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Course Notes

Accounting Fundamentals

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Advance Your Career

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Session Objectives

Format balance sheet


Format income statement
Record transactions

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The Three Key Financial Statements

Balance Sheet
A statement of financial position
Assets, liabilities, equity

LIABILITIES
(What a business owes)
ASSETS
(What a business owns)
EQUITY
(What a business is worth)

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The Three Key Financial Statements

Income Statement
Profitability
Revenue, expenses, profit and loss

EXPENSES

REVENUE

PROFIT OR LOSS

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The Three Key Financial Statements

Cash flow statement


Classifies all the different cash flows
Cash flow from operations, financing and investing

CFO

TOTAL CASH FLOWS CFF

CFI

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The Balance Sheet: Asset

Assets are required for business

1. Current Asset: assets that are quickly liquidated


2. Non-current asset:
Long term intangible assets
Property, plant and equipment
Financial assets

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The Balance Sheet: Liabilities

Obligations owed by the company

1. Current Liabilities: obligations to be paid in under a year


2. Non-current liabilities: long term debt

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The Balance Sheet: Equity

Equity begins as initial investments


Equity increases with retained earnings, which increases with
positive income and decreases with losses and dividends

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Balancing the Balance Sheet

Assets = Liability + Equity


This formula must always be true

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Balancing the Balance Sheet

Double entry journal keeping holds that:


Transactions have an equal effect in one or more accounts
on the other side of the balance sheet; or,
Transactions have an positive effect and equal negative
effect in one or more accounts on the same side of the
balance sheet.

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Recording Transactions

Company undergoes the following transactions:

Issue shares for 100 in cash


Four year bank loan of 50
Buys equipment for 80
Buys inventory for 60
Sells the inventory for 90
Pays salaries of 20
Pays interest of 3

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Recording Transactions: Shares for 100 in cash

Cash of 100 falls under current assets


Offsetting effect in equity as 100 to common shares
Assets equals liabilities and equity

Dr. Cash 100


Cr. Common Shares 100

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Recording Transactions: Bank Loan

Company owes 50 to the bank


This is a non-current liability

Dr. Cash 50
Cr. Loans 50

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Recording Transactions: Property Purchase

Property cost 80 in cash, in exchange for a non-current asset worth 80

Dr. Property, Plant and Equipment 80


Cr. Cash 80

Assets (+80)
Assets (-80)

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Recording Transactions: Buying Inventory

Purchase of inventory for 60 in cash

Dr. Inventory 60
Cr. Cash 60

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Recording Transactions: Selling Inventory

Selling inventory worth 60 for 90 in revenue


We lose 60 in inventory, but receive 100 in cash

Dr. Cash 90
Dr. Cost of Goods Sold (Expense) 60
Cr. Sales Revenue 90
Cr. Inventory 60

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Recording Transactions: Selling Inventory

Alternatively:

Dr. Cash 90
Cr. Inventory 60
Cr. Retained Earnings 30

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Recording Transactions: Salaries

Salaries are paid out in cash or bank deposits


Salaries are paid in 20 of cash

Dr. Salaries Payable 20


Cr. Cash 20

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Recording Transactions: Payment of Interest

Paying interest expense of 3


Interest expense reduces profits by 3

Dr. Interest Payable 3


Cr. Interest Expense 3

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Account Receivable and Account Payable

In the previous examples, the company only operated with cash


However, accrual accounting result in buying and selling on credit

Two terms are important in this regard,


Account receivable: Amount owed by customer to the company
Account payable: Amount owed by the company to suppliers

So, if the inventory transaction was on credit, how the balance sheet would
look like?
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Buying or Selling on Credit

Inventory sold on credit creates an accounts receivable balance


Instead of debiting cash, debit accounts receivables
When the customer pays the balance, accounts receivables is reduced
and cash is increased

Inventory purchased on credit creates an accounts payables balance


Instead of crediting cash, credit accounts payables
When the company pays the balance, accounts payables is reduced
and cash is reduced
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Exercise

Follow the video for the exercise:

Vadero Inc.
Check your work against the Vadero Inc. Solution

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The Income Statement

Statement of operations
Profit and loss

Income statement transactions are a flow in time


Balance sheet transactions were a snapshot of a point in time

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The Income Statement: Gross Profit

Revenue cost of goods sold

Revenue is sales net of returns and allowances

Cost of goods sold are direct costs for generating that revenue

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The Income Statement: Operating Income

There are other expenses that should be deducted.

Indirect operating expenses


Selling, general and administrative expenses
Interest expense
Tax expense

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Creating a Full Income Statement

From the previous balance sheet transactions, the income statement values
are:

- Gross profit is 30
- Operating Income is 10
- Net Income is 7

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Recording Income and Expenses

Income statement record the revenues and expenses during a year

Some transactions must be prorated

For example:
Company buys insurance worth 12,000 at the 12th month of the financial
year.

Only 1000 would be included in this years income statement.

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Prepayments

What will happen with the rest 11000?

Prepaid expense in the balance sheet


An asset
Asset will be used up over the course of the remaining 11 months

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Another Example: Accrued Expenses

Company use 2000 worth of office supplies but will pay in the following year.

How much expense should be included in the income statement?

Answer:
The full expense
Record current liability
Company owes supplier within the next year

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Depreciation

The equipment purchased was worth 80

Eventually, the equipment will be worth less as it is used up (think used

cars)

This is depreciation

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The Impact of Depreciation

Residual value = 30

Useful life = 4 years

Depreciation = (80 30) / 4 = 12.5

Net value = 80 12.5 = 67.5 in the first year

The deducted values will appear in the balance sheet

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Conclusion

This module concludes:

Learning how to construct the balance sheet and income statement

Exploring financial terms e.g. account payable, prepayment

Learning how to record the transactions in the statements

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Constructing Cash Flow Statement

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Overview

This module will explore:

Formatting and constructing cash flow statements

Difference between cash flow and income

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Key Financial Statements

How the business uses cash for:

Operating;

Investing; and,

Financing

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The Role of Cash Flow Statement

Cash flows can technically be deduced from the balance sheet


But in practice, cash flow statement recorded all the details
Gives insights as to how cash is sourced and used

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The Cash Flow Statement: Operating Cash Flow

Operating cash flow includes:


Cash collections from customers
Payment to suppliers and employees
(Possibly) Dividends and interest payments or receipts

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The Cash Flow Statement: Cash Before Financing

Investing activities organizes the flows of:

Sale and purchase of PP&E

Sale and purchase of investments

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The Cash Flow Statement: Cash Before Financing

Investing activities organizes the flows of:

Sale and purchase of PP&E

Sale and purchase of investments

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The Cash Flow Statement: Net Cash Flow

Net cash flow is arrived after accounting for financing activities:

Issuance of shares

Paying dividends

Issuing bonds, and

Repaying loans

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Recording Income and Expenses

The accrual concept

Profit =/= Cash

Income Statement records revenue and cost which is


- Incurred or earned

In contrast, cash flow statement records


- Cash received and cash paid

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The Idea of Matching Over Time

A five day transit pass costs $40


Paid in cash on Monday

How much is the daily cost on Thursday:


On a cash flow basis?
On a accrual basis?

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Matching Over Time Solution

On a cash flow basis the expense on Thursday is $0


Since payment (cash outflow) occurred on Monday

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Matching Over Time Solution

On an accrual basis, the expense is $8


Although the payment of $40 occurred on Monday, we used up a days
worth of the weekly pass ($40/5) on Thursday

Which basis better reflects the cost of an individual journey?


Answer: Both can provide valuable information

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PP&E and Depreciation Recap

ABC Inc. buys a truck for $45,000 and after 5 years it sells for $15000

What do we record?

Cash flow statement: $45,000

Income statement: $6,000

Balance sheet: $39,000 at year 1, reduced by $6,000 every year

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Calculating Operating Cash Flow - Direct Method

Rarely used in practice


Sum of customer receipts + supplier payments + employee payments

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Calculating Operating Cash Flow - Indirect Method

Widely used
Begins with net income
Adds back non-cash expenses from the income statement

Adjustment is required in case of:


Sales and purchase on credit
Unsold inventory
Others e.g. depreciation

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Deriving the Complete Cash Flow

Complete cash flow statement uses:

Current years balance sheet


Last years balance sheet
Current years income statement

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Deriving the Complete Cash Flow

Now let's discuss the method analyst use to forecast:


Future income statement
Balance sheet

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Stage One: Compare the Balance Sheet

To complete the entire cash flow statement, compare the balance sheet of:
Current year
Previous year

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Stage One: Compare the Balance Sheet

For every item, the difference between current and previous year is
calculated:
Asset increase Cash outflow (and vice versa)
Liability increase Cash inflow (and vice versa)

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Stage One: Compare the Balance Sheet

The sum of all effects = net change in cash balance


Net change in cash balance should equal the difference between the
current year and prior year cash balances

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Dealing with Property, Plant and Equipment

For PP&E, cash and balance sheet differences happens due to


Depreciation
Net capital expenditure (CAPEX)

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Dealing with Property, Plant and Equipment

Depreciation is accounted for when added back to net income


under CFO
Any new CapEx is an outflow under CFI

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Calculating Net CAPEX

Requires:

Opening net book value of PP&E from balance sheet

Closing net book value of PP&E from balance sheet

Depreciation expense from the income statement

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Advance Your Career

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