Principles of Accounting and Finance Exam 4

Uses for ratio analysis

- Provide info that's useful for investment decisions - Provide info regarding whether we should buy or sell the company's stock or lend money to that company - Help internal management of an organization gain an awareness of their company's strengths and weaknesses

How might revenues become overstated?

- Record fictitious revenues - Record revenues before they are earned

Common fraudulent activities

- bait and switch tactics - making false statements - acting in conflict of interest - extortion - failure to report a felony - false advertising - over billing - filing false insurance claims

Limited Liabilities Partnerships

Are partnerships and are taxed as such - Partners are liable for their own acts and those of individuals under their direction

Expenses (Statement of activity)

Are reported as decreases in net assets without donor restrictions. Must be reported separately from revenues. Netting is generally not permitted.

Economy and Efficiency audits

Are reviews to determine if the organization is acquiring, protecting, and using its resources efficiently. Checking for waste Can be external or internal auditors

Unrestricted funds

Are used to account for day to day operations

Partnerships

Businesses owned by more than one person. Partners report their share of the business income on their personal tax returns.

Program audits

Check for effectiveness. They determine whether the organizations programs are accomplishing their objectives. Can be formal or relatively informal.

Return on Investment (ROI) ratios

Class of profitability ratios. Different definition that each firm determines for themselves. Is used as a measure of both individual and firm performances.

Margin Ratios

Class of profitability ratios. Firms commonly compute their gross margin, operating margins, and profit margins as a % of sales. (Basically common size rations) Often watched closely.

How do we get a starting point?

Common size ratios.

Firms history

Compare ratios of this year to previous years. Enables us to discover favorable or unfavorable trends that are developing gradually over time as well as point out numbers that have changed drastically in the time of just one year.

Average tax rate

Compare total tax to the tax base to find it

Interest Coverage Ratio Summary

Compares funds available to pay interest to the total amount of interest that has to be paid. Funds available for interest are the firms profits before interest and taxes. As long as this amount (operating income) is > the amount of interest, the firm will have enough to pay the interest owed.

Earnings per Share (EPS)

Connecting profitability to owners A measure of the net income earned on each share of common stock; computed as net income minus preferred dividends divided by the average number of common shares outstanding during the year.

Dividends paid

Considered to be a financing activity because they are a return to the owners

Income Statement

Consists of reporting their revenues and expenses for the entire accounting period To prepare we look in each revenue and expense ledger account

Ponzi scheme

Convincing people they have an investment that is doing well BUT in actuality the money is being taken by someone (Twedt's definition)

Inventory turnover ratio

Cost of goods sold / average inventory (beginning + ending inventory divided by 2)

Current Ratio

Current Assets/Current Liabilities Compares all of the firm's current assets to all current liabilities

Liquidity ratios

Current ratio = Current assets /Current Liabilities Quick ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities Both have been commonly used as measure of the firms risk - how likely it is that the firm is getting into financial difficulty.

Accounting policies

The notes section begins with this. Its important because of the alternative choices of accounting methods allowed, even within the constraints of GAAP.

Operating Activities

The ordinary revenue and expense activities of the firm or day to day activities May include - payments to employees, suppliers Payments of taxes, of interest to creditors - Collections of cash from customers

Tax base

Defines what is subject to tax

T/F if the project is expected to earn more than the proposed investment X required rate, there will be residual left over after the subtraction.

True

T/F ratios sometimes need to be investigated

True

T/F the lower the liabilities relative to stockholders equity, the less risky the firm.

True

GAAP

Generally Accepted Accounting Principles

Return on Equity (ROE)

Good for evaluating overall firm performances but not for manager evaluation. AKA return on net assets. Focuses on how well firm did in earning a return on stockholders equity.

T/F a control system can help prevent or detect frauds

True Are likely to prevent, discourage, and less likely to allow for people to get away with frauds

T/F If individuals have access/ability to steal insignificant amounts, they should be bonded.

True - Bonding means the organization is insured for employee theft

Limited Liability Companies (LLCs)

Type of organization that has the benefits of limited liability for all of their owners. - May elect to be taxed as if they were corporations or partnerships. - In some states, LLCs may have their own negative aspects, such as being subject to gross receipts taxes.

What is the VHWO organization?

Voluntary health and welfare organization helps (FINISH)

Too much liquidity

Implies that long-term investments with greater profitability have been missed.

What are notes to the financial statements?

Notes accompanying statements to explain companies significant accounting policies and gives other info not on the balance sheet, income statement, and statement of cash flows.

Financial statement ratios:

Numbers are compared that are taken from the financial statement

Specific competitors

Obtain copies of their annual reports and compare each of our ratios with each of theirs. This approach is especially valuable helping pinpoint why firm is doing better or worse compared to others.

Misstatements

Organizations could list assets that either don't exist, are inflated, or are not owned by the organization. - Inventory may not actually exist - A/R are not written off when uncollectible

Not for profit organizations do not have to:

Segregate assets and liabilities into current and long term but they must segregate assets that are subject to donor imposed restrictions.

Corporations

Pay corporate income taxes. - When corps distribute earnings to their owners, who must also pay personal income taxes, creating double taxation on the same income. - Corps may temporarily avoid the second layer of taxes by retaining their profits rather than distributing them to the firms owners.

Return on Assets (ROA)

ROI measure that evaluates the firms return or net income relative to the asset base used to generate the income. Particularly good at evaluating managers. Focuses on how well they used the assets entrusted to them.

Too much liquidity results in:

Raises possibility of default and bankruptcy. Financial officers have to walk a tight line to maintain enough, but not too much, liquidity.

Tax Rate types

Progressive system: has increasing rates as the tax base increases. Proportional tax: would maintain one tax rate for all payers regardless of their tax base Regressive tax: has declining rates as the tax base grows.

What do tax consultants do?

Provide valuable assistance in minimizing tax obligations

Chart of Accounts

Provides a guide to the system of accounts used by an organization Company may choose to use chart to identify specific programs, projects, departments or other info.

Fund accounting

Separates the organization into a number of distinct entities called funds (not used for reporting, which presents the organization as a whole.) Tracks each restricted pool of assets in a separate entity.

Financial Statement

Report of what happened over a period of time (Month, quarter, year) Used to present the firm's financial position financial position and results of operations to interested users of financial information.

Debt to Equity Ratio Summary

Several different types/equity ratios. (i.e. comparing long term debt to stockholders equity, or total liabilities to stockholders equity)

Gross Margin Calculation

Revenue - Cost of goods sold

What are apart of statement of activities

Revenue and support Expenses Gains and losses on investments

Profitable ratios show:

Show how well the firm did - given the level of risk and type of risk it actually assumed during the year.

Gains and losses on investments

Shown as changes in net assets without donor restrictions unless specific donor imposed restrictions prohibit their use

Revenue and Support

Shown as increases in net assets without donor restrictions unless there are donor imposed restrictions

Statement of cash flows

Shows where a firm gets its cash and how it uses its cash over a period covered by the financial statement.

Solvency Ratios

Take more of a long time view. Attempt to determine if the firm has overextended itself through use of financial leverage. Sometimes referred to as leverage of capital structure ratios

Not for profits have to:

1. Show assets in order to of declining liquidity or 2. Disclose relative liquidity in the notes to the financial statements

Days of inventory

= 365 / Inventory turnover

Days receivable

= 365 / Receivables turnover

Inventory turnover ratio

= Costs of good sold / Average inventory balance

Receivables Turnover ratio

= Credit sales / Average receivables balance Indicator of efficiency in collecting receivables. Measures how many times during year our receivables are generated and collected. We compare sales on credit to our average accounts receivable balance

Interest coverage Ratio

= Operating income / interest expense Focus on ability to meet interest payments arising form liabilities.

Total asset turnover ratio

= Total sales / total assets The more sales generated per dollar of assets, the more efficient it is, other things being equal.

Debt to assets Ratio

= total debt / total assets Focuses on the protective cushion that assets provide for creditors.

Debt of equity ratio

= total liabilities / stockholders equity Focuses on the protective cushion owners' equity that provides for creditors>

Management control system (MCS)

A set of policies and procedures designed to keep operations going according to plan - also to detect variations from plans and provide managers with info needed to take corrective actions when necessary - internal control systems are mandatory for publicly help companies

Why require vacations?

Another employee is moved into each role periodically and can perhaps discover a discrepancy. (added benefit is cross training)

Business Fraud

An intentional deception for financial gain Intentional Deception Financial gain

Receivables Ratios

Want to collect receivables promptly. Once received it can be used to pay of suppliers or pay off loans or be invested

Are dividends received by a company from another company included in operating activities?

Yes

Can understating expenses overstate profits?

Yes - is expenses are recorded as capital (assets), the expense is spread out of a period of years in the future. (Or expenses may simply not be recorded.)

Do Overstating revenues overstates profits?

Yes - sometimes revenues are overstated by mgmt in order to keep their jobs.

Do managerial decisions affect taxes?

Yes - their decisions may result in higher or lower for the organization.

Custodial funds

are those being held for another entity

Restricted funds

correspond to pools of assets given to the organization by donors who have restricted their use in some way. i.e. - Endowment funds - Custodial funds - Board designated funds

Program services

Category of functional expenses used by many NFP organizations to describe expenses related to fulfilling the mission of the organization. Contrasted with supporting services. Program expenses are listed individually with all direct and allocated costs assigned.

Endowment funds

Organizations are generally only allowed to use the earnings on the endowment for operating purposes

T/F Contributions, gifts, and donations are recorded at fair market value at the time of donation.

True

T/F The more assets available to repay debt, the less risky the company is

True

S corporaation

"Pass through entity" or a "conduit entity", "S corp", "S sub" Allows corps to be treated as if they were partnerships for tax purposes. This gives the benefit of limited liability while avoiding corporate income taxes.

Quick ratio

(Cash + Marketable Securities + Receivables) / current liabilities Compares current assets quickly convertible into cash to current liabilities

Long Term Assets

(On balance sheet) Assets that will not become cash or be completely used up in the coming year - Fixed assets (property, plant/building, equipment) - Investments - Intangibles

Stockholders equity

(On balance sheet) Contributed capital - Common stock - per value - Common stock - excess over par - Preferred stock and Retained earnings

Liabilities

(On balance sheet) Current - obligations that need to be repaid in coming year or Long-term - obligations due more than one year from balance sheet date

Current Assets

(On balance sheet) The most liquid resources, listed in order of liquidity - Cash - Marketable securities - AR - Inventory - Prepaid expenses

Internal controls

- Proper procedures - Proper authorization - Emphasis on ethics - Having an audit trail - Separation of duties - Proper authorization - Bonding, Vacay's - Performance audits

Types of fraud committed

- Asset misappropriation - Corruption - Fraudulent statements

Physical safeguards

- Computer protocols implemented - Cash and blank checks should be kept locked when not in use - Property is secured - Backup copies of computer records should be maintained in a separate location - Controls should be put in place to protect valuable inventory

Adjustments to income

- Depreciation (subtracted on the income statements as expense, doesn't consume cash, so is added back on the cash flow statement) - Other factors that can cause net income to over or understate the true cash flow

Types of common frauds

- Embezzlement - Bribes - Writing bad checks

Proper procedures helps:

- Give consistency - Minimize errors - When questions of fairness or completeness arise, policies help document what should have happened. - If unexpected employee change, work still gets done.

Incidence (i.e. who pays?)

- Individuals - Corporations

Three most common solvency ratios

- Interest Coverage Ratio - Debt to Equity Ratio - Debt to Assets Ratios

Cost Benefit Analysis

- Internal control systems can be simple or quite elaborate - Systems should be cost effective (organization should not spend more on system than what it is worth) - No matter how careful we are with control system - fraud, embezzlement etc, can take place

Federal Income Tax

- NFP are generally exempt - Unrelated business tax: income tax on profits from activities that compete with for profit organizations. - growing pressure to tax all NFP profits (Separation of church and state issues; failure to provide sufficient charitable benefit to society issues. - Payment in lieu of taxes

Statement of Cash Flows Categories

- Operating Activities: relate to the ordinary revenue and expense producing activities of the firm - Investing Activities: relate to the purchase and sale of fixed assets and securities - Financing Activities: relate to borrowing and repayment of money, issuance of stock and payment of dividends.

Individual tax brackets

- Separate rate schedules for singles, heads of households, married filing joint returns, and married filing separate returns

Corporation tax brackets

- Separate tax structures for corporations and individuals - Corporate tax rate structure was designed to ease the tax burden on small corps. Encourages individuals to incorporate to get the benefits of limited liability without creating a tremendous tax burden. - Rates in excess of 35% eliminate the benefit that corps with low profits receive.

Rationalization of fraud

- Society tends to glamorize it - Sometimes seen as a victim less crime - Many people who commit fraud contend that "they were unfair to me - I was just taking what I deserved"

Unincorporated businesses examples

- Sole proprietorships - Partnerships - LLC (Limited Liability Company)

Taxes Companies are subject to:

- State and local income or franchise taxes - sales tax - Social Security tax - Real estate tax also - Charges and user fees such as sewer levies, motor vehicle charges, and excise fees.

Personal services are recorded as both support and an expense if:

- They create or enhance nonfinancial assets (e.g. equipment) or - The services require specialized skill, are provided by individuals with those skills and they would typically need to be purchased if they were not donated

Why does complexity exits in US taxes?

- To respond to policy goals - Of loopholes that have been created to lower the taxes paid by some taxpayers. - Tax code becomes even more tortuous as as efforts are made to close unintended loopholes.

Operating loss carryovers

- When deductions are greater than gross income, it is a net operating loss (NOL). - The corporation may carry back the NOL to offset income (and therefore taxes), two years before the current tax year, then from the year before the current tax year, then any remaining balance may be carried forward for up to 20 years. - Corporations may choose not to carry back the NOL, but instead only carry it forward. This might be done so taxes are reduced in years the corporation is in a higher tax bracket, rather than years it was in a lower bracket.

Dividends received

- Will be taxable income - One corp earns profits and pays tax on the profit - Then pays dividends to a second corporation that owns some of its stock. - Second corp must pay tax on dividend income - Corporations are allowed, subject to some limitations, a dividends received deduction to minimize triple taxation.

Characteristics of good ethics programs

- Written statement - Strong support from top management - Visible examples of actions management has taken which indicate adherence to, and support of, the policy - Periodic discussions focusing on ethical corporate behavior (formal discussions, frequent references in general meetings) - Clear consequences for failure to adhere to the policies - Policy should be perceived as being attainable within culture of organization

The three sections of the statement of cash flow are:

1. Cash from operating activities 2. Cash from investing activities 3. Cash from financing activities

Four types of assets

1. Current Long Term 2. Fixed 3. Investments 4. Intangibles

Two methods to calculate statement of cash flows:

1. Direct Method 2. Indirect Method

2 types of performance audits

1. Economy and Efficiency audits 2. Program audits

Information from Financial statements

1. Manage firm better 2. Be able to review the financial statements of close competitors (evaluate our performance) 3. Evaluate financial statement of a firm we wish to invest in 4. Evaluate financial statements of firms we are considering extending credit to

What three things affect tax rates?

1. Marginal tax rate 2. Average tax rate 3. Effective Tax rate

Calculating Federal Income tax steps

1. Taxpayers determine their total income. 2. Items that are specifically exempt are then excluded. 3. If the exclusions become too great, they are subject to the alternative minimum tax (AMT). 4. Total income, less exclusions, is gross income. From this gross income, deductions and exemptions are subtracted. For a business, the basic expenses of running the business are subtracted. For an individual, this refers to itemized or standard deductions and personal exemptions. 5. Net result is taxable income. 6. Tax rate schedules are applied before consideration of tax credits. 7. Credits are allowed for a variety of reasons. A credit is subtracted after the tax has been computed. (A deduction is subtracted before taxes are calculated.) 8. Once credits have been subtracted, the result is the tax obligation to the government.

Three principal comparison benchmarks

1. The firms history 2. Specific competitors 3. Industry-wide comparison

What is a ratio?

A comparison of two numbers

Residual income (RI)

A firm specifies minimum required ROA rate, using one of the approaches. Then multiply amount of asset investment required for project by the ROA rate.

Debit

An increase in an item on the left side of the accounting equation (Left side decreases with a credit)

Credit

An increase in an item on the right side of the accounting equation (Right side decreases with a debt)

Performance audits

AKA operational audits Are system reviews and there are 2 types

Separation of functions

Activities that involve assets should be separated so no one individual controls too much of a process. i.e. person who writes checks shouldn't sign them or reconcile the bank statements... Clerks don't know how much cash should be in the register

Proper Authorization is a system for authorized spending that helps an organization:

Adhere to spending policies Includes General authorization and specific authorization Is required for things like signing contracts as well.

Marginal tax rate

Amount the tax payer will have to pay on additional income that is earned.

Accounting Equation

Assets + Liabilities = Owners Equity

What do Liquidity ratios do?

Attempts to assess whether a firm is maintaining an appropriate level of liquidity.

Key numbers

Balance sheet it is total assets or total equities Income statement all numbers are compared to total sales of total revenue

Permanent account

Balances provide info for balance sheets. Usually have a balance in them at the end of each accounting period Is representative of the firm as of a certain date.

Ledgers

Book or files of accounts. Every time we make a journal entry, we are changing amount in at least two ledger accounts

Average age of receivables

Divide 365 by receivables turnover ratio

Effective tax rate

Divide tax by total income of taxpayer, including income that is not taxable

General Journal

Each economic event is recorded in this journal AKA book of original entry - derived because an event is first entered into the firms official history via a journal entry

Double entry

Each entry in a general journal has two components/sides Term double entry means every action has an offsetting reaction

T/F neither income statement nor statement of cash flows cover an accounting period.

False

T/F the lower the ratio is for interest coverage, the more comfortable creditors feel

False

T/F Restricted funds may be commingled for operating purposes and are not for reporting purposes.

False - It is flip flopped. "may not be and are" Only assets not available for current use are segregated for reporting.

T/F Investments owned for less than one year are taxed at substantially lower rates than ordinary income?

False - if it is for more than one year.

T/F The firm that generates more income, unrelative to the amount of investment, is doing a better job.

False - should be relative

T/F There is a relationship between par value and a fair or correct value of the firms stock

False - there is no relationship

T/F Organizations can not ignore liabilities or understate debt.

False - they can by: - Not recording capital leases (long-term commitments) - Show a debt at less than its present value

The Entity Perspective

Financial transactions from an entity are just for that entity. Firm events are kept separate from the owners financial transactions

Industry wide comparison

Firms that collect financial data, compute ratios by industry, and publish the results. Industry averages are available but the info is often broken down by both size of firm and in a way to determine how relatively how far away you are from the norm.

Notes to financial statements are necessary for:

For statements to be a fair representation of the firms financial position and the results of its operations.

Multiple-Step Income Statement

Gross Margin Operating Expenses Net Income

Operating income calculation

Gross margin - day to day operating expenses

Outside independent auditors

Have the benefit of experience from reviewing control systems in many different organizations - Can offer suggestions for improvements in internal controls - They are more likely to see flaws in the system - May be required by law or lending institutions.

Efficiency Ratios

Help a firm determine how efficiently they are running and allow for comparison between firms.

Why is adequate documentation important

Helps an organization maintain documentation to allow them to trace back, explain and verify transactions that have occurred. (Critical in personnel issues) The loss of electronic data can be devastating so offsite storage is critical and disaster plans are good

Financing Activities

Includes: - Borrowing Money (and repaying it) - Issuance of stock - Payment of dividends

Benefits of separation of functions

Innocent mistakes are less likely to occur Activities like embezzlement and theft more likely to be discovered and therefore, less likely to occur.

Most common Solvency ratios

Interest coverage Debt of equity Debt to assets

What qualifies for lower rate, long term capital gains tax treatment

Investments held for more than one year

Common size ratios

Is the first step in ratio analysis. Usually converted to percentages. To find it we need a key number for comparison

How is an audit trail effective?

It serves as a preventive and detective device and It is used to identify and examine discrepancies or unusual spending patterns.

Internal Audit departments

Larger organizations have these and they: Seek out weakness in controls Try to improve systems to reduce the chances that errors will occur in the recording or reporting of financial info. Smaller businesses need to have the owners involved to make sure things are on track (owners may review the checkbook at regular intervals)

Personal Income tax

Levied on US citizens and residents

Corporate income tax

Levied on entities that have incorporated in the US. which can be formed as: - Sole proprietorship - Partnerships - Limited liability companies - Corporations - Limited liability partnership

Direct method for statement of cash flow

Lists each individual type of account that resulted in a change in cash. Net income reconciliation to cash is required by GAAP

Statement of Functional Expenses

Meant to break down functions of cost of each area (more detail.) - Expenses by nature and function must be present either in the activity statement, the notes, or another statement for all NFP organizations.

Voluntary health and welfare organizations (VHWOs) must:

Must report information by both function and nature in a separate statement of functional expenses

Are dividends paid included in operating activities?

No - They are not classified as expenses.

Fraud and ethics

Organizational culture can have a big impact on employee actions - If employees see top management as unethical, problems typically follow - Ethics programs help communicate ethics policies to employees

Net income calculation

Operating income - financing costs and taxes

Other concerns for corporations

Operating loss carryovers Dividends received

Sole proprietorships

Owned and run by one person. Profits of business are direct profits to the individual and are reported to the gov't on the individuals own federal tax return.

Another look at the basic equation

Owners equity = contributed capital + retained earnings So Assets = Liabilities + Contributed Capital + Retained Earnings

Tax rate

Percentage that is multiplied by the tax base to calculate the tax.

Progressive taxes

Personal income tax structure is based primarily on this

Audit trail

Refers to the ability to trace each transaction back to its source. Documentation of all transactions are required and maintained

Sarbanes-Oxley Act (SOX)

Regulations passed by Congress to reduce unethical corporate behavior. - Requires internal control systems and disclosure of conflicts of interests. - Greater level of responsibility for managers and board members - CEO and CFO have additional responsibilities - Requires senior executives to take responsibility for accuracy and completeness of corporate financial reports

Investing Activities

Relate to the purchase and sale of fixed assets and securities of other companies I.e. - purchase of property, plant and equipment represent an investment and are accounted for in this category - Lending money (and receiving payments)

Options for having the benefits of limited liability without double taxation are:

S corporations LLC's LLP's

Inventory ratios

Same type of ratios calculated for receivables can be calculated with respect to inventory Especially useful to compute the turnover and age of inventory separately for raw materials, work in process and finished goods for manufacturing companies

Adjusting entries

Some events happen over period of time (like the expiration of part of an insurance policy) - Are made at end of accounting period - Also made for events that haven't been recorded yet but affect the current accounting period

General authorization

Standing approval of certain spending: i.e. normal monthly bills; usually relatively minor amount

C corporation

Stands alone and pays income taxes

Indirect method for statement of cash flow

Starts with net income as a tentative measure of cash from operation. Net income is adjusted to an amount that equates to cash received from operations

Balance sheet

Statement of Financial position shows a firms financial position at a single point in time. This balance at the beginning of the year will be identical to its financial position as the end of the previous year.

Principal efficiency or activity ratios measure:

The efficient handling of receivables, inventory, and total assets.

Why does fraud happen?

The fraud triangle - Motive: perceived as needed - Opportunity: weak internal controls - Rationalization: some justification

What happens when a corporation does not pay dividends?

The impact of double taxation is first deferred while the profits are retained, and then partially offset when owners ultimately sell their stock at lower capital gains tax rates.

Formal rotation system

The kind of system that established that no employee will be doing exactly the same job year after year.

T/F As donor restrictions expire, donations become unrestricted support

True

Specific authorization requires an individual to:

To get written permission to make a purchase Like: Non routine purchase or usually larger purchase

Ending Balances

To summarize financial info the ending balance is needed Provides the info needed for a complete set of financial statements

Benefit of Ledger system

We can determine the balance in any account at any time.

Capital Gain

When owners of corporations sell some of their stock, they earn capital gain

Per value

concept related to limited liability of stock holders.

Board designated funds

contain resources that have been internally restricted for some special purpose. For reporting purposes, these funds are without donor restrictions