kartik case study (with solution)

1 Private and Confidential – Not for

Circulation

Private and Confidential

Finance for Non-Finance

Prepared by: Dheeraj Vaidya

[email protected]

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mailto:[email protected]

Private and Confidential – Not for Circulation 2

Discussion topics

Introduction to accounting

Background

Business Cycle

Use of Financial Statements

Income Statement

Introduction

Accrual basis of accounting

Cash basis of accounting

Revenue recognition principle

Matching principle of costs

Balance Sheet

Introduction

Accounting Equation

Debit and Credit

Assets / Liabilities

Key Questions

Cash flow Statement

Introduction

Calculating cash flow from operations, investing and finance

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3Private and Confidential – Not for Circulation

Introduction to Accounting

Private and Confidential – Not for Circulation

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Starting a Business: some background

Kartik want to start a new business. Kartik sees the need for “Movers and Packers” business in Mumbai. He has researched this idea and has prepared a business plan that documents the viability of his new business

Kartik is a hard worker and a smart man, but admits he is not comfortable with matters of accounting

Kartik asks his banker to recommend a professional analyst who is skilled in explaining business accounting to someone without an accounting background

Kartik wants to understand financial statements and wants to keep on top of his new business

Kartik asks you the following questions

What is business cycle?

Why do we use financial statements at all?

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What is a Business Cycle?

Simple Business Cycle for FastTrack Inc

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Kartik Infuses Capital

Uses the money to purchase

trucks, inventory, pay

labor and admin costs

Provides Service

“Movers and Packers”

Receives Money from Clients,

Earns Profit/Loss

Cash OutflowCash Inflow

Shareholder of the

firm

Kartik receives money from the clients – Profit or Loss

Kartik has following options

Kartik can reinvest the profit made in the business to expand his business or

Can simply keep the money!


Why do we use Financial Statements?

FastTrack Movers & Packers Transactions

Based on Kartik’s business plan, you now understand that there will likely be thousands of transactions each year

Kartik seems puzzled by the term transaction, so you gives him five examples of transactions that FastTrack Inc will need to record:

Kartik will start his business by putting some of his own personal money into it. In effect, he is buying shares of FastTrack Inc common stock

FastTrack Inc will need to buy a few transport vehicles - truck

The business will begin earning fees and billing clients for relocating their parcels from one place to another

The business will be collecting the fees that were earned

The business will incur expenses in operating the business, such as a salary for Kartik, labors, expenses associated with packaging material, delivery vehicle, advertising, etc

With thousands of such transactions in a given year, Kartik is being advised to make an entry of these transactions in an accounting software on a daily basis

Why Accounting?

Understanding of company’s profitability, assets and cash position

Generate sales invoices and accounting entries

Prepare statements for customers with no additional work

Can you now explain Kartik, the content and purpose of the three main financial statements –Income Statement, Balance Sheet and Cash Flow statementF

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Income Statement


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Income Statement – Jargons introduced!

The order of deduction of cost is as follows:

Cost of products sold

Sales, general and administrative costs

Interest Expenses

Tax Expenses

Lets get back to our FastTrack Inc example

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Revenues result from the entity’s operating activities (selling

merchandise, selling services)

Costs and expenses are incurred in generating revenues and operating

the entity

The income statement shows the profit for the period of time under consideration

FastTrack Movers & Packers Inc.

Sales $ xxx

Cost of goods sold $ xxx

Gross Profit $ xxx

Selling,general and admin. expenses $ xxx

Income from operations $ xxx

Interest expense $ xxx

Income before taxes $ xxx

Net Income $ xxx

Earnings per share $ xxx

Income Statement, for year ended 31st December, 2007


FastTrack Movers & Packers Revenues

Even though Kartik’s clients won't be paying FastTrack Inc until January 15, the accrual basis of accounting requires that the $1,000 be recorded as December revenues, since that is when the delivery work actually took place

What is accrual basis of accounting?

What is cash method of accounting?

What is revenue recognition principle?

After expenses are matched with these revenues, the income statement for December will show just how profitable the company was in delivering parcels in December

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Case 1: Revenues

If Kartik delivers 200 parcels in December for $5 per delivery, he has technically earned fees totaling

$1,000 for that month. He sends invoices to his clients for these fees and his terms require that his

clients must pay by January 15


FastTrack Movers & Packers Revenues

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Receipts of $1,000 will not be considered to be January revenues, since the revenues were already reported as revenues in December when they were earned

This $1,000 of receipts will be recorded in January as a reduction in Accounts Receivable (In December Kartik had made an entry to Accounts Receivable and to Sales) – Don’t worry, we will explain you this in a bit!

The actual date of payment of $400 does not matter

What matters is when the work was done and when the corresponding expense was incurred

In our case work was done in December and hence, $400 expense is counted as a December expense even though the money will not be paid out until January 3

What is matching principle?

Case 2: Revenues

When Kartik receives the $1,000 worth of payment checks from his customers on January 15, he will

make an accounting entry to show the money was received.

Case 3: Expenses

If Kartik hires some labor to help him with December deliveries and Kartik agrees to pay him $300 on

January 3 and another $100 for pakaging and other supporting material; Total expenses of $400

expense for December deliveries


Income Statement - Expenses

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What is the monthly interest expense that is shown for Kartik’s monthly income statement?

Case 4: Expenses

FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December

and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on

December 1st of each year.

FastTrack Income Statement as per the transaction discussed for the month of December, 2007


Sales $1,000

Cost of goods sold $400

Gross Profit $600

Selling,general and admin. Expenses 1

$30

Income from operations $570

Interest expense $83

Income before taxes $487

Income Tax @ 33% $161

Net Income $326

Note 1: SG&A expense is assumed to be $30 in December,2007

Income Statement, for month ended 31st December, 2007


Consolidating the Income Statement

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Accrual basis of accounting

Concept of Matching Principle

Concept of Matching Principle


Balance Sheet


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Balance Sheet – Jargons reintroduced!

“Snapshot" of a company's financial position at a given moment

Reports the amount of a company's

Assets – Current assets/Long term assets

Liabilities – Current liabilities/Long term liabilities

Stockholders' (or owner's) equity – Common stock / Retained earnings

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Assets Liabilities & Stockholder's Equity

Current assets Current Liabilities

Cash $ xxx Short-term debt $ xxx

Accounts Receivables $ xxx Accounts Payable $ xxx

Inventory $ xxx Total current liabilities $ xxx

Total current assets $ xxx

Long term Liabilities

Long term assets Long term debt $ xxx

Plant and Equipment $ xxx

Less:Acc depreciation ($ xxx) Stockholder's Equity

Net PPE $ xxx Common Stock $ xxx

Retained Earnings $ xxx

Total Stockholder's Equity $ xxx

Total Assets $ xxx Liabilities & Stockholder's Equity $ xxx

FastTrack Movers & Packers Inc

Balance Sheet, December 31st 2007

Assets Liability Shareholder’s Equity= +

Shareholder’s Equity

Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset)

Retained Earnings will increase when the corporation earns a profit and there will be a decrease when the corporation has a net loss

Core link between a company's balance sheet and income statement


Balance Sheet

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Cash $20,000 Liabilities $0

Stockholder's Equity

Common Stock $20,000

Total Assets $20,000 $20,000



Cash from Kartik’s personal investment

Increase in its stockholders' equity account Common Stock

by $20,000

Case 5: Cash and Common Stock

On December 1, 2007 Kartik starts his business FastTrack Movers and Packers. The first transaction that

Kartik will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of

FastTrack Movers & Packers common stock. There are no revenues because no delivery fees were earned

by the company, and there were no expenses.

Kartik also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation

What is Depreciation

Matching principle?

Depreciation of land?

The accountant might match $2,800 ($14,000 5 years) of depreciation expense with each year's revenues for five years


Balance Sheet

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Cash reduces to $6,000 and vehicle account increases to

$14,000

No change in stockholder’s position



Vehicle $14,000



Total Assets $20,000 $20,000


Balance Sheet, December 2nd 2007

Case 6: Purchase of Vehicle

On December 2, FastTrack Movers & Packers purchases a truck for $14,000 by writing a check for $14,000.

The two accounts involved are Cash and Vehicles (or Delivery Truck)


Balance Sheet

Between Dec 1st & Dec 31st, $100 worth of insurance premium is "used up" or "expires"

The expired amount will be reported as Insurance Expense on December's income statement

The remaining portion of unexpired insurance premium is reported as Pre-paid Insurance

What is the remaining portion of Pre-paid insurance as of Dec 31st , 2007?

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Cash reduces further to $4,800 and Prepaid insurance account increases to $1,200

No change in stockholder’s position



Prepaid Insurance $1,200


Vehicle $14,000 Common Stock $20,000

Total Assets $20,000 $20,000


Balance Sheet, December 2nd 2007

Case 7: Prepaid Expenses

On December 2 when Kartik contacts an insurance agent regarding insurance coverage for the Truck just

purchased. The agent informs him that $1,200 will provide insurance protection for the next one year.

Kartik immediately writes a check for $1,200.



Prepaid Insurance $1,200 Long term debt $20,000



Total Assets $40,000 Liabilities & Stockholder's Equity $40,000


Balance Sheet, December 3rd 2007


Balance Sheet

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Cash increases by $20,000 (amount of debt raised from

the bank)

Long term debt raised from the bank

Case 4 Revisited : Raising Debt




On 10th December, wholesale price of boxes has been risen by 20% & at today's price Kartik’s could purchase them for $1.20 each. What is the value of inventory shown on balance sheet?

What is Cost Principle?

Lets say that since the time Kartik bought inventory, the wholesale price of boxes has been cut by 40% and at today's price he could purchase them for $0.60 each. What is the value of inventory shown on the balance sheet in this case?

What is the principle of Conservatism?



Prepaid Insurance $1,200 Long term debt $20,000

Inventory $1,000 Stockholder's Equity


Vehicle $14,000


Balance Sheet, December 3rd 2007



Balance Sheet

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Cash decreases by $1,000 and inventory increases by $1,000

No change

Case 8: Inventory

Kartik keeps an inventory of packing boxes not only to use it for his business but also earn additional

revenues by carrying an inventory of packing boxes to sell. Let's say that FastTrack Movers and Packers

purchased 1,000 boxes wholesale for $1.00 each.

Other liabilities

For the loan Kartik received from Bank (Notes Payable or Loan Payable), the interest on the loan he owes to his bank (Interest Payable)

Amount he owes to the supply store for items purchased on credit (Accounts Payable)

Wages he owes an employee but hasn't yet paid to him (Wages Payable)



Prepaid Insurance $1,200 Unearned Revenue $600

Inventory $1,000 Long term debt $20,000




Balance Sheet, December 4th 2007



Balance Sheet

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Cash increases by $600 Liability increases by $600

Case 9: Unearned Revenues

In addition to 200 parcels delivered by FastTrack Movers and Packers in December, they enters into an

agreement with one of its customers stipulating that the customer prepays $600 in return for the delivery

of 30 parcels every month for 6 months. Assume FastTrack Movers & Packers receives $600 payment on

Dec 1,2007 for deliveries to be made between Dec 1,2007 and May 31,2007


Missing links

Accounts Receivables

Accounts Payable

Interest Payable

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The arrow indicates that net income affects retained earnings, which is a component of owners’ equity

Assets = Liabilities +

Owners'

Equity Net income = Revenues - Expenses

Balance Sheet Income Statement

Case 1&2: Revenues

If Kartik delivers 200 parcels in December for $5 per delivery, he has technically earned fees totaling

$1,000 for that month. He sends invoices to his clients for these fees and his terms require that his

clients must pay by January 15

Case 3: Expenses

If Kartik hires some labor to help him with December deliveries and Kartik agrees to pay him $300 on

January 3 and another $100 for pakaging and other supporting material; Total expenses of $400

expense for December deliveries

Case 4: Expenses





Sales $1,100

Cost of goods sold $400

Gross Profit $700

Selling,general and admin. Expenses 1

$30

Depreciation Expense $233

Insurance Expense $100

Income from operations $337

Interest expense $83

Income before taxes $254

Income Tax @ 33% $84

Net Income $170

Note 1: SG&A expense is assumed to be $30 in December,2007

Income Statement, for month ended 31st December, 2007


Consolidating all cases in Income Statement

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Case 1 (accrual) + Case 9 (earned revenue for December)

Case 6, monthly depreciation = $2,800/12 = $233

Case 7, insurance premium worth $1,200/12 =$100 is utilized per

month


Consolidated Balance Sheet

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Current assets Current Liabilities

Cash $24,370 Unearned Revenue $500

Prepaid Insurance $1,100 Accounts Payable $400

Accounts Receivable $1,000 Interest Payable $83

Inventory $1,000 Income Tax Payable $84

Total Current Assets $27,470 Total Current liabilities $1,067

Vehicle $14,000 Long term debt $20,000

Accumulated depreciation $233

Net $13,767 Stockholder's Equity


Retained Earnings $170




Insurance premium worth $1,200/12 =$100 is utilized for

December

Cash receipt on January 15th, however, sales has been completed

and booked as Accounts Receivables

Net Income Flows through the Income Statement

Revenues worth $100 earned in December, hence Unearned revenue

of $600 adjusted for the earned revenues

Unpaid expenses, classified as

liabilities


Balance Sheet – Key questions?

Balance sheet shows the company’s assets worth?

YES?

NO?

Balance sheet does not provide us with the fair market value of the company?

Long-term assets reported at their cost minus amounts already sent to Income Statement as depreciation expense

The asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost

However, Short-term asset amounts are likely to be close to their market values, since they tend to "turn over" in relatively short periods of time

Is reputation cost captured in Balance Sheet – Brand, Logo etc?

Bill Gates

Nike

BMW

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Cash Flow Statement


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Cash Flow Statement – Cash is the King!

Purpose of this cash flow statement is to identify sources & uses of cash during the year

Cash Flow is divided into three parts

Cash flow from operations: Include all the transactions and other events related to its earnings process

Cash flow from Investments: Include all the transactions involving acquiring and selling long-term investment, property, plant, and equipment

Cash Flow from Finance: Include all the transactions involved in obtaining and disbursing resources from and to owners and repaying the amounts borrowed

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Net Cash

Cash flow from

Operations

Cash flow from

InvestingCash flow from

Finance+ +

Cash Inflows:

Generation of funds in normal operations

Cash Outflows:

Expenditure of funds in normal operations

Cash Inflows:

Debt issuance, common stock, preferred stock and other securities

Cash Outflows:

Retirement of debt, common stock and preferred stock

Payment of cash dividend

Cash Inflows:

Sale of plants and equipments

Liquidation of long term investments

Cash Outflows:

Purchase of plants and equipments

Investments in long term investments


Calculating Cash flows

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CasesCash Impact

(yes/no)Cash Amount Classification Comments

Case 1 No $0 Operation Revenues earned but not paid

Case 2 No $0 Operation Revenues earned but not paid

Case 3 No $0 Operation Expenses incurred but not paid

Case 4 No $0 Operation Interest expense incurred but not paid

Case 4 Yes $20,000 Finance FastTrack borrows from the bank

Case 5 Yes $20,000 Finance Kartik infuses capital

Case 6 Yes ($14,000) Investing Purchase of truck

Case 7 Yes ($1,200) Operation Prepaid expenses

Case 8 Yes ($1,000) Operation Purchase of Inventory (boxes)

Case 9 Yes $600 Operation Customer Prepays

Others Yes ($30) Operation SG&A expenses incurred and paid

Cash flows $24,370

Cash flow from operations ($1,630)

Cash flow from investing ($14,000)

Cash flow from financing $40,000

Total Change in cash $24,370

End CashCash at the

beginningChange in cash during

the period= +

Flows into the Balance Sheet as “Cash”


Sum up..


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kartik case study (with solution)

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