Week #2 Flashcards
Convertible bonds
Bonds that may be convertible into shares of stock at the option of the bondholder. This feature is not common, but sometimes you do see that with bonds.
Callable Bonds
This is where the company that issues the bonds has the option to require that the bonds be redeemed before the maturity date. The reason this happens is because the company, let’s say, is paying 5% interest on those bonds and suppose that the interest rates have gone down to 2%. By calling in those bonds, they can then issue new bonds and only have to pay 2% interest instead of 5%. At any rate, when bonds are called-in, there’s usually a gain or a loss on this early retirement.
Gain/Loss of Retirement (what does it refer to?)
Refers to what happens to a Callable Bond:
If the cash that’s paid to the bondholders is more than the carrying value of the bonds, then a Loss on Retirement is recorded, whereas if the cash paid to the bondholders is less than the carrying value of the bonds, then a Gain on Retirement is recorded. These gains or losses appear on the income statement, the gains increasing the net income, the losses decreasing the net income.
Name four key differences between Bonds and Capital Stock
1) bonds must be repaid to the bondholders
2) bonds need to pay interest to the bondholders
3) interest is reported as an expense and therefore reduces net income (stocks: dividends are not expenses, they’re merely distributions of earnings. They do not reduce net income)
4) no dilution of ownership for bonds (new bonds issues won’t affect the percentage of ownership of company)
Stock: If a stockholder owns 1% of the company and the company issues additional shares of stock and that stockholder doesn’t buy any, then that stockholder will subsequently own less than the 1% that he had before, so there’s a dilution.
Why would one want Preferred stock over Common stock and vice versa?
Preferred stock holders get paid dividends and liquidation before common stockholders (in liquidation creditors get paid first)
Common stock holders have voting rights and thus true owners
What is a par value (aka stated value) of capital stock?
nominal value assigned to and printed on the face of each share of corporation’s stock. It is NOT tied to the market vlaue
Where does the amount above par value of a stock go on a balance sheet?
Paid-in capital aka Additional Paid in Capital (see page 39)
How can a company increase earnings per share?
Recall that earnings per share is the net income divided by the number of shares outstanding. One way of increasing earnings per share is to increase net income. The other way is to reduce the number of shares outstanding. That is, reduce the denominator by buying back shares of stock from shareholders.
What is treasury stock, and is it an asset?
No. buying back shares of the company’s own stock is not considered an asset. Instead, it’s a deduction in the stockholders’ equity section of the balance sheet and therefore it’s called a contra-equity account
What is contra-equity?
it’s a deduction in the stockholders’ equity section of the balance sheet. It is not an asset. It refers to stock buy back (treasury stock)
What happens when treasury stock is reissued
the FASB does not want companies affecting their net income by engaging in transactions involving their own stock, so no gain or loss is recognized when treasury shares are reissued.
Contrary to ASSETS: when a company sells assets, as we’ve seen in an earlier session, there very often have a gain or a loss reported on the income statement.
What is the Date of Declaration, Date of Record, and Date of Payment
relates to cash dividends
There are three important dates to discuss in relation to cash dividends. The first is the date of declaration. That’s when the board of directors votes to pay dividends, and it is at that time that the dividend payment becomes a liability of the corporation, and so it’s on that date that the liability for dividends would appear on the company’s balance sheet. Let’s skip over to the third date, which is the date of payment. That’s when the cash dividends are actually paid out by the company. The middle date, called the date of record, just indicates who is to receive the dividends. So for example, if a company declared dividends on October first, and they paid the dividends on November first, then the question becomes what happens if there is a sale of shares of stock, between October first and November first – who gets the dividends? The date of record, which is established by the board of directors on the date of declaration, determines who receives the dividends. So, for my example, suppose the date of record was established as October 20th. So, whoever owns the stock on October 20th is the one that receives dividends, and everybody knows this, so that’ll be reflected in the price of the stock if it is sold between the declaration date and the payment date.
Explain Current Dividend Preference vs Cumulative Dividend Preference
Current Dividend Preference; This is where the preferred stockholders get a percentage of total par, that percentage being called dividend rate, and then the common stockholders get the remainder of whatever has been declared. So as an example, suppose a company has 10,000 shares of 5% preferred stock, the 5% being the dividend rate, having a par value of $10 per share. We calculate the current dividend preference by taking 5% of 10,000 times $10 – 10,000 times $10 would be $100,000 – that is the total par – and 5% of that would be $5,000. So if the company declared dividends in the amount of $4,800, the preferred shareholders would get it all, and the common shareholders would get nothing. If the company declared dividends of $5,500, the preferred shareholders would get 5,000, and the common shareholders would get the remaining $500. Suppose a company were to declare $1,000,000 in dividends. The preferred shareholders would get only $5,000, and the common shareholders would get the remaining $995,000.
Cumulative Dividend Preference:
This is where the preferred stockholders get the current dividend preference, plus they also get any dividends in arrears. Arrears refers to the missed dividends from past years,. Common shareholders get the remainder
example) 4 times $5,000 would be $20,000 – this is the amount of cumulative dividend preference. Suppose the company declared dividends in the amount of $18,000. The preferred shareholders would get it all, and then $2,000 would remain in arrears.
What are dividends in arrears? How do they appear in the balance sheet?
Arrears refers to the missed dividends from past years, the dividends that they would’ve gotten had the company declared dividends in the amount of the dividend rate.
they do not represent actual liabilities and thus they’re not recorded in the accounts and they’re not put on the balance sheet. The reason for this is that the company really never has to declare dividends, they never have to pay dividends, and so therefore these dividends in arrears, while they’re likely to be paid in the future, there’s no legal obligation to do so, and therefore, there’s no actual liability. However, the amount of dividends in arrears does need to be disclosed in the notes to the financial statements.
What is a stock dividend? Why do companies do it?
Not cash dividend. Stock dividends are distributions of additional stock in proportion to the shareholder’s current holdings.
So, for example, if a company declared a 10% stock dividend and a shareholder currently has 100 shares to stock, then the shareholder would receive an additional 10 shares.
Why do companies give stocks instead of cash?
- not have enough cash
- used cash for investments
What are the effects of Stock Dividends? What do they not effect?
page 44 Week 2
they increase the number of shares outstanding and secondly, they transfer retained earnings to paid-in capital. Note that the total stockholders’ equity’s not changing. Stock dividends have no effect on assets. They also have no effect on the percentage ownership of stock by the shareholders.
What are Stock Splits?
These are designed to increase the number of shares of stock and reduce the par value per share, so that there will be no effect on the accounts, specifically no effect on the common stock or the preferred stock account that appears on the balance sheet.
total amount of paid-in capital would stay the same.
Nividia - make it easier for everyday person to buy the stock
What are reverse stock splits?
This decreases the number of shares of stock and increases the par value per share.
Why?
if a company’s stock price is projected to be going below a dollar, to avoid being de-listed, they might do a reverse stock split to prop up the market value per share
Meet minimum pension fund rules
Non-controlling interests and where does it appear?
appears in Stock Holder Equity Balance Sheet
when a company owns more than 50% of another company. The non-controlling interest would be, in these consolidated balance sheets, the portion of owners’ equity that’s not controlled by the parent.
Stock-Based Compensation, where does it appear?
Nowadays, however, stock-based compensation must be expensed, much to the chagrin of many companies
What are accounts receivable (A/R) How is it different from accounts payable?
How to deal with bad debt expense?
Matching principle
allowance methods. This is where we estimate losses. These estimates require consideration of historical loss experience, adjusted for current conditions, trends in customer payment frequency, and judgments
Accounts Receivable
A/R (net) = AR - Allowance for bad debts
What are Contra-asset accounts?
1) Allowance for bad debts
This allowance for bad debts is referred to as a contra-asset account because it is a deduction from the asset, accounts receivable, to get the net amount of accounts receivable
A/R (net) = AR - Allowance for bad debts
How do you estimate bad debt expense and the allowance amount? Name two methods
1) Percentage of Credit Sales Method (simply by taking a percentage of credit sales, typically based on the company’s past history. does not consider anything about accounts receivable or what’s already in the allowance for bad debt accounts.)
2) Percentage of Receivables Method
= New Allowance for Bad Debts minus Percentage(s) of ending balance in A/R
Does bad debt expense carry over to the next year?
No. bad debt expense is an account that appears on the income statement, so it does not carry over from one year to the next.
The allowance account is a balance sheet account, and as such, it does carry over from one year to the next.
What are notes receivable? Where are they on the balance sheet?
formal contracts
These contracts will specify due dates for the payments, they’ll specify interest that must be paid, the interest rates and these are classified as current or long term depending on the due date.
Difference between notes receivable and accounts receivable
Notes receivable and accounts receivable are both assets representing amounts owed to a creditor. However, notes receivable are based on formal, interest-bearing promissory notes while accounts receivable are informal amounts owed by customers in the normal course of business: Debtors repay accounts receivable according to the invoice’s billing terms and don’t incur interest charges when paid on time.
Accounts receivable are current assets because they usually have a single, short-term due date, such as 30 or 60 days from invoice date. Notes receivable usually have longer terms, with payments made over regular intervals during the note’s term or in full at the maturity date. Notes receivable can be classified as current or long-term assets or both: Amounts due within 12 months are classified as short-term and any amounts beyond that are classified as long-term.
How do you calculate interest rate ( for notes recievable)
Interest = Principal * Interest Rate * Time (usually out of a year)
What is Maturity value (for notes recievable)
The Maturity Value refers to the Principal plus the interest
What are Factoring Accounts Receivable?
selling accounts receivables to someone else like a bank. Company A gets contingent liability (it AR from Company B defaults, then bank can come after Company A)
What are Discounting Notes Receivable?
selling notes receivables earlier to someone else like a bank
Contingent liability
Comes with recourse
does NOT have to be financial statements because its potential liability not actual libality
What is inventory?
Inventory refers to merchandise that is either manufactured or purchased for resale.
Goods in Transit (Inventory)
whoever is responsible to pay for the shipping records the inventory on its balance sheet (can either be Company A or Company B)
Goods on Consignment (Inventory)
Sometimes rather than selling merchandise to another company, a company will give those goods on consignment telling them that if they don’t sell the merchandise, they can return it to them or if they do sell the merchandise, they can keep a certain percentage, perhaps 10% and just return 90% to the seller.
Cost of Goods Sold (CGS)
Appears on the income statement
Beginning inventory cost
+ Net purchases
- Ending Inventory (cost of goods that were NOT sold)
=Cost of goods sold
Net purchases
Part of the Cost of Goods sold formula
Purchase (cost)
+ freight-in (transportation cost)
- Purchase returns & allowances (allowance is 30% discount if its a defect)
-Purchase discounts
=Net purchases
Perpetual vs Periodic Inventory Systems
Gross Method vs Net Method for Cost of goods sold
the gross method will show higher sales revenue and many financial statement users like to focus on sales revenue and sales growth
However, in order to use the gross method, the company really has to assume ownership risks. So if a company just acts as a broker to enact a transaction between a buyer and the seller, they must use the net method.
Gross Margin
Sales
- Cost of goods sold (whats the formula?)
= Gross Margin
Pros and Cons for FIFO vs LIFO
LIFO is a better reflection of cost of goods sold
- better measure of income
most up-to-date cost of goods
FIFO is a better measure of ending inventory
better measure for balance sheet
(you sell oldest merchandise first, left with the most recent recent merchandise
When prices are increasing,
FIFO has lower cost of goods sold
LIFO has higher cost of goods sold
LIFO conformity rule
Applies to INVENTORIES
If you use LIFO for income tax purposes, you must also use LIFO for financial reporting
because companies are incentivized to use LIFO (high cost of goods, lower profits) for tax purposes but FIFO (shows higher profits) for financial reporting purposes
Lower Cost (or Net Realizable Value NRV)
major exception to the cost principle.
Recall that the cost principle said that assets on the balance sheet need to be reported at their historical cost. For inventories though, we have a rule called lower of cost or net realizable value. Inventories will be reported at the lower of the cost amount or the net realizable value, which is essentially a market value less any selling or disposal costs. The justification for this rule is referred to as the principle of conservatism.
we will never report it above the cost.
Prepaid Expenses (examples?)
Prepaid rent
Prepaid insurance
Follows the mathcing principal, we do not record these as expenses when the payment is made. It’s spreadout over a period
Marketable securities. What are they?
short term investments in stocks or bonds
For marketable securities, there is a major exception to the cost principle, which is the principle that states assets should be reported on the balance sheet at cost. We’ve already talked about one exception, for inventories, referred to as a lower of cost or NRV rule. For marketable securities, we even have a more major exception. It’s called mark to market. This means that investment in stocks will be reported at their market values. Bonds, on the other hand, are reported at cost if the intention is to hold them to maturity. If not, then they are marked to market like stocks.
What’s mark to market?
that investment in stocks will be reported at their market values
example)
In the right-hand column, it has the estimated fair value, which totals an amount that’s less, $810 million, an amount less by $3 million. It is this lesser amount, this $810 million estimated fair value that is reported on the UPS balance sheet for its marketable securities.
Company ownership from 20% to 50%
Equity Method
If a company owns more than 50% of another company’s stock, it must consolidate the financial statements. What that means is, it combines the financial statements of both companies as if they were one company [Consolidated Financial Statements]
When a company owns between 20% and 50% of another company’s stock, it must use what’s referred to as the equity method of accounting. [Equity Method] , in which they do not recognize Company B dividends when they receive them, but rather they will recognize dividend revenue as it’s being earned by the company they’ve invested in (Company B) So my example of Sears owning 40% of another company’s stock, if the other company had profits of $100,000, then Sears would have to report 40% of that, in other words $40,000 as income from the investment, even if they received no dividends at all from that company.
If a company owns less than 20% of another company’s stock, then the accounting is the same as for short-term investments, in other words, the mark to market rule.
What are Amortization?
depreciation for Intangible assets (copyrights…etc)
Types of Fixed Tangible Assets
Land (NO depreciation)
Buildings, Equipment, Land (depreciates)
Natural resources (deprecieates
capitalized interest
Capitalization means treating something as an asset, rather than an expense.
interest that’s paid during the construction period. Ordinarily, when interest is incurred, it’s recorded as an expense on the income statement right away. However, during a construction period, interest that is incurred is treated as an asset. It becomes part of the cost of the equipment, building, or whatever is being constructed, and then later on, when depreciation expense is taken, that’s when it turns into an expense.
Investopedia:
Capitalized interest is an accounting practice required under the accrual basis of accounting. Capitalized interest is interest that is added to the total cost of a long-term asset or loan balance. This makes it so the interest is not recognized in the current period as an interest expense. Instead, capitalized interest is treated as part of the fixed asset or loan balance and is included in the depreciation of the long-term asset or loan repayment. Capitalized interest appears on the balance sheet rather than the income statement.
When a company capitalizes accrued interest, it takes the total amount of interest it owes on a long-term asset or loan balance since the last payment, and capitalizes it by adding the total interest owed to the total cost of the long-term asset or loan balance.
Self-Constructed Assets
Costs includes all expenditures incurred to build the asset and make it ready for use
- materials used to build asset
-construction labor
-general company overhead
-capitalized interest
Ordinary Expenditures vs Capitalized Expenditures on existing assets. What’s the criteria for capitalized expenditures?
An ordinary expenditure typically benefits only the period in which they’re made. Things like repairs, maintenance, and minor improvements are considered to be benefiting only the period in which the expenditure is made, and therefore, they will be expensed immediately on that year’s income statement.
capitalized expenditure, and those are ones which benefit the company over several periods, not just the current one. And, because of the Matching Principle, which says that we need to recognize the expenses in the periods that were benefiting from those expenses, we do not expense them immediately, but rather, we capitalize them on the balance sheet, meaning we treat them as assets, and then, those assets will be depreciated over the periods in which we are benefiting from those assets.
CRITERIA TO CAPITALIZE: expenditure has to increase the productive life of the asset or, it has to increase the capacity of the asset.
How do you determine the depreciation of property plant and equipment
Estimate useful intended life
Estimate salvage value
What are the methods of depreciation for property plant and equipment?
- Straight Line (majority) - equally allocated time periods
- Units of Output
- Accelerated Depreciation (more depreciation expense now, less expense later)
Sum-of-years digits
double decline balance
reasons: 1)assets become obsolete or lose productivity more so in the early years than in the later years. 2)Assets are often more productive in the early years, thereby generating more revenues in the early years 3) later years, the company will likely have more repairs and maintenance expense for the assets than in the early years, and so, therefore, to sort of even things out, we have more depreciation expense in the early years.
All these types have the same net value, just distributed different every year
How to calculate depreciation on the balance sheet?
Equipment
-Accumulated depreciation (contra asset account)
= Equipment net (Book Value)
These contra asset accounts are deductions from the asset accounts to arrive at the net asset account, in this case, net equipment, which is often referred to as the book value of the equipment.
Asset retirement
disposal of assets, which includes selling assets, trading in an asset for another asset, or casualty losses from things like fires or floods that destroy an asset
The gain or loss is determined by comparing the proceeds to the book value. The proceeds just refers to whatever is received for the asset, generally cash. If the proceeds are more than the BOOK VALUE, then we record a gain. Whereas, if the proceeds are less than the book value, we record a loss.
Definite life Intangible asset
We amortize those intangible assets having a definite life over the minimum of the economic life and the legal life.
omputer software, licences, trademarks, patents, films, copyrights and import quotas.
Indefinite life intagible assets
they’re tested for something called impairment on an annual basis, instead of amortization(depreciation)
Basically that involves comparing the book value of the asset to some estimate of future cash flows, and if this estimate of future cash flows is deemed by management to be less than the book value, then the asset is said to be impaired.
e.g
intellectual property, like patents, trademarks, copyrights, or even non-monetary government grants, like airport landing rights or broadcasting licenses
What is Goodwill? What kind of asset is it?
Goodwill arises when only when a company purchases an entire business unit. . Goodwill arises when the purchase price is greater than the fair market value of the net assets.
Goodwill is considered an indefinite-lived intangible asset and therefore is tested annually for impairment.
Research and Development - is it capitalized?
R&D is not capitalized. Instead, it’s expensed immediately. There is so much uncertainty as to whether or not R&D will provide any benefits at all, so therefore it must be expensed.
. You might think that the matching principle would dictate that research and development costs should be capitalized because after all, research and development generally does not only benefit the current period but benefits future periods as well, and the matching principle tells us that if we do have benefits in future periods, we should spread the expenses over those future periods as well as the current period.
I just want to mention that the international financial reporting standards distinguish between research and development. For the research costs, those must be expensed. The development costs however are capitalized. But again, with US GAAP, both research and development costs are expensed immediately when incurred.
Difference between income statement and balance sheet
An income statement assesses the profit or loss of a business over a period of time, whereas a balance sheet shows the financial position of the business at a specific point in time.
The balance sheet is a financial statement comprised of assets, liabilities, and equity at the end of an accounting period.
The income statement, often called a profit and loss statement, shows a company’s financial health over a specified time period. It also provides a company with valuable information about revenue, sales, and expenses. These statements are used to make important financial decisions. Income statements include revenue, costs of goods sold, and operating expenses, along with the resulting net income or loss for that period.
What’s the difference between Bad debt expense vs Allowance for bad debts
Bad debt expense
Is an income statement account. It starts from zero every year. No carry over
Allowance for bad debts
Balance sheets accounts do carry over. Cash ending in one year carry for next year. Allowance for bad debts is a contra-asset and appears on the balance sheet. It does carry over from one year to the next
What are arrears (in context to paying dividends)
Dividends that were not paid out (witheld in past years)
Arrears ARE NOT appear in balance sheet as a liability (no legal obligation)
Difference between sales and net income and gross margins
Difference between sales and net income and gross margins
Where does dividends declared appear in the balance sheet
Dividends declared–> when that happens it becomes a liability. At that time they must have a dividends payable setup. So at that time of the balance sheet it would show up on the sheet as a dividends payable. There is NO account for dividends declared
is notes payable a long term liability?
No. depends on the due date
What is Deferred Revenues and where is it on the balance sheet
Deferred Revenues Liability BS**
Deferred Revenue vs Deferred Expense
The deferred expense is recorded as an asset on the company’s balance sheet (e.g., prepaid rent).
What is the accrual accounting method?
Follows the matching principal (same period)
opposite of Cash accounting (where transactions are recognized only when payment is made)
In other words, the revenue earned and expenses incurred are entered into the company’s journal regardless of when money exchanges hands. Accrual accounting is usually compared to cash basis of accounting, which records revenue when the goods and services are actually paid for.
How do you calculate net income? What about gross income
