Test of Profitability
Chapter 6: Sales Revenue & Accounts Receivables
Return on
equity (ROE)
Net Income / Average Stockholders′ Equity
Return on
assets (ROA)
Net Income + Interest Exp / Average Total Assets
Financial
leverage
𝐴𝑣𝑔 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 / 𝐴𝑣𝑔 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦
Earnings per
share (EPS)
Net Income
Avg No. of Shares of Common Stock Outstanding
Quality of
income
Cash Flows from Operating Activities / Net Income
Profit margin
Net Income / Net Sales Revenue (Operating Revenues)
Gross Profit
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
Gross profit
margin
𝑅𝑒𝑣−𝐶𝑂𝐺𝑆
Serves as paying expense and future savings
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Asset
turnover ratio
Net Sales Revenue / Average Total Assets
Fixed asset
turnover ratio
Net Sales Revenue
Average Net Fixed Assets
Measures operating
efficiency
Tests of Liquidity
Current ratio
Quick ratio
(Acid Test)
Current Assets / Current Liabilities
Quick Assets
Current Liabilities
The safety margin to
meet L
Net Credit Sales
Receivable
turnover ratio
Inventory
turnover
(T/O) ratio
SR liquidity & operating
efficiency
Average Net Receivables
𝐷𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑌𝑒𝑎𝑟
𝐴𝑣𝑔 𝐴𝑔𝑒 𝑜𝑓 𝑅𝑒𝑣(𝐷𝑎𝑦𝑠) =
𝑅𝑒𝑣 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
COGS
High indicates out of stock,
loss of sales
Average Inventory
365
Avg Days Supply in Inventory =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇/𝑂 𝑅𝑎𝑡𝑖𝑜
Accounts
Payable
Turnover
Ratio
Cost of Goods Sold / Average Accounts Payable
Debt-toequity ratio
Total Liabilities / Stockholders′ Equity
𝐴𝑣𝑔 𝐴𝑔𝑒 𝑜𝑓 𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 = 365 / 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 𝑇/𝑂 𝑅𝑎𝑡𝑖𝑜
Tests of Solvency
Market Tests
Price/
earnings (P/E)
ratio
Dividend
yield ratio
Market Price per Share / Earnings per Share
Dividends per Share / Market Price per Share
Chapter 4: Accrual Accounting
Accrued
Expense
Deferred
Expense
Accrued
Revenue
Deferred
Revenue
Expense incurred,
not paid
Paid but expense
not incurred
Revenue earned,
cash not received
Cash received,
revenue not earned
Expense(+E, -SE)
Payable(+L)
Expense(+E, -SE)
Prepaid Expense (-A)
Receivables(+A)
Revenue(+R, +SE)
Unearned Rev(-L)
Revenue(+R, +SE)
Wages /
Taxes
Prepaid
Rent
Payment on
account
Rent
collection
Chapter 9: Reporting and Interpreting Liabilities
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Recovered Bad Debt
−𝐶𝑟𝑒𝑑𝑖𝑡 𝐶𝑎𝑟𝑑 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡
Accounts Receivable (+A)
−𝑆𝑎𝑙𝑒𝑠 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡
Allowance for Doubtful Acct (+XA, -A)
−𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑡𝑢𝑟𝑛𝑠 & 𝐴𝑙𝑙𝑜𝑤𝑎𝑛𝑐𝑒𝑠 Cash (+A)
𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠
Accounts Receivable (-A)
Step
Record estimated
bad debt
adjustments
Timing
End of period in
which sales are
made
Identify and write off Throughout period
actual bad debts
as bad debts
become known
Accounts Affected
Dr: Bad Debt Expense
Cr: Allowance for
Doubtful Accounts
Dr: Allowance for Doubtful
Accounts
Cr: Accounts Receivable
Ending Balance per Bank
+ Deposits in Transit
= 𝑐𝑜𝑦 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 − 𝑏𝑎𝑛𝑘 𝑑𝑒𝑝𝑜𝑠𝑖𝑡
− Outstanding Checks
Contingent
Subject to
estimate
Not subject
to estimate
Financial Statement
↑ Net Income
↓
↑ Assets (AR, Net) ↓
↓ Net Income
NE
↓ Assets (AR, Net)
Beginning Inventory + Purchases = Goods Available for Sale
Goods Available for Sale − Ending Inventory = COGS
Account
Current Year (Overstate)
Subsequent Year
Beginning Inventory
Correct
↑
Ending Inventory
↑
Correct
Cost of Goods Sold
↓
↑
Net Income
↑
↓
Income Tax Expense
↑
↓ Self-Correct
Retained Earnings
↑
↓ Self-Correct
Taxes Payable
↑
↓ Self-Correct
Chapter 8: Reporting and Interpreting PPE
Interest Expense part of acquisition cost for constructed assets, not purchased
Goodwill: Amount purchase price exceeds fair market value of net assets
𝐶𝑜𝑠𝑡 − 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
𝐿𝑖𝑓𝑒 𝑖𝑛 𝑌𝑒𝑎𝑟𝑠
𝐶𝑜𝑠𝑡 − 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 =
𝐿𝑖𝑓𝑒 𝑖𝑛 𝑈. 𝑜. 𝑃
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 = 𝑅𝑎𝑡𝑒 x 𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑
𝑛
Declining𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑁𝐵𝑉 × (
)
𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑖𝑛 𝑌𝑒𝑎𝑟𝑠
Balance
Measuring Asset Impairment
1) Asset impaired if: Book Value > Future Cash Flows (Future Benefits)
2) Then, 𝑖𝑚𝑝𝑎𝑖𝑟𝑚𝑒𝑛𝑡 𝑙𝑜𝑠𝑠 = 𝑁𝐵𝑉 − 𝐹𝑎𝑖𝑟 𝑉𝑎𝑙𝑢𝑒 (𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒)
Disposal of PPE
Gain
Cash (+A)
(Loss)
Accumulated Depreciation (-XA, +A)
(Loss on Sale (+Loss, -SE) )
Gain on Sale (+Gain, +SE)
Equipment (-A)
Treatment
Financial Statement Effect
Statement
Expense
Income
Taxes
Capital
Balance sheet
Deferred
Higher
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
account Debited
Income Statement
Account Debited
Currently
Recognized
Disclose in note
Remote
Disclosure not
required
Disclosure not
required
1
× 𝐴𝑚𝑜𝑢𝑛𝑡
(1 + 𝑖)𝑛
1 − (1 + 𝑖)−𝑛
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑛 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝐴𝑚𝑜𝑢𝑛𝑡 × (
)
𝑖
31 Dec
Interest Expense (+E, -SE)
Interest Payable (+L)
Notes Payable (+L)
Cash (-A)
Chapter 11: Reporting and Interpreting Owner’s Equity
Chapter 7: Inventory & Cost of Goods Sold
Expenditure
Revenue
Expenditure
Reasonably Probable
Disclose in note
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑆𝑖𝑛𝑔𝑙𝑒 𝐴𝑚𝑜𝑢𝑛𝑡 =
Ending Balance per Book
+ Deposits by Bank (credit memo)
− Service Charge
= 𝑐ℎ𝑒𝑐𝑘𝑠 𝑤𝑟𝑖𝑡𝑡𝑒𝑛 − 𝑐ℎ𝑒𝑐𝑘𝑠 𝑐𝑙𝑒𝑎𝑟𝑒𝑑
− NSF Checks
±Bank Errors
= Correct Balance
StraightLine
Units-ofProduction
Probable
Record as
liability
Disclose in note
Lower
Small Stock Dividend
Large Stock Dividend
Stock Dividend < 20-25%
Stock Dividend > 20-25%
Record at current market value
Record at par value of stock
Retained Earnings (-SE)
Retained Earnings (-SE)
Common Stock (+SE)
Common Stock (+SE)
Additional Paid-in Capital (+SE)
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑏𝑦 𝑥%
Total SE
Common Stock
Paid-in Capital
Retained Earnings
No. of Shares Outstanding
Par Value per Share
Purchase of Treasury
Stock
Treasury Stock (+XSE, -SE)
Cash (+A)
Issuance of
Common
Stock
Small Stock
Dividend
NE
↑
↑
↓
↑
NE
Large Stock
Dividend
NE
↑
NE
↓
↑
NE
Stock
Splits
NE
NE
NE
NE
↑
↓
Reissuance of Treasury Stock
Cash (+A)
(Capital in excess of par value (-SE) )
Treasury Stock (-XSE, +SE)
Capital in excess of par value (+SE)
Cash (+A)
Common Stock (+SE)
Capital in Excess of Par Value (+SE)
Chapter 13: Statement of Cash Flows
Operating
Investing
Financing
Inflows
-Customers
-Dividends and interest on
investments
-Sale or disposal of PPE
-Sale or maturity of
investments in securities
-Borrowings on notes,
mortgages, bonds, etc. from
creditors
-Issuance of stock
Outflows
-Inventory
-Salaries and Wages
-Income taxes
-Interest on liabilities
-Purchase of PPE
-Purchase of investments in
securities
-Repayment of principle to
creditors (excl. interest, which
is Operating)
-Purchase of Treasury Stock
-Dividends payment