FIN3403 - Exam One Review Questions (Chp 3)

Compare and contrast depreciation expense and amortization expense

Depreciation expense is the amount by which a firm's fixed assets are written down in a period during which the assets are utilized for generating cash flows. Amortization is the amount by which intangible assets like goodwill, patents, license, copyrights, and trademarks are written down in any period that they are utilized by the firm to generate benefits. Both depreciation and amortization are non cash expenses that will serve to boost the firm's aftertax cash flows, and generate actual value of the asset at the end of the period.

Explain the account concept behind depreciation

Depreciation in accounting is a non cash expense that helps to allocate the cost of an item over its expected life. It reflects the estimated decrease in the value of an asset due to wear and tear and obsolescence

What is net working capital? Why might a low value for this number be considered undesirable?

Net working capital is the difference between total current assets and total current liabilities. A low value for this number is undesirable, for it indicates that the company may not have enough cash on hand to cover its immediate expenses.

What is treasury stock

Treasury stock is the stock that the company purchased back from its investors. These shares do no pay dividends, have no voting rights, and should not be included in shares outstanding calculations.

Why do firms prefer to use accelerated depreciation methods over the straight-line method for tax purposes

When a firm uses accelerated depreciation, the depreciation expense is higher than with the straight-line method. This reduces the taxable income and the amount of tax paid by the firm. As a result of this higher non cash expense, the firm's cash flow is higher

What does it mean when a firm's cash flow to investors is negative?

When a firm's investment of cash flow from net working capital and long-term assets exceeds the firm's cash flow from operating activity, the cash flow to investors will be negative. A negative cash flow to investors means that the firm must raise money from new issues of debt or equity

The going concern assumption of GAAP implies that the firm

Will continue to operate and that all assets should be recorded at their cost rather than at their liquidation value

Identify the five fundamental principles of GAAP

1. The assumption of arm's length transaction 2. The cost principle 3. The realization principle 4. The matching principle 5. The going concern assumption

What accounting events trigger changes to the retained earnings account?

A firm's report of net income or loss and the board of directors' declaration of a cash dividend

Assumption of Arm's Length Transaction

Assumes that all business transactions between two parties are made rationally from an economic perspective and both parties will make the deal that provides them the best value

What's the difference between book value and market value?

Book value is the price you paid for a particular asset. This price doesn't change as long as you own the asset. Market value, is the price at which you can sell an asset today, as it takes into account how much it can earn in the future.

Define book-value account and market-value accounting

Book-value accounting implies that all assets and liabilities are recorded and reported at the historical cost when they were acquired. Market-value accounting requires that all assets and liabilities are reported at their current market value

The cost principle

Calls for the recognition of all accounting transactions at historic cost, or the amount paid or received when the transaction was concluded at arm's length

What are the tax implications of a decisions to finance a project using debt rather than new equity?

Difference between financing and financing through new equity is in the tax treatment of interest and dividends. While interest payments on debt are tax-deductible business expenses, dividends paid to common or preferred stockholders are not deductible

Marginal Tax Rate

Represents the tax rate that is paid on the last dollar of income earned, or the rate that will be paid on the next dollar earned

What's the matching principle and how can it cause accounting expenses to differ from actual cash outflows?

The matching principle is an accounting principle under which accounts match revenues with the costs incurred to generate those revenues when they prepare an income statement. Because the actual cash flows associated with expenses might not be incurred in accounting expenses can differ from actual cash inflows

Describe the organization of the statement of cash flows

The statement of cash flows identifies the cash inflows and cash outflows of the firms for a specified period. This allows one to estimate the net cash flows from operations. This financial statement is organized to report the cash flows resulting from the three basic activities in any firm - operating, investing, and financing. The cash flows from operations are the results of meeting all revenues and expenses that result from the operating activities of the firm. Buying and selling a firm's assets lead to cash flows from investing activities. Cash flows from financing activities arise from the firm borrowing from its investors and/or making payments to its lenders and shareholders

Average Tax Rate

The total taxes paid divided by taxable income

What is treasury stock? Why do firms have treasury stock?

Any shares repurchased by the company in the open market are recorded as treasury stock in the shareholders' equity account in the balance sheet. The most common reason for firms doing this is to reduce the number of shares outstanding in the market when the management believes that its firm's stock is undervalued. This reduction in the number of shares outstanding is expected to boost the share price

Explain how the choice of FIFO vs LIFO can affect a firm's balance sheet and income statement

FIFO makes sense during times of rising prices because it allows the firm to eliminate the lower priced inventory first, resulting in higher profit margin. This allows the firm to leave higher valued inventory on the balance sheet. During inflationary times, a firm using LIFO would see a lower profit margin and lower values of inventory on the balance sheet. It's important that anyone who is analyzing firms using different accounting methods on inventory recognize the impact on the bottom line (profit margin and net income) and on current assets

The realization principle

Implies that revenue should be recognized and then is matched with the costs incurred in producing the revenue

The going concern assumption

Implies that the firm will continue to operate and that all assets should be recorded at their cost rather than at their liquidation value