Module 1: Financial Accounting

Form 10‑K

the audited annual report that includes the four financial statements, discussed below, with explanatory notes and the management's discussion and analysis (MD&A) of financial results.

Cash Conversion Cycle (CCC)

the length of time funds are tied up in working capital, or the length of time between paying for working capital and collecting cash from the sale of the working capital

Statement of Cash Flows

A financial statement that provides financial information about the cash receipts and cash payments of a business for a specific period of time.

land, buildings, equipment

Asset. (often referred to as property, plant, and equipment or just PPE) will generate cash over a long period of time and are therefore, classified as long-term assets.

Gross Profit Margin

Gross Profit / Sales

Non-current Liabilities

Long-term debts owed by the business, obligations due after one year.

LIFO inventory costing method

The LIFO inventory costing method transfers the most recent inventory costs from the balance sheet to COGS. That is, the LIFO method assumes that the most recent inventory purchases (last-in) are the first costs transferred from inventory (first-out).

Current Liabilities

The balance sheet lists liabilities in order of maturity. Obligations that must be settled within one year are called current liabilities.

FIFO inventory costing method

Using the price of merchandise *purchased* first to calculate the cost of merchandise *sold* first. That is, FIFO assumes that the first costs recorded in inventory (first-in) are the first costs transferred from inventory (first-out).

When a cost creates an immediate benefit...

When a cost creates an immediate benefit, such as gasoline used in delivery vehicles, the company records the cost in the income statement as an expense.

Common stock

par value received from the original sale of common stock to investors

There are two ways a company can finance its assets.

It can raise money from stockholders; this is owner financing. It can also raise money from banks or other creditors and suppliers; this is non-owner financing. This means both owners and non-owners hold claims on company assets.

bottom‑line

On the income statement. Revenues less expenses. Net income amount (also called profit or earnings).

Retained Earnings

On the statement of stockholder's equity. (also called earned capital or reinvested capital) net income over the life of the company minus all dividends ever paid. Represents the cumulative total amount of income the company has earned and that has been retained in the business; that is, not distributed to stockholders in the form of dividends.

Productivity (Asset Turnover)

Productivity relates sales to assets. This component, called asset turnover (AT), reflects sales generated by each dollar of assets. Management wants to maximize asset productivity to achieve the highest possible sales level for a given level of assets (or to achieve a given level of sales with the smallest level of assets)

Accounting Equation

Since all financing must be invested in something, we obtain the following basic relation: investing equals financing. This equality is called the accounting equation.

Equity (on the balance sheet)

The equity section of a balance sheet consists of two basic components: contributed capital and earned capital.

Financing Activities

To pay for assets, companies use a combination of owner (or equity) and non-owner financing (liabilities or debt).

Additional paid-in capital

amounts received from the original sale of stock to investors in excess of the par value of stock.

Accounts Receivable

Amounts to be received in the future due to the sale of goods or services

Accounts receivable, net

Asset on the Balance Sheet. Amounts due from customers arising from the sale of products and services on credit ("net" refers to the subtraction of un-collectible accounts).

Short-term investments (marketable securities)

Asset on the Balance Sheet. Marketable securities and other investments the company expects to dispose of in the short run.

Accounting Equation

Assets = Liabilities + Owner's Equity

Cost of Goods Sold Equation

Beginning Inventory (prior period balance sheet) + Inventory purchased or produced = Cost of Goods Available for Sale Cost of Goods Available for Sale - Ending Inventory (current period balance sheet) = Cost of Goods Sold (current period income statement)

Gross Profit (Income Statement)

COGS is then deducted from sales to yield gross profit. Sales - COGS = Gross Profit.

Capitalization of Inventory Cost

Capitalization means that a cost is recorded on the balance sheet and is not immediately expensed in the income statement. Once costs are capitalized, they remain on the balance sheet as assets until they are used up, at which time they are transferred from the balance sheet to the income statement as expense.

Cash

Most liquid asset on the balance sheet. Currency, bank deposits, and investments with an original maturity of 90 days or less (called cash equivalents)

Gross Profit

Net Sales - COGS. On the income statement. First equation to determine Revenue minus Expenses.

Statement of Shareholders' Equity

The statement of stockholders' equity reconciles the beginning and ending balances of stockholders' equity accounts.

Capitalization of an asset

Adds it to the balance sheet as an asset.

Current Assets

A company expects to convert its current assets into cash or use those assets in operations within the coming fiscal year.

Liabilities

Amounts owed to creditors. (or debt) non-owner claims on assets.

Input Markets

Input markets generate most expenses (or costs) such as inventory, salaries, materials, and logistics. Part of generating net income.

Balance Sheet

Investing activities are represented by the company's assets. These assets are financed by a combination of non-owner financing (liabilities) and owner financing (equity).

Contributed Capital

On statement of stockholder's equity. the stockholders' net contributions to the company. Assets the company received from issuing stock to stockholders/shareholders.

Equity

Owner claims on assets.

Book Value

Stockholders' equity is the "value" of the company determined by generally accepted accounting principles (GAAP) and is commonly referred to as the company's *book value*.

Long-Term Assets

The second section of the balance sheet reports long-term (non-current) assets. Long-term assets include the following: Property, Plant and Equipment + Long Term Investments + Intangible and other Assets.

Statement of Cash Flows

The statement of cash flows reports the change (either an increase or a decrease) in a company's cash balance over a period of time. The statement reports cash inflows and outflows from operating, investing, and financing activities over a period of time.

True or False: To properly analyze the information contained in financial statements, it is important to understand the business context in which the information is created.

True. Regulatory forces, competitive forces,

True or False? Historical financial statements provide important relevant information that allows managers to effectively plan their company's business for the upcoming year.

True. We can use historical information to help guide decisions and predict future performance.

When are Cost of Goods sold recorded?

When inventories are sold, their costs are transferred from the balance sheet to the income statement as cost of goods sold (COGS).

double declining balance depreciation

a accelerated method that allocates a higher depreciation in the earlier years of the asset's life and lower depreciation in later years

Form 10‑Q

the un-audited quarterly report that includes summary versions of the four financial statements and limited additional disclosures.

Preferred stock

value received from the original sale of preferred stock to investors; preferred stock has fewer ownership rights than common stock.

Accounting or Fiscal Year

A one-year, or annual, reporting period is common.

Inventories

Goods available for sale that must first be sold before cash can be collected.

Net Income

On the income statement. Remaining profit available to shareholders. Revenue minus expenses.

Treasury Stock

Amount the company paid to reacquire its common stock from shareholders.

Net Revenue

On the income statement. Revenue after adjustments (e.g., for estimated returns or for amounts unlikely to be collected). Sales to customers.

Market Value

This book value is different from a company's market value (market capitalization or market cap), which is computed by multiplying the number of outstanding common shares by the company's stock price.

Net Income

To generate net income, companies engage in operating activities that use company resources to produce, promote, and sell products and services. These activities extend from input markets involving suppliers of materials and labor to a company's output markets, involving customers of products and services.

True or False: Financial statements provide important input into the evaluation of the company's success in carrying out its strategic plan.

True.

True or False: Financial statements provide substantial information that is used in all phases of the planning process, including the way in which the company is financed and which investments are pursued.

True.

Accounts Payable

(Current Liability) Amounts to be paid by the company in the future for goods or services already acquired. Amounts owed to suppliers for goods and services purchased on credit.

Unearned revenues

(Current Liability) obligations created when the company accepts payment in advance for goods or services it will deliver in the future; also called advances from customers, customer deposits, or deferred revenues.

Accrued Liabilities

(Current Liability) obligations for expenses that have been incurred but not yet paid; examples are accrued wages payable (wages earned by employees but not yet paid), accrued interest payable (interest that is owing but has not been paid), and accrued income taxes (taxes due); also called accrued expenses.

Owner Financing

(equity) resources (mostly cash, but sometimes non-cash assets) contributed to the company by its owners, and profits retained by the company.

Non-owner Financing

(liabilities) Nonowner financing is borrowed money.

An asset must possess two characteristics to be reported on the balance sheet.

1) It must be owned (or controlled) by the company 2) It must confer expected future economic benefits that result from a past transaction or event.

Balance Sheet

A balance sheet reports a company's financial position at a point in time. The balance sheet reports the company's resources (assets), namely, what the company owns. The balance sheet also reports the sources of asset financing.

Business Strategy

A company's strategic (or business) plan reflects how it plans to achieve its goals and objectives. A plan's success depends on an effective analysis of market demand and supply. Specifically, a company must assess demand for its products and services and assess the supply of its inputs (both labor and capital). Historical financial statements provide insight into the success of a company's strategic plan and are an important input to the planning process.

Average days inventory outstanding (DIO)

Also called days inventory outstanding. We calculate the number of days required to sell all of the inventory held (on average). Average Days Inventory Outstanding = 365 x Average Inventory / COGS

Asset on the balance sheet

An asset remains on the company's balance sheet until it is used up. When a cost creates a future economic benefit, such as inventory to be resold or equipment to be later used for manufacturing, the company capitalizes the cost (i.e., adds it to the balance sheet as an asset).

Income Statement

An income statement reports on a company's performance over a period of time and lists amounts for its top line revenues (also called sales) and its expenses.

Contributed capital (on the balance sheet)

Contributed capital is the net funding a company received from issuing and reacquiring its shares; that is, the funds received from issuing shares less any funds paid to repurchase such.

Cash Conversion Cycle / Cash Flow Cycle

Each time a company completes one cash conversion cycle, it has purchased and sold inventory (realizing sales and gross profit), and paid accounts payable and collected accounts receivable. The cycle increases cash flow (unless the sales are not-profitable).

Retained Earnings (On Balance Sheet / Equity)

Earned Capital under Equity on the Balance Sheet. Accumulated net income (profit) that has not been distributed to stockholders as dividends.

Earned Capital (on the balance sheet)

Earned capital is the cumulative net income (loss) that has been retained by the company (not paid out to stockholders as dividends).

How much cost is capitalized on the balance sheet?

For purchased inventories (such as merchandise), the amount capitalized is the purchase price.

Days Payable Outstanding (DPO)

How many days it takes to pay it supplies on average. Business-to-business (B2B) payables are usually non-interest bearing. This means accounts payable represent a low-cost financing source and companies should defer payment as long as allowed by the vendor. The average length of time that payables are deferred is reflected in the days payable outstanding (DPO) ratio

How are assets listed on the balance sheet?

In order of liquidity or their nearness to cash, with short-term assets (also called current assets) expected to generate cash within one year from the balance sheet date.

Balance Sheet

It provides information about the resources available to management and the claims against those resources by creditors and stockholders.

Liablities

Liabilities represent a company's future economic sacrifices. Liabilities are borrowed funds, such as accounts payable and obligations to lenders. They can be interest-bearing or non-interest-bearing.

Return on Assets (ROA)

Measures how profitably a company uses its assets. Net income / Average total assets. The important point is that a company's profitability must be assessed with respect to the size of its investment. This is done with a common metric: the return on assets (ROA)—defined as net income for that period divided by the average total assets during that period.

Return on Equity (ROE)

Net Income / Average Stockholders' Equity ROE reflects the return to stockholders, which is different from the return for the entire company (ROA). Net income divided by average stockholders' equity, where average equity is commonly defined as (beginning-year equity 1 ending-year equity)/2

long-term debt

Non-current Liability on the Balance Sheet. Amounts borrowed from creditors that are scheduled to be repaid more than one year in the future; any portion of long-term debt that is due within one year is reclassified as a current liability called current maturities of long‑term debt. Long-term debt includes bonds, mortgages, and other long-term loans.

Depreciation

Once capitalized, the cost of plant and equipment is recognized as expense over the period of time that the assets produce revenues (directly or indirectly) in a process called depreciation. Depreciation recognizes using up of the asset over its useful life.

Retained Earnings Reconciliation

One of the most important articulations between financial statements involves the balance sheet and income statement. The two statements are linked via retained earnings. Retained earnings reflect cumulative income that has not yet been distributed to shareholders.

Selling, general, and administrative expenses (SG&A)

Operating Expense on the Income Statement. This is a company's overhead and includes salaries, marketing costs, occupancy costs, HR and IT costs, and all the other operating expenses the company incurs other than the cost of purchasing or manufacturing inventory (which is included in cost of goods sold).

Cost of Goods Sold (COGS)

Operating Expense on the Income Statement. While revenues represent the retail selling price of the goods sold to customers, cost of goods sold is the amount the company paid to purchase or manufacture the goods (inventories) that it sold.

Output Markets

Output markets generate revenues (or sales) to customers. Output markets also generate some expenses such as marketing and distributing products and services to customers. Part of generating net income.

Profitability (Profit Margin)

Profitability relates profit to sales. This ratio is called the profit margin (PM), and it reflects the net income (profit after tax) earned on each sales dollar. Management wants to earn as much profit as possible from sales.

Stockholders' Equity

Stockholders' equity reflects financing provided from company owners. Equity is often referred to as residual interest. That is, stockholders have a claim on any assets in excess of what is needed to meet company obligations to creditors.

Stockholders' Equity

Stockholders' equity represents capital that has been invested by the stockholders, either directly via the purchase of stock, or indirectly in the form of retained earnings that reflect earnings that are reinvested in the business and not paid out as dividends.

When inventory is purchased or produced, it is "capitalized."

That is, it is carried on the balance sheet as an asset until it is sold, at which time its cost is transferred from the balance sheet to the income statement as an expense (cost of goods sold).

Balance Sheet

The balance sheet reports the assets, liabilities, and equity at a point in time. Balance sheet accounts are called "permanent accounts" in that they carry over from period to period; that is, the ending balance from one period becomes the beginning balance for the next

When are costs recognized as an expense on the income statement?

The point is that all costs are *eventually* recognized in the income statement as an expense. Those that create an immediate benefit are recognized as an expense immediately, and those that create a future benefit are added to the balance sheet as an asset (capitalized) and recognized as an expense in the future as the benefit is realized.

Statement of Stockholders' Equity

The statement of stockholders' equity reports on year-over-year changes in the equity accounts that are reported on the balance sheet. For each type of equity, the statement reports the beginning balance, a summary of the activity in the account during the year, and the ending balance.

Straight Line Depreciation

Under the straight-line (SL) method, depreciation expense is recognized evenly over the estimated useful life of the asset. Method that allocates an equal portion of the depreciable cost of plant asset (cost - salvage value) to each accounting period in its useful life.

Inventory (on the balance sheet)

When a company purchases or manufactures goods for resale, the cost is recorded on the balance sheet as an asset called inventories. When inventories are sold, they no longer have an economic benefit to the company, and their cost is transferred to the income statement in an expense called cost of goods sold.

Net Working Capital

current assets - current liabilities. We usually prefer to see more current assets than current liabilities to ensure that companies are liquid. That is, companies should have sufficient funds to pay their short-term debts as they mature.

Equipment (on the balance sheet)

when a company acquires equipment, the cost is recorded on the balance sheet in an asset called equipment (often included in the general category of property, plant, and equipment, or PPE). As the equipment is used in operations, a portion of the acquisition cost is transferred to the income statement as an expense. To illustrate, if an asset costs $100,000, and 10% is used up during the period in operating activities, then 10% of the asset's cost ($10,000) is transferred from the balance sheet to the income statement. This systematic allocation process is called depreciation.