Financial Accounting

Change in Net Working Capital - equation

Change in NWC* = Current Year NWC - PY NWC *Can be positive or negative

Common Stock - pro forma equation

Common Stock current year = Common stock prior year **unless the firm issues more stock or buys back outstanding shares.

Common Size Financial Statements - definition

Common size financial statements divide each number on the balance sheet by total assets, and each number in the income statement by sales. This converts the financial statement items into ratios that help us see trends and can easily be compared from one company to another.

Days Inventory - definition and equation

Days Inventory: Days Inventory is a measure related to inventory turnover that shows the average number of days the inventory is held before it is sold. It can be calculated by dividing average inventory by the COGS per day. Alternatively, it can be calculated by dividing 365 by the Inventory Turnover. - You want this number to be low Days Inventory = 365 / Inventory Turnover -or- Days Inventory = Average Inventory / (COGS/365)

Days Purchases Outstanding - definition and equation

Days Purchases Outstanding is a measure related to accounts payable turnover that shows the number of days it takes a business to pay its vendors. It can be calculated by dividing the average accounts payable by the credit purchases per day. Alternatively, it can be calculated by dividing 365 by the Accounts Payable Turnover. - You want this number to be low - Days Purchases Outstanding is to AP Turnover what Days Inventory is to Inventory Turnover Days Purchases Outstanding = Average AP / (Annual Credit Purchases*/365) *Can use COGS as substitute -or- Days Purchases Outstanding = 365/ AP Turnover

Deferred Taxes - definition

Deferred Taxes arise from a temporary difference in the timing between recognizing the tax expense for a given period on the financial records compared to actually filing and paying the taxes per the tax records. There are many valid reasons that the two amounts may differ. Some examples include differences in depreciation methods, differences in bad debt estimates and actual write offs, tax-loss carry-forwards, and some pension payments and expenses. Deferred taxes can be either an asset or a liability, and can be either current or non-current, depending on when the temporary timing difference is expected to reverse. At a given point in time, a balance sheet may show both a deferred tax asset and a deferred tax liability.

EBIAT - definition and equation

EBIAT: EBIAT is an acronym for Earnings Before Interest After Taxes. It is a measure of how much income the business has generated while ignoring the effect of financing and capital structure of the business. It is calculated by adding back interest and taxes to net income, and then calculating and subtracting income tax expense based on the earnings before interest and taxes. EBIAT = EBIT x (1 - Tax Rate)

EBIT equation

EBIT = Net Income + Interest Expense + Income Tax Expense

Free Cash Flows - equation

FCF = EBIAT + Depreciation - Capital Expenditures - Change in Net Working Capital

Financial Leverage - definition

Financial Leverage is one of the three components of the DuPont Framework. For the purposes of the DuPont Framework, it is measured using the Leverage Ratio, also referred to as the Equity Multiplier, but another measure of leverage is the Debt to Equity Ratio. - Measures the impact of all non-equity financing or debt on firm's ROE

Pro-Forma Financial Statements - definition

Financial Statements forecasted for future periods. In this course, we use pro-formas as a depiction of what the financial statements for the business will look like over a certain period of time, if the assumptions made when preparing them hold true.

Forecasted Interest Expense - Pro Forma equation

Forecasted Interest Expense = Prior Year Long-Term Debt + Prior Year Short-Term Debt (Current Portion)

Dividends Paid - which section on cash flow statement? (IFRS & GAAP)

GAAP: Financing IFRS: Operating or Financing

Dividends Received - which section on cash flow statement? (IFRS & GAAP)

GAAP: Operating IFRS: Operating or Financing

Interest Paid - which section on cash flow statement? (IFRS & GAAP)

GAAP: Operating IFRS: Operating or Financing

Interest Received - which section on cash flow statement? (IFRS & GAAP)

GAAP: Operating IFRS: Operating or Investing

Financial Accounting Standards Board (FASB) - definiton

Governing body that issues accounting rules and standards in the United States. These rules and standards are often referred to as generally accepted accounting principles, or GAAP.

Gross Profit Margin - definition and equation

Gross Profit Margin is calculated by dividing the gross profit by the total sales for the period, and is used as a measure of profitability. It tells us what percentage of our revenue is left to cover other expenses after the cost of goods sold is subtracted. May also be referred to as Gross Profit Percentage. - A company could have a shrinking profit margin but a growing gross profit margin if operating expenses or other non-COGS expenses are rising. Gross Profit Margin = Gross Profit / Total Sales (Revenue) ** Remember, GP = Revenue - COGS

International Financial Reporting Standards (IFRS) - definition

IFRS are the accounting rules and standards issued by the International Accounting Standards Board (IASB) which are followed in many countries outside the United States (US). In the US companies adhere to a slightly different set of accounting rules and principles, referred to as GAAP (Generally Accepted Accounting Principles) are issued by the Financial Accounting Standards Board (FASB).

Deferred Tax Asset - definition

In cases where a temporary timing difference leads to a higher taxable income in the current period than the financial income reported, then the excess tax paid is recorded and shown in the financial statements as a Deferred Tax Asset. A Deferred Tax Asset reflects a prepayment of taxes that will be due in the future related to activity already reported in the financial statements. - Arises when taxable income exceeds income before taxes

Financing Activities - definition & examples

Includes cash flows related to raising and paying back investors and creditors. - Ex: taking out or paying off loans, contributions from owners, dividends paid to shareholders (US GAAP - see chart below), repurchasing common stock , issuing stock/bonds, raising debt, issuing stock.

Investing activities - definition & examples

Includes information on cash flows related to long-lived assets. - Ex: PP&E, intangible assets (goodwill, brand recognition, intellectual property, etc), financial investments (loans receivable (loans made to third parties), investment securities, etc.)

Goodwill - definition

Intangible, long-term asset. Goodwill is the excess of the amount paid to acquire a business over the fair market value of the business' net assets. It is called Goodwill because this excess is often associated with the assumed value of the otherwise undefined intangible aspects of the business. Although a company may feel that it has value in its brands and name, goodwill is only recorded as the result of an acquisition. Self-generated brand value is not recorded as goodwill. Similar to land, goodwill is not amortized over time, but is tested for impairment annually.

Inventory Turnover - definition and equation

Inventory Turnover is a ratio that is used to measure how efficiently a business is managing its inventory levels. It is calculated by dividing the Cost of Goods Sold for the period by the average inventory for the period and represents how many times the inventory turned over during the period. - You want this number to be high (indicates high efficiency rate) - Indicates you are keeping less inventory on hand relative to inventory sold Inventory Turnover = COGS / Average Inventory

Income Taxes Payable - definition & equation

Liability since these will not be paid until April. The amount determined by multiplying the applicable income tax rate by the taxable income on the income tax return. - This is what you ACTUALLY owe in taxes Taxes Payable = Taxable Income x Tax Rate

Chart of Accounts - definition

List of all of the accounts of a business. This list includes all asset, liability, equity, revenue, and expense accounts. The accounts and naming of accounts can vary from business to business.

Leasehold Improvements

Long-lived (multiple year) improvements made to a leased property by the tenant in order to make the property better serve the tenant's needs. The value of these improvements is treated as a long-lived asset (Property, Plant & Equipment, or PP&E) and is depreciated over the life of the asset or the life of the lease, whichever is shorter.

Notes Receivable - Definition

Notes Receivable is an asset that arises when a business issues a promissory note to another business. Essentially, it is a loan recorded from the lender's point of view. A portion or all of the note receivable may be recorded in the current assets or non-current assets section of the balance sheet, depending on how soon the business expects to settle the note. (AKA, the claim to receive cash at a future date for loans that your company has supplied to a third party).

Non-current liabilities - definitions and examples

Obligations that will not be settled or paid within a year. - Ex: long-term debt, notes payable, long-term bond

Generally Accepted Accounting Principles (GAAP) - definition

Often referred to as US GAAP as it is usually associated with accounting rules and standards in the United States (US) issued by the Financial Accounting Standards Board (FASB).

Credit - definition (accounting entries)

One half of an accounting entry. Credits increase the balances in Revenue, Liability, and Owners' Equity accounts. Credits reduce the balances in Asset and Expense accounts. Credits are shown on the right side in journal entries, T-Accounts, and trial balances.

Debit - definition (accounting entries)

One half of an accounting entry. Debits increase the balances in Asset and Expense accounts. Debits reduce the balances in Revenue, Liability, and Owners' Equity accounts. Debits are shown on the left side in journal entries, T-Accounts, and trial balances.

Money Measurement Principle - definition

Only values that can be measured in monetary terms should be recorded in the financial accounting records. (Ex: do not record the estimated value of a client relationship on the financial statement).

Operating Efficiency - definition

Operating Efficiency is one of the three components of the DuPont Framework. For the purposes of the DuPont Framework, it is measured using the Asset Turnover, but other measures of efficiency include Inventory Turnover, Accounts Receivable Turnover, and Accounts Payable Turnover.

Operating income - equation

Operating Income = Gross Profit - Operating Expenses

Operating Income - definition

Operating Income is the amount that remains after the operating expenses are deducted from the gross profit. Gives a good picture of whether business is earning enough to cover expenses.

Gordon Growth Model - formula

PV of Infinite Cash Flows (AKA "Terminal Value") = Cash Flows in Final Year of Projection / (Discount Rate* - Growth Rate) *Here, the "discount rate" is the rate at which the cash depreciates, and the "growth rate" is the rate at which it grows in revenue.

Payback Period - equation

Payback Period = # of Years + (Shortfall / Final Year)

Profit Margin - Equation

Profit Margin = Net Income / Sales (Revenue) ** remember Revenue = Gross Profit + COGS

Profitability - definition

Profitability is one of the three components of the DuPont Framework. For the purposes of the DuPont Framework, it is measured using the Profit Margin, but other measures of profitability include the Gross Profit Margin and EBIAT.

ROE Equation (2)

ROE = Net Income / Total Owners' Equity ROE = Profitability x Efficiency x Leverage

Benefit of Using Ratios

Ratios help equalize the size difference when comparing multiple companies, or one company over time

Indirect Method - definition

Refers to the method of reporting the cash flow from operating activities on the statement of cash flows by using net income and adjusting for non-cash items such as depreciation, adjusting for non-operating items such as gains and losses, and adjusting for changes in current asset and current liability accounts. The method starts with net income and adjusts it by the amounts accruals changed during the period to arrive at the increase or decrease in cash from operations during the period. Essentially, it is akin to de-accruing the income statement. *Note: Indirect & Direct Methods yield the same total numbers, however Indirect Method can yield more detailed information for those reviewing financial statements.

Consistency Principle - definition

Requires that the methods be consistently applied by the company over time in recording and reporting unless there is a sound reason to change them. Consistency refers only to consistency over time; it does not imply consistency across accounts.

Forecasting Retained Earnings - Pro Forma Statement

Retained Earnings = PY Retained Earnings + (Current Year Net Income - Amounts to be Distributed to Shareholders)

Revenue Equation (2)

Revenue = Net Income + Expenses Revenue = Gross Profit + COGS

Loss - definition

Similar to an expense, a loss reduces owners' equity. However, a loss relates to some activity that is outside the normal operations of the business, such as the sale of a long-lived asset for less than its net book value.

Gain - definition

Similar to revenue, a gain increases owners' equity. However, a gain relates to some activity that is outside the normal operations of the business, such as the sale of a long-lived asset for more than its net book value.

Materiality - definition

Something is considered to be material if it is reasonably likely to impact the decision-making of those who are using the accounting data or financial reports. Businesses are only required to do detailed record-keeping and reporting for items that are material.

Revenue Recognition Principle:

States that revenues should be recorded when (or as) an organization satisfies its performance obligation(s).

Income Statement - definition

Summarizes the earnings of a business (revenues minus expenses) over a designated period of time. Shows activity during the period for all nominal accounts. - Using two trial balances as bookends from any two points in time, a business can create an income statement to tell their financial story within that time period. - Connected to balance sheet via retained earnings.

T-Account

T-account is the summary of several journal entries. By convention, all debit activity is shown on the left side of T-accounts and all credit activity is shown on the right side of the T-accounts. There is a separate T-Account for each account, such as Cash or Accounts Receivable Every T-account has a beginning and an ending balance, though the balance may be zero A T-account covers activity for a period of time, for example, the month of January or the year 2014 Every transaction will affect at least two T-accounts If you add the ending balances of all T-accounts, the total of all debits must equal the total of all credits

Current Ratio - definition and equation

The Current Ratio is a measure of a business' ability to pay its short term obligations. It can be calculated by dividing current assets by current liabilities. - Only uses short-term assets & liabilities - Ratio of < 1 could indicate that a business may have trouble meeting near-term obligations. - The higher the current ratio, the better the business, however if it's too high the business may not be managing working capital effectively. Current Ratio = Current Assets / Current Liabilities

Debt to Equity Ratio - definition and equation

The Debt to Equity Ratio is calculated by dividing the total liabilities by the total equity. It is a common measure of leverage. Debt to Equity = Average Total Liabilities / Average Total Equity

Interest Coverage Ratio / "Times Interest Earned" - definition and equation

The Interest Coverage Ratio is a measure of a business' ability to make interest payments on its debt. It can be calculated by dividing Earnings Before Interest and Taxes (EBIT) by the interest expense for the period. It may also be referred to as Times Interest Earned, as it measures the number of times a company can cover its interest expense using its earnings before interest & taxes. - You want this to be high Interest Coverage Ratio = EBIT / Interest Expense

International Accounting Standards Board (IASB) - definition

The International Accounting Standards Board (IASB) is the governing body that issues accounting rules and standards known as International Financial Reporting Standards, or IFRS. IFRS are commonly used throughout the world.

Leverage Ratio / "Equity Multiplier" - definition & equation

The Leverage Ratio is calculated by dividing the total assets by the total equity. This calculation is used as a measure of financial leverage in the DuPont Framework. - If all assets are financed by equity, the multiplier is 1 (company has no debt) - Is assts are financed by liabilities, the multiplier increases, demonstrating the leverage impact of debt. - Higher leverage ratio means higher ROE, but also higher risk (if a business reports a loss, the loss will be amplified) Leverage Ratio = Average Total Assets / Average Total Equity

Quick Ratio / "Acid Test Ratio" - definition and equation

The Quick Ratio is a measure of a business' ability to pay its short term obligations that is a more stringent test than the current ratio. It can be calculated by subtracting inventory from current assets, then dividing the result by current liabilities. - Uses only highly liquid assets (excludes inventory) - You want this to be high Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Statement of Cash Flows - definition

The Statement of Cash Flows is one of the three primary financial statements. It shows the net change in cash during the year and includes three sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. - Shows cash in and out regardless of whether service has been delivered, and does not include non-cash transactions.

Taxable Income - definition

The amount on an income tax return after all deductions and adjustments. Taxable income is the amount against which the tax rate will be applied and the taxes payable for the period will be determined.

Income Before Taxes - definition

The amount shown on the Income Statement after all expenses have been taken away from the revenue for the period but before any tax expense for the period.

Capital Expenditures - definition and where to find them

The cash flow related to the purchase of property and equipment. Capital expenditures is part of the free cash flow equation. - Information about capital expenditures is most likely to be found in the investing section on the statement of cash flows

Net Working Capital - definition and equation

The cash that is tied up in a business' operations. Usually calculated as current assets less current liabilities. The change in net working capital is part of the free cash flow equation. - Be sure to exclude PP&E, Accumulated Depreciation, and other non-current assets! Net Working Capital = Current Assets - Current Liabilities

Time Value of Money - definition

The concept that a unit of currency (such as a dollar) received today is worth more than the same unit of currency received at some future point. Furthermore, the further into the future, the less the unit of currency is worth. This is because of three factors; the opportunity cost of not having the currency to invest, the impact of inflation, and the risk of not receiving the unit of currency in the future. - Therefore, to make calculations involving multiple money from different time periods, amounts must be converted to uniform values, typically the present value.

Internal Rate of Return (IRR) - definition

The discount rate that sets the net present value (NPV) of a project equal to zero (using NPV equation above). The IRR allows us to find the percentage rate that would be earned for a given set of cash flows. (In other words, what discount rate would make the Net Present Value of an investment zero). - IRR is often used when there is a lack of clarity or consensus as to what discount rate should be used in calculating NPV.

Weighted Average Cost of Capital (WACC) - definition

The discount rate which represents the cost to the business of raising funds. This rate will vary from one business to the next, but is the discount rate that many companies use in the NPV calculation. If a project or investment cannot return more than the WACC, the company would lose money on the investment.

Historical Cost Principle - definition

The historical cost principle refers to the fact that transactions are recorded at the cost that existed at the time the transaction occurred. In the case of assets, it means that their value in the financial records is shown at historical cost, rather than current market value. When combined with the principle of Conservatism, it means that an asset's value may be reduced if it is deemed to have permanently lost value but it cannot be increased if it is deemed to have gained value.

Amortization - definition

The method for recognizing the expense of long-lived intangible assets such as patents, copyrights, and brands, over the life of the assets. Amortization is usually calculated similar to straight-line depreciation. Some companies use an accumulated amortization account, while other companies may directly reduce the value of the associated asset.

Revenue - definition and equation

The money that a business brings in from its customers for providing goods or services related to its normal operations. Revenue = Gross Profit + COGS

Common Stock - definition

The most typical stock or share type representing an ownership interest in the business. Owners' equity account used to show amounts of cash invested in the business by the business owners in exchange for stock in the company).

Net Present Value (NPV) - definition

The net present value is a calculation of the present values of all the cash inflows and outflows of a project or investment. The result is a single number that gives a good indication of what a business or a particular investment is worth today. - Unlike PV, if NPV is negative, it means projected inflows are less than projected outflows, and firm should NOT invest

Sales General and Administrative Expenses (SG&A) - definition

The operating expenses of a company that relate to selling expenses and general and administrative expenses (such as rent, electricity, salaries of non-sales personnel).

Capitalization - definition

The practice of recording the cost of the purchase as an asset, rather than recording it as an expense when an item is purchased. For example, when a long-lived asset is purchased, such as a machine, the cost of the machine is said to be capitalized because it is recorded as an asset in the accounts. In contrast, something small and immaterial, such as pens and pencils, may be expensed immediately. - Cost is included in the value of the asset, and expensed over useful life (recorded as asset on balance sheet, with only depreciation recorded on income statement)

Terminal value - definition

The present value of a stream of funds that extends into the indefinite future. See also Gordon Growth Model for a formula that may be used to calculate terminal value.

Return on Equity (ROE) - definition

The return that a business generated during a period on the equity invested in the business by the owners of the business. Calculated by dividing net income by average total owners' equity. For most ratios in this course, we use averages when calculating ratios with balance sheet numbers, but this is not necessary and some may choose to use beginning or ending balances.

Present Value - definition

The value in today's currency of a future amount or a series of future amounts which have been converted into today's currency value using the discount rate. Can be found using Present Value tables, calculators, or software programs with Present Value functions. Also can be calculated using the following formula for any given amount in the future: PV = FV*(1/(1+i)n) where PV equals the present value, FV equals the future value that is being converted to its present value, i equals the discount rate, and n is the number of periods into the future that the future value exists. There are also tables and functions that can be used to find the present value of an annuity.

Transferring Inventory Between Manufacturing Stages of Inventory (in steps)

To transfer the inventory from one phase to the next: 1. debit (increase) the new phase 2. credit (decrease) the previous phase. When a good is sold: 1. credit (decrease) "finished goods" for sale price less manufacturing cost 2. debit (increase) COGS (expense -> Owners Equity) for same amount.

Payback Period - definition

Used as a way to evaluate a potential investment, Payback Period is a calculation that shows how soon the investors can expect to have their initial investment returned. It is simple to calculate and easy to understand. However, it does not consider time value of money or the amount of funds that the project will generate over and above the initial investment.

Salvage Value - definition & equation

Value of an asset after it is no longer used by the business to generate revenue. Sometimes also called scrap value.

Deferred Tax Liability - definition

When a temporary timing difference results in lower taxable income in the current period than the financial income reported, then there is an amount of tax that is going to be due in the future related to income reported in the current period. This amount is shown in the financial statements as a Deferred Tax Liability. A Deferred Tax Liability reflects an obligation to pay taxes in the future related to the income already reported in the financial statements. - Arises when taxable income is less than income before taxes.

Recording Inventory Adjustments (in steps)

When inventory is sold and shipped: 1. credit (decrease) inventory account 2. debit (incease) COGS (expense -> owners equity) To correct for shrinkage: 1. debit (increase) shrinkage expense (expense -> owners equity) 2. credit (decrease) inventory account

Recording a Deferred Expense (in steps)

When payment is made: 1. Credit (decrease) cash (asset account) for cash paid 2. Debit (increase) Deferred Expense (asset) account for right to receive future goods/services When goods/services are delivered: 1. Credit (decrease) deferred expense account to remove right to receive goods/service in future 2. debit (increase) expense account to record expense (equity)

EBIAT equation

(1-t) x EBIT = EBIAT

Turnover vs Days Relationship

- High Turnover = Low Days (generally good) - Low Turnover = High Days (generally bad)

Effect of Lower / Higher Tax Depreciation

- Higher tax depreciation -> lower taxable income - Lower tax depreciation -> higher taxable income

Statement of Sources & Uses of Funds: - Increase in assets = ?? of funds - Decrease in assets = ?? of funds - Increase in liability = ?? of funds - Decrease in liability = ?? of funds - Increase in equity = ?? of funds - Decrease in equity = ?? of funds

- Increase in assets = use of funds - Decrease in assets = source of funds - Increase in liability = source of funds - Decrease in liability = use of funds - Increase in equity = source of funds - Decrease in equity = use of funds

Characteristics of a company in the Decline Stage

- Operating cash flow is negative - Investing cash flow is positive (less buying, more sell-off) - Financing cash flow depends

Characteristics of a Company in the Startup / Fast Growing Stage

- Operating cash flow typically low or negative (buying lots of inventory and still sourcing customers) - Investing cash flow typically negative - Financing cash flow can fluctuate

Characteristics of a Company in the Profitable / Growth Stage

- Operating cash flow typically positive - Investing cash flow typically negative - Financing cash flow can fluctuate (fast growth -> more investment from investors)

Characteristics of a company in the Mature / Steady Stage:

- Operating cash flow typically positive - Investing cash flow typically slightly negative (to cover aging PP&E) - Financing cash flow typically negative (at this stage operations are sufficient to cover needs)

- When NPV < 0, IRR ?? WACC - When NPV = 0, IRR ?? WACC - When NPV > 0, IRR ?? WACC

- When NPV < 0, IRR < WACC - When NPV = 0, IRR = WACC - When NPV > 0, IRR > WACC

Sources of Information for Creating Cash Flow Statement (3)

1. Beginning and End of Period Balance Sheets 2. Income Statement for the Period 3. Transactional Data

Recording Tax Payment in April (in steps)

1. Credit (decrease) cash paid. 2. Debit (decrease) Taxes Payable, to remove the liability.

Recording taxes at YE (in steps)

1. Credit (increase) Taxes Payable (liability) for Taxable Income x Tax Rate. 2. Debit (increase) Tax Expense for Income Before Taxes x Tax Rate. 3. If Taxable Income < Income Before Taxes, credit (increase) Deferred Tax Liability for the difference. 4. If Taxable Income > Income Before Taxes, debit (increase) Deferred Income Tax Asset for the difference.

Recording Accrued Expenses at EOY Close - in steps

1. Debit the appropriate expense account (payroll expense, rent expense, legal expense, etc) 2. Credit the accrued expense account for same amount, which is a liability because it represents an obligation which will need to be paid in the future.

6 Steps to Create a Financial Statement

1. Identify Transaction 2. Understand Transaction 3. Create Journal Entry 4. Create Trial Balance 5. Create the Financial Statement

3 Sections That Make Up the Cash Flow Statement

1. Operating Activities 2. Investing Activities 3. Financing Activities

Manufacturing Stages of Inventory (3)

1. Raw Materials 2. Work in Process (WIP): Work in process inventory includes all inventory that is currently in production, somewhere between being raw materials and finished goods. Work in process inventory includes not only the costs associated with the raw materials being used in production, but also the costs of any labor and overhead also contributing to the production. 3. Finished Goods *Note: these costs build on one another, meaning the cost of the previous stage is incorporated into the following cost.

Direct Method - definition

1. Refers to the method of reporting the cash flow from operating activities on the statement of cash flows by using transactional data. Lists all cash collections and disbursements relating to operating activities in the period to arrive at the increase or decrease in cash from operations during the period. - Simply take all transactions from cash collections for operating activities, and subtract cash dispersement transactions from operating activities. - Positive numbers (inflow) are at the top and negative numbers (outflow) are at the bottom in parentheses.

2 Guiding Principles for which information to include on a financial statement

1. Relevance: Relevance means that the information is useful and capable of influencing the decision of the users of the financial statements. 2. Reliability: Reliability means that the information faithfully represents the underlying economics. The three dimensions of reliability are validity, verifiability, and unbiasedness.

Disposing of an Asset (in steps)

1. Remove asset from books by crediting (decreasing) PP&E account by gross book value of asset (original purchase price) 2. Remove Accumulated Depreciation associated with asset by debiting (decreasing) Accumulated Depreciation account (contra asset account). Use annual depreciation rate x number of years that have passed. 3. Record cash received for sale by debiting (increasing) cash account 4. Reconcile difference between accumulated depreciation value (expected depreciation value) and actual depreciation value (original cost less resale value). a. If item was sold at a gain, credit (increase) Gain on Sale of Equipment account (revenue-adjacent account) b. If item was sold as a loss, debit (increase) Loss on Sale of Equipment / Loss on Impairment account (expense-adjacent account). *Note: if account is "gain/loss" on disposal, use debit for loss and credit for gain

Indirect Method (de-accruing) - in steps

1. Start with net income from income statement 2. Make adjustments to undo impact of accruals made during period, to convert net income to actual cash flow: a. Reverse any non-cash expenses / revenues on income statement. Common non-cash expenses are depreciation and amortization, so add these back in. b. Adjust for gains & losses on assets sold, since these do not represent operating cash flows. (Gains are deducted from net income; losses are added to net income). c. Adjust for operating assets that were bought or sold, but weren't recorded in cash. Subtract increases in assets (means cash was paid); add decreases in assets (means cash was received but wasn't recorded). d. Adjust for operating liabilities that increased or decreased, but weren't recorded in cash. This works the opposite way as adjusting for assets. Add increases in liabilities (this is like spending less in cash than we incurred for an expense), and subtract decreases in liabilities this means we paid cash to pay down the liability).

Paying off an AP Account (in steps)

1. assets decrease (cash paid), 2. liabilities decrease (removing obligation to pay in the future)

IRR Formula in Excel

=IRR(values) - Where values are an array of numbers related to cash flow, with at least one positive and one negative number. - Here INCLUDE year zero (this will typically be the negative value, indicating the upfront cost of the initial investment

Calculating NPV in Excel

=NPV(rate, value 1, value 2, etc) + inflows from year 0* - Where: - Rate = interest rate (also called "discount rate") for the period - Value 1, value 2, etc = equally spaced cash flows that occur at the end of each period (cash flow arrays)

Excel Formula for calculating PV

=PV(rate, nper, pmt) - Where: - Rate = interest rate (also called "discount rate") for the period - Nper = number of payment period for given cash flow - Pmt = payment or cash flow, to be discounted *PV formula assumes payments are equal over total number of periods (in other words, use only for annuities or regular dispersements. **PV formula results in a negative number!!! This is the amount you'd be WTP now for a future annuity.

Straight Line Depreciation - definition & equation

A common method of depreciating long-lived assets that spreads the anticipated decline in the value of the asset evenly over the expected useful life of the asset. The yearly depreciation amount is calculated as: ANNUAL* Depreciation Amount = (Gross Book Value - Salvage Value) / Useful Life * Divide this number by 12 for monthly depreciation expense.

Accumulated Depreciation - definition

A contra ASSET account (real account) that includes the cumulative total of all depreciation expenses recorded to date for specific assets. The credit balance in this account offsets the debit balance in the asset account which shows the original value of the asset. When the original asset value is netted against the accumulated depreciation for the asset you arrive at the net book value of the asset.

DuPont Framework - definition

A framework of ratios that breaks down Return on Equity (ROE) into three components: 1. Profitability -> Profit Margin 2. Efficiency -> Asset Turnover 3. Leverage -> Leverage Ratio

Journal Entry - definition

A journal entry is the entry made to record a transaction in the financial records of a business. The information entered will include the accounts impacted, the dollar (or other currency) amounts involved, the date of the transaction, and often some notes explaining the transaction. A journal entry always includes at least one debit and at least one credit, and the total debits must always equal the total credits.

Trial Balance - definition

A list of all the general ledger accounts of the business and their balances at a point in time. The total amount of the debits must always equal the total amount of the credits. Includes both real & nominal accounts. - In contrast to a T-Account, includes only beginning and ending balance for each account, rather than individual transactions. - Beginning credit = beginning debit // Ending credit = ending debit - Preparing a Trial Balance is the first step toward preparing a financial statement. - Debit is indicated on the left, and credit on the right.

Gordon Growth Model - definition

A method for calculating the terminal value of an indefinite stream of cash flows. The calculation gives the present value of infinite cash flows by dividing the cash flow in the final year of our projection by the difference between the discount rate and the growth rate. - Makes assumption that growth will remain steady indefinitely. Therefore, should only be used once cash flows are expected to stabilize.

Period Inventory System - definition

A method of determining the ending value of inventory and cost of goods sold in which detailed inventory transactions are not recorded on a regular basis. Instead, a physical count of inventory is performed periodically, and the cost of goods sold for a period are determined by subtracting the value of counted inventory from the goods available for sale (calculated as beginning inventory plus inventory purchases during the period). Due to modern technology, the periodic inventory system has been replaced in most cases by the perpetual inventory system. However, most businesses still perform periodic inventory counts, even if they use a perpetual inventory system.

Perpetual Inventory System - definition

A method of inventory tracking in which all inventory purchases and movements are recorded when they occur. The transactions are typically entered into an inventory tracking system which is integrated with the accounting system. At any point in time, including at a period end, the amount and value of inventory is available and can be reported by the system. However, most businesses still perform periodic inventory counts to correct for shrinkage, even if they use a perpetual inventory system.

Discount Rate - definition

A percentage rate determined by a company used to calculate the present value for a stream of future cash flows. The discount rate is somewhat subjective and is meant to take all of the factors that impact the time value of money into account, e.g. opportunity cost, inflation, and risk.

Impairment - definition

A permanent reduction in the value of an asset due to technological or market factors that cause the asset to have less value than it currently has in the accounts of the business. Impairment typically applies to intangible assets such as goodwill or patents.

Prepaid Expense - Definition

A prepaid expense is an asset that represents the right to receive goods or services in the future.

Circularity - definition and example

A problem with two variables in which the value of each variable impacts the value of the other variable so that changing either value impacts the other value. - Interest Expense is tricky to forecast, because it is calculated based on long-term debt, but debt may increase in order to cover interest expenses.

Accrual - definition

A revenue amount that is recorded after the revenue is earned but before the payment is received or an expense amount that is recorded after it has been incurred but before the payment has been made. In either case, for an accrual the exchange of cash is expected at some future point after the initial revenue or expense is recognized.

Depreciation Expense - definition

A temporary account (nominal) that shows the depreciation for the current accounting period. It's an expense reported on the income statement. DEPRECIATION EXPENSE IS AN OPERATING EXPENSE!!!

Principle of Conservativism - definition

Accounting should reflect the more cautious estimated valuation rather than the more optimistic one. For assets it means recording the lower valuation while for liabilities it means recording the higher possible valuation. For revenues and gains it means recording them when they are reasonably certain but for expenses and losses it means recording them when they are reasonably possible.

AP Turnover - definition and equation

Accounts Payable Turnover is a ratio that is used to measure how efficiently a business is paying its vendors. It is calculated by dividing the credit purchases for the period by the average accounts payable balance for the period. In the absence of credit purchases information, we may use cost of goods sold as a substitute. The ratio represents how many times the accounts payable turned over during the period. For most ratios in this course, we use averages when calculating ratios with balance sheet numbers, but this is not necessary and some may choose to use beginning or ending balances. - Generally, you want this number to be high (indicates high efficiency rate) AP Turnover = Credit Purchases* / Average AP *Can use COGS as substitute

Accounts Receivable Turnover - definition and equation

Accounts Receivable Turnover is a ratio that is used to measure how efficiently a business is collecting receivables from its customers. It is calculated by dividing the credit sales for the period by the average accounts receivable balance for the period. In the absence of credit sales information, we may use total sales as a substitute. The ratio represents how many times the accounts receivable turned over during the period. For most ratios in this course, we use averages when calculating ratios with balance sheet numbers, but this is not necessary and some may choose to use beginning or ending balances. - You want this number to be high (indicates high efficiency rate) - Indicates the number of times per year a company collects outstanding AR (low AR turnover indicates that customers are having trouble paying which can lead to cash flow problems) AR Turnover = Credit Sales* / Average Accounts Receivable *Can use total sales as substitute

Accumulated Depreciation (equation for Pro Forma statement)

Accumulated Depreciation = Current Year Depreciation Expense + Past Year Accumulated Depreciation

EBIT - definition and equation

Acronym for Earnings Before Interest and Taxes. Can be calculated by adding interest and taxes back to Net Income. EBIT = Net Income + Interest + Taxes

Other Income & Expenses - definition and examples

Activity outside core line of business (side hustle). This does NOT include tax expenses. - Ex: Loss on disposal (a company sells an asset at less than its booked value)

Period Costs - definition

All other (non-product) costs a company incurs while doing business (expensed during the period during which they are incurred (SG&A).

Contra Account - definition

An account for which the typical balance is contrary to other accounts in its category. Used to adjust the net value of the account to which it relates. - Contra asset account has a credit balance (where asset account has debit balance) - Contra revenue account has debit balance (where revenue account has credit balance)

Contra Asset Account - Definition & examples

An account that exists to adjust the net value of the asset on the financial records of the company. It is called a contra-asset account because it has a credit balance and its only purpose is to modify the value of the related asset. The contra-asset account is typically shown beneath the related asset in the chart of accounts and in the financial reports. Examples of a contra-asset accounts are Reserve for Bad Debts, which is a contra-asset account related to Accounts Receivable, and Accumulated Depreciation, which is a contra-asset related to Property, Plant, & Equipment.

Realization Principle

An amount is realized when the cash (or claim to cash) is received, and an amount is realizable when receipt of payment (or claim to cash) is reasonably certain. Revenue can only be recognized once the revenue is both earned and realized or realizable.

Deferral - definition

An amount that is recorded when payment is received for revenue that is yet to be earned (such as deferred revenue/unearned revenue) or when payment has been made prior to an expense being incurred (such as prepaid insurance). In either case, for a deferral the exchange of cash takes place before the actual revenue or expense is recognized.

Deferred Expense - definition

An asset account that records amounts paid towards expenses not yet recognized on the income statement.

Accrued Revenue - definition

An asset account that records revenue that has been earned and recognized on the income statement but not yet paid for by the customer.

Retained Earnings - definition

An owners' equity account that reflects the earnings that have been retained in the business to finance growth or future operations. At the end of each accounting period, the net income for the period is closed to retained earnings.

Asset Turnover - definition and equation

Asset Turnover is calculated by dividing the total sales for the period by the average total assets. This calculation is used as a measure of efficiency in the DuPont Framework. For most ratios in this course, we use averages when calculating ratios with balance sheet numbers, but this is not necessary and some may choose to use beginning or ending balances. - You want this number to be high (indicates high efficiency rate) - Uses both income statement and balance sheet Asset Turnover = Total Sales (Revenue) / AVERAGE Total Assets

Average Collection Period - definition and equation

Average Collection Period is a measure related to accounts receivable turnover that shows the average number of days it took for a business to collect payment from a customer. It can be calculated by dividing the average accounts receivable by the credit sales per day. Alternatively, it can be calculated by dividing 365 by the Accounts Receivable Turnover. For most ratios in this course, we use averages when calculating ratios with balance sheet numbers, but this is not necessary and some may choose to use beginning or ending balances. - You want this number to be low - Average Collection Period is to AR Turnover what Days Inventory is to Inventory Turnover Average Collection Period = 365 / AR Turnover -or- Average Collection Period = Average AR / (sales (revenue) / 365)

Net Profit - definition & equation

Calculated by the formula Income before taxes - taxes, or total revenue - total expenses. A company's total earnings. Also called net earnings, net income, and the bottom line. Net Profit = Income Before Taxes - Taxes -or- Net Profit = Total Revenue - Total Expenses

Cash Conversion Cycle - Equation

Cash Conversion Cycle = Days Inventory + Average Collection Period - Days Purchases Outstanding ***Use the Days' Formulas for all of the above

Cash Conversion Cycle - definition

Cash conversion cycle is a measure of how long it takes a business from the time it has to pay for inventory from its suppliers until it collects cash from its customers. It can be calculated as the Days Inventory, plus the Average Collection Period, minus the Days Purchases Outstanding. - Units are measured in days - A negative cash conversion cycle means a company collects cash from customers before paying suppliers (especially beneficial if business is growing). Negative is good!

Free Cash Flows - definition

Cash flows that are free, or available, to distribute to investors or to reinvest in the business after the business has covered all its expenses. FCF does not consider the impact of how a business is financed.

- Increase in operating current assets -> ?? net income

decrease

Decrease in operating current liabilities -> ?? net income

decrease

Income Tax Expense - definition

he amount determined by multiplying the applicable income tax rate by the income before taxes (or pretax profit) on the Income Statement. - Amount of tax related to Income Before Taxes for the year *Note: when closing out YE, record tax expense even though taxes are not due until April of the following year.

- Decrease in operating current assets -> ?? net income

increase

Increase in operating current liabilities -> ?? net income

increase

Operating activities - definition

this section includes information on cash used or received in preparing or providing goods / services to customers. - Ex: Cash from sales, cash paid to manufacture goods, cash paid for salaries, taxes, interest paid on loans. - Closely tied to net income.

Recording Advance Payment from a Customer (in steps)

1. Advance payments increase assets (cash received) 2. Increase liability (obligation to deliver good or service in the future).

Paying Off Credit (in steps)

1. Assets decrease (cash paid), 2. Liabilities decrease (removing obligation to pay in the future).

Recording a sale of inventory to a customer who pays in cash (in steps)

1. Debit (increase) cash (asset) 2. Credit (increase) revenue (owners' equity) - same amount as step #1 3. Credit (decrease) inventory (asset) 4. Debit (increase) COGS (expense -> owners' equity) - same amount as step #3

Recording Depreciation Expense (in steps)

1. Debit (increase) depreciation expense (expense -> owners' equity) 2. Credit (increase) accumulated depreciation (contra-asset)

Sections on Income Statement (5)

1. Gross Profit 2. Operating Income 3. Other Income & Expenses 4. Income Before Taxes 5. Net Income

Double-declining depreciation - definition

A common accelerated deprecation method of calculating and recording depreciation expense. It recognizes more depreciation expense in the early years and less in the later years compared to straight-line depreciation.

Net Income - definition

A company's total earnings. Also called net earnings, net profit, and the bottom line. Shows overall health of company during accounting period.

Nominal Accounts - definition

Accounts that are reset to zero at the end of each accounting period. Nominal accounts include all revenue and expense accounts. The net balance of nominal accounts is transferred to retained earnings at the end of each accounting period. Also called "temporary" or "income statement accounts"

Real Accounts - definition

Accounts which contain cumulative balances since the inception of the business. The balances in these accounts flow from one accounting period to the next. Real accounts include all asset, liability, and owners' equity accounts. Also called "Permanent" or "Balance Sheet" accounts.

Accumulated Depreciation - equation

Accumulated Depreciation = Monthly Depreciation Expense x Number of Months Asset Has Been in Service

Paid-In Capital - definition

Amounts contributed to (invested in) the business by the owners.

Last In First Out (LIFO) - definition

An inventory valuation method which determines the value of inventory sold as if the current units sold are the newest units placed into inventory (Last In First Out). In a time of steadily rising inventory costs, this method leaves the lower costs in the inventory account and recognizes the latest, higher costs as an expense in Cost of Goods Sold. - Allowed only by US GAAP

First In First Out (FIFO) - definition

An inventory valuation method which determines the value of inventory sold as if the current units sold are the oldest units remaining in the inventory (First In First Out). In a period of steadily rising inventory costs, this method leaves the higher costs in the inventory account and recognizes the older, lower costs as an expense in Cost of Goods Sold. - Allowed by US GAAP and IFRS

Shipping Expense - where does this go

COGS

Non-current Assets - definition and examples

Assets that the business will likely hold in their current form for more than a year. - Ex: PP&E, "long-term assets", long-term marketable securities

Long-Lived Assets - definition

Assets which are expected to provide value to the business for periods in excess of one year. Examples include buildings, vehicles, or machines. Also referred to as Property, Plant, & Equipment (PP&E). - Note: Land does not depreciate over time, unlike most other PP&E

Recording Accrued Expense (in steps)

At the time good or service is delivered: 1. debit expense account to record expense (owners' equity) 2. credit accrued expense account (liability) for obligation to pay to recognize expense At the time cash is exchanged: 1. credit cash to record payment 2. debit accrued expense account to remove liability.

Recording Accrued Revenue (in steps)

At the time of the accrual: 1. we debit the receivable (asset) account 2. credit (increase) the appropriate accrued revenue (equity) account. When the cash transfer ultimately occurs: 1. we debit the cash account to record payment 2. credit the receivable account to remove promise to receive payment in future.

Goods Available for Sale - equation

Beginning Inventory + Inventory Purchased Throughout Period = Goods Available for Sale

COGS Equation

COGS = Revenue - Gross Profit

Product Costs - definition

Costs that a business incurs to buy, manufacture, and deliver a good or service to a customer. These are recorded as inventory when purchased, and COGS when sold. - Recording product costs is more complex for manufacturers than for retailers, since they create their own inventory.

Current Assets - definition & examples

Current Assets: An asset that will be used or converted into cash within one year or one operating cycle, whichever is longer. - Ex: cash, cash equivalents, accounts receivable, inventory

Deferred Revenue - definition

Deferred revenue is a liability that represents the obligation to provide goods or services to a customer in the future. Deferred revenue is recorded when a business receives a payment in advance from a customer, but the business has not yet delivered the good or provided the service. May also be referred to as unearned revenue.

IFRS Balance Sheet Format

Each section goes in order from least liquid to most liquid: 1. Non-current assets 2. Current assets 3. Shareholders' Equity // Owners' Equity 4. Non-current liabilities 5. Current liabilities

US GAAP Balance Sheet Format

Each section goes in order from most liquid to least liquid: 1. Current assets 2. Non-current assets 3. Current liabilities 4. Non-current liabilities 5. Shareholders' Equity // Owners' Equity

Adjusting Journal Entry - definition

Entries made to adjust the balances of asset and liability accounts to reflect changes in their values due to the passage of time or another implicit transaction.

Balance Sheet - definition

Financial report that shows the financial position of a company at a specific point in time; a snapshot of the resources that are owned or controlled by company, and how those resources were financed. The balance sheet shows the balance of all asset, liability, and equity accounts as of a given date. - Takes all real accounts from trial balance. - Prepared at least 1x annually.

COGS equation (in inventory context)

Goods Available for Sale - Inventory on Hand = COGS

Gross Profit - equation

Gross Profit = Revenue - COGS

Income Before Taxes - Equation

Income Before Taxes = Operating Income - Other Income & Expenses

Accrued Expenses - definition

Liability account used to record amounts at the end of an accounting period to recognize expenses that were incurred in the period but for which no invoice has yet been received nor payment has yet been made. Examples are salaries/wages payable, accrued rent expense, accrued legal fees.

Notes Payable - definition

NON-CURRENT liability (unless otherwise indicated) that arises when a business receives a promissory note (loan) from another business. A portion or all of the note payable may be recorded in the current liabilities or non-current liabilities section of the balance sheet, depending on how soon the business expects to settle the note.

Net Income - equations (2)

Net Income = Income Before Taxes - Taxes Net Income = Revenue - Expenses

Intangible Asset - definition

Non-physical long-lived assets such as patents, brands, and goodwill. - Recorded similarly to physical assets, except depreciation of intangible assets is called amortization - Similar to land, Goodwill is a long-term intangible asset which is not amortized over time, but is tested for impairment annually.

Current Liabilities - definition and examples

Obligations that will be settled or paid in cash within a year (or within one operating cycle, if the company's operating cycle is longer than one year). - Ex: short-term debt, accounts payable, deferred revenue, accrued expenses

Entity Concept - definition

Refers to the fact that a business is a separately identifiable entity. Thus, the accounts of a business should be separate and distinct from the accounts of the owners and managers of the business. In addition, financial records should be kept and reported for each separate entity, especially in the case of multi-national companies and large companies with subsidiaries.

Gross Book Value - definition & equation

The amount at which an asset is recorded in the financial records of the business. When an asset has just been purchased, this is normally the price that was paid to purchase the asset plus any costs to prepare the asset for service in the business. These extra costs may include delivery, installation, and testing. Net Book Value + Accumulated Depreciation = Gross Book Value

Gross Profit - definition

The amount by which the revenue exceeds the cost of goods sold (or cost of sales). Gross Profit shows whether business is profitable.

Income Before Taxes - definition

The amount shown on the Income Statement after all expenses have been taken away from the revenue for the period but before any tax expense for the period. May also be referred to as Pretax Profit.

Operating Expenses - definition

The costs that a business incurs to run its normal operations. Operating expenses include items such as sales and marketing expenses, research and development expenses, and general and administrative expenses. Within those categories are costs such as payroll costs for employees in those departments, advertising costs, legal fees, and other cost items.

Net Revenue/ Net Sales - definition

The net amount of revenue less any contra-revenue accounts. Contra-revenue accounts may include sales returns and allowances, cash discounts or warranty reserves, all of which are accounts with debit balances that reduce gross revenue to a net revenue amount. Some companies report net revenue as the top line on their income statements rather than gross revenue, implying that contra-revenue accounts exist but are not material.

Net Book Value - definition & equation

The net value of the equipment account (gross book value) and the accumulated depreciation account. May also be referred to as book value or carrying value. Net Book Value = Gross Book Value - Accumulated Depreciation

Double Entry Accounting - definition

The system of accounting that requires that every transaction be entered using both debits and credits and that the value of the debits must equal the value of the credits.

Implicit Transactions - definition

Transactions that do not involve a specific triggering activity, event, or exchange of resources from one party to another, and that are not accompanied by an invoice or other paper documentation. Often, implicit transactions represent changes in value related to the passage of time, such as depreciation, interest expense, and the amortization of a prepaid expense. Implicit transactions are often recorded using adjusting journal entries.

Explicit Transactions - definition

Transactions that involve some activity, event, or exchange of resources from one party to another. Explicit transactions are often accompanied by invoices or other paper documentation that initiates the recording of the transaction.

Recording a Prepaid Expense (in steps)

When cash is paid: 1. credit (decrease) cash (asset account) 2. debit (increase) prepaid expense account (asset) When good/service is delivered: 1. credit (decrease) prepaid account (asset) 2. debit (increase) expense account (expense -> owners' equity).

Recording Deferred Revenue (in steps)

When cash is received: 1. debit (increase) cash 2. credit (increase) deferred revenue (liability). When good or service is delivered: 1. debit (decrease) deferred revenue (liability) 2. Credit (increase) revenue (owners' equity) 3. debit (increase) COGS (expense -> owners' equity) 4. credit (decrease) inventory (assets)

Recording an AR payment (in steps)

When payment from a customer credit account is received: 1. assets increase from receipt of cash 2. assets decrease because the business no longer has a claim to receive cash in the future.