Module 2

Question 1

Balance Sheet & the Flow of Costs: When a cost creates an immediate benefit (such as gasoline in delivery vehicles), where does the company record the cost?

Answer 1

Inthe income statement as an expense

Question 2

Balance Sheet & the Flow of Costs: When a cost creates a future economic benefit (such as inventory to be resold or equipment to be later used for manufacturing), where does the company record the cost?

Answer 2

Cost is capitalized, i.e., adds it to the balancesheet as an asset

An asset remains on the balance sheet until it’s used up (and when it’s used up, the asset’s cost is transferred from the balance sheet to the income statement, where it is recognized as an expense)

Question 3

The balance sheet lists assets in order of decreasing _________

Answer 3

liquidity

Question 4

What is liquidity?

Answer 4

The ability / ease of converting noncash assets into cash

Question 5

What are the most liquid assets called?

Answer 5

Current assets

Question 6

When does a company expect to convert its current assets into cash or use those assets in operations?

Answer 6

Within the next operating cycle or fiscal year

Question 7

What are some typical examples of current assets?

Answer 7

• Cash: currency, bank deposits, and investments with an original maturity of 90 days or less (called cash equivalents)
• Short-term investments: marketable securities & other investmentsthe company expects to dispose of in the short run
• Inventories: goods purchased for sale to customers
• Prepaid expenses: costs paid in advance for rent, insurance, advertising, and other expenses

Question 8

Why would a company not necessarily want to have excessive current assets?

Answer 8

Current assets such as receivables and inventories are expensive to hold and typically generate relatively low returns.

Companies seek to maintain just enough current assets to cover liquidity needs, but not so much as to unnecessarily reduce income

Question 9

What are some examples of long-term/noncurrent assets?

Answer 9

• Property, plant, & equipment (PPE), net: land, factory buildings, warehouses, machinery, office buildings,motor vehicles, office equipment, and other items used in operating activities (“net” refers to the subtraction of accumulated depreciation, the portion of the assets’ cost that has been expensed)
• Long-term investments: investments the company does not intend to sell within the next fiscal year
• Intangible and other assets: assets without physical substance, including patents, trademarks, franchise rights, goodwill, and other costs incurred that provide future benefits

Question 10

At what cost are assets reported?

Answer 10

Historical cost (their original acquisition costs)

Question 11

Why are assets reported at historical cost and not market value?

Answer 11

ACTUAL selling price can’t be measured reliably (it’s only an expectation)

Question 12

When are intangible assets listed on thebalance sheet?

Answer 12

Only when assets are purchased. Any internally created intangible assets are not reported on the balance sheet.

Question 13

What are some examples of knowledge-based intangible assets?

Answer 13

a strong management team, a well-designed supply chain, and superior technology

Question 14

Why do companies obtain capital from both borrowed funds and stockholders?

Answer 14

• Creditors have first claim on assets, therefore their position is not as risky and the expected return on investment is less than that required by shareholders (interest is tax-deductible). Debt is a less expensive source of capital by than equity.
• Companies don’t entirely borrow because they have to pay it back. If a company can’t make payments, creditors can force a company into bankruptcy and put them out of business. Shareholders can’t require a company to repurchase its stock or even to pay dividends.

Question 15

What are examples of current liabilities?

Answer 15

• Accounts payable
• Accrued liabilities
• Unearned revenues
• Short-term debt
• Current maturities of long-term debt

Question 16

What is (net) working capital?

Answer 16

the difference between current assets & current liabilities

Question 17

Net Working Capital =

Answer 17

= Current Assets - Current Liabilities

Question 18

How much working capital is required to conduct business?

Answer 18

Depends on the company’s operating (or cash) cycle (the time between paying cash for goods and receiving cash from customers)

Question 19

What is the operating (or cash) cycle?

Answer 19

the time between paying cash for goods and receiving cash from customers

Question 20

Why are assets such as inventories or accounts receivable costly to hold?

Answer 20

They tie up cash - a prime objective is to shorten the operating cycle in order to complete as many cycles as possible during the year. Doing so maximizes profit and cash flow

Question 21

To shorten the operating cycle, managers can undertake any or all of what strategies?

Answer 21

• decrease accounts receivable with tighter credit; granting policies and more assertive collection procedures
• reduce inventory levels by improved production systems and management of the depth and breadth of inventory
• increase accounts payable (supplier credit) to minimize the cash invested in inventories

Question 22

What does a negative cash conversion cycle represent?

Answer 22

suggests that a company can invest the cash it receives from sales for X amount of days (the negative value) before making payment to suppliers, thus realizing investment income as well as profit on the sales

Question 23

What are examples of noncurrent liabilities?

Answer 23

• long-term debt: borrowed amounts that are scheduled to be repaid more than 1 year in the future; any portion of long-term debt that is due within 1 year is reclassified as a current liability called current maturities of long-term debt. Long-term debt includes bonds, mortgages, and other long-term loans.
• other long-term liabilities: various obligations, such as pension liability and long-term tax liabilities, that will be settled in greater than 1 year

Question 24

Equity is often referred to as residual interest, meaning:

Answer 24

stockholders have a claim on any assets in excess ofwhat is needed to meet company obligations to lenders

Question 25

What are examples of stockholders’ equity?

Answer 25

• common stock
• additional paid-in capital
• preferred stock
• treasury stock
• retained earnings
• accumulated other comprehensive income or loss

Question 26

What stockholders’ equity is considered contributed capital?

Answer 26

• common stock
• additional paid-in capital
• preferred stock
• treasury stock

Question 27

What stockholders’ equity is considered earned capital?

Answer 27

• retained earnings
• accumulated other comprehensive income or loss

Question 28

What is common stock?

Answer 28

par value received from the original sale of common stock to investors

Question 29

What is additional paid-in capital (APIC)?

Answer 29

amounts received from the original saleofstock to investors in excess of the par value of stock

Question 30

What is preferred stock?

Answer 30

value received from the original sale of preferred stock to investors; preferred stock has fewerownership rights than common stock

Question 31

What is treasury stock?

Answer 31

the amount the company paid to reacquire its common stock from shareholders

Question 32

What are retained earnings?

Answer 32

accumulated net income (profit) that has not been distributed to shareholders as dividends or stock repurchases

Question 33

What is accumulated other comprehensive income or loss?

Answer 33

accumulated changes in asset and liability fair values that are not reported in the income statement

Question 34

What is contributed capital?

Answer 34

the net funding a company received from issuing and reacquiring its shares; that is, funds received from issuing shares less any funds paid to repurpose stock

Question 35

What is earned capital?

Answer 35

primarily includes retained earnings, which is the cumulative net income (loss) that the company has earned but not paid out to stockholders as dividends. Retained earnings also includes the cost of repurchased stock that the company has retired.

Question 36

Retained Earnings =

Answer 36

Beginning Retained Earnings
PLUS Net Income (or - Net Loss)
MINUS Dividends
MINUS Stock Repurchased and Retired
= Ending retained earnings

Question 37

What is book value?

Answer 37

shareholders’ equity is the “value” of the company determined by GAAP

Question 38

What is market value (or market capitalization/market cap)?

Answer 38

computed by multiplying the number of outstanding common shares by the company’s stock price

Question 39

What is the formulaic structure of the income statement?

Answer 39

Revenue
MINUS Cost of Goods Sold
EQUALS Gross Profit
MINUS Operating Expenses
EQUALS Operating Profit
MINUS Nonoperating expenses
PLUS Nonoperating Revenues
MINUS Income Tax Expense
EQUALS Income from Continuing Operations
PLUS/MINUS Discontinued Operations, Net of Tax
EQUALS Net Income

Question 40

What are operating expenses?

Answer 40

The usual and customary costs a company incurs to support its operating activities (i.e., COGS, selling expenses, depreciation expense, R&D expense)

Question 41

What are nonoperating income & expense?

Answer 41

Income and expenses relating to the company’s financing and investing activities, including interest expense, interest and divident income, and gains and losses from the sale of securities

Question 42

Do operating or nonoperating expenses generate value for shareholders?

Answer 42

Operating expenses generate value for shareholders. Investments do earn additional returns, but only at the going market rate and shareholders could invest that themselves. A company holding the investments does not create additional shareholder value.

Question 43

What is the revenue recognition principle?

Answer 43

recognize revenue when a performance obligation is satisfied by transferring to a customer a promised good or service

Question 44

What is expense recognition (matching) principle?

Answer 44

recognizing expenses when incurred

Question 45

What two principles are the foundation of accrual accounting?

Answer 45

revenue recognition principle & expense recognition (matching) principle

Question 46

What is the general approach of accrual accounting?

Answer 46

FIRST, recognize revenues in the time period when the company satisfies the performance obligation ofthe sales contract at the amount expected to be received.

THEN record all expenses incurred to generate those revenues during that same time period (this is called matching expenses to revenues)

Question 47

What are the 2 components of discontinued operations?

Answer 47

1. Net income (loss) from the discontinued segment’s business activities prior to the sale
2. any gain or loss onthe actual sale of the discontinued segment