Tim Redmer Accounting

Chapter One: Accounting and Finance: An Introduction

An Introduction to Accounting and Finance: Text and Cases

by Timothy A. O. Redmer Copyright Ó 1999

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Chapter One: Accounting and Finance: An Introduction

Table of Contents Chapter One: Accounting and Finance: An Introduction ....................... 1 Chapter Objectives ............................................................................... 1 The Objective and Scope of this Text Book ........................................... 1 Chapter Content ................................................................................... 2 Accounting Defined .............................................................................. 4 Finance Defined.................................................................................... 6 The Role of Ethics in Accounting and Finance ....................................... 7 Summary ............................................................................................ 10 Chapter Questions.............................................................................. 12 Cases ................................................................................................. 13 Chapter Two: The Income Statement and the Balance Sheet .............. 17 Objectives .......................................................................................... 17 Account Categories ............................................................................ 17 Accrual Accounting............................................................................. 26 The Accounting Process...................................................................... 27 Income Statement............................................................................... 33 Statement of Retained Earnings .......................................................... 35 Balance Sheet ..................................................................................... 36 Summary ............................................................................................ 39 Study Problems................................................................................... 40 Problems ............................................................................................ 59 Cases ................................................................................................. 66 Chapter Three: Financial Statement Analysis....................................... 73 Objectives .......................................................................................... 73 The Role and Purpose of Financial Statement Analysis ........................ 73 Benefits of Financial Statement Analysis ............................................. 74 Limitations of Financial Statement Analysis......................................... 74 Liquidity Ratios................................................................................... 77 Activity Ratios..................................................................................... 78 Debt Ratios......................................................................................... 86 Profitability Ratios .............................................................................. 91 Market Ratios ..................................................................................... 97 Horizontal and Vertical Analysis ....................................................... 102 Summary .......................................................................................... 104 Problems .......................................................................................... 106 Cases ............................................................................................... 114 Chapter Four: Budgets and the Budget Process ................................. 121 Chapter Objectives ........................................................................... 121 The Nature and Purpose of the Budget.............................................. 121 The Budget Process .......................................................................... 122 Benefits of a Budget Process ............................................................. 123 Disadvantages of a Budget Process................................................... 124 Types of Budgets .............................................................................. 124 Summary .......................................................................................... 139 Self-Study Problems ......................................................................... 140 ii

Chapter One: Accounting and Finance: An Introduction Problems .......................................................................................... 153 Cases ............................................................................................... 162 Chapter Five: Performance Evaluation ............................................... 169 Objectives ........................................................................................ 169 Standard Accounting Systems ........................................................... 169 Performance Reports ........................................................................ 172 Variance Analysis.............................................................................. 177 Summary .......................................................................................... 183 Self-Study Problems ......................................................................... 184 Problems .......................................................................................... 200 Cases ............................................................................................... 207 Chapter Six: Differential Analysis....................................................... 211 Objectives ........................................................................................ 211 Differential Analysis.......................................................................... 211 Contribution Margin Analysis............................................................ 213 Short-Term Decision-making Techniques ........................................ 216 Summary .......................................................................................... 224 Self-Study Problems ......................................................................... 226 Problems .......................................................................................... 236 Cases ............................................................................................... 251 Chapter Seven: Current Asset Management: Cash and Marketable Securities............................................................................................ 257 Objectives ........................................................................................ 257 Cash and Marketable Securities ........................................................ 257 The Cash Flow Process ..................................................................... 261 Management of Cash Flows .............................................................. 265 Bank Reconciliation .......................................................................... 266 Summary .......................................................................................... 270 Self-Study Problems ......................................................................... 271 Problems .......................................................................................... 284 Cases ............................................................................................... 290 Chapter Eight: Statement of Cash Flows ............................................ 297 Objectives ........................................................................................ 297 The Cash Flow Statement.................................................................. 297 Preparing a Statement of Cash Flows ................................................ 298 Summary .......................................................................................... 307 Self-Study Problems ......................................................................... 308 Problems .......................................................................................... 323 Cases ............................................................................................... 330 Chapter Nine: Current Asset Management: Accounts Receivable and Inventory............................................................................................ 339 Chapter Objectives ........................................................................... 339 Accounts Receivable Management .................................................... 339 Accounts Receivable Ratios............................................................... 343 Marginal Analysis of Accounts Receivable ......................................... 344 Inventory Management ..................................................................... 345 iii

Chapter One: Accounting and Finance: An Introduction Inventory Ratios................................................................................ 349 Summary .......................................................................................... 350 Self-Study Problems ......................................................................... 351 Problems .......................................................................................... 360 Cases ............................................................................................... 369 Chapter Ten: Current Liability Management ...................................... 373 Chapter Objectives ........................................................................... 373 Current Liability Management ........................................................... 373 Types of Current Liabilities ............................................................... 373 Cost of Credit ................................................................................... 379 Summary .......................................................................................... 384 Self-Study Problems ......................................................................... 385 Problems .......................................................................................... 394 Cases ............................................................................................... 398 Chapter Eleven: The Time Value of Money ......................................... 401 Objectives ........................................................................................ 401 Time Value of Money ........................................................................ 401 Time Value of Money Models ............................................................ 404 Procedures Used in Computing Time Value of Money Models ........... 407 Bond Valuation Time Value of Money Model ..................................... 409 Summary .......................................................................................... 413 Self-Study Problems ......................................................................... 414 Problems .......................................................................................... 438 Cases ............................................................................................... 441 Chapter Twelve: Risk and Return ....................................................... 445 Objectives ........................................................................................ 445 Risk .................................................................................................. 445 Return .............................................................................................. 447 Diversification .................................................................................. 449 Summary .......................................................................................... 453 Self-Study Problems ......................................................................... 454 Problems .......................................................................................... 462 Cases ............................................................................................... 467 Chapter Thirteen: Security Valuation and the Cost of Capital ............ 471 Objectives ........................................................................................ 471 Valuation of Securities ...................................................................... 471 Security Valuation Models................................................................. 473 Cost of Capital.................................................................................. 480 Summary .......................................................................................... 484 Self-Study Problems ......................................................................... 485 Problems .......................................................................................... 502 Cases ............................................................................................... 508 Chapter Fourteen: Capital Budgeting ................................................. 513 Objectives ........................................................................................ 513 The Role of Capital Budgeting........................................................... 513 Cash Flows and Capital Investments ................................................. 514 iv

Chapter One: Accounting and Finance: An Introduction Capital Budgeting Methods of Analysis ............................................. 518 Summary .......................................................................................... 526 Self-Study Problems ......................................................................... 527 Problems .......................................................................................... 535 Cases ............................................................................................... 547 Chapter Fifteen: Long-Term Debt....................................................... 553 Objectives ........................................................................................ 553 Long-Term Debt............................................................................... 553 Leases .............................................................................................. 561 Financial and Operating Leverage ..................................................... 563 Summary .......................................................................................... 566 Self-Study Problems ......................................................................... 567 Problems .......................................................................................... 575 Cases ............................................................................................... 586 Chapter Sixteen: Equity Funding ........................................................ 589 Objectives ........................................................................................ 589 Equity Funding ................................................................................. 589 Dividend Policy ................................................................................. 593 Earnings Per Share and Other Equity Related Measures ..................... 595 Summary .......................................................................................... 598 Self-Study Problems ......................................................................... 599 Problems .......................................................................................... 604 Cases ............................................................................................... 609

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Chapter One: Accounting and Finance: An Introduction

Chapter One: Accounting and Finance: An Introduction Chapter Objectives 1. 2. 3. 4.

Review the overall objective and scope of this textbook. Define accounting and understand its role in the business world. Define finance and understand its role in the business world. Examine the role of ethics as it relates to accounting and finance.

The Objective and Scope of this Text Book Individuals in virtually every profession today come into contact with business principles and concepts. Unfortunately, many people neither have the time nor opportunity to learn basic business concepts and especially accounting and finance topics. In the education process, there appears to be little middle ground, students either get no exposure to these topics or they have to take an entire course which gets into details beyond their fundamental needs. An Introduction to Accounting and Finance: Text and Cases is designed to introduce critical topics in the areas of accounting and finance in a basic context. This material is relevant for the general business manager as well as those who do not have a business background but wish to gain a foundational level of understanding and expertise. The topics are presented from a conceptual point of view to give the manager a fundamental understanding of the material. Additionally, an underlying emphasis of each topic presentation will be; what does the individual need to know to ask the correct questions or to comprehend information as presented by the accountant or financial manager. It is not the intent of this text to make one an expert in either the area of accounting or finance. However, at the same time, it is expected that anyone completing this text will be able to understand and work through basic examples and illustrations of accounting and finance problems. Exercises of this nature will help to reinforce the important concepts and principles presented in the text. A manager, who does not have a strong background in accounting or finance, must rely on having good people in those positions. Individuals who tend toward the accounting and finance career fields are often classified as the "numbers people" or "those with quantitative skills". Such a stereotyping can present a dilemma for the nonfinancial individual. The very reason an individual manager may be classified as nonfinancial is because of an aversion to a quantitative or numbers orientation. A successful business manager, in many cases, must rely on the support of capable people in critical positions within the organization. The manager will need to make decisions based upon the input of information from these members of the management team. Financial or quantitative information is a key ingredient in the decision-making process. The dilemma for the manager, without a comprehension of the accounting and financial aspects of the business, is a possible misunderstanding of the presentation of such information. Misinterpretation of information can sometimes be worse than no information in a decision process, especially when it leads to incorrect courses of action. With no 6

Chapter One: Accounting and Finance: An Introduction

information, business managers will likely resist change; however, with incorrect information, or the misinterpretation of information, the business manager could select courses of action that might change a company for the worse. This need for an individual to gain at least the basic skills and understanding in the areas of accounting and finance, so they can compete effectively in the business world, is the underlying reason and objective for a text of this nature. A manager, while often being a specialist, with abundant skills and abilities in a particular area, also needs to be a generalist, with a fundamental knowledge level in all areas of business. To be effective in the decision-making process, the manager is going to have to have a basic understanding in all areas of business management, including both quantitative and qualitative skills. The business or nonbusiness individual, without the expertise in specific areas, is going to have to know how to converse with the experts in those areas, and know how to analyze and interpret information for decision-making purposes. Some may say that a particular individual has just enough information to be dangerous, or individuals with a little knowledge in a particular area suddenly become experts. In such cases, the presentation of accounting and finance information in a basic format, as an objective of this text, could be misleading and could have dysfunctional results. However, at the same time, an equally relevant argument could be made for the idea that a little information is better than no information. Basically, knowledge is good for the soul, and one should never stop learning. It is not the accumulation of knowledge that is the problem, it is what an individual does with the knowledge once obtained. Such a philosophy lends credibility to a text of this nature. The benefits to any individual, with a limited understanding of financial and accounting skills, to be exposed to a broad and basic overview of these topics, should far outweigh the potential hazards of possible misuse or misunderstanding of the knowledge in the business setting. This text is designed to appeal to the nurse who has to evaluate performance measures, as well as the teacher who needs to prepare a budget for yearly classroom activities. It should also appeal to the preacher who has to develop a capital campaign for a new church building program or the dentist who has to monitor cash flow. An individual does not have to be a business major to benefit from the topics presented in this test. However, if that nurse, or teacher, or preacher, or dentist is going to be involved in business related decision situations, the concepts learned in this book can make it easier to understand those processes.

Chapter Content Specific topic areas addressed in this text will begin with the accounting process and the development of financial statements. A basic understanding of financial statements to include the income statement, balance sheet, and statement of retained earnings is critical in many decision-making situations. Following the presentation of the financial statements is Chapter 3 covering the analysis of financial statements. Accounting reports have limited usefulness unless they can be properly analyzed. The information obtained from financial statements serves as the basis for the development of financial ratios that can be used in the review of a company.

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Chapter One: Accounting and Finance: An Introduction

Budgeting, presented in Chapter 4, is an essential component related to both the planning and control functions of management. The budget by its very nature is a plan, and serves as a guideline for future management courses of action. The budget can also serve as a control tool by providing a standard against which performance can be measured. Performance reporting is a natural follow up to the budgeting and financial reporting process. Areas of responsibility at various levels of management need to have a system of accountability and control. Reports need to be properly developed and procedures established to analyze variations between predetermined standards and actual results. Accounting information plays an important role in future decisions. The concept of relevant or differential cost, presented in Chapter 6, underlies decisions using contribution margin and cost behavior patterns, such as discontinue or start products, make or buy options, and sell or process products further. A major reason that many businesses are unsuccessful is cash management or the lack of cash management. The role and use of cash in a business impacts many areas of management, but it is especially important in the operating function. Following the chapter on cash management, Chapter 8 will present a detailed discussion on the statement of cash flows. The introduction of this financial statement was delayed until after the cash management chapter to give the reader a greater appreciation of the role of cash in a company. Working capital management specifically addresses cash management but also considers important areas such as accounts receivable, inventory and short-term debt management. Chapters 9 and 10 give a comprehensive overview of the importance of managing working capital. Company management can quickly lose liquidity if they allow accounts receivable and inventory to build to excessive levels. Additionally, the effective rate of interest can be substantially higher than a quoted simple interest rate and a manager needs to understand the difference when it comes to borrowing money. Certain technical skills need to be understood even with a minimum competency in quantitative processes. The principles of time value of money in Chapter 12 and the risk return relationship in Chapter 13 are fundamental in the application of several financial concepts. Business calculators and software programs essentially reduce the use and understanding of these technical methods to a data entry process. Capital budgeting is a technique, which incorporates the use of time value of money into decisions involving major asset acquisitions, and the results could impact the company over an extended time period. Business managers need to be aware of the most appropriate methods to evaluate major decisions involving substantial outlays of capital that are often irreversible without large additional sums of cash. To support long-term asset requirements, business managers need to be aware of the many sources of funds broadly classified as debt, covered in Chapter 15, and equity, covered in Chapter 16. Active markets with trading in bonds and stocks provide underlying liquidity to the process of issuing corporate bonds and/or preferred and common stock. Ethical situations can easily arise in any business setting when money is involved. The lack of understanding of the accounting and finance process by the business manager is an incentive for the unethical employee to manipulate the system. An appreciation of

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Chapter One: Accounting and Finance: An Introduction

ethical standards and a commitment to the proper reporting and disclosure of financial information needs to be constantly reinforced within the area of accounting and finance. Obviously not every area of accounting and finance can be covered in a single text at the introductory level. In accounting, topics such as adjusting entries and more in-depth presentations on the various methods to record inventory and depreciation are left for a more advanced accounting text. Detailed discussions of the acquisition, use, and disposal of fixed assets and debt instruments are not included. In the area of finance, specific presentations related to stockholders equity, dividend policy, convertible securities, warrants, and options are left for more advanced finance texts.

Accounting Defined The American Accounting Association defines accounting as "the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by the users of the information."1 Accounting is called the "language of business" as it provides a means of systematically recording and reporting information in a financial format. The Accounting Process The accountant begins the process by observing a business-related activity that has financial implications. Not all business activities can be measured in monetary terms, and the accountant needs to differentiate between these activities. Financial business activities are called transactions. Once the accountant has observed the transaction, the appropriate accounts that are affected need to be identified. Sometimes, a business transaction will recognize some actions coming into the business and some actions leaving the business. These actions should be equal and offsetting. The identification of accounts is broadly classified as assets, liabilities, and equity, which include revenues and expenses. In any financial business transaction, two or more accounts within these broad categories will increase or decrease in size. The measurement process involves determining the nature and extent of the increase or decrease in the appropriate accounts. Once the transaction is identified and measured, it needs to be recorded in the proper account categories. Without the recording step, the transaction will not get into the system and its impact on the overall performance will be unknown. The input of data through the recording process completes the journal entry phase of a business transaction. With the appropriate data now entered into the accounting system, the information needs to be summarized into a usable fashion so that it can be usefully presented in an organized report format. Summarization of accounting information into specific account categories called ledgers is recognized as the posting process. The accounts are either increased or decreased in each transaction, and the resulting balance in the ledger account is summarized for reporting purposes. Since the information needs to be presented for decision-making purposes, this collection process is critical. The whole purpose of accumulating data is to American Accounting Association, A Statement of Basic Accounting Theory (Evanston, Ill., 1966), p. 1. 1

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Chapter One: Accounting and Finance: An Introduction

Action Observation Business Transaction Recording Process Summarization of Data Reporting

The Accounting Process Illustration 1-1 Accounting Activity Determine Accounting Action Identify and Measure Journal Entry Post in Account Ledger Financial Statements

have it available in different types of report formats to aid the business manager in all aspects of the business. Some accounting reports that will be examined by external users outside of the company need to be in a specific format as directed by generally accepted accounting principles. Other reports can follow formats directed by management, as their primary purpose will be for use within the company. Reports summarizing the various financial activities of the company can be analyzed and interpreted by management and used to aid in relevant decision-making situations. This communication process of economic information completes the accounting process as defined; however, there are many activities and other related actions that go into the accounting function. The business manager needs to be aware that the information gathered and presented in the accounting process be both relevant and reliable. Relevant information means that the information will be useful for decision-making purposes. A company does not need to clutter its record keeping activities with information that is not useful. In a time of increased automation, the probability of information overload is a distinct possibility. Reliable information is essentially correct information. This information does not necessarily have to be precisely accurate, such as to the nearest penny, to be reliable. However, the users of information have to have confidence in the values so they can be comfortable when applying the knowledge in the decision process. Illustration 1-1 highlights the accounting process.

Finance Defined Finance does not generally have a definition in the way that accounting was previously defined. Finance seems to be recognized more as a means to achieving an objective. An underlying goal for a company is the maximization of shareholder wealth, or the maximization of the total market value of the current shareholders' common stock. The financing activity is oriented toward achieving this specific goal. Years ago finance focused primarily on descriptive activities such as raising capital, government and other forms of regulation, and merger and acquisition activities. More recently, the area of finance has broadened with greater emphasis on internal activities in support of management. Issues such as working capital management, capital budgeting,

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Chapter One: Accounting and Finance: An Introduction

firm valuation, security analysis, and capital structure theory are critical to a company's financial operation. Shareholder wealth maximization goes beyond the concept of profit maximization by factoring in the conditions of uncertainty on return and timing of returns. Uncertainty is a condition of risk and there is a perceived direct correlation between risk and return. The higher the risk, the higher the required return needed to offset the increased risk component. Timing relates to how long it takes to realize returns. The sooner returns are realized, usually in the form of cash, the higher the wealth maximization. The faster return of cash also decreases the uncertainty and related risk and offers the investor more time to earn supplementary returns. Shareholders react to the overall performance of a company through the market price of its common stock. The price reflects potential future cash flows through capital appreciation or capital depreciation plus any dividends. The timing of these cash flows are discounted by a rate of return dependent upon the perceived riskiness of the company. A market price of the company is directly related to cash flow timing and amount and indirectly related to risk. The sooner the cash flows occur, or the greater the cash flow amount, the higher the market price. The higher the level of risk, the lower the market price of the stock. A stock’s price is usually higher when a company · receives cash flows sooner versus later · receives more versus less cash flows · has less versus greater risk Illustration 1-2 considers shareholder wealth maximization in another way. If an investor had the choice of two equally priced investments: one with a cash flow in year one and a second with an equal cash flow in year two, the investor should select the investment with the cash flow in year one. This situation underlies the concept of the time value of money. Likewise, if an investor had the choice of two equally priced investments: one with a lower level of risk and the other with a higher level of risk, the investor should select the investment with the lower level of risk. This situation underlies the concept of uncertainty as measured by risk. Shareholder Wealth Maximization Illustration 1-2

Factor Cash Flow Risk

More Favorable Situation Early Low

Less Favorable Situation Late High

The Role of Ethics in Accounting and Finance Several professional organizations in accounting and finance have developed codes of professional conduct or codes of ethics. A review of the major components of these codes can assist the business manager in understanding how the accountant or financial manager is expected to act in an ethical manner.

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Chapter One: Accounting and Finance: An Introduction

The American Institute of Certified Public Accountants Code of Professional Conduct includes six articles, which define the principles to which the accountant performs unswerving commitment to honorable behavior, even at the sacrifice of personal advantage. Article 1: Responsibilities In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities. Article 2: The Public Interest Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism. Article 3: Integrity To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity. Article 4: Objectivity and Independence A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services. Article 5: Due Care A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member's ability. Article 6: Scope and Nature of Services A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.2 The Institute of Management Accountants has published Standards of Ethical Behavior for Management Accountants, which lists four major responsibilities of management accountants. Competence Management accountants have a responsibility to: · Maintain an appropriate level of professional competence by ongoing development of their knowledge and skills. · Perform their professional duties in accordance with relevant laws, regulations, and technical standards. · Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information. Confidentiality Management accountants have a responsibility to: · Refrain from disclosing confidential information acquired in the course of their work except when authorized, unless legally obligated to do so. American Institute of Certified Public Accountants Code of Professional Conduct, American Institute of Certified Public Accountants, New York, New York, as revised June 30, 1992 2

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Chapter One: Accounting and Finance: An Introduction

·

·

Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their work and monitor their activities to assure the maintenance of that confidentiality. Refrain from using or appearing to use confidential information acquired in the course of their work for unethical or illegal advantage either personally or through third parties.

Integrity Management accountants have a responsibility to: · Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. · Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically. · Refuse any gift, favor, or hospitality that would influence or would appear to influence their actions. · Refrain from either actively or passively subverting the attainment of the organization's legitimate and ethical objectives. · Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. · Communicate unfavorable as well as favorable information and professional judgments or opinions. · Refrain from engaging in or supporting any activity that would discredit the profession. Objectivity Management accountants have a responsibility to: · Communicate information fairly and objectively. · Disclose fully all-relevant information that could reasonably be expected to influence an intended user's understanding of the reports, comments, and recommendations presented.3 The Financial Executives Institute has also published a Code of Ethics, which is shown below in its entirety. As a member of Financial Executives Institute, I will: · Conduct my business and personal affairs at all times with honesty and integrity. · Provide complete, appropriate, and relevant information in an objective manner when reporting to management, stockholders, employees, government agencies, other institutions, and the public. · Comply with rules and regulations of federal, state, provincial, and local governments, and other appropriate private and public regulatory agencies.

National Association of Accountants (now Institute of Management Accountants), Statements on Management Accounting: Objectives of Management Accounting, Statement No. 1C, New York, N. Y., June 1, 1983. 3

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Chapter One: Accounting and Finance: An Introduction

·

Discharge duties and responsibilities to my employer to the best of my ability, including complete communication on all matters within my jurisdiction · Maintain the confidentiality of information acquired in the course of my work except when authorized or otherwise legally obligated to disclose. Confidential information acquired in the course of my work will not be used for my personal advantage. · Maintain an appropriate level of professional competence through continuing development of my knowledge and skills. · Refrain from committing acts discreditable to myself, my employer, FEI, or fellow members of the Institute.4 Ethical codes and codes of conduct are necessary; however, ethical behavior involves more than adherence to codes. Individuals generally know the difference between right and wrong, yet there can be variations on what an individual may consider as right or wrong. Additionally, for the accountant or financial manager, the opportunities and temptations to "get rich quick" create an additional burden to maintain ethical integrity. All the codes will do little to stop an individual with misguided intentions. As a business professional, most individuals place a great deal of value on their reputation or integrity. This self-imposed criterion is usually sufficient for most individuals to maintain ethical standards. Also, all individuals in the business world make mistakes, but if their intentions are good, these mistakes are usually forgiven and the individual can recover. On the other hand, if an individual knowingly makes an ethical violation, a trust has been broken, and often such mistakes are irrevocable and career ending. Severe penalties and the loss of an individual’s and/or a company's integrity are generally sufficient to curtail unethical actions. However, we all have sinned and come short of the glory of God. Greed can be a powerful motivator, and pressures can build up for quick personal gain regardless of the potential risk. The business manager has to be constantly aware of the possibility for ethical violations and create a business environment that will promote ethical conduct. The golden rule in Matthew 7:12 states: Therefore all things whatsoever ye would that men should do to you, do ye even so to them: this is the law and the prophets.

Such a practice would be a good start toward building a business environment based on sound ethical behavior.

Summary Business managers or any individuals with an interest in business need to have a basic level of knowledge in the area of accounting and finance even if they have no intention of undertaking day to day activities within these disciplines. This text is organized to provide a conceptual understanding and introduction to the basic skills in critical areas of accounting and finance.

4

Adopted by the Board of Directors of the Financial Executives Institute, October 13, 1985.

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Chapter One: Accounting and Finance: An Introduction

Ethics is an important aspect especially when it comes to dealing with money and financial accountability. Professional accounting and financial associations have taken a strong stand in support of codes of conduct and financial integrity. The business manager should be aware of the ethical standards to which the accountant or financial manager is held accountable. Everyone in the business environment should work together in the stewardship of company resources by following ethical guidelines. Maintaining an individual and company’s integrity should be a primary objective in any business setting.

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Chapter One: Accounting and Finance: An Introduction

Chapter Questions 1-1.

As a business manager what is the most important accounting or finance related activity that you need to understand? Explain. 1-2. As a business manager, if you needed to hire a financial manager, what qualifications would you consider important? 1-3. Shareholder wealth maximization is an objective of the financial manager. How would this objective fit into the overall objectives you would establish for a company? 1-4. Explain how accounting and finance information can aid in the decision-making process? How can accounting and finance information hinder the decision-making process? 1-5. How does the accountant go through the accounting transaction process? 1-6. What actions might company management take to increase the price of its company stock? 1-7. After reviewing the American Institute of Certified Public Accountants’Code of Professional Conduct, which article do you think is most important from the viewpoint of a business manager? Which article do you think is most important from the viewpoint of the accountant? 1-8. After reviewing the Institute of Management Accountants’Standards of Ethical Behavior, which responsibility do you think is most important from the viewpoint of a business manager? Which responsibility do you think is most important from the viewpoint of the accountant? 1-9. After reviewing the Financial Executives Institute’s Code of Ethics, which provision do you think is most important from the viewpoint of a business manager? Which provision do you think is most important from the viewpoint of the financial manager? 1-10. How would you apply the golden rule to your business, and specifically to the accounting and financing activities? 1-11. Identify three verses of scripture that relate to accounting and finance and explain how they apply. 1-12.Case Study Creating an Ethics Case Develop an ethics related case and propose how to deal with the dilemma. You may rely on an example you have experienced through your own employment or make up a situation.

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Chapter One: Accounting and Finance: An Introduction

Cases Case Study 1-1 Accounting Fraud at Maybury Bank Steve Russell, president of Maybury Bank, was enjoying record profits for the last year. As a bonus, he gave one-month salary to each of the bank employees. Times had never been better and company moral was high. The regional economy was also growing which led Steve to believe that the bank should continue to prosper for the immediate future. David Watson, the head of the internal audit staff, was in a monthly meeting with Steve going over internal audit procedures and any recent findings. He noted that a member of his staff was having trouble getting the numbers to balance in the credit card loan department. There was a difference of around $13,000 in the balance, but Dave was more concerned that the numbers just did not “feel” right. Steve suggested that Dave contacts their public accounting firm and see if the balances could be reconciled with the public accounting firm’s records. Two days later, Dave met again with Steve to give a follow up report on the problem. After questioning the public accounting firm, Dave determined that during the audit procedure, the audit staff took the bank employee’s word on specific figures, and if there were not an exact balance, they would force the numbers. Any difference in amounts was not especially significant. Steve became extremely concerned. Even though the amount that was currently out of balance did not appear significant, he now did not have a reliable way to determine exactly what the dollar amount should equal for this department. Steve demanded to have an immediate meeting with the senior partner of the public accounting firm. This firm had audited the bank for 35 years, and the close relationship between companies has gone back to a previous generation. Ed Simpkins, the senior partner was very apologetic for the misunderstanding of the audit, but said the company had been handling this situation the same way for a number of years, and that the amount of the difference was very insignificant. Ed indicated that there sometimes needs to be a cost benefit tradeoff between gaining accuracy to the nearest dollar and the reasonable cost of providing the audit without sacrificing integrity. Ed assured Steve that he was sure that the audited financial records presented fairly the current financial status of Maybury Bank. Steve was also concerned about the auditors taking the bank employee’s word on the correctness of figures without some form of verification. Ed did admit that there seemed to be a breakdown in the attest function here and he would see to it that verification process would be reviewed. However, the bank employee in question who had provided that data had been a trusted employee for years, and the audit firm had every reason to support the figures presented. Also, Ed assumed that internal control procedures at the bank should safeguard against any falsifying of accounting information. Dave continued to examine the area in question and began to come up with loans made by the bank that were not properly accounted for in the records. These loans appeared to be “Mickey Mouse” loans, a bank term used for loans that are created from nothing. Additionally, the amount in question quickly grew from a few thousand dollars to over $1,000,000 dollars. This information sent Steve into an outrage. He had been relying on numbers that all of a sudden had no basis of support. There was no way of knowing how widespread the deception had become within the bank. 17

Chapter One: Accounting and Finance: An Introduction

Steve took immediate action by firing the employee in question, as there was sufficient evidence that fraudulent activities had taken place within this employee’s area of responsibility. Furthermore, the members of the internal audit staff who had responsibility to establish internal controls within this area of the bank operation were fired. Dave Watson and the employee who originally found the discrepancy retained their jobs only because they brought this matter to light. Steve also fired the public accounting firm after receiving board approval and sought the assistance from a national public accounting firm to help in determining the extent of the problem. The public accounting firm reviewed the loan function and found inconsistencies in loans approaching $5,000,000. The very solvency of the bank was now in jeopardy. Just a few months ago, the bank was recording record profits and distributing bonuses, and now they faced the possibility of bankruptcy. Steve acted quickly by laying off around 100 employees, and task the public accounting firm to start from scratch in developing a new accounting system. Each remaining employee was asked to demonstrate how his or her function fit into the accounting system. Steve learned that employee personalities would often have an impact on how records were kept. “If John did not like Sue, he would give her incorrect data which would make it harder for her to do her job.” There was also sufficient evidence that accounting control procedures were lacking, and often times processes were being done more than once or not at all because of a lack of coordination between departments. When that finding became evident, there was a wholesale purging of the accounting department. With the bank accounting system in disarray and the bank solvency an uncertainty, employee moral sank to an all time low. Steve was also very depressed, as he had to make hard decisions about layoffs and firings that effected families and livelihoods, but he had to keep the bank open until it could get reestablished. In all it took four years to get through the financial crisis. However, in the creation of the new accounting system and the thorough review of the accounting procedures, many cost savings measures were implemented. For instance, processed checks used to sit sometimes for a number of days before being sent to the Federal Reserve for clearing. Through a review of the accounting system, procedures were established to have processed checks sent at least twice a day to the Federal Reserve. This improvement in cash flow resulted in increased interest revenue of $500,000 a year. Required A. What ethical or code of conduct guideline was violated at Mr. Russell’s bank? B. Why did a problem of this nature happen in the first place? C. What actions can a business manager take to guard against a situation such as that which occurred at Maybury Bank? D. Review the way Mr. Russell dealt with the problem at his bank. How would you deal with the problem? Specifically, what would you do the same, differently?

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Chapter One: Accounting and Finance: An Introduction

Case Study 1-2 Ethics as a Write-off On March 26, 1996, The Wall Street Journal published an article entitled “For Many Executives, Ethics Seem to be a Write-off.” The article was based on a study on fraud that was published in the February issue of the Journal of Business Ethics. Almost 400 individuals played the role of an executive that had to make a decision about understating a write-off that would cut into company profits. The findings of the study indicated that 47 percent of top executives, 41 percent of controllers, and 76 percent of graduate-level business students were willing to commit fraud by understating the writeoff. The case scenario was set up that the business executive had just returned from a twoweek business trip and had a full in-basket of paperwork to review as quickly as possible before leaving for another business trip. Included in the paper work were some memos containing important financial information. The write-off situation was similar to an actual SEC case. There was also a memo stating that the business executive would be up for a promotion based on his ability to improve net income. The adoption of a code of ethics seemed to have little, if any, impact on the executives behavior. This apparent lack of personal values has ethics experts concerned. The rigors of the workplace seem to erode the sense of value in a business setting. The authors concluded that what is necessary to prevent fraud is not only a company code of ethics, but an entire business climate that reinforces ethical behavior. These situations may be difficult to achieve, however, if the results cannot be shown on a company’s bottom line net income. Required A. Why do you believe that ethical standards seem to be declining in the business environment? B. Attempts have been made by professional organizations and company’s to develop and incorporate codes of ethics for the business community; however, individual employees still commit ethical violations. Why do employees compromise ethical standards when working on their job? C. In the study, the number of graduate-level business students that committed fraud was almost twice as high as the number of business executives. What, if any, significance can be attributed to this finding? D. Profit motive is a big incentive in measuring corporate performance. How can a company that commits to high ethical standards be competitive in a business environment? E. How does the profit motive lead to compromises in ethical conduct? What can company management do to promote synergy or a positive association between the profit motive and ethical standards? F. If you were the president of a company, what actions would you take to incorporate a code of ethics into your corporate structure?

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Chapter Two: The Income Statement and the Balance Sheet

Chapter Two: The Income Statement and the Balance Sheet Objectives 1. 2. 3. 4.

Identify the major account categories used in accounting. Understand the accounting process. Analyze the income statement and its role in business. Analyze the balance sheet and its role in business.

Account Categories Accounting systems within businesses rely on a chart of accounts as a means of classifying the activities within the business into categories for reporting and decisionmaking purposes. A chart of accounts to a business is much like a dictionary to a writer. The management of a company needs to be able to identify and define in consistent terms what is taking place within a business. The five major categories within a chart of accounts are assets, liabilities, stockholders equity, revenues, and expenses. Within each of these major categories are more specific account titles related directly to business activities. The major categories of accounts tie into the basic accounting equation, which states that assets equal liabilities plus stockholders equity. Equity consists of a capital stock portion and a retained earnings component. Revenues and expenses are incorporated into the retained earnings. See Self-Study Problem 2-1. Formula 2-1 Assets = Liabilities + Stockholders Equity Assets Assets represent items of future value that are owned by the company. Assets identify resources of the business, which will bring some measure of value to the company in the future. The assets are used to aid in the company's overall objective of providing goods and services. Examples of assets include cash, inventory, investments, equipment, and goodwill. Assets do not have to have a physical substance; however, they do have to have a future value. Assets are classified according to their liquidity, or their ability to be converted into cash. The most liquid assets are identified first, and assets are often broken out between the two major categories of current assets and long-term assets. The difference between current assets and long-term assets is a matter of liquidity, with current assets identified as cash or capable of being converted into cash within a one-year time frame. Long-term assets by their nature are less liquid and are not expected to be converted into cash within a one year time period and may never be converted into cash.

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Chapter Two: The Income Statement and the Balance Sheet

Current Assets Cash is the most liquid current asset and includes a company's cash on hand, petty cash, checking accounts and savings accounts. Marketable securities are often considered as cash equivalents and may be included in the cash account if the amount is not significant. The major distinction between cash and marketable securities is the length to time to maturity. Cash has an immediate maturity date whereas marketable securities could have maturity dates anywhere from thirty days to one year. Securities with a time delay because of a maturity date means that they cannot be used as cash for other purposes for that period of time. A certificate of deposit with a maturity date in thirty days means that the holder of the certificate cannot use that amount of cash until the security matures. Companies will maintain amounts of marketable securities which are less liquid than cash in order to gain a higher rate of return for agreeing to have some of the assets tied up for a period of time. A financial manager or accountant can project future cash needs over time and with proper cash management take full advantage of marketable securities with different maturity dates. If a company does not need a certain amount of cash for a thirty-day period, then it is not worthwhile to keep that money in cash. Cash may not earn any return and if there is a return it will be at a minimum. Additionally, because cash is very liquid, it can be most easily confiscated. Accounts receivable represents an i.o.u. from a customer who purchased company goods and services. Sales on account, whereby the customer agrees to pay later, results in the creation of an account receivable. The vast majority of sales for many business is “on account” or credit sales. Payment of the account receivable by customers usually takes place from thirty to ninety days after the sale. Management has to carefully screen customers before allowing credit on sales; however, there usually always is some percent of the accounts that will never be collected. Inventory represents the product that the company is in the business of selling. The inventory can be either created within the company (manufacturer) or secured in its basic final form for resale to a customer (merchandiser). Prepaid expenses are not expenses but assets because they have future value. Prepaid expenses represent items of service paid for in advance. Once the service is provided, the prepaid asset actually becomes an expense. Examples include prepaid rent and prepaid insurance. All the assets discussed to this point are classified as current assets because they are either in the form of cash or can be expected to be converted into cash within one year. Current assets are also usually directly associated with the operating activities of the company. Illustration 2-1 gives a summary of current asset accounts.

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Chapter Two: The Income Statement and the Balance Sheet

Long-Term Assets Long-term assets have an expected future value of more than one year. They are the least liquid of the assets and may never be converted to cash. Many of the assets undergo a depreciation process to recognize their use over time. As the asset is depreciated an amount is transferred from the asset account to an expense account reflecting the use of the asset. Some long-term assets called intangible assets have no physical substance. Additionally, the long-term assets may increase or decrease in value; however, for accounting record keeping purposes they are usually always maintained on the books at their original historical cost. Land is a long-term asset, which represents the property or location of the company. The land is not subject to a depreciation or decrease in value because it is not used up in the company production of goods and services. Buildings and facilities and equipment are all assets that support the production of company product. These assets have a life of more than one year but gradually deteriorate over their useful life. A depreciation process is used to prorate the cost of these assets over an extended time period. As an asset is depreciated it becomes an expense because it no longer has a future value. Intangible assets are assets that do not have a physical being but represent future value to the company. Examples of intangible assets include goodwill, patents, copyrights, and trademarks. The intangible assets are depreciated over a specific time period, which represents the use of the asset. Illustration 2-2 gives a summary of long-term asset accounts.

Account Cash Marketable Securities Accounts Receivable Inventory Prepaid Expense Supplies

Current Asset Accounts Illustration 2-1 Discussion and Explanation Most liquid current asset Cash type items with a maturity date and the ability to earn interest Generated from the sale of a company’s goods and services, represent a customer’s promise to pay in the future Product the company is in the business to sell Represents a cash payment in advance for services to be received in the future Miscellaneous assets used to support the creation of goods and services

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Chapter Two: The Income Statement and the Balance Sheet

Account Land Buildings Equipment Investments Intangible

Long-Term Asset Accounts Illustration 2-2 Discussion and Explanation Physical property not subject to depreciation Physical facilities subject to depreciation Machine type items subject to depreciation Long-term type investments usually in stocks or bonds of other companies Long-term assets without a physical substance, examples include goodwill, patents, copyrights

Liabilities Liabilities are debts owned by a company. Liabilities represent one of two major sources of funding for the resources or assets of the company. A liability obligates the company to the repayment of the debt and sometimes an interest charge is included. The lenders of money or other assets to a company expect to be repaid in full with the principal representing the amount loaned and due on a specific maturity date, and interest reflecting the charge for receiving money in advance. The failure to comply with the provisions of the obligation can result in default of the liability and additional charges or the repossession of the asset. The principle that the borrower is servant to the lender underlies the concept of borrowing. The lender, by providing cash or other assets in advance, establishes a contractual arrangement, which must be complied with by the borrower. Harsh penalties can result if the borrower fails to fulfill this obligation. The company that borrows funds to support the acquisition of assets may be subject to limitations and conditions with regard to its operations, financial condition, or distribution of funds. These restrictions are established to protect the lender in case of default. Companies can make effective use of liabilities provided they maintain an ability to fulfill stated contractual obligations. Liabilities are often the least costly source of funds, and any related interest will reduce the amount of corporate taxes. If companies can generate returns from the assets purchased with debt in excess of the cost of debt itself, then the companies will increase their profitability. However, if the cost of debt or interest exceeds the returns generated from the assets, then the company is not earning enough to pay the interest and profits decline. If these declines in profit and the related assets are severe enough, the company could risk the danger of default or even bankruptcy. Remember again, the borrower is servant to the lender. Liabilities are classified according to their liquidity, and like assets, the most liquid liabilities are listed first. Liabilities can be classified into two major groups: current liabilities and long-term liabilities. The criterion for the segmentation of the liabilities is the same as the criterion used to divide the assets. Obligations that have to be fulfilled within one year are current liabilities, and liabilities that have maturity time periods of more than one year are long-term liabilities. Some liabilities do not include an interest charge. These liabilities are generally shortterm in their maturity date and are only given if a company can establish itself with a 23

Chapter Two: The Income Statement and the Balance Sheet

Account Accounts Payable Salaries Payable Accruals Notes Payable Deferred Liabilities

Current Liability Accounts Illustration 2-3 Discussion and Explanation Obligation of the company usually incurred in the purchase of inventory Employee wages that have been earned but not paid for Obligations incurred but not paid Obligations that have an interest charge associated with the payment Advance payments made by customers that represent a future obligation by the company to provide a good or service

good credit rating. Generally, the longer the term of the liability the higher the rate of interest. This higher rate of interest is directly correlated with the increased liquidity risk that is assumed by the lender. Current Liabilities Accounts payable is a current liability that usually includes no interest charge and is generated through the purchase of goods and services. It is the opposite of accounts receivable. One company's accounts receivable is another company's accounts payable. The liability is created through the purchase of goods and services, which will probably be used by a company to create their inventory. Specific terms are included with the account payable and most often the balance is due in thirty days. If the company does not fulfill its obligation, an interest charge may be imposed and/or the company could lose its credit standing. Other similar current liabilities include salaries payable, taxes payable, and accruals. These obligations are due within one year and will probably not include an interest charge if paid within the specified time frame. The account, interest payable, is usually associated with another liability that charges an interest rate, and the interest payable account represents only that portion of interest that is currently due. Notes payable is a current liability that differs from accounts payable in that an interest charge is included in the amount due. When a company incurs a note payable, there is generally a contractual agreement established at the time of the note which dictates the terms of the repayment. Included in the repayment is the principle value of the obligation plus an interest charge. Interest payments can be made periodically or at the maturity date of the note. Unearned revenue or deferred liabilities is not a revenue but a liability. The account is created when a customer pays for a good or service in advance. The company then has an obligation to provide the good or service in the future. As long as the obligation remains, the unearned revenue account will remain. Unearned revenue is essentially the opposite of a prepaid expense. What is one company's prepaid expense is another company's unearned revenue. The key to the creation of either account is that cash is paid or received prior to the providing of goods or services. Illustration 2-3 gives a summary of current liability accounts.

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Chapter Two: The Income Statement and the Balance Sheet

Account Notes Payable Bonds Payable Mortgage Payable Deferred Taxes Payable

Long-Term Liability Accounts Illustration 2-4 Discussion and Explanation Obligations with interest that have a maturity date at least one year later Obligations greater than one year that have fixed coupon (interest) payment dates Long-term obligations that are usually created to fund longterm assets like buildings Long-term obligations to the government for taxes due which do not have to be paid immediately primarily because of accounting and government tax rules

Long-Term Liabilities Long-term liabilities are also classified as various payables. Examples include long-term notes payable, mortgage payable, bonds payable, and deferred taxes payable. These obligations all have a maturity date that is greater than one year from the current date. For notes that include a periodic or a serial payment pattern the current portion of the long-term liability may be reclassified as a current liability in an account called current portion of long-term notes payable. Deferred taxes payable is a unique liability created by the tax laws of the federal and state governments. Tax laws allow companies to record various expenses and revenues in different amounts from normal recording practices. These differences generally result in favorable tax treatments, which will cause a delay in the payment of taxes. The resulting delay in the tax payment creates a deferred tax liability. If the delay in the tax payment is one year or less, the deferred tax liability is listed as a current liability. If the deferred tax liability is for greater than one year, the deferred tax liability is a long-term liability. In many cases the deferred tax liability is actually a permanent tax deferral because the tax law perpetuates the favorable recognition of either an expense or revenue and its related tax implications as long as the company is in business. The deferred tax liability becomes a permanent source of interest free funding from the government. The company must retain the long-term liability account even though technically the account may never be repaid. This is one of only a very few situations where a company can actually gain a tax advantage from the government. Illustration 2-4 gives a summary of long-term liability accounts. Stockholders Equity The category of stockholders equity represents the second major source of funds to acquire a company's resources or its assets. The equity category represents the owners' (stockholders) contribution and the business' (retained earnings) contribution to the creation of assets. This equity category is really larger than just stockholders equity because it represents both the owners and business interest in the company.

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Chapter Two: The Income Statement and the Balance Sheet

The stockholders equity account indicates the owner’s commitment into a company. In return for this commitment the owners can share in the company's success either through dividend payments and/or increases in the value of their ownership or stock. However, there is no guarantee that the owners will receive any repayment or increase in the value of their investment. The company is generally under no legal obligation to make any repayment to the owners. One form of stock, preferred stock, usually includes specific provisions regarding dividend payments. Preferred shareholders have some protection in that no common stock dividends can be paid until all current and past due preferred stock dividends are paid in full. However, there is still no guarantee that a company will pay dividends. Preferred stock also has limited potential for its increase in value. Dividends are fixed in amount and preferred shareholders can not expect increases in value as the company prospers. Also preferred stockholders can usually not be voting members of the company. Common stock is the more recognized classification of equity. For an owner’s contribution into the business, the common stockholders have the potential for return on their investment through dividends and/or increase in the market price of their investment. There is no guarantee that either of these events will occur and the company has no contractual obligation to make any payments. Additionally, the common stockholders are the last in line in the case of a liquidation to recapture their investment through the securing of assets. Because there are no guarantees, the common stockholders face the greatest risk but have the potential for the highest return. Dividends are classified as an equity account. The sole purpose of this account is to recognize the distribution of company earnings to the shareholders. The dividend account will often be offset by a dividend payable liability account to represent the fact that a company has declared a dividend but has not yet paid the dividend. Since the company still has this obligation the dividend payable liability account is established. Retained earnings is the equity account that represents in summary form all of the operating activities of the business in generating resources for the company. Retained earnings can be increased as the company generates income, which occurs when revenues exceed expenses. Retained earnings will decrease when there is a net loss from operating activities when expenses exceed revenues. Retained earnings is also decreased through the payment of dividends. A positive balance in retained earnings represents the excess of net income over the payment of dividends and can be considered as the business' contribution to the company resources or assets. A positive balance in retained earnings does not imply that there is a similar positive balance in cash, but only that the total amount of assets is higher by the amount of retained earnings. Retained earnings can have a negative balance resulting when net losses exceed net income over a period of time. Also, if a company pays out dividends in excess of the accumulated net income over a period of time, the retained earnings balance could become negative. Generally, holders of liabilities will impose restrictions on companies in the amount of dividends that can be paid to prevent a negative balance in retained earnings and to keep the common stockholders from receiving distributions of assets before the creditors. Illustration 2-5 presents a summary of shareholders equity accounts.

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Chapter Two: The Income Statement and the Balance Sheet

Account Sales Revenue Interest Revenue Dividend Revenue Gains on Sale

Revenue Accounts Illustration 2-6 Discussion and Explanation Generated through the sale of goods and services Generated through interest earned on interest bearing accounts Dividends received from investments in other company stock Created when an asset is sold for more than its value as recorded on the accounting records

Revenues Revenue is a broad category of accounts that represent the sale of goods and services by the company. Revenues represent the business contribution of resources to the company and they have a positive impact on the total amount in the stockholders equity section. Sales revenue is the major account and there could be subclassifications of sales revenue by product line or product type. Interest revenue is associated with financing charges and should be separated from sales revenue. Interest revenue occurs when a company receives interest income from a customer on a note receivable. Interest revenue can also represent the interest earned on various company investments included in marketable securities. Dividend revenue is similar to interest revenue except that a company is receiving dividends from stock versus interest income from interest bearing notes like certificates of deposit. Gains on the sale of assets not including inventory also are classified as revenue. When a company sells a long-term asset at a price higher than the book value of that asset a gain is recognized which is included as a revenue item and an increase in net income. (Book value of an asset is what the asset is worth according to the company's accounting record or book.) Illustration 2-6 gives a summary of revenue accounts.

Shareholders Equity Accounts Illustration 2-5 Account Discussion and Explanation Preferred Stock Preferred with regard to dividend payments and distribution of assets in a liquidation Common Stock Major equity account with potential for increases in dividends and market price Dividends Represents the distribution of company earnings to holders of stock Retained Earnings Company’s contribution to equity in the form of net income less any distributions through dividends

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Chapter Two: The Income Statement and the Balance Sheet

Account Cost of Goods Sold Wage Expense Depreciation Expense Interest Expense Tax Expense Loss on Sale

Expense Accounts Illustration 2-7 Discussion and Explanation Represents the cost of the inventory sold in conjunction with the sales revenue The wages and salaries of company employees A prorated cost of using long-term assets over an extended period of time The interest cost associated with obligations that include an interest charge Costs due to the government Created when an asset is sold for less than its value as recorded on the accounting records

Expenses Expenses represent the cost of doing business. Expenses are offset against revenues to determine the net income or loss of a company. There are many more expense categories than revenue categories. Cost of goods sold represents the sale of goods by the company. Originally recorded as an asset account, inventory, once the product is sold it has no future value and cannot be an asset but is transferred to an expense classification as a cost of goods sold. Expenses can be classified for any business-related activity such as wages, utilities, supplies, rent, and advertising. Depreciation expense represents the use of an asset over a period of time. Since most long-term assets have a limited useful life, a portion of those assets is used up every year. The depreciation process represents a prorated expensing of an asset during each time period. Interest expense, as in interest revenue, should be shown separately as a financing charge versus an operating charge. However, while dividend revenue, which represents earnings from an investment in another company, appears in the income statement, dividends, which are paid by the company, are not recorded as expenses, and are not part of the income statement. Losses from the sale of assets behave similar to expenses and are shown in the income statement. When assets other than inventory are sold for less than the book value there is a loss on sale, which will decrease the amount of net income. Illustration 2-7 presents a summary of expense accounts.

Accrual Accounting Accrual accounting relates revenues and expenses to the time period in which they are incurred. This method of accounting is required for financial reporting purposes by generally accepted accounting principles. Virtually all businesses use an accrual accounting system versus a cash based system.

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Chapter Two: The Income Statement and the Balance Sheet

In a cash based system, accounts such as accounts receivable, accounts payable, prepaid expenses and unearned revenue may not be needed because business transactions would be dictated by the receipt and payment of cash. Revenues would be recognized upon payment of cash regardless of when the good or service was provided. Expenses would be recognized upon the payment of cash regardless of when the cost was incurred. This failure by the cash based system to recognize revenues and expenses in the appropriate time period is why an accrual accounting system is required for so many companies. The recognition of revenues and expenses in an accrual accounting system is not dependent on the receipt or payment of cash. In fact, expenses like depreciation will never involve a payment of cash. The occurrence of an activity such as the sale of a good or service is the critical factor in the recognition of revenue. The cash receipt in association with the sale may occur before, at the time of the sale, or after the sale. The revenue is realized after substantial performance has been completed and the value is known; generally this takes place at the point of sale. Expenses are matched in the same time period as revenues in an accrual accounting system. This matching is promoted to relate earned revenues with appropriate expenses. Again, the cash payment of these expenses is not the critical factor. In most cases the occurrence of an event is sufficient to identify and match an expense with a related revenue. However, in many situations activities have to be essentially developed to identify appropriate expenses during a particular time period. Depreciation expense is an example of creating an activity to reflect the use of an asset and its resulting expense for a time period. The use of the asset as shown by the depreciation expense is matched against the revenue it helped to generate during a specific period of time.

Depreciation The utilization of long-term assets over time is reflected through a depreciation process. As the asset is used up, it loses some of its future value, and by definition can no longer be classified as an asset. During each time period a portion of the asset will be reclassified as an expense. When the long-term asset is first acquired the company estimates its useful life and salvage value i.e., what the asset would be worth at the end of its useful life. Accrual accounting requires that the use of this asset be prorated over this useful life time period in a process known as the depreciation of the asset. As the asset is used up it is recorded as a depreciation expense. The accrual accounting matches the depreciation expense to the same time period in which appropriate revenues are generated from using the asset. The accounting treatment in the depreciation process is to debit depreciation expense and credit an account called accumulated depreciation. The debit to the depreciation expense account will increase that account and ultimately decrease net income. The accumulated depreciation account is a contra asset account. A contra account is an account that carries an opposite balance. Therefore, a contra asset account would carry a credit balance. The depreciation journal entry causes an increase in the credit balance of the accumulated depreciation account, and an overall decrease to the net balance of the asset account. 29

Chapter Two: The Income Statement and the Balance Sheet

Depreciation is a noncash expense account since the offsetting credit is to accumulated depreciation versus cash or some liability account. Essentially, the cash payment occurred when the original asset was purchased, and the depreciation reflects the use of this paid for asset. Since both the long-term asset and the accumulated depreciation accounts are assets they will appear on the balance sheet. Generally the accounts are set against each other with a resulting net balance to the asset account. The amount in the accumulated depreciation account can never exceed the amount in the long-term asset account so the net balance will always be a debit amount, although it can be zero. The following illustration shows how the depreciation process works. On January 2, 1996, Philip Company purchased with cash a molding machine for $30,000. The machine is expected to last for 8 years and have a salvage value of $2,000. Record the appropriate journal entries for 1996 to include journal entries for the purchase of the equipment and the depreciation of the equipment. Show how the equipment will be recorded on the balance sheet. January 2, 1996 - Purchased asset. Equipment Cash

30,000 30,000

December 31, 1996 - Depreciation of molding machine. Annual Depreciation = (Purchase Price - Salvage Value)/Useful Life = ($30,000 - $2,000)/8 years = $3,500 per year Depreciation Expense Accumulated Depreciation

3,500 3,500

Balance Sheet Presentation Molding Machine (Debit Bal) - Accumulated Depreciation (Credit Bal) = Molding Machine (Net) (Debit Bal)

$30,000 -3,500 $26,500

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Chapter Two: The Income Statement and the Balance Sheet

Accounting Transaction Illustration 2-8 Daniel & Son’s Inc. purchased a vehicle for $15,000 by paying a $2,000 down payment and signing a note payable for $13,000. Journal Entry Debit Vehicle (asset) 15,000 Credit Cash (asset) 2,000 Credit Notes Payable (liability) 13,000

The Accounting Process With an understanding of the major account categories it is easier to follow the accounting process, which reflects the accounting treatment of business activities and presents information in a usable form for decision-making purposes. Accounting treatments to business activities follows a double entry system. Double entry means that for each business transaction that is recorded for accounting purposes, there are two parts, and each of the parts must result in an equal total dollar amount. This equality of a double entry system is necessary for the development of appropriate accounting information to aid in the managerial decision-making process. The accounting process begins with the accounting transaction or journal entry, which identifies a business activity. The journal entry represents a chronological recording of the business events of a company. Each journal entry has two parts a debit and a credit. Debit means left hand side and credit means right hand side. The two sides of the transaction must be equal, that is the total of the debits on the left hand side must equal the total of the credits on the right hand side. Illustration 2-8 gives an example of an accounting transaction and related journal entry. See Self-Study Problem 2-4. Each of the major account categories can be impacted by accounting transactions through debits and credits, and each account category has a typical balance as either a debit or credit. Assets, expenses, and dividends are increased in amount by debits and decreased by credits and these accounts typically carry a debit balance during any particular time period. Liabilities, stockholders equity and revenue accounts are increased by credits and decreased by debits and typically carry a credit balance during any particular time period. Illustration 2-9 summarizes the balances of the major account titles.

Debit/Credit Account Balance Summary Illustration 2-9 Normal Balance DEBIT CREDIT Assets Liabilities Expenses Stockholders Equity Dividends Revenue

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Chapter Two: The Income Statement and the Balance Sheet

Increase or Decrease in Account Balance Illustration 2-10 ACCOUNT Assets Liabilities Stockholders Equity Revenue Expense Dividend

DEBIT Increase Decrease Decrease Decrease Increase Increase

CREDIT Decrease Increase Increase Increase Decrease Decrease

When a business transaction is recorded, the debits are recorded first and are placed to the left. The credit entries are entered after the debits and are indented to the right. When an account is debited, it simply means that that account is entered on the left hand side of the transaction. When an account is credited, it is entered on the right hand side of the transaction. The balances in accounts are either increased or decreased by every transaction. In a transaction, if an asset, expense, or dividend account is debited, it means that the balance in that particular account is increased. If the asset, expense, or dividend is credited, its balance is decreased by that transaction. Vice versa, in a transaction, if a liability, stockholders equity or revenue account is debited, it means that the balance in that particular account is decreased. If the liability, stockholders equity, or revenue is credited, its balance is increased by that transaction. Illustration 2-10 summarizes the impact of a debit or credit from a journal entry on the account balance. See Self-Study Problem 2-2. No attempt should be made to relate or associate debit and credit with any other concept or activity. Debit and credit do not mean good and bad or up and down or plus and minus, they simply represent left hand side and right hand side in a journal entry which reflects a business transaction. After the journal entry has been completed, a determination can be made on the effect of the transaction on the balances of the specific accounts according to the rules about debit and credit balances as previously presented. The primary uses of debit and credit are: (1) how accounts are recorded in the journal entry, and (2) their effect on the account balance. Journal entries are the key to a successful accounting system. Unless business transactions are properly classified and recorded the information obtained will be useless for decision-making purposes. It is like garbage in garbage out. If the journal entry is not correct what a company manager receives is garbage. There is a consistent decision process that can be associated with every business transaction and related journal entry. By following a systematic process in the development of a journal entry, management can minimize the potential for error and bad data. A specific step by step process can be applied to every journal entry as follows: 1. analyze the business transaction to determine what accounts are impacted 2. determine whether the account balances will be increased or decreased 32

Chapter Two: The Income Statement and the Balance Sheet

3. identify if the accounts should be debited or credited 4. determine the monetary amount associated with each account 5. record the transaction 6. verify that the total of the debits equals the total of the credits If the journal entry process is done correctly, many of the remaining accounting procedures are essentially automatic. After the journal entry is the posting process, which involves recording the impact of the transactions on the account balances of the specific accounts. Each account classification has a ledger, which includes the effect of all of the transactions for a particular time period. If the account is an asset, expense, or dividend, than the ledger balance is typically a debit, and if the account is a liability, stockholders equity, or revenue, than the ledger balance is typically a credit. Illustration 2-11 gives the basic column format of a ledger. See Self-Study Problem 2-5. Illustration of a Ledger Illustration 2-11 Account Title Debit Credit Balance Description of Journal Entry Once the journal entry has been posted to the ledger, it is possible to summarize the information from the ledgers into a report format. Before reports such as the income statement or balance sheet can be completed a trial balance is computed. The purpose of a trial balance is to determine if the total debit balances of all appropriate accounts equals the total credit balances of all appropriate accounts. The trial balance does not insure the accuracy of specific account balances, but only insures that the totals are equal. The trial balance also does not insure that the totals are correct. The total debits and total credits can be equal but with an incorrect total. Most of the potential errors that may occur and be highlighted through a trial balance can be eliminated through a sound accounting system or automated process that will immediately indicate when the debit portion of the journal entry does not equal the credit portion. However, errors in the journal entry regarding the classification of accounts and/or whether the amount is properly recorded as a debit or credit will go undetected in the trial balance process. Account categories can be classified as permanent or temporary. Accounts appearing in the balance sheet are permanent accounts, which include assets, liabilities, and stockholders equity. These permanent accounts carry a balance from one accounting period to the next. Temporary accounts are included in the income statement and statement of retained earnings. Revenues and expenses from the income statement and dividends from the statement of retained earnings are temporary accounts. The balance of the temporary account is returned to zero at the end of the accounting period. Illustration 2-12 summarizes the role of permanent and temporary accounts. See Self-Study Problem 2-3. Nature and Use of Accounts Illustration 2-12 Permanent Financial Account Temporary Statement Asset Permanent Balance Sheet 33

Chapter Two: The Income Statement and the Balance Sheet

Liability Stockholders Equity Revenue Expense Dividends

Permanent Permanent Temporary Temporary Temporary

Balance Sheet Balance Sheet Income Statement Income Statement Statement of Retained Earnings

With properly recorded journal entries and proper posting of the ledger accounts, accountants can generate reports and information for any specific purpose. The most recognized of those reports are: (1) the income statement, (2) the statement of retained earnings, (3) the balance sheet, and (4) the statement of cash flows. In an automated accounting system, these reports can be generated automatically through predeveloped software programs. In manual systems the development of reports involves the use of ledger account balances from specific accounts, i.e., for an income statement the balances from the revenue and expense accounts are used. A step-by-step summary of the accounting process can be identified as follows: 1. Identify a business transaction/event. 2. Record an accounting journal entry to reflect the business transaction. 3. Post the amounts of the accounts in the journal entry to specific account ledgers. 4. Determine a total balance in the account ledgers. 5. Summarize the account balances in a trial balance to verify that total debits equal total credits. 6. Transfer the account balances from the trial balance to various financial statements. 7. Revenue and expense accounts make up the income statement. 8. The beginning balance in retained earnings, net income (revenue minus expense), and dividends make up the statement of retained earnings. 9. Assets, liabilities, stockholders equity, and the retained earnings ending balance are used in the balance sheet. 10. Close the temporary accounts of revenue, expense, and dividends to a zero balance.

Income Statement The income statement for many companies is considered as the most important statement because of the emphasis on company operating performance. The income statement represents a measure of performance over a period of time with the most common period being one year. Income statements may also be prepared for a quarterly or monthly basis, but these will be subsidiary reports to the one year income statement. The income statement should begin with a heading identifying the name of the company, the name of the statement, and the time period of the statement. The time period will not be a specific date but will reflect the entire period of time that the statement represents, such as, for the year ended December 31, 1997. The account categories included in the income statement are only the revenue and expense classifications. These accounts are identified as temporary accounts in that they do not carry a balance from one accounting period to the next. When computing an 34

Chapter Two: The Income Statement and the Balance Sheet

income statement, the company management is only interested in the operating performance for the period in question, usually one year. To avoid mixing the performance activities from different time periods, the revenue and expense account balances start at zero at the beginning of the period and are reset to zero at the end of the period after the income statement is completed. The process of resetting the temporary revenue and expense accounts to zero is called the closing process. Journal entries are constructed to support the closing entry process and a temporary account called income summary is established to complete the transaction. To close out the revenue accounts a journal entry must include a debit to the revenue and an offsetting credit to the income summary account. To close out the expense accounts a journal entry must include a credit to the expense and an offsetting debit to the income summary account. If the balance in the income summary account is a debit amount, then the company experiences a net loss because the expenses exceeded the revenues. If the balance in the income summary account is a credit amount, then the company experiences a net income because the revenues exceed the expenses. The format of the income statement begins with the operating revenues. There are special revenue accounts called contra revenue accounts, which carry a debit balance and will reduce the amount of net revenue. (When an account is called a contra account it means that it carries an opposite normal balance, i.e., a revenue account carries a credit balance while a contra revenue account carries a debit balance.) The contra revenue accounts are sales discounts and sales return and allowances. The resulting sales revenue figure is called net sales revenue. The cost of goods sold expense is deducted from net sales revenue to arrive at a supplementary figure called gross margin. The gross margin gives company management an idea of how much they are making over the cost of the good being sold. While there is no set figure, companies should be realizing a gross margin percentage of sales of at least 25 percent and preferably a figure closer to 40 percent. A 25 percent gross margin means that for every dollar of sales, 25 cents remains after a cost of goods sold of 75 cents. This gross margin needs to be sufficient to cover the remaining expenses plus provide some profit potential for the company. Other operating expenses are listed next in the income statement. These expenses are sometimes categorized as selling and administrative expenses or general administrative expenses. A supplementary figure computed by subtracting these operating expenses from gross margin is income from operations or operating margin. The income from operations gives an indication to management on how well their operating revenues cover all related operating expenses. The financing section of the income statement includes interest revenue and interest expense. It important to keep interest related items separate from operating activities if the amounts are significant because of the legal obligations related to financing activities. Also gains and losses from the sale of assets would be recognized as a separate component of the income statement. After the consideration of all revenue and expense items, a supplementary figure called net income before tax is computed. The only remaining expense item to be determined is the income tax. If this figure represents a loss, a company may be allowed to enter a tax credit (representing a potential refund.) 35

Chapter Two: The Income Statement and the Balance Sheet

The final figure in the income statement is the net income, which is the difference between revenues and expenses. The net income figure represents the business contribution to the company as a source of assets to go along with the owners' contribution in stockholders equity. It is the only figure coming out of the income statement that will appear on the statement of retained earnings, and serves as a connecting figure between the two statements. In the illustrations 2-13 and 2-14, the net income amount of $1,800 appears in both statements. Also, the amount of net income should agree with the balance in the income summary account. In summary, net income is the consolidation of all the revenue and expense accounts and represents the business activities of a company for a particular period of time. The net income figure represents the company contribution to the resources of the company. Illustration 2-13 shows the basic format of an income statement. See Self-Study Problem 2-6.

36

Chapter Two: The Income Statement and the Balance Sheet

Income Statement Illustration 2-13 Daniel & Son’s Company Income Statement For the Year Ending December 31, 1997 Sales Revenue - Sales Returns & Allowances - Sales Discounts = Net Sales Revenue - Cost of Goods Sold = Gross Margin - Operating Expenses Selling & Administrative Depreciation Total Operating Expenses = Operating Income + Interest Revenue - Interest Expense = Net Income Before Tax - Income Tax Expense = Net Income

$100,000 $ 5,000 7,000

-12,000 88,000 -62,000 26,000

13,000 9,000 -22,000 4,000 1,000 -2,000

-1,000 3,000 -1,200 $ 1,800

Statement of Retained Earnings The statement of retained earnings identifies the company's accumulated contribution of resources through net income and the distribution of any of those earnings via dividends. The ending balance in the retained earnings account will also appear on the balance sheet at the end of the accounting period and is the connecting figure between the two statements. In illustrations 2-14 and 2-15 $15,600 is the ending balance in retained earnings, which is also in the balance sheet. Net income or net loss is a summary of all of the revenue and expense balances and its balance is in the income summary account. Since revenues and expenses are temporary accounts, income summary is also a temporary account and must be reduced to a zero balance at the end of the accounting period. Net income has a credit balance in income summary, which is reduced to zero through the closing process to the retained earnings account. The income summary is debited and the retained earnings is credited. Since retained earnings normally maintains a credit balance and it is increased with a credit entry, the positive net income is reflected by an increase in retained earnings. A net loss will have the opposite effect on retained earnings through the closing process with a debit to the retained earnings account and a reduction in its balance. Dividend is also a temporary account, which reflects the distribution of earnings to the owners of the company. However, dividend is not an expense account and will not appear on the income statement. Dividends carry a debit balance and the transaction involving dividends is a debit to dividends and a credit to dividends payable or to cash. At the end 37

Chapter Two: The Income Statement and the Balance Sheet

of the accounting period, the dividend account needs to be closed with a debit to retained earnings and a credit to dividends. This closing transaction represents a reduction in retained earnings. The statement of retained earnings is basically a summary of the closing transactions of income summary and dividends. Since retained earnings is a permanent account which will appear on the balance sheet, it will have a beginning balance. The two primary activities that can impact the retained earnings account, the net income or net loss and the payment of dividends are reflected in the statement. Net income will increase the balance in retained earnings and net loss and dividends will decrease the balance in retained earnings. The ending balance of retained earnings will then be transferred to the balance sheet. Illustration 2-14 shows the basic format of a statement of retained earnings. See Self-Study Problem 2-7. Statement of Retained Earnings Illustration 2-14 Daniel & Son’s Company Statement of Retained Earnings For the Year Ending December 31, 1997 Beginning Balance Retained Earnings + Net Income $1,800 - Dividends 1,200 = Ending Balance Retained Earnings

$15,000 600 $15,600

Balance Sheet The balance sheet is the only statement, which measures the condition of a company at a point in time. The other financial statements reflect performance over a period of time. The balance sheet, by its nature, includes the balances of all the permanent accounts. The permanent accounts are the assets, liabilities and stockholders equity accounts. Revenues, expenses, and dividends individually are not part of the balance sheet; however, the collective impact of all the accounts as reflected in the ending balance of retained earnings will appear on the balance sheet. A critical requirement of the balance sheet is that it must be in balance. The accounting equation: assets equal liabilities plus stockholders equity reflects the balance sheet. Formula 2-1 Assets = Liabilities + Stockholders Equity Assets, or the resources of the company, are listed according to liquidity and divided between current assets and long-term assets. Cash, as the most liquid asset, is listed first, and intangible assets are usually the last assets listed. Liabilities, as one of the sources of the asset resources, are also listed according to liquidity beginning with accounts payable and ending with long-term payables or deferred taxes payable. Stockholders equity, the other source of the company's asset resources, is also listed on the balance sheet. Stockholders equity is divided into two major sections, the preferred and common stock which represents an owners contribution to the company, and the retained earnings which represents the business' contribution to the company assets.

38

Chapter Two: The Income Statement and the Balance Sheet

The net debit balance of the assets equals the net credit balance of the liabilities plus stockholders equity. Again, this report is only reflective of the balances of the accounts at one specific point in time. The financial statements highlighted in this chapter all serve a useful purpose in providing information for decision-making purposes for both internal and external users. For this reason, the accounting profession has established very strict guidelines or generally accepted accounting principles in conjunction with these reports. Companies must remain in compliance with these principles especially when the information is published for external purposes. Without these guidelines, external users of the accounting information would have no basis of comparison of the reports. Illustration 215 shows the basic format of the balance sheet. See Self-Study Problem 2-8.

39

Chapter Two: The Income Statement and the Balance Sheet

ASSETS Current Assets Cash Marketable Securities Accounts Receivable Inventory Supplies Prepaid Expenses = Total Current Assets Long-Term Assets Land Equipment - Accumulated Depreciation = Net Equipment Buildings - Accumulated Depreciation = Net Buildings Investments Goodwill Patents = Total Long-Term Assets Total Assets LIABILITIES % EQUITY Current Liabilities Accounts Payable Notes Payable Salaries Payable Taxes Payable = Total Current Liabilities Long-Term Liabilities Mortgage Payable Bonds Payable = Total Long-Term Liabilities Total Liabilities Stockholders Equity Preferred Stock Common Stock Retained Earnings = Total Stockholders Equity Total Liabilities & Stockholders Equity

Balance Sheet Illustration 2-15 Daniel & Son’s Inc Balance Sheet December 31, 1997 $ 20,000 6,000 32,000 65,000 9,000 4,000

$220,000 - 25,000 350,000 -170,000

$ 15,000 12,000 8,000 1,400 $150,000 80,000

$136,000

40,000 195,000 180,000 25,000 10,000 5,000

455,000 $591,000

$ 36,400

230,000 25,000 284,000 15,600

$266,400

324,600 $591,000

40

Chapter Two: The Income Statement and the Balance Sheet

Summary This chapter highlights the basic accounting process from the individual transaction as represented by a journal entry through the development of accounting statements including the income statement, statement of retained earnings, and balance sheet. The accounting process is a very systematic procedure to insure that financial related activities are properly accounted for within the business environment. The key for this system to function properly is at the data entry point, the journal entry. Each financially related business transaction must be properly classified and recorded in accounting terms. Once the data entry activity has been completed, the remaining functions in the accounting process are almost routine. Many companies with automated accounting systems will have the posting and financial reports generated automatically. It is important for the nonfinancial manager to be able to understand the accounting process and how the reports are developed. An individual needs to know how to interpret and use the information presented in financial reports for decision-making purposes and other decision related activities.

41

Chapter Two: The Income Statement and the Balance Sheet

Study Problems Self-Study Problem 2-1 Account Classifications Classify the following accounts as asset (A), liability (L), stockholders equity (S), revenue (R), expense (E), or dividend (D). ACCOUNT Investment Accounts Payable Accounts Receivable Sales Cash Common Stock Dividend Inventory Unearned Revenue Land Accrued Salaries Supplies Retained Earnings Prepaid Expenses Cost of Goods Sold Depreciation Equipment Taxes Accumulated Depreciation

CLASSIFY

42

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-1 Solution Account Classifications Classify the following accounts as asset (A), liability (L), stockholders equity (S), revenue (R), expense (E), or dividend (D). ACCOUNT CLASSIFY Investment A Accounts Payable L Accounts Receivable A Sales R Cash A Common Stock S Dividend D Inventory A Unearned Revenue L Land A Accrued Salaries L Supplies A Retained Earnings S Prepaid Expenses A Cost of Goods Sold E Depreciation E Equipment A Taxes E Accumulated Depreciation A

43

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-2 Debit and Credit Balance on Accounts Determine the normal balance as debit (D) or credit (C) for each of the following accounts: ACCOUNT Sales Accounts Receivable Cash Accumulated Depreciation Accounts Payable Cost of Goods Sold Common Stock Dividend Building Dividend Payable Building Unearned Revenue Tax Expense Retained Earnings Prepaid Expense Goodwill

BALANCE

44

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-2 Solution Debit and Credit Balance on Accounts Determine the normal balance as debit (D) or credit (C) for each of the following accounts: ACCOUNT BALANCE Sales C Accounts Receivable D Cash D Accumulated Depreciation C Accounts Payable C Cost of Goods Sold D Common Stock C Dividend D Building D Dividend Payable C Building D Unearned Revenue C Tax Expense D Retained Earnings C Prepaid Expense D Goodwill D

45

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-3 Characteristics of Accounts Complete the matrix for each of the following classifications of account.

ACCOUNT

NORMAL BALANCE (D) (C)

Asset Liability Shareholder Equity Revenue Expense Dividend

46

PERMANEN T TEMPORAR Y (P) (T)

FINANCIAL STATEMEN T (I, R, B)

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-3 Solution Characteristics of Accounts Complete the matrix for each of the following classifications of account.

ACCOUNT

Asset Liability Shareholder Equity Revenue Expense Dividend

NORMAL BALANCE (D) (C)

D C C C D D

47

PERMANEN T TEMPORAR Y (P) (T) P P P T T T

FINANCIAL STATEMEN T (I, R, B) B B B I I R

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-4 Journal Entries Construct journal entries for each of the following transactions: 1. Purchased equipment for $10,000 and paid cash. 2. Sold $500 of the company product and received cash. 3. The cost of the product sold in entry number 2 above was $300. 4. Sold $1,000 of product on account. 5. Purchased $5,000 of inventory on account. 6. $50,000 of cash was received by the company in exchange for stock. 7. Collected the $1,000 of account receivable. 8. Paid a salary expense of $2,000. 9. Paid the account payable of $5,000. 10. Paid a dividend of $3,000.

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Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-4 Solution Journal Entries 1. Purchased equipment for $10,000 and paid cash. Equipment Cash

10,000 10,000

2. Sold $500 of the company product and received cash. Cash Sales Revenue

500 500

3. The cost of the product sold in entry number 2 above was $300. Cost of Goods Sold Inventory

300 300

4. Sold $1,000 of product on account. Accounts Receivable Sales Revenue

1,000 1,000

5. Purchased $5,000 of inventory on account. Inventory Accounts Payable

5,000 5,000

6. $50,000 of cash was received by the company in exchange for stock. Cash Common Stock

50,000 50,000

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Chapter Two: The Income Statement and the Balance Sheet

7. Collected the $1,000 of accounts receivable. Cash Accounts Receivable

1,000 1,000

8. Paid a salary expense of $2,000. Salary Expense Cash

2,000 2,000

9. Paid the account payable of $5,000. Accounts Payable Cash

5,000 5,000

10. Paid a dividend of $3,000. Dividend Cash

3,000 3,000

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Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-5 Account Ledgers Construct all of the account ledgers for the journal entries completed in Self-Study problem 4. Assume that there is a beginning cash balance of $25,000, a beginning balance of inventory of $3,000, and a beginning balance in common stock of $28,000. An illustration for the cash ledger format is shown below. Cash Ledger

Debit

51

Credit

Balance

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-5 Solution Account Ledgers Construct all of the account ledgers for the journal entries completed in Self-Study problem 4. Assume that there is a beginning cash balance of $25,000, a beginning balance of inventory of $3,000, and a beginning balance in common stock of $28,000 Cash Ledger Beginning Balance Purchase Equipment Product Sale Issue Stock Collect Account Receivable Paid Salary Paid Account Payable Paid Dividend

Debit

Credit $10,000

$

500 50,000 1,000 2,000 5,000 3,000

Accounts Receivable Ledger Beginning Balance Sold Product on Account Collected Account Receivable

Debit

Inventory Ledger Beginning Balance Sold Product Purchased Inventory

Debit

Equipment Ledger Purchased Equipment

Debit

Credit

1,000 1,000 Credit 300 5,000

52

Credit

Balance $25,000 15,000 15,500 65,500 66,500 64,500 59,500 56,500

Balance 0 1,000 0 Balance 3,000 2,700 7,700 Balance 10,000

Chapter Two: The Income Statement and the Balance Sheet

Accounts Payable Ledger Purchase Inventory Pay Accounts Payable

Debit

Credit 5,000

Balance 5,000 0

Common Stock Ledger Beginning Balance Issued Common Stock

Debit

Credit

Balance 28,000 78,000

Dividend Ledger Paid Dividend

Debit 3,000

Credit

Balance 3,000

Sales Revenue Ledger Cash Sales Credit Sales

Debit

Credit 500 1,000

Balance 500 1,500

Cost of Goods Sold Ledger Cash Sales

Debit 300

Credit

Balance 300

Salary Expense Ledger Paid Salary Expense

Debit 2,000

Credit

Balance 2,000

5,000

50,000

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Chapter Two: The Income Statement and the Balance Sheet

Use the following trial balance to construct an income statement, statement of retained earnings, and a balance sheet for Self-Study problems 2-6, 2-7, and 2-8. Daniel & Son’s Inc. Trial Balance December 31, 1997 Numbers in $1,000s ACCOUNT Cash Accounts Receivable Inventory Prepaid Expenses Land Buildings Accumulated Depreciation Accounts Payable Notes Payable Mortgage Payable Common Stock Retained Earnings Dividends Sales Revenue Cost of Goods Sold Depreciation Expense Administrative Expense Interest Expense Tax Expense Total

DEBIT $ 160 180 350 40 180 900

40 650 50 100 30 80 $2,760

54

CREDIT

$ 200 120 140 400 600 300 1,000

$2,760

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-6 Income Statement Construct an income statement from the trial balance.

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Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-6 Solution Income Statement Construct an income statement from the trial balance. Daniel & Son’s Inc. Income Statement For the Year Ending December 31, 1997 Number’s in $1,000s Sales Revenue - Cost of Goods Sold = Gross Margin - Other Expenses Depreciation Administration = Operating Income - Interest Expense = Net Income Before Tax - Tax Expense = Net Income

$1,000 650 350 $ 50 100

56

-150 200 30 170 80 $ 90

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-7 Statement of Retained Earnings Construct a statement of retained earnings from the trial balance.

57

Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-7 Solution Statement of Retained Earnings Construct a statement of retained earnings from the trial balance. Daniel & Son’s Inc. Statement of Retained Earnings For the Year Ending December 31, 1997 Numbers in $1,000’s Beginning Balance Retained Earnings + Net Income - Dividends = Ending Balance Retained Earnings

$300 90 40 $350

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Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-8 Balance Sheet Construct a balance sheet from the trial balance.

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Chapter Two: The Income Statement and the Balance Sheet

Self-Study Problem 2-8 Solution Balance Sheet Construct a balance sheet from the trial balance. Daniel & Son’s Balance Sheet December 31, 1997 Numbers in $1,000s ASSETS Current Assets Cash Accounts Receivable Inventory Prepaid Expenses Total Current Assets Long-Term Assets Land Building - Accumulated Depreciation Total Long-Term Assets Total Assets

$ 160 180 350 40

$ 900 200

LIABILITIES & EQUITY Current Liabilities Accounts Payable Notes Payable Total Current Liabilities Long-Term Liabilities Mortgage Payable Total Liabilities

$ 730

180 700

$ 120 140

880 $1,610

$ 260 400 660

Stockholders Equity Common Stock Retained Earnings Total Stockholders Equity Total Liabilities & Equity

600 350

60

950 $1,610

Chapter Two: The Income Statement and the Balance Sheet

Problems Problem 2-1 Account Classifications Classify the following accounts as asset (A), liability (L), stockholders equity (S), revenue (R), expense (E), or dividend (D). ACCOUNT Depreciation Accounts Receivable Utilities Sales Supplies Preferred Stock Dividend Inventory Prepaid Expense Cash Inventory Retained Earnings Accounts Payable Unearned Revenue Cost of Goods Sold Accumulated Depreciation Equipment Taxes Land

CLASSIFY

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Chapter Two: The Income Statement and the Balance Sheet

Problem 2-2 Debit and Credit Balance on Accounts Determine the normal balance as debit (D) or credit (C) for each of the following accounts: ACCOUNT Dividends Accounts Payable Goodwill Depreciation Accounts Receivable Cost of Goods Sold Common Stock Retained Earnings Building Dividend Payable Equipment Prepaid Expense Tax Expense Unearned Revenue Cash Sales

BALANCE

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Chapter Two: The Income Statement and the Balance Sheet

Problem 2-3 Characteristics of Accounts Complete the matrix for each of the following accounts.

ACCOUNT

NORMAL BALANCE (D) (C)

PERMANEN T TEMPORAR Y (P) (T)

FINANCIAL STATEMEN T (I, R, B)

Sales Accounts Receivable Accumulated Depreciation Unearned Revenue Preferred Stock Dividend Sales Return Cost of Goods Sold Depreciation Prepaid Expense Problem 2-4 Journal Entries Construct journal entries for each of the following transactions. 1. Investors gave $100,000 to start D & S Inc. in exchange for common stock. 2. D & S purchased a building for $250,000 by paying 10% down in cash and taking out a mortgage for the balance due. 3. D & S purchased equipment for $90,000 by paying $20,000 and signing a note payable. 4. Inventory in the amount of $35,000 was purchased on account. 5. Cash sales amounted to $32,500. 6. The cost of the inventory sold equaled $17,000. 7. Employee salaries in the amount of $15,000 were paid. 8. The utility bill of $2,500 was received but not paid. 9. Sales on account amounted to $18,000. 10. The cost of the inventory for the sales on account equaled $9,500. 11. D & S paid the amount due for the purchase of inventory. 12. D & S collected $14,000 from customers for previous sales on account. 13. Dividends in the amount of $5,000 were paid to D & S shareholders. Problem 2-5 Posting journal entries to account ledgers. Using the journal entries in problem 2-4, establish ledger account balances for each of the accounts established in the journal entries. Problem 2-6 Trial Balance Using the ledger account balances established in problem 2-5, develop a trial balance showing each account and its debit or credit balance.

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Chapter Two: The Income Statement and the Balance Sheet

Problem 2-7 Financial Statements Using the trial balance established in problem 2-6, develop an income statement, statement of retained earnings, and balance sheet for D & S Inc. Problem 2-8 Journal Entries Construct journal entries for each of the following accounts. March 1 Investors gave Dan Company $200,000 in cash and a building valued at $300,000 in exchange for company common stock. March 3 Dan Company purchased a fleet of 10 vehicles for $200,000 by paying $25,000 in cash and establishing a note payable for the balance due. March 6 Equipment was rented for $5,000 per month with the first two monthly payment made in advance. March 10 Dan Company provided services and was paid $30,000 in cash. March 15 Dan Company paid the following expenses: Salaries $10,000 Utilities 3,000 Advertising 8,000 March 20 Standard Co., a customer of Dan Company paid 47,500 in advance for services to be provided. March 22 Dan Company provided services for $21,000 on account with the customers agreeing to pay in full in 30 days. March 23 Dan Company purchased supplies in the amount of $6,000 agreeing to pay for them in 30 days. March 31 The interest expense accrued on the note payable amounted to $1,400. March 31 The Dan Company recorded the following depreciation amounts: Building Depreciation $1,000 Vehicle Depreciation $2,000 Problem 2-9 Account Classifications Using the following list of accounts, reorganize them in the following order: Current Assets, Long-Term Assets, Current Liabilities, Long-Term Liabilities, Stockholders Equity, Revenue, and Expense. Within each of the categories, list the accounts in the order in which they would usually appear in a financial statement, and indicate the normal balance, permanent or temporary, and in which financial statement they would appear. Investment Accounts Payable Accounts Receivable Sales Cash Common Stock Dividend Inventory Unearned Revenue Land Accrued Salaries 64

Chapter Two: The Income Statement and the Balance Sheet

Supplies Retained Earnings Notes payable Prepaid Expenses Cost of Goods Sold Depreciation Equipment Taxes Accumulated Depreciation Salaries Mortgage Payable Utilities

65

Chapter Two: The Income Statement and the Balance Sheet

Problem 2-10 Zero Balance Accounts Indicate which of the following accounts should start each accounting period with a zero balance. ACCOUNT Preferred Stock Dividend Inventory Prepaid Expense Cash Accrued Interest Inventory Retained Earnings Accounts Payable Unearned Revenue Cost of Goods Sold Accumulated Depreciation Sales

BALANCE

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Chapter Two: The Income Statement and the Balance Sheet

Problem 2-11 Trial Balance Using the following accounts and their balances, construct a trial balance for DSSR Industry for the year ending December 31, 1996. Remember the total debit balance must equal the total credit balance. ACCOUNT

AMOUNT

Investment Accounts Payable Accounts Receivable Sales Cash Common Stock Dividend Inventory Unearned Revenue Land Accrued Salaries Supplies Retained Earnings Notes Payable-Short-term Prepaid Expenses Cost of Goods Sold Depreciation Equipment Taxes Accumulated Depreciation Salaries Mortgage Payable Utilities

$ 18,000 27,000 52,000 260,000 49,000 180,000 13,000 48,000 6,000 50,000 9,000 10,000 25,000 15,000 17,000 184,000 12,000 200,000 18,000 32,000 30,000 160,000 13,000

Problem 2-12 Income Statement From the data given in problem 2-11, construct an income statement for DSSR Industry for the year ending December 31, 1996. Problem 2-13 Statement of Retained Earnings From the data given in problem 2-11, construct a statement of retained earnings for DSSR Industry for the year ending December 31, 1996. Problem 2-14 Balance Sheet From the data given in problem 2-11, construct a balance sheet as of December 31, 1996.

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Chapter Two: The Income Statement and the Balance Sheet

Cases Case Study 2-1 Swan and Son’s Laundry Service Tom Swanson, a recent MBA graduate, decided to start his own laundry service business. He was especially interested in this type of business because it gave him the opportunity to hire individuals with some physical disabilities and the learning disabled and provide them with an opportunity to develop a trade skill and make a positive contribution in the workplace. Tom wanted to gain service contracts with various businesses whereby his company would pick up laundry items and have them cleaned and folded. Ideally, there would be sufficient quantities of laundry items, that clean replacements could be left at the time dirty items were picked up, and service could be provided on a daily basis. Tom believed that smaller hotels, restaurants, and nursing homes would be logical businesses that could benefit from his laundry service. These companies would not have to go through the large capital expenditure of securing capital equipment for laundry purposes as well as the labor cost for cleaning the laundry items. He felt his prices could be competitive with other laundry service businesses and even less per piece than it would cost for those businesses that would do the laundry service in house. This business also provided a job enrichment opportunity for the disabled. These individuals could be trained in the basic skills of laundry service, which could give them a feeling of self worth as well as allow them to make a meaningful contribution to society versus having to rely on welfare. Tom planned to start the employees at a competitive wage and give merit increases after the completion of a training and probationary period of employment. Due to his willingness to help the disabled, Tom was able to secure a small business loan of $200,000 at a 9.0% annual rate of interest. Tom also put up $25,000 of his own funds along with a used van valued at $9,000 to start the business. The van should last five years. Through some effective negotiation and because of the purpose of his business to help disadvantaged, Tom was able to buy used equipment from a large hotel chain. He obtained 10 industrial grade washing machines for a total of $21,000, which had a market value of $35,000 and would have cost $60,000 if purchased new. He also obtained 5 industrial grade dryers for a total of $24,000 which had a market value of $48,000 and would have cost $70,000 if purchased new. The washers and dryers are expected to last for five years. Tom secured a Butler building type of facility with 2,000 square feet of space, which rented out for $5 per month per square foot. One month’s rent was required for deposit and the rent was due monthly payable in advance. The utility bill was going to be high due to the running of the wash machines and dryers for almost eight hours a day, five days a week, for an average of 22 days in a month. Tom estimated the utility bill to be $100 for every working day plus an extra $100 per month for the days when the company was closed. Initially, Tom would do all of the front office work on his own along the sales effort to establish accounts. He believes that he can gain enough contracts to begin full-scale operations within one month.

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Chapter Two: The Income Statement and the Balance Sheet

The city social service agency, through a government program, has agreed to train twelve handicapped employees for a two-week period of time on location. They have also agreed to provide transportation to and from work on a city bus. There will be no charge for this service provided Tom agrees to pay the employees at least a minimum wage plus workman’s compensation. The employee’s health care will be covered under Medicare. The director of social services is very supportive of this business opportunity and believes that Tom’s plan for employee compensation and merit raises is fair. Tom anticipates that telephone and other office expenses will equal about $2,500 per month. Cleaning supplies like detergent and fabric spray will add up to $1,000 per month. Liability insurance for the employees, vehicle, and materials is estimated at $1,600 per month. The transportation cost to pick up and deliver the laundry items will probably be $750 per month. Many of the businesses will want the laundry items ironed. Tom purchased 10 heavyduty irons and ironing boards with stools for a total cost of $1,200. He plans to set up six ironing board work stations, and keep the other equipment on reserve if there is excess demand or equipment breakdown. The irons and boards are expected to last for five years. Of the initial 12 employees; two will be trained to sort and prepare the laundry items, two will monitor the washing process, two will monitor the drying process, four will iron, and the final two, as most skilled, will learn all of the functions and prepare the laundry items for return to the customer. Ten employees will begin at $6.00 per hour plus $2.50 per hour for other benefits and social security. The two most skilled employees will begin at $7.00 per hour plus $3.00 per hour for other benefits and social security. All employees will work a 40-hour week at 8.0 hours per day plus one unpaid hour per day for lunch and breaks. Every month, the social service department will provide three hours of training and evaluation of the employees. Tom will pay the employees during this training. Tom realizes that once the business gets started that he is going to need help with a supervisor to oversee the operation. Tom’s brother John is currently working on a masters degree at night and would be willing to work with the business. Tom will pay John $9.00 per hour plus $4.00 per hour for benefits. Tom plans to charge $1.50 per piece to clean large items such as sheets, large towels, table cloths, and uniforms, and $.75 per piece to clean small items like pillow cases, napkins, shirts, pants, small towels, and wash cloths. The price will double if the item needs to be ironed. Required A. Establish a company balance sheet for Swan and Son’s Laundry Service after all of the equipment is obtained and facilities are rented, but before the employees are hired. You may want to construct journal entries to support the balance sheet. B. Determine the total monthly expenses to run the laundry service business. C. Assuming that Tom averages $2.00 per laundry item, how many items must be cleaned in a month for the business to cover its monthly expenses? D. Establish an income statement assuming the company earned $50,000 in revenue in the first month. Use a tax rate of 40 percent. E. If you were a business entrepreneur, with limited accounting and finance expertise, what accounting and finance type of information do you believe would be important to 69

Chapter Two: The Income Statement and the Balance Sheet

gain in the starting of a business either through the use of an outside service, the hiring of an employee, or through self training.

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Chapter Two: The Income Statement and the Balance Sheet

Case Study 2-2 Pleasant Private School Rita Roebuck is a member of the finance committee of the board of directors for Pleasant Private School. One of her duties is to review the performance of the fund raising committee and recommend which, if any, of the current fund raising projects should be considered for the next school year. The school relies on fund raising to support 5 to 10 percent of its expenditures, with donations accounting for 10 to 15 percent. However, if donations fall short, then more money must come from additional fundraisers. Tuition revenue accounts for the other 80 percent of the school income. The total operating budget for the school year is expected to be $300,000 for the next school year, which is about a 10 percent increase over the current school year. Fund raising has become a necessary evil. Parents are never very enthused about having their children sell everything from candy to coupon books. Additionally, it is always hard to get volunteers to help with projects and sales. At the same time, the school needs to keep tuition as low as possible so families can afford to send there children to a private school, and there are only so many sources of potential revenue. With the increase in popularity of home schooling, and competition from other private and religious based schools, it is sometimes difficult to enroll and maintain students. Pleasant Private school has grades of kindergarten through eighth and needs a critical mass of 20 students in each class to justify the cost of a teacher and other related costs. The need to enroll students restricts the school’s ability to raise tuition, and makes the fund raising activities a critical component of revenue generation. Rita received the following report from the chairman of the fund raising committee, which summarized the activities for the year. She needs to review the report and prepare her briefing for the school board, which will meet next week. Rita is a big supporter of fund raising activities and has worked closely with the committee over the year. However, there are several members of the school board that are getting tired of these activities. Some board members want to raise tuition, and other board members are considering options like downsizing, or consolidation with another private school. Rita wants the school to stay independent and hopefully grow to include a high school. She knows that for this goal to become a reality, she will really need to sell the success of fund raising as a source of revenue.

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Chapter Two: The Income Statement and the Balance Sheet

Fund Raising Committee Year to Date Activity Beg. Balance First PTO Meeting - Refreshments Supplies: Checks Typewriter for Teachers Rubber Stamps (library/deposit) Fruit Sale: Total Dep. Total Exp. Teachers/Classroom: Conference, Newspaper week, supplies Library: Books, Magazines, Supplies Computers: Printers, software Items for School: Set up Sick room Chairs/Library Cart Standing Risers Mascot Lg. Bulletin Board, bul. strips 2-Chair Holders on wheels General Fund Set Up (helps with copy paper art sup. kitchen sup.) Kitchen Supplies Therapy: books, teachers conf. Board: Bldg. Fund Endowment Fund Light for Parking Lot Sub Sale: Total Dep. Total Exp. T-Shirts/Sweat Shirts/School Bags Deposit for T-shirts, etc Carnival Sale: Total Dep. Food, prizes, games for carnival Garage Sale and Auction: Total Dep. Food and exp. for garage sale End. Balance

966 -106 -50 -100 -26 12,696 -6,697 -462 -207 -1,327 -54 -675 -994 -81 -216 -300 -705 -52 -446 -1,250 -270 -286 5,007 -1,756 -2,050 916 2,540 -2,076 3,798 -363 5,374

Required: A. Revise the fund raising committee report into some form of an income statement and fund balance statement which will highlight the success or failure of each of the various fund raising activities. B. Identify how the money earned from the fund raising activities was used during the school year. C. Prepare a report for Rita to present to the school board regarding the fund raising activities of the school. Include recommendations for fund raising activities for the following year, if you believe they are feasible. Feel free to make suggestions for other possible fund raising activities, which might be considered. Be objective in your report,

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Chapter Two: The Income Statement and the Balance Sheet

but remember that Rita needs to convince board members as well as disgruntled parents of the necessity of continuing the need for fund raising activities.

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Chapter Three: Financial Statement Analysis

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Chapter Three: Financial Statement Analysis

Chapter Three: Financial Statement Analysis Objectives 1. 2. 3. 4. 5. 6. 7.

Review the role and purpose of financial statement analysis. Identify the strengths and weaknesses of financial statement analysis. Analyze liquidity ratios. Analyze activity ratios. Analyze debt ratios. Analyze profitability ratios. Analyze market ratios.

The Role and Purpose of Financial Statement Analysis Financial statement analysis, or more specifically financial ratios, gives both the internal and external users of financial statements an opportunity to examine the performance of a company through its publicly available financial record. The information gathered can be useful for decision-making purposes in a variety of circumstances. This ratio analysis is a simple and easily understood process of measuring performance in percentage notation or some measure of activity such as the number of days or number of times. Ratios take the form of a fraction with a numerator and a denominator, and imply a relationship between the activities or accounts being measured. The mathematical computation process is no more difficult than multiplication or division. However, the ratios are only as good as the data provided and the user must be careful to insure the validity of the data, the accuracy of the calculation, and the correctness of the solution including items such as proper unit labeling and decimal placement. The ratios themselves provide a means of comparison of this financial data with a predetermined or established standard. Indeed, a ratio analysis is virtually useless unless there is a means of comparison with some type of standard. The standard of comparison can be a budgeted or predetermined standard of the company, or it can be representative of a prior year result of the company being analyzed. Standards could also be established externally such as an industry standard or economic standard. While financial statement analysis can be a very powerful tool in measuring company performance, it is just that, a tool. The process is not an end in itself, but a means to an end. The ratios developed should lead to very important questions regarding company performance, but the analysis process will not answer the questions. Management and other users must rely on key individuals within the company or industry analyst to propose answers to the questions raised through the financial ratio information. Ratio analysis can be conducted using several formats including: (1) trend analysis over time with ratios measuring absolute and percentage changes from one period to the next in a horizontal analysis format (2) trend percentages using a base year or base amount in a horizontal analysis format (3) percentages of single items to an aggregate total in a vertical analysis format (4) comparisons within a single time period with a predetermined standard

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Chapter Three: Financial Statement Analysis

Benefits of Financial Statement Analysis Probably the greatest benefit of financial statement analysis is that it is a readily acceptable means of analysis of company performance. The information generated is easy to understand and interpret. Since the ratios are simple to compute, there is a vast selection of standards and other performance measures that can be used for comparison purposes. Both internal and external users can conduct financial statement analysis and the information gathered will aid in the users decision-making process. Often external users have limited access to a company's performance; however, the publishing of financial statements provides critical information that can be evaluated by external users for analysis purposes. The procedures are common enough to allow for meaningful comparisons, even by external users. Financial statement analysis can provide information, which will generate important questions regarding the performance of the company. The analysis is based primarily on historical data and provides a system of control to evaluate what has taken place. Questions can then be asked which should lead to planning activities to best prepare for situations in the future. Therefore, financial statement analysis plays an important role in the management functions of planning and control.

Limitations of Financial Statement Analysis Financial ratios are primarily based on historical information, which may not be relevant for the decision-making purposes of either the internal or external users. Companies are in a dynamic environment with constantly changing conditions. The users of financial statement analysis must be aware of the changing situations when making their analysis and adjust accordingly. Industry standards are often at best just guidelines and may not be entirely appropriate measures of comparisons for specific companies. Also, within an industry, it may be difficult to compare companies because of subtle differences in variables such as size, product mix, or the age of the company. Accounting practices may differ between companies or even within divisions of a single company. The generally accepted accounting principles actually allow for some variation in the reporting of financial information and the preparation of financial statements. Disclosure requirements state that a company must identify the differences in accounting practice; however, these disclosures are often confusing and lengthy and an analyst could easily overlook or ignore the information. (Note: The following financial statements will be used to develop examples of financial ratios.)

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Chapter Three: Financial Statement Analysis

Luke’s Sky & Walking Manufacturing Income Statement For the Years Ending December 31, 1995, 1996, & 1997 Numbers in $1,000s ACCOUNT Sales Revenue

1995 $2,50 0

1996 $2,80 0

1997 $3,00 0

1,500

1,600

1,900

1,000 400 150 450 170 280 110 $ 170

1,200 450 160 590 220 370 150 $ 220

1,100 520 170 410 270 140 60 $ 80

Luke’s Sky & Walking Manufacturing Statement of Retained Earnings $1.70 $2.20 For the Years Ending December 31, 1995, 1996, & 1997 Numbers in $1,000s ACCOUNT 1995 1996

$ .80

- Cost of Goods Sold = Gross Margin = = =

Operating Expenses Depreciation Expense Operating Income Interest Expense Net Income Before Tax Tax Expense Net Income

Earnings Per Share

Beginning Balance

$30 0 170 100 $37 0

+ Net Income - Dividends = Ending Balance

77

$37 0 220 120 $47 0

1997

$470

80 140 $410

Chapter Three: Financial Statement Analysis

Luke’s Sky & Walking Manufacturing Balance Sheet December 31, 1995, 1996, & 1997 Numbers in $1,000s ACCOUNT Cash Accounts Receivable Inventory Prepaid Expenses Total Current Assets

1995 $ 50 320 350 30 750

1996 $ 80 300 400 20 800

1997 $ 60 360 450 30 900

300 2,200 990 3,490

300 2,500 1,140 3,940

300 2,400 1,400 4,100

Total Assets

$4,240

$4,740

$5,000

Accounts Payable Notes Payable Taxes Payable Deferred Revenue Total Current Liabilities

$

90 250 10 20 370

$ 110 320 20 20 470

$ 150 400 20 20 590

700 800 1,500

900 900 1,800

800 1,200 2,000

Total Liabilities

$1,870

$2,270

$2,590

Common Stock Retained Earnings Total Stockholders Equity

$2,000 370 $2,370

$2,000 470 $2,470

$2,000 410 $2,410

Total Liabilities & Equity

$4,240

$4,740

$5,000

100,00 0 $20.00 $ 1.00

100,000

100,000

$25.00 $ 1.20

$17.00 $ 1.40

Land Building (Net) Equipment (Net) Total Long-Term Assets

Mortgage Payable Bonds Payable Total Long-Term Liabilities

Number of Shares of Stock Market Price Per Share Dividend Per Share

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Chapter Three: Financial Statement Analysis

Liquidity Ratios Liquidity ratios are designed to determine the company’s ability to meet short-term obligations. The ratios should aid in answering questions such as does a company have enough cash or current assets that can be converted into cash within a short period of time to pay its current liabilities on a timely basis. The ratios focus strictly on the current assets and current liabilities from the balance sheet. Current ratio

The current ratio is computed as follows: Current Assets Current Liabilities The ratio gives an indication of the number of times a company can pay its current liabilities with current assets. Current assets are defined as cash or those assets which can be readily converted into cash within a one year period of time and thus be available to fulfill the obligation of the current liabilities. Current liabilities are obligations that will mature and need to be paid within a one year period of time. A standard is about 2.0 times for a current ratio. This amount means that there are twice as many current assets as current liabilities. A company does not want a current ratio that varies significantly in either direction from the standard. A current ratio that is too low could indicate a liquidity problem and a possible default situation. A current ratio that is too high could indicate an unwise use of available assets, as the current assets generally earn a lower return than the longer term assets. If given the choice; however, it is better to have a current ratio that is too high versus too low, because of problems associated with a default condition. Using the financial statements for Luke’s Sky and Walking Manufacturing, the current ratios for 1995, 1996, and 1997 are shown in Illustration 3-1. Current Ratio Illustration 3-1 Current Ratio

1995

1996

1997

Current Assets 750 = 2.02 800 = 1.70 900 = 1.53 Current Liabilities 370 470 590 Since a general industry guideline for the current ratio is 2.00, Luke’s company has failed to meet the standard for the last two years. Additionally, the trend is getting worse as the ratio shows a continued and somewhat rapid decline. this is an area of concern and there needs to be additional investigation into the company’s liquidity situation.

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Chapter Three: Financial Statement Analysis

Quick Ratio The quick ratio is computed as follows: Current Assets - (Inventories + Prepaid Expenses) Current Liabilities The quick ratio measures the same activity as the current ratio; however, it does not consider some of the less liquid current assets in the analysis. Inventory is not as liquid a current asset because there is often not a ready market for inventory, and if the inventory is sold, usually it generates an account receivable before the ultimate conversion to cash. This two step process from inventory to account receivable to cash makes inventory a less reliable source of ready cash to pay for current liabilities. Prepaid expenses are often a nonrefundable current asset, which can not be converted back into cash. These prepaid items actually represent a payment of cash in advance for the right to receive something in the future. Prepaid items are not considered useful in the payment of liabilities. The generally recognized standard for the quick ratio is about 1.0 times which means that the amount of current assets not including inventory and prepaid expenses is essentially equal to the amount of current liabilities. The same rules and guidelines that apply to the current ratio also apply to the quick ratio. The computation of the quick ratio for Luke’s company for 1995 through 1997 is seen in Illustration 3-2. The same conclusion regarding the current ratio can also apply to the quick ratio. The company failed to equal the standard of 1.00 for the last two years. Also, there is a two year downward trend in the ratio. These ratio results reinforce the need for an evaluation of the liquidity related activities of the company. The overall conclusion regarding the liquidity ratio is not good, especially in light of the declining trend for both ratios. While the company may be efficiently managing their current assets and current liabilities, there is little room for error. When current liabilities are due and payable, Luke’s company needs to have the current assets, and more importantly the cash, available to fulfill the obligation. The ratios are at about half the standard in 1997.

Activity Ratios Activity ratios attempt to determine how well a company is using its resources or assets to generate sales. The ratios can be considered as a measure of efficiency with the output of resources leading to the input of sales. A company is considered more efficient if fewer assets (output) are needed to generate a given level of sales (input), or if more sales

Quick Ratio

Quick Ratio Illustration 3-2 1995 1996

Cash & Accts Receivable 370 Current Liabilities 370 are generated from a given level of assets.

= 1.00

80

380 470

= 0.81

1997 420 590

= 0.71

Chapter Three: Financial Statement Analysis

Activity ratios, also called turnover ratios, are developed by taking a value from the income statement, usually sales, in the numerator, and a value from the balance sheet, some measure of assets, in the denominator. The income statement measure represents an activity occurring over a period of time. For consistency, the balance sheet measure in the denominator should also represent a period of time. To obtain the consistency, an average value is determined for the denominator, which is usually the average of a beginning balance and an ending balance. The input over output relationship gives the measure of efficiency. The value of the turnover ratios are measured in a number of times, with the greater the number of times indicating higher turnover or more efficiency. Number of days ratios are also measures of activities. The format of these ratios is to include a measure of an asset in the numerator, usually accounts receivable or inventory and a daily sales or daily cost of goods sold in the denominator. These ratios indicate in a number of days how long it takes to turnover a particular asset. The ratio is somewhat like a reciprocal to the turnover ratios with the number of days in a year as a basis. If an accounts receivable turnover ratio is 9.0 times, then the number of days in accounts receivable is 40 days (9.0 times 40 days equals 360 days or one year). The greater the number of days in a ratio, the less efficient a company is at turning over a particular asset.. Accounts Receivable Turnover Ratio The accounts receivable turnover ratio is computed as follows: Total Annual Credit Sales Average Accounts Receivable Total annual credit sales is considered in the numerator versus total annual sales because only credit sales will generate an accounts receivable. Average accounts receivable is determined by summing the beginning balance of accounts receivable and the ending balance of accounts receivable and dividing that total by two. It is better to have an average balance then to use either the beginning balance or the ending balance of accounts receivable since an average is generally more representative of the time period in question as reflected by the sales amount in the numerator. One could argue that an even more representative figure for average accounts receivable would be to obtain a balance at the end of each month and divide that total by twelve. The difficulty with this process is the extra work involved and the possibility that monthly data will not be available, especially for external users. The increased accuracy from using monthly data to compute an average balance of accounts receivable probably will usually not offset the cost of obtaining the additional data and therefore cannot be justified in most situations. A standard for accounts receivable turnover may be about 6.0 times; however, this number can vary widely depending on the industry being measured and the terms for collection. The higher the number of turnovers the better the company is performing in terms of the efficient use of its accounts receivable assets in generating credit sales. A higher turnover means that a company is doing a better job of collecting their accounts receivable. The accounts receivable turnover ratio for 1996 and 1997 for Luke’s company are computed in Illustration 3-3. The assumption is made that all sales are sales on account. Additionally, ratios for only two years can be calculated because an average balance in accounts receivable must be 81

Chapter Three: Financial Statement Analysis

Accounts Receivable Turnover Ratio Illustration 3-3 Accounts Receivable Turnover 1996 Credit Sales Average Balance in Accts Receivable

=

Accounts Receivable Turnover Credit Sales Average Balance in Accts Receivable

2800 (320 + 300)/2

= 9.03

1997 =

3000 (300 + 360)/2

= 9.09

determined. Two years of balance sheet data must be used to compute the average balance. Luke’s company seems to be doing well with regard to the accounts receivable turnover ratio. The rate of 9.0+ is well above the standard of 6.00 and the rate showed a slight increase in the second year.

Average Collection Period The average collection period ratio is computed as follows: Average Accounts Receivable Annual Credit Sales/360 Days The average accounts receivable figure in the numerator is the same number used in the denominator of the accounts receivable turnover ratio. The annual credit sales divided by 360 days gives a value for daily credit sales. 365 days may also be used for the number of days in a year. The answer to the ratio is the average number of days it takes to collect an account receivable. A standard for this ratio may be about 60 days. Note: The average collection period can also be found by dividing the number of days in the year by the accounts receivable turnover ratio. (365 days/6.0 times = 61 days) The average collection period is a useful ratio because its answer in days can be easily applied to a company's credit policy. If a company is requesting payment of accounts receivable in 30 days and the average collection period is 60 days, then even though the ratio agrees with the standard, it does not appear that the accounts receivable collection period is very effective. For this ratio, the lower the number of days for the average collection, the more efficient the company is in its collection of accounts receivable. The collection process is important because accounts receivable serves as a major source of cash within the current assets and the cash is needed to pay off the current liabilities. Companies can have very good current and quick ratios; however, if they do not have a good turnover of accounts receivable, they still may have a liquidity problem because they do not have sufficient cash. Companies can not pay off current liabilities with

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accounts receivable, and using accounts receivable as collateral can be a very expensive (high effective rate of interest) way to borrow money. The average collection period for Luke’s company for the years of 1996 and 1997 are computed in Illustration 3-4. The average collection period is about 40 days. If the terms of credit sales are net 30 days, then the 40 day average is satisfactory. However, there is room for improvement. There could be delays due to mailing both the invoice to the customer and in receipt of the payment. Additionally, there could be some processing inefficiencies. A goal of the company management could be to get the average collection period to no more than 30 days. Inventory Turnover Ratio The inventory turnover ratio is computed as follows: Cost of Goods Sold Average Inventory The cost of goods sold figure is used in the numerator because inventory is recorded at cost, and as the inventory is sold an accounting transaction will show a decrease in the inventory account and an equal increase in the cost of goods sold account. The same logic and discussion used for the average accounts receivable amount holds for the average inventory amount. A standard for inventory turnover may be about 4.0 times; however, the values for this ratio can probably vary more than any other ratio. In some companies inventory may turnover almost daily and in that case the turnover could approach 300 times or more, and in other companies turnovers could be only one or two times per year. One needs to be careful in examining this ratio and understand the specific circumstances of each company. As usual a higher turnover ratio is generally better because it demonstrates increased efficiency in its use of the asset inventory. However, it is possible that too high an inventory turnover could mean inventory shortages which would have a negative impact on company sales.

Average Collection Period Illustration 3-4 Average Collection Period 1996 Avg Balance of Accts Receivable Credit Sales Per Day

=

(320 + 300)/2 2800/360

Average Collection Period Avg Balance of Accts Receivable Credit Sales Per Day

=

310 7.78

= 39.9 days

=

330 8.33

= 39.6 days

1997 =

(300 + 360)/2 3000/360

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Chapter Three: Financial Statement Analysis

Inventory Turnover Ratio Illustration 3-5 Inventory Turnover Ratio Cost of Goods Sold Average Inventory

=

Inventory Turnover Ratio

1996

1600 (350 + 400)/2

= 4.27

1997

Cost of Goods Sold Average Inventory

=

1900 (400 + 450)/2

= 4.47

Some of the new inventory control models such as "just in time" inventory have led to great improvements in inventory turnover and greater company performance and efficiency. Improved turnover does have an upper limit and companies may find that the increased cost of more refined inventory control models may exceed the benefit of increased inventory turnover. Never the less, companies should continue to strive to identify cost effective ways to improve inventory turnover. The inventory turnover ratio for Luke’s company for the years of 1996 and 1997 is computed in Illustration 3-5. The inventory turnover ratio is slightly better than the standard of 4.0. Additionally, the trend shows a small improvement in turnover in 1997. A specific standard for this company and industry is needed before any additional conclusions can be made regarding the company’s inventory practices. Average Inventory Period The average inventory period ratio is computed as follows: Average Inventory Cost of Goods Sold/360 Days The cost of goods sold divided by 360 days gives a daily cost of goods sold. The answer to this ratio is the average number of days it takes for a company to sell its inventory. A standard for this ratio may be about 90 days. Note: The average inventory period can be found by dividing the number of days in a year by the inventory turnover ratio. (365 days/4.0 times = 91 days) Just as it is with the inventory turnover ratio, the average inventory period can vary widely. The ratio is still very useful because it measures its value in days. As with the average collection period for accounts receivable, the average inventory period shows how long it takes for inventory to be sold. If it is assumed that when inventory is sold it is sold on credit, then one also needs to consider the average collection period in determining how long it takes from the time a company obtains inventory until it receives the cash for its sale. For instance if the average collection period is 60 days and the average inventory period is 90 days, then it will take 150 days from the time a company obtains inventory until a company obtains 84

Chapter Three: Financial Statement Analysis

cash for the sale of this inventory. This two step process of going from inventory to accounts receivable to cash is the reason why inventory is not included in the quick ratio calculation. Companies must be very careful to maintain control of inventory. Even though inventory is a current asset, it is possible that inventory may never be converted into cash. Inventory can only result in cash if it is sold, and it can only be sold if it is what the customer wants. Companies can get overloaded with obsolete inventory and still have a good current ratio; however, unless the inventory turnover ratio is satisfactory, the company can have a liquidity problem. Companies cannot pay off current liabilities with inventory, and the use of inventory as collateral can be a very expensive form of financing. The average inventory period in days for Luke’s company for the years of 1996 and 1997 is computed in Illustration 3-6. The average number of days in inventory improves from 84.4 days to 80.5 days which is consistent with the improved inventory turnover ratio. A specific industry standard is needed to determine if the average inventory period is satisfactory. Total Asset Turnover Ratio The total asset turnover ratio is computed as follows: Sales Average Total Assets Total sales is used in the numerator because the assets used to generate sales do not distinguish between credit sales and cash sales. The average value of total assets is used as opposed to an asset value on a specific date for the same reason that averages are used on other turnover ratios. A standard for total asset turnover is about 1.5 times. The capital intensity of a company or its proportion of long-term assets can have a significant impact on the total asset turnover ratio. Companies with a large amount of long-term assets will generally have lower total asset turnover ratios.

Average Inventory Period Illustration 3-6 Average Inventory Period 1996 Average Inventory Balance Cost of Goods Sold/Day

=

Average Inventory Period Average Inventory Balance Cost of Goods Sold/Day

(350 + 400)/2 1600/360

=

375 4.44

= 84.4 days

=

425 5.28

= 80.5 days

1997 =

85

(400 + 450)/2 1900/360

Chapter Three: Financial Statement Analysis

Total Asset Turnover Ratio Illustration 3-7 Total Asset Turnover 1996 Sales Average Total Assets

=

2800 (4240 + 4740)/2

Total Asset Turnover Sales Average Total Assets

= 0.62

1997 =

3000 (4740 + 5000)/2

= 0.62

The total asset turnover ratio is an important component in the return on investment computation which is one of the most widely recognized ratios by both internal and external users to measure overall company performance. The ratio considers two of the most important values from the financial statements, sales and total assets, and combines information from the income statement and the balance sheet. Additionally, the total asset turnover ratio gives an overall measure of company efficiency as it relates the output of total assets with the input of sales. The total asset turnover ratio is computed for Luke’s company for 1996 and 1997 in Illustration 3-7. The total asset turnover ratio of 0.62 for each year appears to be quite low when compared to a standard of 1.50. The trend is constant, but it appears that there is considerable room for improvement. The overall conclusion regarding the activity ratios is fair to poor. The accounts receivable and inventory turnover ratios are close to standard and the trend is improving. However, the total asset turnover ratio is low and not improving. It appears that this is a highly capital intensive company (large amounts of long-term assets) which can be typical for manufacturing companies. The large amounts of long-term assets do not appear to be generating the necessary levels of sales, which can have a detrimental effect on important ratios like return on assets and return on equity.

Debt Ratios Debt ratios relate to the use of borrowed funds to obtain assets. There are two broad sources of assets, lenders and owners. Debt ratios determine the make up of these sources of assets between lenders and owners. Debt ratios also identify a company's ability to repay debt obligations with earnings and cash. A company that uses debt or liabilities to obtain assets is said to be using financial leverage. Using other people’s money to secure assets which leads to generating return for the owners can be a very useful technique in business, but there are risks involved. With the creation of liabilities comes a contractual obligation for repayment with interest in a prescribed time period. If a company does not generate enough earnings to fulfill 86

Chapter Three: Financial Statement Analysis

such obligations then the company is in risk of default and bankruptcy. The higher the level of financial debt, the greater the risk a company could incur if something goes wrong, but the greater the potential reward if something goes right. The debt ratios assess how much of a company's assets are funded by debt, and the company's ability to meet its financial obligations. Balance sheet leverage ratios include the debt to asset ratio and the debt to equity ratio. These ratios take values from the balance sheet and aid in identifying the proportion of assets funded by debt. Coverage ratios include the times interest earned ratio and the cash flow coverage ratio. These ratios take values from the income statement and help to analyze a company's ability to repay debt and interest. Debt to Asset Ratio The debt to asset ratio is computed as follows: Total Liabilities Total Assets Total liabilities represents a single figure at the time the ratio is computed. Average total liabilities does not need to be used as in the activity ratios because the balance sheet figure is not being compared to an income statement figure. Total assets is also a single figure at the time the ratio is computed. Both figures are readily obtainable from the balance sheet. The value of the ratio is given in a percentage. Since assets can be funded through both liabilities and equities, the total asset figure should be larger than the total liability figure and the ratio percentage should be less than 100 percent. A standard average may be about 55 percent, which means that slightly more than half of a company's assets are funded by liabilities. Company management needs to be very careful in determining the amount of debt as a source of assets. Debt financing is considered a less risky source of funds because of the contractual obligation to repay the principal amount plus interest within a specific period of time. The holders of company debt do not incur as much risk as the holders of company stock and therefore should not demand as high a return on their investment. Also, interest expense is a deduction from net income before tax as opposed to dividends, which are paid from earnings after taxes. The net cost of interest expense to the company is reduced by the tax rate thus aiding in making it a less costly source of funding. While debt financing may be less costly, increased uses of debt can increase the risk of default or bankruptcy by the company. Also, external users of financial information may not look favorably at companies that get overextended with regards to the level of debt. Companies with a high proportion of debt have fewer options available for future asset acquisition opportunities. The debt situation for companies is similar to an individual that gets too much in debt. A greater portion of their earnings has to go to debt repayment, which could reduce the opportunities for asset growth. When an individual with high levels of debt desires additional assets, their only source of funds is often more debt, and that debt is even more expensive. Debt financing can be acceptable as long as it remains under control and the individual can fulfill any repayment obligations. However, unforeseen circumstances can radically change an individual's financial position, and if that individual is in a high debt position the financial risk is even greater. 87

Chapter Three: Financial Statement Analysis

Debt To Asset Ratio Illustration 3-8 1995 1996

Debt/Asset Ratio Total Liabilities Total Assets

1870 4240

= 44.1%

2270 4740

= 47.9%

1997 2590 5000

= 51.8%

The debt to asset ratio for Luke’s company for the years 1995 through 1997 can be computed as in Illustration 3-8. The debt to asset ratio is below the standard but there is a definite increasing trend. It appears as though the company is funding a larger portion of its assets with debt. The increased debt funding can be advantageous for the company if it can make positive use of financial debt. If the increased levels of debt create a financial hardship, then this trend could be an indication of future problems. Debt to Equity Ratio The debt to equity ratio is computed as follows: Total Liabilities Total Equity This ratio is virtually identical to the debt ratio with the only difference being the use of total equity in the denominator versus total assets. The ratio gives in a percentage the relationship between liabilities and equity. If more assets are funded by liabilities than equity then the ratio will be greater than 100 percent. When equity is the greatest source of funding for assets, the ratio is less than 100 percent. A standard average may be slightly greater than 100 percent meaning that liabilities are higher than equities. The same cautions and concerns that apply to the debt ratio also apply to the debt to equity ratio. Companies need to balance the risk and return possibilities associated with debt financing. The debt to equity ratio for Luke’s company for the years 1995 through 1997 can be computed as is it is in Illustration 3-9. The debt to equity ratio is consistent with the debt to asset ratio. The trend shows the increasing reliance on debt financing to fund assets. The company has gone from liabilities equal to 79% of equity to almost 108% of equity. The level of total equity has remained essentially stable while both assets and liabilities are steadily increasing with the liabilities increasing as a faster rate. The previous ratios are classified as balance sheet ratios as they involve balance sheet figures, which identify the sources of assets. The other types of debt ratios are classified

Debt/Equity Ratio Total Liabilities Total Equity

Debt to Equity Ratio Illustration 3-9 1995 1996 1870 2370

= 78.9%

88

2270 2470

1997 = 91.9%

2590 2410

= 107.5%

Chapter Three: Financial Statement Analysis

Times Interest Operating Income Interest Expense

Times Interest Earned Ratio Illustration 3-10 1995 1996 450 170

= 2.65

590 220

= 2.68

1997 410 270

= 1.52

as coverage ratios. The coverage ratios are used to determine a company's ability to pay the finance charges of interest and principal repayment. Times Interest Earned Ratio The times interest earned ratio is computed as follows: Net Operating Income Annual Interest Expense or Earnings before Interest and Taxes Annual Interest Expense The numerator of net operating income considers all revenue and expense items with the exception of financing related activities and taxes. The supplementary income figure is a measure of the operating performance of the company over a period of time usually one year. The ratio indicates how many times the operating income will cover the interest expense obligation. A standard for this ratio is about 2.5 times. If companies cannot generate enough operating income to cover financing charges they are in risk of default on their debt obligations. Companies that have higher degrees of financial leverage will tend to have a lower times interest earned ratio. With this ratio, there is no real danger if the amount is considerably higher than some standard, the major concern should be for a low times interest earned value. The times interest earned ratio for Luke’s company for 1995 through 1997 is computed in Illustration 3-10. The company is near the standard for times interest earned until 1977 when there is a noticeable decline in the rate. The decline is caused by both a drop in operating income and an increase in the interest expense. The company is getting close to being in danger regarding the responsibility of paying interest with available income. Cash Flow Overall Coverage Ratio The cash flow coverage ratio is computed as follows: Net Operating Income + Lease Expense + Depreciation Interest Expense + Lease Expense + Preferred Dividends/ (1 - Marginal Tax Rate) + Principal Repayment/(1 - Marginal Tax Rate) This rather complex ratio addresses the issue that interest expenses must be paid for with cash, and net operating income does not necessarily mean cash. The numerator needs to be converted from a net operating income position to a cash position. Lease expenses are usually deducted as part of an operating expense to arrive at net income, therefore the amount of lease expense needs to be added back to net operating income. Net operating income is based on an accrual concept and some of the expenses may not involve cash. The most obvious expense of this nature is depreciation. In order to arrive 89

Chapter Three: Financial Statement Analysis

at a cash position, the amount of all noncash types of expenses needs to be added back to the net operating income. The resulting numerator could be classified as cash flow from operating income activities. The amount in the numerator represents the amount of cash available from operating activities. In the denominator is all of the potential fixed financing types of obligations. Interest expense is just one of the categories to be considered. Since lease expense was moved from an operating activity to a financing activity, it too must be included in the denominator for cash coverage purposes. Some cash payments can be made with only after tax net income or cash. Preferred dividends which display characteristics similar to debt instruments are paid with after tax dollars. Also, any principal repayment of debt is made without the benefit of any tax savings. To get all of the terms in the ratio on a consistent tax related basis, those items paid with after tax dollars are divided by the fraction of 1.0 minus the marginal tax rate. This adjustment results in the amount of before-tax cash flows that are required to make the required payments. The cash flow coverage ratio has significant advantages over a times interest earned ratio. To begin with it recognizes that cash is needed to fulfill financial obligations and cash is not the same as net operating income. Additionally, the ratio identifies all financial obligations and adjusts them as appropriate for tax implications. Just because a company can cover their interest expenses does not mean that they have adequate cash coverage for all financial obligations. A company with a satisfactory times interest earned ratio may not have sufficient cash for a satisfactory cash flow coverage ratio. If only the more easily determined times interest earned ratio is computed, the analyst may come to an incorrect conclusion. As with the times interest earned ratio, the only real danger is a low number. A company that does not have coverage ability is in risk of default whether it fails to meet interest payments or debt principal or lease payments. The cash flow overall coverage ratio is a relatively new ratio which has gained its recognition of importance as companies realize the necessity to closely monitor cash. The cash flow overall coverage ratio for Luke’s company for the years 1995 through 1997 can be computed as in Illustration 3-11.

90

Chapter Three: Financial Statement Analysis

Note: From the financial data there is no preferred stock dividends or evidence of leases, so these amounts in the numerator and denominator of the ratio will be zero. An assumption will be made that $100 of principal repayments will be due every year and this amount is included in the denominator. Given the amount of debt, the $100 per year assumption is reasonable. Also, the tax rate is computed by dividing the tax expenses by the net income before tax and the rate equals about 40 percent each year. The cash flow coverage is lower than the times interest earned for each year with a considerable decline in 1997. Again, the company is showing signs of weakness in its ability to cover fixed financial obligations and the trend indicates the situation is getting worse. The debt ratios all confirm a trend that is leading to greater levels of debt. The balance sheet ratios show that asset expansion is being funded solely by increases in the level of debt. This action is beginning to have an effect on the income statement as higher amounts of interest expense are causing decreases in the coverage ratios. Luke’s company could be just about at its limit in the debt situation. Action needs to be taken to reverse or at least curtail this trend.

Profitability Ratios Profitability ratios relate to the earning ability of the company. A major purpose of the income statement is to measure net income or company profitability. A company cannot

Cash Flow Coverage Ops Income + Depreciate Interest Expense + Principal Payment/(1.0 - Tax Rate)

Cash Flow Coverage Ratio Illustration 3-11 1995 =

450 + 150 170 + [(100)/(1.0 - .393)]

Cash Flow Coverage Ops Income + Depreciate Interest Expense + Principal Payment/(1.0 - Tax Rate)

=

600 335

= 1.79

=

750 388

= 1.93

1996 =

590 + 160 220 + [(100)/(1.0 - .405)]

Cash Flow Coverage

1997

Ops Income + Depreciate = 410 + 170 = 580 = 1.30 Interest Expense + Principal 270 + [(100)/(1.0 - .429)] 445 Payment/(1.0 - Tax Rate) expect to have a long-term existence if it continues to fail to make a profit. An absolute amount representing a company's net income or profit has value; however, this figure cannot address questions such as how much of a dollar of sales was converted into profit, or how much of a dollar of assets or equity was converted into profit. Profitability ratios

91

Chapter Three: Financial Statement Analysis

can make comparisons between profit and other measures of performance on a relative basis. Profitability ratios can be classified into two broad categories to include profitability related to sales or other income statement items and profitability related to investments or other balance sheet items. In all the profitability ratios, net income or some supplementary measure of income statement performance such as net operating income or gross margin will be the numerator. For income statement related ratios sales will generally be the denominator. For balance sheet related ratios average total assets or average total equity will usually be the denominator. Gross Profit Margin The gross profit margin is computed as follows: Gross Margin Net Sales The numerator gross margin equals net sales less cost of goods sold. The denominator equals total sales revenue less items like sales returns and allowances and sales discounts. Net sales represents the level of sales revenue that can be attributed to the earnings potential of the company. Frequently, net sales is the same as sales revenue as the amount of the deduction from gross sales is relatively insignificant. If a net sales figure is not available from the income statement the sales figure is an acceptable and sometimes a preferred alternative because it is easier to identify and interpret. The value of this ratio in percent terms identifies how much of the sales dollar remains after covering the cost of the good or service that has been sold. A standard for gross profit margin is between 25 and 30 percent. This ratio implies that for every dollar of sales between 70 and 75 cents goes to the actual cost of the good or service sold and only between 25 and 30 cents remains to cover other operating, financial, and tax expenses plus leaving a profit margin. The higher the percentage, the better the company is doing in generating potential profitability. For Luke’s company, the gross profit margin for the years of 1995 through 1997 can be computed as in Illustration 3-12. The gross profit margins for Luke’s company are all above standard. The company appears to be earning a satisfactory revenue above the cost of its product. The gross profit margin has shown a negative trend in 1997, which could be a sign of trouble in the future. Also, the depreciation expense listed under operating expenses could easily be part of cost of goods sold which would cause a decrease in the margin. Gross Profit Margin Ratio Illustration 3-12 Gross Profit 1995 1996 1997 Gross Margin Sales Revenue

1000 2500

= 40.0%

1200 2800

Operating Profit Margin Ratio The operating profit margin ratio is computed as follows: Net Operating Income

92

= 42.9%

1100 3000

= 36.7%

Chapter Three: Financial Statement Analysis

Operating Profit Operating Income Sales Revenue

Operating Profit Margin Ratio Illustration 3-13 1995 1996 450 2500

= 18.0%

590 2800

= 21.1%

1997 410 3000

= 13.7%

Net Sales

The numerator net operating income is a supplementary income figure that is determined after all operating expenses have been deducted from net sales revenue. The percentage value for this ratio indicates what portion of the sales dollar remains for financing charges, taxes and profit margin. A standard for the net operating margin is about 10 percent. This value means that for every dollar of sales approximately 90 cents goes to operating expenses leaving only about 10 cents for finance charges, taxes and profit. This figure seems relatively low and indicates that profit portion of any dollar of sales is relatively quite small. As with the gross profit margin ratio, a higher percentage would indicate that the company is doing a better job at generating potential profitability. The only danger with this ratio is if the value is too low, it could indicate that the company is not generating sufficient earnings from their sales and operating activities, especially if there are significant financial charges. The operating profit margin ratio for Luke’s company for the years 1995 through 1997 is computed in Illustration 3-13. The operating profit margin ratios are above standard; however, there is a significant decrease for 1997. The satisfactory operating profit margin is a carryover from the satisfactory gross profit margin. The fact that the company has good margins gives them the opportunity to adequately cover the interest expense related to debt or to have a superior net profit margin. Net Profit Margin Ratio The net profit margin ratio is computed as follows: Net Income Net Sales

This ratio considers the after tax net income figure in the numerator and reflects the residual of all items of revenue and expense from the income statement. The percentage value of the ratio identifies what percentage of a dollar of sales ends up as net profit. A standard for this ratio is only about 4.0 percent. The average net profit margin reinforces the fact that only a very small proportion of every sales dollar ends up as net profit. The higher the ratio, the better the company performance as measured in terms of profitability.

93

Chapter Three: Financial Statement Analysis

The net profit margin ratio for Luke’s company for the years 1995 through 1997 is computed in Illustration 3-14. The company experienced good net profit margins above industry standards for the first two years. There was a noticeable decline in the net profit margin in 1997. This may be a temporary condition of the company or it may be an early indication of continuing problems. All the income statement profitability ratios showed a declining trend in 1997, with the most significant decline occurring on the net profit margin. The previous profitability ratios were measured in relation to sales. A measure of sales revenue was included in the denominator of every ratio. The remaining profitability ratios are measured in relation to investment. The denominator of these ratios will include a balance sheet item such as average total assets or average total equity. Return on Total Assets or Return on Investment Ratio The return on total assets ratio is computed as follows: Net Income Average Total Assets The denominator uses average total assets just as in the activity ratios because a balance sheet item is being related to an income statement item. The net income reflects activities over a period of time, revenues minus expenses. To have consistency in the ratio, the asset measure should attempt to reflect an appropriate balance over the entire time period. A single beginning or ending balance figure may or may not represent what the total asset amount could have been over the entire period. Using an average of the beginning and ending balances will probably give a closer approximation of the proper amount of total assets to compare to net income. The value of this ratio is recorded in a percent figure, and a standard is around 6.0 percent. The ratio implies that for every dollar of assets a company owns it earns a net income of about six cents. The return on total assets ratio is frequently broken down into two ratios, which have been previously, discussed; the total asset turnover ratio and the net profit margin ratio. The computations for these two ratios are as follows: = Net Income Sales X Net Income Average Total Assets Sales Average Total Assets The breakdown of the return on total assets ratio can help to determine the level of impact on the return due to asset turnover and what impact is due to profit margin. Some

Net Profit Margin Ratio Illustration 3-14 1995 1996

Net Profit Margin Net Income Sales Revenue

170 2500

= 6.8%

220 2800

= 7.9%

1997 80 3000

= 2.7%

companies may have a high asset turnover ratio but a very low profit margin. In other cases a company can have a low turnover, but the profit margin is relatively high. Ideally, 94

Chapter Three: Financial Statement Analysis

Return on Total Assets

Return on Total Assets Illustration 3-15 1996

Net Income Average Total Assets

220 (4240 + 4740)/2

Return on Total Assets

1997

Net Income Average Total Assets

80 (4740 + 5000)/2

= 4.90%

= 1.64%

of course, a company would desire high asset turnover and high profit margin, but often the company cannot have the best of both situations. Return on Total Assets Illustration 3-16 1996

1997

Asset Turnover x Profit Margin = Return on Assets

Asset Turnover x Profit Margin = Return on Assets

0.62 x 7.9% = 4.90%

0.62 x 2.7% = 1.64%

The return on total assets for Luke’s company for the years of 1996 and 1997 can be computed as in Illustration 3-15. The return on total assets is below the standard for both years with a noticeable decline in 1997. A break out of the ratio into the turnover component and the profit margin component, which have been computed earlier, are illustrated in 3-16. The total asset turnover is consistent but below standard for both years. Only a good net profit margin in 1996 resulted in a relatively satisfactory return on asset ratio. In 1997 when the net profit margin fell, both components of the return on asset ratio were less than satisfactory which resulted in a very low return on asset value. In 1997, the ratio implies that for every dollar of assets, the company earned 1.64 cents. Return on Common Equity Ratio The return on common equity ratio is computed as follows: Net Income Available to Common Shareholders Average Common Equity The numerator net income figure is adjusted for any dividend payments to preferred shareholders leaving only the earnings available for potential distribution to the common shareholders. The denominator includes all equity with the exception of preferred stock. An average figure is used for common equity because a balance sheet figure in the denominator is related to an income statement figure in the numerator. 95

Chapter Three: Financial Statement Analysis

An investor desires to know what percentage of return is gained through a stock investment in a specific company. A standard is between 9 and 10 percent. This figure states that for every dollar of investment in common stock, the owner of the shares is receiving 9 to 10 cents per year. A higher return is generally better as it indicates that investors are gaining more return for dollar invested. The return on common equity has to be considered in light of the risk. A certificate of deposit may generate a return of only about 5 percent per year but with virtually no risk. To gain increased return the investor needs to assume more risk. How much risk an investor wants to assume for additional return is an individual investor decision. A company with the highest return on common equity may not be the best option because of the potential greater degree of risk. The return on equity ratio for Luke’s company for the years of 1996 and 1997 are computed in Illustration 3-17. The return on equity ratio is generally equal to the standard for 1996, but declines considerably in 1997. The 1997 results indicate only a 3.28% rate of return on every dollar invested by owners of the company. The risk associated with holding common stock, and the fact that the rate of return on equity may be lower than the return on a risk free investment instrument like a US Treasury bill is cause for concern. Investors need to know whether this trend is temporary or an indication of more long-term problems. Also, it is possible that some of the factors causing the decline may be related to external factors, such as, the economy going into a recession or increased foreign competition. The profitability ratios showed relatively good but not great performance for 1995 and 1996. However, in 1997 a declining trend was evident in every ratio. Many factors may be causing the decline, but the increased debt load certainly appears to be contributing to a reduced net income.

Market Ratios Since many financial statement analysts are concerned with company performance and its impact on the market price of a company's stock, it is necessary to have financial ratios

Return on Equity

Return on Equity Ratio Illustration 3-17 1996

Net Income Average Equity

220 (2370 + 2470)/2

Return on Equity

1997

Net Income Average Equity

80 (2470 + 2410)/2

= 9.09%

= 3.28%

that consider common stock relationships. These market ratios include not only dollar

96

Chapter Three: Financial Statement Analysis

information from the financial statements but values such as market price of the company stock and the number of shares of common stock actively traded on the open market. Earnings Per Share Ratio The earnings per share ratio is computed as follows: Net Income The Number of Shares of Common Stock Outstanding The number of shares of common stock outstanding in the denominator represents the number of shares actively traded in the stock market. These shares are available for any investor to buy and sell at a going market price. The earnings per share value is a dollar amount per share of stock and it represents a dollar amount of annual return for each share of stock owned by an investor. A higher earnings per share figure is better; however, the value must be considered in relation to a trend and also the market price of the stock. Keeping all other factors constant, an investor would be better off with an earnings per share of $1.00 on a stock with a market price of $10.00 than an earnings per share of $9.00 on a stock with a market price of $100.00. Since it is difficult to objectively determine a standard, there is no industry average for earnings per share. A better approach to analyze earnings per share is to look at the earnings per share trend for each individual company over time. Ideally, the trend is increasing at a steady and constant rate. This condition indicates that the company is continuously earning more income for each share of stock. Companies recognize the importance of the earnings per share figure and promote it extensively, especially when it is responding favorably. The earnings per share ratio has been included in the income statement for Luke’s company for the years of 1995 through 1997. The computation is seen in Illustration 318. Earnings Per Share Ratio Illustration 3-18 Earnings/Share 1995 1996 1997 Net Income 170 = $1.70 220 = $2.20 80 = $0.80 Number of Shares of 100 100 100 Stock Outstanding Note: There were 100,000 shares of common stock outstanding. Since the dollar amount of net income was in $1,000s, the number of shares also has to be listed in 1,000s for a consistent ratio computation. The earnings per share ratio has an acceptable increase in 1996 followed by a significant decline in 1997. The decline in 1997 will no doubt have a negative impact in the minds of investors as reflected in the market price of the stock, which declines in 1997. Earnings Yield on Common Stock Ratio The earnings yield on common stock ratio is computed as follows: Earnings Per Share Market Price Per Share 97

Chapter Three: Financial Statement Analysis

The earnings yield ratio overcomes the problem associated with the earnings per share ratio when it is not compared to the market price of common stock. An absolute measure of earnings per share may not give an accurate measure of performance until the relative measure of earnings yield on common stock is determined. Since both the numerator and denominator contain dollar amounts per share measurements, the dollar per share components cancel out and the ratio measurement is a percentage described as the yield. This earnings yield is a measure of return for each dollar invested in the market price of a share of stock. The higher the yield rate the better, and given the level of risk associated with holding common stock, the earnings yield should be considerably above the yield on a virtually risk free investment like a certificate of deposit. In the example previously described in the earnings per share ratio discussion, the first stock with an earnings per share of $1.00 and a market price per share of $10.00 has a yield of 10 percent. The second stock which has a much higher earnings per share of $9.00 has a market price per share of $100.00 and an earnings yield of only 9 percent. The better selection is the $10.00 stock which has the higher earnings yield of 10 percent versus 9 percent for the $100.00 stock. The earnings yield on the common stock for Luke’s company for 1995 through 1997 is computed in Illustration 3-19. The earnings yield on common stock remains relatively constant for the years 1995 and 1996. The increase in the market price of the common stock in 1996 is a reflection of the increase in the earnings per share. However, in 1997, the overall decline in performance caused a reduction in the market price and a decrease in the earnings yield to a low 4.7%. There is a possibility for even further erosion in the market price, especially if the problems surfacing in 1997 are ongoing. Price Earnings Ratio The price earnings ratio is computed as follows: Market Price Per Share Earnings Per Share The price earnings ratio is the reciprocal of the earnings yield ratio. The ratio states how many times greater the market price for a share of company stock is over the earnings of that stock. A general guideline is that a stock should sell for about 15 times earnings; however, that equates to an earnings yield of only about 6.6 percent (1\15 = .067). A price earnings of 15 times may be a good average to use for a portfolio of stocks, but to apply that standard to an individual stock can be risky. A major purpose of the price

Earnings Yield Earnings/Share Market Price of Common Stock

Earnings Yield Ratio Illustration 3-19 1995 1996 1.70 20.00

= 8.5%

98

2.20 25.00

1997 = 8.8%

0.80 17.00

= 4.7%

Chapter Three: Financial Statement Analysis

earnings ratio is to aid in determining if a stock is under or overvalued. To make a generalization that a stock selling for greater than 15 times earnings is overvalued is a mistake. Sometimes stocks selling for 40 times earnings are still undervalued; especially if the potential for rapid growth, such as in the technologies industry, is evident. At the same time a stock selling for only 5 times earnings may be overvalued if the company is on the way to bankruptcy. An investor should use the price earnings ratio with caution and in conjunction with other relevant ratios and financial information before making a determination if a stock is over or undervalued. Generally, it is better to consider the price earnings ratio for an individual company over a time horizon. If the trend in the price earnings ratio is increasing that could indicate a favorable situation, and if the trend is decreasing, the situation could be unfavorable. However, an increase in the price earnings ratio could occur when earnings fall and the stock price does not react immediately to the decline in earnings with a proportional decline in its price. Likewise, the price earnings ratio could decline in a time of increasing earnings because the market price of the stock does not increase. The price earnings ratio for Luke’s company for the years of 1995 through 1997 is computed in Illustration 3-20. The company stock seemed to be selling at a relatively consistent price earnings ratio of between 11 and 12 times earnings, which is below the standard. The lower price earnings ratio could be related to many factors in the minds of investors, such as higher risk level, product life cycle, nature of the industry, and level of competition. The increase in the price earnings ratio in 1997 to 21.3, almost double the previous year’s amount does not necessarily imply increased investor confidence in the company as could be reflected in a higher market price. In fact the market price went down by a considerable amount. The greatest cause for the increase in the price earnings ratio is due to a decline in earnings per share, which could imply that the stock is still overpriced and could be due for an additional correction. The stock has already declined in value and could be subject to a greater decline in the current conditions of the company do not improve.

Price Earnings Ratio Illustration 3-20 Price Earnings Price/Share Earnings/Share

1995 20.00 1.70

1996 = 11.8

25.00 2.20

99

1997 = 11.4

17.00 0.80

= 21.3

Chapter Three: Financial Statement Analysis

Dividend Yield on Common Stock Ratio The dividend yield on common stock ratio is computed as follows: Dividend Per Share Market Price Per Share Investors that obtain stocks paying dividends desire to know the percentage return the dividend is providing in relation to the market price of the common stock. The dividend yield may be relatively low in relation to yields on securities such as certificates of deposit; however, common stocks can also gain returns through growth in the market price of the stock. Also, some companies, especially in growth industries, may not pay any dividends. The goal of the investor in common stock will determine whether a high or low dividend yield is desirable. Investors interested in income oriented stocks are looking for higher dividend yields. Investors looking for growth oriented stocks are satisfied with low dividend yields. The dividend yield ratio for Luke’s company for the years of 1995 through 1997 is computed in Illustration 3-21. The dividend yield appears to be reasonable and maybe high for this company for 1995 and 1996. In 1997, the dividend yield increases because of the decline in the stock market price and the continued increase in the dividend rate per share. The company may be trying to maintain a policy of always increasing dividends but they are facing a risk of declining retained earnings and may be forced to cut or eliminate dividends in the future. Payout Ratio on Common Stock The payout ratio on common stock ratio is computed as follows: Dividend Per Share Earnings Per Share For every dollar of earnings a company can either pay out the dollar as a dividend or retain the dollar and reinvest it in new company assets. Companies in growth industries will have a low payout ratio, as there are many opportunities to reinvest earnings in productive assets that will lead to higher earnings and the potential for an increasing market price of the common stock. Companies in more mature industries will tend to have higher payout ratios because the opportunities to reinvest earnings in productive assets are limited. The market price of the mature industry stock may not increase as rapidly; however, this is made up to an extent by the higher dividend payout ratio, and the likelihood for a higher dividend yield. Investors will make the decision regarding the type of stock they are most interested in

Dividend Yield Dividend/Share Price/Share

Dividend Yield Ratio Illustration 3-21 1995 1996 1.00 20.00

= 5.0%

100

1.20 25.00

= 4.8%

1997 1.40 17.00

= 8.2%

Chapter Three: Financial Statement Analysis

obtaining. Income oriented investors will be looking for stocks with higher dividend payout ratios. Growth oriented investors will select stocks with low dividend payout ratios. A relationship called the retention ratio is equal to 1.0 minus the dividend payout ratio. Company earnings are either paid out as dividends or retained in the company for future asset acquisition. The sum of the two options equals 100 percent. Once the dividend payout ratio is computed in terms of a percent, the retention ratio can be determined as the remaining percentage. The dividend payout ratio for Luke’s company for the years of 1995 through 1997 is computed in Illustration 3-22. The dividend payout ratio was relatively constant in 1995 and 1996. The company was paying out more than half of its earnings in dividends. This can be an acceptable payout ratio for a company in a mature industry without high levels of growth. The company total asset growth in 1996 was almost 12% (4740 - 4240)/4240 = 12%. In 1997, the total asset growth was (5000 - 4740)/4740 = 5.5%. The dividend payout ratio may have been too high in 1995 and 1996 to support the level of asset growth. The company was trying to expand its asset base and maintain attractive dividends at the same time, which could have put severe restrictions on its cash position. The company had to rely on debt issues to finance asset growth. In 1997, the company maintained a consistent policy of increasing dividends in the face of declining earnings. The dividends were greater than earnings and resulted in a decreased balance in retained earnings.

Dividend Payout Dividend/Share Earnings/Share

Dividend Payout Ratio Illustration 3-22 1995 1996 1.00 1.70

=58.8%

1.20 2.20

=54.6%

1997 1.40 0.80

=175.0%

Horizontal and Vertical Analysis Horizontal analysis is a measure of performance of an individual company over time or a comparison of a company against another company or industry at a point in time. The ratios that have been presented in the chapter with values from different years is an example of a horizontal analysis. Ratios presented in this format lend themselves to trend analysis, which will show if a company is improving, staying the same or getting worse over a period of time. With any ratio there needs to be a standard or guideline for comparison purposes. Horizontal analysis lends itself to ease of comparison as trends can be used to compare one time period against another or one entity against another in the same time period. Vertical analysis reviews one company or entity at one point in time. The emphasis on a vertical analysis is centered on one financial statement. Percentage rates are established

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Illustration 3-23 Luke’s Sky & Walking Manufacturing Income Statement For the Year Ending December 31, 1995 Numbers in $1,000s ACCOUNT Sales Revenue = = = =

1995 $2,50 0 1,500 1,000 400 150 450 170 280 110 $ 170

Cost of Goods Sold Gross Margin Operating Expenses Depreciation Expense Operating Income Interest Expense Net Income Before Tax Tax Expense Net Income

Percent 100.0 60.0 40.0 16.0 6.0 18.0 6.8 11.2 4.4 6.8

for each item analyzed in the specific financial statement; however, the information alone is limited unless there can be some standard for comparison purposes. The vertical analysis of an income statement uses sales revenue as the denominator and various measures of expense or margin as the numerator. Sales revenue represents a 100 percent component of the income statement and each segment is some fraction of sales. Several profitability ratios that have already been presented are examples of vertical analysis. The gross profit margin ratio, operating profit margin ratio, and net profit margin ratio all represent vertical analysis from the income statement. Specific expense categories such as cost of goods sold, operating expenses, interest expenses and tax expenses are sometimes compared to sales revenue on a percentage basis. Each line item on an income statement can be represented as a percent of total sales revenue, with the sum of all of the expense percentages and net income equaling 100 percent. In the case of Luke’s company the sum of cost of goods sold, operating expenses, depreciation expense, interest expense, tax expense, and net income equals 100 percent. (60.0 + 16.0 + 6.0 + 6.8 + 4.4 + 6.8 = 100.0) An income statement with a vertical analysis for each line item for 1995 is presented in Illustration 3-23 Vertical analysis is also used with the balance sheet. Total assets is used as the denominator, and other line items in the balance sheet can be used as the numerator. Debt to total assets, an important ratio for debt analysis, is an example of a balance sheet vertical analysis. Other balance sheet categories used as numerators include current assets, current liabilities, and total stockholders equity. The more common individual line items that are compared to total assets include cash, accounts receivable, and inventory. Sometimes a balance sheet is presented with every line item shown as a percent of total assets. A balance sheet with vertical analysis for each line item for 1995 is presented in Illustration 3-24.

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Summary Financial statement analysis is a very critical process for the overall evaluation of company performance. There is a wide variety of ratios that can be determined to review all phases of a company operation. The ratios presented were broken out into five major categories: liquidity, activity, debt, profitability, and market. An analyst must consider ratios from all areas before arriving at any conclusions regarding performance. Ratio analysis by itself will be insufficient without some standards of comparison. These standards may be generated internally over time or externally in comparison with other companies or an industry. Ratio analysis is not an end in itself but a means to an end. Proper financial statement evaluation should generate the correct questions to be asked to determine how and why a company performed as it did. Note: Self-Study problems will not be presented for this chapter as detailed examples were computed for each ratio in the text.

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Illustration 3-24 Luke’s Sky & Walking Manufacturing Balance Sheet December 31, 1995 Numbers in $1,000s ACCOUNT

1995

Percent

Cash Accounts Receivable Inventory Prepaid Expenses Total Current Assets

$ 50 320 350 30 750

1.2 7.6 8.3 0.7 17.7

Land Building (Net) Equipment (Net) Total Long-Term Assets

300 2,200 990 3,490

7.1 51.9 23.4 82.3

$4,240

100.0

Accounts Payable Notes Payable Taxes Payable Deferred Revenue Total Current Liabilities

$ 90 250 10 20 370

2.1 5.9 0.2 0.5 8.7

Mortgage Payable Bonds Payable Total Long-Term Liabilities

700 800 1,500

16.5 18.9 35.4

Total Liabilities

$1,870

44.1

Common Stock Retained Earnings Total Stockholders Equity

$2,000 370 $2,370

47.2 8.7 55.9

Total Liabilities & Equity

$4,240

100.0

Total Assets

Note: The total percent amounts may not equal the sums of the components due to rounding.

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Problems Use the income statement, statement of retained earnings and balance sheet for the FAC Inc. to answer problems 3-1 through 3-13.

Sales Revenue

FAC Inc. Income Statement For the Year Ending December 31, 1997 Numbers in $1,000s

- Cost of Goods Sold = Gross Margin - Other Expenses Depreciation

$ 50

Administration = = =

100

Operating Income Interest Expense Net Income Before Tax Tax Expense Net Income

FAC Inc. Statement of Retained Earnings For the Year Ending December 31, 1997 Numbers in $1,000s

Beginning Balance Retained Earnings + Net Income - Dividends = Ending Balance Retained Earnings

105

$1,00 0 650 350

-150 200 30 170 80 90

$320 90 60 $350

Chapter Three: Financial Statement Analysis

FAC Inc. Balance Sheet December 31, 1997 Numbers in $1,000s ASSETS Current Assets Cash

$ 160 180 350 40

Accounts Receivable Inventory Prepaid Expenses Total Current Assets Long-Term Assets Land Building

$ 900

- Accumulated Depreciation

200

Total Long-Term Assets Total Assets LIABILITIES & EQUITY Current Liabilities Accounts Payable

180 700 880 $1,61 0

$ 120 140

Notes Payable Total Current Liabilities Long-Term Liabilities Mortgage Payable Total Liabilities

$ 730

$ 260 400 660

Stockholders Equity Common Stock 100,000 shares Retained Earnings Total Stockholders Equity Total Liabilities & Equity Market Price Stock = $12/share

600 350

106

950 $1,610

Chapter Three: Financial Statement Analysis

Use the income statement, statement of retained earnings and balance sheet for the FAC Inc. to answer problems 3-1 through 3-13. Note when questions refer to a comparison to standards, use the standards as identified in the text. Problem 3-1 Liquidity Ratios Compute the current ratio and the quick ratio for the FAC Inc. for 1997. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-2 Accounts Receivable Ratios Compute the accounts receivable turnover ratio and the average collection period for the FAC Inc. for 1997. What conclusion can be made regarding these ratios when compared to the standard? Note: the beginning balance of accounts receivable was $140. Unless otherwise stated, assume that all sales are on account. Problem 3-3 Inventory Ratios Compute the inventory turnover ratio and the average inventory period for the FAC Inc. for 1997. What conclusion can be made regarding these ratios when compared to the standard? Note: the beginning balance of inventory was $300. Problem 3-4 Total Asset Ratio Compute the total asset turnover ratio for the FAC Inc. for 1997. What conclusion can be made regarding this ratio when compared to the standard? Note: the beginning balance of total assets was $1,550. Problem 3-5 Balance Sheet Debt Ratios Compute the debt to asset ratio and the debt to equity ratio for the FAC Inc. for 1997. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-6 Coverage Debt Ratios Compute the times interest earned ratio and the cash flow coverage ratio for the FAC Inc. for 1997. What conclusion can be made regarding these ratios when compared to the standard? Assume that $20 of the mortgage payable was paid during the year.

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Problem 3-7 Profitability Ratios Compute the gross profit margin ratio, the operating profit margin ratio, and the net profit margin ratio for the FAC Inc. for 1997. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-8 Return on Assets Ratio Compute the return on assets ratio for the FAC Inc. for 1997. Divide the return on assets ratio into a total asset turnover ratio and a net profit margin ratio. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-9 Return on Equity Ratio Compute the return on equity ratio for the FAC Inc. for 1997. Note: the beginning balance for total stockholders equity was $920. Compare the return on equity ratio with the return on asset ratio computed in problem 8 above. Why are the values different? What conclusion can be made regarding these ratios when compared to the standard? Problem 3-10 Market Ratio Compute the earnings per share ratio, the earnings yield on common stock ratio, and the price earnings ratio for FAC Inc. for 1997. What conclusions can be made regarding these ratios when compared to the standard? Problem 3-11 Dividend Ratios Assume that FAC Inc. paid $60,000 in dividends in 1997. Compute the dividend yield on common stock ratio, and the dividend payout ratio for FAC Inc. for 1997. Problem 3-12 Vertical Analysis Complete a line item vertical analysis for the income statement of the FAC Inc. for 1997. Problem 3-13 Vertical Analysis Complete a line item vertical analysis for the balance sheet of the FAC Inc. for 1997.

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Use the following financial statements to answer problems 3-14 through 3-26. Lucky Manufacturing Inc. Income Statement For the Years Ending December 31, 1995, 1996, & 1997 Numbers in $1,000s ACCOUNT Sales Revenue = = = =

Cost of Goods Sold Gross Margin Operating Expenses Depreciation Expense Operating Income Interest Expense Net Income Before Tax Tax Expense Net Income

Earnings Per Share

1995

1996

1997

$4,800

$5,000

3,000 1,800 600 200 1,000 200 800 320 $ 480

3,200 1,800 650 300 850 300 550 220 $ 330

$6,20 0 4,000 2,200 700 300 1,200 500 700 280 $ 420

$2.40

$1.65

$2.10

Lucky Manufacturing Inc. Statement of Retained Earnings For the Years Ending December 31, 1995, 1996, & 1997 Numbers in $1,000s ACCOUNT

1995

1996

1997

Beginning Balance + Net Income - Dividends = Ending Balance

$500 480 300 $680

$680 330 350 $660

$660 420 400 $680

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Chapter Three: Financial Statement Analysis

Lucky Manufacturing Inc. Balance Sheet December 31, 1995, 1996, & 1997 Numbers in $1,000s ACCOUNT

1995

1996

1997

$ 100 580 400 50 1,130

$ 120 640 700 80 1,540

$ 200 720 800 100 1,820

800 3,600 1,540 5,940

800 4,000 2,060 6,860

800 6,000 2,200 9,000

$7,070

$8,400

$10,820

$ 300 450 90 50 890

$ 450 520 220 50 1,240

$ 770 700 120 50 1,640

1,000 2,000 3,000

2,000 2,000 4,000

3,000 3,000 6,000

Total Liabilities

$3,890

$5,240

$ 7,640

Common Stock Retained Earnings Total Stockholders Equity

$2,500 680 $3,180

$2,500 660 $3,160

$ 2,500 680 $ 3,180

Total Liabilities & Equity

$7,070

$8,400

$10,820

200,000 $36.00 $ 1.50

200,000 $30.00 $ 1.75

200,000 $32.00 $ 2.00

Cash Accounts Receivable Inventory Prepaid Expenses Total Current Assets Land Building (Net) Equipment (Net) Total Long-Term Assets Total Assets Accounts Payable Notes Payable Taxes Payable Deferred Revenue Total Current Liabilities Mortgage Payable Bonds Payable Total Long-Term Liabilities

Number of Shares of Stock Market Price Per Share Dividend Per Share

Use the income statement and balance sheet for the Lucky Manufacturing Inc. to answer problems 3-14 through 3-26. 110

Chapter Three: Financial Statement Analysis

Problem 3-14 Liquidity Ratios Compute the current ratio and the quick ratio for the Lucky Manufacturing Inc. for 1995 through 1997. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-15 Accounts Receivable Ratios Compute the accounts receivable turnover ratio and the average collection period for the Lucky Manufacturing Inc. for 1996 and 1997. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-16 Inventory Ratios Compute the inventory turnover ratio and the average inventory period for the Lucky Manufacturing Inc. for 1996 and 1997. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-17 Total Asset Ratio Compute the total asset turnover ratio for the Lucky Manufacturing Inc. for 1996 and 1997. What conclusion can be made regarding this ratio when compared to the standard? Problem 3-18 Balance Sheet Debt Ratios Compute the debt to asset ratio and the debt to equity ratio for the Lucky Manufacturing Inc. for 1995 through 1997. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-19 Coverage Debt Ratios Compute the times interest earned ratio and the cash flow coverage ratio for the Lucky Manufacturing Inc. for 1995 through 1997. Assume that $120,000 of principal repayment is made each year. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-20 Profitability Ratios Compute the gross profit margin ratio, the operating profit margin ratio, and the net profit margin ratio for the Lucky Manufacturing Inc. for 1995 through 1997. What conclusion can be made regarding these ratios when compared to the standard?

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Problem 3-21 Return on Assets Ratio Compute the return on assets ratio for the Lucky Manufacturing Inc. for 1996 and 1997. Divide the return on assets ratio into a total asset turnover ratio and a net profit margin ratio. What conclusion can be made regarding these ratios when compared to the standard? Problem 3-22 Return on Equity Ratio Compute the return on equity ratio for the Lucky Manufacturing Inc. for 1996 and 1997. Compare the return on equity ratio with the return on asset ratio computed in problem 21 above. Why are the values different? What conclusion can be made regarding these ratios when compared to the standard? Problem 3-23 Market Ratio Compute the earnings per share ratio, the earnings yield on common stock ratio, and the price earnings ratio for Lucky manufacturing Inc. for 1995 through 1997. What conclusions can be made regarding these ratios when compared to the standard? Problem 3-24 Dividend Ratios Compute the dividend yield on common stock ratio, and the dividend payout ratio for Lucky Manufacturing Inc. for 1995 through 1997. Problem 3-25 Vertical Analysis Complete a line item vertical analysis for the income statement of the Lucky Manufacturing Inc. for 1995 through 1997. Problem 3-26 Vertical Analysis Complete a line item vertical analysis for the balance sheet of the Lucky Manufacturing Inc. for 1995 through 1997.

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Cases Case Study 3-1 Chesapeake College Dr. George Heileg, provost of Chesapeake College, had just finished reading an article in the Journal of Higher Education, which highlighted special ratios that could be more appropriate for measuring the performance of nonprofit organizations like universities, and social and medical agencies. Additionally, the article included some industry standards for the ratios. The provost thought it would be a worthwhile exercise for the controller of Chesapeake College to complete a financial statement analysis using these specific ratios so he sent a copy of the article and ratios to Teri Black, the controller. Ratio Computation Standard Cash Ratio Cash and Equivalents/Current Liabilities 1.40 Cash Reserve Ratio Average Cash and Equivalents/Daily Expenses 55 Days Donation Ratio Total Contributions/Total Revenues 0.64 Net Operating Ratio Total Surplus or Deficit/Total Revenue 0.06 Fund Balance Ratio Average Fund Balance/Total Expenses 0.89 Program Expense Ratio Total Program Expense/Total Expense 0.80 Support Services Ratio Total Support Service Expense/Total Expense 0.20 Teri liked the idea of analyzing the statements using the new ratios, and also suggested trying several other ratios, which could be more appropriate for Chesapeake College. These ratios would not have industry standards for comparison purposes but the ratios could be compared over time within Chesapeake College. Ratio Computation Standard Tuition Ratio Total Tuition/Total Revenue Fund Balance Return Total Surplus or Deficit/Average Fund Balance Cash Liquidity Ratio Cash and Equivalents/Current Assets Capital Structure Ratio Total Liabilities/Total Assets Fund Balance Structure Restricted Fund Balance/Total Fund Balance

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The financial statements for the last two years for Chesapeake College are presented below. The balance sheet categories have been summarized and an extra year representing beginning balances for 1995 is presented. Chesapeake College Statement of Activities and Fund Balance For the Years Ended 1996 and 1995 (Dollars in Thousands) Account Revenues Tuition and Fees Endowment Gifts Government Grants Total Revenue Expenditures Instruction Research Academic Support Student Services Institutional Support Educational Plant Financial Aid Total Expenditures Change in Fund Balance Fund Balance - Beginning of Year Fund Balance - End of Year

114

1996

1995

$15,975 2,437 540 1,824 $20,776

$14,105 2,520 778 2,046 $19,449

$ 6,733 235 2,945 3,011 3,762 1,495 3,906 $22,087 -1,311 3,159 1,848

$6,548 853 2,539 2,858 3,448 2,206 2,733 $21,185 -1,736 4,895 3,159

Chapter Three: Financial Statement Analysis

Chesapeake College Balance Sheet December 31, 1996, 1995 and 1994 (Dollars in Thousands) 1996

Account Assets Cash and Equivalents Other Current Assets Total Current Assets Land Buildings and Equipment Total Assets Liabilities Current Liabilities Long-Term Liabilities Total Liabilities Fund Balance Unrestricted Fund Balance Restricted Fund Balance Total Fund Balance Total Liabilities and Fund Balance

1995

1994

$ 947 2,585 3,532 24,099 $27,631

$ 1,360 2,436 3,796 23,890 $27,686

$ 1,505 2,440 3,945 23,603 $27,548

2,984 22,799 25,783

2,530 21,997 24,527

2,129 20,524 22,653

598 1,250 1,848 $27,631

1,959 1,200 3,159 $27,686

3,795 1,100 4,895 $27,548

Required A. Compute the 12 special ratios for Chesapeake College for 1995 and 1996. B. Compare the performance of Chesapeake College with the industry standard for the seven ratios given by the provost. C. Comment on the overall performance for Chesapeake College for 1995 and 1996 based on the ratio calculations.

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Chapter Three: Financial Statement Analysis

Case 3-2 Big Sky Resort and Conference Center Big Sky Resort and Conference Center was started in 1953 by John Golie as a small motel in Whitefish, Montana called the Mountain View Inn. As more people began automobile traveling for vacationing, and the splendor of Waterton-Glacier International Peace Park became known, there was a big demand for lodging in the area. John, seeing the opportunity to start a good motel business, purchased a large prime piece of property on Whitefish Lake with panoramic views of the mountains and sufficient land for hiking and horse back riding. The property was also adjacent to the Whitefish State Recreation Area, which provided ample opportunity for recreational activities. The popularity of the motel was greater than expected, and John expanded from 20 units to 100 units by 1975. He remained at that size until he turned over operations to his daughter Jana in 1992. John had been content over the last fifteen years of the hotels operation to keep it more of a family business. Many of the customers returned year after year, and liked the small-sized, homelike environment. Also, there were plenty of other motels that were started in the area, including national chains, which seemed to cover the increased tourist demand. The hotel had provided John and his family a comfortable living and lasting friends from the community and his customers. When Jana took over the business in 1992 she saw a potential for growth and opportunity, hopefully without sacrificing the family friendly environment that had been built up during the last 40 years. The Mountain View Inn had this large track of prime land that was still largely undeveloped. Also, with the popularity of snow skiing, and several lifts in the immediate area, vacationing was becoming a year round business for Whitefish. Another important factor was the expansion of the Glacier Park International Airport. The airport made access to the area a reality for anyone in the United States in a matter of hours. Jana believed that an upscale resort and conference center to cater to the rich and famous would be an instant success. The area offered many unique and exciting things to do all during the year. The ski season started as much as a month earlier than the popular resorts in Colorado and often could last a month later in the spring. There were opportunities to view animals in the wild in the spring and fall, some of which were unique to the area. Plus there was the popularity of the summer season with the rugged splendor of Glacier National Park. Jana was sure that people in the upper middle class and above who enjoyed unusual vacations and conferences would be drawn to the area. Jana had no trouble convincing others of her ideas. Several prominent business people from the local area as well as in the greater northwest wanted to invest in Jana’s proposal. Jana would need a large influx of capital to build the new resort center and to develop recreational activities on the property. This outside interest seemed to be the perfect source of support. Jana could fulfill her vision without any extensive financial sacrifice on the part of her family. With advice from an investment firm, Jana concluded that the motel operation should go public under the corporate name of Big Sky Resort and Conference Center. A successful stock issue was made in 1993 with the Golie family retaining 51% of the voting shares. The capital raised from the other investors along with some debt was used to build the new eighty room resort and conference center plus amenities. Additionally, the original 116

Chapter Three: Financial Statement Analysis

100 room motel was modernized and incorporated into the center. The original motel was set at a somewhat lower scale so as not to price out many of the loyal customers who were used to the Mountain View Inn. Jana’s goal was to be able to offer vacation packages for anyone from middle income to upper income from one night to one month. She also wanted to cater to organizations, travel groups, and other professional associations for conventions and extended meetings. There were enough activities available on the property and in the immediate vicinity to encourage family attendance at the conventions, which would make the resort an even more attractive promotion. The resort and conference center opened on schedule in September 1994 just before the start of the ski season and during the peak of leaf season. The operation was an instant success and bookings quickly increased for much of the 1995 season. As word of the resort spread and more organizations scheduled conferences, operations for 1996 and 1997 were also better than expected. All of this success led to some impressive revenue and net income results for the first three years of operations. The outside investors who had funded this project were also happy with the resort performance as reflected in the price of the company stock. The years had passed by very quickly since Jana had taken over operations, and she wanted a chance to review the company’s performance during the last three years. She had her accountant give her the financial statements for 1995 through 1997 for her review. Big Sky Resort and Conference Center Income Statement For the Years Ending December 31, 1995, 1996, & 1997 Numbers in $1,000s ACCOUNT Sales Revenue = = =

Direct Room Expense Conference Expenses Depreciation Expense Other Operating Expenses Operating Income Interest Expense Net Income Before Tax Tax Expense Net Income

Earnings Per Share

1995 $1,82 5 460 550 200 365 250 50 200 80 $ 120

1996 $2,46 5 600 980 210 370 305 65 240 96 $ 144

1997 $3,23 5 800 1,345 220 400 470 90 380 152 $ 228

$1.00

$1.20

$1.90

Big Sky Resort and Conference Center Balance Sheet December 31, 1995, 1996, & 1997 Numbers in $1,000s ACCOUNT

1995 117

1996

1997

Chapter Three: Financial Statement Analysis Assets

Cash

$ 50 100 40 10 200

$ 60 160 50 10 280

$ 100

350 1,690 250 2,290

350 1,750 280 2,380

350 1,850 300 2,500

$2,490

$2,660

$3,060

$ 130 70 10 5 215

$ 110 90 13 20 233

$ 195 230 20 30 475

400

480

500

$ 615

$ 713

$ 975

Common Stock Retained Earnings Total Stockholders Equity

$1,800 75 $1,875

$1,800 147 $1,947

$1,800 285 $2,085

Total Liabilities & Equity

$2,490

$2,660

$3,060

Number of Shares of Stock

120,00 0

120,00 0

$20.00 $0.50

$25.00 $0.60

120,00 0 $32.00

Accounts Receivable Supplies Prepaid Expenses Total Current Assets Land Building (Net) Furnishings (Net) Total Long-Term Assets Total Assets Liabilities and Equity Accounts Payable Notes Payable Taxes Payable Deferred Revenue Total Current Liabilities Mortgage Payable Total Liabilities

Market Price Per Share Dividend Per Share

Big Sky Resort and Conference Center Statement of Retained Earnings For the Years Ending December 31, 1995, 1996, & 1997 Numbers in $1,000s 118

390 60 10 560

$0.75

Chapter Three: Financial Statement Analysis

ACCOUNT

1995

Beginning Balance + Net Income - Dividends = Ending Balance

$ 15 120 60 $ 75

1996

$ 75 144 72 $147

1997

$147 228 90 $285

Required A. Compute the liquidity ratios including the current ratio and quick ratio for 1995, 1996, and 1997. B. Compute the activity ratios including the accounts receivable turnover ratio, the average collection period, and the total asset turnover. Note for ratios requiring average values, just compute the ratios for 1996 and 1997. C. Compute the debt ratios including the debt to asset ratio, the debt to equity ratio, and the times interest earned ratio for 1995, 1996, and 1997. D. Compute the profitability ratios including the operating profit margin ratio, the net profit margin ratio, the return on asset ratio, and the return on equity ratio for 1995, 1996, and 1997, or just for 1996 and 1997 if average figures are needed. E. Compute the market ratios including the earnings per share ratio, the earnings yield ratio, the price earnings ratio, the dividend yield ratio, and the payout ratio for 1995, 1996, and 1997. F. Comment on the overall performance of Big Sky Resort and Conference Center for the three year period from January 1, 1995 through December 31, 1997. Include any changes or recommendations that you might suggest for the company.

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Chapter Four: Budgets and the Budget Process

Chapter Four: Budgets and the Budget Process Chapter Objectives 1. 2. 3. 4. 5.

Define the nature and purpose of a budget. Review the budget process. Identify strengths and weaknesses of the budget process. Identify several different types of budgets. Analyze the behavioral impact of the budget process.

The Nature and Purpose of the Budget A budget is a plan, preferably a written plan, which should reflect a company's goals and objectives. In the order of the business strategic and tactical planning process, a budget should operationalize the overall company strategy. Budgets can be used to show how a company intends to acquire and use resources (a capital budget), what its operations will be like for a period of time (master budget), its projected financial performance (financial budget), and its acquisition and use of cash (cash budget). For these budgets to be beneficial; however, they need to be consistent with each other and consistent with the goals and objectives of the company. While the budget preparation is an important phase of the planning process, the budget also serves another important management function, that of control. Budgets can serve as a standard which can be compared to actual performances and provide feedback regarding the level of achievement of the company goals and objectives. Statements have been made such as: "If you fail to plan, you plan to fail." and "If you don't know where you are going, you will probably get there." These ideas underlie why it is so important to implement the budget process. By completing a budget, a company is following an organized process of quantifying their overall goals and objectives in a written format. The very act of the budget process serves as a communication tool and makes all interested participants aware of company goals. The concept of a budgeting activity in order to be successful needs top management support. Top management is responsible for developing the strategic plans and identifying company goals and objectives. In order to see that these plans, goals and objectives are reached, top management needs to convey these desires to the lower levels of management. One of the best ways to communicate these desires of top management is through the budget process. Top management support should be primarily for the budget concept in general as opposed to the specifics and the mechanical procedures in developing and implementing the budget. The budget process needs cooperation and participation at all levels of management. Frequently the levels of management closest to the operational activities of the company have unique insight as to how goals and objectives can be most efficiently and effectively accomplished. By allowing all levels of management to participate, a sense of ownership develops and managers feel their importance. This participation process should certainly increase the levels of motivation of those involved. The budget is a communication tool both orally and in writing. For communication to be effective, the sender needs to be sure that the receiver gets the correct message. The 120

Chapter Four: Budgets and the Budget Process

budget process needs to be timely, reasonably accurate, and understandable. Since the budget is a plan for the future, absolute accuracy can never be assured. If for no other reason, the very fact that the budget is a communication mechanism, makes its implementation worthwhile. Any activity that promotes the communication process within a company can have beneficial results. A budget needs to be flexible. While a company may often present only one budget, there needs to be an understanding that conditions can change and the budget may change as well. Since the budget is a future plan it needs to be based on a variety of assumptions and conditions. A static type budget quickly looses its relevance as assumptions and conditions change. Management will lack confidence in the budget process if it is not flexible in nature and responsive to new situations. The control aspect of a budget is equally important as the planning aspect. Without proper follow-up and feedback to the budget, an important aspect of the budget process is lost. The follow-up procedure should be frequent, especially in times when there are dramatic changes. Actions taken with regard to the follow-up should not just be limited to the actual activities of the company but should consider possible modifications of the budget itself.

The Budget Process After top management identifies the company strategic plans and the resulting company goals and objectives, a budget process should be developed to aid in the implementation of the top management desires. Generally the controllers office oversees the budget process. Standard operating procedures are developed and distributed to participating managers. A budget committee is often established through the controller’s office with representation from all of the critical areas within the company. The purpose of the committee is to establish policies and procedures for the implementation of the budget process. Input and dialogue is encouraged from all of the representatives on the committee to promote a fully participatory budget process. Timetables and documents are developed to emphasize standardization and consistency in submissions by each department. The budget review and approval process is also clarified. The role of the accountant or financial manager is that of a facilitator or of providing advice and expertise. The actual budget preparation needs to be done by the managers responsible for their various functional areas. Budget submissions can be consolidated through the controller’s office and moved to the next higher level for review and approval. The accountant can also aid in the development of necessary financial information to give credibility to the quantitative aspect of the submission. The budget submission basically follows a bottom up approach in a participatory budget process. Input starts at the lowest level of management reflecting the knowledge of those managers closest to the actual operations and activities of specific functions. As the submissions move up the levels of management they are reviewed and consolidated. Once the budget reaches top management, final consolidation and approval is given. Distribution of company resources in support of the budget follows a top down approach. As the budget moves back down through the levels of management, resources are

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distributed in accordance with the approved budget. Managers at the lowest level should be given resources consistent with approved budget submissions. The budget process does not end with the distribution of resources. The implementation of the budget is the beginning of the control phase of the budget process. Managers are monitored and performance reports are developed to compare actual performance with the predetermined standard as established by the budget. This form of feedback allows top management to monitor how well the company is achieving its goals and objectives. Corrective action may be taken as a result of the feedback in a variety of ways. Current activities can be modified and budget standards can be changed to reflect the immediate circumstances. As much as possible, these changes should be done in a positive manner to prevent the implemation of a budget as a punitive tool. The motivation associated with the budget process can be a very powerful factor. Top management can establish a climate such that the motivations are positive and supportive to management or the motivations can be negative and dysfunctional. A participative management style and the use of Christian principles in management including servant leadership practices can go a long way toward making the budget a positive motivational experience. Keeping in mind that the budget is only a plan and that it does not have to be "cast in stone" can also help the budget process. Flexibility and adaptability to various situations, no two of which may be alike, should ease the tensions especially in relation to performance evaluation.

Benefits of a Budget Process There are many benefits from implementing a budget process at a company. A budget: 1. will show management in writing the plans for the future 2. quantifies company goals and objectives 3. forces management to think ahead 4. can be used as a motivational tool 5. helps to coordinate business activities 6. communicates manager’s plans to each other 7. helps to conserve resources 8. provides for a systematic review of performance 9. gives managers a vision for the company that is consistent with company goals and objectives 10. allows managers to feel as though they are a part of the process 11. gives managers a chance to provide input to the budget process 12. provides a means to measure and compare actual activity 13. serves as a means of feedback

Disadvantages of a Budget Process A budget process can have some disadvantages especially if it is misunderstood or not implemented properly. A budget: 1. can have dysfunctional impact on managers 2. can be used as an enforcement mechanism 3. may be ignored 4. may not be relevant to the current situation 122

Chapter Four: Budgets and the Budget Process

5. may not have total management support or commitment 6. may cater to the managers that cause the greatest outcry 7. may have unrealistic and unattainable goals 8. may be imposed on management without an opportunity for their input 9. process may not be understood 10. may be perceived as unfair especially in its performance evaluation phase

Types of Budgets Master Budget The master budget is a reflection of the operations of the company over a period of time. Since the income statement summarizes the operation of the company over a period of time, the ultimate form of the master budget will be a projection of the income statement. The income statement begins with sales revenue, and that figure is the key component of the master budget. Many of the activities of a business are dependent upon the level of sales, and the master budget cannot be successfully completed until a sales figure is determined. Since the master budget is a plan for some future period of time, the sales figure cannot be known with certainty. This uncertainty has an immediate impact on the accuracy of the budget. To complicate the effort to forecast sales are the many variables and assumptions both internally and externally which must be factored into the budget. Critical assumptions that need to be considered when developing a budget include: 1. what is the state of the economy 2. what is the status of both existing and proposed product lines 3. what is the nature of competition in the industry 4. what is the impact of government taxes and regulations 5. what role does globalization and international activities have on the company 6. what is the proposed monetary and fiscal policy 7. what is the attitude of consumers Sales forecasting, because of the many assumptions, can be a difficult process. Many factors outside of the control of the company, such as consumer buying habits, and what competitors are doing, can impact the level of sales. Internal considerations including product mix, new product development, pricing and cost can all have an effect on the proposed level of sales. Past experience is often used as a starting point to project future annual sales. Modifications are made based on the relevant assumptions and other factors that are perceived to have an impact of sales. Sometimes forecasting models can be developed to aid in the projection of sales; however, the models are only as good as the data and assumptions used to develop the relationships. Sales and marketing managers can be helpful in developing sales projections as these managers are working with sales on a daily basis and are familiar with sales activities. One needs to be cautious regarding sales estimates by determining any underlying motivations for budget projections. Sales personnel can sometimes be overly optimistic in sales forecasts, or bonus programs may encourage conservative estimates.

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Once sales forecasts are finished, the remaining components of the master budget can be completed. The master budget follows the format of the income statement with the development of the amount for cost of goods sold followed by other operating expenses and then financial expenses. The production and purchasing schedules need to be determined based on projected sales. These schedules also have an impact on the levels of inventory and the amount of the cost of goods sold. The purchasing schedule relates to raw materials used in the manufacturing process. The projected ending balance of raw material inventory plus the raw materials used in the production process equals the total budgeted amount of raw materials needed. Subtracting the currently available raw materials (a beginning balance amount) away from the raw materials needed leaves the amount of raw materials that need to be purchased. The purchasing of raw materials has an impact on the inventory account and the accounts payable account. See illustration 4-1. Purchase Schedule Illustration 4-1 Projected Ending Balance for Raw Materials

+ Raw Material Used in Production

$ 10,000

150,000

= Raw Material Desired

160,000 15,000 $145,00 0

- Beginning Balance for Raw Materials = Raw Material Purchases

The amount of raw materials needed in the production process depends on the projected level of sales and the desired amounts of finished goods inventory. The same basic procedure is used to compute a production budget. The costs to produce a finished product include raw materials, labor costs, and manufacturing overhead. The projected level of sales plus the forecasted ending balance of finished goods inventory equals the total amount of finished product needed. Subtracting the finished goods available (the beginning balance of finished goods inventory) from the total amount of finished goods needed will equal the amount of finished goods that need to be produced. See illustration 4-2. Production Schedule Illustration 4-2 Projected Ending Balance for Finished Goods + Finished Goods Sold

$ 50,000 700,000

= Total Finished Goods Needed - Beginning Balance for Finished Goods = Production Level of Finished Goods

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750,000 40,000 $710,00 0

Chapter Four: Budgets and the Budget Process

Units of Volume Total Variable Variable Cost/Unit

Variable Cost Illustration 4-3

1,000 1,200 1,400 $15,00 $18,00 $21,00 0 0 0 $15 $15 $15

1,600 $24,000

2,000 $30,000

$15

$15

Graphical Representation

The production level of finished goods includes the raw material used in production from the purchase schedule plus input of labor and manufacturing overhead costs. This budgeted production schedule will aid in developing budgets for the entire manufacturing process. Managers can make projections within their areas of responsibility for levels of labor, amounts of materials and inventory, and amounts of other manufacturing related expenses. Some of these costs will vary directly with sales or production. A cost of this nature is classified as a variable cost. Variable costs have a constant cost per unit and the total cost changes, as there is a change in volume like the level of sales. For instance if a cost is identified at a variable rate of $15 per each unit of sales and 1,000 units are sold the total cost will be $15,000. If 1,600 units are sold the total cost will be $24,000. See illustration 4-3. Fixed costs retain a constant total as levels of volume change. The cost per unit is not a critical component in the fixed cost budget, but it declines as the level of activity increases. As an example, if a fixed cost for an item is $20,000, when the sales level is 1,000 units the fixed cost per unit is $20. If the sales level increases to 1,600 units the total fixed cost remains at $20,000 and the fixed cost per unit declines to $12.50. For budgetary purposes the total fixed cost of $20,000 is the figure that would be included for any calculations. See illustration 4-4. The managers responsible for the occurrence of these costs can develop other operating expenses for budgetary purposes. Each cost should probably be identified as fixed or variable in its behavior so as to aid in the budget process should the level of activity change. With changes in the levels of activity, the total variable costs included in the budget will change, but the total fixed costs will not change. 125

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The completion of all revenues and expenses related to operating activities carries the budget process through the net operating income on the income statement. Other financing related revenues and expenses can be budgeted for and incorporated into the income statement to complete this financial statement. In generating budget figures for operating activities, managers will usually start with past experience, or last year’s figures, and then make adjustments as deemed appropriate. The greater the significance of the assumptions and projections the more difficult it will be to forecast the projected budget figures. If the uncertainties are substantial, managers may budget a range of values or present several discrete values depending on the conditions, such as optimistic, most likely, and pessimistic. Flexible budgets can also be used in situations where a high degree of variability is expected. Flexible Budgets A flexible budget is based on the behavioral characteristics of the accounts included in the budget and some common measure of activity. The behavioral characteristics can be divided into fixed and variable classifications, and the activity measure is frequently sales volume. As the level of sales changes, the flexible budget recognizes this change with appropriate changes in the totals of all of the variable cost items. The total fixed costs will remain constant as long as the change in the activity remains within what is called a relevant range. Eventually all costs both fixed and variable will change with changes in activities but for fixed costs those changes occur when activities go beyond a relevant range. A flexible budget process can be a very useful approach to budgeting as long as the accounts can be reasonably classified according to behavior. As changes occur in the levels of activities, a revised budget can be quickly established which serves as a more appropriate standard for the new conditions. See illustration 4-5. Formulas can be created which reflect the behaviors of the revenues and expenses included in a flexible budget. Through the establishment of a series of formulas, flexible budgets can be more easily developed and modified as situations cause changes in any of the budget items. Formulas can be integrated into software programs and flexible budgets can be developed virtually instantaneously. Since revenues are defined to behave in a variable fashion with a constant selling price per unit and a change in total with changes in levels of volume, the revenues can be combined with variable costs to determine a contribution margin. Contribution margin is simply sales revenue minus variable cost, and it can be recognized on a per unit basis or a total cost basis. Contribution margin is sometimes recognized as the contribution to fixed cost. Formula 4.1 identifies the contribution margin relationship. Formula 4.1 CM/U = SP/U - VC/U Contribution Margin Per Unit = Selling Price Per Unit - Variable Cost Per Unit Definition of Variables CM = Contribution Margin SP = Selling Price VC = Variable Cost /U = Per Unit

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If the selling price per unit and the variable cost per unit are known, then the contribution margin per unit is the difference between the two values. A total contribution margin can be determined by multiplying the per unit value times a level of volume. The total contribution margin amount is needed to complete the development of the flexible budget. Formula 4.2 relates to the computation of net income before tax, which includes the impact of fixed cost. Formula 4.2 NIBT = (CM/U)V - FC Net Income Before Tax = (Contribution Margin Per Unit)(Sales Volume) - Total Fixed Cost NIBT = Net Income Before Tax FC = Fixed Cost V = Volume The net income before tax is based on a total dollar amount and is computed after the total of all fixed and variable costs is deducted from total sales revenue. The only remaining costs to be considered in the flexible budget is income tax. The amount on net income is usually established as a rate based on the net income before tax. Formula 4.3 highlights the relationship between net income before tax and a final net income figure. Formula 4.3 NI = NIBT(1.0 - TR) Net Income = Net Income Before Tax(1.0 - Tax Rate) NI = Net Income TR = Tax Rate These three formulas can be used to develop a flexible budget in its most basic form. Revenue is defined according to a variable format, all costs are divided according to behavior between variable and fixed, and tax expense is a rate based on net income before tax. All of these relationships can be accounted for in a single flexible budget formula 4.4. Formula 4.4 NI = [(SP/U -VC/U)(V) - FC](1.0 - TR) Net Income = [(Selling Price Per Unit - Variable Cost Per Unit)(Sales Volume) - Total Fixed Cost](1.0 - Tax Rate) Formula 4.4 is a consolidation of formulas 4.1, 4.2, and 4.3. In order to compute net income values will need to be known for the selling price per unit, the variable cost per unit, a level of volume, the total fixed cost, and the tax rate. See Self-Study Problem 41. Simulation analysis takes place when one or more of the values of the variables change and the impact of that change on net income is determined. As would be expected, net income should increase with increases in the selling price per unit or increases in volume, and net income should decrease with increases in variable cost per unit, total fixed cost and the income tax rate. Frequently volume is the variable of change as a flexible budget is used to determine levels of income at various levels of volume. Also, when performance reports are developed, a meaningful comparison can only take place between actual results and a predetermined budget when both are based on the same levels of volume. A flexible budget will be developed after the fact using the same level of volume as the actual results for comparison purposes. See Self-Study Problems 4-2 through 4-5.

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Units of Volume Total Fixed Cost Fixed Cost/Unit

1,000 $20,000 $20.00

Fixed Cost Illustration 4-4 1,200 1,400 $20,000 $20,000 $16.67 $14.29

1,600 $20,000 $12.50

2,000 $20,000 $10.00

Graphical Representation

Financial Budgets Financial budgets are basically the financial statements to include the income statement, statement of retained earnings, and the balance sheet. The income statement is created through the master budget, and as with the financial statements, the statement of retained earnings and the balance sheet can be completed after the income statement. In the completion of the budgeted retained earnings, the only additional information needed beyond the income statement is the projected amount of dividends. Top management will probably forecast expected dividend payments based on the current level of dividends, the proposed level of net income, and a calculated dividend payout ratio (the percent of earnings that will be paid out as dividends.) Management will have a tendency to be conservative in the amount of dividends as a precaution if earnings do not attain the budgeted level.

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Flexible Budget Illustration 4-5 The income statement format requires that all revenue and expense items in the income statement be classified according to behavior, as fixed or variable, depending on their relationship to some measure of activity such as sales volume. Sales Revenue Variable in nature (Selling Price/Unit x Sales Volume) - Variable Manufacturing Cost (Variable Cost/Unit x Sales Volume) - Variable Selling & Administrative Cost (Var Cost/Unit x Sales Volume) = Contribution Margin (Variable Margin/Unit x Sales Volume) - Fixed Manufacturing Cost (Constant in Total Dollars) - Fixed Selling & Administrative Cost (Constant in Total Dollars) = Net Income Before Tax - Income Tax (Net Income Before Tax x Tax Rate) = Net Income See the Self-Study Problems 4-1 through 4-5 at the end of the chapter for examples of flexible budget problems. The budgeted balance sheet requires budget projections for all of the permanent accounts, assets, liabilities, and equity. This is the final budgeted statement that can be completed because the balances in the appropriate accounts depend on the results of all of the other budgets. Particular attention needs to be given to the ending cash balance, which will be determined through the cash budget. Also, the company will need accurate projections for long-term assets. The capital budgeting process will help in determining the levels of long-term assets. Once long-term assets have been identified, the means of funding those assets with long-term liabilities, preferred stock, common stock, or retained earnings, or combinations of these sources of funds will need to be established. Part of the capital budgeting process along with a concept called optimal capital structure will assist in determining the proper mix of funds. Capital Budget The capital budgeting process is specifically directed toward long-term assets. Specific projects are identified that have time periods of greater than one year. The concept of time value of money needs to be integrated into the capital budgeting process for a proper analysis of the projects. These capital budgeting projects tend to be very large in scope such as a new product line, or a new plant. The projects usually involve several areas of management and require a combined effort such as a project team to develop a budget request. As with other budget requests, which involve estimates into the future, the capital budgeting request is subject to even greater uncertainties, because of the longer time period involved and the uniqueness of the projects. Capital budgeting projects often are forecasted for five or more years into the future. The projected revenues and expenses and other possible capital costs can be very hard to determine. Also, the uniqueness of the projects makes it difficult to rely on past experience as a basis for the projections of future costs. 129

Chapter Four: Budgets and the Budget Process

Since capital budgeting projects involve such significant use of resources, their success or failure could have a major impact on the overall results of the company. Additionally, those managers responsible for the development of the capital budgeting projects may be promoted or long gone before the final results from the project are known. Subsequent managers are often left to pay for their previous manager’s mistakes. With this potential lack of accountability and the size of the capital budgeting projects, top management has to impose very careful criteria and insist on the most sophisticated methods in the capital budgeting process. A detailed discussion of capital budgeting will be presented in Chapter 14. Cash Budgets Concern about a company's liquidity and especially its cash position is critical. There can be no substitute for cash in the payment of liabilities or the payment of dividends. Company's can appear sound financially with regard to their debt ratios, profitability, and even liquidity ratios but still be in a poor cash position. The importance of the level of cash at any point in time makes it necessary to have a comprehensive cash budget procedures. The process of monitoring actual activities through a cash flow statement and cash management techniques will be covered in detail in Chapters 7 and 8. The cash budget process involves projected cash receipts and cash disbursements along with a desired ending balance by time period (usually monthly) and a financing or investing section. The format of the cash budget adds cash receipts to a beginning cash balance to give the amount of cash available. Cash disbursements are deducted from the available cash to give an ending cash balance. The ending cash balance is compared to a minimum desired balance to determine any surplus or shortage in cash. Projected shortages in cash are covered with short-term borrowing arrangements, and projected surpluses in cash are available for investing in marketable securities. See illustration 4-6. Frequently the receipt or disbursement of cash is delayed from its related revenue or expense. When a sale is made on account, the revenue is recognized; however, the cash is not collected until the customer pays the account receivable. This delay in cash receipts must be reflected in the cash budget so that the figures can be tied into the sales revenue amounts in the master budget. Estimates are generally made regarding the time it takes to collect on accounts receivable and that factor is processed into the cash budget. There may be a similar delay in cash disbursements when the company purchases items on credit. The expense is recorded at the time of purchase and the cash disbursement is recorded at a later time when the liability is paid.

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Cash Budget Illustration 4-6 Dar Ya Enterprises Cash Budget For the Year 1996 Beginning Balance + Cash Receipts Cash Sales Collection of Receivables = Total Cash Available - Cash Disbursements Cash Expenses Payments of Payables - Desired Minimum Cash Balance = Cash Surplus or Shortage + Financing + Borrowing - Repayments plus Interest - Investing = Ending Balance See the Self-Study Problem 4-6 at the end of the chapter for an example of the cash budget process. Illustration 4-7 presents an example of the cash receipts by month. The first exhibit identifies the projected amount of dollar sales in cash and on credit by month for a five month period of time. The cash sales will represent cash receipts in the same month; however, there will be a delay between the credit sale and the collection of accounts receivable. The second exhibit represents an estimate of how long it will take to collect accounts receivable. The exhibit indicates that 50 percent of the credit sales are expected to be collected about 30 days after the sale. The total percent collected adds up to only 98 percent of the total accounts receivable. The remaining 2 percent represent bad debts that are not expected to be collected. The percent values from the second exhibit are applied to the credit sales amounts to establish the third exhibit, which summarizes the collection of credit sales. For instance 8 percent of the January credit sales, or $8,000, will be collected three months after the sale. This exhibit still does not identify the specific month for the cash collections. The final exhibit summarizes the cash collections by month. Cash sales would be in the same month. The lagging process from the collection of accounts receivable is appropriately summarized. For instance, the $8,000 of January sales on account collected three months later is included in the April cash collections. Total cash collections would represent the cash receipts in a cash budget.

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Month January February March April May

Month Percent Collected

Cash Receipts Activities Illustration 4-7 Dollar Sales by Month Cash $10,000 $12,000 $10,000 $14,000 $15,000

Credit $100,000 $120,000 $ 90,000 $150,000 $140,000

Collection of Accounts Receivable Schedule Month of One Month Two Months Three Months Sale After Sale After Sale After Sale 25%

50%

15%

8%

Collection of Accounts Receivable

Month

January February March April May

Total Credit Sales $100,000 $120,000 $ 90,000 $150,000 $140,000

Collect 25% Month of Sale

Collect 50% 1 Month Later

Collect 15% 2 Months Later

$25,000 $30,000 $22,500 $37,500 $35,000

$50,000 $60,000 $45,000 $75,000 $70,000

$15,000 $18,000 $13,500 $22,500 $21,000

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Collect 8% 3 Months Later $ 8,000 $ 9,600 $ 7,200 $12,000 $11,200

Chapter Four: Budgets and the Budget Process

Month Cash Sales Accounts Receivable 25% in the Same Month 50% in the First Month After Sale 15% in the Second Month After Sale Month 8% in the Third Month After Sale January Total Cash February Collection March April May

Cash Collections by Month January February March April $ 10,000 $ 12,000 $ 10,000 $ 14,000

25,000

May $ 15,000

30,000

22,500

37,500

35,000

50,000

60,000

45,000

75,000

Payment of Accounts Payable 15,000 18,000 13,500 Pay in 40% Pay 50% Pay 10% Total Current One Two Payment Month Month 8,000Months9,600 Later Later $40,000 $16,000 $20,000 $ 4,000 $30,000 $12,000 $15,000 $ 35,000 $ 92,000 $107,500 $122,500 $ 3,000 $148,100 $50,000 $20,000 $25,000 $ 5,000 $60,000 $24,000 $30,000 $ 6,000 $35,000 $14,000 $17,500 $ 3,500 Cash Payments by Month

Month January February March April May Cash Expense $ 40,000 $ 45,000 $ 50,000 $ 40,000 $ 60,000 Payment of Cash Disbursements Activities Payable 4-8 40% in the Illustration Same Dollar Expenses by Month 12,000 Month 16,000 20,000 24,000 14,000 Month Cash Payable 50% in the First January $40,000 $40,000 Month After 20,000 15,000 25,000 30,000 February $45,000 $30,000 Purchase March $50,000 $50,000 10% in the April $60,000 Second Month $40,000 4,000 3,000 5,000 May $35,000 After Purchase $60,000 Total Cash Payment of Accounts Payable$Schedule Payments $ 56,000 $ 77,000 89,000 $ 92,000 $109,000 Month Month of One Month After Two Months Purchase Purchase After Purchase Percent Paid 40% 50% 10% Illustration 4-8 represents an example of cash disbursement activities by month. Just as with the cash receipts activities presentation, four exhibits are used in a step by step 133

Chapter Four: Budgets and the Budget Process

process to determine cash disbursements. The occurrence of expenses by month does not necessarily represent the cash payment of those expenses in the same month. The creation of a payables account related to an expense means that the cash payment will be delayed. The first exhibit summarizes the cash and credit expenses by month. The second exhibit summarizes the time delay in the percent of accounts payable payments. The percentages total 100 percent, which assumes the company, will pay in full all accounts payable obligations. The dollar amount of monthly payables in the first exhibit is multiplied by the percent values in the second exhibit to generate dollar amounts of cash payments. For instance, 10 percent of January payables ($40,000 x .10 = $4,000) are paid two months later. This third exhibit does not classify the cash payables by month. The final exhibit summarizes the cash payments as well as the payment of accounts payable by month. The $4,000 of January payables paid two months later shows up as a cash disbursement in March. The sum of the cash payments by month would appear in the cash disbursement section of the cash budget. See Self-Study Problem 4-6. Illustration 4-9 shows a cash budget with summary information from cash receipts and cash disbursements schedules. Illustration 4-9 Dar Ya Enterprises Cash Budget January - May, 1996 Month Beginning Cash Bal Plus Cash Receipts Total Cash Avail Less Cash Disbursement Less Desired Min Balance Equals Surplus or Shortage Plus Cash Borrowed Less Cash Repaid* Less Cash Invested Ending Cash Balance

Jan

Feb

Mar

Apr

May

$ 10,000 35,000 45,000 56,000

$ 10,000 92,000 102,000 77,000

$ 10,000 107,500 117,500 89,000

$ 10,000 122,500 132,500 92,000

$ 10,000 148,100 158,100 109,000

10,000

10,000

10,000

10,000

10,000

-21,000

15,000

18,500

30,500

39,100

21,000

0

0

0

0

0 0

15,000 0

6,270 12,230

0 30,500

0 39,100

$ 10,000

$ 10,000

$ 10,000

$ 10,000

$ 10,000

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*Note: The total interest expense for the borrowed funds equals approximately $270. The calculation of interest expense is $15,000 x .12 x 1/12 = $150 + $6,000 x .12 x 2/12 = $120. The financing section of a cash budget identifies any potential cash surplus or shortage in the ending balance. Generally a minimum cash balance is desired as a safety measure to insure that the company has cash in the event of unforeseen fluctuations in the cash balance. If the amount of cash disbursements plus the minimum desired balance exceed the beginning balance plus the amount of cash receipts, a cash shortage exists. When the total cash available exceeds the total cash needs, there is a cash surplus. The financing section of the cash budget identifies the time periods of surplus and shortage and identifies when the company may need (1) to borrow, (2) make a repayment of loans plus interest, (3) make any short-term investments, and (4) the use of previous investments to cover subsequent shortages.

Summary The budgeting process is an important activity for the management functions of planning and control. Companies with a sound budget process have a natural means of communicating strategic plans and company goals and objectives throughout the organization. Budgeting has a large behavioral component. The use of a participative budgeting process and a servant leader style of management can result in positive responses from the managers involved in the budget process. Various budgets can be developed which when completed will reflect projected financial statements.

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Self-Study Problems Use the following flexible budget and flexible budget formulas to complete Self-Study problems 4-1 through 4-5. Dar Ya Enterprises 1996 Flexible Budget Projected Sales 100,000 Units Sales

$1,500,00 0

- Variable Manufacturing Cost = = =

Variable Selling & Administrative Cost Contribution Margin Fixed Manufacturing Cost Fixed Selling & Administrative Cost Net Income Before Tax Income Tax Expense Net Income

1,000,000 50,000 450,000 160,000 200,000 90,000 36,000 $ 54,000

Flexible Budget Formulas Contribution Margin Per Unit = Selling Price Per Unit - Variable Cost Per Unit Formula 4.1 CM/U = SP/U - VC/U Net Income Before Tax = (Contribution Margin Per Unit)(Sales Volume) - Total Fixed Cost Formula 4.2 NIBT = (CM/U)V - FC Net Income = Net Income Before Tax(1.0 - Tax Rate) Formula 4.3 NI = NIBT(1.0 - TR) Net Income = [(Selling Price Per Unit - Variable Cost Per Unit)(Sales Volume) - Total Fixed Cost](1.0 - Tax Rate) Formula 4.4 NI = [(SP/U -VC/U)(V) - FC](1.0 - TR) Formula 4.4 is a consolidation of formulas 4.1, 4.2, and 4.3.

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Self-Study Problem 4-1 Flexible Budget Formulas Determine the amounts of the variables in the flexible budget formulas for Dar Ya Enterprises.

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Chapter Four: Budgets and the Budget Process

Self-Study Problem 4-1 Solution Flexible Budget Formulas Selling Price Per Unit SP/U Sales Dollars Sales Volume

$1,500,000 100,000

= $15.00/Unit

Variable Cost Per Unit VC/U Total variable cost equals the sum of the variable manufacturing cost plus the variable selling and administrative cost; i.e., $1,000,000 + $50,000 = $1,050,000. Variable Cost Sales Volume

$1,050,000 100,000

= $10.50/Unit

Total Fixed Cost FC Total fixed cost equals the sum of the fixed manufacturing cost plus the fixed selling and administrative cost; i.e., $160,000 + $200,000 = $360,000. Income Tax Rate TR Income Tax Expense Net Income Before Tax

$36,000 $90,000

Formula 4.1 SP/U - VC/U = CM/U $15/U - $10.50/U = $4.50/U Formula 4.2 (CM/U)(V) - FC = NIBT ($4.50/U)(100,000) - $360,000 = $90,000 Formula 4.3 NIBT(1.0 - TR) = NI $90,000(1.0 - .40) = $54,000 Formula 4.4 [(SP/U -VC/U)(V) - FC](1.0 - TR) = NI -$360,000](1.0 - .40) = NI [($4.50/U)(100,000) - $360,000](.60) = NI [$450,000 - $360,000](.60) = NI [$90,000](.60) = $54,000 = Net Income

138

= 40%

[($15/U - $10.50/U)(100,000)

Chapter Four: Budgets and the Budget Process

Self-Study Problem 4-2 Construct a flexible budget for 120,000 units of sales.

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Chapter Four: Budgets and the Budget Process

Self-Study Problem 4-2 Solution Construct a flexible budget for 120,000 units of sales. Formula 4.1 SP/U - VC/U = CM/U $15/U - $10.50/U = $4.50/U Formula 4.2 (CM/U)(V) - FC = NIBT ($4.50/U)(120,000) - $360,000 = $180,000 Formula 4.3 NIBT(1.0 - TR) = NI $180,000(1.0 - .40) = $108,000 Formula 4.4 [(SP/U -VC/U)(V) - FC](1.0 - TR) = NI [($15/U - $10.50/U)(120,000) -$360,000](1.0 - .40) = NI [($4.50/U)(120,000) - $360,000](.60) = NI [$540,000 - $360,000](.60) = NI [$180,000](.60) = $108,000 = Net Income

Dar Ya Enterprises 1996 Flexible Budget Projected Sales 120,000 Units Sales - Variable Manufacturing Cost - Variable Selling & Administrative Cost = Contribution Margin - Fixed Manufacturing Cost - Fixed Selling & Administrative Cost = Net Income Before Tax - Income Tax Expense = Net Income

$1,800,000 1,200,000 60,000 540,000 160,000 200,000 180,000 72,000 108,000

The company would favor the option proposed by the sales manager because the net income would increase from the current $54,000 to $108,000.

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Chapter Four: Budgets and the Budget Process

Self-Study Problem 4-3 Find a break even level of sales. What is the break even level of sales volume. Hint: What level of sales volume will give a net income of zero.

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Chapter Four: Budgets and the Budget Process

Self-Study Problem 4-3 Solution Find a break even level of sales. Formula 4.4 [(SP/U -VC/U)(V) - FC](1.0 - TR) = NI [($15/U -$10.50/U)(V) - $360,000](1.0 - .40) = 0 = NI [($4.50/U)(V) - $360,000](.60) = 0 = NI ($2.70/U)(V) - $216,000 = 0 = NI V = $216,000 $2.70/U

V = 80,000 units of sales Dar Ya Enterprises 1996 Flexible Budget Projected Sales 80,000 Units Sales - Variable Manufacturing Cost - Variable Selling & Administrative Cost = Contribution Margin - Fixed Manufacturing Cost - Fixed Selling & Administrative Cost = Net Income Before Tax - Income Tax Expense = Net Income

$1,200,000 800,000 40,000 360,000 160,000 200,000 0 0 0

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Self-Study Problem 4-4 Simulation Analysis Complete a new flexible budget if the selling price per unit is dropped to $14, and the level of sales increases to 105,000 units. Would Dar Ya Enterprises prefer to make these changes over the original flexible budget?

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Self-Study Problem 4-4 Solution Simulation Analysis Formula 4.1 SP/U - VC/U = CM/U $14/U - $10.50/U = $3.50/U Formula 4.2 (CM/U)(V) - FC = NIBT ($3.50/U)(105,000) - $360,000 = $7,500 Formula 4.3 NIBT(1.0 - TR) = NI $7,500(1.0 - .40) = $4,500 Formula 4.4 [(SP/U -VC/U)(V) - FC](1.0 - TR) = NI [($14/U - $10.50/U)(105,000) -$360,000](1.0 - .40) = NI [($3.50/U)(105,000) - $360,000](.60) = NI [$367,500 - $360,000](.60) = NI [$7,500](.60) = $4,500 = Net Income Dar Ya Enterprises 1996 Flexible Budget Projected Sales 105,000 Units Sales - Variable Manufacturing Cost - Variable Selling & Administrative Cost = Contribution Margin - Fixed Manufacturing Cost - Fixed Selling & Administrative Cost = Net Income Before Tax - Income Tax Expense = Net Income

$1,470,000 1,050,000 52,500 367,500 160,000 200,000 7,500 3,000 4,500

Dar Ya Enterprises would not want these proposed changes as net income declines from $54,000 to $4,500.

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Self-Study Problem 4-5 Simulation Analysis The sales manager proposes that if the selling price of the product is reduced to $14 and if the fixed advertising expense is increased by $100,000, the total sales volume will be increased from 100,000 units to 140,000 units. Should management make the change?

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Self-Study Problem 4-5 Solution Simulation Analysis Formula 4.1 SP/U - VC/U = CM/U $14/U - $10.50/U = $3.50/U Formula 4.2 (CM/U)(V) - FC = NIBT ($3.50/U)(140,000) - $460,000 = $30,000 Formula 4.3 NIBT(1.0 - TR) = NI $30,000(1.0 - .40) = $18,000 Formula 4.4 [(SP/U -VC/U)(V) - FC](1.0 - TR) = NI [($14/U - $10.50/U)(140,000) -$460,000](1.0 - .40) = NI [($3.50/U)(140,000) - $460,000](.60) = NI [$490,000 - $460,000](.60) = NI [$30,000](.60) = $18,000 = Net Income Dar Ya Enterprises 1996 Flexible Budget Projected Sales 140,000 Units Sales - Variable Manufacturing Cost - Variable Selling & Administrative Cost = Contribution Margin - Fixed Manufacturing Cost - Fixed Selling & Administrative Cost = Net Income Before Tax - Income Tax Expense = Net Income

$1,960,000 1,400,000 70,000 490,000 160,000 300,000 30,000 12,000 18,000

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Self-Study Problem 4-6 Cash Budget Complete a cash budget using the information from the cash collection and cash payment schedules in Illustrations 4-7 and 4-8. Assume the following beginning cash balance and minimum desired cash balance. The interest rate on any borrowed funds equals 12%. Cash Balance on January 1, 1996 = $10,000 Desired Minimum Cash Balance = $10,000 Dar Ya Enterprises Cash Receipts Schedule January - May, 1996 (From Illustration 4-7) Month Cash Receipts

Jan $35,000

Feb $92,000

Mar $107,500

Apr $122,500

May $148,100

Apr $92,000

May $109,000

Dar Ya Enterprises Cash Disbursements Schedule January - May, 1996 (From Illustration 4-8) Month Cash Disbursements

Jan $56,000

Feb $77,000

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Mar $89,000

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Self-Study Problem 4-6 Solution Cash Budget

Dar Ya Enterprises Cash Budget January - May, 1996 Month Beginning Cash Balance Plus Cash Receipts Total Cash Available Less Cash Disbursement Less Desired Min Balance Equals Surplus or Shortage Plus Cash Borrowed Less Cash Repaid* Less Cash Invested Ending Cash Balance

Jan $ 10,000

Feb $ 10,000

Mar $ 10,000

Apr $ 10,000

May $ 10,000

35,000 45,000

92,000 102,000

107,500 117,500

122,500 132,500

148,100 158,100

56,000

77,000

89,000

92,000

109,000

10,000

10,000

10,000

10,000

10,000

-21,000

15,000

18,500

30,500

39,100

21,000

0

0

0

0

0 0

15,000 0

6,270 12,230

0 30,500

0 39,100

$ 10,000

$ 10,000

$ 10,000

$ 10,000

$ 10,000

*Note: The total interest expense for the borrowed funds equals $270. The calculation of interest expense is ($21,000 - $15,000) x .12 x 2/12 = $120 + $15,000 x .12 x 1/12 = $150.

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Problems Problem 4-1 Cost Behavior RuDee Company has determined that at a volume of 120,000 units of sales, the total fixed cost will be $900,000 and the total variable cost will be $720,000. Required: Compute the total variable cost and the variable cost per unit, and the total fixed cost and the fixed cost per unit for the following levels of sales volume. Note: Assume that all levels of sales volume are within the relevant range. Volume Total Variable Cost Variable Cost Per Unit Total Fixed Cost Fixed Cost Per Unit

100,000

115,000

130,000

145,000

Problem 4-2 Behavior Patterns RDR Enterprises determined that at a level of sales volume of 50,000 units, the selling price per unit was $20, the variable cost per unit was $12, and the fixed cost per unit was $5. Required: Compute a budgeted income statement for RDR Enterprises at a level of sales activity of 60,000 units. The income tax rate is 40 percent. Problem 4-3 Contribution Margin RD Inc. has the following revenues and expenses for 1,000 units of sales: sales $5,000 fixed administrative 300 fixed manufacturing 900 variable administrative 700 variable manufacturing 2,000 Required: Compute the total contribution margin and the contribution margin per unit for 1,000 units of sales, and for 1,200 units of sales. Use the following flexible budget for Dar Ya Enterprises to answer problems 4-4 through 4-10. Dar Ya Enterprises 1997 Flexible Budget Income Statement Projected Sales 70,000 Units Sales

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- Variable Manufacturing Cost - Variable Selling & Administrative Cost = Contribution Margin - Fixed Manufacturing Cost - Fixed Selling & Administrative Cost = Net Income Before Tax - Income Tax Expense = Net Income

1,050,000 140,000 560,000 260,000 100,000 200,000 80,000 120,000

Problem 4-4 Flexible Budgets Using the 1997 Dar Ya Enterprises’flexible budget, compute the flexible budgeting formulas for contribution margin, net income before tax, net income and the combination formula for net income. Problem 4-5 Flexible Budgets Using the 1997 Dar Ya Enterprises’flexible budget, construct flexible budget income statements for 50,000 units and 80,000 units of sales volume. Problem 4-6 Breakeven Volume Using the 1997 Dar Ya Enterprises’flexible budget, determine the breakeven level of sales activity. Problem 4-7 Simulation Analysis The financial manager suggests that the unit selling price for Dar Ya Enterprises’product be increased by $5. This increase will result in a decrease in sales volume by 10,000 units to 60,000 units. Should Dar Ya Enterprises make the change suggested by the financial manager?

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Problem 4-8 Simulation Analysis The sales manager would like to increase the fixed advertising cost by $500,000 for Dar Ya Enterprises. The manager believes that the increase in promotion efforts will result in an increase in sales volume by 15,000 units. Should Dar Ya Enterprises make the change suggested by the sales manager? Problem 4-9 Simulation Analysis The production manager would like to improve the automation process in the production of the product which will increase fixed cost by $250,000. The change in automation will reduce the variable cost by $4 per unit. Should Dar Ya Enterprises make the change suggested by the production manager? Problem 4-10 Simulation Analysis The president would like to reduce the selling price by $2 per unit. How much would the sales volume have to increase to make the company indifferent between the current selling price per unit and the presidents proposed selling price per unit? Problem 4-11 Purchase Schedule WinD Company wanted to determine the amount of materials that needed to be purchased this month for the production process. The company currently has $20,000 in material inventory and desires to have $25,000 in ending inventory. During the month production requirements should equal $300,000 worth of materials. Required: Compute the dollar amount of material purchases for the month for WinD Company. Problem 4-12 Purchase Schedule MAT Corporation needed to determine the amount of materials that needed to be purchased this month for the production process. The company currently has 15,000 pounds of material in beginning inventory and desires to have 18,000 pounds in ending inventory. During the month the company expects to produce 40,000 units each of which requires 4 pounds of material. The cost of material is $3.00 per pound. Required: Compute the unit and dollar amount of material purchases for the month for MAT Corporation.

Problem 4-13 Production Schedule MAT Corporation needed to determine the level of production of finished goods for the month. The anticipated sales for the current month are 70,000 units, and for next month is 75,000 units. The company desires to maintain an ending inventory of finished goods equal to 10 percent of the next month’s sales volume. The current beginning inventory of finished goods is just 6,000 units. The cost of the product is $8.00 per unit and the selling price is $15.00 per unit. Required: 151

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Compute the unit and dollar amount of finished goods production for the month for MAT Corporation. Problem 4-14 Purchase and Production Schedule WinD Company has a beginning balance of raw materials of $8,000 and desires an ending balance of $10,000. During the month, $30,000 of raw materials will be used in the production process along with $50,000 of labor cost and $25,000 of overhead costs. The finished goods inventory account has a beginning balance of $15,000 and the company desires an ending balance of $20,000. Required: Compute the dollar amount of raw materials purchased and the dollar amount of finished goods sold during the month.

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Use the following cash receipt information to answer problems 4-15 through 4-16. Cash Receipts Dollar Sales by Month Month Cash Credit January $15,000 $160,000 February $12,000 $150,000 March $20,000 $180,000 April $24,000 $200,000 May $25,000 $240,000

Month Percent Collected

Collection of Accounts Receivable Schedule Month of One Month Two Months Sale After Sale After Sale 30%

40%

20%

Three Months After Sale 8%

Problem 4-15 Collection of Accounts Receivable Compute the breakout of the dollar amount of accounts receivable collected for the credit sales of January through May. Why is the total percent collected not equal to 100%? Problem 4-16 Cash Collections Compute the dollar amounts of cash collections for the months of January through May.

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Use the following cash disbursement information to answer problems 4-17 through 418. Cash Disbursements Dollar Expenses by Month Month Cash Payable January $50,000 $100,000 February $40,000 $85,000 March $65,000 $120,000 April $60,000 $160,000 May $70,000 $130,000 Payment of Accounts Payable Schedule Month Percent Paid

Month of Purchase 30%

One Month After Purchase 50%

Two Months After Purchase 20%

Problem 4-17 Payment of Accounts Payable Compute the breakout of the dollar amount of accounts payable paid for the credit purchases of January through May. Does the total percent paid have to equal to 100%? Why or why not. Problem 4-18 Cash Payments Compute the dollar amounts of cash payments for the months of January through May.

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Use the following information on cash receipts and cash disbursements to answer problems 4-19 through 4-21. The interest rate on any borrowed funds is 12% annually or 1% per month. Dar Ya Enterprises Cash Receipts Schedule January - May, 1996 Month Jan Feb Mar Apr May Cash Receipts $100,000 $92,000 $130,500 $145,500 $150,000

Month Cash Disbursements

Dar Ya Enterprises Cash Disbursements Schedule January - May, 1996 Jan Feb Mar $106,000 $100,000 $120,000

Apr $125,000

May $160,000

Problem 4-19 Cash Budget Assume the cash balance on January 1, 1996 equals $15,000. Develop a cash budget for Dar Ya Enterprises for January through May 1996. Note: Since there is no desired minimum cash balance, excess funds do not have to be invested, and borrowing will occur only if the cash balance is negative. Problem 4-20 Cash Budget Assume the cash balance on January 1, 1996 equals $1,000. Develop a cash budget for Dar Ya Enterprises for January through May 1996. Note: Since there is no desired minimum cash balance, excess funds do not have to be invested, and borrowing will occur only if the cash balance is negative. Problem 4-21 Cash Budget Assume the desired minimum cash balance is $20,000 and the cash balance on January 1, 1996 is only $15,000. Develop a cash budget for Dar Ya Enterprises for January to May 1996.

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Problem 4-22 Financing Section of Cash Budget Given the monthly surplus or shortage amounts, determine the amount of cash that must be borrowed, repaid, or invested each month. Interest on borrowed funds equals 1.0% a month. Cash Budget Financing Section Month Jan Feb Mar Apr May Surplus or Shortage -$9,000 $12,000 -$5,000 $8,000 $10,000 Plus Cash Borrowed Less Cash Repaid Less Interest Repaid Less Cash Invested

Problem 4-23 Comprehensive Cash Budget Use the following schedules to construct a cash budget for the months of January through May for DAR Corporation. The interest rate on any borrowed funds is 12 percent annually or 1 percent per month. The cash balance on January 1, 1997 is $25,000 and the minimum desired cash balance is $12,000. Cash Receipts Dollar Sales by Month Month Cash Credit January $35,000 $100,000 February $30,000 $130,000 March $50,000 $190,000 April $40,000 $200,000 May $45,000 $240,000

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Month Percent Collected

Collection of Accounts Receivable Schedule Month of One Month Two Months Sale After Sale After Sale 20%

40%

Cash Disbursements Dollar Expenses by Month Month Cash January $40,000 February $30,000 March $50,000 April $40,000 May $60,000

Month Percent Paid

25%

Three Months After Sale 10%

Payable $100,000 $110,000 $120,000 $150,000 $210,000

Payment of Accounts Payable Schedule Month of One Month After Two Months After Purchase Purchase Purchase 30% 60% 10%

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Cases Case Study 4-1 Harvest Church Budget Harvest Church wanted to develop a budget for presentation at its annual membership meeting next month. The church had only been organized for two years and had experienced a rapid growth. The church pastor and leadership had never developed a budget before, but they realize that at their current level of expansion, they will need a budget to maintain financial accountability. The leadership would also like to start a building program within the next year, and lending institutions will require financial records before approval can be gained for any capital acquisitions. Weekly deposit records were maintained that showed the amount of offerings from the membership. The monthly offering and church attendance are summarized as follows: Month Offering Attendance January $20,250 440 February $18,430 415 March $21,375 450 April $20,840 465 May $22,625 485 June $25,120 505 July $23,660 490 August $22,380 475 September $27,775 525 October $28,490 540 November $30,825 550 December $29,650 605

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Current expenses are primarily related to salaries. The church has one senior pastor, an assistant pastor, and a youth pastor. There is also a full time secretary on staff. Other administrative types of expenses are listed as follows. Expense Item Annual Amount Senior Pastor Salary Plus Benefits $ 50,000 Assistant Pastor Salary Plus Benefits $ 35,000 Youth Pastor Salary Plus Benefits $ 30,000 Secretary Salary Plus Benefits $ 21,000 Office Supplies $ 23,000 Utilities and Telephone $ 9,600 Sunday School Supplies $ 7,400 Church Supplies $ 16,200 Rental $ 48,000 The church leadership wants to put $100,000 toward a building fund at the end of the year. At the start of this current year, there was a fund balance of $20,000, which was not designated for any purpose but served as a reserve for emergency purposes. There will be a campaign next year to secure donations of $250,000 for the beginning of the building process. Currently a small church was for sale that had sufficient land for parking and some expansion. The market price for this building and land is $500,000. Also, there is vacant property available in the immediate area. The asking price for the land ranged from $100,000 to $300,000. The pastor was concerned about extending the membership in their giving. If too much emphasis was put into a building program, contributions to the general operations may diminish. Also, the undertaking of a building program may curtail growth, as new members will not want to join a church that is involved in major fund raising for a new building. Never the less, the membership was growing, and the leadership believed that the church attendance would grow by 20 percent next year, and the rate of giving would only drop by about 3 percent per attendee, plus the building fund goal could be reached. Salaries and benefits would increase by 4 percent next year, and an additional pastoral staff member would need to be hired at a rate of about $25,000 including benefits. Also, the leadership stressed the importance of a part time office administrator/bookkeeper. Since the position would be part time, benefits would be minimal, and the pastor thought a person could be hired for 20 hours a week at $9 per hour. Office expenses would increase by 10 percent next year to support the anticipated growth. Utility and telephone expenses would increase by 14 percent. The senior pastor felt it was very important to improve the Sunday school program and other activities by the church to encourage active participation by the membership. A 30 percent increase was proposed for Sunday school and church supplies. The landlord also notified the church that there would be a 10 percent increase in the rental rate. The church was located in a prime area of development and the facility could easily be converted into office space which could provide even higher rental rates. The leadership believed that the landlord would apply increased pressure to get the church to move out and that the rental rates would continue to increase significantly every year. Also, with the anticipated growth, the current rental facilities would not be sufficient as there is already overcrowding. 159

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Required: A. Determine the anticipated revenue from contributions for Harvest Church for next year. Show how you computed the revenue figure. B. What are the possible problems the church could face in relying on revenues from membership contributions? C. Construct a budget for the anticipated expenses for next year. D. Can the church meet its goal of $100,000 for the building fund at the end of the current year? at the end of next year based on budget projections? E. Since Harvest Church is a nonprofit organization, discuss the role and importance of the fund balance. Can or should these funds be used for the building fund? F. How should the church monitor and account for its building fund campaign? If there is a shortage in either the operating funds or building funds, can excesses from the other fund be used to cover the shortages?

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Case 4-2 Charlie’s Country to Classic to Chamber Music Store Charlie Kile, a noted business professor, decided that he had had enough of the “publish or parish” environment at a prestigious university. As much as he had enjoyed the university setting and working with college students, he had always wanted to use his business expertise to run his own business. Charlie also had musical talent. He could play several instruments and was always in a band during his days as a college student. In fact, Charlie subsidized a good portion of his college expenses by performing at everything from college fraternity parties to funerals. A music store was a natural business for Charlie to own. He had the business sense, and could use his musical skills to encourage and help children develop their talents. In a way he could still be a teacher and not have to publish journal articles. Maybe now he would use his spare time for writing music versus articles. Charlie wanted to remain in a college town because of the overall academic environment and the general appreciation of the arts. He also found that parents were more supportive of having their children learn musical instruments. Since he was somewhat already well known in his hometown of Cleveland, Tennessee, Charlie decided to open a music store in their new shopping center just a few blocks from the local university. Even though there were other music stores in the area, Charlie’s personality, business skills and musical talent made him an instant hit with the kids from junior high to college. The business prospered. To encourage children to try to learn how to play an instrument Charlie offered a very generous instrument purchase plan. An instrument could be purchased for 10% down for a 90-day trial period. After 90 days, the instrument could be paid for in nine equal installments. It would be one year before the instrument would be paid for in full. If, after the 90-day trial period, the customer did not want the instrument, the 10% down payment would be refunded in full if the instrument was still in like new condition. Charlie took a risk with this promotion. Customers could return a damaged instrument after 90 days that would cost much more to repair than the 10% down payment. Charlie believed, however, that if he were good to the customers, they would be good to him. There were two time periods when there was a big demand for musical instruments, September, with the start of the school year, and December for the holidays. A large amount of his instrument sales occurred during these two months. Essentially all of his customers took advantage of his generous payment plan. Charlie also sold music supplies and materials. Those sales were on a cash basis and relatively uniform during the year. Charlie purchased his instruments from various music instrument companies and distributors. To meet expected demand, the majority of the purchases were in July and October. The instrument companies needed a 30 day lead time on the purchase order, and they generally required payment in full 60 days after the order had been made. The instruments would be shipped or personally delivered to Charlie from 2 to 5 weeks after his purchase order. Music supplies and materials were ordered from wholesalers and had to be paid for 30 days after their receipt. Charlie was able to get away on a vacation for the first time in two years in April. He figured it was a good time to evaluate how the business was going before the busy season started up again in late summer. The business had shown good growth and satisfactory 161

Chapter Four: Budgets and the Budget Process

profits, but his cash flow seemed tight, and he has had to rely on a line of credit from the local banker. The interest charges have cut into his profit margin. He would like to improve his cash flow so that he does not have to depend on the line of credit. Charlie decided to project his cash and credit sales for the next 20 months along with his purchases and other expenses. He currently has a cash balance of $5,000, which is at a minimum, and an outstanding balance on the line of credit of $25,000. He has to pay 1.5% per month on the outstanding balance. Also, the balance due on accounts receivable is $48,000, and the balance due on accounts payable is $2,000. Assume that $960 of the account receivable balance will be paid back to customers returning instruments. The remaining $47,040 will be received in equal installments of $3,920 over the next twelve months. Charlie believes that all of his accounts receivable will be collected. However, 20% of all instrument sales will be returned for refunds after 90 days. The current accounts payable balance will be paid in the following month. In the future, 20% of purchases on account are paid in the same month of purchase and 80% of purchases on account will be paid in the following month. Required A. Set up a monthly cash collection schedule of accounts receivable for Charlie’s music store for the next 20 months. B. Develop a total cash receipts schedule for Charlie’s music store for the next 20 months. C. Set up a monthly cash payment schedule for accounts payable for Charlie’s music store for the next 20 months. D. Develop a total cash disbursements schedule for Charlie’s music store for the next 20 months. E. Develop a complete cash budget for Charlie’s music store for the next 20 months. Include a financing section with the current information on the line of credit, minimum balance, and beginning cash balance. Assume money is borrowed on the line of credit as soon as it is needed and repaid as soon as it is not needed. The current monthly case expenses do not include interest expense on the line of credit. F. What conclusions can you make regarding the cash flow situation for Charlie’s Country to Classic to Chamber Music Store? G. What suggestions or recommendations would you make to help Charlie improve his cash flow situation?

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Month May June July August September October November December January February March April May June July August September October November December

Sales Revenue by Month Cash Credit $4,000 $2,000 $5,000 $4,000 $4,000 $3,000 $5,000 $6,000 $8,000 $28,000 $10,000 $20,000 $6,000 $10,000 $12,000 $36,000 $10,000 $12,000 $6,000 $6,000 $4,000 $3,000 $5,600 $5,000 $4,800 $4,000 $6,400 $6,000 $5,000 $4,800 $6,800 $7,000 $9,000 $31,000 $11,000 $24,000 $6,400 $10,000 $14,000 $40,000

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Dollar Expenses by Month Month Cash May $6,000 June $6,000 July $7,000 August $7,000 September $8,000 October $7,500 November $8,000 December $9,000 January $7,000 February $6,500 March $6,000 April $5,000 May $6,000 June $7,000 July $7,000 August $8,000 September $10,000 October $9,000 November $8,000 December $11,000

Payable $2,000 $3,000 $12,000 $6,000 $4,000 $14,000 $7,000 $3,000 $2,000 $2,000 $1,000 $2,000 $3,000 $4,000 $14,000 $7,000 $5,000 $18,000 $8,000 $5,000

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Chapter Five: Performance Evaluation

Chapter Five: Performance Evaluation Objectives 1. Review the process of establishing standards. 2. Identify the use of performance reports. 3. Analyze the concept of variance analysis.

Standard Accounting Systems A standard accounting system is very much like a budget process, and the establishment of one can help the other and vice versa. A budget often will use standard accounting figures which are developed by using a standard physical measure times a standard dollar amount per unit of physical measure. Budgets also can sometimes be the basis for establishing or revising standards. Additionally, a budget can serve as a standard in its control phase in analyzing actual performance. A standard cost or revenue amount is a predetermined value of what an activity should equal under specific conditions. Standards can serve as goals for what amounts could be used as guidelines for comparison against actual results. The achievement of properly set standards that are in line with company goals and objectives would imply that the company is probably operating efficiently and effectively. Standards may reflect historical trends or could be developed through time and motion studies. Engineers can help in the establishment of proper measurements to use in the development of standards. A standard accounting system follows a basic format of units times dollars per unit. The unit measure cancels out leaving a total dollar amount which can be used in a budget or as a standard or benchmark for evaluation purposes. The measure of units can range from sales, to measures of time, to physical units of material, or number of employees. Standard Dollars = Dollar/Unit x Units The first objective in establishing a standard is to determine a unit of measure that relates to the account. Units of sales relate to sales revenue, hours of work relate to some wage expenses, and units of product relate to inventory. After the relationship is determined, the next step is to arrive at a dollar amount per unit. The unit selling price, labor wage rate per hour or cost per unit of product in inventory are examples that are commonly used. This process completes the standard dollar amount per unit format. The computed standard dollar amount per unit can be applied to the budget process by projecting a unit volume. When the unit volume is multiplied by the amount per unit, a total dollar amount is calculated. This dollar amount such as total sales revenue, total wage expense, or total inventory can be incorporated into a budget or can be used as a standard for other purposes like performance evaluation. Standards can be easily established for items where a natural relationship exists between units and dollars like the sale of a good or service with an established selling price per unit or if employees are paid on an hourly basis. Determining standards for other items may be a little more difficult such as with the cost of the good or service sold by a company. In a manufacturing company there are many inputs that go into the cost of an 165

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item. Some of the items have a clear cost per unit component and some of the items may not be related to any unit measure. Fixed cost items are usually only related to a time period such as a specific dollar amount per year. Fixed cost, by definition, do not have a constant cost per unit of activity which will also make it difficult to relate fixed cost to different levels of activity except on a total cost basis. Often times in establishing a standard cost per unit in which fixed costs are part of the costs being considered, the fixed cost will be treated like a variable cost and be represented by a constant cost per unit. This misrepresentation of fixed cost for standard costing purposes could easily result in incorrect amounts of fixed cost being reported. The problem is overcome through a variance analysis process where the standard costs are compared with actual costs and the difference or variance is accounted for with adjustments to appropriate accounts. The simplicity of the standard cost system can be maintained with modifications made where variations occur. Advantages of Standard Accounting Systems In spite of the perceived complexities in arriving at standards for the various accounts, the process can still be worth the effort. The advantages of using a standard accounting process to determine total costs and revenues include: 1. provides useful information for planning purposes 2. aids in decision-making 3. improves control activities 4. promotes a management by exception reporting format 5. gives more reasonable measurements 6. results in easier record keeping 7. possible reductions in costs The advantage of using standards in the planning function is already evident. The use of standard costs and revenues tie directly into the budget process. The standards provide a goal or target for management to focus on in developing its operating activities. In decision-making, the use of standards can give consistency in submitting bids for jobs. Standards give continuity in performing functions from one time period to the next and aids in comparisons for decision-making purposes. Standards provide the guideline against which actual performance is evaluated. Differences between the actual results and the standards can lead to questions, which will aid in the control process. A management by exception reporting format is used to identify those conditions that are significantly different than an expected norm. By being able to compare actual results to predetermined standards, management can focus their efforts on extreme situations and the unusual circumstances. Actual results that are within a normal range from a standard will receive less time and attention. The management by exception process enables management to put forth the effort where it will do the most good. Even with the difficulty of establishing some relationships between dollar amounts and activities, being able to establish a reasonable standard can be more useful for measurement purposes than having no standard at all. Accounting is not an exact science and sometimes reasonably accurate figures are sufficient especially if their is a

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consistency in how the numbers are developed. Standards can aid in consistency in the measurement process. Record keeping is considerably easier with standard figures. The accountant does not have to try to keep track of every change in actual costs and revenues with a standard cost system. Actual figures can be determined for the units of activity and the actual units are multiplied by a standard dollar amount per unit. Adjustments between the standard amounts recorded and the actual amounts can be made at the end of a time period. This process is easier than trying to keep track of both the actual units and the actual dollar amounts. If both units of activity and dollar amounts per unit are allowed to vary management can easily lose consistency in measurements. Whenever a process is simplified, cost savings can be almost a guaranteed result. A standard system is simpler because actual costs do not have to be monitored for every transaction. Frequently, actual costs will offset each other and the extra effort in monitoring the costs will not gain any benefit. Disadvantages of Standard Accounting Systems While a standard accounting system seems to be worth the effort, there can be some disadvantages to its implementation. Disadvantages for a standard system may include: 1. behavioral implications of an imposed standard 2. failure of standards to identify differences in actual results on a timely basis 3. inaccurate standards The biggest concern about standards could be its behavioral implications. Managers may feel that standards are being imposed and that failure to comply could have negative consequences. This is especially critical if the standards are virtually unattainable. The method of imposing standards has to be clearly communicated to the users and the standards need to be recognized more as guidelines than as mandated criteria. Standards could be so general in nature that it is difficult to determine if significant differences are occurring when being compared to actual data. Standards also may not be able to distinguish differences from actual data and the variability of the data. Actual data that varies widely may appear closer to the standard amounts than actual data with little variability. When using standards it is important to have processes in place that will highlight inconsistencies when they are occurring. Standards could be inaccurate. Keeping in mind that standards are probably developed ahead of their actual implementation and that the standards could be based on general conditions or situations, then over time the standards could become inaccurate. Failure to adjust standards or to allow for inaccuracies could lead to incorrect actions or decisions.

Performance Reports Performance reports are an important part of the budget process with regard to the control function. The reporting process completes the budget cycle and provides a means of feedback to the users of the budget. Performance reports can be used to compare actual results with the predetermined standard or budget figures. Any differences in values are identified as variances.

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The control process from the performance reports centers on the variance analysis. Managers can easily identify the differences or variances and determine which variances are critical or significant and worthy of additional evaluation. The management by exception principle is an approach to analyzing variances. Management identifies all variances but only reviews those variances, which are significant or critical to company performance. A cost benefit trade-off consideration may be used in helping to decide which variances need further evaluation. Flexible Budget Format The format for performance reports usually follows three broad headings to include budget, actual, and variance. The budget or standard is predetermined and could follow a flexible budget format. In the flexible budget format, revenue and cost items that display a variable behavior are separated from fixed cost items. The actual results are summarized after the fact. Variances identify differences between the predetermined standards and the actual results. See Illustration 5-1. A cost that is defined as controllable means that the cost comes under the total responsibility of the manager or department for whom the performance report is being prepared. Controllable indicates that the manager has authority to incur the cost and is responsible for its variance. If a cost is listed as variable it is most likely also controllable; however, fixed cost can be either controllable or noncontrollable. Sometimes the term direct is used in conjunction with controllable. Direct cost come under the direct or complete control of the specific department represented by the performance report. Noncontrollable costs do not come under the complete responsibility or authority of a specific manager or department. Since the manager does not have complete control of these cost, it is important to segment these costs in a performance report. Noncontrollable costs can be either variable or fixed in nature but are most likely fixed costs. Sometimes the term indirect is used in conjunction with noncontrollable. Indirect costs do not come under the complete control of the specific department represented by Flexible Budget Format Illustration 5-1 Matt’s Hats Performance Report For the Year Ending December 31, 1996 Account Sales Revenue - Controllable Variable Cost = Contribution Margin - Controllable Fixed Cost = Segment Margin - Noncontrollable & Allocated Fixed = Net Income

Budget $200,00 0 140,000

Actual $211,00 0

60,000 30,000 30,000 25,000

145,000 66,000 29,000 37,000 28,000

5,000

9,000

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Variance $11,000 (5,000) 6,000 1,000 7,000 (3,000) 4,000

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the performance report. Allocated costs also imply that the cost relates to more than one segment or department, and its division between the different departments is dependent upon some method of distribution. Allocated costs can be another name for noncontrollable costs. Since noncontrollable and allocated costs have a different degree of impact in a performance report than controllable cost, it is important that the different groups be shown separately. Segment margin is an interim measure of a company’s performance, which highlights only those revenues, and costs that come under the direct control of the department’s manager. Segment margin will be used to divide costs that are controllable or direct from those that are uncontrollable, indirect, or allocated. When a performance report is being used to analyze the performance of a manager, it is important for the manager to emphasize the results from the segment margin versus the net income results. While both are important, the manager should have complete responsibility and authority for all revenues and costs used to determine the segment margin, whereas, the noncontrollable and allocated costs will be outside of the manager’s total control. In the case of the performance report illustration, a greater emphasis should be placed on the positive $7,000 segment margin variance than the positive $4,000 net income variance. The negative $3,000 variance from the noncontrollable allocated fixed cost was outside of the complete control and responsibility of the performance report manager. A flexible budget format can be very useful in a performance report arrangement. The flexible budget establishes a standard based upon an actual level of activity, which gives consistency between the standard measure and actual performance. If a budget called a static budget is established based on 1,000 units of sales and actual performance is based on 1,400 units of sales, then it could be difficult to get a true evaluation of the performance of the company. How much of the variance between actual and budget is due to revenue and expense variations and how much of the variance is due to the fact that the level of sales was 400 units higher than anticipated. Without the creation of a flexible budget, it will be virtually impossible to distinguish between the nature of the variances. A flexible budget could be created based on the actual level of sales of 1,400 units. Some of the revenues and expenses would increase in proportion with the increase in volume, these items would be variable in nature. Some of the revenues and expenses may increase but not in proportion to the increase in sales volume, these are classified as semivariable items. A semi-variable item exhibits characteristics of both a variable item and a fixed item. The best way to deal with an item of this nature is to separate out the variable component from the fixed component. Items that would not change in total with the change in volume from the flexible budget are fixed in nature. A flexible budget needs to be able to classify its components according to behaviors, either variable or fixed, to be useful. Once a flexible budget is established with the components properly identified as variable or fixed, then appropriate total amounts can be identified at the actual level of activity. These flexible budget amounts are then compared to the actual results on a consistent volume basis. Any variance between budget and actual will then be related to the

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operating activities of the company. The impact resulting from the different level of activity between static and flexible budgets will not be incorporated in the variance. The flexible budget concept is similar to the "apples-to-apples" scenario. In order to make a meaningful comparison the measure of activity has to be constant. A flexible budget allows for such an "apples-to-apples" comparison. A static budget is more like an "apples-to-oranges" comparison. Without the common unit measure of volume, the comparison loses much of its usefulness. Even though the flexible budget is critical in performance evaluation, there still may be a need for the static budget. In the example discussed earlier, management is going to want to know what factors caused an increase from 1,000 units to 1,400 units. If the static budget is completely ignored, these issues may never be identified and information that may be useful in the decision-making process will be lost. Each budget format has a purpose. The flexible budget is needed to make meaningful budget, actual, and variance computations. The static budget is needed to address the general question of why the company failed to operate at the predetermined level of activity. See Self-Study Problems 5-1 and 5-2. Responsibility Centers The distinction in the flexible budget performance report format between controllable and noncontrollable costs can also be useful in the determination of responsibility centers. Budgets are usually established for responsibility centers with a manager in charge of the responsibility center. A responsibility center is an identifiable segment of the business that undertakes measurable activities and is headed by a specific manager. It is important that the manager has authority commensurate with the responsibilities. Performance reports are established for responsibility centers. The activities undertaken in the responsibility center are measured in terms of a flexible budget and actual results. Managers are responsible for the results of the performance evaluation. Such reports could have an impact on the professional success or failure of the manager and the center. Sometimes costs are assigned to a specific responsibility center over which the manager has no control. These costs are usually classified as allocated costs. The determination of the allocation or distribution of the cost is made at a higher level of management. The allocation is usually made somewhat arbitrarily or subjectively, and because of this, the responsibility center manager has limited control over the occurrence of the cost or the amount. To include costs of this nature in a performance report could be misleading. At the very least costs that are not totally under the control of the responsibility center manager should be separated and identified as noncontrollable. The performance of a manager should not be impacted by uncontrollable activities. The separation of items in the performance report between controllable and noncontrollable is an appropriate format for the responsibility center. A manager who is responsible for the controllable items should be ready to identify and explain any variations in these items. At the same time variations in noncontrollable items should be identified but not come under the same level of authority of the responsibility center manager.

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Responsibility Center Revenue Expense Profit Investment

Responsibility Centers Illustration 5-2 Control Over Control Over Revenues Expenses Yes No No Yes Yes Yes Yes Yes

Control Over Assets No No No Yes

The performance report usually has an interim value called a segment margin, which separates the controllable from the noncontrollable items. The segment margin gives an indication of how the particular responsibility center segment is contributing to the overall performance of the company. Following the segment margin will be the noncontrollable costs. These items can be included in the report as an indication of how well the center is assisting in covering a fair share of nonspecific companywide types of costs. For a company to be successful, generally each responsibility center has to be able to have a positive segment margin large enough to cover a portion of allocated cost plus have a remaining contribution margin for company profits. The inclusion of specific items within the performance report will depend on their level of significance. An income statement format is often used. Generally, any revenue items will be listed first followed by controllable expenses. The noncontrollable expenses will be identified after the segment margin calculation. Types of Responsibility Centers Responsibility centers do not necessarily have to be profit centers. A responsibility center that generates only expenses is also called an expense center. The responsibility center manager does not generate any revenues. Many support functions within a company are expense centers. Activities like the accounting department or personnel department are usually classified as expense centers. Profit centers are often associated with the operating function of the company. The production of a good or service will lead to the generation of revenues. Expenses are also incurred in these responsibility centers. Managers will have control over revenues, expenses and the resulting net profit. Ideally, the profit obtained from the responsibility center will be large enough to cover all controllable and noncontrollable costs plus a profit margin. Some responsibility centers will also have authority over utilization of assets. These segments are called investment centers. Return on investment is a critical measure of performance for these responsibility centers. The return on investment takes into account a revenue minus expense figure in the numerator which equals a net profit. In the denominator, the assets under control represent the investment. Only revenues, expenses, and assets that are controllable within the segment should be used in the evaluation. See illustration 5-2 for a comparison of responsibility centers.

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Variance Analysis A variance analysis, in the relatively simple form, as the difference between a budget or standard and actual results is satisfactory for most performance reports. The purpose of a variance analysis number is to raise a level of awareness of a difference but not to solve the problem. Variance analysis is a "means to an end" and not an "end in itself." Once a variance is identified that requires further evaluation, then management can undertake a more detailed analysis. Questions can be asked of those responsible for the variance and a complete evaluation can be conducted if necessary. A cost benefit tradeoff needs to be considered with any variance analysis. A simple difference between budget and actual results is a relatively inexpensive way to first examine performance results. Using an exception reporting philosophy, only significant or critical variances are then subject to a more extensive and costly analysis. Since standards are developed using a dollar amount per unit times a number of units format, this is a natural way to analyze variances. A total variance in many situations can be divided according to quantity related or price related factors. Quantity related variances are usually called efficiency or usage variances and price related variances are called price or rate variances. Quantity Related Variance A quantity related variance is calculated by determining the difference between the standard or budgeted quantity that should have been used at the flexible budget level of activity and the actual quantity used. This difference in quantity is then multiplied by the standard price per unit. Considering a difference in the quantity of units creates the variance. The dollar amount of the variance is arrived at by multiplying the quantity variance by a dollar per unit standard causing the measure of units to cancel out leaving a dollar amount. For cost related accounts, if the actual quantity used is greater than the standard quantity an unfavorable variance is created. The situation is interpreted as inefficient because more units were actually used than had been initially established in the budget, creating the unfavorable additional cost condition. In the opposite situation, if actual usage was less than the initial budget then the condition is considered favorable. For revenue items, the interpretation of the efficiency variance is reversed. If actual quantity is greater than budgeted, then there is a favorable efficiency variance, and when actual quantity is less than budgeted it is unfavorable. See illustration 5-3 for an explanation of quantity variances. Price Related Variances A price variance is calculated by comparing the standard or budgeted price per unit against the actual price per unit. This price difference is multiplied by the actual quantity used. The price variance highlights the difference in price per unit which when multiplied by a number of actual units equals a total dollar amount. A price variance for an expense item is unfavorable when the actual price per unit is higher than the standard or budgeted price per unit. The situation implies that the actual expense was more than the standard or budgeted amount. If the actual price per unit were less than the standard price per unit then there would be a favorable variance because 172

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actual expenses were less than the standard. For revenue items, the conditions would be reversed. If the actual price per unit was greater than the standard price per unit then a favorable variance would be recognized. This condition represents a situation in which a company earned a higher unit revenue then expected by the standard. If the actual unit price was less than the standard for a revenue item the variance is unfavorable. See illustration 5-4 for an explanation of price variances. Whenever a dollar per unit calculation is computed in arriving at a standard revenue or cost, a variance analysis can be divided into quantity and price related factors. When necessary, managers can conduct evaluations of this magnitude to assist them in identifying the reasons why variances occur. The more complete analysis should help in initiating the proper control procedures to guard against similar variances in the future. Revenue Variances Revenue variances, as previously stated, can be divided into quantity related factors and price related factors. When the actual price or quantity is greater than the corresponding standard, the variance is recognized as favorable because the company is receiving more revenue then expected in the standard due either to a higher selling price or more quantity sold. In the reverse situation, when the actual is less than the standard for either price or quantity, the variance is unfavorable because the company is receiving less revenue then expected in the standard because of a lower selling price or less quantity sold.

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Quantity Variance Illustration 5-3 Standard Price x (Standard Quantity - Actual Quantity) SP x (SQ - AQ) (Standard Price x Standard Quantity) - (Standard Price x Actual Quantity) (SP x SQ) - (SP x AQ) SP = Standard Price SR = Standard Rate SQ = Standard Quantity AP = Actual Price AR = Actual Rate AQ = Actual Quantity Note: Price and Rate can be used interchangeably for variance analysis. Generally price is associated with sales revenue and material expense and rate is associated with labor expense. Quantity Variance Example Standard Price = $10/Unit Assume the price represents a measure of expense. Standard Quantity = 1,200 Units Actual Quantity = 1,400 Units Quantity Variance = SP x (SQ - AQ) $10/Unit x (1,200 Units - 1,400 Units) $10/Unit x -200 Units = ($2,000) = Unfavorable Quantity Variance or Quantity Variance = (SP x SQ) - (SP x AQ) ($10/Unit x 1,200 Units) - ($10/Unit x 1,400 Units) $12,000 - $14,000 = ($2,000) = Unfavorable Quantity Variance The quantity variance is unfavorable because the actual expense quantity used is greater than the standard expense quantity. If the price per unit is a measure of revenue verse a measure of expense, then the $2,000 variance is favorable because the actual units of revenue exceed the standard units of revenue. The revenue quantity variance occurs if the original static budget quantity is different than the flexible budget quantity used in the performance report. However, this variance can not be a direct part of the performance report evaluation. By definition, the flexible budget standard is established based upon the actual volume of sales, thereby eliminating from the direct evaluation the predetermined static budget level of activity. The standard budgeted sales volume is now represented by the flexible budget as opposed to the static budget. The creation of the flexible budget automatically makes the actual sales volume and the standard or flexible budgeted sales volume equal. With equal volumes, there can be no quantity variance, at least as directly identified in the performance report. For example, if the predetermined static budget level of activity is 100,000 units and 120,000 174

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units are actually sold, a flexible budget will be developed based on the 120,000 units sold. Since the flexible budget quantity and actual quantity of units sold each equal 120,000, there can be no revenue quantity variance in the performance report. However, a quantity variance still can be determined separately from the performance report by comparing the standard volume based on the original static budget against the actual volume based on the flexible budget. If the revenue quantity variance is favorable it means that the actual volume represented by the flexible budget was greater than originally anticipated in the static budget. An unfavorable quantity variance means that the actual level of sales volume from the flexible budget failed to reach predetermined static budget levels. In the example presented earlier, a favorable revenue quantity variance can be identified since the actual level of sales volume used in the flexible Price Variance Illustration 5-4 Actual Quantity x (Standard Price - Actual Price) AQ x (SP - AP) (Standard Price x Actual Quantity) - (Actual Price x Actual Quantity) (SP x AQ) - (AP x AQ) Standard Price = $10/Unit Actual Price = $9/Unit Assume the price represents a measure of expense. Actual Quantity = 1,400 Units Price or Rate Variance = AQ x (SP - AP) 1,400 Units x ($10/Unit - $9/Unit) 1,400 Units x $1/Unit = $1,400 = Favorable Price Variance or Price or Rate Variance = (SP x AQ) - (AP - AQ) (1,400 Units x $10/Unit) - (1,400 Units x $9/Unit) $14,000 - $12,600 = $1,400 = Favorable Price Variance The price variance is favorable because the actual expense price is less than the standard expense price. If the price per unit is a measure of revenue verse a measure of expense, then the $1,400 variance is unfavorable because the actual price of revenue is less then the standard price of revenue. budget of 120,000 units is greater than the predetermined static budget level of sales of 100,000 units. The revenue price variance represents the difference between the standard selling price and the actual selling price. If the actual selling price is higher than the standard selling price, the price variance is favorable because the company is receiving more revenue then anticipated. When actual selling price is lower than the standard, the variance is unfavorable.

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In the evaluation of a performance report, the total revenue variance equals only the price variance. If a volume variance occurs, it would have to be shown separately from the other variances in the performance report analysis. See Self-Study Problem 5-3. Variable Cost Variances Variable cost variances include raw or direct material, direct labor, variable overhead, and variable selling and administrative items. All variable cost variances can be divided into separate quantity and price variances because the costs are based on a constant cost per unit of volume computation, which is part of the definition of a variable cost. The measure of volume or quantity used for these variable cost items is usually different than units sold, the volume measure used to establish the flexible budget performance report. Therefore, when a performance report is developed both the quantity and price variances can be analyzed for the variable cost items. The volume measures used are more directly related to the particular cost item itself, like feet or pounds for material, or hours for labor. Variable overhead, which can represent many different individual cost items each with different volume measures, is often related to material or labor in the establishment of a unit of volume. For instance, if it can be determined that there is some relationship between variable overhead and direct labor, then labor hours could be used as the measure of volume to determine a variable overhead rate. As labor hours change, the assumption is made that the variable overhead will also change in some direct proportion. The variable cost quantity variances are a measure of the efficient use of whatever activity that is related to the item. When more of a volume of actual activity is incurred then the standard quantity, there is an unfavorable quantity variance as actual expense is higher then the budgeted or standard amount. The inefficiency in the use of the activity results in higher expenses and an unfavorable variance. The opposite situation occurs when actual activity is less than the standard. Savings are recognized through the efficient use of an activity with lower expenses and a favorable variance. Sometimes variable cost quantity variances can be a little misleading, especially when variable overhead volume is based on an activity measure such as direct labor or some measure of material. The quantity variance is actually a measure of the direct labor hours or material unit efficiency as opposed to actual efficiencies of the variable overhead items. However, if there is any credibility to the relationship between the variable overhead item and the measure of labor or material activity, then one can assume that the efficiency of one is directly related to the efficiency of the other. The variable cost price variances reflect the difference between the actual price per unit of volume and a standard price per unit. If the actual price is greater than the standard price then higher costs are incurred and the variance is unfavorable. For variable cost items like materials and labor the price variance is fairly straightforward. The price variances for items like variable overhead are less clear. Since frequently several different items are included in the total variable overhead, the actual price times actual quantity may only be available as a total amount. Also, since the unit price is based on a different measure of volume, there may not be a recognized relationship between the standard per unit and the total actual costs. The sum of the quantity and price variances for each variable cost category should equal the total variance as reflected in the performance report. This breakout of the variable 176

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cost variances serves as a practical means of analyzing the variances in greater detail. See Self-Study Problems 5-4 and 5-5. Fixed Cost Variances Overhead and selling and administrative costs can also be fixed in nature. Fixed cost variances can usually only be analyzed as a total difference between the standard or flexible budget amount and the actual amount because fixed costs do not have a constant cost per unit value. Without the use of a cost per unit measure, fixed cost can not be divided between quantity related factors and price related factors. By definition, fixed costs are constant in total over changes in levels of volume within a relevant range. Since fixed cost are a constant total, it is possible that the amount of fixed cost will be the same for an original static budget as well as a flexible budget as long as the measures of volume remain within the relevant range. Generally, there should not be a significant variance between actual fixed cost and budgeted fixed cost, since the definition implies a fixed total amount. When a variance does take place, it will be unfavorable if the actual costs are greater than the budgeted costs, and favorable if the actual cost are less than the budgeted cost. Fixed cost can result in a unique volume variance when they are treated like a variable cost. For financial reporting purposes, fixed overhead costs are often assigned a constant cost per unit rate to coincide with the variable overhead rate. The volume variance occurs because of the misrepresentation of the fixed cost. The actual computation of this variance is beyond the scope of this text. Self-Study Problem 5-6 gives a complete performance report evaluation with detailed variance analysis for each component.

Summary A natural follow-up to the establishment of budgets is the use of performance reports for feedback and control purposes. The same standards that are used to establish budgets can be used in the formation of performance reports. Performance reports should follow a flexible budget format and be adjusted based on an actual level of activity. The reports should be established for each responsibility center with a specific manager having the authority and responsibility for the actions of that center. Items in the performance report, especially cost items, should be segmented between those that are controllable by the responsibility center manager and those that are not controllable. Variance analysis is a way of identifying differences between a budgeted or standard amount and actual performance. The variance analysis process can be as general or specific and detailed as necessary to aid in identifying why specific differences occurred and how the company can go about correcting those differences.

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Self-Study Problems Self-Study Problem 5-1 Performance Report Matt’s Hats developed a flexible budget based on a static level of activity of 100,000 units. Matt’s Hats Flexible Budget 100,000 Units For the Year Ending December 31, 1996 Account

Static Budget $150,000 100,000 50,000 15,000 35,000

Sales Revenue - Controllable Variable Cost = Contribution Margin - Controllable Fixed Cost = Segment Margin - Noncontrollable and Allocated Fixed Cost = Net Income

25,000 $ 10,000

Required Reconstruct the budget based on a level of activity of 120,000 units.

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Self-Study Problem 5-1 Solution Performance Report Matt’s Hats Flexible Budget 120,000 Units For the Year Ending December 31, 1996 Account Sales Revenue - Controllable Variable Cost = Contribution Margin - Controllable Fixed Cost = Segment Margin - Noncontrollable and Allocated Fixed Cost = Net Income

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Static Budget $150,000 100,000 50,000 15,000 35,000 25,000 $ 10,000

Flexible Budget $180,000 120,000 60,000 15,000 45,000 25,000 $ 20,000

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Self-Study Problem 5-2 Performance Evaluation Matt’s Hats had the following actual costs based on a level of activity of 120,000 units. Matt’s Hats Income Statement For the Year Ending December 31, 1996 Account Sales Revenue - Controllable Variable Cost = Contribution Margin - Controllable Fixed Cost = Segment Margin - Noncontrollable and Allocated Fixed Cost = Net Income Required Develop a performance report.

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Actual Results $165,000 120,000 45,000 12,000 33,000 30,000 $ 3,000

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Self-Study Problem 5-2 Solution Performance Evaluation Matt’s Hats Performance Report 120,000 Units For the Year Ending December 31, 1996 Account Sales Revenue - Controllable Variable Cost = Contribution Margin - Controllable Fixed Cost = Segment Margin - Noncontrollable & Allocated Fixed Cost = Net Income

Flexible Budget $180,000 120,000 60,000 15,000 45,000 25,000 $ 20,000

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Actual Results $165,000 120,000 45,000 12,000 33,000 30,000 $ 3,000

Variance ($15,000) 0 ( 15,000) 3,000 ( 12,000) (5,000) ($17,000)

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Self-Study Problem 5-3 Sales Revenue Variances Matt’s Hats sold 50,000 Chicago Cub’s baseball hats at $5.25 each during the month of April for a total sales revenue of $262,500. The company had expected to sell 60,000 hats at $5.00 each during the month for a total revenue of $300,000. Required: Explain the variance between the actual sales revenue and the expected sales revenue.

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Self-Study Problem 5-3 Solution Sales Revenue Variances Quantity Variance Standard Price x (Standard Quantity - Actual Quantity) SP x (SQ - AQ) $5.00 x (60,000 hats - 50,000 hats) $5.00 x 10,000 hats = $50,000 Unfavorable Quantity Variance Even though the number is positive, the quantity variance is unfavorable because the standard quantity of revenue is greater than the actual quantity of revenue. Note: In a normal performance report, the 50,000 hats actually sold would become the basis of the flexible budget. Since the actual quantity and the flexible quantity would be the same, there would be no revenue quantity variance in the performance report. Price Variance Actual Quantity x (Standard Price - Actual Price) AQ x (SP - AP) 50,000 hats x ($5.00 - $5.25) 50,000 hats x -$0.25 = -$12,500 Favorable Price Variance Even though the price variance shows a negative value, it is favorable because the standard revenue price per unit is less than the actual revenue price per unit. The negative amount occurs because of the way the problem is set up. Total Variance Quantity Variance + Price Variance = Total Variance $50,000 Unfavorable + $12,500 Favorable = $37,500 Unfavorable Total Variance or Total Actual Sales Revenue - Total Standard Sales Revenue = Total Variance $262,500 - $300,000 = -$37,500 Unfavorable

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Self-Study Problem 5-4 Material Expense Variances Matt’s Hats used 35,000 yards of material to produce Chicago Cub’s baseball hats with material cost of $1.75 per yard during the month of April for a total actual material cost of $61,250. The company had expected to use 34,000 yards of material at a material cost of $1.60 per yard during the month for a total standard material cost of $54,400. Required: Explain the variance between the actual material cost and the standard material cost.

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Self-Study Problem 5-4 Solution Material Expense Variances Quantity Variance Standard Price x (Standard Quantity - Actual Quantity) SP x (SQ - AQ) $1.60 x (34,000 yards - 35,000 yards) $1.60 x -1,000 yards = -$1,600 Unfavorable Quantity Variance The quantity variance is unfavorable because the standard quantity of material is less than the actual quantity of material. Price Variance Actual Quantity x (Standard Price - Actual Price) AQ x (SP - AP) 35,000 yards x ($1.60 - $1.75) 35,000 yards x -$0.15 = -$5,250 Unfavorable Price Variance The price variance is unfavorable because the standard material price per unit is less than the actual material price per unit. Total Variance Quantity Variance + Price Variance = Total Variance -$1,600 Unfavorable + -$5,250 Unfavorable = -$6,850 Unfavorable Total Variance or Total Standard Material Cost - Total Actual Material Cost = Total Variance $54,400 - $61,250 = -$6,850 Unfavorable

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Self-Study Problem 5-5 Labor Expense Variances Matt’s Hats used 4,000 hours of labor to produce Chicago Cub’s baseball hats with a labor rate of $8.50 per hour during the month of April for a total actual labor cost of $34,000. The company had expected to use 4,200 hours of labor with a labor rate of $9.00 per hour during the month for a total standard labor cost of $37,800. Required: Explain the variance between the actual labor cost and the standard labor cost.

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Self-Study Problem 5-5 Solution Labor Expense Variances Quantity Variance Standard Rate x (Standard Quantity - Actual Quantity) SR x (SQ - AQ) $9.00 x (4,200 hours - 4,000 hours) $9.00 x 200 hours = $1,800 Favorable Quantity Variance The quantity variance is favorable because the standard quantity of labor is greater than the actual quantity of labor. Rate Variance Actual Quantity x (Standard Rate - Actual Rate) AQ x (SR - AR) 4,000 hours x ($9.00 - $8.50) 4,000 hours x $0.50 = $2,000 Favorable Rate Variance The rate variance is favorable because the standard labor rate per hour is greater than the actual labor rate per hour. Total Variance Quantity Variance + Rate Variance = Total Variance $1,800 Favorable + $2,000 Favorable = $3,800 Favorable Total Variance or Total Standard Labor Cost - Total Actual Labor Cost = Total Variance $37,800 - $34,000 = $3,800 Favorable

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Self-Study Problem 5-6 Performance Report and Variance Analysis Matt’s Hats Company developed the following static budget based on a production and sales of 100,000 hats for the month of February. Matt’s Hats Company Static Budget February, 1996 100,000 Hats Account Total Sales Revenue $300,000 - Variable Material $ 80,000 - Variable Labor 115,000 195,000 = Contribution Margin $105,000 - Controllable Fixed 65,000 = Segment Margin $ 40,000 - Allocated Fixed 50,000 = Net Income ($10,000) The actual results for the month of February based on a production and sales of 95,000 hats is as follows: Matt’s Hats Company Actual Performance February, 1996 95,000 Hats Account Amount Total Sales Revenue $294,500 - Variable Material $ 90,250 192,850 - Variable Labor 102,600 = Contribution Margin $101,650 - Controllable Fixed 59,000 = Segment Margin $ 42,650 - Allocated Fixed 52,000 = Net Income ($ 9,350)

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Additional information There is a standard of .20 yards of material to produce one hat. The standard price of the material is $4.00 a yard. During February Matt’s Hats actually used 23,750 yards of material at a price of $3.80 per yard. There is a standard of .10 hour of labor to produce one hat. The standard price of labor is $11.50 per hour. During February Matt’s Hats actually used 8,550 hours of labor at a rate of $12.00 per hour. Required: Conduct a complete performance and variance evaluation and explain how even though Matt’s Hats Company produced and sold fewer hats during the month of February, they were able to reduce their loss by $650.

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Self-Study Problem 5-6 Solution Performance Report and Variance Analysis A performance report based on a flexible budget of 95,000 hats produced and sold during the month of February is shown below. Matt’s Hats Company Flexible Budget Performance Report February, 1996 95,000 Hats Account Sales Revenue - Variable Material - Variable Labor = Contribution Margin - Controllable Fixed = Segment Margin - Allocated Fixed = Net Income

Budget $285,000 76,000 109,250 $ 99,750 65,000 $ 34,750 50,000 ($15,250)

Actual $294,500 90,250 102,600 $101,650 59,000 $ 42,650 52,000 ($ 9,350)

Variance $ 9,500 (14,250) 6,650 $ 1,900 6,000 $ 7,900 (2,000) $ 5,900

Variance Analysis Revenue Variances Revenue Quantity Variance = (SP x SQ) - (SP x AQ) Since the flexible budget standard quantity of 95,000 hats is different than the static budget quantity of 100,000 hats, there is a revenue quantity variance. However, this variance will not be used to explain any of the $5,900 difference in net income from the performance report. Never the less, the computation of the revenue quantity variance will aid in answering the question regarding how the company’s net income increased by $650 over the static budget amount. See the discussion at the end of this Self-Study problem. Standard Price is $3 per hat based on a static budget of $300,000 sales revenue for 100,000 hats ($3/hat x 100,000 hats) - ($3/hat x 95,000 hats) = $15,000 U $300,000 - $285,000 = $15,000 U The $15,000 unfavorable variance reflects a production and sales level 5,000 units below the static budget at $3 per hat.

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Revenue Price Variance = (SP x AQ) - (AP x AQ) ($3/hat x 95,000 hats) - ($3.10/hat x 95,000) = $9,500 F $285,000 - $294,500 = -$9,500 F The total sales revenue of $294,500 divided by 95,000 hats equals $3.10 per hat as the actual price. Matt’s Hats sold at $3.10 each which was greater than the standard selling price of $3.00 giving a favorable price variance of $9,500 which is included in the performance report. ($3.00/hat - $3.10/hat)= -$.10/hat x 95,000 hats = -$9,500 Favorable variance. Variable Cost Variances Variable Material Quantity Variance = (SP x SQ) - (SP x AQ) ($4.00/yard x .20 yards/hat x 95,000 hats) - ($4.00/yard x 23,750 yards) = $76,000 - $95,000 = -$19,000 U Matt’s Hats used 25 percent more material, 23,750 yards versus 19,000 yards (.20 yards/hat x 95,000 hats = 19,000 yards) which resulted in the $19,000 unfavorable quantity variance. 19,000 yards - 23,750 yards = -4,750 yards x $4.00/yard = -$19,000 Unfavorable Variance. Variable Material Price Variance = (SP x AQ) - (AP x AQ) ($4.00/yard x 23,750 yards) - ($3.80/yard x 23,750 yards) = $95,000 - $90,250 = $4,750 F Matt’s Hats was able to purchase the material at $.20/yard less than the standard price which resulted in the $4,750 favorable price variance. ($4.00/yard - $3.80/yard) = $.20/yard x 23,750 yards = $4,750 Favorable variance. Total Variable Material Variance ($19,000 U) + $4,750 F = $14,250 U Excess quantities of material were used; however, the cost per yard of material used was less than the standard. The savings on the cost were not enough to offset the extra quantity used. Variable Labor Quantity Variance = (SP x SQ) - (SP x AQ) ($11.50/hour x .10 hours/hat x 95,000 hats) - ($11.50/hour x 8,550 hours) = $109,250 $98,325 = $10,925 F Matt’s Hats was expected to take 9,500 hours to complete the production of 95,000 hats, since it took them only 8,550 hours, there was a favorable variance of $10,925. (.10 hours/hat x 95,000 hats) = 9,500 hours - 8,550 hours = 950 hours x $11.50/hour = $10,925 Favorable variance. Variable Labor Price Variance = (SP x AQ) - (AP x AQ) ($11.50/hour x 8,550 hours) - ($12.00/hour x 8,550 hours) = $98,325 - $102,600 = -$4,275 U Matt’s Hats paid $12.00 per hour of labor versus the standard of $11.50 per hour resulting an a $4,275 unfavorable variance. ($11.50/hour - $12.00/hour) = -$.50/hour x 8,550 hours = -$4,275 Unfavorable variance. Total Variable Labor Variance $10,925 F + ($4,275 U) = $6,650 F The savings of 950 labor hours more than compensated for the extra $.50/hour of labor that was paid for the actual hours worked. Fixed Cost Variances 191

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Total Controllable Fixed Variance Total Budgeted Fixed - Total Actual Fixed $65,000 - $59,000 = $6,000 F Matt’s Hats incurred less actual fixed cost then the predetermined static or flexible budget amount giving a favorable $6,000 variance. Total Segment Margin Variance Revenue Price Variance + Total Variable Material Variance + Total Variable Overhead Variance + Total Controllable Fixed Variance $9,500 F + ($14,250 U) + $6,650 F + $6,000 F = $7,900 F The higher selling price plus the more efficient use of labor hours and the savings in controllable fixed cost made up for the extra material used in the production process. Total Allocated Fixed Variance Total Budgeted Allocated Fixed - Total Actual Allocated Fixed $50,000 - $52,000 = -$2,000 U Actual allocated fixed costs, which are out of control of the manager, were $2,000 higher than the budgeted allocated fixed cost. Total Net Income Variance Total Segment Margin Variance + Total Allocated Fixed Variance $7,900 F + ($2,000 U) = $5,900 F Reconciliation of Total Net Income Variance to Static Budget Even though the level of sales volume was less (95,000 hats vs 100,000 hats), the net income was reduced by $650 to $9,350 in comparison to the projected loss from the static budget of $10,000. The flexible budget variances used to arrive at a $5,900 favorable variance on the performance report can be summarized as follows. When volume declined from 100,000 hats to 95,000 hats there was an unfavorable revenue quantity variance of $15,000 (computed above). There was also a savings for variable material cost of $4.00/yard x .20 yards/hat x 5,000 hats = $4,000 F and a savings for variable labor cost of $11.50/hour x .10hour/hat x 5,000 hats = $5,750 F due to the lower production levels. The contribution margin variance resulting from the decline in sales of 5,000 units from the static budget level equals sales revenue - (variable material cost + variable labor cost) or ($15,000 U) + $4,000 F + $5,750 F = $5,250 U. The unfavorable variance from the static budget versus the flexible budget is $5,250 (-$10,000 less -$15,250 = -$5,250). The favorable variance for the performance report is $5,900 (-$15,250 less -$9,350 = $5,900). When the unfavorable static budget variance of $5,250 is subtracted from the $5,900 favorable flexible budget variance the result is $650 F which fully explains the difference between the static budget net income and the actual net income. As a manager, the more important variances to analyze are those items that make up the segment margin variance, which is $7,900 favorable. See the discussion for each of variances related to the segment margin above.

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Problems Problem 5-1 Flexible Budget Format Present the following information in a flexible budget format for Matt’s Hats for the year of 1997. The dollar amounts are associated with a static level of sales volume of 250,000 hats. ACCOUNT Sales Controllable Variable Manufacturing Cost Controllable Fixed Direct Manufacturing Cost Noncontrollable Fixed Indirect Manufacturing Cost Controllable Variable Selling & Administrative Cost Controllable Fixed Direct Selling & Administrative Cost Noncontrollable Fixed Indirect Selling & Administrative Cost

DOLLAR AMOUNT $2,500,000 800,000 500,000 200,000 250,000 400,000 100,000

Problem 5-2 Flexible Budgeting Using the data in problem 5-1, construct a flexible budget based on a sales volume of 240,000 hats. Problem 5-3 Flexible budgeting Using the data in problem 5-1, construct a flexible budget based on a sales volume of 200,000 hats. This level of sales activity is outside of the relevant range and fixed direct manufacturing cost will be $450,000 and fixed direct selling and administrative cost will be $340,000.

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Problem 5-4 Performance Report Using the budget figures from problem 5-1 and the following actual amounts based on a sales volume of 250,000 hats, construct a performance report for Matt’s Hats for 1997. ACCOUNT Sales Controllable Variable Manufacturing Cost Controllable Fixed Direct Manufacturing Cost Noncontrollable Fixed Indirect Manufacturing Cost Controllable Variable Selling & Administrative Cost Controllable Fixed Direct Selling & Administrative Cost Noncontrollable Fixed Indirect Selling & Administrative Cost

DOLLAR AMOUNT $2,450,000 750,000 510,000 250,000 250,000 370,000 140,000

Problem 5-5 Performance Report Assume the actual amounts reported in problem 5-4 represented a sales volume of 260,000 hats. Reconstruct a flexible budget from the problem 1 data at a 260,000 level of activity and develop a performance report using the problem 5-4 actual amounts. Use the following information to answer problems 5-6 through 5-9. Matt’s Hats Annual Budget 50,000 Units = Static Activity Level For the Year Ending December 31, 1996 Account Static Budget Actual Amount Sales Revenue $250,000 $260,000 - Controllable Variable Cost 100,000 120,000 = Contribution Margin 150,000 140,000 - Controllable Fixed Cost 80,000 65,000 = Segment Margin 70,000 75,000 - Noncontrollable and Allocated Fixed Cost 50,000 60,000 = Net Income $ 20,000 $ 15,000

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Problem 5-6 Performance Report Assume that the actual sales volume was 50,000 hats. Complete a performance report based on the information given in the annual budget. Explain the significance of the amounts in the variance category. Problem 5-7 Performance Report Assume that the actual sales volume was 60,000 hats. Complete a performance report based on the information given in the annual budget. Explain the significance of the amounts in the variance category. Problem 5-8 Performance Report Assume that the actual sales volume was 45,000 hats. Complete a performance report based on the information given in the annual budget. Explain the significance of the amounts in the variance category. Problem 5-9 Performance Report Assume that the actual sales volume was 70,000 hats. Assume also that at this level of activity the budgeted controllable fixed cost increases to $90,000 and the allocated fixed cost increases to $60,000. Complete a performance report based on the information given in the annual budget. Explain the significance of the amounts in the variance category. Problem 5-10 Revenue Variances MRR Corp established the following standards for the sale of its product: Sales Volume 100,000 units Selling Price Per Unit $12.00 The actual results for the year were 120,000 units sold at a selling price of $11.75 per unit. Required: Compute the revenue variances. Problem 5-11 Revenue Variances MSAR Company had a total sales revenue of $61,875 for the month with sales of 8,250 units. The company had expected to sell 9,000 units at $8.00 each. Required: Compute the revenue variances.

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Problem 5-12 Revenue Variances Matt’s Slack Company had a total actual sales revenue this month of $40,250 on sales of 3,500 slacks. The expected level of sales were 3,200 slacks for a total sales revenue of $35,200. Required: Compute the revenue variances. Problem 5-13 Material Variances MRR Corp established the following standards for the use of material in the production of 10,000 units of product: Pounds of Material 40,000 pounds Pounds Needed to Make a Unit 4 pounds per unit Cost Per Pound $3.00 per pound The MRR Corp actually used 43,000 pounds of material to produce 11,000 units at an actual cost of $3.10 per pound. Required: Compute the material variances. Problem 5-14 Material Variances MSAR Company had a total material cost of $34,830 for the month with use of 6,450 pounds of material. The company had expected to use 6,500 pounds at $5.50 per pound. Required: Compute the material variances. Problem 5-15 Material Variances Matt’s Slack Company had a total actual material cost this month of $9,000 on the use of 4,000 yards of fabric. The expected level of material use was 3,800 yards for a total material cost of $9,500. Required: Compute the material variances.

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Problem 5-16 Material Variances Matt’s Manufacturing Inc. has a standard use of 8 feet of material to produce a finished end table. The standard cost is $2.00 per foot for the material. Each month the company expects to produce 250 end tables. During the month of February, 230 tables were produced using 1,955 feet of material at a total cost of $4,301. Required: Compute the material variances. Problem 5-17 Labor Variances MRR Corp established the following standards for the use of labor in the production of 10,000 units of product: Hours of Labor 5,000 hours Hours Needed to Make a Unit 0.5 hours per unit Cost Per Hour $12.00 per hour The MRR Corp actually took 5,600 hours to produce 11,000 units at an actual cost of $11.80 per hour. Required: Compute the labor variances. Problem 5-18 Labor Variances MSAR Company had a total labor cost of $60,200 for the month with use of 7,000 hours of labor. The company had expected to use 7,100 hours at the rate of $9.00 per hour. Required: Compute the labor variances. Problem 5-19 Labor Variances Matt’s Slack Company had a total actual labor cost this month of $36,250 on the use of 5,800 hours of labor. The expected level of labor use was 5,500 hours for a total labor cost of $33,000. Required: Compute the labor variances.

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Problem 5-20 Labor Variances Matt’s Manufacturing Inc. has a standard rate of 2 hours to produce a finished end table. The standard rate is $7.00 per hour for the labor. Each month the company expects to produce 250 end tables. During the month of February, 230 tables were produced using 450 hours at a total cost of $3,240. Required: Compute the labor variances. Problem 5-21 Performance Report and Variance Analysis Matt’s Manufacturing Company developed the following static budget based on a production and sales volume of 50,000 units for 1995. Account Budget Amount Sales Revenue $1,000,000 Controllable Variable Material Cost 250,000 Controllable Variable Labor Cost 300,000 Contribution Margin 450,000 Controllable Fixed Cost 170,000 Segment Margin 280,000 Allocated Fixed Cost 200,000 Net Income $ 80,000 The actual results for the year based on a level of production and sales of 52,000 units are as follows: Account Actual Amount Sales Revenue $1,014,000 Controllable Variable Material Cost 265,000 Controllable Variable Labor Cost 306,000 Contribution Margin 443,000 Controllable Fixed Cost 165,000 Segment Margin 278,000 Allocated Fixed Cost 215,000 Net Income $ 63,000

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Additional Information: The actual selling price was $19.50 per unit versus a standard selling price of $20.00. It takes 2 pounds of material to make a unit at a standard price of $2.50 per pound. 125,000 pounds of material were actually purchased at a price of $2.12 per pound. It takes 15 minutes to make a unit at a standard labor rate of $24.00 per hour. The employees actually worked 12,000 hours and were paid $25.50 per hour. Required a. Develop a performance report based on a level of production and sales of 52,000 units. b. Do a complete analysis of the variance between the flexible budget amounts and the actual results.

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Cases Case Study 5-1 Outreach Mission Outreach Mission is a nonprofit charitable organization established to provide support and training to disadvantaged intercity youth. The organization is supported through the contributions from local businesses, churches, and individuals. They are also part of the United Way fund raising campaign. The city provides some services and support, and the organization is exempt from any city and state taxes. At the start of 1996, the executive director prepared and presented a budget to the board of directors that was exactly the same as the 1995 actual revenue and expense amounts. There was not much time at the end of 1995 to develop a 1996 budget; however, the director believed that there would be minimal changes between the two years and that 1995 was an accurate reflection of 1996. The organization continued to provide needed support to the community during 1996 and was recognized as one of most effective nongovernmental charitable operations in the city. Because of this success, there never seemed to be a lack of need to provide services. Additionally, fund raising was very competitive as more and more organizations were seeking the donors dollar. The board wanted to know how Outreach Mission performed during the 1996 calendar year. To aid in presentation, the executive director presented a 1996 statement of activities and also had available the previous years statement of activities which served as the budget. Required A. Prepare a performance report for Outreach Mission for 1996. Include both absolute dollar and percent variances as appropriate. B. Develop a summary narrative highlighting all aspects of the Outreach Mission activities during 1996. C. Comment on the advantages and disadvantages of using the 1995 actual performance as a budget for 1996. D. What other possible measures or information could be useful in a performance report presentation? E. Suggest a possible way to develop standards or a budget for 1997.

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Outreach Mission Statement of Activities Revenue and Expense Activities Support and Revenue Business and Individual Contributions Gifts-in-Kind Land and Buildings Contributed Skilled Services Investment Income Other Total Support and Revenue Expenses Program Services Mission and Outreach Services Rehab Farm Dental and Medical Literacy and Education Center Food, Clothing and other Gift-in-kind Public Awareness and Education Total Program Service Expenses Supporting Activities General and Administrative Fund Raising Total Support Expenses Total Expenses Change in Net Assets Net Assets, Beginning of Year Net Assets, End of year

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1996 Actual

1995 Actual

$2,626,400 1,335,100 0 37,600 11,900 12,800 $4,023,800

$2,192,000 1,503,200 814,000 84,100 14,800 5,200 $4,613,300

695,900 292,800 278,300 88,100 1,528,000 231,500 $3,114,600

539,800 216,400 178,700 78,100 1,461,400 138,600 $2,613,000

343,700 758,300 $1,102,000 $4,216,600 ($192,800) $1,099,900 $907,100

402,200 594,600 $996,800 $3,609,800 $1,003,500 96,400 $1,099,900

Chapter Five: Performance Evaluation

Case 5-2 Atkinson Lumber Company Atkinson Lumber of Pineland, South Carolina cuts various sizes of pine lumber for sale to building contractors and hardware outlet stores in the southeastern United States. The lumber company owns a 10,000 acre tree farm adjacent to its lumber mill from which they get much of their raw material. Additionally, the lumber company has arrangements with several tree farms around the state to gather pine trees. By having access to their own trees as well as favorable purchasing agreements with other local tree growers, Atkinson Lumber can cut finished lumber at very competitive prices. The most popular sized lumber cut is the 8 foot 2 x 4 inch stud. This board is the basic construction piece for commercial and residential buildings. The pine trees grown in South Carolina are particularly well suited for these types of boards. The trees typically grow to about 40 to 45 feet and are very straight. Ideally, sixty 2 x 4 boards can be cut from each tree with a minimum of waste. The mill has a special processing line for the cutting of these boards. The lumber foreman specifically identifies trees that are fairly straight, between 41 and 43 feet long, and have a base trunk diameter of 14 to 18 inches. The tree is first cut into eight foot logs starting from a clean base cut. The saw is set at the standard eight foot length to speed the cutting process. Next, the logs are squared by using a band saw. A pallet grips the log on both ends, moves the log through the cutting process and rotates the log until all four sides are square. What remains is a 12 x 12 inch block or similar comparable dimensions for logs closer to the top of the tree which can easily be cut into the final 2 x 4 inch sizes. The final cuts of the block are completed in a batch-processing mode. First the four inch cuts are made and then the two inch cuts complete the board. Again a band saw is used to make these cuts. The lumber mill process is somewhat machine oriented; however, skilled labor is needed for the cutting operations. Also, for safety purposes, at least two employees are needed at each saw. The more skilled employee runs the saw while the assistant makes sure that the log is set up properly and is available to help with any operation. Tom Atkinson, manager of operations, had recently developed a standard cost system for the lumber operation. Since 2 x 4s were the most common product, he first established standards for this cutting operation. He determined that a normal pine tree would yield sixty 2 x 4s of an eight foot length. The cost of each tree was about $48. Next he determined that it would take 10 minutes to cut the tree into eight foot logs. It would take another 20 minutes to cut the logs into blocks, and finally about 30 minutes to cut the blocks into 2 x 4 boards. Two employees would be involved in the cutting operation for the hour. The more skilled employee would receive $20 per hour in wages and benefits, and the assistant would receive $13 per hour. The month of March was very productive for the lumber mill. With the onset of spring, demand for construction materials was up and the mill was able to produce 12,000 2 x 4s in 26 workdays. The total material and labor costs to produce these 12,000 boards was $16,834 which could be broken down into $9,450 for the trees and $7,384 for the labor. The standard cost system allowed Tom to make a quick comparison between the actual costs, and the predetermined standard costs. Based upon his estimates, the standard cost for a 2 x 4 should be $1.35 and since 12,000 boards were produced, the total cost should have been only $16,200. There was an unfavorable variance of $634. 202

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After doing some further investigation, Tom learned that 210 trees were used in the production process. The average cost of these trees was just $45 each, but some of the trees were a little short and/or not perfectly straight. He also knew that in addition to working the normal eight hour days, the two employees also worked eight hour shifts on four Saturdays and earned time and a half pay. The Saturday work was necessary because of the expected demand. Required A. Compute the material quantity and price variance for the production of 2 x 4s for the month of March. B. Compute the labor quantity and price variance for the production of 2 x 4s for the month of March. C. Comment on the possible reasons why the material and labor variances in the production process occurred. Could any of the variances have been prevented? D. Comment on the development of the standards. What are some of the advantages and disadvantages of standards for this type of a production process?

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