Tim Redmer Accounting

Chapter One: Accounting and Finance: An Introduction
An Introduction to Accounting and Finance: Text and

Cases
by
Timothy A. O. Redmer
Copyright Ó 1999
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Table of Contents
Chapter One: Accounting and Finance: An Introduction ....................... 1
Chapter Objectives ............................................................................... 1
The Objective and Scope of this Text Book ........................................... 1
Chapter Content ................................................................................... 2
Accounting Defined .............................................................................. 4
Finance Defined.................................................................................... 6
The Role of Ethics in Accounting and Finance ....................................... 7
Summary ............................................................................................ 10
Chapter Questions.............................................................................. 12
Cases ................................................................................................. 13
Chapter Two: The Income Statement and the Balance Sheet .............. 17
Objectives .......................................................................................... 17
Account Categories ............................................................................ 17
Accrual Accounting............................................................................. 26
The Accounting Process...................................................................... 27
Income Statement............................................................................... 33
Statement of Retained Earnings .......................................................... 35
Balance Sheet ..................................................................................... 36
Summary ............................................................................................ 39
Study Problems................................................................................... 40
Problems ............................................................................................ 59
Cases ................................................................................................. 66
Chapter Three: Financial Statement Analysis....................................... 73
Objectives .......................................................................................... 73
The Role and Purpose of Financial Statement Analysis ........................ 73
Benefits of Financial Statement Analysis ............................................. 74
Limitations of Financial Statement Analysis......................................... 74
Liquidity Ratios................................................................................... 77
Activity Ratios..................................................................................... 78
Debt Ratios......................................................................................... 86
Profitability Ratios .............................................................................. 91
Market Ratios ..................................................................................... 97
Horizontal and Vertical Analysis ....................................................... 102
Summary .......................................................................................... 104
Problems .......................................................................................... 106
Cases ............................................................................................... 114
Chapter Four: Budgets and the Budget Process ................................. 121
Chapter Objectives ........................................................................... 121
The Nature and Purpose of the Budget.............................................. 121
The Budget Process .......................................................................... 122
Benefits of a Budget Process ............................................................. 123
Disadvantages of a Budget Process................................................... 124
Types of Budgets .............................................................................. 124
Summary .......................................................................................... 139
Self-Study Problems ......................................................................... 140
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Problems .......................................................................................... 153

Cases ............................................................................................... 162
Chapter Five: Performance Evaluation ............................................... 169
Objectives ........................................................................................ 169
Standard Accounting Systems ........................................................... 169
Performance Reports ........................................................................ 172
Variance Analysis.............................................................................. 177
Summary .......................................................................................... 183
Problems .......................................................................................... 200
Cases ............................................................................................... 207
Chapter Six: Differential Analysis....................................................... 211
Objectives ........................................................................................ 211
Differential Analysis.......................................................................... 211
Contribution Margin Analysis............................................................ 213
Short-Term Decision-making Techniques ........................................ 216
Summary .......................................................................................... 224
Problems .......................................................................................... 236
Cases ............................................................................................... 251
Chapter Seven: Current Asset Management: Cash and Marketable
Securities............................................................................................ 257
Objectives ........................................................................................ 257
Cash and Marketable Securities ........................................................ 257
The Cash Flow Process ..................................................................... 261
Management of Cash Flows .............................................................. 265
Bank Reconciliation .......................................................................... 266
Summary .......................................................................................... 270
Problems .......................................................................................... 284
Cases ............................................................................................... 290
Chapter Eight: Statement of Cash Flows ............................................ 297
Objectives ........................................................................................ 297
The Cash Flow Statement.................................................................. 297
Preparing a Statement of Cash Flows ................................................ 298
Summary .......................................................................................... 307
Problems .......................................................................................... 323
Cases ............................................................................................... 330
Chapter Nine: Current Asset Management: Accounts Receivable and
Inventory............................................................................................ 339
Accounts Receivable Management .................................................... 339
Accounts Receivable Ratios............................................................... 343
Marginal Analysis of Accounts Receivable ......................................... 344
Inventory Management ..................................................................... 345
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Inventory Ratios................................................................................ 349

Summary .......................................................................................... 350
Problems .......................................................................................... 360
Cases ............................................................................................... 369
Chapter Ten: Current Liability Management ...................................... 373
Current Liability Management ........................................................... 373
Types of Current Liabilities ............................................................... 373
Cost of Credit ................................................................................... 379
Summary .......................................................................................... 384
Problems .......................................................................................... 394
Cases ............................................................................................... 398
Chapter Eleven: The Time Value of Money ......................................... 401
Objectives ........................................................................................ 401
Time Value of Money ........................................................................ 401
Time Value of Money Models ............................................................ 404
Procedures Used in Computing Time Value of Money Models ........... 407
Bond Valuation Time Value of Money Model ..................................... 409
Summary .......................................................................................... 413
Problems .......................................................................................... 438
Cases ............................................................................................... 441
Chapter Twelve: Risk and Return ....................................................... 445
Objectives ........................................................................................ 445
Risk .................................................................................................. 445
Return .............................................................................................. 447
Diversification .................................................................................. 449
Summary .......................................................................................... 453
Problems .......................................................................................... 462
Cases ............................................................................................... 467
Chapter Thirteen: Security Valuation and the Cost of Capital ............ 471
Objectives ........................................................................................ 471
Valuation of Securities ...................................................................... 471
Security Valuation Models................................................................. 473
Cost of Capital.................................................................................. 480
Summary .......................................................................................... 484
Problems .......................................................................................... 502
Cases ............................................................................................... 508
Chapter Fourteen: Capital Budgeting ................................................. 513
Objectives ........................................................................................ 513
The Role of Capital Budgeting........................................................... 513
Cash Flows and Capital Investments ................................................. 514
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Capital Budgeting Methods of Analysis ............................................. 518

Summary .......................................................................................... 526
Problems .......................................................................................... 535
Cases ............................................................................................... 547
Chapter Fifteen: Long-Term Debt....................................................... 553
Objectives ........................................................................................ 553
Long-Term Debt............................................................................... 553
Leases .............................................................................................. 561
Financial and Operating Leverage ..................................................... 563
Summary .......................................................................................... 566
Problems .......................................................................................... 575
Cases ............................................................................................... 586
Chapter Sixteen: Equity Funding ........................................................ 589
Objectives ........................................................................................ 589
Equity Funding ................................................................................. 589
Dividend Policy ................................................................................. 593
Earnings Per Share and Other Equity Related Measures ..................... 595
Summary .......................................................................................... 598
Problems .......................................................................................... 604
Cases ............................................................................................... 609
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Chapter Objectives
1. 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 Book

Individuals in virtually every profession today come into contact with business principles
and concepts. Unfortunately, many people neither have the time nor opportunity to learn
basic business concepts and especially accounting and finance topics. In the education
process, there appears to be little middle ground, students either get no exposure to these
topics or they have to take an entire course which gets into details beyond their
fundamental needs.
An Introduction to Accounting and Finance: Text and Cases is designed to introduce
critical topics in the areas of accounting and finance in a basic context. This material is
relevant for the general business manager as well as those who do not have a business
background but wish to gain a foundational level of understanding and expertise. The
topics are presented from a conceptual point of view to give the manager a fundamental
understanding of the material. Additionally, an underlying emphasis of each topic
presentation will be; what does the individual need to know to ask the correct questions
or to comprehend information as presented by the accountant or financial manager.
It is not the intent of this text to make one an expert in either the area of accounting or
finance. However, at the same time, it is expected that anyone completing this text will
be able to understand and work through basic examples and illustrations of accounting
and finance problems. Exercises of this nature will help to reinforce the important
concepts and principles presented in the text.
A manager, who does not have a strong background in accounting or finance, must rely
on having good people in those positions. Individuals who tend toward the accounting
and finance career fields are often classified as the "numbers people" or "those with
quantitative skills". Such a stereotyping can present a dilemma for the nonfinancial
individual. The very reason an individual manager may be classified as nonfinancial is
because of an aversion to a quantitative or numbers orientation.
A successful business manager, in many cases, must rely on the support of capable people
in critical positions within the organization. The manager will need to make decisions
based upon the input of information from these members of the management team.
Financial or quantitative information is a key ingredient in the decision-making process.
The dilemma for the manager, without a comprehension of the accounting and financial
aspects of the business, is a possible misunderstanding of the presentation of such
information.
Misinterpretation of information can sometimes be worse than no information in a
decision process, especially when it leads to incorrect courses of action. With no
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information, business managers will likely resist change; however, with incorrect
information, or the misinterpretation of information, the business manager could select
courses of action that might change a company for the worse.
This need for an individual to gain at least the basic skills and understanding in the areas
of accounting and finance, so they can compete effectively in the business world, is the
underlying reason and objective for a text of this nature. A manager, while often being a
specialist, with abundant skills and abilities in a particular area, also needs to be a
generalist, with a fundamental knowledge level in all areas of business. To be effective in
the decision-making process, the manager is going to have to have a basic understanding
in all areas of business management, including both quantitative and qualitative skills.
The business or nonbusiness individual, without the expertise in specific areas, is going to
have to know how to converse with the experts in those areas, and know how to analyze
and interpret information for decision-making purposes.
Some may say that a particular individual has just enough information to be dangerous, or
individuals with a little knowledge in a particular area suddenly become experts. In such
cases, the presentation of accounting and finance information in a basic format, as an
objective of this text, could be misleading and could have dysfunctional results.
However, at the same time, an equally relevant argument could be made for the idea that
a little information is better than no information.
Basically, knowledge is good for the soul, and one should never stop learning. It is not
the accumulation of knowledge that is the problem, it is what an individual does with the
knowledge once obtained. Such a philosophy lends credibility to a text of this nature.
The benefits to any individual, with a limited understanding of financial and accounting
skills, to be exposed to a broad and basic overview of these topics, should far outweigh
the potential hazards of possible misuse or misunderstanding of the knowledge in the
business setting.
This text is designed to appeal to the nurse who has to evaluate performance measures, as
well as the teacher who needs to prepare a budget for yearly classroom activities. It
should also appeal to the preacher who has to develop a capital campaign for a new
church building program or the dentist who has to monitor cash flow. An individual does
not have to be a business major to benefit from the topics presented in this test. However,
if that nurse, or teacher, or preacher, or dentist is going to be involved in business related
decision situations, the concepts learned in this book can make it easier to understand
those processes.
Chapter Content
Specific topic areas addressed in this text will begin with the accounting process and the
development of financial statements. A basic understanding of financial statements to
include the income statement, balance sheet, and statement of retained earnings is critical
in many decision-making situations. Following the presentation of the financial
statements is Chapter 3 covering the analysis of financial statements. Accounting reports
have limited usefulness unless they can be properly analyzed. The information obtained
from financial statements serves as the basis for the development of financial ratios that
can be used in the review of a company.
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Budgeting, presented in Chapter 4, is an essential component related to both the planning

and control functions of management. The budget by its very nature is a plan, and serves
as a guideline for future management courses of action. The budget can also serve as a
control tool by providing a standard against which performance can be measured.
Performance reporting is a natural follow up to the budgeting and financial reporting
process. Areas of responsibility at various levels of management need to have a system
of accountability and control. Reports need to be properly developed and procedures
established to analyze variations between predetermined standards and actual results.
Accounting information plays an important role in future decisions. The concept of
relevant or differential cost, presented in Chapter 6, underlies decisions using
contribution margin and cost behavior patterns, such as discontinue or start products,
make or buy options, and sell or process products further.
A major reason that many businesses are unsuccessful is cash management or the lack of
cash management. The role and use of cash in a business impacts many areas of
management, but it is especially important in the operating function. Following the
chapter on cash management, Chapter 8 will present a detailed discussion on the
statement of cash flows. The introduction of this financial statement was delayed until
after the cash management chapter to give the reader a greater appreciation of the role of
cash in a company.
Working capital management specifically addresses cash management but also considers
important areas such as accounts receivable, inventory and short-term debt management.
Chapters 9 and 10 give a comprehensive overview of the importance of managing
working capital. Company management can quickly lose liquidity if they allow accounts
receivable and inventory to build to excessive levels. Additionally, the effective rate of
interest can be substantially higher than a quoted simple interest rate and a manager needs
to understand the difference when it comes to borrowing money.
Certain technical skills need to be understood even with a minimum competency in
quantitative processes. The principles of time value of money in Chapter 12 and the risk
return relationship in Chapter 13 are fundamental in the application of several financial
concepts. Business calculators and software programs essentially reduce the use and
understanding of these technical methods to a data entry process.
Capital budgeting is a technique, which incorporates the use of time value of money into
decisions involving major asset acquisitions, and the results could impact the company
over an extended time period. Business managers need to be aware of the most
appropriate methods to evaluate major decisions involving substantial outlays of capital
that are often irreversible without large additional sums of cash.
To support long-term asset requirements, business managers need to be aware of the
many sources of funds broadly classified as debt, covered in Chapter 15, and equity,
covered in Chapter 16. Active markets with trading in bonds and stocks provide
underlying liquidity to the process of issuing corporate bonds and/or preferred and
common stock.
Ethical situations can easily arise in any business setting when money is involved. The
lack of understanding of the accounting and finance process by the business manager is
an incentive for the unethical employee to manipulate the system. An appreciation of
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ethical standards and a commitment to the proper reporting and disclosure of financial
information needs to be constantly reinforced within the area of accounting and finance.
Obviously not every area of accounting and finance can be covered in a single text at the
introductory level. In accounting, topics such as adjusting entries and more in-depth
presentations on the various methods to record inventory and depreciation are left for a
more advanced accounting text. Detailed discussions of the acquisition, use, and disposal
of fixed assets and debt instruments are not included. In the area of finance, specific
presentations related to stockholders equity, dividend policy, convertible securities,
warrants, and options are left for more advanced finance texts.
Accounting Defined
The American Accounting Association defines accounting as "the process of identifying,
measuring, and communicating economic information to permit informed judgments and
decisions by the users of the information."1 Accounting is called the "language of
business" as it provides a means of systematically recording and reporting information in
a financial format.
The Accounting Process

The accountant begins the process by observing a business-related activity that has
financial implications. Not all business activities can be measured in monetary terms,
and the accountant needs to differentiate between these activities. Financial business
activities are called transactions. Once the accountant has observed the transaction, the
appropriate accounts that are affected need to be identified. Sometimes, a business
transaction will recognize some actions coming into the business and some actions
leaving the business. These actions should be equal and offsetting.
The identification of accounts is broadly classified as assets, liabilities, and equity, which
include revenues and expenses. In any financial business transaction, two or more
accounts within these broad categories will increase or decrease in size. The
measurement process involves determining the nature and extent of the increase or
decrease in the appropriate accounts.
Once the transaction is identified and measured, it needs to be recorded in the proper
account categories. Without the recording step, the transaction will not get into the
system and its impact on the overall performance will be unknown. The input of data
through the recording process completes the journal entry phase of a business transaction.
With the appropriate data now entered into the accounting system, the information needs
to be summarized into a usable fashion so that it can be usefully presented in an
organized report format.
Summarization of accounting information into specific account categories called ledgers
is recognized as the posting process. The accounts are either increased or decreased in
each transaction, and the resulting balance in the ledger account is summarized for
reporting purposes. Since the information needs to be presented for decision-making
purposes, this collection process is critical. The whole purpose of accumulating data is to
1American Accounting Association, A Statement of Basic Accounting Theory (Evanston, Ill., 1966),
p. 1.
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Illustration 1-1
Action Accounting Activity
Observation Determine Accounting Action
Business Transaction Identify and Measure
Recording Process Journal Entry
Summarization of Data Post in Account Ledger
Reporting Financial Statements
have it available in different types of report formats to aid the business manager in all
aspects of the business.
Some accounting reports that will be examined by external users outside of the company
need to be in a specific format as directed by generally accepted accounting principles.
Other reports can follow formats directed by management, as their primary purpose will
be for use within the company.
Reports summarizing the various financial activities of the company can be analyzed and
interpreted by management and used to aid in relevant decision-making situations. This
communication process of economic information completes the accounting process as
defined; however, there are many activities and other related actions that go into the
accounting function.
The business manager needs to be aware that the information gathered and presented in
the accounting process be both relevant and reliable. Relevant information means that the
information will be useful for decision-making purposes. A company does not need to
clutter its record keeping activities with information that is not useful. In a time of
increased automation, the probability of information overload is a distinct possibility.
Reliable information is essentially correct information. This information does not
necessarily have to be precisely accurate, such as to the nearest penny, to be reliable.
However, the users of information have to have confidence in the values so they can be
comfortable when applying the knowledge in the decision process. Illustration 1-1
highlights the accounting process.
Finance Defined
Finance does not generally have a definition in the way that accounting was previously
defined. Finance seems to be recognized more as a means to achieving an objective. An
underlying goal for a company is the maximization of shareholder wealth, or the
maximization of the total market value of the current shareholders' common stock. The
financing activity is oriented toward achieving this specific goal.
Years ago finance focused primarily on descriptive activities such as raising capital,
government and other forms of regulation, and merger and acquisition activities. More
recently, the area of finance has broadened with greater emphasis on internal activities in
support of management. Issues such as working capital management, capital budgeting,
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firm valuation, security analysis, and capital structure theory are critical to a company's
financial operation.
Shareholder wealth maximization goes beyond the concept of profit maximization by
factoring in the conditions of uncertainty on return and timing of returns. Uncertainty is a
condition of risk and there is a perceived direct correlation between risk and return. The
higher the risk, the higher the required return needed to offset the increased risk
component. Timing relates to how long it takes to realize returns. The sooner returns are
realized, usually in the form of cash, the higher the wealth maximization. The faster
return of cash also decreases the uncertainty and related risk and offers the investor more
time to earn supplementary returns.
Shareholders react to the overall performance of a company through the market price of
its common stock. The price reflects potential future cash flows through capital
appreciation or capital depreciation plus any dividends. The timing of these cash flows
are discounted by a rate of return dependent upon the perceived riskiness of the company.
A market price of the company is directly related to cash flow timing and amount and
indirectly related to risk. The sooner the cash flows occur, or the greater the cash flow
amount, the higher the market price. The higher the level of risk, the lower the market
price of the stock. A stock’s price is usually higher when a company
· receives cash flows sooner versus later
· receives more versus less cash flows
· has less versus greater risk
Illustration 1-2 considers shareholder wealth maximization in another way. If an investor
had the choice of two equally priced investments: one with a cash flow in year one and a
second with an equal cash flow in year two, the investor should select the investment with
the cash flow in year one. This situation underlies the concept of the time value of
money. Likewise, if an investor had the choice of two equally priced investments: one
with a lower level of risk and the other with a higher level of risk, the investor should
select the investment with the lower level of risk. This situation underlies the concept of
uncertainty as measured by risk.
Shareholder Wealth Maximization
Illustration 1-2
More Favorable Less Favorable

Factor Situation Situation
Cash Flow Early Late
Risk Low High
The Role of Ethics in Accounting and Finance

Several professional organizations in accounting and finance have developed codes of
professional conduct or codes of ethics. A review of the major components of these
codes can assist the business manager in understanding how the accountant or financial
manager is expected to act in an ethical manner.
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The American Institute of Certified Public Accountants Code of Professional Conduct

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

Institute of Certified Public Accountants, New York, New York, as revised June 30, 1992
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· Inform subordinates as appropriate regarding the confidentiality of

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

Management Accounting: Objectives of Management Accounting, Statement No. 1C, New York, N.
Y., June 1, 1983.
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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 work
except when authorized or otherwise legally obligated to disclose.
Confidential information acquired in the course of my work will not be used
for my personal advantage.
· Maintain an appropriate level of professional competence through continuing
development of my knowledge and skills.
· Refrain from committing acts discreditable to myself, my employer, FEI, or
fellow members of the Institute.4
Ethical codes and codes of conduct are necessary; however, ethical behavior involves
more than adherence to codes. Individuals generally know the difference between right
and wrong, yet there can be variations on what an individual may consider as right or
wrong. Additionally, for the accountant or financial manager, the opportunities and
temptations to "get rich quick" create an additional burden to maintain ethical integrity.
All the codes will do little to stop an individual with misguided intentions.
As a business professional, most individuals place a great deal of value on their
reputation or integrity. This self-imposed criterion is usually sufficient for most
individuals to maintain ethical standards. Also, all individuals in the business world
make mistakes, but if their intentions are good, these mistakes are usually forgiven and
the individual can recover. On the other hand, if an individual knowingly makes an
ethical violation, a trust has been broken, and often such mistakes are irrevocable and
career ending.
Severe penalties and the loss of an individual’s and/or a company's integrity are generally
sufficient to curtail unethical actions. However, we all have sinned and come short of the
glory of God. Greed can be a powerful motivator, and pressures can build up for quick
personal gain regardless of the potential risk. The business manager has to be constantly
aware of the possibility for ethical violations and create a business environment that will
promote ethical conduct.
The golden rule in Matthew 7:12 states:
Therefore all things whatsoever ye would that men should do to you, do ye even so to
them: this is the law and the prophets.
Such a practice would be a good start toward building a business environment based on
sound ethical behavior.
Summary
Business managers or any individuals with an interest in business need to have a basic
level of knowledge in the area of accounting and finance even if they have no intention of
undertaking day to day activities within these disciplines. This text is organized to
provide a conceptual understanding and introduction to the basic skills in critical areas of
accounting and finance.
4 Adopted by the Board of Directors of the Financial Executives Institute, October 13, 1985.
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Ethics is an important aspect especially when it comes to dealing with money and
financial accountability. Professional accounting and financial associations have taken a
strong stand in support of codes of conduct and financial integrity. The business manager
should be aware of the ethical standards to which the accountant or financial manager is
held accountable. Everyone in the business environment should work together in the
stewardship of company resources by following ethical guidelines. Maintaining an
individual and company’s integrity should be a primary objective in any business setting.
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Chapter Questions
1-1. As a business manager what is the most important accounting or finance related
activity that you need to understand? Explain.
1-2. As a business manager, if you needed to hire a financial manager, what
qualifications would you consider important?
1-3. Shareholder wealth maximization is an objective of the financial manager. How
would this objective fit into the overall objectives you would establish for a
company?
1-4. Explain how accounting and finance information can aid in the decision-making
process? How can accounting and finance information hinder the decision-making
process?
1-5. How does the accountant go through the accounting transaction process?
1-6. What actions might company management take to increase the price of its
company stock?
1-7. After reviewing the American Institute of Certified Public Accountants’Code of
Professional Conduct, which article do you think is most important from the
viewpoint of a business manager? Which article do you think is most important from
the viewpoint of the accountant?
1-8. After reviewing the Institute of Management Accountants’Standards of Ethical
Behavior, which responsibility do you think is most important from the viewpoint of a
business manager? Which responsibility do you think is most important from the
viewpoint of the accountant?
1-9. After reviewing the Financial Executives Institute’s Code of Ethics, which
provision do you think is most important from the viewpoint of a business manager?
Which provision do you think is most important from the viewpoint of the financial
manager?
1-10. How would you apply the golden rule to your business, and specifically to the
accounting and financing activities?
1-11. Identify three verses of scripture that relate to accounting and finance and explain
how they apply.
1-12.Case Study Creating an Ethics Case
Develop an ethics related case and propose how to deal with the dilemma. You
may rely on an example you have experienced through your own employment or
make up a situation.
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Cases
Case Study 1-1 Accounting Fraud at Maybury Bank

Steve Russell, president of Maybury Bank, was enjoying record profits for the last year.
As a bonus, he gave one-month salary to each of the bank employees. Times had never
been better and company moral was high. The regional economy was also growing which
led Steve to believe that the bank should continue to prosper for the immediate future.
David Watson, the head of the internal audit staff, was in a monthly meeting with Steve
going over internal audit procedures and any recent findings. He noted that a member of
his staff was having trouble getting the numbers to balance in the credit card loan
department. There was a difference of around $13,000 in the balance, but Dave was more
concerned that the numbers just did not “feel” right. Steve suggested that Dave contacts
their public accounting firm and see if the balances could be reconciled with the public
accounting firm’s records.
Two days later, Dave met again with Steve to give a follow up report on the problem.
After questioning the public accounting firm, Dave determined that during the audit
procedure, the audit staff took the bank employee’s word on specific figures, and if there
were not an exact balance, they would force the numbers. Any difference in amounts was
not especially significant. Steve became extremely concerned. Even though the amount
that was currently out of balance did not appear significant, he now did not have a reliable
way to determine exactly what the dollar amount should equal for this department.
Steve demanded to have an immediate meeting with the senior partner of the public
accounting firm. This firm had audited the bank for 35 years, and the close relationship
between companies has gone back to a previous generation. Ed Simpkins, the senior
partner was very apologetic for the misunderstanding of the audit, but said the company
had been handling this situation the same way for a number of years, and that the amount
of the difference was very insignificant. Ed indicated that there sometimes needs to be a
cost benefit tradeoff between gaining accuracy to the nearest dollar and the reasonable
cost of providing the audit without sacrificing integrity. Ed assured Steve that he was
sure that the audited financial records presented fairly the current financial status of
Maybury Bank.
Steve was also concerned about the auditors taking the bank employee’s word on the
correctness of figures without some form of verification. Ed did admit that there seemed
to be a breakdown in the attest function here and he would see to it that verification
process would be reviewed. However, the bank employee in question who had provided
that data had been a trusted employee for years, and the audit firm had every reason to
support the figures presented. Also, Ed assumed that internal control procedures at the
bank should safeguard against any falsifying of accounting information.
Dave continued to examine the area in question and began to come up with loans made
by the bank that were not properly accounted for in the records. These loans appeared to
be “Mickey Mouse” loans, a bank term used for loans that are created from nothing.
Additionally, the amount in question quickly grew from a few thousand dollars to over
$1,000,000 dollars. This information sent Steve into an outrage. He had been relying on
numbers that all of a sudden had no basis of support. There was no way of knowing how
widespread the deception had become within the bank.
17
Steve took immediate action by firing the employee in question, as there was sufficient
evidence that fraudulent activities had taken place within this employee’s area of
responsibility. Furthermore, the members of the internal audit staff who had
responsibility to establish internal controls within this area of the bank operation were
fired. Dave Watson and the employee who originally found the discrepancy retained their
jobs only because they brought this matter to light. Steve also fired the public accounting
firm after receiving board approval and sought the assistance from a national public
accounting firm to help in determining the extent of the problem.
The public accounting firm reviewed the loan function and found inconsistencies in loans
approaching $5,000,000. The very solvency of the bank was now in jeopardy. Just a few
months ago, the bank was recording record profits and distributing bonuses, and now they
faced the possibility of bankruptcy. Steve acted quickly by laying off around 100
employees, and task the public accounting firm to start from scratch in developing a new
accounting system.
Each remaining employee was asked to demonstrate how his or her function fit into the
accounting system. Steve learned that employee personalities would often have an
impact on how records were kept. “If John did not like Sue, he would give her incorrect
data which would make it harder for her to do her job.” There was also sufficient
evidence that accounting control procedures were lacking, and often times processes were
being done more than once or not at all because of a lack of coordination between
departments. When that finding became evident, there was a wholesale purging of the
accounting department.
With the bank accounting system in disarray and the bank solvency an uncertainty,
employee moral sank to an all time low. Steve was also very depressed, as he had to
make hard decisions about layoffs and firings that effected families and livelihoods, but
he had to keep the bank open until it could get reestablished.
In all it took four years to get through the financial crisis. However, in the creation of the
new accounting system and the thorough review of the accounting procedures, many cost
savings measures were implemented. For instance, processed checks used to sit
sometimes for a number of days before being sent to the Federal Reserve for clearing.
Through a review of the accounting system, procedures were established to have
processed checks sent at least twice a day to the Federal Reserve. This improvement in
cash flow resulted in increased interest revenue of $500,000 a year.
Required
A. What ethical or code of conduct guideline was violated at Mr. Russell’s bank?
B. Why did a problem of this nature happen in the first place?
C. What actions can a business manager take to guard against a situation such as that
which occurred at Maybury Bank?
D. Review the way Mr. Russell dealt with the problem at his bank. How would you deal
with the problem? Specifically, what would you do the same, differently?
18
Case Study 1-2 Ethics as a Write-off

On March 26, 1996, The Wall Street Journal published an article entitled “For Many
Executives, Ethics Seem to be a Write-off.” The article was based on a study on fraud
that was published in the February issue of the Journal of Business Ethics.
Almost 400 individuals played the role of an executive that had to make a decision about
understating a write-off that would cut into company profits. The findings of the study
indicated that 47 percent of top executives, 41 percent of controllers, and 76 percent of
graduate-level business students were willing to commit fraud by understating the 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 possible
before leaving for another business trip. Included in the paper work were some memos
containing important financial information. The write-off situation was similar to an
actual SEC case. There was also a memo stating that the business executive would be up
for a promotion based on his ability to improve net income.
The adoption of a code of ethics seemed to have little, if any, impact on the executives
behavior. This apparent lack of personal values has ethics experts concerned. The rigors
of the workplace seem to erode the sense of value in a business setting. The authors
concluded that what is necessary to prevent fraud is not only a company code of ethics,
but an entire business climate that reinforces ethical behavior. These situations may be
difficult to achieve, however, if the results cannot be shown on a company’s bottom line
net income.
Required
A. Why do you believe that ethical standards seem to be declining in the business
environment?
B. Attempts have been made by professional organizations and company’s to develop
and incorporate codes of ethics for the business community; however, individual
employees still commit ethical violations. Why do employees compromise ethical
standards when working on their job?
C. In the study, the number of graduate-level business students that committed fraud was
almost twice as high as the number of business executives. What, if any, significance can
be attributed to this finding?
D. Profit motive is a big incentive in measuring corporate performance. How can a
company that commits to high ethical standards be competitive in a business
environment?
E. How does the profit motive lead to compromises in ethical conduct? What can
company management do to promote synergy or a positive association between the profit
motive and ethical standards?
F. If you were the president of a company, what actions would you take to incorporate a
code of ethics into your corporate structure?
19
Chapter Two: The Income Statement and the Balance Sheet
Chapter Two: The Income Statement and the Balance

Sheet
Objectives
1. 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 Categories
Accounting systems within businesses rely on a chart of accounts as a means of
classifying the activities within the business into categories for reporting and 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 terms
what is taking place within a business.
The five major categories within a chart of accounts are assets, liabilities, stockholders
equity, revenues, and expenses. Within each of these major categories are more specific
account titles related directly to business activities. The major categories of accounts tie
into the basic accounting equation, which states that assets equal liabilities plus
stockholders equity. Equity consists of a capital stock portion and a retained earnings
component. Revenues and expenses are incorporated into the retained earnings. See
Self-Study Problem 2-1.
Formula 2-1 Assets = Liabilities + Stockholders Equity
Assets
Assets represent items of future value that are owned by the company. Assets identify
resources of the business, which will bring some measure of value to the company in the
future. The assets are used to aid in the company's overall objective of providing goods
and services. Examples of assets include cash, inventory, investments, equipment, and
goodwill. Assets do not have to have a physical substance; however, they do have to
have a future value.
Assets are classified according to their liquidity, or their ability to be converted into cash.
The most liquid assets are identified first, and assets are often broken out between the two
major categories of current assets and long-term assets. The difference between current
assets and long-term assets is a matter of liquidity, with current assets identified as cash
or capable of being converted into cash within a one-year time frame. Long-term assets
by their nature are less liquid and are not expected to be converted into cash within a one
year time period and may never be converted into cash.
20
Current Assets
Cash is the most liquid current asset and includes a company's cash on hand, petty cash,
checking accounts and savings accounts. Marketable securities are often considered as
cash equivalents and may be included in the cash account if the amount is not significant.
The major distinction between cash and marketable securities is the length to time to
maturity. Cash has an immediate maturity date whereas marketable securities could have
maturity dates anywhere from thirty days to one year. Securities with a time delay
because of a maturity date means that they cannot be used as cash for other purposes for
that period of time. A certificate of deposit with a maturity date in thirty days means that
the holder of the certificate cannot use that amount of cash until the security matures.
Companies will maintain amounts of marketable securities which are less liquid than cash
in order to gain a higher rate of return for agreeing to have some of the assets tied up for a
period of time.
A financial manager or accountant can project future cash needs over time and with
proper cash management take full advantage of marketable securities with different
maturity dates. If a company does not need a certain amount of cash for a thirty-day
period, then it is not worthwhile to keep that money in cash. Cash may not earn any
return and if there is a return it will be at a minimum. Additionally, because cash is very
liquid, it can be most easily confiscated.
Accounts receivable represents an i.o.u. from a customer who purchased company goods
and services. Sales on account, whereby the customer agrees to pay later, results in the
creation of an account receivable. The vast majority of sales for many business is “on
account” or credit sales. Payment of the account receivable by customers usually takes
place from thirty to ninety days after the sale. Management has to carefully screen
customers before allowing credit on sales; however, there usually always is some percent
of the accounts that will never be collected.
Inventory represents the product that the company is in the business of selling. The
inventory can be either created within the company (manufacturer) or secured in its basic
final form for resale to a customer (merchandiser).
Prepaid expenses are not expenses but assets because they have future value. Prepaid
expenses represent items of service paid for in advance. Once the service is provided, the
prepaid asset actually becomes an expense. Examples include prepaid rent and prepaid
insurance.
All the assets discussed to this point are classified as current assets because they are either
in the form of cash or can be expected to be converted into cash within one year. Current
assets are also usually directly associated with the operating activities of the company.
Illustration 2-1 gives a summary of current asset accounts.
21
Long-Term Assets
Long-term assets have an expected future value of more than one year. They are the least
liquid of the assets and may never be converted to cash. Many of the assets undergo a
depreciation process to recognize their use over time. As the asset is depreciated an
amount is transferred from the asset account to an expense account reflecting the use of
the asset. Some long-term assets called intangible assets have no physical substance.
Additionally, the long-term assets may increase or decrease in value; however, for
accounting record keeping purposes they are usually always maintained on the books at
their original historical cost.
Land is a long-term asset, which represents the property or location of the company. The
land is not subject to a depreciation or decrease in value because it is not used up in the
company production of goods and services.
Buildings and facilities and equipment are all assets that support the production of
company product. These assets have a life of more than one year but gradually
deteriorate over their useful life. A depreciation process is used to prorate the cost of
these assets over an extended time period. As an asset is depreciated it becomes an
expense because it no longer has a future value.
Intangible assets are assets that do not have a physical being but represent future value to
the company. Examples of intangible assets include goodwill, patents, copyrights, and
trademarks. The intangible assets are depreciated over a specific time period, which
represents the use of the asset. Illustration 2-2 gives a summary of long-term asset
accounts.
Current Asset Accounts

Illustration 2-1
Account Discussion and Explanation
Cash Most liquid current asset
Marketable Cash type items with a maturity date and the ability to earn
Securities interest
Accounts Generated from the sale of a company’s goods and services,
Receivable represent a customer’s promise to pay in the future
Inventory Product the company is in the business to sell
Prepaid Expense Represents a cash payment in advance for services to be
received in the future
Supplies Miscellaneous assets used to support the creation of goods
and services
22
Long-Term Asset Accounts

Illustration 2-2
Land Physical property not subject to depreciation
Buildings Physical facilities subject to depreciation
Equipment Machine type items subject to depreciation
Investments Long-term type investments usually in stocks or bonds of
other companies
Intangible Long-term assets without a physical substance, examples
include goodwill, patents, copyrights
Liabilities
Liabilities are debts owned by a company. Liabilities represent one of two major sources
of funding for the resources or assets of the company. A liability obligates the company
to the repayment of the debt and sometimes an interest charge is included. The lenders of
money or other assets to a company expect to be repaid in full with the principal
representing the amount loaned and due on a specific maturity date, and interest reflecting
the charge for receiving money in advance. The failure to comply with the provisions of
the obligation can result in default of the liability and additional charges or the
repossession of the asset.
The principle that the borrower is servant to the lender underlies the concept of
borrowing. The lender, by providing cash or other assets in advance, establishes a
contractual arrangement, which must be complied with by the borrower. Harsh penalties
can result if the borrower fails to fulfill this obligation. The company that borrows funds
to support the acquisition of assets may be subject to limitations and conditions with
regard to its operations, financial condition, or distribution of funds. These restrictions
are established to protect the lender in case of default.
Companies can make effective use of liabilities provided they maintain an ability to fulfill
stated contractual obligations. Liabilities are often the least costly source of funds, and
any related interest will reduce the amount of corporate taxes. If companies can generate
returns from the assets purchased with debt in excess of the cost of debt itself, then the
companies will increase their profitability. However, if the cost of debt or interest
exceeds the returns generated from the assets, then the company is not earning enough to
pay the interest and profits decline. If these declines in profit and the related assets are
severe enough, the company could risk the danger of default or even bankruptcy.
Remember again, the borrower is servant to the lender.
Liabilities are classified according to their liquidity, and like assets, the most liquid
liabilities are listed first. Liabilities can be classified into two major groups: current
liabilities and long-term liabilities. The criterion for the segmentation of the liabilities is
the same as the criterion used to divide the assets. Obligations that have to be fulfilled
within one year are current liabilities, and liabilities that have maturity time periods of
more than one year are long-term liabilities.
Some liabilities do not include an interest charge. These liabilities are generally short-
term in their maturity date and are only given if a company can establish itself with a
23
Current Liability Accounts

Illustration 2-3
Accounts Obligation of the company usually incurred in the purchase
Payable of inventory
Salaries Payable Employee wages that have been earned but not paid for
Accruals Obligations incurred but not paid
Notes Payable Obligations that have an interest charge associated with the
payment
Deferred Advance payments made by customers that represent a future
Liabilities obligation by the company to provide a good or service
good credit rating. Generally, the longer the term of the liability the higher the rate of
interest. This higher rate of interest is directly correlated with the increased liquidity risk
that is assumed by the lender.
Current Liabilities
Accounts payable is a current liability that usually includes no interest charge and is
generated through the purchase of goods and services. It is the opposite of accounts
receivable. One company's accounts receivable is another company's accounts payable.
The liability is created through the purchase of goods and services, which will probably
be used by a company to create their inventory. Specific terms are included with the
account payable and most often the balance is due in thirty days. If the company does not
fulfill its obligation, an interest charge may be imposed and/or the company could lose its
credit standing.
Other similar current liabilities include salaries payable, taxes payable, and accruals.
These obligations are due within one year and will probably not include an interest charge
if paid within the specified time frame. The account, interest payable, is usually
associated with another liability that charges an interest rate, and the interest payable
account represents only that portion of interest that is currently due.
Notes payable is a current liability that differs from accounts payable in that an interest
charge is included in the amount due. When a company incurs a note payable, there is
generally a contractual agreement established at the time of the note which dictates the
terms of the repayment. Included in the repayment is the principle value of the obligation
plus an interest charge. Interest payments can be made periodically or at the maturity date
of the note.
Unearned revenue or deferred liabilities is not a revenue but a liability. The account is
created when a customer pays for a good or service in advance. The company then has an
obligation to provide the good or service in the future. As long as the obligation remains,
the unearned revenue account will remain. Unearned revenue is essentially the opposite
of a prepaid expense. What is one company's prepaid expense is another company's
unearned revenue. The key to the creation of either account is that cash is paid or
received prior to the providing of goods or services. Illustration 2-3 gives a summary of
current liability accounts.
24
Long-Term Liability Accounts

Illustration 2-4
Notes Payable Obligations with interest that have a maturity date at least
one year later
Bonds Payable Obligations greater than one year that have fixed coupon
(interest) payment dates
Mortgage Payable Long-term obligations that are usually created to fund long-
term assets like buildings
Deferred Taxes Long-term obligations to the government for taxes due
Payable which do not have to be paid immediately primarily because
of accounting and government tax rules
Long-Term Liabilities
Long-term liabilities are also classified as various payables. Examples include long-term
notes payable, mortgage payable, bonds payable, and deferred taxes payable. These
obligations all have a maturity date that is greater than one year from the current date.
For notes that include a periodic or a serial payment pattern the current portion of the
long-term liability may be reclassified as a current liability in an account called current
portion of long-term notes payable.
Deferred taxes payable is a unique liability created by the tax laws of the federal and
state governments. Tax laws allow companies to record various expenses and revenues in
different amounts from normal recording practices. These differences generally result in
favorable tax treatments, which will cause a delay in the payment of taxes. The resulting
delay in the tax payment creates a deferred tax liability. If the delay in the tax payment is
one year or less, the deferred tax liability is listed as a current liability. If the deferred tax
liability is for greater than one year, the deferred tax liability is a long-term liability.
In many cases the deferred tax liability is actually a permanent tax deferral because the
tax law perpetuates the favorable recognition of either an expense or revenue and its
related tax implications as long as the company is in business. The deferred tax liability
becomes a permanent source of interest free funding from the government. The company
must retain the long-term liability account even though technically the account may never
be repaid. This is one of only a very few situations where a company can actually gain a
tax advantage from the government. Illustration 2-4 gives a summary of long-term
liability accounts.
Stockholders Equity
The category of stockholders equity represents the second major source of funds to
acquire a company's resources or its assets. The equity category represents the owners'
(stockholders) contribution and the business' (retained earnings) contribution to the
creation of assets. This equity category is really larger than just stockholders equity
because it represents both the owners and business interest in the company.
25
The stockholders equity account indicates the owner’s commitment into a company. In
return for this commitment the owners can share in the company's success either through
dividend payments and/or increases in the value of their ownership or stock. However,
there is no guarantee that the owners will receive any repayment or increase in the value
of their investment. The company is generally under no legal obligation to make any
repayment to the owners.
One form of stock, preferred stock, usually includes specific provisions regarding
dividend payments. Preferred shareholders have some protection in that no common
stock dividends can be paid until all current and past due preferred stock dividends are
paid in full. However, there is still no guarantee that a company will pay dividends.
Preferred stock also has limited potential for its increase in value. Dividends are fixed in
amount and preferred shareholders can not expect increases in value as the company
prospers. Also preferred stockholders can usually not be voting members of the
company.
Common stock is the more recognized classification of equity. For an owner’s
contribution into the business, the common stockholders have the potential for return on
their investment through dividends and/or increase in the market price of their
investment. There is no guarantee that either of these events will occur and the company
has no contractual obligation to make any payments. Additionally, the common
stockholders are the last in line in the case of a liquidation to recapture their investment
through the securing of assets. Because there are no guarantees, the common
stockholders face the greatest risk but have the potential for the highest return.
Dividends are classified as an equity account. The sole purpose of this account is to
recognize the distribution of company earnings to the shareholders. The dividend account
will often be offset by a dividend payable liability account to represent the fact that a
company has declared a dividend but has not yet paid the dividend. Since the company
still has this obligation the dividend payable liability account is established.
Retained earnings is the equity account that represents in summary form all of the
operating activities of the business in generating resources for the company. Retained
earnings can be increased as the company generates income, which occurs when revenues
exceed expenses. Retained earnings will decrease when there is a net loss from operating
activities when expenses exceed revenues. Retained earnings is also decreased through
the payment of dividends. A positive balance in retained earnings represents the excess
of net income over the payment of dividends and can be considered as the business'
contribution to the company resources or assets. A positive balance in retained earnings
does not imply that there is a similar positive balance in cash, but only that the total
amount of assets is higher by the amount of retained earnings.
Retained earnings can have a negative balance resulting when net losses exceed net
income over a period of time. Also, if a company pays out dividends in excess of the
accumulated net income over a period of time, the retained earnings balance could
become negative. Generally, holders of liabilities will impose restrictions on companies
in the amount of dividends that can be paid to prevent a negative balance in retained
earnings and to keep the common stockholders from receiving distributions of assets
before the creditors. Illustration 2-5 presents a summary of shareholders equity accounts.
26
Revenue Accounts
Illustration 2-6
Sales Revenue Generated through the sale of goods and services
Interest Revenue Generated through interest earned on interest bearing
accounts
Dividend Dividends received from investments in other company stock
Revenue
Gains on Sale Created when an asset is sold for more than its value as
recorded on the accounting records
Revenues
Revenue is a broad category of accounts that represent the sale of goods and services by
the company. Revenues represent the business contribution of resources to the company
and they have a positive impact on the total amount in the stockholders equity section.
Sales revenue is the major account and there could be subclassifications of sales revenue
by product line or product type.
Interest revenue is associated with financing charges and should be separated from sales
revenue. Interest revenue occurs when a company receives interest income from a
customer on a note receivable. Interest revenue can also represent the interest earned on
various company investments included in marketable securities. Dividend revenue is
similar to interest revenue except that a company is receiving dividends from stock versus
interest income from interest bearing notes like certificates of deposit.
Gains on the sale of assets not including inventory also are classified as revenue. When a
company sells a long-term asset at a price higher than the book value of that asset a gain
is recognized which is included as a revenue item and an increase in net income. (Book
value of an asset is what the asset is worth according to the company's accounting record
or book.) Illustration 2-6 gives a summary of revenue accounts.
Shareholders Equity Accounts

Illustration 2-5
Preferred Stock Preferred with regard to dividend payments and distribution
of assets in a liquidation
Common Stock Major equity account with potential for increases in
dividends and market price
Dividends Represents the distribution of company earnings to holders
of stock
Retained Earnings Company’s contribution to equity in the form of net income
less any distributions through dividends
27
Expense Accounts
Illustration 2-7
Cost of Goods Represents the cost of the inventory sold in conjunction
Sold with the sales revenue
Wage Expense The wages and salaries of company employees
Depreciation A prorated cost of using long-term assets over an extended
Expense period of time
Interest Expense The interest cost associated with obligations that include an
interest charge
Tax Expense Costs due to the government
Loss on Sale Created when an asset is sold for less than its value as
recorded on the accounting records
Expenses
Expenses represent the cost of doing business. Expenses are offset against revenues to
determine the net income or loss of a company. There are many more expense categories
than revenue categories. Cost of goods sold represents the sale of goods by the company.
Originally recorded as an asset account, inventory, once the product is sold it has no
future value and cannot be an asset but is transferred to an expense classification as a cost
of goods sold.
Expenses can be classified for any business-related activity such as wages, utilities,
supplies, rent, and advertising. Depreciation expense represents the use of an asset over a
period of time. Since most long-term assets have a limited useful life, a portion of those
assets is used up every year. The depreciation process represents a prorated expensing of
an asset during each time period.
Interest expense, as in interest revenue, should be shown separately as a financing charge
versus an operating charge. However, while dividend revenue, which represents earnings
from an investment in another company, appears in the income statement, dividends,
which are paid by the company, are not recorded as expenses, and are not part of the
income statement.
Losses from the sale of assets behave similar to expenses and are shown in the income
statement. When assets other than inventory are sold for less than the book value there is
a loss on sale, which will decrease the amount of net income. Illustration 2-7 presents a
summary of expense accounts.
Accrual Accounting
Accrual accounting relates revenues and expenses to the time period in which they are
incurred. This method of accounting is required for financial reporting purposes by
generally accepted accounting principles. Virtually all businesses use an accrual
accounting system versus a cash based system.
28
In a cash based system, accounts such as accounts receivable, accounts payable, prepaid
expenses and unearned revenue may not be needed because business transactions would
be dictated by the receipt and payment of cash. Revenues would be recognized upon
payment of cash regardless of when the good or service was provided. Expenses would
be recognized upon the payment of cash regardless of when the cost was incurred. This
failure by the cash based system to recognize revenues and expenses in the appropriate
time period is why an accrual accounting system is required for so many companies.
The recognition of revenues and expenses in an accrual accounting system is not
dependent on the receipt or payment of cash. In fact, expenses like depreciation will
never involve a payment of cash. The occurrence of an activity such as the sale of a good
or service is the critical factor in the recognition of revenue. The cash receipt in
association with the sale may occur before, at the time of the sale, or after the sale. The
revenue is realized after substantial performance has been completed and the value is
known; generally this takes place at the point of sale.
Expenses are matched in the same time period as revenues in an accrual accounting
system. This matching is promoted to relate earned revenues with appropriate expenses.
Again, the cash payment of these expenses is not the critical factor. In most cases the
occurrence of an event is sufficient to identify and match an expense with a related
revenue. However, in many situations activities have to be essentially developed to
identify appropriate expenses during a particular time period. Depreciation expense is an
example of creating an activity to reflect the use of an asset and its resulting expense for a
time period. The use of the asset as shown by the depreciation expense is matched
against the revenue it helped to generate during a specific period of time.
Depreciation
The utilization of long-term assets over time is reflected through a depreciation process.
As the asset is used up, it loses some of its future value, and by definition can no longer
be classified as an asset. During each time period a portion of the asset will be
reclassified as an expense.
When the long-term asset is first acquired the company estimates its useful life and
salvage value i.e., what the asset would be worth at the end of its useful life. Accrual
accounting requires that the use of this asset be prorated over this useful life time period
in a process known as the depreciation of the asset. As the asset is used up it is recorded
as a depreciation expense. The accrual accounting matches the depreciation expense to
the same time period in which appropriate revenues are generated from using the asset.
The accounting treatment in the depreciation process is to debit depreciation expense and
credit an account called accumulated depreciation. The debit to the depreciation expense
account will increase that account and ultimately decrease net income. The accumulated
depreciation account is a contra asset account. A contra account is an account that carries
an opposite balance. Therefore, a contra asset account would carry a credit balance. The
depreciation journal entry causes an increase in the credit balance of the accumulated
depreciation account, and an overall decrease to the net balance of the asset account.
29
Depreciation is a noncash expense account since the offsetting credit is to accumulated

depreciation versus cash or some liability account. Essentially, the cash payment
occurred when the original asset was purchased, and the depreciation reflects the use of
this paid for asset.
Since both the long-term asset and the accumulated depreciation accounts are assets they
will appear on the balance sheet. Generally the accounts are set against each other with a
resulting net balance to the asset account. The amount in the accumulated depreciation
account can never exceed the amount in the long-term asset account so the net balance
will always be a debit amount, although it can be zero.
The following illustration shows how the depreciation process works.
On January 2, 1996, Philip Company purchased with cash a molding machine for
$30,000. The machine is expected to last for 8 years and have a salvage value of $2,000.
Record the appropriate journal entries for 1996 to include journal entries for the purchase
of the equipment and the depreciation of the equipment. Show how the equipment will
be recorded on the balance sheet.
January 2, 1996 - Purchased asset.
Equipment 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
30
Accounting Transaction
Illustration 2-8
Daniel & Son’s Inc. purchased a vehicle for $15,000 by paying a $2,000 down payment
and signing a note payable for $13,000.
Journal Entry
Debit Vehicle (asset) 15,000
Credit Cash (asset) 2,000
Credit Notes Payable (liability) 13,000

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

Illustration 2-9
Normal Balance
DEBIT CREDIT
Assets Liabilities
Expenses Stockholders Equity
Dividends Revenue
31
Increase or Decrease in Account Balance

Illustration 2-10
ACCOUNT DEBIT CREDIT

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

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

Stockholders Equity Permanent Balance Sheet
Revenue Temporary Income Statement
Expense Temporary Income Statement
Dividends 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 most
recognized of those reports are: (1) the income statement, (2) the statement of retained
earnings, (3) the balance sheet, and (4) the statement of cash flows. In an automated
accounting system, these reports can be generated automatically through predeveloped
software programs. In manual systems the development of reports involves the use of
ledger account balances from specific accounts, i.e., for an income statement the balances
from the revenue and expense accounts are used. A step-by-step summary of the
accounting process can be identified as follows:
1. Identify a business transaction/event.
2. Record an accounting journal entry to reflect the business transaction.
3. Post the amounts of the accounts in the journal entry to specific account ledgers.
4. Determine a total balance in the account ledgers.
5. Summarize the account balances in a trial balance to verify that total debits equal
total credits.
6. Transfer the account balances from the trial balance to various financial
statements.
7. Revenue and expense accounts make up the income statement.
8. The beginning balance in retained earnings, net income (revenue minus expense),
and dividends make up the statement of retained earnings.
9. Assets, liabilities, stockholders equity, and the retained earnings ending balance
are used in the balance sheet.
10. Close the temporary accounts of revenue, expense, and dividends to a zero
balance.
Income Statement
The income statement for many companies is considered as the most important statement
because of the emphasis on company operating performance. The income statement
represents a measure of performance over a period of time with the most common period
being one year. Income statements may also be prepared for a quarterly or monthly basis,
but these will be subsidiary reports to the one year income statement.
The income statement should begin with a heading identifying the name of the company,
the name of the statement, and the time period of the statement. The time period will not
be a specific date but will reflect the entire period of time that the statement represents,
such as, for the year ended December 31, 1997.
The account categories included in the income statement are only the revenue and
expense classifications. These accounts are identified as temporary accounts in that they
do not carry a balance from one accounting period to the next. When computing an
34
income statement, the company management is only interested in the operating

performance for the period in question, usually one year. To avoid mixing the
performance activities from different time periods, the revenue and expense account
balances start at zero at the beginning of the period and are reset to zero at the end of the
period after the income statement is completed.
The process of resetting the temporary revenue and expense accounts to zero is called the
closing process. Journal entries are constructed to support the closing entry process and
a temporary account called income summary is established to complete the transaction.
To close out the revenue accounts a journal entry must include a debit to the revenue and
an offsetting credit to the income summary account. To close out the expense accounts a
journal entry must include a credit to the expense and an offsetting debit to the income
summary account. If the balance in the income summary account is a debit amount, then
the company experiences a net loss because the expenses exceeded the revenues. If the
balance in the income summary account is a credit amount, then the company experiences
a net income because the revenues exceed the expenses.
The format of the income statement begins with the operating revenues. There are special
revenue accounts called contra revenue accounts, which carry a debit balance and will
reduce the amount of net revenue. (When an account is called a contra account it means
that it carries an opposite normal balance, i.e., a revenue account carries a credit balance
while a contra revenue account carries a debit balance.) The contra revenue accounts are
sales discounts and sales return and allowances. The resulting sales revenue figure is
called net sales revenue.
The cost of goods sold expense is deducted from net sales revenue to arrive at a
supplementary figure called gross margin. The gross margin gives company
management an idea of how much they are making over the cost of the good being sold.
While there is no set figure, companies should be realizing a gross margin percentage of
sales of at least 25 percent and preferably a figure closer to 40 percent. A 25 percent
gross margin means that for every dollar of sales, 25 cents remains after a cost of goods
sold of 75 cents. This gross margin needs to be sufficient to cover the remaining
expenses plus provide some profit potential for the company.
Other operating expenses are listed next in the income statement. These expenses are
sometimes categorized as selling and administrative expenses or general administrative
expenses. A supplementary figure computed by subtracting these operating expenses
from gross margin is income from operations or operating margin. The income from
operations gives an indication to management on how well their operating revenues
cover all related operating expenses.
The financing section of the income statement includes interest revenue and interest
expense. It important to keep interest related items separate from operating activities if
the amounts are significant because of the legal obligations related to financing activities.
Also gains and losses from the sale of assets would be recognized as a separate
component of the income statement.
After the consideration of all revenue and expense items, a supplementary figure called
net income before tax is computed. The only remaining expense item to be determined
is the income tax. If this figure represents a loss, a company may be allowed to enter a
tax credit (representing a potential refund.)
35
The final figure in the income statement is the net income, which is the difference
between revenues and expenses. The net income figure represents the business
contribution to the company as a source of assets to go along with the owners'
contribution in stockholders equity. It is the only figure coming out of the income
statement that will appear on the statement of retained earnings, and serves as a
connecting figure between the two statements. In the illustrations 2-13 and 2-14, the net
income amount of $1,800 appears in both statements. Also, the amount of net income
should agree with the balance in the income summary account.
In summary, net income is the consolidation of all the revenue and expense accounts and
represents the business activities of a company for a particular period of time. The net
income figure represents the company contribution to the resources of the company.
Illustration 2-13 shows the basic format of an income statement. See Self-Study
Problem 2-6.
36
Income Statement
Illustration 2-13
Daniel & Son’s Company
Income Statement
For the Year Ending December 31, 1997
Sales 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 Earnings

The statement of retained earnings identifies the company's accumulated contribution of
resources through net income and the distribution of any of those earnings via dividends.
The ending balance in the retained earnings account will also appear on the balance sheet
at the end of the accounting period and is the connecting figure between the two
statements. In illustrations 2-14 and 2-15 $15,600 is the ending balance in retained
earnings, which is also in the balance sheet.
Net income or net loss is a summary of all of the revenue and expense balances and its
balance is in the income summary account. Since revenues and expenses are temporary
accounts, income summary is also a temporary account and must be reduced to a zero
balance at the end of the accounting period. Net income has a credit balance in income
summary, which is reduced to zero through the closing process to the retained earnings
account. The income summary is debited and the retained earnings is credited. Since
retained earnings normally maintains a credit balance and it is increased with a credit
entry, the positive net income is reflected by an increase in retained earnings. A net loss
will have the opposite effect on retained earnings through the closing process with a debit
to the retained earnings account and a reduction in its balance.
Dividend is also a temporary account, which reflects the distribution of earnings to the
owners of the company. However, dividend is not an expense account and will not appear
on the income statement. Dividends carry a debit balance and the transaction involving
dividends is a debit to dividends and a credit to dividends payable or to cash. At the end
37
of the accounting period, the dividend account needs to be closed with a debit to retained
earnings and a credit to dividends. This closing transaction represents a reduction in
retained earnings.
The statement of retained earnings is basically a summary of the closing transactions of
income summary and dividends. Since retained earnings is a permanent account which
will appear on the balance sheet, it will have a beginning balance. The two primary
activities that can impact the retained earnings account, the net income or net loss and the
payment of dividends are reflected in the statement. Net income will increase the balance
in retained earnings and net loss and dividends will decrease the balance in retained
earnings. The ending balance of retained earnings will then be transferred to the balance
sheet. Illustration 2-14 shows the basic format of a statement of retained earnings. See
Self-Study Problem 2-7.

Illustration 2-14
Daniel & Son’s Company
Beginning Balance Retained Earnings $15,000
+ Net Income $1,800
- Dividends 1,200 600
= Ending Balance Retained Earnings $15,600
Balance Sheet
The balance sheet is the only statement, which measures the condition of a company at a
point in time. The other financial statements reflect performance over a period of time.
The balance sheet, by its nature, includes the balances of all the permanent accounts. The
permanent accounts are the assets, liabilities and stockholders equity accounts.
Revenues, expenses, and dividends individually are not part of the balance sheet;
however, the collective impact of all the accounts as reflected in the ending balance of
retained earnings will appear on the balance sheet.
A critical requirement of the balance sheet is that it must be in balance. The accounting
equation: assets equal liabilities plus stockholders equity reflects the balance sheet.
Formula 2-1 Assets = Liabilities + Stockholders Equity
Assets, or the resources of the company, are listed according to liquidity and divided
between current assets and long-term assets. Cash, as the most liquid asset, is listed first,
and intangible assets are usually the last assets listed. Liabilities, as one of the sources of
the asset resources, are also listed according to liquidity beginning with accounts payable
and ending with long-term payables or deferred taxes payable.
Stockholders equity, the other source of the company's asset resources, is also listed on
the balance sheet. Stockholders equity is divided into two major sections, the preferred
and common stock which represents an owners contribution to the company, and the
retained earnings which represents the business' contribution to the company assets.
38
The net debit balance of the assets equals the net credit balance of the liabilities plus
stockholders equity. Again, this report is only reflective of the balances of the accounts at
one specific point in time.
The financial statements highlighted in this chapter all serve a useful purpose in
providing information for decision-making purposes for both internal and external users.
For this reason, the accounting profession has established very strict guidelines or
generally accepted accounting principles in conjunction with these reports. Companies
must remain in compliance with these principles especially when the information is
published for external purposes. Without these guidelines, external users of the
accounting information would have no basis of comparison of the reports. Illustration 2-
15 shows the basic format of the balance sheet. See Self-Study Problem 2-8.
39
Balance Sheet
Illustration 2-15
Daniel & Son’s Inc
Balance Sheet
December 31, 1997
ASSETS
Current 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 $136,000
Long-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 455,000
Total Assets $591,000
LIABILITIES % EQUITY
Current Liabilities
Accounts Payable $ 15,000
Notes Payable 12,000
Salaries Payable 8,000
Taxes Payable 1,400
= Total Current Liabilities $ 36,400
Mortgage Payable $150,000
Bonds Payable 80,000
= Total Long-Term Liabilities 230,000
Total Liabilities $266,400
Stockholders Equity
Preferred Stock 25,000
Common Stock 284,000
Retained Earnings 15,600
= Total Stockholders Equity 324,600
Total Liabilities &
Stockholders Equity $591,000
40
Summary
This chapter highlights the basic accounting process from the individual transaction as
represented by a journal entry through the development of accounting statements
including the income statement, statement of retained earnings, and balance sheet. The
accounting process is a very systematic procedure to insure that financial related activities
are properly accounted for within the business environment. The key for this system to
function properly is at the data entry point, the journal entry. Each financially related
business transaction must be properly classified and recorded in accounting terms. Once
the data entry activity has been completed, the remaining functions in the accounting
process are almost routine. Many companies with automated accounting systems will
have the posting and financial reports generated automatically. It is important for the
nonfinancial manager to be able to understand the accounting process and how the reports
are developed. An individual needs to know how to interpret and use the information
presented in financial reports for decision-making purposes and other decision related
activities.
41
Study Problems
Self-Study Problem 2-1 Account Classifications
Classify the following accounts as asset (A), liability (L), stockholders equity (S), revenue
(R), expense (E), or dividend (D).
ACCOUNT CLASSIFY
Investment
Accounts Payable
Accounts Receivable
Sales
Cash
Common Stock
Dividend
Inventory
Unearned Revenue
Land
Accrued Salaries
Supplies
Retained Earnings
Prepaid Expenses
Cost of Goods Sold
Depreciation
Equipment
Taxes
Accumulated Depreciation
42
Self-Study Problem 2-1 Solution Account Classifications

ACCOUNT CLASSIFY
Investment A
Accounts Payable L
Accounts Receivable A
Sales R
Cash A
Common Stock S
Dividend D
Inventory A
Unearned Revenue L
Land A
Accrued Salaries L
Supplies A
Retained Earnings S
Prepaid Expenses A
Cost of Goods Sold E
Depreciation E
Equipment A
Taxes E
Accumulated Depreciation A
43
Self-Study Problem 2-2 Debit and Credit Balance on Accounts

Determine the normal balance as debit (D) or credit (C) for each of the following
accounts:
ACCOUNT BALANCE
Sales
Accounts Receivable
Cash
Accounts Payable
Cost of Goods Sold
Common Stock
Dividend
Building
Dividend Payable
Building
Unearned Revenue
Tax Expense
Retained Earnings
Prepaid Expense
Goodwill
44
Self-Study Problem 2-2 Solution Debit and Credit Balance on Accounts

accounts:
ACCOUNT BALANCE
Sales C
Accounts Receivable D
Cash D
Accumulated Depreciation C
Accounts Payable C
Cost of Goods Sold D
Common Stock C
Dividend D
Building D
Dividend Payable C
Building D
Unearned Revenue C
Tax Expense D
Retained Earnings C
Prepaid Expense D
Goodwill D
45
Self-Study Problem 2-3 Characteristics of Accounts

Complete the matrix for each of the following classifications of account.
NORMAL PERMANEN FINANCIAL

ACCOUNT BALANCE T STATEMEN
(D) (C) TEMPORAR T
Y (I, R, B)
(P) (T)
Asset
Liability
Shareholder Equity
Revenue
Expense
Dividend
46
Self-Study Problem 2-3 Solution Characteristics of Accounts

Complete the matrix for each of the following classifications of account.

(D) (C) TEMPORAR T
Y (I, R, B)
(P) (T)
Asset D P B
Liability C P B
Shareholder Equity C P B
Revenue C T I
Expense D T I
Dividend D T R
47
Self-Study Problem 2-4 Journal Entries

Construct journal entries for each of the following transactions:
1. Purchased equipment for $10,000 and paid cash.
2. Sold $500 of the company product and received cash.
3. The cost of the product sold in entry number 2 above was $300.
4. Sold $1,000 of product on account.
5. Purchased $5,000 of inventory on account.
6. $50,000 of cash was received by the company in exchange for stock.
7. Collected the $1,000 of account receivable.
8. Paid a salary expense of $2,000.
9. Paid the account payable of $5,000.
10. Paid a dividend of $3,000.
48
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.

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
49
7. Collected the $1,000 of accounts receivable.
Cash 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.

Cash 5,000
10. Paid a dividend of $3,000.
Dividend 3,000
Cash 3,000
50
Self-Study Problem 2-5 Account Ledgers
Construct all of the account ledgers for the journal entries completed in Self-Study
problem 4. Assume that there is a beginning cash balance of $25,000, a beginning
balance of inventory of $3,000, and a beginning balance in common stock of $28,000.
An illustration for the cash ledger format is shown below.
Cash Ledger Debit Credit Balance
51
Self-Study Problem 2-5 Solution Account Ledgers
Construct all of the account ledgers for the journal entries completed in Self-Study
problem 4. Assume that there is a beginning cash balance of $25,000, a beginning
balance of inventory of $3,000, and a beginning balance in common stock of $28,000
Cash Ledger Debit Credit Balance

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

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

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

Purchased Equipment 10,000
52
Accounts Payable Ledger Debit Credit Balance

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

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

Paid Dividend 3,000 3,000
Sales Revenue Ledger Debit Credit Balance

Cash Sales 500 500
Credit 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
53
Use the following trial balance to construct an income statement, statement of retained
earnings, and a balance sheet for Self-Study problems 2-6, 2-7, and 2-8.
Daniel & Son’s Inc.

Trial Balance
December 31, 1997
Numbers in $1,000s
ACCOUNT DEBIT CREDIT

Cash $ 160
Accounts Receivable 180
Inventory 350
Prepaid Expenses 40
Land 180
Buildings 900
Accumulated Depreciation $ 200
Accounts Payable 120
Notes Payable 140
Mortgage Payable 400
Common Stock 600
Retained Earnings 300
Dividends 40
Sales Revenue 1,000
Cost of Goods Sold 650
Depreciation Expense 50
Administrative Expense 100
Interest Expense 30
Tax Expense 80
Total $2,760 $2,760
54
Self-Study Problem 2-6 Income Statement

Construct an income statement from the trial balance.
55
Self-Study Problem 2-6 Solution Income Statement

Construct an income statement from the trial balance.

Income Statement
Number’s in $1,000s

- 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
56
Self-Study Problem 2-7 Statement of Retained Earnings

Construct a statement of retained earnings from the trial balance.
57
Self-Study Problem 2-7 Solution Statement of Retained Earnings

Construct a statement of retained earnings from the trial balance.

Numbers in $1,000’s
Beginning Balance Retained Earnings $300

+ Net Income 90
- Dividends 40
= Ending Balance Retained Earnings $350
58
Self-Study Problem 2-8 Balance Sheet

Construct a balance sheet from the trial balance.
59
Self-Study Problem 2-8 Solution Balance Sheet

Construct a balance sheet from the trial balance.
Daniel & Son’s

Balance Sheet
December 31, 1997
Numbers in $1,000s
ASSETS
Current Assets
Cash $ 160
Inventory 350
Prepaid Expenses 40
Total Current Assets $ 730
Long-Term Assets
Land 180
Building $ 900
- Accumulated Depreciation 200 700
Total Long-Term Assets 880
Total Assets $1,610
LIABILITIES & EQUITY

Current Liabilities
Accounts Payable $ 120
Notes Payable 140
Total Current Liabilities $ 260
Total Liabilities 660
Stockholders Equity
Common Stock 600
Total Stockholders Equity 950
Total Liabilities & Equity $1,610
60
Problems
Problem 2-1 Account Classifications
ACCOUNT CLASSIFY
Depreciation
Accounts Receivable
Utilities
Sales
Supplies
Preferred Stock
Dividend
Inventory
Prepaid Expense
Cash
Inventory
Retained Earnings
Accounts Payable
Unearned Revenue
Cost of Goods Sold
Equipment
Taxes
Land
61
Problem 2-2 Debit and Credit Balance on Accounts

accounts:
ACCOUNT BALANCE
Dividends
Accounts Payable
Goodwill
Depreciation
Accounts Receivable
Cost of Goods Sold
Common Stock
Retained Earnings
Building
Dividend Payable
Equipment
Prepaid Expense
Tax Expense
Unearned Revenue
Cash
Sales
62
Problem 2-3 Characteristics of Accounts

Complete the matrix for each of the following accounts.

(D) (C) TEMPORAR T
Y (I, R, B)
(P) (T)
Sales
Accounts Receivable
Unearned Revenue
Preferred Stock
Dividend
Sales Return
Cost of Goods Sold
Depreciation
Prepaid Expense
Problem 2-4 Journal Entries

Construct journal entries for each of the following transactions.
1. Investors gave $100,000 to start D & S Inc. in exchange for common stock.
2. D & S purchased a building for $250,000 by paying 10% down in cash and taking
out a mortgage for the balance due.
3. D & S purchased equipment for $90,000 by paying $20,000 and signing a note
payable.
4. Inventory in the amount of $35,000 was purchased on account.
5. Cash sales amounted to $32,500.
6. The cost of the inventory sold equaled $17,000.
7. Employee salaries in the amount of $15,000 were paid.
8. The utility bill of $2,500 was received but not paid.
9. Sales on account amounted to $18,000.
10. The cost of the inventory for the sales on account equaled $9,500.
11. D & S paid the amount due for the purchase of inventory.
12. D & S collected $14,000 from customers for previous sales on account.
13. Dividends in the amount of $5,000 were paid to D & S shareholders.
Problem 2-5 Posting journal entries to account ledgers.

Using the journal entries in problem 2-4, establish ledger account balances for each of
the accounts established in the journal entries.
Problem 2-6 Trial Balance

Using the ledger account balances established in problem 2-5, develop a trial balance
showing each account and its debit or credit balance.
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Problem 2-7 Financial Statements

Using the trial balance established in problem 2-6, develop an income statement,
statement of retained earnings, and balance sheet for D & S Inc.
Problem 2-8 Journal Entries

Construct journal entries for each of the following accounts.
March 1 Investors gave Dan Company $200,000 in cash and a building valued at
$300,000 in exchange for company common stock.
March 3 Dan Company purchased a fleet of 10 vehicles for $200,000 by paying $25,000
in cash and establishing a note payable for the balance due.
March 6 Equipment was rented for $5,000 per month with the first two monthly
payment made in advance.
March 10 Dan Company provided services and was paid $30,000 in cash.
March 15 Dan Company paid the following expenses:
Salaries $10,000
Utilities 3,000
Advertising 8,000
March 20 Standard Co., a customer of Dan Company paid 47,500 in advance for services
to be provided.
March 22 Dan Company provided services for $21,000 on account with the customers
agreeing to pay in full in 30 days.
March 23 Dan Company purchased supplies in the amount of $6,000 agreeing to pay for
them in 30 days.
March 31 The interest expense accrued on the note payable amounted to $1,400.
March 31 The Dan Company recorded the following depreciation amounts:
Building Depreciation $1,000
Vehicle Depreciation $2,000
Problem 2-9 Account Classifications
Using the following list of accounts, reorganize them in the following order: Current
Assets, Long-Term Assets, Current Liabilities, Long-Term Liabilities, Stockholders
Equity, Revenue, and Expense. Within each of the categories, list the accounts in the
order in which they would usually appear in a financial statement, and indicate the normal
balance, permanent or temporary, and in which financial statement they would appear.
Investment
Accounts Payable
Accounts Receivable
Sales
Cash
Common Stock
Dividend
Inventory
Unearned Revenue
Land
Accrued Salaries
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Supplies
Retained Earnings
Notes payable
Prepaid Expenses
Cost of Goods Sold
Depreciation
Equipment
Taxes
Salaries
Mortgage Payable
Utilities
65
Problem 2-10 Zero Balance Accounts

Indicate which of the following accounts should start each accounting period with a zero
balance.
ACCOUNT BALANCE
Preferred Stock
Dividend
Inventory
Prepaid Expense
Cash
Accrued Interest
Inventory
Retained Earnings
Accounts Payable
Unearned Revenue
Cost of Goods Sold
Sales
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Problem 2-11 Trial Balance

Using the following accounts and their balances, construct a trial balance for DSSR
Industry for the year ending December 31, 1996. Remember the total debit balance must
equal the total credit balance.
ACCOUNT AMOUNT
Investment $ 18,000
Sales 260,000
Cash 49,000
Common Stock 180,000
Dividend 13,000
Inventory 48,000
Unearned Revenue 6,000
Land 50,000
Accrued Salaries 9,000
Supplies 10,000
Retained Earnings 25,000
Notes Payable-Short-term 15,000
Prepaid Expenses 17,000
Cost of Goods Sold 184,000
Depreciation 12,000
Equipment 200,000
Taxes 18,000
Accumulated Depreciation 32,000
Salaries 30,000
Mortgage Payable 160,000
Utilities 13,000
Problem 2-12 Income Statement

From the data given in problem 2-11, construct an income statement for DSSR Industry
for the year ending December 31, 1996.
Problem 2-13 Statement of Retained Earnings

From the data given in problem 2-11, construct a statement of retained earnings for
DSSR Industry for the year ending December 31, 1996.
Problem 2-14 Balance Sheet

From the data given in problem 2-11, construct a balance sheet as of December 31, 1996.
67
Cases
Case Study 2-1 Swan and Son’s Laundry Service

Tom Swanson, a recent MBA graduate, decided to start his own laundry service business.
He was especially interested in this type of business because it gave him the opportunity
to hire individuals with some physical disabilities and the learning disabled and provide
them with an opportunity to develop a trade skill and make a positive contribution in the
workplace.
Tom wanted to gain service contracts with various businesses whereby his company
would pick up laundry items and have them cleaned and folded. Ideally, there would be
sufficient quantities of laundry items, that clean replacements could be left at the time
dirty items were picked up, and service could be provided on a daily basis. Tom believed
that smaller hotels, restaurants, and nursing homes would be logical businesses that could
benefit from his laundry service. These companies would not have to go through the
large capital expenditure of securing capital equipment for laundry purposes as well as
the labor cost for cleaning the laundry items. He felt his prices could be competitive with
other laundry service businesses and even less per piece than it would cost for those
businesses that would do the laundry service in house.
This business also provided a job enrichment opportunity for the disabled. These
individuals could be trained in the basic skills of laundry service, which could give them
a feeling of self worth as well as allow them to make a meaningful contribution to society
versus having to rely on welfare. Tom planned to start the employees at a competitive
wage and give merit increases after the completion of a training and probationary period
of employment.
Due to his willingness to help the disabled, Tom was able to secure a small business loan
of $200,000 at a 9.0% annual rate of interest. Tom also put up $25,000 of his own funds
along with a used van valued at $9,000 to start the business. The van should last five
years. Through some effective negotiation and because of the purpose of his business to
help disadvantaged, Tom was able to buy used equipment from a large hotel chain. He
obtained 10 industrial grade washing machines for a total of $21,000, which had a market
value of $35,000 and would have cost $60,000 if purchased new. He also obtained 5
industrial grade dryers for a total of $24,000 which had a market value of $48,000 and
would have cost $70,000 if purchased new. The washers and dryers are expected to last
for five years.
Tom secured a Butler building type of facility with 2,000 square feet of space, which
rented out for $5 per month per square foot. One month’s rent was required for deposit
and the rent was due monthly payable in advance. The utility bill was going to be high
due to the running of the wash machines and dryers for almost eight hours a day, five
days a week, for an average of 22 days in a month. Tom estimated the utility bill to be
$100 for every working day plus an extra $100 per month for the days when the company
was closed.
Initially, Tom would do all of the front office work on his own along the sales effort to
establish accounts. He believes that he can gain enough contracts to begin full-scale
operations within one month.
68
The city social service agency, through a government program, has agreed to train twelve
handicapped employees for a two-week period of time on location. They have also
agreed to provide transportation to and from work on a city bus. There will be no charge
for this service provided Tom agrees to pay the employees at least a minimum wage plus
workman’s compensation. The employee’s health care will be covered under Medicare.
The director of social services is very supportive of this business opportunity and believes
that Tom’s plan for employee compensation and merit raises is fair.
Tom anticipates that telephone and other office expenses will equal about $2,500 per
month. Cleaning supplies like detergent and fabric spray will add up to $1,000 per
month. Liability insurance for the employees, vehicle, and materials is estimated at
$1,600 per month. The transportation cost to pick up and deliver the laundry items will
probably be $750 per month.
Many of the businesses will want the laundry items ironed. Tom purchased 10 heavy-
duty irons and ironing boards with stools for a total cost of $1,200. He plans to set up six
ironing board work stations, and keep the other equipment on reserve if there is excess
demand or equipment breakdown. The irons and boards are expected to last for five
years.
Of the initial 12 employees; two will be trained to sort and prepare the laundry items, two
will monitor the washing process, two will monitor the drying process, four will iron, and
the final two, as most skilled, will learn all of the functions and prepare the laundry items
for return to the customer. Ten employees will begin at $6.00 per hour plus $2.50 per
hour for other benefits and social security. The two most skilled employees will begin at
$7.00 per hour plus $3.00 per hour for other benefits and social security. All employees
will work a 40-hour week at 8.0 hours per day plus one unpaid hour per day for lunch and
breaks. Every month, the social service department will provide three hours of training
and evaluation of the employees. Tom will pay the employees during this training.
Tom realizes that once the business gets started that he is going to need help with a
supervisor to oversee the operation. Tom’s brother John is currently working on a
masters degree at night and would be willing to work with the business. Tom will pay
John $9.00 per hour plus $4.00 per hour for benefits.
Tom plans to charge $1.50 per piece to clean large items such as sheets, large towels,
table cloths, and uniforms, and $.75 per piece to clean small items like pillow cases,
napkins, shirts, pants, small towels, and wash cloths. The price will double if the item
needs to be ironed.
Required
A. Establish a company balance sheet for Swan and Son’s Laundry Service after all of
the equipment is obtained and facilities are rented, but before the employees are hired.
You may want to construct journal entries to support the balance sheet.
B. Determine the total monthly expenses to run the laundry service business.
C. Assuming that Tom averages $2.00 per laundry item, how many items must be
cleaned in a month for the business to cover its monthly expenses?
D. Establish an income statement assuming the company earned $50,000 in revenue in
the first month. Use a tax rate of 40 percent.
E. If you were a business entrepreneur, with limited accounting and finance expertise,
what accounting and finance type of information do you believe would be important to
69
gain in the starting of a business either through the use of an outside service, the hiring of
an employee, or through self training.
70
Case Study 2-2 Pleasant Private School

Rita Roebuck is a member of the finance committee of the board of directors for Pleasant
Private School. One of her duties is to review the performance of the fund raising
committee and recommend which, if any, of the current fund raising projects should be
considered for the next school year.
The school relies on fund raising to support 5 to 10 percent of its expenditures, with
donations accounting for 10 to 15 percent. However, if donations fall short, then more
money must come from additional fundraisers. Tuition revenue accounts for the other 80
percent of the school income. The total operating budget for the school year is expected
to be $300,000 for the next school year, which is about a 10 percent increase over the
current school year.
Fund raising has become a necessary evil. Parents are never very enthused about having
their children sell everything from candy to coupon books. Additionally, it is always hard
to get volunteers to help with projects and sales. At the same time, the school needs to
keep tuition as low as possible so families can afford to send there children to a private
school, and there are only so many sources of potential revenue.
With the increase in popularity of home schooling, and competition from other private
and religious based schools, it is sometimes difficult to enroll and maintain students.
Pleasant Private school has grades of kindergarten through eighth and needs a critical
mass of 20 students in each class to justify the cost of a teacher and other related costs.
The need to enroll students restricts the school’s ability to raise tuition, and makes the
fund raising activities a critical component of revenue generation.
Rita received the following report from the chairman of the fund raising committee,
which summarized the activities for the year. She needs to review the report and prepare
her briefing for the school board, which will meet next week. Rita is a big supporter of
fund raising activities and has worked closely with the committee over the year.
However, there are several members of the school board that are getting tired of these
activities. Some board members want to raise tuition, and other board members are
considering options like downsizing, or consolidation with another private school. Rita
wants the school to stay independent and hopefully grow to include a high school. She
knows that for this goal to become a reality, she will really need to sell the success of
fund raising as a source of revenue.
71
Fund Raising Committee Year to Date Activity

Beg. Balance 966
First PTO Meeting - Refreshments -106
Supplies: Checks -50
Typewriter for Teachers -100
Rubber Stamps (library/deposit) -26
Fruit Sale: Total Dep. 12,696
Total Exp. -6,697
Teachers/Classroom: Conference, Newspaper week, supplies -462
Library: Books, Magazines, Supplies -207
Computers: Printers, software -1,327
Items 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 -300
General Fund Set Up (helps with copy paper art sup. kitchen sup.) -705
Kitchen Supplies -52
Therapy: books, teachers conf. -446
Board: Bldg. Fund -1,250
Endowment Fund -270
Light for Parking Lot -286
Sub Sale: Total Dep. 5,007
Total Exp. -1,756
T-Shirts/Sweat Shirts/School Bags -2,050
Deposit for T-shirts, etc 916
Carnival Sale: Total Dep. 2,540
Food, prizes, games for carnival -2,076
Garage Sale and Auction: Total Dep. 3,798
Food and exp. for garage sale -363
End. Balance 5,374
Required:
A. Revise the fund raising committee report into some form of an income statement and
fund balance statement which will highlight the success or failure of each of the various
fund raising activities.
B. Identify how the money earned from the fund raising activities was used during the
school year.
C. Prepare a report for Rita to present to the school board regarding the fund raising
activities of the school. Include recommendations for fund raising activities for the
following year, if you believe they are feasible. Feel free to make suggestions for other
possible fund raising activities, which might be considered. Be objective in your report,
72
but remember that Rita needs to convince board members as well as disgruntled parents
of the necessity of continuing the need for fund raising activities.
73
Chapter Three: Financial Statement Analysis
74
Objectives
1. 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 Analysis

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

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

Financial ratios are primarily based on historical information, which may not be relevant
for the decision-making purposes of either the internal or external users. Companies are
in a dynamic environment with constantly changing conditions. The users of financial
statement analysis must be aware of the changing situations when making their analysis
and adjust accordingly.
Industry standards are often at best just guidelines and may not be entirely appropriate
measures of comparisons for specific companies. Also, within an industry, it may be
difficult to compare companies because of subtle differences in variables such as size,
product mix, or the age of the company.
Accounting practices may differ between companies or even within divisions of a single
company. The generally accepted accounting principles actually allow for some variation
in the reporting of financial information and the preparation of financial statements.
Disclosure requirements state that a company must identify the differences in accounting
practice; however, these disclosures are often confusing and lengthy and an analyst could
easily overlook or ignore the information. (Note: The following financial statements will
be used to develop examples of financial ratios.)
76
Luke’s Sky & Walking Manufacturing

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

Sales Revenue $2,50 $2,80 $3,00
0 0 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 80
Earnings Per Share $ .80
$1.70 $2.20
Numbers in $1,000s
ACCOUNT 1995 1996 1997
Beginning Balance $30 $37 $470
0 0
+ Net Income 170 220 80
- Dividends 100 120 140
= Ending Balance $37 $47 $410
0 0
77

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

Cash $ 50 $ 80 $ 60
Accounts Receivable 320 300 360
Inventory 350 400 450
Prepaid Expenses 30 20 30
Total Current Assets 750 800 900
Land 300 300 300

Building (Net) 2,200 2,500 2,400
Equipment (Net) 990 1,140 1,400
Total Long-Term Assets 3,490 3,940 4,100
Total Assets $4,240 $4,740 $5,000
Accounts Payable $ 90 $ 110 $ 150

Notes Payable 250 320 400
Taxes Payable 10 20 20
Deferred Revenue 20 20 20
Total Current Liabilities 370 470 590
Mortgage Payable 700 900 800

Bonds Payable 800 900 1,200
Total Long-Term Liabilities 1,500 1,800 2,000
Total Liabilities $1,870 $2,270 $2,590
Common Stock $2,000 $2,000 $2,000

Retained Earnings 370 470 410
Total Stockholders Equity $2,370 $2,470 $2,410
Total Liabilities & Equity $4,240 $4,740 $5,000
Number of Shares of Stock 100,00 100,000 100,000

0
Market Price Per Share $20.00 $25.00 $17.00
Dividend Per Share $ 1.00 $ 1.20 $ 1.40
78
Liquidity Ratios
Liquidity ratios are designed to determine the company’s ability to meet short-term
obligations. The ratios should aid in answering questions such as does a company have
enough cash or current assets that can be converted into cash within a short period of time
to pay its current liabilities on a timely basis. The ratios focus strictly on the current
assets and current liabilities from the balance sheet.
Current ratio
The current ratio is computed as follows:
Current Assets
Current Liabilities
The ratio gives an indication of the number of times a company can pay its current
liabilities with current assets. Current assets are defined as cash or those assets which can
be readily converted into cash within a one year period of time and thus be available to
fulfill the obligation of the current liabilities. Current liabilities are obligations that will
mature and need to be paid within a one year period of time.
A standard is about 2.0 times for a current ratio. This amount means that there are twice
as many current assets as current liabilities. A company does not want a current ratio that
varies significantly in either direction from the standard. A current ratio that is too low
could indicate a liquidity problem and a possible default situation. A current ratio that is
too high could indicate an unwise use of available assets, as the current assets generally
earn a lower return than the longer term assets. If given the choice; however, it is better
to have a current ratio that is too high versus too low, because of problems associated
with a default condition.
Using the financial statements for Luke’s Sky and Walking Manufacturing, the current
ratios for 1995, 1996, and 1997 are shown in Illustration 3-1.
Current Ratio
Illustration 3-1
Current Ratio 1995 1996 1997
Current Assets 750 = 2.02 800 = 1.70 900 = 1.53

Current Liabilities 370 470 590
Since a general industry guideline for the current ratio is 2.00, Luke’s company has failed
to meet the standard for the last two years. Additionally, the trend is getting worse as the
ratio shows a continued and somewhat rapid decline. this is an area of concern and there
needs to be additional investigation into the company’s liquidity situation.
79
Quick Ratio
The quick ratio is computed as follows:
Current Assets - (Inventories + Prepaid Expenses)
Current Liabilities
The quick ratio measures the same activity as the current ratio; however, it does not
consider some of the less liquid current assets in the analysis. Inventory is not as liquid a
current asset because there is often not a ready market for inventory, and if the inventory
is sold, usually it generates an account receivable before the ultimate conversion to cash.
This two step process from inventory to account receivable to cash makes inventory a less
reliable source of ready cash to pay for current liabilities.
Prepaid expenses are often a nonrefundable current asset, which can not be converted
back into cash. These prepaid items actually represent a payment of cash in advance for
the right to receive something in the future. Prepaid items are not considered useful in
the payment of liabilities.
The generally recognized standard for the quick ratio is about 1.0 times which means that
the amount of current assets not including inventory and prepaid expenses is essentially
equal to the amount of current liabilities. The same rules and guidelines that apply to the
current ratio also apply to the quick ratio.
The computation of the quick ratio for Luke’s company for 1995 through 1997 is seen in
Illustration 3-2.
The same conclusion regarding the current ratio can also apply to the quick ratio. The
company failed to equal the standard of 1.00 for the last two years. Also, there is a two
year downward trend in the ratio. These ratio results reinforce the need for an evaluation
of the liquidity related activities of the company.
The overall conclusion regarding the liquidity ratio is not good, especially in light of the
declining trend for both ratios. While the company may be efficiently managing their
current assets and current liabilities, there is little room for error. When current liabilities
are due and payable, Luke’s company needs to have the current assets, and more
importantly the cash, available to fulfill the obligation. The ratios are at about half the
standard in 1997.
Activity Ratios
Activity ratios attempt to determine how well a company is using its resources or assets
to generate sales. The ratios can be considered as a measure of efficiency with the output
of resources leading to the input of sales. A company is considered more efficient if
fewer assets (output) are needed to generate a given level of sales (input), or if more sales
Quick Ratio
Illustration 3-2
Quick Ratio 1995 1996 1997
Cash & Accts Receivable 370 = 1.00 380 = 0.81 420 = 0.71
Current Liabilities 370 470 590
are generated from a given level of assets.
80
Activity ratios, also called turnover ratios, are developed by taking a value from the
income statement, usually sales, in the numerator, and a value from the balance sheet,
some measure of assets, in the denominator. The income statement measure represents
an activity occurring over a period of time. For consistency, the balance sheet measure in
the denominator should also represent a period of time. To obtain the consistency, an
average value is determined for the denominator, which is usually the average of a
beginning balance and an ending balance. The input over output relationship gives the
measure of efficiency. The value of the turnover ratios are measured in a number of
times, with the greater the number of times indicating higher turnover or more efficiency.
Number of days ratios are also measures of activities. The format of these ratios is to
include a measure of an asset in the numerator, usually accounts receivable or inventory
and a daily sales or daily cost of goods sold in the denominator. These ratios indicate in a
number of days how long it takes to turnover a particular asset. The ratio is somewhat
like a reciprocal to the turnover ratios with the number of days in a year as a basis. If an
accounts receivable turnover ratio is 9.0 times, then the number of days in accounts
receivable is 40 days (9.0 times 40 days equals 360 days or one year). The greater the
number of days in a ratio, the less efficient a company is at turning over a particular
asset..
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is computed as follows:
Total Annual Credit Sales
Average Accounts Receivable
Total annual credit sales is considered in the numerator versus total annual sales because
only credit sales will generate an accounts receivable. Average accounts receivable is
determined by summing the beginning balance of accounts receivable and the ending
balance of accounts receivable and dividing that total by two. It is better to have an
average balance then to use either the beginning balance or the ending balance of
accounts receivable since an average is generally more representative of the time period
in question as reflected by the sales amount in the numerator. One could argue that an
even more representative figure for average accounts receivable would be to obtain a
balance at the end of each month and divide that total by twelve. The difficulty with this
process is the extra work involved and the possibility that monthly data will not be
available, especially for external users. The increased accuracy from using monthly data
to compute an average balance of accounts receivable probably will usually not offset the
cost of obtaining the additional data and therefore cannot be justified in most situations.
A standard for accounts receivable turnover may be about 6.0 times; however, this
number can vary widely depending on the industry being measured and the terms for
collection. The higher the number of turnovers the better the company is performing in
terms of the efficient use of its accounts receivable assets in generating credit sales. A
higher turnover means that a company is doing a better job of collecting their accounts
receivable.
The accounts receivable turnover ratio for 1996 and 1997 for Luke’s company are
computed in Illustration 3-3.
The assumption is made that all sales are sales on account. Additionally, ratios for only
two years can be calculated because an average balance in accounts receivable must be
81
Accounts Receivable Turnover Ratio

Illustration 3-3
Accounts Receivable Turnover 1996
Credit Sales = 2800 = 9.03

Average Balance in Accts Receivable (320 + 300)/2
Accounts Receivable Turnover 1997
Credit Sales = 3000 = 9.09

Average Balance in Accts Receivable (300 + 360)/2
determined. Two years of balance sheet data must be used to compute the average
balance.
Luke’s company seems to be doing well with regard to the accounts receivable turnover
ratio. The rate of 9.0+ is well above the standard of 6.00 and the rate showed a slight
increase in the second year.
Average Collection Period

The average collection period ratio is computed as follows:
Average Accounts Receivable
Annual Credit Sales/360 Days
The average accounts receivable figure in the numerator is the same number used in the
denominator of the accounts receivable turnover ratio. The annual credit sales divided by
360 days gives a value for daily credit sales. 365 days may also be used for the number of
days in a year. The answer to the ratio is the average number of days it takes to collect an
account receivable. A standard for this ratio may be about 60 days. Note: The average
collection period can also be found by dividing the number of days in the year by the
accounts receivable turnover ratio. (365 days/6.0 times = 61 days)
The average collection period is a useful ratio because its answer in days can be easily
applied to a company's credit policy. If a company is requesting payment of accounts
receivable in 30 days and the average collection period is 60 days, then even though the
ratio agrees with the standard, it does not appear that the accounts receivable collection
period is very effective. For this ratio, the lower the number of days for the average
collection, the more efficient the company is in its collection of accounts receivable.
The collection process is important because accounts receivable serves as a major source
of cash within the current assets and the cash is needed to pay off the current liabilities.
Companies can have very good current and quick ratios; however, if they do not have a
good turnover of accounts receivable, they still may have a liquidity problem because
they do not have sufficient cash. Companies can not pay off current liabilities with
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accounts receivable, and using accounts receivable as collateral can be a very expensive
(high effective rate of interest) way to borrow money.
The average collection period for Luke’s company for the years of 1996 and 1997 are
The average collection period is about 40 days. If the terms of credit sales are net 30
days, then the 40 day average is satisfactory. However, there is room for improvement.
There could be delays due to mailing both the invoice to the customer and in receipt of
the payment. Additionally, there could be some processing inefficiencies. A goal of the
company management could be to get the average collection period to no more than 30
days.
Inventory Turnover Ratio
The inventory turnover ratio is computed as follows:
Cost of Goods Sold
Average Inventory
The cost of goods sold figure is used in the numerator because inventory is recorded at
cost, and as the inventory is sold an accounting transaction will show a decrease in the
inventory account and an equal increase in the cost of goods sold account. The same
logic and discussion used for the average accounts receivable amount holds for the
average inventory amount.
A standard for inventory turnover may be about 4.0 times; however, the values for this
ratio can probably vary more than any other ratio. In some companies inventory may
turnover almost daily and in that case the turnover could approach 300 times or more, and
in other companies turnovers could be only one or two times per year. One needs to be
careful in examining this ratio and understand the specific circumstances of each
company. As usual a higher turnover ratio is generally better because it demonstrates
increased efficiency in its use of the asset inventory. However, it is possible that too high
an inventory turnover could mean inventory shortages which would have a negative
impact on company sales.
Average Collection Period

Illustration 3-4
Average Collection Period 1996
Avg Balance of Accts Receivable = (320 + 300)/2 = 310 = 39.9 days

Credit Sales Per Day 2800/360 7.78
Average Collection Period 1997
Avg Balance of Accts Receivable = (300 + 360)/2 = 330 = 39.6 days

Credit Sales Per Day 3000/360 8.33
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Inventory Turnover Ratio

Illustration 3-5
Inventory Turnover Ratio 1996
Cost of Goods Sold = 1600 = 4.27

Average Inventory (350 + 400)/2
Inventory Turnover Ratio 1997
Cost of Goods Sold = 1900 = 4.47

Average Inventory (400 + 450)/2
Some of the new inventory control models such as "just in time" inventory have led to
great improvements in inventory turnover and greater company performance and
efficiency. Improved turnover does have an upper limit and companies may find that the
increased cost of more refined inventory control models may exceed the benefit of
increased inventory turnover. Never the less, companies should continue to strive to
identify cost effective ways to improve inventory turnover.
The inventory turnover ratio for Luke’s company for the years of 1996 and 1997 is
The inventory turnover ratio is slightly better than the standard of 4.0. Additionally, the
trend shows a small improvement in turnover in 1997. A specific standard for this
company and industry is needed before any additional conclusions can be made regarding
the company’s inventory practices.
Average Inventory Period

The average inventory period ratio is computed as follows:
Average Inventory
Cost of Goods Sold/360 Days
The cost of goods sold divided by 360 days gives a daily cost of goods sold. The answer
to this ratio is the average number of days it takes for a company to sell its inventory. A
standard for this ratio may be about 90 days. Note: The average inventory period can be
found by dividing the number of days in a year by the inventory turnover ratio. (365
days/4.0 times = 91 days)
Just as it is with the inventory turnover ratio, the average inventory period can vary
widely. The ratio is still very useful because it measures its value in days. As with the
average collection period for accounts receivable, the average inventory period shows
how long it takes for inventory to be sold.
If it is assumed that when inventory is sold it is sold on credit, then one also needs to
consider the average collection period in determining how long it takes from the time a
company obtains inventory until it receives the cash for its sale. For instance if the
average collection period is 60 days and the average inventory period is 90 days, then it
will take 150 days from the time a company obtains inventory until a company obtains
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cash for the sale of this inventory. This two step process of going from inventory to
accounts receivable to cash is the reason why inventory is not included in the quick ratio
calculation.
Companies must be very careful to maintain control of inventory. Even though inventory
is a current asset, it is possible that inventory may never be converted into cash.
Inventory can only result in cash if it is sold, and it can only be sold if it is what the
customer wants. Companies can get overloaded with obsolete inventory and still have a
good current ratio; however, unless the inventory turnover ratio is satisfactory, the
company can have a liquidity problem. Companies cannot pay off current liabilities with
inventory, and the use of inventory as collateral can be a very expensive form of
financing.
The average inventory period in days for Luke’s company for the years of 1996 and 1997
is computed in Illustration 3-6.
The average number of days in inventory improves from 84.4 days to 80.5 days which is
consistent with the improved inventory turnover ratio. A specific industry standard is
needed to determine if the average inventory period is satisfactory.
Total Asset Turnover Ratio

The total asset turnover ratio is computed as follows:
Sales
Average Total Assets
Total sales is used in the numerator because the assets used to generate sales do not
distinguish between credit sales and cash sales. The average value of total assets is used
as opposed to an asset value on a specific date for the same reason that averages are used
on other turnover ratios. A standard for total asset turnover is about 1.5 times. The
capital intensity of a company or its proportion of long-term assets can have a significant
impact on the total asset turnover ratio. Companies with a large amount of long-term
assets will generally have lower total asset turnover ratios.
Average Inventory Period

Illustration 3-6
Average Inventory Period 1996
Average Inventory Balance = (350 + 400)/2 = 375 = 84.4 days

Cost of Goods Sold/Day 1600/360 4.44
Average Inventory Period 1997
Average Inventory Balance = (400 + 450)/2 = 425 = 80.5 days

Cost of Goods Sold/Day 1900/360 5.28
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Total Asset Turnover Ratio

Illustration 3-7
Total Asset Turnover 1996
Sales = 2800 = 0.62

Average Total Assets (4240 + 4740)/2
Total Asset Turnover 1997
Sales = 3000 = 0.62

The total asset turnover ratio is an important component in the return on investment
computation which is one of the most widely recognized ratios by both internal and
external users to measure overall company performance. The ratio considers two of the
most important values from the financial statements, sales and total assets, and combines
information from the income statement and the balance sheet. Additionally, the total
asset turnover ratio gives an overall measure of company efficiency as it relates the output
of total assets with the input of sales.
The total asset turnover ratio is computed for Luke’s company for 1996 and 1997 in
Illustration 3-7.
The total asset turnover ratio of 0.62 for each year appears to be quite low when
compared to a standard of 1.50. The trend is constant, but it appears that there is
considerable room for improvement.
The overall conclusion regarding the activity ratios is fair to poor. The accounts
receivable and inventory turnover ratios are close to standard and the trend is improving.
However, the total asset turnover ratio is low and not improving. It appears that this is a
highly capital intensive company (large amounts of long-term assets) which can be typical
for manufacturing companies. The large amounts of long-term assets do not appear to be
generating the necessary levels of sales, which can have a detrimental effect on important
ratios like return on assets and return on equity.
Debt Ratios
Debt ratios relate to the use of borrowed funds to obtain assets. There are two broad
sources of assets, lenders and owners. Debt ratios determine the make up of these sources
of assets between lenders and owners. Debt ratios also identify a company's ability to
repay debt obligations with earnings and cash.
A company that uses debt or liabilities to obtain assets is said to be using financial
leverage. Using other people’s money to secure assets which leads to generating return
for the owners can be a very useful technique in business, but there are risks involved.
With the creation of liabilities comes a contractual obligation for repayment with interest
in a prescribed time period. If a company does not generate enough earnings to fulfill
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such obligations then the company is in risk of default and bankruptcy. The higher the
level of financial debt, the greater the risk a company could incur if something goes
wrong, but the greater the potential reward if something goes right.
The debt ratios assess how much of a company's assets are funded by debt, and the
company's ability to meet its financial obligations. Balance sheet leverage ratios include
the debt to asset ratio and the debt to equity ratio. These ratios take values from the
balance sheet and aid in identifying the proportion of assets funded by debt. Coverage
ratios include the times interest earned ratio and the cash flow coverage ratio. These
ratios take values from the income statement and help to analyze a company's ability to
repay debt and interest.
Debt to Asset Ratio

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

Illustration 3-8
Debt/Asset Ratio 1995 1996 1997
Total Liabilities 1870 = 44.1% 2270 = 47.9% 2590 = 51.8%

Total Assets 4240 4740 5000
The debt to asset ratio for Luke’s company for the years 1995 through 1997 can be
computed as in Illustration 3-8.
The debt to asset ratio is below the standard but there is a definite increasing trend. It
appears as though the company is funding a larger portion of its assets with debt. The
increased debt funding can be advantageous for the company if it can make positive use
of financial debt. If the increased levels of debt create a financial hardship, then this trend
could be an indication of future problems.
Debt to Equity Ratio

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

Illustration 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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Times Interest Earned Ratio

Illustration 3-10
Times Interest 1995 1996 1997
Operating Income 450 = 2.65 590 = 2.68 410 = 1.52

Interest Expense 170 220 270
as coverage ratios. The coverage ratios are used to determine a company's ability to pay
the finance charges of interest and principal repayment.
Times Interest Earned Ratio
The times interest earned ratio is computed as follows:
Net Operating Income
Annual Interest Expense
or
Earnings before Interest and Taxes
Annual Interest Expense
The numerator of net operating income considers all revenue and expense items with the
exception of financing related activities and taxes. The supplementary income figure is a
measure of the operating performance of the company over a period of time usually one
year. The ratio indicates how many times the operating income will cover the interest
expense obligation. A standard for this ratio is about 2.5 times.
If companies cannot generate enough operating income to cover financing charges they
are in risk of default on their debt obligations. Companies that have higher degrees of
financial leverage will tend to have a lower times interest earned ratio. With this ratio,
there is no real danger if the amount is considerably higher than some standard, the major
concern should be for a low times interest earned value.
The times interest earned ratio for Luke’s company for 1995 through 1997 is computed in
Illustration 3-10.
The company is near the standard for times interest earned until 1977 when there is a
noticeable decline in the rate. The decline is caused by both a drop in operating income
and an increase in the interest expense. The company is getting close to being in danger
regarding the responsibility of paying interest with available income.
Cash Flow Overall Coverage Ratio

The cash flow coverage ratio is computed as follows:
Net Operating Income + Lease Expense + Depreciation
Interest Expense + Lease Expense + Preferred Dividends/ (1 - Marginal Tax Rate) +
Principal Repayment/(1 - Marginal Tax Rate)
This rather complex ratio addresses the issue that interest expenses must be paid for with
cash, and net operating income does not necessarily mean cash. The numerator needs to
be converted from a net operating income position to a cash position. Lease expenses are
usually deducted as part of an operating expense to arrive at net income, therefore the
amount of lease expense needs to be added back to net operating income.
Net operating income is based on an accrual concept and some of the expenses may not
involve cash. The most obvious expense of this nature is depreciation. In order to arrive
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at a cash position, the amount of all noncash types of expenses needs to be added back to
the net operating income. The resulting numerator could be classified as cash flow from
operating income activities.
The amount in the numerator represents the amount of cash available from operating
activities. In the denominator is all of the potential fixed financing types of obligations.
Interest expense is just one of the categories to be considered. Since lease expense was
moved from an operating activity to a financing activity, it too must be included in the
denominator for cash coverage purposes.
Some cash payments can be made with only after tax net income or cash. Preferred
dividends which display characteristics similar to debt instruments are paid with after tax
dollars. Also, any principal repayment of debt is made without the benefit of any tax
savings. To get all of the terms in the ratio on a consistent tax related basis, those items
paid with after tax dollars are divided by the fraction of 1.0 minus the marginal tax rate.
This adjustment results in the amount of before-tax cash flows that are required to make
the required payments.
The cash flow coverage ratio has significant advantages over a times interest earned ratio.
To begin with it recognizes that cash is needed to fulfill financial obligations and cash is
not the same as net operating income. Additionally, the ratio identifies all financial
obligations and adjusts them as appropriate for tax implications. Just because a company
can cover their interest expenses does not mean that they have adequate cash coverage for
all financial obligations. A company with a satisfactory times interest earned ratio may
not have sufficient cash for a satisfactory cash flow coverage ratio. If only the more
easily determined times interest earned ratio is computed, the analyst may come to an
incorrect conclusion.
As with the times interest earned ratio, the only real danger is a low number. A company
that does not have coverage ability is in risk of default whether it fails to meet interest
payments or debt principal or lease payments. The cash flow overall coverage ratio is a
relatively new ratio which has gained its recognition of importance as companies realize
the necessity to closely monitor cash.
The cash flow overall coverage ratio for Luke’s company for the years 1995 through 1997
can be computed as in Illustration 3-11.
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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. An
assumption will be made that $100 of principal repayments will be due every year and
this amount is included in the denominator. Given the amount of debt, the $100 per year
assumption is reasonable. Also, the tax rate is computed by dividing the tax expenses by
the net income before tax and the rate equals about 40 percent each year.
The cash flow coverage is lower than the times interest earned for each year with a
considerable decline in 1997. Again, the company is showing signs of weakness in its
ability to cover fixed financial obligations and the trend indicates the situation is getting
worse.
The debt ratios all confirm a trend that is leading to greater levels of debt. The balance
sheet ratios show that asset expansion is being funded solely by increases in the level of
debt. This action is beginning to have an effect on the income statement as higher
amounts of interest expense are causing decreases in the coverage ratios. Luke’s
company could be just about at its limit in the debt situation. Action needs to be taken to
reverse or at least curtail this trend.
Profitability Ratios
Profitability ratios relate to the earning ability of the company. A major purpose of the
income statement is to measure net income or company profitability. A company cannot
Cash Flow Coverage Ratio
Illustration 3-11
Cash Flow Coverage 1995
Ops Income + Depreciate = 450 + 150 = 600 = 1.79

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


expect to have a long-term existence if it continues to fail to make a profit. An absolute
amount representing a company's net income or profit has value; however, this figure
cannot address questions such as how much of a dollar of sales was converted into profit,
or how much of a dollar of assets or equity was converted into profit. Profitability ratios
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can make comparisons between profit and other measures of performance on a relative
basis.
Profitability ratios can be classified into two broad categories to include profitability
related to sales or other income statement items and profitability related to investments or
other balance sheet items. In all the profitability ratios, net income or some
supplementary measure of income statement performance such as net operating income or
gross margin will be the numerator. For income statement related ratios sales will
generally be the denominator. For balance sheet related ratios average total assets or
average total equity will usually be the denominator.
Gross Profit Margin

The gross profit margin is computed as follows:
Gross Margin
Net Sales
The numerator gross margin equals net sales less cost of goods sold. The denominator
equals total sales revenue less items like sales returns and allowances and sales discounts.
Net sales represents the level of sales revenue that can be attributed to the earnings
potential of the company. Frequently, net sales is the same as sales revenue as the
amount of the deduction from gross sales is relatively insignificant. If a net sales figure is
not available from the income statement the sales figure is an acceptable and sometimes a
preferred alternative because it is easier to identify and interpret.
The value of this ratio in percent terms identifies how much of the sales dollar remains
after covering the cost of the good or service that has been sold. A standard for gross
profit margin is between 25 and 30 percent. This ratio implies that for every dollar of
sales between 70 and 75 cents goes to the actual cost of the good or service sold and only
between 25 and 30 cents remains to cover other operating, financial, and tax expenses
plus leaving a profit margin. The higher the percentage, the better the company is doing
in generating potential profitability.
For Luke’s company, the gross profit margin for the years of 1995 through 1997 can be
The gross profit margins for Luke’s company are all above standard. The company
appears to be earning a satisfactory revenue above the cost of its product. The gross
profit margin has shown a negative trend in 1997, which could be a sign of trouble in the
future. Also, the depreciation expense listed under operating expenses could easily be
part of cost of goods sold which would cause a decrease in the margin.
Gross Profit Margin Ratio
Illustration 3-12
Gross Profit 1995 1996 1997
Gross Margin 1000 = 40.0% 1200 = 42.9% 1100 = 36.7%

Sales Revenue 2500 2800 3000
Operating Profit Margin Ratio

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

Illustration 3-13
Operating Profit 1995 1996 1997
Operating Income 450 = 18.0% 590 = 21.1% 410 = 13.7%

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

The net profit margin ratio is computed as follows:
Net Income
Net Sales
This ratio considers the after tax net income figure in the numerator and reflects the
residual of all items of revenue and expense from the income statement. The percentage
value of the ratio identifies what percentage of a dollar of sales ends up as net profit.
A standard for this ratio is only about 4.0 percent. The average net profit margin
reinforces the fact that only a very small proportion of every sales dollar ends up as net
profit. The higher the ratio, the better the company performance as measured in terms of
profitability.
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The net profit margin ratio for Luke’s company for the years 1995 through 1997 is
The company experienced good net profit margins above industry standards for the first
two years. There was a noticeable decline in the net profit margin in 1997. This may be a
temporary condition of the company or it may be an early indication of continuing
problems. All the income statement profitability ratios showed a declining trend in 1997,
with the most significant decline occurring on the net profit margin.
The previous profitability ratios were measured in relation to sales. A measure of sales
revenue was included in the denominator of every ratio. The remaining profitability
ratios are measured in relation to investment. The denominator of these ratios will
include a balance sheet item such as average total assets or average total equity.
Return on Total Assets or Return on Investment Ratio

The return on total assets ratio is computed as follows:
Net Income
Average Total Assets
The denominator uses average total assets just as in the activity ratios because a balance
sheet item is being related to an income statement item. The net income reflects activities
over a period of time, revenues minus expenses. To have consistency in the ratio, the
asset measure should attempt to reflect an appropriate balance over the entire time period.
A single beginning or ending balance figure may or may not represent what the total asset
amount could have been over the entire period. Using an average of the beginning and
ending balances will probably give a closer approximation of the proper amount of total
assets to compare to net income.
The value of this ratio is recorded in a percent figure, and a standard is around 6.0
percent. The ratio implies that for every dollar of assets a company owns it earns a net
income of about six cents.
The return on total assets ratio is frequently broken down into two ratios, which have
been previously, discussed; the total asset turnover ratio and the net profit margin ratio.
The computations for these two ratios are as follows:
Sales X Net Income = Net Income
Average Total Assets Sales Average Total Assets
The breakdown of the return on total assets ratio can help to determine the level of impact
on the return due to asset turnover and what impact is due to profit margin. Some
Net Profit Margin Ratio

Illustration 3-14
Net Profit Margin 1995 1996 1997
Net Income 170 = 6.8% 220 = 7.9% 80 = 2.7%

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

Illustration 3-15
Return on Total Assets 1996
Net Income 220 = 4.90%

Return on Total Assets 1997

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

Illustration 3-16
1996 1997
Asset Turnover x Profit Margin = Asset Turnover x Profit Margin =

Return on Assets Return on Assets
0.62 x 7.9% = 4.90% 0.62 x 2.7% = 1.64%
The return on total assets for Luke’s company for the years of 1996 and 1997 can be
The return on total assets is below the standard for both years with a noticeable decline in
1997. A break out of the ratio into the turnover component and the profit margin
component, which have been computed earlier, are illustrated in 3-16.
The total asset turnover is consistent but below standard for both years. Only a good net
profit margin in 1996 resulted in a relatively satisfactory return on asset ratio. In 1997
when the net profit margin fell, both components of the return on asset ratio were less
than satisfactory which resulted in a very low return on asset value. In 1997, the ratio
implies that for every dollar of assets, the company earned 1.64 cents.
Return on Common Equity Ratio

The return on common equity ratio is computed as follows:
Net Income Available to Common Shareholders
Average Common Equity
The numerator net income figure is adjusted for any dividend payments to preferred
shareholders leaving only the earnings available for potential distribution to the common
shareholders. The denominator includes all equity with the exception of preferred stock.
An average figure is used for common equity because a balance sheet figure in the
denominator is related to an income statement figure in the numerator.
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An investor desires to know what percentage of return is gained through a stock

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

Illustration 3-17
Return on Equity 1996

Average Equity (2370 + 2470)/2
Return on Equity 1997

Average Equity (2470 + 2410)/2
that consider common stock relationships. These market ratios include not only dollar
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information from the financial statements but values such as market price of the company
stock and the number of shares of common stock actively traded on the open market.
Earnings Per Share Ratio

The earnings per share ratio is computed as follows:
Net Income
The Number of Shares of Common Stock Outstanding
The number of shares of common stock outstanding in the denominator represents the
number of shares actively traded in the stock market. These shares are available for any
investor to buy and sell at a going market price.
The earnings per share value is a dollar amount per share of stock and it represents a
dollar amount of annual return for each share of stock owned by an investor. A higher
earnings per share figure is better; however, the value must be considered in relation to a
trend and also the market price of the stock. Keeping all other factors constant, an
investor would be better off with an earnings per share of $1.00 on a stock with a market
price of $10.00 than an earnings per share of $9.00 on a stock with a market price of
$100.00.
Since it is difficult to objectively determine a standard, there is no industry average for
earnings per share. A better approach to analyze earnings per share is to look at the
earnings per share trend for each individual company over time. Ideally, the trend is
increasing at a steady and constant rate. This condition indicates that the company is
continuously earning more income for each share of stock. Companies recognize the
importance of the earnings per share figure and promote it extensively, especially when it
is responding favorably.
The earnings per share ratio has been included in the income statement for Luke’s
company for the years of 1995 through 1997. The computation is seen in Illustration 3-
18.
Earnings Per Share Ratio
Illustration 3-18
Earnings/Share 1995 1996 1997
Net Income 170 = $1.70 220 = $2.20 80 = $0.80

Number of Shares of 100 100 100
Stock Outstanding
Note: There were 100,000 shares of common stock outstanding. Since the dollar amount
of net income was in $1,000s, the number of shares also has to be listed in 1,000s for a
consistent ratio computation.
The earnings per share ratio has an acceptable increase in 1996 followed by a significant
decline in 1997. The decline in 1997 will no doubt have a negative impact in the minds
of investors as reflected in the market price of the stock, which declines in 1997.
Earnings Yield on Common Stock Ratio

The earnings yield on common stock ratio is computed as follows:
Earnings Per Share
Market Price Per Share
97
The earnings yield ratio overcomes the problem associated with the earnings per share
ratio when it is not compared to the market price of common stock. An absolute measure
of earnings per share may not give an accurate measure of performance until the relative
measure of earnings yield on common stock is determined.
Since both the numerator and denominator contain dollar amounts per share
measurements, the dollar per share components cancel out and the ratio measurement is a
percentage described as the yield. This earnings yield is a measure of return for each
dollar invested in the market price of a share of stock. The higher the yield rate the better,
and given the level of risk associated with holding common stock, the earnings yield
should be considerably above the yield on a virtually risk free investment like a certificate
of deposit.
In the example previously described in the earnings per share ratio discussion, the first
stock with an earnings per share of $1.00 and a market price per share of $10.00 has a
yield of 10 percent. The second stock which has a much higher earnings per share of
$9.00 has a market price per share of $100.00 and an earnings yield of only 9 percent.
The better selection is the $10.00 stock which has the higher earnings yield of 10 percent
versus 9 percent for the $100.00 stock.
The earnings yield on the common stock for Luke’s company for 1995 through 1997 is
The earnings yield on common stock remains relatively constant for the years 1995 and
1996. The increase in the market price of the common stock in 1996 is a reflection of the
increase in the earnings per share. However, in 1997, the overall decline in performance
caused a reduction in the market price and a decrease in the earnings yield to a low 4.7%.
There is a possibility for even further erosion in the market price, especially if the
problems surfacing in 1997 are ongoing.
Price Earnings Ratio

The price earnings ratio is computed as follows:
Earnings Per Share
The price earnings ratio is the reciprocal of the earnings yield ratio. The ratio states how
many times greater the market price for a share of company stock is over the earnings of
that stock. A general guideline is that a stock should sell for about 15 times earnings;
however, that equates to an earnings yield of only about 6.6 percent (1\15 = .067).
A price earnings of 15 times may be a good average to use for a portfolio of stocks, but to
apply that standard to an individual stock can be risky. A major purpose of the price
Earnings Yield Ratio

Illustration 3-19
Earnings Yield 1995 1996 1997
Earnings/Share 1.70 = 8.5% 2.20 = 8.8% 0.80 = 4.7%

Market Price of 20.00 25.00 17.00
Common Stock
98
earnings ratio is to aid in determining if a stock is under or overvalued. To make a

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

Illustration 3-20
Price Earnings 1995 1996 1997
Price/Share 20.00 = 11.8 25.00 = 11.4 17.00 = 21.3

Earnings/Share 1.70 2.20 0.80
99
Dividend Yield on Common Stock Ratio

The dividend yield on common stock ratio is computed as follows:
Dividend Per Share
Investors that obtain stocks paying dividends desire to know the percentage return the
dividend is providing in relation to the market price of the common stock. The dividend
yield may be relatively low in relation to yields on securities such as certificates of
deposit; however, common stocks can also gain returns through growth in the market
price of the stock. Also, some companies, especially in growth industries, may not pay
any dividends.
The goal of the investor in common stock will determine whether a high or low dividend
yield is desirable. Investors interested in income oriented stocks are looking for higher
dividend yields. Investors looking for growth oriented stocks are satisfied with low
dividend yields.
The dividend yield ratio for Luke’s company for the years of 1995 through 1997 is
The dividend yield appears to be reasonable and maybe high for this company for 1995
and 1996. In 1997, the dividend yield increases because of the decline in the stock
market price and the continued increase in the dividend rate per share. The company may
be trying to maintain a policy of always increasing dividends but they are facing a risk of
declining retained earnings and may be forced to cut or eliminate dividends in the future.
Payout Ratio on Common Stock

The payout ratio on common stock ratio is computed as follows:
Dividend Per Share
Earnings Per Share
For every dollar of earnings a company can either pay out the dollar as a dividend or
retain the dollar and reinvest it in new company assets. Companies in growth industries
will have a low payout ratio, as there are many opportunities to reinvest earnings in
productive assets that will lead to higher earnings and the potential for an increasing
market price of the common stock. Companies in more mature industries will tend to
have higher payout ratios because the opportunities to reinvest earnings in productive
assets are limited. The market price of the mature industry stock may not increase as
rapidly; however, this is made up to an extent by the higher dividend payout ratio, and the
likelihood for a higher dividend yield.
Investors will make the decision regarding the type of stock they are most interested in
Dividend Yield Ratio

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

Illustration 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
Horizontal and Vertical Analysis

Horizontal analysis is a measure of performance of an individual company over time or
a comparison of a company against another company or industry at a point in time. The
ratios that have been presented in the chapter with values from different years is an
example of a horizontal analysis. Ratios presented in this format lend themselves to trend
analysis, which will show if a company is improving, staying the same or getting worse
over a period of time. With any ratio there needs to be a standard or guideline for
comparison purposes. Horizontal analysis lends itself to ease of comparison as trends can
be used to compare one time period against another or one entity against another in the
same time period.
Vertical analysis reviews one company or entity at one point in time. The emphasis on a
vertical analysis is centered on one financial statement. Percentage rates are established
101
Illustration 3-23
Income Statement
Numbers in $1,000s
ACCOUNT 1995 Percent
Sales Revenue $2,50 100.0
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
for each item analyzed in the specific financial statement; however, the information alone
is limited unless there can be some standard for comparison purposes.
The vertical analysis of an income statement uses sales revenue as the denominator and
various measures of expense or margin as the numerator. Sales revenue represents a 100
percent component of the income statement and each segment is some fraction of sales.
Several profitability ratios that have already been presented are examples of vertical
analysis. The gross profit margin ratio, operating profit margin ratio, and net profit
margin ratio all represent vertical analysis from the income statement. Specific expense
categories such as cost of goods sold, operating expenses, interest expenses and tax
expenses are sometimes compared to sales revenue on a percentage basis. Each line item
on an income statement can be represented as a percent of total sales revenue, with the
sum of all of the expense percentages and net income equaling 100 percent. In the case
of Luke’s company the sum of cost of goods sold, operating expenses, depreciation
expense, interest expense, tax expense, and net income equals 100 percent. (60.0 + 16.0
+ 6.0 + 6.8 + 4.4 + 6.8 = 100.0)
An income statement with a vertical analysis for each line item for 1995 is presented in
Illustration 3-23
Vertical analysis is also used with the balance sheet. Total assets is used as the
denominator, and other line items in the balance sheet can be used as the numerator.
Debt to total assets, an important ratio for debt analysis, is an example of a balance sheet
vertical analysis. Other balance sheet categories used as numerators include current
assets, current liabilities, and total stockholders equity.
The more common individual line items that are compared to total assets include cash,
accounts receivable, and inventory. Sometimes a balance sheet is presented with every
line item shown as a percent of total assets.
A balance sheet with vertical analysis for each line item for 1995 is presented in
Illustration 3-24.
102
Summary
Financial statement analysis is a very critical process for the overall evaluation of
company performance. There is a wide variety of ratios that can be determined to review
all phases of a company operation. The ratios presented were broken out into five major
categories: liquidity, activity, debt, profitability, and market. An analyst must consider
ratios from all areas before arriving at any conclusions regarding performance.
Ratio analysis by itself will be insufficient without some standards of comparison. These
standards may be generated internally over time or externally in comparison with other
companies or an industry.
Ratio analysis is not an end in itself but a means to an end. Proper financial statement
evaluation should generate the correct questions to be asked to determine how and why a
company performed as it did.
Note: Self-Study problems will not be presented for this chapter as detailed examples
were computed for each ratio in the text.
103
Illustration 3-24
Balance Sheet
December 31, 1995
Numbers in $1,000s
ACCOUNT 1995 Percent
Cash $ 50 1.2
Accounts Receivable 320 7.6
Inventory 350 8.3
Prepaid Expenses 30 0.7
Total Current Assets 750 17.7
Land 300 7.1

Building (Net) 2,200 51.9
Equipment (Net) 990 23.4
Total Long-Term Assets 3,490 82.3
Total Assets $4,240 100.0
Accounts Payable $ 90 2.1

Notes Payable 250 5.9
Taxes Payable 10 0.2
Deferred Revenue 20 0.5
Total Current Liabilities 370 8.7
Mortgage Payable 700 16.5

Bonds Payable 800 18.9
Total Long-Term Liabilities 1,500 35.4
Total Liabilities $1,870 44.1
Common Stock $2,000 47.2

Retained Earnings 370 8.7
Total Stockholders Equity $2,370 55.9
Total Liabilities & Equity $4,240 100.0
Note: The total percent amounts may not equal the sums of the components due to
rounding.
104
Problems
Use the income statement, statement of retained earnings and balance sheet for the FAC
Inc. to answer problems 3-1 through 3-13.
FAC Inc.
Income Statement
Numbers in $1,000s
Sales Revenue $1,00
0
- Cost of Goods Sold 650
= Gross Margin 350
- Other Expenses
Depreciation $
50
Administration -150
100
= Operating Income 200
- Interest Expense 30
- Tax Expense 80
= Net Income 90
FAC Inc.
Numbers in $1,000s
Beginning Balance Retained Earnings $320
+ Net Income 90
- Dividends 60
= Ending Balance Retained Earnings $350
105
FAC Inc.
Balance Sheet
December 31, 1997
Numbers in $1,000s
ASSETS
Current Assets
Cash $
160
Inventory 350
Prepaid Expenses 40
Total Current Assets $
730
Long-Term Assets
Land 180
Building $
900
- Accumulated Depreciation 700
200
Total Long-Term Assets 880
Total Assets $1,61
0
LIABILITIES & EQUITY

Current Liabilities
Accounts Payable $
120
Notes Payable 140
Total Current Liabilities $ 260
Total Liabilities 660
Stockholders Equity
Common Stock 100,000 shares 600
Total Stockholders Equity 950
Total Liabilities & Equity $1,610
Market Price Stock = $12/share
106
Use the income statement, statement of retained earnings and balance sheet for the FAC
Inc. to answer problems 3-1 through 3-13. Note when questions refer to a
comparison to standards, use the standards as identified in the text.
Problem 3-1 Liquidity Ratios
Compute the current ratio and the quick ratio for the FAC Inc. for 1997. What conclusion
can be made regarding these ratios when compared to the standard?
Problem 3-2 Accounts Receivable Ratios

Compute the accounts receivable turnover ratio and the average collection period for the
FAC Inc. for 1997. What conclusion can be made regarding these ratios when compared
to the standard? Note: the beginning balance of accounts receivable was $140. Unless
otherwise stated, assume that all sales are on account.
Problem 3-3 Inventory Ratios

Compute the inventory turnover ratio and the average inventory period for the FAC Inc.
for 1997. What conclusion can be made regarding these ratios when compared to the
standard? Note: the beginning balance of inventory was $300.
Problem 3-4 Total Asset Ratio

Compute the total asset turnover ratio for the FAC Inc. for 1997. What conclusion can be
made regarding this ratio when compared to the standard? Note: the beginning balance
of total assets was $1,550.
Problem 3-5 Balance Sheet Debt Ratios

Compute the debt to asset ratio and the debt to equity ratio for the FAC Inc. for 1997.
What conclusion can be made regarding these ratios when compared to the standard?
Problem 3-6 Coverage Debt Ratios

Compute the times interest earned ratio and the cash flow coverage ratio for the FAC Inc.
for 1997. What conclusion can be made regarding these ratios when compared to the
standard? Assume that $20 of the mortgage payable was paid during the year.
107
Problem 3-7 Profitability Ratios

Compute the gross profit margin ratio, the operating profit margin ratio, and the net profit
margin ratio for the FAC Inc. for 1997. What conclusion can be made regarding these
ratios when compared to the standard?
Problem 3-8 Return on Assets Ratio

Compute the return on assets ratio for the FAC Inc. for 1997. Divide the return on assets
ratio into a total asset turnover ratio and a net profit margin ratio. What conclusion can
be made regarding these ratios when compared to the standard?
Problem 3-9 Return on Equity Ratio

Compute the return on equity ratio for the FAC Inc. for 1997. Note: the beginning
balance for total stockholders equity was $920. Compare the return on equity ratio with
the return on asset ratio computed in problem 8 above. Why are the values different?
What conclusion can be made regarding these ratios when compared to the standard?
Problem 3-10 Market Ratio

Compute the earnings per share ratio, the earnings yield on common stock ratio, and the
price earnings ratio for FAC Inc. for 1997. What conclusions can be made regarding
these ratios when compared to the standard?
Problem 3-11 Dividend Ratios

Assume that FAC Inc. paid $60,000 in dividends in 1997. Compute the dividend yield on
common stock ratio, and the dividend payout ratio for FAC Inc. for 1997.
Problem 3-12 Vertical Analysis

Complete a line item vertical analysis for the income statement of the FAC Inc. for 1997.

Complete a line item vertical analysis for the balance sheet of the FAC Inc. for 1997.
108
Use the following financial statements to answer problems 3-14 through 3-26.
Lucky Manufacturing Inc.
Income Statement
Numbers in $1,000s
ACCOUNT 1995 1996 1997
Sales Revenue $4,800 $5,000 $6,20

0
- Cost of Goods Sold 3,000 3,200 4,000
= Gross Margin 1,800 1,800 2,200
- Operating Expenses 600 650 700
= Operating Income 1,000 850 1,200
= Net Income $ 480 $ 330 $ 420
Earnings Per Share $2.40 $1.65 $2.10

Numbers in $1,000s
ACCOUNT 1995 1996 1997
Beginning Balance $500 $680 $660

+ Net Income 480 330 420
- Dividends 300 350 400
= Ending Balance $680 $660 $680
109

Balance Sheet
December 31, 1995, 1996, & 1997
Numbers in $1,000s
ACCOUNT 1995 1996 1997
Cash $ 100 $ 120 $ 200

Inventory 400 700 800
Total Current Assets 1,130 1,540 1,820
Land 800 800 800

Building (Net) 3,600 4,000 6,000
Equipment (Net) 1,540 2,060 2,200
Total Assets $7,070 $8,400 $10,820

Total Current Liabilities 890 1,240 1,640
Mortgage Payable 1,000 2,000 3,000

Bonds Payable 2,000 2,000 3,000
Total Long-Term Liabilities 3,000 4,000 6,000
Total Liabilities $3,890 $5,240 $ 7,640
Common Stock $2,500 $2,500 $ 2,500

Total Stockholders Equity $3,180 $3,160 $ 3,180

Market Price Per Share $36.00 $30.00 $32.00
Dividend Per Share $ 1.50 $ 1.75 $ 2.00
Use the income statement and balance sheet for the Lucky Manufacturing Inc. to answer
problems 3-14 through 3-26.
110
Problem 3-14 Liquidity Ratios

Compute the current ratio and the quick ratio for the Lucky Manufacturing Inc. for 1995
through 1997. What conclusion can be made regarding these ratios when compared to the
standard?
Problem 3-15 Accounts Receivable Ratios

Compute the accounts receivable turnover ratio and the average collection period for the
Lucky Manufacturing Inc. for 1996 and 1997. What conclusion can be made regarding
these ratios when compared to the standard?
Problem 3-16 Inventory Ratios

Compute the inventory turnover ratio and the average inventory period for the Lucky
Manufacturing Inc. for 1996 and 1997. What conclusion can be made regarding these
Problem 3-17 Total Asset Ratio

Compute the total asset turnover ratio for the Lucky Manufacturing Inc. for 1996 and
1997. What conclusion can be made regarding this ratio when compared to the standard?
Problem 3-18 Balance Sheet Debt Ratios

Compute the debt to asset ratio and the debt to equity ratio for the Lucky Manufacturing
Inc. for 1995 through 1997. What conclusion can be made regarding these ratios when
compared to the standard?
Problem 3-19 Coverage Debt Ratios

Compute the times interest earned ratio and the cash flow coverage ratio for the Lucky
Manufacturing Inc. for 1995 through 1997. Assume that $120,000 of principal repayment
is made each year. What conclusion can be made regarding these ratios when compared
to the standard?
Problem 3-20 Profitability Ratios

Compute the gross profit margin ratio, the operating profit margin ratio, and the net profit
margin ratio for the Lucky Manufacturing Inc. for 1995 through 1997. What conclusion
can be made regarding these ratios when compared to the standard?
111
Problem 3-21 Return on Assets Ratio

Compute the return on assets ratio for the Lucky Manufacturing Inc. for 1996 and 1997.
Divide the return on assets ratio into a total asset turnover ratio and a net profit margin
ratio. What conclusion can be made regarding these ratios when compared to the
standard?
Problem 3-22 Return on Equity Ratio

Compute the return on equity ratio for the Lucky Manufacturing Inc. for 1996 and 1997.
Compare the return on equity ratio with the return on asset ratio computed in problem 21
above. Why are the values different? What conclusion can be made regarding these
Problem 3-23 Market Ratio

Compute the earnings per share ratio, the earnings yield on common stock ratio, and the
price earnings ratio for Lucky manufacturing Inc. for 1995 through 1997. What
conclusions can be made regarding these ratios when compared to the standard?
Problem 3-24 Dividend Ratios

Compute the dividend yield on common stock ratio, and the dividend payout ratio for
Lucky Manufacturing Inc. for 1995 through 1997.

Complete a line item vertical analysis for the income statement of the Lucky
Manufacturing Inc. for 1995 through 1997.

Complete a line item vertical analysis for the balance sheet of the Lucky Manufacturing
Inc. for 1995 through 1997.
112
Cases
Case Study 3-1 Chesapeake College

Dr. George Heileg, provost of Chesapeake College, had just finished reading an article in
the Journal of Higher Education, which highlighted special ratios that could be more
appropriate for measuring the performance of nonprofit organizations like universities,
and social and medical agencies. Additionally, the article included some industry
standards for the ratios. The provost thought it would be a worthwhile exercise for the
controller of Chesapeake College to complete a financial statement analysis using these
specific ratios so he sent a copy of the article and ratios to Teri Black, the controller.
Ratio Computation Standard
Cash Ratio Cash and Equivalents/Current Liabilities 1.40
Cash Reserve Ratio Average Cash and Equivalents/Daily Expenses 55 Days
Donation Ratio Total Contributions/Total Revenues 0.64
Net Operating Ratio Total Surplus or Deficit/Total Revenue 0.06
Fund Balance Ratio Average Fund Balance/Total Expenses 0.89
Program Expense Ratio Total Program Expense/Total Expense 0.80
Support Services Ratio Total Support Service Expense/Total Expense 0.20
Teri liked the idea of analyzing the statements using the new ratios, and also suggested
trying several other ratios, which could be more appropriate for Chesapeake College.
These ratios would not have industry standards for comparison purposes but the ratios
could be compared over time within Chesapeake College.
Ratio Computation Standard
Tuition Ratio Total Tuition/Total Revenue
Fund Balance Return Total Surplus or Deficit/Average Fund Balance
Cash Liquidity Ratio Cash and Equivalents/Current Assets
Capital Structure Ratio Total Liabilities/Total Assets
Fund Balance Structure Restricted Fund Balance/Total Fund Balance
113
The financial statements for the last two years for Chesapeake College are presented
below. The balance sheet categories have been summarized and an extra year
representing beginning balances for 1995 is presented.
Chesapeake College
Statement of Activities and Fund Balance
For the Years Ended 1996 and 1995
(Dollars in Thousands)
Account 1996 1995
Revenues
Tuition and Fees $15,975 $14,105
Endowment 2,437 2,520
Gifts 540 778
Government Grants 1,824 2,046
Total Revenue $20,776 $19,449
Expenditures
Instruction $ 6,733 $6,548
Research 235 853
Academic Support 2,945 2,539
Student Services 3,011 2,858
Institutional Support 3,762 3,448
Educational Plant 1,495 2,206
Financial Aid 3,906 2,733
Total Expenditures $22,087 $21,185
Change in Fund Balance -1,311 -1,736
Fund Balance - Beginning of Year 3,159 4,895
Fund Balance - End of Year 1,848 3,159
114
Chesapeake College
Balance Sheet
December 31, 1996, 1995 and 1994
(Dollars in Thousands)
Account 1996 1995 1994
Assets
Cash and Equivalents $ 947 $ 1,360 $ 1,505
Other Current Assets 2,585 2,436 2,440
Total Current Assets 3,532 3,796 3,945
Land Buildings and Equipment 24,099 23,890 23,603
Total Assets $27,631 $27,686 $27,548
Liabilities
Current Liabilities 2,984 2,530 2,129
Long-Term Liabilities 22,799 21,997 20,524
Total Liabilities 25,783 24,527 22,653
Fund Balance
Unrestricted Fund Balance 598 1,959 3,795
Restricted Fund Balance 1,250 1,200 1,100
Total Fund Balance 1,848 3,159 4,895
Total Liabilities and Fund Balance $27,631 $27,686 $27,548
Required
A. Compute the 12 special ratios for Chesapeake College for 1995 and 1996.
B. Compare the performance of Chesapeake College with the industry standard for the
seven ratios given by the provost.
C. Comment on the overall performance for Chesapeake College for 1995 and 1996
based on the ratio calculations.
115
Case 3-2 Big Sky Resort and Conference Center
Big Sky Resort and Conference Center was started in 1953 by John Golie as a small
motel in Whitefish, Montana called the Mountain View Inn. As more people began
automobile traveling for vacationing, and the splendor of Waterton-Glacier International
Peace Park became known, there was a big demand for lodging in the area.
John, seeing the opportunity to start a good motel business, purchased a large prime piece
of property on Whitefish Lake with panoramic views of the mountains and sufficient land
for hiking and horse back riding. The property was also adjacent to the Whitefish State
Recreation Area, which provided ample opportunity for recreational activities.
The popularity of the motel was greater than expected, and John expanded from 20 units
to 100 units by 1975. He remained at that size until he turned over operations to his
daughter Jana in 1992. John had been content over the last fifteen years of the hotels
operation to keep it more of a family business. Many of the customers returned year after
year, and liked the small-sized, homelike environment. Also, there were plenty of other
motels that were started in the area, including national chains, which seemed to cover the
increased tourist demand. The hotel had provided John and his family a comfortable
living and lasting friends from the community and his customers.
When Jana took over the business in 1992 she saw a potential for growth and opportunity,
hopefully without sacrificing the family friendly environment that had been built up
during the last 40 years. The Mountain View Inn had this large track of prime land that
was still largely undeveloped. Also, with the popularity of snow skiing, and several lifts
in the immediate area, vacationing was becoming a year round business for Whitefish.
Another important factor was the expansion of the Glacier Park International Airport.
The airport made access to the area a reality for anyone in the United States in a matter of
hours.
Jana believed that an upscale resort and conference center to cater to the rich and famous
would be an instant success. The area offered many unique and exciting things to do all
during the year. The ski season started as much as a month earlier than the popular resorts
in Colorado and often could last a month later in the spring. There were opportunities to
view animals in the wild in the spring and fall, some of which were unique to the area.
Plus there was the popularity of the summer season with the rugged splendor of Glacier
National Park. Jana was sure that people in the upper middle class and above who
enjoyed unusual vacations and conferences would be drawn to the area.
Jana had no trouble convincing others of her ideas. Several prominent business people
from the local area as well as in the greater northwest wanted to invest in Jana’s proposal.
Jana would need a large influx of capital to build the new resort center and to develop
recreational activities on the property. This outside interest seemed to be the perfect
source of support. Jana could fulfill her vision without any extensive financial sacrifice
on the part of her family.
With advice from an investment firm, Jana concluded that the motel operation should go
public under the corporate name of Big Sky Resort and Conference Center. A successful
stock issue was made in 1993 with the Golie family retaining 51% of the voting shares.
The capital raised from the other investors along with some debt was used to build the
new eighty room resort and conference center plus amenities. Additionally, the original
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100 room motel was modernized and incorporated into the center. The original motel
was set at a somewhat lower scale so as not to price out many of the loyal customers who
were used to the Mountain View Inn.
Jana’s goal was to be able to offer vacation packages for anyone from middle income to
upper income from one night to one month. She also wanted to cater to organizations,
travel groups, and other professional associations for conventions and extended meetings.
There were enough activities available on the property and in the immediate vicinity to
encourage family attendance at the conventions, which would make the resort an even
more attractive promotion.
The resort and conference center opened on schedule in September 1994 just before the
start of the ski season and during the peak of leaf season. The operation was an instant
success and bookings quickly increased for much of the 1995 season. As word of the
resort spread and more organizations scheduled conferences, operations for 1996 and
1997 were also better than expected. All of this success led to some impressive revenue
and net income results for the first three years of operations. The outside investors who
had funded this project were also happy with the resort performance as reflected in the
price of the company stock.
The years had passed by very quickly since Jana had taken over operations, and she
wanted a chance to review the company’s performance during the last three years. She
had her accountant give her the financial statements for 1995 through 1997 for her
review.
Big Sky Resort and Conference Center
Income Statement
Numbers in $1,000s
ACCOUNT 1995 1996 1997
Sales Revenue $1,82 $2,46 $3,23
5 5 5
- Direct Room Expense 460 600 800
- Conference Expenses 550 980 1,345
- Other Operating Expenses 365 370 400
= Operating Income 250 305 470
= Net Income $ $ $
120 144 228
Earnings Per Share $1.00 $1.20 $1.90

Balance Sheet
December 31, 1995, 1996, & 1997
Numbers in $1,000s
ACCOUNT 1995 1996 1997
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Assets
Cash $ $ $ 100
50 60
Supplies 40 50 60
Total Current Assets 200 280 560
Land 350 350 350

Building (Net) 1,690 1,750 1,850
Furnishings (Net) 250 280 300
Total Assets $2,490 $2,660 $3,060
Liabilities and Equity

Total Current Liabilities 215 233 475
Mortgage Payable 400 480 500
Total Liabilities $ 615 $ 713 $ 975
Common Stock $1,800 $1,800 $1,800

Total Stockholders Equity $1,875 $1,947 $2,085

0 0 0
Market Price Per Share $32.00
$20.00 $25.00
Dividend Per Share $0.50 $0.60 $0.75

Numbers in $1,000s
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ACCOUNT 1995 1996 1997

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

A budget is a plan, preferably a written plan, which should reflect a company's goals and
objectives. In the order of the business strategic and tactical planning process, a budget
should operationalize the overall company strategy.
Budgets can be used to show how a company intends to acquire and use resources (a
capital budget), what its operations will be like for a period of time (master budget), its
projected financial performance (financial budget), and its acquisition and use of cash
(cash budget). For these budgets to be beneficial; however, they need to be consistent
with each other and consistent with the goals and objectives of the company.
While the budget preparation is an important phase of the planning process, the budget
also serves another important management function, that of control. Budgets can serve as
a standard which can be compared to actual performances and provide feedback regarding
the level of achievement of the company goals and objectives.
Statements have been made such as: "If you fail to plan, you plan to fail." and "If you
don't know where you are going, you will probably get there." These ideas underlie why
it is so important to implement the budget process. By completing a budget, a company is
following an organized process of quantifying their overall goals and objectives in a
written format. The very act of the budget process serves as a communication tool and
makes all interested participants aware of company goals.
The concept of a budgeting activity in order to be successful needs top management
support. Top management is responsible for developing the strategic plans and
identifying company goals and objectives. In order to see that these plans, goals and
objectives are reached, top management needs to convey these desires to the lower levels
of management. One of the best ways to communicate these desires of top management
is through the budget process. Top management support should be primarily for the
budget concept in general as opposed to the specifics and the mechanical procedures in
developing and implementing the budget.
The budget process needs cooperation and participation at all levels of management.
Frequently the levels of management closest to the operational activities of the company
have unique insight as to how goals and objectives can be most efficiently and effectively
accomplished. By allowing all levels of management to participate, a sense of ownership
develops and managers feel their importance. This participation process should certainly
increase the levels of motivation of those involved.
The budget is a communication tool both orally and in writing. For communication to be
effective, the sender needs to be sure that the receiver gets the correct message. The
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budget process needs to be timely, reasonably accurate, and understandable. Since the
budget is a plan for the future, absolute accuracy can never be assured. If for no other
reason, the very fact that the budget is a communication mechanism, makes its
implementation worthwhile. Any activity that promotes the communication process
within a company can have beneficial results.
A budget needs to be flexible. While a company may often present only one budget,
there needs to be an understanding that conditions can change and the budget may change
as well. Since the budget is a future plan it needs to be based on a variety of assumptions
and conditions. A static type budget quickly looses its relevance as assumptions and
conditions change. Management will lack confidence in the budget process if it is not
flexible in nature and responsive to new situations.
The control aspect of a budget is equally important as the planning aspect. Without
proper follow-up and feedback to the budget, an important aspect of the budget process is
lost. The follow-up procedure should be frequent, especially in times when there are
dramatic changes. Actions taken with regard to the follow-up should not just be limited
to the actual activities of the company but should consider possible modifications of the
budget itself.
The Budget Process

After top management identifies the company strategic plans and the resulting company
goals and objectives, a budget process should be developed to aid in the implementation
of the top management desires. Generally the controllers office oversees the budget
process. Standard operating procedures are developed and distributed to participating
managers.
A budget committee is often established through the controller’s office with
representation from all of the critical areas within the company. The purpose of the
committee is to establish policies and procedures for the implementation of the budget
process. Input and dialogue is encouraged from all of the representatives on the
committee to promote a fully participatory budget process. Timetables and documents
are developed to emphasize standardization and consistency in submissions by each
department. The budget review and approval process is also clarified.
The role of the accountant or financial manager is that of a facilitator or of providing
advice and expertise. The actual budget preparation needs to be done by the managers
responsible for their various functional areas. Budget submissions can be consolidated
through the controller’s office and moved to the next higher level for review and
approval. The accountant can also aid in the development of necessary financial
information to give credibility to the quantitative aspect of the submission.
The budget submission basically follows a bottom up approach in a participatory budget
process. Input starts at the lowest level of management reflecting the knowledge of those
managers closest to the actual operations and activities of specific functions. As the
submissions move up the levels of management they are reviewed and consolidated.
Once the budget reaches top management, final consolidation and approval is given.
Distribution of company resources in support of the budget follows a top down approach.
As the budget moves back down through the levels of management, resources are
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distributed in accordance with the approved budget. Managers at the lowest level should
be given resources consistent with approved budget submissions.
The budget process does not end with the distribution of resources. The implementation
of the budget is the beginning of the control phase of the budget process. Managers are
monitored and performance reports are developed to compare actual performance with
the predetermined standard as established by the budget. This form of feedback allows
top management to monitor how well the company is achieving its goals and objectives.
Corrective action may be taken as a result of the feedback in a variety of ways. Current
activities can be modified and budget standards can be changed to reflect the immediate
circumstances. As much as possible, these changes should be done in a positive manner
to prevent the implemation of a budget as a punitive tool.
The motivation associated with the budget process can be a very powerful factor. Top
management can establish a climate such that the motivations are positive and supportive
to management or the motivations can be negative and dysfunctional. A participative
management style and the use of Christian principles in management including servant
leadership practices can go a long way toward making the budget a positive motivational
experience. Keeping in mind that the budget is only a plan and that it does not have to be
"cast in stone" can also help the budget process. Flexibility and adaptability to various
situations, no two of which may be alike, should ease the tensions especially in relation to
performance evaluation.
Benefits of a Budget Process

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

A budget process can have some disadvantages especially if it is misunderstood or not
implemented properly. A budget:
1. can have dysfunctional impact on managers
2. can be used as an enforcement mechanism
3. may be ignored
4. may not be relevant to the current situation
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5. may not have total management support or commitment

6. may cater to the managers that cause the greatest outcry
7. may have unrealistic and unattainable goals
8. may be imposed on management without an opportunity for their input
9. process may not be understood
10. may be perceived as unfair especially in its performance evaluation phase
Types of Budgets
Master Budget
The master budget is a reflection of the operations of the company over a period of time.
Since the income statement summarizes the operation of the company over a period of
time, the ultimate form of the master budget will be a projection of the income statement.
The income statement begins with sales revenue, and that figure is the key component of
the master budget. Many of the activities of a business are dependent upon the level of
sales, and the master budget cannot be successfully completed until a sales figure is
determined.
Since the master budget is a plan for some future period of time, the sales figure cannot
be known with certainty. This uncertainty has an immediate impact on the accuracy of
the budget. To complicate the effort to forecast sales are the many variables and
assumptions both internally and externally which must be factored into the budget.
Critical assumptions that need to be considered when developing a budget include:
1. what is the state of the economy
2. what is the status of both existing and proposed product lines
3. what is the nature of competition in the industry
4. what is the impact of government taxes and regulations
5. what role does globalization and international activities have on the company
6. what is the proposed monetary and fiscal policy
7. what is the attitude of consumers
Sales forecasting, because of the many assumptions, can be a difficult process. Many
factors outside of the control of the company, such as consumer buying habits, and what
competitors are doing, can impact the level of sales. Internal considerations including
product mix, new product development, pricing and cost can all have an effect on the
proposed level of sales.
Past experience is often used as a starting point to project future annual sales.
Modifications are made based on the relevant assumptions and other factors that are
perceived to have an impact of sales. Sometimes forecasting models can be developed to
aid in the projection of sales; however, the models are only as good as the data and
assumptions used to develop the relationships.
Sales and marketing managers can be helpful in developing sales projections as these
managers are working with sales on a daily basis and are familiar with sales activities.
One needs to be cautious regarding sales estimates by determining any underlying
motivations for budget projections. Sales personnel can sometimes be overly optimistic
in sales forecasts, or bonus programs may encourage conservative estimates.
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Once sales forecasts are finished, the remaining components of the master budget can be
completed. The master budget follows the format of the income statement with the
development of the amount for cost of goods sold followed by other operating expenses
and then financial expenses. The production and purchasing schedules need to be
determined based on projected sales. These schedules also have an impact on the levels
of inventory and the amount of the cost of goods sold.
The purchasing schedule relates to raw materials used in the manufacturing process. The
projected ending balance of raw material inventory plus the raw materials used in the
production process equals the total budgeted amount of raw materials needed.
Subtracting the currently available raw materials (a beginning balance amount) away
from the raw materials needed leaves the amount of raw materials that need to be
purchased. The purchasing of raw materials has an impact on the inventory account and
the accounts payable account. See illustration 4-1.
Purchase Schedule
Illustration 4-1
Projected Ending Balance for Raw Materials $
10,000
+ Raw Material Used in Production
150,000
= Raw Material Desired
160,000
- Beginning Balance for Raw Materials 15,000
= Raw Material Purchases $145,00
0
The amount of raw materials needed in the production process depends on the projected
level of sales and the desired amounts of finished goods inventory. The same basic
procedure is used to compute a production budget. The costs to produce a finished
product include raw materials, labor costs, and manufacturing overhead. The projected
level of sales plus the forecasted ending balance of finished goods inventory equals the
total amount of finished product needed. Subtracting the finished goods available (the
beginning balance of finished goods inventory) from the total amount of finished goods
needed will equal the amount of finished goods that need to be produced. See illustration
4-2.
Production Schedule
Illustration 4-2
Projected Ending Balance for Finished Goods $

50,000
+ Finished Goods Sold
700,000
= Total Finished Goods Needed
750,000
- Beginning Balance for Finished Goods 40,000
= Production Level of Finished Goods $710,00
0
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Variable Cost
Illustration 4-3
Units of Volume 1,000 1,200 1,400 1,600 2,000
Total Variable $15,00 $18,00 $21,00 $24,000 $30,000
0 0 0
Variable $15 $15 $15 $15 $15
Cost/Unit
Graphical Representation
The production level of finished goods includes the raw material used in production from
the purchase schedule plus input of labor and manufacturing overhead costs.
This budgeted production schedule will aid in developing budgets for the entire
manufacturing process. Managers can make projections within their areas of
responsibility for levels of labor, amounts of materials and inventory, and amounts of
other manufacturing related expenses. Some of these costs will vary directly with sales or
production. A cost of this nature is classified as a variable cost. Variable costs have a
constant cost per unit and the total cost changes, as there is a change in volume like the
level of sales. For instance if a cost is identified at a variable rate of $15 per each unit of
sales and 1,000 units are sold the total cost will be $15,000. If 1,600 units are sold the
total cost will be $24,000. See illustration 4-3.
Fixed costs retain a constant total as levels of volume change. The cost per unit is not a
critical component in the fixed cost budget, but it declines as the level of activity
increases. As an example, if a fixed cost for an item is $20,000, when the sales level is
1,000 units the fixed cost per unit is $20. If the sales level increases to 1,600 units the
total fixed cost remains at $20,000 and the fixed cost per unit declines to $12.50. For
budgetary purposes the total fixed cost of $20,000 is the figure that would be included for
any calculations. See illustration 4-4.
The managers responsible for the occurrence of these costs can develop other operating
expenses for budgetary purposes. Each cost should probably be identified as fixed or
variable in its behavior so as to aid in the budget process should the level of activity
change. With changes in the levels of activity, the total variable costs included in the
budget will change, but the total fixed costs will not change.
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The completion of all revenues and expenses related to operating activities carries the
budget process through the net operating income on the income statement. Other
financing related revenues and expenses can be budgeted for and incorporated into the
income statement to complete this financial statement.
In generating budget figures for operating activities, managers will usually start with past
experience, or last year’s figures, and then make adjustments as deemed appropriate. The
greater the significance of the assumptions and projections the more difficult it will be to
forecast the projected budget figures. If the uncertainties are substantial, managers may
budget a range of values or present several discrete values depending on the conditions,
such as optimistic, most likely, and pessimistic. Flexible budgets can also be used in
situations where a high degree of variability is expected.
Flexible Budgets
A flexible budget is based on the behavioral characteristics of the accounts included in
the budget and some common measure of activity. The behavioral characteristics can be
divided into fixed and variable classifications, and the activity measure is frequently sales
volume. As the level of sales changes, the flexible budget recognizes this change with
appropriate changes in the totals of all of the variable cost items. The total fixed costs
will remain constant as long as the change in the activity remains within what is called a
relevant range. Eventually all costs both fixed and variable will change with changes in
activities but for fixed costs those changes occur when activities go beyond a relevant
range. A flexible budget process can be a very useful approach to budgeting as long as
the accounts can be reasonably classified according to behavior. As changes occur in the
levels of activities, a revised budget can be quickly established which serves as a more
appropriate standard for the new conditions. See illustration 4-5.
Formulas can be created which reflect the behaviors of the revenues and expenses
included in a flexible budget. Through the establishment of a series of formulas, flexible
budgets can be more easily developed and modified as situations cause changes in any of
the budget items. Formulas can be integrated into software programs and flexible
budgets can be developed virtually instantaneously.
Since revenues are defined to behave in a variable fashion with a constant selling price
per unit and a change in total with changes in levels of volume, the revenues can be
combined with variable costs to determine a contribution margin. Contribution margin
is simply sales revenue minus variable cost, and it can be recognized on a per unit basis
or a total cost basis. Contribution margin is sometimes recognized as the contribution to
fixed cost. Formula 4.1 identifies the contribution margin relationship.
Formula 4.1 CM/U = SP/U - VC/U

Contribution Margin Per Unit = Selling Price Per Unit - Variable Cost Per Unit
Definition of Variables
CM = Contribution Margin
SP = Selling Price
VC = Variable Cost
/U = Per Unit
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If the selling price per unit and the variable cost per unit are known, then the contribution
margin per unit is the difference between the two values. A total contribution margin can
be determined by multiplying the per unit value times a level of volume. The total
contribution margin amount is needed to complete the development of the flexible
budget. Formula 4.2 relates to the computation of net income before tax, which includes
the impact of fixed cost.
Formula 4.2 NIBT = (CM/U)V - FC
Net Income Before Tax = (Contribution Margin Per Unit)(Sales Volume) - Total Fixed
Cost
NIBT = Net Income Before Tax
FC = Fixed Cost
V = Volume
The net income before tax is based on a total dollar amount and is computed after the
total of all fixed and variable costs is deducted from total sales revenue. The only
remaining costs to be considered in the flexible budget is income tax. The amount on net
income is usually established as a rate based on the net income before tax. Formula 4.3
highlights the relationship between net income before tax and a final net income figure.
Formula 4.3 NI = NIBT(1.0 - TR)
Net Income = Net Income Before Tax(1.0 - Tax Rate)
NI = Net Income
TR = Tax Rate
These three formulas can be used to develop a flexible budget in its most basic form.
Revenue is defined according to a variable format, all costs are divided according to
behavior between variable and fixed, and tax expense is a rate based on net income before
tax. All of these relationships can be accounted for in a single flexible budget formula
4.4.
Formula 4.4 NI = [(SP/U -VC/U)(V) - FC](1.0 - TR)
Net Income = [(Selling Price Per Unit - Variable Cost Per Unit)(Sales Volume) - Total
Fixed Cost](1.0 - Tax Rate)
Formula 4.4 is a consolidation of formulas 4.1, 4.2, and 4.3. In order to compute net
income values will need to be known for the selling price per unit, the variable cost per
unit, a level of volume, the total fixed cost, and the tax rate. See Self-Study Problem 4-
1.
Simulation analysis takes place when one or more of the values of the variables change
and the impact of that change on net income is determined. As would be expected, net
income should increase with increases in the selling price per unit or increases in volume,
and net income should decrease with increases in variable cost per unit, total fixed cost
and the income tax rate. Frequently volume is the variable of change as a flexible budget
is used to determine levels of income at various levels of volume. Also, when
performance reports are developed, a meaningful comparison can only take place between
actual results and a predetermined budget when both are based on the same levels of
volume. A flexible budget will be developed after the fact using the same level of
volume as the actual results for comparison purposes. See Self-Study Problems 4-2
through 4-5.
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Fixed Cost
Illustration 4-4
Units of Volume 1,000 1,200 1,400 1,600 2,000
Total Fixed Cost $20,000 $20,000 $20,000 $20,000 $20,000
Fixed Cost/Unit $20.00 $16.67 $14.29 $12.50 $10.00
Graphical Representation
Financial Budgets
Financial budgets are basically the financial statements to include the income statement,
statement of retained earnings, and the balance sheet. The income statement is created
through the master budget, and as with the financial statements, the statement of retained
earnings and the balance sheet can be completed after the income statement.
In the completion of the budgeted retained earnings, the only additional information
needed beyond the income statement is the projected amount of dividends. Top
management will probably forecast expected dividend payments based on the current
level of dividends, the proposed level of net income, and a calculated dividend payout
ratio (the percent of earnings that will be paid out as dividends.)
Management will have a tendency to be conservative in the amount of dividends as a
precaution if earnings do not attain the budgeted level.
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Flexible Budget
Illustration 4-5
The income statement format requires that all revenue and expense items in the
income statement be classified according to behavior, as fixed or variable,
depending on their relationship to some measure of activity such as sales volume.
Sales Revenue Variable in nature (Selling Price/Unit x Sales Volume)

- Variable Manufacturing Cost (Variable Cost/Unit x Sales Volume)
- Variable Selling & Administrative Cost (Var Cost/Unit x Sales Volume)
= Contribution Margin (Variable Margin/Unit x Sales Volume)
- Fixed Manufacturing Cost (Constant in Total Dollars)
- Fixed Selling & Administrative Cost (Constant in Total Dollars)
= Net Income Before Tax
- Income Tax (Net Income Before Tax x Tax Rate)
= Net Income
See the Self-Study Problems 4-1 through 4-5 at the end of the chapter for
examples of flexible budget problems.
The budgeted balance sheet requires budget projections for all of the permanent accounts,
assets, liabilities, and equity. This is the final budgeted statement that can be completed
because the balances in the appropriate accounts depend on the results of all of the other
budgets. Particular attention needs to be given to the ending cash balance, which will be
determined through the cash budget. Also, the company will need accurate projections
for long-term assets. The capital budgeting process will help in determining the levels of
long-term assets. Once long-term assets have been identified, the means of funding those
assets with long-term liabilities, preferred stock, common stock, or retained earnings, or
combinations of these sources of funds will need to be established. Part of the capital
budgeting process along with a concept called optimal capital structure will assist in
determining the proper mix of funds.
Capital Budget
The capital budgeting process is specifically directed toward long-term assets. Specific
projects are identified that have time periods of greater than one year. The concept of
time value of money needs to be integrated into the capital budgeting process for a proper
analysis of the projects. These capital budgeting projects tend to be very large in scope
such as a new product line, or a new plant. The projects usually involve several areas of
management and require a combined effort such as a project team to develop a budget
request.
As with other budget requests, which involve estimates into the future, the capital
budgeting request is subject to even greater uncertainties, because of the longer time
period involved and the uniqueness of the projects. Capital budgeting projects often are
forecasted for five or more years into the future. The projected revenues and expenses
and other possible capital costs can be very hard to determine. Also, the uniqueness of
the projects makes it difficult to rely on past experience as a basis for the projections of
future costs.
129
Since capital budgeting projects involve such significant use of resources, their success or
failure could have a major impact on the overall results of the company. Additionally,
those managers responsible for the development of the capital budgeting projects may be
promoted or long gone before the final results from the project are known. Subsequent
managers are often left to pay for their previous manager’s mistakes. With this potential
lack of accountability and the size of the capital budgeting projects, top management has
to impose very careful criteria and insist on the most sophisticated methods in the capital
budgeting process. A detailed discussion of capital budgeting will be presented in
Chapter 14.
Cash Budgets
Concern about a company's liquidity and especially its cash position is critical. There can
be no substitute for cash in the payment of liabilities or the payment of dividends.
Company's can appear sound financially with regard to their debt ratios, profitability, and
even liquidity ratios but still be in a poor cash position. The importance of the level of
cash at any point in time makes it necessary to have a comprehensive cash budget
procedures. The process of monitoring actual activities through a cash flow statement
and cash management techniques will be covered in detail in Chapters 7 and 8.
The cash budget process involves projected cash receipts and cash disbursements along
with a desired ending balance by time period (usually monthly) and a financing or
investing section. The format of the cash budget adds cash receipts to a beginning cash
balance to give the amount of cash available. Cash disbursements are deducted from the
available cash to give an ending cash balance. The ending cash balance is compared to a
minimum desired balance to determine any surplus or shortage in cash. Projected
shortages in cash are covered with short-term borrowing arrangements, and projected
surpluses in cash are available for investing in marketable securities. See illustration 4-6.
Frequently the receipt or disbursement of cash is delayed from its related revenue or
expense. When a sale is made on account, the revenue is recognized; however, the cash is
not collected until the customer pays the account receivable. This delay in cash receipts
must be reflected in the cash budget so that the figures can be tied into the sales revenue
amounts in the master budget. Estimates are generally made regarding the time it takes to
collect on accounts receivable and that factor is processed into the cash budget. There
may be a similar delay in cash disbursements when the company purchases items on
credit. The expense is recorded at the time of purchase and the cash disbursement is
recorded at a later time when the liability is paid.
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Cash Budget
Illustration 4-6
Dar Ya Enterprises
Cash Budget
For the Year 1996
Beginning Balance
+ Cash Receipts
Cash Sales
Collection of Receivables
= Total Cash Available
- Cash Disbursements
Cash Expenses
Payments of Payables
- Desired Minimum Cash Balance
= Cash Surplus or Shortage
+ Financing
+ Borrowing
- Repayments plus Interest
- Investing
= Ending Balance
See the Self-Study Problem 4-6 at the end of the chapter for an example of the
cash budget process.
Illustration 4-7 presents an example of the cash receipts by month. The first exhibit
identifies the projected amount of dollar sales in cash and on credit by month for a five
month period of time. The cash sales will represent cash receipts in the same month;
however, there will be a delay between the credit sale and the collection of accounts
receivable. The second exhibit represents an estimate of how long it will take to collect
accounts receivable. The exhibit indicates that 50 percent of the credit sales are expected
to be collected about 30 days after the sale. The total percent collected adds up to only 98
percent of the total accounts receivable. The remaining 2 percent represent bad debts that
are not expected to be collected.
The percent values from the second exhibit are applied to the credit sales amounts to
establish the third exhibit, which summarizes the collection of credit sales. For instance 8
percent of the January credit sales, or $8,000, will be collected three months after the sale.
This exhibit still does not identify the specific month for the cash collections. The final
exhibit summarizes the cash collections by month. Cash sales would be in the same
month. The lagging process from the collection of accounts receivable is appropriately
summarized. For instance, the $8,000 of January sales on account collected three months
later is included in the April cash collections. Total cash collections would represent the
cash receipts in a cash budget.
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Cash Receipts Activities

Illustration 4-7
Dollar Sales by Month
Month Cash Credit
January $10,000 $100,000
February $12,000 $120,000
March $10,000 $ 90,000
April $14,000 $150,000
May $15,000 $140,000
Collection of Accounts Receivable Schedule

Month of One Month Two Months Three Months
Month Sale After Sale After Sale After Sale
Percent
Collected 25% 50% 15% 8%
Collection of Accounts Receivable

Total Collect 25% Collect 50% Collect 15% Collect
Month Credit Month of 1 Month 2 Months 8%
Sales Sale Later Later 3 Months
Later
January $100,000 $25,000 $50,000 $15,000 $ 8,000
February $120,000 $30,000 $60,000 $18,000 $ 9,600
March $ 90,000 $22,500 $45,000 $13,500 $ 7,200
April $150,000 $37,500 $75,000 $22,500 $12,000
May $140,000 $35,000 $70,000 $21,000 $11,200
132
Cash Collections by Month

Month January February March April May
Cash Sales $ 10,000 $ 12,000 $ 10,000 $ 14,000 $ 15,000
Accounts
Receivable
25% in the
Same Month 25,000 30,000 22,500 37,500 35,000
50% in the
First Month 50,000 60,000 45,000 75,000
After Sale
15% in the
Second Month Payment of Accounts Payable
15,000 18,000 13,500
After Sale Pay in 40% Pay 50% Pay 10%
Month
8% in the Total Current One Two
Third Month Payment Month Month 8,000Months9,600
After Sale Later Later
January
Total Cash $40,000 $16,000 $20,000 $ 4,000
February
Collection $30,000
$ 35,000 $12,000
$ 92,000 $107,500 $122,500 $ 3,000
$15,000 $148,100
March $50,000 $20,000 $25,000 $ 5,000
April $60,000 $24,000 $30,000 $ 6,000
May $35,000 $14,000 $17,500 $ 3,500
Cash Payments by Month
Month January February March April May

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

with the cash receipts activities presentation, four exhibits are used in a step by step
133
process to determine cash disbursements. The occurrence of expenses by month does not
necessarily represent the cash payment of those expenses in the same month. The
creation of a payables account related to an expense means that the cash payment will be
delayed. The first exhibit summarizes the cash and credit expenses by month. The
second exhibit summarizes the time delay in the percent of accounts payable payments.
The percentages total 100 percent, which assumes the company, will pay in full all
accounts payable obligations.
The dollar amount of monthly payables in the first exhibit is multiplied by the percent
values in the second exhibit to generate dollar amounts of cash payments. For instance,
10 percent of January payables ($40,000 x .10 = $4,000) are paid two months later. This
third exhibit does not classify the cash payables by month. The final exhibit summarizes
the cash payments as well as the payment of accounts payable by month. The $4,000 of
January payables paid two months later shows up as a cash disbursement in March. The
sum of the cash payments by month would appear in the cash disbursement section of the
cash budget. See Self-Study Problem 4-6.
Illustration 4-9 shows a cash budget with summary information from cash receipts and
cash disbursements schedules.
Illustration 4-9
Dar Ya Enterprises
Cash Budget
January - May, 1996
Month Jan Feb Mar Apr May
Beginning Cash Bal $ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 10,000

Plus Cash Receipts 35,000 92,000 107,500 122,500 148,100
Total Cash Avail 45,000 102,000 117,500 132,500 158,100
Less Cash 56,000 77,000 89,000 92,000 109,000
Disbursement
Less Desired Min 10,000 10,000 10,000 10,000 10,000
Balance
Equals Surplus or -21,000 15,000 18,500 30,500 39,100
Shortage
Plus Cash 21,000 0 0 0 0
Borrowed
Less Cash Repaid* 0 15,000 6,270 0 0
Less Cash Invested 0 0 12,230 30,500 39,100
Ending Cash
Balance $ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 10,000
134
*Note: The total interest expense for the borrowed funds equals approximately $270.
The calculation of interest expense is $15,000 x .12 x 1/12 = $150 + $6,000 x .12 x 2/12
= $120.
The financing section of a cash budget identifies any potential cash surplus or shortage in
the ending balance. Generally a minimum cash balance is desired as a safety measure to
insure that the company has cash in the event of unforeseen fluctuations in the cash
balance. If the amount of cash disbursements plus the minimum desired balance exceed
the beginning balance plus the amount of cash receipts, a cash shortage exists. When the
total cash available exceeds the total cash needs, there is a cash surplus. The financing
section of the cash budget identifies the time periods of surplus and shortage and
identifies when the company may need (1) to borrow, (2) make a repayment of loans plus
interest, (3) make any short-term investments, and (4) the use of previous investments to
cover subsequent shortages.
Summary
The budgeting process is an important activity for the management functions of planning
and control. Companies with a sound budget process have a natural means of
communicating strategic plans and company goals and objectives throughout the
organization.
Budgeting has a large behavioral component. The use of a participative budgeting
process and a servant leader style of management can result in positive responses from
the managers involved in the budget process.
Various budgets can be developed which when completed will reflect projected financial
statements.
135
Self-Study Problems
Use the following flexible budget and flexible budget formulas to complete Self-Study
problems 4-1 through 4-5.
Dar Ya Enterprises
1996 Flexible Budget
Projected Sales 100,000 Units
Sales $1,500,00
0
- Variable Manufacturing Cost
1,000,000
- Variable Selling & Administrative Cost 50,000
= Contribution Margin 450,000
- Fixed Manufacturing Cost 160,000
- Fixed Selling & Administrative Cost 200,000
- Income Tax Expense 36,000
Flexible Budget Formulas

Contribution Margin Per Unit = Selling Price Per Unit - Variable Cost Per Unit
Formula 4.1 CM/U = SP/U - VC/U
Net Income Before Tax = (Contribution Margin Per Unit)(Sales Volume) - Total Fixed
Cost
Formula 4.2 NIBT = (CM/U)V - FC
Net Income = Net Income Before Tax(1.0 - Tax Rate)
Formula 4.3 NI = NIBT(1.0 - TR)
Net Income = [(Selling Price Per Unit - Variable Cost Per Unit)(Sales Volume) - Total
Fixed Cost](1.0 - Tax Rate)
Formula 4.4 NI = [(SP/U -VC/U)(V) - FC](1.0 - TR)
Formula 4.4 is a consolidation of formulas 4.1, 4.2, and 4.3.
136
Self-Study Problem 4-1 Flexible Budget Formulas

Determine the amounts of the variables in the flexible budget formulas for Dar Ya
Enterprises.
137
Self-Study Problem 4-1 Solution Flexible Budget Formulas
Selling Price Per Unit SP/U
Sales Dollars $1,500,000 = $15.00/Unit

Sales Volume 100,000
Variable Cost Per Unit VC/U

Total variable cost equals the sum of the variable manufacturing cost plus the variable
selling and administrative cost; i.e., $1,000,000 + $50,000 = $1,050,000.
Variable Cost $1,050,000 = $10.50/Unit

Sales Volume 100,000
Total Fixed Cost FC

Total fixed cost equals the sum of the fixed manufacturing cost plus the fixed selling and
administrative cost; i.e., $160,000 + $200,000 = $360,000.
Income Tax Rate TR
Income Tax Expense $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/U
Formula 4.2 (CM/U)(V) - FC = NIBT
($4.50/U)(100,000) - $360,000 = $90,000
Formula 4.3 NIBT(1.0 - TR) = NI
$90,000(1.0 - .40) = $54,000
Formula 4.4 [(SP/U -VC/U)(V) - FC](1.0 - TR) = NI [($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
138
Self-Study Problem 4-2 Construct a flexible budget for 120,000 units of sales.
139
Self-Study Problem 4-2 Solution Construct a flexible budget for 120,000 units of
sales.

$15/U - $10.50/U = $4.50/U
($4.50/U)(120,000) - $360,000 = $180,000
$180,000(1.0 - .40) = $108,000
Formula 4.4 [(SP/U -VC/U)(V) - FC](1.0 - TR) = NI
[($15/U - $10.50/U)(120,000) -$360,000](1.0 - .40) = NI
[($4.50/U)(120,000) - $360,000](.60) = NI
[$540,000 - $360,000](.60) = NI
[$180,000](.60) = $108,000 = Net Income
Dar Ya Enterprises
Sales $1,800,000
- Variable Manufacturing Cost 1,200,000
= Net Income 108,000
The company would favor the option proposed by the sales manager because the net
income would increase from the current $54,000 to $108,000.
140
Self-Study Problem 4-3 Find a break even level of sales.

What is the break even level of sales volume. Hint: What level of sales volume will give
a net income of zero.
141
Self-Study Problem 4-3 Solution Find a break even level of sales.

[($15/U -$10.50/U)(V) - $360,000](1.0 - .40) = 0 = NI
[($4.50/U)(V) - $360,000](.60) = 0 = NI
($2.70/U)(V) - $216,000 = 0 = NI
V = $216,000
$2.70/U
V = 80,000 units of sales
Dar Ya Enterprises
Sales $1,200,000
- Variable Manufacturing Cost 800,000
- Income Tax Expense 0
= Net Income 0
142
Self-Study Problem 4-4 Simulation Analysis

Complete a new flexible budget if the selling price per unit is dropped to $14, and the
level of sales increases to 105,000 units. Would Dar Ya Enterprises prefer to make these
changes over the original flexible budget?
143
Self-Study Problem 4-4 Solution Simulation Analysis

$14/U - $10.50/U = $3.50/U
($3.50/U)(105,000) - $360,000 = $7,500
$7,500(1.0 - .40) = $4,500
[($14/U - $10.50/U)(105,000) -$360,000](1.0 - .40) = NI
[($3.50/U)(105,000) - $360,000](.60) = NI
[$367,500 - $360,000](.60) = NI
[$7,500](.60) = $4,500 = Net Income
Dar Ya Enterprises
Sales $1,470,000
= Net Income 4,500
Dar Ya Enterprises would not want these proposed changes as net income declines from
$54,000 to $4,500.
144
Self-Study Problem 4-5 Simulation Analysis

The sales manager proposes that if the selling price of the product is reduced to $14 and if
the fixed advertising expense is increased by $100,000, the total sales volume will be
increased from 100,000 units to 140,000 units. Should management make the change?
145
Self-Study Problem 4-5 Solution Simulation Analysis

$14/U - $10.50/U = $3.50/U
($3.50/U)(140,000) - $460,000 = $30,000
$30,000(1.0 - .40) = $18,000
[($14/U - $10.50/U)(140,000) -$460,000](1.0 - .40) = NI
[($3.50/U)(140,000) - $460,000](.60) = NI
[$490,000 - $460,000](.60) = NI
[$30,000](.60) = $18,000 = Net Income
Dar Ya Enterprises
Sales $1,960,000
= Net Income 18,000
146
Self-Study Problem 4-6 Cash Budget

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

Cash Receipts $35,000 $92,000 $107,500 $122,500 $148,100
Dar Ya Enterprises
Cash Disbursements Schedule
January - May, 1996
(From Illustration 4-8)

Cash Disbursements $56,000 $77,000 $89,000 $92,000 $109,000
147
Self-Study Problem 4-6 Solution Cash Budget
Dar Ya Enterprises
Cash Budget
January - May, 1996

Beginning Cash $ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 10,000
Balance
Plus Cash Receipts 35,000 92,000 107,500 122,500 148,100
Total Cash 45,000 102,000 117,500 132,500 158,100
Available
Less Cash 56,000 77,000 89,000 92,000 109,000
Disbursement
Less Desired Min 10,000 10,000 10,000 10,000 10,000
Balance
Equals Surplus or -21,000 15,000 18,500 30,500 39,100
Shortage
Plus Cash 21,000 0 0 0 0
Borrowed
Less Cash Repaid* 0 15,000 6,270 0 0
Less Cash Invested 0 0 12,230 30,500 39,100
Ending Cash
Balance $ 10,000 $ 10,000 $ 10,000 $ 10,000 $ 10,000
*Note: The total interest expense for the borrowed funds equals $270. The calculation of
interest expense is ($21,000 - $15,000) x .12 x 2/12 = $120 + $15,000 x .12 x 1/12 =
$150.
148
Problems
Problem 4-1 Cost Behavior
RuDee Company has determined that at a volume of 120,000 units of sales, the total fixed
cost will be $900,000 and the total variable cost will be $720,000.
Required:
Compute the total variable cost and the variable cost per unit, and the total fixed cost and
the fixed cost per unit for the following levels of sales volume.
Note: Assume that all levels of sales volume are within the relevant range.
Volume 100,000 115,000 130,000 145,000

Total Variable
Cost
Variable Cost
Per Unit
Total Fixed
Cost
Fixed Cost Per
Unit
Problem 4-2 Behavior Patterns

RDR Enterprises determined that at a level of sales volume of 50,000 units, the selling
price per unit was $20, the variable cost per unit was $12, and the fixed cost per unit was
$5.
Required:
Compute a budgeted income statement for RDR Enterprises at a level of sales activity of
60,000 units. The income tax rate is 40 percent.
Problem 4-3 Contribution Margin

RD Inc. has the following revenues and expenses for 1,000 units of sales:
sales $5,000
fixed administrative 300
fixed manufacturing 900
variable administrative 700
variable manufacturing 2,000
Required:
Compute the total contribution margin and the contribution margin per unit for 1,000
units of sales, and for 1,200 units of sales.
Use the following flexible budget for Dar Ya Enterprises to answer problems 4-4
through 4-10.
Dar Ya Enterprises
1997 Flexible Budget Income Statement
Sales $1,750,000
149

= Net Income 120,000
Problem 4-4 Flexible Budgets

Using the 1997 Dar Ya Enterprises’flexible budget, compute the flexible budgeting
formulas for contribution margin, net income before tax, net income and the combination
formula for net income.
Problem 4-5 Flexible Budgets
Using the 1997 Dar Ya Enterprises’flexible budget, construct flexible budget income
statements for 50,000 units and 80,000 units of sales volume.
Problem 4-6 Breakeven Volume

Using the 1997 Dar Ya Enterprises’flexible budget, determine the breakeven level of
sales activity.
Problem 4-7 Simulation Analysis

The financial manager suggests that the unit selling price for Dar Ya Enterprises’product
be increased by $5. This increase will result in a decrease in sales volume by 10,000
units to 60,000 units. Should Dar Ya Enterprises make the change suggested by the
financial manager?
150

The sales manager would like to increase the fixed advertising cost by $500,000 for Dar
Ya Enterprises. The manager believes that the increase in promotion efforts will result in
an increase in sales volume by 15,000 units. Should Dar Ya Enterprises make the change
suggested by the sales manager?

The production manager would like to improve the automation process in the production
of the product which will increase fixed cost by $250,000. The change in automation will
reduce the variable cost by $4 per unit. Should Dar Ya Enterprises make the change
suggested by the production manager?

The president would like to reduce the selling price by $2 per unit. How much would the
sales volume have to increase to make the company indifferent between the current
selling price per unit and the presidents proposed selling price per unit?
Problem 4-11 Purchase Schedule

WinD Company wanted to determine the amount of materials that needed to be purchased
this month for the production process. The company currently has $20,000 in material
inventory and desires to have $25,000 in ending inventory. During the month production
requirements should equal $300,000 worth of materials.
Required:
Compute the dollar amount of material purchases for the month for WinD Company.
Problem 4-12 Purchase Schedule

MAT Corporation needed to determine the amount of materials that needed to be
purchased this month for the production process. The company currently has 15,000
pounds of material in beginning inventory and desires to have 18,000 pounds in ending
inventory. During the month the company expects to produce 40,000 units each of which
requires 4 pounds of material. The cost of material is $3.00 per pound.
Required:
Compute the unit and dollar amount of material purchases for the month for MAT
Corporation.
Problem 4-13 Production Schedule

MAT Corporation needed to determine the level of production of finished goods for the
month. The anticipated sales for the current month are 70,000 units, and for next month
is 75,000 units. The company desires to maintain an ending inventory of finished goods
equal to 10 percent of the next month’s sales volume. The current beginning inventory of
finished goods is just 6,000 units. The cost of the product is $8.00 per unit and the selling
price is $15.00 per unit.
Required:
151
Compute the unit and dollar amount of finished goods production for the month for MAT
Corporation.
Problem 4-14 Purchase and Production Schedule

WinD Company has a beginning balance of raw materials of $8,000 and desires an
ending balance of $10,000. During the month, $30,000 of raw materials will be used in
the production process along with $50,000 of labor cost and $25,000 of overhead costs.
The finished goods inventory account has a beginning balance of $15,000 and the
company desires an ending balance of $20,000.
Required:
Compute the dollar amount of raw materials purchased and the dollar amount of finished
goods sold during the month.
152
Use the following cash receipt information to answer problems 4-15 through 4-16.
Cash Receipts
Month Cash Credit
January $15,000 $160,000
February $12,000 $150,000
March $20,000 $180,000
April $24,000 $200,000
May $25,000 $240,000

Month Month of One Month Two Months Three Months
Sale After Sale After Sale After Sale
Percent
Collected 30% 40% 20% 8%
Problem 4-15 Collection of Accounts Receivable

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

Compute the dollar amounts of cash collections for the months of January through May.
153
Use the following cash disbursement information to answer problems 4-17 through 4-
18.
Cash Disbursements
Dollar Expenses by Month
Month Cash Payable
January $50,000 $100,000
February $40,000 $85,000
March $65,000 $120,000
April $60,000 $160,000
May $70,000 $130,000
Payment of Accounts Payable Schedule
Month Month of One Month After Two Months After

Purchase Purchase Purchase
Problem 4-17 Payment of Accounts Payable

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

Compute the dollar amounts of cash payments for the months of January through May.
154
Use the following information on cash receipts and cash disbursements to answer
problems 4-19 through 4-21. The interest rate on any borrowed funds is 12% annually
or 1% per month.
Dar Ya Enterprises
Cash Receipts Schedule
January - May, 1996
Cash Receipts $100,000 $92,000 $130,500 $145,500 $150,000
Dar Ya Enterprises
Cash Disbursements Schedule
January - May, 1996
Cash Disbursements $106,000 $100,000 $120,000 $125,000 $160,000
Problem 4-19 Cash Budget

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

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

Assume the desired minimum cash balance is $20,000 and the cash balance on January 1,
1996 is only $15,000. Develop a cash budget for Dar Ya Enterprises for January to May
1996.
155
Problem 4-22 Financing Section of Cash Budget

Given the monthly surplus or shortage amounts, determine the amount of cash that must
be borrowed, repaid, or invested each month. Interest on borrowed funds equals 1.0% a
month.
Cash Budget Financing Section
Surplus or
Shortage -$9,000 $12,000 -$5,000 $8,000 $10,000
Plus Cash
Borrowed
Less Cash Repaid
Less Interest
Repaid
Less Cash Invested
Problem 4-23 Comprehensive Cash Budget

Use the following schedules to construct a cash budget for the months of January through
May for DAR Corporation. The interest rate on any borrowed funds is 12 percent
annually or 1 percent per month. The cash balance on January 1, 1997 is $25,000 and the
minimum desired cash balance is $12,000.
Cash Receipts
Month Cash Credit
January $35,000 $100,000
February $30,000 $130,000
March $50,000 $190,000
April $40,000 $200,000
May $45,000 $240,000
156

Month Month of One Month Two Months Three Months
Sale After Sale After Sale After Sale
Percent
Collected 20% 40% 25% 10%
Cash Disbursements
Month Cash Payable
January $40,000 $100,000
February $30,000 $110,000
March $50,000 $120,000
April $40,000 $150,000
May $60,000 $210,000
Payment of Accounts Payable Schedule

Month Month of One Month After Two Months After
Purchase Purchase Purchase
157
Cases
Case Study 4-1 Harvest Church Budget

Harvest Church wanted to develop a budget for presentation at its annual membership
meeting next month. The church had only been organized for two years and had
experienced a rapid growth. The church pastor and leadership had never developed a
budget before, but they realize that at their current level of expansion, they will need a
budget to maintain financial accountability. The leadership would also like to start a
building program within the next year, and lending institutions will require financial
records before approval can be gained for any capital acquisitions.
Weekly deposit records were maintained that showed the amount of offerings from the
membership. The monthly offering and church attendance are summarized as follows:
Month Offering Attendance
January $20,250 440
February $18,430 415
March $21,375 450
April $20,840 465
May $22,625 485
June $25,120 505
July $23,660 490
August $22,380 475
September $27,775 525
October $28,490 540
November $30,825 550
December $29,650 605
158
Current expenses are primarily related to salaries. The church has one senior pastor, an
assistant pastor, and a youth pastor. There is also a full time secretary on staff. Other
administrative types of expenses are listed as follows.
Expense Item Annual Amount
Senior Pastor Salary Plus Benefits $ 50,000
Assistant Pastor Salary Plus Benefits $ 35,000
Youth Pastor Salary Plus Benefits $ 30,000
Secretary Salary Plus Benefits $ 21,000
Office Supplies $ 23,000
Utilities and Telephone $ 9,600
Sunday School Supplies $ 7,400
Church Supplies $ 16,200
Rental $ 48,000
The church leadership wants to put $100,000 toward a building fund at the end of the
year. At the start of this current year, there was a fund balance of $20,000, which was not
designated for any purpose but served as a reserve for emergency purposes. There will be
a campaign next year to secure donations of $250,000 for the beginning of the building
process. Currently a small church was for sale that had sufficient land for parking and
some expansion. The market price for this building and land is $500,000. Also, there is
vacant property available in the immediate area. The asking price for the land ranged
from $100,000 to $300,000.
The pastor was concerned about extending the membership in their giving. If too much
emphasis was put into a building program, contributions to the general operations may
diminish. Also, the undertaking of a building program may curtail growth, as new
members will not want to join a church that is involved in major fund raising for a new
building. Never the less, the membership was growing, and the leadership believed that
the church attendance would grow by 20 percent next year, and the rate of giving would
only drop by about 3 percent per attendee, plus the building fund goal could be reached.
Salaries and benefits would increase by 4 percent next year, and an additional pastoral
staff member would need to be hired at a rate of about $25,000 including benefits. Also,
the leadership stressed the importance of a part time office administrator/bookkeeper.
Since the position would be part time, benefits would be minimal, and the pastor thought
a person could be hired for 20 hours a week at $9 per hour.
Office expenses would increase by 10 percent next year to support the anticipated growth.
Utility and telephone expenses would increase by 14 percent. The senior pastor felt it
was very important to improve the Sunday school program and other activities by the
church to encourage active participation by the membership. A 30 percent increase was
proposed for Sunday school and church supplies.
The landlord also notified the church that there would be a 10 percent increase in the
rental rate. The church was located in a prime area of development and the facility could
easily be converted into office space which could provide even higher rental rates. The
leadership believed that the landlord would apply increased pressure to get the church to
move out and that the rental rates would continue to increase significantly every year.
Also, with the anticipated growth, the current rental facilities would not be sufficient as
there is already overcrowding.
159
Required:
A. Determine the anticipated revenue from contributions for Harvest Church for next
year. Show how you computed the revenue figure.
B. What are the possible problems the church could face in relying on revenues from
membership contributions?
C. Construct a budget for the anticipated expenses for next year.
D. Can the church meet its goal of $100,000 for the building fund at the end of the
current year? at the end of next year based on budget projections?
E. Since Harvest Church is a nonprofit organization, discuss the role and importance of
the fund balance. Can or should these funds be used for the building fund?
F. How should the church monitor and account for its building fund campaign? If there is
a shortage in either the operating funds or building funds, can excesses from the other
fund be used to cover the shortages?
160
Case 4-2 Charlie’s Country to Classic to Chamber Music Store
Charlie Kile, a noted business professor, decided that he had had enough of the “publish
or parish” environment at a prestigious university. As much as he had enjoyed the
university setting and working with college students, he had always wanted to use his
business expertise to run his own business. Charlie also had musical talent. He could
play several instruments and was always in a band during his days as a college student. In
fact, Charlie subsidized a good portion of his college expenses by performing at
everything from college fraternity parties to funerals.
A music store was a natural business for Charlie to own. He had the business sense, and
could use his musical skills to encourage and help children develop their talents. In a way
he could still be a teacher and not have to publish journal articles. Maybe now he would
use his spare time for writing music versus articles.
Charlie wanted to remain in a college town because of the overall academic environment
and the general appreciation of the arts. He also found that parents were more supportive
of having their children learn musical instruments. Since he was somewhat already well
known in his hometown of Cleveland, Tennessee, Charlie decided to open a music store
in their new shopping center just a few blocks from the local university. Even though
there were other music stores in the area, Charlie’s personality, business skills and
musical talent made him an instant hit with the kids from junior high to college. The
business prospered.
To encourage children to try to learn how to play an instrument Charlie offered a very
generous instrument purchase plan. An instrument could be purchased for 10% down for
a 90-day trial period. After 90 days, the instrument could be paid for in nine equal
installments. It would be one year before the instrument would be paid for in full. If,
after the 90-day trial period, the customer did not want the instrument, the 10% down
payment would be refunded in full if the instrument was still in like new condition.
Charlie took a risk with this promotion. Customers could return a damaged instrument
after 90 days that would cost much more to repair than the 10% down payment. Charlie
believed, however, that if he were good to the customers, they would be good to him.
There were two time periods when there was a big demand for musical instruments,
September, with the start of the school year, and December for the holidays. A large
amount of his instrument sales occurred during these two months. Essentially all of his
customers took advantage of his generous payment plan. Charlie also sold music supplies
and materials. Those sales were on a cash basis and relatively uniform during the year.
Charlie purchased his instruments from various music instrument companies and
distributors. To meet expected demand, the majority of the purchases were in July and
October. The instrument companies needed a 30 day lead time on the purchase order, and
they generally required payment in full 60 days after the order had been made. The
instruments would be shipped or personally delivered to Charlie from 2 to 5 weeks after
his purchase order. Music supplies and materials were ordered from wholesalers and had
to be paid for 30 days after their receipt.
Charlie was able to get away on a vacation for the first time in two years in April. He
figured it was a good time to evaluate how the business was going before the busy season
started up again in late summer. The business had shown good growth and satisfactory
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profits, but his cash flow seemed tight, and he has had to rely on a line of credit from the
local banker. The interest charges have cut into his profit margin. He would like to
improve his cash flow so that he does not have to depend on the line of credit.
Charlie decided to project his cash and credit sales for the next 20 months along with his
purchases and other expenses. He currently has a cash balance of $5,000, which is at a
minimum, and an outstanding balance on the line of credit of $25,000. He has to pay
1.5% per month on the outstanding balance. Also, the balance due on accounts receivable
is $48,000, and the balance due on accounts payable is $2,000. Assume that $960 of the
account receivable balance will be paid back to customers returning instruments. The
remaining $47,040 will be received in equal installments of $3,920 over the next twelve
months. Charlie believes that all of his accounts receivable will be collected. However,
20% of all instrument sales will be returned for refunds after 90 days. The current
accounts payable balance will be paid in the following month. In the future, 20% of
purchases on account are paid in the same month of purchase and 80% of purchases on
account will be paid in the following month.
Required
A. Set up a monthly cash collection schedule of accounts receivable for Charlie’s music
store for the next 20 months.
B. Develop a total cash receipts schedule for Charlie’s music store for the next 20
months.
C. Set up a monthly cash payment schedule for accounts payable for Charlie’s music
store for the next 20 months.
D. Develop a total cash disbursements schedule for Charlie’s music store for the next 20
months.
E. Develop a complete cash budget for Charlie’s music store for the next 20 months.
Include a financing section with the current information on the line of credit, minimum
balance, and beginning cash balance. Assume money is borrowed on the line of credit as
soon as it is needed and repaid as soon as it is not needed. The current monthly case
expenses do not include interest expense on the line of credit.
F. What conclusions can you make regarding the cash flow situation for Charlie’s
Country to Classic to Chamber Music Store?
G. What suggestions or recommendations would you make to help Charlie improve his
cash flow situation?
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Sales Revenue by Month

Month Cash Credit
May $4,000 $2,000
June $5,000 $4,000
July $4,000 $3,000
August $5,000 $6,000
September $8,000 $28,000
October $10,000 $20,000
November $6,000 $10,000
December $12,000 $36,000
January $10,000 $12,000
February $6,000 $6,000
March $4,000 $3,000
April $5,600 $5,000
May $4,800 $4,000
June $6,400 $6,000
July $5,000 $4,800
August $6,800 $7,000
September $9,000 $31,000
October $11,000 $24,000
November $6,400 $10,000
December $14,000 $40,000
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Month Cash Payable
May $6,000 $2,000
June $6,000 $3,000
July $7,000 $12,000
August $7,000 $6,000
September $8,000 $4,000
October $7,500 $14,000
November $8,000 $7,000
December $9,000 $3,000
January $7,000 $2,000
February $6,500 $2,000
March $6,000 $1,000
April $5,000 $2,000
May $6,000 $3,000
June $7,000 $4,000
July $7,000 $14,000
August $8,000 $7,000
September $10,000 $5,000
October $9,000 $18,000
November $8,000 $8,000
December $11,000 $5,000
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Chapter Five: Performance Evaluation
Objectives
1. Review the process of establishing standards.
2. Identify the use of performance reports.
3. Analyze the concept of variance analysis.
Standard Accounting Systems

A standard accounting system is very much like a budget process, and the establishment
of one can help the other and vice versa. A budget often will use standard accounting
figures which are developed by using a standard physical measure times a standard dollar
amount per unit of physical measure. Budgets also can sometimes be the basis for
establishing or revising standards. Additionally, a budget can serve as a standard in its
control phase in analyzing actual performance.
A standard cost or revenue amount is a predetermined value of what an activity should
equal under specific conditions. Standards can serve as goals for what amounts could be
used as guidelines for comparison against actual results. The achievement of properly set
standards that are in line with company goals and objectives would imply that the
company is probably operating efficiently and effectively.
Standards may reflect historical trends or could be developed through time and motion
studies. Engineers can help in the establishment of proper measurements to use in the
development of standards.
A standard accounting system follows a basic format of units times dollars per unit. The
unit measure cancels out leaving a total dollar amount which can be used in a budget or as
a standard or benchmark for evaluation purposes. The measure of units can range from
sales, to measures of time, to physical units of material, or number of employees.
Standard Dollars = Dollar/Unit x Units
The first objective in establishing a standard is to determine a unit of measure that relates
to the account. Units of sales relate to sales revenue, hours of work relate to some wage
expenses, and units of product relate to inventory. After the relationship is determined,
the next step is to arrive at a dollar amount per unit. The unit selling price, labor wage
rate per hour or cost per unit of product in inventory are examples that are commonly
used. This process completes the standard dollar amount per unit format.
The computed standard dollar amount per unit can be applied to the budget process by
projecting a unit volume. When the unit volume is multiplied by the amount per unit, a
total dollar amount is calculated. This dollar amount such as total sales revenue, total
wage expense, or total inventory can be incorporated into a budget or can be used as a
standard for other purposes like performance evaluation.
Standards can be easily established for items where a natural relationship exists between
units and dollars like the sale of a good or service with an established selling price per
unit or if employees are paid on an hourly basis. Determining standards for other items
may be a little more difficult such as with the cost of the good or service sold by a
company. In a manufacturing company there are many inputs that go into the cost of an
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item. Some of the items have a clear cost per unit component and some of the items may
not be related to any unit measure.
Fixed cost items are usually only related to a time period such as a specific dollar amount
per year. Fixed cost, by definition, do not have a constant cost per unit of activity which
will also make it difficult to relate fixed cost to different levels of activity except on a
total cost basis. Often times in establishing a standard cost per unit in which fixed costs
are part of the costs being considered, the fixed cost will be treated like a variable cost
and be represented by a constant cost per unit. This misrepresentation of fixed cost for
standard costing purposes could easily result in incorrect amounts of fixed cost being
reported. The problem is overcome through a variance analysis process where the
standard costs are compared with actual costs and the difference or variance is accounted
for with adjustments to appropriate accounts. The simplicity of the standard cost system
can be maintained with modifications made where variations occur.
Advantages of Standard Accounting Systems

In spite of the perceived complexities in arriving at standards for the various accounts, the
process can still be worth the effort. The advantages of using a standard accounting
process to determine total costs and revenues include:
1. provides useful information for planning purposes
2. aids in decision-making
3. improves control activities
4. promotes a management by exception reporting format
5. gives more reasonable measurements
6. results in easier record keeping
7. possible reductions in costs
The advantage of using standards in the planning function is already evident. The use of
standard costs and revenues tie directly into the budget process. The standards provide a
goal or target for management to focus on in developing its operating activities.
In decision-making, the use of standards can give consistency in submitting bids for jobs.
Standards give continuity in performing functions from one time period to the next and
aids in comparisons for decision-making purposes.
Standards provide the guideline against which actual performance is evaluated.
Differences between the actual results and the standards can lead to questions, which will
aid in the control process.
A management by exception reporting format is used to identify those conditions that are
significantly different than an expected norm. By being able to compare actual results to
predetermined standards, management can focus their efforts on extreme situations and
the unusual circumstances. Actual results that are within a normal range from a standard
will receive less time and attention. The management by exception process enables
management to put forth the effort where it will do the most good.
Even with the difficulty of establishing some relationships between dollar amounts and
activities, being able to establish a reasonable standard can be more useful for
measurement purposes than having no standard at all. Accounting is not an exact science
and sometimes reasonably accurate figures are sufficient especially if their is a
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consistency in how the numbers are developed. Standards can aid in consistency in the
measurement process.
Record keeping is considerably easier with standard figures. The accountant does not
have to try to keep track of every change in actual costs and revenues with a standard cost
system. Actual figures can be determined for the units of activity and the actual units are
multiplied by a standard dollar amount per unit. Adjustments between the standard
amounts recorded and the actual amounts can be made at the end of a time period. This
process is easier than trying to keep track of both the actual units and the actual dollar
amounts. If both units of activity and dollar amounts per unit are allowed to vary
management can easily lose consistency in measurements.
Whenever a process is simplified, cost savings can be almost a guaranteed result. A
standard system is simpler because actual costs do not have to be monitored for every
transaction. Frequently, actual costs will offset each other and the extra effort in
monitoring the costs will not gain any benefit.
Disadvantages of Standard Accounting Systems

While a standard accounting system seems to be worth the effort, there can be some
disadvantages to its implementation. Disadvantages for a standard system may include:
1. behavioral implications of an imposed standard
2. failure of standards to identify differences in actual results on a timely basis
3. inaccurate standards
The biggest concern about standards could be its behavioral implications. Managers may
feel that standards are being imposed and that failure to comply could have negative
consequences. This is especially critical if the standards are virtually unattainable. The
method of imposing standards has to be clearly communicated to the users and the
standards need to be recognized more as guidelines than as mandated criteria.
Standards could be so general in nature that it is difficult to determine if significant
differences are occurring when being compared to actual data. Standards also may not be
able to distinguish differences from actual data and the variability of the data. Actual data
that varies widely may appear closer to the standard amounts than actual data with little
variability. When using standards it is important to have processes in place that will
highlight inconsistencies when they are occurring.
Standards could be inaccurate. Keeping in mind that standards are probably developed
ahead of their actual implementation and that the standards could be based on general
conditions or situations, then over time the standards could become inaccurate. Failure to
adjust standards or to allow for inaccuracies could lead to incorrect actions or decisions.
Performance Reports
Performance reports are an important part of the budget process with regard to the control
function. The reporting process completes the budget cycle and provides a means of
feedback to the users of the budget. Performance reports can be used to compare actual
results with the predetermined standard or budget figures. Any differences in values are
identified as variances.
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The control process from the performance reports centers on the variance analysis.
Managers can easily identify the differences or variances and determine which variances
are critical or significant and worthy of additional evaluation.
The management by exception principle is an approach to analyzing variances.
Management identifies all variances but only reviews those variances, which are
significant or critical to company performance. A cost benefit trade-off consideration
may be used in helping to decide which variances need further evaluation.
Flexible Budget Format

The format for performance reports usually follows three broad headings to include
budget, actual, and variance. The budget or standard is predetermined and could follow a
flexible budget format. In the flexible budget format, revenue and cost items that display
a variable behavior are separated from fixed cost items. The actual results are
summarized after the fact. Variances identify differences between the predetermined
standards and the actual results. See Illustration 5-1.
A cost that is defined as controllable means that the cost comes under the total
responsibility of the manager or department for whom the performance report is being
prepared. Controllable indicates that the manager has authority to incur the cost and is
responsible for its variance. If a cost is listed as variable it is most likely also
controllable; however, fixed cost can be either controllable or noncontrollable.
Sometimes the term direct is used in conjunction with controllable. Direct cost come
under the direct or complete control of the specific department represented by the
performance report.
Noncontrollable costs do not come under the complete responsibility or authority of a
specific manager or department. Since the manager does not have complete control of
these cost, it is important to segment these costs in a performance report.
Noncontrollable costs can be either variable or fixed in nature but are most likely fixed
costs. Sometimes the term indirect is used in conjunction with noncontrollable. Indirect
costs do not come under the complete control of the specific department represented by
Flexible Budget Format

Illustration 5-1
Matt’s Hats
Performance Report
Account Budget Actual Variance
Sales Revenue $200,00 $211,00 $11,000
0 0
- Controllable Variable Cost 140,000 (5,000)
145,000
= 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 & Allocated 25,000 28,000 (3,000)
Fixed
= 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 one
segment or department, and its division between the different departments is dependent
upon some method of distribution. Allocated costs can be another name for
noncontrollable costs.
Since noncontrollable and allocated costs have a different degree of impact in a
performance report than controllable cost, it is important that the different groups be
shown separately. Segment margin is an interim measure of a company’s performance,
which highlights only those revenues, and costs that come under the direct control of the
department’s manager. Segment margin will be used to divide costs that are controllable
or direct from those that are uncontrollable, indirect, or allocated.
When a performance report is being used to analyze the performance of a manager, it is
important for the manager to emphasize the results from the segment margin versus the
net income results. While both are important, the manager should have complete
responsibility and authority for all revenues and costs used to determine the segment
margin, whereas, the noncontrollable and allocated costs will be outside of the manager’s
total control. In the case of the performance report illustration, a greater emphasis should
be placed on the positive $7,000 segment margin variance than the positive $4,000 net
income variance. The negative $3,000 variance from the noncontrollable allocated fixed
cost was outside of the complete control and responsibility of the performance report
manager.
A flexible budget format can be very useful in a performance report arrangement. The
flexible budget establishes a standard based upon an actual level of activity, which gives
consistency between the standard measure and actual performance.
If a budget called a static budget is established based on 1,000 units of sales and actual
performance is based on 1,400 units of sales, then it could be difficult to get a true
evaluation of the performance of the company. How much of the variance between actual
and budget is due to revenue and expense variations and how much of the variance is due
to the fact that the level of sales was 400 units higher than anticipated. Without the
creation of a flexible budget, it will be virtually impossible to distinguish between the
nature of the variances.
A flexible budget could be created based on the actual level of sales of 1,400 units. Some
of the revenues and expenses would increase in proportion with the increase in volume,
these items would be variable in nature. Some of the revenues and expenses may
increase but not in proportion to the increase in sales volume, these are classified as semi-
variable items. A semi-variable item exhibits characteristics of both a variable item and a
fixed item. The best way to deal with an item of this nature is to separate out the variable
component from the fixed component. Items that would not change in total with the
change in volume from the flexible budget are fixed in nature. A flexible budget needs to
be able to classify its components according to behaviors, either variable or fixed, to be
useful.
Once a flexible budget is established with the components properly identified as variable
or fixed, then appropriate total amounts can be identified at the actual level of activity.
These flexible budget amounts are then compared to the actual results on a consistent
volume basis. Any variance between budget and actual will then be related to the
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operating activities of the company. The impact resulting from the different level of
activity between static and flexible budgets will not be incorporated in the variance.
The flexible budget concept is similar to the "apples-to-apples" scenario. In order to
make a meaningful comparison the measure of activity has to be constant. A flexible
budget allows for such an "apples-to-apples" comparison. A static budget is more like an
"apples-to-oranges" comparison. Without the common unit measure of volume, the
comparison loses much of its usefulness.
Even though the flexible budget is critical in performance evaluation, there still may be a
need for the static budget. In the example discussed earlier, management is going to want
to know what factors caused an increase from 1,000 units to 1,400 units. If the static
budget is completely ignored, these issues may never be identified and information that
may be useful in the decision-making process will be lost.
Each budget format has a purpose. The flexible budget is needed to make meaningful
budget, actual, and variance computations. The static budget is needed to address the
general question of why the company failed to operate at the predetermined level of
activity. See Self-Study Problems 5-1 and 5-2.
Responsibility Centers
The distinction in the flexible budget performance report format between controllable and
noncontrollable costs can also be useful in the determination of responsibility centers.
Budgets are usually established for responsibility centers with a manager in charge of the
responsibility center. A responsibility center is an identifiable segment of the business
that undertakes measurable activities and is headed by a specific manager. It is important
that the manager has authority commensurate with the responsibilities.
Performance reports are established for responsibility centers. The activities undertaken
in the responsibility center are measured in terms of a flexible budget and actual results.
Managers are responsible for the results of the performance evaluation. Such reports
could have an impact on the professional success or failure of the manager and the center.
Sometimes costs are assigned to a specific responsibility center over which the manager
has no control. These costs are usually classified as allocated costs. The determination of
the allocation or distribution of the cost is made at a higher level of management. The
allocation is usually made somewhat arbitrarily or subjectively, and because of this, the
responsibility center manager has limited control over the occurrence of the cost or the
amount.
To include costs of this nature in a performance report could be misleading. At the very
least costs that are not totally under the control of the responsibility center manager
should be separated and identified as noncontrollable. The performance of a manager
should not be impacted by uncontrollable activities.
The separation of items in the performance report between controllable and
noncontrollable is an appropriate format for the responsibility center. A manager who is
responsible for the controllable items should be ready to identify and explain any
variations in these items. At the same time variations in noncontrollable items should be
identified but not come under the same level of authority of the responsibility center
manager.
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Responsibility Centers
Illustration 5-2
Responsibility Control Over Control Over Control Over
Center Revenues Expenses Assets
Revenue Yes No No
Expense No Yes No
Profit Yes Yes No
Investment Yes Yes Yes
The performance report usually has an interim value called a segment margin, which
separates the controllable from the noncontrollable items. The segment margin gives an
indication of how the particular responsibility center segment is contributing to the
overall performance of the company. Following the segment margin will be the
noncontrollable costs. These items can be included in the report as an indication of how
well the center is assisting in covering a fair share of nonspecific companywide types of
costs. For a company to be successful, generally each responsibility center has to be able
to have a positive segment margin large enough to cover a portion of allocated cost plus
have a remaining contribution margin for company profits.
The inclusion of specific items within the performance report will depend on their level
of significance. An income statement format is often used. Generally, any revenue
items will be listed first followed by controllable expenses. The noncontrollable
expenses will be identified after the segment margin calculation.
Types of Responsibility Centers

Responsibility centers do not necessarily have to be profit centers. A responsibility center
that generates only expenses is also called an expense center. The responsibility center
manager does not generate any revenues. Many support functions within a company are
expense centers. Activities like the accounting department or personnel department are
usually classified as expense centers.
Profit centers are often associated with the operating function of the company. The
production of a good or service will lead to the generation of revenues. Expenses are also
incurred in these responsibility centers. Managers will have control over revenues,
expenses and the resulting net profit. Ideally, the profit obtained from the responsibility
center will be large enough to cover all controllable and noncontrollable costs plus a
profit margin.
Some responsibility centers will also have authority over utilization of assets. These
segments are called investment centers. Return on investment is a critical measure of
performance for these responsibility centers. The return on investment takes into account
a revenue minus expense figure in the numerator which equals a net profit. In the
denominator, the assets under control represent the investment. Only revenues, expenses,
and assets that are controllable within the segment should be used in the evaluation. See
illustration 5-2 for a comparison of responsibility centers.
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Variance Analysis
A variance analysis, in the relatively simple form, as the difference between a budget or
standard and actual results is satisfactory for most performance reports. The purpose of a
variance analysis number is to raise a level of awareness of a difference but not to solve
the problem. Variance analysis is a "means to an end" and not an "end in itself."
Once a variance is identified that requires further evaluation, then management can
undertake a more detailed analysis. Questions can be asked of those responsible for the
variance and a complete evaluation can be conducted if necessary. A cost benefit tradeoff
needs to be considered with any variance analysis. A simple difference between budget
and actual results is a relatively inexpensive way to first examine performance results.
Using an exception reporting philosophy, only significant or critical variances are then
subject to a more extensive and costly analysis.
Since standards are developed using a dollar amount per unit times a number of units
format, this is a natural way to analyze variances. A total variance in many situations can
be divided according to quantity related or price related factors. Quantity related
variances are usually called efficiency or usage variances and price related variances are
called price or rate variances.
Quantity Related Variance

A quantity related variance is calculated by determining the difference between the
standard or budgeted quantity that should have been used at the flexible budget level of
activity and the actual quantity used. This difference in quantity is then multiplied by the
standard price per unit. Considering a difference in the quantity of units creates the
variance. The dollar amount of the variance is arrived at by multiplying the quantity
variance by a dollar per unit standard causing the measure of units to cancel out leaving a
dollar amount.
For cost related accounts, if the actual quantity used is greater than the standard quantity
an unfavorable variance is created. The situation is interpreted as inefficient because
more units were actually used than had been initially established in the budget, creating
the unfavorable additional cost condition. In the opposite situation, if actual usage was
less than the initial budget then the condition is considered favorable. For revenue items,
the interpretation of the efficiency variance is reversed. If actual quantity is greater than
budgeted, then there is a favorable efficiency variance, and when actual quantity is less
than budgeted it is unfavorable. See illustration 5-3 for an explanation of quantity
variances.
Price Related Variances

A price variance is calculated by comparing the standard or budgeted price per unit
against the actual price per unit. This price difference is multiplied by the actual quantity
used. The price variance highlights the difference in price per unit which when
multiplied by a number of actual units equals a total dollar amount.
A price variance for an expense item is unfavorable when the actual price per unit is
higher than the standard or budgeted price per unit. The situation implies that the actual
expense was more than the standard or budgeted amount. If the actual price per unit were
less than the standard price per unit then there would be a favorable variance because
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actual expenses were less than the standard. For revenue items, the conditions would be
reversed. If the actual price per unit was greater than the standard price per unit then a
favorable variance would be recognized. This condition represents a situation in which a
company earned a higher unit revenue then expected by the standard. If the actual unit
price was less than the standard for a revenue item the variance is unfavorable. See
illustration 5-4 for an explanation of price variances.
Whenever a dollar per unit calculation is computed in arriving at a standard revenue or
cost, a variance analysis can be divided into quantity and price related factors. When
necessary, managers can conduct evaluations of this magnitude to assist them in
identifying the reasons why variances occur. The more complete analysis should help in
initiating the proper control procedures to guard against similar variances in the future.
Revenue Variances
Revenue variances, as previously stated, can be divided into quantity related factors and
price related factors. When the actual price or quantity is greater than the corresponding
standard, the variance is recognized as favorable because the company is receiving more
revenue then expected in the standard due either to a higher selling price or more quantity
sold. In the reverse situation, when the actual is less than the standard for either price or
quantity, the variance is unfavorable because the company is receiving less revenue then
expected in the standard because of a lower selling price or less quantity sold.
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Quantity Variance
Illustration 5-3
Standard Price x (Standard Quantity - Actual Quantity)
SP x (SQ - AQ)
(Standard Price x Standard Quantity) - (Standard Price x Actual Quantity)
(SP x SQ) - (SP x AQ)
SP = Standard Price
SR = Standard Rate
SQ = Standard Quantity
AP = Actual Price
AR = Actual Rate
AQ = Actual Quantity
Note: Price and Rate can be used interchangeably for variance analysis. Generally price
is associated with sales revenue and material expense and rate is associated with
labor expense.
Quantity Variance Example
Standard Price = $10/Unit
Assume the price represents a measure of expense.
Standard Quantity = 1,200 Units
Actual Quantity = 1,400 Units
Quantity Variance = SP x (SQ - AQ)

$10/Unit x (1,200 Units - 1,400 Units)
$10/Unit x -200 Units = ($2,000) = Unfavorable Quantity Variance
or Quantity Variance = (SP x SQ) - (SP x AQ)

($10/Unit x 1,200 Units) - ($10/Unit x 1,400 Units)
$12,000 - $14,000 = ($2,000) = Unfavorable Quantity Variance
The quantity variance is unfavorable because the actual expense quantity used is greater
than the standard expense quantity. If the price per unit is a measure of revenue verse a
measure of expense, then the $2,000 variance is favorable because the actual units of
revenue exceed the standard units of revenue.
The revenue quantity variance occurs if the original static budget quantity is different than
the flexible budget quantity used in the performance report. However, this variance can
not be a direct part of the performance report evaluation. By definition, the flexible
budget standard is established based upon the actual volume of sales, thereby eliminating
from the direct evaluation the predetermined static budget level of activity. The standard
budgeted sales volume is now represented by the flexible budget as opposed to the static
budget. The creation of the flexible budget automatically makes the actual sales volume
and the standard or flexible budgeted sales volume equal. With equal volumes, there can
be no quantity variance, at least as directly identified in the performance report. For
example, if the predetermined static budget level of activity is 100,000 units and 120,000
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units are actually sold, a flexible budget will be developed based on the 120,000 units
sold. Since the flexible budget quantity and actual quantity of units sold each equal
120,000, there can be no revenue quantity variance in the performance report.
However, a quantity variance still can be determined separately from the performance
report by comparing the standard volume based on the original static budget against the
actual volume based on the flexible budget. If the revenue quantity variance is favorable
it means that the actual volume represented by the flexible budget was greater than
originally anticipated in the static budget. An unfavorable quantity variance means that
the actual level of sales volume from the flexible budget failed to reach predetermined
static budget levels. In the example presented earlier, a favorable revenue quantity
variance can be identified since the actual level of sales volume used in the flexible
Price Variance
Illustration 5-4
Actual Quantity x (Standard Price - Actual Price)
AQ x (SP - AP)
(Standard Price x Actual Quantity) - (Actual Price x Actual Quantity)
(SP x AQ) - (AP x AQ)
Standard Price = $10/Unit

Actual Price = $9/Unit
Assume the price represents a measure of expense.
Actual Quantity = 1,400 Units
Price or Rate Variance = AQ x (SP - AP)

1,400 Units x ($10/Unit - $9/Unit)
1,400 Units x $1/Unit = $1,400 = Favorable Price Variance
or Price or Rate Variance = (SP x AQ) - (AP - AQ)

(1,400 Units x $10/Unit) - (1,400 Units x $9/Unit)
$14,000 - $12,600 = $1,400 = Favorable Price Variance
The price variance is favorable because the actual expense price is less than the standard
expense price. If the price per unit is a measure of revenue verse a measure of expense,
then the $1,400 variance is unfavorable because the actual price of revenue is less then
the standard price of revenue.
budget of 120,000 units is greater than the predetermined static budget level of sales of
100,000 units.
The revenue price variance represents the difference between the standard selling price
and the actual selling price. If the actual selling price is higher than the standard selling
price, the price variance is favorable because the company is receiving more revenue then
anticipated. When actual selling price is lower than the standard, the variance is
unfavorable.
175
In the evaluation of a performance report, the total revenue variance equals only the price
variance. If a volume variance occurs, it would have to be shown separately from the
other variances in the performance report analysis. See Self-Study Problem 5-3.
Variable Cost Variances

Variable cost variances include raw or direct material, direct labor, variable overhead, and
variable selling and administrative items. All variable cost variances can be divided into
separate quantity and price variances because the costs are based on a constant cost per
unit of volume computation, which is part of the definition of a variable cost.
The measure of volume or quantity used for these variable cost items is usually different
than units sold, the volume measure used to establish the flexible budget performance
report. Therefore, when a performance report is developed both the quantity and price
variances can be analyzed for the variable cost items. The volume measures used are
more directly related to the particular cost item itself, like feet or pounds for material, or
hours for labor. Variable overhead, which can represent many different individual cost
items each with different volume measures, is often related to material or labor in the
establishment of a unit of volume. For instance, if it can be determined that there is some
relationship between variable overhead and direct labor, then labor hours could be used as
the measure of volume to determine a variable overhead rate. As labor hours change, the
assumption is made that the variable overhead will also change in some direct proportion.
The variable cost quantity variances are a measure of the efficient use of whatever activity
that is related to the item. When more of a volume of actual activity is incurred then the
standard quantity, there is an unfavorable quantity variance as actual expense is higher
then the budgeted or standard amount. The inefficiency in the use of the activity results
in higher expenses and an unfavorable variance. The opposite situation occurs when
actual activity is less than the standard. Savings are recognized through the efficient use
of an activity with lower expenses and a favorable variance.
Sometimes variable cost quantity variances can be a little misleading, especially when
variable overhead volume is based on an activity measure such as direct labor or some
measure of material. The quantity variance is actually a measure of the direct labor hours
or material unit efficiency as opposed to actual efficiencies of the variable overhead
items. However, if there is any credibility to the relationship between the variable
overhead item and the measure of labor or material activity, then one can assume that the
efficiency of one is directly related to the efficiency of the other.
The variable cost price variances reflect the difference between the actual price per unit of
volume and a standard price per unit. If the actual price is greater than the standard price
then higher costs are incurred and the variance is unfavorable. For variable cost items
like materials and labor the price variance is fairly straightforward. The price variances
for items like variable overhead are less clear. Since frequently several different items are
included in the total variable overhead, the actual price times actual quantity may only be
available as a total amount. Also, since the unit price is based on a different measure of
volume, there may not be a recognized relationship between the standard per unit and the
total actual costs.
The sum of the quantity and price variances for each variable cost category should equal
the total variance as reflected in the performance report. This breakout of the variable
176
cost variances serves as a practical means of analyzing the variances in greater detail. See
Self-Study Problems 5-4 and 5-5.
Fixed Cost Variances

Overhead and selling and administrative costs can also be fixed in nature. Fixed cost
variances can usually only be analyzed as a total difference between the standard or
flexible budget amount and the actual amount because fixed costs do not have a constant
cost per unit value. Without the use of a cost per unit measure, fixed cost can not be
divided between quantity related factors and price related factors.
By definition, fixed costs are constant in total over changes in levels of volume within a
relevant range. Since fixed cost are a constant total, it is possible that the amount of fixed
cost will be the same for an original static budget as well as a flexible budget as long as
the measures of volume remain within the relevant range. Generally, there should not be
a significant variance between actual fixed cost and budgeted fixed cost, since the
definition implies a fixed total amount. When a variance does take place, it will be
unfavorable if the actual costs are greater than the budgeted costs, and favorable if the
actual cost are less than the budgeted cost.
Fixed cost can result in a unique volume variance when they are treated like a variable
cost. For financial reporting purposes, fixed overhead costs are often assigned a constant
cost per unit rate to coincide with the variable overhead rate. The volume variance
occurs because of the misrepresentation of the fixed cost. The actual computation of this
variance is beyond the scope of this text.
Self-Study Problem 5-6 gives a complete performance report evaluation with detailed
variance analysis for each component.
Summary
A natural follow-up to the establishment of budgets is the use of performance reports for
feedback and control purposes. The same standards that are used to establish budgets can
be used in the formation of performance reports.
Performance reports should follow a flexible budget format and be adjusted based on an
actual level of activity. The reports should be established for each responsibility center
with a specific manager having the authority and responsibility for the actions of that
center. Items in the performance report, especially cost items, should be segmented
between those that are controllable by the responsibility center manager and those that are
not controllable.
Variance analysis is a way of identifying differences between a budgeted or standard
amount and actual performance. The variance analysis process can be as general or
specific and detailed as necessary to aid in identifying why specific differences occurred
and how the company can go about correcting those differences.
177
Self-Study Problems
Self-Study Problem 5-1 Performance Report
Matt’s Hats developed a flexible budget based on a static level of activity of 100,000
units.
Matt’s Hats
Flexible Budget
100,000 Units
Account Static
Budget
- Controllable Variable Cost 100,000
- Controllable Fixed Cost 15,000
= Segment Margin 35,000
- Noncontrollable and
Allocated Fixed Cost 25,000
Required
Reconstruct the budget based on a level of activity of 120,000 units.
178
Self-Study Problem 5-1 Solution Performance Report

Matt’s Hats
Flexible Budget
120,000 Units
Account Static Flexible

Budget Budget
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
179
Self-Study Problem 5-2 Performance Evaluation

Matt’s Hats had the following actual costs based on a level of activity of 120,000 units.
Matt’s Hats
Income Statement
Account Actual
Results
- Controllable Variable Cost 120,000
- Controllable Fixed Cost 12,000
= Segment Margin 33,000
- Noncontrollable and Allocated Fixed Cost 30,000
Required
Develop a performance report.
180
Self-Study Problem 5-2 Solution Performance Evaluation

Matt’s Hats
Performance Report
120,000 Units
Account Flexible Actual

Budget Results 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)
181
Self-Study Problem 5-3 Sales Revenue Variances

Matt’s Hats sold 50,000 Chicago Cub’s baseball hats at $5.25 each during the month of
April for a total sales revenue of $262,500. The company had expected to sell 60,000
hats at $5.00 each during the month for a total revenue of $300,000.
Required:
Explain the variance between the actual sales revenue and the expected sales revenue.
182
Self-Study Problem 5-3 Solution Sales Revenue Variances

Quantity Variance
SP x (SQ - AQ)
$5.00 x (60,000 hats - 50,000 hats)
$5.00 x 10,000 hats = $50,000 Unfavorable Quantity Variance
Even though the number is positive, the quantity variance is unfavorable because the
standard quantity of revenue is greater than the actual quantity of revenue.
Note: In a normal performance report, the 50,000 hats actually sold would become the
basis of the flexible budget. Since the actual quantity and the flexible quantity would be
the same, there would be no revenue quantity variance in the performance report.
Price Variance
AQ x (SP - AP)
50,000 hats x ($5.00 - $5.25)
50,000 hats x -$0.25 = -$12,500 Favorable Price Variance
Even though the price variance shows a negative value, it is favorable because the
standard revenue price per unit is less than the actual revenue price per unit. The negative
amount occurs because of the way the problem is set up.
Total Variance
Quantity Variance + Price Variance = Total Variance
$50,000 Unfavorable + $12,500 Favorable = $37,500 Unfavorable Total Variance or
Total Actual Sales Revenue - Total Standard Sales Revenue = Total Variance
$262,500 - $300,000 = -$37,500 Unfavorable
183
Self-Study Problem 5-4 Material Expense Variances

Matt’s Hats used 35,000 yards of material to produce Chicago Cub’s baseball hats with
material cost of $1.75 per yard during the month of April for a total actual material cost
of $61,250. The company had expected to use 34,000 yards of material at a material cost
of $1.60 per yard during the month for a total standard material cost of $54,400.
Required:
Explain the variance between the actual material cost and the standard material cost.
184
Self-Study Problem 5-4 Solution Material Expense Variances

Quantity Variance
SP x (SQ - AQ)
$1.60 x (34,000 yards - 35,000 yards)
$1.60 x -1,000 yards = -$1,600 Unfavorable Quantity Variance
The quantity variance is unfavorable because the standard quantity of material is less than
the actual quantity of material.
Price Variance
AQ x (SP - AP)
35,000 yards x ($1.60 - $1.75)
35,000 yards x -$0.15 = -$5,250 Unfavorable Price Variance
The price variance is unfavorable because the standard material price per unit is less than
the actual material price per unit.
Total Variance
Quantity Variance + Price Variance = Total Variance
-$1,600 Unfavorable + -$5,250 Unfavorable = -$6,850 Unfavorable Total Variance or
Total Standard Material Cost - Total Actual Material Cost = Total Variance
$54,400 - $61,250 = -$6,850 Unfavorable
185
Self-Study Problem 5-5 Labor Expense Variances

Matt’s Hats used 4,000 hours of labor to produce Chicago Cub’s baseball hats with a
labor rate of $8.50 per hour during the month of April for a total actual labor cost of
$34,000. The company had expected to use 4,200 hours of labor with a labor rate of
$9.00 per hour during the month for a total standard labor cost of $37,800.
Required:
Explain the variance between the actual labor cost and the standard labor cost.
186
Self-Study Problem 5-5 Solution Labor Expense Variances

Quantity Variance
Standard Rate x (Standard Quantity - Actual Quantity)
SR x (SQ - AQ)
$9.00 x (4,200 hours - 4,000 hours)
$9.00 x 200 hours = $1,800 Favorable Quantity Variance
The quantity variance is favorable because the standard quantity of labor is greater than
the actual quantity of labor.
Rate Variance
Actual Quantity x (Standard Rate - Actual Rate)
AQ x (SR - AR)
4,000 hours x ($9.00 - $8.50)
4,000 hours x $0.50 = $2,000 Favorable Rate Variance
The rate variance is favorable because the standard labor rate per hour is greater than the
actual labor rate per hour.
Total Variance
Quantity Variance + Rate Variance = Total Variance
$1,800 Favorable + $2,000 Favorable = $3,800 Favorable Total Variance or
Total Standard Labor Cost - Total Actual Labor Cost = Total Variance
$37,800 - $34,000 = $3,800 Favorable
187
Self-Study Problem 5-6 Performance Report and Variance Analysis

Matt’s Hats Company developed the following static budget based on a production and
sales of 100,000 hats for the month of February.
Matt’s Hats Company
Static Budget
February, 1996
100,000 Hats
Account Total
- Variable Material $ 80,000
- Variable Labor 115,000 195,000
= Contribution Margin $105,000
- Controllable Fixed 65,000
= Segment Margin $ 40,000
- Allocated Fixed 50,000
= Net Income ($10,000)
The actual results for the month of February based on a production and sales of 95,000
hats is as follows:
Actual Performance
February, 1996
95,000 Hats
Account Amount Total
- 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)
188
Additional information
There is a standard of .20 yards of material to produce one hat. The standard price of the
material is $4.00 a yard. During February Matt’s Hats actually used 23,750 yards of
material at a price of $3.80 per yard.
There is a standard of .10 hour of labor to produce one hat. The standard price of labor is
$11.50 per hour. During February Matt’s Hats actually used 8,550 hours of labor at a rate
of $12.00 per hour.
Required:
Conduct a complete performance and variance evaluation and explain how even though
Matt’s Hats Company produced and sold fewer hats during the month of February, they
were able to reduce their loss by $650.
189
Self-Study Problem 5-6 Solution Performance Report and Variance Analysis

A performance report based on a flexible budget of 95,000 hats produced and sold during
the month of February is shown below.

Flexible Budget Performance Report
February, 1996
95,000 Hats
Account Budget Actual Variance

Sales 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 Analysis
Revenue Variances
Revenue Quantity Variance = (SP x SQ) - (SP x AQ)
Since the flexible budget standard quantity of 95,000 hats is different than the static
budget quantity of 100,000 hats, there is a revenue quantity variance. However, this
variance will not be used to explain any of the $5,900 difference in net income from the
performance report. Never the less, the computation of the revenue quantity variance will
aid in answering the question regarding how the company’s net income increased by $650
over the static budget amount. See the discussion at the end of this Self-Study problem.
Standard Price is $3 per hat based on a static budget of $300,000 sales revenue for
100,000 hats
($3/hat x 100,000 hats) - ($3/hat x 95,000 hats) = $15,000 U
$300,000 - $285,000 = $15,000 U
The $15,000 unfavorable variance reflects a production and sales level 5,000 units below
the static budget at $3 per hat.
190
Revenue Price Variance = (SP x AQ) - (AP x AQ)

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

Total Budgeted Fixed - Total Actual Fixed
$65,000 - $59,000 = $6,000 F
Matt’s Hats incurred less actual fixed cost then the predetermined static or flexible budget
amount giving a favorable $6,000 variance.
Total Segment Margin Variance
Revenue Price Variance + Total Variable Material Variance + Total Variable Overhead
Variance + Total Controllable Fixed Variance
$9,500 F + ($14,250 U) + $6,650 F + $6,000 F = $7,900 F
The higher selling price plus the more efficient use of labor hours and the savings in
controllable fixed cost made up for the extra material used in the production process.
Total Allocated Fixed Variance
Total Budgeted Allocated Fixed - Total Actual Allocated Fixed
$50,000 - $52,000 = -$2,000 U
Actual allocated fixed costs, which are out of control of the manager, were $2,000 higher
than the budgeted allocated fixed cost.
Total Net Income Variance
Total Segment Margin Variance + Total Allocated Fixed Variance
$7,900 F + ($2,000 U) = $5,900 F
Reconciliation of Total Net Income Variance to Static Budget
Even though the level of sales volume was less (95,000 hats vs 100,000 hats), the net
income was reduced by $650 to $9,350 in comparison to the projected loss from the static
budget of $10,000. The flexible budget variances used to arrive at a $5,900 favorable
variance on the performance report can be summarized as follows. When volume
declined from 100,000 hats to 95,000 hats there was an unfavorable revenue quantity
variance of $15,000 (computed above). There was also a savings for variable material
cost of $4.00/yard x .20 yards/hat x 5,000 hats = $4,000 F and a savings for variable labor
cost of $11.50/hour x .10hour/hat x 5,000 hats = $5,750 F due to the lower production
levels.
The contribution margin variance resulting from the decline in sales of 5,000 units from
the static budget level equals sales revenue - (variable material cost + variable labor cost)
or ($15,000 U) + $4,000 F + $5,750 F = $5,250 U. The unfavorable variance from the
static budget versus the flexible budget is $5,250 (-$10,000 less -$15,250 = -$5,250).
The favorable variance for the performance report is $5,900 (-$15,250 less -$9,350 =
$5,900). When the unfavorable static budget variance of $5,250 is subtracted from the
$5,900 favorable flexible budget variance the result is $650 F which fully explains the
difference between the static budget net income and the actual net income.
As a manager, the more important variances to analyze are those items that make up the
segment margin variance, which is $7,900 favorable. See the discussion for each of
variances related to the segment margin above.
192
Problems
Problem 5-1 Flexible Budget Format
Present the following information in a flexible budget format for Matt’s Hats for the year
of 1997. The dollar amounts are associated with a static level of sales volume of 250,000
hats.
ACCOUNT DOLLAR
AMOUNT
Sales $2,500,000
Controllable Variable Manufacturing Cost 800,000
Controllable Fixed Direct Manufacturing Cost 500,000
Noncontrollable Fixed Indirect Manufacturing Cost 200,000
Controllable Variable Selling & Administrative Cost 250,000
Controllable Fixed Direct Selling & Administrative Cost 400,000
Noncontrollable Fixed Indirect Selling & Administrative 100,000
Cost
Problem 5-2 Flexible Budgeting

Using the data in problem 5-1, construct a flexible budget based on a sales volume of
240,000 hats.
Problem 5-3 Flexible budgeting

Using the data in problem 5-1, construct a flexible budget based on a sales volume of
200,000 hats. This level of sales activity is outside of the relevant range and fixed direct
manufacturing cost will be $450,000 and fixed direct selling and administrative cost will
be $340,000.
193
Problem 5-4 Performance Report

Using the budget figures from problem 5-1 and the following actual amounts based on a
sales volume of 250,000 hats, construct a performance report for Matt’s Hats for 1997.
ACCOUNT DOLLAR
AMOUNT
Sales $2,450,000
Controllable Variable Manufacturing Cost 750,000
Controllable Fixed Direct Manufacturing Cost 510,000
Noncontrollable Fixed Indirect Manufacturing Cost 250,000
Controllable Variable Selling & Administrative Cost 250,000
Controllable Fixed Direct Selling & Administrative Cost 370,000
Noncontrollable Fixed Indirect Selling & Administrative 140,000
Cost

Assume the actual amounts reported in problem 5-4 represented a sales volume of
260,000 hats. Reconstruct a flexible budget from the problem 1 data at a 260,000 level of
activity and develop a performance report using the problem 5-4 actual amounts.
Use the following information to answer problems 5-6 through 5-9.

Matt’s Hats
Annual Budget
50,000 Units = Static Activity Level
Account Static Budget Actual Amount
Sales Revenue $250,000 $260,000
- Controllable Variable Cost 100,000 120,000
= Contribution Margin 150,000 140,000
- Controllable Fixed Cost 80,000 65,000
= Segment Margin 70,000 75,000
- Noncontrollable and Allocated Fixed Cost 50,000 60,000
= Net Income $ 20,000 $ 15,000
194

Assume that the actual sales volume was 50,000 hats. Complete a performance report
based on the information given in the annual budget. Explain the significance of the
amounts in the variance category.



Assume that the actual sales volume was 70,000 hats. Assume also that at this level of
activity the budgeted controllable fixed cost increases to $90,000 and the allocated fixed
cost increases to $60,000. Complete a performance report based on the information given
in the annual budget. Explain the significance of the amounts in the variance category.
Problem 5-10 Revenue Variances

MRR Corp established the following standards for the sale of its product:
Sales Volume 100,000 units
Selling Price Per Unit $12.00
The actual results for the year were 120,000 units sold at a selling price of $11.75 per
unit.
Required:
Compute the revenue variances.

MSAR Company had a total sales revenue of $61,875 for the month with sales of 8,250
units. The company had expected to sell 9,000 units at $8.00 each.
Required:
195

Matt’s Slack Company had a total actual sales revenue this month of $40,250 on sales of
3,500 slacks. The expected level of sales were 3,200 slacks for a total sales revenue of
$35,200.
Required:
Problem 5-13 Material Variances

MRR Corp established the following standards for the use of material in the production
of 10,000 units of product:
Pounds of Material 40,000 pounds
Pounds Needed to Make a Unit 4 pounds per unit
Cost Per Pound $3.00 per pound
The MRR Corp actually used 43,000 pounds of material to produce 11,000 units at an
actual cost of $3.10 per pound.
Required:
Compute the material variances.

MSAR Company had a total material cost of $34,830 for the month with use of 6,450
pounds of material. The company had expected to use 6,500 pounds at $5.50 per pound.
Required:

Matt’s Slack Company had a total actual material cost this month of $9,000 on the use of
4,000 yards of fabric. The expected level of material use was 3,800 yards for a total
material cost of $9,500.
Required:
196

Matt’s Manufacturing Inc. has a standard use of 8 feet of material to produce a finished
end table. The standard cost is $2.00 per foot for the material. Each month the company
expects to produce 250 end tables. During the month of February, 230 tables were
produced using 1,955 feet of material at a total cost of $4,301.
Required:
Problem 5-17 Labor Variances

MRR Corp established the following standards for the use of labor in the production of
10,000 units of product:
Hours of Labor 5,000 hours
Hours Needed to Make a Unit 0.5 hours per unit
Cost Per Hour $12.00 per hour
The MRR Corp actually took 5,600 hours to produce 11,000 units at an actual cost of
$11.80 per hour.
Required:
Compute the labor variances.

MSAR Company had a total labor cost of $60,200 for the month with use of 7,000 hours
of labor. The company had expected to use 7,100 hours at the rate of $9.00 per hour.
Required:

Matt’s Slack Company had a total actual labor cost this month of $36,250 on the use of
5,800 hours of labor. The expected level of labor use was 5,500 hours for a total labor
cost of $33,000.
Required:
197

Matt’s Manufacturing Inc. has a standard rate of 2 hours to produce a finished end table.
The standard rate is $7.00 per hour for the labor. Each month the company expects to
produce 250 end tables. During the month of February, 230 tables were produced using
450 hours at a total cost of $3,240.
Required:
Problem 5-21 Performance Report and Variance Analysis

Matt’s Manufacturing Company developed the following static budget based on a
production and sales volume of 50,000 units for 1995.
Account Budget
Amount
Sales Revenue $1,000,000
Controllable Variable Material Cost 250,000
Controllable Variable Labor Cost 300,000
Contribution Margin 450,000
Controllable Fixed Cost 170,000
Segment Margin 280,000
Net Income $ 80,000
The actual results for the year based on a level of production and sales of 52,000 units are
as follows:
Account Actual
Amount
Sales Revenue $1,014,000
Controllable Variable Material Cost 265,000
Controllable Variable Labor Cost 306,000
Contribution Margin 443,000
Controllable Fixed Cost 165,000
Segment Margin 278,000
Net Income $ 63,000
198
Additional Information:
The actual selling price was $19.50 per unit versus a standard selling price of $20.00.
It takes 2 pounds of material to make a unit at a standard price of $2.50 per pound.
125,000 pounds of material were actually purchased at a price of $2.12 per pound.
It takes 15 minutes to make a unit at a standard labor rate of $24.00 per hour.
The employees actually worked 12,000 hours and were paid $25.50 per hour.
Required
a. Develop a performance report based on a level of production and sales of 52,000 units.
b. Do a complete analysis of the variance between the flexible budget amounts and the
actual results.
199
Cases
Case Study 5-1 Outreach Mission

Outreach Mission is a nonprofit charitable organization established to provide support
and training to disadvantaged intercity youth. The organization is supported through the
contributions from local businesses, churches, and individuals. They are also part of the
United Way fund raising campaign. The city provides some services and support, and the
organization is exempt from any city and state taxes.
At the start of 1996, the executive director prepared and presented a budget to the board
of directors that was exactly the same as the 1995 actual revenue and expense amounts.
There was not much time at the end of 1995 to develop a 1996 budget; however, the
director believed that there would be minimal changes between the two years and that
1995 was an accurate reflection of 1996.
The organization continued to provide needed support to the community during 1996 and
was recognized as one of most effective nongovernmental charitable operations in the
city. Because of this success, there never seemed to be a lack of need to provide services.
Additionally, fund raising was very competitive as more and more organizations were
seeking the donors dollar.
The board wanted to know how Outreach Mission performed during the 1996 calendar
year. To aid in presentation, the executive director presented a 1996 statement of
activities and also had available the previous years statement of activities which served as
the budget.
Required
A. Prepare a performance report for Outreach Mission for 1996. Include both absolute
dollar and percent variances as appropriate.
B. Develop a summary narrative highlighting all aspects of the Outreach Mission
activities during 1996.
C. Comment on the advantages and disadvantages of using the 1995 actual performance
as a budget for 1996.
D. What other possible measures or information could be useful in a performance report
presentation?
E. Suggest a possible way to develop standards or a budget for 1997.
200
Outreach Mission
Statement of Activities
Revenue and Expense Activities 1996 Actual 1995 Actual

Support and Revenue
Business and Individual Contributions $2,626,400 $2,192,000
Gifts-in-Kind 1,335,100 1,503,200
Land and Buildings 0 814,000
Contributed Skilled Services 37,600 84,100
Investment Income 11,900 14,800
Other 12,800 5,200
Total Support and Revenue $4,023,800 $4,613,300
Expenses
Program Services
Mission and Outreach Services 695,900 539,800
Rehab Farm 292,800 216,400
Dental and Medical 278,300 178,700
Literacy and Education Center 88,100 78,100
Food, Clothing and other Gift-in-kind 1,528,000 1,461,400
Public Awareness and Education 231,500 138,600
Total Program Service Expenses $3,114,600 $2,613,000
Supporting Activities
General and Administrative 343,700 402,200
Fund Raising 758,300 594,600
Total Support Expenses $1,102,000 $996,800
Total Expenses $4,216,600 $3,609,800
Change in Net Assets ($192,800) $1,003,500
Net Assets, Beginning of Year $1,099,900 96,400
Net Assets, End of year $907,100 $1,099,900
201
Case 5-2 Atkinson Lumber Company

Atkinson Lumber of Pineland, South Carolina cuts various sizes of pine lumber for sale
to building contractors and hardware outlet stores in the southeastern United States. The
lumber company owns a 10,000 acre tree farm adjacent to its lumber mill from which
they get much of their raw material. Additionally, the lumber company has arrangements
with several tree farms around the state to gather pine trees. By having access to their
own trees as well as favorable purchasing agreements with other local tree growers,
Atkinson Lumber can cut finished lumber at very competitive prices.
The most popular sized lumber cut is the 8 foot 2 x 4 inch stud. This board is the basic
construction piece for commercial and residential buildings. The pine trees grown in
South Carolina are particularly well suited for these types of boards. The trees typically
grow to about 40 to 45 feet and are very straight. Ideally, sixty 2 x 4 boards can be cut
from each tree with a minimum of waste.
The mill has a special processing line for the cutting of these boards. The lumber
foreman specifically identifies trees that are fairly straight, between 41 and 43 feet long,
and have a base trunk diameter of 14 to 18 inches. The tree is first cut into eight foot logs
starting from a clean base cut. The saw is set at the standard eight foot length to speed
the cutting process. Next, the logs are squared by using a band saw. A pallet grips the
log on both ends, moves the log through the cutting process and rotates the log until all
four sides are square. What remains is a 12 x 12 inch block or similar comparable
dimensions for logs closer to the top of the tree which can easily be cut into the final 2 x 4
inch sizes. The final cuts of the block are completed in a batch-processing mode. First
the four inch cuts are made and then the two inch cuts complete the board. Again a band
saw is used to make these cuts.
The lumber mill process is somewhat machine oriented; however, skilled labor is needed
for the cutting operations. Also, for safety purposes, at least two employees are needed at
each saw. The more skilled employee runs the saw while the assistant makes sure that the
log is set up properly and is available to help with any operation.
Tom Atkinson, manager of operations, had recently developed a standard cost system for
the lumber operation. Since 2 x 4s were the most common product, he first established
standards for this cutting operation. He determined that a normal pine tree would yield
sixty 2 x 4s of an eight foot length. The cost of each tree was about $48. Next he
determined that it would take 10 minutes to cut the tree into eight foot logs. It would take
another 20 minutes to cut the logs into blocks, and finally about 30 minutes to cut the
blocks into 2 x 4 boards. Two employees would be involved in the cutting operation for
the hour. The more skilled employee would receive $20 per hour in wages and benefits,
and the assistant would receive $13 per hour.
The month of March was very productive for the lumber mill. With the onset of spring,
demand for construction materials was up and the mill was able to produce 12,000 2 x 4s
in 26 workdays. The total material and labor costs to produce these 12,000 boards was
$16,834 which could be broken down into $9,450 for the trees and $7,384 for the labor.
The standard cost system allowed Tom to make a quick comparison between the actual
costs, and the predetermined standard costs. Based upon his estimates, the standard cost
for a 2 x 4 should be $1.35 and since 12,000 boards were produced, the total cost should
have been only $16,200. There was an unfavorable variance of $634.
202
After doing some further investigation, Tom learned that 210 trees were used in the
production process. The average cost of these trees was just $45 each, but some of the
trees were a little short and/or not perfectly straight. He also knew that in addition to
working the normal eight hour days, the two employees also worked eight hour shifts on
four Saturdays and earned time and a half pay. The Saturday work was necessary because
of the expected demand.
Required
A. Compute the material quantity and price variance for the production of 2 x 4s for the
month of March.
B. Compute the labor quantity and price variance for the production of 2 x 4s for the
month of March.
C. Comment on the possible reasons why the material and labor variances in the
production process occurred. Could any of the variances have been prevented?
D. Comment on the development of the standards. What are some of the advantages and
disadvantages of standards for this type of a production process?
203
204

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Chapter One: Accounting and Finance: An Introduction

An Introduction to Accounting and Finance: Text and

Problems .......................................................................................... 153

Inventory Ratios................................................................................ 349

Capital Budgeting Methods of Analysis ............................................. 518

Chapter One: Accounting and Finance: An Introduction

The Objective and Scope of this Text Book

Budgeting, presented in Chapter 4, is an essential component related to both the planning

The Accounting Process

The Accounting Process

More Favorable Less Favorable

The Role of Ethics in Accounting and Finance

The American Institute of Certified Public Accountants Code of Professional Conduct

2 American Institute of Certified Public Accountants Code of Professional Conduct, American

· Inform subordinates as appropriate regarding the confidentiality of

3National Association of Accountants (now Institute of Management Accountants), Statements on

· Discharge duties and responsibilities to my employer to the best of my ability,

Case Study 1-1 Accounting Fraud at Maybury Bank

Case Study 1-2 Ethics as a Write-off

Chapter Two: The Income Statement and the Balance

Formula 2-1 Assets = Liabilities + Stockholders Equity

Current Asset Accounts

Long-Term Asset Accounts

Current Liability Accounts

Long-Term Liability Accounts

Shareholders Equity Accounts

Depreciation is a noncash expense account since the offsetting credit is to accumulated

The following illustration shows how the depreciation process works.

January 2, 1996 - Purchased asset.

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

Balance Sheet Presentation

Molding Machine (Debit Bal) $30,000

The Accounting Process

Debit/Credit Account Balance Summary

Increase or Decrease in Account Balance

ACCOUNT DEBIT CREDIT

3. identify if the accounts should be debited or credited

Liability Permanent Balance Sheet

income statement, the company management is only interested in the operating

Statement of Retained Earnings

Statement of Retained Earnings

Self-Study Problem 2-1 Solution Account Classifications

Self-Study Problem 2-2 Debit and Credit Balance on Accounts

Self-Study Problem 2-2 Solution Debit and Credit Balance on Accounts

Self-Study Problem 2-3 Characteristics of Accounts

NORMAL PERMANEN FINANCIAL

Self-Study Problem 2-3 Solution Characteristics of Accounts

NORMAL PERMANEN FINANCIAL

Self-Study Problem 2-4 Journal Entries

Self-Study Problem 2-4 Solution Journal Entries

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

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

Cost of Goods Sold 300

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

Accounts Receivable 1,000

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

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