Quantitative Finance

Question 1

What are the accounting standard bodies?

Answer 1

1. International Accounting Standards Board
   
   1. accepted in most of the world’s major economies
2. Generally Accepted Accounting Principles
   
   1. U.S. GAAP

Question 2

Double Entry System

Answer 2

When any transaction is entered into an accounting system, there must be at least two accounts affected (there can be more)

assets = liabilities + owner’s equity

As with any equation, a change to one side must be offset by either an equal change in the same direction on the other side, or an opposite and offsetting change on the same side.

Question 3

Debit vs. Credit

EXAMPLE

1. Let’s look at an example. Assume that a hardware store buys a case of hammers from a supplier for $100. This transaction is a purchase of inventory (goods for resale). Inventory goes up while cash goes down by the same amount.

Answer 3

We use the terms debit and credit in double entry accounting, which are Latin for “left side” and “right side.”

Asset or Expense/Loss

1. A debit is an accounting entry that either increases an asset or expense account, or decreases a liability or equity account.

Liabilities, Owner’s Equity, Revenues & Gains, Expenses & Losses

1. A credit is always positioned on the right side of an entry. It increases liability, revenue or equity accounts and decreases asset or expense accounts.

EXAMPLE

1. The accounting entry for this sale would be to debit one account, Inventory, and credit another account, Cash.
2. A debit to an asset account (inventory) produces an increase on the asset side of the accounting equation. A credit to an asset account (cash) produces a decrease on the asset side of the accounting equation.

Question 4

Accrual accounting says…

Matching Principle

Answer 4

1. The general definition of accrual accounting says that revenues are recorded when earned, regardless of when cash is collected.
2. Likewise, expenses are recorded when incurred, regardless of when they are paid.

Matching principle. The matching principle requires revenues to be matched or recorded with the expenses related to generating those revenues. If revenues and expenses are not properly matched within the same accounting period, it is difficult to identify which products or services are profitable and which ones are not.

1. Some expenses cannot be specifically identified with particular revenues. These should simply be recorded in the period they are incurred. One example might be the utility bill for office space.

Question 5

Assume that a firm has an accounts receivable balance of $1,000. This means that the firm has sold $1,000 in products but has not yet collected the cash. As the firm collects cash from its credit sales, the collections will be recorded as

Credit…?

Debit…?

Answer 5

Debit (increase) cash

Credit (decrease) accounts receivable

Question 6

Balance Sheet?

Answer 6

The balance sheet shows the company’s resources at a point in time, as well as claims to those resources

1. Claims can be categorized as liabilities (lenders’ and creditors’ claims) and equity (owners’ claims). The balance sheet is also referred to as the statement of financial position.

Question 7

Current Assets and Liabilities

Answer 7

Current assets and liabilities are those that will be converted to cash, used up, or satisfied (in the case of liabilities) within one year or within the operating cycle, whichever is longer.

They are typically listed in decreasing order of liquidity. Those that are most liquid, at the top, will be converted to cash or used up sooner than those below them. Classifying the balance sheet in such a way allows users of financial information to quickly determine the firm’s overall level of liquidity

Question 8

Working Capital

Answer 8

The difference between current assets and current liabilities is called working capital (or sometimes net working capital).

Who does this interest the most?

1. Short-Term Creditors

Why?

1. measure of the firm’s ability ro meet current obligations

Danger in relying on working capital?

1. Current assets consisting of obsolete inventory or uncollectible receivables would present a deceiving picture of the firm’s short-term liquidity

Question 9

Marketable Securities

Answer 9

Securities owned by the firm are classified as available for trading, available for sale, or held to maturity. Their classification will determine whether they are shown on the balance sheet at current market value or historical cost.

Question 10

Inventory

Answer 10

Goods purchased or produced for resale. Inventory is carried on the balance sheet at the lower of cost or realizable value.

Question 11

Deferred Tax Assets

Answer 11

Deferred tax items result from timing differences between financial accounting and tax accounting. A deferred tax asset is created when these differences cause taxes due (on the company’s tax form) to be greater than income tax expense (on the company’s income statement).

The situation can happen when a business overpaid taxes or paid taxes in advance on its balance sheet.

Question 12

Pre-Paid Expenses

Answer 12

Prepaid expenses. Prepaid expenses are accruals that result when the firm pays in advance for items such as rent, insurance premiums, subscriptions, or fees. Prepaid expenses are an asset because they will bring a future benefit.

Question 13

Long Term Fixed Assets?

Answer 13

Long-term fixed assets. Long-term fixed assets are commonly referred to as property, plant, & equipment, and are carried on the balance sheet at a net book value.

• Land is typically valued at its historical cost.
• Plant represents the buildings that house the firm’s production or selling activities. Plant is typically valued at historical cost less accumulated depreciation. Depreciation is an expense the firm recognizes in each period to reflect the fact that plant and equipment wear out over time.

Question 14

1. Contributed (paid-in-capital)
2. Other Paid-in-capital
3. Common stock
4. Retained Earnings

Answer 14

1. Contributed capital (paid-in-capital) is the amount of the stockholders’ investment in the firm’s equity securities.
2. Other paid-in-capital is the excess of the shareholders’ investment over the stock’s par value.
3. Common stock is the portion of stockholders’ investment valued at par or stated value.
4. Retained earnings is the total net income less the amount distributed to the owners as dividends from the beginning of business. Retained earnings do not represent ready cash; rather, they represent earnings that the firm has reinvested in its business (for example, by buying plant and equipment).

Question 15

Balance Sheet and Income Statement

Answer 15

Income Statement = Time Period

1. The income statement allows the user of financial information to see the results of a company’s day-to-day operations for the entire year

Balance Sheet = Snapshot

Question 16

Income Statement Revenues

Answer 16

Revenues primarily include sales of goods and services, but may also include items such as interest and dividend income or rental income. Gains are created when companies sell assets (buildings, equipment, investments, etc.) for more than their book value.

Question 17

Income Statement Expenses for goods producing companies vs. service producing companies

Answer 17

Expenses represent use of resources.

1. One of the greatest uses stems from the purchase or production of goods for resale. As the costs of producing inventory are incurred, they are recorded in the balance sheet as inventory for as long as the company owns the asset. Once the asset is sold, however, its cost is removed from the balance sheet and sent to the income statement as an expense, cost of goods sold. Subtracting cost of goods sold from revenue results in gross profit. This provides information about the company’s primary source of profit—selling goods.
2. Companies that sell services do not have an account called cost of goods sold; all costs incurred for selling services are expensed as incurred.

Question 18

Depcriation

Answer 18

Depreciation is an expense firms recognize over an asset’s useful life that represents its decline in value through use or age.

Question 20

Non-recurring items vs. Unusual/infrequent Items

Answer 20

Non-recurring items are income (or losses) from outside the company’s normal business operations and caused by events or transactions that do not typically occur. How these appear on the income statement depends on the nature of the items

Unusual or infrequent items are events that are either unusual in nature or infrequent in occurrence, but not both. Some examples of unusual or infrequent items are gains or losses from the sale of assets; impairments; and restructuring costs. Unusual or infrequent items are included in income before taxes.

Extraordinary items are events that are both unusual and infrequent. Examples of these include losses from an expropriation of assets or uninsured losses from natural disasters. Under U.S. GAAP, extraordinary items are reported separately in the income statement, net of tax, similar to discontinued operations. IFRS, however, does not allow items to be treated as extraordinary

Question 21

Discontinued Operation