HBX FA

Implicit Transaction

do not have a specific trigger, and are not accompanied by an invoice, but instead involve some degree of judgement in determining the timing and amount of the journal entries. ex. depreciation, interest expense, amortization of a prepaid expense. Key identifiers of implicit transactions: 1) entries linked to either generating revenue or incurrring an expense 2) entries internal to the compnay 3) transactions that don't involve cash 4) entries made at the end of an accounting period

Payback Period

tells us how fast the investors can expect to have their money returned. This metric (Payback Period) is more useful for someone who is concerned about limiting the downside potential rather than evaluating the whole project. It ignores the time value of money and the cash flows that occur after the payback period. The best way to calculate the payback period is to calculate the CUMULATIVE CASH FLOWS. Another way to think of the payback period is that it is the "breakeven" point, or the point at which positive cash flows and negative cash flows incurred to date net to zero.

Deferred Tax Asset

the amount that arises when Taxable Income exceeds Income Before Taxes due to a TEMPORARY timing difference.

Income Statement

shows the company's financial performance, because it shows the accumulation of all nominal accounts over a period of time (shows all Revenue and Expense accounts for a given period of time). The net effect of the Nominal Accounts on the Trial Balance (Revenue and Expenses) is transferred to Retained Earnings. Using trial balances from any two points in time, a business can create an income statement that will tell the financial story of the activities for that period. shows the following measures of income: 1) gross profit (sales less cost of goods sold), 2) operating income (gross profit less operating expenses), 3) income before taxes (operating income less nonoperating expenses), and 4) finally, net income (income before taxes less taxes).

Consistency

requires that the accounting methods be consistently applied by the company over time in recording and reporting unless there is a sound reason to change them. If the motivation is to more accurately match expenses to revenues, the company may find this reason more compelling than consistency and decide to make the change.

Assets

resources owned or controlled by an entity that will produce benefits in the future.

Reliability

the info faithfully represents the underlying economics: Valid, Verifiable, Unbiased

Relevance

the info is useful and also capable of influencing the users of the financial statement

Accrual Method of Accounting

transactions are recorded in the period to which they relate, regardless of when cash is exchanged.

Double Entry Accounting

used to record transactions in journal entries with debits on the left and credits on the right. Total debits must always equal total credits and balance out the Accounting Equation. ASSETS AND EXPENSES INCREASE WITH A DEBIT.

t-Account

shows all activity for a given account for a specific period of time (summary of all journal entries involving that account) with debits on the left and credits on the right. - there is a separate T-account for each account - each T-account has a beginning and ending balance, which may be zero - 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

Internal Rate of Return

IRR is the discount rate that sets the NPV of a project equal to zero. The IRR allows us to see the percentage rate that would be earned for a given set of cash flows. This metric (IRR) is often used when there is a lack of clarity or a lack of consensus within the company as to what discount rate should be used in an NPV calculation. =IRR(values) Values is an array of numbers for which to calculate the internal rate of return. Values must contain at least one positive value and one negative value. The order of values must be in the order of cash flows.

Adjusting Journal Entries

Implicit transactions often lead to what are known as adjusting entries, which are journal entries made at the end of a given accounting period (month, quarter, or year) to record necessary adjustments. The goal is generally to conform to the revenue recognition and matching principles. Adjusting journal entries typically relate to either accruals or deferrals.

Materiality

Something is MATERIAL if it is important or significant. Some material can be reported combined - - Trivial matters don't have to be recorded/reported in DETAIL.

The Entity Concept

A business is a separately identifiable entity, and only the business that belongs to the business should be recorded in the financial statements of a firm. Avoids managers including their own personal expenses, firms making up entities that don't exist - ex. Enron used special purpose entities to conceal many of the accounting transactions that happened in the firm.

Periodic Inventory System

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).

Perpetual Inventory System

A method of inventory tracking in which all inventory purchases and movements are recorded when they occur with an inventory tracking system.

Impairment

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.

Free Cash Flow

Another important component in planning and evaluating the future of a business is to look at the expected cash flows that the company will generate. These provide an indication of how much actual cash is generated, and hence available, to be paid out to investors in the business or invest in new projects. FCF = (1-t)EBIT + DEP - CAPX - change in NWC t= tax rate EBIT= Earning before Interest and Taxes Dep = Depreciation and Amortization CapX = Capital Expenditures change in NWC = Change in net working capital (NWC= Assets-Liabilities)

Double Declining Balance Depreciation

an accelerated method, which causes more depreciation expense to be recognized in the early years and less in the later years. Over the life of the asset a company using double declining balance depreciation will report lower net income in the early years, and higher in the later years, compared to a company using straight-line depreciation.

Expenses

the costs associated with provided goods or services to a customer.

Revenue

the money that a business receives from providing goods or services to a customer.

Statement of Cash Flows - Investing Section

this section of the statement of cash flows contains cash flows relating to long-lived assets, such as property, plant, and equipment. Additional inflows and outflows that would be included in this section relate to loans made to another entity, called loans receivable, and certain investment securities.

Explicit Transaction

those that are triggered by a specific event, often an exchange of resources between two parties. Usually accompanied by an invoice.

The Accounting Equation

Assets = Liabilities + Owner's Equity

Conservatism Principle

Businesses should anticipate and record future losses when they are probable as a liability. Anticipated Future gains, however, should not be recorded until they are realized (turned into cash, cash equivalents, or good receivables). Accounting numbers are less likely to be overinflated or optimistic, which results in lower Net Income, lower Assets and lower Stockholder's Equity

Manufacturing Business Inventory

Product Costs - those that a business incurs to buy, manufacture, and deliver a good or service to a customer. The product costs will include the raw materials and parts that are purchased from suppliers as well as direct labor and supervision and overhead costs such as rent on the plant building and depreciation of plant equipment. Period Costs - all of the other costs a company incurs while doing business, such as executive salaries or office rent. A manufacturing business will track its inventory in three stages: raw materials, work in process (WIP), and finished goods. Raw Materials - - Raw materials are the components and supplies that a manufacturing business purchases to be used in the production of its inventory. 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. Finished Goods - - Goods at the final stage of the manufacturing process when they are complete and available for sale to customers. The cost of finished goods inventory includes raw materials, labor, and factory overhead costs.

Profitability Ratios

Profit Margin = Net Income / Total Sales reveals how much profit is left from each dollar of sales after all expenses have been subtracted Gross Profit Margin = Gross Profit / Total Sales tells us what percentage of our revenue is left to cover other expenses after the cost of goods sold is subtracted EBIAT (Earnings Before Interest After Taxes) a measure of how much income the business has generated while ignoring the effect of financing and capital structure, or the proportion of debt that the business has

The Dupont Framework

Return on Equity (ROE) = Profitability x Efficiency x Leverage profitability - This ratio shows the % of each dollar of sales that ends up as net profit. Profit Margin = Net Income / Total Sales efficiency - This tells us how well a business is using its assets to produce sales. Asset Turnover = Total Sales / Average Total Assets Note: An interesting thing to note here is that this ratio uses both the income statement and the balance sheet. Because the income statement covers the entire year, but the balance sheet is as of a specific point in time, we typically use the average of the beginning and ending balance sheet amounts to estimate the average level of assets during the period. leverage - measures the impact of all non-equity financing, or debt of all sorts, on the firm's ROE. If all of the assets are financed by equity, the multiplier is one. As liabilities, which are forms of debt, increase, the multiplier increases from one, demonstrating the leverage impact of the debt. Leverage Ratio (or Equity Multiplier) = Average Total Assets / Average Total Equity

Return on Equity

Return on Equity (ROE) = Profitability x Efficiency x Leverage shows the return that a business generated during a period on the equity invested in the business by the owners of the business. ROE = Net Income / Owners Equity

Policy Differences

While accounting standards attempt to minimize the differences between companies, situations exist where two companies will reasonably elect different ways of accounting for items that appear very similar. Understanding these differences is essential to analyzing companies using ratio analysis. In some cases, you'll need to make adjustments to financial statements to account for the differences before they can be used for comparisons. Typical Policy Differences: Revenue Recognition Capitalizing Expenditures Depreciation

The Matching Principle

a company is required to match its expenses to the related revenues in the accounting period to which they relate.

Historical Cost Principle

a good example of how accounting standards require that reliable information be used to record transactions. Transactions are to be recorded at the actual price that existed at the time of the transaction - - more reliable b/c it tracks back to the actual amount that changed hands. Upside - - businesses can not adjust value of assets based on assumptions, which alleviates an overstatement of assets on financial statements (ex. Cardullo's Nutella shrotage) Downside - - it might result in less relevant information if the values have changed since the transaction took place. (ex. Land)

Accruals

Accruals related to revenue arise when a company delivers goods or performs a service before receiving payment. ex. Accounts Receivable Accruals related to expenses arise when a company uses resources before paying for them. ex. interest payable, salaries payable, accrued expenses (before receiving an invoice for goods/services already delivered)

Closing Process

All of the adjusting journal entries discussed in this module are part of the closing process. The closing process is really just an opportunity for a company to evaluate its trial balance and ensure that the proper accruals and other adjusting entries have been made so that the financial statements will accurately reflect the results of all transactions that occurred during the period.

LIFO

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.

FIFO

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.

Efficiency Ratios

Asset Turnover = Sales / Average Assets tells us how well a business is using its assets to produce sales tells us how well a business is using its assets to produce sales. A business that can create more revenue with fewer assets is more efficient. This ratio uses both the income statement and the balance sheet; we typically use the average of the beginning and ending balance sheet amounts to estimate the average level of assets during the period. Inventory Turnover = COGS / Average Inventory helps understand how efficiently a business is managing its inventory levels. A higher inventory turnover represents more efficient inventory management. Days Inventory = 365 / Inventory Turnover the average number of days the inventory is held before it is sold AR Turnover = Sales / Average Accts. Receivable indicates a business' efficiency in collecting receivables from customers. A higher AR turnover represents more efficient cash collections. Average Collection Period or Days Sales Outstanding = 365 / Accts. Receivable Turnover is the average number of days it took for a business to collect payment from a customer. AP Turnover = COGS / Average Accts. Payable we look at how long it takes us to pay our vendors Days Purchases Outstanding = 365 / Accts. Payable Turnover the average number of days an account was outstanding Cash Conversion Cycle = Days Inventory + Average Collection Period - Days Purchase Outstanding 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.

Direct Method vs. Indirect Method

Both result in the same number = net cash flow from operating activities. Direct Method - - 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. Indirect Method - - 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, building the operating activities section of the statement of cash flows using the indirect method is an exercise in de-accrual. • An increase in operating current assets is subtracted from net income. • A decrease in operating current assets is added to net income. • An increase in operating current liabilities is added to net income. • A decrease in operating current liabilities is subtracted from net income.

Other Ratios

Current Ratio = Current Assets / Current Liabilities helps us understand the business' ability to pay its short term obligations. It focuses on the business' more liquid assets and liabilities, or those that are convertible to cash or coming due, within a year. Quick Ratio = (Current Assets - Inventory) / Current Liabilities The quick ratio is an even more stringent test than the current ratio to see if a business can meet its current obligations because it depends only on the most readily available current assets. Also called the Acid Test Ratio. Interest Coverage Ratio = EBIT / Interest Expense a good way to gauge how capable a business is of making the interest payments on its debt. also called the Times Interest Earned.

Deferrals

Deferrals related to revenue arise when a company receives cash before delivering goods or performing a service. ex. deferred revenue Deferrals related to expenses arise when a company pays for resources before receiving the benefit from them. ex. prepaid insurance

Leverage Ratios

Equity Multiplier = Average Total Assets / Average Total Equity measures the impact of all non-equity financing, or debt of all sorts, on the firm's ROE. If all of the assets are financed by equity, the multiplier is 1. As liabilities, which are forms of debt, increase, the multiplier increases from 1 demonstrating the leverage impact of the debt. Debt to Equity Ratio = Average Total Liabilities / Average Total Equity

Time Value of Money

In order for stakeholders to fairly compare the valuation of various projects the value of the cash flows has to be considered at the same time period. For simplicity we often translate all cash flows to the value that they would be worth today, the "present value." In order to make the calculation, you need a discount rate, which is the rate that would otherwise be available in the market or the rate that best captures the risk inherent in the project being evaluated. Present Value =PV(rate,nper,pmt) Rate is the interest rate (also known as discount rate) for the period. Nper is the number of payment periods for the given cash flow. Pmt is the payment, or cash flow, to be discounted. Notice that the PV formula makes the answer negative. This is because it represents the amount you would be willing to pay today to receive the given cash flows. You would be willing to pay this amount because it is equivalent to the amount you will receive, so the net amount you pay and receive will be zero.

Seasonality

Many businesses have repeating fluctuations in their performance due to seasonality. For many, the pattern follows the course of a year. When we analyze annual financial statements, we learn about the average performance for the business over that time period. If we were to look at financial statements for several smaller periods throughout the year, such as quarters or months, we would see that some may be far different from others. These cycles are important to consider for both management inside a business as they plan for the future and outside investors considering the performance of the business. Quarter three may see depleted cash flows as the business stocks up on inventory but has lower than average sales. After the holiday season, a business may have low inventory and lots of cash. A business' ratios will look very different depending on where they are in the cycle.

Net Present Value

The NPV nets out the present values of ALL THE CASH INFLOWS AND OUTFLOWS of the project. The result is a single number that gives a good indication of what a business or a particular investment is worth today. The discount rate that most companies use in the NPV calculation is the weighted average cost of capital, or WACC. Others use a discount rate that best captures the risk inherent in the project being evaluated independent of how the company is being financed. Note: The sooner the cash inflows are received, the more valuable they are. Alternatively, the longer the cash outflows are delayed, the better. Calculate NPV using PV tables or Excel =NPV(rate, value1,value2,...) There is one important thing to note about using the NPV formula. The formula itself does not include any cash flow at time 0 (today). Instead, the formula takes into account all future cash flows, and nets them back to the present value today, so if there are any cash flows at time 0 (today), those MUST BE ADDED OR SUBTRACTED MANUALLY. If the NPV is positive, even if it is very small, it means that the sum of the discounted cash inflows is greater than the sum of the discounted cash outflows, so the project would yield a return greater than the discount rate.

Going Concern

The business will continue to operate for the foreseeable future - - allows accountants to make estimates and generate financial statement under the assumption that the business is a going concern

Statement of Cash Flows

The purpose of the statement of cash flows is to provide a more detailed picture of what happened to a business' cash during an accounting period. It shows the different areas in which a business used or received cash, and reconciles the beginning and ending cash balances. The sources of info for creating the Statement of Cash Flows are: the balance sheet from both the beginning and end of the period, the Income Statement for the period and some transactional data. The sections of a statement of cash flows are: Operating Activities Investing Activities Financing Activities

Statement of Cash Flows - Operating Activities

This section includes info on cash used or received in providing goods or services to customers, as well as taxes. typical cash flows from Operating Activities include the following: Cash received from customers: • cash received from current period sales • cash collections from previous period credit sales • cash received in advance for future period sales Cash paid to suppliers: • cash paid for current period operating activity purchases • cash paid for previous period credit purchases • cash paid in advance for future period purchases

Deferred Tax Liability

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. This is the amount that arises when Taxable Income is less than Income Before Taxes due to a temporary timing difference.

Sale of an Asset

When an asset is sold, the journal entry to record the sale eliminates net book value by writing off the asset and the accumulated depreciation on the asset and then recognizes any gain or loss based on whether the asset sold for higher or lower than its net book value at the time of the sale. ex. goodwill Non-physical long-lived assets such as intangible assets are treated in a similar manner, except the expense is called amortization, rather than depreciation. In some cases, the journal entry will directly reduce the asset account, while in other cases, the journal entry will use a contra-asset account called accumulated amortization.

Trial Balance

a list of ALL the business' accounts that have balances at that date, and the amount in each account shown in either the debit or the credit column. Provides a snapshot of a business at a specific point in time. Contains two types of accounts: 1) Real Accounts (Assets, Liabilities and Equity) which reflect the cumulative balance in each account from the inception of the business on the Balance Sheet; 2) Nominal Accounts (Revenues and Expenses) which represent activity over a period of time and end up on the Income Statement. At the end of each accounting period, the balance of all nominal accounts is transferred to RETAINED EARNINGS , so that their balances start back at zero at the beginning of each accounting period. REVENUE AND EXPENSE ACCOUNTS BEGIN WITH A $0 TRIAL BALANCE. Assets and Expenses typically have a Debit balance at the end, while Liability, Equity and Revenue should have a Credit balance at the end. Trial balance on Day 1 of fiscal period are only Real Accounts - asset, liability and owner's equity - because the business hasn't had any revenues or expenses yet. All Nominal Accounts - Revenues and expenses - are reset to zero at the end of the previous period. Accounts from the trial balance are typically combined into condensed accounts on the Balance Sheet and Income Statement due to Materiality. Under US GAAP, the balance sheet presents accounts in the following order: current assets, non-current assets, current liabilities, non-current liabilities, and owners' equity. Within each asset and liability group, items are presented in order of liquidity, with the most liquid (those that can be most easily and quickly converted to cash) first. Under IFRS, the balance sheet is generally presented with the least liquid items first, and in the following order: non-current assets, current assets, owners' equity, non-current liabilities, and current liabilities.

Balance Sheet

a snapshot of the financial position of a business at any particular point in time. It allows those interested in the business to quickly see what resources are available and how those resources were financed. Only the asset, liability, and stockholders' equity account balances from the general ledger or from the trial balance are presented in the appropriate section of the balance sheet. Sections of a Balance Sheet: 1) Current Assets - those converted into cash / other assets within one operating cycle (ususally one year); Cash, Accts Receivable, Inventories 2) Non-current Assets - those which the business will hold for more than a year; equipment, buildings 3) Current Liabilities - those that come due within one year; accounts payable, income taxes payable, long-term debt 4) Non-current Liabilities - longer term liabilities; long-term debt 5) Owners Equity - The equity section of the balance sheet is generally quite simple as there are no subsections. US GAAP and IFRS generally present this section in a similar order with capital stock accounts first (Common Stock, Preferred Stock, Treasury Stock) and the retained earnings account last, but you may see some variations.

Gordon Growth Model

a way to estimate the value of a seemingly endless stream of cash flows. This model makes a major assumption that growth will remain steady indefinitely. As a result, this model should only be used once the cash flows are expected to stabilize. Since this equation gives us the present value of the cash flows as of the end of our forecast, we still need to discount the value back to the beginning of our forecast using the present value technique we introduced in the previous concept. Present Value of Infinite Cash Flows = Cash Flows in the Final Year of Our Project / (Discount Rate - Growth Rate)

Straight Line Depreciation

calculated by dividing the gross book value by the estimated useful life of the asset. Any salvage value should be subtracted from the gross book value and any disposal costs should be added to the gross book value before calculating depreciation. Annual Depreciation = (Gross Book Value - salvage value (or +disposal costs)) / useful life of the asset The original cost of the asset less accumulated depreciation (a contra-asset account - increases with a credit and decreases with a debit) is the net book value of the asset. Remember that land is an exception to the rule. We do not depreciate land because it is not "used up" by the business, and its value is typically not reduced or consumed.

Owners' Equity

consists of funds contributed by owners as well as profits generated by the business.

Statement of Cash Flows and the Phase of a Business

fast-growing startup - A start-up will typically have negative or very low cash flow from operating activities, negative cash flow from investing activities, and large fluctuations in cash flow from financing activities. profitable/growing - A profitable/growing business will usually have positive cash flow from operating activities, negative cash flow from investing activities, and positive, negative, or neutral cash flow from financing activities. mature company - A mature company will generally have positive cash flow from operating activities, slightly negative cash flow from investing activities, and negative cash flow from financing activities. company in state of decline - A business in decline will typically have negative cash flow from operating activities, positive cash flow from investing activities, and cash flow from financing activities that could be either positive or negative.

Realization Principle

if a business has performed the work and it can reasonably expect to receive cash / accounts payable from the customer, it can recognize revenue even though it has not yet received the cash. *Revenue is recognized when merchandise is delivered.

Statement of Cash Flows - Financing Section

includes cash flows associated with raising and paying back money to investors and creditors. Dividends paid are included in this section under US GAAP, but under IFRS dividends paid may be included in the operating rather than the financing section. While interest paid is included in the operating section under US GAAP, it can sometimes be included here under IFRS.

Liabilities

obligations to pay a third party for resources provided to an entity.

Money Measurement Principle

only values that can be measured in monetary terms get recorded in the financial statement Events / circumstnaces that could have a financial impact on your business are not recorded in accounts unless they can be reliably measured in monetary terms and they relate to a historical transaction that has occurred.