Tim Redmer Accounting

Chapter One: Accounting and Finance: An Introduction

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An Introduction to Accounting and Finance: Text andCases

byTimothy A. O. Redmer

Copyright Ó 1999


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Table of Contents

Chapter One: Accounting and Finance: An Introduction ....................... 1Chapter Objectives ............................................................................... 1The Objective and Scope of this Text Book ........................................... 1Chapter Content ................................................................................... 2Accounting Defined .............................................................................. 4Finance Defined.................................................................................... 6The Role of Ethics in Accounting and Finance ....................................... 7Summary ............................................................................................ 10Chapter Questions.............................................................................. 12Cases ................................................................................................. 13

Chapter Two: The Income Statement and the Balance Sheet .............. 17Objectives .......................................................................................... 17Account Categories ............................................................................ 17Accrual Accounting............................................................................. 26The Accounting Process...................................................................... 27Income Statement............................................................................... 33Statement of Retained Earnings .......................................................... 35Balance Sheet ..................................................................................... 36Summary ............................................................................................ 39Study Problems................................................................................... 40Problems ............................................................................................ 59Cases ................................................................................................. 66

Chapter Three: Financial Statement Analysis....................................... 73Objectives .......................................................................................... 73The Role and Purpose of Financial Statement Analysis ........................ 73Benefits of Financial Statement Analysis ............................................. 74Limitations of Financial Statement Analysis......................................... 74Liquidity Ratios................................................................................... 77Activity Ratios..................................................................................... 78Debt Ratios......................................................................................... 86Profitability Ratios .............................................................................. 91Market Ratios ..................................................................................... 97Horizontal and Vertical Analysis ....................................................... 102Summary .......................................................................................... 104Problems .......................................................................................... 106Cases ............................................................................................... 114

Chapter Four: Budgets and the Budget Process ................................. 121Chapter Objectives ........................................................................... 121The Nature and Purpose of the Budget.............................................. 121The Budget Process .......................................................................... 122Benefits of a Budget Process ............................................................. 123Disadvantages of a Budget Process................................................... 124Types of Budgets .............................................................................. 124Summary .......................................................................................... 139Self-Study Problems ......................................................................... 140


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Problems .......................................................................................... 153Cases ............................................................................................... 162

Chapter Five: Performance Evaluation ............................................... 169Objectives ........................................................................................ 169Standard Accounting Systems........................................................... 169Performance Reports ........................................................................ 172Variance Analysis.............................................................................. 177Summary .......................................................................................... 183Self-Study Problems ......................................................................... 184Problems .......................................................................................... 200Cases ............................................................................................... 207

Chapter Six: Differential Analysis....................................................... 211Objectives ........................................................................................ 211Differential Analysis.......................................................................... 211Contribution Margin Analysis............................................................ 213Short-Term Decision-making Techniques ........................................ 216Summary .......................................................................................... 224Self-Study Problems ......................................................................... 226Problems .......................................................................................... 236Cases ............................................................................................... 251

Chapter Seven: Current Asset Management: Cash and MarketableSecurities............................................................................................ 257

Objectives ........................................................................................ 257Cash and Marketable Securities ........................................................ 257The Cash Flow Process ..................................................................... 261Management of Cash Flows .............................................................. 265Bank Reconciliation .......................................................................... 266Summary .......................................................................................... 270Self-Study Problems ......................................................................... 271Problems .......................................................................................... 284Cases ............................................................................................... 290

Chapter Eight: Statement of Cash Flows ............................................ 297Objectives ........................................................................................ 297The Cash Flow Statement.................................................................. 297Preparing a Statement of Cash Flows ................................................ 298Summary .......................................................................................... 307Self-Study Problems ......................................................................... 308Problems .......................................................................................... 323Cases ............................................................................................... 330

Chapter Nine: Current Asset Management: Accounts Receivable andInventory............................................................................................ 339

Chapter Objectives ........................................................................... 339Accounts Receivable Management .................................................... 339Accounts Receivable Ratios............................................................... 343Marginal Analysis of Accounts Receivable ......................................... 344Inventory Management ..................................................................... 345


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Inventory Ratios................................................................................ 349Summary .......................................................................................... 350Self-Study Problems ......................................................................... 351Problems .......................................................................................... 360Cases ............................................................................................... 369

Chapter Ten: Current Liability Management ...................................... 373Chapter Objectives ........................................................................... 373Current Liability Management ........................................................... 373Types of Current Liabilities ............................................................... 373Cost of Credit ................................................................................... 379Summary .......................................................................................... 384Self-Study Problems ......................................................................... 385Problems .......................................................................................... 394Cases ............................................................................................... 398

Chapter Eleven: The Time Value of Money ......................................... 401Objectives ........................................................................................ 401Time Value of Money ........................................................................ 401Time Value of Money Models ............................................................ 404Procedures Used in Computing Time Value of Money Models ........... 407Bond Valuation Time Value of Money Model ..................................... 409Summary .......................................................................................... 413Self-Study Problems ......................................................................... 414Problems .......................................................................................... 438Cases ............................................................................................... 441

Chapter Twelve: Risk and Return ....................................................... 445Objectives ........................................................................................ 445Risk .................................................................................................. 445Return .............................................................................................. 447Diversification .................................................................................. 449Summary .......................................................................................... 453Self-Study Problems ......................................................................... 454Problems .......................................................................................... 462Cases ............................................................................................... 467

Chapter Thirteen: Security Valuation and the Cost of Capital ............ 471Objectives ........................................................................................ 471Valuation of Securities ...................................................................... 471Security Valuation Models................................................................. 473Cost of Capital.................................................................................. 480Summary .......................................................................................... 484Self-Study Problems ......................................................................... 485Problems .......................................................................................... 502Cases ............................................................................................... 508

Chapter Fourteen: Capital Budgeting ................................................. 513Objectives ........................................................................................ 513The Role of Capital Budgeting........................................................... 513Cash Flows and Capital Investments ................................................. 514


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Capital Budgeting Methods of Analysis ............................................. 518Summary .......................................................................................... 526Self-Study Problems ......................................................................... 527Problems .......................................................................................... 535Cases ............................................................................................... 547

Chapter Fifteen: Long-Term Debt....................................................... 553Objectives ........................................................................................ 553Long-Term Debt............................................................................... 553Leases .............................................................................................. 561Financial and Operating Leverage ..................................................... 563Summary .......................................................................................... 566Self-Study Problems ......................................................................... 567Problems .......................................................................................... 575Cases ............................................................................................... 586

Chapter Sixteen: Equity Funding........................................................ 589Objectives ........................................................................................ 589Equity Funding ................................................................................. 589Dividend Policy ................................................................................. 593Earnings Per Share and Other Equity Related Measures ..................... 595Summary .......................................................................................... 598Self-Study Problems ......................................................................... 599Problems .......................................................................................... 604Cases ............................................................................................... 609


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Chapter Objectives1. Review the overall objective and scope of this textbook.2. Define accounting and understand its role in the business world.3. Define finance and understand its role in the business world.4. Examine the role of ethics as it relates to accounting and finance.

The Objective and Scope of this Text BookIndividuals in virtually every profession today come into contact with business principlesand concepts. Unfortunately, many people neither have the time nor opportunity to learnbasic business concepts and especially accounting and finance topics. In the educationprocess, there appears to be little middle ground, students either get no exposure to thesetopics or they have to take an entire course which gets into details beyond theirfundamental needs.An Introduction to Accounting and Finance: Text and Cases is designed to introducecritical topics in the areas of accounting and finance in a basic context. This material isrelevant for the general business manager as well as those who do not have a businessbackground but wish to gain a foundational level of understanding and expertise. Thetopics are presented from a conceptual point of view to give the manager a fundamentalunderstanding of the material. Additionally, an underlying emphasis of each topicpresentation will be; what does the individual need to know to ask the correct questionsor 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 orfinance. However, at the same time, it is expected that anyone completing this text willbe able to understand and work through basic examples and illustrations of accountingand finance problems. Exercises of this nature will help to reinforce the importantconcepts and principles presented in the text.A manager, who does not have a strong background in accounting or finance, must relyon having good people in those positions. Individuals who tend toward the accountingand finance career fields are often classified as the "numbers people" or "those withquantitative skills". Such a stereotyping can present a dilemma for the nonfinancialindividual. The very reason an individual manager may be classified as nonfinancial isbecause of an aversion to a quantitative or numbers orientation.A successful business manager, in many cases, must rely on the support of capable peoplein critical positions within the organization. The manager will need to make decisionsbased 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 financialaspects of the business, is a possible misunderstanding of the presentation of suchinformation.Misinterpretation of information can sometimes be worse than no information in adecision process, especially when it leads to incorrect courses of action. With no


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information, business managers will likely resist change; however, with incorrectinformation, or the misinterpretation of information, the business manager could selectcourses 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 areasof accounting and finance, so they can compete effectively in the business world, is theunderlying reason and objective for a text of this nature. A manager, while often being aspecialist, with abundant skills and abilities in a particular area, also needs to be ageneralist, with a fundamental knowledge level in all areas of business. To be effective inthe decision-making process, the manager is going to have to have a basic understandingin all areas of business management, including both quantitative and qualitative skills.The business or nonbusiness individual, without the expertise in specific areas, is going tohave to know how to converse with the experts in those areas, and know how to analyzeand interpret information for decision-making purposes.Some may say that a particular individual has just enough information to be dangerous, orindividuals with a little knowledge in a particular area suddenly become experts. In suchcases, the presentation of accounting and finance information in a basic format, as anobjective 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 thata little information is better than no information.Basically, knowledge is good for the soul, and one should never stop learning. It is notthe accumulation of knowledge that is the problem, it is what an individual does with theknowledge 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 accountingskills, to be exposed to a broad and basic overview of these topics, should far outweighthe potential hazards of possible misuse or misunderstanding of the knowledge in thebusiness setting.This text is designed to appeal to the nurse who has to evaluate performance measures, aswell as the teacher who needs to prepare a budget for yearly classroom activities. Itshould also appeal to the preacher who has to develop a capital campaign for a newchurch building program or the dentist who has to monitor cash flow. An individual doesnot 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 relateddecision situations, the concepts learned in this book can make it easier to understandthose processes.

Chapter ContentSpecific topic areas addressed in this text will begin with the accounting process and thedevelopment of financial statements. A basic understanding of financial statements toinclude the income statement, balance sheet, and statement of retained earnings is criticalin many decision-making situations. Following the presentation of the financialstatements is Chapter 3 covering the analysis of financial statements. Accounting reportshave limited usefulness unless they can be properly analyzed. The information obtainedfrom financial statements serves as the basis for the development of financial ratios thatcan be used in the review of a company.


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Budgeting, presented in Chapter 4, is an essential component related to both the planningand control functions of management. The budget by its very nature is a plan, and servesas a guideline for future management courses of action. The budget can also serve as acontrol tool by providing a standard against which performance can be measured.Performance reporting is a natural follow up to the budgeting and financial reportingprocess. Areas of responsibility at various levels of management need to have a systemof accountability and control. Reports need to be properly developed and proceduresestablished to analyze variations between predetermined standards and actual results.Accounting information plays an important role in future decisions. The concept ofrelevant or differential cost, presented in Chapter 6, underlies decisions usingcontribution 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 ofcash management. The role and use of cash in a business impacts many areas ofmanagement, but it is especially important in the operating function. Following thechapter on cash management, Chapter 8 will present a detailed discussion on thestatement of cash flows. The introduction of this financial statement was delayed untilafter the cash management chapter to give the reader a greater appreciation of the role ofcash in a company.Working capital management specifically addresses cash management but also considersimportant areas such as accounts receivable, inventory and short-term debt management.Chapters 9 and 10 give a comprehensive overview of the importance of managingworking capital. Company management can quickly lose liquidity if they allow accountsreceivable and inventory to build to excessive levels. Additionally, the effective rate ofinterest can be substantially higher than a quoted simple interest rate and a manager needsto understand the difference when it comes to borrowing money.Certain technical skills need to be understood even with a minimum competency inquantitative processes. The principles of time value of money in Chapter 12 and the riskreturn relationship in Chapter 13 are fundamental in the application of several financialconcepts. Business calculators and software programs essentially reduce the use andunderstanding of these technical methods to a data entry process.Capital budgeting is a technique, which incorporates the use of time value of money intodecisions involving major asset acquisitions, and the results could impact the companyover an extended time period. Business managers need to be aware of the mostappropriate methods to evaluate major decisions involving substantial outlays of capitalthat are often irreversible without large additional sums of cash.To support long-term asset requirements, business managers need to be aware of themany 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 provideunderlying liquidity to the process of issuing corporate bonds and/or preferred andcommon stock.Ethical situations can easily arise in any business setting when money is involved. Thelack of understanding of the accounting and finance process by the business manager isan incentive for the unethical employee to manipulate the system. An appreciation of


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ethical standards and a commitment to the proper reporting and disclosure of financialinformation 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 theintroductory level. In accounting, topics such as adjusting entries and more in-depthpresentations on the various methods to record inventory and depreciation are left for amore advanced accounting text. Detailed discussions of the acquisition, use, and disposalof fixed assets and debt instruments are not included. In the area of finance, specificpresentations related to stockholders equity, dividend policy, convertible securities,warrants, and options are left for more advanced finance texts.

Accounting DefinedThe American Accounting Association defines accounting as "the process of identifying,measuring, and communicating economic information to permit informed judgments anddecisions by the users of the information."1 Accounting is called the "language ofbusiness" as it provides a means of systematically recording and reporting information ina financial format.

The Accounting ProcessThe accountant begins the process by observing a business-related activity that hasfinancial implications. Not all business activities can be measured in monetary terms,and the accountant needs to differentiate between these activities. Financial businessactivities are called transactions. Once the accountant has observed the transaction, theappropriate accounts that are affected need to be identified. Sometimes, a businesstransaction will recognize some actions coming into the business and some actionsleaving the business. These actions should be equal and offsetting.The identification of accounts is broadly classified as assets, liabilities, and equity, whichinclude revenues and expenses. In any financial business transaction, two or moreaccounts within these broad categories will increase or decrease in size. Themeasurement process involves determining the nature and extent of the increase ordecrease in the appropriate accounts.Once the transaction is identified and measured, it needs to be recorded in the properaccount categories. Without the recording step, the transaction will not get into thesystem and its impact on the overall performance will be unknown. The input of datathrough the recording process completes the journal entry phase of a business transaction.With the appropriate data now entered into the accounting system, the information needsto be summarized into a usable fashion so that it can be usefully presented in anorganized report format.Summarization of accounting information into specific account categories called ledgersis recognized as the posting process. The accounts are either increased or decreased ineach transaction, and the resulting balance in the ledger account is summarized forreporting purposes. Since the information needs to be presented for decision-makingpurposes, this collection process is critical. The whole purpose of accumulating data is to 1 American Accounting Association, A Statement of Basic Accounting Theory (Evanston, Ill., 1966),p. 1.


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have it available in different types of report formats to aid the business manager in allaspects of the business.Some accounting reports that will be examined by external users outside of the companyneed 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 willbe for use within the company.Reports summarizing the various financial activities of the company can be analyzed andinterpreted by management and used to aid in relevant decision-making situations. Thiscommunication process of economic information completes the accounting process asdefined; however, there are many activities and other related actions that go into theaccounting function.The business manager needs to be aware that the information gathered and presented inthe accounting process be both relevant and reliable. Relevant information means that theinformation will be useful for decision-making purposes. A company does not need toclutter its record keeping activities with information that is not useful. In a time ofincreased automation, the probability of information overload is a distinct possibility.Reliable information is essentially correct information. This information does notnecessarily 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 becomfortable when applying the knowledge in the decision process. Illustration 1-1highlights the accounting process.

Finance DefinedFinance does not generally have a definition in the way that accounting was previouslydefined. Finance seems to be recognized more as a means to achieving an objective. Anunderlying goal for a company is the maximization of shareholder wealth, or themaximization of the total market value of the current shareholders' common stock. Thefinancing 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. Morerecently, the area of finance has broadened with greater emphasis on internal activities insupport of management. Issues such as working capital management, capital budgeting,

The Accounting ProcessIllustration 1-1

Action Accounting ActivityObservation Determine Accounting ActionBusiness Transaction Identify and MeasureRecording Process Journal EntrySummarization of Data Post in Account LedgerReporting Financial Statements


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firm valuation, security analysis, and capital structure theory are critical to a company'sfinancial operation.Shareholder wealth maximization goes beyond the concept of profit maximization byfactoring in the conditions of uncertainty on return and timing of returns. Uncertainty is acondition of risk and there is a perceived direct correlation between risk and return. Thehigher the risk, the higher the required return needed to offset the increased riskcomponent. Timing relates to how long it takes to realize returns. The sooner returns arerealized, usually in the form of cash, the higher the wealth maximization. The fasterreturn of cash also decreases the uncertainty and related risk and offers the investor moretime to earn supplementary returns.Shareholders react to the overall performance of a company through the market price ofits common stock. The price reflects potential future cash flows through capitalappreciation or capital depreciation plus any dividends. The timing of these cash flowsare 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 andindirectly related to risk. The sooner the cash flows occur, or the greater the cash flowamount, the higher the market price. The higher the level of risk, the lower the marketprice 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 investorhad the choice of two equally priced investments: one with a cash flow in year one and asecond with an equal cash flow in year two, the investor should select the investment withthe cash flow in year one. This situation underlies the concept of the time value ofmoney. Likewise, if an investor had the choice of two equally priced investments: onewith a lower level of risk and the other with a higher level of risk, the investor shouldselect the investment with the lower level of risk. This situation underlies the concept ofuncertainty as measured by risk.

Shareholder Wealth MaximizationIllustration 1-2

FactorMore Favorable

SituationLess Favorable

SituationCash Flow Early LateRisk Low High

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


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The American Institute of Certified Public Accountants Code of Professional Conductincludes six articles, which define the principles to which the accountant performsunswerving commitment to honorable behavior, even at the sacrifice of personaladvantage.

Article 1: ResponsibilitiesIn carrying out their responsibilities as professionals, members should exercisesensitive professional and moral judgments in all their activities.Article 2: The Public InterestMembers should accept the obligation to act in a way that will serve the publicinterest, honor the public trust, and demonstrate commitment to professionalism.Article 3: IntegrityTo maintain and broaden public confidence, members should perform allprofessional responsibilities with the highest sense of integrity.Article 4: Objectivity and IndependenceA member should maintain objectivity and be free of conflicts of interest indischarging professional responsibilities. A member in public practice should beindependent in fact and appearance when providing auditing and other attestationservices.Article 5: Due CareA member should observe the profession's technical and ethical standards, strivecontinually to improve competence and the quality of services, and dischargeprofessional responsibility to the best of the member's ability.Article 6: Scope and Nature of ServicesA member in public practice should observe the Principles of the Code ofProfessional Conduct in determining the scope and nature of services to beprovided.2

The Institute of Management Accountants has published Standards of Ethical Behaviorfor Management Accountants, which lists four major responsibilities of managementaccountants.

CompetenceManagement accountants have a responsibility to:

· Maintain an appropriate level of professional competence by ongoingdevelopment 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 afterappropriate analysis of relevant and reliable information.

ConfidentialityManagement accountants have a responsibility to:

· Refrain from disclosing confidential information acquired in the courseof their work except when authorized, unless legally obligated to doso.

2 American Institute of Certified Public Accountants Code of Professional Conduct, AmericanInstitute of Certified Public Accountants, New York, New York, as revised June 30, 1992


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· Inform subordinates as appropriate regarding the confidentiality ofinformation acquired in the course of their work and monitor theiractivities to assure the maintenance of that confidentiality.

· Refrain from using or appearing to use confidential informationacquired in the course of their work for unethical or illegal advantageeither personally or through third parties.

IntegrityManagement accountants have a responsibility to:

· Avoid actual or apparent conflicts of interest and advise all appropriateparties of any potential conflict.

· Refrain from engaging in any activity that would prejudice their abilityto carry out their duties ethically.

· Refuse any gift, favor, or hospitality that would influence or wouldappear to influence their actions.

· Refrain from either actively or passively subverting the attainment ofthe organization's legitimate and ethical objectives.

· Recognize and communicate professional limitations or otherconstraints that would preclude responsible judgment or successfulperformance of an activity.

· Communicate unfavorable as well as favorable information andprofessional judgments or opinions.

· Refrain from engaging in or supporting any activity that woulddiscredit the profession.

ObjectivityManagement 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 shownbelow 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, governmentagencies, other institutions, and the public.

· Comply with rules and regulations of federal, state, provincial, and localgovernments, and other appropriate private and public regulatory agencies.

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


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· 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 workexcept when authorized or otherwise legally obligated to disclose.Confidential information acquired in the course of my work will not be usedfor my personal advantage.

· Maintain an appropriate level of professional competence through continuingdevelopment of my knowledge and skills.

· Refrain from committing acts discreditable to myself, my employer, FEI, orfellow members of the Institute.4

Ethical codes and codes of conduct are necessary; however, ethical behavior involvesmore than adherence to codes. Individuals generally know the difference between rightand wrong, yet there can be variations on what an individual may consider as right orwrong. Additionally, for the accountant or financial manager, the opportunities andtemptations 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 theirreputation or integrity. This self-imposed criterion is usually sufficient for mostindividuals to maintain ethical standards. Also, all individuals in the business worldmake mistakes, but if their intentions are good, these mistakes are usually forgiven andthe individual can recover. On the other hand, if an individual knowingly makes anethical violation, a trust has been broken, and often such mistakes are irrevocable andcareer ending.Severe penalties and the loss of an individual’s and/or a company's integrity are generallysufficient to curtail unethical actions. However, we all have sinned and come short of theglory of God. Greed can be a powerful motivator, and pressures can build up for quickpersonal gain regardless of the potential risk. The business manager has to be constantlyaware of the possibility for ethical violations and create a business environment that willpromote 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 tothem: this is the law and the prophets.

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

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

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


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


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Chapter Questions1-1. 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 acompany?

1-4. Explain how accounting and finance information can aid in the decision-makingprocess? How can accounting and finance information hinder the decision-makingprocess?

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 theviewpoint of a business manager? Which article do you think is most important fromthe viewpoint of the accountant?

1-8. After reviewing the Institute of Management Accountants’ Standards of EthicalBehavior, which responsibility do you think is most important from the viewpoint of abusiness manager? Which responsibility do you think is most important from theviewpoint of the accountant?

1-9. After reviewing the Financial Executives Institute’s Code of Ethics, whichprovision 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 financialmanager?

1-10. How would you apply the golden rule to your business, and specifically to theaccounting and financing activities?

1-11. Identify three verses of scripture that relate to accounting and finance and explainhow they apply.

1-12.Case Study Creating an Ethics CaseDevelop an ethics related case and propose how to deal with the dilemma. Youmay rely on an example you have experienced through your own employment ormake up a situation.


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Cases

Case Study 1-1 Accounting Fraud at Maybury BankSteve 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 neverbeen better and company moral was high. The regional economy was also growing whichled 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 Stevegoing over internal audit procedures and any recent findings. He noted that a member ofhis staff was having trouble getting the numbers to balance in the credit card loandepartment. There was a difference of around $13,000 in the balance, but Dave was moreconcerned that the numbers just did not “feel” right. Steve suggested that Dave contactstheir public accounting firm and see if the balances could be reconciled with the publicaccounting 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 auditprocedure, the audit staff took the bank employee’s word on specific figures, and if therewere not an exact balance, they would force the numbers. Any difference in amounts wasnot especially significant. Steve became extremely concerned. Even though the amountthat was currently out of balance did not appear significant, he now did not have a reliableway 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 publicaccounting firm. This firm had audited the bank for 35 years, and the close relationshipbetween companies has gone back to a previous generation. Ed Simpkins, the seniorpartner was very apologetic for the misunderstanding of the audit, but said the companyhad been handling this situation the same way for a number of years, and that the amountof the difference was very insignificant. Ed indicated that there sometimes needs to be acost benefit tradeoff between gaining accuracy to the nearest dollar and the reasonablecost of providing the audit without sacrificing integrity. Ed assured Steve that he wassure that the audited financial records presented fairly the current financial status ofMaybury Bank.Steve was also concerned about the auditors taking the bank employee’s word on thecorrectness of figures without some form of verification. Ed did admit that there seemedto be a breakdown in the attest function here and he would see to it that verificationprocess would be reviewed. However, the bank employee in question who had providedthat data had been a trusted employee for years, and the audit firm had every reason tosupport the figures presented. Also, Ed assumed that internal control procedures at thebank should safeguard against any falsifying of accounting information.Dave continued to examine the area in question and began to come up with loans madeby the bank that were not properly accounted for in the records. These loans appeared tobe “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 onnumbers that all of a sudden had no basis of support. There was no way of knowing howwidespread the deception had become within the bank.


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Steve took immediate action by firing the employee in question, as there was sufficientevidence that fraudulent activities had taken place within this employee’s area ofresponsibility. Furthermore, the members of the internal audit staff who hadresponsibility to establish internal controls within this area of the bank operation werefired. Dave Watson and the employee who originally found the discrepancy retained theirjobs only because they brought this matter to light. Steve also fired the public accountingfirm after receiving board approval and sought the assistance from a national publicaccounting firm to help in determining the extent of the problem.The public accounting firm reviewed the loan function and found inconsistencies in loansapproaching $5,000,000. The very solvency of the bank was now in jeopardy. Just a fewmonths ago, the bank was recording record profits and distributing bonuses, and now theyfaced the possibility of bankruptcy. Steve acted quickly by laying off around 100employees, and task the public accounting firm to start from scratch in developing a newaccounting system.Each remaining employee was asked to demonstrate how his or her function fit into theaccounting system. Steve learned that employee personalities would often have animpact on how records were kept. “If John did not like Sue, he would give her incorrectdata which would make it harder for her to do her job.” There was also sufficientevidence that accounting control procedures were lacking, and often times processes werebeing done more than once or not at all because of a lack of coordination betweendepartments. When that finding became evident, there was a wholesale purging of theaccounting 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 tomake hard decisions about layoffs and firings that effected families and livelihoods, buthe 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 thenew accounting system and the thorough review of the accounting procedures, many costsavings measures were implemented. For instance, processed checks used to sitsometimes 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 haveprocessed checks sent at least twice a day to the Federal Reserve. This improvement incash flow resulted in increased interest revenue of $500,000 a year.RequiredA. 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 thatwhich occurred at Maybury Bank?D. Review the way Mr. Russell dealt with the problem at his bank. How would you dealwith the problem? Specifically, what would you do the same, differently?


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Case Study 1-2 Ethics as a Write-offOn March 26, 1996, The Wall Street Journal published an article entitled “For ManyExecutives, Ethics Seem to be a Write-off.” The article was based on a study on fraudthat 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 aboutunderstating a write-off that would cut into company profits. The findings of the studyindicated that 47 percent of top executives, 41 percent of controllers, and 76 percent ofgraduate-level business students were willing to commit fraud by understating the write-off.The case scenario was set up that the business executive had just returned from a two-week business trip and had a full in-basket of paperwork to review as quickly as possiblebefore leaving for another business trip. Included in the paper work were some memoscontaining important financial information. The write-off situation was similar to anactual SEC case. There was also a memo stating that the business executive would be upfor 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 executivesbehavior. This apparent lack of personal values has ethics experts concerned. The rigorsof the workplace seem to erode the sense of value in a business setting. The authorsconcluded 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 bedifficult to achieve, however, if the results cannot be shown on a company’s bottom linenet income.RequiredA. Why do you believe that ethical standards seem to be declining in the businessenvironment?B. Attempts have been made by professional organizations and company’s to developand incorporate codes of ethics for the business community; however, individualemployees still commit ethical violations. Why do employees compromise ethicalstandards when working on their job?C. In the study, the number of graduate-level business students that committed fraud wasalmost twice as high as the number of business executives. What, if any, significance canbe attributed to this finding?D. Profit motive is a big incentive in measuring corporate performance. How can acompany that commits to high ethical standards be competitive in a businessenvironment?E. How does the profit motive lead to compromises in ethical conduct? What cancompany management do to promote synergy or a positive association between the profitmotive and ethical standards?F. If you were the president of a company, what actions would you take to incorporate acode of ethics into your corporate structure?

Chapter Two: The Income Statement and the Balance Sheet

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Chapter Two: The Income Statement and the BalanceSheet

Objectives1. Identify the major account categories used in accounting.2. Understand the accounting process.3. Analyze the income statement and its role in business.4. Analyze the balance sheet and its role in business.

Account CategoriesAccounting systems within businesses rely on a chart of accounts as a means ofclassifying the activities within the business into categories for reporting and decision-making 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 termswhat is taking place within a business.The five major categories within a chart of accounts are assets, liabilities, stockholdersequity, revenues, and expenses. Within each of these major categories are more specificaccount titles related directly to business activities. The major categories of accounts tieinto the basic accounting equation, which states that assets equal liabilities plusstockholders equity. Equity consists of a capital stock portion and a retained earningscomponent. Revenues and expenses are incorporated into the retained earnings. SeeSelf-Study Problem 2-1.

Formula 2-1 Assets = Liabilities + Stockholders Equity

AssetsAssets represent items of future value that are owned by the company. Assets identifyresources of the business, which will bring some measure of value to the company in thefuture. The assets are used to aid in the company's overall objective of providing goodsand services. Examples of assets include cash, inventory, investments, equipment, andgoodwill. Assets do not have to have a physical substance; however, they do have tohave 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 twomajor categories of current assets and long-term assets. The difference between currentassets and long-term assets is a matter of liquidity, with current assets identified as cashor capable of being converted into cash within a one-year time frame. Long-term assetsby their nature are less liquid and are not expected to be converted into cash within a oneyear time period and may never be converted into cash.


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Current AssetsCash 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 ascash 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 tomaturity. Cash has an immediate maturity date whereas marketable securities could havematurity dates anywhere from thirty days to one year. Securities with a time delaybecause of a maturity date means that they cannot be used as cash for other purposes forthat period of time. A certificate of deposit with a maturity date in thirty days means thatthe 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 cashin order to gain a higher rate of return for agreeing to have some of the assets tied up for aperiod of time.A financial manager or accountant can project future cash needs over time and withproper cash management take full advantage of marketable securities with differentmaturity dates. If a company does not need a certain amount of cash for a thirty-dayperiod, then it is not worthwhile to keep that money in cash. Cash may not earn anyreturn and if there is a return it will be at a minimum. Additionally, because cash is veryliquid, it can be most easily confiscated.Accounts receivable represents an i.o.u. from a customer who purchased company goodsand services. Sales on account, whereby the customer agrees to pay later, results in thecreation of an account receivable. The vast majority of sales for many business is “onaccount” or credit sales. Payment of the account receivable by customers usually takesplace from thirty to ninety days after the sale. Management has to carefully screencustomers before allowing credit on sales; however, there usually always is some percentof the accounts that will never be collected.Inventory represents the product that the company is in the business of selling. Theinventory can be either created within the company (manufacturer) or secured in its basicfinal form for resale to a customer (merchandiser).Prepaid expenses are not expenses but assets because they have future value. Prepaidexpenses represent items of service paid for in advance. Once the service is provided, theprepaid asset actually becomes an expense. Examples include prepaid rent and prepaidinsurance.All the assets discussed to this point are classified as current assets because they are eitherin the form of cash or can be expected to be converted into cash within one year. Currentassets 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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Long-Term AssetsLong-term assets have an expected future value of more than one year. They are the leastliquid of the assets and may never be converted to cash. Many of the assets undergo adepreciation process to recognize their use over time. As the asset is depreciated anamount is transferred from the asset account to an expense account reflecting the use ofthe asset. Some long-term assets called intangible assets have no physical substance.Additionally, the long-term assets may increase or decrease in value; however, foraccounting record keeping purposes they are usually always maintained on the books attheir original historical cost.

Land is a long-term asset, which represents the property or location of the company. Theland is not subject to a depreciation or decrease in value because it is not used up in thecompany production of goods and services.Buildings and facilities and equipment are all assets that support the production ofcompany product. These assets have a life of more than one year but graduallydeteriorate over their useful life. A depreciation process is used to prorate the cost ofthese assets over an extended time period. As an asset is depreciated it becomes anexpense because it no longer has a future value.Intangible assets are assets that do not have a physical being but represent future value tothe company. Examples of intangible assets include goodwill, patents, copyrights, andtrademarks. The intangible assets are depreciated over a specific time period, whichrepresents the use of the asset. Illustration 2-2 gives a summary of long-term assetaccounts.

Current Asset AccountsIllustration 2-1

Account Discussion and ExplanationCash Most liquid current assetMarketableSecurities

Cash type items with a maturity date and the ability to earninterest

AccountsReceivable

Generated from the sale of a company’s goods and services,represent a customer’s promise to pay in the future

Inventory Product the company is in the business to sellPrepaid Expense Represents a cash payment in advance for services to be

received in the futureSupplies Miscellaneous assets used to support the creation of goods

and services


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LiabilitiesLiabilities are debts owned by a company. Liabilities represent one of two major sourcesof funding for the resources or assets of the company. A liability obligates the companyto the repayment of the debt and sometimes an interest charge is included. The lenders ofmoney or other assets to a company expect to be repaid in full with the principalrepresenting the amount loaned and due on a specific maturity date, and interest reflectingthe charge for receiving money in advance. The failure to comply with the provisions ofthe obligation can result in default of the liability and additional charges or therepossession of the asset.The principle that the borrower is servant to the lender underlies the concept ofborrowing. The lender, by providing cash or other assets in advance, establishes acontractual arrangement, which must be complied with by the borrower. Harsh penaltiescan result if the borrower fails to fulfill this obligation. The company that borrows fundsto support the acquisition of assets may be subject to limitations and conditions withregard to its operations, financial condition, or distribution of funds. These restrictionsare established to protect the lender in case of default.Companies can make effective use of liabilities provided they maintain an ability to fulfillstated contractual obligations. Liabilities are often the least costly source of funds, andany related interest will reduce the amount of corporate taxes. If companies can generatereturns from the assets purchased with debt in excess of the cost of debt itself, then thecompanies will increase their profitability. However, if the cost of debt or interestexceeds the returns generated from the assets, then the company is not earning enough topay the interest and profits decline. If these declines in profit and the related assets aresevere 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 liquidliabilities are listed first. Liabilities can be classified into two major groups: currentliabilities and long-term liabilities. The criterion for the segmentation of the liabilities isthe same as the criterion used to divide the assets. Obligations that have to be fulfilledwithin one year are current liabilities, and liabilities that have maturity time periods ofmore than one year are long-term liabilities.Some liabilities do not include an interest charge. These liabilities are generally short-term in their maturity date and are only given if a company can establish itself with a

Long-Term Asset AccountsIllustration 2-2

Account Discussion and ExplanationLand Physical property not subject to depreciationBuildings Physical facilities subject to depreciationEquipment Machine type items subject to depreciationInvestments Long-term type investments usually in stocks or bonds of

other companiesIntangible Long-term assets without a physical substance, examples

include goodwill, patents, copyrights


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good credit rating. Generally, the longer the term of the liability the higher the rate ofinterest. This higher rate of interest is directly correlated with the increased liquidity riskthat is assumed by the lender.

Current LiabilitiesAccounts payable is a current liability that usually includes no interest charge and isgenerated through the purchase of goods and services. It is the opposite of accountsreceivable. One company's accounts receivable is another company's accounts payable.The liability is created through the purchase of goods and services, which will probablybe used by a company to create their inventory. Specific terms are included with theaccount payable and most often the balance is due in thirty days. If the company does notfulfill its obligation, an interest charge may be imposed and/or the company could lose itscredit 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 chargeif paid within the specified time frame. The account, interest payable, is usuallyassociated with another liability that charges an interest rate, and the interest payableaccount represents only that portion of interest that is currently due.Notes payable is a current liability that differs from accounts payable in that an interestcharge is included in the amount due. When a company incurs a note payable, there isgenerally a contractual agreement established at the time of the note which dictates theterms of the repayment. Included in the repayment is the principle value of the obligationplus an interest charge. Interest payments can be made periodically or at the maturity dateof the note.Unearned revenue or deferred liabilities is not a revenue but a liability. The account iscreated when a customer pays for a good or service in advance. The company then has anobligation 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 oppositeof a prepaid expense. What is one company's prepaid expense is another company'sunearned revenue. The key to the creation of either account is that cash is paid orreceived prior to the providing of goods or services. Illustration 2-3 gives a summary ofcurrent liability accounts.

Current Liability AccountsIllustration 2-3

Account Discussion and ExplanationAccountsPayable

Obligation of the company usually incurred in the purchaseof inventory

Salaries Payable Employee wages that have been earned but not paid forAccruals Obligations incurred but not paidNotes Payable Obligations that have an interest charge associated with the

paymentDeferredLiabilities

Advance payments made by customers that represent a futureobligation by the company to provide a good or service


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Long-Term LiabilitiesLong-term liabilities are also classified as various payables. Examples include long-termnotes payable, mortgage payable, bonds payable, and deferred taxes payable. Theseobligations 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 thelong-term liability may be reclassified as a current liability in an account called currentportion of long-term notes payable.Deferred taxes payable is a unique liability created by the tax laws of the federal andstate governments. Tax laws allow companies to record various expenses and revenues indifferent amounts from normal recording practices. These differences generally result infavorable tax treatments, which will cause a delay in the payment of taxes. The resultingdelay in the tax payment creates a deferred tax liability. If the delay in the tax payment isone year or less, the deferred tax liability is listed as a current liability. If the deferred taxliability 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 thetax law perpetuates the favorable recognition of either an expense or revenue and itsrelated tax implications as long as the company is in business. The deferred tax liabilitybecomes a permanent source of interest free funding from the government. The companymust retain the long-term liability account even though technically the account may neverbe repaid. This is one of only a very few situations where a company can actually gain atax advantage from the government. Illustration 2-4 gives a summary of long-termliability accounts.

Stockholders EquityThe category of stockholders equity represents the second major source of funds toacquire a company's resources or its assets. The equity category represents the owners'(stockholders) contribution and the business' (retained earnings) contribution to thecreation of assets. This equity category is really larger than just stockholders equitybecause it represents both the owners and business interest in the company.

Long-Term Liability AccountsIllustration 2-4

Account Discussion and ExplanationNotes Payable Obligations with interest that have a maturity date at least

one year laterBonds Payable Obligations greater than one year that have fixed coupon

(interest) payment datesMortgage Payable Long-term obligations that are usually created to fund long-

term assets like buildingsDeferred TaxesPayable

Long-term obligations to the government for taxes duewhich do not have to be paid immediately primarily becauseof accounting and government tax rules


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The stockholders equity account indicates the owner’s commitment into a company. Inreturn for this commitment the owners can share in the company's success either throughdividend 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 valueof their investment. The company is generally under no legal obligation to make anyrepayment to the owners.One form of stock, preferred stock, usually includes specific provisions regardingdividend payments. Preferred shareholders have some protection in that no commonstock dividends can be paid until all current and past due preferred stock dividends arepaid 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 inamount and preferred shareholders can not expect increases in value as the companyprospers. Also preferred stockholders can usually not be voting members of thecompany.Common stock is the more recognized classification of equity. For an owner’scontribution into the business, the common stockholders have the potential for return ontheir investment through dividends and/or increase in the market price of theirinvestment. There is no guarantee that either of these events will occur and the companyhas no contractual obligation to make any payments. Additionally, the commonstockholders are the last in line in the case of a liquidation to recapture their investmentthrough the securing of assets. Because there are no guarantees, the commonstockholders 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 torecognize the distribution of company earnings to the shareholders. The dividend accountwill often be offset by a dividend payable liability account to represent the fact that acompany has declared a dividend but has not yet paid the dividend. Since the companystill has this obligation the dividend payable liability account is established.Retained earnings is the equity account that represents in summary form all of theoperating activities of the business in generating resources for the company. Retainedearnings can be increased as the company generates income, which occurs when revenuesexceed expenses. Retained earnings will decrease when there is a net loss from operatingactivities when expenses exceed revenues. Retained earnings is also decreased throughthe payment of dividends. A positive balance in retained earnings represents the excessof 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 earningsdoes not imply that there is a similar positive balance in cash, but only that the totalamount of assets is higher by the amount of retained earnings.Retained earnings can have a negative balance resulting when net losses exceed netincome over a period of time. Also, if a company pays out dividends in excess of theaccumulated net income over a period of time, the retained earnings balance couldbecome negative. Generally, holders of liabilities will impose restrictions on companiesin the amount of dividends that can be paid to prevent a negative balance in retainedearnings and to keep the common stockholders from receiving distributions of assetsbefore the creditors. Illustration 2-5 presents a summary of shareholders equity accounts.


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RevenuesRevenue is a broad category of accounts that represent the sale of goods and services bythe company. Revenues represent the business contribution of resources to the companyand 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 revenueby product line or product type.Interest revenue is associated with financing charges and should be separated from salesrevenue. Interest revenue occurs when a company receives interest income from acustomer on a note receivable. Interest revenue can also represent the interest earned onvarious company investments included in marketable securities. Dividend revenue issimilar to interest revenue except that a company is receiving dividends from stock versusinterest income from interest bearing notes like certificates of deposit.Gains on the sale of assets not including inventory also are classified as revenue. When acompany sells a long-term asset at a price higher than the book value of that asset a gainis recognized which is included as a revenue item and an increase in net income. (Bookvalue of an asset is what the asset is worth according to the company's accounting recordor book.) Illustration 2-6 gives a summary of revenue accounts.

Shareholders Equity AccountsIllustration 2-5

Account Discussion and ExplanationPreferred Stock Preferred with regard to dividend payments and distribution

of assets in a liquidationCommon Stock Major equity account with potential for increases in

dividends and market priceDividends Represents the distribution of company earnings to holders

of stockRetained Earnings Company’s contribution to equity in the form of net income

less any distributions through dividends

Revenue AccountsIllustration 2-6

Account Discussion and ExplanationSales Revenue Generated through the sale of goods and servicesInterest Revenue Generated through interest earned on interest bearing

accountsDividendRevenue

Dividends received from investments in other company stock

Gains on Sale Created when an asset is sold for more than its value asrecorded on the accounting records


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ExpensesExpenses represent the cost of doing business. Expenses are offset against revenues todetermine the net income or loss of a company. There are many more expense categoriesthan 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 nofuture value and cannot be an asset but is transferred to an expense classification as a costof 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 aperiod of time. Since most long-term assets have a limited useful life, a portion of thoseassets is used up every year. The depreciation process represents a prorated expensing ofan asset during each time period.Interest expense, as in interest revenue, should be shown separately as a financing chargeversus an operating charge. However, while dividend revenue, which represents earningsfrom 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 theincome statement.Losses from the sale of assets behave similar to expenses and are shown in the incomestatement. When assets other than inventory are sold for less than the book value there isa loss on sale, which will decrease the amount of net income. Illustration 2-7 presents asummary of expense accounts.

Accrual AccountingAccrual accounting relates revenues and expenses to the time period in which they areincurred. This method of accounting is required for financial reporting purposes bygenerally accepted accounting principles. Virtually all businesses use an accrualaccounting system versus a cash based system.

Expense AccountsIllustration 2-7

Account Discussion and ExplanationCost of GoodsSold

Represents the cost of the inventory sold in conjunctionwith the sales revenue

Wage Expense The wages and salaries of company employeesDepreciationExpense

A prorated cost of using long-term assets over an extendedperiod of time

Interest Expense The interest cost associated with obligations that include aninterest charge

Tax Expense Costs due to the governmentLoss on Sale Created when an asset is sold for less than its value as

recorded on the accounting records


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In a cash based system, accounts such as accounts receivable, accounts payable, prepaidexpenses and unearned revenue may not be needed because business transactions wouldbe dictated by the receipt and payment of cash. Revenues would be recognized uponpayment of cash regardless of when the good or service was provided. Expenses wouldbe recognized upon the payment of cash regardless of when the cost was incurred. Thisfailure by the cash based system to recognize revenues and expenses in the appropriatetime 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 notdependent on the receipt or payment of cash. In fact, expenses like depreciation willnever involve a payment of cash. The occurrence of an activity such as the sale of a goodor service is the critical factor in the recognition of revenue. The cash receipt inassociation with the sale may occur before, at the time of the sale, or after the sale. Therevenue is realized after substantial performance has been completed and the value isknown; generally this takes place at the point of sale.Expenses are matched in the same time period as revenues in an accrual accountingsystem. 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 theoccurrence of an event is sufficient to identify and match an expense with a relatedrevenue. However, in many situations activities have to be essentially developed toidentify appropriate expenses during a particular time period. Depreciation expense is anexample of creating an activity to reflect the use of an asset and its resulting expense for atime period. The use of the asset as shown by the depreciation expense is matchedagainst 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 longerbe classified as an asset. During each time period a portion of the asset will bereclassified as an expense.

When the long-term asset is first acquired the company estimates its useful life andsalvage value i.e., what the asset would be worth at the end of its useful life. Accrualaccounting requires that the use of this asset be prorated over this useful life time periodin a process known as the depreciation of the asset. As the asset is used up it is recordedas a depreciation expense. The accrual accounting matches the depreciation expense tothe 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 andcredit an account called accumulated depreciation. The debit to the depreciation expenseaccount will increase that account and ultimately decrease net income. The accumulateddepreciation account is a contra asset account. A contra account is an account that carriesan opposite balance. Therefore, a contra asset account would carry a credit balance. Thedepreciation journal entry causes an increase in the credit balance of the accumulateddepreciation account, and an overall decrease to the net balance of the asset account.


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Depreciation is a noncash expense account since the offsetting credit is to accumulateddepreciation versus cash or some liability account. Essentially, the cash paymentoccurred when the original asset was purchased, and the depreciation reflects the use ofthis paid for asset.

Since both the long-term asset and the accumulated depreciation accounts are assets theywill appear on the balance sheet. Generally the accounts are set against each other with aresulting net balance to the asset account. The amount in the accumulated depreciationaccount can never exceed the amount in the long-term asset account so the net balancewill 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 purchaseof the equipment and the depreciation of the equipment. Show how the equipment willbe recorded on the balance sheet.

January 2, 1996 - Purchased asset.

Equipment 30,000 Cash 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 3,500 Accumulated Depreciation 3,500

Balance Sheet Presentation

Molding Machine (Debit Bal) $30,000- Accumulated Depreciation (Credit Bal) -3,500= Molding Machine (Net) (Debit Bal) $26,500


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The Accounting ProcessWith an understanding of the major account categories it is easier to follow theaccounting process, which reflects the accounting treatment of business activities andpresents information in a usable form for decision-making purposes.Accounting treatments to business activities follows a double entry system. Double entrymeans that for each business transaction that is recorded for accounting purposes, thereare two parts, and each of the parts must result in an equal total dollar amount. Thisequality of a double entry system is necessary for the development of appropriateaccounting information to aid in the managerial decision-making process.The accounting process begins with the accounting transaction or journal entry, whichidentifies a business activity. The journal entry represents a chronological recording ofthe 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 thetransaction must be equal, that is the total of the debits on the left hand side must equalthe total of the credits on the right hand side. Illustration 2-8 gives an example of anaccounting transaction and related journal entry. See Self-Study Problem 2-4.Each of the major account categories can be impacted by accounting transactions throughdebits and credits, and each account category has a typical balance as either a debit orcredit. Assets, expenses, and dividends are increased in amount by debits and decreasedby credits and these accounts typically carry a debit balance during any particular timeperiod. Liabilities, stockholders equity and revenue accounts are increased by credits anddecreased by debits and typically carry a credit balance during any particular time period.Illustration 2-9 summarizes the balances of the major account titles.

Accounting TransactionIllustration 2-8

Daniel & Son’s Inc. purchased a vehicle for $15,000 by paying a $2,000 down paymentand signing a note payable for $13,000.

Journal EntryDebit Vehicle (asset) 15,000Credit Cash (asset) 2,000Credit Notes Payable (liability) 13,000

Debit/Credit Account Balance SummaryIllustration 2-9

Normal BalanceDEBIT CREDITAssets Liabilities

Expenses Stockholders EquityDividends Revenue


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When a business transaction is recorded, the debits are recorded first and are placed to theleft. The credit entries are entered after the debits and are indented to the right. When anaccount is debited, it simply means that that account is entered on the left hand side of thetransaction. When an account is credited, it is entered on the right hand side of thetransaction.The balances in accounts are either increased or decreased by every transaction. In atransaction, if an asset, expense, or dividend account is debited, it means that the balancein that particular account is increased. If the asset, expense, or dividend is credited, itsbalance 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 thatparticular account is decreased. If the liability, stockholders equity, or revenue iscredited, its balance is increased by that transaction. Illustration 2-10 summarizes theimpact of a debit or credit from a journal entry on the account balance. See Self-StudyProblem 2-2.No attempt should be made to relate or associate debit and credit with any other conceptor activity. Debit and credit do not mean good and bad or up and down or plus andminus, they simply represent left hand side and right hand side in a journal entry whichreflects a business transaction.After the journal entry has been completed, a determination can be made on the effect ofthe transaction on the balances of the specific accounts according to the rules about debitand 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 accountbalance.Journal entries are the key to a successful accounting system. Unless businesstransactions are properly classified and recorded the information obtained will be uselessfor decision-making purposes. It is like garbage in garbage out. If the journal entry is notcorrect what a company manager receives is garbage.There is a consistent decision process that can be associated with every businesstransaction and related journal entry. By following a systematic process in thedevelopment of a journal entry, management can minimize the potential for error and baddata.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 impacted2. determine whether the account balances will be increased or decreased

Increase or Decrease in Account BalanceIllustration 2-10

ACCOUNT DEBIT CREDITAssets Increase DecreaseLiabilities Decrease IncreaseStockholders Equity Decrease IncreaseRevenue Decrease IncreaseExpense Increase DecreaseDividend Increase Decrease


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3. identify if the accounts should be debited or credited4. determine the monetary amount associated with each account5. record the transaction6. 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 accountingprocedures are essentially automatic. After the journal entry is the posting process,which involves recording the impact of the transactions on the account balances of thespecific accounts. Each account classification has a ledger, which includes the effect ofall of the transactions for a particular time period. If the account is an asset, expense, ordividend, 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. Illustration2-11 gives the basic column format of a ledger. See Self-Study Problem 2-5.

Illustration of a LedgerIllustration 2-11

Account Title Debit Credit BalanceDescription of Journal Entry

Once the journal entry has been posted to the ledger, it is possible to summarize theinformation from the ledgers into a report format. Before reports such as the incomestatement or balance sheet can be completed a trial balance is computed. The purpose ofa trial balance is to determine if the total debit balances of all appropriate accountsequals the total credit balances of all appropriate accounts. The trial balance does notinsure 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 totalcredits can be equal but with an incorrect total.Most of the potential errors that may occur and be highlighted through a trial balance canbe eliminated through a sound accounting system or automated process that willimmediately indicate when the debit portion of the journal entry does not equal the creditportion. However, errors in the journal entry regarding the classification of accountsand/or whether the amount is properly recorded as a debit or credit will go undetected inthe trial balance process.Account categories can be classified as permanent or temporary. Accounts appearing inthe balance sheet are permanent accounts, which include assets, liabilities, andstockholders equity. These permanent accounts carry a balance from one accountingperiod to the next. Temporary accounts are included in the income statement andstatement of retained earnings. Revenues and expenses from the income statement anddividends from the statement of retained earnings are temporary accounts. The balance ofthe temporary account is returned to zero at the end of the accounting period. Illustration2-12 summarizes the role of permanent and temporary accounts. See Self-StudyProblem 2-3.

Nature and Use of AccountsIllustration 2-12

AccountPermanentTemporary

FinancialStatement

Asset Permanent Balance Sheet


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Liability Permanent Balance SheetStockholders Equity Permanent Balance SheetRevenue Temporary Income StatementExpense Temporary Income StatementDividends Temporary 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 mostrecognized of those reports are: (1) the income statement, (2) the statement of retainedearnings, (3) the balance sheet, and (4) the statement of cash flows. In an automatedaccounting system, these reports can be generated automatically through predevelopedsoftware programs. In manual systems the development of reports involves the use ofledger account balances from specific accounts, i.e., for an income statement the balancesfrom the revenue and expense accounts are used. A step-by-step summary of theaccounting 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 StatementThe income statement for many companies is considered as the most important statementbecause of the emphasis on company operating performance. The income statementrepresents a measure of performance over a period of time with the most common periodbeing 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 notbe 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 andexpense classifications. These accounts are identified as temporary accounts in that theydo not carry a balance from one accounting period to the next. When computing an


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income statement, the company management is only interested in the operatingperformance for the period in question, usually one year. To avoid mixing theperformance activities from different time periods, the revenue and expense accountbalances start at zero at the beginning of the period and are reset to zero at the end of theperiod after the income statement is completed.The process of resetting the temporary revenue and expense accounts to zero is called theclosing process. Journal entries are constructed to support the closing entry process anda 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 andan offsetting credit to the income summary account. To close out the expense accounts ajournal entry must include a credit to the expense and an offsetting debit to the incomesummary account. If the balance in the income summary account is a debit amount, thenthe company experiences a net loss because the expenses exceeded the revenues. If thebalance in the income summary account is a credit amount, then the company experiencesa net income because the revenues exceed the expenses.The format of the income statement begins with the operating revenues. There are specialrevenue accounts called contra revenue accounts, which carry a debit balance and willreduce the amount of net revenue. (When an account is called a contra account it meansthat it carries an opposite normal balance, i.e., a revenue account carries a credit balancewhile a contra revenue account carries a debit balance.) The contra revenue accounts aresales discounts and sales return and allowances. The resulting sales revenue figure iscalled net sales revenue.The cost of goods sold expense is deducted from net sales revenue to arrive at asupplementary figure called gross margin. The gross margin gives companymanagement 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 ofsales of at least 25 percent and preferably a figure closer to 40 percent. A 25 percentgross margin means that for every dollar of sales, 25 cents remains after a cost of goodssold of 75 cents. This gross margin needs to be sufficient to cover the remainingexpenses plus provide some profit potential for the company.Other operating expenses are listed next in the income statement. These expenses aresometimes categorized as selling and administrative expenses or general administrativeexpenses. A supplementary figure computed by subtracting these operating expensesfrom gross margin is income from operations or operating margin. The income fromoperations gives an indication to management on how well their operating revenuescover all related operating expenses.The financing section of the income statement includes interest revenue and interestexpense. It important to keep interest related items separate from operating activities ifthe 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 separatecomponent of the income statement.After the consideration of all revenue and expense items, a supplementary figure callednet income before tax is computed. The only remaining expense item to be determinedis the income tax. If this figure represents a loss, a company may be allowed to enter atax credit (representing a potential refund.)


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The final figure in the income statement is the net income, which is the differencebetween revenues and expenses. The net income figure represents the businesscontribution 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 incomestatement that will appear on the statement of retained earnings, and serves as aconnecting figure between the two statements. In the illustrations 2-13 and 2-14, the netincome amount of $1,800 appears in both statements. Also, the amount of net incomeshould agree with the balance in the income summary account.In summary, net income is the consolidation of all the revenue and expense accounts andrepresents the business activities of a company for a particular period of time. The netincome figure represents the company contribution to the resources of the company.Illustration 2-13 shows the basic format of an income statement. See Self-StudyProblem 2-6.


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Income StatementIllustration 2-13

Daniel & Son’s CompanyIncome Statement

For the Year Ending December 31, 1997Sales Revenue $100,000 - Sales Returns & Allowances $ 5,000 - Sales Discounts 7,000 -12,000 = Net Sales Revenue 88,000- Cost of Goods Sold -62,000= Gross Margin 26,000- Operating Expenses Selling & Administrative 13,000 Depreciation 9,000 Total Operating Expenses -22,000= Operating Income 4,000+ Interest Revenue 1,000- Interest Expense -2,000 -1,000= Net Income Before Tax 3,000- Income Tax Expense -1,200= Net Income $ 1,800

Statement of Retained EarningsThe statement of retained earnings identifies the company's accumulated contribution ofresources 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 sheetat the end of the accounting period and is the connecting figure between the twostatements. In illustrations 2-14 and 2-15 $15,600 is the ending balance in retainedearnings, which is also in the balance sheet.Net income or net loss is a summary of all of the revenue and expense balances and itsbalance is in the income summary account. Since revenues and expenses are temporaryaccounts, income summary is also a temporary account and must be reduced to a zerobalance at the end of the accounting period. Net income has a credit balance in incomesummary, which is reduced to zero through the closing process to the retained earningsaccount. The income summary is debited and the retained earnings is credited. Sinceretained earnings normally maintains a credit balance and it is increased with a creditentry, the positive net income is reflected by an increase in retained earnings. A net losswill have the opposite effect on retained earnings through the closing process with a debitto the retained earnings account and a reduction in its balance.Dividend is also a temporary account, which reflects the distribution of earnings to theowners of the company. However, dividend is not an expense account and will not appearon the income statement. Dividends carry a debit balance and the transaction involvingdividends is a debit to dividends and a credit to dividends payable or to cash. At the end


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of the accounting period, the dividend account needs to be closed with a debit to retainedearnings and a credit to dividends. This closing transaction represents a reduction inretained earnings.The statement of retained earnings is basically a summary of the closing transactions ofincome summary and dividends. Since retained earnings is a permanent account whichwill appear on the balance sheet, it will have a beginning balance. The two primaryactivities that can impact the retained earnings account, the net income or net loss and thepayment of dividends are reflected in the statement. Net income will increase the balancein retained earnings and net loss and dividends will decrease the balance in retainedearnings. The ending balance of retained earnings will then be transferred to the balancesheet. Illustration 2-14 shows the basic format of a statement of retained earnings. SeeSelf-Study Problem 2-7.

Statement of Retained EarningsIllustration 2-14

Daniel & Son’s CompanyStatement of Retained Earnings

For the Year Ending December 31, 1997Beginning Balance Retained Earnings $15,000+ Net Income $1,800- Dividends 1,200 600= Ending Balance Retained Earnings $15,600

Balance SheetThe balance sheet is the only statement, which measures the condition of a company at apoint 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. Thepermanent 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 ofretained earnings will appear on the balance sheet.A critical requirement of the balance sheet is that it must be in balance. The accountingequation: assets equal liabilities plus stockholders equity reflects the balance sheet.

Formula 2-1 Assets = Liabilities + Stockholders EquityAssets, or the resources of the company, are listed according to liquidity and dividedbetween 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 ofthe asset resources, are also listed according to liquidity beginning with accounts payableand ending with long-term payables or deferred taxes payable.Stockholders equity, the other source of the company's asset resources, is also listed onthe balance sheet. Stockholders equity is divided into two major sections, the preferredand common stock which represents an owners contribution to the company, and theretained earnings which represents the business' contribution to the company assets.


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The net debit balance of the assets equals the net credit balance of the liabilities plusstockholders equity. Again, this report is only reflective of the balances of the accounts atone specific point in time.The financial statements highlighted in this chapter all serve a useful purpose inproviding information for decision-making purposes for both internal and external users.For this reason, the accounting profession has established very strict guidelines orgenerally accepted accounting principles in conjunction with these reports. Companiesmust remain in compliance with these principles especially when the information ispublished for external purposes. Without these guidelines, external users of theaccounting information would have no basis of comparison of the reports. Illustration 2-15 shows the basic format of the balance sheet. See Self-Study Problem 2-8.


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Balance SheetIllustration 2-15

Daniel & Son’s IncBalance Sheet

December 31, 1997 ASSETSCurrent Assets Cash $ 20,000 Marketable Securities 6,000 Accounts Receivable 32,000 Inventory 65,000 Supplies 9,000 Prepaid Expenses 4,000= Total Current Assets $136,000Long-Term Assets Land 40,000 Equipment $220,000 - Accumulated Depreciation - 25,000 = Net Equipment 195,000 Buildings 350,000 - Accumulated Depreciation -170,000 = Net Buildings 180,000 Investments 25,000 Goodwill 10,000 Patents 5,000= Total Long-Term Assets 455,000Total Assets $591,000 LIABILITIES % EQUITYCurrent Liabilities Accounts Payable $ 15,000 Notes Payable 12,000 Salaries Payable 8,000 Taxes Payable 1,400= Total Current Liabilities $ 36,400Long-Term Liabilities Mortgage Payable $150,000 Bonds Payable 80,000= Total Long-Term Liabilities 230,000Total Liabilities $266,400Stockholders Equity Preferred Stock 25,000 Common Stock 284,000 Retained Earnings 15,600= Total Stockholders Equity 324,600Total Liabilities &Stockholders Equity $591,000


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SummaryThis chapter highlights the basic accounting process from the individual transaction asrepresented by a journal entry through the development of accounting statementsincluding the income statement, statement of retained earnings, and balance sheet. Theaccounting process is a very systematic procedure to insure that financial related activitiesare properly accounted for within the business environment. The key for this system tofunction properly is at the data entry point, the journal entry. Each financially relatedbusiness transaction must be properly classified and recorded in accounting terms. Oncethe data entry activity has been completed, the remaining functions in the accountingprocess are almost routine. Many companies with automated accounting systems willhave the posting and financial reports generated automatically. It is important for thenonfinancial manager to be able to understand the accounting process and how the reportsare developed. An individual needs to know how to interpret and use the informationpresented in financial reports for decision-making purposes and other decision relatedactivities.


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Study ProblemsSelf-Study Problem 2-1 Account ClassificationsClassify the following accounts as asset (A), liability (L), stockholders equity (S), revenue(R), expense (E), or dividend (D).

ACCOUNT CLASSIFYInvestmentAccounts PayableAccounts ReceivableSalesCashCommon StockDividendInventoryUnearned RevenueLandAccrued SalariesSuppliesRetained EarningsPrepaid ExpensesCost of Goods SoldDepreciationEquipmentTaxesAccumulated Depreciation


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Self-Study Problem 2-1 Solution Account ClassificationsClassify the following accounts as asset (A), liability (L), stockholders equity (S), revenue(R), expense (E), or dividend (D).ACCOUNT CLASSIFYInvestment AAccounts Payable LAccounts Receivable ASales RCash ACommon Stock SDividend DInventory AUnearned Revenue LLand AAccrued Salaries LSupplies ARetained Earnings SPrepaid Expenses ACost of Goods Sold EDepreciation EEquipment ATaxes EAccumulated Depreciation A


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Self-Study Problem 2-2 Debit and Credit Balance on AccountsDetermine the normal balance as debit (D) or credit (C) for each of the followingaccounts:

ACCOUNT BALANCESalesAccounts ReceivableCashAccumulated DepreciationAccounts PayableCost of Goods SoldCommon StockDividendBuildingDividend PayableBuildingUnearned RevenueTax ExpenseRetained EarningsPrepaid ExpenseGoodwill


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Self-Study Problem 2-2 Solution Debit and Credit Balance on AccountsDetermine the normal balance as debit (D) or credit (C) for each of the followingaccounts:ACCOUNT BALANCESales CAccounts Receivable DCash DAccumulated Depreciation CAccounts Payable CCost of Goods Sold DCommon Stock CDividend DBuilding DDividend Payable CBuilding DUnearned Revenue CTax Expense DRetained Earnings CPrepaid Expense DGoodwill D


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

ACCOUNTNORMALBALANCE(D) (C)

PERMANENTTEMPORARY(P) (T)

FINANCIALSTATEMENT(I, R, B)

AssetLiabilityShareholder EquityRevenueExpenseDividend


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




Asset D P BLiability C P BShareholder Equity C P BRevenue C T IExpense D T IDividend D T R


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Self-Study Problem 2-4 Journal EntriesConstruct 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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Self-Study Problem 2-4 Solution Journal Entries

1. Purchased equipment for $10,000 and paid cash.

Equipment 10,000 Cash 10,000

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

Cash 500 Sales Revenue 500

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

Cost of Goods Sold 300 Inventory 300

4. Sold $1,000 of product on account.

Accounts Receivable 1,000 Sales Revenue 1,000

5. Purchased $5,000 of inventory on account.

Inventory 5,000 Accounts Payable 5,000

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

Cash 50,000 Common Stock 50,000


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7. Collected the $1,000 of accounts receivable.

Cash 1,000 Accounts Receivable 1,000

8. Paid a salary expense of $2,000.

Salary Expense 2,000 Cash 2,000

9. Paid the account payable of $5,000.

Accounts Payable 5,000 Cash 5,000

10. Paid a dividend of $3,000.

Dividend 3,000 Cash 3,000


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Self-Study Problem 2-5 Account Ledgers

Construct all of the account ledgers for the journal entries completed in Self-Studyproblem 4. Assume that there is a beginning cash balance of $25,000, a beginningbalance 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 Credit Balance


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Self-Study Problem 2-5 Solution Account Ledgers

Construct all of the account ledgers for the journal entries completed in Self-Studyproblem 4. Assume that there is a beginning cash balance of $25,000, a beginningbalance of inventory of $3,000, and a beginning balance in common stock of $28,000

Cash Ledger Debit Credit BalanceBeginning Balance $25,000Purchase Equipment $10,000 15,000Product Sale $ 500 15,500Issue Stock 50,000 65,500Collect Account Receivable 1,000 66,500Paid Salary 2,000 64,500Paid Account Payable 5,000 59,500Paid Dividend 3,000 56,500

Accounts Receivable Ledger Debit Credit Balance Beginning Balance 0Sold Product on Account 1,000 1,000Collected Account Receivable 1,000 0

Inventory Ledger Debit Credit Balance Beginning Balance 3,000Sold Product 300 2,700Purchased Inventory 5,000 7,700

Equipment Ledger Debit Credit BalancePurchased Equipment 10,000


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Accounts Payable Ledger Debit Credit Balance Purchase Inventory 5,000 5,000Pay Accounts Payable 5,000 0

Common Stock Ledger Debit Credit BalanceBeginning Balance 28,000Issued Common Stock 50,000 78,000

Dividend Ledger Debit Credit BalancePaid Dividend 3,000 3,000

Sales Revenue Ledger Debit Credit Balance Cash Sales 500 500Credit Sales 1,000 1,500

Cost of Goods Sold Ledger Debit Credit Balance Cash Sales 300 300

Salary Expense Ledger Debit Credit Balance Paid Salary Expense 2,000 2,000


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Use the following trial balance to construct an income statement, statement of retainedearnings, and a balance sheet for Self-Study problems 2-6, 2-7, and 2-8.

Daniel & Son’s Inc.Trial Balance

December 31, 1997Numbers in $1,000s

ACCOUNT DEBIT CREDITCash $ 160Accounts Receivable 180Inventory 350Prepaid Expenses 40Land 180Buildings 900Accumulated Depreciation $ 200Accounts Payable 120Notes Payable 140Mortgage Payable 400Common Stock 600Retained Earnings 300Dividends 40Sales Revenue 1,000Cost of Goods Sold 650Depreciation Expense 50Administrative Expense 100Interest Expense 30Tax Expense 80Total $2,760 $2,760


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


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Self-Study Problem 2-6 Solution Income StatementConstruct an income statement from the trial balance.

Daniel & Son’s Inc.Income Statement

For the Year Ending December 31, 1997Number’s in $1,000s

Sales Revenue $1,000- Cost of Goods Sold 650= Gross Margin 350- Other Expenses Depreciation $ 50 Administration 100 -150= Operating Income 200- Interest Expense 30= Net Income Before Tax 170- Tax Expense 80= Net Income $ 90


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


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

Daniel & Son’s Inc.Statement of Retained Earnings

For the Year Ending December 31, 1997Numbers in $1,000’s

Beginning Balance Retained Earnings $300+ Net Income 90- Dividends 40= Ending Balance Retained Earnings $350


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


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Self-Study Problem 2-8 Solution Balance SheetConstruct a balance sheet from the trial balance.

Daniel & Son’sBalance Sheet


ASSETSCurrent Assets Cash $ 160 Accounts Receivable 180 Inventory 350 Prepaid Expenses 40 Total Current Assets $ 730Long-Term Assets Land 180 Building $ 900 - Accumulated Depreciation 200 700 Total Long-Term Assets 880Total Assets $1,610LIABILITIES & EQUITYCurrent Liabilities Accounts Payable $ 120 Notes Payable 140 Total Current Liabilities $ 260Long-Term Liabilities Mortgage Payable 400Total Liabilities 660Stockholders Equity Common Stock 600 Retained Earnings 350Total Stockholders Equity 950Total Liabilities & Equity $1,610


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ProblemsProblem 2-1 Account ClassificationsClassify the following accounts as asset (A), liability (L), stockholders equity (S), revenue(R), expense (E), or dividend (D).

ACCOUNT CLASSIFYDepreciationAccounts ReceivableUtilitiesSalesSuppliesPreferred StockDividendInventoryPrepaid ExpenseCashInventoryRetained EarningsAccounts PayableUnearned RevenueCost of Goods SoldAccumulated DepreciationEquipmentTaxesLand


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Problem 2-2 Debit and Credit Balance on AccountsDetermine the normal balance as debit (D) or credit (C) for each of the followingaccounts:

ACCOUNT BALANCEDividendsAccounts PayableGoodwillDepreciationAccounts ReceivableCost of Goods SoldCommon StockRetained EarningsBuildingDividend PayableEquipmentPrepaid ExpenseTax ExpenseUnearned RevenueCashSales


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




SalesAccounts ReceivableAccumulated DepreciationUnearned RevenuePreferred StockDividendSales ReturnCost of Goods SoldDepreciationPrepaid Expense

Problem 2-4 Journal EntriesConstruct 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 ofthe accounts established in the journal entries.

Problem 2-6 Trial BalanceUsing the ledger account balances established in problem 2-5, develop a trial balanceshowing each account and its debit or credit balance.


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Problem 2-7 Financial StatementsUsing 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 EntriesConstruct 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 $10,000Utilities 3,000Advertising 8,000

March 20 Standard Co., a customer of Dan Company paid 47,500 in advance for servicesto be provided.

March 22 Dan Company provided services for $21,000 on account with the customersagreeing to pay in full in 30 days.

March 23 Dan Company purchased supplies in the amount of $6,000 agreeing to pay forthem 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 $1,000Vehicle Depreciation $2,000

Problem 2-9 Account ClassificationsUsing the following list of accounts, reorganize them in the following order: CurrentAssets, Long-Term Assets, Current Liabilities, Long-Term Liabilities, StockholdersEquity, Revenue, and Expense. Within each of the categories, list the accounts in theorder in which they would usually appear in a financial statement, and indicate the normalbalance, permanent or temporary, and in which financial statement they would appear.

InvestmentAccounts PayableAccounts ReceivableSalesCashCommon StockDividendInventoryUnearned RevenueLandAccrued Salaries


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SuppliesRetained EarningsNotes payablePrepaid ExpensesCost of Goods SoldDepreciationEquipmentTaxesAccumulated DepreciationSalariesMortgage PayableUtilities


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Problem 2-10 Zero Balance AccountsIndicate which of the following accounts should start each accounting period with a zerobalance.

ACCOUNT BALANCEPreferred StockDividendInventoryPrepaid ExpenseCashAccrued InterestInventoryRetained EarningsAccounts PayableUnearned RevenueCost of Goods SoldAccumulated DepreciationSales


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Problem 2-11 Trial BalanceUsing the following accounts and their balances, construct a trial balance for DSSRIndustry for the year ending December 31, 1996. Remember the total debit balance mustequal the total credit balance.

ACCOUNT AMOUNTInvestment $ 18,000Accounts Payable 27,000Accounts Receivable 52,000Sales 260,000Cash 49,000Common Stock 180,000Dividend 13,000Inventory 48,000Unearned Revenue 6,000Land 50,000Accrued Salaries 9,000Supplies 10,000Retained Earnings 25,000Notes Payable-Short-term 15,000Prepaid Expenses 17,000Cost of Goods Sold 184,000Depreciation 12,000Equipment 200,000Taxes 18,000Accumulated Depreciation 32,000Salaries 30,000Mortgage Payable 160,000Utilities 13,000

Problem 2-12 Income StatementFrom the data given in problem 2-11, construct an income statement for DSSR Industryfor the year ending December 31, 1996.

Problem 2-13 Statement of Retained EarningsFrom the data given in problem 2-11, construct a statement of retained earnings forDSSR Industry for the year ending December 31, 1996.

Problem 2-14 Balance SheetFrom the data given in problem 2-11, construct a balance sheet as of December 31, 1996.


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Cases

Case Study 2-1 Swan and Son’s Laundry ServiceTom 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 opportunityto hire individuals with some physical disabilities and the learning disabled and providethem with an opportunity to develop a trade skill and make a positive contribution in theworkplace.Tom wanted to gain service contracts with various businesses whereby his companywould pick up laundry items and have them cleaned and folded. Ideally, there would besufficient quantities of laundry items, that clean replacements could be left at the timedirty items were picked up, and service could be provided on a daily basis. Tom believedthat smaller hotels, restaurants, and nursing homes would be logical businesses that couldbenefit from his laundry service. These companies would not have to go through thelarge capital expenditure of securing capital equipment for laundry purposes as well asthe labor cost for cleaning the laundry items. He felt his prices could be competitive withother laundry service businesses and even less per piece than it would cost for thosebusinesses that would do the laundry service in house.This business also provided a job enrichment opportunity for the disabled. Theseindividuals could be trained in the basic skills of laundry service, which could give thema feeling of self worth as well as allow them to make a meaningful contribution to societyversus having to rely on welfare. Tom planned to start the employees at a competitivewage and give merit increases after the completion of a training and probationary periodof employment.Due to his willingness to help the disabled, Tom was able to secure a small business loanof $200,000 at a 9.0% annual rate of interest. Tom also put up $25,000 of his own fundsalong with a used van valued at $9,000 to start the business. The van should last fiveyears. Through some effective negotiation and because of the purpose of his business tohelp disadvantaged, Tom was able to buy used equipment from a large hotel chain. Heobtained 10 industrial grade washing machines for a total of $21,000, which had a marketvalue of $35,000 and would have cost $60,000 if purchased new. He also obtained 5industrial grade dryers for a total of $24,000 which had a market value of $48,000 andwould have cost $70,000 if purchased new. The washers and dryers are expected to lastfor five years.Tom secured a Butler building type of facility with 2,000 square feet of space, whichrented out for $5 per month per square foot. One month’s rent was required for depositand the rent was due monthly payable in advance. The utility bill was going to be highdue to the running of the wash machines and dryers for almost eight hours a day, fivedays 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 companywas closed.Initially, Tom would do all of the front office work on his own along the sales effort toestablish accounts. He believes that he can gain enough contracts to begin full-scaleoperations within one month.


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The city social service agency, through a government program, has agreed to train twelvehandicapped employees for a two-week period of time on location. They have alsoagreed to provide transportation to and from work on a city bus. There will be no chargefor this service provided Tom agrees to pay the employees at least a minimum wage plusworkman’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 believesthat Tom’s plan for employee compensation and merit raises is fair.Tom anticipates that telephone and other office expenses will equal about $2,500 permonth. Cleaning supplies like detergent and fabric spray will add up to $1,000 permonth. 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 willprobably be $750 per month.Many of the businesses will want the laundry items ironed. Tom purchased 10 heavy-duty irons and ironing boards with stools for a total cost of $1,200. He plans to set up sixironing board work stations, and keep the other equipment on reserve if there is excessdemand or equipment breakdown. The irons and boards are expected to last for fiveyears.Of the initial 12 employees; two will be trained to sort and prepare the laundry items, twowill monitor the washing process, two will monitor the drying process, four will iron, andthe final two, as most skilled, will learn all of the functions and prepare the laundry itemsfor return to the customer. Ten employees will begin at $6.00 per hour plus $2.50 perhour 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 employeeswill work a 40-hour week at 8.0 hours per day plus one unpaid hour per day for lunch andbreaks. Every month, the social service department will provide three hours of trainingand 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 asupervisor to oversee the operation. Tom’s brother John is currently working on amasters degree at night and would be willing to work with the business. Tom will payJohn $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 itemneeds to be ironed.RequiredA. Establish a company balance sheet for Swan and Son’s Laundry Service after all ofthe 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 becleaned in a month for the business to cover its monthly expenses?D. Establish an income statement assuming the company earned $50,000 in revenue inthe 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


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


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Case Study 2-2 Pleasant Private SchoolRita Roebuck is a member of the finance committee of the board of directors for PleasantPrivate School. One of her duties is to review the performance of the fund raisingcommittee and recommend which, if any, of the current fund raising projects should beconsidered for the next school year.The school relies on fund raising to support 5 to 10 percent of its expenditures, withdonations accounting for 10 to 15 percent. However, if donations fall short, then moremoney must come from additional fundraisers. Tuition revenue accounts for the other 80percent of the school income. The total operating budget for the school year is expectedto be $300,000 for the next school year, which is about a 10 percent increase over thecurrent school year.Fund raising has become a necessary evil. Parents are never very enthused about havingtheir children sell everything from candy to coupon books. Additionally, it is always hardto get volunteers to help with projects and sales. At the same time, the school needs tokeep tuition as low as possible so families can afford to send there children to a privateschool, and there are only so many sources of potential revenue.With the increase in popularity of home schooling, and competition from other privateand religious based schools, it is sometimes difficult to enroll and maintain students.Pleasant Private school has grades of kindergarten through eighth and needs a criticalmass 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 thefund 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 prepareher briefing for the school board, which will meet next week. Rita is a big supporter offund 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 theseactivities. Some board members want to raise tuition, and other board members areconsidering options like downsizing, or consolidation with another private school. Ritawants the school to stay independent and hopefully grow to include a high school. Sheknows that for this goal to become a reality, she will really need to sell the success offund raising as a source of revenue.


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Fund Raising Committee Year to Date ActivityBeg. Balance 966First PTO Meeting - Refreshments -106Supplies: Checks -50 Typewriter for Teachers -100 Rubber Stamps (library/deposit) -26Fruit Sale: Total Dep. 12,696 Total Exp. -6,697Teachers/Classroom: Conference, Newspaper week, supplies -462Library: Books, Magazines, Supplies -207Computers: Printers, software -1,327Items for School: Set up Sick room -54 Chairs/Library Cart -675 Standing Risers -994 Mascot -81 Lg. Bulletin Board, bul. strips -216 2-Chair Holders on wheels -300General Fund Set Up (helps with copy paper art sup. kitchen sup.) -705Kitchen Supplies -52Therapy: books, teachers conf. -446Board: Bldg. Fund -1,250 Endowment Fund -270 Light for Parking Lot -286Sub Sale: Total Dep. 5,007 Total Exp. -1,756T-Shirts/Sweat Shirts/School Bags -2,050Deposit for T-shirts, etc 916Carnival Sale: Total Dep. 2,540Food, prizes, games for carnival -2,076Garage Sale and Auction: Total Dep. 3,798Food and exp. for garage sale -363End. Balance 5,374

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


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

Chapter Three: Financial Statement Analysis

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Objectives1. Review the role and purpose of financial statement analysis.2. Identify the strengths and weaknesses of financial statement analysis.3. Analyze liquidity ratios.4. Analyze activity ratios.5. Analyze debt ratios.6. Analyze profitability ratios.7. Analyze market ratios.

The Role and Purpose of Financial Statement AnalysisFinancial statement analysis, or more specifically financial ratios, gives both the internaland external users of financial statements an opportunity to examine the performance of acompany through its publicly available financial record. The information gathered can beuseful for decision-making purposes in a variety of circumstances. This ratio analysis is asimple and easily understood process of measuring performance in percentage notation orsome 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 arelationship between the activities or accounts being measured. The mathematicalcomputation process is no more difficult than multiplication or division. However, theratios are only as good as the data provided and the user must be careful to insure thevalidity of the data, the accuracy of the calculation, and the correctness of the solutionincluding items such as proper unit labeling and decimal placement.The ratios themselves provide a means of comparison of this financial data with apredetermined or established standard. Indeed, a ratio analysis is virtually useless unlessthere is a means of comparison with some type of standard. The standard of comparisoncan be a budgeted or predetermined standard of the company, or it can be representativeof a prior year result of the company being analyzed. Standards could also be establishedexternally such as an industry standard or economic standard.While financial statement analysis can be a very powerful tool in measuring companyperformance, it is just that, a tool. The process is not an end in itself, but a means to anend. The ratios developed should lead to very important questions regarding companyperformance, but the analysis process will not answer the questions. Management andother users must rely on key individuals within the company or industry analyst topropose 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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Benefits of Financial Statement AnalysisProbably the greatest benefit of financial statement analysis is that it is a readilyacceptable means of analysis of company performance. The information generated iseasy to understand and interpret. Since the ratios are simple to compute, there is a vastselection of standards and other performance measures that can be used for comparisonpurposes.Both internal and external users can conduct financial statement analysis and theinformation gathered will aid in the users decision-making process. Often external usershave limited access to a company's performance; however, the publishing of financialstatements provides critical information that can be evaluated by external users foranalysis purposes. The procedures are common enough to allow for meaningfulcomparisons, even by external users.Financial statement analysis can provide information, which will generate importantquestions regarding the performance of the company. The analysis is based primarily onhistorical 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 forsituations in the future. Therefore, financial statement analysis plays an important role inthe management functions of planning and control.

Limitations of Financial Statement AnalysisFinancial ratios are primarily based on historical information, which may not be relevantfor the decision-making purposes of either the internal or external users. Companies arein a dynamic environment with constantly changing conditions. The users of financialstatement analysis must be aware of the changing situations when making their analysisand adjust accordingly.Industry standards are often at best just guidelines and may not be entirely appropriatemeasures of comparisons for specific companies. Also, within an industry, it may bedifficult 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 singlecompany. The generally accepted accounting principles actually allow for some variationin the reporting of financial information and the preparation of financial statements.Disclosure requirements state that a company must identify the differences in accountingpractice; however, these disclosures are often confusing and lengthy and an analyst couldeasily overlook or ignore the information. (Note: The following financial statements willbe used to develop examples of financial ratios.)


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Luke’s Sky & Walking ManufacturingIncome Statement

For the Years Ending December 31, 1995, 1996, & 1997Numbers in $1,000s

ACCOUNT 1995 1996 1997Sales Revenue $2,50

0$2,80

0$3,00

0- Cost of Goods Sold

1,500 1,600 1,900 = Gross Margin

1,000 1,200 1,100- Operating Expenses 400 450 520- Depreciation Expense 150 160 170= Operating Income 450 590 410- Interest Expense 170 220 270= Net Income Before Tax 280 370 140- Tax Expense 110 150 60= Net Income $

170$

220$

80Earnings Per Share

$1.70 $2.20 $ .80Luke’s Sky & Walking Manufacturing

Statement of Retained EarningsFor the Years Ending December 31, 1995, 1996, & 1997

Numbers in $1,000sACCOUNT 1995 1996 1997

Beginning Balance $300

$370

$470+ Net Income 170 220 80- Dividends 100 120 140= Ending Balance $37

0$47

0$410


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Luke’s Sky & Walking ManufacturingBalance Sheet

December 31, 1995, 1996, & 1997Numbers in $1,000s

ACCOUNT 1995 1996 1997Cash $ 50 $ 80 $ 60Accounts Receivable 320 300 360Inventory 350 400 450Prepaid Expenses 30 20 30Total Current Assets 750 800 900Land 300 300 300Building (Net) 2,200 2,500 2,400Equipment (Net) 990 1,140 1,400Total Long-Term Assets 3,490 3,940 4,100Total Assets $4,240 $4,740 $5,000

Accounts Payable $ 90 $ 110 $ 150Notes Payable 250 320 400Taxes Payable 10 20 20Deferred Revenue 20 20 20Total Current Liabilities 370 470 590Mortgage Payable 700 900 800Bonds Payable 800 900 1,200Total Long-Term Liabilities 1,500 1,800 2,000Total Liabilities $1,870 $2,270 $2,590Common Stock $2,000 $2,000 $2,000Retained Earnings 370 470 410Total Stockholders Equity $2,370 $2,470 $2,410Total Liabilities & Equity $4,240 $4,740 $5,000

Number of Shares of Stock 100,000

100,000 100,000Market Price Per Share $20.00 $25.00 $17.00Dividend Per Share $ 1.00 $ 1.20 $ 1.40


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Liquidity RatiosLiquidity ratios are designed to determine the company’s ability to meet short-termobligations. The ratios should aid in answering questions such as does a company haveenough cash or current assets that can be converted into cash within a short period of timeto pay its current liabilities on a timely basis. The ratios focus strictly on the currentassets and current liabilities from the balance sheet.

Current ratio

The current ratio is computed as follows:Current AssetsCurrent Liabilities

The ratio gives an indication of the number of times a company can pay its currentliabilities with current assets. Current assets are defined as cash or those assets which canbe readily converted into cash within a one year period of time and thus be available tofulfill the obligation of the current liabilities. Current liabilities are obligations that willmature 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 twiceas many current assets as current liabilities. A company does not want a current ratio thatvaries significantly in either direction from the standard. A current ratio that is too lowcould indicate a liquidity problem and a possible default situation. A current ratio that istoo high could indicate an unwise use of available assets, as the current assets generallyearn a lower return than the longer term assets. If given the choice; however, it is betterto have a current ratio that is too high versus too low, because of problems associatedwith a default condition.Using the financial statements for Luke’s Sky and Walking Manufacturing, the currentratios for 1995, 1996, and 1997 are shown in Illustration 3-1.

Current RatioIllustration 3-1

Current Ratio 1995 1996 1997

Current Assets 750 = 2.02 800 = 1.70 900 = 1.53Current Liabilities 370 470 590

Since a general industry guideline for the current ratio is 2.00, Luke’s company has failedto meet the standard for the last two years. Additionally, the trend is getting worse as theratio shows a continued and somewhat rapid decline. this is an area of concern and thereneeds to be additional investigation into the company’s liquidity situation.


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Quick RatioThe 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 notconsider some of the less liquid current assets in the analysis. Inventory is not as liquid acurrent asset because there is often not a ready market for inventory, and if the inventoryis 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 lessreliable source of ready cash to pay for current liabilities.Prepaid expenses are often a nonrefundable current asset, which can not be convertedback into cash. These prepaid items actually represent a payment of cash in advance forthe right to receive something in the future. Prepaid items are not considered useful inthe payment of liabilities.The generally recognized standard for the quick ratio is about 1.0 times which means thatthe amount of current assets not including inventory and prepaid expenses is essentiallyequal to the amount of current liabilities. The same rules and guidelines that apply to thecurrent ratio also apply to the quick ratio.The computation of the quick ratio for Luke’s company for 1995 through 1997 is seen inIllustration 3-2.The same conclusion regarding the current ratio can also apply to the quick ratio. Thecompany failed to equal the standard of 1.00 for the last two years. Also, there is a twoyear downward trend in the ratio. These ratio results reinforce the need for an evaluationof the liquidity related activities of the company.The overall conclusion regarding the liquidity ratio is not good, especially in light of thedeclining trend for both ratios. While the company may be efficiently managing theircurrent assets and current liabilities, there is little room for error. When current liabilitiesare due and payable, Luke’s company needs to have the current assets, and moreimportantly the cash, available to fulfill the obligation. The ratios are at about half thestandard in 1997.

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

are generated from a given level of assets.

Quick RatioIllustration 3-2

Quick Ratio 1995 1996 1997

Cash & Accts Receivable 370 = 1.00 380 = 0.81 420 = 0.71Current Liabilities 370 470 590


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Activity ratios, also called turnover ratios, are developed by taking a value from theincome statement, usually sales, in the numerator, and a value from the balance sheet,some measure of assets, in the denominator. The income statement measure representsan activity occurring over a period of time. For consistency, the balance sheet measure inthe denominator should also represent a period of time. To obtain the consistency, anaverage value is determined for the denominator, which is usually the average of abeginning balance and an ending balance. The input over output relationship gives themeasure of efficiency. The value of the turnover ratios are measured in a number oftimes, 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 toinclude a measure of an asset in the numerator, usually accounts receivable or inventoryand a daily sales or daily cost of goods sold in the denominator. These ratios indicate in anumber of days how long it takes to turnover a particular asset. The ratio is somewhatlike a reciprocal to the turnover ratios with the number of days in a year as a basis. If anaccounts receivable turnover ratio is 9.0 times, then the number of days in accountsreceivable is 40 days (9.0 times 40 days equals 360 days or one year). The greater thenumber of days in a ratio, the less efficient a company is at turning over a particularasset..

Accounts Receivable Turnover RatioThe accounts receivable turnover ratio is computed as follows:

Total Annual Credit SalesAverage Accounts Receivable

Total annual credit sales is considered in the numerator versus total annual sales becauseonly credit sales will generate an accounts receivable. Average accounts receivable isdetermined by summing the beginning balance of accounts receivable and the endingbalance of accounts receivable and dividing that total by two. It is better to have anaverage balance then to use either the beginning balance or the ending balance ofaccounts receivable since an average is generally more representative of the time periodin question as reflected by the sales amount in the numerator. One could argue that aneven more representative figure for average accounts receivable would be to obtain abalance at the end of each month and divide that total by twelve. The difficulty with thisprocess is the extra work involved and the possibility that monthly data will not beavailable, especially for external users. The increased accuracy from using monthly datato compute an average balance of accounts receivable probably will usually not offset thecost 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, thisnumber can vary widely depending on the industry being measured and the terms forcollection. The higher the number of turnovers the better the company is performing interms of the efficient use of its accounts receivable assets in generating credit sales. Ahigher turnover means that a company is doing a better job of collecting their accountsreceivable.The accounts receivable turnover ratio for 1996 and 1997 for Luke’s company arecomputed in Illustration 3-3.The assumption is made that all sales are sales on account. Additionally, ratios for onlytwo years can be calculated because an average balance in accounts receivable must be


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

Average Collection PeriodThe average collection period ratio is computed as follows:

Average Accounts ReceivableAnnual Credit Sales/360 Days

The average accounts receivable figure in the numerator is the same number used in thedenominator of the accounts receivable turnover ratio. The annual credit sales divided by360 days gives a value for daily credit sales. 365 days may also be used for the number ofdays in a year. The answer to the ratio is the average number of days it takes to collect anaccount receivable. A standard for this ratio may be about 60 days. Note: The averagecollection period can also be found by dividing the number of days in the year by theaccounts 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 easilyapplied to a company's credit policy. If a company is requesting payment of accountsreceivable in 30 days and the average collection period is 60 days, then even though theratio agrees with the standard, it does not appear that the accounts receivable collectionperiod is very effective. For this ratio, the lower the number of days for the averagecollection, the more efficient the company is in its collection of accounts receivable.The collection process is important because accounts receivable serves as a major sourceof 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 agood turnover of accounts receivable, they still may have a liquidity problem becausethey do not have sufficient cash. Companies can not pay off current liabilities with

Accounts Receivable Turnover RatioIllustration 3-3

Accounts Receivable Turnover 1996

Credit Sales = 2800 = 9.03Average Balance in Accts Receivable (320 + 300)/2

Accounts Receivable Turnover 1997

Credit Sales = 3000 = 9.09Average Balance in Accts Receivable (300 + 360)/2


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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 arecomputed in Illustration 3-4.The average collection period is about 40 days. If the terms of credit sales are net 30days, 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 ofthe payment. Additionally, there could be some processing inefficiencies. A goal of thecompany management could be to get the average collection period to no more than 30days.

Inventory Turnover RatioThe inventory turnover ratio is computed as follows:

Cost of Goods SoldAverage Inventory

The cost of goods sold figure is used in the numerator because inventory is recorded atcost, and as the inventory is sold an accounting transaction will show a decrease in theinventory account and an equal increase in the cost of goods sold account. The samelogic and discussion used for the average accounts receivable amount holds for theaverage inventory amount.A standard for inventory turnover may be about 4.0 times; however, the values for thisratio can probably vary more than any other ratio. In some companies inventory mayturnover almost daily and in that case the turnover could approach 300 times or more, andin other companies turnovers could be only one or two times per year. One needs to becareful in examining this ratio and understand the specific circumstances of eachcompany. As usual a higher turnover ratio is generally better because it demonstratesincreased efficiency in its use of the asset inventory. However, it is possible that too highan inventory turnover could mean inventory shortages which would have a negativeimpact on company sales.

Average Collection PeriodIllustration 3-4

Average Collection Period 1996

Avg Balance of Accts Receivable = (320 + 300)/2 = 310 = 39.9 daysCredit Sales Per Day 2800/360 7.78

Average Collection Period 1997

Avg Balance of Accts Receivable = (300 + 360)/2 = 330 = 39.6 daysCredit Sales Per Day 3000/360 8.33


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Some of the new inventory control models such as "just in time" inventory have led togreat improvements in inventory turnover and greater company performance andefficiency. Improved turnover does have an upper limit and companies may find that theincreased cost of more refined inventory control models may exceed the benefit ofincreased inventory turnover. Never the less, companies should continue to strive toidentify cost effective ways to improve inventory turnover.The inventory turnover ratio for Luke’s company for the years of 1996 and 1997 iscomputed in Illustration 3-5.The inventory turnover ratio is slightly better than the standard of 4.0. Additionally, thetrend shows a small improvement in turnover in 1997. A specific standard for thiscompany and industry is needed before any additional conclusions can be made regardingthe company’s inventory practices.

Average Inventory PeriodThe average inventory period ratio is computed as follows:

Average InventoryCost of Goods Sold/360 Days

The cost of goods sold divided by 360 days gives a daily cost of goods sold. The answerto this ratio is the average number of days it takes for a company to sell its inventory. Astandard for this ratio may be about 90 days. Note: The average inventory period can befound by dividing the number of days in a year by the inventory turnover ratio. (365days/4.0 times = 91 days)Just as it is with the inventory turnover ratio, the average inventory period can varywidely. The ratio is still very useful because it measures its value in days. As with theaverage collection period for accounts receivable, the average inventory period showshow 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 toconsider the average collection period in determining how long it takes from the time acompany obtains inventory until it receives the cash for its sale. For instance if theaverage collection period is 60 days and the average inventory period is 90 days, then itwill take 150 days from the time a company obtains inventory until a company obtains

Inventory Turnover RatioIllustration 3-5

Inventory Turnover Ratio 1996

Cost of Goods Sold = 1600 = 4.27Average Inventory (350 + 400)/2

Inventory Turnover Ratio 1997

Cost of Goods Sold = 1900 = 4.47Average Inventory (400 + 450)/2


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cash for the sale of this inventory. This two step process of going from inventory toaccounts receivable to cash is the reason why inventory is not included in the quick ratiocalculation.Companies must be very careful to maintain control of inventory. Even though inventoryis 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 thecustomer wants. Companies can get overloaded with obsolete inventory and still have agood current ratio; however, unless the inventory turnover ratio is satisfactory, thecompany can have a liquidity problem. Companies cannot pay off current liabilities withinventory, and the use of inventory as collateral can be a very expensive form offinancing.The average inventory period in days for Luke’s company for the years of 1996 and 1997is computed in Illustration 3-6.The average number of days in inventory improves from 84.4 days to 80.5 days which isconsistent with the improved inventory turnover ratio. A specific industry standard isneeded to determine if the average inventory period is satisfactory.

Total Asset Turnover RatioThe 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 notdistinguish between credit sales and cash sales. The average value of total assets is usedas opposed to an asset value on a specific date for the same reason that averages are usedon other turnover ratios. A standard for total asset turnover is about 1.5 times. Thecapital intensity of a company or its proportion of long-term assets can have a significantimpact on the total asset turnover ratio. Companies with a large amount of long-termassets will generally have lower total asset turnover ratios.

Average Inventory PeriodIllustration 3-6

Average Inventory Period 1996

Average Inventory Balance = (350 + 400)/2 = 375 = 84.4 daysCost of Goods Sold/Day 1600/360 4.44

Average Inventory Period 1997

Average Inventory Balance = (400 + 450)/2 = 425 = 80.5 daysCost of Goods Sold/Day 1900/360 5.28


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The total asset turnover ratio is an important component in the return on investmentcomputation which is one of the most widely recognized ratios by both internal andexternal users to measure overall company performance. The ratio considers two of themost important values from the financial statements, sales and total assets, and combinesinformation from the income statement and the balance sheet. Additionally, the totalasset turnover ratio gives an overall measure of company efficiency as it relates the outputof total assets with the input of sales.The total asset turnover ratio is computed for Luke’s company for 1996 and 1997 inIllustration 3-7.The total asset turnover ratio of 0.62 for each year appears to be quite low whencompared to a standard of 1.50. The trend is constant, but it appears that there isconsiderable room for improvement.The overall conclusion regarding the activity ratios is fair to poor. The accountsreceivable 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 ahighly capital intensive company (large amounts of long-term assets) which can be typicalfor manufacturing companies. The large amounts of long-term assets do not appear to begenerating the necessary levels of sales, which can have a detrimental effect on importantratios like return on assets and return on equity.

Debt RatiosDebt ratios relate to the use of borrowed funds to obtain assets. There are two broadsources of assets, lenders and owners. Debt ratios determine the make up of these sourcesof assets between lenders and owners. Debt ratios also identify a company's ability torepay debt obligations with earnings and cash.A company that uses debt or liabilities to obtain assets is said to be using financialleverage. Using other people’s money to secure assets which leads to generating returnfor 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 interestin a prescribed time period. If a company does not generate enough earnings to fulfill

Total Asset Turnover RatioIllustration 3-7

Total Asset Turnover 1996

Sales = 2800 = 0.62Average Total Assets (4240 + 4740)/2

Total Asset Turnover 1997

Sales = 3000 = 0.62Average Total Assets (4740 + 5000)/2


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such obligations then the company is in risk of default and bankruptcy. The higher thelevel of financial debt, the greater the risk a company could incur if something goeswrong, 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 thecompany's ability to meet its financial obligations. Balance sheet leverage ratios includethe debt to asset ratio and the debt to equity ratio. These ratios take values from thebalance sheet and aid in identifying the proportion of assets funded by debt. Coverageratios include the times interest earned ratio and the cash flow coverage ratio. Theseratios take values from the income statement and help to analyze a company's ability torepay debt and interest.

Debt to Asset RatioThe debt to asset ratio is computed as follows:

Total LiabilitiesTotal Assets

Total liabilities represents a single figure at the time the ratio is computed. Average totalliabilities does not need to be used as in the activity ratios because the balance sheetfigure is not being compared to an income statement figure. Total assets is also a singlefigure at the time the ratio is computed. Both figures are readily obtainable from thebalance sheet. The value of the ratio is given in a percentage. Since assets can be fundedthrough both liabilities and equities, the total asset figure should be larger than the totalliability figure and the ratio percentage should be less than 100 percent. A standardaverage may be about 55 percent, which means that slightly more than half of acompany's assets are funded by liabilities.Company management needs to be very careful in determining the amount of debt as asource of assets. Debt financing is considered a less risky source of funds because of thecontractual obligation to repay the principal amount plus interest within a specific periodof time. The holders of company debt do not incur as much risk as the holders ofcompany 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 companyis 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 ofdefault or bankruptcy by the company. Also, external users of financial information maynot 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 assetacquisition opportunities.The debt situation for companies is similar to an individual that gets too much in debt. Agreater portion of their earnings has to go to debt repayment, which could reduce theopportunities for asset growth. When an individual with high levels of debt desiresadditional assets, their only source of funds is often more debt, and that debt is even moreexpensive. Debt financing can be acceptable as long as it remains under control and theindividual can fulfill any repayment obligations. However, unforeseen circumstances canradically change an individual's financial position, and if that individual is in a high debtposition the financial risk is even greater.


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The debt to asset ratio for Luke’s company for the years 1995 through 1997 can becomputed as in Illustration 3-8.The debt to asset ratio is below the standard but there is a definite increasing trend. Itappears as though the company is funding a larger portion of its assets with debt. Theincreased debt funding can be advantageous for the company if it can make positive useof financial debt. If the increased levels of debt create a financial hardship, then this trendcould be an indication of future problems.

Debt to Equity RatioThe debt to equity ratio is computed as follows:

Total LiabilitiesTotal Equity

This ratio is virtually identical to the debt ratio with the only difference being the use oftotal equity in the denominator versus total assets. The ratio gives in a percentage therelationship between liabilities and equity. If more assets are funded by liabilities thanequity then the ratio will be greater than 100 percent. When equity is the greatest sourceof funding for assets, the ratio is less than 100 percent. A standard average may beslightly 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 toequity ratio. Companies need to balance the risk and return possibilities associated withdebt financing.The debt to equity ratio for Luke’s company for the years 1995 through 1997 can becomputed as is it is in Illustration 3-9.The debt to equity ratio is consistent with the debt to asset ratio. The trend shows theincreasing reliance on debt financing to fund assets. The company has gone fromliabilities equal to 79% of equity to almost 108% of equity. The level of total equity hasremained essentially stable while both assets and liabilities are steadily increasing withthe liabilities increasing as a faster rate.The previous ratios are classified as balance sheet ratios as they involve balance sheetfigures, which identify the sources of assets. The other types of debt ratios are classified

Debt To Asset RatioIllustration 3-8

Debt/Asset Ratio 1995 1996 1997

Total Liabilities 1870 = 44.1% 2270 = 47.9% 2590 = 51.8%Total Assets 4240 4740 5000

Debt to Equity RatioIllustration 3-9

Debt/Equity Ratio 1995 1996 1997

Total Liabilities 1870 = 78.9% 2270 = 91.9% 2590 = 107.5%Total Equity 2370 2470 2410


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as coverage ratios. The coverage ratios are used to determine a company's ability to paythe finance charges of interest and principal repayment.

Times Interest Earned RatioThe times interest earned ratio is computed as follows:

Net Operating IncomeAnnual Interest Expense

orEarnings before Interest and Taxes

Annual Interest ExpenseThe numerator of net operating income considers all revenue and expense items with theexception of financing related activities and taxes. The supplementary income figure is ameasure of the operating performance of the company over a period of time usually oneyear. The ratio indicates how many times the operating income will cover the interestexpense obligation. A standard for this ratio is about 2.5 times.If companies cannot generate enough operating income to cover financing charges theyare in risk of default on their debt obligations. Companies that have higher degrees offinancial 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 majorconcern should be for a low times interest earned value.The times interest earned ratio for Luke’s company for 1995 through 1997 is computed inIllustration 3-10.The company is near the standard for times interest earned until 1977 when there is anoticeable decline in the rate. The decline is caused by both a drop in operating incomeand an increase in the interest expense. The company is getting close to being in dangerregarding the responsibility of paying interest with available income.

Cash Flow Overall Coverage RatioThe 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 withcash, and net operating income does not necessarily mean cash. The numerator needs tobe converted from a net operating income position to a cash position. Lease expenses areusually deducted as part of an operating expense to arrive at net income, therefore theamount 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 notinvolve cash. The most obvious expense of this nature is depreciation. In order to arrive

Times Interest Earned RatioIllustration 3-10

Times Interest 1995 1996 1997

Operating Income 450 = 2.65 590 = 2.68 410 = 1.52Interest Expense 170 220 270


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at a cash position, the amount of all noncash types of expenses needs to be added back tothe net operating income. The resulting numerator could be classified as cash flow fromoperating income activities.The amount in the numerator represents the amount of cash available from operatingactivities. 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 wasmoved from an operating activity to a financing activity, it too must be included in thedenominator for cash coverage purposes.Some cash payments can be made with only after tax net income or cash. Preferreddividends which display characteristics similar to debt instruments are paid with after taxdollars. Also, any principal repayment of debt is made without the benefit of any taxsavings. To get all of the terms in the ratio on a consistent tax related basis, those itemspaid 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 makethe 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 isnot the same as net operating income. Additionally, the ratio identifies all financialobligations and adjusts them as appropriate for tax implications. Just because a companycan cover their interest expenses does not mean that they have adequate cash coverage forall financial obligations. A company with a satisfactory times interest earned ratio maynot have sufficient cash for a satisfactory cash flow coverage ratio. If only the moreeasily determined times interest earned ratio is computed, the analyst may come to anincorrect conclusion.As with the times interest earned ratio, the only real danger is a low number. A companythat does not have coverage ability is in risk of default whether it fails to meet interestpayments or debt principal or lease payments. The cash flow overall coverage ratio is arelatively new ratio which has gained its recognition of importance as companies realizethe necessity to closely monitor cash.The cash flow overall coverage ratio for Luke’s company for the years 1995 through 1997can be computed as in Illustration 3-11.


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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. Anassumption will be made that $100 of principal repayments will be due every year andthis amount is included in the denominator. Given the amount of debt, the $100 per yearassumption is reasonable. Also, the tax rate is computed by dividing the tax expenses bythe 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 aconsiderable decline in 1997. Again, the company is showing signs of weakness in itsability to cover fixed financial obligations and the trend indicates the situation is gettingworse.The debt ratios all confirm a trend that is leading to greater levels of debt. The balancesheet ratios show that asset expansion is being funded solely by increases in the level ofdebt. This action is beginning to have an effect on the income statement as higheramounts of interest expense are causing decreases in the coverage ratios. Luke’scompany could be just about at its limit in the debt situation. Action needs to be taken toreverse or at least curtail this trend.

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

expect to have a long-term existence if it continues to fail to make a profit. An absoluteamount representing a company's net income or profit has value; however, this figurecannot 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

Cash Flow Coverage RatioIllustration 3-11

Cash Flow Coverage 1995

Ops Income + Depreciate = 450 + 150 = 600 = 1.79Interest Expense + Principal

Payment/(1.0 - Tax Rate)170 + [(100)/(1.0 - .393)] 335



Payment/(1.0 - Tax Rate)220 + [(100)/(1.0 - .405)] 388



Payment/(1.0 - Tax Rate)270 + [(100)/(1.0 - .429)] 445


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can make comparisons between profit and other measures of performance on a relativebasis.Profitability ratios can be classified into two broad categories to include profitabilityrelated to sales or other income statement items and profitability related to investments orother balance sheet items. In all the profitability ratios, net income or somesupplementary measure of income statement performance such as net operating income orgross margin will be the numerator. For income statement related ratios sales willgenerally be the denominator. For balance sheet related ratios average total assets oraverage total equity will usually be the denominator.

Gross Profit MarginThe gross profit margin is computed as follows:

Gross MarginNet Sales

The numerator gross margin equals net sales less cost of goods sold. The denominatorequals 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 earningspotential of the company. Frequently, net sales is the same as sales revenue as theamount of the deduction from gross sales is relatively insignificant. If a net sales figure isnot available from the income statement the sales figure is an acceptable and sometimes apreferred alternative because it is easier to identify and interpret.The value of this ratio in percent terms identifies how much of the sales dollar remainsafter covering the cost of the good or service that has been sold. A standard for grossprofit margin is between 25 and 30 percent. This ratio implies that for every dollar ofsales between 70 and 75 cents goes to the actual cost of the good or service sold and onlybetween 25 and 30 cents remains to cover other operating, financial, and tax expensesplus leaving a profit margin. The higher the percentage, the better the company is doingin generating potential profitability.For Luke’s company, the gross profit margin for the years of 1995 through 1997 can becomputed as in Illustration 3-12.The gross profit margins for Luke’s company are all above standard. The companyappears to be earning a satisfactory revenue above the cost of its product. The grossprofit margin has shown a negative trend in 1997, which could be a sign of trouble in thefuture. Also, the depreciation expense listed under operating expenses could easily bepart of cost of goods sold which would cause a decrease in the margin.

Operating Profit Margin RatioThe operating profit margin ratio is computed as follows:

Net Operating Income

Gross Profit Margin RatioIllustration 3-12

Gross Profit 1995 1996 1997

Gross Margin 1000 = 40.0% 1200 = 42.9% 1100 = 36.7%Sales Revenue 2500 2800 3000


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Net SalesThe numerator net operating income is a supplementary income figure that is determinedafter all operating expenses have been deducted from net sales revenue. The percentagevalue for this ratio indicates what portion of the sales dollar remains for financingcharges, taxes and profit margin.A standard for the net operating margin is about 10 percent. This value means that forevery dollar of sales approximately 90 cents goes to operating expenses leaving onlyabout 10 cents for finance charges, taxes and profit. This figure seems relatively low andindicates 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 thecompany is doing a better job at generating potential profitability. The only danger withthis ratio is if the value is too low, it could indicate that the company is not generatingsufficient earnings from their sales and operating activities, especially if there aresignificant financial charges.The operating profit margin ratio for Luke’s company for the years 1995 through 1997 iscomputed in Illustration 3-13.The operating profit margin ratios are above standard; however, there is a significantdecrease for 1997. The satisfactory operating profit margin is a carryover from thesatisfactory gross profit margin. The fact that the company has good margins gives themthe opportunity to adequately cover the interest expense related to debt or to have asuperior net profit margin.

Net Profit Margin RatioThe net profit margin ratio is computed as follows:

Net IncomeNet Sales

This ratio considers the after tax net income figure in the numerator and reflects theresidual of all items of revenue and expense from the income statement. The percentagevalue 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 marginreinforces the fact that only a very small proportion of every sales dollar ends up as netprofit. The higher the ratio, the better the company performance as measured in terms ofprofitability.

Operating Profit Margin RatioIllustration 3-13

Operating Profit 1995 1996 1997

Operating Income 450 = 18.0% 590 = 21.1% 410 = 13.7%Sales Revenue 2500 2800 3000


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The net profit margin ratio for Luke’s company for the years 1995 through 1997 iscomputed in Illustration 3-14.The company experienced good net profit margins above industry standards for the firsttwo years. There was a noticeable decline in the net profit margin in 1997. This may be atemporary condition of the company or it may be an early indication of continuingproblems. 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 salesrevenue was included in the denominator of every ratio. The remaining profitabilityratios are measured in relation to investment. The denominator of these ratios willinclude a balance sheet item such as average total assets or average total equity.

Return on Total Assets or Return on Investment RatioThe 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 balancesheet item is being related to an income statement item. The net income reflects activitiesover a period of time, revenues minus expenses. To have consistency in the ratio, theasset 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 assetamount could have been over the entire period. Using an average of the beginning andending balances will probably give a closer approximation of the proper amount of totalassets to compare to net income.The value of this ratio is recorded in a percent figure, and a standard is around 6.0percent. The ratio implies that for every dollar of assets a company owns it earns a netincome of about six cents.The return on total assets ratio is frequently broken down into two ratios, which havebeen previously, discussed; the total asset turnover ratio and the net profit margin ratio.The computations for these two ratios are as follows:

Sales X Net Income = Net IncomeAverage Total Assets Sales Average Total Assets

The breakdown of the return on total assets ratio can help to determine the level of impacton the return due to asset turnover and what impact is due to profit margin. Some

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

Net Profit Margin RatioIllustration 3-14

Net Profit Margin 1995 1996 1997

Net Income 170 = 6.8% 220 = 7.9% 80 = 2.7%Sales Revenue 2500 2800 3000


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of course, a company would desire high asset turnover and high profit margin, but oftenthe company cannot have the best of both situations.

The return on total assets for Luke’s company for the years of 1996 and 1997 can becomputed as in Illustration 3-15.The return on total assets is below the standard for both years with a noticeable decline in1997. A break out of the ratio into the turnover component and the profit margincomponent, 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 netprofit margin in 1996 resulted in a relatively satisfactory return on asset ratio. In 1997when the net profit margin fell, both components of the return on asset ratio were lessthan satisfactory which resulted in a very low return on asset value. In 1997, the ratioimplies that for every dollar of assets, the company earned 1.64 cents.

Return on Common Equity RatioThe return on common equity ratio is computed as follows:

Net Income Available to Common ShareholdersAverage Common Equity

The numerator net income figure is adjusted for any dividend payments to preferredshareholders leaving only the earnings available for potential distribution to the commonshareholders. 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 thedenominator is related to an income statement figure in the numerator.

Return on Total AssetsIllustration 3-15

Return on Total Assets 1996

Net Income 220 = 4.90%Average Total Assets (4240 + 4740)/2

Return on Total Assets 1997

Net Income 80 = 1.64%Average Total Assets (4740 + 5000)/2

Return on Total AssetsIllustration 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%


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An investor desires to know what percentage of return is gained through a stockinvestment in a specific company. A standard is between 9 and 10 percent. This figurestates that for every dollar of investment in common stock, the owner of the shares isreceiving 9 to 10 cents per year. A higher return is generally better as it indicates thatinvestors are gaining more return for dollar invested.The return on common equity has to be considered in light of the risk. A certificate ofdeposit 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 aninvestor wants to assume for additional return is an individual investor decision. Acompany with the highest return on common equity may not be the best option because ofthe potential greater degree of risk.The return on equity ratio for Luke’s company for the years of 1996 and 1997 arecomputed in Illustration 3-17.The return on equity ratio is generally equal to the standard for 1996, but declinesconsiderably in 1997. The 1997 results indicate only a 3.28% rate of return on everydollar invested by owners of the company. The risk associated with holding commonstock, and the fact that the rate of return on equity may be lower than the return on a riskfree investment instrument like a US Treasury bill is cause for concern. Investors need toknow 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 externalfactors, such as, the economy going into a recession or increased foreign competition.The profitability ratios showed relatively good but not great performance for 1995 and1996. However, in 1997 a declining trend was evident in every ratio. Many factors maybe causing the decline, but the increased debt load certainly appears to be contributing toa reduced net income.

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

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

Return on Equity RatioIllustration 3-17

Return on Equity 1996

Net Income 220 = 9.09%Average Equity (2370 + 2470)/2

Return on Equity 1997

Net Income 80 = 3.28%Average Equity (2470 + 2410)/2


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information from the financial statements but values such as market price of the companystock and the number of shares of common stock actively traded on the open market.

Earnings Per Share RatioThe 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 thenumber of shares actively traded in the stock market. These shares are available for anyinvestor 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 adollar amount of annual return for each share of stock owned by an investor. A higherearnings per share figure is better; however, the value must be considered in relation to atrend and also the market price of the stock. Keeping all other factors constant, aninvestor would be better off with an earnings per share of $1.00 on a stock with a marketprice 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 forearnings per share. A better approach to analyze earnings per share is to look at theearnings per share trend for each individual company over time. Ideally, the trend isincreasing at a steady and constant rate. This condition indicates that the company iscontinuously earning more income for each share of stock. Companies recognize theimportance of the earnings per share figure and promote it extensively, especially when itis responding favorably.The earnings per share ratio has been included in the income statement for Luke’scompany for the years of 1995 through 1997. The computation is seen in Illustration 3-18.

Note: There were 100,000 shares of common stock outstanding. Since the dollar amountof net income was in $1,000s, the number of shares also has to be listed in 1,000s for aconsistent ratio computation.The earnings per share ratio has an acceptable increase in 1996 followed by a significantdecline in 1997. The decline in 1997 will no doubt have a negative impact in the mindsof investors as reflected in the market price of the stock, which declines in 1997.

Earnings Yield on Common Stock RatioThe earnings yield on common stock ratio is computed as follows:

Earnings Per Share Market Price Per Share

Earnings Per Share RatioIllustration 3-18

Earnings/Share 1995 1996 1997

Net Income 170 = $1.70 220 = $2.20 80 = $0.80Number of Shares ofStock Outstanding

100 100 100


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The earnings yield ratio overcomes the problem associated with the earnings per shareratio when it is not compared to the market price of common stock. An absolute measureof earnings per share may not give an accurate measure of performance until the relativemeasure of earnings yield on common stock is determined.Since both the numerator and denominator contain dollar amounts per sharemeasurements, the dollar per share components cancel out and the ratio measurement is apercentage described as the yield. This earnings yield is a measure of return for eachdollar 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 yieldshould be considerably above the yield on a virtually risk free investment like a certificateof deposit.In the example previously described in the earnings per share ratio discussion, the firststock with an earnings per share of $1.00 and a market price per share of $10.00 has ayield 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 percentversus 9 percent for the $100.00 stock.The earnings yield on the common stock for Luke’s company for 1995 through 1997 iscomputed in Illustration 3-19.The earnings yield on common stock remains relatively constant for the years 1995 and1996. The increase in the market price of the common stock in 1996 is a reflection of theincrease in the earnings per share. However, in 1997, the overall decline in performancecaused 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 theproblems surfacing in 1997 are ongoing.

Price Earnings RatioThe price earnings ratio is computed as follows:

Market Price Per ShareEarnings Per Share

The price earnings ratio is the reciprocal of the earnings yield ratio. The ratio states howmany times greater the market price for a share of company stock is over the earnings ofthat 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 toapply that standard to an individual stock can be risky. A major purpose of the price

Earnings Yield RatioIllustration 3-19

Earnings Yield 1995 1996 1997

Earnings/Share 1.70 = 8.5% 2.20 = 8.8% 0.80 = 4.7%Market Price ofCommon Stock

20.00 25.00 17.00


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earnings ratio is to aid in determining if a stock is under or overvalued. To make ageneralization that a stock selling for greater than 15 times earnings is overvalued is amistake. Sometimes stocks selling for 40 times earnings are still undervalued; especiallyif the potential for rapid growth, such as in the technologies industry, is evident. At thesame time a stock selling for only 5 times earnings may be overvalued if the company ison the way to bankruptcy. An investor should use the price earnings ratio with caution and in conjunction withother relevant ratios and financial information before making a determination if a stock isover or undervalued. Generally, it is better to consider the price earnings ratio for anindividual company over a time horizon. If the trend in the price earnings ratio isincreasing that could indicate a favorable situation, and if the trend is decreasing, thesituation could be unfavorable. However, an increase in the price earnings ratio couldoccur when earnings fall and the stock price does not react immediately to the decline inearnings with a proportional decline in its price. Likewise, the price earnings ratio coulddecline in a time of increasing earnings because the market price of the stock does notincrease.The price earnings ratio for Luke’s company for the years of 1995 through 1997 iscomputed in Illustration 3-20.The company stock seemed to be selling at a relatively consistent price earnings ratio ofbetween 11 and 12 times earnings, which is below the standard. The lower price earningsratio 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 theprice earnings ratio in 1997 to 21.3, almost double the previous year’s amount does notnecessarily imply increased investor confidence in the company as could be reflected in ahigher market price. In fact the market price went down by a considerable amount. Thegreatest cause for the increase in the price earnings ratio is due to a decline in earningsper share, which could imply that the stock is still overpriced and could be due for anadditional correction. The stock has already declined in value and could be subject to agreater decline in the current conditions of the company do not improve.

Price Earnings RatioIllustration 3-20

Price Earnings 1995 1996 1997

Price/Share 20.00 = 11.8 25.00 = 11.4 17.00 = 21.3Earnings/Share 1.70 2.20 0.80


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Dividend Yield on Common Stock RatioThe 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 thedividend is providing in relation to the market price of the common stock. The dividendyield may be relatively low in relation to yields on securities such as certificates ofdeposit; however, common stocks can also gain returns through growth in the marketprice of the stock. Also, some companies, especially in growth industries, may not payany dividends.The goal of the investor in common stock will determine whether a high or low dividendyield is desirable. Investors interested in income oriented stocks are looking for higherdividend yields. Investors looking for growth oriented stocks are satisfied with lowdividend yields.The dividend yield ratio for Luke’s company for the years of 1995 through 1997 iscomputed in Illustration 3-21.The dividend yield appears to be reasonable and maybe high for this company for 1995and 1996. In 1997, the dividend yield increases because of the decline in the stockmarket price and the continued increase in the dividend rate per share. The company maybe trying to maintain a policy of always increasing dividends but they are facing a risk ofdeclining retained earnings and may be forced to cut or eliminate dividends in the future.

Payout Ratio on Common StockThe payout ratio on common stock ratio is computed as follows:

Dividend Per ShareEarnings Per Share

For every dollar of earnings a company can either pay out the dollar as a dividend orretain the dollar and reinvest it in new company assets. Companies in growth industrieswill have a low payout ratio, as there are many opportunities to reinvest earnings inproductive assets that will lead to higher earnings and the potential for an increasingmarket price of the common stock. Companies in more mature industries will tend tohave higher payout ratios because the opportunities to reinvest earnings in productiveassets are limited. The market price of the mature industry stock may not increase asrapidly; however, this is made up to an extent by the higher dividend payout ratio, and thelikelihood for a higher dividend yield.Investors will make the decision regarding the type of stock they are most interested in

Dividend Yield RatioIllustration 3-21

Dividend Yield 1995 1996 1997

Dividend/Share 1.00 = 5.0% 1.20 = 4.8% 1.40 = 8.2%Price/Share 20.00 25.00 17.00


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obtaining. Income oriented investors will be looking for stocks with higher dividendpayout ratios. Growth oriented investors will select stocks with low dividend payoutratios.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 futureasset acquisition. The sum of the two options equals 100 percent. Once the dividendpayout ratio is computed in terms of a percent, the retention ratio can be determined asthe remaining percentage.The dividend payout ratio for Luke’s company for the years of 1995 through 1997 iscomputed in Illustration 3-22.The dividend payout ratio was relatively constant in 1995 and 1996. The company waspaying out more than half of its earnings in dividends. This can be an acceptable payoutratio for a company in a mature industry without high levels of growth. The companytotal asset growth in 1996 was almost 12% (4740 - 4240)/4240 = 12%. In 1997, the totalasset growth was (5000 - 4740)/4740 = 5.5%. The dividend payout ratio may have beentoo high in 1995 and 1996 to support the level of asset growth. The company was tryingto expand its asset base and maintain attractive dividends at the same time, which couldhave put severe restrictions on its cash position. The company had to rely on debt issuesto finance asset growth. In 1997, the company maintained a consistent policy ofincreasing dividends in the face of declining earnings. The dividends were greater thanearnings and resulted in a decreased balance in retained earnings.

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

Dividend Payout RatioIllustration 3-22

Dividend Payout 1995 1996 1997

Dividend/Share 1.00 =58.8% 1.20 =54.6% 1.40 =175.0%Earnings/Share 1.70 2.20 0.80


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for each item analyzed in the specific financial statement; however, the information aloneis limited unless there can be some standard for comparison purposes.The vertical analysis of an income statement uses sales revenue as the denominator andvarious measures of expense or margin as the numerator. Sales revenue represents a 100percent component of the income statement and each segment is some fraction of sales.Several profitability ratios that have already been presented are examples of verticalanalysis. The gross profit margin ratio, operating profit margin ratio, and net profitmargin ratio all represent vertical analysis from the income statement. Specific expensecategories such as cost of goods sold, operating expenses, interest expenses and taxexpenses are sometimes compared to sales revenue on a percentage basis. Each line itemon an income statement can be represented as a percent of total sales revenue, with thesum of all of the expense percentages and net income equaling 100 percent. In the caseof Luke’s company the sum of cost of goods sold, operating expenses, depreciationexpense, 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 inIllustration 3-23Vertical analysis is also used with the balance sheet. Total assets is used as thedenominator, 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 sheetvertical analysis. Other balance sheet categories used as numerators include currentassets, 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 everyline item shown as a percent of total assets.A balance sheet with vertical analysis for each line item for 1995 is presented inIllustration 3-24.

Illustration 3-23Luke’s Sky & Walking Manufacturing

Income StatementFor the Year Ending December 31, 1995

Numbers in $1,000sACCOUNT 1995 PercentSales Revenue $2,50

0100.0

- Cost of Goods Sold 1,500 60.0= Gross Margin 1,000 40.0- Operating Expenses 400 16.0- Depreciation Expense 150 6.0= Operating Income 450 18.0- Interest Expense 170 6.8= Net Income Before Tax 280 11.2- Tax Expense 110 4.4= Net Income $ 170 6.8


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


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Illustration 3-24Luke’s Sky & Walking Manufacturing

Balance SheetDecember 31, 1995Numbers in $1,000s

ACCOUNT 1995 Percent

Cash $ 50 1.2Accounts Receivable 320 7.6Inventory 350 8.3Prepaid Expenses 30 0.7Total Current Assets 750 17.7Land 300 7.1Building (Net) 2,200 51.9Equipment (Net) 990 23.4Total Long-Term Assets 3,490 82.3Total Assets $4,240 100.0Accounts Payable $ 90 2.1Notes Payable 250 5.9Taxes Payable 10 0.2Deferred Revenue 20 0.5Total Current Liabilities 370 8.7Mortgage Payable 700 16.5Bonds Payable 800 18.9Total Long-Term Liabilities 1,500 35.4Total Liabilities $1,870 44.1Common Stock $2,000 47.2Retained Earnings 370 8.7Total Stockholders Equity $2,370 55.9Total Liabilities & Equity $4,240 100.0Note: The total percent amounts may not equal the sums of the components due torounding.


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ProblemsUse the income statement, statement of retained earnings and balance sheet for the FACInc. to answer problems 3-1 through 3-13.

FAC Inc.Income Statement

For the Year Ending December 31, 1997Numbers in $1,000s

Sales Revenue $1,000

- Cost of Goods Sold 650= Gross Margin 350- Other Expenses Depreciation $

50 Administration

100 -150

= Operating Income 200- Interest Expense 30= Net Income Before Tax 170- Tax Expense 80= Net Income 90

FAC Inc.Statement of Retained Earnings

For the Year Ending December 31, 1997Numbers in $1,000s

Beginning Balance Retained Earnings $320+ Net Income 90- Dividends 60= Ending Balance Retained Earnings $350


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FAC Inc.Balance Sheet


ASSETSCurrent Assets Cash $

160 Accounts Receivable 180 Inventory 350 Prepaid Expenses 40 Total Current Assets $

730Long-Term Assets Land 180 Building $

900 - Accumulated Depreciation

200 700

Total Long-Term Assets 880Total Assets $1,61

0LIABILITIES & EQUITYCurrent Liabilities Accounts Payable $

120 Notes Payable 140 Total Current Liabilities $ 260Long-Term Liabilities Mortgage Payable 400Total Liabilities 660Stockholders Equity Common Stock 100,000 shares 600 Retained Earnings 350Total Stockholders Equity 950Total Liabilities & Equity $1,610Market Price Stock = $12/share


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Use the income statement, statement of retained earnings and balance sheet for the FACInc. to answer problems 3-1 through 3-13. Note when questions refer to acomparison to standards, use the standards as identified in the text.Problem 3-1 Liquidity RatiosCompute the current ratio and the quick ratio for the FAC Inc. for 1997. What conclusioncan be made regarding these ratios when compared to the standard?

Problem 3-2 Accounts Receivable RatiosCompute the accounts receivable turnover ratio and the average collection period for theFAC Inc. for 1997. What conclusion can be made regarding these ratios when comparedto the standard? Note: the beginning balance of accounts receivable was $140. Unlessotherwise stated, assume that all sales are on account.

Problem 3-3 Inventory RatiosCompute 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 thestandard? Note: the beginning balance of inventory was $300.

Problem 3-4 Total Asset RatioCompute the total asset turnover ratio for the FAC Inc. for 1997. What conclusion can bemade regarding this ratio when compared to the standard? Note: the beginning balanceof total assets was $1,550.

Problem 3-5 Balance Sheet Debt RatiosCompute 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 RatiosCompute 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 thestandard? Assume that $20 of the mortgage payable was paid during the year.


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Problem 3-7 Profitability RatiosCompute the gross profit margin ratio, the operating profit margin ratio, and the net profitmargin ratio for the FAC Inc. for 1997. What conclusion can be made regarding theseratios when compared to the standard?

Problem 3-8 Return on Assets RatioCompute the return on assets ratio for the FAC Inc. for 1997. Divide the return on assetsratio into a total asset turnover ratio and a net profit margin ratio. What conclusion canbe made regarding these ratios when compared to the standard?

Problem 3-9 Return on Equity RatioCompute the return on equity ratio for the FAC Inc. for 1997. Note: the beginningbalance for total stockholders equity was $920. Compare the return on equity ratio withthe 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 RatioCompute the earnings per share ratio, the earnings yield on common stock ratio, and theprice earnings ratio for FAC Inc. for 1997. What conclusions can be made regardingthese ratios when compared to the standard?

Problem 3-11 Dividend RatiosAssume that FAC Inc. paid $60,000 in dividends in 1997. Compute the dividend yield oncommon stock ratio, and the dividend payout ratio for FAC Inc. for 1997.

Problem 3-12 Vertical AnalysisComplete a line item vertical analysis for the income statement of the FAC Inc. for 1997.

Problem 3-13 Vertical AnalysisComplete 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 StatementFor the Years Ending December 31, 1995, 1996, & 1997

Numbers in $1,000s

ACCOUNT 1995 1996 1997

Sales Revenue $4,800 $5,000 $6,200

- Cost of Goods Sold 3,000 3,200 4,000= Gross Margin 1,800 1,800 2,200- Operating Expenses 600 650 700- Depreciation Expense 200 300 300= Operating Income 1,000 850 1,200- Interest Expense 200 300 500= Net Income Before Tax 800 550 700- Tax Expense 320 220 280= Net Income $ 480 $ 330 $ 420Earnings Per Share $2.40 $1.65 $2.10

Lucky Manufacturing Inc.Statement of Retained Earnings


ACCOUNT 1995 1996 1997

Beginning Balance $500 $680 $660+ Net Income 480 330 420- Dividends 300 350 400= Ending Balance $680 $660 $680


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Lucky Manufacturing Inc.Balance Sheet


ACCOUNT 1995 1996 1997

Cash $ 100 $ 120 $ 200Accounts Receivable 580 640 720Inventory 400 700 800Prepaid Expenses 50 80 100Total Current Assets 1,130 1,540 1,820Land 800 800 800Building (Net) 3,600 4,000 6,000Equipment (Net) 1,540 2,060 2,200Total Long-Term Assets 5,940 6,860 9,000Total Assets $7,070 $8,400 $10,820

Accounts Payable $ 300 $ 450 $ 770Notes Payable 450 520 700Taxes Payable 90 220 120Deferred Revenue 50 50 50Total Current Liabilities 890 1,240 1,640Mortgage Payable 1,000 2,000 3,000Bonds Payable 2,000 2,000 3,000Total Long-Term Liabilities 3,000 4,000 6,000Total Liabilities $3,890 $5,240 $ 7,640Common Stock $2,500 $2,500 $ 2,500Retained Earnings 680 660 680Total Stockholders Equity $3,180 $3,160 $ 3,180Total Liabilities & Equity $7,070 $8,400 $10,820

Number of Shares of Stock 200,000 200,000 200,000Market Price Per Share $36.00 $30.00 $32.00Dividend Per Share $ 1.50 $ 1.75 $ 2.00Use the income statement and balance sheet for the Lucky Manufacturing Inc. to answerproblems 3-14 through 3-26.


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Problem 3-14 Liquidity RatiosCompute the current ratio and the quick ratio for the Lucky Manufacturing Inc. for 1995through 1997. What conclusion can be made regarding these ratios when compared to thestandard?

Problem 3-15 Accounts Receivable RatiosCompute the accounts receivable turnover ratio and the average collection period for theLucky Manufacturing Inc. for 1996 and 1997. What conclusion can be made regardingthese ratios when compared to the standard?

Problem 3-16 Inventory RatiosCompute the inventory turnover ratio and the average inventory period for the LuckyManufacturing Inc. for 1996 and 1997. What conclusion can be made regarding theseratios when compared to the standard?

Problem 3-17 Total Asset RatioCompute the total asset turnover ratio for the Lucky Manufacturing Inc. for 1996 and1997. What conclusion can be made regarding this ratio when compared to the standard?

Problem 3-18 Balance Sheet Debt RatiosCompute the debt to asset ratio and the debt to equity ratio for the Lucky ManufacturingInc. for 1995 through 1997. What conclusion can be made regarding these ratios whencompared to the standard?

Problem 3-19 Coverage Debt RatiosCompute the times interest earned ratio and the cash flow coverage ratio for the LuckyManufacturing Inc. for 1995 through 1997. Assume that $120,000 of principal repaymentis made each year. What conclusion can be made regarding these ratios when comparedto the standard?

Problem 3-20 Profitability RatiosCompute the gross profit margin ratio, the operating profit margin ratio, and the net profitmargin ratio for the Lucky Manufacturing Inc. for 1995 through 1997. What conclusioncan be made regarding these ratios when compared to the standard?


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Problem 3-21 Return on Assets RatioCompute 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 marginratio. What conclusion can be made regarding these ratios when compared to thestandard?

Problem 3-22 Return on Equity RatioCompute 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 21above. Why are the values different? What conclusion can be made regarding theseratios when compared to the standard?

Problem 3-23 Market RatioCompute the earnings per share ratio, the earnings yield on common stock ratio, and theprice earnings ratio for Lucky manufacturing Inc. for 1995 through 1997. Whatconclusions can be made regarding these ratios when compared to the standard?

Problem 3-24 Dividend RatiosCompute the dividend yield on common stock ratio, and the dividend payout ratio forLucky Manufacturing Inc. for 1995 through 1997.

Problem 3-25 Vertical AnalysisComplete a line item vertical analysis for the income statement of the LuckyManufacturing Inc. for 1995 through 1997.

Problem 3-26 Vertical AnalysisComplete a line item vertical analysis for the balance sheet of the Lucky ManufacturingInc. for 1995 through 1997.


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Cases

Case Study 3-1 Chesapeake CollegeDr. George Heileg, provost of Chesapeake College, had just finished reading an article inthe Journal of Higher Education, which highlighted special ratios that could be moreappropriate for measuring the performance of nonprofit organizations like universities,and social and medical agencies. Additionally, the article included some industrystandards for the ratios. The provost thought it would be a worthwhile exercise for thecontroller of Chesapeake College to complete a financial statement analysis using thesespecific ratios so he sent a copy of the article and ratios to Teri Black, the controller.Ratio Computation StandardCash Ratio Cash and Equivalents/Current Liabilities 1.40Cash Reserve Ratio Average Cash and Equivalents/Daily Expenses 55 DaysDonation Ratio Total Contributions/Total Revenues 0.64Net Operating Ratio Total Surplus or Deficit/Total Revenue 0.06Fund Balance Ratio Average Fund Balance/Total Expenses 0.89Program Expense Ratio Total Program Expense/Total Expense 0.80Support Services Ratio Total Support Service Expense/Total Expense 0.20

Teri liked the idea of analyzing the statements using the new ratios, and also suggestedtrying several other ratios, which could be more appropriate for Chesapeake College.These ratios would not have industry standards for comparison purposes but the ratioscould be compared over time within Chesapeake College.Ratio Computation StandardTuition Ratio Total Tuition/Total RevenueFund Balance Return Total Surplus or Deficit/Average Fund BalanceCash Liquidity Ratio Cash and Equivalents/Current AssetsCapital Structure Ratio Total Liabilities/Total AssetsFund Balance Structure Restricted Fund Balance/Total Fund Balance


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The financial statements for the last two years for Chesapeake College are presentedbelow. The balance sheet categories have been summarized and an extra yearrepresenting beginning balances for 1995 is presented.

Chesapeake CollegeStatement of Activities and Fund Balance

For the Years Ended 1996 and 1995(Dollars in Thousands)

Account 1996 1995RevenuesTuition and Fees $15,975 $14,105Endowment 2,437 2,520Gifts 540 778Government Grants 1,824 2,046Total Revenue $20,776 $19,449ExpendituresInstruction $ 6,733 $6,548Research 235 853Academic Support 2,945 2,539Student Services 3,011 2,858Institutional Support 3,762 3,448Educational Plant 1,495 2,206Financial Aid 3,906 2,733Total Expenditures $22,087 $21,185Change in Fund Balance -1,311 -1,736Fund Balance - Beginning of Year 3,159 4,895Fund Balance - End of Year 1,848 3,159


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Chesapeake CollegeBalance Sheet

December 31, 1996, 1995 and 1994(Dollars in Thousands)

Account 1996 1995 1994AssetsCash and Equivalents $ 947 $ 1,360 $ 1,505Other Current Assets 2,585 2,436 2,440Total Current Assets 3,532 3,796 3,945Land Buildings and Equipment 24,099 23,890 23,603Total Assets $27,631 $27,686 $27,548LiabilitiesCurrent Liabilities 2,984 2,530 2,129Long-Term Liabilities 22,799 21,997 20,524Total Liabilities 25,783 24,527 22,653Fund BalanceUnrestricted Fund Balance 598 1,959 3,795Restricted Fund Balance 1,250 1,200 1,100Total Fund Balance 1,848 3,159 4,895Total Liabilities and Fund Balance $27,631 $27,686 $27,548

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


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Case 3-2 Big Sky Resort and Conference CenterBig Sky Resort and Conference Center was started in 1953 by John Golie as a smallmotel in Whitefish, Montana called the Mountain View Inn. As more people beganautomobile traveling for vacationing, and the splendor of Waterton-Glacier InternationalPeace 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 pieceof property on Whitefish Lake with panoramic views of the mountains and sufficient landfor hiking and horse back riding. The property was also adjacent to the Whitefish StateRecreation Area, which provided ample opportunity for recreational activities.The popularity of the motel was greater than expected, and John expanded from 20 unitsto 100 units by 1975. He remained at that size until he turned over operations to hisdaughter Jana in 1992. John had been content over the last fifteen years of the hotelsoperation to keep it more of a family business. Many of the customers returned year afteryear, and liked the small-sized, homelike environment. Also, there were plenty of othermotels that were started in the area, including national chains, which seemed to cover theincreased tourist demand. The hotel had provided John and his family a comfortableliving 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 upduring the last 40 years. The Mountain View Inn had this large track of prime land thatwas still largely undeveloped. Also, with the popularity of snow skiing, and several liftsin 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 ofhours.Jana believed that an upscale resort and conference center to cater to the rich and famouswould be an instant success. The area offered many unique and exciting things to do allduring the year. The ski season started as much as a month earlier than the popular resortsin Colorado and often could last a month later in the spring. There were opportunities toview 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 GlacierNational Park. Jana was sure that people in the upper middle class and above whoenjoyed unusual vacations and conferences would be drawn to the area.Jana had no trouble convincing others of her ideas. Several prominent business peoplefrom 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 developrecreational activities on the property. This outside interest seemed to be the perfectsource of support. Jana could fulfill her vision without any extensive financial sacrificeon the part of her family.With advice from an investment firm, Jana concluded that the motel operation should gopublic under the corporate name of Big Sky Resort and Conference Center. A successfulstock 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 thenew eighty room resort and conference center plus amenities. Additionally, the original


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100 room motel was modernized and incorporated into the center. The original motelwas set at a somewhat lower scale so as not to price out many of the loyal customers whowere used to the Mountain View Inn.Jana’s goal was to be able to offer vacation packages for anyone from middle income toupper 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 toencourage family attendance at the conventions, which would make the resort an evenmore attractive promotion.The resort and conference center opened on schedule in September 1994 just before thestart of the ski season and during the peak of leaf season. The operation was an instantsuccess and bookings quickly increased for much of the 1995 season. As word of theresort spread and more organizations scheduled conferences, operations for 1996 and1997 were also better than expected. All of this success led to some impressive revenueand net income results for the first three years of operations. The outside investors whohad funded this project were also happy with the resort performance as reflected in theprice of the company stock.The years had passed by very quickly since Jana had taken over operations, and shewanted a chance to review the company’s performance during the last three years. Shehad her accountant give her the financial statements for 1995 through 1997 for herreview.

Big Sky Resort and Conference CenterIncome Statement


ACCOUNT 1995 1996 1997Sales Revenue $1,82

5$2,46

5$3,23

5- Direct Room Expense 460 600 800- Conference Expenses 550 980 1,345- Depreciation Expense 200 210 220- Other Operating Expenses 365 370 400= Operating Income 250 305 470- Interest Expense 50 65 90= Net Income Before Tax 200 240 380- Tax Expense 80 96 152= Net Income $

120$

144$

228Earnings Per Share $1.00 $1.20 $1.90

Big Sky Resort and Conference CenterBalance Sheet


ACCOUNT 1995 1996 1997


118

AssetsCash $

50$

60$ 100

Accounts Receivable 100 160 390Supplies 40 50 60Prepaid Expenses 10 10 10Total Current Assets 200 280 560Land 350 350 350Building (Net) 1,690 1,750 1,850Furnishings (Net) 250 280 300Total Long-Term Assets 2,290 2,380 2,500Total Assets $2,490 $2,660 $3,060

Liabilities and EquityAccounts Payable $ 130 $ 110 $ 195Notes Payable 70 90 230Taxes Payable 10 13 20Deferred Revenue 5 20 30Total Current Liabilities 215 233 475Mortgage Payable 400 480 500Total Liabilities $ 615 $ 713 $ 975Common Stock $1,800 $1,800 $1,800Retained Earnings 75 147 285Total Stockholders Equity $1,875 $1,947 $2,085Total Liabilities & Equity $2,490 $2,660 $3,060

Number of Shares of Stock 120,000

120,000

120,000

Market Price Per Share$20.00 $25.00

$32.00Dividend Per Share $0.50 $0.60 $0.75

Big Sky Resort and Conference CenterStatement of Retained Earnings



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ACCOUNT 1995 1996 1997Beginning Balance $ 15 $ 75 $147+ Net Income 120 144 228- Dividends 60 72 90= Ending Balance $ 75 $147 $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, theaverage collection period, and the total asset turnover. Note for ratios requiring averagevalues, just compute the ratios for 1996 and 1997.C. Compute the debt ratios including the debt to asset ratio, the debt to equity ratio, andthe times interest earned ratio for 1995, 1996, and 1997.D. Compute the profitability ratios including the operating profit margin ratio, the netprofit 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 yieldratio, 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 thethree year period from January 1, 1995 through December 31, 1997. Include any changesor recommendations that you might suggest for the company.

Chapter Four: Budgets and the Budget Process

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Chapter Objectives1. Define the nature and purpose of a budget.2. Review the budget process.3. Identify strengths and weaknesses of the budget process.4. Identify several different types of budgets.5. Analyze the behavioral impact of the budget process.

The Nature and Purpose of the BudgetA budget is a plan, preferably a written plan, which should reflect a company's goals andobjectives. In the order of the business strategic and tactical planning process, a budgetshould operationalize the overall company strategy.Budgets can be used to show how a company intends to acquire and use resources (acapital budget), what its operations will be like for a period of time (master budget), itsprojected financial performance (financial budget), and its acquisition and use of cash(cash budget). For these budgets to be beneficial; however, they need to be consistentwith 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 budgetalso serves another important management function, that of control. Budgets can serve asa standard which can be compared to actual performances and provide feedback regardingthe 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 youdon't know where you are going, you will probably get there." These ideas underlie whyit is so important to implement the budget process. By completing a budget, a company isfollowing an organized process of quantifying their overall goals and objectives in awritten format. The very act of the budget process serves as a communication tool andmakes all interested participants aware of company goals.The concept of a budgeting activity in order to be successful needs top managementsupport. Top management is responsible for developing the strategic plans andidentifying company goals and objectives. In order to see that these plans, goals andobjectives are reached, top management needs to convey these desires to the lower levelsof management. One of the best ways to communicate these desires of top managementis through the budget process. Top management support should be primarily for thebudget concept in general as opposed to the specifics and the mechanical procedures indeveloping 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 companyhave unique insight as to how goals and objectives can be most efficiently and effectivelyaccomplished. By allowing all levels of management to participate, a sense of ownershipdevelops and managers feel their importance. This participation process should certainlyincrease the levels of motivation of those involved.The budget is a communication tool both orally and in writing. For communication to beeffective, the sender needs to be sure that the receiver gets the correct message. The


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budget process needs to be timely, reasonably accurate, and understandable. Since thebudget is a plan for the future, absolute accuracy can never be assured. If for no otherreason, the very fact that the budget is a communication mechanism, makes itsimplementation worthwhile. Any activity that promotes the communication processwithin 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 changeas well. Since the budget is a future plan it needs to be based on a variety of assumptionsand conditions. A static type budget quickly looses its relevance as assumptions andconditions change. Management will lack confidence in the budget process if it is notflexible in nature and responsive to new situations.The control aspect of a budget is equally important as the planning aspect. Withoutproper follow-up and feedback to the budget, an important aspect of the budget process islost. The follow-up procedure should be frequent, especially in times when there aredramatic changes. Actions taken with regard to the follow-up should not just be limitedto the actual activities of the company but should consider possible modifications of thebudget itself.

The Budget ProcessAfter top management identifies the company strategic plans and the resulting companygoals and objectives, a budget process should be developed to aid in the implementationof the top management desires. Generally the controllers office oversees the budgetprocess. Standard operating procedures are developed and distributed to participatingmanagers.A budget committee is often established through the controller’s office withrepresentation from all of the critical areas within the company. The purpose of thecommittee is to establish policies and procedures for the implementation of the budgetprocess. Input and dialogue is encouraged from all of the representatives on thecommittee to promote a fully participatory budget process. Timetables and documentsare developed to emphasize standardization and consistency in submissions by eachdepartment. The budget review and approval process is also clarified.The role of the accountant or financial manager is that of a facilitator or of providingadvice and expertise. The actual budget preparation needs to be done by the managersresponsible for their various functional areas. Budget submissions can be consolidatedthrough the controller’s office and moved to the next higher level for review andapproval. The accountant can also aid in the development of necessary financialinformation to give credibility to the quantitative aspect of the submission.The budget submission basically follows a bottom up approach in a participatory budgetprocess. Input starts at the lowest level of management reflecting the knowledge of thosemanagers closest to the actual operations and activities of specific functions. As thesubmissions 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 shouldbe given resources consistent with approved budget submissions.The budget process does not end with the distribution of resources. The implementationof the budget is the beginning of the control phase of the budget process. Managers aremonitored and performance reports are developed to compare actual performance withthe predetermined standard as established by the budget. This form of feedback allowstop 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. Currentactivities can be modified and budget standards can be changed to reflect the immediatecircumstances. As much as possible, these changes should be done in a positive mannerto prevent the implemation of a budget as a punitive tool.The motivation associated with the budget process can be a very powerful factor. Topmanagement can establish a climate such that the motivations are positive and supportiveto management or the motivations can be negative and dysfunctional. A participativemanagement style and the use of Christian principles in management including servantleadership practices can go a long way toward making the budget a positive motivationalexperience. 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 varioussituations, no two of which may be alike, should ease the tensions especially in relation toperformance evaluation.

Benefits of a Budget ProcessThere are many benefits from implementing a budget process at a company. A budget:

1. will show management in writing the plans for the future2. quantifies company goals and objectives3. forces management to think ahead4. can be used as a motivational tool5. helps to coordinate business activities6. communicates manager’s plans to each other7. helps to conserve resources8. provides for a systematic review of performance9. gives managers a vision for the company that is consistent with company goals

and objectives10. allows managers to feel as though they are a part of the process11. gives managers a chance to provide input to the budget process12. provides a means to measure and compare actual activity13. serves as a means of feedback

Disadvantages of a Budget ProcessA budget process can have some disadvantages especially if it is misunderstood or notimplemented properly. A budget:

1. can have dysfunctional impact on managers2. can be used as an enforcement mechanism3. may be ignored4. may not be relevant to the current situation


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5. may not have total management support or commitment6. may cater to the managers that cause the greatest outcry7. may have unrealistic and unattainable goals8. may be imposed on management without an opportunity for their input9. process may not be understood10. may be perceived as unfair especially in its performance evaluation phase

Types of Budgets

Master BudgetThe 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 oftime, 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 ofthe master budget. Many of the activities of a business are dependent upon the level ofsales, and the master budget cannot be successfully completed until a sales figure isdetermined.Since the master budget is a plan for some future period of time, the sales figure cannotbe known with certainty. This uncertainty has an immediate impact on the accuracy ofthe budget. To complicate the effort to forecast sales are the many variables andassumptions 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 economy2. what is the status of both existing and proposed product lines3. what is the nature of competition in the industry4. what is the impact of government taxes and regulations5. what role does globalization and international activities have on the company6. what is the proposed monetary and fiscal policy7. what is the attitude of consumers

Sales forecasting, because of the many assumptions, can be a difficult process. Manyfactors outside of the control of the company, such as consumer buying habits, and whatcompetitors are doing, can impact the level of sales. Internal considerations includingproduct mix, new product development, pricing and cost can all have an effect on theproposed 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 areperceived to have an impact of sales. Sometimes forecasting models can be developed toaid in the projection of sales; however, the models are only as good as the data andassumptions used to develop the relationships.Sales and marketing managers can be helpful in developing sales projections as thesemanagers 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 underlyingmotivations for budget projections. Sales personnel can sometimes be overly optimisticin 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 becompleted. The master budget follows the format of the income statement with thedevelopment of the amount for cost of goods sold followed by other operating expensesand then financial expenses. The production and purchasing schedules need to bedetermined based on projected sales. These schedules also have an impact on the levelsof inventory and the amount of the cost of goods sold.The purchasing schedule relates to raw materials used in the manufacturing process. Theprojected ending balance of raw material inventory plus the raw materials used in theproduction process equals the total budgeted amount of raw materials needed.Subtracting the currently available raw materials (a beginning balance amount) awayfrom the raw materials needed leaves the amount of raw materials that need to bepurchased. The purchasing of raw materials has an impact on the inventory account andthe accounts payable account. See illustration 4-1.

Purchase ScheduleIllustration 4-1

Projected Ending Balance for Raw Materials $10,000

+ Raw Material Used in Production150,000

= Raw Material Desired160,000

- Beginning Balance for Raw Materials 15,000= Raw Material Purchases $145,00

0The amount of raw materials needed in the production process depends on the projectedlevel of sales and the desired amounts of finished goods inventory. The same basicprocedure is used to compute a production budget. The costs to produce a finishedproduct include raw materials, labor costs, and manufacturing overhead. The projectedlevel of sales plus the forecasted ending balance of finished goods inventory equals thetotal amount of finished product needed. Subtracting the finished goods available (thebeginning balance of finished goods inventory) from the total amount of finished goodsneeded will equal the amount of finished goods that need to be produced. See illustration4-2.

Production ScheduleIllustration 4-2

Projected Ending Balance for Finished Goods $50,000

+ Finished Goods Sold700,000

= Total Finished Goods Needed750,000

- Beginning Balance for Finished Goods 40,000= Production Level of Finished Goods $710,00

0


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The production level of finished goods includes the raw material used in production fromthe purchase schedule plus input of labor and manufacturing overhead costs.This budgeted production schedule will aid in developing budgets for the entiremanufacturing process. Managers can make projections within their areas ofresponsibility for levels of labor, amounts of materials and inventory, and amounts ofother manufacturing related expenses. Some of these costs will vary directly with sales orproduction. A cost of this nature is classified as a variable cost. Variable costs have aconstant cost per unit and the total cost changes, as there is a change in volume like thelevel of sales. For instance if a cost is identified at a variable rate of $15 per each unit ofsales and 1,000 units are sold the total cost will be $15,000. If 1,600 units are sold thetotal 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 acritical component in the fixed cost budget, but it declines as the level of activityincreases. As an example, if a fixed cost for an item is $20,000, when the sales level is1,000 units the fixed cost per unit is $20. If the sales level increases to 1,600 units thetotal fixed cost remains at $20,000 and the fixed cost per unit declines to $12.50. Forbudgetary purposes the total fixed cost of $20,000 is the figure that would be included forany calculations. See illustration 4-4.

The managers responsible for the occurrence of these costs can develop other operatingexpenses for budgetary purposes. Each cost should probably be identified as fixed orvariable in its behavior so as to aid in the budget process should the level of activitychange. With changes in the levels of activity, the total variable costs included in thebudget will change, but the total fixed costs will not change.

Variable CostIllustration 4-3

Units of Volume 1,000 1,200 1,400 1,600 2,000Total Variable $15,00

0$18,00

0$21,00

0$24,000 $30,000

VariableCost/Unit

$15 $15 $15 $15 $15

Graphical Representation


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The completion of all revenues and expenses related to operating activities carries thebudget process through the net operating income on the income statement. Otherfinancing related revenues and expenses can be budgeted for and incorporated into theincome statement to complete this financial statement.In generating budget figures for operating activities, managers will usually start with pastexperience, or last year’s figures, and then make adjustments as deemed appropriate. Thegreater the significance of the assumptions and projections the more difficult it will be toforecast the projected budget figures. If the uncertainties are substantial, managers maybudget 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 insituations where a high degree of variability is expected.

Flexible BudgetsA flexible budget is based on the behavioral characteristics of the accounts included inthe budget and some common measure of activity. The behavioral characteristics can bedivided into fixed and variable classifications, and the activity measure is frequently salesvolume. As the level of sales changes, the flexible budget recognizes this change withappropriate changes in the totals of all of the variable cost items. The total fixed costswill remain constant as long as the change in the activity remains within what is called arelevant range. Eventually all costs both fixed and variable will change with changes inactivities but for fixed costs those changes occur when activities go beyond a relevantrange. A flexible budget process can be a very useful approach to budgeting as long asthe accounts can be reasonably classified according to behavior. As changes occur in thelevels of activities, a revised budget can be quickly established which serves as a moreappropriate standard for the new conditions. See illustration 4-5.Formulas can be created which reflect the behaviors of the revenues and expensesincluded in a flexible budget. Through the establishment of a series of formulas, flexiblebudgets can be more easily developed and modified as situations cause changes in any ofthe budget items. Formulas can be integrated into software programs and flexiblebudgets can be developed virtually instantaneously.Since revenues are defined to behave in a variable fashion with a constant selling priceper unit and a change in total with changes in levels of volume, the revenues can becombined with variable costs to determine a contribution margin. Contribution marginis simply sales revenue minus variable cost, and it can be recognized on a per unit basisor a total cost basis. Contribution margin is sometimes recognized as the contribution tofixed cost. Formula 4.1 identifies the contribution margin relationship.

Formula 4.1 CM/U = SP/U - VC/UContribution Margin Per Unit = Selling Price Per Unit - Variable Cost Per UnitDefinition of Variables

CM = Contribution MarginSP = Selling PriceVC = 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 contributionmargin per unit is the difference between the two values. A total contribution margin canbe determined by multiplying the per unit value times a level of volume. The totalcontribution margin amount is needed to complete the development of the flexiblebudget. Formula 4.2 relates to the computation of net income before tax, which includesthe impact of fixed cost.

Formula 4.2 NIBT = (CM/U)V - FCNet Income Before Tax = (Contribution Margin Per Unit)(Sales Volume) - Total FixedCost

NIBT = Net Income Before TaxFC = Fixed CostV = Volume

The net income before tax is based on a total dollar amount and is computed after thetotal of all fixed and variable costs is deducted from total sales revenue. The onlyremaining costs to be considered in the flexible budget is income tax. The amount on netincome is usually established as a rate based on the net income before tax. Formula 4.3highlights 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 IncomeTR = 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 tobehavior between variable and fixed, and tax expense is a rate based on net income beforetax. All of these relationships can be accounted for in a single flexible budget formula4.4.

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) - TotalFixed Cost](1.0 - Tax Rate)Formula 4.4 is a consolidation of formulas 4.1, 4.2, and 4.3. In order to compute netincome values will need to be known for the selling price per unit, the variable cost perunit, a level of volume, the total fixed cost, and the tax rate. See Self-Study Problem 4-1.Simulation analysis takes place when one or more of the values of the variables changeand the impact of that change on net income is determined. As would be expected, netincome 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 costand the income tax rate. Frequently volume is the variable of change as a flexible budgetis used to determine levels of income at various levels of volume. Also, whenperformance reports are developed, a meaningful comparison can only take place betweenactual results and a predetermined budget when both are based on the same levels ofvolume. A flexible budget will be developed after the fact using the same level ofvolume as the actual results for comparison purposes. See Self-Study Problems 4-2through 4-5.


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Financial BudgetsFinancial budgets are basically the financial statements to include the income statement,statement of retained earnings, and the balance sheet. The income statement is createdthrough the master budget, and as with the financial statements, the statement of retainedearnings and the balance sheet can be completed after the income statement.In the completion of the budgeted retained earnings, the only additional informationneeded beyond the income statement is the projected amount of dividends. Topmanagement will probably forecast expected dividend payments based on the currentlevel of dividends, the proposed level of net income, and a calculated dividend payoutratio (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 aprecaution if earnings do not attain the budgeted level.

Fixed CostIllustration 4-4

Units of Volume 1,000 1,200 1,400 1,600 2,000Total Fixed Cost $20,000 $20,000 $20,000 $20,000 $20,000Fixed Cost/Unit $20.00 $16.67 $14.29 $12.50 $10.00

Graphical Representation


129

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 completedbecause the balances in the appropriate accounts depend on the results of all of the otherbudgets. Particular attention needs to be given to the ending cash balance, which will bedetermined through the cash budget. Also, the company will need accurate projectionsfor long-term assets. The capital budgeting process will help in determining the levels oflong-term assets. Once long-term assets have been identified, the means of funding thoseassets with long-term liabilities, preferred stock, common stock, or retained earnings, orcombinations of these sources of funds will need to be established. Part of the capitalbudgeting process along with a concept called optimal capital structure will assist indetermining the proper mix of funds.

Capital BudgetThe capital budgeting process is specifically directed toward long-term assets. Specificprojects are identified that have time periods of greater than one year. The concept oftime value of money needs to be integrated into the capital budgeting process for a properanalysis of the projects. These capital budgeting projects tend to be very large in scopesuch as a new product line, or a new plant. The projects usually involve several areas ofmanagement and require a combined effort such as a project team to develop a budgetrequest.As with other budget requests, which involve estimates into the future, the capitalbudgeting request is subject to even greater uncertainties, because of the longer timeperiod involved and the uniqueness of the projects. Capital budgeting projects often areforecasted for five or more years into the future. The projected revenues and expensesand other possible capital costs can be very hard to determine. Also, the uniqueness ofthe projects makes it difficult to rely on past experience as a basis for the projections offuture costs.

Flexible BudgetIllustration 4-5

The income statement format requires that all revenue and expense items in theincome 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 IncomeSee the Self-Study Problems 4-1 through 4-5 at the end of the chapter forexamples of flexible budget problems.


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Since capital budgeting projects involve such significant use of resources, their success orfailure 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 bepromoted or long gone before the final results from the project are known. Subsequentmanagers are often left to pay for their previous manager’s mistakes. With this potentiallack of accountability and the size of the capital budgeting projects, top management hasto impose very careful criteria and insist on the most sophisticated methods in the capitalbudgeting process. A detailed discussion of capital budgeting will be presented inChapter 14.

Cash BudgetsConcern about a company's liquidity and especially its cash position is critical. There canbe 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, andeven liquidity ratios but still be in a poor cash position. The importance of the level ofcash at any point in time makes it necessary to have a comprehensive cash budgetprocedures. The process of monitoring actual activities through a cash flow statementand cash management techniques will be covered in detail in Chapters 7 and 8.The cash budget process involves projected cash receipts and cash disbursements alongwith a desired ending balance by time period (usually monthly) and a financing orinvesting section. The format of the cash budget adds cash receipts to a beginning cashbalance to give the amount of cash available. Cash disbursements are deducted from theavailable cash to give an ending cash balance. The ending cash balance is compared to aminimum desired balance to determine any surplus or shortage in cash. Projectedshortages in cash are covered with short-term borrowing arrangements, and projectedsurpluses 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 orexpense. When a sale is made on account, the revenue is recognized; however, the cash isnot collected until the customer pays the account receivable. This delay in cash receiptsmust be reflected in the cash budget so that the figures can be tied into the sales revenueamounts in the master budget. Estimates are generally made regarding the time it takes tocollect on accounts receivable and that factor is processed into the cash budget. Theremay be a similar delay in cash disbursements when the company purchases items oncredit. The expense is recorded at the time of purchase and the cash disbursement isrecorded at a later time when the liability is paid.


131

Illustration 4-7 presents an example of the cash receipts by month. The first exhibitidentifies the projected amount of dollar sales in cash and on credit by month for a fivemonth 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 accountsreceivable. The second exhibit represents an estimate of how long it will take to collectaccounts receivable. The exhibit indicates that 50 percent of the credit sales are expectedto be collected about 30 days after the sale. The total percent collected adds up to only 98percent of the total accounts receivable. The remaining 2 percent represent bad debts thatare not expected to be collected.The percent values from the second exhibit are applied to the credit sales amounts toestablish the third exhibit, which summarizes the collection of credit sales. For instance 8percent 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 finalexhibit summarizes the cash collections by month. Cash sales would be in the samemonth. The lagging process from the collection of accounts receivable is appropriatelysummarized. For instance, the $8,000 of January sales on account collected three monthslater is included in the April cash collections. Total cash collections would represent thecash receipts in a cash budget.

Cash BudgetIllustration 4-6

Dar Ya EnterprisesCash Budget

For the Year 1996Beginning 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 thecash budget process.


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Cash Receipts ActivitiesIllustration 4-7Dollar Sales by Month

Month Cash CreditJanuary $10,000 $100,000February $12,000 $120,000March $10,000 $ 90,000April $14,000 $150,000May $15,000 $140,000

Collection of Accounts Receivable Schedule

MonthMonth ofSale

One MonthAfter Sale

Two MonthsAfter Sale

Three MonthsAfter Sale

PercentCollected 25% 50% 15% 8%

Collection of Accounts Receivable

MonthTotal

CreditSales

Collect 25%Month of

Sale

Collect 50%1 Month

Later

Collect 15%2 Months

Later

Collect8%

3 MonthsLater

January $100,000 $25,000 $50,000 $15,000 $ 8,000February $120,000 $30,000 $60,000 $18,000 $ 9,600March $ 90,000 $22,500 $45,000 $13,500 $ 7,200April $150,000 $37,500 $75,000 $22,500 $12,000May $140,000 $35,000 $70,000 $21,000 $11,200


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Illustration 4-8 represents an example of cash disbursement activities by month. Just aswith the cash receipts activities presentation, four exhibits are used in a step by step

Cash Collections by MonthMonth January February March April MayCash Sales $ 10,000 $ 12,000 $ 10,000 $ 14,000 $ 15,000AccountsReceivable25% in theSame Month 25,000 30,000 22,500 37,500 35,00050% in theFirst MonthAfter Sale

50,000 60,000 45,000 75,000

15% in theSecond MonthAfter Sale

15,000 18,000 13,500

8% in theThird MonthAfter Sale

8,000 9,600

Total CashCollection $ 35,000 $ 92,000 $107,500 $122,500 $148,100

Cash Disbursements ActivitiesIllustration 4-8

Dollar Expenses by MonthMonth Cash PayableJanuary $40,000 $40,000February $45,000 $30,000March $50,000 $50,000April $40,000 $60,000May $60,000 $35,000

Payment of Accounts Payable ScheduleMonth Month of

PurchaseOne Month AfterPurchase

Two MonthsAfter Purchase

Percent Paid 40% 50% 10%

Payment of Accounts Payable

Month TotalPayment

Pay in 40%Current

Month

Pay 50%One

MonthLater

Pay 10%Two

MonthsLater

January $40,000 $16,000 $20,000 $ 4,000February $30,000 $12,000 $15,000 $ 3,000March $50,000 $20,000 $25,000 $ 5,000April $60,000 $24,000 $30,000 $ 6,000May $35,000 $14,000 $17,500 $ 3,500

Cash Payments by Month

Month January February March April MayCash Expense $ 40,000 $ 45,000 $ 50,000 $ 40,000 $ 60,000Payment ofPayable40% in the SameMonth 16,000 12,000 20,000 24,000 14,00050% in the FirstMonth AfterPurchase

20,000 15,000 25,000 30,000

10% in theSecond MonthAfter Purchase

4,000 3,000 5,000

Total CashPayments $ 56,000 $ 77,000 $ 89,000 $ 92,000 $109,000


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process to determine cash disbursements. The occurrence of expenses by month does notnecessarily represent the cash payment of those expenses in the same month. Thecreation of a payables account related to an expense means that the cash payment will bedelayed. The first exhibit summarizes the cash and credit expenses by month. Thesecond 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 allaccounts payable obligations.

The dollar amount of monthly payables in the first exhibit is multiplied by the percentvalues 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. Thisthird exhibit does not classify the cash payables by month. The final exhibit summarizesthe cash payments as well as the payment of accounts payable by month. The $4,000 ofJanuary payables paid two months later shows up as a cash disbursement in March. Thesum of the cash payments by month would appear in the cash disbursement section of thecash budget. See Self-Study Problem 4-6.Illustration 4-9 shows a cash budget with summary information from cash receipts andcash disbursements schedules.

Illustration 4-9


January - May, 1996

Month Jan Feb Mar Apr May

Beginning Cash Bal $ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 10,000Plus Cash Receipts 35,000 92,000 107,500 122,500 148,100Total Cash Avail 45,000 102,000 117,500 132,500 158,100Less CashDisbursement

56,000 77,000 89,000 92,000 109,000

Less Desired MinBalance

10,000 10,000 10,000 10,000 10,000

Equals Surplus orShortage

-21,000 15,000 18,500 30,500 39,100

Plus CashBorrowed

21,000 0 0 0 0

Less Cash Repaid* 0 15,000 6,270 0 0Less Cash Invested 0 0 12,230 30,500 39,100Ending CashBalance $ 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 inthe ending balance. Generally a minimum cash balance is desired as a safety measure toinsure that the company has cash in the event of unforeseen fluctuations in the cashbalance. If the amount of cash disbursements plus the minimum desired balance exceedthe beginning balance plus the amount of cash receipts, a cash shortage exists. When thetotal cash available exceeds the total cash needs, there is a cash surplus. The financingsection of the cash budget identifies the time periods of surplus and shortage andidentifies when the company may need (1) to borrow, (2) make a repayment of loans plusinterest, (3) make any short-term investments, and (4) the use of previous investments tocover subsequent shortages.

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


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Self-Study ProblemsUse the following flexible budget and flexible budget formulas to complete Self-Studyproblems 4-1 through 4-5.

Dar Ya Enterprises1996 Flexible Budget

Projected Sales 100,000 Units

Sales $1,500,000

- Variable Manufacturing Cost1,000,000

- Variable Selling & Administrative Cost 50,000= Contribution Margin 450,000- Fixed Manufacturing Cost 160,000- Fixed Selling & Administrative Cost 200,000= Net Income Before Tax 90,000- Income Tax Expense 36,000= Net Income $ 54,000

Flexible Budget FormulasContribution Margin Per Unit = Selling Price Per Unit - Variable Cost Per UnitFormula 4.1 CM/U = SP/U - VC/UNet Income Before Tax = (Contribution Margin Per Unit)(Sales Volume) - Total FixedCostFormula 4.2 NIBT = (CM/U)V - FCNet 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) - TotalFixed 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.


137

Self-Study Problem 4-1 Flexible Budget FormulasDetermine the amounts of the variables in the flexible budget formulas for Dar YaEnterprises.


138

Self-Study Problem 4-1 Solution Flexible Budget Formulas

Selling Price Per Unit SP/U

Sales Dollars $1,500,000 = $15.00/UnitSales Volume 100,000

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

Variable Cost $1,050,000 = $10.50/UnitSales Volume 100,000

Total Fixed Cost FCTotal fixed cost equals the sum of the fixed manufacturing cost plus the fixed selling andadministrative cost; i.e., $160,000 + $200,000 = $360,000.Income Tax Rate TR

Income Tax Expense $36,000 = 40%Net Income Before Tax $90,000

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


139

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


140

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

Formula 4.1 SP/U - VC/U = CM/U $15/U - $10.50/U = $4.50/UFormula 4.2 (CM/U)(V) - FC = NIBT ($4.50/U)(120,000) - $360,000 = $180,000Formula 4.3 NIBT(1.0 - TR) = NI $180,000(1.0 - .40) = $108,000Formula 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



Sales $1,800,000- Variable Manufacturing Cost 1,200,000- Variable Selling & Administrative Cost 60,000= Contribution Margin 540,000- Fixed Manufacturing Cost 160,000- Fixed Selling & Administrative Cost 200,000= Net Income Before Tax 180,000- Income Tax Expense 72,000= Net Income 108,000

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


141

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 givea net income of zero.


142

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 = NIV = $216,000 $2.70/UV = 80,000 units of sales



Sales $1,200,000- Variable Manufacturing Cost 800,000- Variable Selling & Administrative Cost 40,000= Contribution Margin 360,000- Fixed Manufacturing Cost 160,000- Fixed Selling & Administrative Cost 200,000= Net Income Before Tax 0- Income Tax Expense 0= Net Income 0


143

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


144

Self-Study Problem 4-4 Solution Simulation Analysis





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 AnalysisThe sales manager proposes that if the selling price of the product is reduced to $14 and ifthe fixed advertising expense is increased by $100,000, the total sales volume will beincreased from 100,000 units to 140,000 units. Should management make the change?


146

Self-Study Problem 4-5 Solution Simulation Analysis






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Self-Study Problem 4-6 Cash BudgetComplete a cash budget using the information from the cash collection and cash paymentschedules in Illustrations 4-7 and 4-8. Assume the following beginning cash balance andminimum 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 EnterprisesCash Receipts Schedule

January - May, 1996(From Illustration 4-7)

Month Jan Feb Mar Apr MayCash Receipts $35,000 $92,000 $107,500 $122,500 $148,100

Dar Ya EnterprisesCash Disbursements Schedule

January - May, 1996(From Illustration 4-8)

Month Jan Feb Mar Apr MayCash Disbursements $56,000 $77,000 $89,000 $92,000 $109,000


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Self-Study Problem 4-6 Solution Cash Budget


January - May, 1996

Month Jan Feb Mar Apr MayBeginning CashBalance

$ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 10,000

Plus Cash Receipts 35,000 92,000 107,500 122,500 148,100Total CashAvailable

45,000 102,000 117,500 132,500 158,100

Less CashDisbursement

56,000 77,000 89,000 92,000 109,000

Less Desired MinBalance

10,000 10,000 10,000 10,000 10,000

Equals Surplus orShortage

-21,000 15,000 18,500 30,500 39,100

Plus CashBorrowed

21,000 0 0 0 0

Less Cash Repaid* 0 15,000 6,270 0 0Less Cash Invested 0 0 12,230 30,500 39,100Ending CashBalance $ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 10,000

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


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ProblemsProblem 4-1 Cost BehaviorRuDee Company has determined that at a volume of 120,000 units of sales, the total fixedcost 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 andthe 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 100,000 115,000 130,000 145,000Total VariableCostVariable CostPer UnitTotal FixedCostFixed Cost PerUnit

Problem 4-2 Behavior PatternsRDR Enterprises determined that at a level of sales volume of 50,000 units, the sellingprice 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 of60,000 units. The income tax rate is 40 percent.

Problem 4-3 Contribution MarginRD Inc. has the following revenues and expenses for 1,000 units of sales:

sales $5,000fixed administrative 300fixed manufacturing 900variable administrative 700variable manufacturing 2,000

Required:Compute the total contribution margin and the contribution margin per unit for 1,000units of sales, and for 1,200 units of sales.Use the following flexible budget for Dar Ya Enterprises to answer problems 4-4through 4-10.

Dar Ya Enterprises1997 Flexible Budget Income Statement


Sales $1,750,000


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- Variable Manufacturing Cost 1,050,000- Variable Selling & Administrative Cost 140,000= Contribution Margin 560,000- Fixed Manufacturing Cost 260,000- Fixed Selling & Administrative Cost 100,000= Net Income Before Tax 200,000- Income Tax Expense 80,000= Net Income 120,000

Problem 4-4 Flexible BudgetsUsing the 1997 Dar Ya Enterprises’ flexible budget, compute the flexible budgetingformulas for contribution margin, net income before tax, net income and the combinationformula for net income.Problem 4-5 Flexible BudgetsUsing the 1997 Dar Ya Enterprises’ flexible budget, construct flexible budget incomestatements for 50,000 units and 80,000 units of sales volume.

Problem 4-6 Breakeven VolumeUsing the 1997 Dar Ya Enterprises’ flexible budget, determine the breakeven level ofsales activity.

Problem 4-7 Simulation AnalysisThe financial manager suggests that the unit selling price for Dar Ya Enterprises’ productbe increased by $5. This increase will result in a decrease in sales volume by 10,000units to 60,000 units. Should Dar Ya Enterprises make the change suggested by thefinancial manager?


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Problem 4-8 Simulation AnalysisThe sales manager would like to increase the fixed advertising cost by $500,000 for DarYa Enterprises. The manager believes that the increase in promotion efforts will result inan increase in sales volume by 15,000 units. Should Dar Ya Enterprises make the changesuggested by the sales manager?

Problem 4-9 Simulation AnalysisThe production manager would like to improve the automation process in the productionof the product which will increase fixed cost by $250,000. The change in automation willreduce the variable cost by $4 per unit. Should Dar Ya Enterprises make the changesuggested by the production manager?

Problem 4-10 Simulation AnalysisThe president would like to reduce the selling price by $2 per unit. How much would thesales volume have to increase to make the company indifferent between the currentselling price per unit and the presidents proposed selling price per unit?

Problem 4-11 Purchase ScheduleWinD Company wanted to determine the amount of materials that needed to be purchasedthis month for the production process. The company currently has $20,000 in materialinventory and desires to have $25,000 in ending inventory. During the month productionrequirements 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 ScheduleMAT Corporation needed to determine the amount of materials that needed to bepurchased this month for the production process. The company currently has 15,000pounds of material in beginning inventory and desires to have 18,000 pounds in endinginventory. During the month the company expects to produce 40,000 units each of whichrequires 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 MATCorporation.

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


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Compute the unit and dollar amount of finished goods production for the month for MATCorporation.

Problem 4-14 Purchase and Production ScheduleWinD Company has a beginning balance of raw materials of $8,000 and desires anending balance of $10,000. During the month, $30,000 of raw materials will be used inthe 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 thecompany desires an ending balance of $20,000.Required:Compute the dollar amount of raw materials purchased and the dollar amount of finishedgoods 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 MonthMonth Cash CreditJanuary $15,000 $160,000February $12,000 $150,000March $20,000 $180,000April $24,000 $200,000May $25,000 $240,000

Collection of Accounts Receivable Schedule Month Month of

SaleOne MonthAfter Sale




Problem 4-15 Collection of Accounts ReceivableCompute the breakout of the dollar amount of accounts receivable collected for the creditsales of January through May. Why is the total percent collected not equal to 100%?

Problem 4-16 Cash CollectionsCompute 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 4-18.

Cash DisbursementsDollar Expenses by Month

Month Cash PayableJanuary $50,000 $100,000February $40,000 $85,000March $65,000 $120,000April $60,000 $160,000May $70,000 $130,000

Payment of Accounts Payable Schedule

Month Month ofPurchase

One Month AfterPurchase

Two Months AfterPurchase


Problem 4-17 Payment of Accounts PayableCompute the breakout of the dollar amount of accounts payable paid for the creditpurchases of January through May. Does the total percent paid have to equal to 100%?Why or why not.

Problem 4-18 Cash PaymentsCompute 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 answerproblems 4-19 through 4-21. The interest rate on any borrowed funds is 12% annuallyor 1% per month.

Dar Ya EnterprisesCash Receipts Schedule

January - May, 1996Month Jan Feb Mar Apr MayCash Receipts $100,000 $92,000 $130,500 $145,500 $150,000

Dar Ya EnterprisesCash Disbursements Schedule

January - May, 1996Month Jan Feb Mar Apr MayCash Disbursements $106,000 $100,000 $120,000 $125,000 $160,000

Problem 4-19 Cash BudgetAssume the cash balance on January 1, 1996 equals $15,000. Develop a cash budget forDar Ya Enterprises for January through May 1996. Note: Since there is no desiredminimum cash balance, excess funds do not have to be invested, and borrowing willoccur only if the cash balance is negative.

Problem 4-20 Cash BudgetAssume the cash balance on January 1, 1996 equals $1,000. Develop a cash budget forDar Ya Enterprises for January through May 1996. Note: Since there is no desiredminimum cash balance, excess funds do not have to be invested, and borrowing willoccur only if the cash balance is negative.

Problem 4-21 Cash BudgetAssume 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 May1996.


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Problem 4-22 Financing Section of Cash BudgetGiven the monthly surplus or shortage amounts, determine the amount of cash that mustbe borrowed, repaid, or invested each month. Interest on borrowed funds equals 1.0% amonth.

Cash Budget Financing SectionMonth Jan Feb Mar Apr MaySurplus orShortage -$9,000 $12,000 -$5,000 $8,000 $10,000Plus CashBorrowedLess Cash Repaid

Less InterestRepaidLess Cash Invested

Problem 4-23 Comprehensive Cash BudgetUse the following schedules to construct a cash budget for the months of January throughMay for DAR Corporation. The interest rate on any borrowed funds is 12 percentannually or 1 percent per month. The cash balance on January 1, 1997 is $25,000 and theminimum desired cash balance is $12,000.

Cash ReceiptsDollar Sales by Month

Month Cash CreditJanuary $35,000 $100,000February $30,000 $130,000March $50,000 $190,000April $40,000 $200,000May $45,000 $240,000


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Collection of Accounts Receivable ScheduleMonth Month of

SaleOne MonthAfter Sale




Cash DisbursementsDollar Expenses by Month

Month Cash PayableJanuary $40,000 $100,000February $30,000 $110,000March $50,000 $120,000April $40,000 $150,000May $60,000 $210,000

Payment of Accounts Payable ScheduleMonth Month of

PurchaseOne Month AfterPurchase

Two Months AfterPurchase



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Cases

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


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Current expenses are primarily related to salaries. The church has one senior pastor, anassistant pastor, and a youth pastor. There is also a full time secretary on staff. Otheradministrative types of expenses are listed as follows.Expense Item Annual AmountSenior Pastor Salary Plus Benefits $ 50,000Assistant Pastor Salary Plus Benefits $ 35,000Youth Pastor Salary Plus Benefits $ 30,000Secretary Salary Plus Benefits $ 21,000Office Supplies $ 23,000Utilities and Telephone $ 9,600Sunday School Supplies $ 7,400Church Supplies $ 16,200Rental $ 48,000The church leadership wants to put $100,000 toward a building fund at the end of theyear. At the start of this current year, there was a fund balance of $20,000, which was notdesignated for any purpose but served as a reserve for emergency purposes. There will bea campaign next year to secure donations of $250,000 for the beginning of the buildingprocess. Currently a small church was for sale that had sufficient land for parking andsome expansion. The market price for this building and land is $500,000. Also, there isvacant property available in the immediate area. The asking price for the land rangedfrom $100,000 to $300,000.The pastor was concerned about extending the membership in their giving. If too muchemphasis was put into a building program, contributions to the general operations maydiminish. Also, the undertaking of a building program may curtail growth, as newmembers will not want to join a church that is involved in major fund raising for a newbuilding. Never the less, the membership was growing, and the leadership believed thatthe church attendance would grow by 20 percent next year, and the rate of giving wouldonly 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 pastoralstaff 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 thoughta 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 itwas very important to improve the Sunday school program and other activities by thechurch to encourage active participation by the membership. A 30 percent increase wasproposed for Sunday school and church supplies.The landlord also notified the church that there would be a 10 percent increase in therental rate. The church was located in a prime area of development and the facility couldeasily be converted into office space which could provide even higher rental rates. Theleadership believed that the landlord would apply increased pressure to get the church tomove 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 asthere is already overcrowding.


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Required:A. Determine the anticipated revenue from contributions for Harvest Church for nextyear. Show how you computed the revenue figure.B. What are the possible problems the church could face in relying on revenues frommembership 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 thecurrent year? at the end of next year based on budget projections?E. Since Harvest Church is a nonprofit organization, discuss the role and importance ofthe 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 isa shortage in either the operating funds or building funds, can excesses from the otherfund be used to cover the shortages?


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Case 4-2 Charlie’s Country to Classic to Chamber Music StoreCharlie Kile, a noted business professor, decided that he had had enough of the “publishor parish” environment at a prestigious university. As much as he had enjoyed theuniversity setting and working with college students, he had always wanted to use hisbusiness expertise to run his own business. Charlie also had musical talent. He couldplay several instruments and was always in a band during his days as a college student. Infact, Charlie subsidized a good portion of his college expenses by performing ateverything from college fraternity parties to funerals.A music store was a natural business for Charlie to own. He had the business sense, andcould use his musical skills to encourage and help children develop their talents. In a wayhe could still be a teacher and not have to publish journal articles. Maybe now he woulduse his spare time for writing music versus articles.Charlie wanted to remain in a college town because of the overall academic environmentand the general appreciation of the arts. He also found that parents were more supportiveof having their children learn musical instruments. Since he was somewhat already wellknown in his hometown of Cleveland, Tennessee, Charlie decided to open a music storein their new shopping center just a few blocks from the local university. Even thoughthere were other music stores in the area, Charlie’s personality, business skills andmusical talent made him an instant hit with the kids from junior high to college. Thebusiness prospered.To encourage children to try to learn how to play an instrument Charlie offered a verygenerous instrument purchase plan. An instrument could be purchased for 10% down fora 90-day trial period. After 90 days, the instrument could be paid for in nine equalinstallments. 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% downpayment 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 instrumentafter 90 days that would cost much more to repair than the 10% down payment. Charliebelieved, 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 largeamount of his instrument sales occurred during these two months. Essentially all of hiscustomers took advantage of his generous payment plan. Charlie also sold music suppliesand materials. Those sales were on a cash basis and relatively uniform during the year.Charlie purchased his instruments from various music instrument companies anddistributors. To meet expected demand, the majority of the purchases were in July andOctober. The instrument companies needed a 30 day lead time on the purchase order, andthey generally required payment in full 60 days after the order had been made. Theinstruments would be shipped or personally delivered to Charlie from 2 to 5 weeks afterhis purchase order. Music supplies and materials were ordered from wholesalers and hadto 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. Hefigured it was a good time to evaluate how the business was going before the busy seasonstarted up again in late summer. The business had shown good growth and satisfactory


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profits, but his cash flow seemed tight, and he has had to rely on a line of credit from thelocal banker. The interest charges have cut into his profit margin. He would like toimprove 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 hispurchases and other expenses. He currently has a cash balance of $5,000, which is at aminimum, and an outstanding balance on the line of credit of $25,000. He has to pay1.5% per month on the outstanding balance. Also, the balance due on accounts receivableis $48,000, and the balance due on accounts payable is $2,000. Assume that $960 of theaccount receivable balance will be paid back to customers returning instruments. Theremaining $47,040 will be received in equal installments of $3,920 over the next twelvemonths. 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 currentaccounts payable balance will be paid in the following month. In the future, 20% ofpurchases on account are paid in the same month of purchase and 80% of purchases onaccount will be paid in the following month.RequiredA. Set up a monthly cash collection schedule of accounts receivable for Charlie’s musicstore for the next 20 months.B. Develop a total cash receipts schedule for Charlie’s music store for the next 20months.C. Set up a monthly cash payment schedule for accounts payable for Charlie’s musicstore for the next 20 months.D. Develop a total cash disbursements schedule for Charlie’s music store for the next 20months.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, minimumbalance, and beginning cash balance. Assume money is borrowed on the line of credit assoon as it is needed and repaid as soon as it is not needed. The current monthly caseexpenses do not include interest expense on the line of credit.F. What conclusions can you make regarding the cash flow situation for Charlie’sCountry to Classic to Chamber Music Store?G. What suggestions or recommendations would you make to help Charlie improve hiscash flow situation?


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Sales Revenue by MonthMonth Cash Credit

May $4,000 $2,000June $5,000 $4,000July $4,000 $3,000

August $5,000 $6,000September $8,000 $28,000

October $10,000 $20,000November $6,000 $10,000December $12,000 $36,000

January $10,000 $12,000February $6,000 $6,000March $4,000 $3,000April $5,600 $5,000May $4,800 $4,000June $6,400 $6,000July $5,000 $4,800




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Dollar Expenses by MonthMonth Cash Payable

May $6,000 $2,000June $6,000 $3,000July $7,000 $12,000



January $7,000 $2,000February $6,500 $2,000March $6,000 $1,000April $5,000 $2,000May $6,000 $3,000June $7,000 $4,000July $7,000 $14,000



Chapter Five: Performance Evaluation

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Objectives1. Review the process of establishing standards.2. Identify the use of performance reports.3. Analyze the concept of variance analysis.

Standard Accounting SystemsA standard accounting system is very much like a budget process, and the establishmentof one can help the other and vice versa. A budget often will use standard accountingfigures which are developed by using a standard physical measure times a standard dollaramount per unit of physical measure. Budgets also can sometimes be the basis forestablishing or revising standards. Additionally, a budget can serve as a standard in itscontrol phase in analyzing actual performance.A standard cost or revenue amount is a predetermined value of what an activity shouldequal under specific conditions. Standards can serve as goals for what amounts could beused as guidelines for comparison against actual results. The achievement of properly setstandards that are in line with company goals and objectives would imply that thecompany is probably operating efficiently and effectively.Standards may reflect historical trends or could be developed through time and motionstudies. Engineers can help in the establishment of proper measurements to use in thedevelopment of standards.A standard accounting system follows a basic format of units times dollars per unit. Theunit measure cancels out leaving a total dollar amount which can be used in a budget or asa standard or benchmark for evaluation purposes. The measure of units can range fromsales, to measures of time, to physical units of material, or number of employees.

Standard Dollars = Dollar/Unit x UnitsThe first objective in establishing a standard is to determine a unit of measure that relatesto the account. Units of sales relate to sales revenue, hours of work relate to some wageexpenses, 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 wagerate per hour or cost per unit of product in inventory are examples that are commonlyused. This process completes the standard dollar amount per unit format.The computed standard dollar amount per unit can be applied to the budget process byprojecting a unit volume. When the unit volume is multiplied by the amount per unit, atotal dollar amount is calculated. This dollar amount such as total sales revenue, totalwage expense, or total inventory can be incorporated into a budget or can be used as astandard for other purposes like performance evaluation.Standards can be easily established for items where a natural relationship exists betweenunits and dollars like the sale of a good or service with an established selling price perunit or if employees are paid on an hourly basis. Determining standards for other itemsmay be a little more difficult such as with the cost of the good or service sold by acompany. In a manufacturing company there are many inputs that go into the cost of an


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item. Some of the items have a clear cost per unit component and some of the items maynot be related to any unit measure.Fixed cost items are usually only related to a time period such as a specific dollar amountper year. Fixed cost, by definition, do not have a constant cost per unit of activity whichwill also make it difficult to relate fixed cost to different levels of activity except on atotal cost basis. Often times in establishing a standard cost per unit in which fixed costsare part of the costs being considered, the fixed cost will be treated like a variable costand be represented by a constant cost per unit. This misrepresentation of fixed cost forstandard costing purposes could easily result in incorrect amounts of fixed cost beingreported. The problem is overcome through a variance analysis process where thestandard costs are compared with actual costs and the difference or variance is accountedfor with adjustments to appropriate accounts. The simplicity of the standard cost systemcan be maintained with modifications made where variations occur.

Advantages of Standard Accounting SystemsIn spite of the perceived complexities in arriving at standards for the various accounts, theprocess can still be worth the effort. The advantages of using a standard accountingprocess to determine total costs and revenues include:

1. provides useful information for planning purposes2. aids in decision-making3. improves control activities4. promotes a management by exception reporting format5. gives more reasonable measurements6. results in easier record keeping7. possible reductions in costs

The advantage of using standards in the planning function is already evident. The use ofstandard costs and revenues tie directly into the budget process. The standards provide agoal 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 andaids 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 willaid in the control process.A management by exception reporting format is used to identify those conditions that aresignificantly different than an expected norm. By being able to compare actual results topredetermined standards, management can focus their efforts on extreme situations andthe unusual circumstances. Actual results that are within a normal range from a standardwill receive less time and attention. The management by exception process enablesmanagement to put forth the effort where it will do the most good.Even with the difficulty of establishing some relationships between dollar amounts andactivities, being able to establish a reasonable standard can be more useful formeasurement purposes than having no standard at all. Accounting is not an exact scienceand 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 themeasurement process.Record keeping is considerably easier with standard figures. The accountant does nothave to try to keep track of every change in actual costs and revenues with a standard costsystem. Actual figures can be determined for the units of activity and the actual units aremultiplied by a standard dollar amount per unit. Adjustments between the standardamounts recorded and the actual amounts can be made at the end of a time period. Thisprocess is easier than trying to keep track of both the actual units and the actual dollaramounts. If both units of activity and dollar amounts per unit are allowed to varymanagement can easily lose consistency in measurements.Whenever a process is simplified, cost savings can be almost a guaranteed result. Astandard system is simpler because actual costs do not have to be monitored for everytransaction. Frequently, actual costs will offset each other and the extra effort inmonitoring the costs will not gain any benefit.

Disadvantages of Standard Accounting SystemsWhile a standard accounting system seems to be worth the effort, there can be somedisadvantages to its implementation. Disadvantages for a standard system may include:

1. behavioral implications of an imposed standard2. failure of standards to identify differences in actual results on a timely basis3. inaccurate standards

The biggest concern about standards could be its behavioral implications. Managers mayfeel that standards are being imposed and that failure to comply could have negativeconsequences. This is especially critical if the standards are virtually unattainable. Themethod of imposing standards has to be clearly communicated to the users and thestandards 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 significantdifferences are occurring when being compared to actual data. Standards also may not beable to distinguish differences from actual data and the variability of the data. Actual datathat varies widely may appear closer to the standard amounts than actual data with littlevariability. When using standards it is important to have processes in place that willhighlight inconsistencies when they are occurring.Standards could be inaccurate. Keeping in mind that standards are probably developedahead of their actual implementation and that the standards could be based on generalconditions or situations, then over time the standards could become inaccurate. Failure toadjust standards or to allow for inaccuracies could lead to incorrect actions or decisions.

Performance ReportsPerformance reports are an important part of the budget process with regard to the controlfunction. The reporting process completes the budget cycle and provides a means offeedback to the users of the budget. Performance reports can be used to compare actualresults with the predetermined standard or budget figures. Any differences in values areidentified 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 variancesare 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 aresignificant or critical to company performance. A cost benefit trade-off considerationmay be used in helping to decide which variances need further evaluation.

Flexible Budget FormatThe format for performance reports usually follows three broad headings to includebudget, actual, and variance. The budget or standard is predetermined and could follow aflexible budget format. In the flexible budget format, revenue and cost items that displaya variable behavior are separated from fixed cost items. The actual results aresummarized after the fact. Variances identify differences between the predeterminedstandards and the actual results. See Illustration 5-1.A cost that is defined as controllable means that the cost comes under the totalresponsibility of the manager or department for whom the performance report is beingprepared. Controllable indicates that the manager has authority to incur the cost and isresponsible for its variance. If a cost is listed as variable it is most likely alsocontrollable; however, fixed cost can be either controllable or noncontrollable.Sometimes the term direct is used in conjunction with controllable. Direct cost comeunder the direct or complete control of the specific department represented by theperformance report.Noncontrollable costs do not come under the complete responsibility or authority of aspecific manager or department. Since the manager does not have complete control ofthese 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 fixedcosts. Sometimes the term indirect is used in conjunction with noncontrollable. Indirectcosts do not come under the complete control of the specific department represented by

Flexible Budget FormatIllustration 5-1

Matt’s HatsPerformance Report

For the Year Ending December 31, 1996Account Budget Actual VarianceSales Revenue $200,00

0$211,00

0$11,000

- Controllable Variable Cost 140,000145,000

(5,000)= Contribution Margin 60,000 66,000 6,000- Controllable Fixed Cost 30,000 29,000 1,000= Segment Margin 30,000 37,000 7,000- Noncontrollable & AllocatedFixed

25,000 28,000 (3,000)= Net Income 5,000 9,000 4,000


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the performance report. Allocated costs also imply that the cost relates to more than onesegment or department, and its division between the different departments is dependentupon some method of distribution. Allocated costs can be another name fornoncontrollable costs.Since noncontrollable and allocated costs have a different degree of impact in aperformance report than controllable cost, it is important that the different groups beshown 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 thedepartment’s manager. Segment margin will be used to divide costs that are controllableor direct from those that are uncontrollable, indirect, or allocated.When a performance report is being used to analyze the performance of a manager, it isimportant for the manager to emphasize the results from the segment margin versus thenet income results. While both are important, the manager should have completeresponsibility and authority for all revenues and costs used to determine the segmentmargin, whereas, the noncontrollable and allocated costs will be outside of the manager’stotal control. In the case of the performance report illustration, a greater emphasis shouldbe placed on the positive $7,000 segment margin variance than the positive $4,000 netincome variance. The negative $3,000 variance from the noncontrollable allocated fixedcost was outside of the complete control and responsibility of the performance reportmanager.A flexible budget format can be very useful in a performance report arrangement. Theflexible budget establishes a standard based upon an actual level of activity, which givesconsistency between the standard measure and actual performance. If a budget called a static budget is established based on 1,000 units of sales and actualperformance is based on 1,400 units of sales, then it could be difficult to get a trueevaluation of the performance of the company. How much of the variance between actualand budget is due to revenue and expense variations and how much of the variance is dueto the fact that the level of sales was 400 units higher than anticipated. Without thecreation of a flexible budget, it will be virtually impossible to distinguish between thenature of the variances.A flexible budget could be created based on the actual level of sales of 1,400 units. Someof 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 mayincrease but not in proportion to the increase in sales volume, these are classified as semi-variable items. A semi-variable item exhibits characteristics of both a variable item and afixed item. The best way to deal with an item of this nature is to separate out the variablecomponent from the fixed component. Items that would not change in total with thechange in volume from the flexible budget are fixed in nature. A flexible budget needs tobe able to classify its components according to behaviors, either variable or fixed, to beuseful.Once a flexible budget is established with the components properly identified as variableor 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 consistentvolume 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 ofactivity 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 tomake a meaningful comparison the measure of activity has to be constant. A flexiblebudget 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, thecomparison loses much of its usefulness.Even though the flexible budget is critical in performance evaluation, there still may be aneed for the static budget. In the example discussed earlier, management is going to wantto know what factors caused an increase from 1,000 units to 1,400 units. If the staticbudget is completely ignored, these issues may never be identified and information thatmay be useful in the decision-making process will be lost.Each budget format has a purpose. The flexible budget is needed to make meaningfulbudget, actual, and variance computations. The static budget is needed to address thegeneral question of why the company failed to operate at the predetermined level ofactivity. See Self-Study Problems 5-1 and 5-2.

Responsibility CentersThe distinction in the flexible budget performance report format between controllable andnoncontrollable costs can also be useful in the determination of responsibility centers.Budgets are usually established for responsibility centers with a manager in charge of theresponsibility center. A responsibility center is an identifiable segment of the businessthat undertakes measurable activities and is headed by a specific manager. It is importantthat the manager has authority commensurate with the responsibilities.Performance reports are established for responsibility centers. The activities undertakenin 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 reportscould 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 managerhas no control. These costs are usually classified as allocated costs. The determination ofthe allocation or distribution of the cost is made at a higher level of management. Theallocation is usually made somewhat arbitrarily or subjectively, and because of this, theresponsibility center manager has limited control over the occurrence of the cost or theamount.To include costs of this nature in a performance report could be misleading. At the veryleast costs that are not totally under the control of the responsibility center managershould be separated and identified as noncontrollable. The performance of a managershould not be impacted by uncontrollable activities.The separation of items in the performance report between controllable andnoncontrollable is an appropriate format for the responsibility center. A manager who isresponsible for the controllable items should be ready to identify and explain anyvariations in these items. At the same time variations in noncontrollable items should beidentified but not come under the same level of authority of the responsibility centermanager.


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The performance report usually has an interim value called a segment margin, whichseparates the controllable from the noncontrollable items. The segment margin gives anindication of how the particular responsibility center segment is contributing to theoverall performance of the company. Following the segment margin will be thenoncontrollable costs. These items can be included in the report as an indication of howwell the center is assisting in covering a fair share of nonspecific companywide types ofcosts. For a company to be successful, generally each responsibility center has to be ableto have a positive segment margin large enough to cover a portion of allocated cost plushave a remaining contribution margin for company profits.The inclusion of specific items within the performance report will depend on their levelof significance. An income statement format is often used. Generally, any revenueitems will be listed first followed by controllable expenses. The noncontrollableexpenses will be identified after the segment margin calculation.

Types of Responsibility CentersResponsibility centers do not necessarily have to be profit centers. A responsibility centerthat generates only expenses is also called an expense center. The responsibility centermanager does not generate any revenues. Many support functions within a company areexpense centers. Activities like the accounting department or personnel department areusually classified as expense centers.Profit centers are often associated with the operating function of the company. Theproduction of a good or service will lead to the generation of revenues. Expenses are alsoincurred in these responsibility centers. Managers will have control over revenues,expenses and the resulting net profit. Ideally, the profit obtained from the responsibilitycenter will be large enough to cover all controllable and noncontrollable costs plus aprofit margin.Some responsibility centers will also have authority over utilization of assets. Thesesegments are called investment centers. Return on investment is a critical measure ofperformance for these responsibility centers. The return on investment takes into accounta revenue minus expense figure in the numerator which equals a net profit. In thedenominator, the assets under control represent the investment. Only revenues, expenses,and assets that are controllable within the segment should be used in the evaluation. Seeillustration 5-2 for a comparison of responsibility centers.

Responsibility CentersIllustration 5-2

ResponsibilityCenter

Control OverRevenues

Control OverExpenses

Control OverAssets

Revenue Yes No NoExpense No Yes No

Profit Yes Yes NoInvestment Yes Yes Yes


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Variance AnalysisA variance analysis, in the relatively simple form, as the difference between a budget orstandard and actual results is satisfactory for most performance reports. The purpose of avariance analysis number is to raise a level of awareness of a difference but not to solvethe 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 canundertake a more detailed analysis. Questions can be asked of those responsible for thevariance and a complete evaluation can be conducted if necessary. A cost benefit tradeoffneeds to be considered with any variance analysis. A simple difference between budgetand actual results is a relatively inexpensive way to first examine performance results.Using an exception reporting philosophy, only significant or critical variances are thensubject to a more extensive and costly analysis.Since standards are developed using a dollar amount per unit times a number of unitsformat, this is a natural way to analyze variances. A total variance in many situations canbe divided according to quantity related or price related factors. Quantity relatedvariances are usually called efficiency or usage variances and price related variances arecalled price or rate variances.

Quantity Related VarianceA quantity related variance is calculated by determining the difference between thestandard or budgeted quantity that should have been used at the flexible budget level ofactivity and the actual quantity used. This difference in quantity is then multiplied by thestandard price per unit. Considering a difference in the quantity of units creates thevariance. The dollar amount of the variance is arrived at by multiplying the quantityvariance by a dollar per unit standard causing the measure of units to cancel out leaving adollar amount.For cost related accounts, if the actual quantity used is greater than the standard quantityan unfavorable variance is created. The situation is interpreted as inefficient becausemore units were actually used than had been initially established in the budget, creatingthe unfavorable additional cost condition. In the opposite situation, if actual usage wasless 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 thanbudgeted, then there is a favorable efficiency variance, and when actual quantity is lessthan budgeted it is unfavorable. See illustration 5-3 for an explanation of quantityvariances.

Price Related VariancesA price variance is calculated by comparing the standard or budgeted price per unitagainst the actual price per unit. This price difference is multiplied by the actual quantityused. The price variance highlights the difference in price per unit which whenmultiplied 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 ishigher than the standard or budgeted price per unit. The situation implies that the actualexpense was more than the standard or budgeted amount. If the actual price per unit wereless than the standard price per unit then there would be a favorable variance because


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actual expenses were less than the standard. For revenue items, the conditions would bereversed. If the actual price per unit was greater than the standard price per unit then afavorable variance would be recognized. This condition represents a situation in which acompany earned a higher unit revenue then expected by the standard. If the actual unitprice was less than the standard for a revenue item the variance is unfavorable. Seeillustration 5-4 for an explanation of price variances.Whenever a dollar per unit calculation is computed in arriving at a standard revenue orcost, a variance analysis can be divided into quantity and price related factors. Whennecessary, managers can conduct evaluations of this magnitude to assist them inidentifying the reasons why variances occur. The more complete analysis should help ininitiating the proper control procedures to guard against similar variances in the future.

Revenue VariancesRevenue variances, as previously stated, can be divided into quantity related factors andprice related factors. When the actual price or quantity is greater than the correspondingstandard, the variance is recognized as favorable because the company is receiving morerevenue then expected in the standard due either to a higher selling price or more quantitysold. In the reverse situation, when the actual is less than the standard for either price orquantity, the variance is unfavorable because the company is receiving less revenue thenexpected in the standard because of a lower selling price or less quantity sold.


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The revenue quantity variance occurs if the original static budget quantity is different thanthe flexible budget quantity used in the performance report. However, this variance cannot be a direct part of the performance report evaluation. By definition, the flexiblebudget standard is established based upon the actual volume of sales, thereby eliminatingfrom the direct evaluation the predetermined static budget level of activity. The standardbudgeted sales volume is now represented by the flexible budget as opposed to the staticbudget. The creation of the flexible budget automatically makes the actual sales volumeand the standard or flexible budgeted sales volume equal. With equal volumes, there canbe no quantity variance, at least as directly identified in the performance report. Forexample, if the predetermined static budget level of activity is 100,000 units and 120,000

Quantity VarianceIllustration 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 PriceSR = Standard RateSQ = Standard QuantityAP = Actual PriceAR = Actual RateAQ = Actual Quantity

Note: Price and Rate can be used interchangeably for variance analysis. Generally priceis associated with sales revenue and material expense and rate is associated withlabor expense.

Quantity Variance ExampleStandard Price = $10/Unit

Assume the price represents a measure of expense.Standard Quantity = 1,200 UnitsActual 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 greaterthan the standard expense quantity. If the price per unit is a measure of revenue verse ameasure of expense, then the $2,000 variance is favorable because the actual units ofrevenue exceed the standard units of revenue.


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units are actually sold, a flexible budget will be developed based on the 120,000 unitssold. Since the flexible budget quantity and actual quantity of units sold each equal120,000, there can be no revenue quantity variance in the performance report.However, a quantity variance still can be determined separately from the performancereport by comparing the standard volume based on the original static budget against theactual volume based on the flexible budget. If the revenue quantity variance is favorableit means that the actual volume represented by the flexible budget was greater thanoriginally anticipated in the static budget. An unfavorable quantity variance means thatthe actual level of sales volume from the flexible budget failed to reach predeterminedstatic budget levels. In the example presented earlier, a favorable revenue quantityvariance can be identified since the actual level of sales volume used in the flexible

budget of 120,000 units is greater than the predetermined static budget level of sales of100,000 units.The revenue price variance represents the difference between the standard selling priceand the actual selling price. If the actual selling price is higher than the standard sellingprice, the price variance is favorable because the company is receiving more revenue thenanticipated. When actual selling price is lower than the standard, the variance isunfavorable.

Price VarianceIllustration 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/UnitActual Price = $9/UnitAssume 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 standardexpense 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 thenthe standard price of revenue.


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In the evaluation of a performance report, the total revenue variance equals only the pricevariance. If a volume variance occurs, it would have to be shown separately from theother variances in the performance report analysis. See Self-Study Problem 5-3.

Variable Cost VariancesVariable cost variances include raw or direct material, direct labor, variable overhead, andvariable selling and administrative items. All variable cost variances can be divided intoseparate quantity and price variances because the costs are based on a constant cost perunit 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 differentthan units sold, the volume measure used to establish the flexible budget performancereport. Therefore, when a performance report is developed both the quantity and pricevariances can be analyzed for the variable cost items. The volume measures used aremore directly related to the particular cost item itself, like feet or pounds for material, orhours for labor. Variable overhead, which can represent many different individual costitems each with different volume measures, is often related to material or labor in theestablishment of a unit of volume. For instance, if it can be determined that there is somerelationship between variable overhead and direct labor, then labor hours could be used asthe measure of volume to determine a variable overhead rate. As labor hours change, theassumption 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 activitythat is related to the item. When more of a volume of actual activity is incurred then thestandard quantity, there is an unfavorable quantity variance as actual expense is higherthen the budgeted or standard amount. The inefficiency in the use of the activity resultsin higher expenses and an unfavorable variance. The opposite situation occurs whenactual activity is less than the standard. Savings are recognized through the efficient useof an activity with lower expenses and a favorable variance.Sometimes variable cost quantity variances can be a little misleading, especially whenvariable overhead volume is based on an activity measure such as direct labor or somemeasure of material. The quantity variance is actually a measure of the direct labor hoursor material unit efficiency as opposed to actual efficiencies of the variable overheaditems. However, if there is any credibility to the relationship between the variableoverhead item and the measure of labor or material activity, then one can assume that theefficiency 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 ofvolume and a standard price per unit. If the actual price is greater than the standard pricethen higher costs are incurred and the variance is unfavorable. For variable cost itemslike materials and labor the price variance is fairly straightforward. The price variancesfor items like variable overhead are less clear. Since frequently several different items areincluded in the total variable overhead, the actual price times actual quantity may only beavailable as a total amount. Also, since the unit price is based on a different measure ofvolume, there may not be a recognized relationship between the standard per unit and thetotal actual costs.The sum of the quantity and price variances for each variable cost category should equalthe total variance as reflected in the performance report. This breakout of the variable


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cost variances serves as a practical means of analyzing the variances in greater detail. SeeSelf-Study Problems 5-4 and 5-5.

Fixed Cost VariancesOverhead and selling and administrative costs can also be fixed in nature. Fixed costvariances can usually only be analyzed as a total difference between the standard orflexible budget amount and the actual amount because fixed costs do not have a constantcost per unit value. Without the use of a cost per unit measure, fixed cost can not bedivided between quantity related factors and price related factors.By definition, fixed costs are constant in total over changes in levels of volume within arelevant range. Since fixed cost are a constant total, it is possible that the amount of fixedcost will be the same for an original static budget as well as a flexible budget as long asthe measures of volume remain within the relevant range. Generally, there should not bea significant variance between actual fixed cost and budgeted fixed cost, since thedefinition implies a fixed total amount. When a variance does take place, it will beunfavorable if the actual costs are greater than the budgeted costs, and favorable if theactual cost are less than the budgeted cost.Fixed cost can result in a unique volume variance when they are treated like a variablecost. For financial reporting purposes, fixed overhead costs are often assigned a constantcost per unit rate to coincide with the variable overhead rate. The volume varianceoccurs because of the misrepresentation of the fixed cost. The actual computation of thisvariance is beyond the scope of this text.Self-Study Problem 5-6 gives a complete performance report evaluation with detailedvariance analysis for each component.

SummaryA natural follow-up to the establishment of budgets is the use of performance reports forfeedback and control purposes. The same standards that are used to establish budgets canbe used in the formation of performance reports.Performance reports should follow a flexible budget format and be adjusted based on anactual level of activity. The reports should be established for each responsibility centerwith a specific manager having the authority and responsibility for the actions of thatcenter. Items in the performance report, especially cost items, should be segmentedbetween those that are controllable by the responsibility center manager and those that arenot controllable.Variance analysis is a way of identifying differences between a budgeted or standardamount and actual performance. The variance analysis process can be as general orspecific and detailed as necessary to aid in identifying why specific differences occurredand how the company can go about correcting those differences.


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Self-Study ProblemsSelf-Study Problem 5-1 Performance ReportMatt’s Hats developed a flexible budget based on a static level of activity of 100,000units.

Matt’s HatsFlexible Budget100,000 Units

For the Year Ending December 31, 1996

Account StaticBudget

Sales Revenue $150,000- Controllable Variable Cost 100,000= Contribution Margin 50,000- Controllable Fixed Cost 15,000= Segment Margin 35,000- Noncontrollable and Allocated Fixed Cost 25,000= Net Income $ 10,000

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


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Self-Study Problem 5-1 Solution Performance ReportMatt’s Hats

Flexible Budget120,000 Units


Account StaticBudget

FlexibleBudget

Sales Revenue $150,000 $180,000- Controllable Variable Cost 100,000 120,000= Contribution Margin 50,000 60,000- Controllable Fixed Cost 15,000 15,000= Segment Margin 35,000 45,000- Noncontrollable and Allocated Fixed Cost 25,000 25,000= Net Income $ 10,000 $ 20,000


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Self-Study Problem 5-2 Performance EvaluationMatt’s Hats had the following actual costs based on a level of activity of 120,000 units.

Matt’s HatsIncome Statement


Account ActualResults

Sales Revenue $165,000- Controllable Variable Cost 120,000= Contribution Margin 45,000- Controllable Fixed Cost 12,000= Segment Margin 33,000- Noncontrollable and Allocated Fixed Cost 30,000= Net Income $ 3,000

RequiredDevelop a performance report.


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Self-Study Problem 5-2 Solution Performance EvaluationMatt’s Hats

Performance Report120,000 Units


Account FlexibleBudget

ActualResults Variance

Sales Revenue $180,000 $165,000 ($15,000)- Controllable Variable Cost 120,000 120,000 0= Contribution Margin 60,000 45,000 ( 15,000)- Controllable Fixed Cost 15,000 12,000 3,000= Segment Margin 45,000 33,000 ( 12,000)- Noncontrollable & Allocated Fixed Cost 25,000 30,000 (5,000)= Net Income $ 20,000 $ 3,000 ($17,000)


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Self-Study Problem 5-3 Sales Revenue VariancesMatt’s Hats sold 50,000 Chicago Cub’s baseball hats at $5.25 each during the month ofApril for a total sales revenue of $262,500. The company had expected to sell 60,000hats 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 VariancesQuantity VarianceStandard 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 VarianceEven though the number is positive, the quantity variance is unfavorable because thestandard 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 thebasis of the flexible budget. Since the actual quantity and the flexible quantity would bethe same, there would be no revenue quantity variance in the performance report.Price VarianceActual 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 VarianceEven though the price variance shows a negative value, it is favorable because thestandard revenue price per unit is less than the actual revenue price per unit. The negativeamount occurs because of the way the problem is set up.Total VarianceQuantity Variance + Price Variance = Total Variance$50,000 Unfavorable + $12,500 Favorable = $37,500 Unfavorable Total Variance orTotal 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 VariancesMatt’s Hats used 35,000 yards of material to produce Chicago Cub’s baseball hats withmaterial cost of $1.75 per yard during the month of April for a total actual material costof $61,250. The company had expected to use 34,000 yards of material at a material costof $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 VariancesQuantity VarianceStandard 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 VarianceThe quantity variance is unfavorable because the standard quantity of material is less thanthe actual quantity of material.Price VarianceActual 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 VarianceThe price variance is unfavorable because the standard material price per unit is less thanthe actual material price per unit.Total VarianceQuantity Variance + Price Variance = Total Variance-$1,600 Unfavorable + -$5,250 Unfavorable = -$6,850 Unfavorable Total Variance orTotal 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 VariancesMatt’s Hats used 4,000 hours of labor to produce Chicago Cub’s baseball hats with alabor 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 VariancesQuantity VarianceStandard 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 VarianceThe quantity variance is favorable because the standard quantity of labor is greater thanthe actual quantity of labor.Rate VarianceActual 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 VarianceThe rate variance is favorable because the standard labor rate per hour is greater than theactual labor rate per hour.Total VarianceQuantity Variance + Rate Variance = Total Variance$1,800 Favorable + $2,000 Favorable = $3,800 Favorable Total Variance orTotal 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 AnalysisMatt’s Hats Company developed the following static budget based on a production andsales of 100,000 hats for the month of February.

Matt’s Hats CompanyStatic Budget

February, 1996100,000 Hats

Account TotalSales 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 95,000hats is as follows:

Matt’s Hats CompanyActual Performance


Account Amount TotalSales Revenue $294,500- Variable Material $ 90,250- Variable Labor 102,600 192,850= 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 informationThere is a standard of .20 yards of material to produce one hat. The standard price of thematerial is $4.00 a yard. During February Matt’s Hats actually used 23,750 yards ofmaterial 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 rateof $12.00 per hour.

Required:

Conduct a complete performance and variance evaluation and explain how even thoughMatt’s Hats Company produced and sold fewer hats during the month of February, theywere able to reduce their loss by $650.


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Self-Study Problem 5-6 Solution Performance Report and Variance AnalysisA performance report based on a flexible budget of 95,000 hats produced and sold duringthe month of February is shown below.

Matt’s Hats CompanyFlexible Budget Performance Report


Account Budget Actual VarianceSales Revenue $285,000 $294,500 $ 9,500- Variable Material 76,000 90,250 (14,250)- Variable Labor 109,250 102,600 6,650= Contribution Margin $ 99,750 $101,650 $ 1,900- Controllable Fixed 65,000 59,000 6,000= Segment Margin $ 34,750 $ 42,650 $ 7,900- Allocated Fixed 50,000 52,000 (2,000)= Net Income ($15,250) ($ 9,350) $ 5,900

Variance AnalysisRevenue VariancesRevenue Quantity Variance = (SP x SQ) - (SP x AQ)Since the flexible budget standard quantity of 95,000 hats is different than the staticbudget quantity of 100,000 hats, there is a revenue quantity variance. However, thisvariance will not be used to explain any of the $5,900 difference in net income from theperformance report. Never the less, the computation of the revenue quantity variance willaid in answering the question regarding how the company’s net income increased by $650over 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 for100,000 hats($3/hat x 100,000 hats) - ($3/hat x 95,000 hats) = $15,000 U$300,000 - $285,000 = $15,000 UThe $15,000 unfavorable variance reflects a production and sales level 5,000 units belowthe 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 FThe total sales revenue of $294,500 divided by 95,000 hats equals $3.10 per hat as theactual price. Matt’s Hats sold at $3.10 each which was greater than the standard sellingprice of $3.00 giving a favorable price variance of $9,500 which is included in theperformance report. ($3.00/hat - $3.10/hat)= -$.10/hat x 95,000 hats = -$9,500 Favorablevariance.Variable Cost VariancesVariable 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 UMatt’s Hats used 25 percent more material, 23,750 yards versus 19,000 yards (.20yards/hat x 95,000 hats = 19,000 yards) which resulted in the $19,000 unfavorablequantity variance. 19,000 yards - 23,750 yards = -4,750 yards x $4.00/yard = -$19,000Unfavorable 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 FMatt’s Hats was able to purchase the material at $.20/yard less than the standard pricewhich 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 UExcess quantities of material were used; however, the cost per yard of material used wasless than the standard. The savings on the cost were not enough to offset the extraquantity 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 FMatt’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. (.10hours/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 UMatt’s Hats paid $12.00 per hour of labor versus the standard of $11.50 per hour resultingan 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 FThe savings of 950 labor hours more than compensated for the extra $.50/hour of laborthat was paid for the actual hours worked.Fixed Cost Variances


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Total Controllable Fixed VarianceTotal Budgeted Fixed - Total Actual Fixed$65,000 - $59,000 = $6,000 FMatt’s Hats incurred less actual fixed cost then the predetermined static or flexible budgetamount giving a favorable $6,000 variance.Total Segment Margin VarianceRevenue Price Variance + Total Variable Material Variance + Total Variable OverheadVariance + Total Controllable Fixed Variance$9,500 F + ($14,250 U) + $6,650 F + $6,000 F = $7,900 FThe higher selling price plus the more efficient use of labor hours and the savings incontrollable fixed cost made up for the extra material used in the production process.Total Allocated Fixed VarianceTotal Budgeted Allocated Fixed - Total Actual Allocated Fixed$50,000 - $52,000 = -$2,000 UActual allocated fixed costs, which are out of control of the manager, were $2,000 higherthan the budgeted allocated fixed cost.Total Net Income VarianceTotal Segment Margin Variance + Total Allocated Fixed Variance$7,900 F + ($2,000 U) = $5,900 FReconciliation of Total Net Income Variance to Static BudgetEven though the level of sales volume was less (95,000 hats vs 100,000 hats), the netincome was reduced by $650 to $9,350 in comparison to the projected loss from the staticbudget of $10,000. The flexible budget variances used to arrive at a $5,900 favorablevariance on the performance report can be summarized as follows. When volumedeclined from 100,000 hats to 95,000 hats there was an unfavorable revenue quantityvariance of $15,000 (computed above). There was also a savings for variable materialcost of $4.00/yard x .20 yards/hat x 5,000 hats = $4,000 F and a savings for variable laborcost of $11.50/hour x .10hour/hat x 5,000 hats = $5,750 F due to the lower productionlevels.The contribution margin variance resulting from the decline in sales of 5,000 units fromthe 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 thestatic 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 thedifference 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 thesegment margin variance, which is $7,900 favorable. See the discussion for each ofvariances related to the segment margin above.


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ProblemsProblem 5-1 Flexible Budget FormatPresent the following information in a flexible budget format for Matt’s Hats for the yearof 1997. The dollar amounts are associated with a static level of sales volume of 250,000hats.

ACCOUNT DOLLARAMOUNT

Sales $2,500,000Controllable Variable Manufacturing Cost 800,000Controllable Fixed Direct Manufacturing Cost 500,000Noncontrollable Fixed Indirect Manufacturing Cost 200,000Controllable Variable Selling & Administrative Cost 250,000Controllable Fixed Direct Selling & Administrative Cost 400,000Noncontrollable Fixed Indirect Selling & AdministrativeCost

100,000

Problem 5-2 Flexible BudgetingUsing the data in problem 5-1, construct a flexible budget based on a sales volume of240,000 hats.

Problem 5-3 Flexible budgetingUsing the data in problem 5-1, construct a flexible budget based on a sales volume of200,000 hats. This level of sales activity is outside of the relevant range and fixed directmanufacturing cost will be $450,000 and fixed direct selling and administrative cost willbe $340,000.


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Problem 5-4 Performance ReportUsing the budget figures from problem 5-1 and the following actual amounts based on asales volume of 250,000 hats, construct a performance report for Matt’s Hats for 1997.

ACCOUNT DOLLARAMOUNT

Sales $2,450,000Controllable Variable Manufacturing Cost 750,000Controllable Fixed Direct Manufacturing Cost 510,000Noncontrollable Fixed Indirect Manufacturing Cost 250,000Controllable Variable Selling & Administrative Cost 250,000Controllable Fixed Direct Selling & Administrative Cost 370,000Noncontrollable Fixed Indirect Selling & AdministrativeCost

140,000

Problem 5-5 Performance ReportAssume the actual amounts reported in problem 5-4 represented a sales volume of260,000 hats. Reconstruct a flexible budget from the problem 1 data at a 260,000 level ofactivity 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 Budget50,000 Units = Static Activity Level

For the Year Ending December 31, 1996Account 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 ReportAssume that the actual sales volume was 50,000 hats. Complete a performance reportbased on the information given in the annual budget. Explain the significance of theamounts in the variance category.



Problem 5-9 Performance ReportAssume that the actual sales volume was 70,000 hats. Assume also that at this level ofactivity the budgeted controllable fixed cost increases to $90,000 and the allocated fixedcost increases to $60,000. Complete a performance report based on the information givenin the annual budget. Explain the significance of the amounts in the variance category.

Problem 5-10 Revenue VariancesMRR Corp established the following standards for the sale of its product:Sales Volume 100,000 unitsSelling Price Per Unit $12.00

The actual results for the year were 120,000 units sold at a selling price of $11.75 perunit.Required:Compute the revenue variances.

Problem 5-11 Revenue VariancesMSAR Company had a total sales revenue of $61,875 for the month with sales of 8,250units. 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 VariancesMatt’s Slack Company had a total actual sales revenue this month of $40,250 on sales of3,500 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 VariancesMRR Corp established the following standards for the use of material in the productionof 10,000 units of product:Pounds of Material 40,000 poundsPounds Needed to Make a Unit 4 pounds per unitCost Per Pound $3.00 per pound

The MRR Corp actually used 43,000 pounds of material to produce 11,000 units at anactual cost of $3.10 per pound.Required:Compute the material variances.

Problem 5-14 Material VariancesMSAR Company had a total material cost of $34,830 for the month with use of 6,450pounds 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 VariancesMatt’s Slack Company had a total actual material cost this month of $9,000 on the use of4,000 yards of fabric. The expected level of material use was 3,800 yards for a totalmaterial cost of $9,500.Required:Compute the material variances.


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Problem 5-16 Material VariancesMatt’s Manufacturing Inc. has a standard use of 8 feet of material to produce a finishedend table. The standard cost is $2.00 per foot for the material. Each month the companyexpects to produce 250 end tables. During the month of February, 230 tables wereproduced using 1,955 feet of material at a total cost of $4,301.Required:Compute the material variances.

Problem 5-17 Labor VariancesMRR Corp established the following standards for the use of labor in the production of10,000 units of product:Hours of Labor 5,000 hoursHours Needed to Make a Unit 0.5 hours per unitCost Per Hour $12.00 per hourThe 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 VariancesMSAR Company had a total labor cost of $60,200 for the month with use of 7,000 hoursof 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 VariancesMatt’s Slack Company had a total actual labor cost this month of $36,250 on the use of5,800 hours of labor. The expected level of labor use was 5,500 hours for a total laborcost of $33,000.Required:Compute the labor variances.


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Problem 5-20 Labor VariancesMatt’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 toproduce 250 end tables. During the month of February, 230 tables were produced using450 hours at a total cost of $3,240.Required:Compute the labor variances.

Problem 5-21 Performance Report and Variance AnalysisMatt’s Manufacturing Company developed the following static budget based on aproduction and sales volume of 50,000 units for 1995.Account Budget

AmountSales Revenue $1,000,000Controllable Variable Material Cost 250,000Controllable Variable Labor Cost 300,000Contribution Margin 450,000Controllable Fixed Cost 170,000Segment Margin 280,000Allocated Fixed Cost 200,000Net Income $ 80,000

The actual results for the year based on a level of production and sales of 52,000 units areas follows:Account Actual

AmountSales Revenue $1,014,000Controllable Variable Material Cost 265,000Controllable Variable Labor Cost 306,000Contribution Margin 443,000Controllable Fixed Cost 165,000Segment Margin 278,000Allocated Fixed Cost 215,000Net 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. Requireda. 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 theactual results.


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Cases

Case Study 5-1 Outreach MissionOutreach Mission is a nonprofit charitable organization established to provide supportand training to disadvantaged intercity youth. The organization is supported through thecontributions from local businesses, churches, and individuals. They are also part of theUnited Way fund raising campaign. The city provides some services and support, and theorganization is exempt from any city and state taxes.At the start of 1996, the executive director prepared and presented a budget to the boardof 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, thedirector believed that there would be minimal changes between the two years and that1995 was an accurate reflection of 1996.The organization continued to provide needed support to the community during 1996 andwas recognized as one of most effective nongovernmental charitable operations in thecity. 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 wereseeking the donors dollar.The board wanted to know how Outreach Mission performed during the 1996 calendaryear. To aid in presentation, the executive director presented a 1996 statement ofactivities and also had available the previous years statement of activities which served asthe budget.RequiredA. Prepare a performance report for Outreach Mission for 1996. Include both absolutedollar and percent variances as appropriate.B. Develop a summary narrative highlighting all aspects of the Outreach Missionactivities during 1996.C. Comment on the advantages and disadvantages of using the 1995 actual performanceas a budget for 1996.D. What other possible measures or information could be useful in a performance reportpresentation?E. Suggest a possible way to develop standards or a budget for 1997.


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Outreach MissionStatement of Activities

Revenue and Expense Activities 1996 Actual 1995 ActualSupport and RevenueBusiness and Individual Contributions $2,626,400 $2,192,000Gifts-in-Kind 1,335,100 1,503,200Land and Buildings 0 814,000Contributed Skilled Services 37,600 84,100Investment Income 11,900 14,800Other 12,800 5,200Total Support and Revenue $4,023,800 $4,613,300

ExpensesProgram ServicesMission and Outreach Services 695,900 539,800Rehab Farm 292,800 216,400Dental and Medical 278,300 178,700Literacy and Education Center 88,100 78,100Food, Clothing and other Gift-in-kind 1,528,000 1,461,400Public Awareness and Education 231,500 138,600Total Program Service Expenses $3,114,600 $2,613,000Supporting ActivitiesGeneral and Administrative 343,700 402,200Fund Raising 758,300 594,600Total Support Expenses $1,102,000 $996,800Total Expenses $4,216,600 $3,609,800Change in Net Assets ($192,800) $1,003,500Net Assets, Beginning of Year $1,099,900 96,400Net Assets, End of year $907,100 $1,099,900


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Case 5-2 Atkinson Lumber CompanyAtkinson Lumber of Pineland, South Carolina cuts various sizes of pine lumber for saleto building contractors and hardware outlet stores in the southeastern United States. Thelumber company owns a 10,000 acre tree farm adjacent to its lumber mill from whichthey get much of their raw material. Additionally, the lumber company has arrangementswith several tree farms around the state to gather pine trees. By having access to theirown 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 basicconstruction piece for commercial and residential buildings. The pine trees grown inSouth Carolina are particularly well suited for these types of boards. The trees typicallygrow to about 40 to 45 feet and are very straight. Ideally, sixty 2 x 4 boards can be cutfrom each tree with a minimum of waste.The mill has a special processing line for the cutting of these boards. The lumberforeman 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 logsstarting from a clean base cut. The saw is set at the standard eight foot length to speedthe cutting process. Next, the logs are squared by using a band saw. A pallet grips thelog on both ends, moves the log through the cutting process and rotates the log until allfour sides are square. What remains is a 12 x 12 inch block or similar comparabledimensions for logs closer to the top of the tree which can easily be cut into the final 2 x 4inch sizes. The final cuts of the block are completed in a batch-processing mode. Firstthe four inch cuts are made and then the two inch cuts complete the board. Again a bandsaw is used to make these cuts.The lumber mill process is somewhat machine oriented; however, skilled labor is neededfor the cutting operations. Also, for safety purposes, at least two employees are needed ateach saw. The more skilled employee runs the saw while the assistant makes sure that thelog is set up properly and is available to help with any operation.Tom Atkinson, manager of operations, had recently developed a standard cost system forthe lumber operation. Since 2 x 4s were the most common product, he first establishedstandards for this cutting operation. He determined that a normal pine tree would yieldsixty 2 x 4s of an eight foot length. The cost of each tree was about $48. Next hedetermined that it would take 10 minutes to cut the tree into eight foot logs. It would takeanother 20 minutes to cut the logs into blocks, and finally about 30 minutes to cut theblocks into 2 x 4 boards. Two employees would be involved in the cutting operation forthe 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 4sin 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 actualcosts, and the predetermined standard costs. Based upon his estimates, the standard costfor a 2 x 4 should be $1.35 and since 12,000 boards were produced, the total cost shouldhave been only $16,200. There was an unfavorable variance of $634.


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


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Documents

Tim Redmer Accounting