ACCT 303 Quiz 2 Study Guide

What is the income statement?

Reports a company’s profit during a particular reporting period.

What is the statement of cash flows?

Provides information about the cash receipts and cash payments of a company during a particular reporting period.

What are revenues?

Inflows of resources resulting from providing goods or services to customers.

What are expenses?

Outflows of resources incurred while generating revenue. They represent the costs of providing goods and services.

What are gains and (losses)?

Increases or (decreases) in equity from transactions not classified as revenues or expenses and not involving owners. In general, they do not reflect normal operating activities of a company, but they represent transactions that affect a company’s financial position.

What is income from continuing operations?

Includes revenues, expenses (including income taxes), gains, and losses arising from operations that are more likely to continue.

What are the three major components of income from continuing operations?

Operating income, nonoperating income, and income tax expense.

What is operating income?

Includes revenues, expenses, gains, and losses directly related to the primary revenue generating activities of the company.

What is nonoperating income?

Includes revenues, expenses, gains, and losses not related to primary activities of the company.

What is intraperiod tax allocation?

Companies are required to report income tax expense associated with operations that are continuing separately from income tax expense associated with operations that are being discontinued.

Does GAAP have specific standards on the format of income statements?

NO

What is the single-step format income statement?

Revenues and gains:

Total revenues and gains

Expenses and losses:

Total expenses and losses

Income before taxes

Income tax expense

Net income

What is the multiple-step format income statement?

Sales revenue

Cost of goods sold

Gross profit

Operating Expenses:

Total operating expenses

Operating Income

Other income (expense):

Total other income

Income before taxes

Income tax expense

Net income

What is Earnings Quality?

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

How do analysts enhance predictive value of financial statements?

Analysts try to separate a company’s temporary earnings from its permanent earnings.

What are temporary earnings?

Arise from transactions or events that are not likely to occur again in the foreseeable future or that are likely to have a different impact on earnings in the future.

What are permanent earnings?

Arise from operations that are expected to generate similar profits in the future. Begin assessment with income before discontinued operations aka income from continuing operations.

What is income smoothing?

Within the rules allowed by GAAP, managers have the power to change reported income by altering assumptions and estimates.

What is an example of income smoothing?

In a year when income is high, managers may create reserves by overestimating certain expenses, thus reducing reported income in the current year. Then, years later, they can use those reserves by underestimating expenses which will increase reported income.

What is classification shifting?

Involves misclassifying operating expenses as nonoperating expenses. Inflates core performance.

What is an example of classification shifting?

By shifting operating expenses to a nonoperating expense classification, managers report fewer operating expenses and higher operating income.

What are restructuring costs?

Associated with management’s plans to materially change the scope of business operations or the manner in which they are conducted. Recognized in the period the exit or disposal cost obligation actually is incurred.

What are examples of restructuring costs?

Termination benefits payable to employees to be terminated: to be accrued in the period the employees render their services.

Costs associated with closing facilities: recognized when services or goods associated with those activities are received.

What are other unusual items of operating income and earnings quality?

Long-lived asset impairments: tangible or intangible. Asset balance reduced if there has been a significant impairment value.

Revenue issues affecting earnings quality: a company loses a major customer that can’t be replaced, misstatement of revenue, premature revenue recognition.

What are Non-GAAP earnings?

Management’s judgment. Exclude certain expenses and sometimes certain revenues. Common expenses excluded are restructuring costs, acquisition costs, write downs of impaired assets, and stock based compensation.

What constitutes a discontinued operation?

A component of an entity or group of components has been sold or disposed of, or is considered held for sale.

AND

If the disposal represents a strategic shift that has, or will have, a major effect on a company’s operations and financial results.

How is discontinued operations reported when the component has been sold in the reporting period?

Income from continuing operations before taxes

Income tax expense

Income from continuing operations

Discontinued operations:

Income (loss) from operations of discontinued component (including gain [loss] on disposal of x)

Income tax benefit (expense)

Income (loss) on discontinued operations

Net income

How is discontinued operations reported when the component is held for sale at the end of the reporting period?

Income from continuing operations before taxes

Income tax expense

Income from continuing operations

Discontinued operations:

Income (loss) from operations of discontinued component (including impairment loss of x [do not include a gain!])

Income tax benefit (expense)

Income (Loss) on discontinued operations

Net income

What three categories do accounting changes fall into?

Change in accounting principle

Change in estimate

Change in reporting entity

(Correction of an error is another adjustment that is accounted for in the same way as certain accounting changes)

What is a change in accounting principle?

Refers to a change from one acceptable accounting method to another.

What are examples of a change in accounting principle?

Choice among FIFO, LIFO, and average cost for the measurement of inventory.

Alternate revenue recognition methods.

What is the retrospective approach of mandated changes in accounting principles?

The new standard is applied to ALL periods presented in the financial statements. We restate prior period financial statements as if the new accounting method had been used in those prior periods. We revise the balance of each account affected to make those statements appear as if the newly adopted accounting method had been applied all along.

What is the modified retrospective approach of mandated changes in accounting principles?

The new standard is applied to the adoption period only. Prior period financial statements are not restated. The cumulative effect of the change on prior periods’ net income is shown as an adjustment to the beginning balance of retained earnings in the adoption period.

What is the prospective approach of mandated changes in accounting principles?

Requires neither modification of prior period financial statements nor an adjustment to account balances. Instead, the change is simply implemented in the current year and all future periods.

How are voluntary changes in accounting principles implemented?

Accounted for retrospectively by revising prior years’ financial statements.

What is change in accounting estimate?

Changes due to modification of estimates as new information comes to light. Accounted for PROSPECTIVELY.

What are examples of changes in accounting estimates?

The amount of future bad debts on existing accounts receivable.

The useful life and residual value of a depreciable asset.

Future warranty expenses.

What is change in depreciation, amortization, or depletion method?

Considered to be a change in accounting estimate achieved by a change in accounting principle. Accounted for PROSPECTIVELY and in the same way as a change in accounting estimate. Requires justification.

What are accounting errors?

Caused by a transaction being recorded incorrectly or not recorded at all.

How do we correct accounting errors discovered in the same year?

Erroneous journal entry is reversed and the appropriate entry is recorded.

How do we correct accounting errors discovered in subsequent years?

Prior period adjustment recorded (if material). Adjust any balance sheet accounts to their appropriate levels and account for the income effects of the error by increasing/decreasing the beginning retained earnings balance.

What is Earnings per Share (EPS)?

Ratio that indicates the amount of income earned by a company expressed on a per share basis.

What is Basic Earnings per Share?

(Net income - Preferred stock dividends) / Weighted average number of common shares outstanding

Suppose the Fetzer Corporation reported net income of $600,000 for the fiscal year ended December 31, 2024. Preferred stock dividends of $75,000 were declared during the year. Fetzer had 1,000,000 shares of common stock outstanding at the beginning of the year and issued an additional 1,000,000 shares on March 31,2024. What is the basic earnings per share?

(600,000 - 75,000) / (1,000,000 + 1,000,000×9/12) = $0.30

What is Diluted Earnings per Share?

Refers to the reduction in EPS that occurs as the number of common shares outstanding increases. Incorporates the dilutive effect of all potential common shares in the calculation of EPS.

What is the format of basic earnings per share on the income statement?

How can information in the income statement and other comprehensive income items be presented as?

Single, continuous statement of comprehensive income (Statement of comprehensive income)

OR

Two separate, but consecutive statements (Income statement and statement of comprehensive income)

What is the format of a single, continuous statement of comprehensive income?

Revenues and gains

Expenses and losses

Net income

Other comprehensive income, net of taxes:

Put gains/losses here

Other comprehensive income (OCI)

Comprehensive income

What is the format of a separate statement of comprehensive income?

Net income

Other comprehensive income, net of taxes:

Put stuff here

Other comprehensive income

Comprehensive income

Where do you report accumulated other comprehensive income?

Balance sheet. Reported as an additional component of shareholders’ equity and is consistent with how accumulated net income is reported in the balance sheet as retained earnings.

How do you reconcile between retained earnings and accumulated other comprehensive income?

Add net income to RE and deduct dividends from RE. Add other comprehensive income to AOCI.

Is total shareholders’ equity affected by classification of retained earnings vs accumulated other comprehensive income?

NO! Eventually, items in accumulated other comprehensive income are reclassified to retained earnings.

What is the statement of cash flows?

Provides information about the cash receipts and cash disbursements of an enterprise. Cash refers to cash plus cash equivalents and restricted cash. REQUIRED.

What is the statement of cash flows helpful in assessing?

Future profitability, liquidity, and long-term solvency.

What are the categories of transactions affecting cash?

Operating activities, investing activities, and financing activities.

What are the four steps of preparing the statement of cash flows?

1. Determine the net cash provided by (or used in) operating activities.

2. Determine the net cash provided by (or used in) investing and financing activities.

3. Determine the change (increase or decrease) in cash during the period.

4. Reconcile the change in cash with the beginning and the ending cash balances.

What are operating activities?

Inflows and outflows of cash that result from activities reported in the income statement.

What are examples of operating activities in the statement of cash flows?

Inflows:

• Sale of goods or services (from customers)

• Interest and dividends from investments

Outflows:

• Purchase of inventory

• Salaries, wage, and other operating expenses

• Interest on debt

• Income taxes

What are the methods of reporting operating activities in the statement of cash flows?

Direct and indirect

What is the direct method of reporting operating activities in the statement of cash flows?

Cash effect of each operating activity is reported directly in the statement.

What is the indirect method of reporting operating activities in the statement of cash flows?

Net cash flow is derived indirectly by starting with reported net income and working backwards to convert that amount to a cash basis.

What is the format of indirect method of operating activities in the statement of cash flows?

Net income

Adjustments for noncash effects:

Depreciation expense +

Changes in operating assets and liabilities:

Increase in accounts receivable -

Decrease in prepaid insurance +

Increase in accrued liabilities +

Decrease in income taxes payable -

Net cash flows from operation activities

What is the format of direct method of operating activities in the statement of cash flows?

Cash received

Cash paid for

Net cash flows from operating activities

What are investing activities in the statement of cash flows?

Inflows and outflows of cash related to the acquisition and disposition of: long-lived assets used in the operations of the business and investment assets.

What are examples of investing activities in the statement of cash flows?

Inflows

• The sale of long-lived assets used in the business

• The sale of investment securities

• The collection of a nontrade receivable [PRINCIPAL] (excluding the collection of interest, which is an operating activity) (i.e., collection of NR)

Outflows

• Purchase of long-lived assets used in the business (i.e., equipment)

• Purchase of investment securities like stocks and bonds of other entities (i.e. stock of another corp)

• Loans to other entities

What are financing activities in the statement of cash flows?

Inflows and outflows of cash related to external financing of the company with owners and creditors.

What are examples of financing activities in the statement of cash flows?

Inflows

• From owners when shares are sold to them (i.e., issuance of common stock)

• From creditors when cash is borrowed through notes, loans, mortgages, and bonds (i.e., cash proceeds from issuance of NP)

Outflows

• To owners in the form of dividends or other distributions

• To owners for the reacquisition of shares previously sold

• To creditors as repayment of the principal amounts of debt (excluding trade payables that related to operating activities)

What are noncash investing and financing activities?

Activities that do not involve cash flows at all and are reported on the face of the statement of cash flows or in a disclosure note.

What is an example of a noncash investing and financing activity?

Acquisition of equipment (investing) by simultaneously issuing either a long term note payable or equity securities (financing) to the seller of the equipment.

What are the activity ratios?

Asset turnover ratio, receivables turnover ratio, inventory turnover ratio, average collection period, average days in inventory.

What is the asset turnover ratio?

Asset turnover ratio = Net sales / Average total assets

What is the receivables turnover ratio?

Receivables turnover ratio = Net sales / Average accounts receivable (net)

What is the inventory turnover ratio?

Inventory turnover ratio = Cost of goods sold / Average inventory

What is the average collection period?

Average collection period = 365 / Receivables turnover ratio

What is the average days in inventory?

Average days in inventory = 365 / Inventory turnover ratio

What are the profitability ratios?

Profit margin on sales, return on assets, return on equity

What is the profit margin on sales?

Profit margin on sales = Net income / Net sales

What is the return on assets?

Return on assets = Net income / Average total assets

What is the return on equity?

Return on equity = Net income / Average shareholders’ equity

What is the equity multiplier?

Equity multiplier = Average total assets / Average total equity

What is the DuPont framework?

Provides an analysis that breaks the return on equity into three key components:

• Profitability (Net income / Net sales)

• Activity (Net sales / Average total assets)

• Financial leverage (Average total assets / Average total equity)

What are the other formulas for return on equity?

Return on equity = Profit margin * Asset turnover * Equity multiplier

Return on equity = Return on assets * Equity multiplier

How are changes in assets added/subtracted from net income when using the indirect method to prepare the operating activities section of the statement of cash flows?

Increases in assets = Subtract

Decreases in assets = Add

How are changes in liabilities added/subtracted from net income when using the indirect method to prepare the operating activities section of the statement of cash flows?

Increases in liabilities = Add

Decreases in liabilities = Subtract

When there is a decrease in accounts receivable, you:

Add to net income

When there is a depreciation expense you:

Add to net income

When there is an increase in interest receivable, you:

Subtract from net income

When there is a decrease in accounts payable, you:

Subtract from net income

When there is a gain on the sale of equipment, you:

Subtract from net income

When there is a decrease in utilities payable, you:

Subtract from net income

When there is an increase in inventory, you:

Subtract from net income

What items must be removed from continuing operations and reported separately for a discontinued operation?

Revenues, expenses, gains, losses, and income tax

When preparing earnings per share section of income statement, how do you calculate each portion?

Income from continuing operations / shares of common stock outstanding

Loss on discontinued operations / shares of common stock outstanding

Net income

How do you calculate ending shareholders’ equity?

Beginning Shareholders’ Equity + Net income - Dividends

What is cash received from interest on notes receivable?

Operating activity

What is collection of notes receivable?

Investing activity

What is issuance of notes payable?

Financing activity

What is interest on notes payable?

Operating activity