- Four Principal Activities of Business Firms: Establish goals & strategies; obtain financing; make investments; conduct operations.
- Financial Accounting: provides information primarily to people outside the firm.
- Managerial Accounting: provides information to people inside the firm.
- Tax Accounting: provides information for the tax authorities.
The Conceptual Framework
- Fundamental Qualities: Fin. info must be relevant, reliable, comparable, & consistent.
Assumptions:
- Going Concern: assumes the firm will remain in operations long enough to carry out all of its current plans.
- Monetary Unit: inflation and exchange rates change the value of $1
- Economic Entity: a company is separate from its owners.
- Periodic Reporting: business operations can be recorded and separated into different periods.
Key Principles
- Historical Cost Principle
- Revenue Recognitions
Principle
- Matching Principle: match revenues to their related expenses in the same time period.
Key Constraints
- Materiality: whether an item affects the decision of a reasonable individual.
- Conservatism: recognize a loss immediately and gains only when reasonably certain.
The Annual Report
- Management Letter: summary of past year activities and assessment of next year prospects.
- Management Discussion and Analysis (MD&A) section: management discusses reasons for changes in profitability and risk during the past year, and the firm's financial statements and supplementary information.
- Financial Statements and supplementary Information
- 10-K: Audited Annual SEC Filing. This is included in the Annual Report.
- 10-K: Audited Annual SEC Filing. This is included in the Annual Report.
- The Auditor's Opinion (evaluate fair presentation & internal control system)
- First paragraph: indicates the financial presentations covered by the opinion and indicates that the responsibility for the financial statements rests with management.
- Second paragraph: affirms that the auditor has followed auditing standards and practices generally accepted by the accounting profession unless otherwise noted and described.
- Third paragraph: contains the auditor's opinion regarding the financial statement's fair presentation of financial position and results of operations. The auditor's opinion may be unqualified or qualified.
- Unqualified: no exceptions or qualifications. Most opinions are unqualified.
- Qualified: material uncertainties.
- Disclaimer/Adverse: cannot express an opinion.
Other Financial Reports
- 10-Q: Unaudited Quarterly SEC Filing
- 8-K: Current Filing. For significant events (i.e. bankruptcy, detection of fraud)
- 20-F: Foreign Companies
Financial Statements
- B/S, I/S, SCF, Sof Stockholders' Equity, Footnotes
Authorities:
- SEC: An agency of the federal government that has the legal authority to set acceptable accounting methods and standards in the US
- GAAP: Compilation of accounting rules, procedures, and practices
- FASB: Private sector body, designated by the SEC to set accounting standards.
- IASB: issues Internal Financial Reporting Standards (IFRS)
Balance Sheet (B/S)
The Golden Rule/Basic Accounting Equation:
Assets = Liabilities + Shareholders' Equity
Ask, "What is the financial health of the firm?"
Balance Sheet (snapshot at a moment in time of investing & financing activities)
ASSETS
Current Assets (consume within one year of B/S date; Cash, A/R, Prepaid)
Non-Current Assets (use and hold for several years; PP&E, intangibles-patents)
Total Assets
LIABILITIES & SHAREHOLDERS' EQUITY
Current Liabilities (A/P, Advances)
Non-Current Liabilities (Long-term Loans)
Total Liabilities
Contributed Capital
Common Stock {# of shares outstanding * par/face value}
APIC {(# of shares outstanding * market value) – Common Stock}
Retained Earnings
Total Shareholders' Equity (Total Assets – Total Liabilities)
Total Liabilities + Shareholders' Equity
Asset Valuation
- Acquisition/Historical valuation: the original acquisition cost of the asset.
- Includes not only invoice price, but also all other expenditures made or obligations incurred to prepare an asset for its intended use. (Transportation costs, installation costs, handling charges, painting costs, etc).
- Includes not only invoice price, but also all other expenditures made or obligations incurred to prepare an asset for its intended use. (Transportation costs, installation costs, handling charges, painting costs, etc).
- Depreciated Historical Cost: the original acquisition cost of the asset minus depreciation. For buildings, equipment, patents.
- Market value: marketable securities
- Current replacement
cost: the current cost of acquiring the asset. This is more relevant, but can be hard to measure (i.e. buildings: don't know the replacement cost until you sell the building or find something that was recently sold with a similar history).
Assets: RULES!
- Assets= an exchange must take place; future benefits must be quantifiable.
- A brand name developed by a firm is generally not an accounting asset, even though it may provide future benefits. (Those future benefits are too difficult to quantify with sufficient precision, so you cannot recognize it as an asset.)
- If, however, a competitor buys a brand name, then they can list it as an asset since it is assumed the company would not buy the brand unless they believed it would bring future benefits.
- Goodwill is an asset ONLY when one company buys another company.
- Research & Development (R&D) is not an asset. Must expense it.
- Advertising is not an asset (unless it's Pre-Paid Advertising). Must expense it.
- Accumulated Depreciation is a contra-account used to decrease tangible assets (Buildings). It is an asset account, but acts like a liability account.
- If straight-line, use:
Asset Cost – Salvage Value
------------------------------------ = Yearly Deprecation Expense
Expected life of the asset
- Amortization: used to decrease intangible assets (rights, patents).
- Depletion: used to decrease natural resources (oil, coal).
- Allowance for Doubtful Accounts: contra-account used to decrease the A/R asset account. (see Accumulated Depreciation)
Liabilities: RULES!
- Warranties are liabilities.
- Loan guarantees are NOT liabilities.
- Obligations created by mutually unexecuted contracts, such as leases or employment contracts, are NOT liabilities!
Income Statement (I/S)
Net Income (Profit) = Revenues – Expenses + Gains - Loses
Income Statement (presents the results of operating activities of a firm for a period of time, like a calendar year. Measures "performance.")
REVENUES (inflows/benefits generated)
Sales Revenues
Other Revenues (interest, dividends)
Total Revenues
Cost of Goods Sold (COGS)
Gross Profit
LESS EXPENSES (outflows/sacrifices incurred)
Other Expenses (interest, depreciation, utilities, salaries, advertising, marketing, rent)
Total Expenses
Operating Income
Gains (+) / Loses (-)
EBIT
Income Taxes
Net Income or Net Loss
Revenues & Expenses: RULES! (Accrual Accounting)
- Revenue Recognition: when BOTH the following are met:
- EARNED: Goods/Service has been received/performed.
- REALIZED: An exchange of cash has occurred or payment is reasonably certain to occur (i.e. sales on account).
- Dividends are NOT an expense and DO NOT appear on the I/S!!!
- Interest revenue and interest expense must be recognized in the period it occurs.
- At the end of the B/S period, you MUST recognize revenues and expenses, even if cash has not been exchanged. i.e. close out the B/S accounts to bring them back to zero and transfer everything to the I/S.
- Expense your period costs: depreciation, interest paid, utility, salary, advertising, marketing, etc.
- Recognize your period revenues: A/R, interest received.
- In practice, income taxes are paid quarterly.
- Expense your period costs: depreciation, interest paid, utility, salary, advertising, marketing, etc.
- Uncollectible accounts have no value and are not included in revenue.
- Sales discounts and allowances are reduction in price and not included in revenue.
- Sales returns are a reversal of the sale and are not included in revenue.
- If a firm receives services over a time period spanning two or more accounting periods, ONLY RECOGNIZE THE PROPORTION of service received as an expense.
Other
- The I/S links the beginning and ending B/S through the Retained Earnings account. The amount of net income helps explain the change in retained earnings between the beginning and end of the period.
- Net Income – ∆
in Retained Earnings = Dividends - Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earning
- EPS= Net Income
Basic: True EPS; Diluted: pretends
- Net Income – ∆
# of shares outstanding stock equivalents are stock.
- Cash basis of accounting- Revenues are recognized when cash is received and expenses are recognized when cash is paid.
Criticisms:
- Revenues are not matched to expenses.
- Postpones the time of recognizing revenue.
- Subject to manipulation: can delay expense recognition.
- Accrual basis of accounting- Revenues and expenses are recognized on an economic basis regardless of the actual flow of cash.
- Measurement- involves both the amount and the timing of the recognition of revenues and expenses.
- Measurement- involves both the amount and the timing of the recognition of revenues and expenses.
- Tools useful in I/S analysis:
- Common size statements- I/S as a % of revenues
- Time series analysis- compares common-size I/S for two or more periods.
- Cross-section analysis- involves using common-size I/S to compare two or more firms.
Statement of Cash Flows (SCF)- Indirect Method
- Basic SCF Equation: ∆in Cash= ∆ in Liab + ∆ in SE - ∆ in Assets
- Cash collected from customers: Sales - ∆Net A/R +∆Advances
- ∆Net A/R = BB + Sales – Bad Debt Expense
- ∆Net A/R = BB + Sales – Bad Debt Expense
Statement of Cash Flows Cheat Sheet | |||
| CFO | Increases | Subtract |
| CFO | Increases | Add |
| CFI | Increases | Subtract |
| CFF | Increases | Add |
Life Cycle and SCF | |||
CFO | CFI | CFF | |
Growth | - | - | + (equity) |
Mature | + | - | - (pay div) |
Dying | - | + (selling off) | + (more debt) |
Statement of Cash Flows (reports the net cash flows relating to operating, investing, and financing activities for a period of time)
OPERATIONS (cash from customers - cash paid in carrying out operating activities)
Net Income
Additions
(Depreciation, decreases in noncash current assets, increases in current liabilities,
Dividends received, interest received)
Subtractions
(Increases in noncash current assets, decreases in current liabilities, interest paid)
Cash Flow from Operations
INVESTING (Acquisition/Sale of non-current assets only)
PP&E (Bldg, Land, Equip)
Other (patents, licenses, contractual rights, marketable securities)
Cash Flow from Investing
FINANCING (obtaining funds from owners & creditors; issue/redemption of debt)
Short-term debt /Long-term debt (loan principle; issuing/retiring debt)
Common Stock / Bond issuance/buy-back
Dividends Paid
Cash Flow from Financing
Change in Cash
Cash, Beginning of Year
Cash, End of Year
Statement of Cash Flows RULES!
- Cash is defined as: cash and currency on hand (paper money), balances in checking accounts available for immediate withdrawal, coins, cash equivalents.
- Other current liabilities belong in Operations.
- Receipt of cash from interest and dividend revenues are classified as CFO.
- Interest Expense is an operating activity.
- Other non-operating assets belong in CFI; Other non-operating liabilities belong in CFF.
Why Cash Flows are Important
- Accrual accounting relies on subjective judgments that may introduce measurement error and uncertainty. Also, one-time write-offs and restructuring charges can reduce the quality of reported earnings. Finally, management can readily manipulate accrual income.
Revenue Recognition and Receivables
Gross A/R – Allowance = A/R, Net
- Revenue Recognition Rules:
- At time of sale
- Percentage of completion
- Completed Contract
- Installment Sales
- Cost Recovery First
- Bad Debt Expense: the amount that the firm charges to its income statement due to customers not paying the firm its receivables.
- Estimated each period.
- Includes both known and estimated future write-offs.
- Trade-off between timeliness and reliability.
- It is an Adjusting entry!
Journal entry:
DR: Bad Debt Expense xxx (goes to I/S)
CR: Allowance for Doubtful Accounts xxx (contra-account to A/R on B/S)
- Estimated each period.
- Write-offs: the specific account receivable that is deemed to be uncollectible.
- Write off an account when we are fairly certain that it will be uncollectible.
- Write off a specific account, e.g.. Ms. Jones
Journal entry:
DR: Allowance for Doubtful Accounts xxx
CR: Account Receivable- Ms. Jones xxx
- Write off an account when we are fairly certain that it will be uncollectible.
- Bad Debt Recovery: A/R that was written off but now gets paid.
Journal entries:
DR: Account Receivable- Ms. Jones xxx
CR: Allowance for Doubtful Accounts xxx
DR: Cash xxx
CR: Account Receivable- Ms. Jones xxx
- Direct write-off Method: recognize losses from uncollectible accounts in the period when a firm decides that specific customers' accounts are uncollectible.
Shortcomings:
- It does not recognize the loss from uncollectible accounts in the period in which the firm recognizes revenue
- It provides the firms with opportunity to manipulate earnings each period by determining which accounts are uncollectible.
- The amount of A/R on the B/S does not reflect the amount a firm expects to collect in cash.
Journal entry:
DR: Bad Debt Expense xxx
CR: Accounts Receivable xxx
- It does not recognize the loss from uncollectible accounts in the period in which the firm recognizes revenue
Bad Debt Recovery Steps
1. Recognize the Sale on Account
Debit: Accounts Receivable xxx
Credit: Revenues xxx
2. During the Period, write off non-performing specific accounts
Debit: Allowance for Uncollectible Accounts xxx
Credit: Accounts Receivable – specific account xxx
3. During the period, put in bad debt recoveries (if any)
Debit: Accounts Receivable – specific account xxx
Credit: Allowance for Uncollectible Accounts xxx
Debit: Cash xxx
Credit: Accounts Receivable – specific account xxx
4. During the period, show cash collections
Debit: Cash xxx
Credit: Accounts Receivable xxx
5. At end of current period, put in adjusting entry for the recognition of the bad debt expense and the change in the allowance for uncollectible accounts
Debit: Bad Debt Expense xxx
Credit: Allowance for Uncollectible Accounts xxx
Estimating Bad Debt Expense
Percentage of Sales: Based on historical relationships between credit
sales and uncollectible debts:
- "Credit sales for the year were $100,000. Historically, 3% of credit sales were uncollectible." àBad Debt Exp = $3,000
- Aging of the Accounts: first, figure out End. Bal of Allowance account based on past history. Then, plug in bad debt expense:
- Percentage of Accounts Receivable: Based on year-end A/R à first figure out ending allowance account based on past history, then plug in bad debt exp:
SCF Examples
- Effects of Sale of Long-Term Assets
Journal Entry:
DR: Cash
DR: Accumulated Depreciation
CR: Asset (Equip, Bldg, etc)
CR: Gain (or loss) on Sale
- 1st line cash, adds a line to the investing section
- 4th line: gain/loss, reversed out in the operating section
- 1st line cash, adds a line to the investing section
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