ACG 5026
Discuss the concept of financial leverage
the extent to which debt is used to finance a company. Having a financial leverage is when there is a lot of debt (credit) in their capital. Debt is desirable because it creates returns for shareholders without using of their money. However, debt increases default risk by committing the company to future cash obligations (the company may not be able to pay back debt as it comes due) and debt is usually accompanied by restrictive covenants imposed by creditors. Nike does not have a lot of financial leverage, their assets mostly come from financial equity.
identify the criteria for revenue recognition(in general and five steps)
the timing and amount of revenue reported by the company. general criteria- revenue must be realized or realizable (the company has the cash) and revenue must be earned (the seller has executed its duties under the terms of the sales agreement and/or title has passed to the buyer 5 steps- 1 identify the contract with the customer 2 identify the performance obligation in the contract 3 determine the transaction price 4 allocate the transaction price 5 recognize revenue when or as the entity satisfies a performance obligation
identify and discuss nonrecurring items
useful to separate recurring from nonrecurring on the income statement because to evaluate company performance or management quality, current performance is compared with prior year's recurring income and estimation of company value involves forecasts of income and cash flows in which only recurring amounts should be expected to recurr in future. restructing charges- expenses and losses related to significant reorganization of a company's operations, does not involve the sale of a separately identifiable business unit. involves activities such as consolidating production facilities, reorganizing sales operations, discontinuing product lines within business unit and outsourcing some activities. reported on income statement as employee severance costs- estimated total costs of terminating or relocating employees or asset write downs- write down of long term assets as a result of closure or relocation of manufacturing/administrative facilities. discontinued operations is income related to business units that the company has discontinued and sold or plans to sell. reported on the income statement below income from continuing operations because they will not persist in the future
Describe how to use financial ratios
1 return- determines a profit or loss for the year. ROE generates amount for every dollar in its average equity throughout the year. EWI in ROA measures the income generated by the firm before taking into account any of its financing costs. 2 profitability uses sales revenue and COGS to determine the percentage of each sales dollar that is left over after product costs. 3 turnover uses the level of sales generated by each dollar that a company invests in assets and reveals productivity and efficiency. 4 liquidity uses current ratio/quick ratio to determine if the company is likely to pay its current liabilities as they come due and if they need to sell inventory to do so. 5 solvency (leverage) uses debt-to-equity and times interest earned to determine if more risky. TIE is preferred to be high, implying smaller risk of default.
Identify five categories of financial ratios and give an example or two of each
1 return- return on equity (ROE) is the primary summary measure of company's performance. return on assets (ROA) measures the return earned on each dollar the firm invests in assets. 2 profitability- profit margin measures profit before interest expense, that is generated from each dollar of sales revenue. Gross profit margin measures the percent of each sales dollar that is left over after product costs are subtracted 3 turnover- accounts receivable turnover measures how many times receivables have been collected during the period. Inventory turnover measures the flow of goods out of inventory relative to the balance that is held in inventory. 4 liquidity- the analysis of available cash. current ratio is the relative magnitude of current assets and current liabilities. Want a current ratio of about 2, all businesses need to pay their liabilities off. quick ratio reflects a company's ability to meet its current liabilities without liquidating inventories that could include markdowns, excludes inventories and prepaid assets. Closer to now 5 solvency (leverage)- a company's ability to meet its debt obligations. More in time. debt-to-equity conveys how reliant a company is on creditor financing compared with equity financing. times interest earned is how much operating profit is available to pay interest, bigger chunk it is, more risky the firm.
Account for accounts receivable, including determining allowance for doubtful accounts(percentage of sales and percentage of accounts receivable methods)
A/R arise from selling goods and services to customers on account, recorded at the amount to be collected. sometimes, people do not pay. GAAP requires companies to estimate the amount of these uncollectable accounts called allowance for doubtful accounts which is a contra-asset. A/R is reported at net realizable value on the balance sheet. Allowance for doubtful accounts is recorded as an adjusting journal entry (fulfills matching) and can be estimated by percentages of sales (focuses on potentially uncollectible accounts among current period sales) and percentage of A/R (focuses on receivables owed by the customers that might be uncollectible) Matching because putting expense people not paying in the year the revenue was recorded to effect net income in the same period. Lives with the assets but have a credit balance.
Explain when an expenditure should be expensed and when it should be capitalized
An item is capitalized(account for expenditure as an asset on the balance sheet, may become an expense of a future period like when inventory becomes cost of goods sold when sold and equipment gets depreciated) when it is recorded as an asset, rather than an expense(account for an expenditure as an expense on the income statement). If it extends the life, or makes it do something different, we are going to capitalize The expenditure will appear on the balance sheet, rather than the income statement. All expenditures must either be capitalized or expensed. Expense the small stuff, capitalize the big
identify the steps in the accounting cycle
Analyze -> record -> adjust -> report -> close Continuously analyze and record end of the accounting period is when you adjust, report and close occurs each fiscal period. represents a systematic process for accumulating and reporting a company's financial data
Identify the 4 financial statements and their components and discuss how they are related
Balance sheet lists the company's investments and sources of financing, uses the accounting equation (assets equal liabilities plus equity). A point in time. Income statement reports the results of a company's operating activities (everything that happens on the income statement. should be positive. start up companies are expected to be negative at first) over a period of time. Uses equation revenues minus expenses equals net income. measures performance. determine if company is profitable, how did it get profitable, will profits continue. Statement of stockholders equity reports changes in equity over a period of time (contributed capital and retained earnings). Statement of cash flows reports net cash flows from operating, investing, and financing activities over a period of time.
Discuss components of the financial accounting conceptual framework
Benefits > costs: reported accounting info must be cost effective Materiality: info not large enough to affect one's decision need not comply with GAAP Understandability: should be presented so reader can understand how relates to decision process. Relevance: have ability to make a difference in a decision-timeless, predictive value relability: be accurate and free of misstatement or bias- representational faithfulness. comparability: enable users to identify similarities and differences between sets of economic phenomena Consistency: exhibit conformity from one reporting period to the next with unchanging policies and procedures.
Discuss the concepts of earnings management and earnings quality
Earnings management occurs when management uses discretion to mask the underlying economic performance of a company. Depreciate assets over longer period of time Write down inventory (no longer worth on market what we have it as) next year looks better. 'motives- the desire to mislead some financial statement users about the financial performance of the company to gain economic advantage and the desire to influence legal contracts that use reported accounting numbers to specify contractual obligations and outcomes. examples- estimates (overly optimistic or pessimistic estimates in accrual accounting like revenue recognition timing or bad debt expense) channel stuffing (arises when a company uses its market power over customers to induce them to purchase more goods than necessary to meet immediate needs) and timing (strategic timing of nonrecurring gains and losses like income smoothing-occurs when management times gains or losses in order to maintain a steady improvement in income each year. and big bath (occurs when management reports the recognition of a nonrecurring loss in a period of already depressed income) earnings quality is the overall reasonableness of reported earnings and is free from manipulation by management. Earnings management reduces earnings quality.
Discuss the advantages and disadvantages of the corporate entity form
Is a legal entity. A Large number of owners or shareholders are not involved in managing day-to-day operations. Advantages- limited liability, ability to raise capital, ability to separate ownership from management, ease of transfer ability of ownership. Disadvantages- double taxation (corporate profits and dividends/capital gains, Company pays profits and shareholders pay on shares of their return) paperwork and formalities
Describe what an audit opinion is
NOT a guarantee. A report to the board of directors of the company and to the shareholders of the company by an independent auditor, express an opinion as to whether the financial statements present fairly the financial activities of the company and if they are in accordance with GAAP. Does not state the statements are "accurate"
identify two events that affect retained earnings, explain how it connects the income statement to the balance sheet
Net income or net loss and dividends affect retained earnings. The ending retained earnings is reported on the balance sheet in the stockholder's equity section
Describe the closing process
Occurs at the end of the accounting period. Balances in temporary (income statement) accounts are transferred to permanently update retained earnings and set to zero. On the balance sheet, net income is moved to retained earnings. Move net income into retained earnings, close all income statement accounts (revenues, expenses, gains losses)
Relate the 3 basic business activities to the financial statements
Operating is revenues and expenses, is reflected on the income statement and statement of cash flows. Investing includes assets, is reflected on the balance sheet and statement of cash flows. Financing- ask where did the money come from? debt financing (creditor) and Equity financing (owners) and is reflected on the balance sheet, statement of cash flows and statement of stockholders equity.
Describe accounting treatment of research & development expenditures
Prior to 1974, most companies capitalized research and development costs, then amortized the cost of future periods. The FASB stated in SFAS 2 that, because "future benefits" were uncertain, companies should expense all R & D costs, unless they were related to tangible assets (building or equipment) that had multi-year lives. Companies complied with the standard but for several years many companies actually reduced their R & D activities, because of concern for excess expense on the income statement. EXPENSED
Describe general concept of when to recognize revenue
Revenue recognition requires that revenue be recognized (recorded) only when earned and realized or realizable. To recognize is to record a transaction in the financial accounting records (prepare a journal entry)
Describe the institutions that regulate financial accounting and their role in establishing Generally Accepted Accounting Principles (GAAP)
Securities and Exchange Commision (SEC) regulates the issuance and trading of securities in the US, came about from the Securities Act of 1934. Sarbanes-Oxley Act of 2002 was developed by Congress due to concerns over the quality of corporate financial reporting. SOX then established the PCAOB to approve auditing standards and to monitor the quality of financial statement and audits (GAAP). Financial Accounting Standards Board (FASB) currently establishes framework to serve as a guide for accounting issues not covered by standards, did not exist until 2002. Accounting used to be self regulated but not anymore because people do not behave. SEC & FASB regulate and oversee GAAP (standards and accepted practices designed to guide the preparation of financial statements, "rules based accounting")
Discuss the general uses of accounting and who uses it
The process of recording, summarizing and analyzing financial transactions. To help people make better decisions. Financial is mainly for decision makers outside the company like investors, analysts, creditors, suppliers, and customers. Managerial is mainly for decision makers within the company like top management, marketing teams, production and operations.
Account for inventory purchases under a variety of conditions(e.g. FOB)
a company should recognize all inventories to which it holds legal title. Sometimes when not on premise. general rule- inventory is buyer's when received except: FOB shipping point (buyers at time of delivery to common carrier), consignment goods (sellers), sales with buybacks (sellers), sales with high rates of returns (buyers, if you can estimate returns), and sales on installments (buyers, if you can estimate collectibility)
Define basic financial accounting terms
asset- must be owned or controlled by the company and must possess expected future economic benefit current asset- converted into cash within one year noncurrent asset- not expected to be converted into cash within one year current liability- due in 1 year noncurrent liability- if not due in 1 year equity- the ownership interest includes contributed capital (stock) and earned capital (retained earnings) common stock- the par value or stated value of stock issued to the primary owners of the company retained earnings- the accumulated earnings that have not been distributed to stockholders as dividends revenue- (sale) inflow from delivering goods, rendering services, or performing other activities that constitute the entity's ongoing major operations. expense- outflow or the using up of an asset in an effort to generate revenues for an entity. gain- inflow caused by a transaction that is not part of the entity's ongoing major operations. loss-outflow not in an effort to generate revenues (not part of the ongoing major operation)
Describe cash vs accrual accounting
cash- basis accounting recognizes revenues and expenses only when cash is received or paid. does not show performance very well. accrual- required by GAAP and IFRS, states that revenues increase in net assets that are earned by delivering goods and services to customers and expenses decrease in net assets from generating revenue and supporting operations.
account for intangible assets
characterized by lack of physical substance and high uncertainty about future benefits. cost is amortized (same as depreciation) over the useful life (or legal life, if less) but not to exceed 40 years. Under IFRS, revaluation of intangibles is an option but not a requirement. Under US GAAP, revaluation is not an option. intangible assets can be purchases from another company or individual, or internally developed. purchase cost is capitalized. includes patents, copyrights, trademarks, or franchise rights. Amortization expense is reported on the income statement as operating income
discuss the concept of operating income
comes from net income, specifically income from continuing operations. Includes revenues less operating expenses (COGS, selling, general & administrative expenses, research and development, depreciation-when high, more operating cash flow exists than net income, and amortization)
explain how goodwill arises and how it is accounted for
goodwill is the excess of the purchase price paid over the fair value of its indentifiable net assets to buy an entire company. cannot be separated from the acquired company or sold separately. Has an indefinite life. never amortized. Subject to impairment of value. GAAP requires annual testing for impairment. step 1 the fair value of the investee company is compared with the current book value of that company, including the revaluations made at acquisition. step 2 if the fair value is less than book value, the investment is impaired. must be written down to market value. impairment loss recognized on the income statement. Can only buy goodwill Goodwill can never be internally generated and is not amortized
Analyze gross profit margin and inventory management
gross profit margin is important because it is monitored by external users and management. inventory turnover can be used to indicate how quickly inventory is being sold. average inventory days outstanding indicates how long inventories are held before being sold. inventory turnover can be compared with prior periods and competitors (higher turnover is favorable). turnover level may imply- change in product mix to higher or lower margin products, excessive purchases or production, missed trends or technological advances, increased competition, change in promotion policies, or improvement in manufacturing efficiency.
account for the purchase and sale of long live assets
include all costs necessary to acquire an asset and prepare it for its intended use, including installation costs, taxes, shipping costs, legal fees, set up and calibration costs and asset retirement obligations. also when assets are constructed by a company for its own use, capitalized costs should include all direct material and labor costs, a reasonable amount of overhead costs and capitalized interest of debt incurred to finance construction. selling long term assets produces either a gain (if the proceeds are greater than the book value of the asset) or a loss (if the proceeds are less than the book value of the asset). gains and losses can be reported in income from continuing operations or if applicable, as discontinued operations. to record a gain/loss- 1 remove the cost of the disposed asset from the balance sheet asset account (a credit to the asset account) 2 remove the depreciation related to the disposed asset from the acc. dep. balance sheet account (a debit to acc. dep) 3 record the proceeds as an increase in cash (debit the cash account) 4 record the gain (credit) or a loss (debit) on the income statement
Account for inventory sales and writedowns
inventory book value is written down to current market value, reducing total assets. inventory write down is reflected as an expense (included in COGS) on the income statement, reducing current period gross profit
identify what constitutes inventory for financial accounting purposes
inventory is goods purchase or produced for sale to customers, when inventory is purchases or produced, it is capitalized and carried on the balance sheet as an asset until it is sold. When it is sold, its cost is transferred to cost of goods sold on the income statement. COGS is subtracted from sales revenue to yield gross profit. inventory is bought with the intent to sell.
Apply the lower of cost or market rule to inventory
inventory is reported on the balance sheet at lower of cost or market (LCM). if market value of inventory is less than inventory cost, company must write down inventory to market. Market value = replacement cost. If market value of inventory is greater than inventory cost, inventory cost remains on the balance sheet
Distinguish tangible from intangible assets
long term operating assets are acquired for the purpose of producing and delivering products and services that generate revenues and help produce revenues for multiple periods (provide future economic benefit). tangible- have physical substance, usually include land, buildings, machinery, fixtures and equipment. intangible- have no physical substance. provide the owner with specific rights and privileges includes trademarks, patents, copyrights
identify which sections that various financial activities belong
operating- cash received from customers, cash paid for inventory, wages, rent, advertising, interest, insurance or taxes investing- noncurrent operating assets (PPE) and marketable securities and long term financial assets financing- long term liabilities and some short term notes payable, stockholders equity
Identify and describe the three sections of a cash flow statement
operating- the focus is on selling goods or rendering services, broad enough to include any cash receipts or payments that are not classified as investing or financing activities. reported on IS (accrual accounting) and statement of cash flows (cash basis) investing- acquiring and disposing of property, plant, equipment and intangible assets. Purchasing and selling government securities including other company's stocks, bonds, and other non-cash equivalent securities lending and subsequent collection of money. buying stock in other companies, collecting that money) financing- involving receiving cash from shareholders, returning cash to shareholders, borrowing from creditors and repaying amounts borrowed from creditors.
Describe common size financial statements and their use
restates financial statement info in ratio form, income statement items as a percentage of net sales and balance sheet items as a percent of total assets. Facilitates comparison- most useful within industry, across companies of different sizes and between accounts within a set of financial statements. See how they are doing without the dollars.
