Analysis of the Cost of Goods Sold

Breakdown of the CGS Components
The application of standard costs, variable costs and variance analysis in analysis of raw materials, direct labor and direct overhead.

Cost trends and abrupt changes

Understanding Income Statement

1) The use of "Revenue" and Sales
2) Revenue Breakdown
a) As to sources (sales of products, interest income on cash inBank and Investments, sales of assets, commissions, etc)
b) Cash or Accounts receivables
c) Accounts affected by Revenues or sales (finished goods inventory, accounts receivables, cash)

Implicaton of Interest income- an indicator of company's liquidity

3) Marketing and Selling Expenses as a line item before gross profits.
4) Using Gross profit rate on sales as a benchmark consideration

Income Statement Analysis -Part II

First Three Lines of the Income Statement Investing Putting It Together Thus Far:
We’ve actually covered a lot of ground. Here’s an example to help reiterate and / or clarify everything we’ve discussed.

If the owner of an ice cream parlor purchased 10 cups of vanilla ice cream for P2 per cup, and sold each of those cups to her customers for P5, the first three lines on her income statement would look something like this:

Total Revenue P50(The total revenue is the amount of money rung up at the cash register. The owner sold 10 cups of vanilla ice cream to her customers for P5 per cup. 10 cups x P5 a cup = P50.)
Cost of Revenue P20(The cost of goods sold was 10 cups x P2 per cup = P20)
Gross Profit P30(The total revenue subtracted by the cost to earn that revenue is P30. Before taxes, and other expenses, this is the ice cream parlor’s gross profit.)
Gross Margin: .6 (or 60%)

Operating Expense on the Income Statement

Operating Expense

The next section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business. Operating expense consists of salaries paid to employees, research and development costs, and other misc. charges that must be subtracted from the company’s income. As an investor / owner, you want to work with managements that strive to keep operating expense as low as possible while not damaging the underlying business.
Selling General and Administrative Expenses (SGA)SGA expenses consist of the combined payroll costs (salaries, commissions, and travel expenses of executives, sales people and employees), and advertising expenses a company incurs. High SGA expenses can be a serious problem for almost any business. A good management will often attempt to keep SGA expenses limited to a certain percentage of revenue. This can be accomplished through cost-cutting initiatives and employee lay-offs.

There have been several cases in the past where bloated selling, general and administrative expenses have literally cost shareholders billions in profit.

Non-Recurring and Extraordinary Items or EventsIn the unpredictable world of business, events will arise that are not expected and most likely not occur again. These one-time events are separated on the income statement and classified as either non-recurring or extraordinary. This allows investors to more accurately predict future earnings. If, for instance, you were considering purchasing a gas station, you would base your valuation on the earning power of the business, ignoring one-time costs such as replacing the station’s windows after a thunderstorm. Likewise, if the owner of the station had sold a vintage Coke machine for P17,000 the year before, you would not include it in your valuation because you had no reason to expect that profit would be realized again in the future.

What is the difference between non-recurring and extraordinary events? A nonrecurring charge is a one-time charge that the company doesn’t expect to encounter again. An extraordinary item is an event that materially* affected a company’s finance and needs to be thoroughly explained in the annual report or SEC filings. Extraordinary events can include costs associated with a merger, or the expense of implementing a new production system.
Non-recurring items are recorded under operating expenses.

*The term material is not specific. It generally refers to anything that affects a company in a meaningful and significant way. Some investors try to put a number on the figure, saying an event is material if it causes a change of 5% or more in the company’s finances.
Depreciation and AmortizationThere are two different kinds of "depreciation" an investor must grapple with when analyzing financial statements, accumulated depreciation and depreciation expense. They are entirely different things, and are often confused with one another. In order to understand them, we must discuss them individually.

Depreciation Expense

"Depreciation is the process by which a company gradually records the loss in value of a fixed asset. The purpose of recording depreciation as an expense over a period is to spread the initial purchase price of the fixed asset over its useful life. [emphasis added] Each time a company prepares its financial statements, it records a depreciation expense to allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike other expenses, depreciation expense is a "non-cash" charge. This simply means that no money is actually paid at the time in which the expense is incurred."

An Example of Depreciation Expense

To help you understand the concept, let’s look at an example of depreciation expense:
Sherry’s Cotton Candy Co., earns P10,000 profit a year. In the middle of 2002, the business purchases a P7,500 cotton candy machine that is expected to last for five years. If an investor examined the financial statements, they might be discouraged to see that the business only made P2,500 at the end of 2002 [P10k profit - P7.5k expense for purchasing the new machinery]. The investor would wonder why the profits had fallen so much during the year.
Thankfully, Sherry’s accountants come to her rescue and tell her that the P7,500 must be allocated over the entire period it is going to benefit the company. Since the cotton candy machine is expected to last five years, Sherry can take the cost of the cotton candy machine and divide it by five [P7,500 / 5 years = P1,500 per year]. Instead of realizing a one-time expense, the company can subtract P1,500 each year for the next five years, reporting earnings of P8,500. This allows investors to get a more accurate picture of how the company’s earning power. The practice of spreading-out the cost of the asset over its useful life is "depreciation expense".

This presents an interesting dilemma; although the company reported earnings of P8500 in the first year, it was still forced to write a P7,500 check [effectively leaving it with P2500 in the bank at the end of the year [P10,000 profit - P7,500 cost of machine = P2,500 left over]. This means that the cash flow of the company is actually different from what it is reporting in earnings. The cash-flow is very important to investors because they need to be ensured that the company can pay its bills on time. The first year, Sherry’s would report earnings of P8,500, but only have P2,500 in the bank. Each subsequent year, it would still report earnings of P8,500, but have P10,000 in the bank since, in reality, the business paid for the machinery up-front in a lump-sum. Hence, if an investor knew that Sherry had a P3,000 loan payment due to the bank in the first year, he may incorrectly assume that the company would be able to cover it since it reported earnings of P8,500. In reality, the business would be P500 short.*
This is where the third major financial report, the cash flow statement, comes into an investor's analysis. The cash flow statement is like a company’s checking account. It shows how much cash was spent, at what time, and where. That way, an investor could look at the income statement of Sherry’s Cotton Candy Co. and see a profit of P8,500 each year, then turn around and look at the cash flow statement and see that the company really spent P7,500 on a machine this year, leaving it only P2,500 in the bank.

Accounting for Depreciation Expense in Your Income Statement Analysis

Some investors and analysts incorrectly maintain that depreciation expense should be added back into a company’s profits because it requires no immediate cash outlay. In other words, Sherry wasn’t really paying P1,500 a year, so the company should have added those back in to the P8,500 in reported earnings and valued the company based on a P10,000 profit, not the P8,500 figure. This is incorrect. Depreciation is a very real expense. Depreciation attempts to match up profit with the expense it took to generate that profit. This provides the most accurate picture of a company’s earning power. An investor who ignores the economic reality of depreciation expense will be apt to overvalue a business and find his or her returns lacking.
*Depreciation expenses are deductible; Sherry’s would only pay taxes on P8,500 each year, spreading out her tax burden to the future. Some investors assume incorrectly that the business would pay taxes on P2,500 the first year and the full P10,000 each year after.

Income Statement Analysis

Income Statement Analysis

Introduction

Purpose of the Income Statement

The primary purpose of the income statement is to report a company's earnings to investors over a specific period of time. Years ago, the income statement was referred to as the Profit and Loss (or P&L) statement, and has since evolved into the most well-known and widely used financial report. Many times, investors make decisions based entirely on the reported earnings from the income statement without consulting the balance sheet or cash flow statements (which, while a mistake, is a testament to how influential it is).

Using Income Statement Analysis to Calculate Expenses, Earnings, Financial Ratios and Profit Margins

To an enterprising investor, income statement analysis reveals much more than a company's earnings. It provides important insights into how effectively management is controlling expenses, the amount of interest income and expense, and the taxes paid. Investors can use income statement analysis to calculate financial ratios that will reveal the rate of return the business is earning on the shareholders' retained earnings and assets; they can also compare a company's profits to its competitors by examining various profit margins such as the gross profit margin, operating profit margin, and net profit margin.

Beginning our Analysis of the Income Statement

As we progress through this series of investing lessons, you must remember the basic truth that a business is only worth the profit that it will generate for its owners from now until doomsday, discounted back to the present, adjusted for inflation. The income statement is the "report card" of those earnings, which ultimately determine the price you should be willing to pay for a business.

Sit back in your chair, take out a copy of an annual report, flip to the consolidated income statement for the most recent year, and let’s begin working through it. In the end, I think you’ll be surprised by how much you’ve learned. As always, there will be quiz following the lesson; you should be able to pass without missing more than two questions.

Total Revenue or Total Sales Investing

Total Revenue or Total Sales. The first line on any income statement is an entry called total revenue or total sales. This figure is the amount of money a business brought in during the time period covered by the income statement. It has nothing to do with profit. If you owned a pizza parlor and sold 10 pizzas for P10 each, you would record P100 of revenue regardless of your profit or loss.The revenue figure is important because a business must bring in money to turn a profit. If a company has less revenue, all else being equal, it’s going to make less money. For startup companies and new ventures that have yet to turn a profit, revenue can sometimes serve as a gauge of potential profitability in the future.Many companies break revenue or sales up into categories to clarify how much was generated by each division. Clearly defined and separate revenues sources can make analyzing an income statement much easier. It allows more accurate predictions on future growth. Starbucks’ 2001 income statement is an excellent example:

Starbucks CoffeeConsolidated Statement of Earnings – ExcerptPage 29, 2001 Annual Report
In thousands except earnings per share


Fiscal year ended
Sep 30, 2001
Oct 1, 2000
Net Revenues


Retail
P2,229,594
P1,823,607
Specialty
419,386
354,007

Total net revenues
2,648,980
2,177,614

Starbucks’ sales come primarily from two sources: retail and specialty. In the annual report, management explains the difference between the two several pages before the income statement. "Retail" revenues refer to sales made at company-owned Starbucks stores across the world. Every time you walk in and order your favorite latte, you are adding P3-5 in revenue to the company’s books. "Specialty" operations, on the other hand, are money the company brings in by sales to "wholesale accounts and licensees, royalty and license fee income and sales through its direct-to-consumer business". In other words, the specialty division includes money the business receives from coffee sales made directly to customers through its website.

Cost of Goods Sold - COGS Investing

Cost of Revenue, Cost of Sales, Cost of Goods Sold (CGS) Cost of goods sold (CGS for short) is the expense a company incurred in order to manufacture, create, or sell a product. It includes the purchase price of the raw material as well as the expenses of turning it into a product. Cost of goods sold (CGS) is also known as cost of revenue or cost of sales.

Going back to our Pizza Parlor example, your cost of goods sold (CGS) include the amount of money you spent purchasing items such as flour and tomato sauce.

Gross Profit Investing

Gross ProfitThe gross profit is the total revenue subtracted by the cost of generating that revenue. It tells you how much money a business would have made if it didn’t pay any other expenses such as salary, income taxes, etc. Gross Profit should be broken out and clearly labeled on the income statement. Here’s the formula to calculate it yourself:

Total Revenue - Cost of Goods Sold (COGS) = Gross Profit

The gross profit figure is important because it is used to calculate something called gross margin, which we will discuss later.

Gross Profit Margin. Although we are only a few lines into the income statement, we can already calculate our first ratio. The gross profit margin is a measurement of a company’s manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue / sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient.

Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled [overhead refers to rent, utilities, etc.]

To calculate gross profit margin, use this formula:

Gross Profit----------(divided by)----------Total Revenue

For illustration purposes, let’s calculate the gross profit margin of Greenwich Golf Supply (a fictional company) using its income statement.
Greenwich Golf SupplyConsolidated Statement of Earnings – Excerpt
In thousands except earnings per share


Fiscal year ended
Sep 30, 2001
Oct 1, 2000
Total Revenue
P405,209
P315,000
Cost of Sales
P243,125
P189,000
Gross Profit
P162,084
P126,000

Assume the average golf supply company has a gross margin of 30%. We can take the numbers from Greenwich Golf Supply’s income statement and plug them into our formula:

P162,084 gross profit----------(divided by)----------P405,209 total revenue

The answer, .40 [or 40%], tells us that Greenwich is much more efficient in the production and distribution of its product than most of its competitors.

The gross margin tends to remain stable over time. Significant fluctuations can be a potential sign of fraud or accounting irregularities. If you are analyzing the income statement of a business and gross margin has historically averaged around 3-4%, and suddenly it shoots upwards of 25%, you should be seriously concerned.

Quick Overview - Financial Controls

Quick Overview - Financial Controls

Financial Reports

Financial reports are your financial controls. Explanations of the three major financial reports used for financial management are given below.

The Balance Sheet

The balance sheet shows the financial position of a business at a specific point in time, for example, the last day of the month or the year. This financial statement shows total assets (what the business owns -- items of value) and total liabilities (what the business owes).
The total assets are broken down into subcategories of current assets, fixed assets and other assets. The total liabilities are broken down into subcategories of current liabilities, long-term liabilities/debt and owner's equity. The total assets must equal the total liabilities plus owner's equity.

The accounting equation, assets = liabilities + owner's equity, is a simple formula to describe the balance sheet.

The Income/Proft and Loss (P&L) Statement
The income/profit and loss (P&L) statement shows revenues, minus the cost of goods sold, minus operating expenses, plus other revenues and expenses and the net income/loss before taxes.

The Cashflow Statement

The cash flow statement is the detail of cash received and cash expended for each month of the year. A projected cash flow statement helps you determine if the company has positive cash flow. If your company's projections show a negative cash flow, you must revisit your business plan and solve this problem.

Summary

Accurate and timely financial reports show the progress and current condition of the business. You can compare performance during one period of time (month, quarter or year) with another period, calculate trends and plan for the business's future.
Comprehensive Overview - Financial Controls

Introduction

By analyzing your business's financial reports, you are able to determine how well your business is doing and what you may need to do to improve its financial viability. There are three basic financial reports that all business owners need to understand and interpret in order to manage their businesses successfully—the balance sheet, the income/profit and loss (P&L) and the cash flow statement. These are often referred to as the financials. Pro forma financials are projections, usually these are projected for three fiscal years. Financial controls provide the basis for sound management and allow you to establish guidelines and policies that enable the business to succeed and grow.

Proactive vs Reactive Financial Management

The proactive financial manager uses pro forma or projections to plan ahead for the problems the business is likely to encounter and the opportunities that may arise. To be proactive you must read and analyze your financial statements on a regular basis. Monthly financial analysis is preferred, quarterly is more common, yearly is not often enough. The proactive manager has financial data available based on actual results and compares them to the budget. This process points out weaknesses in the business before they reach crisis proportion and allows the manager to make the necessary changes and adjustments before major problems develop.
A reactive manager waits to react to problems, and then solves them by crisis management. This type manager goes from crisis to crisis with little time in between to notice opportunities that may become available. The reactive manager's business is seldom prepared to take advantage of new opportunities quickly. Businesses that are managed proactively are more likely to be successful.

Assistance in Developing Financial Controls

You may need an accountant or business consultant to assist you in setting up your chart of accounts. Accountants use a standard numbering system for the business accounts in the chart, but each business may have a different chart of accounts depending on the operational plan. The accountant or business consultant also will assist you in setting up the financial reports you need to manage the operation of your business. Many business owners purchase computer software programs to do recordkeeping and develop financials. These programs provide a chart of accounts that can be individualized to your business and the templates for each account ledger, the general ledgers, etc. and the financial reports. These programs are menu driven and user-friendly, but knowing how to input your data correctly is not enough. You must know where to input each piece of data and how to analyze the reports compiled from the data. If you have not learned a manual recordkeeping system, you need to do this before attempting to use a computerized system.

Financial - Definitions and Classifications

THE BALANCE SHEET

The balance sheet is a snapshot of the business's financial position at a certain point in time. This can be any day of the year, but balance sheets are usually done at the end of each month.
This financial statement is a listing of total assets (what the business owns- items of value) and total liabilities (what the business owes). The total assets are broken down into subcategories of current assets, fixed assets and other assets. The total liabilities are broken down into subcategories of current liabilities, long-term liabilities/debt and owner's equity.

Assets
Current Assets
Current assets are those assets that are cash or can be readily converted to cash in the short term, such as accounts receivable or inventory. In the balance sheet shown for Sterling Retail, the current assets are cash, petty cash, accounts receivable and inventory.
Some business people define current assets as those the business expects to use or consume within the coming fiscal year. Thus, a business's noncurrent assets would be those that have a useful life of more than one year. These include fixed assets and intangible assets.

Fixed Assets
Fixed assets are those assets that are not easily converted to cash in the short term; i.e., they are assets that only change over the long term. Land, buildings, equipment, vehicles, furniture and fixtures are some examples of fixed assets. In the balance sheet for Sterling Retail (below), the fixed assets shown are furniture and fixtures and equipment. Note that these fixed assets are shown less accumulated depreciation.

Intangible Assets (Net)
Intangible assets also may be shown on a balance sheet. These may be goodwill, trademarks, patents, licenses, copyrights, formulas, franchises, etc. In this instance, net means the value of intangible assets minus amortization.

Liabilities

Current Liabilities
Current liabilities are those coming due in the short term, usually the coming year. These are accounts payable; employment, income and sales taxes; salaries payable; federal and state unemployment insurance and the current year's portion of multi-year debt. (See the sample balance sheet below.)

A comparison of your current assets and your current liabilities reveals your working capital.

Many managers use an accounts receivable aging report and a current inventory listing as tools to help them in management of the current asset structure. (See also current assets above.)

Long-term Debt
Long-term debt/liabilities may be bank notes or loans made to purchase your business's fixed asset structure. Long-term debt/liabilities come due in a time period of more than one year. The portion of a bank note that is not payable in the coming year is long-term debt/liability.
For example, a business owner may take out a bank note to buy land and a building. If the land is valued at P50,000 and the building is valued at P50,000, the business's total fixed assets are P100,000. If P20,000 is made as a down payment and P80,000 is financed with a bank note for 15 years, the P80,000 is the long-term debt.

Owner's Equity
Owner's equity refers to the amount of money the owner has invested in the firm. This amount is determined by subtracting current liabilities and long-term debt from total assets. The remaining capital/owner's equity is what the owner would have left in the event of liquidation, or the dollar amount of the total assets that the owner can claim after all creditors are paid.

THE INCOME PROFIT AND LOSS STATMENT (P&L)

The income/profit and loss statement (P&L) represents the relation of income and expenses for a specific time interval. The income/P&L statement is expressed in a one-month format, January 1 through January 31, or a quarterly year-to-date format, January 1 through March 31. This financial statement is cumulative for a twelve-month fiscal period, at which time it is closed out. A new cumulative record is started at the beginning of the new twelve-month fiscal period.
The profit and loss statement is divided into five major categories.
Sales or Revenue
Cost of Goods Sold/Cost of Sales
Gross Profit
Operating Expenses
Net Income
Sales or Revenue

The sales or revenue portion of the income statement is where the retail price of the product is expressed in terms of dollars times the number of units sold. This can be product units or service units. Sales can be expressed in one category as total sales or can be broken out into more than one type of sales category: car sales, part sales and service sales, for example.

Cost of Goods Sold/Cost of Sales
The cost of goods sold/sales portion of the income statement is where you show the cost of products purchased for resale, or show the direct labor cost (service person wages) for service businesses. Cost of goods sold/sales also may include additional categories, such as freight charges cost or sub-contract labor costs. These costs also may be expressed in one category as total cost of goods sold/sales or can be broken out to match the sales categories: car purchases, parts, purchases and service salaries, for example.

Breaking out sales and cost of goods sold/sales into separate categories can have an advantage over combining all sales and costs into one category. When you break out sales, you can see how much each product you have sold cost and the gross profit for each product. This type analysis enables you to make inventory and sales decisions about each product individually.

Gross Profit
The gross profit portion of the income/P&L statement tells you the difference between what you sold the product or service for and what the product or service cost you. The goal of any business is to sell enough units of product or service to be able to subtract the cost and have a high enough gross profit to cover operating expenses, plus yield a net income that is a reasonable return on your investment. The key to operating a profitable business is to maximize gross profit.
If you increase the retail price of your product too much above the competition, you might lose units of sales to the competition and not yield a high enough gross profit to cover your expenses. On the other hand, if you decrease the retail price of your product too much below the competition, you might gain additional units of sales but not make enough gross profit per unit sold to cover your expenses.

A carefully thought out pricing strategy maximizes gross profit to cover expenses and yield a positive net income.
Operating Expenses
The operating expense section of the income/P&L statement is a measurement of all the operating expenses of the business. There are two types of expenses, fixed and variable. Fixed expenses are those expenses that do not vary with the level of sales, thus, you will have to cover these expenses even if your sales are less than the expenses. The entrepreneur has little control over these expenses once they are set. Examples of fixed expenses are rent (contractual agreement), interest expense (note agreement), an accounting or law firm retainer for legal services of X amount per month for twelve months, local phone charges, etc.
Variable expenses are those expenses that vary with the level of sales. Examples of variable expenses are bonuses, employee wages (hours per week worked), long distance telephone expense, etc. (Note: categorization of these may differ from business to business.) Expense control is an area where the entrepreneur can maximize net income by holding expenses to a minimum.

Net Income
The net income portion of the income/P&L statement is the bottom line. This is the measure of a firm's ability to operate at a profit. Many factors affect the outcome of the bottom line. Level of sales, pricing strategy, inventory control, accounts receivable control, ordering procedures, marketing of the business and product, expense control, customer service and productivity of employees are just a few of these factors. The net income should be enough to allow growth in the business through reinvestment of profits and to give the owner a reasonable return on investment.

THE CASHFLOW STATEMENT

The cash flow statement is the most important financial tool you have. The cash flow statement is the detail of cash received and cash expended for each month of the year. By closely monitoring the cash flow, the entrepreneur can manage the business's most important asset effectively.

Many entrepreneurs think that the only financial statement they need to manage their business effectively is an income/P&L statement, that a cash flow statement is excess detail. They mistakenly believe that the bottom line profit is all they need to know and that if the company is showing a profit, it is going to be successful. In the long run profitability and cash flow have a direct relationship, but profit and cash flow do not mean the same thing in the short run. A business can be operating at a loss and have a strong cash flow position. Conversely, a business can be showing an excellent profit but not have enough cash flow to sustain its sales growth.

The cashflow statement is composed of:

Beginning cash on hand
Cash receipts for the month
Cash paid out for the month
Ending cash position
Cash on Hand
Cash on hand is the starting cash position of the business on the first day of the month. It usually represents the business's checkbook balance.

Cash Receipts

Cash receipts is the total of cash inflows—cash sales, collections from accounts receivable, monies received from loans, etc. The cash flow statement considers only cash. It does not take into account any uncollected portion of a credit sale.
Cash Expense

Cash expense represents the total cash paid out of the business account. Purchases, wages, taxes, expenses, capital equipment purchases, loan repayments and owner's withdrawals represent most cash expenses. The cash flow statement measures and takes into account all of these cash expenditures as they are paid.

Ending Cash Position
Total cash available minus total cash paid out equals the end of month cash position. The ending cash position should equal the balance of the checkbook account at the end of the month of business activity.

Chapter Summary

Financial controls are important tools that enable you to take a proactive management position in your business. The three most important financial controls are: (1) the balance sheet, (2) the profit and loss (P&L)/ income statement and (3) the cash flow statement. Each gives the entrepreneur a different perspective on and insight into how well the business is operating toward its goals. The business plan requires a projection of these statements to obtain financing. The financial controls provide a blueprint to compare against the actual results once the business is in operation. A comparison and analysis of the business plan against the actual results can tell the entrepreneur whether or not the business is on target. Corrections or revisions to policies and strategies may be necessary to achieve the business's goals. Analyzing monthly financial statements is a must if you want to successfully manage your new business.

Chart of Accounts

The chart of accounts is a listing of all the accounts in the general ledger, each account accompanied by a reference number. To set up a chart of accounts, one first needs to define the various accounts to be used by the business. Each account should have a number to identify it. For very small businesses, three digits may suffice for the account number, though more digits are highly desirable in order to allow for new accounts to be added as the business grows. With more digits, new accounts can be added while maintaining the logical order. Complex businesses may have thousands of accounts and require longer account reference numbers. It is worthwhile to put thought into assigning the account numbers in a logical way, and to follow any specific industry standards. An example of how the digits might be coded is shown in this list:
Account Numbering
1000 - 1999: asset accounts2000 - 2999: liability accounts3000 - 3999: equity accounts4000 - 4999: revenue accounts5000 - 5999: cost of goods sold6000 - 6999: expense accounts7000 - 7999: other revenue (for example, interest income)8000 - 8999: other expense (for example, income taxes)
By separating each account by several numbers, many new accounts can be added between any two while maintaining the logical order.
Defining Accounts
Different types of businesses will have different accounts. For example, to report the cost of goods sold a manufacturing business will have accounts for its various manufacturing costs whereas a retailer will have accounts for the purchase of its stock merchandise. Many industry associations publish recommended charts of accounts for their respective industries in order to establish a consistent standard of comparison among firms in their industry. Accounting software packages often come with a selection of predefined account charts for various types of businesses.
There is a trade-off between simplicity and the ability to make historical comparisons. Initially keeping the number of accounts to a minimum has the advantage of making the accounting system simple. Starting with a small number of accounts, as certain accounts acquired significant balances they would be split into smaller, more specific accounts. However, following this strategy makes it more difficult to generate consistent historical comparisons. For example, if the accounting system is set up with a miscellaneous expense account that later is broken into more detailed accounts, it then would be difficult to compare those detailed expenses with past expenses of the same type. In this respect, there is an advantage in organizing the chart of accounts with a higher initial level of detail.
Some accounts must be included due to tax reporting requirements. For example, BIR requires that travel, entertainment, advertising, and several other expenses be tracked in individual accounts. One should check the appropriate tax regulations and generate a complete list of such required accounts.
Other accounts should be set up according to vendor. If the business has more than one checking account, for example, the chart of accounts might include an account for each of them.
Account Order
Balance sheet accounts tend to follow a standard that lists the most liquid assets first. Revenue and expense accounts tend to follow the standard of first listing the items most closely related to the operations of the business. For example, sales would be listed before non-operating income. In some cases, part or all of the expense accounts simply are listed in alphabetical order.
Sample Chart of Accounts
The following is an example of some of the accounts that might be included in a chart of accounts.
Sample Chart of Accounts
Asset Accounts
Current Assets

Sample Chart of Accounts

The following is an example of some of the accounts that might be included in a chart of accounts.

Sample Chart of Accounts

Asset Accounts

Current Assets

1000	Petty Cash
1010	Cash on Hand (e.g. in cash registers)
1020	Regular Checking Account
1030	Payroll Checking Account
1040	Savings Account
1050	Special Account
1060	Investments - Money Market
1070	Investments - Certificates of Deposit
1100	Accounts Receivable
1140	Other Receivables
1150	Allowance for Doubtful Accounts
1200	Raw Materials Inventory
1205	Supplies Inventory
1210	Work in Progress Inventory
1215	Finished Goods Inventory - Product #1
1220	Finished Goods Inventory - Product #2
1230	Finished Goods Inventory - Product #3
1400	Prepaid Expenses
1410	Employee Advances
1420	Notes Receivable - Current
1430	Prepaid Interest
1470	Other Current Assets

Fixed Assets

1500	Furniture and Fixtures
1510	Equipment
1520	Vehicles
1530	Other Depreciable Property
1540	Leasehold Improvements
1550	Buildings
1560	Building Improvements
1690	Land
1700	Accumulated Depreciation, Furniture and Fixtures
1710	Accumulated Depreciation, Equipment
1720	Accumulated Depreciation, Vehicles
1730	Accumulated Depreciation, Other
1740	Accumulated Depreciation, Leasehold
1750	Accumulated Depreciation, Buildings
1760	Accumulated Depreciation, Building Improvements

Other Assets

1900	Deposits
1910	Organization Costs
1915	Accumulated Amortization, Organization Costs
1920	Notes Receivable, Non-current
1990	Other Non-current Assets

Liability Accounts

Current Liabilities

2000	Accounts Payable
2300	Accrued Expenses
2310	Sales Tax Payable
2320	Wages Payable
2330	401-K Deductions Payable
2335	Health Insurance Payable
2340	Federal Payroll Taxes Payable
2350	FUTA Tax Payable
2360	State Payroll Taxes Payable
2370	SUTA Payable
2380	Local Payroll Taxes Payable
2390	Income Taxes Payable
2400	Other Taxes Payable
2410	Employee Benefits Payable
2420	Current Portion of Long-term Debt
2440	Deposits from Customers
2480	Other Current Liabilities

Long-term Liabilities

2700	Notes Payable
2702	Land Payable
2704	Equipment Payable
2706	Vehicles Payable
2708	Bank Loans Payable
2710	Deferred Revenue
2740	Other Long-term Liabilities

Equity Accounts

3010	Stated Capital
3020	Capital Surplus
3030	Retained Earnings

Revenue Accounts

4000	Product #1 Sales
4020	Product #2 Sales
4040	Product #3 Sales
4060	Interest Income
4080	Other Income
4540	Finance Charge Income
4550	Shipping Charges Reimbursed
4800	Sales Returns and Allowances
4900	Sales Discounts

Cost of Goods Sold

5000	Product #1 Cost
5010	Product #2 Cost
5020	Product #3 Cost
5050	Raw Material Purchases
5100	Direct Labor Costs
5150	Indirect Labor Costs
5200	Heat and Power
5250	Commissions
5300	Miscellaneous Factory Costs
5700	Cost of Goods Sold, Salaries and Wages
5730	Cost of Goods Sold, Contract Labor
5750	Cost of Goods Sold, Freight
5800	Cost of Goods Sold, Other
5850	Inventory Adjustments
5900	Purchase Returns and Allowances
5950	Purchase Discounts

Expenses

6000	Default Purchase Expense
6010	Advertising Expense
6050	Amortization Expense
6100	Auto Expenses
6150	Bad Debt Expense
6200	Bank Fees
6250	Cash Over and Short
6300	Charitable Contributions Expense
6350	Commissions and Fees Expense
6400	Depreciation Expense
6450	Dues and Subscriptions Expense
6500	Employee Benefit Expense, Health Insurance
6510	Employee Benefit Expense, Pension Plans
6520	Employee Benefit Expense, Profit Sharing Plan
6530	Employee Benefit Expense, Other
6550	Freight Expense
6600	Gifts Expense
6650	Income Tax Expense, Federal
6660	Income Tax Expense, State
6670	Income Tax Expense, Local
6700	Insurance Expense, Product Liability
6710	Insurance Expense, Vehicle
6750	Interest Expense
6800	Laundry and Dry Cleaning Expense
6850	Legal and Professional Expense
6900	Licenses Expense
6950	Loss on NSF Checks
7000	Maintenance Expense
7050	Meals and Entertainment Expense
7100	Office Expense
7200	Payroll Tax Expense
7250	Penalties and Fines Expense
7300	Other Taxes
7350	Postage Expense
7400	Rent or Lease Expense
7450	Repair and Maintenance Expense, Office
7460	Repair and Maintenance Expense, Vehicle
7550	Supplies Expense, Office
7600	Telephone Expense
7620	Training Expense
7650	Travel Expense
7700	Salaries Expense, Officers
7750	Wages Expense
7800	Utilities Expense
8900	Other Expense
9000	Gain/Loss on Sale of Assets

Tentative Course Outline and Contents

Classification of Accounts (for Chart of Accounts)

In accounting, different types of financial transactions (eg, paying telephone bills, copier bills, getting money from sales, getting money from interest income, etc.) are assigned specific numbers (account numbers) which help to record and track those types of transactions. Businesses might create their own list (or chart) of accounts or adopt a chart used by other organizations. In any case, you should have some basic impression of a chart of accounts. The following links will help you.

Setting Up a Chart of Accounts
What Should a Chart of Accounts Include?

Financial Controls
Financial controls exist to help ensure that financial transactions are recorded and maintained accurately, and that personnel don't unintentionally (or intentionally) corrupt the financial management system. Controls range from very basic (eg, using a checkbook and cash register tapes to more complex, eg, yearly financial audits).

Internal Financial Controls for a Small Business
another set of controls


CRITICAL OPERATING ACTIVITIES IN YEARLY ACCOUNTING CYCLE:
Now that you have a basic sense of the overall accounting and financial management process, we'll look at the key parts at the beginning of the overall process, including budgeting, managing cash and credit.

Budget Management
A budget depicts what you expect to spend (expenses) and earn (revenue) over a time period. Amounts are categorized according to the type of business activities, or accounts (for example, telephone costs, sales of catalogs, etc.). Budgets are useful for planning your finances and then tracking if you're operating according to plan. They are also useful for projecting how much money you'll need for a major initiative, for example, buying a facility, hiring a new employee, etc. There are yearly (operating) budgets, project budgets, cash budgets, etc. The overall format of a budget is a record of planned income and planned expenses for a fixed period of time.

Budgeting in a Small Business
What Type of Capital Does Your Business Need?

Managing Cash Flow
As a new business, your biggest challenge is likely to be managing your cash flow -- probably the most important financial statement for a new business is the cash flow statement. The overall purpose of managing your cash flow is to make sure that you have enough cash to pay current bills. Businesses can manage cash flow by examining a cash flow statement and cash flow projection. Basically, the cash flow statement includes total cash received minus total cash spent. Cash management looks primarily at actual cash transactions.


Basics of Cash Management
The Importance of Cash Management
Basic Cash Management Techniques
Basic Cash Management Techniques
cash management techniques
Techniques for Improving Cash Flow

Preparing a Cash Flow Statement
Develop a Cash Flow Statement
Preparing Your Cash Flow Statement
Cash Flow Worksheet cash flow worksheet

Preparing Cash Flow Projections and Forecasts
More information on doing cash flow forecast

Annual Cash Flow Projections
Short-Term Cash Flow Projections

Managing Your Checking Account
For a new business, your check register very likely will be your primary means to record and track cash. Whether yours is a new business or an established business, you'll need to know how to manage your bank account.

Reconciling Your Bank Account

Settting Up and Managing Your Bank Account
You will need to set up a business bank account, which will include a business checking account. Banks often classify and handle business bank accounts differently than private or personal bank accounts. The following links will help you set up your account. Be sure to also see Getting a Banker.


Credit and Collections
One of your biggest challenges in managing cash flow may be decisions about granting credit to customers or clients, and how to collect payment from them.
Debt Collection-Know Your Rights
Debt Collection Basics

Budget Deviation Analysis
You learned above that a budget depicts what you expect to spend (expenses) and earn (revenue) over a time period. Budget deviation analysis regularly compares what you expected, or planned, to earn and spend with what you actually spent and earned. The budget deviation analysis can help greatly when detecting how well you're tracking your plans, how much to accurately budget in the future, where there may be upcoming problems in spending, etc.


ACTIVITIES IN YEARLY ACCOUNTING CYCLE: Financial Statements and Analysis
Financial Statements
To really understand the current and future conditions of your business, you have to look at certain financial statements. These statements are generated by organizing and analyzing numbers from your accounting activities. You should understand the two primary financial statements, the Profit and Loss Statement (or Income Statement) and the Balance Sheet. (Some sources believe that there are other primary statements, too, such as the cash flow statement or change in capital, etc. However, the Income Statement and Balance Sheet are the two standard statements for any business.) The following links will give you an overview of these two key statements, and we'll soon get into them in more detail later on below. Here are several perspectives on the statements.

Introduction to Using Financial Statements
Using Financial Statements
Basic Guide to Understanding Financial Statements
Introduction to Understanding Financial Statements
Understanding Financial Statements



Financial Planning and Analysis -- Profit and Loss (Income) Statements
These "P and L" statements depict the status of your overall profits. These statements include much money you've earned (your revenue) and subtract how much you've spent (your expenses), resulting in how much you've made money (your profits) or lost money (your deficits). Basically, the statement includes total sales minus total expenses. It presents the nature of your overall profit and loss over a period of time. Therefore, the Income Statement gives you a sense for how well the business is operating.

Understanding Income Statements
Income Statement Analysis
Income Statement Analysis
The Income Statement

Financial Planning and Analysis -- Balance Sheets
Whereas the P and L statement depicts the overall status of your profits (or deficits) by looking at income and expenses over a period of time, the balance sheet depicts the overall status of your finances at a fixed point in time. It totals your all your assets and subtracts all your liabilities to compute your overall net worth (or net loss). This statement are referenced particularly when buying or selling a business, or applying for funding. Here are several perspectives.

Basics About Balance Sheets
Understanding Balance Sheets
Balance Sheet Analysis

Financial Analysis
Financial analysis can tell you a lot about how your business is doing. Without this analysis, you may end up staring at a bunch of numbers on budgets, cash flow projections and profit and loss statements. You should set aside at least a a few hours every month to do financial analysis. Analysis includes cash flow analysis and budget deviation analysis mentioned above. Analysis also includes balance sheet analysis and income statement analysis. There are some techniques and tools to help in financial analysis, for example, profit analysis, break-even analysis and ratios analysis that can substantially help to simplify and streamline financial analysis. How you carry out the analysis depends on the nature and needs of you and your business. The following links will help you get a sense for the "territory" of financial analysis.

Financial Planning and Analysis -- Profit Analysis
There are a variety of ways to help determine profitability of your business.
Cost/Volume/Profit Analysis
Calculating Profitability Ratios



Financial Planning and Analysis -- Break-Even Analysis
The break-even analysis uses information from the income statement and cash flow statements to compute how much sales much be accomplished in order to pay for all of your fixed and variable expenses. Fixed expenses are expenses that you'd have regardless of the level of sales of products or services (eg, sales, rent, insurance, maintenance, etc.). Variable expenses are incurred according to the level of sales of products or services (eg, sales commissions, sales tax, freight to ship products, etc.). Break-even analysis can help you when projecting when you'll make a profit, deciding how much to charge for a product, setting a sales goal, etc.
Break-Even Analysis
Break-Even Analysis

Financial Planning and Analysis -- Ratios
There are a variety of ratios that can be used to help determine the current and future condition of a business. The following links provide explanation and procedures for using those ratios. The ratios are produced from numbers on the financial statements. Note that the usefulness of ratios often are from comparing ratios from different time periods in the same business or from industry standards for a type of business, eg, manufacturing, wholesale, service, etc.
Overview of major types of ratios and how they're computed

RMI

Financial Managers

Financial Managers

Significant Points

Jobseekers are likely to face competition.
About 3 out of 10 work in finance and insurance industries.
A bachelor’s degree in finance, accounting, or a related field is the minimum academic preparation, but employers increasingly seek graduates with a master’s degree in business administration, economics, finance, or risk management.
Experience may be more important than formal education for some financial manager positions—most notably, branch managers in banks.

Nature of the Work

Almost every firm, government agency, and other type of organization has one or more financial managers. Financial managers oversee the preparation of financial reports, direct investment activities, and implement cash management strategies. Managers also develop strategies and implement the long-term goals of their organization.

The duties of financial managers vary with their specific titles, which include controller, treasurer or finance officer, credit manager, cash manager, risk and insurance manager, and manager of international banking. Controllers direct the preparation of financial reports, such as income statements, balance sheets, and analyses of future earnings or expenses, that summarize and forecast the organization’s financial position. Controllers also are in charge of preparing special reports required by regulatory authorities. Often, controllers oversee the accounting, audit, and budget departments. Treasurers and finance officers direct the organization’s budgets to meet its financial goals. They oversee the investment of funds, manage associated risks, supervise cash management activities, execute capital-raising strategies to support a firm’s expansion, and deal with mergers and acquisitions. Credit managers oversee the firm’s issuance of credit, establishing credit-rating criteria, determining credit ceilings, and monitoring the collections of past-due accounts.

Cash managers monitor and control the flow of cash receipts and disbursements to meet the business and investment needs of the firm. For example, cash flow projections are needed to determine whether loans must be obtained to meet cash requirements or whether surplus cash should be invested in interest-bearing instruments. Risk and insurance managers oversee programs to minimize risks and losses that might arise from financial transactions and business operations. They also manage the organization’s insurance budget. Managers specializing in international finance develop financial and accounting systems for the banking transactions of multinational organizations. (Chief financial officers and other executives are included with top executives elsewhere in the Handbook.)

Financial institutions—such as commercial banks, savings and loan associations, credit unions, and mortgage and finance companies—employ additional financial managers who oversee various functions, such as lending, trusts, mortgages, and investments, or programs, including sales, operations, or electronic financial services. These managers may solicit business, authorize loans, and direct the investment of funds, always adhering to Federal and State laws and regulations.

Branch managers of financial institutions administer and manage all of the functions of a branch office. Job duties may include hiring personnel, approving loans and lines of credit, establishing a rapport with the community to attract business, and assisting customers with account problems. Branch mangers also are becoming more oriented toward sales and marketing. As a result, it is important that they have substantial knowledge about all types of products that the bank sells. Financial managers who work for financial institutions must keep abreast of the rapidly growing array of financial services and products.

In addition to the preceding duties, all financial managers perform tasks unique to their organization or industry. For example, government financial managers must be experts on the government appropriations and budgeting processes, whereas health care financial managers must be knowledgeable about issues surrounding health care financing. Moreover, financial managers must be aware of special tax laws and regulations that affect their industry.

Financial managers play an increasingly important role in mergers and consolidations and in global expansion and related financing. These areas require extensive, specialized knowledge to reduce risks and maximize profit. Financial managers increasingly are hired on a temporary basis to advise senior managers on these and other matters. In fact, some small firms contract out all their accounting and financial functions to companies that provide such services.

The role of the financial manager, particularly in business, is changing in response to technological advances that have significantly reduced the amount of time it takes to produce financial reports. Financial managers now perform more data analysis and use it to offer senior managers ideas on how to maximize profits. They often work on teams, acting as business advisors to top management. Financial managers need to keep abreast of the latest computer technology to increase the efficiency of their firm’s financial operations.

Work environment. Working in comfortable offices, often close to top managers and to departments that develop the financial data those managers need, financial managers typically have direct access to state-of-the-art computer systems and information services. They commonly work long hours, often up to 50 or 60 per week. Financial managers generally are required to attend meetings of financial and economic associations and may travel to visit subsidiary firms or to meet customers.

Training, Other Qualifications, and Advancement

Most financial managers need a bachelor’s degree, and many have a master’s degree or professional certification. Bank managers often have experience as loan officers. Financial managers also need strong interpersonal and business skills.

Education and training. A bachelor’s degree in finance, accounting, economics, or business administration is the minimum academic preparation for financial managers. However, many employers now seek graduates with a master’s degree, preferably in business administration, economics, finance, or risk management. These academic programs develop analytical skills and teach the latest financial analysis methods and technology.

Experience may be more important than formal education for some financial manager positions—most notably, branch managers in banks. Banks typically fill branch manager positions by promoting experienced loan officers and other professionals who excel at their jobs. Other financial managers may enter the profession through formal management training programs offered by the company. The American Institute of Banking, which is affiliated with the American Bankers Association, sponsors educational and training programs for bank officers at banking schools and educational conferences.

Other qualifications. Candidates for financial management positions need many different skills. Interpersonal skills are important because these jobs involve managing people and working as part of a team to solve problems. Financial managers must have excellent communication skills to explain complex financial data. Because financial managers work extensively with various departments in their firm, a broad understanding of business is essential.

Financial managers should be creative thinkers and problem-solvers, applying their analytical skills to business. They must be comfortable with the latest computer technology. Financial managers must have knowledge of international finance because financial operations are increasingly being affected by the global economy. Proficiency in a foreign language also may be important. In addition, a good knowledge of compliance procedures is essential because of the many recent regulatory changes.

Certification and advancement. Financial managers may broaden their skills and exhibit their competency by attaining professional certification. Many associations offer professional certification programs. Continuing education is vital to financial managers, who must cope with the growing complexity of global trade, changes in Federal and State laws and regulations, and the proliferation of new and complex financial instruments. Firms often provide opportunities for workers to broaden their knowledge and skills by encouraging them to take graduate courses at colleges and universities or attend conferences related to their specialty. Financial management, banking, and credit union associations, often in cooperation with colleges and universities, sponsor numerous national and local training programs. Trainees prepare extensively at home and then attend sessions on subjects such as accounting management, budget management, corporate cash management, financial analysis, international banking, and information systems. Many firms pay all or part of the costs for employees who successfully complete the courses. Although experience, ability, and leadership are emphasized for promotion, advancement may be accelerated by this type of special study.

Because financial management is so important to efficient business operations, well-trained, experienced financial managers who display a strong grasp of the operations of various departments within their organization are prime candidates for promotion to top management positions. Some financial managers transfer to closely related positions in other industries. Those with extensive experience and access to sufficient capital may start their own consulting firms.

Employment

Although they can be found in every industry, approximately 3 out of 10 were employed by finance and insurance establishments, such as banks, savings institutions, finance companies, credit unions, insurance carriers, and securities dealers.

Job Outlook

Employment growth for financial managers is expected is to be about as fast as the average for all occupations. However, applicants will likely face strong competition for jobs. Those with a masters’ degree and a certification will have the best opportunities.



Some companies may hire financial managers on a temporary basis, to see the organization through a short-term crisis or to offer suggestions for boosting profits. Other companies may contract out all accounting and financial operations. Even in these cases, however, financial managers may be needed to oversee the contracts.

Job prospects. As with other managerial occupations, jobseekers are likely to face competition because the number of job openings is expected to be less than the number of applicants. Candidates with expertise in accounting and finance—particularly those with a master’s degree and or certification—should enjoy the best job prospects. Strong computer skills and knowledge of international finance are important; as are excellent communication skills because financial management involves working on strategic planning teams.

As banks expand the range of products and services they offer to include insurance and investment products, branch managers with knowledge in these areas will be needed. As a result, candidates who are licensed to sell insurance or securities will have the most favorable prospects.

Tentative Reference Textbook

Financial Management in Philippine Setting
by Cesar Seldana
Text and Cases