Accounting 321 Exam #2

chapters 3 & 4

basic accounting equation

assets = liabilities + shareholders' equity

liquidity

ability to pay current liabilities as they come due

long-term solvency

ability to pay all liabilities over the long run

financial flexibility

ability to alter cash flows and obtain financing to take advantage of opportunities or unexpected needs

book value formula

assets − liabilities

why book value differs from market value

assets are often reported at historical cost and valuable resources like employees, customer loyalty, brand reputation, and management expertise are not recorded

current asset definition

asset expected to provide benefit within one year or operating cycle, whichever is longer

examples of current assets

cash, cash equivalents, short-term investments, accounts receivable, inventory, prepaid expenses

operating cycle

cash → raw materials → finished goods → receivables → cash

investments (long-term assets)

assets not used directly in operations such as securities, land held for speculation, and long-term notes receivable

intangible assets

assets used in operations that have no physical substance, such as patents, copyrights, franchises, and trademarks

when does goodwill arise?

when one company acquires another company

goodwill formula

purchase price − fair value of net assets

current liabilities definition

obligations due within one year or operating cycle

examples of accrued liabilities

salaries payable, interest payable, taxes payable, utilities payable

why are salaries payable and income taxes payable operating liabilities?

they relate to operating expenses and are adjusted under the indirect method

retained earnings definition

accumulated profits not distributed as dividends

retained earnings formula

beginning RE + net income − dividends

what accumulates in AOCI?

other comprehensive income (OCI)

what accumulates in retained earnings?

net income

working capital formula

current assets − current liabilities

current ratio formula

current assets ÷ current liabilities

current ratio interpretation

dollars of current assets available for each dollar of current liabilities

quick ratio formula

(cash + short-term investments + accounts receivable) ÷ current liabilities

items excluded from quick ratio

inventory, prepaid expenses, restricted cash

debt-to-equity ratio formula

total liabilities ÷ total shareholders' equity

what does a higher debt-to-equity ratio indicate?

greater solvency risk

times interest earned formula

(net income + interest expense + income tax expense)/interest expense

EBIT definition

earnings before interest and taxes

revenue definition

generated from normal operations, such as sales revenue and service revenue

gain definition

increase in equity not from normal operations

expense definition

cost incurred to generate revenue

loss definition

decrease in equity not related to normal operations

operating income formula

gross profit − operating expenses

flow of a multi-step income statement

sales revenue → COGS → gross profit → operating expenses → operating income → nonoperating items → income before tax → income tax → income from continuing operations

earnings quality definition

ability of current earnings to predict future earnings

permanent earnings

expected to continue into the future

examples of permanent earnings

sales revenue and interest expense

temporary earnings

unlikely to continue into the future

examples of temporary earnings

restructuring charges, asset impairments, discontinued operations

requirements for discontinued operations

must be a component of the entity and represent a strategic shift

where are discontinued operations reported?

below income from continuing operations

are discontinued operations reported before or after tax?

net of tax

gain on disposal formula

selling price − book value

loss on disposal formula

book value − selling price

if total discontinued operations income exceeds operating income from the component, what occurred?

gain on disposal

if total discontinued operations income is less than operating income from the component, what occurred?

loss on disposal

steps for solving discontinued operations problems

1. find operating income/loss

2. find gain/loss on sale

3. combine amounts

4. apply taxes

5. report net-of-tax amount

impairment loss formula

book value − net selling price

when is impairment recognized?

when net selling price is less than book value

change in accounting estimate examples

useful life, bad debt estimate, warranty estimate

treatment for change in accounting estimate

prospective

change in accounting principle example

changing inventory methods

treatment for change in accounting principle

usually retrospective

how is a change in depreciation method treated?

change in estimate achieved by a change in principle; accounted for prospectively

when is a prior period adjustment required?

material error in previously issued financial statements

where is a prior period adjustment reported?

beginning retained earnings

basic EPS formula

(net income − preferred dividends) ÷ weighted average common shares outstanding

why use weighted-average shares in EPS?

because shares outstanding may change throughout the year

diluted EPS includes

convertible securities, stock options, and warrants

which is larger: basic EPS or diluted EPS?

basic EPS

operating activities definition

cash flows related to income statement activities

examples of operating activities

cash from customers, interest paid, income taxes paid

investing activities definition

cash flows involving long-term assets and investments

examples of investing activities

purchase equipment, sell equipment, purchase investments

financing activities definition

cash flows involving owners and creditors

examples of financing activities

issue stock, borrow money, repay debt principal, pay dividends

interest paid classification

operating activity

dividend paid classification

financing activity

repayment of loan principal classification

financing activity

purchase of equipment classification

investing activity

sale of equipment classification

investing activity

indirect method starting point

net income

depreciation treatment under indirect method

add back depreciation expense

why is depreciation added back under the indirect method?

it reduced net income but did not use cash

increase in operating asset under indirect method

subtract

decrease in operating asset under indirect method

add

increase in operating liability under indirect method

add

decrease in operating liability under indirect method

subtract

accounts receivable decreases under indirect method

add

accounts receivable increases under indirect method

subtract

inventory increases under indirect method

subtract

inventory decreases under indirect method

add

prepaid expenses increase under indirect method

subtract

prepaid expenses decrease under indirect method

add

salaries payable increases under indirect method

add

salaries payable decreases under indirect method

subtract

income taxes payable decreases under indirect method

subtract

income taxes payable increases under indirect method

add

indirect method memory trick

assets move opposite; liabilities move same

book value formula

assets − liabilities

working capital formula

current assets − current liabilities

operating income formula

gross profit − operating expenses

OCI accumulates in

AOCI

net income accumulates in

retained earnings

discontinued operations reporting rule

reported below continuing operations and net of tax

income from continuing operations before tax formula

income before taxes − discontinued operations gain or loss (or add back a discontinued operations loss)

net income formula

operating income + nonoperating revenues − nonoperating expenses − interest − taxes

operating income for manufacturing and merchandising companies

gross profit − operating expenses

current liabilities examples

accounts payable, notes payable, accrued liabilities, deferred revenue, current portion of long-term debt