Midterm 1 Flashcards
Three types of businesses
-an organization which seeks to provide goods and services to customers
- Manufacturing - builds tangible parts/products
- Merchandising - retail and wholesale (sells directly)
- Service
- some are all three (Restaurants)
To start a business you need: (3)
- Idea - can be sold at a profit
- Capital - $/resources that bring product/service to life
- Management skill - ability to employ those resources and produce a profit
Some business are on non-profit basis (purpose) but still need those three things (like a hospital)
2 Ways to access capital - “Financing of a business” (how capital is obtained for a business)
- Debt financing - borrow from creditors/lenders
- Equity financing - contributing from investors in exchange for part ownership in the company (or your own $ as an owner)
Debt Financing
(temporary financing) -borrowed capital must be repaid in future with interest -harsh consequences in failure to repay -difficult to qualify for KEY ADVANTAGE -no sacrificing ownership rights -interest (but it is upfront)
Equity financing
-Capital for ownership (in corporation it is in shares of stock)
—right to vote and say in business affairs
—right to share in profits (Marriott lost $ bc of this)
—right to share in remaining resources if business terminates
KEY ADVANTAGE
-permanent financing (don’t have to repay and no interest)
2 ways owners/investors make a profit/loss on an investment
- Sharing in the business operating profits
- —dividend - one way an owner/investor gets a return on their stocks - Capital gains/losses on the sale of stock or distributions if the business terminates
Who requires information for investment decisions?
Creditors - evaluate company’s credit worthiness
-capable of repaying debt?
Investors - want to evaluate profit potential of an investment in company’s stock
Financial accounting
Primary Purpose is to provide info to assist investors/creditors in these evaluations (External users)
- Provide info to current/future providers of capital and other interested parties (gov. regulatory)
- financial statements: summarized historical information of financial position
Managerial accounting
-provide information to internal users - managers in operation
-customized, detailed reports of current, future, and historical data
Purpose: to improve managerial performance
General Purpose Financial Statements
- Balance Sheet (Statement of financial position)
- –to show assets and how business obtained them - Income Statement (statement of operations)
- –shows result of operations (profit) - Statement of cash flows (use of cash at given times)
- these are all found in company’s annual report available to the public
Two conditions for financial statements to be useful
Comparability and credibility
Comparability
Need for company’s to prepare statements in same methods as other companies
-standard form when investors look at info from other companies - comparative analysis (consistency)
GAAP
Generally accepted accounting principles
- rules and standards of acc used to create comparable info
- need became obvious in 1929 stock market crash - (no standardized information requirements)
In response, Congress created SEC (Securities and exchange commission) - to regulate capital transactions of publicly-held companies (large companies with stocks/bonds
- SEC determines GAAP, originally delegated to AICPA (Am institute of certified public accountants
- not successful bc CPAs were really conservative - business wanted to show more optimistic/promising info to investors
- private organization FASB (Financial acc standards board) formed and took over responsibility of GAAP
Credibility
Provide accurate and reliable info
- company’s management is responsible - may have conflicts of interest
- inaccurate financial statements are worthless and deceiving
- SEC requires all fin stmts of publicly held companies be subject to outside AUDIT for accuracy by a certified public accounting firm (CPA) - to test and verify material accuracy
- CPA issues auditor’s report which must accompany the company’s fin stmts
Publicly held companies…
FEDERAL AGENCIES
-SEC regulates publicly held companies
-IRS - collects income taxes
*Publicly held companies provide annual report for investors and creditors
PRIVATE ORGANIZATIONS
-AICPA license and certify CPAs who audit the annual reports
-FASB creates GAAP
Accounting is often referred to as…
the “language of business”
-bc it involves organizing and analyzing information to evaluate and make business decisions
Why is financial accounting information applicable to investors?
They are questioning the long-term profitability of the company
-look at past for clues to the future
Why is GAAP important?
Important for consistency in comparative analysis and credibility
- rules and standards by which accounting info is prepared and presented to external users
- MANAGERIAL ACCOUNTING is not governed by standardized rules
SEC, FASB, AICPA, IRS
SEC - regulate capital transactions of business and public in stocks and bonds
FASB - Financial accounting standards board - currently determines GAAP (independent, private institution - not gov. regulated)
AICPA - used to be responsible for GAAP, now licenses and certifies CPAs - establish procedures of auditing
IRS - (internal revenue service) - collect income taxes (An. institute of CPAs)
Do only large publicly held companies have audits performed?
They must have external audits to ensure their financial stmts are accurate
- businesses that seek to acquire capital from the public
- any business bc it adds credibility to their business
3 Basic legal forms of business
Proprietorship, partnership, corporation
Proprietorship
- one owner
- no legal red tape except if you hire employees (legal hire standards, safety issues, license, sales tax if you are selling products)
- no separation of business and personal liability
- –can sue and take your business and personal resources - exposes personal life to risk
- –no separate income taxation - any income or loss are taken to you directly - no separate tax for business
Partnership
- same as proprietorship except more than 1 owner
- a formal partnership is recommended, but not required (anticipate how to split profits and losses)
- no separate income taxation (if a partner is sued it affects the others assets as well)
- —tax return is to each individual personally
Corporation
Separate legal entity apart from its owners
- legal red tape in formation and operation imposed by state
- one or more owners
- separation of business and personal liability of owners
- —sue claims only business assets - no personal risk
- DOUBLE TAXATION!!
- —Corporate tax + state + personal = (less left to owners)
- —Can avoid by salaries and bonuses (decrease net income)
- —or use LLC (limited liability corp.) - treated like a partnership in taxing - no double taxation but any business decisions must be approved by all owners
Corp ownership, governance, and management
- states authorize the formation of separate corp. entities
- –Articles of Incorporation and By Laws are filed to determined how it will be governed
- Corporate ownership if evidence by stock certificates (shares of stock)
- shareholders have the right subject to the by-laws to vote on corporate matters (1 vote per share) and right to share on dividends
- senior management is accountable to the Board and therefore the owners (responsible for business operations to max profits for the benefit of owners)
- Business owners are those who invest capital in corp. (shareholders)
Corporation owners
Shareholders (invest capital) *ELECT Board of Directors (advise for a fee) *HIRES Top management personnel (manage for a salary) *HIRES Other employees (work for salary) *PRODUCE profits for owners
Balance Sheet
ASSETS = LIABILITIES + OWNER’S EQUITY
-basic accounting equation
(Business resources = amount from creditors + amount from owners)
-when something increases or decreases on the left of the equation, it must also be done to the right
Purpose of a balance sheet is to send it out of creditors/investors
Assets
Resources (PROPERTY/RIGHTS) owned or controlled by a company and provide FUTURE ECONOMIC BENEFIT
-obsolete products are not an asset bc no future benefit
- Cash (most companies do NOT have cash as largest asset)
- Inventory (purchased and held for resale)
- equipment - comp. purchased to use not resell - future benefit
- Accounts receivable (amounts receivable from customers due to sales made on account) - own right to receive profit from customers in the future
- **Prepaid expenses (Asset bc pay before you use it and get the benefit - insurance, rent)
- office supplies/land/factories/buildings
- patents - a right issued by gov. to use invention exclusively
Liabilities
Probable future obligations to pay assets or provide services to another entity - amount of DEBT FINANCING - how they pay for their assets
- Accounts payable - obligation arising from purchase of INVENTORY on account - debt I owe to my supplier
- notes payable - typically arises from borrowing CASH
- warranty obligations - responsibility to provide service - if product breaks down you promised future service - UNEARNED REVENUE* same as warranty obligations - owe future service
Accrued Liability - “accrued” means to build up gradually over time
- wages payable: when employee works, the money builds up over time, but they are only paid every other week
- money to IRS - builds but only paid in April
Owner’s equity
Amount of assets from owners (EQUITY FINANCING)
2 ways:
1. Contributing cash/assets to business in exchange for ownership rights evidence by shares of stock (contributed capital/capital stock)
2. Allowing any increase in assets arising from profitable operations to be retained in the business rather than distributed to owners as a dividend
-Retained earnings
***added RE from when the store opens (can be negative for startups bc revenue doesn’t cover expenses yet) - total amount of money kept in the company since it began (Adds or subtracts each year)
OE = Capital stock + retained earnings
-retained earnings are reduced by dividends
Income Statement
Shows the profitability from the operations of the business
revenues (inflow) - expenses (outflow) = net income
Revenues
The amount of inflowing assets from the sale or providing of goods/services to customers
- this amount is usually reflected in the sales price
- no always cash, sometimes account receivables
- Comes in bc SOLD to customers - owner contributed cash or buying inventory is not revenue
- Revenues are not the asset received but simply a description of why we received that asset
- describing the asset - revenues of $100 mess that $100 worth of assets are received from a customer by the sale of a product rather than from borrowing or an owners contribution
Expenses
The amount of outflowing assets (or the incurring of liabilities recurring the future outflow of assets) representing a cost of providing goods/services for sale
- explains WHY the asset is given up (or will be given up in the future)
- wage expense of $500 means that $500 worth of assets were paid out/will be to employees and represents a cost incurred in the operating the business
Dividends
Not an expense - celebration of profits
-describe the amount of assets distributed to owners (stockholders) from current or previous profits
Obsolete inventory…
Should NOT be included on a balance sheet - bc it has no probably future economic benefit to the company
A company’s purchase of inventory with cash…
would have NO affect on business assets, liabilities, or equity
Inflows of cash/any asset are recorded as revenues…
ONLY when received as a result of providing goods/services to customers
Balance Sheet is cumulative data..
From the inception of the business up to that point in time
- annual comparisons are useful to investors/creditors to identify past performance and highlight changes in A, L, and OE in a particular year (to make projections for the future) - compare to see if company is growing/profitable
- written (“ as of 1/31/X1)
- Income statements explain why balance sheet changed that year
- written (“for the month ending 1/31/XI)
- same for stmt of retained earnings
Assets =
Assets = Liabilities + Owners Equity
Owners Equity =
Capital stock + Retained earnings
Retained earnings =
Net income for the year - dividends for the year
Net Income =
Revenues - expenses
How Fin stmts relate to one another
Balance sheet 12/31/X5 - Balance Sheet 12/31/X6
- income statement shows why balance sheet changed for a period of time (1 year)
- statement of cash flows - explains why balance sheet changed specific to cash
- statement of retained earnings
Balance Sheet format
Company Name
Balance Sheet
For the year ended 12/31/X1
ASSETS
-current assets (cash or any asset that can and will be converted to cash within one year - or used up in 1 year - cash, accts. receivable, inventory)
-long term assets: land, buildings, equipment, notes receivable
-total assets
LIABILITIES AND OWNERS EQUITY
Liabilities
-current liabilities (obligations to be paid within 1 year - accounts payable, other payables)
-long-term liabilities (long term debt) (notes payable)
-total liabilities
Owners (stockholders) Equity
-Capital Stock (if you have 10,000 shares and have $100,000 in capital stock for that year - it shows on average the company has contributed 10$ per share of stock)
-retained earnings
-total
Total Liabilities and Owners Equity (should match total assets)
*current and long-term assets and liabilities help determine a companies liquidity - in a position to pay obligations in the short term
Statement of retained earnings format (for during the year, not the end of each year)
Company Name
Statement of Retained Earnings
For the year ending 12/31/X1
Retained earnings, 01/01/X1: (Ending RE for previous year)
Add: Net income for year
Less: dividends for the year (x)
Retained earnings, 12/31/X1:
Income Statement format (total amount of activity for a period of time) - format according to GAAP
Company Name
Income Statement
For the years ended 20X1, 20X2
REVENUES:
-sales revenues (Net sales)
-cost of goods sold
-total revenues (gross profit - margin)
Less: EXPENSES -operating expenses (what most expenses are beside interest/tax/cost of goods sold/prepaid expenses) - amount is controlled by management -----operating income -other expenses ---interest expense ---interest revenue ---tax expense -total expenses NET INCOME EPS (Earnings per share) = net income/# of shares
Earnings per share (EPS) =
Net income / # of shares
(150,000/10,000 shares = $15.00 per share)
Written on the Income Statement under net income
Wholesale purchase
Cost of sales (goods sold)/ Net sales
-When Wal-Mart sells you an item for $1.00, on average, what is Wal-Mart’s wholesale purchase of this item?
(358,096 / 473,076 = 75 cents)
Finding profit
How much a company gets to keep after paying ALL business expenses if you buy something for $1.00
Net income / Net Sales
(16,551 / 473,076 = 3.5 cents
*Return on sales (LOW FOR LARGE COMPANIES/SUPERMARKETS - HIGH VOLUME, LOW RETURN - LOTS OF PRODUCTS)
Debt ratio =
Total Liabilities / total assets
Gross profit percentage =
(revenue - cost of revenue (cost of sales)) / revenue
Return on Sales
Net income / (net sales)
*How much cents per dollar the company keeps as a profit (low for large companies)
-IF Wal-mart has a sale of $1.00, on average how much of that $1.00 is left as net income after the payment of all expenses?
Return on Equity
Net income / equity
*measures how much the shareholders earned for their investment in the company
What business has high receivables?
- right to collect cash in the future (Asset)
* Banks!
Subsidiaries and investments
*Berkshire example - owns lots of small companies
Subsidiaries - include all balance sheet companies for each company
Investments - include as an asset to original company
Consolidated fin stmts - original company plus all companies it owns
Contro: if you own more than 50% of the company
Cost of Goods Sold
(Cost of sales) - inventory purchased for resale is an asset, but once it is sold it is an expense
Depreciation expense
When equipment or buildings are purchased they are recorded as assets - they become expenses to the company over life of the asset (2-40 years)
- (Computer that will last 2 years - 500 1 year under expenses and 500 second year)
- NOT inventory only for buildings/factories/equipment used in producing the inventory
- want depreciation to go up each period bc this means you have more assets (growing/expanding)
Bad Debt expense
(uncollectible accounts expense)
- when a company makes a sale on account it is an asset (Accounts receivable)
- not all customers pay their accounts in full
- bad debt expense is re-classifying the asset into an expense
- estimate how much accounts receivable will go bad
- Negative is good! It means they estimated people would not pay back and they did!
- Banks have highest bad debt expense and accounts receivable
Income tax expense % =
(Income before income taxes) * (tax RATE) = income tax expense %
Cash accounting vs. Accrual accounting
Cash accounting
- revenue: recorded when you COLLECT cash
- expense: recorded when you SPEND cash
Accrual Accounting
- revenue: recorded when you EARN revenue - do the work, doesn’t mean they’ve paid you ye
- expense: recorded when you CONSUME the expense - make judgments and assumptions
- Accrual is what we always use!!
What % Net Sales increased or decreased between years?
(Sales CY - Sales PY) / Sales PY
(Sales current year - sales previous year) / sales previous year
Asset valuation
(dollar amount of assets on balance sheet)
- subjective valuation: interpretation and opinion
- objective: take a group and come up with value - required by GAAP
Historical cost principle
Assets will be valued at the price paid upon acquisition
- OR at the fair market value of the asset at the time of its acquisition or receipt - exception in cases where the transaction was not an arms-length purchase (sold at less than its value - FMV determines at date of purchase)
- OR if there is credible evidence that an asset’s FMV is below its historical cost, the cost will usually be reduced to reflect the lower FMV
FMV (Fair Market Value)
Historical cost of an asset in an arms-length purchase (seller wants highest price and buyer wants lowest price
= FMV at the time of purchase
*Attitude of Conservatism - if you don’t know the value, stay conservative - better to understate than overstate value
Monetary Measurement principle
Measure value of assets in dollars - based on historical cost in US dollars
Entity Concept
Only include on the balance sheet of a business the assets owned by the business
-separate business and personal assets
5 Steps of an accounting system
-means whereby all a company’s transactions are identified, recorded, and summarized to produce fin stmts
- identify each business transaction
- analyze each transaction to determine its effect on the financial position of the business (A = L + OE)
- Record the transactions and their effect on the financial position in a journal
- Post to general ledger
- Prepare a trial balance
Debit and Credit
Debit - means left side
Credit - means right side
DR - CR
ASSETS + -
Liabilities - +
Owners Equity - +
Capital Stock - +
Retained Earnings - +
Revenues - +
EXPENSES + -
DIVIDENDS + -
- Assets, expenses, and dividends increase on the left - DR
- Liabilities, Owners Equity, and revenue increases on right -CR
Banks perspective
- Bank stmt shows debits as decreases and credits as increases in cash accounts (opposite)
- it is a reflection of your cash from a standpoint of the banks accounting, not from yours
- If a student opens a checking acct by depositing $1000 at bank, the bank will account for this transaction from their perspective
- bank stmt sent to depositors is a representation of the bank’s liability account to the depositor
Are bills for rent/utilities/salaries a liability bc money you owe or an expense?
It depends
- If you make no journal entry in the first place and just pay when the bill is due, then you record it as an expense
- but if you record it when you get the bill it would be an increase in rent payable and decrease in rent expense - once you pay it is a decrease in cash and decrease in rent payable - same net effect as before bc it ends up as a decrease in cash and decrease in rent expense in the end
General Ledger
- A file system that has a separate record for eau kind of asset, liability, or owners equity including each kind of revenue, expense, and dividend
- each of these records is referred to as an account
- each account in the general ledger is intended to accumulate the increases and decreases recorded in the journal producing a periodic summarizing balance for the account
- purpose is to separate each asset and the accumulated transactions associated with s - any inflows or outflows
Trial Balance
Listing of all A, L, OE noting their ending general ledger balances
- shows if each account ended debit or credit
- totals all debit and credit accounts for the business
- debit should = credit
- is a self checking device!
DR = CR for EVERY transaction
-fin stmts are prepared from trial balance bc it lists the general ledger balances for each account
what company has highest return on sales?
What was the highest finance of Wal-mart?
retained earnings
GAAP questions
- -not mostly regulated by SEC
- -in US requires historical cost NOT fair value
For accrual accounting…
you ONLY do economic values earned or consumed
- –not collecting cash or purchasing inv. - only when selling inv. (cost of goods sold) and collecting cash earned from that sale
- –pay interest on loans for months of that year (amt. of interest you have consumed front hat loan for a year)
For accrual accounting does revenue increase when company signs consulting contracts totaling 30,000,000
NO - rev = 0 for just signing contracts
- –only rev. when they complete WORK for those contracts
- -dont include when company collects cash
company purchased equipment for 15,000,000 - equipment purchase isn’t counted as expense taken out - only the depreciation
–it depreciates over 3 years so you only take out (15,000,000 / 3) = 5000
paid fee of 5000 for a 5 year contract - only count the expense for that year bc it lasts for 5 years (5000 / 5) = 1000 exp.
For accrual accounting does revenue increase when company signs consulting contracts totaling 30,000,000
NO - rev = 0 for just signing contracts
- –only rev. when they complete WORK for those contracts
- -dont include when company collects cash
company purchased equipment for 15,000,000 - equipment purchase isn’t counted as expense taken out - only the depreciation
–it depreciates over 3 years so you only take out (15,000,000 / 3) = 5000
paid fee of 5000 for a 5 year contract - only count the expense for that year bc it lasts for 5 years (5000 / 5) = 1000 exp.
inv. =
goods purchased and held for resale
purpose of gaap
to create comparable information
consolidated balance sheet
contains all the assets and liabilities owned by the parent company and all the subsidiaries owned by the parent company
consolidated balance sheet
contains all the assets and liabilities owned by the parent company and all the subsidiaries owned by the parent company
When calc. tax rate..
take sales rev. less all expenses before income tax exp. = interest expense comes BEFORE taxes so is taken out also
When calc. tax rate..
take sales rev. less all expenses before income tax exp. = interest expense comes BEFORE taxes so is taken out also
paid-in-capital
credit - OE
paid-in-capital
credit - OE
T/F walmart has high COGS
TRUE
What would have highest depreciation
exxon mobil - or general motors - lots of PP&E
DEBT FINANCING
you CAN share in remaining resources when business is terminated
