FIN621 Exam 1

Proprietorship

Advantage: Ease of formation, few regulations, less reporting and no corporate tax Disadvantage: difficult to raise capital, unlimited liability and limited life

Partnership

Advantage: easily formed, more reporting, income allocated on a pro rata basis, no corporate tax Disadvantage: difficult to raise capital, unlimited liability, limited life

Corporation

Advantage: unlimited life, easy transfer of ownership, limited liability, ease of raising capital, owners have reduced liability, greater growth potential, Disadvantage: double taxation, cost of setup, reporting filing

Auditing Opinions

Unqualified opinion (no errors), qualified opinion (one or two errors but compliant), adverse opinion (misstated), disclaimer of opinion (not enough info)

10-K documents

Balance sheet (2 yrs) Income Statement (3 yrs) Statement of Cash flows (3 yrs) Other important info Management's discussion and analysis (MD&A)

10-K

annual independently audited report

10-Q

Brief quarter report that is not audited

8-K

reports major corporate events

Definitive Proxy (DEF14A)

must be filed with SEC and sent to shareholders at least 20 calendar days prior to shareholder meeting

What did Sarbanes-Oxley establish?

1. audit firms are independent from companies they audit and cannot give non-audit services

2. Establish Public Company Accounting Oversight Board (PCAOB)

3. Investment banks must disclose conflict of interest

4. senior executives are personally responsible for financial reports

5. establish internal control systems

6. Management must review internal controls

7. Board members must be financially literate and oversee auditing

Financial Statement Analysis

Extract information to understand current and future performance

Who does financial statement analysis benefit?

management, investors/analysts, creditors/lenders and regulatory agencies

Valuation

The practice of assigning monetary value to seemingly intangible benefits and natural capital. value of company = claims on company

What activities do companies undertake?

plan, finance, invest and operate

Strategic plan

an organization's broadest plan, developed as a guide for major policy setting and decision making

Who demands financial accounting information?

managers/employees, investment analysts, creditors/suppliers, stockholders, customers, strategic partners, regulators, tax agencies, voters

Benefits of Disclosure

cost of captial (lower interest rates); recruiting efforts in labor market; establish supplier-customer relations

Costs of Disclosure

Preparation and dissemination, competitive disadvantages, litigation potential, and political costs

What is the balance sheet?

company's financial positiong at a point in time Resources (assets), nonowner sources (banks), and owner sources (stockholder)

What are Investing Activities

Represented by company assets (ranked in terms of liquidity)

What are Financing Activities

Represented by owner (equity) and nonowner financing (liabilites)

Income Statement

performance over a period of time (temporary) including the revenue - expenses = net income

Cost of goods sold

revenue - cost of goods sold = gross profit

operating income

profitability from normal operations that equals gross profit less operating expenses

Statement of Stockholder's Equity

year-over-year changes in equity accounts that are on balance sheet seen through contributed captial and retained earnings

What are the statements of cash flows

operating, investing, financing

What other informaton is included beyond financial statements

footnotes, management discussion and analysis (MD&A), auditor report and regulator filings (proxies)

How to analyze business environment?

Porter's value chain model, Porter's 5 forces and SWOT

What are Porter's 5 forces

1.) Bargaining power of suppliers 2.) Bargaining power of customers 3.)Threat of new entrants 4.) Threat of substitutes 5.) Competitive rivalry within the industry

What 5 forces can lead to competitive advantage

barriers to entry, product/service differentiation, and cost leader

Advantage of publicly traded company

ability to directly access capital markets; easily value and transfer shares; separation of ownership and management

Disadvantage of publicly traded company

double taxation and signification reporting requirements

GAAP

Generally Accepted Accounting Principles

FASB

Financial Accounting Standards Board private, nonprofit company to establish GAAP

Assumptions under GAAP

going concern, historic cost, conservatism, matching principle with accrual accounting, full disclosure and materiality

What are the limitations of financial reportnig

general inaccuracies; use of estimates; choice of accounting policy; time dimension; influence of management; market pressure for short term results and retrospective nature

Flow of auditor report

first paragraph = introductory paragraph second paragraph = scope third paragraph = opinion fourth paragraph = internal control

Flow of adverse opinion report

intro, scope, explanatory, opinion, internal control

Flow of disclaimer of opinion report

intro, explanatory, opinion, internal control

Cash flows from operations

CFO; company transactions and events related to business operations

Cash flows from investing

CFI; from acquisitions and divestitures of investments and long-term assets

Cash flows from financing

CFI; cash flows from issuances of and payments towards borrowings (debt/bonds) and equity

Why is the cash flow statement important?

profitability needs to be transformed into positive cash flow need cash to stay in business/pay bills

what is the value of the company?

Present value of future cash flows

What is the direct method of cash flow

rewrite the income statement on a cash basis only affects CFO

What is the indirect method of cash flow

begins with the net income and makes adjustments only affects CFO

How does the cash flow statement fit in with the other financial statements?

it is a period of time the same period of time as income state starts with beginning balance sheet and ends with ending balance sheet

Cash equation

cash + noncash = liabilities + equity

What impacts cash inflows

decrease asset accounts increase liability and equity

What impacts cash outflows

increase asset accounts decrease liability and equity

what do you want to see in a CFO

profitable strong and growing negative CFO are usually startups healthy firms with good credit can usually fund all activities from operations

Cash flow from Operations in relation to net income

CFO starts with net income CFO will exceed net income

What are red flags in cash flow statements

net income higher than CFO positive CFO (why are they receiving debt?) positive CFI (why are we selling longterm assets?)

CFI inflows and outflows

inflow: selling assets, buying assets and the principal payments of loans outflow: purchase assets, purchase debt/equity from other companies

CFF inflows and outflows

inflow: borrowing money or issuing stock outflow: repaying debt, repurchasing stock, or paying dividends

Start-up CFO, CFI, CFF

CFO: insignificant, probably negative CFI: negative CFF: positive (receiving money from loans/stock)

Mature company with expansion opportunities CFO, CFI, CFF

CFO: very positive CFI: negative CFF: insignificant, maybe negative

Company with no potential expansion but strong cash flow CFO, CFI, CFF

CFO: positive CFI: insignificant CFF: negative

Company using debt to stay afloat CFO, CFI, CFF

CFO: negative CFI: insignificant CFF: positive

Company selling assets to stay afloat CFO, CFI, CFF

CFO: negative CFI: positive CFF: insignificant

Liquidating company CFO, CFI, CFF

CFO: insignificant CFI: positive CFF: negative

Cash Flow to Equity Investors (CFE)

CFE = CFO - CAPEX made to maintain current base assets strong CFE shows company has enough money to make capital expenditures, reduce debt and buy back stock

Cash Flow Distorters

1. acquiring another company (show in CFI but future needs to be in CFF)

2. capitalizing operating expenses (CFO is larger)

3. Bond investments in other companies producing dividends/interests are placed in CFO (should be in CFI)

4. Interest expense on debt is cash outflow in CFO (should be CFF)

5. noncash event isn't included

Accrual basis of accounting

revenue is recognized when earned, not when cash is received. expenses are recognized when they occur, not when bills are paid. Revenue and expenses are matched to the same period

Revenue recognition principle

The principle that companies recognize revenue in the accounting period in which the performance obligation is satisfied. AKA when customer obtains control of good/service, not when cash is given

Revenue recognition when sales are on credit

revenue is recognized when good is transferred to the customer and records an accounts receivable to be collected later

Is revenue recognition affected by delayed receipt of cash if good /service is fulfilled?

No, when the good/service was fulfilled, the company recognized the revenue and recorded an account recievable

5 steps in revenue recognition

1. Identify the contract

2. Identify the performance obligations

3. Determine the transaction price

4. Allocate the transaction price

5. Recognize revenue when (or as) each performance obligation is satisfied

Complications of revenue recognition

Nonrefundable up-front fees Bill and hold arrangements Consignment sales Licenses Franchises Variable consideration Multiple element contracts Right of return Gift cards

Cost-to-cost method

Recognize revenue as a proportion of total costs incurred to fulfill the contract

What is questionable revenue

selling to customer who won't be able to pay selling to affiliated party quid pro quo (give something of value that is unrelated) grossing up invoices

What is not revenue

sale of an assets, loan proceeds and supplier rebates

Discontinued operations

the disposal of a significant component of a business (net income from business prior to sale and any gain on actual sale)

Adjustment for discontinued operations - operating

the subsidary is treated as operating asset, so any gain/loss is treated as operating

Adjustment for discontinued operations - nonoperating

subsidary is no longer part of the company's operations. Any income is not core of CFO and will not be included in the future

gross profit margin

Gross profit/sales revenue x 100

operating expense margin

Operating expense/Sales

What is vertical analysis

every line on the income statement is divided by the total revenue and expressed as a percentage compares performance across 2+ yrs or performance to other company

Modified Single Step Income statement includes

separated interest expense and taxes EBIT EBT Net income

Modified Step Income Statement profit points

Gross profit > EBITDA > net operating income > EBIT > EBT > net income

What is the balance sheet?

What the company owns and how the company paid for it at a specific point in time

What type of accounts are balance sheet accounts?

permanent accounts

What type of accounts are income statements or cash flow statement accounts?

nonpermanent

What is an asset?

-expected to have future economic benefits

-owned/controlled by company

-arise from past transaction

What are current assets?

cash, cash equivalents, short-term investments, accounts receivable, inventories and prepaid expenses

What are net accounts receivable?

amounts due from customers after uncollectible accounts have been subtracted

How do companies handle Accounts Receivables that can’t be paid?

they have a “reserve” account where they hold back some of the accounts receivables, so Accounts Receivable is not overstated. Also known as Allowance for Doubtful Accounts

Sales Revenue Approach to uncollected accounts

amount estimated as uncollectible is based on a percentage of total sales

Gross Accounts Receivable Approach to uncollected accounts

amount estimated as collectible based on a percentage of total gross receivables

What is Allowance for Uncollectible Accounts on a financial statement?

-on the balance sheet current assets

-carries negative balance (credit)

-”contra” account

Why are reserve accounts manipulated?

management wants to smooth income from period to period for more consistent performance

-overstate bad debt expense to reverse in next period. This increase in current period will decrease bottom line (higher expenses and lower net A/R)

How to determine potential reserve account issues?

1. no growth/shrink patterns

2. relationship of AR to sales (grow in same percent)

3. bad debt expense to AR (move in tandem)

4. Actual write-offs to recognized bad debt expense (be equal)

Flow of costs for inventory

beginning inventory + purchases = goods available for sale = cost of goods sold + ending inventory

flow of Goods available for sale

income statement : Goods available for sale = cost of goods sold (to gross profit to net income)

balance sheet: Goods available for sale = ending inventory (to current assets to total assets)

Retail vs manufacturing COGS

retail inventory - COGS = costs of products purchased

manufacturing - materials + direct labor + overhead

Explain the flow of costs

when inventory is purchased, it is capitalized on the balance sheet.

When inventory is sold, its cost is transferred from the balance sheet to the income statement as cost of goods sold

What does it mean to capitalize inventory costs

costs are recorded on the balance sheet and is not immediately expensed on income statement

-purchased inventory: capitalize purchase price

-manufactured inventory: capitalize manufacturing price (materials, labor + overhead)

Explain the flow of Cost of Goods Sold

1. beginning inventory is carryover from ending inventory at end of previous period

2. current period inventory purchases are added to the beginning balance

3. yield cost of goods available for sale

4. goods are sold and unsold goods are still in inventory at end of period

How does gross profit change upon managerial choice

Sales - COGS = gross profit

-higher cost units are transferred = higher COGS = lower gross profit

-lower cost units are transferred = lower COGS = higher gross profit (also higher tax)

FIFO inventory

first in, first out

-Assumes that the unsold inventory is the most recently purchased

-transfer oldest costs from balance sheet to COGS