Study Session 6 & 7

Question 1

How can expenses be grouped?

Answer 1

Expenses can be grouped by:

1. The nature of the expense (i.e. group all depreciation costs together)
2. The function of the expense (e.g. group all manufacturing costs together)

Question 2

What are the types of measurement base?

Answer 2

1. Historical Cost
2. Amortized Cost
3. Current Cost
4. Net Realizable Value
5. Present value
6. Fair value

Question 3

What is historical cost

Answer 3

Historical Cost is the amount originally paid for the asset

Question 4

What is amortized cost?

Answer 4

Amortized cost is the historical amount (amount originally paid for the asset), adjusted for depreciation, amortization, depletion, and impairment

Question 5

What is current cost?

Answer 5

The current cost is the amount the firm would have to pay for the same asset

Question 6

What is net realizable value?

Answer 6

The net realizable value is the estimated selling price of the asset in the normal course of business, minus the selling costs

Question 7

What is present value?

Answer 7

The present value is the asset’s expected future cash flows

Question 8

What is the fair value?

Answer 8

The price at which an asset could be sold, or a liability transferred, in an orderly transaction between willing parties

Question 9

Are footnotes in financial statements audited?

Answer 9

Damn straight/yes, footnotes are audited. Pls remember this thnx.

Question 10

What 2 characteristics make financial information useful?

Answer 10

Relevance and faithful representation make financial information useful

Question 11

What 4 characteristics enhance relevance and faithful representation?

Answer 11

Comparability,
Verifiability,
Timeliness,
Understandability

are the 4 characteristics that enhance relevance and faithful representation

Question 12

What is the income statement equation?

Answer 12

The income statement equation is:

Revenue-Expenses = Net income

Question 13

When should revenue be recognized?

Answer 13

Revenue should be recognized when the goods/services are transferred, not necessarily when payment is received, but when the revenue is EARNED!

Question 14

For a non-financial firm, what expenses are considered operating, and which are considered financing?

Answer 14

For a non-financial firm, operating profit is (Revenue - CoGS) –> profit before financing costs, income taxes, and non-operating items. Subtracting interest expense and income taxes from operating profit will give you the bottom line (net inc)

Question 15

What is an expense?

Answer 15

An expense is a decrease in economic benefits during the account period in the form of outflows, or depletions of assets, or incurrence of liabilities, that result in decreases in equity other than those relating to distributions to equity participants

Question 16

What is the matching principle?

Answer 16

Expenses incurred to generate revenue are recognized in the same period as the revenue

Question 17

What’s the formula for straight line depreciation?

Answer 17

(Cost- Residual Value)/Useful Life

Question 18

What’s the formula for double-declining balance depreciation?

Answer 18

(2/useful life)*(cost-accumulated depreciation)

Question 19

What happens if the residual value is 0 and the double declining balance depreciation method is used?

Answer 19

The double declining balance will never fully depreciate the asset, so at some point in the asset’s life, the residual value is used.

Question 20

When is bad debt or warranty expense recognized?

Answer 20

In the period of the sale, in accordance with the matching principle

Question 21

Why would a firm split its stock?

Answer 21

Allows the price of the stock to go down so that the security becomes more liquid, and then it’s easier to trade

Question 22

What is the difference between a simple and a complex capital structure?

Answer 22

A complex capital structure contains potentially dilutive securities, while a simple capital structure contains no potentially dilutive securities

Question 23

Basic EPS formula

Answer 23

             WA common shares outstanding 

WA common shares outstanding

Question 24

How does a stock split or stock dividend affect the EPS calculation?

Answer 24

You need to adjust the number of shares outstanding before the stock split or dividend, but not after. This is because after the stock split the adjustment is inherent in (would be doing it twice)

Question 25

Walk me through the differences between the basic and diluted EPS formulae

Answer 25

If a company has any potentially dilutive securities, it has to report both basic and diluted EPS.

The diluted EPS formula is the basic EPS formula with the following elements added:

• dilutive conv preferred stock –> preferred stock that can be converted to common stock. need to add back in that stock since it can be available to common stockholders. NB you subtract out pref dividends from net inc for basic EPS, but you add back in the pref dividends from convertible stock to account for the increase in net inc available to common stockholders
• dilutive conv debt –> gain back the interest paid on convertible debt notes but lose the tax shield. Again only consider if dilutive
• Warrants or convertible stock options - DO NOT AFFECT THE NUMERATOR but the company needs to create new stocks if those warrants are exercised. Would be exercised if X < AVERAGE market price. You need to use the treasury stock method to add the net increase in shares (number of shares created-number of shares that can be bought back with proceeds from stock exercising)

Question 26

What MUST you do when doing a calculation for diluted EPS?

Answer 26

You need to check if each potentially dilutive security is in fact dilutive before adding it to your calc for diluted EPS

Question 27

What happens if the bond or stock option is antidilutive?

Answer 27

Basic EPS = Diluted EPS if the bond/stock is antidilutive

Question 28

What does a common size income statement do, and why is it important?

Answer 28

Common size income statements express each category on the income statement as a percentage of revenue. This allows for the comparison of income over time (time series) and across firms (cross-sectional)

Question 29

What are the popular margin ratios?

Answer 29

Gross profit margin = gross profit/revenue

net profit margin = net profit / revenue

Question 30

How do transactions that affect net income (and the income statement, by extension) affect stockholders equity?

Answer 30

Since retained earnings (net income - dividends declared) is added to stockholder’s equity, any transaction that affects net income will also affect stockholder’s equity

Question 31

What are the 3 kinds of debt securities a firm can have and how are they reported on the income statement?

Answer 31

1) Trading securities - reported on income statement. Own and intend to sell
2) Held to maturity - not gonna sell. Not reported on Income statement or as OCI
3) Available for sale - not gonna sell, not gonna hold until maturity. Unrealized gains or losses reported as OCI.

Question 32

What transactions does OCI include that are not included in net inc?

Answer 32

1) Foreign currency G&L
2) Adjustments for min pension liability
3) Unrealized G&L on available for sale
4) Unrealized G&L on cash flow hedging

Question 33

What is an asset?

Answer 33

Resources controlled as a result of past transactions that are expected to provide future economic benefits

Question 34

What is a liability?

Answer 34

Obligations as a result of past events and which are expected to result in future cash outflow

Question 35

What is shareholder’s equity?

Answer 35

Owners’ residual interest in assets after deducting liabilities

Question 36

When should an item be recognized on the financial statement?

Answer 36

When it is probable and can be reliably measured