Midterm Terms Flashcards
Financial Accounting
Concerns the preparation and use of the accounting information provided in a company’s financial statements.
The overall objective of Financial Accounting
Is to provide a basis upon which to evaluate the financial position and performance of a company for those that have invested in the company
Managerial Accounting(First financial accounting measurement)
Focuses on the production of accounting information internal to a firm for deciding such operational questions as how much inventory to produce, what price to charge and measure performance
Tax Accounting(Second financial accounting measurement)
Refers to the system of measurement used by tax authorities to determine the amount of taxes to levy on a company
Four Primary Financial Statements
1) Balance Sheet2) Income Statement3) Statement of cash flow4) Statement of Shareholders equity
Balance Sheet
Shows what resources the company currently has and who provided the financing to acquire the various resources1)Assets2)Liabilities3)Equity
Assets(Balance Sheet)
Refer to the resources of a company that are expected to provide future economic benefit
Liabilities(Balance Sheet)
Represent the value of the company’s obligations to repay monies loaned to it, to pay for goods or services received by it, or to fulfill commitments made by it
Shareholders equity(Balance Sheet)
The difference between a companies assets and liabilities represents the shareholders financial stake in a company
Basic Accounting Equation
Assets = Liabilities + Shareholders Equity
Accounts Receivables(Balance Sheet)
Asset - The amount that the company expects to receive from its customers for prior purchases
Accounts Payables(Balance Sheet)
Liabilities - The amount a company expects to pay to its suppliers for prior credit purchases of inventory
Accrual basis of accounting
This approach requires a company to record the financial effects of a business transaction even though the timing of the cash effects of the event takes place at a different time
Income Statement
Reports how much merchandise the company sold and how much profit, if any, it made from those sales
Bottom Line(Income Statement)
Net Income - How much the company made or lost
Going Concern Assumption
This notion specifies that financial statements are prepared assuming that a business will continue operating in the future unless there is a substantial evidence to the contrary
Statement of cash flow
Tells us how much cash a company generated from its core business operations versus received from its shareholders and debtholders, and how much is spent to buy its long-term assets, such as software and equipment
Why are investors usually very interested in the Statement of cash flow?
Because it provides insight into a business beyond that provided by the balance sheet which reflects a company’s current financial heal, or an income statement which depicts a firms recent operating performance
Statement of shareholders equity
It reveals how the shareholders investment in a business grew by the amount o any net income retained in the business or declined as a consequence of any dividend distribution to shareholders or any loss sustained by a business
Decision Usefulness(Qualitative Attributes of Accounting Information)
Decide Price of product to charge, bank credit, decision to invest in shares and at what price
Relevance(First attribute that underlies accounting information)
Refers to the capacity of accounting information to influence a decision
Feedback Value(Second attribute that underlies accounting information)
Pertains to decisions and actions already taken
Predictive Value
Suggests that accounting information helps financial statement users for predictions about future outcomes
Faithful Representation
Refers to the fact that accounting information is, or should be, free from error or bias
GAAP
Generally Accepted Accounting Principles - Provide guidance to companies regarding the preferred way to measure and report their performance
Footnotes
A way for companies to provide details about their accounting methods and how the various accounts are measuredExample: Inventory is primarily accounted for using the first-in, first -out method
Audit Report
Audit firms work hard to provide assurance because errors in detecting defective financial statements can result in significant lost of investors capitol
SEC
Securities Exchange Commission - Created after the Stock Market Crash during the Great Depression. Sets standards
Risk and Expected Return
Return - expected income to be earnedRiskiness - refers to the uncertainty associated with the expected return- Risk and Return are positively correlated. Higher risk = Higher Reward
Supply of Capital
The portfolio decisions of millions of individuals and businesses in allocating funds across different investment opportunities
Go Public
Sell ownership shares i the public capital market as a means to gain access to capital to grow, to provide original investors with “liquidity” (ability to sell their ownership assets) and to have shares to be used to facilitate future mergers and acquisitions
Raise Funds
Obtain capital by issuing shares to shareholders and/or by borrowing from creditors such as financial institutions and bond investors.
Return on Investment
Derived from dividend payments and any appreciation or depreciation experienced from changes in a company’s share price
Data Analytics
Defined as the science of gatherings and analyzing raw data and then using the results to make better decisions
Big Data
A specific form of data analytics is the examination of enormous amounts of data to help the analyst uncover hidden patterns, correlations and other insights
FinTech
Any new technology that seeks to improve and automate the delivery and use of financial services
Blockchain
An evolving record of data that is managed by a multitude of different users and computers, together not owned or managed by any single entity. Example: Bitcoin
GAAP are a set of rigid rules that if followed correctly, will lead to a correct representation of the financial performance and healthy of a firm(Accounting Myth 1)
False - A certain amount of flexibility exists within GAAP
GAAP is created from a comprehensive analytical process, which is free from political influence(Accounting Myth 2)
False - Politics can affect accountingExample: Enron, Great Depression
The basic financial statements, consisting of a balance sheet, an income statement, a statement of shareholders equity and cash flow, reflect a complete, accurate and timely portrayal of the financial performance and well being of a firm(Accounting Myth 3)
FALSE
All of a firms identifiable assets and liabilities appear on the balance sheet, and the difference between a firms assets and its liabilities represents the value of the firm(Accounting Myth 4)
FALSE
Each of the financial statements is independent, with each reflecting a different aspect of a firms performance and financial health(Accounting Myth 5)
FALSE
Cash Flow is ultimately what matters to firm and its investors(Accounting Myth 6)
FALSE
A knowledge of accounting is necessary only for someone who wants to be an accountant(Accounting Myth 7)
FALSE
Corporations
Owned by shareholders under the laws of the state or province in which a company is incorporated
Corporate Charter
Set of bylaws governing the rights and responsibilities of the board of directors to a firms shareholders and covering such topics as annual meetings, the election of directors, the type of shares to be sold and voting rights
Conflicts between managers and shareholders
Incentivize contract work to align the financial interests of managers with those of a company’s stockholders, thereby encouraging the managers to simultaneously work to maximize their own wealth as well as shareholders
Conflict between debtholders and shareholders
Shareholders re-distribute the borrowed wealth rom the debtholder’s to themselves, potentially leaving the debtholders with a worthless corporate shell and no resources to repay the loan
Fiscal Periods
Segment its operational life into reporting periods. Provides interested parties with a timely, relevant information about its various activities
10-Q
Public corporations that report to the SEC quarterly financial statements
10-k
Public corporations that report to the SEC Annual financial statements
Assets
Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or eventsIncludes: Cash, stocks, bonds, and real estate
Liabilities
Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactionsIncludes: Car loans, credit card debt, student loans, mortgages
Equity
The residual interest in the assets that remain after deducting its liabilities
Revenues(Income Statement)
Inflows or other enhancements of assets to an entity or settlement of its liabilities from delivering or producing goods, services or carrying out other activities that constitute the entity’s purpose
Expenses(Income Statement)
Outflows or other using up of assets r incurrences of liabilities from delivering or producing goods, services or carrying out activities
Gains(Income Statement)
Increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and events affecting the entity except those that result from revenues or investments by owners
Losses(Income Statement)
Decreases in equity from peripheral or incidental transactions of an entity and from all other transactions and events affecting the entity except those that result from revenues or investments by owners
Comprehensive Income(Income Statement)
The change in equity of a business enterprise during a period from transactions and other events from sources other than investments by owners or distribution to owners
Investment by owners(Transfers between a business and its owners)
Increase in equity of a particular business enterprise resulting from transfers to it for the purpose of increasing ownership interests
Distributions to owners(Transfers between a business and its owners)
Decreases in the equity of a particular business enterprise resulting from transferring assets, rendering services or incurring liabilities to owners
Net Worth
A - L = NWSimply the difference between what you have and what you owe
SE
Share Equity
CS
Common Stock
RE
Retained Earnings
Balance Sheet Equation
A = L + (CS + RE)
Net Worth - Individual(Balance Sheet Equation)
The difference between what you have and what you owe.Total assets less liabilitiesA - L = NW
Balance Sheet EquationLenders Relationship
Creditors have a claim on listed assets, they are in a less risky positionA = L + NW
Balance Sheet EquationShareholder Relationship
Shareholders (those that purchase ownership shares in the business) have the last claim on the corporate assets listed on the balance sheet.A = L + SE
Financing Decision
Some companies borrow sparingly and thus are financed principally by shareholders. Other companies borrow extensively (referred to as leveraged) The relative mix of funding between shareholders and lenders can have a dramatic effect on a firms financial performance.
Asset
An economic resource that is expected to generate future benefits for a business
Liability
An obligation to make future payments
Off-Balance Sheet liabilities
Liabilities that are often not reported on the balance sheet
Shareholders Equity
Residual value of a business - Value of any assets remaining after all liabilities have been satisfiedCS + RE = SE
Common Stock (CS)
Value of the shareholders direct investment in a business
Retained Earnings (RE)
Amount of any profits retained in the business to support future operations
Issuing Shares
The number of shares issued by a company and their related value. The amount of money given for a set of shares becomes the basis for the starting equity value
Entity Principle
This principle stipulates that the financial affairs of a business must be maintained separate and distinct from the affairs of the owners of the business
Accrual Basis of accounting
Any interest owed but not paid will be recorded as necessary at future balance sheet dates with an appropriate charge to earnings and retained earnings
Tangible Assets
Most recorded assets such as buildings have an actual physical presence
Intangible Assets
Include such items as patents, copyrights and brand names
Forecasted Financial Statement
Financial statements prepared on an “as if” bases using assumptions about what might happen in the future
Opportunity Cost
Extending credit to customers. Equal to the cost of borrowing over the time period during which the purchase price remains unpaid
Historical Cost Principle
Stipulates that all assets should initially be recorded at their historical acquisition cost
Relation between Revenues and Expenses
Revenues - which increase net income also increase retained earningsExpenses - Decrease net income and also decreases retained earningsWe include income statement accounts as subcomponents of retained earnings
Revenue Recognition Principle
Recognizing revenue is a wealth-increasing event for a business and its shareholders and this is reflects by an increase in shareholders equity (through the retained earnings account).
Expenses
Represent the using up of goods and services associated with the production of revenues by a business. Expenses reduce assets or increase liabilities, expenses are a wealth-reducing event
Matching Concept
Within a given accounting period, a business is able to convey its accomplishments (revenue) with its efforts (expenses)
Contra Accounts (CA)
Balance Sheet accounts that are subtracted from other accounts (such as accumulated depreciation)
Net Book Value
The difference between the cost of an asset (eg equipment) and its accumulated depreciation
Depreciation
Refers to the systematic expensing of an asset as a consequence of the passage of timeAsset = Accumulated DepreciationShareholder Equity = Depreciation
Amortization
The write-off of the purchased brand name-Just estimates, and as such, can be quite imprecise
Additional Shares
The issuance of additional common shares increase SE. As a consequence of selling shares to the outside investor, the owners must share control of the business and its profits with the investor who has become co-owner
Income Tax
cost of doing business. This expense must be matched with the company’s revenue
Balance Sheet Includes…
The income statement accountsEx. Revenues, COGS, Wages and Salaries, Selling and Administrative, Depreciation, Amortization, Interest expense, income tax, dividends all under Retained Earnings
Preparing the Financial Statements
Summing up the various values in each of the rows. These final balances are entered in the final column labeled “ending balance”.
Current Assets
Those assets that are expected to be converted into cash or used to support operations during the next 12 months
Noncurrent Assets
Those assets expected to be available to support the coninuing operations of a business beyond 12 months
Current Liabilities
those liabilities that are expected to require payment within the next 12 months
Noncurrent Liabilities
Obligations that not expected to require payment for more than one year. The phrase “long-term” is often used instead of “noncurrent”.
Revenue
Measure the inflow of cash and other assets (such as accounts receivable) from a firms primary business activity.
Gross Profit
Measures the amount of cash and assets remaining after deducting the cost of sales (COGS)
Operating Income
Refers to a firms net income before deducting such items as interest expense and income taxes
Net Income
The firms bottom-line performance - the company’s net income after all expenses are deducted, both operating and nonoperating, recurring or non-recurring
Recurring Operations
core business of producing and selling product
Evaluating Firm Profitability
To evaluate the profitability of a business, it is often useful to consider various performance indicators from the financial statement’s
Return on Sales (ROS)
One profitability measure that considers relative firm size.AKA Net income divided by sales revenue
Return on Assets (ROA)
Another measure of profitability that considers relative firm size.Net income plus after tax interest expense divided by total assets
Tax Shield
Positive impact of interest expense on a firms income tax expense.The amount of interest added back to net income should be reduced by the amount of the tax shield which is already reflected in a firms income tax provision
Operating Cycle
Almost all companies have an identifiable cycle of activities that reflect the ongoing operations of the business. This repetitive cycle of events is commonly referred to as Operating CycleExample: Retail companies buy inventory > sell inventory > receive payment
Operating CycleWalmart vs Ford
Walmart customers pay in debit or cash so sales are recognized right away as they do not extend credit to customers.Ford will extend credit to customers through its financing subsidiary and recognizes sales when payment is received.
Revenue
Refers to the inflow of assets (such as cash, accounts receivable, or bartered asset)Since revenue recognition increases shareholders wealth, it is also considered to be a primary driver of company share price and a key driver of company value.
Recognized
Revenue could be reported on the income statement as having been earned at the point in time at which a company provides goods or services
Revenue Recognition Guidance: ASC 606
1) There has been a transfer of goods or services to customers2) That the company is entitled to consideration from the customer in exchange for those goods or services
Revenue Recognition Guidance: ASC 6065 Step Model
1) Identify the contract with a customer2) Identify the separate performance obligations in the contract3) Determine the transaction price4) Allocate the transaction price (if necessary)5) Recognize revenue when (or as) the entity satisfies a performance obligation
Revenue Recognition by Retail and service companies
Point of sale or completion of service - Customers pay with cash, debit card or checkPoint of cash collection - When account payment is not reasonably assured, companies instead recognize revenue at the point of cash collection
Installment Method
(Point of cash collection) Revenue is recognized only to the extent of any cash received. Under the installment method, the company will recognize only the initial down payment as revenue and record cost of goods sold for the percent paid up front.
Accounts Receivable
refers to short term (usually 30, 60 or 90 days in duration) credit arrangements that are typically interest free
Notes Receivable
refer to credit that is longer term for large amounts and consequently, is likely to involve interest charges
Opportunity Cost
Charging interest on a notes receivable
Revenue Recognition over time
That is, revenue is recognized in proportion to the completion each fiscal period
unbilled account receivable
an internal billing for revenue, which, for contractual reasons, is not yet sent to a customer for payment, but for all practical purposes is an amount owed by the customer
Deferred Revenue
Revenue whose recognition on the income statement has been deferred to the future until other criteria have been met
Rear-end loading
Rear-end loading of revenues (deferral of the income statement recognition of certain revenues until a later fiscal period) reduces the total level of revenues currently recognized, and thus reduces currently reported operating income
Earnings Reserve
Enabling the firm to manage its reported earnings and consistently meet or exceed wall streets earnings expectations
Recognizing revenue at a point in time
Recognizes all the gross profit in the year of completion
Net realizable value
An amount that reflects the expected net collectability of the total accounts receivable balance.The account reflects the expectation of receiving cash at a later date for a sale made at an earlier date.
Percentage of credit sales method
A company estimates its expected future credit losses as a function of the relationship between its historical credit losses and its historical credit sales.
Allowance for uncollectible accounts
A contra-account on the balance sheet to reflect the amount of the outstanding receivables that are not expected to be collected
Aging Method
The focus is on the balance sheet and specifically how much is owed to the company as of the balance sheet date.A company first categorizes its outstanding accounts receivable according to how much time has elapsed since the credit sale took place.
Write-off of uncollectible accounts
Executed by reducing accounts receivable and adjusting the the allowance for uncollectible accounts for an equivalent amount
Sales DiscountsDuration
To maximize the return on a company’s investment un accounts receivable, and thus, the firms overall profitability, it is important to keep the duration of interest free loans as short as possible.
Sales DiscountsCredit Terms / Trade Terms
2/10, n/30The term “2/10’ indicates that if a customer pays their bull within ten days of purchase, they will be given a 2% reduction in the gross purchase price. Term n/30 (net 30) indicates that if the customer fails to take advantage of the the quick payment, the full purchase price is expected within 30 days of the sales transaction
Sales Discount
Is reported on the income statement as a deduction from gross revenue. This is a contra-revenue account.
Receivable Collection Period
365 Days / Net Sales/Account receivable
Sales Returns
Customer returns are typically estimated on the basis of recent historical experiences. Sales returns can be a serious problem in some companies. The most effective way to manage this problem is through a program of continuous quality control of manufacturing processes to ensure the production of high-quality goods
Factoring
The process of selling accounts and notes receivables. Factors convert a company’s receivables into cash at their face value less a service charge and a charge for the time value of money
Receivables that are sold with recourse
Means that if a factor is unable to collect on a particular account or not receivable, the factor has the right to return the uncollectable receivable to the seller and recover its money directly from the seller.
Receivables that are sold without recourse
The factor assumes all risk of collection and thus will charge a considerably higher fee (such as 12 to 15%) to compensate for the potential loss associated with any uncollectable receivable.
Pledging
A common form of financing for most companies because it is a lower-cost option than factoring. Company uses its receivables as collateral to obtain bank financing
Special purpose entities or special purpose vheicals
To sell receivables to a private legal entity created by a company for the exclusive purpose of buying its receivables.
Securitization
In essence, an SPE or SPV acts like a company-owned factor. The SPE borrows money from investors to form a financial services company and then uses the borrowed funds to buy accounts and notes receivable from its parent company.The advantage over pledging is that the parent company does not increase its leverage.
Front end loading
Recognizing revenue prematurely.
Operating Cycle
Most companies have an identifiable cycle of activities that reflect the day to day operations of the business.
Retail Operating Cycle
The company acquires inventory that is, for all practical purposes, ready for sale to its customers. Initially, the inventory is carried as an asset on the retailers balance sheet, but upon the sale, the cost of the inventory is removed from the balance sheet and transferred to cost of goods sold on the income statement, to be matched with operating revenue produced by the sale.
Manufacturing Operating Cycle
More complex. Begins its operating cycle with the purchase of raw material, which then enters a production process.
Work-in-process inventory(Manufacturing Operating Cycle)
The raw material is initially altered by the production-line-workers and manufacturing equipment
Finished Goods Inventory(Manufacturing Operating Cycle)
When the production process is finally complete and is ready for sale
Manufacturer’s inventory
Recognized as an asset on the balance sheet. When raw material enters the manufacturing process, its value is transferred to the work-in-process inventory account. As work in progress is completed, it is transferred to the finished goods account. Upon the sale of the finished goods, the cost of the sold inventory is transferred to cost of goods sold on the income statement and replaced by cash or accounts receivable on the balance sheet.
Measuring Cost of Goods Sold and ending inventory
Inventory values on the balance sheet are charged to earnings in the period in which the inventory is sold. This is an example of the “matching” concept at work, wherein the effort is recorded in the same period during which any benefit is received by the company.
FIFO(Inventory Valuation Method)
This approach assumes that the first units purchased are the first units sold. The units remaining on hand are the units purchased more recently so the company’s ending inventory would be the cost of the last unit purchased.
LIFO(Inventory Valuation Method)
Last in, first out. This methods assumes that the units purchased most recently, are the first units sold.
LIFO Conformity Rule
IRS Requires businesses that use LIO for income tax purposes to also use LIFO in preparation of their audited financial reports to share holders
Average Cost Method(Inventory Valuation Method)
Average of units cost
Weighted-average cost method(Inventory Valuation Method)
Different from average cost method. Each inventory price is weighted by the quantity of units purchased at a given price, whereas the average cost method calculates a simple average of the various inventory purchase prices without regard to the quantities purchased.
Replacement Cost Method(Inventory Valuation Method)
Valued both the unit sold and the unit on hand at the inventory’s replacement cost.
Specific identification method(Inventory Valuation Method)
If the CEO could identify exactly which product was sold on a given day, then the actual price of the identified item would be charged to cost of goods sold and the cost basis of the remaining barrel would also be known.
Inventory Management System
Tool used to keep track of the inventory purchased, sold and on hand
Periodic System(Inventory Management System)
Periodically updates such information as the cost and quantity of inventory on hand, but only when new goods are purchased and when a physical count on hand inventory is undertaken. Presumes that management does not need minute-by-minute information regarding the quantity of inventory on hand or its costs.
Perpetual System(Inventory Management System)
Updates a firms inventory data after every purchase and every sale, providing a constant source of reliable information about the cost and quantity of goods available for sale
Inventory Count
Almost all types of inventory are subject to damage, deterioration and theft. GAAP requires that a physical inventory count be taken at least once a year so as to ensure the integrity of the inventory balances. It should be noted that any amount needed to adjust ending inventory will affect no only inventory on the balance sheet but also cost of goods sold and net income on the income statement.
Computations of Cost of Goods Sold
The adjustment of cost of goods sold and inventory can be best understood:Beginning Inventory + Purchases = Goods available for sale - Ending inventory = COGS
Choosing an Inventory Method
Once a company has selected a particular inventory valuation method, they do not have to keep it consistent among all items.
Lower of Cost or Net Realizable Value
Companies are required to ensure that the value of ending inventory carrier on the balance sheet is recorded at an amount that does not exceed its Net Realizable Value.- If the NRV is less than its recorded books value, the company must write the value of its inventory down to NRV.-If the, however, the NRV is higher than its recorded book value, the inventory is not written up to the higher value but remains valued at its cost.
Net Realizable
(NVR) Measured as the estimated selling price in the ordinary course of business. minus cost of completion, disposal, and/or transportation.
LIFO Layers
Since the LIFO method assumes that the most recently purchased inventory is the first inventory to be sold, it is not unusual for a company to have multiple LIFO layers, often reflecting prices from several prior fiscal periods.
LIFO Reserve
Accounting standard-setters require that companies using LIFO disclose the value of the inventory reserve in their footnotes.
Inventory Reserve
Significant because it enables investment professionals to restate gross profit under LIFO to estimate what gross profit would have been had FIFO been used instead. It is a cumulative measure of the difference between the LIFO cost of ending inventory and the FIFO cost of ending inventory.
Liquidating LIFO Layers
Sometimes it is impossible to meet internal or external earnings expectations by increasing sales and thus managers may look for other ways to increase net income (such as cutting costs). One temporary profit-enhancing approach used by some managers of LIFO-accounted companies is the liquidation of LIFO layers.-Liquidating a LIFO layer has the effect of lowering the reported cost of goods sold, and hence, raising gross profit because a lower cost of inventory is effectively matched with revenue.
Phantom Profit(Liquidating LIFO Layers)
Although gross profit is increased, cash flow is not. In fact, the operating cash flow from LIFO price-layer liquidations is actually reduced as a consequence of the additional income taxes that must be paid on the phantom profits generated by sales.
Managing a company’s investment in inventories
When a company holds large quantities of inventory to service its customer needs, the company is required to invest its cash not only to purchase and/or manufacture the inventory, but also for warehousing and insurance on the inventory.
Days Payable Period
Customers look to the credit provided by their suppliers as a source of interest free financing for their own operation.Days Payable Period = 365 / Cost of goods sold / Accounts PayableThis ratio indicates the average number of days that a company normally takes to pay its out-standing accounts payable.
Myth or Truth
1) Only Cash flows mater, so it is all right to ignore net income
2) Only Accountants need to understand financial accounting
3) Financial accounting is intended to be useful in decision making
4) The accounting rule making process is seldom if ever influenced by politics
5) Financial accounting is intended to be useful for external users whereas managerial accounting is intended to be useful for internal users
6) The financial statements are inter-dependent and not each fully independent of the other statements
7) A certain amount of flexibility exists within GAAP rather than GAAP being a rigid set of rules
1) Myth - NI is important because of accrual base accounting because we want to see when costs occurred that help us generate the income and cash flows don’t do that.
2) Myth - If you are an investor trying to figure out stocks to by, loan officer looks at financial accounting, a customer to extend credit looks at financial accounting, going to work for a company
3) Truth - If you are an investor, you need the info you need
4) Myth - Money requires politics
5) Truth - FA is the definition and MA is the definition
6) Truth - If you make a change in one, it changes the other
7) True - Estimates are needed sometimes so there is flexibility and which method you use
