CMA Part 1 Comprehensive

What is the definition of depreciation?

"The systematic and rational allocation of the costs of a fixed asset over its expected useful life." What is accumulated depreciation?~Accumulated depreciation is a contra-asset account which serves to decrease the carrying value of fixed assets to their book value. The book value is the gross amount minus the accumulated depreciation. What is estimated useful life?~The estimated useful life is how long we expect the asset to be useful and it is the period of time over which we will recognize depreciation expense. At the end of its useful life the asset should have a book value equal to the expected salvage value. (The estimated useful life may also be called service life.) What is estimated salvage value?~The estimated salvage value is the value we expect the asset to have at the end of its useful life. The book value of the asset may not be depreciated below the salvage value. Some companies have an accounting policy that the salvage value is always equal to $0. (The estimated salvage value may also be called residual value.) What is depreciable amount (depreciable base)?~The depreciable amount or depreciable base is the amount to be depreciated over the useful life of the asset. It is equal to the capitalized amount (this is the cost of the asset) minus the salvage value of the asset. How is straight-line depreciation calculated?~Straight-line depreciation (STL) is the simplest method and results in an equal amount of depreciation expense charged to the income statement each period. It is calculated as: Depreciable Amount ÷ Estimated Useful Life How is double declining balance depreciation calculated?~In double declining balance (DDB) method we use a rate that is two times (twice) the percentage that would be recognized under the straight-line method. The annual depreciation expense is calculated as: Double declining rate × book value of the asset at the beginning of the year

What is a LIFO layer?

A LIFO layer arises when a company purchases more inventory before it sells all of its previous purchase of inventory. Because we assume in LIFO that the most recently purchased (newest) inventory item is sold, it leads to having many different individual prices for the units in ending inventory. Each time the company buys more inventory before selling all of the inventory it has on hand, a layer is added.

What is a copyright and how is it accounted for?

A copyright is granted for intellectual property consisting of original works and is effective for the life of the author plus 70 years. Copyrights are identified with the symbol ©. As with patents, if a copyright is purchased, it is recorded at its purchase price. An internally generated copyright can be recorded at its registration costs only. Capitalized costs for copyrights are amortized over the useful life of the copyright if less than its legal life. Any research and development costs that lead to a copyright must be expensed as they are incurred and thus are not capitalized or amortized.

What is a cumulative preferred dividend?

A cumulative dividend is one that is earned each year by the preferred share. It is important to note that the word is "earned." This does not mean that company actually distributes the dividend each period, just that the shareholder has earned the dividend and has a right to receive that dividend in the future.

What is a deferred tax asset and how is one created?

A deferred tax asset is created by an item that causes taxable income in the current period to be higher than book income in the current period. Because taxable income is higher, the company has had to pay more in taxes than its book income indicates it should have paid. Therefore, for book purposes this is a prepaid tax, or a deferred tax asset. A deferred tax asset is created by either: A revenue that is taxable in the current period but is not included in book income for the current period. For example, a deposit received for work to be performed in the future, rental income received in advance of the period covered, or subscription payments received in advance. Or an expense that is included in book income but is not deductible for tax purposes in the current period. For example, warranty expense debited to the income statement and credited to estimated warranty liabilities.

What is a deferred tax liability and how is one created?

A deferred tax liability is created by an item that causes taxable income in the current period to be lower than book income in the current period. Because taxable income is lower, the company does not pay as much as its book income indicates it should pay in taxes in the current period. However, because the company knows that these temporary timing differences will reverse, it understands that the tax that was not paid this year will need to be paid in the future. Therefore, for book purposes this difference is recorded as a deferred tax liability. A deferred tax liability is created by either: A revenue that is included in book income but not in taxable income in the current period. For example, interest income accrued monthly for book purposes on a debt security investment when the interest is received only semi-annually. Or an expense that is deductible for tax purposes but is not an expense for book purposes in the current period. For example, payment of an insurance premium in advance for insurance coverage during the coming year or the early years of an asset's life when accelerated depreciation is used for tax purposes while straight-line depreciation is used for book purposes.

What is a patent and how is a patent accounted for?

A patent is the right of exclusive use granted by the U.S. Patent Office. Previously patents were valid for 17 years, but the length of time is now 20 years for all new patents. Patents are amortized over the shorter of the patent's legal life or the economic useful life of the patent. It is very possible that the economic useful life of the patent will be shorter than the legal life of the patent because of changing technologies. For patents that are purchased, the patent should be recorded on the books at the purchase price. The purchase price is also the amount that should be amortized over the useful life of the patent. For internally developed patents, the capitalized and amortized amount is generally limited to registration fees and legal fees for filing the patent. This accounting treatment is related to the accounting treatment for research and development. Research and development costs are generally expensed as incurred and thus they cannot be capitalized and amortized.

What is a self-correcting error?

A self-correcting error is one that will correct itself in time, even if it is not discovered. The miscounting of inventory is a self-correcting error. While the error in ending inventory will have an effect on two balance sheets and two income statements, if inventory is correctly counted at the end of the next year, then there will be no further errors as a result of the miscounting.

What is a stock dividend?

A stock dividend occurs when the company distributes a dividend in the form of additional shares.

What is a stock split?

A stock split is initiated by a company as the result of the market price for a share becoming too high. In order to reduce the market price of the share, the company essentially cuts all of their shares into smaller pieces. As a result more shares are outstanding and each share is worth a lower market price. In a stock split, the par value of each share of the stock is also reduced in the same ratio.

What is a trademark and how is accounted for?

A trademark or trade name is a distinctive sign, word or symbol. Trademarks can be registered for 20 years and renewed for longer time periods. The costs that should be capitalized include legal and registration fees, design costs and any cost of successfully defending the name. The trademark should be amortized over its useful life, but the amortization period should not exceed 40 years. Trademarks are identified with the symbol ®.

What is a warranty and what are the two types of warranties?

A warranty is a promise that a company makes to a buyer that if the product breaks during a specific time period, the company will pay to fix or replace the defective product. Warranties can be of two types: An expense warranty is a manufacturer's warranty given along with the sale of the product, without any additional payment being required from the customer. A sales warranty is an extended warranty that is sold separately from the product. Sales warranties may be offered by the manufacturer but also may be offered by either the reseller or by a third party.

What are the three methods of calculating depreciation in the years of acquisition and disposal?

Actual time of ownership - the company recognizes depreciation expense for the actual time that it owned the asset in the year of acquisition and the year of disposal. This is the most accurate method, but also the most time consuming. Full year in the year acquired and no depreciation in the year disposed - the company takes a full year of depreciation in the year that the asset is acquired and has no depreciation in the year in which the asset is disposed of. This will be the case no matter when in the year the asset is acquired or disposed of. Half-year convention - the company recognizes six months of depreciation in the year of acquisition and six months of depreciation in the year of disposal, regardless of when during the years the acquisition and disposal take place.

What are four potential events that will cause a difference between book and taxable income?

An income item is recognized as taxable income before it is recognized in the accounting records as revenue. An expense item is deductible from taxable income before it is deducted in the accounting records as an expense. An income item is recognized in the accounting records as a revenue before it is recognized as taxable income on the tax return. An expense item is deducted in book income as an expense before it is deductible in taxable income.

What is the fair value option for reporting a security?

An investor may choose to report a specific security using the fair value option, with all gains and losses related to changes in its fair value reported on the income statement. The option is applied to a specific instrument on an instrument-by-instrument basis, and it is available only when the investor first purchases the financial asset. If an investor chooses the fair value option, it must apply that option consistently as long as it continues to own that security.

What are assets, liabilities, and equity?

Assets are probable future economic benefits that have been obtained or are controlled by an entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits due to present obligations of an entity to transfer assets or provide services in the future, resulting from past transactions or events. Equity is net assets, or the residual (remaining) interest in the assets of an entity after deducting its liabilities from its assets. For a business entity, equity is the ownership interest.

What are the rules for adjusting net income for changes in assets and liabilities?

Assets: The amount of an increase in an asset should be deducted from net income. The amount of a decrease in an asset should be added to net income. Liabilities: The amount of an increase in a liability should be added to net income. The amount of a decrease in a liability should be deducted from net income.

What are the five financial statements used under US GAAP?

Balance Sheet (also called the Statement of Financial Position). Income Statement. Statement of Cash Flows. Statement of Comprehensive Income. Statement of Changes in Stockholders' Equity.

What is book income and what is taxable income?

Book income is the pre-tax financial income reported in the financial statements calculated using the rules of GAAP. Book income is the "correct" income because it is calculated according to GAAP. Taxable income is a tax accounting term and it is used for the amount upon which the company's income tax payable is computed. Taxable income is calculated by following the tax code of the IRS.

How is the High-Low Points Method calculated?

Calculate the Variable Cost Per Unit by dividing the difference between the costs for the highest production volume and the costs for the lowest production volume by the difference between the highest and lowest production volumes: Variable Cost per Unit = Difference in Costs ÷ Difference in Units This calculation gives us the variable cost per unit. We know this because the difference in costs between the two months is related only to variable costs (since we are assuming that all other costs are fixed and therefore unchanging with changes in production volume). Multiply the Variable Cost per Unit by the unit volume at either the highest or the lowest production volume to get the total variable cost at that level. Subtract the total variable cost from the total cost at that level to get the fixed cost.

What are the steps in the percentage of sales method of calculating allowance for doubtful accounts?

Calculate the bad debt expense for the period as a percentage of total credit sales. Make the journal entry to debit bad debt expense for the calculated bad debt expense amount and credit the allowance for doubtful debts for the same amount. Calculate the ending balance in the allowance account. Check the reasonableness of the allowance account balance.

What is depletion?

Depletion is the method of depreciation used for natural resources. It is calculated principally as the Units of Production Method of depreciation.

What are the steps in the percentage of receivables method of calculating allowance for doubtful accounts?

Calculate what the ending balance in the allowance account should be using some percentage of ending accounts receivable. Determine what the "plug figure" in the allowance account needs to be in order for the ending balance in the account to be as calculated in Step 1. This "plug figure" is the bad debt expense for the period. Make the journal entry to debit bad debt expense for the amount calculated as bad debt expense in Step 2 and credit the allowance for doubtful debts account for the same amount.

What are the six categories of equity?

Capital stock, the par or stated value of the shares issued. Additional paid-in capital, or the excess of amounts contributed by owners from the sale of shares over and above the par or stated value of the shares issued. Retained earnings, or profits of the company that have not been distributed as dividends. Accumulated other comprehensive income items, or specific items that are not included in the income statement but are included in equity and do adjust the balance of equity, even though they do not flow to equity by means of the income statement as retained earnings do. Treasury stock, or the amount of shares repurchased (a contra-equity account that reduces equity on the balance sheet). Noncontrolling interest (minority interest), or a portion of the equity of subsidiaries that the reporting entity owns but does not own wholly.

What are the specific items classified as operating activities?

Cash received from customers and paid to suppliers in the course of the company's primary business activity. Interest paid on bonds and other debt (loans, leases, and mortgages). Interest received and dividends received from debt and equity investments. Cash paid to the government for taxes and cash received back from the government as tax refunds, except as noted below under Cash Flows from Financing Activities. Cash flows from the purchase, sale and maturity of trading securities usually will be classified as operating activities, not investing activities.

What is comprehensive income?

Comprehensive income is the total change in equity that results from all sources other than distributions to owners and investments by owners. It is a little closer to being an economic measure of income than net income is. What is the primary purpose of the statement of cash flows?~The primary purpose of the statement of cash flows is to provide information regarding receipts and uses of cash for the company during a period of time.

What are consigned goods and how are they accounted for in inventory?

Consigned goods are given by one company (the consignor) to another company (the consignee) for that second company to sell to the end consumer. Goods may be consigned because the consignee is physically closer to the consumer or because consignment enables the consignor to get a wider distribution of goods than the company could achieve on its own. Goods out on consignment belong in the inventory of the company that has put the goods out on consignment (the consignor). The goods should be carried on the consignor's balance sheet at the cost the consignee paid for the goods plus any shipping costs the consignor paid to get the goods to the consignee company that will sell the goods. The shipping costs to the consignee are costs of making the goods available for sale to the customer and thus are inventoriable costs. Goods held on consignment do not belong to the company that holds them (consignee) and therefore should not be included in the consignee's inventory.

What is contributed capital?

Contributed capital consists of the assets that are put into the company by the owners in return for their share of ownership of the company. The fair value of what is received in exchange for the shares (whether it is cash or another asset) will be recorded in two different equity accounts. What is retained earnings?~Retained earnings represent the undistributed profits of the company that have been reinvested in the company. These may also be called undistributed profits or undistributed earnings. We will use the term "retained earnings" in this book.

What are convertible preferred shares?

Convertible preferred shares may be converted into common shares at the option of the shareholder. If they are converted, the newly issued common shares are recorded at the book value of the preferred shares that were converted. There is no gain or loss recorded on this transaction as the newly issued common shares replace the preferred shares on the books.

What are current and noncurrent assets?

Current assets are assets that will be converted into cash or sold or consumed within 12 months or within one operating cycle if the operating cycle is longer than 12 months. Noncurrent assets are assets that will not be converted into cash within one year or during the operating cycle if the operating cycle is longer than one year.

What are current liabilities?

Current liabilities are obligations that will be settled through the use of current assets or by the creation of other current liabilities. What are noncurrent liabilities?~Noncurrent liabilities are liabilities that will not be settled within one year or the operating cycle if the operating cycle is longer than one year.

What are examples of noncash investing and financing transactions?

Debt converted to equity. Borrowing money to purchase a fixed asset when the lender pays the loan proceeds directly to the seller of the asset to make sure the loan proceeds are used as intended. Buying or selling fixed assets for something other than cash (for example, stock). Obtaining a building or other item by gift. Exchanging noncash assets or liabilities for other noncash assets or liabilities.

What are direct and indirect users of financial information?

Direct users are those who are directly affected by the results of a company. Direct users include investors and potential investors, employees, management, suppliers, and creditors. Direct users are individuals who stand to lose money financially if the company has financial problems. Indirect users are those people or groups who represent direct users. They include financial analysts and advisors, stock markets, and regulatory bodies.

What are dividends?

Dividends are the distribution of current profits and/or the retained earnings of the company to its owners. The declaration of cash or property dividends reduces total stockholders' equity as a result of either the distribution of an asset (cash or other property) or the incurrence of a liability (dividends payable if the dividend is not immediately distributed).

What is a noncumulative preferred dividend?

Dividends that are noncumulative are "lost" if they are not declared for any given year. These are simply dividends that are payable at the discretion of the company. What are unappropriated retained earnings?~All retained earnings start out classified as unappropriated retained earnings. The term "unappropriated" simply means that the dividends are available to be distributed to shareholders in the form of dividends.

How do LIFO and FIFO impact inventory calculations under rising and falling prices?

Ending Inventory Cost of Goods Sold Gross Profit Rising Prices FIFO Higher LIFO Higher FIFO Higher Falling Prices LIFO Higher FIFO Higher LIFO Higher

What is equity?

Equity is the remaining balance of assets after the subtraction of all liabilities. Equity is the portion of the company's assets owned by and owed to the owners. If the company were to be liquidated, equity represents the amount that would theoretically be distributable to the owners.

What is preferred stock?

Even though preferred shares do not have the right to vote, there are three preferences over common stock that make stock preferred: Preference in the claims to assets in a liquidation, and Preference in the payment of dividends, and A difference in how dividends are calculated. Preferred shares usually have a higher par value than common shares, and the dividend that is paid is usually a percentage of that par (or stated) value. Therefore, the preferred dividend is more of a fixed amount than the common dividend because the common dividend is dependent on earnings and management decisions.

What is factoring?

Factoring is when accounts receivable are sold to a third party. A commercial finance company called a factor essentially makes a loan guaranteed (collateralized) by the receivables to the seller of the receivables. The factor notifies the seller's customers to remit their payments directly to the factor. The factor receives repayment of the loan as it collects the receivables.

What is factoring with recourse?

Factoring with recourse meaning that if a customer does not pay the receivable, the seller of the receivable is liable to the factor for the uncollectible amount. When a factor purchases receivables with recourse, the factor's risk of uncollectibility is limited.

What is factoring without recourse?

Factoring without recourse means that the factor assumes the risk of any inability to collect the receivables. If a sold receivable proves to be uncollectible, the purchaser (the factor) has no recourse against the seller—the loss is the factor's loss. Some companies factor their receivables primarily for the purpose of transferring the bad debt risk in this manner.

What are the four main inventory cost flow assumptions?

First in First Out (FIFO), in which we assume that the item sold to the customer is the earliest unit purchased by the seller that has not yet been sold (in other words, the oldest item in inventory). Last in First Out (LIFO), in which we assume that the item sold to the customer is the latest unit purchased by the seller (in other words, the newest item in inventory). Weighted Average, in which we sum the costs paid for all the individual units of a given item in inventory and divide by the number of units purchased to find the average cost for each unit. Specific Identification, in which we actually keep track of each unit of inventory individually. The specific identification method is used for low quantity, high value inventory items, such as merchandise in a jewelry store or serialized electronic merchandise where records are kept by serial number.

At what value are fixed assets initially recorded?

Fixed assets should be initially recorded in the accounting records at the amount paid for the asset and all other costs that are necessary to get the asset ready for use.

What costs are included in the cost of buildings?

For buildings, costs included are: the purchase price, costs of renovating or preparing the building, cost of permits, any taxes assumed by the purchaser, insurance paid during the construction of the building, materials, labor, and overhead of construction.

What are some examples of reasons that book and taxable income differ?

For financial reporting, the full accrual method is used to report revenues, whereas for tax purposes a modified cash basis is used. For tax purposes, expense accrued for financial reporting for estimated liability for warranties is not allowed as a tax deduction until the amounts are paid. For tax purposes, expense accrued for financial reporting for estimated liability for pending litigation is not allowed as a tax deduction until the amounts are paid. By using accelerated depreciation methods for fixed assets for tax purposes, depreciation expense for tax purposes can be greater than depreciation expense for financial reporting purposes, leading to a lower taxable income in the early years of the assets' lives as compared with pretax financial income for the same years.

How are short-term receivables valued for the financial statements?

For financial statement presentation, short-term receivables are valued and reported at net realizable value, or the net amount expected to be received in cash. The net amount expected to be received in cash may be different from the amount legally receivable. Determining net realizable value involves estimation of (1) uncollectible receivables, and (2) any returns or allowances to be granted.

What costs are included in the cost of land?

For land, costs included are: the purchase price including the amount of any mortgages on the property that are assumed by the purchaser, transaction costs, site preparation costs, the cost of purchasing an existing structure that will be destroyed, the costs of razing (destroying and removing) an existing building, the amount of any delinquent real estate taxes assumed by the purchaser, permanent improvements, and other costs necessary to prepare the land for its intended use. The costs of destroying an existing building are included in the cost of the land because until the old building is removed, the land is not ready for its intended use.

What costs are included in the cost of machinery and equipment?

For machinery and equipment, costs included are: the cost of the machine, freight-in, handling, taxes, testing the machinery, and any other costs of getting the machinery ready for its intended use. For example, if the wall of the factory needs to be destroyed in order to get the machine into the factory, this cost, along with the cost of rebuilding the wall, will be included in the cost of the machinery because these were necessary to get the machine ready for its intended use.

What are goods out on approval?

Goods out on approval are goods that are currently held by the customer but have not yet been purchased by the customer. The customer physically has the product and has some period of time to decide whether to purchase it or return it. Goods-out-on-approval items should be included in inventory at their original cost until the customer accepts the goods. Only when the customer accepts the goods (or the time period for return passes without the customer returning the goods) will the sale be recognized and the cost of the inventory moved from inventory to cost of goods sold. What is obsolete inventory?~Inventory that is obsolete can no longer be sold and should not be included in the inventory balance on the balance sheet. Any inventory that becomes obsolete should be written off as a loss in the period in which it is determined to be obsolete.

What is goodwill and how is it accounted for?

Goodwill is defined as the amount that a purchaser has paid for a company that is greater than the fair value of the net identifiable assets. Purchased goodwill must be reported as a separate line item on the balance sheet. Generally, other intangibles are combined and reported as one figure on the balance sheet. Goodwill can be acquired or developed internally, but the only goodwill recognized in the accounting records is purchased goodwill. The amount of goodwill purchased is equal to the difference between the purchase price paid for a business and the fair value of the net assets received.

What does it mean when goods are shipped FOB Shipping Point?

If goods are shipped FOB Shipping Point, the seller should recognize revenue and a receivable at the time the goods are delivered to the carrier. Under FOB Shipping Point terms, ownership of the goods transfers to the buyer when the goods are delivered to the carrier. Thus, the seller will write the inventory off its books and recognize revenue and a receivable as soon as the goods are turned over to the carrier.

What is an impaired asset?

If the asset's book value > future cash flows, then the asset is considered to be impaired. An impaired asset is written down to its fair value. The amount by which the asset is written down is reported as a loss during that period.

What are two important differences between preferred shares and bonds?

If the company does not pay dividends on the preferred shares in a certain period, that does not constitute a default. While preferred shares have a preference in dividends over common shares, the receipt of dividends is not guaranteed for preferred shareholders Preferred shares do not have a face amount that needs to be repaid at a maturity date in the future the way bonds do.

What does it mean when goods are shipped FOB Destination?

If the goods are shipped FOB Destination, the transfer of the goods will not take place until the goods reach the buyer, so the seller will not recognize revenue or a receivable until the goods have been delivered to the buyer by the carrier.

What is a property dividend?

In a property dividend, the company is distributing an asset other than cash as the dividend. For example, the company may distribute inventory, fixed assets or shares in another company that it holds. The fact that a company declares a property dividend does not mean that the company does not have cash. A property dividend may be declared because the company is using its cash to finance an expansion or some other investment opportunity.

How is sum-of-the-years'-digits depreciation calculated?

In the sum-of-the-years'-digits method, the amount of depreciation to be recorded for any given period is calculated using fractions based on the estimated useful life of the asset. Under the sum-of-the-years'-digits method the depreciable base is multiplied by a fraction that is determined using the useful life of the asset. The denominator (bottom number) is a sum of all of its expected years of life. Sum of the Years' Digits = [n(n + 1)] ÷ 2

How are in transit goods counted in inventory?

In transit goods are goods that have been shipped prior to year end but had not yet been received by the buyer as of year end. To whom the goods belong is determined by the terms of shipping. Goods sent FOB Shipping Point belong to the buyer from the moment the seller gives them to the shipping company. Thus, while the goods are in transit they belong to the buyer because title was transferred at the shipping point. Goods sent FOB Destination belong to the shipper until the buyer receives them. While the goods are in transit, they belong to the seller and title is transferred at the destination point only when they are received by the buyer.

What are intangible assets?

Intangible assets are assets that do not have a physical substance but provide benefit to the firm over a period of time. Intangible assets may be either purchased or developed internally. However, because an asset comes about only as a result of a prior transaction, internally-generated intangible assets are not recorded on the balance sheet.

What are internal and external users of financial information?

Internal users make decisions within the firm whereas external users make decisions from outside of the firm about whether or not to begin a relationship with the firm, continue a relationship with the firm, or change their relationship to the firm.

How is inventory valued?

Inventory should be recorded in the books at the amount that includes all of the costs paid for getting the inventory ready and available for sale. All the costs include not only the cost of the inventory itself, but also shipping costs to receive the inventory, insurance, taxes and tariffs, duties, storage, and any other costs without which the company could not sell the inventory to the customer.

What are the specific items classified as financing activities?

Issuance of stock. Treasury stock transactions. Paying dividends (note that dividends paid are financing activities, but dividends received are operating activities). Issuing debt (bonds). Obtaining a loan and repaying the principal of the loan. Repayment of principal on other debt obligations, including repayment of the principal portion of capital lease payments for fixed assets. (The interest portion of payments on capital leases and loans is classified as cash flows from operating activities.) Normally, cash flows from taxes paid and tax refunds received are classified as operating activities. However, certain cash flows relating to income tax expense associated with share-based compensation are classified as financing activities.

What are leasehold improvements and how are they accounted for?

Leasehold Improvements are improvements that: Are made by a lessee to a building or property that the lessee is leasing. Cannot be removed by the lessee when the lease period is over. The cost of leasehold improvements should be amortized over the shorter of the remaining lease term or the useful life of the improvements.

What is liquidity?

Liquidity refers to the time expected to elapse until an asset is converted into cash or until a liability needs to be paid. The greater a company's liquidity is, the lower its risk of failure.

What are the four adjustments to net income using the indirect method of preparing the statement of cash flows?

Net income is adjusted for four types of items: Eliminate noncash income and expense items such as depreciation that are included in the income statement. Eliminate investing and financing activity events whose results are included in the income statement, for example gains and losses on the income statement. Include the effect of any operating activities that were not included in net income but did have a cash effect and exclude (eliminate) the effect of any events that are included in net income but did not have a cash effect. Cash flows from the purchase, sale and maturity of trading securities will usually be classified as operating activities, not investing activities. If those cash flows are to be classified as operating activities on the SCF, those cash flows will need to be included as an adjustment to reconcile net income to net cash from operating activities.

What is off-balance sheet financing?

Off-balance sheet financing is any form of funding that avoids placing owners' equity, liabilities or assets on a firm's balance sheet. Off-balance sheet financing can be accomplished through the use of: Operating leases Sale of receivables (factoring) Joint ventures Non-consolidated subsidiaries Variable interest entities

What are the three main categories of activities in the statement of cash flows?

Operating activities: cash inflows and outflows that result from the company's main business activities and central operations. Investing activities: activities that the company undertakes to generate a future profit, or return, from investments. Financing activities: activities that a company undertakes to raise capital to finance the business.

What is the par value of stock?

Par value is the specified value printed on the share itself. Par value is the maximum amount of a shareholder's personal liability to the creditors of the company, because as long as the par value has been paid in to the corporation by the shareholders, the shareholders obtain the benefits of limited liability, and their potential for loss is limited to the amount they paid for their shares.

What are the two systems for the frequency of making inventory entries?

Periodic System: entries and calculations are made only at the end of the period (every month, year or quarter). Perpetual System: the calculation of the cost of the item of inventory that is sold is made after each individual sale.

What are permanent accounts?

Permanent accounts are not closed out at the end of each accounting period but rather their balances are cumulative. They keep on accumulating transactions and changing with each transaction, year after year.

What are permanent timing differences with regards to income tax?

Permanent timing differences are items that cause differences between taxable income and book income but do not reverse over time. Permanent differences do not give rise to deferred tax assets or liabilities because of the fact that by definition a permanent timing difference is something that will be recognized for either book or tax purposes, but not both.

What are fixed assets (property, plant, and equipment)?

Property, plant, and equipment (PP&E) are tangible assets that are used in operations and will be used past the end of the current period. When the fixed assets are purchased they are recorded at their cost, including costs such as installation costs needed to bring the asset to usable condition. The cost is then expensed over the life of the asset through depreciation.

What are the specific items classified as investing activities?

Purchasing and selling property, plant and equipment (fixed assets). Making and collecting loans to other parties. Acquiring and disposing of available-for-sale or held-to-maturity securities (equities and debt instruments). In addition, as mentioned above, cash flows from the purchase, sale and maturity of trading securities may be classified as investing activities if the securities are not being held for sale in the near term.

What are the three classifications of inventory for a manufacturing company?

Raw materials - the individual parts and pieces that will be assembled to make the finished goods. Work-in-process - units of inventory for which production has started, but has not yet been completed. Finished goods - units that have been completed but not yet sold.

What is revenue?

Revenue represents inflows or other enhancements to assets or settlements of liabilities as a result of delivering goods or providing services that are the entity's main or central operations. Revenues are usually recognized when the earnings process (the provision of goods or services to the customer) is complete and an exchange has taken place. The exchange does not need to include cash but may include a promise to pay in the future (a receivable). What are expenses?~Expenses are outflows or other using-up of assets or the incurrence of liabilities as a result of delivering goods or providing services that are the entity's main or central operations. What are gains?~Gains are increases in equity as a result of transactions that are not part of the company's main or central operations and that do not result from revenues or investments by the owners of the entity. What are losses?~Losses are decreases in equity as a result of transactions that are not part of the company's main or central operations and that do not result from expenses or distributions made to owners of the entity.

What is risk?

Risk refers to the unpredictability of future events, transactions and circumstances that can affect the company's cash flows and financial results.

What is solvency?

Solvency refers to the company's ability to pay its obligations when they are due. A company with a high level of long-term debt relative to its assets has lower solvency than a company with a lower level of long-term debt. What is financial flexibility?~Financial flexibility is the ability of a business to take actions to alter the amounts and timing of its cash flows that enable the business to respond to unexpected needs and take advantage of opportunities.

Add all depreciation and amortization expense back to net income. Add all non-operating losses on the income statement back to net income. Subtract all non-operating gains on the income statement from net income. Add and subtract the changes in balance sheet accounts that are related to operating activities - net accounts receivable, accounts payable, inventory, other payables and receivables, bond discount or premium, and other assets and liabilities. If purchases, sales and maturities of trading securities are being classified as operating activities, subtract cash used to purchase trading securities and add cash received for trading securities that were sold or that matured. In addition to the above adjustments, the cash amounts for income taxes paid and interest paid need to be disclosed in a supplemental schedule.

Summarize the steps for preparing the operating activities section under the indirect method.

What is the High-Low Points Method?

The High-Low Points Method is often used to separate fixed from variable costs when they are not segregated in the information we have. For this, we use the highest and lowest observed values of the cost driver within the relevant range.

What are temporary accounts?

The accounts that are used to record revenues, expenses, gains and losses are temporary accounts. They are closed to a permanent account (retained earnings on the balance sheet) at the end of each period (fiscal year). Thus at the beginning of each fiscal year, the balances in the income statement accounts are zero.

What is the purpose of the balance sheet?

The balance sheet, also called a statement of financial position, provides information about an entity's assets, liabilities, and owners' equity at a point in time (usually the end of a reporting period). The statement shows the entity's resource structure—the major classes and amounts of assets—and its financing structure—the major classes and amounts of liabilities and equity.

What is a the date of declaration in a stock dividend?

The date of declaration is the date when the board formally declares the dividend. It is on this date that the first journal entry is made. In this entry the retained earnings account is debited (this reduction represents that some of the available money has been distributed, reducing the amount that remains available to the shareholders) and a liability is set up.

What is the date of payment in a stock dividend?

The date of payment is the date on which the dividend is paid. On this date the liability is eliminated and the cash account is decreased. What are liquidating dividends?~Liquidating dividends are those dividends that are a return of capital rather than a return on capital. These occur when the dividend distributed is greater than the amount in retained earnings. Any dividend paid in excess of the balance in retained earnings will be classified as a liquidating dividend because there are no profits to distribute.

What is the date of record in a stock dividend?

The date of record is the date that is used to determine who actually will receive the dividend. Theoretically, no journal entry is made on this date because the entry on the date of declaration recognized the liability and the reduction in retained earnings. However, in reality, a company may need to make an entry on the date of record to correct the estimate that was made regarding the calculated amount of dividend that would be payable on the date of declaration.

What is the direct method for preparing the statement of cash flows?

The direct method shows each item that affected cash flow, such as cash collected from customers. Each item is calculated by starting with the relevant item on the income statement and adjusting it using the balances in the relevant balance sheet account(s) at the beginning of the period and at the end of the period covered by the income statement. Each individual line on the income statement is also adjusted to remove the effect of noncash transactions and non-operating activity transactions.

What are the main adjustments that need to be made to eliminate intercompany transactions?

The elimination of intercompany receivables and payables. The elimination of the effect of intercompany sales of inventory. The elimination of the effect of intercompany sales of fixed assets.

What is the equity method for investment in equity securities?

The equity method is used when the investor has significant influence over the investee. Owning between 20% and 50% of the outstanding voting stock usually indicates significant influence. The investment is initially recorded at cost, but the investor corporation subsequently adjusts the balance in the investment account for changes in the investee's net assets. The investor's portion of the investee's earnings (or losses) periodically increases (or decreases) the investment's carrying amount on the balance sheet of the investor.

What are the three methods of accounting for investments?

The fair value method, used for marketable debt and equity securities. The fair value method is used for debt securities and for certain equity securities. The equity method, used generally when an investor corporation owns less than 50 percent of the outstanding stock of the investee but has the ability to exercise significant influence over the operations of the investee company. The consolidation method, used when the investor corporation owns more than 50% of the investee corporation's outstanding common stock. With greater than 50% of the outstanding common stock, the investor corporation has a controlling interest in the investee and the investee is a subsidiary of the investor. The investor consolidates the financial results of the investee with its own financial results and prepares consolidated financial statements.

What is the income statement?

The income statement reports on the success of a company's operations during a given period of time. The income statement provides users with information to help them predict the amounts, timing, and uncertainty of (prospects for) future cash flows.

What is the objective of financial reporting?

The objective of financial reporting is to provide financial information about the entity that is useful for decision-making.

What is the statement of changes in stockholders' equity?

The statement of changes in stockholders' equity reports the changes in each stockholders' equity account and in total stockholders' equity during the year and reconciles the beginning balance in each account with the ending balance. Since stockholders' equity accounts are permanent accounts that keep on accumulating their balances from year to year, information about the sources of changes in the separate accounts is required to make the financial statements sufficiently informative.

What are the two models for reporting consolidated investments in equity securities?

The voting-interest model: When one corporation owns more than 50 percent of another corporation's outstanding common stock, it has a controlling interest in the other corporation. The other corporation is a subsidiary and the parent corporation must consolidate the financial statements of the subsidiary with its own financial statements. The parent company (the controlling company) will present the financial statements of the consolidated companies as if the two, or more, companies were a single economic entity. The risk-and-reward model: Although control is normally demonstrated by ownership of more than 50 percent of the voting stock of a company, it is possible for there to be control with a smaller ownership percentage or no control with a higher percentage. If a company cannot determine control based on voting interest, it must use the risk-and-reward model. The risk-and-reward model states that if a company is involved substantially in the economics of another company, then consolidated financial statements must be prepared. The risk-and-reward model applies primarily to variable-interest entities, discussed further in this book in the topic of Off-Balance Sheet Financing.

What are redeemable preferred shares?

These preferred shares may be sold back to the company at a specified price at the option of the shareholder. What are callable preferred shares?~Callable preferred shares can be called (or retired) at the option of the corporation.

What are the criteria for classification as extraordinary items?

Unusual nature. The event or transaction should be highly abnormal and be clearly unrelated to the ordinary and typical activities of the company. Infrequency of occurrence. The event or transaction should be something the company does not reasonably expect to recur in the foreseeable future.

What are the three types of journal entries made that involve the allowance account?

To record the bad debt expense for the period. To write off a specific receivable when it becomes uncollectible. To collect a previously written-off receivable.

What are the three categories of debt securities?

Trading: Securities bought and held principally for the purpose of selling them in the near term (generally within hours or days) with the objective of generating profits from short-term price changes. These are accounted for at fair value. Held-to-Maturity: Debt securities that are purchased with the intent to hold them to maturity. These are accounted for at amortized cost. Available-for-Sale: Securities not classified as either trading or held-to-maturity. These are accounted for at fair value. What are equity securities?~Equity securities are accounted for using the fair value method when the investor owns less than 20 percent of the investee company's outstanding common stock and has little or no influence over the investee. Equity securities under the fair value method are classified as either trading securities or available-for-sale securities. Equity securities cannot be classified as held-to-maturity since equity has not maturity date.

What is the indirect method for preparing the statement of cash flows?

Under the indirect method, all adjustments are made to the net income figure from the income statement. The adjustments that are made will be the same as they are for the direct method: adjustments for changes in balance sheet accounts and the elimination of noncash and non-operating activity transactions.

How does the percentage of receivables method calculate potentially collectible receivables?

Under the percentage of receivables method, a company focuses on making the ending balance in the allowance account be whatever it needs to be to create a net accounts receivable figure that represents the amount of receivables the company estimates are collectible. It values the ending receivables by estimating the percentage of the year-end receivables that will not be collected in the future. In this manner, the company uses the balance sheet to value the accounts receivable. The amount of bad debt expense the company records is whatever amount is needed to change the unadjusted balance in the allowance account to a balance that will create the correct net accounts receivable figure when the allowance account is combined with the accounts receivable account. (A certain amount of "working backwards" is necessary in this calculation.) Under this method, the bad debt expense figure on the income statement becomes the balancing figure.

How does the percentage of sales method calculate potentially collectible receivables?

Under the percentage of sales method, a company estimates the amount of its credit sales from the period that will not be collected in the future. This uncollectible amount is recognized as the bad debt expense for the period. In this method, the company uses the income statement to value and match the bad debt expense correctly. The ending balance in the allowance account is the beginning balance adjusted by any accounts written off during the period (debits to the allowance account) and by the bad debt expense recorded for the period (a credit to the allowance account). The ending balance in the allowance account becomes a balancing figure.

How is units of production depreciation calculated?

Under the units of production method, we determine the number of units the asset will be able to produce over its useful life, and then the appropriate ratio of the depreciable amount is recognized as depreciation expense for each year of the asset's estimated useful life, based on the actual production of the asset during that period.

What happens when the value of inventory declines?

When inventory's value declines, it should be written down to its lower market value. For inventory, the evaluation is done by comparing the cost of the inventory (what is recorded on the books) to the market value of the inventory. The value of the inventory on the balance sheet will then be adjusted to the lower of its cost or its market value. The term for this inventory valuation is lower of cost or market, or just LCM. The general rule for the "market value" is the price a reseller would have to pay to replace the inventory item or the cost to a manufacturer to reproduce the item.