Terms of Accounting

Accounting

the recording of business transactions and the preparation of reports summarizing these transactions
Financial Accounting
refers specifically to the records and related reports that are available to be read by people outside of the company
3 types of business transactions
1. Financing 2. Operating 3. Investing
Financing activity
Those transactions that raise funds for the company to operate
Investing Activity
The transactions in which the company is investing in assets that it will keep in the business to use in its operations
Operating Activity
All of the other transactions that a business engages in which cannot specifically be classified as financing or investing
Two basic ways a company can raise money to help finance its operations:
1. Equity 2. Debt
What does equity refer to? Who buys it?
Ownership, stockholders
The 2 rights buying stock entitles the stockholder to:
1. To vote for the “directors” of the company. All the directors together form the corporation’s “board of directors”. The job of the directors is to represent the stockholders’ interest to management and protect the stockholders’ investment
2. To receive dividends from the company when dividends are paid
Two ways an equity investor can make money on his or her investment:
1. Receiving dividends
2. By selling their stock at some time in the future when the stock price has increased
To what does debt refer in financing activities?
This refers to borrowing money from investors or banks
Who loans a company money?
Creditors
What is a maturity date?
The date by which the loan is to be repaid
Collateral
Refers to the assets that are pledged by the borrower to the creditor if the borrower is not able to repay the loan
Default
The term for the company being unable to repay its loans
Fixed Assets
Land, buildings, and equipment to help them operate the business
What makes an asset fixed?
(1) likely to last a number of years and (2) expected to be used in the operations of the business rather than sold as part of the company’s general operations (generally 2+ years)
Operating Activities
Any transactions that are related to running the business and marketing the company’s product
Examples of Operating Activities
Salaries and wages, rent, utilities, insurance, and purchases of goods to be resold
SEC
Securities and Exchange Commission: The basic purpose of the SEC is to maintain fair and truthful capital markets. The SEC’s coverage only extends to “publicly-held corporations"
Publicly-Held
A corporation is “publicly-held” if its stock is traded on an exchange, such as the New York Stock Exchange or NASDAQ
What reports does the SEC require of companies?
Form 10K: annually (audited financial report)
Form 10Q: quarterly (unaudited financial reports covering the most current quarter)
Annual Report: must be audited by an outside, independent auditor. These annual reports are mailed to stockholders and are available on the company’s website
4 Required parts of every annual report:
(1) balance sheet, (2) income statement, (3) statement of stockholders’ equity (or statement of
retained earnings), and (4) statement of cash flows
Typically includes a letter from the president of the company discussing management’s performance to date and what the company hopes to accomplish in the future
Footnotes
Give additional information supporting the data in the financial statements
Cover sheet
A letter from the company’s independent auditors which states the auditor’s opinion as to whether or not the auditors have found the financial statements to have been prepared in accordance with the required accounting standards
Independent auditor
An accounting firm that specializes in “public accounting”. Public accounting means the company is in business to provide accounting services to other companies.
They audit the 10K and annual report of the companies
What classifies an auditor as independent?
(1) do not work for the company they are auditing and (2) do not own a substantial investment in this company
The Big Four
the largest of all the public accounting firms. They are international and are responsible for much of the public accounting work done in the world.
Deloitte
Ernst and Young
Price water house Coopers (pwc)
KPMG
Corporate Governance
The mechanisms which encourage managers in a business to report the truth in their financial statements
3 ways corporate governance is encouraged
1. The reputation of the managers and of the business
2. The threat of legal liability
3. "Ethics”, meaning that running the business and reporting the results of operations in a clear, truthful manner is the right thing to do
What set of rules are publicly-held companies required to follow in the US?
Generally Accepted Accounting Principles”, or “GAAP
What type of system is GAAP considered?
A Rules-Based system
-Tries to give specific directions for how to account for all types of transactions
Who is responsible for organizing GAAP?
"Financial Accounting Standards Board” (“FASB”)- private institution
What set of rules do foreign countries use in accounting?
”International Financial Reporting Standards” (“IFRS”). These are the responsibility of an organization called the “International Accounting Standards Board” (“IASB”).
What type of system is the IFRS considered?
Principles-based
-Gives substantially less guidance and relies on interpretation to be handled on an individual basis by the preparers of the statements and their external auditors
Norwalk Agreement
The FASB and IASB have been working hard to develop standards to merge GAAP and IFRS while keeping the best of both
Reporting Entities
Those organizations that prepare financial statements. One type of reporting entity is a profit-seeking business (also called “company” or “firm”). charitable organizations and foundations
governmental entities, such as cities, states, and school districts
3 common types of businesses (profit-seeking)
1. Retail
2. Service
3. Manufacturing
Capital Markets
The networks that exist for raising money. Many types of markets, including public markets (called “exchanges”), exist to facilitate the transfer of debt and equity investments
Largest= NYSE
Two groups which are in a position to oversee management
The board of directors and the audit committee
Board of Directors
Elected by stockholders
-Determine company policies, decide if dividends should be paid, and review the performance of the company’s officers as well as determine their compensation
Audit Committee
A subcommittee of the board of directors. This committee’s main responsibility is to select the audit firm that will perform the annual audit and to make sure that the audit was performed in a professional manner
Where would disagreement between an audit committee/company management and an audit firm be reported?
In a Form 8K
Sarbanes-Oxley Act
An act that was passed in 2002 in response to several corporate scandals which resulted in billions of dollars in losses to stockholders and debt holders
What did the Sarbanes-Oxley Act establish?
(1) more controls on management, (2) more responsibility on the Audit Committee and the Board of Directors, and (3) stricter requirements for the external auditors
The Act placed more emphasis on the quality of the company’s “internal controls”.
Internal controls of a company
The procedures and policies in place which have the purpose of protecting the company’s assets and helping to ensure the financial statements are correct
Tone at the top
The term for the ethical tone set by top management
What financial statement is the backbone of accounting?
The Balance Sheet
The basic Balance Sheet Equation
Assets= Liabilities + Stockholder's Equity
Assets, Liabilities, Equity
Assets= What a business owns
Liabilities= What the business owes
Equity= a representation of the owners’ interest in the asset
Alternative Balance Sheet equation
Assets – Liabilities = Equity
Double-Entry bookkeeping
There are always at least two entries for each transaction of a business
4 types of assets
1. Current- cash and assets that are expected to be converted into cash (or used up) in about one year or less from the Balance Sheet date
2. Investment- assets purchased by the company to be held as an investment
stock investments, bond investments, and land held for resale
3. Fixed-( Property, Plant, and Equipment”) are assets that are purchased by the business to be used in its operations but that are not expected to be used up quickly and are not to be resold in the ordinary operations of the business
4. Intangibles- no physical substance
patents, copyrights, trademarks, and goodwill
2 types of Liabilities
Current- Paid within a year
Long-term- Not paid within a year
Equity
Measure of the portion of a company’s assets that are owned outright, meaning that the company does not owe for this portion of its assets
2 categories of stockholder's Equity
Common stock and retained earnings
Common stock
The amount of money received when the company originally sells shares of ownership to various investors is the amount shown in the common stock account
Retained Earnings
The total profits of the company (minus any losses) and minus any amounts that have been paid to stockholders over the lifetime of the company
2 unique aspects of the Balance Sheet

1. The Balance Sheet is a picture at a point in time. Because of this, it is called a “snapshot” of the business.
2. The ending balances reported on one Balance Sheet roll over to become the beginning balances for the next period
Liquidity of Assets
A measure of how fast it is expected to be converted into cash
Income statement basic formula
Revenues-Expenses= Net income
Revenues
Amounts the company earns by doing what it is in business to do. Recorded on the Income statement regardless if cash was received or not
Invoice
A listing of the all charges the purchaser made during the period and the total amount now due to the seller
Expenses
Amounts that were used up during the period in order to generate the revenue
-Cost of products sold, payroll, insurance, taxes, utilities, rent, and supplies
When are expenses to be recorded on the income statement?
When an expense is incurred- used up (not necessarily when cash is paid for the expense
Accrual Accounting method
Used by GAAP and IFRS- attempts to show revenue in the period it was earned
Matching
Expenses are shown as deductions from the associated revenue
Two concepts that make the Balance Sheet and Income Statement differ from one another
1. the Income Statement always covers a period of time
2. The numbers on the Income Statement are eliminated, and the starting figures on the Income Statement for the next period are zero
Retained Earnings
The total of the all of the net incomes earned by the company over all the years it has been in business (minus any net losses) and minus any amounts paid out in dividends over all the company’s years of operations
Statement of Retained Earnings formula
Beginning retained earnings
+Net income (or minus net loss)
-Dividends
=Ending retained earnings
The correct order of Financial statement
Always prepare the Income Statement first, then the Statement of Retained Earnings, and then the ending Balance Sheet
Statement of Cash Flows
In preparing this Statement, look only for those transactions that had an impact on cash
-A reconciliation that takes the reader from the beginning cash to the ending cash by adding in cash receipts and subtracting out cash payments made during the period
Statement of Cash Flows formula
Cash, beginning of period
+/- Operating cash flows
+/- Financing cash flows
+/- Investing cash flows =
Cash, end of period
Note Payable
An amount of money borrowed from usually a bank (loan) that goes into the long-term liabilities as well as increasing cash
Prepaid Expenses
Rent and Insurance
-Become an expense in the income statement when used up
When equipment is purchased, management must estimate the asset's...
(1) expected useful life and (2) the value of the asset at the end of its useful life
Salvage Value
Value at the end of its useful life
Straight-Line depreciation
We subtract the salvage value from the purchase price (which leaves us with an amount called the “amount to be depreciated”) and divide this remainder evenly over the period of time we expect to be using the asset
Fully Depreciated
Accumulated depreciation equals the depreciable amount of the asset, or until the asset is sold
Only fixed asset that never depreciates
Land
Analysis Over time
Looking over prior year's financial statements to see how a company has progressed over time
Analysis Within the Industry
Looking at the financial statements of companies in the same industry to see how they handle some of the same obstacles
Common-Size Financial Statements
Makes the total Asset amount equal to 100% and divides the different assets to see what percentage of a company they are. Income statement, total revenue is set to 100%
Debt-to-Equity ratio
Average total liabilities/Average Stockholder's Equity
Leverage
The finance term for the extent a company uses debt
Commonly used average Debt-to-equity ratio formula
(Beginning total liabilities + ending total liabilities)/2 /
(Beginning stockholders’ equity + ending stockholders equity)/2
Return on Equity Ratio
A measure of how efficiently the company is using its equity
- Net income/
Average stockholders’ equity
-This is a profitability ratio
-Net income/
(Beginning stockholders’ equity + ending stockholders’ equity)/2
Current Ratio
A commonly-used estimate of the company’s ability to pay its debts
- Current assets/
Current liabilities
Inventory Turnover ratio
A measure of how fast the company moves its inventory through the company (asset turnover ratio)

Cost of goods sold/ Average inventory
General Rule for Inventory turnover ratio
a company which has a gross profit of 20% to 30% should try to achieve an inventory turnover ratio of 5 to 7 times per year
Earnings Per Share ratio
Net income/
Average number of shares outstanding
-or Net income
(Beginning number of shares outstanding + ending number of shares outstanding)/2
-it is a return on each share of stock outstanding. In addition, it is easy to compare companies in different industries and of different sizes by using this one ratio.
What is the 1 ratio that is required to be on Financial statements
EPS
-On the Income Statement directly below Net Income
-It is usually seen as the most important of all ratios because it is often an important component in determining the value of a share of stock