lesson 1 and 2 Flashcards
Two ways of debt financing
Bank loans (private)
Bonds (public)
why do we need accounting
- information asymmetry between managers and outside stakeholders
- accounting ensures some level of verifiable information that allows markets to function
Sarbanes-Oxley act
imposed additional regulations on firms with publically traded securities and on their auditors
- CEO and CFO personally attest to the accuracy and completeness of financial statements and effectiveness of internal control over financial reporting
- Auditors test effectiveness of companies’ internal control over financial reporting
U.S. Account standards issued by
Financial Accounting Standards Board (FASP)
Generally Accepted Accounting Principles (GAAP)
International Accounting Rules are created by
International Accounting Standards Board (IASB)
International Financial Reporting Standards (IFRS)
Annual Report
(Q4): 10-K
Quarterly report
(Q1, Q2, Q3): 10-Q
6 components of Financial Statements
1) Balance sheet (statement of financial position)
2) Income statement (profit or loss)
3) Statement of Shareholders’ Equity
4) Cash Flow Statement
5) Footnotes to above financial statements
6) Audit opinion
Footnotes
- explain line items in four main financial statement
- provide information not in main financial statements
ex: firms’ accounting policies or its segment-level financial data
Audit Opinion
- cannot test every transaction, regular audits not designed to detect fraud
- ‘reasonable assurance’ financial statements meet required standards
Unqualified / Clean: conforms with GAAP
Qualified: ‘material but not pervasive’ violation
Adverse: Pervasive violation
Disclaimer: cannot obtain information to audit
2 Fundamental qualitative characteristics of decision-useful accounting information
Relevance: info makes a difference in users’ decisions
- material and predictive/confirmatory
Faithful representation: complete, neutral, and free from error
Enhancing Qualitative characteristics
Comparability: information can be compared across time and entities
- consistency: same accounting methods
Verifiability: Different knowledgeable and independent observers could reach consensus that information is faithfully represented
Timeliness: older information is less useful
Understandability: information is as clear and concise as possible, to a reasonably knowledgeable user
Cost constraint
accounting information should only be prepared if the cost of collecting, processing, verifying, and disseminating it Is outweighed by its benefits
accounting entity (assumption)
economic activity can be identified to a particular unit of accountability (a business or other organization), separate from its owners
monetary unit (assumption)
economic activity can be measured (quantified) in monetary accounts
going concern (assumption)
the business will continue operating in the future
periodicity (assumption)
the entity’s economic activity can be measured over specified time periods (years, quarters)
Guiding questions
Recognition: When should an item be included or removed from financial statements?
Measurement (Valuation): At what value should an item be shown in financial statements (and how should the value change over time)?
Presentation and disclosure: How should an item be classified in the financial statements? What related information should be disclosed?
*** Revenue recognition
revenue is only recognized when it is earned and realized or realizable
*** Matching principle
expenses are recognized at the same time as the revenue they helped generate
Historical cost
assets and liabilities are accounted for on the basis of their acquisition prices
Conservatism (prudence)
when in doubt, choose the accounting treatment that least likely overstates assets
Accounting Equation
Asset = Liability + Shareholders’ Equity
- must hold at every point in time
Economic resources = Claims to Economic Resources from creditors and shareholders
Balance Sheet
i) what is owned (ASSETS)
ii) what is owed (LIABILITIES)
iii) what is left for owners (SHAREHOLDERS’ EQUITY)
at the end of the report period
Assets
Future economic benefits or rights that are owned or controlled by the firm
ex: equipment, land, cash, accounts receivable, prepaid rent
Liabilities
fixed and unavoidable obligations to transfer cash or another good / service to an outside party at some future time
ex: accounts payable, sales of gift cards
Shareholders’ Equity
money invested in the firm by its owners
i) directly, when they purchase shares from the company
ii) indirectly, when they allow the firm to retain its earnings rather than paying them in the form of dividends
Liquidity
How easily can asset / liability be converted to cash inflow / outflow?
Contributed Capital (Common Stock and Paid-In Capital)
amount invested in the company by its owners
Retained earnings
cumulative amount of profits kept for use in the business
Retained Earnings = Reinvested Profits
Income Statement
Reports on the operating performance of the firm, all the revenues and expenses during a given period.
Revenue - Expense = Net Income
Statement of Shareholders’ Equity
reports the amounts and sources of changes in each shareholders’ equity account over the reporting period
Two types of shareholders’ equity
- Investment by owners: Paid-in Capital (Common stocks / ordinary shares / contributed capital)
- Cumulative earnings since incorporated: Retained Earnings
Balance of Paid-in Capital
The issuance of proceeds of the current outstanding shares
Outstanding
Shares that are actively-held by investors
Stock Issuance / Stock Repurchase
Stock Issuance: Distribute more ownership to the investors
Stock Repurchase: Firms buy back their own shares from the marketplace
Balance of Retained Earnings
the cumulative amount of profits kept for use in the business
Change in Retained Earnings = Net Income - Dividends
Retained Earnings (Ending Balance) = Retained Earnings (Beginning Balance) + Net Income - Dividends
Statement of Cash Flows
describes the flow of cash in and out of the firm during a period of time
- sum of operating, investing, and financing activities cash flows = total change in cash
Stockholders’ equity
Contributed Capital + Retained Earnings
Net Income
Revenues - Expenses + Gains - Losses
