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3 Intro To Financial Accounting PDF
3 Intro To Financial Accounting PDF
Financial Accounting
Pre-Class Material
www.ibtraining.com
Table of Contents
I. Introduction to Accounting
V. Advanced Topics
2
Introduction
What is accounting?
Accounting is the language of business
Three main types of accounting
Financial accounting How financial information of a business is recorded
and classified (i.e. financial statements of public companies)
Managerial accounting Typically used within an organization by
management for planning and decision making
Tax accounting Branch of accounting used to comply with jurisdictional
tax regulations
In this class will be concerned exclusively with financial accounting
All developed countries have standards of financial accounting or
Generally Accepted Accounting Principles (GAAP)
GAAP includes the standards, conventions and rules that accountants
follow when recording and summarizing transactions and in the
preparation of financial statements
In the United States, the organization whose primary purpose is to
develop these generally accepted accounting principles is the Financial
Accounting Standards Board (FASB).
FASB is a private-sector organization, not a government body
3
Introduction
4
Introduction
5
Table of Contents
I. Introduction to Accounting
V. Advanced Topics
6
Balance Sheet Overview
7
Assets
Recognition of assets:
A firm will recognize an asset only if (1) the firm has acquired rights to its
use in the future as a result of a past transaction or exchange and (2) the
firm can measure or quantify the future benefits with a reasonable degree
of precision
While all assets represent future benefits, not all future benefits are
assets
Valuation of assets:
Accountants must assign a monetary amount to each asset in the balance
sheet. Several methods can be used to assign value:
Acquisition or Historical Cost represents the amount of cash (or cash
equivalent) paid in acquiring the asset
Current Replacement Cost represents the amount currently required to acquire
the asset
Current Net Realizable Value represents the amount of cash that a firm would
receive if it sold the asset (less the cost involved to sell the asset)
Present Value of Future Net Cash Flows represents the future benefits of the
asset discounted to the current period by an appropriate discount rate
8
Assets
9
Assets
10
Assets
11
Liabilities
Liability recognition
A liability is recognized when the firm receives a benefit or service and in
exchange, promises to pay the provider of that good or service a
reasonably definite amount in a reasonably definite time
Similar to the discussion of assets, all liabilities are obligations but not all
obligations are liabilities
Valuation of liabilities
Liabilities that require payments of specific amounts of cash due in less
than one year appear on the balance sheet at the amount of cash the firm
expects to pay to discharge the obligation
Obligations that require specific amounts of cash due in more than one
year appear at the present value of the future cash outflows
Liabilities that require delivery of goods or providing services rather than
cash can appear on the balance sheet either at the cost of providing the
goods or service, or at the cash amount received for providing the future
goods or services (depending on circumstances). For example:
Liability for a product warranty for goods already sold appears at the expected
cost of providing the warranty
Liability for advance payment for goods to be sold appear as the amount of cash
received
12
Liabilities
13
Working Capital
While not its own balance sheet item, working capital is a key
concept that is derived from the balance sheet as well as an
important measure of firms short-term financial health
Working capital is also sometimes referred to as net working
capital
Working capital equals a firms current operating assets less its
current operating liabilities
Current operating assets = current assets cash and cash
equivalents
Current operating liabilities = current liabilities short-term debt
14
Shareholders equity
15
Balance Sheet Example
16
Table of Contents
I. Introduction to Accounting
V. Advanced Topics
17
Income Statement Overview
18
Cash vs. Accrual Accounting
There are two accounting approaches that a firm can use to measure
operating performance: (1) cash basis or (2) accrual basis
Cash basis of accounting
Under the cash basis, a firm recognizes revenue from selling goods or
providing services in the period when it received cash from customers
Similarly, the firm recognizes expenses in the period when it makes cash
expenditures (i.e. pays) for merchandise, salaries, taxes, etc.
Disadvantages of cash basis accounting
The cost of generating revenues are not adequately matched with the
benefits of generating revenues.
For example, if inventory is purchased at the end of a year, and that inventory is
sold to customers at the beginning of the following year, the firms income
statement will show an expense (but no revenue) the first year and revenue (but
no expense) the following year
This mismatch makes it difficult to compare operational performance from
one year to the next
19
Cash vs. Accrual Accounting
20
Cash vs. Accrual Accounting
21
Revenue
Revenue recognition
Under accrual accounting, revenue is recognized when the following two
conditions have been met:
A firm has performed all or most of the services it expects to provide
The firm has received cash or another asset (such as a receivable) capable of
measuring (reasonably precisely) the revenue to be recognized
Adjustments to revenue
If a firm recognizes revenue in a period before it collects cash, it may
need to make adjustments to the agreed upon price. These adjustments
are made at the same time (or same period) as the revenue is recognized.
Such adjustments include:
Uncollectible amounts or bad debts: the firm does not expect to collect the
entire amount
Sales discounts, allowances or returns: discounts off the purchase price or
allowances for unsatisfactory merchandise or services or returned goods
Delayed payments: payments longer than one-year from delivery of the goods or
services require the revenue to be reduced by an implied interest charge
Gross revenue net of any adjustments is referred to as Net Revenue
Usually, only net revenue will be reported on a firms income statement
but sometimes gross revenue and adjustments will also be shown
22
Expenses
Expense recognition
Under accrual accounting, expenses are recognized as follows:
If an asset expiration (e.g. using inventory) can be associated directly
with a particular revenue, that expiration becomes an expense when
the firm recognizes revenue
9 This is knows as the matching principle. Costs are matched with revenues
If an asset expiration does not clearly associate with particular
revenue, then that asset expiration becomes an expense in the period
when the firm consumes or uses the benefit of that asset
Costs that can be easily matched to revenues are known as direct
costs or Cost of Goods Sold or COGS (also called cost or sales,
cost of revenue, cost of product). Examples include:
Cost of materials that comprise the goods being sold
Cost of labor directly responsible for making the goods being sold
On the income statement, net revenues less COGS equals Gross
Profit (also called Gross Margin)
23
Expenses
24
Depreciation Expense
One additional and significant operating cost that has not been
mentioned yet is depreciation
Accrual accounting stipulates that when assets such as factories and
equipment are purchased, rather than have the entire amount
expensed through the income statement when the property is
purchased, the property gets depreciated over time
Because the asset will be used for a future benefit (e.g. used to generate
future revenues), the cost of depreciating the asset is accountings
attempt to match the benefit of the asset with the cost of the asset
The periodic (e.g. annual) cost of depreciating the assets becomes a cost
on the income statement
Depreciation is a process of cost allocation, and NOT meant to measure
the decline in value of the asset
There are various methods of depreciating assets (i.e. straight-line,
accelerated) and because different assets have different useful lives, they
can be depreciated over differing time periods
Land is not typically depreciated as it does not have a finite life
25
Depreciation Expense
26
Interest and Other Income
27
Taxes and Net Income
The income statement will also have a line item for taxes
(often called Provision for income taxes).
This represents the income taxes that the company owes based on
financial accounting (book basis) but not necessarily the amount
that will actually be paid to the government (see Advanced Topics
for more information)
In the United States, the statutory rate for income taxes is 35%
but the actual tax that a firm pays can vary significantly
depending on many factors including state taxes, foreign taxes,
previous operations and tax treatments (e.g. Net Operating
Losses), etc.
Earnings Before Taxes (EBT) less the Income Tax Provision
equals Net Income (also called Net Earnings or the bottom
line)
28
Net Income and EPS
29
Income Statement Example
30
Table of Contents
I. Introduction to Accounting
V. Advanced Topics
31
Cash Flow Statement Overview
The statement of cash flows reports the net cash flows relating to
operating, investing and financing activities for a period of time (the
same period of time as the income statement)
Due to accrual accounting, the income statement does not measure
cash inflows and outflows. However, since cash is so important
(cash is king), the cash flow statement is a very important tool for
understanding the operations of the company
The basic equation of the cash flow statement is: cash at the
beginning period + cash from operations + cash from investing + cash
from financing = cash at the end of period
The cash flow statement is divided into three categories:
Cash from operations equals cash received from selling goods and
services less cash paid for providing goods and services
Cash from investing equals cash received from sales of investments and
PP&E less cash paid for the acquisition of investments and PP&E
Cash from financing equals cash received from the issue of debt or equity
less cash paid for dividends and the reacquisition of debt or equity
32
Cash Flow Statement Overview
33
Cash Flow from Operations
Most firms report cash flow from operations using the indirect
method
In the indirect method, cash flow from operations is the result of
adjusting net income for non-cash items
An alternative, but less frequently used method is the direct
method whereby cash flow from operations lists the cash
received from customers and the cash expenditures to suppliers
This difference between the two methods is purely presentation
numerically they will give the same result
Under the indirect method, the first line in this section is net
income
Typically, the next line is depreciation and amortization (D&A)
While D&A does not provide cash, it must be added back in the
cash flow statement since it was included in net income (as an
expense).
D&A will have a positive sign on the cash flow statement
34
Cash Flow from Operations
Then adjust for changes in operating assets (i.e. working capital). For
example:
Change in accounts receivable (asset)
Change in inventories (asset)
Change in other current assets (asset)
Change in accounts payable (liability)
Change in accrued expenses (liability)
Change in other current liabilities (liability)
Remember, an increase in assets is a negative cash impact or use of
cash while an increase in liabilities is a positive cash impact or
source of cash
Be mindful of the signs (positive/negative): an increase in assets will
have a negative sign and an increase in liabilities will have a positive sign
(and vice versa for decreases)
Summing up net income, D&A, changes in working capital and changes
in other operating items results in Cash Flow from Operations
35
Cash Flow from Investing
36
Cash Flow from Financing
Cash flow from Financing takes into account changes to a firms debt
and equity positions. Line items in this section include:
Increase/decrease in short-term borrowings or short-term debt
Increase/decrease in long-term borrowings or long-term debt
Payments of dividends
Issue of capital stock (i.e. common stock, preferred stock)
Purchase of treasury stock (decrease of capital stock)
Other financing transactions
Again, increases in liabilities and shareholders equity (e.g. increase
in borrowings) will have a positive sign and decreases will have a
negative sign (e.g. purchase of treasury stock)
The sum of all of the above line items results in Cash Flow from
Financing
The sum of Cash Flow from Operations, Cash Flow from Investing and
Cash Flow from Financing equals net cash flow for the period and the
sum of net cash flow + the beginning cash balance equals the ending
cash balance
37
Cash Flow Statement Example
38
Table of Contents
I. Introduction to Accounting
V. Advanced Topics
39
Inventory
Valuing inventory
There are a number of different techniques that can be used to
value inventory, however, GAAP generally requires the technique
called lower-of-cost-or-market for most purposes
Lower-of-cost-or-market is the lower of (1) acquisition cost and (2)
market value (generally measured as replacement cost)
New inventory will generally be valued at cost
However, if, for example, inventory (e.g. raw materials) is held for a
long period, and the market value of the inventory declines, then the
firm will likely reduce the value (take a write-down) of inventory on
its balance sheet
Cost flow assumptions
Under the accrual basis, when revenue is realized, the associated
costs of producing that revenue (COGS) is also booked. There are
several methods for which firms can account for the cost of the
inventory that makes up COGS
40
Inventory
41
Taxes
42
Leases
43
Leases
Capital leases
In a capital lease, the lessee assumes some of the risks of ownership and
enjoys some of the benefits. A lease will be treated as a capital lease if
any of the following conditions are met:
The lease term is greater than 75% of the property's estimated economic life
The lease contains an option to purchase the property for less than fair market
value
Ownership of the property is transferred to the lessee at the end of the lease
term
The present value of the lease payments exceeds 90% of the fair market value of
the property
Accounting rules treat capital leases as if the firm had purchased the
property
Both an asset and a liability is created on the balance sheet equal to the present
value of the lease expenses
Each period (i.e. year), (1) the asset (lease) is amortized and the asset value is
reduced on the balance sheet, (2) interest expense is realized on the income
statement, and (3) the liability on the balance sheet is reduced
Operating and capital leases methods differ only in the timing of
accounting entries but not in the amount of expense in aggregate
44
Intangible Assets
Assets that have no physical form but provide future benefits are
known as intangible assets. These include:
Research costs
Advertising costs
Patents
Trade secrets
Trademarks and copyrights
Generally speaking, GAAP requires that expenditures for research and
development (the activity that creates trade secrets and patents) and
for advertising (the activity that creates trademarks and copyrights)
be expensed in the period the expenses are incurred
This is a controversial topic in accounting but the rationale is that the
benefits of R&D and advertising are too uncertain and difficult to measure
to warrant capitalizing them
Therefore, intangible assets will generally not appear on a firms balance
sheet if the activities associated with generating those assets were
carried out by the firm itself
45
Intangible Assets
46
Purchase Accounting
47