Accounting Exam 2

Interest

"Rent" paid for the use of money for some period of time. Amount of money paid or received in excess of the amount borrowed or lent.

When are Discontinued Operations Reported

-A component of an entity or group of components has been sold or disposed of, or it is considered held for sale -If the disposal represents a strategic shift, that has, or will have, a major effect on a company's operations and financial results.

Four Variables of Present Value Problems Involving Annuities

-Present Value of ordinary annuity (PVA) or Present value of annuity due (PVAD) -The amount of each annuity payment -The number of periods, n -The interest rate. If you know any three of these, the fourth can be determined.

Four Variables in Process of Adjusting Single Cash Flow Amounts for the Time Value of Money:

-Present value (PV) -Future value (FV) -Number of compounding periods (n) -Interest rate (i)

Net of Tax Gain Reported in One of Two Ways:

1. As a gain in net income 2. As a gain in other comprehensive income

Reported Income Effects of Discontinued Operation Includes:

1. Income or loss from operations (revenues, expenses, gains and losses) of the component from the beginning of the reporting period to the disposal date. 2. gain or loss on disposal of the component's assets. Two elements can be combined or reported separately, net of their tax effects.

Two Components of the Reported Amount are Modified as Follows: (When held for Sale)

1. Income or loss from operations (revenues, expenses, gains and losses) of the component from the beginning of the reporting period to the end of the reporting period. 2. An impairment loss if the book value (sometimes called carrying value or amount) of the assets of the component is more than fair value minus cost to sell. The two income elements can be combined or reported separately, net of their tax effects.

Operating Cycle of a Typical Merchandising or Manufacturing Company

1. Use cash to acquire inventory 2. Prepare inventory for sale to customers 3. Deliver inventory to customer 4. Collect cash from customer

Accounting Changes Categories

A change in accounting principle Change in estimate Change in reporting entity.

Default Risk

A company's ability to pay its obligations when they come due.

Return on Assets (ROA)

A company's profitability in relation to overall resources, measured as net income divided by average total assets. Percentage of the average total assets available to generate that income. Inclusive way of measuring earning power that ignores specific sources of financing ROA=Profit margin x Asset turnover Net income/Average total assets Net income+interest expense (1-tax rate)/average total assets.

Operating Segment

A component of an enterprise that engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other companies of the same enterprise); whose operating results are regularly reviewed by the enterprises's chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance; for which discrete financial information is available.

Accumulated Other Comprehensive Income (AOCI)

A component of stockholders' equity that reports the accumulated amount of other comprehensive income items in the current and prior periods. Required to report this amount separetly.

Balance Sheet

A financial statement that presents an organized list of a company's assets, liabilities, and shareholders' equity at a particular point in time. Provides a list of assets and liabilities that are classified according to common characteristics. Sometimes referred to as the statement of financial position

Subsequent Events

A significant development that takes place after the company's fiscal year-end but before the financial statements are issued. Examples include the issuance of debt or equity securities, a business combination or the sale of a business, the sale of assets, an event that sheds light on the outcome of a loss contingency, or any other event having material effect on operations.

Times Interest Earned Ratio

A way to gauge the ability of a company to satisfy its fixed debt obligations by comparing interest charges with the income available to pay those charges. Net Income+Interest expense+income taxes / Interest expense

Equity

AKA net assets, shareholders' equity, or stockholders' equity. Residual interest in the assets of an entity that remains after deducting liabilities. Total assets minus total liabilities.

Ability to Generate Cash

Ability to sell products and services for amounts greater than the costs of providing those products and services (that is, generate a profit).

Management's Responsibilities

Acknowledges responsibility and certifies accuracy of financial statements. To enhance awareness of the users of financial statements concerning the relative roles of management and the auditor. Management's Report on Internal Control over Financial Reporting

Non-GAAP Earnings

Actual (GAAP) earnings reduced by any expenses the reporting company feels are unusual and should be excluded. Exclude certain expenses and sometimes certain revenues. Common expenses include restructuring costs, acquisition costs, write-down of impaired assets, and stock-based compensation. Management's view of "permanent earnings" Controversial because determining which expenses to exclude is at the discretion of management. By removing certain expenses from reported earnings, management has the potential to report misleadingly higher profits. SOX Act requires reconciliation between the two earnings determined.

Prior Period Adjustments

Addition to or reduction in the beginning retained earnings balance in a statement of shareholders' equity due to a correction of an error.

Earnings Quality Affect

Affected by revenue issues. Intentional misstatement of revenue. Issues related to non operating items.

Future Value (FV)

Amount of money that a dollar will grow to at some point in the future. FV=I(1+i)^n FV=future value of invested amount I=Amount invested at beginning of period i= interest rate n=number of compounding periods. Use the table (Illustration 5-1) Inclusion of compound interest

Return on Equity (ROE)

Amount of profit management can generate from shareholders' equity, measured as net income divided by average shareholders' equity Measures return to suppliers of equity capital. Net income/average shareholders' equity

Retained Earnings

Amounts earned by the corporation on behalf of its shareholders and not (yet) distributed to them as dividends.

Comprehensive Income GAAP vs. IFRS

An additional OCI item, changes in revaluation surplus, is possible under IFRS. IAS no 16 permits companies to value property, plant, and equipment at cost less accumulated depreciation or fair value (revaluation) IAS no 38 provides similar option for valuation of intangible assets. GAAP prohibits revaluation.

Long-Term Solvency

An assessment of whether a company will be able to pay all its liabilities, which includes long-term liabilities. Also provides information about financial flexibility.

Fraud

An intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception that results in a misstatement in the financial statements that are the subject of an audit. Errors are unintentional, and this is intentional misappropriation of assets or incorrect financial reporting.

Permanent Earnings

Arise from operations that are expected to generate similar profits in future. Analysts begin their assessment of these with income before discontinued operations, which is income from continuing operations.

Temporary Earnings

Arise from transactions or events that are not likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future.

Management Intent

Asset classification is affected by this. Management may intend to use land for long term operating purposes (property, plant, and equipment), hold it for future resale (investment), or sell it in its ordinary course of business (inventory for a real estate company).

Book Value

Assets minus liabilities as shown in the balance sheet. Usually will not directly measure the company's market value

Investments

Assets not used directly in operations. Include investments in debt and equity securities of other corporations, land held for speculation, long-term receivables, and cash set aside for special purposes (such as for future plant expansion). Classified as long term because management does not intend to convert the assets into cash in the next year (or operating cycle).

Accounting Equation

Assets=Liabilities+ Equity

Profitability Ratios

Attempt to measure a company's ability to earn an adequate return relative to sales or resources devoted to operations. Resources devoted to operations can be defined as total assets or only those assets provided by owners, depending on evaluation objective. Aspects of company's profit-making activities Profit margin on sales, return on assets, and return on equity To enhance predictive value, analysts often adjust net income in these ratios to separate a company's temporary earnings from permanent earnings.

Unqualified with an Explanatory Pragraph

Auditor believes the financial statements are in conformity with GAAP, but the auditor feels that other important information needs to be emphasized to financial statement users. Lack of consistency, going concern, and material misstatement.

Shifting Income

By doing this, managers effectively smooth the pattern in reported income over time, portraying a steadier income stream to investors, creditors, and other financial statement users.

Financial Leverage

By earning a return on borrowed funds that exceeds the cost of borrowing the funds, a company can provide its shareholders with a total return higher than it could achieve by employing equity funds alone. Favorable means earning a return on borrowed funds that exceeds the cost of borrowing the funds. Any time the cost of additional debt is less than the return on assets invested, the return to shareholders is higher with borrowing. If the return on assets are too low and the company has become too leveraged, it faces the risk of not being able to make its interest and debt payments.

Direct Method

Cash effect of each operating activity (i.e., income statement item) is reported directly on the statement of cash flows. Four components. Service revenue, general and administrative expense, income tax expense. Affect cash flows. One component, depreciation reduces net income but not cash.

Ordinary Annuity

Cash flows occur at the end of each period

Annuity Due

Cash flows occurring at the beginning of each period

Annuity

Cash flows received or paid in the same amount each period. Common one encountered in practice is a loan on which periodic interest is paid in equal amounts.

Deferred Revenues

Cash received from a customer for goods or services to be provided in a future period.

Restricted Cash

Cash that is restricted for a special purpose and not available for current operations. Should not be included in the primary balance of cash and cash equivalents. Could include future plans to repay debt, purchase equipment, or make investments. Classified as current asset if expected to be used within one year from balance sheet date.

Minimum Disclosures Interim Reporting

Certain required as follows: -Sales, income taxes, and net income -EPS -Seasonal revenues, costs, and expenses -Significant changes in estimates for income taxes -Discontinued operations and unusual items -Contingencies -Changes in accounting principles or estimates -Information about fair value of financial instruments and the methods and assumptions used to estimate fair values -Significant changes in financial position.

Comprehensive Income

Change in shareholders' equity for the period from non-owner sources; equal to net income plus other comprehensive income. Traditional net income plus other non-owner changes in equity.

Statement of Cash Flows

Change statement summarizing the transactions that caused cash to change during the period.

Other Comprehensive Income (OCI)

Changes in stockholders' equity other than transactions with owners and other than items that affect net income.

GAAP

Companies are required to report earnings based on them. This number includes all revenues and expenses.

Valuation of Long Term Leases

Companies frequently acquire use of assets by leasing rather than purchasing. Usually require the payment of fixed amounts at regular intervals over life of the lease. Lessee records an asset and corresponding lease liability at the present value of the lease payments.

Accumulated Deficit Account

Companies that report net losses could end up with a negative balance in the retained earnings account.

Interim Reporting

Companies whose ownership shares are publicly traded in the US must file quarterly reports with the SEC.

Annual Report

Companies with public securities are required to provide shareholders with this at the end of each fiscal year. Includes financial statements such as the balance sheet. Critical to understanding the financial statements and to evaluating a company's performance and financial health are additional disclosures included as part of the financial statements and also as part of the annual reporting requirements to the SEC.

Debt to Equity Ratio

Compares resources provided by creditors with resources provided by owners. The higher the ratio, the higher the company's risk. More meaningful if compared to some standard such as industry average or a competitor. Makeup of liabilities also is important. Total liabilities/shareholders' equity

Horizontal Analysis

Comparison by expressing each item as a percentage of that same item in the financial statements of another year (base amount) in order to more easily see year-to-year changes.

Ratio Analysis

Comparison of accounting numbers to evaluate the performance and risk of a firm. Allows analysts to control for size differences over time and among firms.

Basic EPS

Computed by dividing income available to common stockholders (net income less any preferred stock dividends) by the weighted average number of common shares outstanding for the period.

Simple Interest

Computed by multiplying an initial investment times both the applicable interest rate and the period of time for which the money is used.

Change in Depreciation, Amortization, or Depletion Method

Considered to be a change in accounting estimate that is achieved by a change in account principle. Account for this change prospectively, almost exactly as we would other change in estimate. One difference is that most changes in estimate do not require a company to justify the change. Result of changing an accounting principle and therefore requires clear justification as to why new method is preferable.

Proxy Statement

Contains disclosures on compensation to directors and executives; sent to all shareholders each year.

Summary of Significant Accounting Policies

Conveys valuable information about the company's choices from among various alternative accounting methods. For example, management chooses whether to use certain things like FIFO or LIFO, or measuring options. Essential step in analyzing financial statements. Knowing which methods were used to derive certain accounting numbers is critical to assessing adequacy of those amounts.

Comparative Financial Statements

Corresponding financial statements from the previous years accompanying the issued financial statements.

Prepaid Expenses

Costs of assets acquired in one period and expensed in a future period. Examples are supplies, prepaid rent, and prepaid insurance. Not converted to cash like receivables collected and inventory sold, but they instead are consumed in the future.

Acid Test Ratio

Current assets, excluding inventories and prepaid items, divided by current liabilities. More stringent indication of a company's ability to pay its current obligations. Numerator consists of cash, short term investments, and accounts receivable (quick assets).

Current Ratio

Current assets/current liabilities

DuPont Framework

Depict return on equity as determined by profit margin (representing profitability), asset turnover (representing efficiency), and the equity multiplier (representing leverage) Three components; profitability, (net income / sales) activity, (sales / average total assets) and financial leverage (average total assets / average total equity). ROE= Profit margin x asset turnover x equity multiplier Focusing on financial ratios helps adjust for size differences and this helps identify the determinants of profitability from the perspective of shareholders.

Working Capital

Differences between current assets and current liabilities. Popular measure of a company's ability to satisfy its short term obligations.

Reporting Unusual Items

Discontinued operations and unusual items are reported entirely within the interim period in which they occur. Treatment of these items is more consistent with discrete view.

Information in the Income Statement Can Be Presented In:

Either in a single, continuous statement of comprehensive income or in two separate, but consecutive statements, an income statement and a statement of comprehensive income.

EDGAR System

Electronic Data Gathering, Analysis, and Retrieval System. Improves the efficiency with which company information is collected and disseminated.

Unusual or Infrequent Event

Events that may be unlikely to occur again in the near future, so we report them as part of operating income because they are so closely related to the company's core business.

Accrued Liabilities

Expenses already incurred but not yet paid (accrued expenses) Salaries payable, interest payable, taxes payable, utilities payable, and legal fees payab;e.

Vertical Analysis

Expression of each item in the financial statements as a percentage of an appropriate corresponding total, or base amount, but within the same year.

Interim Reports

Financial statements covering periods of less than a year. Must be available on timely basis. One objective is to enhance the timeliness of financial information Downside is the amounts are often less reliable. Fundamental debate regarding this topic centers on the choice between discrete and integral part approaches.

Deferred Annuity

First cash flow occurs more than one period after the date the agreement begins.

Present Value of Annuity Due

First cash payment won't include interest PVAD If payment amounts not the same each year, we don't have an annuity and can't find a solution by using annuity tables.

Initial Current Assets for Merchandising and Manufacturing

For merchandising, the initial purchase of inventory often is for a finished good, although some preparation may be necessary to get the inventory ready for sale (such as packaging or distribution). For manufacturing, the initial outlay of cash often involves the purchase of raw materials, which are then converted into a finished product through the manufacturing process.

Segment Reporting GAAP vs. IFRS

GAAP requires information about reported segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement. IFRS no. 8 requires that companies also disclose total liabilities or its reportable segments.

Liquidity Ratios

General idea of the firm's ability to pay its short term debts as they come due. Two common measures of liquidity are the current ratio and the acid-test/quick ratio. Should be assessed in the context of both profitability and efficiency of managing assets.

Disclosures Required for Areas to be Determined Reportable Operating Segments

General information about the operating segment Info about reported segment profit or loss, including certain revenues and expenses included in reported segment profit or loss, segment assets, and the basis of measurement. Reconciliations of the totals of segments revenues, reported profit or loss, assets, and other significant items to corresponding entity amounts. Interim period information.

Executive Stock Options

Give their holders the right to buy the company's stock at a set price, regardless of how high the stock price rises.

Illustration 5-22: Summary of Time Value of Money Concepts

Go to textbook

Inventory

Goods awaiting sale (finished goods), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials). Goods acquired, manufactured, or in the process of being manufactured for sale.

Other Unusual Items

Goodwill impairments and asset impairments. Any long lived asset, whether tangible or intangible, should have its balance reduced if there has been a significant impairment of value. Unusual items included in operating income require investigation to determine their permanent or temporary nature.

Operational Risk

How adept a company is at withstanding various events and circumstances that might impair its ability to earn profits.

Interim Reporting GAAP vs. IFRS

IAS no. 34 requires a company applies the same account policies in its interim financial statements as it applies in its annual financial statements. IFRS takes much more of a discrete period approach than does GAAP. For example, cost for repairs, property taxes, and advertising that do not meet the definition of an asset at the end of an interim period are expensed entirely in the period in which they occur under IFRS, but are accrued or deferred and then charged to each of the periods they benefit under GAAP. Difference would tend to make interim period income more volatile under IFRS than under gAAP. In GAAP, income taxes are accounted for based on an estimate of the tax rate expected to apply for the entire year.

Balance Sheet Presentation and GAAP vs. IFRS

IFRS has minimum list of items to be presented in balance sheet. GAAP does not. IFRS IAS No. 1 changed the title of the balance sheet to statement of financial position, although companies not required to use that title. Under GAAP, we present current assets and liabilities before non-current. IAS No. 1 doesn't prescribe the format of the balance sheet, but often report non-current first.

Valuation of Pension Obligations

Important compensation vehicles used by many US companies. Forms of deferred compensation as the pension benefits are paid to employees after they retire. Obligations funded through employment period.

Reporting Accounting Changes in Interim Reporting

In financial reports of subsequent interim periods of the same fiscal year, we disclose how that change affected income from continuing operations, net income, and related per share amounts for the post change interim period. Reported retrospectively applying changes to prior financial statements.

Non-Cash Investing and Financing Activities

In order to provide complete information about these activities, any significant non cash investing and financing activities (non cash exchanges) are reported either on the face of the statement of cash flows or in a disclosure note. Example is acquisition of equipment (investing activity) by simultaneously issuing a long term note payable or equity securities (financing activity) to the seller of equipment.

Income Tax Benefit

In the case that there is a loss from discontinued operations, there would be this instead of expense; losses from discontinued operations are tax deductible and would reduce overall taxes owed, thereby providing this.

Current Assets

Include cash and other assets that are reasonably expected to be converted to cash or consumed within one year from the balance sheet date, or within the normal operating cycle of the business if that's longer than one year.

Other Common Disclosures

Include details concerning earnings per share calculations, income taxes, property and equipment, contingencies, long term debt, leases, pensions, stock compensation, changes in accounting methods, fair values of financial instruments, and exposure to market risk and credit risk.

Component of an Entity

Includes activities and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the company. Could include an operating segment, a reporting unit, a subsidiary, or an asset group.

Operating Income

Includes revenues, expenses, gains, and losses directly related to the principal revenue-generating activities of the company. Often presented as gross profit minus operating expenses. For service company, it would include service revenue minus operating expenses (and no COGS)

Non-Operating Income

Includes revenues, expenses, gains, and losses related to peripheral or incidental activities of the company. Often included in income statement under other income (expense)

Reporting Discontinued Operations

Income or loss stream from a discontinued operation no longer will continue. It is informative for companies to separate the effects of the discontinued operations from the results of operations that will continue. For this reason, the revenues, expenses, gains, losses, and income tax related to a discontinued operation must be removed from continuing operations and reported separately for all years presented.

Single Step Income Statement Format

Income statement format that groups all revenues and gains together and all expenses and losses together.

Multiple-Step Income Statement Format

Income statement format that includes a number of intermediate subtotals before arriving at income from continuing operations. Primary advantage is that by separately classifying operating and non-operating items, it provides information that might be useful in analyzing trends.

Diluted EPS

Incorporates the dilutive effect of all potential common shares in the calculation of EPS. Refers to reduction in EPS that occurs as the number of common shares outstanding increases.

Gains and Losses

Increases or decreases in equity from peripheral or incidental transactions of an entity. Do not reflect normal operating activities of the company, but they nevertheless represent transactions that affect a company's financial position. Losses can occur on inventory due to obsolescence, on assets for impaired values, and on litigation claims.

Receivables Turnover Ratio

Indicates how quickly a company is able to collect its accounts receivable. Net sales/average accounts receivable (net) Extension is average collection period

Average Days in Inventory

Indicates the average number of days it normally takes to sell inventory. 365/Inventory turnover ratio

Average Collection Period

Indication of the average age of accounts receivable 365/Receivables turnover ratio

Classification Shifting

Inflates core performance. Involves misclassifying operating expenses as non-operating expenses. By shifting operation expenses to non expense classification (often referred to as special charges or items), managers report fewer operating expenses and higher operating income. Creates appearance of stronger performance for core operations.

Operating Activities

Inflows and outflows of cash related to transactions entering into the determination of net income Cash inflows include cash received from customers from the sale of goods or services. Interest and dividends from investments Cash outflows include cash paid for the purchase of inventory, salaries, wages, and other operating expenses, interest on debt, and income taxes. Difference between inflows and outflows is called net cash flows from operating activities.

Revenues

Inflows of assets or settlements of liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.

Valuation of Installment Notes

Installment payments are equal amounts each period so they constitute an annuity. Each payment includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance (principal reduction) Periodic reduction of the balance is sufficient that at maturity the note is completely paid.

Compound Interest

Interest computed not only on the initial investment but also on the accumulated interest in previous periods. Results in increasingly larger interest amounts for each period of the investment

Income Statement Presentation GAAP vs IFRS

International standards require minimum information to be reported on face of income statement. GAAP has no minimum requirement. International allow expenses to be classified either by function or by natural description. SEC regulations require that expenses be classified by function US, bottom line of income statement usually called net income or net loss. Descriptive term for international is profit or loss.

Two Components of Asset Turnover

Inventory turnover and receivables turnover

Paid In Capital

Invested capital consisting primarily of amounts invested by shareholders when they purchase shares of stock from the corporation. Common stock and additional paid in capital.

Short Term Investments

Investments not classified as cash equivalents that the company has the ability and intent to sell within one year (or operating cycle if longer). Include items such as equity investments in the common stock of other corporations, as well as debt investments in commercial paper and US Treasury securities.

Solvency Ratios

Investors and creditors, particularly long term creditors are vitally interested in this. Two common ratios are the debt to equity ratio and the times interest earned ratio.

Financing Activities

Involve cash inflows and outflows from transactions with creditors (excluding trade creditors) and owners. Inflows include cash received from Owners when shares are sold to them, creditors when cash is borrowed through notes, loans, mortgages, and bonds. Outflows include cash paid to owners in the form of dividends or other distributions, owners for the reacquisition of shares previously sold, and creditors as repayment of the principal amounts of debt (excluding trade payables that relate to operating activities) Difference between inflows and outflows is net cash flows from financing activities

Investing Activities

Involve the acquisition and sale of long term assets used in the business and non-operating investment assets. Cash outflows include cash paid for the purchase of long lived assets used in the business, the purchase of investment securities like stocks and bonds of other entities (other than those classified as cash equivalents and trading securities), loans to other entities. Cash inflows from these transactions are considered these activities as follows: the sale of long lived assets used in the business, the sale of investment securities (other than cash equivalents and trading securities), the collection of a non-trade receivable (excluding the collection of interest, which is an operating activity) Difference between inflows and outflows is net cash flows from investing activities.

Component Discontinued that Has Not Yet Been Sold

Its income effects, including any impairment loss, usually still are reported separately as discontinued operations. Held for sale. Balance sheet affected by assets and liabilities of the component considered held for sale are reported at the lower of their book value or fair value minus cost to sell. Whether sold or held for sale is reported in disclosure note.

Compensation of Directors and Top Executives

Large US corporations pay their top executives is public debate and controversy. Huge pay packages questioned. Compensation gap between executives and lower level employees much wider in the US.

Future Value of Annuity Due

Last cash payment will include interest. If unequal amounts invested each year, we can't solve the problem by using annuity tables.

Income Tax Expense

Levied on taxpayers in proportion to the amount of taxable income reported to taxing authorities. Reported in a separate line in income statement. Provision for income taxes. Separately reporting it from operations that are continuing from it with operations being discontinued is called intra-period tax allocation. Percentage of income before taxes.

Classification of Cash Flows GAAP vs. IFRS

Like GAAP, international also require statement of cash flows. US designates cash outflows for interest payments and cash inflows from interest and dividends received as operating cash flows. Dividends paid to shareholders are financing cash flows. IAS no 7 allows more flexibility. Companies can report interest and dividends paid as either operating or financing cash flows and interest and dividends received as either operating or investing cash flows. Interest and dividend payments usually are reported as financing activities, and received normally are classified as investing.

Business Risk

Liquidity and long-term solvency. Other things being equal, the risk that a company will not be able to pay its debt increases as its liabilities, relative to equity, increases.

Two Primary Reasons that Company's Book Value Does not Equal its Market Value

Many assets like land and buildings are measured at their historical costs rather than for amounts the assets could be sold (often referred to as assets' fair values). Many aspects of a company may represent valuable resources. These items are not recorded as assets in the balance sheet and therefore have zero book value.

Limitation of the Balance Sheet

Many items are heavily reliant on estimates and judgments rather than determinable amounts. Even though the balance sheet does not directly measure the market value of the entity, it provides valuable information that can be used to help judge market value.

Income Smoothing

May help investors to predict future performance but it could also hide underlying risk. May be fooling investors and creditors into believing that the company's operations are lower-risk than they really are.

Activity Ratios

Measure a company's efficiency in managing its assets. The greater the number of times an asset turns over, the fewer assets that are required to maintain a given level of activity (revenue) High turnover ratio usually preferred. Asset turnover ratio, receivables turnover ratio, inventory turnover ratio

Asset Turnover Ratio

Measure of a company's efficiency in using assets to generate revenue. Net sales/average total assets

Inventory Turnover Ratio

Measures a company's efficiency in managing its investment in inventory. Cost of goods sold/ average inventory More frequently a business is able to sell, or turn over inventory, the lower its investment in inventory must be for a given level of sales. High ratio is desirable Average days in inventory

Monetary Assets

Money and claims to receive money, the amount of which is fixed or determinable

Time Value of Money

Money can be invested today to earn interest and grow to a larger dollar amount in the future. Concept has nothing to do with the worth or buying power of those dollars. Useful in valuing several assets and liabilities as well as some revenues and expenses. The valuation of leases, bonds, pension obligations, and certain notes receivable and payable are a few prominent examples.

Components of Earnings in Income Statement

Most relate directly to the ordinary, continuing operations of the company. But some such as interest or the gains and losses on the sale of investments relate only tangentially to normal operations. Investors need to understand that some of these items may recur, such as interest expense, while others are less likely to recur, such as gains and losses on investments.

Comprehensive Income Equation

Net Income + Other Comprehensive Income

Profit Margin on Sales

Net income divided by net sales; measures the amount of net income achieved per sales dollar. Measures important dimension of company's profitability, portion of each dollar of revenue that is available after all expenses have been covered. Highly sensitive to nature of business activity. Net income/Net sales

Bottom Line for Net Income

Net income is the same regardless of format used.

Retrospective Approach

New standard applied to all periods presented in the financial statements. Restate prior period financial statements as if the new accounting method had been used in those prior periods. Revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along

Modified Retrospective Approach

New standard applied to the adoption period only. Prior period financial statements are not restated. Cumulative effect of the change on prior periods' net income is shown as adjustment to the beginning balance of retained earnings in the adoption period.

Long-Term Liabilities

Obligations that are due to be settled or have a contractual right by the borrowing company to be settled in more than one year (or operating cycle) after the balance sheet date. Examples are long term notes, bonds, pension obligations, and lease obligations. Payment terms, interest rates, and other details needed to assess the impact of these obligations on future cash flows and long term solvency are reported in a disclosure note.

Current Liabilities

Obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities. Includes all liabilities expected to be satisfied within one year from the balance sheet date (or within the operating cycle). Most common are accounts payable, notes payable (short term borrowings), deferred revenues, accrued liabilities, and the currently maturing portion of long term debt.

Monetary Liabilities

Obligations to pay amounts of cash, the amount of which is fixed or determinable.

Accounts Payable

Obligations to suppliers of merchandise or of services purchased on account.

Voluntary Changes in Accounting Princples

Occasionally, without being required by FASB, company will change from one GAAP to another. To improve comparability and consistency, GAAP typically requires that voluntary accounting changes be accounted for retrospectively.

Categories of Cash Flows

Operating activities, investing activities, and financing activities.

Intangible Assets

Operational assets that lack physical substance; examples include patents, copyrights, franchises, and goodwill. Many reported in the balance sheet at their purchase price less accumulated amortization. Some are developed internally.

Unqualified

Or clean opinion, issued when the auditor has undertaken professional care to ensure that the financial statements are presented in conformity with GAAP. Professional care would include sufficient planning of the audit, understanding the company's internal control procedures, and gathering evidence to attest to the accuracy of the amounts reported in the financial statements. "Present fairly" "In conformity with GAAP"

Cumulative Total of OCI

Or comprehensive loss, reported as accumulated other comprehensive income (AOCI), an additional component of shareholders' equity that is displayed separately.

Expenses

Outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing operations. Causality can be determined, expenses reported in same period that related revenue is recognized.

Usefulness of the Statement of Cash Flows

Over short periods of time, operating cash flows may not be indicative of the company's long-run cash-generating ability, and that accrual-based net income provides a more accurate prediction of future operating cash flows. Information about cash flows from operating activities, when combined with information about cash flows from other activities, can provide information helpful in assessing future profitability, liquidity, and long-term solvency. A company must pay its debts with cash, not with income. These activities must provide the necessary cash to pay debts, provide dividends to shareholders, and provide for future growth.

Present Value of Ordinary Annuity

PVA table (Illustration 5-11) Relationship between present and future value of annuity can be depicted graphically, interpreted in several ways.

Operating Cycle

Period of time necessary to convert cash to raw materials, raw materials to finished product, the finished product to receivables, and then finally receivables back to cash. Initial outlay of cash for the purchase of inventory until the time the company collects cash from a customer from the sale of inventory.

Assets

Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Economic resources of a company.

Liabilities

Probably future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Obligations of a company.

Notes Payable

Promissory notes (essentially an IOU) that obligate the issuing corporation to repay a stated amount at or by a specified maturity date and to pay interest to the lender between the issue date and maturity.

Management's Discussion and Analysis (MD&A)

Provides a biased but informed perspective of a company's operations, liquidity, and capital resources.

Accounts Receivable

Receivables resulting from the sale of goods or services on account. Also referred to as trade receivables because they arise in the course of a company's normal trade.

Notes Receivable

Receivables supported by a formal agreement or note that specifies payment terms.

Change in Accounting Principle

Refers to a change from one acceptable accounting method to another. Example is FIFO to LIFO. FASB change in accounting principle potentially hamper the ability of external users to compare financial information among reporting periods because information lacks consistency. Various approaches to require implementation by companies.

Earnings Quality

Refers to the ability of reported earnings (income) to predict a company's future earnings. Used as framework for more in depth discussions of operating and non operating income.

Cash in Statement of Cash Flows

Refers to the total of cash, cash equivalents, and restricted cash.

Change in Accounting Estimate

Reflected in the financial statements of the current period and future periods. Amount of future bad debts on existing accounts receivable, the useful life and residual value of a depreciable asset, and future warranty expenses. Since estimates require prediction of future events, it is not unusual for them to turn out to be wrong.

Restructuring Costs

Reorganization or realignment costs. Costs associated with plans by management to materially change either the scope or manner in which its company's operations are conducted. Include costs associated with shutdown or relocation of facilities or downsizing of operations. Recognized in the period the exit or disposal cost obligation actually is incurred. Many represent long term liabilities. Financial statement user must interpret these charges in light of a company's past history and financial statement note disclosures that outline the plan and the period over which it will take place.

Auditor's Report

Report issued by CPAs who audit the financial statements that informs users of the audit findings. Four basic types, unqualified, unqualified with an explanatory or emphasis paragraph, qualified, and adverse or disclaimer

Other Long-Term Assets

Represents a catchall classification of long term assets that were not reported separately in one of the other long-term classifications. Most often includes long term prepaid expenses, called deferred charges. Might also include any long term investments not material in amount and were not reported separately in the long term investments category.

Market Value

Represents the price at which something could be sold in a given market. Represented by the trading price of a share of the corporation's stock (in a public corporation). Share price times number of shares outstanding.

Additional Disclosures

Required to provide beyond the basic financial statements. Critical to understanding the financial statements and to evaluating a firm's performance and financial health.

Prospective Approach

Requires neither a modification of prior period financial statements nor an adjustment to account balances. Instead, the change is simply implemented in the current period and all future periods.

Valuation of Long Term Bonds

Requires the issuing (borrowing) company to repay a specified amount at maturity and make periodic stated interest payments over life of the bond. Stated interest payments are equal to the contractual stated rate multiplied by the face value of the bonds. At the date the bonds are issued (sold), the marketplace will determine the price of the bonds based on the market rate of interest for investments with similar characteristics. Bonds issued at more than face value are issued at premium, less than face value are discount.

Resources and Private Enterprises

Resources should be allocated to private enterprises that will provide the goods and services our society desires and at the same time provide a fair rate of return to those who supply the resources.

Approaches to Require Implementation of New Accounting Principle

Retrospective Approach Modified retrospective approach Prospective approach

Certain Geographic Information Required by GAAP

Revenues from external customers attributed to the entity's country of domicile and attributed to all foreign countries in total from which the entity derives revenues Long lived assets other than financial instruments, long term customer relationships of a financial institution, mortgage and other servicing rights, deferred policy acquisition costs, and deferred tax assets located in the entity's country of domicile and located in all foreign countries in total in which the entity holds material assets

Information about Major Customers

Revenues from major customers must be disclosed.

Income from Continuing Operations

Revenues, expenses (including income taxes), gains, and losses, excluding those related to discontinued operations and extraordinary items. Operating income, non-operating income, income tax expense.

Cash Equivalents

Short term investments that have a maturity date no longer than three months from the date of purchase.

Disclosure Notes

Some are provided by including additional information on the face of the statement. Common examples are allowance for uncollectible accounts and information about common stock. Pension plans, leases, long term debt, investments, income taxes, property, plant, and equipment, and employee benefit plans. Must include certain specific notes such as a summary of significant accounting policies, descriptions of subsequent events, and related third party transactions, but many notes are fashioned to suit the disclosure needs of the particular reporting enterprise.

Other than Unqualified Opinion

Some need to do this due to exceptions such as nonconformity with GAAP, inadequate disclosures, and a limitation or restriction of the scope of the examination.

Income Statement

Statement of operations or statement of earnings that is used to summarize the profit-generating activities that occurred during a particular reporting period. Reports the revenues, expenses, gains and losses that have occurred during the reporting period. Measures activity over a period of time.

Change Statement

Summarizing the transactions that affected cash during the period.

Property, Plant, and Equipment

Tangible, long-lived assets used in the operations of the business, such as land, buildings, equipment, machinery, furniture, and vehicles, as well as natural resources, such as mineral mines, timber tracts, and oil wells. The difference between original cost and accumulated depreciation is the net amount of this.

Financial Flexibility

The ability of a company to alter cash flows in order to take advantage of unexpected investment opportunities and needs. The less of this, the more risk there is that an enterprise will fail.

Liquidity

The ability of a company to convert its assets to cash to pay its current liabilities

Effective Rate

The actual rate at which money grows per year. Effective annual interest rate also referred to as annual yield.

Earnings per Share (EPS)

The amount of income earned by a company expressed on a per share basis. To relate the amount of net income a company generates to the number of common shares outstanding. Provides a convenient way for investors to link the company's profitability to the value of an individual share of ownership. Two specific calculations of EPS: basic EPS and diluted EPS

Companies Estimate:

The amount of receivables they will be able to actually collect The amount of warranty costs they will eventually incur for products already sold The residual values and useful lives of their long term assets Amounts used to calculate employee pension obligations.

Broad Distinction Made in the Balance Sheet

The current versus long term (non-current) classification of both assets and liabilities

Discontinued Operations

The discontinuance of a component of an entity whose operations and cash flows can be clearly distinguished from the rest of the entity. Income from this and its tax effect are reported separately.

Future Value of Ordinary Annuity

The last cash payment will not include any interest. Table, Illustration 5-8 FVA

Capital Structure

The mixture of liabilities and shareholders' equity in a company.

Indirect Method

The net cash increase or decrease from operating activities is derived indirectly by starting with reported net income and working backwards to convert that amount to a cash basis. Need to adjust net income, then, to eliminate the non- cash effects so that we're left with only the cash flows. Two types of adjustments to net income needed: Components of net income that do not affect operating cash are reversed Net income is adjusted for changes in operating assets and liabilities during the period.

Current Maturities of Long-Term Debt

The portion of long term notes, loans, mortgages, and bonds payable that is payable within the next year (or operating cycle), reported as a current liability.

Predictive Value

The relevance of any historical based financial statement hinges on this. To enhance it, analysts try to separate a company's temporary earnings from its permanent earnings.

Objective of Discontinued Operations Format

To inform financial statement users of which components of net income are continuing. Separate reporting includes taxes as well.

Present Value (PV)

Today's equivalent of a particular amount in the future, after backing out the time value of money. PV= FV/(1+i)^n The table (Illustration 5-2) can be used to find the present value of any single amount to be received in the future by multiplying that future amount by the value in the table that lies at the intersection of the column for the appropriate rate and the row for the number of compounding periods. The higher the time value of money, the lower is the present value of a future amount. The longer you have to wait for your money, the more you give up in terms of return you could be getting if you could put the money to work now, and the lower is the present value of the future amount. Require removal of compound interest

Changes in Shareholders' Equity Arise from Two Sources

Transactions with owners (shareholders) and transactions with non owners.

Related-Party Transactions

Transactions with owners, management, families of owners or management, affiliated companies, and other parties that can significantly influence or be influenced by the company. Potential problem with it is that their economic substance may differ from their legal form.

EPS and Discrete View

Treated in a manner consistent with the discrete view. Same procedures for interim reports and annual calculations.

Income Statement and Statement of Cash Flows

Two financial statements that are critical for understanding the company's ability to earn profits and generate cash in the future.

Present Value of Deferred Annuity

Two step process: Calculate PV of annuity as of the beginning of the annuity period Reduce the single amount calculated in 1 to its PV as of today. Other ways to determine: -Calculate PV of annuity due, rather than ordinary, and then reduce that amount three periods rather than two. -Subtract two period PVA factor from five period PVA factor and multiply the difference

Restricted Stock

Unit of stock given to an employee, but that unit of stock is not fully transferable until certain conditions are met (such as length of employment or attainment of performance goals).

Available for Sale Debt Securities

Unrealized gains and losses are reported as other comprehensive income in shareholders' equity.

Management Approach

Used in determining which segments of a company are reportable. Based on the way that management organizes the segments within the company for making operating decisions and assessing performance.

Illegal Acts

Violations of the law such as bribes, kickbacks, and illegal contributions to political candidates. Influenced by the Foreign Corrupt Practices Act passed by Congress in 1977.

Long Term Assets

When assets are expected to be converted to cash or consumed in more than one year (or operating cycle, if longer). Typical classifications include investments, property, plant, and equipment, intangible assets, and other long-term assets

Qualified Opinion

When either the audit process has been limited (scope limitation) or there has been a departure from GAAP, but neither is of sufficient seriousness to invalidate the financial statements as a whole.

Adverse Opinion

When the auditor has specific knowledge that financial statements or disclosures are seriously misstated or misleading. Rare because auditors usually are able to persuade management to rectify problems to avoid this undesirable report.

Disclaimer

When the auditor is not able to gather sufficient information that financial statements are in conformity with GAAP.

Correction of Accounting Errors

When transactions either recorded incorrectly or not recorded at all. Various control mechanisms to ensure transactions are accounted for correctly. Most errors discovered in the same year they are made. Simple to correct.

Strategic Shift

Whether disposals represent this requires the judgment of company management. Examples of this include the disposal of operations in a major geographical area, the major line of business, a major equity method investment, or other major parts of the company.