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Study Guide for Exam #1

by: AlissaRabat

Study Guide for Exam #1 Acc 201

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GPA 3.65

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Includes both Theory (with examples of transactions) and Formula Sheet. Do not forget to do the Practice Exam and the Exam from the Previous Semester
Principles of Financial Accouting
Study Guide
Accounting, financial accounting, Principles of Financial Accounting
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This 29 page Study Guide was uploaded by AlissaRabat on Monday February 22, 2016. The Study Guide belongs to Acc 201 at Michigan State University taught by Petroni in Summer 2015. Since its upload, it has received 584 views. For similar materials see Principles of Financial Accouting in Accounting at Michigan State University.


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Date Created: 02/22/16
Study Guide Exam #1 Financial Accounting – ACC 201 Index Theory 3 Financial Accounting 3 Accounting Standards in the US 4 Securities and Exchange Commission (SEC) 4 Financial Accounting Standards Board (FASB) 5 Financial Accounting Foundation (FAF) 5 Others 5 Underlying Assumpt ions and Characteristics 5 Desirable Characteristics 5 Measurement Assumptions 6 The Accounting Cycle and The Operating Cycle 6 Operating Cycle 7 Information on Financial Statements 7 Balance Sheet or Statement of Financial Position 8 Income Statement 10 Classified Income Statement 10 Statement of Stockholder’s Equity 11 Statement of Cash Flow 11 Business Transactions and Accounts 12 The T Accounts and Th e Debit - Credit Framework 12 Journal Entries 13 Adjusting Journal Entries 13 The Trial Balance 14 Revenues and Expenses 14 Revenues 14 Expenses 15 Recording Revenues and Expenses 16 Deferrals and Accruals 16 Profit Margins 17 Profit Driver Analysis 17 Market Book Ratio/ Price to Book Ratio 18 Ratios that use the Income Statement and Balance Sheet 19 Basic Earnings Per Share (EPS) 19 Importance of EPS 19 Other Performance Measures 22 Some Analysis of the Balance Sheet 22 Liquidity Measures 22 Solvency Measures 22 Formula Sheet 24 Balance Sheet 24 Outline Structure 24 Example 24 Income Statement 25 Outline Structure 25 Statement of Cash Flow 26 Journal Entries and T Accounts 26 Updating Inventory 26 If correctly done when Inventory is bought 26 If Expense is debited when Inventory is bought 26 Profit Margins 27 COGS as a percentage of Sales 27 Selling, General and Administrative Expenses (SG&A) as a percent of sales 27 Gross Profit Margin 27 Net Profit Margin 27 Return on Assets (ROA) 27 Market to Book Ratio/Price to Book Ratio 27 Formula #1 27 Formula #2 28 Other Ratios 28 Total Asset Turnover Ratio 28 Earnings Per Share 28 Analysis of Balance Sheet 28 Working Capital 28 Current Ratio 28 Debt-to-Asset 28 Debt-to-Equity 28 Equity-to-Assets 29 Other Formulas 29 Accumulated Depreciation 29 Interest 29 Theory Financial Accounting • Accounting: system that collects and processes financial information about an organization and reports that information to decision makers • Financial Accounting: Measurement and communication of a firm’s economic activities primarily for those outside the firm. • Made up of investors and creditors. o Investors § Owners, shareholders, stockholders, potential investors § People who invest in the company o Creditors: § People who lend money to the company, or to whom the company owes money too. § Ex. Banks • Communication is through the financial statements. • Most noted for calculation and reporting of net income. o Net income or earnings are: § Single most widely used performance metrics § Based on accounting principles audited § Changes overtime are closely watched § Forecasted by analysis an unexpected net income matters. o The association between annual earnings changes and commutative abnormal returns § How to know when to invest on a company. § The biggest abnormal returns will be given to the highest raise in positive earnings change. § You always want to invest on a company who has a positive earnings change • You care more about the earning changes than the cash flow, • Cash flow gives you a smaller positive return on the stock • Disclosure Process o Press Release: written public news announcement normally distributed to major news services o Annual Reports and 10-K § Annual Reports • Include 4 basic financial statements • Related notes • Report of Independent Accountant (Auditor’s Opinion) if audited § Form 10-K • Annual report publicly traded companies must file with the SEC • Principle Components: o Business: description of the company o Selected Financial Data: summarized financial data with 5 year period o Management’s discussion and analysis of financial positions and results of operations o Financial Statements and supplement data o Quarterly Reports and 10-Q § Quarterly Reports • Fewer information than annual reports • Only key notes to statements • Unaudited § Form 10-Q • Quarterly report publicly traded companies must file with the SEC o Form 8-K § Used by publicly traded companies to disclose any material event not previously reported that is important to investors • Important points: o Accounting is both the measurement and communication of economic activities of the firm o Financial accounting produce financial statements that contain information about underlying economic events for investors and creditors. o Managerial accounting focuses on the use of accounting information by those inside the firm. o Net income is the most widely used performance metrics of the rules that determine its measurements are important. Accounting Standards in the US • Responsibility for the financial statements o Management § Responsible for creating financial statements. o Auditor § Provide assurance services on financial statements. § Auditors report on financial statements: • Clean (unqualified) o Conform to gap and fairly percent • Qualified o Does not conform to GAAP • In the US publicly traded firms have to conform § Audit: examination of the financial reports to ensure that they represent what they claim and conform to GAAP • 3 Steps to ensure Accuracy: o System of Controls o External Auditors o Board of Directors Securities and Exchange Commission (SEC) • 1933/1934 • Created as a response to the stock market crash and the Great Depression o Blamed on wrongful accounting, so they fixed financial reporting • Made up primarily of lawyers • Legal rights to both set and enforce accounting standards • Primarily an enforcer o Follow the rules not create them o Some additional rules that apply to a publicly held firm • Delegated its right to set standards for private sector organization (FASB) Financial Accounting Standards Board (FASB) • 1973 • Delegated standard setter o Rules for content and creation of financial statements. § GAAP: generally accepted accounting principles. • No enforcement o Just writes the standards. • Seven members and the board • Can only be paid by FASB Financial Accounting Foundation (FAF) • Select members of the FASB • Fund their activities • Exercises general oversight Others • Financial Accounting Standards Advisory Council (FASAC) o Advisers on policy issues • International Standards Board (ISB) o US firms can’t follow it. • Public Company Accounting Oversight Board (PCAOB) o Sets Generally Accepted Auditing Standards (GAAS) o Created by the Sarbanes-Oxley act Underlying Assumptions and Characteristics • Separate Entity o Activities (transactions) of the business are separate from activities of the owners. o Example: CEO Buys a car for his personal use and doesn’t record it as an asset of the firm • Going Concern or Continuity o A business will operate into the future, or assuming to have an indefinite life. • Time Period or Periodicity o The indefinite life of a business must be reported over a series of shorter time periods. • Stable Monetary Unit of Measure o Each business accounts and reports its financial results using the currency unit of its primary place of business without adjustments for changing urgency power. Desirable Characteristics • Relevant o Capable of making a difference • Faithful Representation o Complete, neutral, free from error • Other characteristics o Comparable o Understandable o Verifiable Measurement Assumptions • Historical Cost Principle o Reporting items at their cost on the date they weren’t originally acquired. o Items on the balance sheet. o Most assets and liabilities • Fair Value Principle o Use instead of the historical cost. o Reporting items at the market value on the data balance sheet is prepared. o Only a few o Example: investment income and stock: Which changes depending on rise or fall of the stock. • Mix Attribute Model o Assets and Liabilities are measured using both attributes, one or the other. o Mixes both principals on the balance sheet o Most common is the historical cost • Cost-Benefit Constraint o Information benefits should outweigh the cost of gathering and recording. The Accounting Cycle and The Operating Cycle • Start of accounting Period o Steps taken during the accounting period as transactions occur with parties external to the company o Record journal entries and post the amount to accounts • Required steps at the end of the accounting. o Prepare trial balance o Record and post adjusting entries o Prepare adjusted trial balance o Prepare financial statements o Recording post closing entries • End of accounting • The Closing Process o Impacts Temporary Accounts § Revenues, expenses, gains, losses, and retained earnings o Information is accumulated in these accounts over the accounting. o At the end of the period they are close to retained earnings o Information is then accumulated for the next accounting. o Revenues are closed by putting the balance on the debit side and transferring it to retained earnings on the credit side § Revenue DEBIT § Retained Earnings CREDIT o Expenses and losses are closed on the credit side and the balance is put into retained earnings on the debit side § Retained Earnings DEBIT § All Expenses CREDIT Operating Cycle • Time it takes to purchase goods or services, pay for the goods or services, make sales to customers, and collect cash from customers • Usual Operating Cycle: o Purchase merchandise from supplier o Pay suppliers for merchandise o Sell merchandise to customer o Collect cash from customer Information on Financial Statements • Report the resources that a company (Assets) and obligations that a company owes (Liabilities) • There’re two roles of the financial statements o Stewardship § Monitor Management o Valuation § Pricing and capital markets • Summarize business activities • They should be: o Fairly Presented § Not necessarily accurate § Within guidelines of generally accepted accounting principles (GAAP) § On the whole not materially misstated • Material means would influence the decision adequate § Ponzi Scheme: borrowing money from new creditors to pay older creditors in a never-ending cycle. o Adequate Disclosure § Sufficient to aid users § Explain complex events of the company • Frequency of Recording o Time Period Assumption: over a month, quarter, or year § Internally • As frequently as they choose usually on a monthly basis § Externally • Quarterly • Annual Basis o Fiscal year is the period of firm chooses to report their annual results. § 12 month or 50 to 53 weeks which means • Ending on December 31 • January 31 o Retailers biggest sales are on Christmas and biggest returns are in January • Ending Saturday closest to January 31 • Financial Statement Footnotes o Different types of footnotes § Additional details supporting the amounts in the financial statements • How stuff is accounted for § Relevant financial information not disclosed on the financial statements • Extra stuff investors need to know about § Voluntary disclosures • At items the GAAP doesn’t require • Example: sales divided by product lines § A statement of significant accounting policies • Describes policies used by the company • The basic financial statements are: o Balance Sheet o Income Statement o Statement of Stockholders Equity o Statement of Cash Flow • Financial Statement Articulation o First calculate income statement to get net income o Then statement of stockholders equity will use net income to calculate retained earnings end of year § Also known as Retained Earnings Statement • ????????????.???????????????????????????????? ???????????????????????????? + ???????????? − ???????????????????????????????????? ???????? ???????????????????????????????? = ???????????? ???????????????????????????????? ???????????????????????????????? o Finally balance sheet uses the assets, liabilities, contributed capital and calculated retained earnings. Balance Sheet or Statement of Financial Position • A financial snapshot at a specific point in time. o Heading for date says ON (specific date) • Tells you about the Assets, Liabilities and Stockholder’s Equity. o Assets § The things the firm has § Probable future economic benefits owned by the business as a result of past transactions. § Stated in order of liquidity • Liquidity: how quickly can it be turned into money § Divided into: • Current Assets o Short term assets, usually get used up in one year § Ex. Cash, Accounts Receivable (A/R), Supplies Inventory, Inventory • Non-current Assets o Long term assets, usually last longer than a year § Ex. Property, Plant, and Equipment (PP&E), Building, Long-term Investments o Liability § Things the firm owes § Probable debts or obligations of the business that results from past transactions will be paid with assets or services in the future. § Stated in order of maturity • Maturity: How soon must it be paid § Divided into: • Current Liabilities o Debts or obligations that must be pay within the fiscal year § Ex. Short-term Notes Payable, Rent Payable, Accounts Payable • Non-current Liabilities o Debts or obligations that do not need to be paid within a year § Ex. Long-term Notes Payable o Unrecorded assets and liabilities § Not recorded transactions § Executory contract • Agreement between two parties we’re no party has your performance • Example: Nike make long-term agreement with Tiger Woods the day they signed is an executor contract because there was no exchange. § Internally generated intangible assets • Such as copyright and goodwill • Example Nikes internally developed smooch is not recorded. § Off-balance-sheet financing • Obligations a firm has that don’t show up • Example long-term lease doesn’t show up on the balance sheet. o Stockholders Equity § Amount of financing provided by owners of the business and generated by the operations of the business. § Made up of: • Contributed Capital o Financing provided by owners of the business • Retained Earnings o Earnings retained by the operations of the business o Earnings not returned to owner in the form of dividends • Also includes may include Common Stock • Consolidated balance sheet means: o Distributed between current and noncurrent o Includes all companies owned by the larger company combined • The basic accounting equation ???????????????????????? = ???????????????????????????????????????????? + ???????????????????????????????????????????? ???? ???????????????????????? o Economic resources: = services of financing § Economic Resources: don’t get something for nothing § Services of Financing: Liabilities from creditors, Equity from stockholders, contributed capital, retain profits Income Statement • Reports the performance of the economic unit over a period of time o Heading says FOR THE YEAR ENDED (and date) • Formula ???????????????????????????? − ???????????????????????????????? = ???????????? ???????????????????????? ???????? ???????????? ???????????????? • Revenues (sales) o Inflows of Assets from ongoing operations o Temporary Account (closes at the end of fiscal period) o Affects Stockholder’s Equity component Retained Earnings § Makes it go up, increase § If not recorded the SE can be Understated • Because Net Income is Understated o Recognize in the period in which goods and services are provided not necessarily when cash is received. § It does not matter if cash was received, if sale was made and customer was billed on account the revenue is recognized. • Expenses o Amount of resources used up by the entity to earn revenue during the period o Outflow of Assets from ongoing operations o Temporary Accounts (Closes at the end of fiscal period) o Affects Stockholder’s Equity component Retained Earnings § Makes it go down, decrease § If not recorded SE can be Overstated • Because Net Income is Overstated o Recognizing in the period in which the resources are used § If paid in advance: the balance goes into a payable and as it is used up it is subtracted from the payable and added to the Expense Account o Important: Dividends is NOT an expense; Cost of Goods Sold (COGS) is an expense § COGS is subtracted from sales to get Gross Profit Classified Income Statement • Consolidated: it has Gross Profit • Historical Story on Classified Income Statement (9/11) o Before 2016 there were Extraordinary Items with 2 requirements: § Unusual in Nature • High degree of abnormality § Infrequent • Not reasonably expected to recur in the foreseeable future o American Airlines Classified Income Statement § Did not show any extraordinary items in 2011, even though 9/11 happened § Accountants said it was not an extraordinary item • Could not be reasonably measured • Some companies benefited because of 9/11 o 2016 extraordinary Items were eliminated § More in accordance with the International Standards • International Standards never had Extraordinary items, only a GAAP thing • Notes on Extraordinary Items o Very biased § Only bad things were recorded as Extraordinary to make up for the loss § Not a lot of things were extraordinary • Hurricane Sandy and Hurricane Katrina were not extraordinary § Elimination help NOI not to be changed or adapted by managers o Lessons Gained: § How things get reported matters • Economic implications o Change in Stock prices o Bonuses • Impact Financial Statements (ex. EPS) § Subjected application • Guidance not always available • Requires expertise § Rules constantly evolve § Set in aglobal economy • Four subtotals: o Gross profit: Net sales - Cost of Goods Sold o Total operating expenses: All expenses added together o Operating income: Gross profit - Total Operating Expenses (SG&A) o Income before income taxes: Gross profit minus all expenses § ▯▯▯ ▯▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯ (▯▯▯) ▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯ Statement of Stockholder’s Equity • Shows increases and decreases in all stockholders equity accounts for the period o Heading says FOR THE YEAR ENDED (date) • Includes o Changes in contributed capital accounts o Sales of stock o Changes in retained earnings § Increases from net income or decreases from net loss § Dividends declared • Dividends must be declared to be subtracted Statement of Cash Flow • Shows cash receipts and cash payments by category • Equation: o ???????????? ????????????ℎ ???????????????? ???????????????????????????????????????? +\−????????????ℎ ???????????????? ???????????????????????????????????? ???????????????????????????????????????? + \−????????????ℎ ???????????????? ???????????????????????????????????? ???????????????????????????????????? = ????ℎ???????????????? ???????? ????????????ℎ ???????????? ????ℎ???? ???????????????????????? • Categories are: o Net Cash from Operations § The day to day processes of purchasing raw materials from suppliers, manufacturing products, delivering products, collecting cash, and paying suppliers § Directly related to earning income o Net Cash from Investing Activities § Buying or selling items such as plant and equipment o Net Cash from Financing Activities § Evidence to shareholders = change in cash § Borrowing or paying back money to lenders and receiving additional funds from stockholders or paying them dividends. § Directly related to the financing of the company itself Business Transactions and Accounts • Events that create a transaction must be measured and recorded o Transaction: An exchange of assets or services for assets, services, or promises to pay between a firm and external party. o A measurable internal event such as adjustments for the use of asset operations • Account o An organized format used by companies to accumulate the dollar effective transactions on each financial statement item. o Chart of accounts § List of all account titles. o Ending account balances are aggregated and reported in the financial statements • Duality of the effects o Every transaction affects at least two accounts o Something is given up only if something is received in return o Double entry accounting system • The fundamental accounting equation must remain in balance after each transaction. o Determine if the event is in accounting transaction o Identified the accounts affected, assets, liabilities, or stockholders equity o Determine whether the accounts increased or decreased o Check that the accounting equation remains in balance The T Accounts and The Debit - Credit Framework o Debit is left side of an account o Credit is right side of an account o Debits must always equal credit o Assets are increased with debits and decreased with credits o Liabilities and stockholders equity increased with credits and decreased with debits o Normal balance in accounts: § Assets normally have a debit balance § Liabilities and Stockholders Equity normally have a credit balance Journal Entries • Shows transactions on accounts in a debit or credit for that period • Used to express the effects of a transaction on accounts in a debit to credit format • Journal is a chronological listing of journal entries • When recording in a journal entry usually put account debited first and account credit second with an indent followed by a description of the entry. o However it is not mandatory o Journal entries are then posted to the general ledger account balances can be calculated. • Net book value is the minimum amount an outsider would pay for the company o The extent assets exceed liabilities o In other words, the balance in stockholders equity Adjusting Journal Entries • Journal entries recorded at the end of the accounting period to: o Update the accounts for proper revenue recognition and expense matching o Properly reflect the assets and liabilities • Can be seen in Adjusted Income Statement • Examples o Accumulated depreciation (Contra-Asset) § Depreciation Expense DEBIT § Accumulated Depreciation CREDIT § To figure out Accumulated Depreciation ▯▯▯▯ ▯▯ ▯▯▯▯▯▯▯▯▯ • ∗ ????????????????ℎ???? ???????????????????????????????? ▯▯▯▯▯▯ ▯▯▯▯ o Updated of supplies inventory § If properly recorded when supplies bought, AKA Supplies Inventory is Debited • Supplies Expense DEBIT • Supplies Inventory CREDIT • To obtain number: o ????????????.???????????????????????????????????? + ???????????????????????????????? ????????????????ℎ???? − ???????????? ???????????????????????????????????? = ???????????????? o Plug à number you input into the journal entry § If at time of purchase Supplies Expense is debited • Supplies Expense DEBIT • Supplies Inventory CREDIT • To obtain number: o First Calculate Total Supplies Expense, or all the supplies used up § ???????????? ???????????????????????????????????? + ????????????????ℎ???????????????? − ???????????? ???????????????????????????????????? = ???????????????????? ???????????????????????????????? ???????????????? o Then use that number to figure out the plug § ???????????? ???????????????????????????????? ???????????????????????????? 0 + ????????????????ℎ???????????????? ???????????????????????????? − ???????????????????? ???????????????????????????????? ???????????????? = ???????????????? § The plug is the number to be used in the journal entries o Interest expense for notes payables § Interest Expense DEBIT § Interest Payable CREDIT § To figure out Interest Expense ▯▯▯▯ ▯▯▯▯▯▯▯∗▯▯▯▯▯▯▯▯ • ∗ ????????????????ℎ???? ▯▯▯▯▯ ▯▯▯ ▯▯▯▯ • If no specific time frame is given, assume 12 months. Always the time is in months. o Recorded incorrectly Payment of Revenue in advance § Service Revenue DEBIT § Unearned Revenue CREDIT § To get number: • First Figure out how much Revenue has actually been earned ▯▯▯▯▯ ▯▯▯ o ∗ ????????????????ℎ???? ???????????????????????????????? ▯▯▯▯▯ ▯▯ ▯▯▯▯▯▯ • Then Figure out PLUG o ???????????????????????????????????????? ???????????????????????????????? ???????????????????????? − ???????????????????????????? ???????????????????????? ????????????.???????????????????????????? = ???????????????? The Trial Balance • A simple list of each account with its dollar balance on some specific date • Different Forms o Unadjusted § Includes revenue and expenses o Adjusted § Includes adjusting journal entries o Closing § Includes closing journal entries, expenses and revenues are closed o Post closing § Final trial balance § All revenues and expenses are zeroed out § Retained earnings contains revenues and expenses Revenues and Expenses Revenues • Increases in assets from ongoing operations o Increase to owners equity due to the operations of the business • Gains are similar to revenues but they are from peripheral transactions • Bases of accounting determine when revenues are recognized o Cash Basis Accounting § Revenue is recognized or recorded when cash is received § Not allowed by GAAP for publicly traded companies • If it is a small company with no stock exchange then it is allowed o Accrual Basis Accounting § Required by GAAP § Revenue principle indicates the revenue is recognized when: • Earnings process is complete • And exchange transaction takes place • The amount is measurable and collection is reasonably a shirt • Examples: Provided services for cash o Assets increased by an amount and stockholders equity increases by the same amount § Asset (Usually Cash) DEBIT § Revenue CREDIT • Example: Provided services on account and billed the customer o Revenue or stockholders equity goes up and accounts receivable as up § A/R DEBIT § Revenue CREDIT • Example: Received fee in advance from client. Provided first month of services o First journal entry cash goes up and unearned revenue (Liability) goes up § Cash DEBIT § Unearned Revenue CREDIT o After first month of services unearned revenue goes down and revenue or stockholders equity goes up § Unearned Revenue DEBIT § Revenue CREDIT § To get number: ▯▯▯▯▯ ▯▯▯ • ∗ ????????????????ℎ???? ???????????????????????????????? ▯▯▯▯▯▯ ▯▯ ▯▯▯▯▯▯ Expenses • Decreases in assets from ongoing operations o Outflows from the firm related to the delivery of goods or services and using up of its assets • Outflows from the firm that decreased the owner’s equity due to the normal operations of the firm • Losses are similar to expenses but they are peripheral transactions • Bases of accounting o Cash basis accounting § Expenses recorded when cash is paid o Accrual basis accounting § Expenses are recognized during the period that they are incurred or used up to earn revenues • Referred to as the matching principle § Example: Payment of wages • Salary expense goes up (stockholders equity goes down) and cash goes down if cash is paid o Wages/Salary Expense DEBIT o Cash CREDIT § Example: Payment of wages after it is incurred • First Journal Entry: wages expense goes up (stockholders equity goes down) and salaries payable goes up o Wage/Salary Expense DEBIT o Salaries/Wages Payable CREDIT • Second Journal Entry: salaries payable goes down and cash goes down o Wages/Salaries Payable DEBIT o Cash CREDIT § Example: Payment of an expense before it is incurred • First Journal Entry: prepaid expense (Asset) goes up and cash goes down o Prepaid Expense DEBIT o Cash CREDIT • Once expense is incurred, expense go up and the prepaid account goes down o Expense DEBIT o Prepaid Expense CREDIT § Inventory: bought but not sold the cost of the product or cost of goods sold is recognized when they are incurred so when they are sold Recording Revenues and E xpenses • Retained earnings o Earnings from the first day of business to the current date that have remained in business o Normal balance is credit § Part of stockholders equity: up in credit and down in debit • Expenses: Recorded on the Debit Side o Make net income go down; Retained Earnings goes down • Revenues: Recorded on Credit Side o Make net income go up; Retained Earnings goes up • Balance Sheet Accounts are considered real or permanent accounts • Income Statement Accounts are temporary or nominal accounts o Revenue and expenses are closed for the period and put into Retained Earnings o Therefore they are Temporary Accounts Deferrals and Accruals • Timing of recognition of revenue or expense relative to cash receipt or disbursement • Accrual: recognition of revenue or expense before a cash is received • Example: Rent space to tenant but no cash has been received. o Adjusting journal entry would be: § Accounts Receivable DEBIT § Rent Revenue CREDIT o Revenue is recorded when earned not when cash is received • Referral: recognition of revenue or expense after the cash receipt or disbursement • Example: Pay in advance for insurance, o Adjusting journal entry would be: § Insurance Expense DEBIT § Prepaid Insurance CREDIT Profit Margins • Used to compare companies • Cost of Goods Sold (COGS) as a percentage of sales o How much of the sales covers the making of the product o ▯▯▯▯ ▯▯▯▯▯ • Selling, General and Administrative Expenses (SG&A) as a percent of sales o Percentage of sales used to cover SG&A expenses § Includes Advertising and Marketing § How much the company uses for marketing of the product ▯▯&▯ o ▯▯▯▯▯ • Gross Profit Margin o Doesn’t include advertising expense o How much of profit is sales ▯▯▯▯▯ ▯▯▯▯▯▯ o ▯▯▯▯▯ o ???????????????????? ???????????????????????? = ???????????????????? − ???????????????? • Net Profit Margin o How much of sales is the profit per dollar o How much of income is sales ▯▯▯ ▯▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯ (▯▯▯) o ▯▯▯▯▯ o ???????????? = ???????????????????? ???????????????????????????? − ???????????????????????????????? (????????????????,????????&????) • Example: Company Comparison o Service Companies: do not have cost of goods sold therefore no Gross Profit Margin o Example advertising accounting o Wholesale Companies: have factories to make the products therefore have a smaller gross profit margin and higher property, plant and equipment o Retail stores: have a lower property, plant and equipment and higher inventory, have a higher Gross Profit margin because they sell a higher price to cover the expenses o Luxury retail stores have higher inventory than low-end retail store Profit Driver Analysis • ???????????????????????? ???????? ???????????????????????? ???????????? = ???????????? ???????????????????????? ???????????????????????? ∗ ???????????????????? ???????????????????? ???????????????????????????????? • ???????????? = ???????????? ???????????????????????? ∗ ???????????? ???????????????????? ???????????? ???????????????????? ???????????????????????????? ???????????????????? ???????????????????????? • ???????????? = ???????????? ???????????????????????? ???????????????????????????? ???????????????????? ???????????????????????? • Net Profit Margin: measure of profitability • Total Asset Turnover: measure of Efficieny • Shows the percentage of profit a company earns in relation to its overall resources • How much income is generated per Assets • Managers and analysts can use it to understand what drives profit o One goal: Maximize ROA § 2 ways: • Generate more Net Income (Profitability) • Generate more sales from Assets (Efficiency) § Usually one is bigger than the other • Example: Company Comparison o Brand Product (Coca-Cola): has a higher Net Profit Margin because it sells the product at a higher price. Lower ROA § More investment in Marketing o Discount Product (National Beverage): has a lower Net Profit Margin, but a much higher Asset Turnover. Higher ROA § Supplies product at lowest possible price § Business model is to keep price low § Uses the few Assets they have very efficiently Market Book Ratio/ Price to Book Ratio • More related to balance sheet ▯▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯▯▯▯▯ • ▯▯▯▯ ▯▯▯▯▯ • Market Capitalization o ???????????????????????? ???????????????????????????????????????????????????????? = # ???????? ????ℎ???????????????? ???????????????????????????????????????????? ∗ ????ℎ???????????? ???????????????????? § What market values the firm at § Changes with the stock price • Book Value ▯ o ???????????????? ???????????????????? = ???????????????????????? − ???????????????????????????????????????????? ???????? ????????????????????ℎ???????????????????? ???? ???????????????????????? o Extend to how resources exceed responsibilities o Balance sheets suggest is value of the firm • Other Formula ▯▯▯▯▯ ▯▯▯ ▯▯▯▯▯ o ▯▯▯▯ ▯▯▯▯▯ ▯▯▯ ▯▯▯▯▯ o Price per Share § ???????????????????? ???????????? ????ℎ???????????? = ???????????????????? ???????????????????? ???????????? ????ℎ???????????? o Book Value per share ′ § ???????????????? ???????????????????? ???????????? ????ℎ???????????? = ????????????????????????−???????????????????????????????????????????? (????????????????????ℎ???????????????????? ???? ????????????????????????) ????ℎ???????????????? § Reveals how much the market is willing to pay for $1 of Book Value • Not equal to 1 because they are hardly ever the same o Most assets are not recorded at current price instead they are recorded at historical price o Some assets are missed in the balance sheet, Market values the assets different than accountants § Example: internally generated intangible assets, growth opportunities Ratios that use the Income Statement and Balance Sheet • Earnings Per Share • Total Asset Turnover Ratio ▯▯▯ ▯▯▯▯▯ o ▯▯▯▯▯▯▯ ▯▯▯▯▯ ▯▯▯▯▯▯ § ???????????????????????????? ???????????????????? ???????????????????????? = ????????????. ???????????????????? ????????????????????????+????????????. ???????????????????? ???????????????????????? 2 • Beg. Assets is the End Assets of previous year o Varies across companies o How much sales is generated for each dollar of assets § For every dollar of assets the company generates x amount of sales o The higher the better because it uses assets more efficiently Basic Earnings Per Share (EPS) • ▯▯▯ ▯▯▯▯▯▯ ▯▯▯▯▯▯▯ ▯▯▯▯▯▯ ▯▯ ▯▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯▯ • Amount of earnings distributed to shareholders • Not the same as dividends paid Importance of EPS • EPS is a number that gets predicted and reporting press releases • Important to the management compensation o Compensation is the function of earnings o Higher level managers link EPS to bonus • Managers o Usually stop at point of higher bonus and then do nothing o Always maximize their bonus o Can move legal financial estimates to get And the number they want § § Example depreciation and the estimated life § Hard to prove that depreciation is incorrect • Equity Compensation o Managers are often paid with stock issues and stock prices o Net income goes up mean stock prices go up and so does their wealth • Stock prices are highly correlated with EPS o Important to the stock market o Investors base valuation decisions on EPS • Firms with a string of consecutive increases in quarterly EPS o Always goes up o Trade out of premium § Premium: stock prices are sold for more • When the string breaks o Quarter when earnings goes down § Stock price decline or torpedo • 29 days prior: -4.29% • 3 days prior: -1.77% • What do we know about earnings management o Earnings are intentionally misrepresented with a 20% within GAAP o Standard motivations § To influence stock price § Pressure to hit earnings benchmarks § Influence executive compensation § Avoid violation of debt covenants § To influence other stakeholders • Customers • Suppliers • Employees Other Performance Measures • Comprehensive Income o Measure of performance o Things that happened to the firm that investors need to know about o Broader than net income § Net income plus some other stuff § Example: foreign currency translation, increase or decrease of market value from a historical cost o GAAP measure • Non-GAAP measures o EBITDA § Earnings before interest, taxes, depreciation and an amortization § Created by analyst using the information from financial statements § A measure that analysts use and compute by adding back expenses they thinker on important § Compared between years § Adjustment to GAAP Some Analysis of the Balance Sheet Liquidity Measures • Ability to meet current maturing debts • Ordered from most liquid to lease liquid • Working capital (Short-term liquidity) o ???????????????????????????? ???????????????????????? − ???????????????????????????? ???????????????????????????????????????????? o Dollar amount, you want it to be positive o Extent to which assets that can be turned to cash quickly exceed the debts currently owed • Current Ratio ▯▯▯▯▯▯▯ ▯▯▯▯▯▯ o ▯▯▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯▯ o The greater than 1 it is the better but if it’s too big it means the company isn’t using their assets properly o Looked at overtime o Current assets as a percentage of current liabilities o For every dollar of liabilities how much of assets does it have Solvency Measures • Ability to meet long-term obligations • Debt-to-Assets ▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯▯ o ▯▯▯▯▯ ▯▯▯▯▯▯ o Tells you how risky a company is o The more debt equals a more risk o You want it low o For every dollar of assets it is funded by X amount of debt § If it is not funded by debt it is funded by equity o If it’s equal to one there is no equity which means there are no owners and liabilities can exceed assets which means the company is bankrupt • Debt-to-Equity ▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯▯ o ▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯▯ ▯ ▯▯▯▯▯▯ o You want it low o One way to keep it low is to keep net income come high so that retained earnings goes up o For every dollar of equity the firm has X amount of debt o If it is equal to one: half is funded by liabilities and half is funded by equity • Equity-to-Assets ▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯▯ ▯ ▯▯▯▯▯▯ o ▯▯▯▯▯ ▯▯▯▯▯▯ o 1 − (???????????????? − ???????? − ????????????????????) o For every dollar of assets it is funded by X amount of equity • Death Covenants o Promise borrower makes to lender to ensure borrow or replace back o Based on accounting measures o Example: the debt to equity ratio will not exceed a certain number Formula Sheet Balance Sheet ▯ ???????????????????????? = ???????????????????????????????????????????? + ????????????????????ℎ???????????????????? ???? ???????????????????????? ????????????.???????????????????????????????? ???????????????????????????? + ???????????? − ???????????????????????????????????? ???????? ???????????????????????????????? = ???????????? ???????????????????????????????? ???????????????????????????????? Outline Structure Assets Current Assets Total Current Assets Property Plant and Equipment Total Assets Liabilities Current Liabilities Total Current Liabilities Other Liabilities Total Liabilities Stockholder’s Equity Retained Earnings Contributed Capital Common Stock Total Stockholder’s Equity Liabilities + Stockholder’s Equity (Same as Total Assets) Example Company Balance Sheet For the Year Ending December 31, 2014 (amount in dollars) Assets Current Assets: Cash $18,000 Supplies $7,100 Accounts Receivables $10,000 Total Current Assets: $35,100 Buildings $25,500 Total Assets $60,600 Liabilities Current Liabilities: Notes Payable $15,000 Salaries Payable $8,300 Total Liabilities $23,300 Stock Holder’s Equity Contributed Capital $16,000 Retained Earnings* $21,300 Total Stockholder’s Equity $37,300 Total Stockholder’s Equity & Liabilities $60,600 *Retained Earnings Beginning of Year: $7,200 Income Before Taxes (from Income Statement): $17,700 Dividends (If Declared): ($3,600) Retained Earnings End of Month: $21,300 Income Statement ???????????????????????????? − ???????????????????????????????? = ???????????? ???????????????????????? ???????? ???????????? ???????????????? ???????????????????? ???????????????????????? = ???????????????????? − ???????????????? ???????????????????????????????????? ???????????????????????? = ???????????????????? ???????????????????????? − ???????????????????? ???????????????????????????????????? ???????????????????????????????? (????????&????) ???????????????????????? ???????????????????????? ???????????????????????? ???????????????????? = ???????????????????? ???????????????????????? − ???????????? ???????????????????????????????? ???????????? ???????????????????????????????????? ???????????????????????? (????????????) ???????????????????????? ???????????????????????? ???????????????????????? ???????????????????? = 1 − ???????????? ???????????????????????????????????????? Outline Structure Net Sales - COGS Gross Profit A SG&A Expenses Total Operating Expenses B Operating Income C = A-B Other Expenses D Income Before Income Taxes E = C - D Tax to be Paid F = [E * Tax %] NOI G = E - F Statement of Cash Flow ???????????? ????????????ℎ ???????????????? ???????????????????????????????????????? +\− ????????????ℎ ???????????????? ???????????????????????????????????? ???????????????????????????????????????? +\− ????????????ℎ ???????????????? ???????????????????????????????????? ???????????????????????????????????? = ????ℎ???????????????? ???????? ????????????ℎ ???????????? ????ℎ???? ???????????????????????? Journal Entries and T Accounts ???????????????????????? = ???????????????????????????? ???????????????????????? ???????? ???????? ???????? ???????????????????? ???????????? ???????????????? ???????? ???????????????????????? ???????????????????????????????????????????? ???????? ???????? ???????? ???????????????????????? ???????????? ???????????????? ???????? ???????????????????? ▯ ????????????????????ℎ???????????????????? ???? ???????????????????????? ???????? ???????? ???????? ???????????????????????? ???????????? ???????????????? ???????? ???????????????????? ???????????????????????????????? ???????? ???????? ???????? ???????????????????? ???????????? ???????????????? ???????? ???????????????????????? ???????????????????????????????? ???????? ???????? ???????? ???????????????????????? ???????????? ???????????????? ???????? ???????????????????? Fixing Wrongfully Credited Revenue Entry For Advanced Payment First Figure out how much Revenue has actually been earned ???????????????????? ???????????? ????????????????ℎ ???????? ???????????????????????? ∗ ????????????????ℎ???? ???????????????????????????????? Then Figure out PLUG ???????????????????????????????????????? ???????????????????????????????? ???????????????????????? − ???????????????????????????? ???????????????????????? ????????????.???????????????????????????? = ???????????????? Updating Inventory If correctly done when Inventory is bought ????????????.???????????????????????????????????? + ???????????????????????????????? ????????????????ℎ???? − ???????????? ???????????????????????????????????? = ???????????????? If expense is debited when Inventory is bought First Calculate Total Supplies Expense: ???????????? ???????????????????????????????????? + ????????????????ℎ???????????????? − ????????????


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