Accounting Crash Course

Basic Accounting Principles

1. Historical Cost: financial statements report companies resources at an initial historical
cost e.g. a company purchased a piece of land 10 years ago for $1M, the original
purchase price (book value) will continue to be recorded in financial statements despite
changes in market value (there is some subjectivity in IFRS9)
2. Accrual Accounting:
a. Revenue recognition: revenues must be recorded when earned and measurable
b. Matching principle: costs associated with making a product must be recorded
during the same period as revenues generated from that product
Income Statement
- Definition: financial report that depicts operating performance of a company
(profitability) over a specific period of time. Also referred to as P&L statement.
- Cash Accounting (as opposed to accrual accounting) : recognizes revenues and costs
when cash is paid out/received
- Revenue: all proceeds from sale of G&S, not all income is revenue e.g. income from
investments, legal settlement.
- Revenue Recognition: Revenue cannot be recorded until it is earned e.g. even though a
product order was sent on 01/01, the revenue is not earned until that order is shipped
to a customer and collection from customer is assured
o Multiple deliverables: for sales of bundled products, companies should assign
individual values to each of their bundled components e.g. Apple sells iphone
for $x, estimate the standalone price of software upgrade rights to be $y. so ($x
y) only realized in revenue evenly over several years
o Long term projects: 1) percentage of completion method: revenues are
recognised on basis of % of total work completed during accounting period. 2)
completed contract method: allows revenue recognition once entire project
complete
- COGS: direct costs of manufacturer and procurement, e.g. inventory, direct labour costs,
shipping and delivery and factory overhead.Does not include administrative costs.
- Gross Profit: Revenues COGS
- SG&A: operating costs not directly associated with production/procurement e.g. payroll,
wages, travel, advertising
- EBITDA (Earnings before interest, taxes, depreciation & amortization): Gross Profit
SG&A R&D
- Depreciation and Amortization: allocation of cost over a fixed assets useful life in order
to match the timing of the cost of the asset with when it is expected to generate
revenue benefits.
o Depreciation quantifies the wear and tear of a physical asset, Land is a fixed
asset but it is not depreciated (it is a non-cash expense)
o Straight line depreciation method: depreciable cost of an asset spread evenly
over assets useful life. Annual depreciation expense: (Original cost salvage
value)/Useful life.
o Amortisation Expense: allocation of cost of intangible assets (e.g. customer lists,
patents, technology, membership, licenses trademarks are not amortised b.c
they have indefinite useful life) over the number of years that these assets are
expected to help generate revenue for the company.
- Operating Profit (EBIT): EBITDA D&A
- Interest Expense: the amount the company has to pay on debt owed e.g. to bond
holders/banks. EBT (earnings before tax) = EBIT I
- Interest Income: A companys income from its cash holdings and investments
- Income tax expense: tax liabilities
- Other non-operating income: legal settlements, insurance proceeds, gains of sales of
assets
- Other non-operating expense: restructuring and severance costs, losses on sale
- Net income: EBIT Net interest expense other non-operating income taxes
- Shares Outstanding: represents number of common stock outstanding. Shares that have
been issued but repurchased by the company are called treasure stock and are no
longer outstanding. Shares outstanding = shares issues treasury stock
- Dividends: a portion of the profits generated by a company (Net income) is returned to
shareholders
Balance Sheet
- Definition: reports the companys assets are funded (liabilities and shareholders equity)
on a particular date (end of quarter/year). Contrast with income statement which
reports a companys revenues, expenses and profitability over a specific time period.
- Assets: represent the companys resources (owned, of value, and quantifiable cost) e.g.
cash, securities, accounts receivable (payment owed to business by customers for goods
already delivered to them), inventories (any goods waiting to be sold and the direct
costs associated with the production of these gods), prepaid expenses (prepays for
things like utilities the right to future services), property plant & equipment, intangible
assets and goodwill
- Liabilities & Equity: represents the companys sources of funds (how it pays for assets).
o Liabilities: represent what the company owes to others. Short term debt
(<12mos) and long term debt
o Equities: represent sources of funds through equity investment, retained
earnings (what the company has earned through operations)
- Double entry accounting: In a balance sheet, there are many accounts: asset accounts,
liability accounts, expenses etc.. Double entry system records 2 sides of every
transaction 1) Credit - the funding source and 2) Debit - how funds are used E.g. if you
debit a cash account then this means that the amount of hand increases, however if you
debit an accounts payable account, the amount of accounts payable liability decreases
- Assets = Liabilities + Equity : because you can only have assets if you have paid for them
in equities or liabilities
o Debit: increases in asset or expense
account, decreases in liabilities and
equity account (LEFT)
o Credit: increases in liabilities and equity
account, decreases in asset or expense
account (RIGHT)
- Examples: Sale for cash: debit the cash account, credit the revenue account. If they
purchase a machine for $15K on credit, this results in an addition to fixed assets account
with a debit and increase in the accounts payable account with a credit
- All income on income statement increases retained earnings in balance sheet (credits)
- All expenses on the income statement (COGS) reduced retained earnings (debits)
- But not all changes on B/S that don't affect retained earnings in income statement e.g.
raising capital
Assets
- Assets are presented in descending order of liquidity e.g. cash is most liquid. As long as
assets can be converted into cash within 12 months they are presented as current
- Cash and Cash Equivalents: cash equivalents are extremely liquid assets
- Accounts Receivable: A/R represents sales that a company has made on credit; the
product has been sold and delivered but not received cash for the sale yet. Linked to
income statement e.g. if book store sells $1000 worth of books only collected $800 in
cash and remaining $200 within 14 days, under accrual revenue is recognized when
earned so it recognizes the full $1000 as revenue
- Prepaid expenses: when a company prepays for
utilities, cash is reduced but the expense is not yet
recognized in income statement. Under accrual
concept, expenses are recognised when the
associated benefit has been received. With
prepayment the benefit hasn't been received so an
asset is created to reflect that the company now has
the right to the future service
- Inventory: inventories represent goods waiting to be sold and direct/indirect costs
associated with the production/procurement of these goods. Merchandiser inventory
is the products procured for resale. Manufacturer inventory includes the costs of
producing the finished inventory
o Cycles in and out of B/S and into I/S as COGS. Before it is done so it calculates
the beginning and ending inventory = beginning inventory COGS + new
inventory purchases
o Under IFRS LIFO inventory costing is not allowed (last in first out e.g. items
purchased last are the first to be sold and COGS are first out. Therefore the cost
of inventory most recently acquired (ending inventory last in) is assigned to
COGS (first out)
o FIFO the earliest goods purchased are the first ones removed from inventory
account. Results in remaining items in inventory being accounted for at the
most recently incurred costs so that inventory asset recorded in B/S contains
cost close to the recent costs obtained in market. But also means that older
historical costs being matched against current revenues
o Cannot markup inventories because of historical cost but they can mark down
i.e. IFRS- when a value of something drops below its historical value it must be
recognized immediately in income statement (write down expense)
- Property, Plant and Equipment (PP&E) : represents land, building, machinery used in
the manufacture of companys G&S plus all costs (transportation, installation) necessary
t prepare those fixed assets for their service
o PP&E cycles from B/S to I/S as depreciation, eiter in COGs, SG&A or elsewhere.
o Net PP&E = Gross PP&E accumulated depreciation
o Net PP&E in the balance sheet thus refers to the remaining value of the asset
o Write downs value declines need to be written down. The loss can be
presented in COGS/SG&A in income statement
o Asset sales if a company sells their PP&E, the associated gross PP&E balance
and accumulated depreciation is removed from the B/S and offset by cash
received and any gain/loss on sale in the income statement
 o Gains on sale if a company receives more than the net book value it
recognizes on the B/S (i.e. after accumulated depreciation, a gain is recorded on
the I/S as a non-operating income or within the expense category where the
asset was being depreciated
o Intangible Assets non-physical acquired assets. Have value based on rights
belonging to that company, and is amortised in value over their useful life in
income statement
o Goodwill the amount by which the purchase price for a company exceeds its
fair market value (FMV) representing the intangible value stemming from the
acquired companys business name, customer relations, company morale (it is
effectively an accounting plug created if purchase price exceed FMV of all
assets)
Goodwill impairment - Unlike finite life intangible assets, Goodwill is
not amortised but tested annually for loss of value (impairment) if the
value of previously acquired company declines, goodwill is reduced
with the corresponding reduction to RE via income statement by
amount of impairment. Goodwill writedowns imply that a company
overpaid
Liabilities
- Are presented in order of when they will be paid
- Accounts Payable (A/P) current liability representing amounts owed by company to
suppliers for prior purchases or services
- Accrued expenses expenses incurred but not yet paid e.g. wages
- Deferred (unearned) revenue Revenue received for G&S not yet provided by the
company e.g. magazine subscriptions (can be current/long-term)
- Capital leases long-term liabilities defined as contractual agreements, allowing a
company to lease (rent) PP&E for a certain period of time in exchange for regular
payments. Has to hit certain criteria e.g. if lease life >75% of life of asset etc.
Equity
- Preferred stock: stock that has special rights and takes priority over common stock.
When companies raise capital esp. at early stages, investors often prefer to contributed
capital in the form of preferred over common stock. The special rights include priority
over dividends and claims on assets in bankruptcy. Preferred stock is often structured to
include conversion into common stock at a pre-set exchange rate
- Common stock: represents capital received by a company when it issues shares
o Accounting for common stock involves splitting the value of a shre of common
stock into 2 components: 1) Common stock par value (represents some nominal
value to an issued share) 2) additional paid in capital APIC (represents the excess
value of the share over par value
o E.g. when google went public it received $85 per share offered each share had a
par value of $0.01 Google cannot write up the value of its common equity from
the $85 to reflect the higher current share price (historical cost)
- Treasury stock: common stock that is issues and reacquired by company for reasons
including boosting EPS (repurchase reduces total shares outstanding) or to change the
companys capital structure (more debt/less equity)
o Often times treasury stock is an even larger amount on B/S than common stock
and APIC. This is because common stock & APIC cannot be written up
 - Retained earnings: total company earnings/losses since its inceptions less all dividends.
The I/S is connected to the B/S via RE all income on the I/S increases retained earnings
on balance sheet (credits) all expenses on the I/S decrease retained earnings (debit). All
common/preferred dividends decrease retained earnings (debits)
- Other comprehensive income (OCI) equity line that captures accumulation of income
or loss that the company has recognised time that is not recognised directly in I/S and
thus not captured in retained earnings. It captures gains/losses from foreign currency
translations, unrealized gains/losses on available for sale securities
Cash Flow Statement
- The CFS reconciles net income to a companys actual change in cash balance over a
period in time (quarter)
- While the I/S is useful it is potentially misleading about the companys liquidity. They
might show high profitability but running out of cash b/c significant revenues recognised
were non cash
- The CFS identifies the year over year of every B/S line items that affect cash:
o CFO captures the impact of retained earnings, current assets/liabilities (and the
D&A part of fixed assets & intangibles)
o CFI captures the impact of long term assets
o CFF captures the impact of long term liabilities and equity
- Structure of Cash Flow Statement: (virtually all companies use indirect method for
reporting cash flow) requires cashflows to be classified into 3 components
1. Cash from Operations (CFO) how much ash did the company generate from
operations during the period? Uses net incomes as a starting point and converts accrual
based net income into cash flow from operations via series of adjustments (i.e. non
cash, and accrual)
o Start with net-income and back all the non-cash expense and income out of net
income to get cash income or cash from operations
o Often the largest adjustment is depreciation expense b/c it is usually largest
non-cash expense included (added back to CFO as it is a non-cash expense)
o The other major adjustment is for a specific grouping of B/S line items working
capital. Current assets like A/R, inventories, prepaid expenses are called working
capital assets and current liabilities are called working capital liabilities. Both
represent assets/liabilities that are tied up in the ordinary course of operations
o The impact of changes in working capital assets/liabilities is because increases in
assets represent a usage of funds (cash outflow) and increases and in liabilities
and equity represent a source of funds (cash inflow)
o Increases in working capital assets e.g. A/R, inventory, prepaid inventory are
represented as subtractions from net income to get to CFO
o Increases in working capital liabilities e.g. A/Pm accrued expenses should be
added to net income to get to CFO
- Typical line items in CFO section
 2. Cash from investing (CFI) capital expenditures / asset sales and purchases
- Tracks additions and reductions to fixed assets and investments during the year e.g.
capital expenditures (cash outflow - money spent by a business or organization on
acquiring or maintaining fixed assets, such as land, buildings, and equipment) purchase
of intangible assets (cash outflow), asset sales (cash inflow),
3. Cash from financing (CFF) new borrowing /paydown of debt / new issuance of stock /
share repurchases, issuances of dividends
- Tracks changes in companys sources of debt and equity financing e.g.
issuance/repayment of debt (inflow/outflow), common stock issued (inflow/outflow)
payment of dividends (outflow)
4. Effect of Exchange rate changes on cash and cash equivalents net change in exchange
rate impact
5. Change in Cash and Cash Equivalents net change in cash
6. Total cash and cash equivalents
Financial Statement (Ratio) Analysis
- Financial statement analysis relies on looking at relationships (ratios) between 2 or more
financial statement accounts and seeing how those ratios change over time and how
they compare across companies or industries
1. Liquidity Ratios measures of a firms short term ability to meet its current obligations /
short term financing needs e.g. Current Ratio
o Current Ratio = current assets / current liabilities
o Quick ratio (acid test) = cash and AR / current liabilities
o Current ratio > 1 is good
2. Profitability Ratios measures a firms profitability relative to its assets (operating
efficiency) and to its revenues (operating profitability) e.g. Gross Margin, EPS
o Operating margin = operating profit / revenue
o Net profit margin = net income / revenue
o Asset turnover = revenue / average assets
o Return on assets (ROA) = net income / average assets
o Return on equity (ROE) = net income / total equity
o Financial leverage is the amount of debt that an entity uses to buy more assets.
Leverage is employed to avoid using too much equity to fund operations. An
excessive amount of financial leverage increases the risk of failure, since it
becomes more difficult to repay debt. ROA uses a levered measure of
profitability (b/c net income is sensitive to leverage via interest expense) with
an unlevered measure of assets (assets can be financed by lots or no leverage)
ROE solves this issue by factoring leverage into the denominator
o Basic EPS = net income less preferred dividends / weighted avg. shares out
o Diluted EPS = diluted net income / weighted avg. diluted shares out
o Dividend yield = dividends / net income
3. Activity Ratios measure of efficiency of a firms assets e.g. inventory turnover
o Receivables turnover = revenue / average accounts receivable
o Days sales outstanding (DSO) = Days in period / receivables turnover OR
(AR/Credit Sales) * days in period
o ^ for both they are identical conceptually to inventory turnover. If you collect
very fast from customers you immediately get cash if you had to wait a long
time for customers to pay, cash that you need for other activities will have to be
from debt
 o Inventory turnover = COGS / average inventory. If you only need $50 inventory
to support $1000 in COGS it means you carry very little inventory can be
advantageous b/c means you don't need large amounts of cash for inventory
requirements until a sale is made. If you need large inventory purchase prior to
sale, you would have had to tap other financing sources e.g. debt
o A/P turnover = COGS / average AP. Measures how quickly a company pays its
vendors. Longer credit terms provide company with more flexibility e.g. if your
average DSO takes 30 days but average PPP is 1 days that means cash from
customers takes longer to collect than the terms your vendors have provided
you implies you cannot rely on receivables alone to fund your short term credit
terms
o Payment Payables Period (PPP) = days in period / AP turnover
4. Solvency Rations measures of a firms ability to repay its debt obligations. Important
to investors (esp. lenders) as they try to determine whether borrowers have sufficient
profits to make interest payments and sufficient equity to carry debt
o Debt to EBITDA = Debt / EBITDA. Used to determine debt capacity
o Interest coverage ratio = EBIT / interest expense
o Fixed charge coverage = (EBIT + lease charges) / (lease charges + interest
expenses)
o ^ analyse how much profit is available to satisfy interest expenses
o Debt to total assets = Total debt / total assets
o Debt to Equity = total liabilities / total equity. Used to understand how levered a
company is. the higher the D/E the more highly levered a firm is. (but book value
of equity can seriously understate value of equity)