Financial Accounting for Decision Making - Case Studies

Case Study 1: XYZ Inc.

A merchandizing business, XYZ Inc., sells clothing and accessories. The company maintains an inventory of goods that it purchases from various suppliers and resells to customers. The accounting transactions for XYZ Inc. would involve the following:

1. Purchase of inventory: When XYZ Inc. purchases inventory from suppliers, it would record a debit to the inventory account and a credit to the accounts payable account.
2. Sales of inventory: When XYZ Inc. sells goods to customers, it would record a credit to the sales revenue account and a debit to the inventory account.
3. Inventory accounting: XYZ Inc. would need to account for the cost of goods sold (COGS) and the value of its remaining inventory. This would involve calculating the cost of the goods sold during a period, and subtracting that amount from the beginning inventory to determine the ending inventory.
4. Depreciation: XYZ Inc. would need to account for the depreciation of its fixed assets, such as buildings and equipment. This would involve calculating the depreciable amount of the assets and allocating that amount over their useful lives.
5. Income statement: XYZ Inc. would need to generate an income statement, which would show its revenues, COGS, gross profit, operating expenses, and net income for a period.
6. Balance sheet: XYZ Inc. would need to generate a balance sheet, which would show its assets, liabilities, and equity at a specific point in time.
7. Cash flow statement: XYZ Inc. would need to generate a cash flow statement, which would show its cash inflows and outflows from operating, investing, and financing activities for a period.

Sample calculations for each of the accounting transactions mentioned above:

• Purchase of inventory: Let's say XYZ Inc. purchases $10,000 worth of inventory from a supplier. The accounting entries would be:

Debit: Inventory (Asset) $10,000

Credit: Accounts Payable (Liability) $10,000

• Sales of inventory: Let's say XYZ Inc. sells $15,000 worth of inventory to customers. The accounting entries would be:

Debit: Inventory (Asset) $7,500 (assuming a 50% gross margin)

Credit: Sales Revenue (Revenue) $15,000

• Inventory accounting: Let's say XYZ Inc. had $50,000 worth of inventory at the beginning of the period and $60,000 worth of inventory at the end of the period. The cost of goods sold (COGS) for the period would be calculated as follows:

COGS = Beginning Inventory + Purchases - Ending Inventory

= $50,000 + $10,000 - $60,000

= $0

The value of the remaining inventory at the end of the period would be $60,000.

• Depreciation: Let's say XYZ Inc. has a building that cost $100,000 and has a useful life of 20 years. The annual depreciation for the building would be calculated as follows:

Depreciation = Cost of Asset - Salvage Value / Useful Life

= $100,000 - $0 / 20

= $5,000

• Income statement: The income statement would show the revenues, COGS, gross profit, operating expenses, and net income for a period.

Revenues: $15,000

COGS: $7,500

Gross Profit: $7,500

Operating Expenses: $5,000 (for example, salaries, rent, utilities, etc.)

Net Income: $2,500

• Balance sheet: The balance sheet would show the assets, liabilities, and equity at a specific point in time.

Assets: $60,000 (Inventory), $95,000 (Building)

Liabilities: $10,000 (Accounts Payable)

Equity: $55,000 (Retained Earnings)

• Cash flow statement: The cash flow statement would show the cash inflows and outflows from operating, investing, and financing activities for a period.

Operating activities:

• Cash inflow from sales: $15,000
• Cash outflow for COGS: $7,500
• Cash outflow for operating expenses: $5,000
• Net cash inflow from operating activities: $2,500

Investing activities:

• Cash outflow for purchase of building: $0

Financing activities:

• Cash inflow from issuing stock: $0
• Cash outflow for paying dividends: $0
• Net cash inflow from financing activities: $0

Net increase in cash: $2,500

Case Study 2: PQR Company

PQR Company is a small business that manufactures and sells electronic devices. The company operates on a calendar year basis, and its accounting records are kept on an accrual basis.

Step 1: Recording Transactions

Throughout the year, PQR Company records all of its transactions in the general ledger. These transactions include sales, purchases, payments, and receipts. Each transaction is recorded with a debit and a credit to the appropriate accounts.

Step 2: Recording Adjusting Entries

At the end of the year, PQR Company makes adjusting entries to ensure that the financial statements are accurate. These entries include accruing for unpaid expenses, such as rent and utilities, and recording depreciation on the company's fixed assets.

Step 3: Preparing an Income Statement

The first financial statement that PQR Company prepares is the income statement. This statement shows the company's revenues and expenses for the year, resulting in net income or loss. To prepare the income statement, the company starts by listing all of its revenues at the top of the statement. These include sales revenue, interest income, and any other revenues. Below the revenues, the company lists all of its expenses, including cost of goods sold, operating expenses, and taxes. The difference between the revenues and expenses is the net income or loss for the year.

Step 4: Preparing a Balance Sheet

The next financial statement that PQR Company prepares is the balance sheet. This statement shows the company's assets, liabilities, and equity at the end of the year. To prepare the balance sheet, the company starts by listing all of its assets at the top of the statement. These include cash, accounts receivable, inventory, and fixed assets. Below the assets, the company lists all of its liabilities, including accounts payable, loans, and taxes owed. The difference between the assets and liabilities is the equity.

Step 5: Preparing a Statement of Cash Flows

The final financial statement that PQR Company prepares is the statement of cash flows. This statement shows the company's cash inflows and outflows for the year. To prepare the statement of cash flows, the company starts by listing all of its cash inflows at the top of the statement. These include cash from sales, loans, and investments. Below the cash inflows, the company lists all of its cash outflows, including payments for expenses, investments in fixed assets, and loan payments. The difference between the cash inflows and outflows is the net increase or decrease in cash for the year.

This is a simple example of how a company would prepare its financial statements. In reality, the process can be more complex, depending on the size and type of company, and the accounting software used.

Income statement

Income Statement for PQR Company for the Year Ended December 31, 2022

Revenue: $1,000,000

Cost of Goods Sold: $600,000

Gross Profit: $400,000

Operating Expenses: $250,000

Operating Income: $150,000

Interest Expense: $25,000

Net Income Before Taxes: $125,000

Income Tax Expense: $37,500

Net Income: $87,500

This income statement shows the revenue, cost of goods sold, gross profit, operating expenses, operating income, interest expense, net income before taxes, income tax expense, and net income for PQR Company for the year 20XX. It is important to note that this is a fictional example and not based on any real financial information.

Balance sheet

Balance Sheet for PQR Company as of December 31, 2022

Assets:

Cash: $50,000

Accounts Receivable: $75,000

Inventory: $200,000

Prepaid Expenses: $10,000

Fixed Assets: $300,000

Total Assets: $635,000

Liabilities:

Accounts Payable: $100,000

Notes Payable: $150,000

Accrued Expenses: $25,000

Income Tax Payable: $37,500

Total Liabilities: $312,500

Stockholders' Equity:

Common Stock: $100,000

Retained Earnings: $222,500

Total Stockholders' Equity: $322,500

Total Liabilities and Stockholders' Equity: $635,000

Cash statement

Cash Flow Statement for PQR Company for the Year Ended December 31, 2022

Cash Flow from Operating Activities:

Net Income: $87,500

Adjustments for:

Depreciation: $50,000

Loss on Sale of Equipment: $5,000

Increase in Accounts Receivable: $(15,000)

Increase in Inventory: $(25,000)

Increase in Accounts Payable: $10,000

Cash Provided by Operating Activities: $92,500

Cash Flow from Investing Activities:

Purchase of Equipment: $(50,000)

Sale of Equipment: $10,000

Cash Used in Investing Activities: $(40,000)

Cash Flow from Financing Activities:

Proceeds from Issue of Stock: $50,000

Repayment of Notes Payable: $(25,000)

Cash Provided by Financing Activities: $25,000

Net Increase in Cash: $77,500

Inventory Accounting

PQR Company Inventory Accounting for the Year Ended December 31, 20XX

Beginning Inventory: $100,000

Purchases: $500,000

Freight-in: $10,000

Total Cost of Goods Available for Sale: $610,000

Ending Inventory: $10,000

Cost of Goods Sold: $600,000

In this example, PQR Company had a beginning inventory of $100,000 at the start of the year. They purchased additional goods for $500,000 and incurred $10,000 in freight charges. The total cost of goods available for sale was $610,000. At the end of the year, the company had an ending inventory of $10,000, which means that the cost of goods sold for the year was $600,000 ($610,000 - $10,000).

Depreciation Schedule

PQR Company Depreciation Schedule for the Year Ended December 31, 2022

Asset: Delivery Van

Cost: $50,000

Salvage Value: $5,000

Useful Life: 5 Years

Depreciation Method: Straight-Line

Year 1: ($50,000 - $5,000) / 5 = $9,000

Year 2: $9,000

Year 3: $9,000

Year 4: $9,000

Year 5: $9,000

Asset: Office Equipment

Cost: $20,000

Salvage Value: $2,000

Useful Life: 3 Years

Depreciation Method: Double Declining Balance

Year 1: ($20,000 x 2) x (1/3) = $13,333

Year 2: ($20,000 - $13,333) x (2/3) = $4,444

Year 3: ($20,000 - $13,333 - $4,444) x (1/3) = $1,852

Asset: Building

Cost: $150,000

Salvage Value: $15,000

Useful Life: 30 Years

Depreciation Method: Straight-Line

Year 1: ($150,000 - $15,000) / 30 = $4,500

Year 2: $4,500

This is a fictional example and does not represent real financial information. In this example, PQR Company has a delivery van that cost $50,000 and has a salvage value of $5,000. The useful life of the van is 5 years and the depreciation method used is straight-line. Each year $9,000 is recorded as depreciation expense.

The company also has office equipment that cost $20,000 and has a salvage value of $2,000. The useful life of the equipment is 3 years and the depreciation method used is double declining balance. The depreciation expense for the first year is $13,333.

Lastly, the company has a building which cost $150,000 with a salvage value of $15,000 and has a useful life of 30 years and the depreciation method used is straight-line. Each year $4,500 is recorded as depreciation expense.

Analysis of Financial Statements

Analysis of financial statements is the process of evaluating a company's financial information in order to make informed decisions. Financial statements include the income statement, balance sheet, and cash flow statement. These statements provide a detailed overview of a company's financial performance, position, and cash flow.

There are several techniques and tools used for analyzing financial statements, including:

1. Ratio analysis: This technique involves calculating and comparing different financial ratios, such as the current ratio, quick ratio, debt-to-equity ratio, and return on equity. These ratios provide insight into a company's liquidity, solvency, profitability, and efficiency.
2. Trend analysis: This technique involves comparing financial data over time, such as comparing current income statement and balance sheet numbers to those of previous periods. This can help identify trends and patterns in a company's financial performance.
3. Common-size analysis: This technique involves expressing financial statement items as a percentage of a common base, such as total assets or total revenue. This allows for easy comparison between companies of different sizes.
4. DuPont Analysis: This technique breaks down a company's return on equity (ROE) into three components: net profit margin, total asset turnover and leverage.
5. Benchmarking: This technique compares a company's financial performance to that of its industry peers or to an industry average. This can help identify areas where a company is performing well or poorly compared to its competitors.

By performing these analysis, one can get a clear picture of a company's financial health, identify areas for improvement, and make informed decisions about investments, operations, and other financial matters. It also helps in identifying risks and opportunities that the company may be facing, and also helps to measure the company's progress over time.

Conclusion

In conclusion, financial accounting is an essential aspect of any business that provides critical information for making important business decisions. Businesses use financial accounting information to evaluate investment, financing, and operational decisions. It's also important for businesses to have accurate and timely financial accounting information to make informed decisions that will improve the performance of the business. By understanding the importance of financial accounting and using it effectively, businesses can make better decisions and achieve greater success.