Accounting and Its Relationship to Engineering Economy

Accounting and Its Relationship to Engineering Economy

ENGECOA – T42, 1st Term, SY ’09-’10

• Accounting is often referred to as the language of business

• Engineers need to learn about a firm’s accounting practice so that they can communicate better with management

Accounting Fundamentals (1/4)

• All accounting is based on the fundamental accounting equation:

Assets = Liabilities + Owners’ Equity• Assets are those things of monetary value that the firm

possesses• Liabilities are those things of monetary value that the

firm owes to its creditors• Owners’ equity is the worth of what the firm owes to its

stockholders


• This basic accounting equation defines the format of the balance sheet


• Another important accounting relationship is:

Revenues – Expenses = Profit (or Loss)

• The relationship above defines the format of the income statement

• Given the relationship above, the basic accounting equation can be expanded to:

Assets = Liabilities + (Beginning Owner’s Equity + Revenue – Expenses)


• Profit is the increase in money value resulting from a firm’s operations

• Profit (or part of it) can either be:• Distributed to the stockholders in the form

of dividends• Retained by the firm to have more

spending money for its operations; this is known as retained earnings

Accounting: The Basis of Decision Making (1/4)

• Most business entities and individuals keep accounting records to aid in making decisions

• Accounting…• …is the information system that measures

business activities…• …processes that information into reports…• …and communicates the results to

decision makers


• Accounting information is used in many ways:

• Individual people use accounting information (among other things) to manage bank accounts, evaluate job opportunities, make investments, or decide whether to rent or buy a house


• Business managers use accounting information to set goals for their organizations

• Investors and creditors provide the money a business may need to begin operations; before granting a loan, banks determine whether the borrower has the ability to meet scheduled payments


• An important output of an accounting information system is a series of financial statements that allow individuals and businesses make informed and intelligent decisions

Net Worth: How Well Are You Doing?

• Two important statements in monitoring financial progress:• Cash flow statement - how much you

earned and spent during a specific time period

• Net worth statement – tells what assets you have and where it stands with respect to its financial goals• Net worth is what you would be left over with

you if you sold everything and paid off all your debts

Assets: What You Own (1/2)

• Cash reserve assets• Cash• Cash equivalents: money in checking,

savings, money market accounts, certificate of deposits (CDs), treasury bills, cash value of your life insurance policy

• Investment assets• Stocks• Bonds• Mutual funds

Assets: What You Own (2/2)

• Real Estate

• Business interests• Partnership interests• Shares in closely held corporations

Liabilities: What You Owe

• Unsecured loans or short-term debts – current bills:• Credit card purchases• Installment and personal loans• Income and real estate taxes• Insurance premiums

• Secured loans or long-term debts• Mortgages or other loans that you repay in

installments over several years

The Worth of Net Worth Statements

• Banks require a statement of assets and liabilities as part of the application in securing a loan

• Certain high-risk investments require that an individual meets a certain net worth

Financial Status for Businesses (1/3)

• The annual report is the most important report corporations issue to stockholders• Contains basic financial statements• Shows management’s opinions of the past

year’s operations and the firm’s future prospects


• Four basic questions that managers or investors are likely to ask:• What is the company’s financial position at

the end of the fiscal period?• How well did the company operate during

the fiscal period?• Where did the company decide to use their

profits for?• How much cash did the company generate

and spend during the period?

How much profit did the company make during the fiscal period?

Where did the company decide to use their profit for?

How much did the company generate and spend during the period?

What is the company’s financial position at the end of the fiscal period?

INCOME STATEMENT

STATEMENT OF RETAINED EARNINGS

STATEMENT OF CASH FLOWS

BALANCE SHEET


The Balance Sheet (1/2)

• Sometimes called the statement of financial position

• Reports three main categories of items:• Assets• Liabilities• Stockholders’ equity

The Balance Sheet (2/2)

• The accounting equation is the most basic tool of accounting• It shows the relationship among assets,

liabilities, and owners’ equity

Assets = Liabilities + Owners’ Equity

Assets (1/4)

• Asset items are listed in order of their liquidity• Liquidity is the length of time it takes to

convert them to cash

CURRENT ASSETS

FIXED ASSETS

OTHER ASSETS

most liquid least liquid

Assets (2/4)

• Current assets can be converted to cash or its equivalent in less than one year• Three types:

• Cash• Accounts receivable (A/R)• Inventories (raw materials, work-in-process,

finished goods)

Assets (3/4)

• Fixed assets are relatively permanent and take time to be converted to cash• Examples: land, buildings, factory

machinery, office equipment, and automobiles

• Most fixed assets have a limited useful life• As time passes, the value of such fixed

assets become expenses, which are known as depreciation expenses

Assets (4/4)

• Other assets include investments made in other companies and intangible assets (e.g. goodwill, copyrights, patents)

Liabilities and Stockholders’ Equity (1/6)

• Liabilities mean the money the company owes• The money borrowed by the firm is used to

acquire and build its assets

• Stockholders’ equity is the portion of the assets of a company which are provided by the investors (owners)


• Current liabilities are debts that must be paid within one year• Accounts payable• Notes payable• Accrued expenses (wages, salaries,

interest, rent, taxes owed)• Advance payments and deposits from

customers


• Other liabilities include long-term liabilities payable more than one year in the future; these include:• Bonds• Mortgages• Long-term notes


• Stockholders’ equity represents the amount that is available to the owners after all debts have been paid; generally consists of:• Preferred stock• Common stock• Treasury stock• Capital surplus (paid-in capital)• Retained earnings


• Preferred stock ranks below debt but above common stock

• Preferred stock dividends are fixed• Common stock is the aggregate par

value of the company’s stock issued• Capital surplus is the amount of money

received from the sale of stock more than the par value of the stock• Outstanding stock is the number of shares

issued that actually is held by the public• If a corporation buys back part of its own

issued stock, it is listed as a Treasury Stock


• Retained earnings represent the cumulative net income of the firm since its incorporation, less the total dividends that have been paid to the stockholders

The Income Statement (1/3)

• The Income Statement indicates whether the company is making or losing money during a stated period

• A company’s accounting period refers to the period covered by an income statement


• Revenue is the price of goods sold and services rendered during a given accounting period

• The net sales or net revenues figure represents the gross sales less any sales return and allowances

• The cost of revenue or the cost of goods sold is the cost of producing the product


• Net revenues less the cost of goods sold give us the gross margin or gross income

• All operating expenses are subtracted from the gross income to obtain the operating income or net income before tax (NIBT)

• Net income, which is also known as net income after tax (NIAT) or accounting tax is finally determined by subtracting the income taxes from the operating income

Earnings Per Share

• Earnings per share (EPS) is obtained by dividing the “available earnings to common stockholders” by the number of shares of common stock outstanding

• Two types:• Basic• Diluted

Retained Earnings vs Dividends

• When a corporation makes a profit, it can either:

1. Distribute the profit to its stockholders (dividends)

2. Keep the remaining profits in the business (retained earnings)

The Cash Flow Statement (1/3)

• The cash flow statement gives us a detailed look on how the firm generated cash and how it used cash during the reporting period

• Managers want to maximize cash flows available to investors over the long run


• Operating activities • Operating cash flows represent those cash

flows related to the production and sales of goods or services

• All non-cash expenses (such as depreciation and change in working capital) are added back to net income (after tax)


• Investing activities• Include purchasing of new fixed assets,

reselling old equipment, or buying and selling financial assets

• Financing activities• Any activity related to raising capital to be

used in business• e.g. borrow from banks, sell more stocks or

bonds, pay off existing debts

Accounting Entries (1/3)

• Suppose that an individual decides to undertake an investment opportunity and the following sequence of events occurs over a period of one year:

1. Organize XYZ firm and invest PhP300,000 cash as capital

2. Purchase equipment for a total cost of PhP200,000 by paying cash


3. Borrow PhP150,000 through a note to the bank

4. Manufacture a year’s supply of inventory through the following:

a. Pay PhP120,000 cash for laborb. Incur PhP40,000 accounts payable for

materialc. Recognize the partial loss in value

(depreciation) of the equipment amounting to PhP5,000


5. Sell on credit all goods produced for year: 1,000 units at PhP200 each. Recognize that the accounting cost of these goods is Php110,000.

6. Collect PhP120,000 of accounts receivable.

7. Pay PhP30,000 of accounts payable and PhP100,000 of bank note.

Cost Accounting (1/2)

• Cost accounting (or management accounting) is a phase of accounting that is of particular importance in engineering economic analysis because it is concerned with decision making and control in a firm

• Cost accounting is the source of the cost data needed in making engineering economy studies

Cost Accounting (2/2)

• Modern cost accounting may satisfy any or all of the following objectives:

1. Determination of the actual cost of products or services

2. Provision of a rational basis for pricing goods or services

3. Provision of a means for allocating and controlling expenditures

4. Provision of information on which operating decisions may be based

The Elements of Cost (1/3)

• One of the first problems of cost accounting is that of determining the elements of cost that arise in the production of an item or the rendering of a service

• The general elements of cost are:1. Direct materials2. Direct labor3. Overhead (a.k.a. burden, indirect costs)


• Direct materials• Materials that can be conveniently and

economically charged directly to the cost of the product

• Should be readily measurable• Should be of the same quantity in identical

products• Should be used in economically significant

amounts

• Materials that do not meet the criteria above are classified as indirect materials


• Labor costs are also divided into direct and indirect categories• Direct labor cots are those that can be

conveniently and easily charged to the product or service in question

• Total overhead costs are customarily associated with a certain level of production

• One method of allocation of overhead costs assumes that overhead is incurred in direct proportion to the cost of direct labor used

periodfor pesosin labor direct

periodfor pesosin overhead total Rate Overhead

• Thus, to compute for the overhead cost per unit:

unitper cost labor direct x rate overhead cost/unit Overhead

• This method is simple and easy to apply and in many cases gives quite satisfactory results

Cost Accounting Example (1/5)

Direct Materials

Direct Labor

Factory Overhead

Jobs (work in progress)

Finished Goods Inventory

Cost of Goods Sold

Cost of Goods Sold

Cost of Goods Sold

Cost of Goods Sold


• Consider how an order for 100 tennis rackets accumulates costs at a sporting goods company:


• Direct labor and material expenses in the example are as follows:

• The cost above is NOT the total cost because we still need to take into consideration the factory costs that cannot be directly identified to the job


• To allocate the overhead costs to the 100 rackets using the overhead rate, the equation discussed earlier will be used:

hourlabor direct per $3

hours 200,000

000,600$ Rate Overhead

• This means that $600 of the total annual overhead cost would be allocated


• The total cost of Job # 161 would be:

Documents

Accounting and Its Relationship to Engineering Economy