Module 1: Financial Accounting Flashcards
1
Q
Proprieterships & Partnerships
A
Business is owned by a single owner or partners
Legally NOT separate from owners
Unlimited liability (bank can go after owners)
No taxation of business (owners pay taxes)
2
Q
Corporation
A
Legally separate entity from owners
Limited liability (cannot go after shareholders if default on loans)
Double taxation (both shareholders and business pay taxes)
Shareholders –elect–> Board –appoint–> Management
3
Q
Assumptions of corporations discussed in this course
A
Separate entity (biz and owners are separate)
Unit of Measurement (can agg everything to a common unit – $ –)
Going Concern (company is not going out of biz)
Periodicity (can arbitrarily choose a time period and report financial results)
Materiality (only info useful for decision making is disclosed)
4
Q
Users of financial reports
A
Investors (shareholders)
Creditors (banks)
Gov’t Agencies (SEC)
Company Management (only non-outsiders listed)
Financial Analysts
5
Q
Generally Accepted Accounting Principles (GAAP)
A
Governed by SEC, often delegated rule-making to FASB (made up of reps from public accounting firms, industry, gov’t agencies and academia)
Separate from Tax Accounting (used by IRS)
6
Q
International Financial Reporting Standards (IFRS)
A
At one point considered switching in the US to too much push back
7
Q
Qualities of Financial Statements
A
Understandability Timeliness Full Disclosure Comparability (trends over time and to other companies) Objectivity Decision Relevance
**last two sometimes at odds, accuracy not included by financial statements contain so much estimation and judgement calls
8
Q
3 Required Financial Statements
A
Balance Sheet
Income Statement
Statement of Cash Flow
9
Q
Balance Sheet
A
Measure of financial position at point in time
Snapshot at one moment, what biz has and what it owes
A = L + OE
10
Q
Accounting Equation
A
Assets = Liabilities + Owners Equity
Resources = Sources provided by creditors + Sources provided by owners
Resources = Claims to assets
11
Q
Assets
A
Listed on Balance Sheet
Resources owned or rights to receive resources
- Physical (cash, buildings, inventory, equipment)
- Intangible (copyrights, patents, trademarks)
- Legal Rights (eg rights to receive payments, like Macys sells merch on credit, asset is A/R)
12
Q
Common asset accounts
A
Cash Accounts Receivable, Notes Receivable Inventory Investments Buildings, equipment, land Copyrights, Patents
**presented in order of liquidity (which convert to cash first)
13
Q
Valuation of Assets
A
Historic costs (most OBJECTIVE)
Sales value (most DECISION RELEVANT)
Replacement cost
General price level costs (adj for inflation)
**historic costs are the only ones that do not involve judgement or estimation
14
Q
COST PRINCIPLE
A
On BALANCE SHEET assets are usually evaluated at historic cost
Long ago regulators decided OBJECTIVITY is most important
15
Q
Liabilities
A
obligations owed to creditors (money, goods/services)
16
Q
Common Liability accounts
A
Accounts payable Notes payable Interest payable Accrued salaries/wages Deferred/unearned revenues (when paid in advance of providing goods or services)
17
Q
Classified Balance Sheets
A
Distinguish between current and long term assets/liabilities
Current assets/liabilities: conversion to cash or due within 1 year
Long-term assets/liabilities: conversion or due > 1 year
18
Q
Stockholders Equity
A
OE for corporations
Capital stock (what the company received when selling shares)
Retained earnings (accumulated earnings since inception less dividends paid out)
19
Q
Dividends
A
A distribution of earnings, only occurs when board decides to (not required to)
20
Q
Statement of Retained Earnings
A
Beginning Retained Earnings \+ Net Income - Dividends -------------------------------------------- = Ending Retained Earnings
21
Q
Statement of Stockholders Equity
A
Beginning Stockholders Equity \+ Net Income - Dividends \+ Issuance of Capital Stock ------------------------------------------------ = Ending Shareholders Equity
22
Q
Different types of accounting
A
Cash Basis Accounting
Accrual Basis Accounting
23
Q
Cash Basis Accounting
A
Revenues or expenses are recognized only when cash is received or paid out
24
Q
Accrual Basis Accounting
A
Revenue Recognition Principle: revenue is recognized when earned (as soon as goods are delivered or services are performed)
Earning process is considered complete even if cash is not collected
Used by GAAP
Matching principle
25
Matching Principle
costs are reported as expenses in SAME time period as related revenues
costs that cannot be matched w specific revenues are spread over time periods that benefit
If macys buys good in December 2019 but sells them in January 2020 the expense is recognized in January (same period revenues occur)
2 year insurance policy for 10k beginning of 2019, MP says spread cost as expense over 2 years with 5k in 2019 and 5k in 2020
26
Income Statement
Shows results of a companies OPERATIONS (ie successes or failures) OVER A TIME PERIOD (min 1 year)
Not point in time like Balance Sheet
Fiscal year is whatever 12 month period chosen by company (sometimes 52 weeks sometimes 53)
27
Single Step Income Statement
Revenues Earned
- Expenses Incurred
------------------------------
= Net Income
**lists ALL revenue and expenses using accrual basis accounting & MP
Typically starts with Net Sales
28
Gross Margin
Net Sales
- Cost of Goods Sold
--------------------------------
Gross Margin
29
Earnings Per Share
On Income Statement
Dividends paid is not used as an expense to calculate earnings bc it is a distribution of earnings
Net Income (or Loss) / # Share of Stock
Fully diluted EPS includes all potential stock (eg Stock Options) in the denominator (will always be equal to or less than standard EPS)
30
Statement of Cash Flows
How did the company receive and use cash
Important bc when using accrual basis accounting there is no focus on cash in the Income Statement
Reports the amount of cash collected and paid out by a company in OPERATING, FINANCING, and INVESTING activities
```
+/- Operating Cash
+/- Investing Cash
+/- Financing Cash
-----------------------------
= change in cash from beginning of PERIOD to end of PERIOD
```
31
Operating Activities
Cash flow related to day-to-day activities
Considered most important section
Cash inflow - cash receipts from selling goods or providing services
Cash outflow - payments to purchase inventory and to pay operating expenses
32
Direct vs. Indirect Methods for Stating Cash Flow
Direct: explicitly state where cash came from and went (hard)
Indirect: starts w/ net income from income statement and makes adjustments to get cash flow from operating activities (much simpler, most common in US, not allowed by IFRS
33
Investing Activities
Buying/Selling LONG-TERM assets (land, buildings, equipment, etc)
34
Financing Activities
Focus: liabilities and stockholder equity items
Cash obtained from or repaid to owners & creditors (loans made or received, repayments of laons, stock issuance)
35
Enron
reported an item in the operating section that should have been reported in the investing section to make operating cash flows look better
said to be their biggest violation of GAAP among many
36
Notes to Financial Statements
Summary of significant accounting policies & assumptions, estimates, and judgements
37
Audits
Issuedby INDEPENDENT CPA firms
attest to whether financial statements are aligned with GAAP (not to the accuracy bc so much of the statements involve judgement and estimation)
38
Audit opinions
- Unqualified (clean)
- Modified (auditor objects to something)
- Adverse (a publicly held company will be delisted, this is really bad and no one wants this)
**financial statements are the responsibility of the company's management NOT the CPA
39
Sarbanes-Oxley Act of 2002
Opinions on Internal Controls
SOX
40
"Financial position"
refers to the balance sheet
41
"Results of Operation"
refers to the Income Statement
42
"Cash Flows"
Found on the cash flow statement
43
Cash
First Item on Balance Sheet
Anything a bank will accept for deposit
Checks
Money Orders
BANK credit slips (eg Mastercard/Visa etc -- not Macys card, which is an A/R)
Cash Equivalents (anything that can be converted w/i 3 mos., eg securities w. maturities of 3 mos or less)
44
Accounts Receivable
Second Item on Balance Sheet
45
bad debt expense
once sale is made it is final, cannot undo it from reports so we record BAD DEBT EXPENSE on the INCOME STATEMENT per the matching principle
Does not carry over from one year to the next
46
Contra Asset Account
When you take a deduction from an account to get the net amount
47
Allowance for bad debts
Estimate Losses using one of 2 estimation methods
"Contra Asset" Account
A/R (net) = A/R - Allowance for Bad Debts
Allowance Account (unlike bad debt expense) is a BALANCE SHEET ACCOUNT --> does carry over from one year to next (amnt at end of one year becomes balance at beginning of next year)
48
Percentage of Credit Sales Method
simply take a percentage of all credit sales and add to allowance for bad debts account
Ex: Bad debt expense = 2% of $500k in credit sales = $10k
--> list $10k on income statement as bad debt expense and add to running allowance on BS
Cons: does not consider anything about A/R of what is already in bad debts
49
Percentage of Receivables Method
New Allowance for Bad Debts = % of Ending Balance in A/R
Bad Debt Expense = New Allowance for BD - Previous Allowance for B/D
50
Aging of Receivables
Prev Allowance for BD: $1.8k
End balance in A/R: $100k
<30 days: $62k * 0.01 = $620
31 - 60 days: $15k * 0.03 = $450
61 - 120 days: $20k * 0.07 = $1.4k
> 120 days: $3k * 0.2 = $600
New Allowance for BD = 620 + 450 + 1400 + 600 = 3070
Bad Debt Expense = 3070 - 1800 = 1270
--> recorded on Income Statement & added to allowance account on BS
51
Notes Receivable
Formal contracts signed when a customer buys merch or services on credit
Specific due dates for the payments, interest that must be paid, interest RATES
CURRENT if due w/i one year
52
Principal (N/R)
Face Amount (amnt borrowed)
53
Interest Rate (N/R)
% of principal maker is charged to borrow money
54
Maturity Value
Maturity Value = Principal + Interest
55
Interest
Interest = Principal * Interest Rate * Fraction of Time Corresponding to IR
IR is generally annual so time would be fraction of year
Ex: 5000 * 0.14 * 90/365 = 172.60
56
Selling Notes Receivable
Companies do not always like to wait for due date so sell AR or NR
57
When A/R are sold
Factoring Accounts Receivable
58
When N/R are sold
Discounting Notes Receivable
59
Recourse
Company A sells something in exchange for N/R
Before due, A takes N/R to bank where it is discounted w/ recourse
If B defaults, bank can go after A
When A discounted the note they got a Contingent Liability (does NOT need to be reported on balance sheet & as expense on IS bc NOT LIKELY to occur
BUT
If a contingent liability is likely to occur and is estimatable MUST be recorded as liability on BS and expense on IS)
60
Inventory
Goods either manufactured or purchased for resale
61
Who owns goods in transit
Whoever is responsible for shipping cost
If seller pays for shipping: sale is NOT recorded until shipping is complete
If buyer pays for shipping: sale is recorded at beginning of shipping process
62
Goods on Consignment
Title/ownership remains with vendor unless 100% transferred
Consigner does not record consigned goods on balance sheet
63
Cost of Goods Sold
```
Beginning Inventory
+ Net Purchases
- Ending Inventory (aka cost of goods not sold)
-----------------------------
= Cost of Goods Sold
```
64
Net purchases
```
Purchases
+ Freight-In (if paid for shipping)
- Purchase returns & allowances
- Purchase discounts
----------------------------------------------
= Net Purchases
```
** allowances are deducted for defects etc.
65
Where does inventory used to determine COGS appear
Income Statement
66
Gross Margin
Gross Method vs. Net Method
Gross Method shows higher sales revenue BUT must assume ownership risks, if acts as BROKER between buyer and seller must use NET METHOD
Evaluate controls model, if you act as principle instead of agent can report Gross Method
67
Gross Method
Sales of item cost $150 for $250
sales rev (250)
- cogs (150)
---------------------
= gm (100)
68
Net Method
Sales of item cost $150 for $250
sales rev (100)
69
2 Types of Inventory Systems
Perpetual Inventory System
Periodic Inventory System
70
Perpetual Inventory System
High Value Items
Records updated every time purchase or sale is made
**if note in financial statement reads "we occasionally do physical inventory counts to confirm records" mean company is using perpetual system and confirm w. physical check
Only Method that allows for determination of SHRINKAGE (lost inventory)
71
Periodic Inventory System
Used for Low Value Items
Physical Inventory Count (once per year go check)
records not updated every time purchase is made
Cannot determine SHRINKAGE / SWELLAGE using this method
72
Specific Identification
Can identify which batch a product came from and determine exact cost
Car dealership for example
73
First-In First-Out (FIFO)
Use if BALANCE SHEET Is most important bc wil show HIGHER profits from LOWER cogs
Presumes cost is from first batch
Best measure of ENDING INVENTORY
74
Last-In First-Out
Use if INCOME STATEMENT is most important or for TAX ACCOUNTING (bc shows HIGHER cogs and LOWER profits)
Presumes what is sold first is from latest purchase made
Best reflection of COGS (most up-to-date)
75
Weighted Average
Average cost of all purchases made weighted by number of units
76
LIFO Conformity Rule
If you use LIFO for tax accounting must also use for GAAP financial reporting (as far as inventories are concerned)
**you can use FIFO for tax accounting and LIFE for financial just not other way around
77
Lower of Cost or Net Realizable Value
Inventories are reported at lower of the cost amount or net realizable value
Net Realizable Value: market value less any selling or disposable costs
Justified by Principle of Conservatism
78
Principle of Conservatism
Companies like to report high profits and high assets
due to overstatement concern we have inventory lowered if amount goes below cost
Inventory is reported at less than cost when either future value is in doubt bc of damage, obsolescence, etc OR if can be replaced at new price less than OG cost
79
Prepaid rent
If prepay rent for 2 year record some for first year and some for second
Transferred to expenses over time (when benefits are received)
Due to matching principle not recorded when payment is made but rather spread over periods where we benefit from expense
80
Marketable Secuities
MAJOR exception to the COST principle
short term investments in stocks or bonds --> MARK TO MARKET
bonds reported at cost if intention is to hold to maturity, otherwise MARK TO MARKET
81
Mark to Market
Okay to make exception to cost principle bc objectivity is considered to be included in market numbers
can lower amounts below cost if market is lower but if higher must raise
82
Long-Term Investment Accounting
Depends on % of ownership
83
Ownership > 50% of another companies stock
must CONSOLIDATE financial statements (combine as if one company)
84
Ownership 20% - 50%
must us EQUITY METHOD
do not recognize when they receive the dividends but AS THE EARNINGS OCCUR
"significant influence" voting wise, could potentially affect dividend payouts w/ votes)
85
Ownership < 20%
MARK TO MARKET (same as short term)
86
Example of Ownership 20% - 50%
Under "Basis of Consolidation" section on notes
If sears owned 40% of another companies stock and other company has $100k in profits, search has to report 40% of $100k ($40k) as INCOME from INVESTMENT even if receive 0 dividend payouts
87
2 types of assets
Fixed (Tangible) Assets
Intangible Assets
88
Fixed (Tangible) Assets
Land --> NO DEPRECIATION
Buildings, Equpt, Land Improvements --> DEPRECIATION
Natural Resources --> DEPLETION
89
Intangible Assets
Amortization
90
Depreciation/Depletion/Amoritization
Related to Matching Principle
Process of cost allocation that assigns the cost of the asset to periods benefitted
Includes freight, installation, tests, etc required to prepare equipment for initial use
91
CAPITALIZED INTEREST
Normally when interest is incurred it is recorded as an expense on the income statement BUT this is an exception
Interest is treated as an asset during construction period, turns into an expense when depreciations are taken
capitalization = treating something as an asset instead of an expense
92
Expenditures on existing assets
Ordinary Expenditures: benefit ONLY period in which made (expensed on INCOME STATEMENT)
Capitalized Expenditures: benefit company over several periods (not just current) --> capitalized on BALANCE SHEET, treated as assets, depreciated over period benefitting, usually preferred so profits are maximized
93
Rule guiding capitalization
Must either increase EXPECTED life or asset OR CAPACITY of asset (like a new wing of a building)
94
Lifespan of asset
Intended trumps useful if shorter
95
Straight Line Method of Depreciation
Cost of asset is allocated equally over the periods of estimated life
Annual Amnt = (Cost - Salvage Value) / Useful Life
**majority of public companies use this
96
Units of Output Method of Depreciation
more output produced, more depreciation recorded
97
Accelerated Depreciation
More expense in earlier years
Sum of Year Digits
Double Declining Balance
Reasons:
Assets become obsolete and lost more productivity in earlier years
Assets more productive in earlier years so gen more rev (MP)
Later years likely more repairs and maintenance
98
Balance Sheet Presentation of Depreciation
Equipment
- Accumulated Depreciation
----------------------------------------
Equipment NET (aka Book Value)
**Contra Asset account similar to allowance for bad debts, deduction from related asset account to arrive at net asset account
99
Disposal of Assets
Generally cause either a gain or a loss
IF:
Proceeds > Book Value --> Gain on Sale (like revenues)
Proceeds < Book Value --> Loss on Sale (like an expense)
INCOME STATEMENT
100
Natural Resources
Oil Fields, Copper Mines, ETC
DEPLETION EXPENSE : similar to units of output method of depreciation
101
Intangible Assets: Definite Life
Amoritization over argmin{economic life, legal life}
ex: if patent legal life is 20 years but mgmt deems useful life to be 5 years amoritize over 5 years
102
Intangible Assets: Indefinite Life
NOT AMORITIZED
Tested for IMPAIRMENT on annual basis, compare book value vs. est of future cash flows, if deemed less than future flows asset is deemed impaired and loss is recorded on INCOME STATEMENT
103
Goodwill
Occurs when an entire business unit or company is purchased
Purchase price of business - Fair market value of net assets and liabilities
^ if this is greater than 0 than goodwill is recorded
**result of value of a company’s brand name, solid customer base, good customer relations, good employee relations, and proprietary technology
104
Expense of R&D
Per US GAAP R&D is generally expensed immediately
Bc so much uncertainty about whether benefit will ever come
EXCEPTION: Software R&D
105
Software Development Costs
Special form of R&D, can be capitalized bc economic viability can be determined more accurately and earlier than other R&D
Capitalization begins when TECHNOLOGICAL FEASIBILITY is reached
--------------------------------|-TechFeas-------------------------------|-GenRelease-----------------------|
R&D expensed on IS-|-R&D costs capitalized on BS-----|Costs expensed on IS----------|
Capitalization ends and amoritizations begins once product is available for public
106
Technological feasibility
Sufficiently to a point where mgt believes specs have been reached (eg it will work)
107
Current Liabilities
Debts/Obligations due w/i one year
```
Accounts Payable
Wages Payable
Income Taxes Payable
Accrued Interest
Unearned Revenues (eg gift cards)
```
108
Working Capital
Working Capital = Current Assets - Current Liabilities
109
Contingent Liabilities
Probable and reasonably estimated: record on BALANCE SHEET and INCOME STATEMENT (eg warranty liabilities)
Reasonably possible OR amnt cannot be reasonably estimated: disclosure in Notes (most common: LAWSUITS)
Remote (very small possibility): no need to disclose
110
Example of warrant liability (probable and reasonably estimated)
Product sold in 2019, 2year warranty, warranty claim made for defect in 2020:
revenue was recorded in 2019 WHEN SALE MADE company also records ESTIMATED warranty liability AS WELL AS expense on Income STatement
111
LONG-TERM LIABILITIES
Not due within one year
Transferred to current liability states year before due ("current maturities of long term debt and commercial paper")
112
Time Value of Money
Considered in measurement and recording of long term liabilities
Dollar in future is < dollar now
113
Present value of liability
Future amounts are discounted to obtain future value
114
Operating Lease
Simple, short-term rental agreement
115
Capital Lease
Asset & Liability are recorded at PRESENT VALUE of future payments (eg treated as a purchase)
criteria: lease term > 1 year
Leases sometimes preferred by companies bc don't have to claim liabilities (was a loophole before)
116
Deferred Taxes
Results from TIMING differences between taxable income on Income Statement and taxable income for IRS
NOT referring to perm differences, like interest on municipal bonds for example, which is treated as revenue on IS but not on IRS statement; some companies will use straight line depreciation for IS and accelerated for IRS
117
Bonds Payable
Type of liability
Debt instruments sold to public and publicly traded (must repay principle and interest)
118
Face Value
amount to pay when bond MATURES (not necessarily selling price of bond)
aka: "par value"
selling price determined by stated rate and market rate
stated interest rate < mkt rate --> DISCOUNT
stated interest rate > mkt rate --> PREMIUM
119
Debentures
Unsecured bonds (lack collateral)
120
Balance sheet presentation of DISCOUNT
Bonds Payable (face amnt)
- discount on BP
--------------------------
= Bonds payable (net) (carrying value)
$100k
- $3k
-----------
= $97k
121
Balance sheet presentation of PREMIUM
Bonds payable (fact amnt)
+ premium on BP
--------------------------
= Bonds payable (net) (carrying value)
$100k
+ $4k
----------
= $104k
122
Convertible bonds
can be converted to stocks
123
Callable bonds
Company issuing bonds can require you redeem before maturity (would do this if paying 5% interest rate but rate drops to 2%, calling in the bond allows them to issue new bonds paying only 2%)
gain or loss on early retirement
cash paid > carrying value: LOSS on retirement
cash paid < carrying value: GAIN on retirement
^ recorded on INCOME STATEMENT
124
2 things company can use to raise money from public
Borrowing in form of bonds or issuing shares of stocks
125
Pros/Cons of Bonds
Cons:
Must repay bonds
Must pay interest
Interest reduces net income bc reported as expense
Pros:
No dilution of ownership
126
Pros/Cons of Stocks for Borrowing
Pros:
No repayment of stock
Need not pay dividends (but can)
Dividends do not reduce net income (not reported as expenses)
Cons:
Dilutes ownership
127
Paid-in-capital
accounts involving capital stock
stockholders equity = PIC + retained earnings
128
Authorized shares
Authorized = # Issues + # Unissued
129
Issued Shares of stock
Issued = # Outstanding + # Treasury
Outstanding: still in hands of stockholders (have voting rights, receive dividends etc)
Treasury: shares company bought back
130
Preferred stock
Dashes on balance sheet mean authorized but not yet issued
Get dividends first
If company liquidates creditors get paid first, then preferred stockholders, then common
131
Common stock
hold main voting rights (true owners)
decide on board of directors
can be split into classes where some classes have diff number of votes per share
132
Par (stated) value
nominal value assigned to and printed on face of each share of stock
nothing to do w market value
company cannot issue stock below par value
dividends cannot be paid from, this is for creditors
generally VERY low
133
Treasury Stock
when company buys back from shareholders
CONTRA-Equity account (not an asset but deduction)
can increase EPS by buying back shares
purchase of treasury stock is recorded at cost
NO gain or loss reported on sales of treasury stocks
134
Retuned earnings
Cash dividends decrease retained earnings
date of declaration --> liabilitiy : when board votes to pay dividends div payment becomes liabilitiy
date of record --> who gets dividends is whoever owns on this date
date of payment
135
Current dividend preference
preferred shareholders get dividend rate % of total par
common get remainder
136
Ex of current dividend payout
Company has 10,000 shares of 5% p. stock, $10 par value
current dividend preference = 0.05 * 10,000 * 10 = 5000
--> if company declares $4.8k dividends, preferred shareholders get it all (common none)
--> if declares $5,500 preferred gets $5,000, common gets $500
137
Cumulative dividend preference
preferred stockholders get current div pref PLUS dividends in arrears (missed from past years)
Company has 10,000 shares of 5% p. stock, $10 par value, no dividends for past 3 years
cumulative dividend preference = 4 * 5000 = 20,000
if company declared $18k in dividends, pref gets all and 2k remains in arrears
if declared $25k, common gets $5k
138
Dividends in Arrears
Do not represent actual liabilities -> NOT recorded
reported in notes
139
Stock dividends
distribution of additional stock in proportion to current holdings
why? don't have cash , would rather use cash elsewhere, accounting
--> ALLOWS transfer from RETAINED EARNINGS to PAID IN CAPITAL
Effects: Increases # of shares outstanding
Transfers retained earnings to PIC
No effect on :
Assets
Total Stockholders Equity
% ownership of stock by shareholders
140
Stock splits
Increases # of net shares
Decreases par value per share
No affect on accounts
Why?
To reduce market value per share of stock (more affordable)
141
Reverse stock split
Decreases number of shares
Increase par value per share (no efffect on accounts)
Why?
some stock exchanges have min trading prices for stocks
as do some institutional investors (eg pension funds)
142
Noncontrolling Interests
Portion of owners equity not controlled by parent company
| Reported in stockholders equity section
143
Stock based compensation
Must report as expenses on income statement
