Financial Accounting, Appunti di Contabilità Finanziaria

Scarica Financial Accounting e più Appunti in PDF di Contabilità Finanziaria solo su Docsity! FINANCIAL ACCOUNTING LECTURE 1 – 9.02.2022 PART 1 – UNDERSTAND THE ROLE ACCUNTING IN COMMUNICATING FINANCIAL INFO ACCOUNTING = is the process of identifying, measuring, recording, and communicating an organization’s economic activities to users. It is the language of communication in all businesses. Accounting is an information system that: • Measures business activities • Processes data into reports • Communicates results to decision makers It helps to make Business Decisions: Decision makers outside the entity Decision makers inside the entity FINANCIAL ACCOUNTING = the area of accounting that focuses on external reporting and meeting the needs of external users. MANAGERIAL ACCOUNTING = serves the decision-making needs of internal users Do not work for the organization and include investors, creditors, government agencies, labour unions and customers. Work for the organization and are responsible for planning, organizing, and operating the entity. Include budgets, forecasts, and projections. BUSINESS ORGANIZATION = is a group of individuals who come together to pursue a common set of goals and objectives. There are two types of business organizations: • A business organization – sells products and/or services for profit • A non-profit organization – exists to meet various societal needs and does not have profit as a goal, such as charity and hospitals There are three common forms of business organizations – a proprietorship, a partnership, and a corporation. PROPRIETORSHIP • Business owned by one person • Not separate legal entity, which means that the business and the owner are considered to be the same entity • Unlimited liability – if the business could not pay its debts, the owner would be responsible (even if the debts were greater that the owner’s personal resources) • Distinct entity, separate from its proprietor, for accounting purposes Advantages: -You’re the boss -Keep all profits -Income from business is taxed as personal income -Can discontinue your business at will Disadvantage: -You assume unlimited liability -Amount of investment capital you can raise is limited -Life of business is dependent on the owner’s PARTNERSHIP • Business owned by two or more individuals • It is not a separate legal entity • Its owners are subject to unlimited liability Advantage: -More investment capital is available -Partners pay only personal income tax Disadvantage: -Partners have unlimited liability -Must share all profits -Life of business is limited -Partners may disagree CORPORATION • Business owned by one or more owners (shareholders) • Shareholders owns shares of the corporation, which are units of ownership in a corporation • The number of shares held by a shareholder represents how much of the corporation they own • Limited liability - shareholders have no personal obligation for debts • Legally distinct from its owner • A corporation that holds its shares privately is known as private enterprise (PE). A corporation that sells its shares publicly, typically on stock exchange, is called publicly accountable enterprise (PAE) Advantage: -Stockholders have limited liability -Corporations can raise the most investment capital -Corporation have unlimited life -Ownership is easily transferable -Corporations utilize specialists Disadvantage: -Double taxation -Starting a corporation is expensive -Closely regulated by government agencies THE INCOME STATEMENT Communicates information about a business’s financial performance by summarizing revenues less expenses over a period of time. The bottom line = Revenues – Expenses • When revenues are greater than expenses = NET INCOME/ PROFIT • When expenses are greater than revenues = NET LOSS THE STATEMENT OF CHANGES IN EQUITY Provides information about how the balances in Share Capital and Retained earnings changed during the period. • Share Capital = is a heading in the shareholders’ equity section of the balance sheet and represents how much sareholders have invested. When shareholders buy shares, they are investing in the business. • Retained Earnings = is the sum of all net incomes earned by a corporation over its life, less any distribution of these incomes to shareholders. o Dividends = distributions of net income to shareholders. Shareholders generally have the right to share in dividens according to the percentage of their ownership interest. o Revenues = inflow sources from delivering goods or services o Expenses = outflow of resources due to the cost of operations THE BALANCE SHEET (statement of financial position) Shows a business’s assets, liabilities and equity at a point in time. It reflects the company’s position at a specific moment in time. • Assets are the investment held by a business. • The liabilities and equity explain how the assets have been financed or funded. ! Accounting Equation THE STATEMENT OF CASH FLOW (SCF) Explains how the balance in cash changed over a period of time by detailing the sources (inflows) and uses (outflows) of cash by type of activity: operating, investing and financing as these are the three types of actvities a busienss engages in. • Operating activies = are the day-to-day processes involved in selling products and/or services to generate net income ( include purchase and use of supplies, paying employees, fuelling equipment, and renting space) • Investing activities = are the buying of assets needed to generate revenues. • Financing activities = are the raising of money needed to invest in assets (can involve issuing share capital or borrowing) An essential part of financial statements are the notes that accompany them. These notes are generally located at the end of a set of financial statements. The notes provide greater detail about various amounts shown in the financial statements or provide non-quantitative information that is useful to users. How is financial reporting regulated: globally, regionally, and locally? GENERALLY ACCEPTED ACCOUNTING PRINCIPLE (GAAP) Various methods, rules, practices, and other procedures – preparing financial statements. LEGAL SYSTEM • Common Law System – fewer statutes written into the laws and thus more reliance on interpretation by the courts. Since laws are less detailed, non- governmental bodies develop detailed rules. (e.g., United Kingdom and USA) • Code Law System – more detailed rules written into the statute. Accounting standards much briefer. (e.g., Germany) TAXATION Some countries have significant differences between accounting income and taxable income (USA) while others have fewer differences (most Europe). Accounting methods differ if net income is used for taxation à very strict rules, ask to justify every expense I the net income FINANCING Corporations in some countries get financing from outside sources (creditors and stockholders) and accountability is important. In other countries, financing can come from families, banks and the government, therefore less need to develop detailed rules for disclosure. INFLATION In countries where inflation is rampant (Latin and South America), companies have been required to adjust their statements for inflation. USA no longer presents financial information adjusted for inflation. RELATIONSHIP BETWEEN COUNTRIES Countries that have strong political and economic ties often share similar accounting practices. (e.g., Canada and Australia) STATE OF ECONOMIC DEVELOPMENT More developed countries have detailed accounting rules to deal with complex business arrangements and need more detailed accounting. While developing countries are developing their accounting standards. The principal feature of accounting in the 21st century is a global convergence of accounting through the worldwide adoption of the INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS) – for stock-listed companies. • International harmonization (or convergence) à the development of a unified set of high-quality, international accounting standards that would be used in at least all major capital markets. Benefits from a Single Set of Standards International convergence of accounting standards first arose in the late 1950s in response to post World War II economic integration and related increases in cross-border capital flows. Initial efforts focused on reducing differences among accounting principles used in major capital markets around the world. First attempts to regulate convergence: • The International Accounting Standards Committee – formed 1973 – was the first international standards-setting body • It was recognized in 2001 and became an independent international standard setter, the INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB) INTERNATIONAL FINANCIAL REPORTING FRAMEWORK (IFRS) àThe European Union and more than 100 other countries require or permit the use of IFRS àThe USA has not formally adopted IFRS àIt is issued by the IASB (or local variant) àLondon – based world-wide standard àFollows the Anglo-Saxon accounting principles (e.g., fair value concept) àInternational Accounting Standards Board (IASB) issues the: • International Financial Reporting Standards (IFRS) • International Accounting Standards (IAS) • Practice Statements (PS) International Accounting Standards Board (IASB): • Develops world-wide accounting standards • Yet some countries only allow local standards to be applied to their companies (e.g., USA) United States of America FINANCIAL ACCOUNTING STANDARDS BOARD (FASB) Authority to set US accounting standards (Accounting Standards Codification) SECURITIES AND EXCHANGE COMMISSION (SEC) Federal agency with ultimate authority to determine the rules for preparing statements AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AICPA) Professional organization of Certified Public Accountants (CPAs) PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD (PCAOB) Five-member body created by an act of Congress in 2002 to set auditing standards (AS) ACCOUNTING STANDARDS ADVISORY FORUM (ASAF) à Its purpose is to improve cooperation among world-wide standards setters and advise the IASB as it develops International Financial Reporting Standards (IFRS). • The FASB was selected as one of the ASAF’s twelve members • The FASB’s membership on the ASAF is an opportunity to represent U.S. interests in the IASB’s standard- setting process and to continue the process of improving and converging U.S. Generally Accepted Accounting Principles and IFRS MATERIALITY The magnitude of an accounting information omission or misstatement that will affect the judgment of someone relying on the information. The issue is whether the error is large enough to affect the judgment of someone relying on the information. The threshold varies from one company to the next depending largely on the company’s size. The amount of a transaction may be immaterial but still be considered significant because of the type of transaction – transactions involving illegal or unethical behaviour by a company officer. PART 3 – EXPLAIN THE PRIMARY ASSUMPTIONS MADE IN PREPARING FINANCIAL STATEMENTS Important assumptions of the conceptual framework: ECONOMIC ENTITY CONCEPT • Single, identifiable unit must be accounted for in all situations • Specific entity be the subject of a set of financial statements • Does not intermingle the personal assets and liabilities of the employees or any of the other stockholders COST PRINCIPLE • Assets are recorded at the cost to acquire them ü Original cost or historical cost – until the company disposes them • More objective than market value GOING CONCERN • Refers to an entity’s intention to, and its ability to, operate into the foreseeable future • Assume entity will continue indefinitely into the future • An entity cannot selectively apply the standards it likes and proclaim compliance with IFRS ü Name of the reporting entity ü If it is a consolidated or individual account ü End date of the reporting period or period covered by the financial statements MONETARY UNIT • Yardstick used to measure amounts in financial statements ü The dollar is used because it is the recognized medium of exchange in the United States ü Assumes monetary unit is relatively stable; no adjustment for inflation made in financial statements TIME PERIOD ASSUMPTION • Artificial segment on the calendar used as the basis for preparing financial statements • Accountants assume that it is possible to prepare an income statement that accurately reflects net income or earnings for a specific time period Determine what accounting assumption principle has been violated in each situation below: The owner of a small shop (a sole proprietorship) purchases a new computer for her personal use at home. She records the computer as an asset of the Shop. Company A purchased an office building several years ago for $500,000. The office building could be sold today for $850,000. Mr X is a new accountant for Funny Walks Corp. he is extremely busy and has decided that he can prepare the financial statements every two years. PART 4 – UNDERSTAND THE ROLE OF ETHICS IN ACCOUTING Ethics plays a critical role in providing useful financial information. Investors and other users must have confidence in a company, its accountants, and its outside auditors that the information presented in financial statements is relevant, complete, neutral, and free from error. • Moral and social ethical behaviour must be considered while decision making o Recent news of questionable accounting practices has placed increased scrutiny on the accounting profession o Professional judgement is often needed to arrive at appropriate decisions when some questions arises about the application of GAAP. IESBA (International Ethics Standards Board for Accountants) à good business requires decision making, which requires good judgement. Provides the industry a Code of Ethics for Professional Accountants with these principles: 1. Integrity 2. Objectivity 3. Professional competence and due care 4. Confidentiality 5. Professional behaviour Evaluate Business Decision Ethically ECONOMICS Decision should maximize the economic benefits LEGAL Free societies are governed by laws written to provide clarity and prevent abuse of others’ rights ETHICAL Recognizes that even when economically profitable and legal, some actions still may not be right. LECTURE 3 – 16.02.2022 PART 1 – EXPLAIN WHAT A BUSINESS TRANSACTION IS TRANSACTION = any event that has a financial impact on the business and can be measured reliably in monetary terms. • An accountant only reacts to a business action that is indeed a transaction All the numbers in the financial statements come from: Income Statement, Balance Sheet, Cash Flow Statement and Retained Earnings. CHART OF ACCOUNTS = contains a listing of all the accounts and their appropriate account numbers. These accounts are those used in recording the transactions of a company. Each company has a customized listing of accounts which should be sufficient to record any transaction that specific company may encounter. PART 3 – ANALYZE THE IMPACT OF BUSINESS TRANSACTIONS ON ACCOUNTS 1. Transaction 1 On April 1, Starr Williams and a few friends invest $50,000 to open RedLotus Travel, Inc., and the business issues common stock to the stockholders. 2. Transaction 2 RedLotus purchases land for a new location and pays cash of $40,000. T-ACCOUNT = is a visual representation of individual accounts in the form of a “T”, making it so that all additions and subtractions (debits and credits) to the account can be easily tracked and represented visually. Records of increases and decreases in a specific asset, liability, equity, revenue and expense. LEFT SIDE = DEBIT RIGHT SIDE = CREDIT The type of account determines how to record increases and decreases. A debit can increase as well as decrease an account. The same is true for a credit. The actual account classification determines the impact of each of these on an account. On which side should you put the total? A normal balance of an account is the side of the t-account that increases are recorded on. Assets and expenses have normal debit balances. They are increased with a debit and decreased with a credit. Liabilities, Owners’ Equity, and Revenue accounts have normal credit balances. Each is increased with a credit and decreased with a debit. • Asset, expense, and owner's drawing accounts normally have debit balances. • Liability, revenue, and owner's capital accounts normally have credit balances. To determine the correct entry, identify the accounts affected by a transaction, which category each account falls into, and whether the transaction increases or decreases the account's balance. Whether it is good or bad depends on the type of account and the registering party. PART 4 – RECORD TRANSACTIONS IN THE BOOK • Journalizing = recording transactions chronologically o Specify each account affected by the transaction and classify by type o Determine if each account is increased or decreased (debit or credit) o Record in the journal • Posting the journal entries into the ledger = the process of transferring entries in the journal into the accounts in the ledger. Posting to the ledger is the classifying phase of accounting. o Posting is simply transferring the amounts from the journal to the respective accounts in the ledger. o Accounting ledger = refers to a book that consists of all accounts used by the company, the debits and credits under each account, and the resulting balances. ACCOUNTING CYCLE = beginning with the journalising of the transactions and ending with the communication of financial information in financial statements, is commonly referred to as the accounting cycle. The key difference between the cash and accrual methods relates to the timing of revenue and expenses: When they’re received/paid and when they’re earned/incurred. • Many businesses prefer to use cash accounting because the financial statements closely reflect their cash position, which is especially important for small business owners. The simplicity also makes bookkeeping easier and cheaper. And under cash-basis accounting a business doesn’t have to pay taxes on cash it hasn’t collected. • The accrual basis of accounting is the gold standard because it gives a more accurate representation of a company’s finances. With accrual accounting, businesses can more easily keep track of credit transactions using an accounts receivable system, which shows the full transaction history of each customer. An accounts payable system shows the transaction history between your company and a vendor or supplier. GAAP compliant accrual accounting is required for companies of a certain size, with certain debt covenants or that are publicly traded. Both cash- and accrual-basis accounting can use double entry bookkeeping. PART 2 – APPLY ACCOUNTING PRINCIPLES REVENUE RECOGNITION PRINCIPLE deals with two issues: 1) When to record (recognize) revenue 2) What amount of revenue to record Revenue is recognized when: • The buyer bears ownership risks and rewards • The entity has no effective control over goods sold • The amount of revenue can be measured reliably EXPENSE RECOGNITION PRINCIPLE To recognize an expense along with related revenues means to subtract expenses from related revenues to compute net income or net loss. MATCHING PRINCIPLE Explains the relationship between expenses and revenues. (ex. How much did it cost us to earn this specific income item?) Matching expenses with revenues - Measure the expenses and recognize them in the same period in which any related income is earned. TIME-PERIOD CONCEPT A business should report the financial results of its activities over a standard time period, which is usually monthly, quarterly, or annually. Current expenses are subtracted from the current revenue earned to determine the income PART 3 – ADJUST THE ACCOUNTS DEFERRALS First cash then delivery ACCRUALS First delivery then cash àPrepaid Expenses – an expense paid in advance. They are assets because they provide a future benefit for the owner. àUnearned Service Revenue – receipt of cash before earning the revenue creates a liability àDepreciation – is the process of allocating cost to expense for a long-term plant asset. Plant assets are long-lived tangible assets, such as land, buildings, furniture, and equipment. • Decline in usefulness • Spread the cost of the plant asset over its useful life àAccrued Expenses – a liability that arise from an expense that has not yet been paid. It is recorded at the end of the period as an adjusting entry. àAccrued Revenues – a revenue that has been earned but not yet collected. At the end of an accounting period, before financial statements can be prepared, the accounts must be reviewed for potential adjustments. This review is done by using the unadjusted trial balance. The unadjusted trial balance is a trial balance where the accounts have not yet been adjusted. • Adjusting entries are made at the end of an accounting period • Include adjustment of either an asset or a liability with a corresponding change in revenue or expense Two purposes of the adjusting process are to_ • Measure income • Update the balance sheet Therefore, every adjusting entry affects both of the following: 1) Revenue or expenses – to measure income 2) Asset or liability – to update the balance sheet PART 4 – PREPRARE UPDATES FINANCIAL STATEMENTS ADJUSTED TRIAL BALANCE = Summarizes all accounts and their final balances after all adjusting entries have been journalized and posted. Construct the FINANCIAL STATEMENT prepared from the adjusted trial balance. ACCOUNTING CYCLE = consists of the steps followed each accounting period to prepare financial statements. 1. Transactions are analysed and recorded in the general journal 2. The journal entries in the general journal are posted to accounts in the general ledger 3. An adjusted trial balance is prepared to ensure total debits equal total credits 4. The unadjusted account balances are analysed and adjusting entries are journalized in the general journal and posted to the general ledger 5. An adjusted trial balance is prepared to prove the equality of debits and credits 6. The adjusted trial balance is used to prepare financial statements 7. Closing entries are journalized and posted 8. Prepare a post-closing trial balance Lump-sum • Combined purchase price of land and building = 2.7 mil € • Fair value of the land = 1 mil € • Fair value of building = 2 mil € 2,700,00 € CAPITAL EXPEDITURE (CapEx) = funds that are used by a company for the purchase, improvement, or maintenance of the long-term assets to improve the efficiency or capacity of the company. Long-term assets are usually physical, fixed and non-consumable assets such as property, equipment, or infrastructure, and that have a useful life of more than one accounting cycle. CAPITAL EXPEDITURES ARE WHAT IS ADDED TO THE NET PPE ON THE BALANCE SHEET. • Purchase of items such as new equipment, machinery, land, plant, buildings, furniture and fixtures, business vehicles, software, or intangible assets such as a patent or license • The expenditures amount for an accounting period are disclosed in the cash flow statement. Capital expenditure normally have a substantial effect on the short-term and long-term financial standing of an organization. Making wise CapEx decisions is of critical importance to the financial health of a company. • CapEx are seen as an investment in the future of a company (investment that is considered to add value to the business) • Two forms of capital expenditures: (1) expenses to maintain levels of operation present within the company and (2) expenses that will enable an increase in future growth. CAPITALISED = an item is recorded as an asset, rather than an expense (the cost is added to an asset account). This means that the expenditure will appear in the Balance Sheet, rather than the Income Statement. • Ex – A company pays $500 for a notebook computer. The computer has a useful life of three years, but it does not meet the company’s $1.000 capitalisation limit, so the controller charges it to expense in the current period. • Ex – A company pays $2,000 for maintenance on a machine. The payment exceeds the company’s capitalisation limit, but it has no useful life, so the controller charges it to expense in the current period. 1,000,00 3,000,00 = 33,3% 2,000,00 3,000,00 = 66,6% Capital expenditures vs Operating expenses -CapEx – are items that are designed to be used across multiple years. -Opex – reflect the everyday costs of doing business, they are used short-term without any expected future gain attached to their purchase. (rent, salaries, utilities, property taxes …) DEPRECIATION = a non-cash business expense that is allocated and calculated over the period that an asset is useful to your business (show the use of an asset over a period of time). • It is used in accounting to allocate the cost of a tangible asset over its useful life. It is the reduction in the value of an asset that occurs over time due to usage, wear or obsolescence. • Necessary as plant assets wear out, grow obsolete, and lose value over time • Allocates cost against revenue à it helps earn each period • Depreciation expense is reported on the Income Statement • Land is NOT depreciated Depreciation reduces the value of property, plant, and equipment on the balance sheet as the value of assets is lowered over time due to wear and tear and the reduction of their useful life. Allocating Cost of assets over used life Airbus 220 àcost $30 million àannual revenue $9 million TYPES OF DEPRECIATION Most companies use straight-line depreciation for financial reporting, but the double-declining balance method for tax purposes. Accelerated depreciation provides fastest tax deductions à Tax deductions reduce income taxes à Reduced income taxes helps conserve cash. Data for depreciation computations: Straight Line Method (Constant allocation) Straight-line depreciation is the simplest way of calculating depreciation expense. The expense amount is the same every year over the useful life of the asset. Depreciation Expense = (Cost – Salvage value) / Useful life Example Consider a piece of equipment that costs $25,000 with an estimated useful life of 8 years and a $0 salvage value. The depreciation expense per year for this equipment would be as follows: Depreciation Expense = ($25,000 – $0) / 8 = $3,125 per year Double Declining Balance Method (Accelerated allocation) Results in a larger amount expensed in the earlier years as opposed to the later years of an asset’s useful life. The method reflects the fact that assets are typically more productive in their early years than in their later years. The depreciation factor is 2x that of the straight-line method. Periodic Depreciation Expense = Beginning book value x Rate of depreciation Sales Price vs Cost of Inventory When an inventory item is sold, the item’s cost is removed from inventory and the cost is reported on the company’s income statement as the COST OF GOODS SOLD. Cost of goods sold is likely the largest expense reported on the income statement. When the cost of goods sold is subtracted from sales, the remainder is the company’s GROSS PROFIT. COST OF GOODS SOLD (COGS) = measures the “the direct costs” incurred in the production of any goods or services. It includes material cost, direct labour cost, and direct factory overheads, and is directly proportional to revenue. The basic purpose of finding COGS is to calculate the “true cost” of merchandise sold in the period. ü As revenue increases, more resources are required to produce the goods or service. COGS is often the second line item appearing on the Income Statement, coming right after sales revenue. COGS is deducted from revenue to find gross profit. ü Consists of all the costs associated with producing the goods or providing the services offered by the company. For goods, these costs may include the variable costs involved in manufacturing products, such as raw materials and labour. ü Does not include general selling expenses, such as management salaries and advertising expenses. Estimating Inventory and COGS when the cost is constant Assume a retailer has in stock 3 shirts that cost $30 each. The store sells 2 of the shirts for $50 each. Estimating Inventory and COGS with differing cost throughout the year INVENTORY COSTING METHODS IFRS and US GAAP allow different policies for accounting for inventory and cost of goods sold. Very briefly, there are four main valuation methods for inventory and cost of goods sold. SPECIFIC IDENTIFICATION Each item can be identified with a specific purchase and invoice. As sales occur, cost of goods is debited for the actual or invoice cost, leaving actual costs of inventory on hand in the inventory account. FIRST-IN, FIRST-OUT (FIFO) Assumes costs flow in the order incurred. Assumes the oldest units are sold first, the newest units are still in stock. -First costs into inventory are the first costs assigned to cost of goods sold -Ending inventory is based on the latest costs incurred 1) SALES REVENUE – is based on the sale price of inventory sold 2) COST OF GOODS SOLD (COGS) – is based on the cost of inventory sold 3) INVENTORY – on the balance sheet is based on the cost of inventory still on hand LAST-IN, FIRST-OUT (LIFO) Assumes costs flow in the reverse order occurred. Assumes newest units are sold first, the oldest units are still in stock. -Costing is the opposite of FIFO -Last costs into inventory go immediately to cost of goods sold -Ending inventory is based on the oldest costs WEIGHTED AVERAGE Assumes costs flow in an average of the costs available. As sales occur, weighted average computes the average cost per unit of inventory at time of sale and charges this cost per unit sold to cost of goods sold leaving average cost per unit on hand in inventory. Financial Statement Effects of the FIFO and LIFO Methods Inventory Errors Inventory errors can cause the ending inventory balance to be incorrect, which in turn affects the cost of goods sold and profits. (1) Incorrect Unit Count (2) Incorrect Unit of Measure - when you count a certain quantity and enter it into the accounting records, but the designated unit of measure in the item master file for that item is different (3) Incorrected Standard Cost (4) Incorrect Inventory Layering Inventory Turnover • Ration of cost of goods sold to average inventory • Indicates how rapidly inventory is sold • Varies from industry to industry Inventory turnover: used to measure how quickly a company sells its inventory and can affect a merchandiser’s ability to pay its short-term obligations. 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 Days Sales in inventory: used to measure how much inventory is available in terms of the number of days’ sales. Inventory management is a major emphasis for most merchandisers, as they must both plan and control inventory purchases and sales. 𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐶𝑂𝐺𝑆 = 365 Strategies to shorten credit cycle and collect cash more quickly: • Sales discounts for early payment • Charge interest after a certain time period • Adopt more effective credit and collection procedures • Emphasize credit card or bankcard sale • Selling (factoring) receivable LECTURE 8 – 23.03.2022 PART I – CURRENT LIABILITIES AND CONTINGENT LIABILITY LIABILITY = is a present obligation of the entity for an outflow of resources that results from a past event. An item that meets the definition of a liability should be recognized if: a) It is probable that there will be an outflow of service potential or economic benefits from the entity b) The item has a cost or fair value that can be measured with reliably ACCOUNTS PAYABLE -Amounts owed for products or services purchased on account -Example: credit purchase of inventory -Accounts Payable Turnover measures the number of times a year a company can pay its accounts payable 1.On December 15, Thai Airways collects $1,000 for a round- trip ticket from Bangkok to Madrid. It records the cash collection and related liability: 2.Suppose on December 28, the customer flies to Madrid. The entry is as follows: 3.On January 4,2011, the customer returns to Bangkok and Thai Airways records the revenue earned as follows: ACCRUED LIABILITIES -Results form an expense that the business has incurred but not yet paid -Accrued expenses create a liability -Categories: salaries and wages payable, interest payable UNEARNED REVENUES -Business has received cash from customers before earning the revenue -Creates a liability – an obligation to provide goods or services to the customer NOTES PAYABLE (Short-term) -Common form of financing -Due within one year -Issued to borrow cash or purchase assets -May accrue interest expense and interest payable at the end of the period 1.The following entries cover the purchase of inventory costing $8,000, accrual of interest expense, and payment of a 10% short- term note payable due in one year: 2.The following entry records the note’s payment at maturity on March 1, 2011: DEBTS (current portion of long-term debt) -Amount of the principal that is payable within one year -At the end of each year, company reclassifies amount of long-term debt that must be paid next year in current-term debt CONTINGENT LIABILITIES = is a potential liability that may or may not occur, depending on the result of an uncertain future event. The relevance of a contingent liability depends on the probability of the contingency becoming an actual liability. • It is recorded if the contingency is probable, and the related amount can be estimated with a reasonable level of accuracy. • examples include product warranty, guarantees on debts, liquidated damages, outstanding lawsuits and government probes. • Both GAAP and IFRS require companies to record contingent liabilities, due to their connection with three important accounting principles: (1) Full disclosure principle, (2) Materiality principle and (3) Prudence principle. PART II – LONG TERM DEBT AND TIME VALUE OF MONEY LONG-TERM DEBT (long term liabilities) = are debts a company owes third-party creditors that are payable beyond 12 months. This distinguishes them from current liabilities, which a company must pay within 12 months. • On the Balance Sheet, long-term liabilities appear along with current liabilities. Together, these represent everything a company owes. • Companies tend to use them to finance assets that are also enduring in nature, such as land, buildings, and equipment. • Payment and other details of these debts are found in the Notes to the financial statements, included with the BS. Recording Contingent liabilities can be broken down into three categories based on the likelihood of occurrence. a) High Probability – the probability of the liability arising is greater than 50% and the amount associated with it can be estimated with reasonable accuracy. Such events are recorded as an expense on the Income Statement and a liability on the Balance Sheet. b) Medium Probability – it satisfies either, but not both, of the parameters of a high probability contingency. These liabilities must be disclosed in the footnotes of the financial statements if either of the two criteria is true. c) Low Probability – contingent liabilities that do not fall into the categories above. the likelihood of a cost arising due to these liabilities is extremely low and, therefore, it is not required to report them in the financial statements. Issuing Bonds Payable at a Discount 1.Jardine issued $100,000 of 9%, five-year bonds when the market interest rate is 10%. The market price of the bonds drops, and Jardine receives $96,139 at issuance. 2.Jardine’s journal entry to record interest expense and the interest payment for the first 6 months follows: Jardine’s Balance Sheet TIME VALUE OF MONEY = a basic financial concept that holds that holds that money in the present is worth more than the same sum of money to be received in the future, due to its earnings potential in the interim. • Sometimes referred as the Net Present Value (NPV) • Related to the concepts of inflation, rate of return (investment) and purchasing power • Companies consider the time value of money in making decisions about investing in new product development, acquiring new business equipment and facilities. • Formula to calculate the future value of money: 𝐹𝑉 = 𝑃𝑉 × [1 + (𝑖/𝑛)]("×$) Where: FV = the future value of money PV = the present value i = the interest rate or other return that can be earned on the money t = the number of years to take into consideration n = the number of compounding periods of interest per year Time Value of money 𝑛 = 5 × 2 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑎𝑡𝑒 = 10%/2 = 5%, 𝐹𝑎𝑐𝑒 𝑟𝑎𝑡𝑒 = 9%/2 = 4.5% (1)Present Value of maturity value (2)Plus Present Value of future interest payments (annuities) 𝐵𝑜𝑛𝑑′𝑠 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑖𝑠𝑠𝑢𝑎𝑛𝑐𝑒 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑣𝑎𝑙𝑢𝑒 + 𝑃𝑙𝑢𝑠 𝑃𝑟𝑒𝑠𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 PART III – SHAREHOLDERS’ EQUITY SHAREHOLDERS’ EQUITY = shows how much the owners of a company have invested in the business – either by investing money in it or by retaining earnings over time. • On the Balance Sheet, shareholders’ equity is broken down into three categories: (1) Common shares, (2) preferred shares and (3) Retained earnings. • Paid-in Capital (contributed capital) – amount of shareholders’ equity the shareholders have contributed to the corporation • Retained Earnings – amount of shareholders’ equity the corporation has earned through profitable corporations and Reduced dividends. Shareholders’ Rights 1) VOTE – right to vote on matters that come before the shareholders 2) DIVIDENS – right to receive a proportionate part of any dividend 3) LIQUIDATION – right to receive a proportionate share of any assets remaining upon liquidation 4) PREEMPTION – right to maintain one’s proportionate ownership in the corporation Classes of Shares a) ORDINARY SHARES – basic form of share, the owner of the corporation b) PREFERENCE SHARES – certain advantages over ordinary shares, as they receive dividends and receive assets first in liquidation LEVERAGE = is a strategy that companies use to increase assets, cash flows, and returns, though it can also magnify losses. A firm may borrow capital through issuing fixed-income securities or by borrowing money directly from a lender. • There are two types of leverage: Financial and Operating • The financial leverage ratio is an indicator of how much debt a company is using to finance its assets. A high ratio means the firm is highly levered (using a large amount of debt to finance its assets), often a sign of a business that could be a risky bet for potential investors. A low ratio indicates the opposite. 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠&𝐸𝑞𝑢𝑖𝑡𝑦 DEBT RATIO = refers to a financial ratio that measures the extent of a company’s leverage. Measure of an entity’s indebtedness. It is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. • The proportion of a company’s assets that are financed by debt • A ration greater than 1, shows that a considerable portion of a company’s debt is funded by assets, which means the company has more liabilities than assets. • A high ratio indicates that a company may be at risk of default on its loans if interest rates suddenly rise. • A ration below 1, means that a greater portion of a company’s assets is funded by equity 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 Example – Meta For the fiscal year ended Dec 31, 2016, Meta (FB), reported: • Short-term and current portion of long-term debt as $280 million • Long-term debt as $5,77 billion • Total assets as $64.96 billion Using these figures, Meta’s debt ratio can be calculated as($280 𝑚𝑖𝑙 + $5.7 𝑏𝑖𝑙) ÷ $64.96 = 0.092, 𝑜𝑟 9.2%. The company does not borrow from the corporate bond market. It has an easy enough time raising capital through stock. LECTURE 9 – 30.03.2022 PART I – IDENTIFY THE PURPOSE OF THE STATEMENT OF CASH FLOW AND THE MAIN ACTIVITIES STATEMENT OF CASH FLOW = report the cash generated and spent during a specific period of time. It acts as a bridge between the income statement and balance sheet by showing how money moved in and out of the business. A successful business must generate most of its cash from operating activities. Operating, investing and financing activities affect the balance sheet: PART II – PREPARE CASH FLOW FROM OPERATING ACTIVITIES USING THE INDIRECT METHOD There are two methods of producing a statement of cash flows. a) Direct Method – all individual instances of cash that are received or paid out are tallied up and the total is the resulting cash flow b) Indirect Method – the accounting line items such as net income, depreciation, etc. are used to arrive at cash flow. In financial modeling, the cash flow statement is always produced via the indirect method. INDIRECT METHOD = involves the adjustment of net income with changes in balance sheet accounts to arrive at the amount of cash generated by operating activities. It is relatively easily assembled from the accounts that a business normally maintains, but it is less favored by the standard-setting bodies, since it does not give a clear view of how cash flows through a business. Depreciation and Amortization Expenses (1) Added back to net income to convert net income to cash flow (2) No effect on cash, decrease net income (3) Add-back, cancels the deduction on the income statement (4) The Roadster Factory, Inc., reports depreciation expense on their income statement of $18,000 Gains and Losses on the sale of long-term assets (1) An adjustment to net income (2) Add losses from operating activities (3) Subtract gains from operating activities (4) The Roadster Factory sold equipment for $62,000. The book value was $54,000, so there was a gain of $8,000 Revenues 10 - Expenses -2 - Depreciation -3 = NET INCOME Lucas Corporation Statement of Cash Flows Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Amortization Loss on sale of equipment Decrease in accounts receivable Increase in inventories Decrease in prepaid expenses Increase in accounts payable Decrease in accrued liabilities  PAYMENTS FOR OPERATING EXPENSES Prepaid Expenses inni Expiration of prepaid prerinia + Payment — epense (assumed) $7,000 + Xx - 57,000 - x - x _ Ending balance $8,000 $8,000 — $7,000 + $7,000 58,000 Accrued Liabilities Beginning , Accrualofexpenseat _ _ Ending balance year-end (assumed) Payments balance $3,000 + $1,000 x = $1,000 x ‘$1,000 — $3,000 — $1,000 x $3,000 Other Operating Expenses Accrual of spense; Espirationof | _ pismeng — Ending at year-end prepaid expense balance $1,000 + $7,000 x = $17,000 x = $17,000 — $1,000 — $7,000 x = $9,000 Total payments for operating expenses = $8,000 + $3,000 + $9,000 = $20,000 Prspaid Expenses Other Operating Expensos Beg. bal. 7,000 | Expiration of Bg. bal. 3,000 road Payments 8,000 iu 30 Total payments for operating expenses = 520,000 ($8,000 + $3,000 + 59,000) Accrual of 1,000 9,000 End. bal. 17,000 Payments tosuppliers= Paymentsforinventory + Payments for other operating expenses $133,000 = $113,000 + $20,000 PAYMENTS TO EMPLOYEES Salary and Wage Payable Beginning Salary and _ Ending balance Wage expense Payments = balance $6,000 + $56,000 x = $4,000 x = © $4,000 — $6,000 — $56,000 x $58,000 Salary and Wage Payable Beginning balance 6,000 Payments to employees 58,000 | Salary and wage expense 56,000 Ending balance 4,000  Comparison of the indirect and direct methods a) The direct method – reveals too much to competitors by telling them the amount of cash receipts and cash payments from operations b) The indirect method – should separately disclose two important cash payments, income taxes paid and interest paid PART IV – PREPARE CASH FLOWS FROM FINANCING AND INVESTING ACTIVITIES CASH FLOW FROM FINANCING ACTIVITIES CASH FLOW FROM INVESTING ACTIVITIES PART V – EVALUATE A COMPANY’S ABILITY TO GENERATE CASH FLOWS FREE CASH FLOW = is the money left over from revenue after a business pays all of its financial obligations – operating expenses plus capital expenditures – during a specific period, such as a fiscal quarter. FCF is the cash a company is free to use for discretionary spending, such as investing in business expansion or building financial reserves. • Free cash flow tells investors whether a company can pay its bills and still have enough cash to fund growth • Changes in free cash flow can signal problems to shareholders – for example, if revenue is increasing, but free cash flow is not, it could mean customers are not paying invoices on time 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑝𝑟𝑜𝑣𝑖𝑑𝑒𝑑 𝑏𝑦 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠 − 𝐶𝑎𝑠ℎ 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑓𝑜𝑟 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑡𝑠 𝑖𝑛 𝑃𝑃𝑒 • If free cash flow is negative, then it may not be a good investment LECTURE 12 – 27.04.2022 PART I – BASIC ANALYSIS OF FINANCIAL STATEMENTS There are two main types of analysis: HORIZONTAL ANALYSIS The study of percentages from year to year. Look across the income statement at the year-over-year change in each line item. Two steps to compute: (1) Compute amount of change from one period (base period) to the next and (2) Divide the amount of change by the base-period amount. 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑐ℎ𝑎𝑛𝑔𝑒 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑎𝑚𝑜𝑢𝑛𝑡 Example: Nestlé Nestlé sales increased by 0.77% during 2016, and operating profit increased by 6.08% in 2016, computed as follows: 𝐶𝐻𝐹 89,469 − 𝐶𝐻𝐹 88,785 = 𝐶𝐻𝐹 684 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 = 𝐶𝐻𝐹 684 𝐶𝐻𝐹 = 0,77% TREND PERCENTAGE = indicates the direction a business is taking. 𝑇𝑟𝑒𝑛𝑑 % = 𝐴𝑛𝑦 𝑦𝑒𝑎𝑟&𝑠 𝑎𝑚𝑜𝑢𝑛𝑡 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟&𝑠 𝑎𝑚𝑜𝑢𝑛𝑡 Select a base year and set it equal to 100% Each following year is a percentage of the base amount ACCOUNTS PAYABLE TURNOVER Also known as the creditor’s turnover ratio, is a liquidity ratio that measures the average number of times a company pays its creditors over an accounting period. It is measured of short-term liquidity, with a higher payable turnover ratio being more favorable. 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑷𝒂𝒚𝒂𝒃𝒍𝒆 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑃𝑎𝑦𝑎𝑏𝑙𝑒 Where: -Average accounts payable is the sum of accounts payable at the beginning and end of the accounting period, divided by 2. 1.Measures number of times per year the entity pays off its accounts payable CASH CONVERSION CYCLE Is a metric that shows the amount of time it takes a company to convert its investments in inventory to cash. 𝑪𝒂𝒔𝒉 𝑪𝒐𝒏𝒗𝒆𝒓𝒔𝒊𝒐𝒏 𝑪𝒚𝒄𝒍𝒆 = 𝐷𝐼𝑂 + 𝐷𝑆𝑂 − 𝐷𝑃𝑂 Where: -DIO stands for Days Inventory Outstanding -DSO stands for Days Sales Outstanding -DPO stands for Days Payable Outstanding FINANCIAL STREGHT RATIOS WORKING CAPITAL Is a measure of liquidity, revealing whether a business can pay its obligations. The ratio is the relative proportion of an entity’s current assets to its current liabilities and shows the ability of a business to pay for its current liabilities with its current assets. A working capital ratio of less than 1.0 is a strong indicator that there will be liquidity problems in the future, while a ratio in the vicinity of 2.0 is considered to represent good short-term liquidity. 𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 1.measures ability to pay current liabilities 2.In general, the larger the better ability to pay debts LIQUIDITY RATIO CURRENT RATIO Measures the capability of a business to meet its short-term obligations that are due within a year. It indicates the financial health of a company and how it can maximize the liquidity of its current assets to settle debt and payables. 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 SOLVENCY RATIO DEBT RATIO Measure the extent to which an organization uses debt to fund its operations. They can also be sued to study an entity’s ability to pay for that debt. 𝑫𝒆𝒃𝒕 𝒓𝒂𝒕𝒊𝒐 = 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 1.Expresses the relationship between total liabilities and total assets 2.ratio of 1 indicates that debt financed all assets – higher ratio = greater pressure to pay interest and principal PROFITABILITY RATIOS GROSS PROFIT MARGIN PERCENTAGE Compares the gross margin of a company to its revenue. It shows how much profit a company makes after paying off its COGS. Indicates the percentage of each dollar of revenue that the company retains as gross profit. 𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕 𝑴𝒂𝒓𝒈𝒊𝒏 = 𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 Where: -Gross profit is Total revenue – COGS -Sales are Total revenue RETURN ON TOTAL ASSETS (ROA) Measures the profitability of a business in relation to its total assets. This ratio indicates how well a company is performing by comparing the profit (net income) to the capital. The higher the return, the more productive and efficient management. 𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝒂𝒔𝒔𝒆𝒕 = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 Where: -Net income is equal to net earnings or net income in the year -Average assets is equal to ending assets minus beginning assets divided by 2 1.Measure a company’s success in using assets to earn a profit RETURN ON EQUITY (ROE) Is a two-part ratio in its derivation because it brings together the income statement and the balance sheet. The number represents the total return on equity capital and shows the firm’s ability to turn equity investments into profits. 𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑬𝒒𝒖𝒊𝒕𝒚 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐸𝑞𝑢𝑖𝑡𝑦 PART III – USE FINANCIAL RATIOS AND OTHER INFORMATION TO MAKE INVESTMENT DECISIONS Red Flags in Statement Analysis Limitations and Considerations in Financial Statements Analysis Watch for alternative accounting principles Changes in accounting methods e.g., selection of an inventory valuation method Take care when making comparisons Extra caution for extraordinary items and gains and losses from discontinued operations Understand the possible effects of inflation Financial statements are based on historical costs and are not adjusted for the effects of increasing prices