Comprehensive Accounting Study Guide

Two Perspectives of Time

1. Date (point in time): "as of"; balance sheet 2. Time between two dates (period): "for the year ended"; income statement, cash flow

Who uses financial statements?

1. Investors: to check if it is beneficial to invest in the company 2. Lenders: to check if the company can give them back the money they lend to it 3. Suppliers: to check if the company can pay them for supplying it with goods/services 4. Employees: to check the current financial situation of the company torequest raise in salary or to ensure that they will keep their job an dthe company is not going to shut down 5. Customers: to check that the company is going to continue its operations so that it can cover their needs 6. Government: to impose taxes

Define Relevant Benefit

A benefit that should be considered when making decisions

Accumulated Depreciation

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

Allowance for Doubtful Accounts

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

Define Avoidable Cost

A cost that can be eliminated by choosing one alternative over another in a decision. This term is synonymous with differential cost and relevant cost.

Define Sunk Cost

A cost that has already been incurred and that cannot be changed by any decision made now or in the future.

Define Relevant Cost

A cost that should be considered when making decisions.

Define Make or Buy Decision

A decision concerning whether an item should be produced internally or purchased from an outside supplier.

Define Differential Cost

A future cost that differs between any two alternatives.

Define Constraint

A limitation under which a company must operate, such as limited available machine time or raw materials, that restricts the company's ability to satisfy demand.

Define Bottleneck

A machine or some other part of a process that limits the total output of the entire system.

Define Special Order

A one-time order that is not considered part of the company's normal ongoing business.

Accrual

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

Accounts Payable Turnover

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

Accounts Receivable Turnover

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

Additional paid-in capital

Amount paid above the par value for shares of stock

Accrued Payroll

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

Accrued Revenue

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

Accumulated other comprehensive income

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

Define Incremental Cost

An increase in cost between two alternatives

Accounts Receivable

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

Accounting Equation

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

Expanded accounting equation

Assets = Liabilities + Share capital + Revenues - Expenses - Dividends

Define Joint Costs

Costs that are incurred up to the split-off point in a process that produces joint products.

DEAD CRLS

Debits Expenses Assets Dividends declared Credits Revenues Liabilities Stockholders Equity

Accelerated Depreciation Methods

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

Adjusting (Journal) Entries

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

4. Historical cost

Every asset should be in the BS at the cost of purchase not at the current value

2. Monetary business assumption

Everything in FS is in monetary terms

Expense Recognition Principle

Expenses follows the revenues.

3. Time period assumption

FS are prepared for a distinct period in time

If differential cost < differential benefit then...

Financial Advantage => Choose it

Define Differential Revenue

Future revenue that differs between any two alternatives

Major Challenges in Financial Reporting

GAAP is as much a product of political action as it is of careful logic or empirical findings

Measurement Principle

Historical cost and fair value

Comparability

Info should be comparable with info from previous years or info from rival companies

Objectivity

Info should be neutral(unbiased), complete and free from error

Relevance

Info should be relevant to the accounting period they belong to

Understandability

Info should be understandable by people with reasonable financial knowledge

Financial accounting

Information about the financial activities and financial strength of a company

Accrued Expenses

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

Accounts Payable

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

Accrued Liability

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

Accounts payable (A/P)

Money to be paid to suppliers

Accounts receivable (A/R)

Money to be received from customers

1. Economic entity assumption

Owners are not the same as the company The company is a separate legal entity that a customer can sue The owners' income is not the company's income

Objective of Financial Reporting

Provide information about the reporting entity that is useful to present and potential to equity investors, lenders, and others.

Full Disclosure Principle

Providing information that is of sufficient importance to influence the judgement and decisions of an informed user (financial statements, notes to the statements, supplementary information).

Revenue Recognition Principle

Requires companies recognize revenue in the period performance obligation is satisfied.

Asset

Resources with probable future benefits, controlled by the entity as a result of past events or transactions

Common stock

Stock issued to SH that is recorded at par value

Define Split-Off Point

That point in the manufacturing process where some or all of the joint products can be recognized as individual products.

Accounting

The art of interpreting, measuring and communicating the results of a company's economic activities. It gives decision makers useful information to help them make right economic decisions

Financial reporting

The communication of an entity's financial information to its external users

How do you account for mediating a contingent loss liability if the required settlement is greater than the liability set aside?

The excess is added to the contingent expense

Define Vertical Integration

The involvement by a company in more than one of the activities in the entire value chain from development through production, distribution, sales, and after-sales service.

What contingent loss amount is accrued when all possible amounts are equally likely?

The lowest amount is accrued and the amounts in excess are disclosed

What contingent loss amount is accrued when one possible amount is more likely than the others?

The more-likely amount is accrued

Accounting Period

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

Define Opportunity Cost

The potential benefit that is given up when one alternative is selected over another.

How are contingent loss liabilities recorded if they are part of one overall performance obligation? (ie. A quality assurance warranty)

They are recorded as a liability that gives rise to an expense

Accrual Accounting Method

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

Define Joint Products

Two or more products that are produced from a common input

Generally Accepted Accounting Principles (GAAP)

common set of accounting standards and procedures for which either an authoritative accounting rule making body has established a principle of reporting in a given area, or over time, a given practice has been accepted as appropriate because of its universal application

Determining the initial accounting treatment of loss contingencies

•If the claim or contingency (ie. the lawsuit itself) will probably be asserted, move to the probability-estimatability chart •If not, we do nothing

In what year do we account for loss contingencies?

•In the year that the event that gave rise to the contingency happened (NOT the contingency itself) •Ex: The pollution rather than the EPA call; the injury rather than the lawsuit

Why is the cash-based approach to income flawed?

•Income is not necessarily earned just because cash is received •Income is not necessarily reduced just because cash is paid •Capital transactions (owners' contributions and withdrawals) affect cash but are not income •Income is also affected by non-cash assets •Income is created by operating the business, while cash can be paid/received before and after operations

Two criteria of recognizing liabilities on the balance sheet

•It must meet the definition of a liability •Its value can be reliably measured (there is little variety in experts' estimates of value)

Two criteria of recognizing assets on the balance sheet

•It must meet the definition of an asset •Its value can be reliably measured (there is little variety in experts' estimates of value)

Factors of the accounting treatment of loss contingencies

•Likelihood of the future triggering event •Whether the loss about can be reasonably estimated

Two sources of loss contingencies

•Possible liabilities (lawsuits, warranties, etc.) •Possible asset impairment (ADA, valuation allowance)

Why is market value ≠ SE?

•SE does not incorporate several assets such as brand or growth potential •The market value depends on the forward-looking market outlook on the company (optimistic vs. pessimistic)

Mediating a contingent loss liability

•Settling or paying off that liability •Can be given as the year-end cost of the liability or calculated as the money lost x sales??? •Can be for greater or less than the amount set aside for the liability

What does the range of estimates for SE depend on?

•The dispersion of the estimates assets and liability estimates •Mostly driven by the variation in assets, as liabilities are generally easier to value

Financial Accounting

*The process that culminates in the preparation of financial reports on the enterprise for use by both internal and external parties.

Recording and Posting Adjusting Entries

-Deferrals: Cash is paid or received before a related expense or revenue is recognized -Accruals: Cash is paid or received after a related expense or revenue is recognized -Estimates: Accountants must often make estimates in order to comply with the accrual accounting model

Securities and Exchange Commission (SEC)

-Federal agency developed to help develop and standardize financial information presented to stockholders -Companies that issue securities to public are required to file with SEC -Have powers to prescribe auditing practices and standards to be employed by companies that fall within its jurisdiction -Requires registrants to adhere to GAAP -Relies on FASB to develop accounting standards -Mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation -Regulations require filing of annual (10-K) & quarterly (10-Q) reports and others -Enforcement authority

Financial Accounting Standards Board (FASB)

-Major organization of the standard-setting structure for financial accounting -Wants to establish and improve standards of financial accounting and reporting for the guidance and education of the public -Accounting guidance issued by FASB is considered GAAP -Issues: Accounting standards updates & financial accounting concepts

American Institute of CPAs (AICPA)

-National professional org of CPAs -Important to development of GAAP -Established the Committee on Accounting Procedure (CAP) → Accounting Principles Board (APB) → FASB

Owners Equity is made up of ...

-Net contributed capital: accumulated capital contributed to the firm by owners to repurchase shares since inception -Retained earnings: accumulated earnings of the firm less accumulated dividend payments since inception

FASB Codification

-Provides all the authoritative literature related to a particular topic in one place -Topic → subtopics → sections → paragraphs

Owners vs. Managers

-The owners of a company can be millions. -They are not in the company on a daily basis -The managers run the company -Risk: *info asymmetry* the managers know more about the company than its owners which makes it dangerous for the managers to take the company's money and run

Steps in the Accounting Cycle

1. Record and post basic "transactions" 2. Prepare an Unadjusted Trial Balance 3. Record and post adjusting entries 4. Prepare an Adjusted Trial Balance 5. Prepare Income Statement 6. Record and post closing entries 7. Prepare a Closed Trial Balance 8. Prepare Balance Sheet

Which are the most useful financial statements?

1. St. of financial position - what the company owns and how it is funded 2. St of comprehensive income(PorL) - revenues expenses income 3. St of changes in equity - how equity changes over an accounting period 4. St of cash flows - how operating, investing and financing activities change the company's equity

Loss contingencies

•Existing uncertain situation that might bring a loss depending on some future event •Ex: Lawsuits, environmental liabilities, warranties, ADA, etc.

Two main characteristics that make accounting information useful for decision making

•Faithful representation •Relevance

Owners' equity / Shareholders' equity (SE)

•A residual claim on an entity's assets •Assets less liabilities

Liabilities

•An entity's obligations to sacrifice future economic benefits to others •The obligation can be legal or social, and the entity can be bound by contract, promise, or moral responsibility

Four enhancing characteristics that make accounting information useful for decision making

•Comparability/consistency (between years and between companies) •Verifiability •Timeliness •Understandability

Components of faithful representation

•Completeness •Free from material error •Neutrality

Components of relevance

•Confirmatory value (helps to confirm or correct expectations) •Materiality •Predictive value

Contingencies

•Gains or losses that are uncertain as to whether they exist •"Maybe" gains/losses