ACC exam 1 study guide

primary users of financial accounting

providing financial information to external users, investors, creditors, other external users, to predict the future risk and potential return of investments or loans

objectives of financial accounting

useful for decision making, information helps investors and creditors evaluate amounts, timing, and uncertainty of an investment

how to calculate rate of return

dividends+share price appreciation/initial investment

what is rate of return used to evaluate

measures the profitability and performance of an investment relative to the amount initially invested, investors compare the expected rate of return against the risk of an investment

historical cost

records an asset at its original purchase price adjusted for depreciation/amortization, more reliable because original transaction is documented, easy to verify, does not automatically reflect market value changes

fair value

records an asset at its current market based value, more relevant to investors for decision making, reflects what an asset is actually worth today, benefit: relevance/what can you get for it today

historical cost vs fair value debate

historical cost favors reliability, fair value favors relevance, debate on how assets and liabilities should be measured on financial statements, this is why GAAP uses more than one method

the accounting equation

assets=liabilities+shareholders equity, must always balance and each event has a duel effect on the equation

adjusting journal entries

record the effect of internal events at the end of a period, in order to implement accrual accounting

what happens if adjusted journal entries are not made

revenues, expenses, assets, and liabilities will be misstated, net income and the balance sheet wont reflect the true accrual basis financial position

prepayments

occur when the cash flow occurs BEFORE the expense or revenue is recognized, includes prepaid expenses and deferred revenues

accruals

occur when the cash flow comes AFTER the expense or revenue is recognized, includes accrued liabilities and accrued receivables

income statement

reports revenues, expenses, gains, and losses for a period, a change statement showing what caused shareholders equity/retained earnings to change due to operations

statement of comprehensive income

reports changes in equity during the period NOT the result of transactions with owners, includes net income plus “other comprehensive income” items excluded from net income

balance sheet

presents the financial position of a company, organized list of assets, liabilities, and shareholders equity at a point in time

statement of cash flows

reports the events that caused cash to change during the period, organized into operating, investing, and financing activities

statement of shareholders equity

discloses the sources of the changes in the various permanent shareholders equity accounts from : investments by owners, distributions to owners, net income

items that impact retained earnings

• + net income (revenues, gains, net of expenses and losses)

• - dividends (distributions to owners)

• beginning retained earnings+net income-dividends=ending retained earnings

balance sheet usefulness

grouping assets and liabilities by common characteristics provides useful info about: liquidity, long term solvency: whether a company will be able to pay all of its liabilities, and financial flexibility: the ability to alter cash flows to take advantage of unexpected investment opportunities

balance sheet limitations

a company’s book value (net assets/equity) does not directly measure the company’s market value (worth)

why wouldn’t a company’s market value match their book value

many assets are measured at their historical costs rather than the amount the assets could be sold, many aspects of a company may represent valuable resources, but these items are not recorded as assets in the balance sheet, meaning they have zero book value

current assets

assets expected to be converted to cash within the coming year or within the operating cycle, cash/cash equivalents, short term investments, accounts receivable, inventory, prepaid expenses

current liabilities

obligations that are expected to be satisfied through the use of current assets or the creation of other current liabilities, satisfied within one year from the balance sheet date or operating cycle, accounts payable, notes payable, deferred revenues, accrued liabilities

long term assets

assets expected to be converted to cash or consumed in more than one year, investments, operating lease assets, property, plant, and equipment, intangible assets

long term liabilities

obligations that are due to be settled or have a contractual right by the borrowing company to be settled in more than one year after the balance sheet date, long term notes, bonds, pension obligations, and lease obligations

shareholders equity

total assets - total liabilities

two components of shareholders equity

paid in capital and retained earnings

auditors purpose and role

examine financial statements and the internal control procedures, they attest to the fairness of the financial statements, results in an opinion stated in the auditors report

financial statement analysis comparison methods

comparative financial statements, various tools and techniques are needed to formulate predictions

financial statement analysis-horizontal analysis

each item is presented a a percentage of a base year amount

financial statement analysis-vertical analysis

each item is presented as a percentage of a total

financial statement analysis-ratio analysis

financial statement items are converted to ratios

current ratio

current assets/current liabilities, more liquid, better to cover short term obligations

acid test ratio

numerator includes cash+short term investments+accounts receivable (quick assets), divided by liabilities

working capital

current assets-current liabilities

solvency ratio: debt to equity ratio

total liabilities/shareholders equity, higher risk to creditors

solvency ratio: times interest earned ratio

net income+interest expense+income tax expense/interest expense

operating items

items related to the company’s normal, core operations: sales revenue, cost of goods sold, operating expenses→operating income

non-operating items

items that relate only tangentially to the company’s own core operations: interest revenue, interest expense, gains/losses on sales of investments→ combine with operating income to get income before income taxes

income taxes

expense subtracted from income before taxes to arrive at income from continuous operations/net income

earnings quality

the ability of reported earnings (income) to predict a company’s future earnings

permanent earnings

result from transactions likely to generate similar profits in the future, included in income from continuous operations

temporary earnings

result from transactions that are either not likely to recur in the foreseeable future or likely to have a different impact on future earnings

income smoothing

within the rules allows by GAAP, creating a smoother earnings pattern over time by altering assumptions/estimates (overestimating expenses in a good year to reduce net income, then reversing those estimates in a future year to boost net income)

change in accounting principle

switching one acceptable accounting method to another

change in accounting principle mandated

implemented via a retrospective, modified retrospective, or prospective approach

change in accounting principle voluntary

accounted for retrospectively, prior years financial statements are revised as if the new method had always been used

change in accounting estimate

due to new information coming to light, accounted for prospectively, no adjustment to prior periods, reflected in current and future periods only

change in depreciation, amortization, or depletion method

treated as a change in estimate achieved by a change in principle, requires justification for why the new method is preferable

change in reporting entry

a change in the group of companies for which financial statements are prepared

correction of an error

caused by a transaction recorded incorrectly or not recorded at all

comprehensive income

the total change in equity for a reporting period other than from transactions with owners

comprehensive income formula

net income+other comprehensive income

purpose of the statement of cash flows

required for each period a balance sheet and income statement are presented, provides info about the cash receipts and cash disbursements of an enterprise, helps users assess future profitability, liquidity, and long term solvency

operating activities

inflows/outflows from transactions entering into the determination of net income, selling inventory, collecting interest, tax refund, dividends collected, purchasing inventory, paying operating expenses, paying interest, paying income taxes

investing activities

inflows/outflows from acquiring/disposing of long lives assets used in operations and investment assets (purchase/sale of inventory is not investing) selling investments, selling intangible assets, collecting notes receivable, purchasing investments, purchasing intangible assets, lending via notes receivable

financing activities

inflows/outflows from external financing with owners and creditors, issuing stock, bonds, and notes payable, paying dividends buying back stock, repaying bond/note principal

activity ratios

measure how well a company manages/uses its assets, a higher ratio means fewer assets are needed to support a given level of revenue

activity ratios- asset turnover ratio

net sales/average total assets

activity ratios-receivables turnover ratio

net sales/average accounts receivable

activity ratios-average collection period

365/receivables turnover ratio→the average number of days it takes to collect receivables

activity ratios-inventory turnover ratio

cost of goods sold/average inventory→ indicated how quickly inventory is sold, higher=inventory sold more quickly

activity ratios-average days in inventory

365/inventory turnover ratio→ number of days it typically takes to sell inventory, lower=better

profitability ratios

measure a company’s ability to earn an adequate return relative to sales or resources devoted to operations

profitability ratios-profit margin on sales

net income/net sales→higher=more net income earned per dollar of sales

profitability ratios-return on assets

net income/average total assets→higher=more efficient use of assets to generate profit

profitability ratios-return on equity

net income/average shareholders equity→higher=greater return generated for owners

profitability ratios-dupont framework

breaks ROW into three components, ROE=profit margin x asset turnover x equity multiplier