Financial Accounting and Reporting: Key Concepts for External Users and Regulations

Who receives financial accounting information from companies?

External users, such as lenders and investors.

What do companies use capital for?

To acquire assets that can generate revenues and profits.

What are the three types of activities a firm engages in?

Financial, investing, and operating activities.

What is the difference between financial accounting and managerial accounting?

Financial accounting focuses on external reporting, while managerial accounting focuses on internal decision-making.

What happens when a firm goes public with an IPO?

The firm receives equity capital from public investors in exchange for shares of ownership.

What is an advantage of going public?

Shares of ownership can be easily transferred (bought and sold).

What is a disadvantage of going public?

The firm has to follow many rules and regulations.

What is the Sarbanes-Oxley Act of 2002 (SOX)?

A law enacted to enhance corporate governance and accountability after accounting scandals.

What are the main requirements imposed by SOX on company executives?

Executives must personally sign off on their firm's financial statements.

What does SOX require from auditors?

Auditors must be more independent and provide opinions on a firm's internal controls.

What are the mandatory disclosure requirements for publicly listed firms?

They must file annual reports (10-Ks) and quarterly reports (10-Qs).

What information is typically included in a 10-K report?

Financial statements, footnotes, management discussion and analysis (MD&A), and auditor's report.

What are internal controls in the context of financial reporting?

Policies and procedures used by firms to prevent embezzlement of cash.

What are the main components of a balance sheet?

Assets, liabilities, and shareholders' equity.

What types of accounts are included in assets?

Cash, inventory, accounts receivable (A/R), prepaid expenses, property, plant and equipment (PPE), intangibles, and goodwill.

What are examples of liabilities on a balance sheet?

Accounts payable (A/P), accrued expenses, short-term loans, long-term loans, and long-term bonds.

What components make up shareholders' equity?

Common stock, preferred stock, retained earnings, and treasury stock.

What is the difference between current and non-current assets and liabilities?

Current assets and liabilities are due within one year, while non-current are due after more than one year.

Debits and Credits

Use of debits and credits to make increases or decreases to accounts.

Debits

Increase assets.

Credits

Increase liabilities and equity.

Journal Entries Format

Debits first and credits second, to the right.

Operating Transactions

Revenues, COGS, Salaries, Utilities, Depreciation, Interest, and Taxes.

Contra-asset Account

Account to keep track of how much an asset depreciated over time.

Accumulated Depreciation

The contra asset account for PPE.

Income Statement Format

Sometimes referred to as 'multi-step' because it shows multiple subtotals.

Important Income Statement Subtotals

Gross Profit, Operating (aka EBIT), Taxable Income (EBT), Net Income.

Gross Profit Percent

Gross Profit/Total Revenue.

Adjusting journal entries

Needed at the end of a period to properly record expenses for the period in which they occurred.

Permanent accounts

Accounts that are not closed out at the end of the period.

Temporary accounts

Accounts that are closed out at the end of the period (reset to 0).

Accrual Accounting

Involves accrual transactions where the business transaction occurs before the exchange of cash and deferral transactions where it occurs after the exchange of cash.

Revenue recognition

Revenue is recorded when a firm delivers its products to or performs its services for the customer, even if cash payment is not yet received.

Expense recognition

Expenses are recorded in the period in which they are incurred, even if cash is not yet paid.

Matching principle

Revenue and expenses are recorded in the period they happen, not when cash is exchanged.

Gains

Increase net income, but they are not considered the same as revenue.

Losses

Decrease net income, but they are not considered the same as expenses.

Equity

Ownership, earnings are shown on the income statement and it represents a change in equity.

Retained Earnings formula

Retained Earnings (beginning balance) + Net Income/Loss - Dividends for the year = Retained Earnings (ending balance).

Cash flow

Shown on the cash flow statement and it represents change in cash.

Cash Flow Statement

Shows all cash inflows and outflows during the year, segmented by operating, investing, and financing activities.

What are the two formats for the operating section of a cash flow statement?

Direct format and indirect format.

Which format is used by almost all large companies for the operating section?

Indirect format.

What is the starting point of the indirect format in the cash flow statement?

Net Income.

What do you add back in the indirect format of the cash flow statement?

All non-cash expenses and losses.

What do you subtract in the indirect format of the cash flow statement?

All non-cash gains.

What are capital expenditures classified as in the cash flow statement?

Investing outflows.

What are cash payments for dividends and share repurchases classified as?

Financing outflows.

What are cash receipts from issuing bonds and stock classified as?

Financing inflows.

What does CapEX stand for?

Capital Expenditures.

What is Free Cash Flow?

CFFO - CapEX.

FIFO

Method that results in higher profits during inflation affecting firms' inventory costs compared to LIFO.

LIFO

Method that results in lower profits during inflation affecting firms' inventory costs compared to FIFO.

Decline in inventory value

Written off with a credit and a corresponding excess and obsolete inventory expense recorded with a debit.

Non-cash expense

An expense that gets added back to net income in the operating section of the cash flow statement.

Perpetual inventory management system

A system sophisticated enough to know how much inventory there is at all times.

Periodic inventory management system

A less sophisticated system based on a physical count of all inventory at the end of the period.

Uncollectible A/R accounting

A 2-step process involving estimating uncollectible amounts and resolving uncertainty.

Bad A/R Expense

An extra expense estimated for uncollectible accounts receivable.

Allowance for Doubtful Accounts (AFDA)

A contra-asset used in the estimation of uncollectible accounts receivable.

Step 1 of uncollectible A/R accounting

Estimate the amount of uncollectible A/R with Bad A/R Expense and AFDA.

Step 2 of uncollectible A/R accounting

Remove uncollectible A/R from the balance sheet with a credit and debit to AFDA.

ADFA

Allowance for Doubtful Accounts

A/R, net of AFDA

Accounts Receivable reported after deducting the allowance for doubtful accounts

2/10, n/30

Payment terms allowing a 2% discount if paid within 10 days, otherwise full amount due in 30 days

Net realizable value

The amount of Accounts Receivable expected to be collected

Capitalize

To convert an expense into an asset and spread the expense over time

PPE

Property, Plant, and Equipment, one of the largest assets for companies

Book value of equipment

Original cost minus accumulated depreciation

Impairment of PPE

Loss of value of Property, Plant, and Equipment due to damage or market factors

R&D expenses

Research and Development costs that cannot be capitalized as assets

Intangible assets

Non-physical assets identified by legal documentation, such as patents and trademarks

Finite useful life of IA

Intangible assets that have an annual amortization expense

Infinite useful life of IA

Intangible assets that do not have annual amortization but require impairment testing

Goodwill

An intangible asset arising when a company acquires another for more than its net asset value

Present Value (PVs)

The total present value equals the sum of separate present values

Bond terms

Include face value, coupon rate, semi-annual compounding, and yield-to-maturity

Issue price of a bond

The present value of the coupon payments and face value payment

Discount on Bond

Used when accounting for a bond issued at a discount

Premium on Bond

Occurs when a bond is issued at a price above its face value

Equity

Ownership interest in a company

R/E (Retained Earnings)

Beginning retained earnings plus net income minus dividends

Cash dividend announcement

Includes declaration date, payment date, owner of record date, and ex-dividend rate

Earnings per share (EPS)

Calculated as Net Income divided by Weighted-Average Number of Shares Outstanding

Price-To-Earnings (P/E) ratio

Valuation ratio calculated as Stock Price divided by EPS

Market Capitalization

Calculated as stock price multiplied by the number of shares outstanding

Where to retrieve a firm's complete annual report?

SEC & A firm's corporate website, investor relations section.

When dividends are declared, what is the journal entry?

Debit R/E, Credit Dividends Payable.

When dividends are paid, what is the journal entry?

Debit Dividends Payable, Credit Cash.

When bonds are issued, what is the journal entry?

Debit Cash, Credit Bonds.

Under accrual accounting, when can a firm record revenue?

Product has been delivered to the customer and cash is to be paid in one week.

Under the matching principle of accrual accounting, when does a firm record COGS?

When revenues are earned and recorded.

If a customer orders a product from a firm on 5/13/25, the product is delivered to their home on 6/13/25, and the customer pays the full amount on 7/13/25, when should Revenue & COGS be recorded.

Revenue & COGS should be recorded in June.

Which is a true statement based on the conservative nature of US GAAP?

When assets decrease in value, the asset value must be written down.

If an asset account increases, and only one other account changes, then which of the following can occur at the same time?

Another asset account decreases.

Which of the following can apply to a balance sheet.

4/15/2020, it can only be a single day on the B/S.

Additional paid in capital represents which of the following?

Cash received from issuing stock at the price above par value.

If common stock is $1000 and additional paid-in capital is $19000, par value is $.50, how many shares of common stock have been issued?

2000 (1000/.50 = 2000)

Investors want to know how a firm performed operationally during 2023. Which financial statement should they examine?

Income statement for the period 12/31/2022 to 12/31/2023

Where is the cash inflows from issuing common stock found?

Financing section of cash flow statement