BUSI 101: Chapter Three

What is the difference between current assets and liabilities and noncurrent assets and liabilities?

Assets can either be "current assets" or "noncurrent assets." Current assets: Assets expected to be used or consumed within the following year. Noncurrent assets: Assets expected to be held for longer than a year. Liabilities can either be "current liabilities" or "noncurrent liabilities." Current liabilities: Liabilities expected to be paid during the upcoming year. Noncurrent liabilities: Liabilities not to be paid until after the next year.

What does the cost of goods sold figure represent?

"Cost of goods sold": "Cost of goods sold" is the direct costs attributable to the production of the goods sold in a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. The timing of expense recognition is not tied to the payment of cash but rather to the loss of the asset.

What types of financial data will be available on a typical income statement?

A listing of all revenues earned and expenses incurred during a specific period of time as well as all gains and losses.

What is the "accounting equation?"

Accounting Equation: Assets = Liabilities + stockholders' equity. The equation balances because all assets must have a source: a liability, a contribution from an owner (contributed capital), or from operations (retained earnings). Accounting Equation: Assets = Liabilities + Stockholders' equity OR Assets = Liabilities + Capital Stock + Retained earnings OR Assets = The total source of those assets The left side of the equation presents a portrait of future economic benefits, and the right side presents how those assets were derived.

What else, if anything, is presented on an income statement other than revenues and expenses?

An income statement, in addition to reporting revenues and expenses, also reports gains and losses for the same period of time. Gain: An increase in the net assets of an organization created by an occurrence that is outside its primary or central operations. Loss: A decrease in the net assets of an organization created by an occurrence that is outside its primary or central operations.

How does an organization determine whether a cost represents an asset or an expense?

Asset: A cost expected to help generate additional revenue in the future. Expense: A cost that helped a business generate revenue in the past. With an asset, the utility associated with a cost is yet to be consumed completely. With an expense, the utility associated with a cost has been consumed. When a cost is incurred, the accountant must investigate its purpose to determine when the related benefit is expected. This timing indicated whether an asset should be recognized or an expense.

What is the structure of the statement of retained earnings as it appears within a set of financial statements?

Assets, liabilities, and net assets. This is followed by the sources of the net assets, divided into two categories: capital stock and retained earnings.

When clear delineation of a cost between asset and expense appears to be impossible, what reporting is made?

Differentiating between an asset and an expense provides a perfect example of conservatism: If neither scenario appears more likely to occur, the cost is classified as an expense rather than an asset because of conservatism. When the chance of two possibilities is the same, accounting prefers that the more optimistic approach be avoided.

What is "gross margin?"

Gross Margin: Difference between the sales and costs of goods sold; also called gross profit or markup.

What is "gross profit?"

Gross Profit: Difference between the sales and costs of goods sold; also called gross margin or markup.

Why is it important for decision makers to study an entire set of financial statements rather than exclusively on one or two numbers such as net income or gross profit?

However, financial statements present a vast array of data and the importance of any one balance should never be overemphasized. Likewise, only the analysis of all information conveyed by a set of financial statements enables an interested party to arrive at the most appropriate decisions about an organization. In judging a company's financial health and future prospects, an evaluation should be carried out on the entity as a whole; predicting stock prices, dividends, and cash flows requires a complete investigation.

What are the four types of financial statements typically produced by a reporting entity?

Income Statement (also called a statement of operations or a statement of earnings) Statement of retained earnings (or the more inclusive statement of stockholders' equity) Balance sheet (also called a statement of financial position) Statement of cash flows

What is an income statement?

Income Statement: A listing of all revenues earned and expenses incurred during a specific period of time as well as all gains and losses; also called statement of operations or statement of earnings.

What are "investing activities?"

Investing Activities: A statement of cash flow category relating to cash receipts and disbursements arising from an asset transaction other than one related to the primary activities of the organization.

What is "markup?"

Markup: Difference between the sales and costs of goods sold; also called gross margin or gross profit.

What is net income?

Net income = Revenues - expenses Net income represents a company's total earnings or profit.

What are "operating activities?"

Operating Activities: A statement of cash flow category relating to cash receipts and disbursements arising from the primary activities of the organization.

What is "the practice of conservatism?"

Practice of Conservatism: Preference of accountants to avoid making an organization look overly good; when faced with multiple reporting options that are equally likely, the worst possible outcome is reported to help protect the decision maker from information that is too optimistic.

What are "retained earnings?"

Retained Earnings: Accumulated total of the net income earned by an organization during its existence in excess of dividends distributed to the owners; indicates the amount of the net assets currently held that came from operations over the life of the organization. Retained earnings is a measure of the profits left in a business throughout its existence to create growth. Retained earnings are a measure of a company's growth in net assets because of its operations, or internally generated expansion. This reported balance answers the question: How much of the company's net assets have been derived from operation during its life?

If a decision maker studies a company's balance sheet, what information can be discovered?

The balance sheet shows the company's financial condition on one specific date/specified point in time (unlike all of the other financial statements).

Why does the balance sheet balance?

The balance sheet will always balance. The equation balances because all assets must have a source: a liability, a contribution from an owner (contributed capital), or from operations (retained earnings).

What is the difference between revenue and cost of goods sold?

The difference in revenue and cost of goods sold is often referred to as the company's gross profit, gross margin, or markup.

What are the normal contents of an income statement?

The main contents of an income statement are rather straightforward: a listing of all revenues earned and expenses incurred by the reporting organization during the period specified.

What is a balance sheet?

Balance sheet: A listing of all asset, liability, and stockholders' equity accounts at a specific point in time; also called statement of financial position.

Why is income tax expense listed last and by itself on the bottom of the income statement?

Because the nature of the income tax expense is different, it is isolated at the bottom of the income statement, separate from true expenses. It is a government assessment rather than a true expense. Income taxes do not create revenues; instead, they are caused by a company's revenues and related profitability (not an expense in the traditional sense).

Other than through operations, how does a company derive net assets?

Beyond operations (as reflected by the retained earnings balance), a business accumulates net assets by receiving contributions from investors who became owners through the acquisition of capital stock. Capital stock/contributed capital is the amount invested in the business by individuals and groups in order to become owners.

How is financial information actually conveyed to interested parties?

Businesses and other organizations periodically produce financial statements that provide a formal structure for conveying financial information to decision makers. Financial statements serve as the vehicle to report all monetary balances and explanatory information required according to the rules and principles of U.S. GAAP (or IFRS, if applicable). When based on these standards, such statements create a fairly presented portrait of the organization (one that contains no material misstatements).

What is "capital stock?"

Capital Stock: Ownership (equity) shares of stock in a corporation that are issued to raise monetary financing for capital expenditures and operations.

Why does capital stock appear on a company's balance sheet?

Capital stock, a measure of the amount of net assets put into the business by its owners, is reported within stockholders' equity on the balance sheet. Assets, liabilities, and owners' equity all appear on a company's balance sheet.

On a statement of cash flows, what is the difference in an operating activity, an investing activity, and a financing activity?

Cash flows listed as the result of operating activities relate to receipts and disbursements that arose in connection with the central activity of the organization. Ultimately, a business is only worth the cash that it can create from its normal operations. Investing activities report cash flows created by events that: 1. Are separate from the central or daily operations of the business and 2. Involve an asset Thus, the amount of cash collected when either equipment or land is sold is reported within this section. Financing activities are unrelated to daily business operations and relate to either a liability or stockholders' equity balance. Examples include borrowing money from a bank or distributing a dividend to shareholders, as well as issuing new stock to new owners for cash or payment of a noncurrent liability.

What is "common stock?"

Common Stock: A type of capital stock that is issued by every corporation; it provides rights to the owner that are specified by the laws of the state in which the organization is incorporated.

What is "contributed capital?"

Contributed Capital: Amounts invested in a corporation by individuals or groups in order to attain ownership interests; balance indicates the amount of the corporation's net assets that came directly from the owners.

How do you calculate current ratio?

Current Ratio: Formula measuring an organization's liquidity (the ability to pay debts as they come due); calculated by dividing current assets by current liabilities. Another useful measure for measuring short-term operating strength.

What is "current ratio?"

Current Ratio: Formula measuring an organization's liquidity (the ability to pay debts as they come due); calculated by dividing current assets by current liabilities. Another useful measure for measuring short-term operating strength.

Why are dividend distributions not reported as expenses of a corporation on its income statement?

Dividends are not expenses and, therefore, are omitted in preparing an income statement. They are not related in any way to generating revenues; it is a sharing of profits and not a cost incurred to create revenue. An income statement reports revenues, expenses, gains, and losses; dividend distributions do not qualify and must be reported elsewhere in the company's financial statements.

What is a financial statement?

Financial Statement: A formal record of the financial activities and position of a business, person, or other entity. The preparation of financial statements is carried out in the sequential order shown here: Income Statement (also called a statement of operations or a statement of earnings) Statement of retained earnings (or the more inclusive statement of stockholders' equity) Balance sheet (also called a statement of financial position) Statement of cash flows Notes to clarify and explain specified information further

What is the purpose of financial statements?

Financial statements serve as the vehicle to report all monetary balances and explanatory information required according to the rules and principles of U.S. GAAP (or IFRS, if applicable). When based on these standards, such statements create a fairly presented portrait of the organization (one that contains no material misstatements).

What are "financing activities?"

Financing Activities: A statement of cash flow category relating to cash receipts and disbursements arising from a liability or stockholders' equity transaction other than one related to the primary activities of the organization.

What information does a retained earnings balance communicate to an outside decision maker?

Retained earnings is a measure of the profits left in a business throughout its existence to create growth. Retained earnings are a measure of a company's growth in net assets because of its operations, or internally generated expansion. This reported balance answers the question: How much of the company's net assets have been derived from operation during its life?

What is a statement of cash flows?

Statement of cash flows: A listing of all cash inflows (sources) and cash outflows (uses) during a specific period of time categorized as operating activities, investing activities, and financing activities.

What is a statement of retained earnings?

Statement of retained earnings: A financial statement that reports the change in a corporation's retained earnings account from the beginning of a period to the end; the account is increased by net income and decreased by a reported net loss and/or any dividends declared.

What is stockholders' equity (owners' equity)?

Stockholders' equity is the portion of the balance sheet that represents the capital received from investors in exchange for stock (paid-in capital), donated capital, and retained earnings. Assets = Liabilities + Owners' equity Owners' equity = Assets - Liabilities

Is net income the most important number to be found in a set of financial statements?

The net income figure reported for any business is an eagerly anticipated and carefully analyzed piece of financial information. It is the most discussed number disclosed by virtually any company. However, financial statements present a vast array of data and the importance of any one balance should never be overemphasized.

What is the rationale for the practice of conservatism and its effect on financial accounting?

The practice of conservatism is simply an attempt by financial accounting to help safeguard the public.

The preparation of financial statements is carried out in what sequential order?

The preparation of financial statements is carried out in the sequential order shown here: Income Statement (also called a statement of operations or a statement of earnings) Statement of retained earnings (or the more inclusive statement of stockholders' equity) Balance sheet (also called a statement of financial position) Statement of cash flows Notes to clarify and explain specified information further

What are the types of accounts presented on a balance sheet?

The primary purpose of a balance sheet is to report a company's assets and liabilities at a particular point in time. The format is simple: all assets are listed first (usually in order of liquidity) followed by all liabilities.

How is the statement of cash flows structured?

The statement of cash flows provides a portrait of the various ways the reporting company generated cash during the year and the uses that were made of it. Explains how the cash balance changed during the year. Decision makers place considerable emphasis on a company's ability to generate significant cash inflows and then make wise use of that money. All cash transactions are classified as falling within operating activities (daily activities), investing activities (nonoperating activities that affect an asset), or financing activities (nonoperating activities that affect either a liability or a stockholders' equity account).

What are the two main sources of net assets?

The two main source of net assets: capital stock (or contributed capital) and retained earnings.

Does a company receive money when its shares are sold each day on the New York Stock Exchange, NASDAQ, or other stock exchanges?

When shares are sold each day on stock exchanges, a company does not receive money. Purchases and sales on stock markets normally occur between two investors and not directly with the company. Only the initial issuance of the ownership shares to a stockholder creates the inflow of assets reported by a capital stock or contributed capital account. Thus, a corporation's capital stock balance only measure the initial investment contributed directly to the business.

How do you calculate working capital?

Working Capital: Formula measuring an organization's liquidity (the ability to pay debts as they come due); calculated by subtracting current liabilities from current assets. Reflects short-term financial strength, the ability of a business or other organization to generate sufficient cash to pay debts as they come due.

What is "working capital?"

Working Capital: Formula measuring an organization's liquidity (the ability to pay debts as they come due); calculated by subtracting current liabilities from current assets. Reflects short-term financial strength, the ability of a business or other organization to generate sufficient cash to pay debts as they come due.