Accounting for Lawyers Flashcards
Free Cash Flow
Describes net cash provided by operating activities after adjusting for capital expenditures & dividends paid.
Free Cash Flow = Net Cash (provided by operating activities) - Capital Expenditures - Cash Dividends
Useful Information (as defined by FASB & IASB)
Has 2 fundamental qualities: relevance and faithful representation.
Relevance = has predictive value
- materiality is a company-specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor.
Faithful representation = complete, neutral, free from error.
Enhancing Qualities (FASB/IASB)
Comparability, verifiability, timeliness, and understandability. consistency
Monetary Unit Assumption
Requires that only things that can be expressed in money are included in the accounting records. Things like customer satisfaction not reported.
Economic Entity Assumption
Every economic entity can be separately identified/accounted for. Important not to blur company transactions with personal transactions or transactions of other companies.
Periodicity Assumption
Life of a business can be divided into artificial time periods & that useful reports covering those periods can be prepared for the business.
Going Concern Assumption
The business will remain in operation for the foreseeable future.
Historical Cost Principle
Companies record assets at their cost. True at time asset purchased & over the time asset is held.
Tradeoff is btwn relevance and faithful representation.
Fair Value Principle
Price received to sell an asset or settle a liability. May be more useful for certain types of asset/liabilities like investment securities.
Tradeoff is btwn relevance and faithful representation. In general, FASB indicates most assets must follow historical cost principle bc market values may not be representationally faithful. Only I situations where assets are actively traded is the fair value principle applied.
Full Disclosure Principle
Requires companies to disclose all circumstances & events that would make a difference to financial statement users.
If an important item cannot reasonably be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statement.
Cost Constraint
Accounting standard-setters must consider the cost companies incur to provide information against benefit that financial statement users gain from having it available.
Accounting Information System
System of collecting & processing transaction data & communicating financial info to decision-makers.
Factors include: type of transactions, nature of the business, size of company, volume of data, etc.
Accounting Cycle
- Analyze Business Transactions
- Journalize
- Post
- Trial Balance
- Adjusting Entries
- Adjusted Trial Balance
- Financial Statements
- Closing Entries
- Post-Closing Trial Balance
Accounting Transactions
Economic events that require recording in the financial statements
Basic Accounting Equation
Assets = Liabilities + Stockholders’ Equity
Account
An individual accounting record of increases/decreases in a specific asset, liability, stockholders’ equity, revenue, or expense item.
In simplest form, consists of Title, Debit, Credit = T-account. Use terms to describe where entries are made in accounts, do not mean increase/decrease.
Balance
If debit/credit exceed the other, a debit/credit balance exists.
Debit mean increase in cash. Credit means decrease in cash.
DC ADE LER Method for Debit/Credit
Debit +: Assets, Dividends, Expenses
Credit +: Liabilities, Equity, Revenue
Recording Process
- Analyze each transaction in terms of its effects on the accounts
- Enter the transaction info in a journal
- Transfer the journal information to the appropriate accounts in the ledger
The Journal
- Discloses in one place the complete effect of a transaction
- Provides a chronological record of a transaction
- Helps to prevent or locate errors bc the debit/credit amounts for each entry can be readily compared
The Ledger
Provides the balance in each of the accounts and keeps track of changes in these balances.
General Ledger
Contains all the asset, liability, stockholders’ equity, revenue, and expense accounts.
Posting
Procedure of transferring journal entry amounts to ledger accounts.
1. In the ledger, enter in appropriate columns of the debited amount(s) the date & debit amount shown in the journal.
- In the ledger, enter in the appropriate columns of the credited amount(s) the date and credit amount shown in the journal.
The Trial Balance
Proves the mathematical equality of debits & credits after posting. Sum of debit account balances = sum of credit account balances.
- List the account titles & their balances
- Total the debit column & total the credit column
- Verify the equality of the 2 columns
Does not prove that all transactions have been recorded or that the ledger is correct.
Operating Activities
Types of activities a company performs to generate profits.
Like receiving cash in advance from customer, receiving cash for services performed, paying cash for rent, paying cash for insurance policy, paying salaries.
Investing Activities
Purchase/sale of long lived assets used in operating the business OR purchase or sale of investment securities.
Like purchasing equipment.
Financing Activities
Borrowing money, issuing shares of stock, and paying dividends.
Like issuing stock, note payable, or paying cash dividend to stockholders.
Revenue Recognition Principle
Companies must recognize revenue in the accounting period in which the performance obligation is satisfied.
Expense Recognition Principle (Matching Principle)
Efforts (expenses) must be recognized with results (revenues) in the period wen the company makes efforts to generate those revenues.
Accrual-basis Accounting
Transactions that change a company’s financial statements are recorded in the periods in which the events occur.
Cash-basis Accounting
Companies record revenue at the time the receive cash.
Adjusting Entries
Ensure that revenue/expense recognition principles are followed. Necessary bc the trail balance may not contain up-to-date/complete data.
Required every time a company prepares financial statements. Every adjusting entry will include 1 income statement account & 1 balance sheet account.
Types of Adjusting Entries
Deferrals:
- Prepaid expenses: expenses paid in cash before they are used or consumed.
- Unearned revenues: cash received before the services are performed
Accruals
- Accrued revenues: revenues for services performed but not yet received in cash or recorded.
- Accrued expenses: expenses incurred but not yet paid in cash or recorded
Adjusting Entry: Prepaid Expenses
Results in an increase (a debit) to an expense account and a decrease (credit) to an asset account.
Adjusting Entry: Unearned revenues
Results in a decrease (debit) to a liability account and an increase (credit) to a revenue account.
Adjusting Entry: Accrued revenues
Results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.
Adjusting Entry: Accrued expenses
Results in an increase (a debit) to the expense account and an increase (a credit) to the liability account.
Made up of accrued interest & accrued salaries.
Temporary Accounts
Because revenues, expenses, dividends accounts relate only to a given accounting period.
- revenue accounts
- expense accounts
- dividends
Permanent Accounts
Balance sheet accounts bc balances carried forward into future accounting periods.
- asset accounts
- liability accounts
- stockholders’ equity accounts
Closing Entries
Process in which companies transfer the temporary account balances to the permanent stockholders’ equity account - retired earnings.
Closing entries transfer net income/loss and dividends to Retained Earnings, so the balance in Retained Earnings agrees w/the retained earnings statement.
Income Summary
Temporary account to chin revenue & expense accounts are closed.
Post-Closing Trial Balance
Purpose is to prove equality of the total debit balances & total credit balances of the permanent account balances that the company carries forward into the next accounting period.
Since all temp accounts will have zero balances, post-closing trial balance will contain only permanent - balance sheet - accounts.
Merchandising Company - aspects
Sales Revenue
Cost of goods
Operating expenses
Perpetual Inventory System
Companies keep detailed records of the cost of each inventory purchase & sale. Company determines cost of good sold each time a sale occurs.
Traditionally for companies that sell merchandise with high unit values.
Periodic Inventory System
Companies don’t keep detailed inventory records of goods on hand throughout the period and instead determine the COGS only at the end of the accounting period.
Purchase Allowance
Purchaser may choose to keep the merchandise if the seller is willing to grant an allowance (deduction) to the purchase price.
Purchase Discount
Cash discount to buyer for prompt payment.
Single-step Income Statement
One step: subtracting total expenses from total revenues, is required in determining net income/loss.
Used for 1) company does not realize any type of profit/income until total revenues exceed total expenses so it makes sense to divide statement into these 2 categories + 2) form is simple/easy to read
Multiple-step Income Statement
Highlights the components of net income. Has 3 important line items.
- Gross Profit = net sales - COGS
- Income from operations = gross profit - operating expenses
- Net Income = income from operations -/+ activities not related to operations
Gross Profit
merchandising profit of company but not measure of overall profit bc operating expenses have not been deducted
Nonoperating activities
various revenues & expenses & gains & losses unrelated to company’s main line of operations
- Other Revenues & Gains
- interest revenue
- dividend revenue
- rent revenue
- gain (from PPE) - Other Expenses & Losses
- interest expense
- casualty losses
- loss (from PPE)
- loss (from strikes by employers/employees)
Comprehensive Income Statement
Presents items not included in the determination of net income. Part of fair value principle requiring companies to mark recorded values of certain types of assets/liabilities to their fair values at the end of each reporting period.
Gross Profit Rate
Company’s gross profit expressed as a percentage.
Gross Profit/Net Sales = Gross Profit Rate.
Profit Margin
Measure the percentage of each dollar of sales that results in net income.
Net income/net sales (revenue)
Gross Profit Rate vs Profit Margin
Gross profit rate measures margin by which selling price exceeds cost of goods sold. Profit margin measures extent by which selling price covers ALL expenses.
Quality of Earnings Ratio
Quality of Earnings Ratio = Net Cash Provided by Operating Activities / Net Income
Measures < 1 might be red flag about aggressive accounting techniques accelerating income recognition.
Accounts Receivable
Amounts customers owe on account. Result from sale of goods & services. Generally expect to collect accounts receivable within 30-60 days. Usually most significant type of claim held by company.
Notes Receivable
Written promise for amounts to be received. Normally requires collection of interest & extends for time periods of 60-90 days or longer.
Trade Receivable
Accounts + Note Receivables
Other receivables
Nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income tax refundable.
Recognizing Accounts Receivable
Service org records a receivable when it performs a service on account. Merchandiser records accounts receivable at the POS of merchandise on account.
Accounting for Uncollectible Accounts
- Direct Write-Off
2. Allowance Method
Credit Losses
Companies record credit losses as “Bad Debt Expense” or Uncollectible Accounts Expense.
Direct Write-Off
Bad Debt Expense will show only actual losses from uncollectible. Can reduce relevance of both income statement & balance sheet. Companies often record bad debt expense in a period different from period in which they record revenue.
Unless insignificant, direct write-off not acceptable for financial reporting purposes.
Allowance Method
Involves estimating uncollectible accounts at the end of each period, which provides better matching of expenses with revenues on the income statement. Ensures companies state receivable on the balance sheet at their cash (net) realizable value, which is the net amount of company expects to receive in cash.
Companies must use this method when bad debts are material in amount.
Aging the Accounts Receivable
Again schedule helps users determine if the amount of past due accounts is increasing & which accounts require management’s attention.
Percentage-of-Receivables Basis
Management establishes a percentage relationship btwn the amount of receivables & expected losses from uncollectible accounts.
Why Companies Sell Receivables
- they may be the only reasonable source of cash
2. billing & collection are often time-consuming & costly
Formula for Computing Interest of Promissory Note
Face Value of Note X Annual Interest Rate X Time in Terms of One Year = Interest
Accounts Receivable Turnover
Ratio used to assess liquidity of receivables. Net Credit Sales/Average Net Accounts Receivable. Measures # of times on average a company collects receivables during the period.
Average collection period is used too.
Plant Assets
Resources that have physical substance (definite size/shape), are used in the operations of a business, and are not intended for sale to customers.
AKA property, plant & equipment; plant & equipment; fixed assets. Usually decline in service potential (except land).
Historical Cost Principle
Requires that companies record plant assets at cost. Cost consists of all expenditures necessary to acquire an asset & make it ready for its intended use.
Plant Asset Account
Costs that are expensed immediately are known as revenue expenditures. Costs NOT expensed immediately are capital expenditures.
How Cost is Measured
Cash paid in cash transaction or cash equivalent price paid when non cash assets used in payment.
Cash equivalent price = fair value of asset given up or fair value of asset received, whichever is more determinable.
Cost of Land
- Cash purchase price
- closing costs like title & attorney’s fees
- RE Broker commissions
- Accrued property taxes & other liens on land assumed by purchaser
Land Improvements
Structural additions w/limited lives that are made to land, such as driveways, parking lots, fences, etc. They are depreciated over their useful lives.
Inclusion of Interest
Inclusion of interest costs in cost of a constructed building is limited to those incurred during the construction period.
Ordinary Repairs
Expenditures to maintain operating efficiency & expected productive life of the unit. Debited to Maintenance & Repairs Expense as incurred.
Additions & Improvements
Costs incurred to increase the operating efficiency, productive capacity, or expected useful life of plant asset. These are capital expenditures.
Lease Advantages
- Reduced risk of obsolescence
- Little or no down payment
- Shared tax advantages
Depreciation
Process of allocating to expense the cost of a plant asset over its useful (service) life in a rational & systematic manner. It’s a cost allocation process, NOT an asset valuation process. Book value of plant asset may differ significantly from fair value.
Applies to land improvements, buildings & equipment. NOT land, since it maintains usefulness and may even appreciate.
Balance in accumulated depreciation represents total amount of asset’s cost that company has charged to expense to date; it is not a cash fund.
Computation affected by:
Cost, Useful Life, and Salvage Value.
Obsolescence
Process by which an asset becomes out of date before it physically wears out.
Depreciation Methods
- Straight-line (most widely used)
- Declining-Balance
- Units-of-activity
Depreciable Cost
Total amount depreciated over useful life of asset. Equal to cost of the asset less its salvage value.
Declining-Balance Method
Computes depreciation expense using a constant rate applied to a declining book value. this is called accelerated-depreciation method bc it results in higher depreciation in the early years of an asset’s life than the straight line approach does.
Impairment
Permanent decline in fair value of asset.
Earnings Management
Timing recognition of gains/losses on impairments until a yr when it is convenient to do so.
Plant Asset Disposal methods
- Sale
- Retirement
- Exchange
Intangible Assets
Rights, privileges & competitive advantages that result from ownership of long-lived assets that don’t possess physical substance.
Intangibles Arise From…
- Gov grants like patents, copyrights, licenses, trademarks, and trade names.
- Acquisition of another business in which purchase price includes a payment for goodwill.
- Private monopolistic arrangements arising from contractual agreements, such as franchises & leases.
Patent
Enables recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. Initial cost is the cash or cash equivalent price paid to acquire the patent.
If owner incurs legal costs in successfully defending the patent in an infringement suit, such costs are considered necessary to establish the validity of the patent.
Copyrights
Gives owner exclusive right to reproduce & sell an artistic or published work. Last for life of creator + 70 years. Cost of copyright consists of cost of acquiring & defending it.
Trademark
Word, phrase, jingle, or symbol that distinguishes/identifies particular enterprise or product. Creator or original user may obtain exclusive legal right to trademark or trade name by registering it with the USPO, which provides 20 years protection and may be renewed indefinitely as long as it’s in use.
Franchise
Contractual arrangement under which the franchisor grants the franchisee the right to sell certain products, perform specific services, or use certain trademarks or trade names, usually within a designated geographic area.
Another type of franchise is a license.
May be granted for a definite period of time or perpetual time period. Should be recognized when company incurs cost in connection w/acquision.
Goodwill
Usually largest intangible that appears on balance sheet. Represents value of all favorable attributes that relate to a company that are not attributable to any other specific asset. Can only be identified with business as a whole.
Only recorded when there is an exchange transaction that involves the purchase of an entire business. Recorded as excess cost over fail value of net assets acquired.
Return on Assets
Net income/Avg total assets = Return on Assets, which is a measure of profitability
Asset Turnover
How efficiently a company uses its assets to generate sales. How many dollars of sales a company generates for each dollar invested in assets.
Only comparable within industries.
Asset turnover = Net sales/Avg total assets
Profit Margin x Asset Turnover = Return on Assets
Profit Margin x Asset Turnover = Return on Assets
Bonds
Form of interest-bearing notes payable issued by corporations, universities, gov agencies. Usually both board of directors and stockholders must approve bond issues.
Face value is amount of principal due at maturity date. Maturity date is date final payment due to investor from issuing company. Contractual interest rate aka stated rate, is the rate used to determine amount of cash interest issuing company pays. Terms are set forth in bond indenture.
Prices are quoted as a percentage of the face value of a bond, which is usually $1000. Corporation makes journal entries only when it issues or buys back bonds, or when bondholders convert bonds into common stock.
Secured Bonds
Have specific assets of issuer pledged as collateral for the bonds.
Unsecured Bonds aka debenture bonds
Issued against general credit of borrower.
Convertible Bonds
Bonds that can be converted into common stock at the bondholder’s option.
Callable Bonds
Issuing company can redeem (buy back) at a stated dollar amount prior to maturity.
Amortizing the Discount
Following the expense recognition principle, companies allocate bond discount to expense in each period in which bonds are outstanding.
As discount is amortized, balance declines & carrying value of bonds will increase.
When Company Redeems Bond Before Maturity
- Eliminate carrying value of the bonds at the redemption date
- Record cash paid
- Recognize gain/loss on redemption
Carrying Value
Face value of bonds less any remaining bond discount or plus any remaining bond premium at the redemption date.
Liquidity Ratios
Measure short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash.
Current Ratio
Commonly used measure of liquidity. Current assets/Current Liabilities.
If low, companies must rely on other sources of liquidity like a bank line of credit.
Solvency Ratios
Measure the ability of a company to survive over a long period of time.
Debts to Assets Ratio
Used as solvency ratio. Total liabilities (debt) / total assets.
Indicates extent to which company’s assets are financed by debt.
Time Interest Earned
Solvency measure. Provides an indication of a company’s ability to meet regular interest payments as they come due.
(Net income + interest expense + income tax expense) / interest expense = time interest earned.
Contingencies
Events w/uncertain outcomes that may represent potential liabilities. For example, lawsuits or environmental cleanup obligations.
If company can determine reasonable estimate and if it is probable it will use a suit, then it should accrue for the loss. Otherwise, mention in notes.
Off-balance sheet financing
An intentional effort by company to structure its financing arrangements so as to avoid showing liabilities on balance sheet.
Effective-interest Rate
Interest expense as a percentage of carrying value should not change over the life of the bonds. Varying amounts but constant percentage.
When the amounts amortized in each period are materially different from straight-line method, GAAP requires use of the effective-interest method.
Corporation
An entity separate & distinct from its owners. Common ways to classify are by purpose and by ownership.
- separate legal existence
- limited liability of stockholders
- transferable ownership rights
- ability to acquire capital
- continuous life
- corporate management
- subject to gov regulations
S Corporation
Legal treatment as corporation but tax treatment as partnership. But restricting rules such as can’t have more than 100 shareholders.
Charter
State charters are documents that describe the name/purpose of org, types & # of shares of stock authorized to be issued, names of indvls that formed the company, and the # of shares these indvls agreed to purchase. Creates the corporation.
By-Laws
Establish the internal rules & procedures for conducting the affairs of the corporation.
Authorized Stock
Total amount of authorized stock at the time of incorporation anticipates both initial & subsequent capital needs.
Authorization of capital stock doesn’t result in formal accounting entry bc event has no effect on corporate assets or stockholder equity.
Factors on Setting Price of New Stock Issue
- Company’s anticipated future earnings
- Expected dividend rate per share
- Current financial position
- State of economy
- Current state of the securities market
Par Value Stock
Capital stock to which the charter has assigned value per share. Par has no relationship to market price and today many states do not require a par value.
No-par Value Stock
Capital stock to which charter has not assigned a value. In many states, board of directors assigns a stated value to no-par shares.
Stockholders’ equity (aka owners’ equity)
Consists of:
1) Paid-in (contributed) capital
2) Retained earnings (earned capital)
Distinction is important bc corporations can make distributions of earnings (dividends) out of retained earnings. However, in many states, they can’t declare dividends from paid-in capital.
Paid-in Capital
Total amount of cash & other assets paid in to the corporation by stockholders in exchange for capital stock.
2 classifications:
1) Capital Stock, which consists of preferred/common stock.
2) Additional paid-in capital, which includes excess of amounts paid in over par or stated value
Retained Earnings
Net income that a corporation retains for future use
Preferred Stock
Contractual provisions give it preference or priority over common stock in certain areas. Usually in relation to (1) dividends & (2) assets in event of liquidation. Sometimes don’t have voting rights.
Treasury Stock
Corporation’s own stock that has been reacquired by the corporation & is being held for future use.
Generally accounted for by the cost method. Companies increase (debit) Treasury Stock by the price paid to reacquire the shares. Later decreased by same amount when company later sells the shares.
Important Dividend Dates
1) Declaration Date: commits corp. to binding legal obligation.
2) Record Date: company determines ownership of outstanding shares for dividend purposes.
3) Payment Date: makes cash dividend payments to stockholders on record.
Cumulative effect of declaration & payment of cash dividend on company’s assets is to decrease both stockholder’s equity & total assets.
Cumulative dividend
Stipulation that preferred stockholders must be paid both current-yr and any unpaid prior-yr dividend before common stockholders are paid dividends.
Dividends in Arrears
When preferred stock is cumulative & preferred dividends aren’t declared that were supposed to be declared in a given period.
Not considered a liability bc no obligation exists until board of directors formally declares corp. will pay dividend.
Stock Dividend
Pro rata distribution of corporation’s own stock.
Results in a decrease in retained earnings & an increase in paid-in capital. Change composition of stockholders’ equity bc they result in transfer of a portion of retained earnings to paid-in capital but total stockholders’ equity remains the same.
- Satisfy dividend expectations w.o spending cash
- Increase marketability of stock by increasing # of shares outstanding & decreasing market price per share.
- Emphasize that company has permanently reinvested in the business a portion of stockholders’ equity, which therefore is unavailable for cash dividends.
Stock Split
Like a stock dividend, involves issuance of additional shares of stock to stockholders according to their percentage ownership.
- Purpose is to increase marketability by lowering price per share.
- Effect of split on market price is generally inversely proportional to size of split.
Results in reduction in the par or stated value per share. Does NOT affect paid-in capital, retained earnings & stockholders’ equity. Memorandum entry typically made but no need to journalize bc it does not affect balances in any stockholders’ equity accounts.
Deficit
Debt balance in Retained Earnings.
Retained Earning Restrictions
Retained earnings balance generally available for dividends but may not be for legal, contractual, or voluntary reasons.
Bonds vs Stocks
Bond Advantages
- stockholder control not affected since bondholders don’t have voting rights
- tax savings results: bond interest is deductible for tax purposes; dividends on stock are not
- return on common stockholders’ equity may be higher: although bond interest expense reduces net income, return on common stockholders’ equity often is higher under bond financing bc no additional shares of common stock are issued
Statement of Cash Flows
Reports the cash receipts, cash payments, and net change in cash resulting from operating, investing, and financing activities during a period.
Operating Activities
Cash effects of transactions that create revenues & expenses, so enter into determination of net income.
Investing Activities
Include (a) acquiring & disposing of investments & property, plant, and equipment + (b) lending money & collecting loans
Financing Activities
include (a) obtaining cash from issuing debt & repaying the amounts borrowed, and (b) obtaining cash from stockholders, repurchasing shares & paying dividends.
Information to Prepare Statement of Cash Flows comes from
- Comparative balance sheets
- Current income statement
- Additional information
Indirect Method
Adjusts net income for items that don’t affect cash.
It’s easier/less costly to prepare and focuses on differences btwn net income and net cash flow from operating activities.
Create Statement of Cash Flows - Steps
- Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis
Take net income & add back non cash expenses (depreciation expense & amortization expense), deduct gains and add losses from investing/financing activities, and analyze changes to non cash current asset/current liability accounts.
Annual Report
Includes:
* Financial Statements
- Management Discussion & Analysis
- covers company’s ability to pay near-term obligations, ability to fund operations & expansion, and its results of operations. Must highlight favorable/unfavorable trends & identify significant events & uncertainties that affect the the 3 factors above.
- Notes to Financial Statements
- Auditor’s report
- fairness of the presentation of the financial opinion & results of operations & their conformance w/generally accepted accounting principles
