockholders are also deducted. DEPRECIATION Depreciation involves allocating the historical cost of a long-term asset to expense over the useful life of the asset. Long-term or long-lived assets that are used in a business (except land) must be depreciated in order to match the asset's cost to the accounting periods when revenues are earned from using the asset. In other words, depreciation is not an attempt to value an asset. Rather, depreciation is an attempt to achieve the matching principle. Since the depreciation reported in the financial statements is based on the useful life of an asset, there can be different depreciation amounts from one company to another using a similar asset. For example, a new machine might be useful for 10 years in a company that processes soft metals, but a similar machine might be useful for only 5 years in a company that processes hard metals. The result might be annual depreciation expense of $10,000 for 10 years for one company, while another

company's financial statements will report $20,000 per year for 5 years. (The depreciation for tax purposes will likely be still another amount, since tax depreciation is based on income tax regulations.) There are different methods for calculating depreciation expense. Generally, companies use straight line depreciation for its financial statements. The straight line method means the annual depreciation expense will be the same amount for each full year of use. Alternatively, some companies might use an accelerated method of depreciation such as double-declining balance or sum-of-the-years' digits. The accelerated methods mean more depreciation expense in the early years of an asset's life and less in the later years of an asset's life. Another method of calculating depreciation is the units of production or units of activity method. Under the units of activity method, more depreciation is recorded in the accounting periods when the asset's use is greater. In periods when the asset is used less, the amount of depreciation is smaller. The accounting entry for recording depreciation for financial purposes is a debit to Depreciation Expense and a credit to Accumulated Depreciation. Accumulated Depreciation is a contra asset account that is reported in the balance sheet classification Property, Plant and Equipment. Inventory and Cost of Goods Sold A retailer's inventory is its merchandise that has not yet been sold. The cost of the inventory is reported on the balance sheet as a current asset. When merchandise is sold, the cost of the items sold is reported on the income statement as the cost of goods sold. The formula for the retailer's cost of goods sold is the cost of its net purchases minus the increase in inventory, or its cost of net purchases plus the decrease in inventory. This formula assures the matching of costs with revenues. A manufacturer reports three inventory amounts: raw materials (at cost), work in process (at cost), and unsold finished goods (at cost). The cost of these three inventories is reported on the balance sheet as a current asset. The cost of the finished goods that were sold in the current period is reported on the income statement as the cost of goods sold. The formula for a manufacturer's cost of goods sold is the cost of goods manufactured minus the increase in the finished goods inventory, or the cost of goods manufactured plus the decrease in finished goods inventory. Again, this formula assists in the matching of costs with revenues. Costs for inventory include all costs that were necessary to get the items into inventory and ready for sale. For a retailer, the cost of a product is the vendor's invoice amount plus any freight-in on goods purchased FOB shipping point. A manufacturer's cost of finished goods and work in process will be the cost of direct material, direct labor, and manufacturing overhead. When costs of items are increasing, one must decide which costs will be reported as inventory and which costs will be reported as the cost of goods sold. Under the firstin, first-out (FIFO) cost flow assumption, the older (lower) costs will be leaving

inventory first and the most recent costs will remain in inventory. The last-in, firstout (LIFO) cost flow assumption has the recent higher costs flowing out of inventory first (and will become the cost of goods sold). The older lower costs will remain in inventory (unless the quantity is drastically reduced). The LIFO cost flow can be different from the physical movement of goods. In other words, a company can diligently rotate its stock by moving the oldest goods to customers and yet flow the most recent costs to the cost of goods sold on its income statement. Stockholders' Equity Stockholders' equity is one of the three major sections of a corporation's balance sheet. Stockholders' equity is the difference between the reported amounts of a corporation's assets and liabilities. Stockholders' equity is subdivided into components: (1) paid-in capital or contributed capital, (2) retained earnings, and (3) treasury stock, if any. The paid-in capital component reports the amounts the corporation received when it issued its common and preferred (if any) stock. If the stock had a par value, the total par value of each class of stock is reported in a separate "par" account. Any amount received that was greater than the par amount is reported in an account such as Premium on Common or Paid-in Capital in Excess of Par—Common Stock. Retained earnings reports the cumulative net income since the start of the corporation minus the dividends declared since the start of the corporation. (In rare instances there may have been some adjustments to the balance of the retained earnings.) In effect, the retained earnings are the profits that the stockholders have opted to reinvest in the business. The amounts are likely to be invested in various assets and are not likely to be in cash. Treasury stock (cost method) reports the amount paid by the corporation to purchase its own shares of stock. This account will have a debit balance and therefore reduces the amount of stockholders' equity. The total of stockholders' equity is the book value of the corporation. You should realize that the book value or stockholders' equity is not an indication of the market value of the corporation.