Financial Accounting Final

Furniture & Fixtures

A classification of long-lived physical asset.

Double Declining Balance Depreciation

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

Going Concern

A company is considered to be a going concern if the entity is expected to remain in operation and be able to satisfy all commitments and obligations and realize the benefits and values of all assets for the indefinite future. If there is evidence to the contrary, the business may no longer be considered a going concern.

Accumulated Depreciation

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

Allowance for Doubtful Accounts

A contra asset account that nets against Accounts Receivable. It is generally set up as an estimate of accounts that will ultimately prove to be uncollectible. It is then reduced when accounts are written off. It may be adjusted at period end to reflect any updated estimates. May also be referred to as Reserve for Bad Debts.

Expense

A cost associated with providing goods or services to a customer.

DuPont Framework

A framework of ratios that breaks down Return on Equity (ROE) into the three components of Profitability, Efficiency, and Leverage.

Gordon Growth Model

A method for calculating the terminal value of an indefinite stream of cash flows. The calculation gives the present value of infinite cash flows by dividing the cash flow in the final year of our projection by the difference between the discount rate and the growth rate.

Discount Rate

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

Circularity

A problem with two variables in which the value of each variable impacts the value of the other variable so that changing either value impacts the other value.

Asset

A resource that is owned or controlled by a business and is expected to provide some future economic benefit to the business. Examples include cash, inventory, and equipment. The business expects that its assets will help to produce cash inflow in the future.

Accrual

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

Depreciation Expense

A temporary account that shows the depreciation for the current accounting period. It's an expense reported on the income statement.

Accounts Payable Turnover

Accounts Payable Turnover is a ratio that is used to measure how efficiently a business is paying its vendors. It is calculated by dividing the credit purchases for the period by the average accounts payable balance for the period. In the absence of credit purchases information, we may use cost of goods sold as a substitute. The ratio represents how many times the accounts payable turned over during the period. For most ratios in this course, we use averages when calculating ratios with balance sheet numbers, but this is not necessary and some may choose to use beginning or ending balances.

Accounts Receivable Turnover

Accounts Receivable Turnover is a ratio that is used to measure how efficiently a business is collecting receivables from its customers. It is calculated by dividing the credit sales for the period by the average accounts receivable balance for the period. In the absence of credit sales information, we may use total sales as a substitute. The ratio represents how many times the accounts receivable turned over during the period. For most ratios in this course, we use averages when calculating ratios with balance sheet numbers, but this is not necessary and some may choose to use beginning or ending balances.

CAGR

Acronym for Compound Annual Growth Rate. It is a measure of the rate of return of an investment over a given period of time.

EBIT

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

EBITDA

Acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. Used sometimes as a shortcut method to approximate operating cash flows.

Consistency

Although accounting guidelines allow some degree of discretion in how transactions are recorded, the consistency principle requires that the methods be consistently applied by the company over time in recording and reporting unless there is a sound reason to change them. Consistency refers only to consistency over time; it does not imply consistency across accounts. For example, a company may properly choose to use LIFO for US inventory valuation and FIFO for international inventory valuation, and this is not a violation of the consistency principle.

Employee Advances

Amounts paid to employees in advance of the employee earning the amount. Equivalent to a loan to the employee. These advances are made at the discretion of the management of the business and they are often repaid by deducting them from subsequent payroll amounts.

Dividends

Amounts paid to the shareholders of a company, usually in the form of cash.

Contra Account

An account for which the typical balance is contrary to other accounts in its category. Used to adjust the net value of the account to which it relates. An example is Accumulated Depreciation, which is a contra-asset account used to arrive at the net book value of fixed assets.

Contra-Asset

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

Accrued Payroll

An accrued expense recorded at the end of a financial period for amounts of payroll that have been worked but not yet paid. It is a common type of accrued expense. See also Salaries/Wages Payable.

Free Cash Flow

An amount meant to represent the cash flows that a company could be expected to generate from its normal operations for a given period without considering the impact of how the business is financed. In this course we use the following formula to calculate free cash flows: FCF = (1-t) x EBIT + Dep - Capx - D NWC where t is the tax rate, Dep is depreciation expense, Capx is capital expenditures and D NWC is the change in net working capital.

Deferral

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

Deferred Expense

An asset account that records amounts paid towards expenses not yet recognized on the income statement. Note: Deferred expenses are not expenses, rather they are assets.

Accrued Revenue

An asset account that records revenue that has been earned and recognized on the income statement but not yet paid for by the customer. At the time of the accrual, we debit the receivable account and credit the appropriate accrued revenue account. When the cash transfer ultimately occurs, we debit the cash account and credit the receivable account.

Current Asset

An asset that will be used or converted into cash within one year or one operating cycle, whichever is longer.

Accumulated other comprehensive income

An equity account that consists of cumulative unrealized gains or losses on line items classified under other comprehensive income. It includes items such as unrealized gains or losses on investments available for sale, foreign currency gains or losses, and pension plan gains or losses.

First In First Out (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.

Annuity

An investment where the purchaser receives the right to receive a fixed amount each year for a lifetime or for a certain number of years.

Expenses

Costs associated with providing goods or services to customers.

GAAP

GAAP stands for Generally Accepted Accounting Principles. Often referred to as US GAAP as it is usually associated with accounting rules and standards in the United States (US) issued by the Financial Accounting Standards Board (FASB). Outside the US many countries adhere to a slightly different set of accounting rules and principles referred to as IFRS (International Financial Reporting Standards) which are issued by the International Accounting Standards Board (IASB).

Finished Goods Inventory

Goods at the final stage of the manufacturing process when they are complete and available for sale to customers.

Goodwill

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

Gross Profit Margin

Gross Profit Margin is calculated by dividing the gross profit by the total sales for the period, and is used as a measure of profitability. It tells us what percentage of our revenue is left to cover other expenses after the cost of goods sold is subtracted. May also be referred to as Gross Profit Percentage.

Current Liabilities

Obligations that will be settled or paid in cash within a year (or within one operating cycle, if the company's operating cycle is longer than one year).

Credit

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

Debit

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

Gross Book Value

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

Gross Profit

The amount by which the revenue exceeds the cost of goods sold (or cost of sales).

Fair Market Value

The amount that an asset could be sold for on the market at a given point in time; may not correspond to the value of the asset recorded in the financial records at any point in time.

Capital Expenditures

The cash flow related to the purchase of property and equipment. Capital expenditures is part of the free cash flow equation.

Entity Concept

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

Cost of Goods Sold (COGS)

The expense corresponding to the cost of the inventory that is sold to customers. May also be referred to as COGS or Cost of Sales.

Cost of Sales

The expense corresponding to the cost of the inventory that is sold to customers. May also be referred to as Cost of Goods Sold (COGS).

Historical Cost

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

Explicit Transactions

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

Cash Accounting Method

Under the cash accounting method, a business records revenues and expenses only when cash is received or disbursed. Although this method is used by some small, private businesses, it is not an acceptable method under GAAP for publicly held companies.

Discounted Cash Flow

Valuation methodology that takes a company's projected free cash flows and discounts them to arrive a present value.

Credit Terms

When a seller agrees to provide goods or services to a buyer and allows the buyer to remit payment at some future date. The time allowed is typically a specified number of days from the date the goods or services are provided, such as 30 days. May also be referred to as "buying on credit" or "selling on credit."

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.

Asset Turnover

Asset Turnover is calculated by dividing the total sales for the period by the average total assets. This calculation is used as a measure of efficiency in the DuPont Framework. For most ratios in this course, we use averages when calculating ratios with balance sheet numbers, but this is not necessary and some may choose to use beginning or ending balances.

Accounts Receivable

Asset account used to show the claim to receive cash at some future date for goods or services that have been supplied to a customer on credit terms.

Accounting Equation

Assets = Liabilities + Owners' Equity. This equation is fundamental and must always be true in double entry accounting.

Average Collection Period

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

Capital

Capital can have different meanings depending on its context. In many contexts, it refers to wealth of a business, whether accumulated in money or property. This wealth may be used to grow the wealth of the business by investing in projects or other companies; hence the terms, capital expenditures and capital budgeting. In other contexts, capital refers to the money invested in a business, almost synonymous with equity.

Current Assets

Cash and other assets that are expected to be converted into cash within a year (or within one operating cycle, if the company's operating cycle is longer than one year).

Cash Conversion Cycle

Cash conversion cycle is a measure of how long it takes a business from the time it has to pay for inventory from its suppliers until it collects cash from its customers. It can be calculated as the Days Inventory, plus the Average Collection Period, minus the Days Purchases Outstanding.

Free Cash Flows

Cash flows that are free, or available, to distribute to investors or to reinvest in the business after the business has covered all its expenses. FCF does not consider the impact of how a business is financed. Calculated by the formula: FCF = (1-t) * EBIT + Depreciation - Capital Expenditures - Change in Net Working Capital.

Common Size Financial Statements

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

Balance Sheet

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

Days Inventory

Days Inventory is a measure related to inventory turnover that shows the average number of days the inventory is held before it is sold. It can be calculated by dividing average inventory by the COGS per day. Alternatively, it can be calculated by dividing 365 by the Inventory Turnover.

Days Purchases Outstanding

Days Purchases Outstanding is a measure related to accounts payable turnover that shows the number of days it takes a business to pay its vendors. It can be calculated by dividing the average accounts payable by the credit purchases per day. Alternatively, it can be calculated by dividing 365 by the Accounts Payable Turnover.

Deferred Taxes

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

Deferred Revenue

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

Accelerated Depreciation Methods

Depreciation methods that recognize more depreciation expense in the early years and less in the later years. Double-declining balance is an example of an accelerated depreciation method.

EBIAT

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

Adjusting (Journal) Entries

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

Equity

Equity is the residual that belongs to the owners of the business. If you add up all the resources of the business (assets) and subtract all the claims that third parties (such as lenders and suppliers) have against those assets, the residual (what is left over) is equity. Equity includes two elements; first, money contributed to (invested in) a business in exchange for some degree of ownership and second, earnings that the business generates over time and retains in the business. Also commonly known as shareholders' equity, stockholders' equity, or owners' equity.

Financial Leverage

Financial Leverage is one of the three components of the DuPont Framework. For the purposes of the DuPont Framework, it is measured using the Leverage Ratio, also referred to as the Equity Multiplier, but another measure of leverage is the Debt to Equity Ratio.

General Ledger

Historically, accounting systems were comprised of books for each accounts, known as ledgers. The general ledger would include all of the balances from all of the accounts or subsidiary ledgers included in the chart of accounts.

Goods available for sale

In a retail business, goods available for sales can be calculated as beginning inventory plus purchases of additional inventory in the period. This calculation can be useful in determining cost of goods sold, because at the end of a period, the goods available for sale during the period with either remain in inventory or be moved to cost of goods sold. This calculation is often used when using a periodic inventory system.

Deferred Tax Asset

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

Accrued Expenses

Liability account used to record amounts at the end of an accounting period to recognize expenses that were incurred in the period but for which no invoice has yet been received nor payment has yet been made. Examples are salaries/wages payable, accrued rent expense, accrued legal fees. When the accrual is made, the debit is to the appropriate expense account (payroll expense, rent expense, legal expense) and the credit is to the accrued expense account, which is a liability because it represents an obligation which will need to be paid in the future. Remember accrued expenses are NOT expenses.

Accounts Payable

Liability account used to show the obligation to pay suppliers who have provided goods or services on credit terms.

Accrued Liability

Liability accounts that record expenses that have been recognized on the income statement but have not yet been paid. Similar to accrued expenses.

Chart of Accounts

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

Bonds

Long term debt instruments that are issued with a specific rate of interest and maturity date. There are many types of bonds and they are issued by governments, utilities, and public companies to raise funds.

Fixed Assets

Long-lived physical assets which are expected to provide value to the business for periods in excess of one year. Examples include buildings, vehicles, or machines. Also referred to as Property, Plant, & Equipment (PP&E).

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.

Financing Section

Section of the statement of cash flows that includes all cash flows associated with raising and paying back money to investors and creditors, or in other words, financing the business.

Cash Equivalents

Short-term, highly liquid investments that can be quickly converted to cash.

Gain

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

Deductions

Tax term related to amounts that can deducted from "Gross Income" or sales to arrive at taxable income. Deductions are similar to expenses in financial reports but they are not always the same and they are not always identical. Depending on the particular country and its tax code, some expenses may not be deductible and some deductions may not be expenses.

Current Ratio

The Current Ratio is a measure of a business' ability to pay its short term obligations. It can be calculated by dividing current assets by current liabilities.

Debt to Equity Ratio

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

FASB

The Financial Accounting Standards Board (FASB) is the governing body that issues accounting rules and standards in the United States. These rules and standards are often referred to as generally accepted accounting principles, or GAAP.

IASB

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

Conservatism

This principle recognizes that there are some estimates involved in accounting and says that accounting should reflect the more cautious estimated valuation rather than the more optimistic one. For assets it means recording the lower valuation while for liabilities it means recording the higher possible valuation. For revenues and gains it means recording them when they are reasonably certain but for expenses and losses it means recording them when they are reasonably possible.

Amortization

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

Depreciation

The method for recognizing the expense of long-lived physical (tangible) assets over the life of the assets. Common methods include straight-line depreciation and double-declining balance depreciation but other methods can also be used.

Common Stock

The most typical stock or share type representing an ownership interest in the business. Although there can be different classes of common shares, owners of these shares usually have certain rights including the right to share proportionately in the profits of the business and the right to elect directors and vote on proposals made by the directors to the shareholders.

Accounting Period

The period of time for which the financial results are reported; typically either a month or a quarter or a year.

Capitalization

The practice of recording the cost of the purchase as an asset, rather than recording it as an expense when an item is purchased. For example, when a long-lived asset is purchased, such as a machine, the cost of the machine is said to be capitalized because it is recorded as an asset in the accounts. In contrast, something small and immaterial, such as pens and pencils, may be expensed immediately.

Double Entry Accounting

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

Fiscal Year

The twelve month period over which the financial results of a company are reported. For many companies, the fiscal year equals the calendar year with the last day of the fiscal year being December 31. However, for other companies, the fiscal year may end on June 30 or on the last Friday in September or on some other date that is chosen by the company. For some companies, it can be 52 or 53 weeks with the year ending on a slightly different date each year depending on when the week ends.

Future Value

The value at a specified future date of an amount or a series of amounts invested at a given discount rate. The future value will typically be higher than the present value because it will be increased by the discount rate. While present value looks at how much a future amount would be worth in today's currency units, the future value looks at how much an amount in today's currency units would be worth in future currency units if invested at the applicable discount rate.

Accrual Accounting Method

This is the accounting method taught in this course, followed by most companies, and required under US GAAP and IFRS. The method follows the revenue recognition principle, which says that revenue should be recognized in the period in which it is earned and realizable, not necessarily when the cash is received and the matching principle which says that expenses should be recognized in the period in which the related revenue is recognized rather than when the related cash is paid.