90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Is Your Supplier a Going Concern? Intelligently Interpreting Suppliers (or Anyones) Financial Statements Burr Millsap, CPA MBA Associate Vice President for Administrative Affairs Burr Millsap, CPA MB Burr Millsap, CPA MBA Associate Vice President for Administrative Affairs A Associate Vice President for Administrative Affairs 1 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Is Your Supplier a Going Concern? Burr Millsap, CPA MBA Associate Vice President for Administrative Affairs Why Accounting? 2 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Is Your Supplier a Going Concern? Burr Millsap, CPA MBA Associate Vice President for Administrative Affairs The Purpose Of Any Business Enterprise IS To Make Interesting Money 3 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Is Your Supplier a Going Concern? Burr Millsap, CPA MBA Associate Vice President for Administrative Affairs How Is That Measured? 4 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee ROI Return Investment 100 or Return On Investment Return Investment 100 5 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Simple Example $50 $1,000 = 0.05 100 = 5.00% Certificate of Deposit Investment is $1,000 [I] One Years Interest is $50 [R] ROI = 5.00% 6 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee We Always Have Choices About Our Money 7 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Choices 1. Spend it 2. Keep it 3. Donate it 4. Lose it / Destroy it 5. Invest it / Save it 8 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Choices About Investing / Saving Low Risk to High Risk 1.Savings Account / CD 2.T-Note / T-Bill 3.Corporate Bonds 4.Blue Chip Stock 5.Small Cap Stocks 6.Options 7.Futures 8.Starting a Business 9 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Lets Compare $50 $1,000 = 0.05 100 = 5.00% Certificate of Deposit $50 $1,000 = 0.05 100 = 5.00% Starting and Running a Business 10 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Which is More Interesting? CD No work No sweat No risk No worry 5% ROI Business Hard work Lots of sweat Big risk Heavy worry 5% ROI 11 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Go CD No-brainer 12 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Lets Compare Again $50 $1,000 = 0.05 100 = 5.00% Certificate of Deposit $250 $1,000 = 0.25 100 = 25.00% Starting and Running a Business 13 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Which is More Interesting? CD No work No sweat No risk No worry 5% ROI Business Hard work Lots of sweat Big risk Heavy worry 25% ROI 14 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Go Business? Maybe... Could be a Tough Decision Clearly: The Choice is Personal 15 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Why Accounting Must Be CD To know the ROI, we have all the information we need on the face of the certificate: Amount - Rate - Duration Starting a Business To know the ROI, we need Accounting! (As well see later, we get the Investment from the Balance Sheet and the Return from the Income Statement) 16 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Why Accounting Must Be 17 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Why Accounting Must Be 18 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How About Past vs. Future? Good point. With the CD we know the ROI before we even decide. So, what about starting the business? Well... its possible to use Accounting with projected numbers based on reasonable and conservative estimates and assumptions. It isnt perfect information, but its better than nothing. It is helpful for our decision making needs. 19 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "A lie gets halfway around the world before the truth has a chance to get its pants on." -Winston Churchill 20 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Accounting: The Language / The Yardstick Accounting provides the language and the tools to: Substantiate Measure Record Report Transactions that take place in a business 21 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Substantiate Every word and every amount that finds its way onto a financial statement must be based in fact. It must derive from transactions that actually took place in space and time. Otherwise, financial statements would bear information that could be based on fabrications, lies, and vapor. This... we cannot have. 22 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Measure Every business transaction must be measured somehow. The standard unit it America is the U.S. Dollar. Accounting provides the rules that guide us how to measure transactions in units of the U.S. Dollar. Measurement of most transactions is straightforward. Measurement of a few can get a little complicated. 23 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Measure Depreciation is a good and familiar example. Several methods are OK according to GAAP, but each will have a different impact on the bottom line. Straight line Double declining balance method Sum of the years digits (SOYD) 24 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Measure Asset Cost $ 10,000 Useful life in Months 120 Month 1Month 2Month 3Month 4Month 5 Straight line $ Double declining balance $ $ $ $ $ SOYD $ $ $ $ $ 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Record Every business transaction must be recorded. Accounting provides the rules, guidelines, education, training, knowledge, structure, and processes to properly record business transactions. The written record becomes a vital part of the audit, verification, and problem-solving process. 26 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Report Periodically the financial transactions of a business should be reported in a form that is understandable to human beings. The report format should have certain standards so that there is consistency and comparability. Comparability within the business from period to period / Comparability between different businesses within the same period. 27 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Double Entry Double entry is the essence of Accounting. Each transaction must be recorded using at least two entries. Example: DebitCredit Cash Sales $100 (To record a cash sale to a customer) Therefore Accounting is intentionally NOT an efficient process. 28 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Triple (or more) Entry Even though we say Double Entry it is possible to have 3 or more. The minimum requirement is 2. Example: DebitCredit Cash Sales $100 $200 (To record a cash sale to one customer and a sale on account to another customer) Accounts Receivable$100 29 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee So What is the Same? Whether we have two, three, four, or more entries, one thing is always the same: The total dollar amount of the Debit entries must equal the total dollar amount of the Credit entries. DebitCredit Cash Sales $100 $200 Accounts Receivable$100 Cash Sales $100 Ex 1 Ex 2 30 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Father of the Balance Sheet Fr. Luca Paciola 31 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Summa De Arithmetica In 1494, Luca Paciola - an Italian monk - published a book titled Summa De Arithmetica, Geometria, Proportioni et Proportionalita, or Everything There is to Know About Math, Geometry, Proportions and Proportionality. In it, he included a chapter that documented the Accounting practices of the Venetian merchants of that day. 32 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How Old? The point here is to emphasize how old the rules are that well be talking about. Because some of you, when I say, A DEBIT entry to the Cash account will INCREASE the balance of that account, will think that sounds wrong. Well... in fact, it IS right. So, theres a problem with your understanding. 33 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How Old? So, how old are the rules? Lets do the math. This year2011 Lucas book was published1494 Means the rules are at least 517 years old..... Which is to say nothing more than, when we go over the rules in just a few minutes, you need to understand theyre older than you and I together. minus equals 34 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "I'm living so far beyond my income that we may almost be said to be living apart." - e e cummings 35 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Debit and Credit About the only simple things we can say about the words Debit and Credit are: Debit means Left Credit means Right It gets no harder than that... well, OK, maybe just slightly harder... but only slightly. 36 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The 2 Sides of Any Business Luca Paciola observed that the Venetian merchants viewed their businesses from two sides... the Left side and the Right side. ThingsOwnerships = On the left side would be all the things used and controlled by the business. On the right side would be the ownerships of everyone having an interest in the things on the left side. 37 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Total Things = Total Ownerships ThingsOwnerships = Cash Accounts Receivable Inventory Land Buildings Equipment Theirs (that is, they who are NOT us) Ours (that is, they who ARE us) 38 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Assets = Liabilities + Equity AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Equity Visiting Team Home Team 39 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Assets = Liabilities + Equity AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Contributed Capital Retained Earnings Visiting Team Home Team 40 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Assets = Liabilities + Equity AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Contributed Capital Retained Earnings Visiting Team Home Team Revenues Expenses 41 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee A Sports Analogy The GameThe Scoreboard = Stadium Field Players Ball Pitches and Catches Runs Scored Visiting Teams Score Home Teams Score 42 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Coin HeadsTails = 43 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee To Separate / To Assimilate So, heres the deal. To move around successfully in Accounting, we must acquire (unless were born with it) the ability to regard a single thing by attributing a duality to it, because to do so helps us understand that thing more deeply and completely. We must be able to take a business and view it from the perspective of Assets as well as from the perspective of Ownerships... and yet we must, at the same time, keep in mind that it is still a single thing that we are regarding. 44 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Equation The only purpose of an equation can be to enable the deeper and more complete understanding of something. Setting A equal to B allows us to study A in terms of B and B in terms of A. And by requiring that A always equals B, we can explain any changes in A by explaining the changes in B, and in any changes in B by explaining the corresponding changes in A. If A = B, then it must follow that A = B This notion is a fundamental basis for Accounting. 45 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "Never interrupt your enemy when he is making a mistake." - Napoleon Bonaparte 46 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How Debits and Credits Work Then AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Contributed Capital Retained Earnings Visiting Team Home Team Revenues Expenses ThingsOwnerships DebitCredit LeftRight 47 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How Debits and Credits Work Then Assets Liabilities Contributed Capital Retained Earnings Revenues Expenses + + + + + + DebitCredit 48 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Which Is To Say Consider the following entry: DebitCredit Cash Sales $100 (To record a cash sale to a customer) The Debit entry to the Cash account will increase (add to) the balance of that account. Now this may sound wrong to many of us, but remember... the rules have been around for over 517 years. 49 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Lets Take Another Look AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Contributed Capital Retained Earnings Visiting Team Home Team Revenues Expenses ThingsOwnerships DebitCredit LeftRight Sales 50 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Another Look DebitCredit Cash Sales $100 (To record a cash sale to a customer) The Debit entry to the Cash account will increase (add to) the balance of that account. The Credit entry to the Sales account will increase (add to) the balance of that account. Makes sense... this entry is recording a cash sale to a customer. Were adding cash to the business because weve made another sale, and the customer is paying us in cash. 51 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee So... The Question Is Well... if it sounds wrong that making a Debit entry to the Cash account will increase the balance of that account, then the REAL question is, WHY DOES IT SOUND WRONG? The answer is, BECAUSE WE HAVE BEEN TRAINED TO HAVE THAT WRONG FEELING WITHOUT EVEN REALIZING IT. 52 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "I have not failed. I've just found 10,000 ways that won't work." - Thomas Alva Edison 53 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "The optimist proclaims that we live in the best of all possible worlds, and the pessimist fears this is true." - James Branch Cabell 54 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Accounting Cycle An essential requirement is to memorize and understand the Accounting Cycle. The Accounting Cycle provides the structure and basis for getting the actual work done. Just as important, it provides the knowledge roadmap for the Higher Education manager to better understand his/her duties and responsibilities. Here are the steps of the Accounting Cycle. 55 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Accounting Cycle 1.Transaction 2.Evidence 3.Record in the Journal 4.POST to the General Ledger 5.Trial Balance 6.Adjustments 7.Trial Balance 8.Financial Statements 9.Review / Analysis / Decision / Action 56 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction / Evidence The transaction is the starting point of the Accounting Cycle. A transaction is defined as any event of measurable economic benefit or loss to the business. Most transactions arise from economic exchanges between the business and other parties. Most transactions are accompanied by some form of evidence or source document. For example, a sale is evidenced by a sales slip, a purchase is evidenced by an invoice, a payment is evidenced by a check, a bank deposit is evidenced by a deposit slip. 57 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Record In The Journal Once a transaction has taken place and the appropriate evidence has been generated, we record the transaction in the Journal (or General Journal). The Journal is the CHRONOLOGICAL record of the transactions that take place in our business. The Journal is also the place where we translate each transaction into its Double-Entry Debit/Credit form. DebitCredit Cash Sales $75 (To record a cash sale to a customer) 58 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Record In The Journal 59 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Journal Page The pages in a Journal are basically blank, except that they have some columns, which are described on the next slide. Since it is a chronological record, each page has no particular significance, which is not the case with the General Ledger, as we shall see in a few moments. 60 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Columns In The Journal The columns in the Journal are important, as we shall see later. Date To record the date of the transaction. Journal Reference A unique reference (usually a number) to distinguish this transaction from all others. Source Reference Some number or combination of numbers and letters that identifies the evidence or source document (gets us to the right document in the right file). Account Number The number of the account to receive the debit or credit posting. Account Name The name of that account. Debit & Credit Columns The two columns where the debit amount(s) and credit amount(s) are appropriately recorded. 61 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Journal Page 62 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee POST to the General Ledger POSTING is a SACRED and HOLY event. Once we POST a transaction we may not erase it or un-post it. POST in this sense means a completed act that can never be taken back or undone. In England, they POST letters (here we say mail). The act of dropping a letter in the mailbox is one that cant be undone. I give you my word is an act of POSTING. Once you have said it, your honor prevents you from taking it back. 63 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee POST to the General Ledger Posting does not change any of the information recorded in the Journal. Posting merely re-sorts the information and puts it into a different format, giving it a different look. The key point to remember is that the information itself is not changed. 64 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Ledger Page Whereas the pages in the Journal are blank and have no special significance, each page in the General Ledger represents an Account. Accordingly, each page in the General Ledger is primarily identified by an Account Number, and then secondarily by the corresponding Account Name. 65 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Columns In The Ledger The columns in the Ledger are important as well. Date To record the date of the transaction. Journal Reference This is the same reference as in the Journal. It transports us neatly back to that Journal and that particular transaction. Description A short, plain-language description of the transaction. Debit & Credit Transaction Columns The Debit column holds any Debit entries; the Credit column holds any Credit entries. Debit & Credit Balance Columns The Debit column will show any Debit balance; the Credit column will show any Credit balance. 66 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Ledger Page 67 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Normal Balances Which, by the way, brings up the point of Normal Balances. Here they are: AssetsDebit LiabilitiesCredit Contributed CapitalCredit Retained EarningsCredit RevenuesCredit ExpensesDebit 68 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "The true measure of a man is how he treats someone who can do him absolutely no good." - Samuel Johnson 69 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Prepare The Trial Balance There are two purposes for preparing the Trial Balance: 1.To test whether total Debit balances = Total Credit Balances 2.To test whether each accounts balance looks reasonable and fair as against what we expect, or know to be true. 70 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Prepare The Trial Balance 71 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Prepare The Trial Balance Running the Trial Balance does not change any of the information recorded in the Journal or posted to the General Ledger. The Trial Balance merely re-sorts the information and puts it into a different format, giving it a different look. The key point to remember is that the information itself is not changed. 72 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Adjusting Entries 73 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Re-Run The Trial Balance 74 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Prepare The Financials The Financial Statements are Accountings Deliverables. Under GAAP, there are 5 : 1. Balance Sheet 2. Income Statement 3. Statement of Changes in Equity 4. Cash Flow Statement 5. Notes (familiarly: The Footnotes) 75 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Prepare The Financials Preparing the Financials does not change any of the information recorded in the Journal, posted to the General Ledger, or presented in the Trial Balance. The Financials merely re-sort the information and put it into a different format, giving it a different look. The key point to remember is that the information itself is not changed. 76 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Balance Sheet 77 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Income Statement 78 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Statement of Changes In Equity 79 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Cash Flow Statement 80 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Audit Trail Financial Statements 4. Trial Balance 3. General Ledger 2. Journal 1. Evidence / Source Document Is Merely the Accounting Cycle in Reverse 81 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "There is more stupidity than hydrogen in the universe, and it has a longer shelf life." - Frank Zappa 82 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "Fill what's empty, empty what's full, and scratch where it itches." - The Duchess of Windsor, when asked what is the secret of a long and happy life 83 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Double Entry: Accountings Powerful Trick 84 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Double Entry: Accountings Powerful Trick 85 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Double Entry: Accountings Powerful Trick 86 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Higher Education Cash Revenue Receivable All Other Assets Accounts Payable Bonds Payable Net Assets Appropriations Tuition / Fees IDC Salaries/Wages Supplies MRO Assets Liabilities + Net Assets ExpensesRevenues Deptl Budget Rsrv for Comm Rsrv for Encmb Deptl Budget Commitments Encumbrances Expense BudgetRevenue Budget (Requisitions) (Purchase Orders) (Payroll) (Invoices) 87 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Truth About The Right Side Youll notice that all of the Budget Stuff goes on over on the Right side (the Ownership side) of the Balance Sheet... and that the stuff we actually spend (and earn) Cash is back on the Left side (the Asset side). The purpose of pointing this out is to emphasize that budget technically is not cash, but ownership. When you spend budget, you are actually using up the authorization to spend. What you may think of as cash, then, is little more than an idea. 88 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Truth About The Right Side Indeed, thats all Ownership is: an idea. Granted, its a very powerful idea, but it is still just an idea. This is an important distinction to understand. The idea of your spending authority (right side) is actually backed up by cash (left side - remember the concept of The Coin), but to think of it as cash itself is not exactly correct. Its the gas gauge, not the gas. The actual cash on the left side is centrally controlled and managed by the Business Officer / Treasurer. 89 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "A narcissist is someone better looking than you are." - Gore Vidal 90 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Higher Education DebitCredit Expense Budget$500,000 (To set up the departmental budget for the year) + Revenue Budget$500, 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Higher Education DebitCredit Commitments$400 (To record a requisition for office supplies) + Reserve for Commitments$ 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Higher Education DebitCredit Reserve for Commitments$400 (To record the placing of the purchase order for office supplies, which was $15 less than what was estimated on the requisition) - $400 -Commitments Encumbrances$ Reserve for Encumbrances 93 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Higher Education DebitCredit Reserve for Encumbrances$385 (To record the receipt and acceptance of the office supplies, along with the invoice; the actual order came in $17 more than what was originally placed.) - $385 -Encumbrances Office Supplies Expense$ Accounts Payable 94 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Higher Education DebitCredit Accounts Payable$397 (To record the payment of the office supplies invoice along with the fact that we took advantage of the vendors prompt payment discount.) - $390 -Cash $ 7 +Prompt Payment Discount 95 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Higher Education 96 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "In any contest between power and patience, bet on patience." - W.B. Prescott 97 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials If the company is publicly traded (NYMEX, AMEX, NASDAC), you can get good (audited) financial statement information from their filings with the Securities and Exchange Commission (SEC). Otherwise, youll need to ask for the financials from the company. Audited financials are most preferable, followed by Reviewed, followed by Compiled. 98 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials Audit Includes procedures such as confirmation with outside parties, observation of inventories, and testing selected transactions by examining supporting documents. Review Inquiry and analytical procedures applied to financial statements. Compilation Preparing financial statements of private entities based on information provided by the entitys management. 99 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials 100 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials 101 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials 102 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials 103 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials 104 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials 105 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Real-Life Financials 106 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Financials Analysis - Ratios Liquidity Profitability Activity Capital Structure 107 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Liquidity Ratios Do they have sufficient cash to keep operating? Current ratio Quick (or Acid Test) ratio 108 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Liquidity Ratios Current Assets Current Liabilities Current Assets = Cash + Cash Equivalents + Short Term Investments + A/R + Inventory Current Liabilities = A/P + Accrued Expenses + Current Portion of Long Term Debt Current = Cash or anything that can be turned to cash within 1 year, and any liability that is due for payment within 1 year. 109 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Liquidity Ratios Quick Assets Current Liabilities Quick Assets = Current Assets less Inventory Current Liabilities = A/P + Accrued Expenses + Current Portion of Long Term Debt (Almost like the Current Ratio but a stricter test since the value of Inventories is excluded from the numerator) 110 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Profitability Ratios Do they consistently earn profits? Profit Margin Asset Turnover Return on Assets Financial Leverage Multiplier Return on Equity (Profit Margin x Asset Turnover = Return on Assets; Return on Assets x Financial Leverage Multiplier = Return on Equity) 111 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Profitability Ratios Net Income Sales 112 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Profitability Ratios Sales Total A s s e t s 113 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Profitability Ratios Net Income Total A s s e t s 114 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Profitability Ratios Total Assets Total Equity 115 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Profitability Ratios Profit Margin x Asset Turnover = Return on Assets x Financial Leverage Multiplier = Return on Equity Net Income x Sales = Net Income x Total Assets = Net Income SalesTotal Assets Total Equity 116 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Activity Ratios Do they manage their operations effectively and efficiently? Inventory Turnover Accounts Receivable Turnover 117 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Activity Ratios Cost of Goods Sold (Average) Inventory 118 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Activity Ratios Sales (Average) A/R 119 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Capital Structure Ratios Are they sensibly balancing capital and debt? Debt to Equity Ratio Interest Coverage Ratio 120 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Capital Structure Ratios Total Liabilities Total Equity 121 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Capital Structure Ratios Income before Interest and Income Taxes (Operating Profit [Loss]) Interest Expense 122 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Financials Analysis - Ratios 123 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Financials Analysis - Ratios 124 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Financial Analysis See how the Accounting Equation changes from year to year. Amazingly simple, but powerful and revealing. 125 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Financial Analysis 126 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Financial Analysis Year-to-Year Changes 127 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Summary Two vital requirements in becoming a complete Procurement Professional are a solid understanding of Accounting and the ability to analyze and interpret financial information. 128 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Thanks and Good Luck! 129 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Why We Have Feelings About Debit and Credit The next several slides will demonstrate to us why we have feelings about the words Debit and Credit. In one explanation we will represent an Account Receivable to a business. In the other explanation we will represent an Account Payable to a business. The effect of either situation on us is the same: WEVE BEEN BRAINWASHED 130 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Receivable The Gap Assume we go to The Gap to buy a pair of jeans for $50. But, instead of paying cash we ask if we can pay next month. The manager regards us for a moment and reckons that we shower every day... and then hands us a Credit Application to complete, which we do. Here is the Journal Entry that The Gap will make: DebitCredit Accounts Receivable Sales $50 (To record an account sale to a customer) 131 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Lets Take Another Look AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Contributed Capital Retained Earnings Visiting Team Home Team Revenues Expenses ThingsOwnerships DebitCredit LeftRight Sales 132 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How Debits and Credits Work Then Assets Liabilities Contributed Capital Retained Earnings Revenues Expenses + + + + + + DebitCredit 133 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Receivable The Gap We see then that this entry will increase the balance of the Accounts Receivable account, and will increase the balance of the Sales account. DebitCredit Accounts Receivable Sales $50 (To record an account sale to a customer) 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Receivable The Gap Now, at the end of the month, The Gap will send us a statement. It will come out of their Accounts Receivable system because that is where they keep track of what we owe, along with each of their other customers. DebitCredit Accounts Receivable Sales $50 (To record an account sale to a customer) 135 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Receivable The Gap When we open up the statement and read it, we will see the Purchase transaction, and it will appear under which column? Debit or Credit? And, of course, the answer is: Debit And how do we feel when we read that? BAD DebitCredit Purchase 1 Pair Jeans$50 136 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Receivable The Gap OK. Next month we send in our payment to The Gap because were honest people and we want to maintain a good credit record. Here is the Journal Entry that The Gap will make when they receive and deposit our payment: DebitCredit Cash Accounts Receivable $50 (To record a customers payment on his/her account) 137 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Lets Take Another Look AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Contributed Capital Retained Earnings Visiting Team Home Team Revenues Expenses ThingsOwnerships DebitCredit LeftRight Sales 138 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How Debits and Credits Work Then Assets Liabilities Contributed Capital Retained Earnings Revenues Expenses + + + + + + DebitCredit 139 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Receivable The Gap We see then that this entry will increase the balance of the Cash account, and will decrease the balance of the Accounts Receivable account. DebitCredit Cash Accounts Receivable $50 (To record a customers payment on his/her account) 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Receivable The Gap Now, at the end of the month, The Gap will send us a statement. Again, it will come out of their Accounts Receivable system because that is where they keep track of what weve paid on our account, along with each of their other customers. DebitCredit Cash Accounts Receivable $50 (To record an account sale to a customer) 141 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Receivable The Gap When we open up the statement and read it, we will see the Payment transaction, and it will appear under which column? Debit or Credit? And, of course, the answer is: Credit And how do we feel when we read that? GOOD DebitCredit Received payment on account $50 142 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee So... The Answer Is The usual setting in which we see the words Debit and Credit is reading another companys information about us. But, that company has only been using Accounting rules that are over 500 years old. So, the fact that we have feelings about Debit and Credit is really not our fault. But, be that as it may, those feelings get in the way of our trued understanding, and we need to ignore them. OK. So lets see if the same thing holds if we represent and Account Payable to a business. 143 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "The difference between 'involvement' and 'commitment' is like an eggs-and-ham breakfast: the chicken was 'involved' - the pig was 'committed'." - Unknown 144 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank To our bank, we are an account payable. When we deposit our paycheck, the bank can loan out that money. They pay us tiny interest on it, while they charge big interest on the loan. Thats how banks make their money. Still... on their books, they must reflect that we have the ownership interest in that money. 145 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank Assume that our paycheck for the month is $2,000 and that we deposit it with our bank. Here is the Journal Entry that our bank will make: DebitCredit Cash Accounts Payable $2,000 (To record a customers deposit) 146 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Lets Take Another Look AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Contributed Capital Retained Earnings Visiting Team Home Team Revenues Expenses ThingsOwnerships DebitCredit LeftRight Sales 147 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How Debits and Credits Work Then Assets Liabilities Contributed Capital Retained Earnings Revenues Expenses + + + + + + DebitCredit 148 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank We see then that this entry will increase the balance of the banks Cash account, and will increase the balance of the Accounts Payable account. DebitCredit Cash Accounts Payable $2,000 (To record a customers deposit) 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank Now, at the end of the month, our bank will send us a statement. It will come out of their Accounts Payable system because that is where they keep track of what we have on deposit, along with each of the other customers. DebitCredit Cash Accounts Payable $2,000 (To record a customers deposit) 150 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank When we open up the statement and read it, we will see the Deposit transaction, and it will appear under which column? Debit or Credit? And, of course, the answer is: Credit And how do we feel when we read that? GOOD DebitCredit Deposit$2, 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank OK. Next month we write a check for $75 to our friendly neighborhood grocer for our weekly groceries. Our bank will honor that check by paying the grocer on our behalf. Here is the Journal Entry that our bank will make when they pay the grocer: DebitCredit Accounts Payable Cash $75 (To record payment to a grocer in honor of a customers check to that grocer) 152 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Lets Take Another Look AssetsLiabilities + Equity = Cash Accounts Receivable Inventory Land Buildings Equipment Liabilities Contributed Capital Retained Earnings Visiting Team Home Team Revenues Expenses ThingsOwnerships DebitCredit LeftRight Sales 153 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee How Debits and Credits Work Then Assets Liabilities Contributed Capital Retained Earnings Revenues Expenses + + + + + + DebitCredit 154 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank We see then that this entry will decrease the balance of the Accounts Payable account, and will decrease the balance of the Cash account. DebitCredit Accounts Payable Cash $ (To record payment to a grocer in honor of a customers check to that grocer) 155 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank Now, at the end of the month, our bank will send us a statement. Again, it will come out of their Accounts Payable system because that is where they keep track of what we have on deposit, along with each of their other customers. DebitCredit Accounts Payable Cash $75 (To record payment to a grocer in honor of a customers check to that grocer) 156 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Account Payable Our Bank When we open up the statement and read it, we will see the check transaction, and it will appear under which column? Debit or Credit? And, of course, the answer is: Debit And how do we feel when we read that? BAD DebitCredit Check # 1234$75 157 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee So... The Answer Is The usual setting in which we see the words Debit and Credit is reading another companys information about us. But, that company has only been using Accounting rules that are over 517 years old. So, the fact that we have feelings about Debit and Credit is really not our fault. But, be that as it may, those feelings get in the way of our trued understanding, and we need to ignore them. No matter whether were an Account Receivable or an Account Payable to a business, the emotional effect is still the same. 158 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Conclusion Can Only Be We now know why weve developed feelings about Debit and Credit over the years. Its not our fault, really. We also now know the TRUE rules of Debit and Credit. These rules have been in place for more than 517 years. Our conclusion can only be: GET OVER IT! We must put aside our feelings and trust our knowledge of the rules. 159 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Nine Transactions Now well follow 9 transactions through the Accounting Cycle 160 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee The Accounts Well Use Cash Accounts Receivable Inventory Land Building Accumulated Depr Accounts Payable Notes Payable Contributed Capital Retained Earnings Sales CGS Wages Exp Interest Exp Depr Exp Assets Liabilities + Equity ExpensesRevenues 161 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Nine Transactions 1.Contribute $50,000 of our own money into the business. 2.Borrow $50,000 from our bank (interest rate is 8.5%, repayment period is 5 years [60 months]). 3.Purchase a building for $20,000 in cash. 4.Purchase our first load of inventory. Total amount is $10,000. We pay $6,000 in cash and owe the remaining $4, Record the months sales. Total amount is $11,000. We received $7,000 in cash and are owed the remaining $4, 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Nine Transactions 6.Pay our sales person $500 in cash for the months wages. 7.Take physical inventory at the end of the month and determine there is $6,000 (cost value) left in stock. 8.Record depreciation expense on the building. 9.Make our first payment on the note (see transaction #2). 163 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Turning Transactions Into Journal Entries One of the trickiest skills to learn in Accounting is translating a transaction into its Debit / Credit legs. This is fairly difficult to teach, so the task really falls on the student. About the only way to approach it is from the perspective of the Accounting Equation. Assets = Liabilities + Equity 164 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Turning Transactions Into Journal Entries Assets = Liabilities + Equity Assets = Liabilities + [Contributed Capital + Retained Earnings] Assets = Liabilities + [Contr Cap + RE + (Revenue Expenses)] for all prior yearsfor the current year The Dr / Cr translation of each transaction must NEVER result in the Accounting Equations being thrown out of balance. Lets do one entry really slow... just for example. 165 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Turning Transactions Into Journal Entries This is one of the simplest examples: A sale to a customer for cash in the amount of $100. Question: Is anything coming into the business? Answer: Yes. Cash. Question: What entry is needed to show an increase in Cash? Answer: A Debit. Conclusion: One of our entries must be a Debit to the Cash account for $100. Conclusion: Now, we need a balancing Credit entry. 166 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Turning Transactions Into Journal Entries Question: Is any asset being reduced in this transaction? Answer: No. Conclusion: The Credit entry will not be made to the Asset side of the equation; we must look on the Ownerships side. Question: Was a Liability increased from this transaction? Answer: No. Conclusion: The Credit entry will not be made to a Liability account. 167 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Turning Transactions Into Journal Entries Question: Is our Equity being increased because of this transaction? Answer: Yes. Question: Is it Contributed Capital or Retained Earnings? Answer: Retained Earnings, specifically in the form of a Revenue, more specifically in the form of a Sale. Conclusion: The Credit entry must be made to the Sales account for $100. Question: Does this entry leave the Accounting Equation in balance? Answer: Yes. 168 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Turning Transactions Into Journal Entries Result: DebitCredit Cash Sales $100 (To record a cash sale to a customer in the amount of $100) 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Turning Transactions Into Journal Entries +$100 +$100 Assets = Liabilities + Equity +$100 +$100 Assets = Liabilities + [Contributed Capital + Retained Earnings] +$100 +$100 Assets = Liabilities + [Contr Cap + RE + (Revenue Expenses )] for all prior yearsfor the current year 170 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "It is much more comfortable to be mad and know it, than to be sane and have one's doubts." - G. B. Burgin 171 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #1 Contribute $50,000 of our own money into the business. DebitCredit Cash Contributed Capital $50,000 (To record our personal contribution of $50,000 cash into our business) 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #2 Borrow $50,000 from our bank (interest rate is 8.5%, repayment period is 5 years [60 months]). DebitCredit Cash Notes Payable $50,000 (To record our borrowing of $50,000 from the bank, to put into the business) 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #3 Purchase a building for $20,000 in cash. DebitCredit Land Cash $5,000 $20,000 (To record our purchase of a building [and land], paying cash for the entire purchase) Building$15, 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #4 Purchase our first load of inventory. Total amount is $10,000. We pay $6,000 in cash and owe the remaining $4,000. DebitCredit Inventory Cash $10,000 $6,000 (To record our purchase of our first load of inventory, paying $6,000 in cash now, and owing the remaining $4,000 to our supplier) + - Accounts Payable$4, 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #5 Record the months sales. Total amount is $11,000. We received $7,000 in cash and are owed the remaining $4,000. DebitCredit Cash$7,000 (To record the months sales of $11,000. Of the total, $7,000 was received in cash and the remaining $4,000 is owed to us by our customers.) + Sales$11,000 + Accounts Receivable$4, 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #6 Pay our sales person $500 in cash for the months wages. DebitCredit Wages Expense$500 (To record paying our sales person his wages for the month; $500 in cash.) + Cash$ 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #7 Take physical inventory at the end of the month and determine there is $6,000 (cost value) left in stock. DebitCredit ???$??? ? ???$??? ? Here, we have a little work to do. We must analyze the Inventory Account. 178 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #7 To analyze any account, we use the following format: Beginning Balance Plus: Additions Minus: Subtractions Equals: Ending Balance 179 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #7 Lets now analyze the Inventory Account: Beginning Balance$ 0 Additions (Purchases)$10,000 Subtractions (???)$ ??? Ending Balance$ 6, = 180 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #7 Lets now analyze the Inventory Account: Beginning Balance$ 0 Purchases$10,000 Cost of Goods Sold$ 4,000 Ending Balance$ 6, = 181 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #7 Take physical inventory at the end of the month and determine there is $6,000 (cost value) left in stock. DebitCredit Cost of Goods Sold (CGS)$4,000 + Inventory$4,000 - (To record end-of-month physical inventory and the accompanying Cost-of-Goods-Sold [CGS] amount.) 182 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #8 Record depreciation expense on the building. DebitCredit ???$??? ? ???$??? ? Here again, we have a little work to do. We must compute the buildings depreciation. 183 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #8 Depreciation, as used in Accounting, is purely a mathematical process. It does not propose to place a value on something. Its objective is to estimate the cost of an asset each month, as that asset is used up, and then express that cost as a MEASURED expense on each months financial statements. Depreciation is a process of allocation, not valuation. It is arrived at using human judgment and estimation. It is NOT an exact science. It is MEASUREMENT in its roughest form. Understanding Depreciation 184 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #8 Assumptions / Judgments / Estimates Cost of Building$15,000 Useful Life (in years)40 Depreciation per Year$ 375 Months per Year12 Depreciation per Month$ (Rounded [for class purposes] )$ 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #8 Record depreciation expense on the building. DebitCredit Depreciation Expense$30 + Accumulated Depreciation$30 + (To record one months depreciation expense on our building.) 186 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #8 Question: Why do we not depreciate the land ($5,000) as well? Answer: The Accounting theory is that land is not depreciable because it is not subject to wear and tear. It has no moving parts and therefore an unlimited useful life. Therefore, it will remain an asset in perpetuity and will never go away. 187 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #9 Make our first payment on the note (see transaction #2). DebitCredit ???$??? ? ???$??? ? Here yet again, we have a little work to do. We must do some computations in order to develop this entry. 188 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #9 Make our first payment on the note (see transaction #2). We need a financial calculator to help us compute the payment required to amortize this debt. The full explanation of how to use the calculator is beyond the scope of this class. But, the short explanation is that this is a Time-Value-of-Money problem. This type of problem always has four elements. If you can supply any three, the fourth can always be computed. Here we know: (1) the amount borrowed, (2) the interest rate, and (3) the repayment period. 189 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #9 Make our first payment on the note (see transaction #2). Knowing how to use our calculator, then, we enter these three variables and compute the fourth, which is the monthly payment required to amortize the debt. That answer is $1, For our purposes here, well round it to $1,026. Then... knowing that answer, we can construct an amortization table in order to compute the Interest component and Principal component of each months payment. 190 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #9 Make our first payment on the note (see transaction #2). 191 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #9 Make our first payment on the note (see transaction #2). 192 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #9 Make our first payment on the note (see transaction #2). 193 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Transaction #9 Make our first payment on the note (see transaction #2). DebitCredit Interest Expense$354 (To record the first payment on the Note Payable to the bank [see Journal Entry 2]) + Cash$1,026 - Notes Payable$ 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Quote "If everything seems under control, you're just not going fast enough." - Mario Andretti 195 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Record In The Journal 196 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Post To The Ledger 197 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Post To The Ledger 198 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Post To The Ledger 199 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Post To The Ledger 200 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Prepare The Trial Balance 201 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Balance Sheet 202 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Income Statement 203 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Statement of Changes In Equity 204 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Cash Flow Statement 205 90 th Annual Meeting & Exposition April 3 6, 2011 Memphis, Tennessee Interesting Money - ROI Return Investment 100 $6,116 $50,000 100 = =12.23% 206