FINAL EXAM STUDY GUIDE
• Property rights allow individuals to capture the benefits from their actions • Freedom to trade allows workers and companies to specialize
• Specialization creates economies of scale
• Each trade will be BOTH parties better off, or else trading would not occur • Economic goods are not limited to things with price (for example, job satisfaction and leisure)
• Societal collective welfare is maximized by free trade (which is based on self-interest, but encourages others to use knowledge and intelligence to provide maximum value to other members of society
• Maximizing production requires capital (which in turn allowed innovation, economies of scale, and specialization)
• Transaction costs are obstacles to trade (taxes, lack of information, rent controls, etc.) • Information asymmetry is when one party knows more than another. With high information asymmetry, no trade will take place.
• Primary purpose of financial accounting is to reduce information asymmetry between buyers and sellers in financial markets
• Financial accounting increases society’s welfare and is focused on providing information to help investors predict future cash flows
• Management, not the auditor, is responsible for the financial statements • The auditor provides an independent opinion on the “fairness” of the statements with regards to GAAP. Only CPAs are allowed to perform audits
• Revenue recognition is when revenues are recognized as goods or services are transferred, but no revenue is recognized unless the seller is entitled to receive it and it is probable that cash will be received
• Expense recognition/matching principle is after revenue has been recognized, any costs that are directly related to that revenue should be recognized as expenses rather than assets. If matching cannot occur, cost is expensed immediately.
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• All financial information affecting decisions is disclosed (explicitly required under IFRS) • “Face of the Financial Statements” means that notes are being excluded.
• Assets = Liabilities + Equity or Assets-Liabilities = Equity
• Income statement accounts are temporary
• Balance sheet accounts are permanent
• Unearned revenues are a type of deferral (prepayment).
• There is no journal entry during the period for accruals, only an adjusting entry at the end of the period
• The Income Statement reports the causes of the changes in net assets, except investments by owners and distributions to owners Don't forget about the age old question of me365
o Reporting four elements: revenues, expenses, gains, and losses
• The Statement of Comprehensive Income reports miscellaneous gains/losses that the FASB didn’t want on the income statement
o These gains/losses are called “Other Comprehensive Income (OCI)”
o Accumulated Other Comprehensive Income is a stockholder’s Equity account • The Balance Sheet presents the financial position of the company at one particular point in time
o Elements are assets, liabilities, and equity
• The Statements of Cash Flows is not prepared directly from account balances o Reports the causes of the change in cash
o Organized into operating activities, investing activities, and financing activities • The Statement of Stockholders Equity reports the causes of the changes in equity o Include investment by owners, distributions to owners, and comprehensive income
The Balance Sheet:
• Asses efficiency when combined with income statement numbers
• Asses liquidation value – amounts available to creditors if the company goes out of business
• Operating cycle is the period of time it takes to convert cash to goods/services and back to cash
• Current assets are expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer
• Cash equivalents also include commercial paper, money market funds, and U.S. Treasury Bills with maturities of 3 months or less.
• Investments are reported at market value (and classified as current or noncurrent depending on management’s intent).
• Property, plant and equipment is carried at depreciation historical cost. • Current liabilities are expected to be settled within one year, or the operating cycle, whichever is longer. We also discuss several other topics like psych 212
• Companies following IFRS often report noncurrent assets before current assets Disclosures:
• Summary of significant accounting policies is generally the first section and explains methods used to calculate amounts (FIFO, LIFO, etc.) and how items are defined • Noteworthy events and transactions is for information about major events such as mergers, related party transactions, illegal acts, and intentional and unintentional errors in prior years’ financial statements If you want to learn more check out define lazzi
• Management discussion and analysis (MD&A) precedes the financial report and provides info about views on past events and future expectations Don't forget about the age old question of stasis essay example
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Financial Statement Information:
• Horizontal analysis is the comparison across time while vertical analysis involves comparison of one item to another in a single financial statement
• Current ratio: current assets/current liabilities
• Acid-test: Quick assets/current liabilities
• Debt-to-equity ratio measures risk and leverage, the extent to which a large company is financed with debt instead of equity.
• Debtholders prefer low risk because their upside risk is limited; Stockholders prefer higher risk because their upside risk is unlimited.
• Times Interest earned ratio: income before interest and taxes/interest expense; measures the ability of the company to make its interest payments
Limitations of the Balance Sheet and Ratios:
• Amounts do not fully indicate the amounts investors would receive upon dissolution of the company
• Particular point in time; does not reflect past or future trends
• Caution when comparing the results of one company to another
• Many assets are not included in the balance sheet (human capital)
• Some liabilities may not be probable
• Accounts are subject to estimates which can be mistaken, intentionally or otherwise • Management has the ability to mislead investors by entering transactions that did not occur
• Ratios ignore absolutes and may not answer the question you want to answer • GAAP classified interest received, interest paid, and dividends received as operating activities, while dividends paid is a financing activity
• Under IFRS, interest and dividends received are investing, interest paid is financing. Profitability Analysis:
• Asset turnover is net sales/average assets
• Inventory turnover is cost of goods sold/average inventory
• Each ratio is the activity divided by the ratio’s namesake
• ROA is net income/average assets
The Income Statement:
• IFRS allows expenses to be classified either by function or natural description; SEC requires expenses to be classified by function
• Earnings quality refers to its ability to predict future earnings or cash flow. Transitory earnings are not likely to recur, while permanent earnings are.
• Accounting changes require significant disclosures.
• Voluntary changes in accounting principle are handled retrospectively. • Change in depreciation, amortization or depletion methods are handled prospectively, like changes in estimates
• OCI accounts are closed out to AOCI, a stockholder’s equity account
• Revenues are increases in net assets resulting the entity’s ongoing central operations and exclude transactions related to owners.
• Allocate the transaction price to each performance obligation
• Each performance obligation must be separated
• An obligation is, if separated, able to be used on its own or in combination with goods obtainable elsewhere and the good is not highly interrelated to others in the contract. • Prepayments are not obligations
• A quality-assurance warranty is not treated as a separable component of the sales contract and does not affect revenue
• An extended warranty is a separate obligation.
• An agent is a facilitator and a principle retains most of the risk with primary responsibility for delivery.
• If the payment is not based on a contract separable, the payments are deducted from the transaction price.
• Gift Cards are not revenue until used or if there is a near certainty that they will not be used.
• An ordinary annuity is one in which the payments happen at the end of each period. This means that the payment occurs on the last day of the year or time period, but never on the first day.
• An annuity due is one in which the payments are made at the begging of the time period rather than the end. In this case, the financial calculator used must be set to BGN or the answer you get will be incorrect. Remember to change it back when working an ordinary annuity problem.
• Regardless of what type of problem, the number of period (n) is ALWAYS the number of payments. It does not matter when they occur, it only matters how many payments have been made.
• Loans have a zero future value, so when solving, always look for the present value. All loans are this way except for bonds and those with a balloon payment.
• Inflows must have the opposite sign as outflows.
• N cannot be negative.
• Use a financial calculator like normal only if the four following circumstances apply: 1. The payments are the same amount
2. There is only one compounding period per payment date
3. There is an equal amount of time between each payment
4. There is no deferral of payments.
*When in doubt, calculate with Option A (shown directly below).
Deferred Annuity Calculation:
A) Calculate the future or present value of each payment and add them together. This is used if the payments are unequal.
B) Convert the annuity into a single sum of the annuity. Then take the present value or future value of the single sum. This is used in the case that all circumstances are applicable except for the annuity is deferred.
• Stockholders dislike companies to hold large amounts of cash because this indicates waste, as the money is generating little return. Large amounts of cash should be invested rather than sitting in a savings account.
• Short term debt holders like companies to hold large amounts of cash because they will be quickly able to pay off any debt at any given point, not taking much risk. • Liquidity is current assets/current liabilities. This measures the abilities for a company to pay for its short-term obligations. If the ratio is greater than 1, it means that the company has enough cash to pay off debts and continue operation.
• How much cash should a company hold depends on future estimated cash flows, the kind of business the company is, and what investment is expected. Companies ought to keep just enough cash to cover their interest, expenses, and capital expenditures. The Current Ratio and the Quick Ratio are used by investors to determine if the company can meet their cash requirement needs. High levels of cash on the balance sheet can indicate a bad thing; Why is the money not being put to use?
• Trade Receivables – result from the sale of goods or services, also called accounts receivables
• Sales Returns – a contra-Revenue account. The Allowance for Sales Returns is a contra asset. The journal entry for a sales return is as follows.
At year end:
Allowance for Sales Returns
Time of Return:
Allowance for Sales Return
• If accounts receivable is uncollectible, the journal entry is
Bad Debts Expense
Allowance for Uncollectible Accounts
Approaches for Bad Debts/Allowance for Doubtful Accounts:
• Income Statement Approach: Bad Debts Expense = Sales x Estimated percentage. Allowance of Doubtful Accounts can only be calculated after all other numbers have been determined.
• Balance Sheet Approach: Simply, Allowance for Uncollectible Accounts reported = part of Accounts Receivable that is estimated to be uncollectible, which is Accounts Receivable x estimated percentage. A better calculation would be different percentages for the different ages of Accounts Receivable.
• Regardless of the approach, Debit Allowance for Uncollectible Accounts and Credit Accounts Receivable for accounts that are uncollectable.
• If written-off accounts are then collected, simply Debit Accounts Receivable and Credit Allowance for Uncollectible Accounts. Then Debit Cash and Credit Accounts Receivable.
• Do not combine entries so that it can be easily understood what events occurred.
Direct write-off of Uncollectible Accounts:
• Debit Bad Debt Expense and Credit Accounts Receivable when specific accounts are written off.
• No entry is made at the end of the year.
• This is not allowed by GAAP.
• A shortcoming of doing so is that it overstates the balance in Accounts Receivable in the time before the write off, and it distorts net income by postponing recognition of any bad debt expense until the period that the failure to pay actually occurs.
• However, this method is required for income tax purposes for MOST companies.
• Interest expense equals the annual interest rate times the applicable fraction of the year. • Interest is accrued at year-end.
• On the first payment in the following year, Interest Payable is debited to eliminate that account, and Interest Expense is only recorded for that year's portion.
• Notes Receivable is debited for the face amounts and Discount on Notes Receivable is credited for the interest expense over the life of the loan.
• Interest Revenue is recorded by debiting Discount Notes Receivable
• Revenue is the present value of the note.
• Receivables Turnover: Sales/Average Net Receivables
• Collection Period: 365/Receivables Turnover. An increase in the collection period could be caused by more generous credit policies, customers not paying on time, and
manipulating Sales, Bad Debts Expense, Sales Returns, or Sales Discounts. A small percent manipulation in Sales results in a large percentage change in Accounts Receivable.
• An increase in collection period is concerning because they indicate possible low earnings quality and cation for projecting future sales.
• Generous credit policies will temporarily boost sales but is not sustainable in the long run.
• Reductions in the collection period usually indicates a good thing such as customers are better able to pay on time.
• However, reductions in the collection period can be skewed by selling A/R to a financial institution. This is costly and may indicate a dangerous short-term need for cash. • Accounts Receivable = Gross A/R – Allowance for Doubtful Accounts – Allowance for Sales Returns.
• Allowance for Doubtful Accounts and Allowance for Sales Returns are not always reported.
• Current earnings are, typically, most useful in predicting future cash flow. Changes in Accounts Receivable are the starting point for evaluating such.
• Corrected balances of bank and book must equal
+ Outstanding Deposits - Outstanding Checks +/- Bank Errors
+ Collections Made by Bank - Bank Charges
- NSF Checks
• Perpetual inventory system immediately removes cost from the inventory account as they are sold; records COGS in real time
• Periodic inventory systems waits until the end of the period to update the Inventory account
• Unless a company is small or has little inventory, there are more benefits to a perpetual system
• Often, companies have a perpetual system internally and a periodic system externally. • Expenditures included in inventory are direct costs necessary, such as unloading, shipping, etc. These can be recorded separately, but are part of inventory. • FIFO – first in, first out; periodic and perpetual systems always give the same answers under FIFO
• LIFO – last in, first out’ periodic LIFO can result in very different ending inventory and COGS.
• IFRS does not allow LIFO
• Companies can only use LIFO for tax purposes if they also use it for financial reporting; LIFO results in lower income and therefore lower taxes (typically).
• A LIFO reserve is the difference between ending Inventory under LIFO and FIFO, but is only required to be disclosed if LIFO is used.
• Although LIFO reduces taxes, due to income being higher under a LIFO liquidation, taxes are higher under LIFO. Pretax LIFO liquidation profit must be disclosed. • Gross Profit Ratio: Gross Profit/Net Sales. High ratio results from efficiency in getting inventory and charging highly for it.
• Inventory Turnover Ratio: COGS/Average Inventory. Fewer days in inventory indicates success at minimizing unnecessary inventory.
• When ending inventory is overstated (understated), COGS will be understated (overstated). When beginning inventory is overstated (understated), COGS will be overstated (understated).
Basics of PPE:
• Property, Plant, and Equipment and Intangibles indicate important business information. • Provides approximate net realizable value
• If compared earnings to the cost, investors evaluate success and ability of management. • Comparing accumulated depreciation to cost tells investors the age of all PPE, therefore providing information as to when it will need replaced and future cash outflows. • To be useful, investors need to know what is and is not included in these assets and how the depreciation/amortization expenses and gains/losses are calculated.
Types of Assets:
• Property, Plant, and Equipment (PPE)
• Natural Resources
Capitalize vs expense:
• Cost includes everything necessary to get the asset ready for its intended use, including condition and location.
• All costs must be either capitalized or expensed
• Capitalized - include them in an asset account
• Expensed - include them in an expense account
• Capitalized cost of equipment always included the purchase price, shipping, insurance, and installation.
• Training costs are rarely capitalized.
• Cost of land includes title insurance, commissions, delinquent property taxes, costs of removing structures, clearing trees, etc.
• Property taxes incurred after purchase are expensed.
• Land improvements need to be depreciated and should be recorded separately from land (i.e. drainage system)
• Cost of natural resources includes acquisition, exploration, development, and restoration. • Equipment can be included if it as no other use.
• Asset retirement obligations (ARO) are legal obligations associated with the retirement on long-lived assets.
• ARO is capitalized at fair value
• Accretion expense is similar to interest expense; it is the increase in the PV of the ARO caused of the passage of time.
• Neither physical nor financial
• Include exclusive legal rights (trademarks, song lyrics)
• Contractual rights with specific parties (franchise agreements, non-compete employment agreements)
• Purchased intangibles are capitalized, but the costs of many internally developed intangibles are expensed.
• When companies are purchased, the price exceeds the fair value of identifiable assets • Unidentifiable assets include customer loyalty and human capital of employees • Goodwill is a proxy for the value of the unidentifiable assets
• The journal entry to purchase a company is as follows:
Identifiable assets at fair value
Lump Sum Purchases:
• The price must be allocated to each asset in proportion to their estimated fair values
• If a liability is incurred in the acquisition of an asset, the liability is recorded and capitalized at fair value
• Fair value is present value, not necessarily the face amount, of the liability
Issuance of equity securities:
• Capitalize at its estimated fair value or the estimated value of the asset, whichever is more reliable
• Most commonly, corporations receive donations because a local government provides resources in an attempt to entice businesses to relocate or open a new facility • However, it is unusual for a for-profit corporation to receive donations • If there is a difference between the fair value of the asset received and the cost paid, the difference is almost certainly caused by discounts, sales, etc. or unreliable estimates of fair values
• Never assume the transaction involves a donation; Must verify intent
Fixed Asset Turnover Ratio: Net Sales/Average Fixed Assets
Dispositions and Exchanges
• Debit Cash and Accumulated Depreciation and Credit the diposed asset • Then Debit a loss or Credit a Gain to make the debits equal the credits. • If PPE is held for resale, it will be reported at the lower of book value or net disposal price
• Acquired asset is recorded at its estimated fair value or the estimated fair value of what is paid, whichever is more reliable
• Keep in mind that the value received must equal the value paid
• The loss/gain will equal the fair value minus the book value, regardless of any cash exchange
No gain is allowed unless the exchange affects anticipated future cash flows, to preclude managers from making exchanges only to recognize a gain.
Self Constructed Assets in Research and Development:
• Both direct and indirect overhead costs are capitalized
• If money is borrowed to self-construct an asset, interest should be capitalized instead of expensed.
• Disclosures include interest cost capitalized and total interest incurred • Research and Development ends when production activities start
Determining R&D costs:
• Internal operating R&D costs are generally expensed when incurred
• Capital assets used in R&D activities are capitalized when purchased and depreciated over the time period they are used in R&D activity (not the time period in which the company benefits from products developed from the R&D)
• Direct costs of a patent are capitalized (such as legal feeds, patent filing fees) • Expenses for R&D must be disclosed.
• Costs paid to others in connection with internally developed projects are expensed • Start-up costs include the cost of opening new stores, introducing new products, and organizing a new entity and are expensed
• Development Costs that are incurred prior to technological feasibility are expensed and subsequent costs are capitalized.
• Technological feasibility is reached “when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements”
• Capitalized software development costs are amortized to expense using the larger of the percentage-of-revenue method or the straight-line method, either of which is allowed by IFRS
• When a business is acquired, part of the purchase price is allocated to the in-process R&D. Unlike internally developed R&D, in-process R&D is capitalized.
• IFRS requires “research” costs to be expensed but “development” costs to be capitalized. An R&D cost is “development” if the product or process is technically and commercially feasible, and the future economic benefits are probable
Summary of R&D and Software
Research salaries, supplies, etc.
Service fees paid for internal R&D projects
Development salaries, supplies, etc.
Patent legal costs and filing fees
R&D long-term costs and filing fees
R&D depreciation on long-term purchases
R&D performed for others
Purchased R&D – compete projects
Software – before technical/commercial feasibility
Software – after technical/commercial feasibility
Software Costs incurred after product is released
An example of an “unsuccessful effort” is the drilling of an oil well that turns out to have no oil. • The Full Cost method capitalizes the exploration costs of both successful and unsuccessful efforts.
• The Successful Efforts method capitalizes only the exploration costs of successful efforts; unsuccessful efforts are expensed.
Depreciation, Depletion and Amortization:
• Costs are allocated to expense each period based on the degree to which they help generate revenues.
• Depreciated cost has the advantages of verifiability and less subject to manipulation the factors they are based on are subject to far less uncertainty than fair value.
• Useful service life of PPE is usually less than its physical life because of obsolescence and increased competition for the product produced.
• Companies are allowed to write PPE up or down to fair value. When asset is revalued, the entire class of PPE must be revalued.
• Biological assets are carried at fair value less estimated cost to sell.
• Assets are only tested for impairment if events or changes in circumstances indicated that the book value may not be recoverable.
• 1) If the undiscounted future cash flows are great than book value, no impairment loss is recorded so step 2 is unnecessary.
• 2) The impairment loss equals the excess of book value over fair value. Subsequent Expenditures:
• Costs are capitalized if they extend the useful life of an assets, increase operational efficiency, or increase the quality of products or services.
• Repairs and maintenance are expensed because they do not extend the life of the asset • Additions are capitalized.
• Improvements are capitalized.
• Rearrangements are capitalized only if they increase operational efficiency. • Costs of defending intangible rights should be capitalized if the litigation was successful. IFRS – all litigations costs are expensed.
• The principal at the date of the investments is the amount paid; Premium or discount is the difference between the maturity value and the principal; Nominal (stated) interest rate determines the cash received per period.
• The 3 classifications of debt securities are Hold to Maturity, Trading Securities, and Available for Sale Investments
• Hold to Maturity:
o Only realized gains are reported, unrealized gains/losses are not recognized. o Investment is held at amortized cost
o Market value is disclosed
• Trading Securities:
o FV adjustment account is a valuation account – used to adjust the amortized cost of the investment to fair value.
• Available for Sale:
o Handed similar to trading securities except unrealized holding gains are OCI o Cash flows from buys and selling are classified as Investing Activities • Companies are allowed to account for any investment similar to trading securities • Note disclosures required for TS are aggregate fair value and unrealized ains and losses • Note disclosures required for HTM and AFS include information about total fair value, gross gains/losses, changes in gains/losses; Account types are cross-classified by levels. o Level 1 – quote prices for identical trades
o Level 2 – estimates from observable inputs (market prices)
o Level 3 – derived from unobservable inputs
▪ Disclosure is required for transfers in and out of the category and well as sensitivity of FV to changes in inputs
• Accounting for equity investments is different depending on the level of control • Control manifests with greater than 50% ownership
• FVNI securities are presented separately from trading securities
• When the investor has control of the investee, two companies are considered to be a single entity
• Significant influence is usually present when the ownership is between 20-50% generally. • Initial investment is recorded at cost