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Department of Chemical

Engineering University of Engineering


&Technology , Lahore

Cost & Asset


Accounting

Prof.Dr.G.M.Mamoor

Department of Chemical Engineering , U.E.T. Lahore Course: CHE349


Accounting Introduction
 Engineers typically hate accounting and finance.
 The view is that it is dry and wholly uninteresting (and
Economics is not far away from this).
 While there is some truth in all this, there is much utility
also. Accounting can not be ignored, it intrudes into every
aspect of work.
 The best approach is to learn as much as possible, use it
when appropriate, but you don’t have to become
accountants, just understand what they do.
 What you need is a good basic understanding of it.
 You can not tell how well the business or the project is
doing without accurate and timely financial information.

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Some History
 It has been with us since the earliest civilisations. They
kept a record of the goods stored with the temple
priests.
 "Double-entry" bookkeeping can be traced back as far
as 1494 when an Italian monk described such a
methodology in a mathematics textbook.
 It is simply put: a way of keeping track or scoring the
financial results of an individual, a corporation etc.
 It is very important in today's society when it is
common place for the owners not to be present.
 Accounting information in its truest form is used to
evaluate uses of limited economic resources.
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Why do we Need it?
 Accounting information is so valuable that many people
make a career out of analysing and evaluating the
resulting statements and advising their clients.
 management consultants
 business planners
 accountants
 financial analysts
 investment managers
 securities brokers/underwriters
 There are two fundamental users of accounting
information. They are external and internal groups to
the "organisation".
 Accounting keeps the score in business.
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Management's Need
 Every textbook will discuss planning and controlling as
the two most important uses of accounting info.
 By having an historical perspective you can see trends
and relationships appearing.
 You can use this information to plan into the future.
 One must never forget that history does not always
repeat itself and variances from your plan will occur.
 Once a plan is in place you can then monitor results
and control or alter certain activities as needed
 The changes or variances - positive or negative - from a
plan provide very useful information.
 Costing of products is another common use of
information provided by an accounting system.
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Government Needs
 The best example here are the various tax authorities.
 Our tax structure is set up to tax "income" or "profits".
 It is critical that we all have a "level" playing field and a
common system of "score-keeping" which we use to
measure progress.
 We wouldn't want to have the yardsticks or methods of
measurement to move while the "game is on".
 It is every taxpayer’s right to arrange his/her affairs in
such a way as to minimise taxes.
 So accounting is important and is required by all levels
of Government so that they can audit your tax paying
methodologies
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Outsiders' Need
 There are a number of external “stakeholders” who
also have an interest in how things are going.
 Investors/owners of the firm need information.
 Bankers, tax authorities, other government agencies,
insurance companies, suppliers etc. are only a few
examples of the regular contacts that the person in
charge of accounting can expect to have.
 In every case it is important that the accountant
represent the company's best interest.
 The score keeping process is done according to a set of
rules - the GAAP - so that everyone understands what
certain things really mean.
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Cost Concepts
 The most difficult, time-consuming part of an EE study is
the estimation of costs and other data.
 Cost estimating is to forecast the present and future cost
consequences of engineering design
 Most projects are unique
 It requires active participation of not only engineering designers
but also personnel from marketing, finance, manufacturing and
top management.

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Cost Estimating – Cont.
 The results are used for a variety of purposes
 Providing information in setting a selling price
 Determining whether a proposed product can be made at a
profit
 There are two approaches to cost estimating
 Top-down: uses historical data for similar projects
 Bottom-up: a more detailed method which breaks down the
project into manageable units

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Example: Estimating the cost of
getting a Bachelor of Science
Bottom-up approach

Sum over 4 years to obtain


Total Cost

2003, 2004, 2005, 2006

Tuition and Books and Living Transportation


Fees Supplies Expenses
fuel
tuition books food
insurance
Activity fees supplies rent
maintenance
Medical software clothing
insurance

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Fixed and Variable Costs
Fixed costs
Remain constant over a specific range of operating
conditions
Example: general management and administrative
salaries
Variable costs
Vary in total with the quantity of output
Example: material and labor costs
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Direct and Indirect Costs

Direct costs
Related to a particular output
Example: the cost of piece of wood used to
make a baseball bat

Indirect costs
Difficult to relate to a specific output
Example: the cost of lighting in the factory
where the bat was made

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Sunk Cost
Has occurred in the past
Has no relevance to the future costs and
benefits
Example: A firm is considering the replacement
of a piece of equipment. It originally cost $50,000,
is presently shown on the company records with a
value of $20,000 and can be sold for an estimated
$5,000. For purpose of replacement, $50,000 is a
sunk cost.
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The Matching Principle
 This is a very important principle:
 "Transactions are to be recorded when they
occur, not when the cash is actually exchanged"
 This is known as ACCRUAL accounting.
 this means that you may pay tax on moneys you have not yet
received
 but you can also claim expenses that you have not paid for yet
 in both cases, however, there is evidence that something has
happened
 If cash is used as the time to recognise a transaction,
then we have CASH BASIS accounting
 While the former is used in almost all businesses, the
latter is useful for small cash based business
 Don’t confuse this with “cash flow” however!
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OUTLINE OF ACCOUNTING PROCEDURE

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Financial Accounting
 Therefore, the accounting function has two parts,
financial accounting and management accounting.
 Financial Accounting is concerned with the recording
and organising the financial data of a business:
 revenues
 expenses
 resources owned
 obligations to others
 owners' value (equity)
 Management Accounting is concerned with the costs
and benefits of the various activities of the enterprise.
 Provide managers with useful and timely information
 assist in decision making by crunching numbers as required
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Firm Performance Measure
 Areas of interest to everyone include how the enterprise
gathers revenues and disburses resources.
 There are three basic summary statements everyone is
interested in:
 Balance Sheet
 Income statement
 Statement of changes in financial position
 There are other interesting statements but we will leave
those for another course.
 These statements form the basis of a regular, usually
monthly, written report.
 So the use of these statements is the real interest for us.

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The Balance Sheet
 Often called a position statement
 It is a snapshot in time of the firm's assets owned and
liabilities (debts) owed and the owner(s) equity.
 So the first category of financial information lists the
assets of the firm and divides these into current and long
term assets
 Current Assets lists cash and cash equivalents, such as
marketable securities, receivables, prepaid expenses etc.,
anything that can be quickly converted into cash.
 Long Term Assets show assets owned which are not likely
to be quickly converted into cash, such as buildings. In
fact, the business might have to be sold first.

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More on the Balance Sheet
 Liabilities are also split into "current" and "long-term".
Obligations due within a year of the statement are current while
those repayable at a date more than a year in the future are
classified as Long-term Liabilities.
 The difference between assets and liabilities represent the value
that the owners have in the enterprise the Owner's Equity and
that typically has two parts: Paid-in Capital and Retained
Earnings.
 We have then:
Assets = Liabilities + Owner's Equity put another way:
What a business has = Creditors' contribution + Owners' contribution
 If the owner's Equity is negative, the firm is almost certainly in
trouble!

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Assets
 Assets are everything of value that belong to the
business.
 Value only implies future usefulness. It does not reflect
the liquidation value of the assets.
 When presented on the balance sheet the most liquid
assets are listed first.
 Assets are placed on the books at their full cost,
whether they have been paid for or not - some
examples
Current are:
Assets Fixed Assets
Cash in bank Land
Government securities Buildings
Market investments Equipment and fixtures
Accounts Receivables
Inventories Vehicles
Pre-paid Expenses
Mortgages receivable
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Liabilities and Shareholders'
Equity
 Liabilities represent everything owed to creditors.
 These claims to creditors are against the assets of the company.
 Examples of liabilities would be accounts payable, payroll, taxes
payable, bondholders etc.
 Arrange them according to their urgency to be paid
 Shareholders' Equity is also a liability and:
 This represents the excess of assets over liabilities.
 Assets = Liabilities + Shareholders' equity
 It would begin with an investment in the company through the
purchase of shares and then each year would grow or shrink by the
profits/losses less any dividends.
 In plain language, this the "worth" of the company from a
shareholder's investment point of view

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Example of a Balance Sheet
The ABC Shutters Manufacturing Co.
ASSETS
Current Assets
Cash 25,000
Accounts Receivable 115,000
Raw materials 8,500
Work in progress 7,000
Finished good in inventory 15,500
Total current Assets 171,000
Fixed Assets
Land 30,000
Buildings (net of depreciation) 150,000
Equipment (less of depreciation) 600,000
Office equipment (net of depreciation) 10,000
Total fixed Assets 790,000

Total Assets 961,000


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Example of a Balance Sheet
continued
LIABILITIES
Current Liabilities
Accounts Payable 32,000
Payroll Taxes payable 15,000
Total current Liabilities 47,000
Long-term Liabilities
Mortgage payable 130,000
Equipment loan payable 350,000
Total long-term Liabilities 480,000
Owner's Equity
Common stock 325,000
Retained Earnings 109,000
Total Equity 434,000
Total Liabilities and Equity 961,000
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Income Statement
The ABC Shutters Manufacturing Co.
SALES
Goods and services 1,200,000

EXPENSES
Labour 532,000
Materials 302,000
Depreciation 98,000
Maintenance and repairs 41,500
Utilities 11,500
Administration 76,000
Marketing 49,000
Interest payments 35,000
Total Expenses 1,145,000
Net Profit before taxes 55,000
Income Taxes 26,000
NET PROFIT 29,000
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The Journal

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The Ledger

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Statement of Changes in
Financial Position
 One shortfall of both the balance sheet and income
statement is that neither one gives you any indication of
cash flow and sources and uses of cash.
 The Statement of Changes in Financial Position statement is
relatively new compared to the balance sheet and income
statements. Its quick acceptance is likely due to the fact
that it offers a wealth of information to the analyst.
 Using both the balance sheet and income statement
information, cash is reconciled during a particular period
from its opening to closing position.
 Many firms found themselves with healthy profits but had
expanded too fast to fund their short term liabilities.

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Cost Accounting Methods
 Cost accounting is the determination and
analysis of the cost of producing a product or
rendering a service.
 Maintenance and interpretation of records of
actual expenditures for labor , materials, power
etc. is known as actual or post-mortem cost
 Deviations of standard cost from actual costs
are designated as variant.

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Pricing Problem
 Current –average method
 First-in-first-out(FIFO)
 Last-in-first-out

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Materials Costs

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Manufacturing Cost Works
Inventory

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Cost-Of-Sales Account

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Statement of Changes in
Financial Position - Cont'd
 Four major sections: cash from operations, financing
activities, investing activities and change in cash.
 Cash from operations shows movement from one period
to the next in net working capital plus net income
adjusted for any non-cash expenses (eg: depreciation).
 Financing activities shows the change in any long term
debt and any equity financing or dividend payments.
 Investing activities: long term assets acquired in period.
 This all ties into the net change in cash from one period
to the next. There really is never enough cash.
 Many would argue that this is the most critical statement
early on in the life of a new business.
 Many great ideas never turn into thriving businesses
because of the lack of proper/adequate financing.
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Some Thoughts
 Financial statement preparation is designed to be
conservative to avoid "surprises".
 Assets are recorded at cost or market value, whichever
is less - so land goes up in value over the years but no
change in the value of the asset, inventory values are
adjusted only downward if there is a doubt of the value.
 So while the statements appear accurate and
authoritative, many items are estimates:
 accounts receivables
 finished goods value in inventory
 depreciated assets - any assets, especially long term
 So remember that many figures are estimates when
you read a financial statement.
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Costs and Management
 In all businesses there are many different costs:
1. Discretionary costs - can decide to postpone
2. Relevant costs - trade-in, training, space etc.
3. Sunk costs - costs which incurred in the past
4. Fixed costs - rent, machine costs, HVAC etc.
5. Variable costs - raw materials, labour, etc.
6. Semi fixed/variable costs - most costs are of this type
7. Standard costs - based on some assumptions
 Then there are various cost analyses where a decision is
involved once all the costs are known - which piece of
equipment to buy, is a company worth the price, should we
close the dining room at the Golf Club in the winter, can we
be absent from a trade-show etc.
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Variable Costs
 Some costs that a company incurs are directly
proportional to the level of production.
 Raw materials would be a good example of a variable
cost.
 They increase in direct proportion to the production.
 Labour component in manufacturing may be variable
but not in a direct relationship with production.
 Thus, if an employee can produce 2 “devices” an hour,
then if you only make 1 device you still need the staff,
but, if 3 devices are made, another employee is needed
 Although "smoother" than fixed costs, there are still
marginal decisions that must be made.
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Fixed Costs
 Fixed costs are those costs that do not go up or down with
slight fluctuations in volume. E.g: the building costs or the
President's base salary.
 These costs, within certain parameters, are fixed.
 Also, typically, fixed cost steps come in large values - you
must buy a whole machine even if you need only 10% for
the new sales available at this time.
 Fixed costs are the difficult ones to deal with as you
attempt to cost out a future production.
 It is critical to forecast sales volumes. If you could only sell
100 pens you would have to either raise your selling price
or decide whether or not to stay in business, if you can not
change your fixed costs component.

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Fixed/Variable Cost Example
 We are Selling $1.00 Pens, and expect to sell 200 a day
Variable costs: Raw Materials $.20/pen
Labour $.30/pen
Fixed Costs: Rent $50/day
Support Staff $25/day
 No matter what, the fixed costs are $75.00 per day, so:
 200 pens’ fixed cost is $75/200=$0.375/pen
 Now let's compare the situation at different sales levels:
At 100 At 200 At 400
Revenue$ 100 $ 200 $400
Expenses
- Variable 50 100 200
- Fixed 75 75 75
Profit $(25) $ 25 $125
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Financial Statement Analysis
 The June 1994 Issue of "Better Investing" magazine, page 26
has a three-page article about this topic:
 Start with the notes and read from back to front since the front is
management fluff.
 Look for litigation that could obliterate equity, a pension plan in sad
shape, or accounting changes that inflated earnings.
 Use it to evaluate management. The boring things need be read for
long term growth. A quick in and out, such as buying depressed stocks,
don't waste time.
 Look for notes on relevant details; not "selected" and "certain" assets.
Profits of operating divisions, geographical divisions, etc.
 How the company keeps its books, especially as compared to other
companies in its industry.
 Inventory. Is it down because of a different accounting method?
 What assets does the company own and what assets are leased?

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Financial Ratios
 It is natural then that people use the "standard"
financial data available from financial statements to
judge the performance of the firm.
 Performance measures thus developed can be used to
answer questions such as:
 is the firm able to meet its short term obligations?
 are the firm's assets generate sufficient profits?
 how dependent the firm is on its creditors?
 do their customers pay them promptly?
 do they pay their suppliers promptly?
 Financial Ratios are a common way to answer these and
other questions.
 They provide the analyst a framework for asking
questions about various performance measures.
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Interpretation of Financial
Ratios
 While calculating these ratios are simple enough,
interpretation is not as simple and require some skill.
 Ratios also have problems because of:
 overly simplistic approaches
 they lack support tools
 there is a lack of analytical framework
 don’t reflect process complexities
 not multidimensional
 assumption of comparable units
 constant returns to scale
 often contradictory ratios - lack objectivity
 Nevertheless, they are used everywhere and some
actually show meaningful results on the firm as a whole
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Interpretation Rules
 To properly interpret ratios, analysts compare such
ratios from the same company's results over time.
 The ratios can also be compared to industry standard
ratios and thus judge company performance.
 Such financial ratio analysis can be done when
industry standard ratios are available from companies
like Dun & Bradstreet, TRW, StasCan and others.
 When comparing specific company financial statements
to those from, say, StatsCan composites, the firm's
financial health can be judged.
 Care must be taken to use more than one source of
standard data because regional difference can count.
 Ratios in Orange are in the book others are additional.
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Financial Ratio: Liquidity
 Liquidity Ratios:
 evaluate the business' ability to meet its current cash obligations
 Working Capital adequacy is measured here
Working Capital = Current Assets - Current Liabilities
 The Current Ratio (or Working Capital Ratio) is:
Current Ratio = Current Assets/Current Liabilities
 all the current assets are involved, even those which may be
difficult to turn into cash quickly (prepaid expenses, etc.)
 A more stringent ratio is the Acid Test Ratio (or Quick
Ratio):
Acid Test Ratio = Quick Assets/Current Liabilities
 Quick assets are: cash, government securities, A/R, notes
receivable - highly liquid assets can turn into cash immediately
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Financial Ratio: Leverage
 Leverage or Debt Management Ratios:
 Captures the extent to which the firm relies on debt for its operations.
 The Equity Ratio measures owner's equity to total assets
 the smaller this is, the more the reliance on debt
Total Owner's Equity Total Owner's Equity
Equity Ratio = ------------------------------------------ =
----------------------------
Total Liabilities+Total Equity Total Assets
 Debt to Total Assets
 this compares the debt level to the total assets of the firm
Total Debt
Debt to Total Assets = -----------------------
Total Assets

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Financial Ratio: Asset
Management
 This ratio assesses how efficiently the firm is using its assets.
 Inventory-Turnover Ratio looks at how efficiently
inventories are utilised.
Sales
Inventory turnover ratio = -----------------------
Inventories
 note however that sales are generated over a period of time while
inventories are at a point in time. Average inventory over the sales
period would be more accurate
 also, sales are achieved at market prices while inventories are at cost
of manufacturing them - thus the ratio overstates the facts
 Net Profit (Return-on-total-assets) Ratio
Profit after taxes (before extraordinaries)
Return on Total Assets =
--------------------------------------------------------------
Total Assets

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Financial Ratio: Profitability
 Return on Sales - measures the profit margin on sales
Net Profit
Return on Sales = -----------------------
Sales
 Return on Equity - measures the returns on funds
invested by shareholders.
Net Profit
Return on Equity = -----------------------
Tangible net worth
 Dividend Payout - shows how much cash is received on
moneys invested in the firm.
Dividend on Common Shares
Dividend Payout = ---------------------------------------------
Net Profit - Preferred Dividend
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Financial Ratio: Cash
Management
 Receivables in Days measures the firm's ability to
collect its money from customers
Accounts Receivables
Receivables in Days = ----------------------------------
Daily Sales
 Inventory in Days measures the inventory levels in days
Inventory
Inventory in Days = -------------------------------------
Daily Cost of Goods Sold
 Accounts Payables in Days - shows how promptly the
firm pays its creditors.
Accounts Payable
Payment Period in Days = ------------------------------
Daily Purchases
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Financial Ratio: Markets
(stock)
 Earnings per Share - returns on a share owned
Net Profit - Preferred Dividend
Earnings/Share = ------------------------------------------------
Number of Common Shares
 Price Earnings Ratio - share price to earnings
Market price of Common Shares
Price Earnings Ratio = --------------------------------------------------
Earnings/Share
 Dividends per Share - cash returns per share
Common Stock Dividends
Dividends/Share = -----------------------
Number of Common Shares
 Dividend Yield - % cash received to share price
Dividends/Common Share
Dividend Yield = -----------------------------------------------------
Market price of Common Shares
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Leverage
 This is a concept that is tied into ownership (equity)
considerations as well as needs for cash. Leverage
works if you could sell more if you had more money:
 Simply put it works like this:
 The company makes a profit of $1,200 with an equity
investment of $10,000. If there were 1,000 shares
issued for the investment, the EPS = $1.20
 Now we borrow $5,000 at a yearly interest of 8% and
thus make a profit of $1,800 less the interest $400.00
this results in an EPS of $1.40
 We did not give up equity, so earnings rose per share
as there borrowing cost less that the profit we made.
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Leverage Risks
 Naturally, there is no free lunch! There are problems!
 If sales fall, interest is still paid, so profit falls much
faster, profit can decline to $400 before losses start
 repayment of the debt requires the recovery of the cash which in
poor times will be difficult
 lenders get nervous when leverage works against you, so they
become less tolerant
 So, what is the best debt/equity ratio? Sorry, there is
no such number. But, lenders like to have it at the
published industry average.
 Be careful about debt if it can not be paid back quickly.
 But manageable debt increases profitability and hence
shareholder value.
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Summary
 Remember when calculating numbers, use 360 days for
a year and 5 days for a week, 8 hours for a day.
 Financial Accounting is a big subject and can not be
dealt with here adequately, so if interested, read up or
take a course in Accounting 101.
 Balance Sheets MUST balance, if they don't, find the
problem.
 Knowing what item is a Balance Sheet item and what is
Income statement is crucial if you are constructing
financial statements.
 Everyone must adhere to the rules GAAP or the
statements will mean different things to different
readers - consistency is essential
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