Accounting

Accounting is the study of the measurement and reporting of a financial institution.

Financial Statements

Financial reports are a big part of accounting. They should be easy to understand, comparable, timeliness, objective, and full disclosed. Investors/shareholders, creditors (banks), government agencies (SEC), management, and financial analysts all use this report. They typically have 3 sections: 1) Balance Sheet 2) Income Statement 3) Statement of Cash Flow

Income Statement

Income Statement shows a company’s operation over time; what happened over a period of time. Usually, it is done yearly. It highlights how it incurs revenue and expenses. Shows net profit across a given time period.

It basically highlights: $RevenuesEarned - ExpensesIncurred = NetIncome / Profit / Earnings$.

EPS is Earnings per Share. It’s the net income / number of shares.

Diluted Earnings Per Share is the net income / total possible shares. Total possible shares include outstanding plus potential.

It includes: marketing expenses, cost of goods sold, depreciation expense, bad debt expense. Note that dividends are not included as an expense.

The Cost Principal assets are evaluated at their historic costs.

*Income statement has all the *expenses **

Income statement has to be done before the balance sheet.

Statement of Cash Flows

State of Cash flows looks at how a company receives and uses cash during a given time period. There are three main sections: Operating, investing, and financing.

Cash outflow is any money leaving the business. It would capture things like dividends, taxes, interest payments, and salaries. But it would not include depreciation (not cash movement).

Balance Sheet

The Balance Sheet measures financial position at a point in time. A snapshot of the companies finances in a given moment. What it owns, what it owes. Assets, liabilities, and Owner’s Equity. It shows the claims owners have against the assets of the firm. It does not provide a representation of the current market value for the company.

The balance sheet is a point value. Balance requires a point to stand on.

Accounting Equation: $Assets=Liabilities+OwnersEquity$. It must balance!

Assets

Assets are the resources or rights of resources of the company. They can be physical, like buildings, cash, equipment. They could be intangible like trademarks, patents, and copyrights. They could even be legals rights, like legal rights to a payment. Usually these are sorted on the balance sheet by liquidity. The more liquid (closer to cash) something is, the closer to the top it is.

Assets could be worth:

  • What you paid for them
  • What you could sell it for now
  • The cost to replace one
  • Accounted for inflation

But generally speaking, on the balance sheet, its accepted to be objective and just take the historical asset cost of what you paid for it.

Current assets are assets that are expected to be converted to cash within a year. They include cash, marketable securities, prepaid assets, and accounts receivable.

Marketable Securities can be converted to cash quickly. Instead of just having cash sitting stagnant, these are low risk trades to make some money.

Cash

Cash is anything the bank will accept for deposit: checks, money orders, bank credit card slips.

Credit Card slips are basically receipts from companies like American Express, VISA, ect that say they are good for this amount. If you as a company have your own card, say Khols, you are responsible for collecting that money and cannot take it to the bank.

Cash Equivalents are investments the company made that are due within 3 months. These are so close to being cash that they are considered cash.

Accounts Receivable

Accounts receivable are compensation that is owed to the company by someone else.

What to do about bad debts? Some debts don’t get collected. Make a bad debt expense, does the same thing as reducing net sales, but recorded this way. Bad debts are often calculated by the product sum of Amount Receivable multiplied by the % uncollectible, subtract the existing balance. Bad Debt Expense = Ending Allowance - Existing Allowance

Direct method doesn’t follow the matching principal.

Allowance methods tries to account for Estimated Losses. You can use a Allowance For Bad Debts as a “Contra-asset” account. Bad debt expenses are on the income statement and hence don’t carry over till next year. The allowance amount is on the balance sheet and hence carries from year to year. Percentage of Receivables Method is the new balance for bad debts - previous allowance for bad debts.

Contra basically just means “subtracted from”

Notes Receivable

Formal contracts signed when a customer buys merchandise or services on credit. They’re usually for bigger items. They have interest, due dates, interest dates. Principal is how much was borrowed. Interest Rate is the cost of borrowing the money. Maturity Value is principal plus interest. If you need your money sooner, you can sell their debt to someone else.

Inventory

Goods for resale. It is a current asset.

Goods in transit: What if shipping happens during the account date? Turns out, its what ever company is paying for shipping or who owns it until the delivery date.

Goods on consignment: If you don’t sell these goods, you can return them. If you do, you can keep some of the profit. Maybe you have like a soap company and Kroger. The soap company gives Kroger 100 soaps to sell. Who owns the inventory? And who writes it on their balance sheet? It will actually be the vendor because they still own the title.

Costs of Goods Sold (CGS): Beginning Inventory + Net Purchases - Ending Inventory = Costs of Goods Sold. Categorized as an expense.

Gross Margin is Sales - Cost of Goods Sold. This is split in gross* vs **net.

Sales are revenue.

Discounts and Returns are contra-revenue.

Perpetual Inventory System: Records are updated automatically when a purchase or sale is made.

Periodic Inventory System: Records are not updated when there is a purchase or sale. Once a year, you have to keep track of everything you have.

Sometimes your raw materials price fluctuates. Sometimes you’re unable what you paid for when (think box of cheeros), sometimes you can like a specific car. When you can, that is called Specific Identification. You can just take an average of the different prices and have it be representative.

Income statement? LIFO (last in first out) is the best way to go. But prices keep going up usually so LIFO is hard because it keeps going up. Unless you’re trying to cover for taxes, then you should use LIFO so that your profit is lower and you pay less taxes. It is most up to date! Balance sheet? FIFO (first in first out) says you get rid of the old stuff first. But now there is a law you have to choose LIFO tax reporting, you must also for income reporting.

Inventories are reported at the lower of: cost amount or net realizable value (NRV). It pretty much says inventory is reported at less than cost when the future value is questionable (damage, used, obsolete).

Prepaid Expenses & Investments

Even if you prepay all your rent for the year, the price would be distributed across the months.

Short term investments in stocks or bond. For marketable securities we have a big exception. It is called Mark to Market Rule. Investments in stocks are reported at the current value, not what you bought them at.

Long term investments depends on how much the company has. If it has ownership over 50% then you’d have consolidated financial statements. If you own 20%-50% you must use the Equity Method. You see dividends as the company is doing well, not at quarterly times.

Property, Plant & Equipment

Fixed Assets (tangible): Land, buildings, equipment, and natural resources. Not only is it the individual items, but any costs incurred to get it there, start up fees, testing fees. Even the interest counts, if you are building the assets over time.

Ordinary Expenditures occur when the asset will only benefit them for that period. Think of repairs or maintenance. This is expensed on the income statement.

Capitalized Expenditures benefit the company over several periods not just one, and they’re on the balance sheet. This is preferred because you can pay over time. In order to categorize as this as capitalized, you have to increase capacity or production.

Intangible Assets: like patents and copy rights and stuff. No physical substance, but can be really key. If you have a definite life, you have amortization which is same as depreciation, just said differently. A patent lasts 20 years, copyright has 50 years after the author’s demise. If they have an indefinite life, they do not depreciate, instead, they’re tested for impairment every year. Compare book value of the asset against estimate of future cash flows.

Goodwill is when a company buys another business unit (company or division of company). This occurs when the purchase price is greater than the fair market value. You buy both the assets and liabilities. It is tested for impairment yearly. It is a long term asset.

Depreciation

Estimate of useful (intended) life. Estimate of salvage (residual, scrap) value.

Depreciation, depletion, amortization: all the same thing. Depreciation methods all have the same way but differently ditributed.

Straight Line is when the cost decreases equally over the assets useful life. Most companies use this.

Units of Output the more you use it, the more it goes down.

Accelerated Appreciation which has sum of the years digits and double decline balance. More in the initial years, less in the later years. This is because it’s hard to get things up and started.

Disposal of assets which is trading in, selling, or losing due to accident. Assets disposal is either a gain or loss. Natural resources have depletion expenses.

Accumulated Depreciation is a long term contra asset.

Liabilities

Liabilities are obligations owned to creditors. They can be money, or even goods and services. Includes: deferred revenue, accounts payable, wages payable, dividends payable. Does not include depreciation.

Looks for the word “payable” to give off a clue of a liability

Current Liabilities are liabilities that are expected to be due within one year. They include: Accounts Payable, Wages Payable, Taxes Payable, Accrued Interest,Unearned Revenues. Accrued and Unearned and Payable are interchangeable.

Contingent Liabilities are potential liabilities that may occur.

Deferred Revenue refers to payment a business gets ahead of doing the work.

Accounts Payable refers to money a business owns to others.

There is probable liabilities where it can be reasonably estimated. These are recorded in the balance sheet. They mostly include warranty claims. You have to keep in mind the matching principle so that if you have a dishwasher bought in 2018 with 2 year warrenty, on your statements, you’re going to estimate a warranty loss two years out, today.

Reasonably Possible is less than probable and just needs to be mentioned, not quantified.

Remote is less than reasonably and does not need to be disclosed at all.

Longterm Liabilities are not due within 1 year. These include: notes payable, mortgages payable, lease obligations, deferred taxes, bonds payable, and pension obligations. These are valued at their current worth.

Lease Obligations: There is operating lease and capital lease. An operating lease is just a short term rental agreement. Capital lease is where an asset and liability will be on the balance sheet. If the lease is more than one year, it must be capitlized.

Deferred taxes are the difference between taxable income on the income sheet and taxable income for the IRS from a timing perspective. Permanent Differences are where things might be treated differently by the IRS vs analysts.

Bonds Payable instead of going to the bank for lending, companies can borrow from the general public. There is usually interest. The face value is what the bond is worth. Sometimes there is discounts on the initial purchase of the face value.

Carrying value is the face - discount.

Bonds vs Stocks? Must repay bonds, must pay interest, no dilution of interest.

Discounts on Bonds Payable are contra liabilities (in the long term). These are when bonds are issued for less than their face value. This happens because the bond interest rate is lower than market interest rates.

Contra liabilities are accounts that’re debited for the explicit purpose of offsetting a credit to another liability account. Reduction to a liability.

Premium on Bonds Payable is a long term liability.

Capital Stock: Authorized Shares can be sold and they are owned by others (outstanding) or in the treasury (owned by company). Preferred Stock gets dividends before common dividends. Also has to deal with liquidation and bankruptcy. Common Stock has main voting rights, sometimes there are different classes that have different values. Often they are called class A or class B. Par Value printed on the face of a stock; tries to protect creditors. Can’t issue stock below par value. Lower par value means more flexibility. Treasury stock is not seen as an asset. Buying back stocks can be done to give to execs or to prop up the company’s values a bit.

Treasury Stock or reacquired stock, is previous outstanding stock that is bought back by the company. It is a contra eqquity account because it will increase EPS.

Contra Equity subtraction in the equity section.

Cash Dividends: Date of payment, date of record, and date of declaration are important to keep track of. Current dividend is where the preferred stockholder gets a % of holders. Common stockholders get the remaining. Cumulative Dividend Preference is where preferred shareholders get the dividend, plus missed dividends from previous quarters. Common stockholders get the remaining.

When giving dividends, it is preferred first. They get paid Last year’s arrears (scheduled - paid) plus this years based off of how many shares there are, what the par value is and the percentage.

Cumulative Preffered Dividends are less risky because you’ll always get the dividend eventually.

Anything above a certain amount goes to the common share holders.

Stock Dividends are dividends that are paid in stocks. They might not have cash, they may want to give people shares.

Stock splits increase the number of shares, prices get lower, but values stay constant. They want to make it more affordable for everyone to buy. Reverse stock splits increases the price and makes less shares. Once again, the total value is constant. Certain stock exchangers have minimum values for a listing. Some hedge funds have rules on how much a stock minimum can be.

The board votes

Owner’s Equity

This represents the residual interest of owners to the assets. If you rearrange the equation, it’s the assets subtracted by the liabilities. This becomes retained earnings.

Audits occurs to ensure whether the financial statements are in conformity with generally accepted accounting principles, GAAP. They’re concerned with if the numbers provided are given fairly. They say it is unqualified (clean and acceptable), modified (auditor takes exception to something), or adverse (statement is not fair).

The date on a balance sheet shows the financial position on the firm for that date. Remember, balance sheet is a snapshot, not a period.

Stockholder’s Equity

Treasury + Retained Earnings + Common Stock makes stockholder’s earnings.

Revenues

Revenues: Value received for goods sold or services provided

See the word revenue? Goes on income statement!

Expenses:

Expenses: Payment or obligations for goods or services rendered.

Expenses go on the Income Statement.

Cash Accounting only accounts for when cash exchanges hands.

Accrual Accounting accounts of everything (including the trading of services or goods). An accrual basis also means revenues are recognized when earned rather than when the cash is collected.

You have an interesting problem when goods are bought in 4Q 2019, but sold in 1Q 2020. The Matching Principle says both the cost and the revenue should go together in Q1 2020. Matching means expenses and revenues go in the same year. When we make a purchase for assets, don’t record them as assets right away but over the long period of time we use the assets.

Currents assets are anything that can turn to cash within the year. They include: cash, marketable securities, accounts receivable, pre-paid expenses.

Reseach and Development

Although R&D can help in the right now and the future, R&D expenses are not capitalized, they are expensed. There’s a lot of uncertainty if R&D will give any benefits in the future, hence expensed when incurred.

There is a special exception of software development once the technology has been proven viable. It can be capitalized. Technology Feasibility must be reached which is the point that the software will work. Before that, it is expensed.

Ratio Analysis

Ratio Metrics are used to identify a company’s strengths and weaknesses. They are also used to forecast future performance.

The only mandatory ratio is Earnings Per Share

Liquidity

Liquidity ratios help analyze a company’s ability to meet its short term obligations.

Current Ratio: Current Assets to Current Liabilities $=\frac{Current Assets}{Current Liabilities}$. A Current Ratio of greater than 1 is desired, because you’d like to have more assets than liabilities.

Quick Ratio (Acid Test): A more specific version of the Current Ratio. The denominator of Current Liabilities stays the same, but instead of the entire Current Assets, only a portion of current assets that can be cashed in quickly, namely: Cash, Marketable Securities, and Receivables are used. It does not include inventories because it is the least liquid. A higher Quick Ratio is desired.

Capital Adequacy (Financial Leverage)

Debt Ratio: Represents Total Liabilities compared to Total Assets. You don’t want this close to 0 because that means a company isn’t spending, but too close to 1 and you’ll have a lot of liabilities. A value closer to 50% is more desired. Total Liabilities to Total Assets.

Interest Coverage Ratio: Evaluates company’s ability to reach its interest obligations. It is Earnings Before Interest and Taxes over Interest Expense. We’d like this value to be well over 1.

Asset Quality (Asset Management)

Inventory Turnover Ratio: Cost of Goods Sold over Average Inventory. It’s how much you spent that year divided by (Final Inventory - Initial Inventory)/2. The higher, the better. It measure how quickly inventory is moving.

Asset Turnover Ratio: Tries to measure how efficiently a companies assets are being used to generate sales. It is Sales over Average Total Assets. The higher this ratio, the better.

Earnings (Profitability)

Profit Margin: Comparison of Net Income to Sales. The higher, the better. Helps you evaluated profit across different sizes of companies.

Return on Assets Ratio: Once again used to compare companies of different sizes. It compares Net Income to Average Total Assets. Evaluates efficiency of assets to income.

Net Income: Net income is the revenues that remain after all expenses are paid. Dividends are never included. Dividends are not an expense!!!

Earnings Before Interest and Tax is net income but before taxes and interest.

Random

Forming a business is to legally separate its owners from a corporation

Industries

1) Financial

  • Focuses on: Day’s Receivables, Leverage, Asset Turnover

2) Retail

  • Focuses on: Return on Sales, Gross Margin Ratio, Asset Turnover

3) High Technology

  • Focuses on: Return on Sales, Day’s Inventory, PP&E as % of Assets

4) Service

  • Focuses on: Receivables, Inventories, PP&E as % of Assets

5) Capital Intensive

  • Focuses on: Day’s Inventory, PP&E as a % of Assets, Debt to Total Assets

PPE = property plant and equipment

Debt to Equity is Total Debt / Total Equity

Profit Margin is Net Income / Net Sales