Final Exam Prep Flashcards
3 ways to evaluate a Balance Sheet
- Change in equity
- Is Net Income > 0
- Is Cash From Operations (CFO) > 0
Statement of Cash Flows - 3 ways
- Operations
- Investing
- Financing
(Operating income is preferred)
4 Types of Financial Statements
- Balance Sheet
- Income Statement
- Statement of Cash Flows
- Statement of Changes in Stockholder’s Equity
Income Statement tells us…
Did we make any money?
Statement of Cash Flows tells us…
Where did the cash come from and what did we do with it?
Balance Sheet tells us…
What do we own?
To whom do we owe money?
Profit Margin ratio
Profit Margin = Net Income / Revenues
Compute this every time you look at an Income Statement
Why we have financial statements
- Managers need to make decisions
- Creditors need to determine whether to lend us money
- Investors need to determine whether to invest in the cmopany
Objectives of Financial Reporting
- Useful in making financial decisions
- Helpful in assessing the ability of a company to generate future cash flows
- Provide information about a company’s economic resources and the claims on those resources
GAAP
Generally Accepted Accounting Principles
Revenues are
receipts of assets from sales of products and services to customers
Revenue Recognition
when the entity satsifies a performance obligation by transferring a promised good or a service (that is, an asset) to a customer.
Recognizing Revenue for a Service
when the service is performed (over the contract period)
Accrual Basis
Revenue is recognized when earned, not necessarily when the cash is collected
4 Special Issues with Revenue Recognition
- Warrnaties
- Principal versus Agent
- Non-refundable upfront fees
- Rights of return
Accounts Receivable
Sales we’ve not yet collected
Accounts Receivables (BS) / Sales (IS)
Assets versus Expenses
Expenses = “cost of resource” used to generate revenue recognized in the same period as the revenue
Assets = “cost of resource” used to generate future revenues
Matching principle = expenses used to generate revenues are matched (recognized) in the same period as the revenue (and not necessarily in the period that the cash was paid.)
Expenses (IS
A
Examples of Accrual Costs
- Inventory
- Fixed Assets
- Selling, General, & Admin
- Inventory = Cost of Goods Sold
- Fixed Assets =- Depreciation expense
- Selling, General, & Admin = SG&A expense
What does Depreciation measure
It matches the cost of an asset in the period in which it generates revenue
What are the components of T accounts
Two Accounting Identies
- Assets = Liabilities + Equity
- Debits (Dr.) - Credits (Cr.)
Increases go on the right side
Decrease goes on the left side
The ‘+’ sign goes on the same side of the T account as the T account is on WRT the ‘+’ sign. i.e. the Assets T is on the left side of the ‘=,’ therefor the ‘+’ goes on the left. The Liabilities and Equity are on the right side fo the ‘=’ and therefor the ‘+’ goes on the right
However, Debits alwas are on the left, Credits are always on the right
The Accounting Cycle
During the Accounting Year
- General Journal
- General Ledger
End of the Accounting Year
- Trial Balance
- Adjusting Entries
- Adjusted Trial Balance
- Closing Entries
- Financial Statements
For each example below (A&B), indicate whether each account is a BS or IS Account.
For BS accounts, identify whether it’s an Asset, Liability, or Equity
For IS accounts, idnetify whether it’s Revenue or Expense
Understanding the Impact of the Income Statement (IS) on the Balance Statement (BS)
Keys to accounting
- Understanding the differnece between cash and accrual
- These differences are recorded on the Balance Sheet (BS)
5 Types of Revenue Entries
Cash
Unearned revenue (BS lia)
Cash
Revenue (IS)
Unearned revenue (BS)
Revenue (IS)
Accounts receivable (BS)
Revenue (IS)
Cash
Accounts receivable (BS)
5 Types of Expense Entries
Income Statement Margins
Classification of expenses on the Income Statement
Balance Sheet are divided into what 3 sections
Assets = Liabilities + Equity
When is Revenue Earned:
If product is sold
If service is provided
Accrual Basis
What is the best measure of firm performance and why
Income Statement
Because of the matching principle
What 2 characteristics must an Asset posess to be reported on the balance sheet
- It must be owned (or controlled) by the company
- It must confer expected future economic benefits that result from a past transaction or event
5 examples of Current Assets
- Cash - currency, bank deposits, and cash equivalents (investments with an original maturity of ≤ 90 days)
- Short-term investments - marketable securities, other investments expected to be disposed of in the short run
- Accounts receivable, net - amounts due from custtomers arising from the sale of products and services on credit. “Net” refers to the subtraction of estimated uncollectable amounts
- Inventories - goods purchased or produced for sale to cusotmers
- Prepaid expenses - costs paid in advance for rent, insurance, advertising, and other services
Note: the goal is to maintain just enough current assets to cover liquidity needs, but not so much that you unnecessarily reduce income
3 examples of Long-Term Assets
- Property, plant, and equipment (PPE), net - land, factory buildings, warehouses, office buildings, machinery, motor vehicles, office equipment, and other items used in operating activities
- Long-term investments - investments the company does not intend to sell in the next financial year
- Intangible and other assets - assets without physical substance, including patents, trademarks, franchise rights, goodwill, and other costs the company incurred that provide future benefits
Liabilities and Equity
Liabilities and stockholders’ equite represent the source of capital the company uses to finance the acquisition of assets
- Liabilities represent a company’s future economic sacrifices
-
Stockholders’ equity represents capital that has been invested by the stockholders either
- directly via the purchase of stock, or
- indirectly in the form of retained earnings
5 examples of Current Liabilities
Obligations that must be settled within one year
- Accounts payable - amounts owed to suppliers for goods and services purchased on credit
- Accrued liabilities - obligations for expenses that have been incurred but not yet paid; also called accrued expenses
- Unearned revenues - cash the seller receives in advance from customers for goods or services it will deliver int he future
- Short-term debt - loans from banks or other creditors; includes short=term notes and commercial paper
- Current maturities of long-term debt - principal portion of long-term debt that is due to be paid within one year
Net Working Capital
Networking Capital = Current assets - Current liabilities
Describe the Operating Cycle
What is the Cash Conversion Cycle
the number of days the company has cash tied up in receivables and inventories less the number of days of trade credit provided by company suppliers.
2 examples of Noncurrent Liabilities (and definition of)
Noncurrent liabilities are obligations due after one year
- Long-term debt - borrowed amounts that are scheduled to be repaid more than one year in the future
- Other long-term liabilities - various obligations, such as pension liabilities and long-term tax liabilities, that will be settled a year or more into the future
6 examples of Stockholders’ Equity (and definition of)
financing provided from company owners
- Common stock - par value received from the original sale of common stock to investors
- Additional paid-in captial - amounts received from the original sale of stock to investors in excess of the par value of stock
- Preferred stock - value received from the original sale of preferred stock to investors; preferred stock has fewer ownership rights than common stock
- Treasury stock - amount the company paid to reacquire its common stock from shareholders
- Retained earnings - accumulated net income (profit) that has not been distributed to stockholders as dividends or as stock repurchases
- Accumulated other comprehensive income or loss - accumulated changes in asset and liability fair values that are not reported in the income statement
What are the two basic components of the equity section of a balance sheet
- Contributed Capital: the net funding a company received from issuing and reacquiring its shares (i.e. issued - repurchased = contributed capital)
- Earned Capital: primarily includes Retained earnings, which is the cumulative net income [or] (loss) that the company has earned but not paid out to stockholders as dividends
Common-sized balance sheet
A balance sheeet where each item is recast as a percent of total assets. Used to:
- Compare a company’s balance sheet across two or more years
- Compare two or more companies’ balance sheets
- Compare balance sheets with an industry average or some other benchmark
Retained Earnings
Beginning retained earnings
+ Net income (or - Net loss)
- Dividends
- Stock repurchased and retired
= Ending retained earnings
Market Value vs. Book Value
and why they can differ
- GAAP generally reports assets and liabilities at historical costs, whereas the market attempts to estimate fair market values
- GAAP excludes resources that cannot be reliably measured (due to the absence of a past transaction or event), such as talented management, employee morale, recent innovations, and successful marketing, whereas the market attempts to value these
- GAAP does not consider the business environment in which companies operate, such as competitive conditions and expected changes, whereas the market attempts to factor in these differences in determining value
- GAAP does not usually capture expected future performance, whereas the market attempts to predict and value future performance
What are the two ways to determine when a company will realize the benefit from a cost
- When the cost creates an immediate benefit (e.g. gas)
- When the cost creates a future economic benefit (e.g. inventory to be resold or equipment to be used later for manufacturing)
Give two examples of how asset costs are transferred from the balance sheet to the income sheet
- Inventory - when a company purchases or manafactures goods for resale. When the inventories are sold, they no longer have an economic benefit to the company, and their cost is transferred to the income statement in an expense called cost of goods sold.
- Equipment - when a company acquires equipment, the cost is recorded ont eh balance sheet in an asset called equipment (or PPE). As the quipment is used in operations, a portion of the acquisition cost is transferred to the income statement as an expense. This systematic allocation process is called depreciation.
What does an Income Statement report
- revenues earned from products sold and services provided during a period
- the expenses incurred to produce those revenues
- the resulting net income or loss
What are Operating Expenses
The usual and customer costs a company incurs to support its operating activites.
Includes cogs, selling expenses, depreciation expense and research and development
What are Nonoperating income and expenses
Relates to the company’s financing and investing activities
Includes interest expense, interest or dividend income, and gains and losses from the sale of securities
What are the two fundamental principles that guide recognition of revenues and expenses
What are they the foundation of?
- Revenue recognition principle: recognize revenue when a performance obligation is satisfied by transferring to a customer a promised good or service
- Expense recognition (matching) principle: recognize expenses when incurred
These are the foundation of Accrual Accounting (used to prepare all GAAP-based financial statements)
What is the general approach of Accrual Accounting
- Recognize revenues in the time period when the company satisfies the performance obligations of the sales contract at the amount expected to be received;
- Record all expenses incurred to generate those revenues during that same time period (this is called matching expenses to revenues)
What are Transitory Items and how are they Reported
Transitory items refer to income statement line items for divested segments of business (typically related to a change in strategy). These are listed as discontinued operations on the Income Statement
- Net income (loss) from the discontinued segment’s business activites prior to sale
- Any gain or loss on the actual sale of the discontinued segment
The Income Statement separately reports the per share effects with two EPS numbers
- Earnings per share from continuing opetations
- Earnings per share from discontinued operations
What is Return on Assets (ROA)
What are the Components of ROA
Net income for that period divided by the average total assets durning that period
Components:
- Profitability relates profit to sales - This ratio is called the profit margin )PM), and it reflects the net income (profit after tax) earned on each sales dollar.
- Productivity relates sales to assets - The component is called asset turnover (AT), reflects sales generated by each dollar of assets.
- Gross profit margin (Gross profit / Sales) - Is influenced by both the selling price of the company’s products and the cost to make or buy those products
- Operating expense margins - focuses on each expense category reported by the company as a percentage of sales over time and compared with peer companies
What are the components of the Statement of Scockhholders’ Equity
- Common stock and additional paid-in capital increase by the proceeds from the sale of stock
- Retained earnings increase by the net income (or decrease by the net loss) reported on the income statejment and decrease by the dividends to shareholders
- Retained earnings also decrease if a company repurchases shares from stockholders and then retires the repurchased shares
What is the purpose of the Statement of Cashflows
Provides information about the company’s ability to generate cash from [sales of product and services] transactions
What are the three primary business activities reported on the Statement of Cash Flows
- Cash flows from operating activities: Cash flows from the company’s transactions and events that relate to its operations
- Cash flows from investing activities: Cash flows from acquisitions and divestures of investments and long-term assets
- Cash flows from financing activities: Cash flows from issuances of and payments towards borrowings and equity
What does our analysis focus on WRT the Statement of Cash Flows
Sources and uses of cash
- Is the company generating cash from operating activities
- Is the operating cash flow sustainable
- Is the company investing its cash to grow its infrastructure (PPE) or to enter new markets by acquiring other companies
- Is the company using its excess cash to build liquidity (purchase marketable securities)
- Is the company paying down debt or paying dividends
- Is the comapny repurchasing stock
Describe Retained Earnings Reconciliation
It links the Income Statement and the Balance Sheet
Beginning retained earnings
± Net income (loss)
- Dividends
- Shares repurchased and retired
+ Ending retained earnings
What are the linkages between the four financial statements.
The Four Step Accounting Cycle
- Step 1: Record transactions in the accounting records
- Setp 2: Prepare accounting adjustments for events taht have occured but not hey been recorded
- Step 3: Prepare financial statements
- Step 4: Close the books
Financial Statement Effects Template
What are the four types of Accounting Adjustments
- Prepaid expenses: reflect advance cash payments that will ultimately become expenses (e.g. payment for radio advertising)
- Unearned revenues: reflect cash received from customers before any services or goods are provided (e.g. cash from patrons for tickets to an upcoming event)
- Accrued expenses: expenses incurred and recognized on the IS even though they are not yet paid in cash (e.g. wages owed to an employee)
- Accrued revenues: revenues earned and recognized on the IS even though cash is not yet received (e.g. sales on credit and revenue earned under a long-term contract)
Order of oeprations for Preparing Financial Statements
- First: prepare the Income Statement using the income statement accounts
- Second: prepare the Balance Sheet using the updated retained earnings account along with the remaining balance sheet accounts
- Third: prepare Statement of Stockholders’ Equity
- Fourth: prepare the Statement of Cash Flows using the information from the cash account
What are the four basic processes of the Accounting Cycle
- Analyze transactions and prepare (and post) entries
- Prepare (and post) accounting adjustments
- Prepare financial statements
- Perform the closing process
What are the 5 Steps to applying FASB’s Accounting Standards Update 2014-09 Revenue from Contracts with Customers (Topic 606)
- Identify the contract(s) with a customer
- Identify the performance obligation(s) in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligation(s)
- Recognize revenue when the performance obligation is satisfied
List 9 Complications of Revenue Recognition
- Nonrefundable up-front fees
- Bill-and-hoild arrangements
- Consignment sales
- Licenses
- Franchises
- Variable consideration
- Multiple-element-contracts
- Right of return
- Gift cards
Module 5-6 for details
Name the 2 ratios and their simple formula used to analyze the magnitude and quality of Accounts Receivable
- Accounts receivable turnover
= Sales / Average accounts receivable
- Days sales outstanding (DSO)
= 365 (days) / Accounts receivable turnover, which
= 365 x Average accounts receivable / Sales
How does one analyze the quality of Accounts Receivable
use (focus on) the allowance for uncollectible accounts
Allowance for Doubtful Accounts (from Pfizer statement)
What are two possbile reasons for a decrease in the Allowance Account
- Credit quality has improved
- Underestimating allowance account
What is the Gross margin ratio a nd how is it calculated
The ratio of sales to COGS. Increase in ratio implise sales are growing faster than costs
GMR = Sales less COGS / Sales
What is a Receivable turnover and how is it calculated
Ratio of sales to receivables
RT = Sales on IS / Ending Receivables on BS
When you Analyze Receivables, what 3 things do you need to look at?
- How does the firm generate revenue? (Check the first footnote)
- Analyze the following ratios
- Gross margin
- Receivables turnover
- What are the estimated expenses related to sales (Bad debts, returned goods, warranties, etc)
- Is the amounbt of write-offs equal to the expense (check the Valuation and Qualifying accounts section of the 10-K)?
5 Types of Adjusting Entries & Where do they get recorded
- Prepaid items - Current assets (BS)
- Unearned or deferred revenues - Current Liabilities (BS)
- Accrued expenses - Current Liabilities (BS)
- Accrued revenues - Current assets (BS)
- Estimated items
6 Items from the Balance Sheet
- Unbilled revenue: Revenue that has been earned, but not collected
- Increases: when revenue is earned
- Decreases: when cash is collected
- Prepaid expenses: Expenses paid before they can be recognized as expenses
- Increases: when cash is paid
- Decreases: when expense is recognized
- Accounts payable: Used for inventory purchases
- Increases: when inventory is purchased
- Decreases: when cash is paid
- Line of credit: This is debt
- Increases: wehn cash is borrowed
- Decreases: when cash is paid
- Sales tax payable, accrued expenses payable: Expenses incurred but not yet paid
- Increases: when expense is recognized
- Decreases: when cash is paid
- Deferred revenue: Revenue collected in advance before it is earned
- Increases: when cash is collected
- Decreases: when revenue is earned
Listing order of Accounts Receivable
- Cash
- Marketable Securities
- Accounts receivable
- Inventories
- Prepaid items (or expenses)
What are the two classes for Recording Bad Debts
- Direct write-off (would lead to a poor mathcing method for expenses) - not acceptable for accounting purposes
- Allowance methods (this is an adjusting entry at the balance sheet date)
- Percetnage of sales method
- Aging schedule method
- Percent of ending accounts receivable method (similar to aging schedule)
Allowance Methods are the methods we use for Accounting
3 Entries that can change Accounts Receivable
- Debit Account Receivables, Credit Sales
- Allowance for bad debts (BS) debit, Credit Accoutns receivables (BS)
- Cash debits, Credits for accounts receivables
Define the Cash Conversion Cycle
Days sales outstanding (accounts receivable)
+ Days inventory outstanding
- Days payable outstanding
= Cash conversion cycle
What is capitalization
When PPE is acquired, it is recorded at cost on the balance sheet (BS)
To determine depreciation, what three estimates does a company make
- Useful life - period of time over which the asset is expected to generate measurable benefits
- Salvage value - amount expected for the asset when disposed of at the end of its useful life
- Depreciation method - estimate of how the asset is used up over its useful life
There are three reasons why R&D costs are expensed in the income statement as tehy are incurred. What are they?
- Whether an tangible projects or services will be developed is often uncertain while the R&D is ongoing.
- Even for R&D programs that look promising, the timing of future products and services is uncertain
- Salaries for R&D are no different than for other personnel whose salaries and wages are expensed when incurred
The gain or loss on the sale (disposition) of a tangible asset is computed how?
Gain or Loss on Asset Sale = Proceeds from Sale - Net Book Value of Asset Sold
What is an Asset’s net book value
It’s acquisition cost - accumulated depreciation
What is impairment of PPE
if the sum of the expected cash flow is less than net book value, the asset is deemed impaired and it is written down to its current fair value
How do you record an impairment charge
You reduce assets by the amount of the write-down and recognize a loss in the income statement (IS)
What 3 components typically comprise Restructuring Costs
- Employee severance or relocation costs
- Asset write-downs
- Other restructuring costs
