Lecture 6

Financial Accounting
Spring Semester 2019
Exam Preparation

 Accounting record
 Revenue recognition of inventory
 FIFO
 Weighted average cost method
 Depreciation
 EPS
 Ratios

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The accounting record
# Date Business Activities Company XYZ
1) 01-01-2018 Initially capitalize the company through deposit of
€100,000.
2) 01-01-2018 Borrow €200,000 as a loan from a bank. Interest is payable
annually 6 percent. The maturity is 10 years. Besides paying the
interest at year end, at the end of each year an installment of €
20,000 is made to reduce the debt.
3) 31-03-2018 Purchase a production machine for € 50,000. The machine has an
estimated life of 5 years with no salvage value.
4) 15-04-2018 Purchase inventory for €75,000. €50,000 is paid in cash, €25,000
is due till the end of the month. XYZ pays it on time on April 30.
5) 10-05-2018 Sell inventory for €200,000 to a retailer. Cost of goods sold are
€50,000. Half is paid in cash, the other half is due within 1 month.
The retailer pays on May 31.
6) 01-07-2018 XYZ issues shares for €50,000.

7) 31-12-2018 XYZ pays wages of €50,000 to its employees in cash.

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The accounting record

 Analysis of transactions
1.Identify which accounts are affected, by what amount, and
whether the accounts are increased or decreased
2.Determine the element type for each account identified in
Step 1 (e.g., cash is an asset) and where it fits in the basic
accounting equation. Rely on the economic characteristics of
the account and the basic definitions of the elements to make
this determination
3.Use the information from Steps 1 and 2, enter the amounts in
the appropriate column of the spreadsheet
4.Verify that the accounting equation is still in balance

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Debits and credits
Account Debit Credit
Asset
Increase X
Decrease X
Liability
Increase X
Decrease X
Equity
Increase X
Decrease X
Revenue
Increase X
Decrease X
Expense
Increase X
Decrease X

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Journal entries
Date Account DR CR
01/01/18 Cash €100,000
Contributed capital €100,000
1/01/18 Cash €200,000
Bank debt €200,000
03/31/18 Machine €50,000
Cash €50,000
04/15/18 Inventory €75,000
Cash €50,000
Accounts payable €25,000
04/30/18 Accounts payable €25,000
Cash €25,000
05/10/18 Cash €100,000
Accounts receivable €100,000
Cost of goods sold €50,000
Revenue €200,000
Inventory €50,000

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Journal entries
Date Account DR CR
05/31/18 Cash €100,000
Accounts receivable €100,000
07/01/18 Cash €50,000
Contributed capital €50,000
12/31/18 Wage expenses €50,000
Cash €50,000
12/31/18 Interest expense €12,000
Bank debt €20,000
Cash €32,000
12/31/18 Depreciation expense €7,500
Accumulated depreciation €7,500

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The accounting record
XYZ, Income Statement for the year 2018
Total revenue €200,000

Expenses
Cost of goods sold €50,000

Wage expense €50,000

Depreciation expense €7,500

Interest expense €12,000

Total expenses (€119,500)

Net Income (loss) €80,500

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The accounting record
XYZ, Balance sheet at year end 2018
Assets
Cash €343,000
Inventory €25,000
Machine €50,000
Accumulated Depreciation -€7,500
Total Assets €410,500

Liabilities and owners´ equity

Bank debt €180,000
Contributed capital €150,000
Retained earnings €80,500
Total Liabilities and owners´ equity €410,500

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The accounting record
XYZ, Statement of Cash Flows for the year 2018
Cash received from customers €200,000
Cash paid to suppliers (€75,000)
Interest paid (€12,000)
Wage expenses (€50,000)
Cash flow from operating activities €63,000
Purchase of PPE (€50,000)
Cash flow from investing activities (€50,000)
Capitalizing €100,000
Borrowing €200,000
Issuance of shares €50,000
Installment (€20,000)
Cash flow from financing activities €330,000
Cash at 1/01/2018 €0
Cash at 12/31/2018 €343,000

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The accounting record
XYZ, Statement of Cash Flows for the year 2018
Net income €80,500
Depreciation €7,500
Change in inventory (€25,000)
Cash flow from operating activities €63,000
Purchase of PPE (€50,000)
Cash flow from investing activities (€50,000)
Capitalizing €100,000
Borrowing €200,000
Issuance of shares €50,000
Installment (€20,000)
Cash flow from financing activities €330,000
Cash at 1/01/2018 €0
Cash at 12/31/2018 €343,000

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Revenue and expense recognition of
inventory

 The XYZ purchases inventory items for resale.

Inventory Purchases Units Cost per unit (in €)
First quarter 750 27
Second quarter 150 35
Third quarter 800 38
Fourth quarter 200 33
Total 1,900 62,500

 Sales
 July: 300 units with €58,00 per unit
 September: 550 units with €62,00 per unit
 Revenue and expense for these transactions during the
year and remaining inventory at year end?
1) Using the FIFO method
2) Using the weighted average
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Revenue and expense recognition of
inventory – FIFO

 Sales in July
 Revenue: 300*€58,00=€17,400
 Cost of goods sold:
Units Cost per unit (in €) Cost of goods sold
300 27 €8,100

 Sales in September
 Revenue: 550*€62,00=€34,100
 Cost of goods sold:
Units Cost per unit (in €) Cost of goods sold
450 27 €12,150
100 35 €3,500
550 €15,650

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Revenue and expense recognition of
inventory – FIFO

 Remaining inventory
Inventory Purchases Units Cost per unit (in €)
First quarter 750 27
Second quarter (150-100) = 50 35
Third quarter 800 38
Fourth quarter 200 33
Total 1,050

 (50*35)+(800*38)+(200*33)=€38,750

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Revenue and expense recognition of
inventory – Weighted average

 Sales July
 Revenue: 300*€58,00=€17,400
 Cost of goods sold:
€62,500/1,900 = €32.89 per unit

300 * €32,89 = €9,867

 Sales September
 Revenue: 550*€62,00=€34,100
 Cost of goods sold:
€62,500/1,900 = €32.89 per unit

550 * €32,89 = €18,089.50

 Remaining inventory
 1,050*€32.89=€34,534.50

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Expense recognition – Depreciation

 Company XYZ buys a manufacturing machine for

€100,000
 Estimated residual value: €10,000
 Expected useful life: 10 years

 Annual Depreciation using the straight line method

(Historical cost – Residual value)/Useful life

 Calculate the annual depreciation

 What is the machine´s net book value after 3 years of
usage

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Expense recognition – Depreciation

 Annual Depreciation
(Historical cost – Residual value)/Useful life
(€100,000 - €10,000)/10 = €9,000

 Net book value after 3 years of usage

(100,000 – 3*€9,000) = €73,000
Accumulated
Beginning Net Depreciation Year-End Ending Net
Book Value Expense Depreciation Book Value
Year 1 €100,000 €9,000 €9,000 €91,000
Year 2 €91,000 €9,000 €18,000 €82,000
Year 3 €9,000 €27,000 €73,000
… … €9,000 … …
Year 10 €19,000 €9,000 €90,000 €10,000

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Expense recognition – Depreciation

 Company XYZ buys a manufacturing machine for

€100,000
 Estimated residual value: €10,000
 Expected useful life: 10 years
 Total estimated productive capacity: 250,000 units
 Production in the first 3 years: 32,000; 23,000;35,000
 Annual depreciation:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑖𝑖𝑖𝑖 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑡𝑡
× (𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 − 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣)
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐

 Calculate the annual depreciation

 What is the machine´s net book value after 3 years of
usage

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Expense recognition – Depreciation

 Annual depreciation
 Year 1:
32,000
× €90,000 = €11,520
250,000
 Year 2:
23,000
× €90,000 = €8,280
250,000
 Year 3:
35,000
× €90,000 = €12,600
250,000
 Net book value after 3 years of usage
€100,000 – €32,400 = €67,600

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Basic EPS
 Earnings available to common shareholders divided by
weighted average number of shares outstanding
Basic EPS= (Net income-Preferred dividends)
Weighted average number of shares outstanding

 Example:
A Company had net income of €4,500,000 for the year and paid €800,000 of
preferred dividends.

500,000 Shares outstanding on 1 January 2018

300,000 Shares issued on 1 April 2018

300,000 Shares issued on 1 August 2018

1,100,000 Shares outstanding on 31 December 2018

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Basic EPS

 Weighted average of shares outstanding

500,000 * (3/12) = 125,000
800,000 * (4/12) = 266,667
1,100,000 * (5/12) = 458,333
= 850,000

 Basic EPS
(€4,500,000 - €800,000)/850,000 = €4.35

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Diluted EPS – Stock options

 Diluted EPS is calculated as if the financial instruments

had been exercised and the company had used the
proceeds from exercise to repurchase as many shares of
common stock as possible at the average market price of
common stock during the period
 The treasury stock method
 The company is assumed to receive cash upon exercise and, in exchange,
to issue shares

 The company is assumed to use the cash proceeds to repurchase shares

at the weighted average market price during the period
Diluted EPS= (Net income-Preferred dividends)
[Weighted average number of shares outstanding +
(New ordinary shares that would have been issued-
shares that could have been purchased with cash
received upon exercise) * Proportion of year during
which the financial instruments were outstanding]

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Diluted EPS – Stock options

 Assume a company has the following

 Net income of €4,500,000
 An average of 850,000 of ordinary shares outstanding
 20,000 options with an exercise price of €35 outstanding
 No other potentially dilutive securities
 Over the year, its market price averaged €52 per share
 Calculate the company’s basic and diluted EPS

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Diluted EPS – Stock options example

 Calculate Denominator

850,000 Weighted average number of shares

outstanding
+ 20,000 New shares issued at option exercise
-13,461 Shares that could be purchased with cash
received upon exercise, calculated as 700,000
(€35 for each of the 20,000 options exercised)
divided by average market price of €52 per
share = 13,461 shares

= 856,539 Shares

 €4,500,000/853,539 = €5.25

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Relevant ratios for the midterm exam
Net income
 Net profit margin =
Revenue

 Higher level of net profit margin indicates higher profitability

Current assets
 Current ratio =
Current liabilities

 Company´s ability to meet its short term obligations

Cash + Marketable securities + Receivables
 Quick ratio =
Current liabilities

 Company´s ability to meet its short term obligations with its

most liquid assets

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Relevant ratios for the midterm exam
Total debt
 Debt to equity =
Total equity

 Measure of the degree to which a company finances its

operations through debt versus owned funds
 Financial leverage = Total assets
Total equity

 Indicates how the company is financed

 No ideal ratio but an exceptional high ratio can be
dangerous

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Relevant ratios for the midterm exam
CFO
 Cash flow to revenue =
Net revenue

 Operating cash generated per dollar of revenue

 Indicator for poor receivable collection and also higher
expenses for running its business (efficiency)
CFO
 Cash return on assets =
Average total assets

 Operating cash generated per dollar of asset investment

 Efficiency ratio for the company´s assets in generating cash
flows

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Relevant ratios for the midterm exam
CFO
 Cash return on equity =
Average shareholder´s equity

 Operating cash generated per dollar of owner investment

CFO
 Debt coverage =
Total debt

 Measures financial risk and financial leverage

 Investing and financing ratio =
CFO
Cash outflows for investing and financing activities

 Ability to acquire assets, pay debts, and make distributions

to owners

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