Transition from

Financial
Accounting to
Management
Accounting
Dr. Mohammad Albahloul
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 Lecture contents

1. Financial Statements
2. Cost, Volume, and Profitability

4
 FINANCIAL STATEMENTS

USING THE INCOME STATEMENT AND BALANCE SHEET FOR

DECISIONS

1. Income Statement
2. Balance Sheet
3. Statement of Cash Flows

5
INCOME STATEMENT

• Revenues
– Total sales value of goods or services
provided to customers in an accounting
period (revenue recognition)
• Expenses
– Cost of resources consumed in process of
earning revenue (matching)

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INCOME STATEMENT EQUATION

Revenues
- Expenses
Net Income (Net Loss)

7
 INCOME STATEMENTS

• Key Principles
– Revenue Recognition
• Shown in period earned
– Not when cash received
– Not when sales contract signed
– Matching
• Expense matched to revenue
– Not when expense paid

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 INCOME STATEMENT
Super Stereos
Comparative Income Statement
Year Ended Dec 31st (£000s)
2018 2017 2016
£ % £ % £ %
Net sales 545000 100 % 505000 100 % 486000 100 %
Cost of goods sold 33000 60.55 % 30400 60.20 % 286000 58.89 %
Gross margin on sales 215000 39.45 % 201000 39.8 % 20000 41.15 %
Operating expenses 133000 24.40 % 93000 18.42 % 89000 18.31 %
Interest expense 9450 1.73 % 8320 1.65 % 8380 1.72 %
Earnings before income tax 72550 13.31 % 9968 19.74 % 102620 21.12 %
Income tax @ 30% 21765 3.99 % 29904 5.92 % 30786 6.33 %
Net income 50785 9.32 % 69776 13.82 % £ 71834 14.78 %
Average shares outstanding 80000 50000 50000
Earnings per share 0.63 1.4 £ 1.44
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 SECTIONS OF AN
INCOME STATEMENT
• Sales
• Cost of goods sold
• Gross margin
• Operating expenses
• Interest income and expense
– Shown separately

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 I.S. SECTIONS (CONT)

• Income before tax

• Income tax
• Net Income
– Also earnings or profit
• Basic earnings per share
– Net income ÷ stock shares outstanding

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 BALANCE SHEET

• Assets
– Economic resources of company
• Liabilities
– Portion of economic resources provided by
creditors
• Owner’s Equity
– Portion of economic resources provided by
owner

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 BALANCE SHEET EQUATION

•Proprietorship
•Assets= Liabilities + Owner Equity
– A=L+OE

• Corporation
• Assets= Liabilities + Shareholders Equity
– A=L+SE

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 BALANCE SHEET PRINCIPLES

• Entity Concept
– Business separate from owners’ personal
affairs
• Historical Cost Concept
– Assets and most items shown at their
originally recorded amount
– Unless fair market value is less

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 PRINCIPLES (CONTINUED)

• GOING CONCERN CONCEPT

– Firms usually are assumed to continue
indefinitely
– If a firm is near bankruptcy, special
accounting needed
• Assets must be marked down to “fire sale” levels

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 ASSETS

• Current Assets
• Property and Equipment
• Other Assets
More recently:
• Under IFRS: Current or Non-Current Assets
• Also, Tangible and Intangible Assets.

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 CURRENT ASSETS

Super Stereos
Comparative Balance Sheets
December 31st

Assets (£000) 2018 2017 2016

Current Assets
Cash £ 48500 £ 58000 52000
Accounts Receivable, net 89000 76000 68000
Merchandise Inventory 165000 154000 150000
Prepaid expenses 26450 28650 28650

Total Current Assess £ 328950 £316650 £298650

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 PROPERTY AND EQUIPMENT
Non Current Assets / Tangible assets

Super Stereos
Comparative Balance Sheets
December 31st

Assets (£000) 2018 2017 2016

Property and Equipment:
Land 93000 68000 68000
Building 325000 154000 154000
Equipment 96000 62030 61040

514000 284030 283040

Accumulated Depreciation (122000) (86120) (86000)
Property and Equipment, net 392000 197910 197040

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 OTHER ASSETS
Intangible assets
• Patents
• Trademarks
• Copyrights
• Contract Rights
• Goodwill

Note: Research and

Development costs are
expensed.

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 CURRENT LIABILITIES

Super Stereos
Comparative Balance Sheets
December 31st

Liabilities and Stockholders’ Equity 2018 2017 2016

(£000)

Current Liabilities:
Note Payables 40050 30050 10000
Accounts Payables 44000 59000 61000
Accrued expenses 48060 27650 28450
Income tax payable 36000 34210 35550

Total Current Liabilities 168110 150910 135000

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 LONG-TERM LIABILITIES
Non-Current Liabilities
• Mortgage payable
• Bonds payable
• Capital leases
• Deferred taxes

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 STOCKHOLDERS’ EQUITY
Shareholders Equity
Super Stereos
Comparative Balance Sheets
December 31st

Stockholders’ Equity (£000) 2018 2017 2016

Ordinary Shares £1 Par 80000 50000 50000

Additional paid-in Capital 150000 70000 70000
Retained Earning 160160 126970 124010
Total Stockholders’ Equity 390160 246970 244010

Total Liabilities and £ 734270 £ 527880 £ 509010

Stockholders’ Equity

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 THE GOODWILL ASSET

• Acquired in the purchase of another entity

• Goodwill = Purchase price - fair market value of
the net assets
• Goodwill is an intangible asset
• Amortized over forty years or less

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 LINKS BETWEEN FINANCIAL
STATEMENTS

Retained Earnings - beginning of the year

Net income less dividends declared

Retained earnings - end of year

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STATEMENT OF CASH FLOWS

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 USING THE STATEMENT OF CASH
FLOWS FOR DECISIONS

• Uses
– Reconcile cash balance
– Estimate future cash flows
– Determine “quality” of earnings

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 STATEMENT OF CASH FLOWS
(CONTINUED)
• Bottom line of statement of cash flows
– Same as cash in balance sheet
– Includes cash in banks and equivalents
– Equivalents are high quality short-term
securities

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 DIRECT METHOD FOR CFO

• Cash flow from operations:

• Cash received from customers xxxxx
• Cash paid to vendors (xxxx)
• Cash paid to employees (xxxx)
• Cash paid for interest on debt (xxxx)
• Cash paid for other operating exp. (xxxx)
• Cash Flow from Operations (CFO) xxx

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 INDIRECT METHOD FOR CFO
• Cash flow from operations
Net income + Depreciation
+ Decrease in current assets (other than cash)
(-) Increase in current assets (other than cash)
+ Increase in current liabilities
(-) Decrease in current liabilities

• Objective: eliminate non-cash components of

accrual income

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 INDIRECT (CONT.)

– Example:
• If sales > collections from customers
• Then accounts receivable increased by that
amount
• Thus to reduce accrual income to cash flow
basis, reduce income by increase in
accounts receivable

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 STATEMENT OF CASH FLOWS
Lightner Corporation
Statement of Cash Flows
Year Ended Dec 31st 2018
Operating Activities
Net income £ 10000
Add (deduct) adjustment to cash basis:
Depreciation expenses 17000
Increase in accounts receivables (2500)
decrease in inventory 4300
decrees in accounts payables (2900) 15900
Net Cash Flow From Operation 25900
Net Cash Flow from Investing Activities -
Net Cash Flow from Financing activities -
Net increase in cash during 2018 25900
Add Cash Balance January 2018 6000
Cash Balance, Dec 31st 2018 £31900

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 CASH FLOW FROM INVESTING

• Negative cash effect

– Purchase of land, buildings or equipment
– Purchase of other assets such as patents
• Positive cash effect
– Proceeds from the sale of any of the above
assets

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 CASH FLOW FROM FINANCING
• Positive cash effect
– Issuance of long-term debt
– Issuance of additional shares in the
corporation

• Negative cash effect

– Pay off of long -term debt
– Repurchase of the corporation’s shares
– Payment of dividend

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IMPORTANCE OF THE STATEMENT OF
CASH FLOWS

1. Helps in the management of cash assets

2. Helps investors evaluate financial
performance
3. CAR and FAR ratios
4. Critical to financial planning

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 COST, VOLUME
&
PROFITABILITY DECISIONS

35
 Cost, Volume and Profitability
Decisions

• Revenue planning
• Cost planning
• Breakeven analysis
• Contribution income statement
• Advantages and disadvantages
• Industry characteristics

36
 REVENUE PLANNING

• Pricing
• Unit sales
• Multi-product companies
• Competition
• Differentiation

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 COST PLANNING

• Variable costs
• Fixed costs
• Mixed costs

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 BREAKEVEN ANALYSIS

• Cost behavior
– Variable cost or expense
• In total: change in proportion to changes in
volume
• Per unit: stays the same

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 BREAKEVEN ANALYSIS

• Cost behavior
– Fixed cost or expense
• In total: doesn’t change in proportion to
volume
• Per unit: changes as volume changes

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 CONTRIBUTION MARGIN (C/M)

• C/M: sales less variable costs

– Total, unit

• C/M ratio: C/M divided by sales

– Unit, total same
– Must use ratio for multiple product firm

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 BREAKEVEN

• In units: total fixed costs ÷ C/M per unit

• In sales $: total fixed costs ÷ C/M ratio
• With desired profit:
– Add profit to fixed costs
• With taxes:
– Add pretax profit to fixed costs

42
 CONTRIBUTION
INCOME STATEMENTS
• Compared to absorption
• Rearrangement of categories
• Relevant Costs for Decisions
• Advantages
– Allows calculation of breakeven
– Allows “what if” questions
• Can assess operating risk

43
 CASE. 1
OPENINGA NEW STORE
• OBJECTIVE: Use the C/M income statement to
make decisions
– Determine contribution margin ratio
– Calculate breakeven point
– Project income based upon assumptions
– Determine target sales to reach £1,000,000
net income

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 CASE. 2
CASHFLOWS FOR THE NEW STORE
• OBJECTIVE: Use cash projection to make
decision on investment opportunity
– Project cash flows for five years
– Calculate cumulative net cash flows
– Determine payback period
– Determine first year sales needed to attain 3-
year payback

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