Financial Accounting PDF

Chapter 1 **(1) Four principal activities of business firms:** 1. **Establishing goals and strategies:** - Maximize the return to owners of the firm, - Provide a stimulating and stable lifetime working environment for employees, and - Contribute to and integrate with national goals a...

Chapter 1 **(1) Four principal activities of business firms:** 1. **Establishing goals and strategies:** - Maximize the return to owners of the firm, - Provide a stimulating and stable lifetime working environment for employees, and - Contribute to and integrate with national goals and policies. 2. **Obtaining financing:** - **There are two principal sources of financing:** 1. [Owners] provide funds to a firm and in return have a claim on the firm's future increases in value. 2. [Creditors] provide funds to a firm and in return typically require periodic payments including interest fees. 3. **Making investments:** - Investments are the necessary [items needed] to [carry out business activities]. - Investments may be [tangible] like land, buildings, equipment, inventories. - Or investments may be [intangible] like patents, licenses and other rights. - Other examples are common shares or bonds of other firms, accounts receivable from customers and cash. 4. **Conducting operations (carrying out operations)** - **The operating activities of a firm:** - [*Purchasing*] -- acquiring raw materials for use or products for sale to customers. - *[Production]* -- combines raw materials, labor and other assets to create the output of the firm. - [*Marketing*] -- selling and distribution of the product. - *[Administration]* -- support for the above activities *(closest link to FA)*. **\ ** **(2) The purpose and content of the three principal financial statements:** A. **Balance sheet:** - Snapshot of the [investing and financing activities] at a moment in time. - The [Basic Accounting Equation]: *Assets = Liabilities + Shareholders' Equity* which are the same ideas as *Investing = Financing* *Resources = Sources of Resources* *Resources = Claims on Resources* B. **Income statement:** - Results of the [operating activities] of a firm for a [specific time period]. - [Basic Income Equation:] *Net Income = [Revenues - Expenses]* - [Revenues] are the [inflows] of assets from [selling goods and services]. - [Expenses] are the [outflows] of assets [used in generating revenues]. **Relation between Balance Sheet and Income Statement:** - The [income statement links] the [balance sheet] at the [beginning] of the period with the [balance sheet] at the [end] of the period. - Retained Earnings is increased by net income and decreased by dividends. ↑ positive net income ↓ losses ↓ payment of dividends to owners and shareholders C. **Statement of cash flows (classification of cash flows):** - Reports details of the [where cash came from and where it went to]. - Cash flows are classified into: - **Operating:** cash from customers less cash paid in carrying out the firm's operating activities (cash changes due to operations). In simpler terms: 1\. \*Cash in\*: Money the company gets from customers for its products or services. 2\. \*Cash out\*: Money the company spends on things like salaries, rent, supplies, etc., to keep the business running. The result shows how much cash the company is left with after paying for its day-to-day operations. - **Investing:** cash paid to acquire noncurrent assets less amounts from any sale of noncurrent assets. In simpler terms: 1\. \*Cash out\*: Money the company spends to buy things it will use for a long time (like buildings or machines). 2\. \*Cash in\*: Money the company earns if it sells any of these long-term assets. The difference between these two shows how much the company is investing or getting back from buying or selling its long-term assets. - **Financing:** cash from issues of long-term debt or new capital less dividends In simpler terms, it\'s about: 1\. \*Cash in\*: Money the company gets from borrowing or selling shares. 2\. \*Cash out\*: Money it gives to shareholders as dividends. So, it's the difference between the cash the company brings in and what it gives back to shareholders.  D. **Notes to the financial statements, including various supporting schedules,** E. **Opinion of the independent certified public accountant.** - Supporting schedules and notes. - Auditor's opinion. - Users and uses of financial reports. - Authority for establishing acceptable accounting standards. - The role of an audit of a firm's financial statements. - Efficiency of capital markets. **(3) Financial reporting issues:** - The multiple uses of financial accounting reports, - The alternative approaches to establishing accounting measurement and reporting standards, - The role of the independent audit of a business firm's financial statements, and - The role of financial reporting in an efficient capital market. - Legal authority to set accounting standards lies with an agency of the federal government, the Securities and Exchange Commission (SEC). - The SEC looks to a private body, the Financial Accounting Standards Board (FASB), for leadership in establishing standards. - Pronouncements of the FASB are called Generally Accepted Accounting Standards (GAAP). - Since its founding in 1973, the FASB has issued 135 statements and several conceptual papers. - The process of setting accounting standards varies widely around the world resulting in a diverse set of accounting principles. - Globalization of economies has increased the need for comparable and understandable financial information. - The International Accounting Standards Committee (IASC) issues recommendations for minimum standards. Chapter 2 **Accounting concepts of assets:** 1. **Asset Recognition:** an asset is a resource that has a future economic benefit. 2. **Asset Valuation:** the monetary amount assigned to an asset. 3. **Asset Classification:** assets are grouped into like categories. **Asset recognition:** - Recognize a resource as 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 (This means that the company has gained permission or ownership to use something because of an agreement or deal it made in the past. So, because of a previous transaction, the company can use that thing in the future.) 2. The firm can measure or quantify the future benefits with a reasonable degree of precision. (This means that the company can predict how much it will benefit from something in the future, and it can do so quite accurately.) - All assets are future benefits but not all future benefits are recognized as assets. Not recognizable assets: things you rent out **Asset Valuation:** - Valuation is the assignment of a monetary amount to an asset. - Several methods of assignment: 1. Acquisition or historical cost, 2. Current replacement cost, 3. Net realizable value, 4. Present value of future net cash flows. **Asset Classification:** - Similar assets are grouped together in the financial statements into *classes.* - Examples of common classes of assets: - Current assets, - Investments, - Property, plant and equipment, and - Intangible assets. **Accounting Concepts of Liabilities** 1. **Liability Recognition:** a liability arises when a firm receives benefits or services and in exchange promises to pay for these at a definite future time. 2. **Liability Valuation:** the monetary amount assigned to the liability. 3. **Liability Classification:** liabilities are grouped into like categories. **Liability Recognition** - Recognize an obligation as a liability: 1. The firm has received benefits, and 2. In exchange, promised to pay the provider, and 3. The payment will occur at a definite future time. - All liabilities are obligations but not all obligations are recognized as liabilities. Obligations that are not recognized as liabilities: moral obligations **Liability Valuation** - Valuation is the assignment of a monetary amount to a liability. - Two main methods of assignment: 1. Liabilities due within a year or less are generally valued at amount of the cash payment. 2. Liabilities due after one year are generally valued at the net present value of the future cash payments. **Liability Classification** - Similar liabilities are grouped together in the financial statements into *classes*: - Examples of common classes of liabilities: - Current Liabilities, - Long-Term Debt, and - Other Long-Term Liabilities. **Shareholders' Equity** - Shareholders' equity is the residual interest in the firm, that is, all assets above those required to satisfy the liabilities. (Shareholders\' equity represents what's left for the owners (shareholders) of a company after all the debts (liabilities) are paid off. Think of it like this: if you take the total value of everything the company owns (assets) and subtract what it owes (liabilities), what remains is the shareholders\' equity. It's basically the owners\' share of the business.) - Shareholders' equity = total assets - total liabilities. - The valuation of assets and liabilities therefore determines the valuation of shareholders' equity. **Classification of Shareholders' Equity** - **Shareholders' equity is divided into:** 1. **Contributed Capital,** which is the original investment by owners, and 2. **Retained Earnings**, which is the amount of earnings left in the firm after the payment of dividends to the owners. **Contributed Capital** - Contributed Capital is divided into: 1. A par or stated value of the shares which has a legal definition, and 2. The remaining amount which is called *Additional Paid-In Capital.* - This distinction is made for legal reasons and may have no relationship to any market value of the shares. **Retained Earnings** - Retained earnings are the [net accumulation of earnings] of the firm since its beginning. - Retained Earnings is [increased by positive net income], but - Is [reduced by losses], and - Is [reduced by the payment of dividends] to the shareholders or owners. ↑ positive net income ↓ losses ↓ payment of dividends to owners and shareholders **Retained Earnings** - Thus, for any accounting period: Beginning Retained Earnings \+ net income (or - net losses) \- dividends declared during the period\ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ = Ending Retained Earnings. **Dual-Entry Recording Framework** - Every economic event has two sides, [a give and a take]. - Accountants record both sides of some economic events as a *transaction.* - Furthermore, accountants require that the [two sides of a transaction balance] so that the basic accounting equation remains in balance. **Dual Effect of a Transaction** - Recall the basic accounting equation *[Assets = Liabilities + Owners' Equity]* - Any transaction will affect one or more on the three classes of accounts. - Remember that the transaction must balance, and - That the basic equation must balance. **Effect on the Equation** - There are [four general combinations:] 1. Increase an asset and a liability or owners' equity by the same amount, Asset↑ Liability↑ 2. Decrease an asset and a liability or owners' equity by the same amount, Asset↓ Liability↓ 3. Increase an asset and decrease another by the same amount, and Asset↑ Asset↓ 4. Increase a liability or owners' equity and decrease another liability or owners' equity by the same amount. Liability↑ Liability↓ **Debits and Credits** - There is a pattern in the dual-entry framework, but it is not always easy to describe. - Accountants use the definitions of [debit and credit] to describe the requirement to [balance the two sides of a transaction] and to keep the basic equation in balance. - [Debits] are defined as [increases to asset] accounts (the left side of the basic equation) or [decreases to liabilities or owners' equity] (the right side). 1\. \*An increase in assets\*: When the company gets more valuable things (like cash, inventory, or equipment). 2\. \*A decreases in liabilities or owners\' equity\*: When the company reduces what it owes (like paying off a loan) or reduces what it owes to owners/shareholders (like paying dividends). In simpler terms, it\'s about getting more valuable stuff or owing less money - [Credits] are defined as [increases to liabilities or owners' equity] (the right side of the basic equation) or [decreases to asset] accounts (the left side). 1\. \*An increase in liabilities or owners\' equity\*: When the company owes more money (like taking out a loan) or increases what belongs to the owners/shareholders (like profits added to equity). 2\. \*A decreases in assets\*: When the company loses or uses up something valuable (like spending cash or using up inventory). In simpler terms, it\'s about owing more or using up what the company owns. - *Debits = Credits* for all transactions and for the basic equation at any time. - Accountants record a transaction by making a *[journal entry]*. - A journal entry shows [both sides of the transaction] with the name of the accounts and their respective debit or credit. - For example, transaction 1 from the Miller Corporation Example would be:  **The Ledger** - The journal entry records both sides to a transaction, but - The *[Ledger]* summarizes changes to individual accounts which may be one side of several transactions. - Accountants often use a shorthand notation for the ledger called a *[T-Account].* - A T-Account summarizes debits and credits to a specific account, for example cash. ----------------------- ------------------------ Account title Debits to the account Credits to the account ----------------------- ------------------------ **Analysis of the Balance Sheet** - The balance sheet reflects the effects of a firm's investing and financing decisions. - The asset side gives the resources that are available to the firm. Owners expect management to make efficient use of the assets that are entrusted to them. - The liabilities and shareholders' equity side gives the sources of those assets. The ratio of liability to shareholders' equity is called *leverage* and shareholders expect management to balance liabilities against new shareholders' equity. Chapter 3 **The Accounting Period** - Income generating activity occurs almost continuously in modern firms. - Financial reports are prepared at the end of time periods of uniform length, for example, months or quarters or years. - Uniform time periods facilitate comparisons and analyses. - Many companies use the end of the calendar year as the end of their accounting period. **Accounting Methods for Measuring Performance** A. Cash basis of accounting. - Revenues are recognized when cash is received and expenses are recognized when cash is paid. B. Accrual basis of accounting. - Revenues and expenses are recognized on an economic basis without regard for the actual flow of cash. **Cash Basis of Accounting** - Intuitive and easy. - Provides reliable information about cash flows. - Provides information on the *liquidity* of a firm. - Liquidity is the ability of a firm to meet its short-term cash obligations. - Subject to manipulation, for example, the firm can delay having to recognize an expense by postponing cash payment. **Accrual Basis of Accounting** - More difficult conceptually. - Economically, changes in wealth may occur without involving cash, for example, a barter trade or a customer purchasing goods on account. - Revenues and expenses are recognized independent of the timing of the cash flow. - Provides information on long-term profitability. - Subject to manipulation by the choice of recognition rules. **Measurement Principles of Accrual Accounting** A. Timing of revenue recognition. B. Measurement of amount of revenue. C. Timing of expense recognition. D. Measurement of amount of expenses. **Revenues -- Timing** - When does the accountant recognize revenue? - When both of the following are met: 1. The firm has performed all or most of the services or it has delivered the goods, that is, it has *earned* the revenue. 2. The firm has received a good, service or right in exchange and can reasonably *measure* the value of the good, service or right. A promise to pay (such as a receivable) is a right. **Revenues -- Amount** - Revenues are measured by the cash or equivalent that it expects to receive. - Uncollectible Accounts have no value by definition and are not included in revenue. - Sales Discounts and Allowances are reductions in price and not included in revenue. - Sales Returns are a reversal of the sale and are not included in revenue. **Expenses -- Timing** - Assets provide future benefits to the firm and are consumed in the process of generating revenues. - As assets are consumed, the value of the remaining asset is reduced and an expense is incurred, thus, assets flow out of the firm as expenses. **Criteria for Expense Recognition** Accountants recognize expenses as follows: 1. If an asset expiration associates directly with a revenue, that expiration becomes an expense in the period when the revenue is recognized, that is, expenses are *matched* to revenues. In simple terms, this means that when a company earns money from selling something, it should also recognize the costs related to that sale in the same time period. For example, if a company sells a product and has to pay for the materials used to make it, it should record both the revenue from the sale and the cost of materials as expenses at the same time. This approach helps provide a clearer picture of how much profit the company actually made during that period. 2. If an asset expiration does not clearly associate with revenues, that expiration becomes an expense of the period in which the firms consumes the benefits of that asset. In simple terms, this means that if a company has an asset (like a piece of equipment) that doesn't directly relate to a specific sale, the costs associated with that asset are recorded as expenses when the company actually uses it. For example, if a company buys a machine, it will expense the cost of using that machine over time, rather than waiting until it sells something related to it. This helps match costs with the periods when the benefits of the asset are realized. Example of an Expired Cost For example, a company spends \$10,000 to acquire product catalogs, which it records as a [prepaid expense] in January. It hands out the catalogs during a trade show in March, at which point it charges the \$10,000 cost to [marketing expense]. The \$10,000 becomes an expired cost in March. As another example, a company pays \$100 for office supplies in June. Though the supplies may not be used for several months, it is not worth the time of the accounting staff to recognize such a small cost over several [reporting periods]. Instead, the \$100 is charged to expense as incurred, which means it is an expired cost in June. **Examples of Expense Recognition** - **Product Costs:** the cost of making a product is not an expense until the product is sold, then it becomes a cost of *goods sold expense*. Prior to this time, the cost is the unexpired asset, inventory. - **Marketing Costs:** may or may not give rise to revenue. Most accountants prefer to expense marketing costs in the period when occurred. - **Administrative Costs:** cannot easily be matched with revenue, so are considered a period cost. **Overview of Accounting Procedures** A. Relation between balance sheet and income statement. B. Purpose and use of individual revenue and expense accounts. C. Debit and credit procedures for revenues, expenses and dividends. D. Adjusting journal entries. **Relation between Balance Sheet and Income Statement** - The balance sheet reports assets and financing of those assets at a point in time. - The income statement reports revenues and expenses over a period of time. - Dividends are a return to the shareholders and are not an expense. - Two consecutive balance sheets are connected by the income statement.  **Purpose and Use of Individual Revenue and Expense Accounts** - Revenue and expenses could be recorded directly to the Retained Earnings account. - It is more informative to collect revenues and expenses separately during the accounting period. - At the end of the accounting period, revenues and expenses are cleared (reset to zero) for the new accounting period. Their balances flow into Retained Earnings. This is called *closing* the accounts*.* **Debit and Credit Procedures for Revenues, Expenses and Dividends** - Revenues, expenses and dividends are *closed* to Retained Earnings. - Recall that Retained Earnings normally carries a *credit* balance since it represents a source of financing; thus, credits increase R.E. while debits decrease R.E. **Adjusting Entries** - Some journal entries are made at the end of the accounting period just to separate the effect of an event into its proper periods. - Examples include: 1. Recognition of accrued revenues and receivables, 2. Interest calculations, 3. Recognition of accrued expenses and payables, 4. Allocation of prepaid operating costs, and 5. Recognition of depreciation. **Recognition of Accrued Revenues and Receivables** - A firm earns revenue as it renders services. If part of the service has been rendered in one accounting period and the remainder in others, accrual accounting calls for apportioning the revenue among the appropriate periods. - For example, a firm earns rental revenue as the tenant occupies the property. If the rental period spans two accounting periods, accrual accounting calls for splitting the rent revenue between the two in proportion to the rental time. **Recognition of Accrued Revenues and Receivables (Cont.)** - Notice in contrast, that cash basis accounting would recognize revenue as the cash rent payments were received. - Other examples include notes receivable which accrue interest revenue as time passes without regard for the timing of cash payments. - The accrued revenue (a credit) is offset by an accrued receivable (a debit) until the cash is paid. **Interest Calculations** - Interest revenue is earned and interest expense is incurred as time passes. Both of these are accrued in proportion to time. - If the interest period spans two or more accounting periods, accrual accounting calls for recognizing the interest at the end of each accounting period in proportion to the amount of time the interest was in effect. - The offsetting journal entry is to a receivable (if a revenue) or a payable (if an expense). **Recognition of Accrued Expenses and Payables** - As a firm receives services, it incurs an obligation to pay for them. - If the services are received over a time period spanning two or more accounting periods, accrual accounting calls for recognizing the proportion of service received as an expense. - The offsetting journal entry is to a liability account, generally a payable. **Allocation of Prepaid Operating Costs** - Sometimes, the firm prepays for a service. Since a prepaid service has future benefit, it is an asset until the time for the service expires. - If the time period of service spans two or more accounting periods, accrual accounting calls for recognizing the asset when the service begins and adjusting the asset down at the end of accounting periods in proportion to the amount of service used. - The asset is reduced (credited) and an expense is recognized (debited). **Recognition of Depreciation** - Depreciation is a long-term form of a prepaid service. An asset may last many years. As the asset is used, it is expensed. - One simple form of depreciation is straight-line. The original cost of the asset is expensed over the useful life in equal amounts over time. - Because assets may be purchased at any time during the accounting period, some special rule must apply to the first year of depreciation \-- some firms just take one half of a year's depreciation for the first year. **Interpreting and Analyzing the Income Statement** - The income statement provides information about the profitability of the firm over the long term. - Three tools are useful in analysis: 1. ***Common size statements*:** revenues are set to 100% and each expense item is shown as a percentage of revenue. 2. ***Time series analysis***: changes from year to year are calculated in both revenue and expense items. It is hoped that revenues will grow but that expenses will remain stable or even reduce in proportion to revenue. 3. ***Cross-section analysis*:** revenues and expenses are compared to competitors. Some differences are strategic and some may be driven by different production technologies, but some differences may be due to inefficiency. Chapter 4 **Overview of the Statement of Cash Flows** The statement of cash flows... A. explains the [reasons] for a [change in cash]. B. classifies the reasons for the change as an [operating, investing or financing activity]. C. [reconciles net income] with [cash flow from operations]. **Classification of Cash Flows** 1. **Operations** \-- cash flows related to selling goods and services; that is, the principle business of the firm. 2. **Investing** \-- cash flows related to the acquisition or sale of noncurrent assets. 3. **Financing** \-- long term and short-term cash flows related to liabilities and owners' equity; dividends are a financing cash outflow. **Preparing the Statement of Cash Flows** Firms could prepare the cash flow statement directly from the cash account. Most, however, find it more efficient to prepare the cash flow statement from the balance sheet and income statement. A. [Direct] and [indirect] methods. B. [Algebraic formulation] will present the underlying concept of the cash flow statement. C. Two approaches to producing the cash flow statement: [columnar worksheet] and [t-account] worksheet. **Direct and Indirect Methods** - [Direct method] of presentation calculates cash flow from operations by subtracting cash disbursements to suppliers, employees, and others from cash receipts from customers. - The [indirect method] calculates cash flow from operations by adjusting net income for noncash revenues and expenses. - [Most firms present their cash flows using the indirect method.] **Algebraic Formulation** Recall the basic accounting equation: *Assets = Liabilities + Shareholders' Equity* or *A = L + SE* Assets are either cash (C) or not (N\$A), so *C + N\$A = L + SE* *∆C + ∆ N\$A = ∆ L + ∆ SE* Where ∆ means the change in the balance, Rearranging gives the basic equation for the statement of cash flows: *∆ C = ∆ L + ∆ SE - ∆ N\$A* **Algebraic Formulation** *∆ C = ∆ L + ∆ SE - ∆ N\$A* - The change in cash, *∆ C,* is the increase or decrease in the cash account. - This amount must equal changes in liabilities *plus* changes in shareholders' equity *minus* changes in assets other than cash. - Thus, we can identify the causes in the change in the cash account by studying the changes in non-cash accounts. *∆ C = ∆ L + ∆ SE - ∆ N\$A* **Two Approaches to Producing the Cash Flow Statement** The basic formula can be implemented using either of two approaches: 1. [Columnar worksheet]\-- changes in balance sheet accounts are classified by definition using a multicolumn worksheet. 2. [T-Account worksheet] \-- changes are classified by analysis of the t-accounts. **Columnar Worksheet** - Works well for relatively simple situations involving few transactions. - Enhances understanding of the cash flow statement. - Does not work as well as the T-account method when the number and complexity of transactions increases. **Columnar Worksheet** *Begin with a comparative balance sheet.* 1. Compute the change in each balance sheet account. 2. Classify each change as operating, investing or financing activity. 3. Make any needed adjustments (for example, for a sale of a long-lived asset). 4. Recast the classified changes in the form of a cash flow statement. **Noncash** - Noncash expenses, such as depreciation expense, are added back. - Not truly sources of cash, even though they are associated with cash inflows; rather, a reversal of the accrual process that required the expenses to be recognized without regard for the cash flow. **T-account Worksheet** - The columnar works well when the change in each balance sheet account affects only one of the three types of activities. It becomes cumbersome for more complex (and realistic) situations. - The T-account approach is a direct extension of T-accounts - facilitates analysis of a transaction which involves more than one activity. For example, the change in *Retained Earnings* can be due to both net income (operating activity) and dividends (financing activity). **T-account Worksheet** 1. Obtain beginning and ending balance sheets. 2. Prepare a T-account worksheet with a master account, cash, divided into operating, investing and financing sections. 3. Explain the change in the master cash account by reconstructing the original entries in a summary form. 4. Make any necessary adjustments. 5. Recast the master account in the format of a cash flow statement.  **Sale of an Asset** - Each of the four parts of the above journal entry require an adjustment in the cash flow statement. - The first line, cash, adds a line to the investing section. - The second line, a debit to accumulated depreciation, increases the depreciation expense above the change in the change in the accumulated depreciation account. - The third line, a credit to the asset, increases the amount of cash invested in long-lived assets above the change in the fixed asset accounts. - The fourth line, a gain or loss, is reversed out in the operating sections since this is not a cash flow. - Net income is an accrual-based concept and purports to show the long-term. - Cash flows purport to show the short term. - Consider the outlook for both short-term and long-term and consider that each is either good or poor. - A strong growing firm would show both good long-term and good short-term outlooks. - A failing firm would show both poor long-term and poor short-term outlooks. - What about a firm with good cash flows (short-term) but poor net income (long-term)? - What about a firm with poor cash flows (short-term) but good net income (long-term)? **An International Perspective** - The International Accounting Standards Board (IAS No. 7) recommends but does not require a statement of cash flows. - An approximation to a cash flow statement can be prepared from a comparative balance sheet with some additional information. Chapter 5 **Objectives of Financial Statement Analysis** - To [understand the economics] of a firm and - To help [forecast] its future [profitability] and [risk] - Profitability is an increase in wealth - Risk is the probability that a specific level of profitability will be achieved. **Usefulness of Ratios** - Help compare different firms, and - Help compare the firm against its past performance - Standards against which to compare ratios 1. The planned ratio for the period 2. The corresponding ratio from a prior period 3. The corresponding ratio for another firm in the same industry 4. The average ratio for other firms in the same industry **Analysis of Profitability** - Profitability is subtle and complex concept. Doing well may be measured by different standards. Three concepts of profitability are given by: - a\. [Return on assets] b. [Return on common equity] c. [Earnings per common share] - Each of these are discussed in turn. **Return on Assets (ROA)** - [ROA] presents profitability independent of the source of financing - Does not consider leverage - Measure of how well the firm uses its assets to generate income  - Disaggregating ROA \-- ROA can be defined as the product of two other ratios 1. Profit margin ratio, and 2. Total assets turnover - Notice that when these two ratios are multiplied, Sales cancel out, giving the definition of ROA - Thus ROA = (profit margin ratio)\*(total sales turnover) **Profit Margin Ratio**  - [Profit margin ratio] measures a firm\'s ability to control its expenses relative to its sales. - We expect expenses to grow as sales grow, but not as fast. - A high profit margin ratio is preferred to a low one. **Total Assets Turnover** - [Total assets turnover] measures a firm\'s ability to generate sales from a given level of assets. - A large asset turnover is preferred to a low one. - Total assets turnover is related to three similar ratios A. Accounts receivable turnover B. Inventory turnover C. Fixed asset turnover **Accounts Receivable Turnover** - [Measures how quickly a firm collects cash]. - If A.R. turn over twice a year, then they average one half of a year in collection. - Less time is preferred to more. - A high turnover is preferred to a low one. **Inventory Turnover** - [Indicates how fast firms sell merchandise]. - If inventory turnover twice a year, then they average one half of a year in inventory. - Holding inventory is costly because the funds invested in inventory could be used elsewhere. - A high turnover is preferred to a low one. **Fixed Asset Turnover** - Measures the relation between investment in long-term or fixed assets (such as property, plant, equipment) and sales. - Efficient use of fixed assets would be associated with high sales. - If fixed assets turn over every four years, then each dollar invested in fixed assets is generating a quarter of a dollar in sales per year. - A high turnover is preferred to a low one. **Return on Common Equity** - The numerator measures return as net income [reduced] by any payments to preferred shareholders as these dividends are not available to the common shareholder and have not been deducted from net income. - The denominator is the average amount contributed by common shareholders which includes - Common stock at par, - Additional paid in capital, and - Retained earnings. **Relation between ROA and ROCE** - [ROCE] is the residual return which goes to the common shareholders. Since it may be low in poor years but high in good years, it has a risk, that is, [the residual return is not known.] - [Debt] is characterized by a [definite schedule] of payments, so there is little risk to the debt holders. - [Preferred stock] is like debt, the dividends are specified. However, debtors must be paid before preferred shareholders and if the money runs out, then they aren\'t paid. **Relation between ROA and ROCE** - ROA can be divided into - Return to creditors or debtors - Return to preferred shareholders, and - Return to common shareholders (ROCE) - Because the return to debtors and preferred shareholders are [fixed], in good years when the firm has high returns, there is a lot of profit left over for the common shareholders; in poor years when returns are low, there is little or maybe no profit left over. **Relation between ROA and ROCE** - Thus, if ROCE and ROA were both linear, then ROCE would have a greater slope than ROA, that is, it is more highly levered. - A prudent firm will borrow funds only when the return on those marginal funds exceeds the cost of borrowing giving a net positive return to the common shareholder. - ROCE can be disaggregated into three related ratios 1. Profit margin ratio 2. Total assets turnover 3. Leverage ratio - The first two have been previously defined. - Leverage ratio indicates the relative proportion of capital provided by common shareholders as distinct from that provided by creditors (debtors) or preferred shareholders. **Relation between ROA and ROCE** - A high leverage ratio means that the firm has a lot of assets at its command, but that the shareholders have less of their own investments at risk. - This is good in good years because the common shareholders capture all profits over what is needed to service the debt. - This bad in poor years because the debt has to be serviced whether or not the common shareholders make a profit.  **Earnings per Share of Common Stock** - This ratio is the profit that goes to each share of common stock. - It would be simply the [net income less preferred dividends divided by the number of common shares.] - However, the number of common shares is complicated by certain securities that may become (convert) to a common share. How to account for these is a complex issue. - For example, if there are 100 common shares but 50 preferred shares that could convert to 50 common shares, do you divide earnings by 100 or 150? [The answer depends on how likely it is that the convertible securities will convert.] **Earnings Per Share** **Analysis of Risk** - Factors that affect risk of a firm - [Economy-wide factors] such as inflation - [Industry-wide factors] such as competition - [Firm-specific factors] such as potential for a labor strike - Questions or issues A. Can the firm [pay short-term obligations] like workers\' wages? That is, what are measures of short-term risk? B. Can the firm [pay long-term obligations] like debt? That is, what are long-term measures of risk? **Measures of Short-Term Risk** - Measures of [short-term liquidity risk] - [Current ratio] - current ratio = (current assets)/(current liabilities) - Measure of ability of the firm to pay short-term liabilities on time - [Quick ratio] - (current [highly liquid] assets)/(current liabilities) - Current highly liquid assets are assets that are quickly and easily converted into cash - This includes bank accounts but not inventories **Measures of Short-Term Risk** - [Cash flow from operations to current liabilities ratio] - (cash flow from operations)/(current liabilities) - Measures the ability of the firm to pay current liabilities without borrowing or additional investments. - [Working capital turnover ratios] - Working capital is a broad definition of cash that includes cash and other assets that are highly liquid such as marketable securities. - Ratios that use working capital show the short-term liquidity of the firm including near-cash assets. **Measures of Long-Term Risk** - [Debt-to-equity ratio] - (total liabilities)/(total equities) - *total equities = total liab. + shareholders' equity* - Percentage of total financing provided by debtors or creditors. - A firm is said to be *highly leveraged* when this ratio is large. - [Cash from operations to total liabilities ratio] - Measures the ability of the firm to pay all liabilities from cash without new debt or additional investment. **Limitations of Ratio Analysis** 1. Ratios based on financial data share the same problems of financial data (such as timeliness). 2. Changes in many ratios correlate with other ratios so a direct interpretation of a change in a ratio is not always apparent. 3. Comparing ratios over time is complicated by the fact that economic conditions may change also. 4. Comparing ratios between two firms is complicated by the fact that the firms may have different economic environments or production technologies even though they produce the same product. **An International Perspective** - The format and terminology of financial statements in different countries often differ making it difficult to find comparable numbers - Economic, political and cultural factors affect the way ratios are interpreted - Foreign accounting principles may be subtly and substantially different from U.S. GAAP **Pro Forma Financial Statements** - [Pro forma] refers to a projection of what the financial statements might look like if certain future conditions prevail. Of course, a pro forma statement is only as good as the forecast of the future conditions. - In order to prepare a set of pro forma statements: 1. Project operating revenues 2. Project operating expenses given the level of revenues 3. Project assets required to support the revenues 4. Project financing for the additional assets 5. Project the cost of the financing 6. Project the cash flow statement based on assumptions about the timing of revenues and payments on debt and for expenses. Class notes Class 1 Dividend: part of the income that declared to pay to the shareholders. (Dividends are payments made by a company to its shareholders as a way to share its profits. When a company earns money, it can either reinvest that money back into the business or distribute some of it to shareholders in the form of dividends.) Dividends are usually paid out in cash, but they can also be given as additional shares of stock. Not all companies pay dividends; some prefer to reinvest their profits for growth. Liabilities - Financing Assets - Investments Class 2 Resource = asset Current asset = inventory Not recognizable assets: things you rent out Acquisition or historical cost = what's on your receipt Net realizable value: if I sell it now, how much can I get for it Assets \| [Balance sheet Johnson & Johnson] Liabilities + shareholders' equity \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ Current assets \| current liabilities Non -- current assets \| None -- current liabilities \| Shareholder's equity \^ \^\ Investing resources Financing (sources of resources) Asset you pay for in the past and enjoy in the future\ Liabilities you benefited in the present and you promise to pay in the future A obligation that is not recognized as a liability: Current assets: less than a year None -- current: more than a year Every financing that you borrow is both current and none-current Owners = shareholders Issue shares = buy shares On account: pay later Issue shares means your equity automatically increases Prepaid insurance: current asset Class 3 Journal Entries: record of your transactions Investing= assets + resources L+SE = financing = resources of resources Residual value = shareholder equity Posting = journalizing On account= huza awoki paga den future Accounts payable = abo mester paga (liability) Accounts receivable = abo mester hanja (asset) (payments due) Si e no indika ku kiko ela paga automatikamente ta cash Asset = loke bo tin derechi riba dje Equipment = short-term (Non -- current asset) Inventory = long-term Dividends = Payable = short term Intangible assets : patents, license Class 5 1. Income statement 2. Period expenses 3. Period expenses 4. Product expense 5. Period expense 6. Period expense 7. Period expense 8. Income statement (e ta bin den resolution) e no ta bin niun kaminda 9. Current liabilities 10. Current assets 11. None current assets 12. Shareholders' equity (asset) 13. Current assets 14.... Assets - sources of resources., has a future economic benefit for the company Liability - enjoy today, pay in the future. Due balance - what is the rest of your liabilities.  Asset Increase - Debit Asset Decrease - Credit Unearned revenue - you didn´t earn the money because you did not deliver yet. Liability because bo debe e costumer servisio/inv. Sales: assets (verkoop) Class 6 Income statement, Statement of retained earning & balance sheet. Exercise day 4 & 5 Rent expense - an expense because after it expires it is no longer an asset but an expense. Dividend - part of the income that you declared to pay to the shareholders. Fixed assets - tangible assets. Accumulated depreciation, u have to decrease it from your total assets. Current assets are items that are expected to be converted into cash or used up within one year. Here are the common types of current assets listed on a balance sheet: 1. **Cash and Cash Equivalents**: Actual cash and short-term investments that are easily convertible to cash. 2. **Accounts Receivable**: Money owed to the company by customers for goods or services already delivered. 3. **Inventory**: Goods available for sale, including raw materials, work-in-progress, and finished products. 4. **Prepaid Expenses**: Payments made in advance for services or goods that will be received in the future (like insurance or rent). 5. **Short-term Investments**: Investments that are expected to be sold or converted to cash within a year. 6. **Marketable Securities**: Financial instruments that are also easily convertible to cash and are typically held for short-term investment purposes. These items are important for assessing a company's liquidity and ability to meet its short-term obligations. Non-current assets are long-term investments or resources that a company expects to hold for more than one year. Here are the common types of non-current assets listed on a balance sheet: 1. **Property, Plant, and Equipment (PP&E)**: Physical assets like buildings, machinery, vehicles, and land used in operations. 2. **Intangible Assets**: Non-physical assets such as patents, trademarks, copyrights, and goodwill. 3. **Long-term Investments**: Investments in other companies or assets that are not expected to be sold within a year. 4. **Deferred Tax Assets**: Taxes that have been paid but can be claimed in future periods. 5. **Other Long-term Assets**: Any other assets that don\'t fall into the categories above and are expected to provide value over a longer period. These assets are important for understanding a company\'s long-term financial health and capacity for growth. Current liabilities are obligations that a company expects to settle within one year. Here are the common types of current liabilities listed on a balance sheet: 1. **Accounts Payable**: Money the company owes to suppliers for goods or services received but not yet paid for. 2. **Short-term Debt**: Loans and borrowings that are due within the year, including current portions of long-term debt. 3. **Accrued Expenses**: Expenses that have been incurred but not yet paid, such as wages, taxes, and interest. 4. **Unearned Revenue**: Money received from customers for services or products that have yet to be delivered or performed. 5. **Current Tax Liabilities**: Taxes owed to the government that are due within the year. 6. **Other Current Liabilities**: Any other obligations that are expected to be settled within one year, such as legal settlements or customer deposits. These liabilities are important for assessing a company's short-term financial obligations and liquidity. Non-current liabilities are obligations that a company expects to settle in more than one year. Here are the common types of non-current liabilities listed on a balance sheet: 1. **Long-term Debt**: Loans and borrowings that are due beyond one year, including bonds payable and mortgages. 2. **Deferred Tax Liabilities**: Taxes that are owed but not payable until future periods, often due to differences between accounting practices and tax regulations. 3. **Pension Liabilities**: Obligations related to employee retirement benefits that the company is committed to paying in the future. 4. **Lease Obligations**: Long-term lease agreements that require future payments, classified as liabilities. 5. **Other Long-term Liabilities**: Any other obligations that are not expected to be settled within one year, such as certain legal settlements or long-term warranties. These liabilities help provide a picture of a company's long-term financial commitments and obligations. Shareholders\' equity represents the owners\' claim on the assets of a company after all liabilities have been settled. Here are the common components of shareholders\' equity listed on a balance sheet: 1. **Common Stock**: The value of shares issued to shareholders, typically at par value. 2. **Preferred Stock**: The value of preferred shares issued, which often have special rights or dividends. 3. **Additional Paid-In Capital (APIC)**: The amount received from shareholders above the par value of the stock. 4. **Retained Earnings**: Cumulative profits that have been retained in the business rather than distributed as dividends. 5. **Treasury Stock**: The cost of shares that have been repurchased by the company and are held in its treasury, subtracted from total equity. 6. **Accumulated Other Comprehensive Income (Loss)**: Gains or losses not included in net income, such as foreign currency translation adjustments or unrealized gains/losses on investments. These components collectively reflect the financial interests of the shareholders in the company. Class 8 Asset ku a bira un expense nos ta yama expired asset Kumpra pa 15 bende pa 18: 18 = revenue 15 = cost of goods sold Cash basis , accrual = income statement None cash expense = depreciation expense None cash assets = accounts receivable, inventory, prepayments Accounts payable = liability