Accounting and Its Relationship to

Engineering Economy
ENGECOA – T42, 1st Term, SY ’09-’10
• Accounting is often referred to as the
language of business
• Engineers need to learn about a firm’s
accounting practice so that they can
communicate better with management
Accounting Fundamentals (1/4)

• All accounting is based on the

fundamental accounting equation:
Assets = Liabilities + Owners’ Equity
• Assets are those things of monetary value that the firm
possesses
• Liabilities are those things of monetary value that the firm
owes to its creditors
• Owners’ equity is the worth of what the firm owes to its
stockholders
Accounting Fundamentals (2/4)

• This basic accounting equation defines

the format of the balance sheet
Accounting Fundamentals (3/4)

• Another important accounting

relationship is:
Revenues – Expenses = Profit (or Loss)
• The relationship above defines the format
of the income statement
• Given the relationship above, the basic
accounting equation can be expanded to:

Assets = Liabilities + (Beginning

Owner’s Equity + Revenue – Expenses)
Accounting Fundamentals (4/4)

• Profit is the increase in money value

resulting from a firm’s operations
• Profit (or part of it) can either be:
• Distributed to the stockholders in the form
of dividends
• Retained by the firm to have more
spending money for its operations; this is
known as retained earnings
Accounting: The Basis of Decision
Making (1/4)

• Most business entities and individuals

keep accounting records to aid in
making decisions
• Accounting…
• …is the information system that measures
business activities…
• …processes that information into reports…
• …and communicates the results to decision
makers
Accounting: The Basis of Decision
Making (2/4)

• Accounting information is used in many

ways:

• Individual people use accounting

information (among other things) to
manage bank accounts, evaluate job
opportunities, make investments, or
decide whether to rent or buy a house
Accounting: The Basis of Decision
Making (3/4)

• Business managers use accounting

information to set goals for their
organizations

• Investors and creditors provide the

money a business may need to begin
operations; before granting a loan, banks
determine whether the borrower has the
ability to meet scheduled payments
Accounting: The Basis of Decision
Making (4/4)

• An important output of an accounting

information system is a series of
financial statements that allow
individuals and businesses make
informed and intelligent decisions
Net Worth: How Well Are You Doing?

• Two important statements in

monitoring financial progress:
• Cash flow statement - how much you
earned and spent during a specific time
period
• Net worth statement – tells what assets
you have and where it stands with respect
to its financial goals
• Net worth is what you would be left over with
you if you sold everything and paid off all your
debts
Assets: What You Own (1/2)

• Cash reserve assets

• Cash
• Cash equivalents: money in checking,
savings, money market accounts,
certificate of deposits (CDs), treasury bills,
cash value of your life insurance policy
• Investment assets
• Stocks
• Bonds
• Mutual funds
Assets: What You Own (2/2)

• Real Estate

• Business interests
• Partnership interests
• Shares in closely held corporations
Liabilities: What You Owe

• Unsecured loans or short-term

debts – current bills:
• Credit card purchases
• Installment and personal loans
• Income and real estate taxes
• Insurance premiums
• Secured loans or long-term debts
• Mortgages or other loans that you repay in
installments over several years
The Worth of Net Worth Statements

• Banks require a statement of assets

and liabilities as part of the application
in securing a loan

• Certain high-risk investments require

that an individual meets a certain net
worth
Financial Status for Businesses (1/3)

• The annual report is the most

important report corporations issue to
stockholders
• Contains basic financial statements
• Shows management’s opinions of the past
year’s operations and the firm’s future
prospects
Financial Status for Businesses (2/3)

• Four basic questions that managers or

investors are likely to ask:
• What is the company’s financial position at
the end of the fiscal period?
• How well did the company operate during
the fiscal period?
• Where did the company decide to use their
profits for?
• How much cash did the company generate
and spend during the period?
Financial Status for Businesses (3/3)
How much profit did the
company make during INCOME STATEMENT
the fiscal period?

Where did the company STATEMENT OF

decide to use their profit RETAINED EARNINGS
for?

How much did the

company generate and STATEMENT OF
spend during the period? CASH FLOWS

What is the company’s

financial position at the BALANCE SHEET
end of the fiscal period?
The Balance Sheet (1/2)

• Sometimes called the statement of

financial position
• Reports three main categories of
items:
• Assets
• Liabilities
• Stockholders’ equity
The Balance Sheet (2/2)

• The accounting equation is the most

basic tool of accounting
• It shows the relationship among assets,
liabilities, and owners’ equity

Assets = Liabilities + Owners’ Equity

Assets (1/4)

• Asset items are listed in order of their

liquidity
• Liquidity is the length of time it takes to
convert them to cash

CURRENT FIXED OTHER

ASSETS ASSETS ASSETS

most liquid least liquid

Assets (2/4)

• Current assets can be converted to

cash or its equivalent in less than one
year
• Three types:
• Cash
• Accounts receivable (A/R)
• Inventories (raw materials, work-in-process,
finished goods)
Assets (3/4)

• Fixed assets are relatively permanent

and take time to be converted to cash
• Examples: land, buildings, factory
machinery, office equipment, and
automobiles
• Most fixed assets have a limited useful life
• As time passes, the value of such fixed
assets become expenses, which are known
as depreciation expenses
Assets (4/4)

• Other assets include investments

made in other companies and
intangible assets (e.g. goodwill,
copyrights, patents)
Liabilities and Stockholders’ Equity (1/6)

• Liabilities mean the money the

company owes
• The money borrowed by the firm is used
to acquire and build its assets

• Stockholders’ equity is the portion of

the assets of a company which are
provided by the investors (owners)
Liabilities and Stockholders’ Equity (2/6)

• Current liabilities are debts that

must be paid within one year
• Accounts payable
• Notes payable
• Accrued expenses (wages, salaries,
interest, rent, taxes owed)
• Advance payments and deposits from
customers
Liabilities and Stockholders’ Equity (3/6)

• Other liabilities include long-term

liabilities payable more than one year
in the future; these include:
• Bonds
• Mortgages
• Long-term notes
Liabilities and Stockholders’ Equity (4/6)

• Stockholders’ equity represents the

amount that is available to the owners
after all debts have been paid;
generally consists of:
• Preferred stock
• Common stock
• Treasury stock
• Capital surplus (paid-in capital)
• Retained earnings
Liabilities and Stockholders’ Equity (5/6)

• Preferred stock ranks below debt but

above common stock
• Preferred stock dividends are fixed
• Common stock is the aggregate par
value of the company’s stock issued
• Capital surplus is the amount of money
received from the sale of stock more than
the par value of the stock
• Outstanding stock is the number of shares
issued that actually is held by the public
• If a corporation buys back part of its own
issued stock, it is listed as a Treasury Stock
Liabilities and Stockholders’ Equity (6/6)

• Retained earnings represent the

cumulative net income of the firm
since its incorporation, less the total
dividends that have been paid to the
stockholders
The Income Statement (1/3)

• The Income Statement indicates

whether the company is making or
losing money during a stated period
• A company’s accounting period refers
to the period covered by an income
statement
The Income Statement (2/3)

• Revenue is the price of goods sold

and services rendered during a given
accounting period
• The net sales or net revenues figure
represents the gross sales less any
sales return and allowances
• The cost of revenue or the cost of
goods sold is the cost of producing
the product
The Income Statement (3/3)

• Net revenues less the cost of goods sold give

us the gross margin or gross income
• All operating expenses are subtracted from
the gross income to obtain the operating
income or net income before tax (NIBT)
• Net income, which is also known as net
income after tax (NIAT) or accounting
tax is finally determined by subtracting the
income taxes from the operating income
Earnings Per Share

• Earnings per share (EPS) is

obtained by dividing the “available
earnings to common stockholders” by
the number of shares of common stock
outstanding
• Two types:
• Basic
• Diluted
Retained Earnings vs Dividends

• When a corporation makes a profit, it

can either:
1. Distribute the profit to its stockholders
(dividends)
2. Keep the remaining profits in the
business (retained earnings)
The Cash Flow Statement (1/3)

• The cash flow statement gives us a

detailed look on how the firm
generated cash and how it used cash
during the reporting period
• Managers want to maximize cash
flows available to investors over the
long run
The Cash Flow Statement (2/3)

• Operating activities
• Operating cash flows represent those cash
flows related to the production and sales
of goods or services
• All non-cash expenses (such as
depreciation and change in working
capital) are added back to net income
(after tax)
The Cash Flow Statement (3/3)

• Investing activities
• Include purchasing of new fixed assets,
reselling old equipment, or buying and
selling financial assets

• Financing activities
• Any activity related to raising capital to be
used in business
• e.g. borrow from banks, sell more stocks or
bonds, pay off existing debts
Accounting Entries (1/3)

• Suppose that an individual decides to

undertake an investment opportunity
and the following sequence of events
occurs over a period of one year:
1. Organize XYZ firm and invest
PhP300,000 cash as capital
2. Purchase equipment for a total cost of
PhP200,000 by paying cash
Accounting Entries (2/3)

3. Borrow PhP150,000 through a note to

the bank
4. Manufacture a year’s supply of
inventory through the following:
a. Pay PhP120,000 cash for labor
b. Incur PhP40,000 accounts payable for
material
c. Recognize the partial loss in value
(depreciation) of the equipment
amounting to PhP5,000
Accounting Entries (3/3)

5. Sell on credit all goods produced for

year: 1,000 units at PhP200 each.
Recognize that the accounting cost of
these goods is Php110,000.
6. Collect PhP120,000 of accounts
receivable.
7. Pay PhP30,000 of accounts payable
and PhP100,000 of bank note.
Cost Accounting (1/2)

• Cost accounting (or management

accounting) is a phase of accounting
that is of particular importance in
engineering economic analysis because
it is concerned with decision making
and control in a firm
• Cost accounting is the source of the
cost data needed in making
engineering economy studies
Cost Accounting (2/2)

• Modern cost accounting may satisfy

any or all of the following objectives:
1. Determination of the actual cost of
products or services
2. Provision of a rational basis for pricing
goods or services
3. Provision of a means for allocating and
controlling expenditures
4. Provision of information on which
operating decisions may be based
The Elements of Cost (1/3)

• One of the first problems of cost

accounting is that of determining the
elements of cost that arise in the
production of an item or the
rendering of a service
• The general elements of cost are:
1. Direct materials
2. Direct labor
3. Overhead (a.k.a. burden, indirect costs)
The Elements of Cost (2/3)

• Direct materials
• Materials that can be conveniently and
economically charged directly to the cost of the
product
• Should be readily measurable
• Should be of the same quantity in identical
products
• Should be used in economically significant
amounts
• Materials that do not meet the criteria above
are classified as indirect materials
The Elements of Cost (3/3)

• Labor costs are also divided into direct

and indirect categories
• Direct labor cots are those that can be
conveniently and easily charged to the
product or service in question
• Total overhead costs are customarily
associated with a certain level of
production
• One method of allocation of overhead
costs assumes that overhead is
incurred in direct proportion to the cost
of direct labor used

total overhead in pesos for period

Overhead Rate =
direct labor in pesos for period
• Thus, to compute for the overhead cost
per unit:

Overhead cost/unit = overhead rate x direct labor cost per unit

• This method is simple and easy to apply and in many

cases gives quite satisfactory results
Cost Accounting Example (1/5)

Direct Materials

Jobs (work in Finished

Direct Labor Cost of
progress) Goods
Goods Sold
Inventory

Cost of
Goods Sold
Factory Overhead Cost of
Cost of
Goods Sold
Goods Sold
Cost Accounting Example (2/5)

• Consider how an order for 100 tennis

rackets accumulates costs at a sporting
goods company:
Cost Accounting Example (3/5)

• Direct labor and material expenses in the

example are as follows:

• The cost above is NOT the total cost because

we still need to take into consideration the
factory costs that cannot be directly
identified to the job
Cost Accounting Example (4/5)

• To allocate the overhead costs to the

100 rackets using the overhead rate,
the equation discussed earlier will be
used:
$600,000
Overhead Rate =
200,000 hours
= $3 per direct labor hour

• This means that $600 of the total annual overhead cost

would be allocated
Cost Accounting Example (5/5)

• The total cost of Job # 161 would be: