Chapter 3 Building A Financial Statement and Cost Accounting System

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A Type of the Financial Statements

1)Balance Sheet: a financial statement showing the financial position of the firm at a specific date.

2) Income or Profit/Loss(PL) Statement: a financial statement showing profit or loss during the operating period of time.

3) Cash Flow Statement: a financial statement showing cash outflows and inflows during the fiscal year.

4) Statement of Changes in Owner’s Equity: a financial statement showing change in the owners’ equity.

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The Example for A Balance Sheet: B/S

Debit: Asset(things that a firm has)

Ex) Tangible AssetCash or equivalentsAcc. ReceivableShort-Term InvestmentInventories

Properties, Plant & Equipment BuildingsComputers & IT etc.

Intangible AssetPatentsTrademarksCopyrights, etc.

Balance SheetCredit:Liabilities & Equity(things that a firm is obliged)

Ex) LiabilitiesAccounts PayableWages PayableAcc. UnearnedAccrued Taxes, etc.

BondsOther Long-Term Debts

Ex) EquityPreferred StocksCommon Stocks & CapitalRetained Earnings

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A Balance Sheet

This system was invented by Pacioli in Italy during the 15th century. It allows us to record the economic events or financial transactions by

discriminating them into debt and credit of the independent account.

- Ex) A firm purchased a CAD/CAM system by paying 300 million won in cash in May of 2009

T-Accounting(Double Accounting)

Dr. Cr.

300,000

Cash Acc.

Dr. Cr.

CAD/CAM Acc.

300,000

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Accounting Equation The sum of all the accounts in a debt section must be equal to that in a credit section

Asset = Liabilities + Owner’s Equity

Dr. Cr.

Acc. w. r. t. Asset

Dr. Cr.

Acc. W. r. t. Liabilities & Equities

Increase Decrease Decrease Increase

A Guide to Record the Financial Transactions into the T-Accounting System

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The Balance Sheet for the SS Electronic Co.(unit: million won)

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Income Statement

It is a financial statement which presents the result of operation during a specific period of time

It also shows the concrete operating activities It is also called an operating or management

performance statement The Key Issues in Preparing An Income Statement

: To clearly indentify the items of revenues(earnings) and cost

Revenues: inflows of assets received in exchange for goods or services provided to customers as part of the major or central operations of the business. Costs: the monetary value of the resources to be consumed to produce products or servicesExpenses: outflows or using up of assets as a result of

the major or central operations of a business.

RevenueExpenses:COGSDepreciationO&M, Adm.

Taxable IncomeTax

Net Income

Income Statement

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The Income Statement for SS Electronic Co.

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9

Cash Flows & Net Income

Net Income- A profitability measurement according to the accounting concept- Profit defined as a matching principle- The time for a cash flow to occur is ignored- It is determined corresponding to the accrual-basis principle

Cash Flow- Given the value of money, the value of the cash flow today is greater than

that tomorrow if the size of the cash flows is equivalent- So, it is desirable to perform an economic evaluation of the project based

on the cash flows- It is determined according to the cash flow-basis principle

Cash Flow Statement The Structure of a Cash Flow Statement)

Net Cash Flows

Operating Activities

Investing Activities

Financing Activities

+

+

+Net Income+Depreciation

-Investment Cost+Proceeds from the Sale of the Fixed Assets- Gain Tax-Working Capital+Recovery of Working Capital

+Borrowing-Principal Repayment

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The Cash Flow Statement for SS Electronic Co.

(Unit: Million won)

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A Statement of Changes in Owner’s Equity

Statement of Changes in Stockholder’s Equity- It shows the beginning and ending balances of the owner’s equity, and also changes

in the owner’s equity occurring during the fiscal

The Key Factors of the Statement- Initial Capital- Net Income- New investment by the Owners- Loss or Dividend

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The Relationships among the Major Financial Statements

Beg. Balance Sheet End. Balance Sheet

Cash Flow Statement

Owner’s Equity

Income statement

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Prepare the Financial StatementsThere are many things to be done for the work. However, we will focus on the way of how to record thetransactions in the accounting system based on the T-Account in this section

Ex 3.1] the way to prepare the financial statements using the T-account

Transaction 1] The owner invested 30million won of cash and opened the bank account with the money in HanKuk Copy Center on Dec. 1 in.

(unit: ooo won)

Capital

30,000

Cash

30,000

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Unit: 000 won

Equipment

6,000 2,5001,100

Materials Acc. Payable

6,0001,100

Transaction 2& 3] HanKuk Copy Center purchased the copy machine for 2 million won and the copy materials for 2.5million won in cash

Transaction 4] The center purchased the materials for 1.1million won and equipment for 6million won on credit

Unit: 000 won

Cash

30,000 2,50020,000

Materials

2,500

Machine

20,000

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Transaction 5] A center made the net income of 2 million won in cash

Transaction 6& 7] The center paid a rent fee of 1million won and wage of 700 thousands won in cash

Cash

30,0002,000

2,5002,000

Unit: 000 won

Capital

30,0002,000

Cash

2,50020,0001,000

700

30,0002,000

Capital

30,0002,000

1,000700

Unit: 000 won

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Transaction 8& 9] The center had provided service for 1.7million won on credit and collected the whole amount of money in 10 days

Transaction 10] The center repaid an account payable of 900 thousands won in cash

Cash

2,50020,0001,000

700

30,0002,0001,700

Unit: 000 won

Acc. Receivable

1,7001,700

Cash

2,50020,0001,000

700900

30,0002,0001,700

Acc. Receivable

6,0001,100900

Unit: 000 won

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Transaction 11] The center paid a dividend of 40 thousands won in cash

단위: 천원

Cash

2,50020,0001,000

700900400

30,0002,0001,700

Capital

30,0002,000

1,000700400

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Changes in the Balance Sheet Equation Created by All Transactions

Tran. Cash Acc. Reiv. Mater. Equip. Capital Acc. Pay.

1 30000 30002 (2500) 2500 3 (20000) 20000

Bal. 7500 2500 20000 300004 1100 6000 7100

Bal. 7500 3600 6000 30000 71005 2000 2000

Bal. 9500 3600 26000 32000 71006 (1000) (1000)

Bal. 8500 3600 26000 31000 71007 (700) (700)

Bal. 7800 3600 26000 30300 71008 1700 1700

Bal. 7800 1700 3600 26000 32000 71009 1700 (1700)

Bal. 9500 0 3600 26000 32000 710010 (900) (900)

Bal. 8600 0 3600 26000 32000 620011 (400) (400)

Bal. 8200 0 3600 26000 31600 6200

Asset Liability & Equity

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The Financial Statements

Balance SheetAssets Liability & EquityCash 8,200 Acc, Payable 6,200Materials 3,600 Capital 31,600Equipment 26,000Total Asset 37,800 Total Lia.&Equity 37,800

Income StatementFrom Dec. 1 to Dec. 31 in 2008Revenue:Copy Service 3,700Operating Expenses:

Rent 1,000Wage 700

Total operating expense 1,700Net Income 2,000

Changes in Owner’s EquityEquity:Capital Invested 30,000

Net Income 2,000Total 32,000

Dividend 400Net Equity 31,600

(unit: 000 won)

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(unit: 000 won)

Cash Flow StatementCash Flow from the Operating Activities:

Cash Inflow from the Copy Service 3,700

Cash outflow for Rent (1,000)

Cash outflow for Wage (700)

Cash outflow for the Purchase of the Materials (2,500)

Net Cash Increase from the Operating Activities (500)

Cash Flow from the Investing Activities:

Purchase of the Copy Machine (20,000)

Net Cash Increase from the Investing Activities (20,000)

Cash Flow from the Financing Activities:

Initial Capital 30,000

Dividend (400)

Loan Repayment (900)

Cash Flow from the Financing Activities 28,700

Net Increase in Cash Flow 8,200

Cash on Dec. 1 in 2008 -0-

Cash on Dec. 31 in 2008 8,200

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The Financial Ratio Analysis

As discussed before, the main purpose of accounting is to provide information for decision making. Theywill tell what has happened during a particular point in time. In that sense, the financial statementsare essentially historical documents. However, most users of financial statements are concernedabout what will happen in the future. For instance,

Stockholders are concerned with future earnings and dividends Creditors are concerned with the company’s ability to repay its debts] Managers are concerned with the company’s ability to finance future expansion Engineers are concerned with planning actions that will influence the future course of business

events

There are in general 5 types of the financial ratio analyses.1) debt management analysis2) liquidity analysis

3) asset management analysis4) profitability analysis5) market value analysis

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Debt Management Analysis All businesses need assets to operate. To purchase them, a firm needs to raise capital through debt andequity. The firm needs information on how to use debt financing and whether or not to meet debtrepayment obligation. To this end. The firm need the following information.

debt ratio: the ratio of the total debt to the total asset

Ex]

The ratio of 16.6% means that the copy center has 16.6% of debt of the total asset. Or it means that thecreditors have supplied 16.6% of the copy center’s total financing.

times-interest-earned ratio : The times-interest-earned ratio is the most common measure of the ability of a firm’s operation to provide protection to the long-term creditor.

EBIT: before interest and income tax

Ex] A firm’s amount of the total EBIT and total interest expense are 317.27million won and 17million won, respectively.

Total DebtDebt Ratio=Total Assets

620 0.1663,740DebtRatio= =

EBIT=Times-Interest-Earned RatioInterest Expense

300,270 17,000 18.661,700Times Interest EarnedRation multiple+− − = =

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Liquidity Analysis Short-term creditors want to be repaid on time. Therefore, they focus on the firm’s cash flows and on its working capital , as these are the firm’s primary sources of cash in the near future. current ratio: It is obtained by dividing current assets by current liabilities

Ex] Current Assets: 8.20million won in cash, 3.60million won in inventoriesCurrent Liabilities: 620,000won in the account payable

-This ratio means that the company hold enough money to pay the current liabilities as much as 19 multiples

CurrentRatio= Current AssetsCurrent Liabilities

8,200 3,600 19620

CurrentRatio multiple+= =

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acid-test ratio: this ratio is obtained by dividing the difference between the current assets and the inventories by the current liabilities

Ex] Current Asset: 8.2 million won, inventories: 3.6million won, current liabilities: 620,000won

( )QuickRatio Acid TestRatio− = Current Assets-InventoriesCurrent Liabilities

8,200 13.2620

QuickRatio multiple= =

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Liquidity Analysis

The ability to sell inventory and collect the accounts receivable is fundamental to business success. So, the asset management analysis measures how effectively the firm is managing assets.

inventory turnover: It measures how many times the company sold and replaced its inventory during the year. It is obtained by dividing sales by the average inventory balance. The average inventory balance is computed by taking the average of the beginning and ending inventory figures.

Ex] Sales: 3.7 million won, inventory: 3.6 million won

- The ratio means that it takes almost one year to turn inventory to sales- It also implies that the copy center has held excessive inventory

days-sales-outstanding(account receivable turnover) ratio: It roughly measures how many times a company’saccounts receivable have been turned into cash during the year. It is obtained by dividing the accounts receivable bythe average sales per day. The average sales per day is computed by dividing the annual sales by 365.

-The ratio indicates the average length of time the firm must wait after making sales before receiving cash.

InventoryTurnover = SalesAverage Inventory Balance

3,700 1.033,600

InventoryTurnover multiple= =

Re/365

Account ceibaleTurnOver = =Receivalble ReceivaleAverage Sales per Day Annual Sales

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Asset Management Analysis

Ex] A firm’s accounts receivable and annual sales are 2.5million won and 35million won, respecitively

- The account receivable of 26 days means that the firm must wait for 26 days to get the accounts receivable into cash.

total asset turnover ratio- It measures how effectively the firm uses its total assets in generating its revenues. It is the ratio of sales to all

the firm’s asset.- It also implies the number of times that the firm’s assets have been used per year

Ex] total assets 37.8million won, annual sales: 3.7 million won

- It may be concluded that the firm’s total asset had been used in much ineffective way.

2,500Re 2635,000 / 365

Account ceivableTurnOver days= =

TotalAssetTurnOver = SalesTotal Assets

3,700 0.137,800

TotalAssetsTurnOver multiple= =

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Asset Management Analysis

One of the most important goals for any business is to earn profit. The ratios examined thus far provide useful clue as to the effectiveness of a firm’s operations, but the profitability ratios show the combined effects of liquidity, asset management, and debt on operating results. Therefore, the ratios that measure profitability play a large role in decision-making. profit margin on sales : it is obtained by dividing net income available to common stockholders by sales

Ex] Net Income: 2million won, Sales: 3.7 million won

- The copy center earned 540 won per sale of 1,000won

Pr argofitM inonSales = Net Income Available to Common StockholdersSales

2,000Pr arg 54%3,700

ofitabilityM inonSales = =

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Profitability Analysis

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Profitability AnalysisReturn on total asset(ROA): it measures a company’s success in using its assets to earn profit. The ratio of the net income to total assets measures the return on total assets after interest and taxes:

The reason for adding back the interest expenses to the net income results in an adjusted earnings figure that shows what earnings would have been if the asset had been acquired solely by selling shares of stock.

Ex] Net Income=2 million won, No interest expenses, total asset=37.8million won

RetunonTotalAsset = Net Income*(1-tax rate)Average Total Asset

5.3%RetunonTotalAsset == 2,00037,800

return on equity(ROE): The ratio shows the relationship between net income and common stockholder’s investment in the company. It is obtained by dividing net income by average common equity.

Ex] Net Income: 2million won, Equity: 31.6million won

RetunonCommonEquity = Net Income Available to Common StockholdersAverage Common Equity

2,000Re 6.3%31,600

turnonEquity = =

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Profitability Analysis

When you purchase a company’s stock what would your primary factors in valuing the stock? In general, thevalue of the stock consists of two parts: (1) gains(or losses) and (2) dividends. The market ratios relates thefirm’s stock price to its earnings and book value per share. They give management an indication of whatinvestors think of the company’s past performance and future prospects.

Price-Earning Ratio: it shows how much the investors are willing to pay per dollar of reported profit. It isobtained by dividing the current stock price by the earning per share

Ex] Stock Price=30,000won, a number of stock outstanding=667 shares.

Market Value Analysis

Pr iceEarningRatio = PriceEPS

2,000 3,000667

won= =EPS30 103

PER = =

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EeaningsperShare = Net IncomeA Number of Shares Outstanding

book value per share :it measures the amount that would be distributed to holders of each share of commonstock if all assets were sold at their balance sheet carrying amount and if all credits were paid off. It iscomputed by dividing total stockholders’ equity-preferred stock.

Ex] Total Equity: 31.6 million won, No Preferred Stocks, # of Stocks Outstanding: 667Shares

BookValueperShare = Total Stockholder's Equity - Preferred Stock# of Stock Outstanding

31,600 47,400667

BookValueperShare won= =

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Market Value Analysis

The Historical Background about The Costing System

The Development States of the Costing System Stage 1) The 19th Century (The Introduction of the Costing System)

The costing system required proper for the industry environment which was characterized by a variety and complexity of production methods

The main purposes of then costing system was to measure a performance of the internal operations and to calculate direct

Stage 2) 1880~1910 (Taylor’s Scientific Management) Since the product was sophisticated and thus the production methods was so, the company needed

to standardize the worker’s work to calculate a product cost in a scientific manner.

Stage 3) 1910~1920 (Du Pont) The characteristics of the industries: it was the period of time in which the companies

independently founded for the manufacturing, purchasing, transporting, and distributing activities had been integrated

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The important themes of the costing system the headquarter company needed to direct, supervise, and control the department activities to

accomplish a common goals the methodology to plan the rational budget was required the technique to estimate the investment profitability was required the performance measurement system to compare the department performance with a company-wide

performance was asked for Stage 4) 1920~1930 (GM)

The characteristics of the industries: it was the period of time in which the companies independently founded were integrated into the company to maximize the economic advantages in the manufacturing and financing management fields

The main purpose of the costing system: to measure and appraise the performance internally achieved and calculate a product’s direct cost

The important themes the professional managers had to secure on average 80% of the facility utilization and at least 20%

of the after-tax return to satisfy the stockholders’ required yield. it was asked to set up a standardized product cost before manufacturing products such that it might

be applied to all the products over the year, which affected to minimize the uncertainty caused by the short process cost and product demand.

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Stage 5) From the management accounting to the cost accounting The characteristics of the industries: those were changed from the economies of scale to the economies

of scope The important themes it became difficult to collect a product information due to a variety of products and a coarse

information technologies it became necessary to provide a objective and overall financial information for the outside

investors to invest

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Traditional and Activity-Based Cost System

Mfg System:

TMS AMS

Costing System:

TCA ABC

Competition Factors:

Price Quality, Delivery, Flex., Price

Product Cost Product Mix Investment Projects

The Influence Diagram of The Market Competition Factors

TMS(traditional manufacturing systemAMS(advanced manufacturing systems)TCA(traditional cost accounting)

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The Comparison of TMS with AMS in Terms of Their Characteristics

TMS AMS

Diversity Small Various

Prod. Volume Mass Small/Medium

Process Method Labor-Intensive Capital-Intensive

Market Domestic Global

Ratio of the Direct Labor Cost

70~80%* About 10%

*:It was based on the ratio that the direct labor cost took up in thetotal manufacturing cost except for the material cost in 1920s

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The Comparison of TCA with ABC SystemTCA ABC

Allocation Basis Direct Labor H/C, Machine Time, Material Cost # of Cost Drivers

Denominator for The Facility Cost Forecasted Pro. Vol. Practical Capacity

Expenses Full Absorption Partial Absorption

Depreciation SL Machine Time

GA.M.S Period Expense Product Cost

The Main Subject to Cause Cost Product Activities

The Main Purpose Inventory Valuation Product Costing

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The Cost Elements for the Projects

accounting costs: a product cost in a traditional costing system(manufacturing cost, inventory cost) a product cost is cost before sold to the customers in the balance sheet a product cost becomes expense after sold to the customers in the income statement ex. Direct labor cost, direct material cost, and indirect manufacturing cost

economic costs they are the costs which are used to make an economic decision and cannot be recorded in the accounting

system. opportunity cost: the alternative advantage foregone as a result of the commitment of resources to one

particular endcf: highest price or rate of return an alternative course of action would provide

marginal cost: increase or decrease in the total costs of a business form as a result of one more or one less unit of output

sunk cost: cots already incurred in a project that can not be changed by present or future actions.

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The Cost Classification by the Usage Purpose

1) By Consumption : material cost, labor cost, indirect manufacturing costs, and so on2) By Traceability: Direct costs, indirect cost3) By A Business Function: Manufacturing cost, Marketing Cost, Administrative cost4) By A Cost Behavior Pattern: Variable Cost, Fixed Costs5) By A Computation Time: Actual cost, standard cost6) By a Measurement Unit: product cost, period cost7) By Controllability: controllable cost, discretionary cost

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A Cost Classification by Consumption

Manufacturing cost Direct material cost: cost of materials used to manufacture a product

ex) woods used to manufacture furniture, steel used to construct a bridge, and so on Direct labor cost: cost of labor consumed to produce a product

ex) a welder wage to make a steel panel, a carpenter wage or in an apartment construction field, and so on

Indirect Manufacturing Cost: all the other costs incurred in the manufacturing field except for the directcosts

ex) indirect material cost, indirect labor cost, maintenance cost, supervisor’s salary, and so on

nonmanufacturing Overhead: depreciation, property tax, heating, and lighting cost related to sales & administrative

activities Marketing : advertise, transportation, marketing promotion, sales commissions, salesman salaries Administrative costs: executive , organizational, and clerical cost associated with the general

management of an organization Administrative function: executive compensation, general accounting, public relations, and secretarial

support

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Classifying Costs for Financial Statements

Matching Principle the costs incurred to generate particular revenue should be recognized as expense in

the same period that the revenue is recognized. The Important Criteria to Discern a Product cost and Period Cost

- period cost: those costs that are charged to expense in the period in which they are incurred.

ex)administrative cost, selling expenses, insurance & income taxes- product cost: costs incurred to manufacture a product

ex) direct material costs, direct labor costs, indirect manufacturing costs

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A Cost Classification for Predicting A Cost Behavior

fixed cost Definition• cost of providing a company’s basic operatingcapacity

• cost that remains constant in total regardless of production volume within a certain range of a production volume

ex) automobile insurance expense, propertytaxes, rent fee, depreciation, license fee,salaries of administrative and productionpersonnel

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variable cost

Definition• the total cost changes according to change in a

production volume.

ex) the cost of the tires for a car

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A Cost Classification for Predicting A Cost Behavior

A Break-even Point Analysis

A production volume which makes a sum of the fixed and variable costs equal to the total revenue which results in a zero profit

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( )

( )

( )

( )

Re / Pr

arg

veune FixedCost VariableCost unit oductionVolumeP X FC VC XX P V FC

FCXP V

P V A ContributionM in

= + ×× = + ×

− =

=−

− =

The Example for the BE Analysis

Ex] The Break-Even Point Analysis

FC=20million won, V=500,000won/unit, P=2million won

Sol]

200,000 133( )( ) (2,000 500)

FX unitsP V

= = =− −

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