Summary -

Financial
Accounting for IBA
Exam preparations for the final exam
of semester 1

By: Jeffrey Engels

TABLE OF CONTENT

Study guide…………………………………………………………………………………………………………………………………….…………………………………..p.2

Lectures Notes………………………………………………………………………………………………………………………………………………….…………p.3-p.23

Lecture 1…………………………………………………………………………………………………………………….………….……………………..p.3+p.4

Lecture 2...……………………………………………………………………………………………………….…….…………………………………….p.5+p.6

Lecture 3………………………………………………………………………………………………………………….……….…………………………..p.7+p.8

Lecture 4…………………………………………………………………………………………………………………………….……………………….p.9+p.10

Lecture 5………………………………………………………………………………………………………………..…………………………………p.11+p.12

Lecture 6…………………………………………………………………………………………………………….……………………………………..p.13-p.14

Lecture 7……………………………………………………………………………………………………………………………………………………..…….p.15

Lecture 8…………………………………………………………………………………………………………………………………………………..……….p.16

Lecture 9………………………………………………………………………………………………………………………………………………………..….p.17

Lecture 10…………………………………………………………………………………………………………………………..…………………….p.18+p.19

Lecture 11…………………………………………………………………………………………………………………………..…………………….p.20+p.21

Lecture 12……………………………………………………………………………………………………………………….……………………..…p.22+p.23

Book Summaries……………………………………………………………………………………………………………………………………………………….p.24-p.53

Chapter 1 - Financial Statements and Business Decisions..…………………..………………………………..…………………..p.24-p.26

Chapter 2 - Investing and Financing Decisions and the Accounting System….……………………………………..…….p.27+p.28

Chapter 3 - Operating Decisions and the Accounting System…………………………………………………………………….p.29+p.30

Chapter 4 - Adjustments, Financial Statements, and the Quality of Earnings………………………..…………………..p.31+p.32

Chapter 5 - Communicating and Interpreting Accounting Information…………………………..……..…………………..p.33+p.34

Chapter 6 - Reporting and Interpreting Sales Revenue, Receivables, and Cash…….…………………………………...p.35+p.36

Chapter 7 - Reporting and Interpreting Cost of Goods Sold and Inventory………………………………………………….p.37-p.39

Chapter 8 - Reporting and Interpreting Property, Plant, and Equipment; Intangibles; and Natural
Resources………………………………………………………………………………………………………………….……………………………..p.40+p.41

Chapter 9 - Reporting and Interpreting Liabilities………………………………………………………………………..…………………….p.42

Chapter 10 - Reporting and Interpreting Bond Securities…………………………………………………………………………..…p.43+44

Chapter 11 - Reporting and Interpreting Stockholders' Equity…………………………………………………………………...p.45+p.46

Chapter 12 - Statement of Cash Flows……………………………………………………………………………………………………….p.47+p.48

Chapter 13 - Analyzing Financial Statements………………………………………………………………………….....................p.49-p.51

Appendix A - Reporting and Interpreting in Other Corporations..……………….……………………………..………………p.52+p.53

Practice test (based on the lectures)………………………………………………………………………………………………………………………….……..p.54

Answers to the test……………………………………………………………………………………………………………………………………………………….….p.55

1
Study guide

Course learning objectives & assessment goals

This course is an introduction to the fundamentals of financial accounting reporting. At the end of
this course, the student will be able to:

1. discuss the role and importance of financial statement information

2. construct the four main financial statements at the end of business period
3. demonstrate the links between the four main financial statements
4. apply journal entries and T-accounts to book transactions in the journal and the general
ledger during the year
5. apply different accounting methods for the evaluation of, amongst others, inventory, & cost
of goods sold, PPE& depreciation, and intangible assets & amortization (IFRS - US GAAP)
6. make adjusting journal entries and closing journal entries at the end of the business period
7. analyse company’s financial performance based on the information reported in financial
statements
8. journalize national and international investments in other firms and discuss the consolidation
of financial statements
9. discuss the current international evolution of the accounting standards (IASB - FASB)

Exam lay-out

The midterm for Financial Accounting consists out and multiple choice questions. Computing
numbers will be needed as well. The final exam consists of 70% of the final grade.

Personal opinions

It seems that an emphasis has been placed on understanding the 4 main financial statements.
Furthermore, T-accounts/journal entries and the general ledger will become a crucial part of the
exams as well. It is recommended to go through the theory in this document (both lecture slides and
book chapters) to gain a key understanding of the basis. It is also crucial to go through the tutorial
exercises which could not be summarized in this document to assess your knowledge in the subjects.
Good luck with the exams!

2
Lectures & tutorials
Lecture 1

Accounting

Accounting if the system of recording and summarizing business and financial transactions, and
analyzing, verifying, and reporting the results. Accounting is used by the owner/manager of a
business, by creditors (these lend money for a specific period of time and gain by charging interest on
the money they lend), and by investors (buy ownership in the company in the form of stock).

Investors purchase stock in businesses hoping to gain in two ways:

1.) Sell ownership interest in the future for more than they paid.
2.) Receive a portion of the company’s earnings in cash (dividends).

Main users of financial accounting information

Accounting is an information system:

• Measures business activities

• Processes data into reports
• Communicates results to people and organizations

Financial accounting & management accounting

Financial accounting provides info for external decision makers. Info, therefore, must be relevant,
reliable, comparable, and consistent. The accountancy system that is generally used is called GAAP
(General Accepted Accounting Principles).

Management account generates info for internal decision makers (managers).

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Because there are different users, different information is needed. The main areas of differences are:

- Nature of report produced (general purpose vs specific purpose)

- Level of detail
- Regulations
- Reporting interval
- Time orientation
- Range & quality of information

The annual report

This is a basic overview of the operational, financial and extra-ordinary performance of a company. It
is always over a specific period (1 year). The annual report is compared to previous periods to see
whether or not the firm is doing better.

Four basic financial statements exist:

➔ The Income Statement (= profit & loss account. If focuses on financial performance over a
period through the received revenues and incurred expenses)
➔ Statement of Stockholders’ equity (This entails how net income and dividends affect
company’s financial position at December)
➔ Balance Sheet (statement of the financial position of the firm)
➔ Statement of Cash Flows (focuses on cash receipt and payments over a certain period of
time)

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Lecture 2

Balance sheet

The balance sheet reports the financial position of an entity at a specific date. The header of the
balance sheet (and of any financial statements) goes as follows:

- Title of the statement (In this case: Balance Sheet)

- Name of the entity
- Date/unit of measure

The balance sheet follows the basic accounting equation: Assets = Liabilities + Stockholders’ Equity.

The basic lay-out for a balance sheet

Assets

An asset is a resource held by the business. An items is treated as an asset when a probably future
benefit exists, the business has an exclusive right to control the benefit, the benefit arises from some
past transaction or event, and when the asset is capable of measurement in monetary terms.

➔ Current assets: These are assets that are expected to convert into cash within 1 year.
➔ Fixed (non-current assets): These are planned to be used during multiple production cycles
and will there not be converted to cash within 1 year.

Assets can be both tangible (machines, office furniture, etc.) and intangible (copyrights, patents,
etc.). Intangibles that are developed inside a company are not placed on the balance sheet.

Liabilities

These are all claims, other than those of owners.

➔ Current liabilities: liabilities that will be paid for within 1 year.

➔ Non-current liabilities: liabilities that will be paid over multiple accountancy periods (more
than 1 year).

Stockholders’ equity

Claim of the owner on the business. It is the owners’ investment (contributed capital) + the
accumulated sum of undistributed profits (retained earnings) + all additional (follow-up) equity
investments (such as common stock).

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Transaction analysis

To understand amounts that appear on a company’s balance sheet we need to answer these
questions:

1. What business activities cause changes in the balance sheet?

2. How do specific activities affect each balance?
3. How do companies keep track of balance sheet amounts?

A transaction is any activity that impacts the financial position of a business that can be measured
reliably. Every transaction has 2 sides: the business gives something, and the business receives
something. Accounting records both sides of a transaction.

T-accounts

For each asset, liability and element of stockholders’ equity a record called an account is used. Debit
and credit are neutral terms (Not good and bad). This means either a decrease or an increase
depending on the type of account. Every transaction has both a debit and a credit.

Journal Entries

A chronological record of the transaction is called a journal. A journal entry is a specific transaction
including all increases and decreases in assets, liabilities, and SE.

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Lecture 3

Income statement format

Recognizing revenues & expenses

Revenue from the sale of goods is recognized when significant risks and rewards of ownership have
been transferred to external parties, normally when the goods are delivered to the customer.

Main criteria for revenue recognition:

- Services had been rendered

- Ownership and control of the item should pass to the buyer
- Amount of revenue can be measured reliably
- It is probable that the economic benefits will be received

An expense is recognized in the period in which goods and services are used, not necessarily the
period in which cash is paid. Matching convention of accounting argues that:

- Expenses should be matched to the revenue that they helped to generate

- Expenses associated with particular item of revenue must be taken into account in the same
reporting period as that in which the item of revenue is included

Accrual based <-> Cash based

In accrual basis accounting, revenues and expenses are recognized when the transaction that causes
them occurs (not necessary when cash is received or paid).

➔ Revenues are recognized when they are earned => Revenue principle

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 ➔ Expenses are recognized when they are incurred => Matching principle

Cash based accounting records revenues when cash is received and expenses when cash is paid.

The accounting cycle

As a group, the T-accounts are called: the general Ledger.

The unadjusted trial balance

This is a listing of individual accounts, usually in financial statement order. Ending debit or credit
balances are listed in two separate columns. Total debits always equal total credits.

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Lecture 4

Adjusting entries

Cash is not always received in period in which revenues are earned, and cash is not always paid in
period in which expenses are incurred. These adjusting entries are recorded at end of every
accounting period.

Deferred (prepaid) expenses are costs that have been incurred, but which has not yet been
consumed. Deferred revenue is a liability because it refers to revenue that has not been earned and
represents products or services that are owed to a customer (cash is gained but the service has yet to
be provided).

Accrued revenue is revenue that has been earned by providing a good or service, but for which no
cash has been received. Accrued expenses refer to expense that is recognized on the books before it
has been paid.

Purpose of adjusting entries

• Measure income
• Update balance sheet

Each adjusting entry affects

• One income statement account (Revenue or Expense)

• One balance sheet account (Asset or liability)

The accounting cycle

During the accounting period, the accounting cycle goes through 7 steps:

During the period

1.) Analyse transactions

2.) Record journal entries in the general journal
3.) Post amounts to the general ledger

At the end of the period

4.) Prepare a trial balance to check balance

5.) Adjust revenues and expenses and related balance sheet accounts
6.) Prepare a complete set of financial statements and disseminate it to users
7.) Close revenues, gains, expenses, and losses to Retained Earnings

The adjusted trial balance is used to prepare the final statements: the income statement, statement
of Retained Earnings, and the Balance Sheet.

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Final step: closing the books

The closing entries set temporary accounts to zero (to start next period)

→ revenues & expenses relate to limited period

→ also dividends account is a temporary account

Important note: balance sheet account balances carry forward from period to period, the income
statement accounts does not.

Closing entries transfer net income/net loss (revenues & expenses) to the Retained Earnings account.
2 steps are used in the closing process

→ Close revenues and gains to Retained earnings

→ Close expenses and losses to Retained earnings

Statement of Retained Earnings

This statement shows changes to the Retained Earnings account. Net income is added to beginning
balance. Dividends are subtracted and, finally, ending Retained Earnings flow to the balance sheet.

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Lecture 5

Reporting sales

The revenue principle states that revenues are recognized:

- When the company transfers promised goods and services to customers

- In the amount it expects to receive.

Companies record credit card discounts, sales discounts, and sales returns and allowances
separately. This allows management to monitor these transactions. Here sales minus credit card
discount, sales discount, and sales returns equals net sales revenue.

Accounting for bad debts

Uncollectible accounts / Bad debts / Doubtful accounts result from credit customers who will not
pay the business the amount they owe, regardless of collection efforts. If a firm at the end of a
period is not sure which customers’ accounts receivable are bad debts, then there is an accounting
problem.

The Allowance method is used to measure bad debt:

1.) Record an estimate of the bad debt expense by an adjusting entry at the end of the
accounting period
2.) Writing off accounts determined to be uncollectible during the period

Bad debt expense (accrued expense) is normally classified as a selling expense and is closed at year-
end.

Contra asset account (normal balance is a credit ending Balance) are always subtracted from balance
of the asset “Accounts Receivable”. These reduce its balance.

Writing off uncollectible accounts

When it is clear that a specific customer’s account receivable will be uncollectible, the amount should
be removed from the accounts receivable account and charged to the allowance for doubtful
accounts.

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Estimating bad debts

This can be done through the percentage of credit sales method (determine bad debt expense as a
percentage of credit sales), and through the aging of accounts receivable method (categorizing each
customer’s accounts receivable by age and estimate the probable bad debt loss rates per age
category).

Example:

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Lecture 6

Accounting standards

Accounting standards are rules and guidelines that a firm needs to follow in preparing its financial
statements. These rules are related to the recognition, measurement, presentation and disclosure.
These rules are set up by governing bodies of a country like Financial Accounting Standards Board
(FASB, determine US accounting rules).

Every country has its own version of GAAP. Different accounting standards lead to different reported
income. The reported income does not mean anything unless you know the accounting standards.

GAAP and IFRS (International Financial Reporting Standards)

The key difference between IFRS and GAAP is the IFRS is seen as principle-based accounting (no
detailed rules, and minimum guidance), while GAAP is seen as rules-based accounting.

The objective of IFRS is to develop, in the public interest, a single set of high quality, understandable
and enforceable global accounting standards that require high quality, transparent, and comparable
information in financial statements and other financial reporting to help participants in the various
capital markets of the world and other users of the information to make economic decisions.

The idea is to :

- Increase quality of profit numbers

- Create uniformity within Europe

In accounting, earnings management is a method of manipulating financial records to improve the

appearance of the company's financial position. As IFRS improves accounting quality, there is a lower
degree of earnings management.

Convergence GAAP and IFRS

This refers to the process of narrowing the differences between IFRS and the accounting standards of
countries that retain their own standards.

These countries could:

- Require financial reporting to comply with their own standards without formally recognizing
IFRS
- Permit all companies to report either under IFRS or domestic standards
- Require domestic companies to comply with domestic standards and permit only cross-listed
foreign companies to comply with either.

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The disclosure process

A publicly traded company is required to provide detailed information in regular filings with the
securities and Exchange Commission (SEC)

The Board of directors and auditors monitor the integrity of the system that produces the
disclosures. Fair disclosure requires that companies provide all investors equal access to all important
company news. Companies issues its earnings press releases within four weeks of the end of the
accounting period. Financial Analyst make earnings forecast, predictions of earnings for future
accounting periods

SEC

The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States
federal government. The SEC holds primary responsibility for enforcing the federal securities laws,
proposing securities rules, and regulating the securities industry, the nation's stock and options
exchanges, and other activities and organizations, including the electronic securities markets in the
United States.

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Lecture 7

Inventory

Inventory is tangible property that is:

- held for sale in the normal course of a business or

- used to produce goods and services for sale

Inventory management on the other hand means having sufficient quantities of high quality
inventory available to serve customers’ needs while minimizing the cost of carrying inventory.

Inventory costing method

Four separate methods exist for inventory costing:

1.) Specific identification: here, the specific cost of each inventory item is known. This is only
used with low volume, high cost items.
2.) FIFO: First-In, First-Out. When using first-in, first-out , we assign the older costs to the units
sold. That leaves the more recent costs to be used to value ending inventory. In other words,
the first-in, first-out method assumes that the first goods purchased (the first in) are the first
goods sold.
3.) LIFO: Last-In, First-Out. LIFO, assumes that the most recently purchased goods (the last ones
in) are sold first and the oldest units are left in ending inventory
4.) Weighted Average cost Method: uses the weighted average unit cost of the goods available
for sale for both cost of goods sold and ending inventory.

Inventory turnover ratio

This can be calculated with the following formula:

𝐶𝑜𝑠𝑡 𝑂𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
Inventory turnover = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

Inventory systems

We recognize two types of inventory systems:

➔ Periodic inventory systems: Inventory is counted periodically => no detailed records of actual
inventory are maintained during accounting period. Here, cost of goods sold are identified
periodically.
➔ Perpetual inventory systems / Continuous inventory system: Continuous records are kept of
quantity and, usually, the cost of individual items bought and sold. Here, cost of goods sold
identified each time a sales is made

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Lecture 8

Measuring and Recording Acquisition Cost

According to the cost principle, acquisition costs includes the purchase price and all expenditures
needed to prepare the asset for its intended use (think of buildings and equipment).

Depreciation

Depreciation is a cost allocation process that systematically and rationally matches acquisition costs
of operational assets with periods benefited by their use. To simplify: the book value of assets such
as machinery decreases over time due to usage and replacing technology. This effect of decreased
value is called depreciation.

There are several methods to measure depreciation:

- Straight-Line Method: Depreciation occurs in a set amount over the years (each year asset
value is decreased by the same amount). →
Depreciation expense per year= Historical cost – Residual value
- Units-of-Production Method:
𝐶𝑜𝑠𝑡−𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
Step 1: Depreciation rate = 𝐿𝑖𝑓𝑒 𝑖𝑛 𝑈𝑛𝑖𝑡𝑠 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
Step 2: Depreciation expense = Depreciation rate x # units produced for year
- Declining-Balance Method:
2
Depreciation expense in year t = Net book value at start of year t * (𝑈𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

Accelerated depreciation matches higher depreciation expense with higher revenues in the early
years of an asset’s useful life when the asset is more efficient.

Impairments

Impairment is the loss of a significant portion of the utility of an asset through casualty,
obsolescence, or lack of demand for the asset’s service. This is a permanent decrease in asset value.

Impairment is a loss in value due to unexpected events.

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Lecture 9
Assets are financed from two external sources: equity and debt.

Liabilities

Liabilities are:

- debts or obligations of the company that result from past transactions, which will be paid
with assets or services.
- Legally binding obligations
- the amount a creditor will accept to settle this liability immediately

If a liability is due within 1 year, it is regarded to as a current liability, an if the maturity if over 1 year,
then it is seen as a noncurrent liability.

List of common current liabilities

- Accounts payable
- Short-term notes payable
- Unearned revenue (=deferred revenues)
- Dividends payable
- Current portion of long-term debt
- Accrued liability (Tax payable, accrued compensation or wages payable, interest payable)

Notes payable means debt raised from a financial service organization. These typically are
noncurrent liabilities.

Bonds

Bonds are public debt provided by multiple bondholders. In a bond contract, two types of cash
payments exist:

- Principal (par value)

- Cash interest payments

The present value is the price at which the bond sells. The present value of €1 can be calculated by
the following formula:

Here:

- C → the cost in the currency (in this case €1)

- i → Market rate of interest
- n → number of periods

Annuity (interest payments) is a series of consecutive payments a bondholder receives over several
periods

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Lecture 10

The corporate form

A corporation is an artificial personal entity, created by law having similar rights and duties as real
persons (contracts, responsible for debt, courts, etc.)

A Limited company is legally separate from the owner/manager. It has a perpetual life and the
owners have limited liability.

In a corporation equity holders (owners of the company) posses both common stock as preferred
stock.

Stock

IPO (or Initial Public Offering) is the first sale of stock to the public. This means that a company has
gone ‘public’.

Treasury stock is stocks that have been reacquired and is held by the corporation (no voting, dividend
or other right in this status). Outstanding shares = issued shares – treasury stock.

To pay dividends upon stock, a company much have achieved enough retained earning to declare
dividend, and possess enough cash to pay these dividends.

Types of investments

We recognize three types of investment, each with their own measuring and reporting method.

➔ Passive investing → fair value method

➔ Significant influence investing → equity method
➔ Control investing → purchase accounting and consolidation

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Passive investments

This consists of trading securities and securities available for sale.

- Trading securities are actively traded. Their objective is to generate profits on short-term
changes in the price of the securities. On the balance sheet this is classified as a current
asset.
- Securities available for sale are both current and non-current assets. A SAS is an investment
with the goal to earn a return in the future.

Significant influence investments

In this type of investment, an investing entity gains between 20 and 50 percent of outstanding shares
(issued shares minus treasure stock).

Control investment

Here, the level of ownership equals to a possession of more that 50% of all outstanding shares. This
type of investment is mainly done through mergers & acquisitions. There are 3 reasons for this:

- Vertical integration (insourcing)

- Horizontal growth
- Synergy

Consolidated accounting is a method of combining the FS of all the companies controlled by the same
stakeholders.

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Lecture 11

Investment decisions

Investment decisions lay on three types of factors:

1.) Economy-wide factors

2.) Industry-wide factors
3.) Individual company factors

For individual company factors, this may come down to their fundamental strategy. This can be
separated between product differentiation and cost differentiation. Cost differentiation is a strategy
where products are offered at the lowest possible price in order to obtain market share, and product
differentiation wins customers over by creating unique benefits to a product.

Financial statement analysis

To analyse financial and discovery the possibility in profitability for investment decisions, 4 types of
ratios can be used:

- Profitability ratios: here, a number of figures are analysed over time. These are return on
equity and return on assets, earnings per share, profit margin, and fixed assets turnover
ratio.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
Return on Equity = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

Return on Assets = → Asset turnover ratio =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒−𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

Earning Per Share (EPS) = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Net Profit margin = 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

EPS is the single most widely watched financial ratio.

- Liquidity ratios: cash ratio, current ratio, quick ratio, receivable turnover ratio, inventory
ratio. A firm’s ability to meet its short-term obligations.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Current Ratio = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠
Quick Ratio = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

- Solvency ratios: Solvency is a firm’s ability to sustain its activity into the long-term.
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Debt-to-Equity ratio =
𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦

20
 - Stock market ratios
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
Price/Earnings (P/E) ratio =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

Interpreting ratios

Ratios may vary because of the company’s industry characteristics, nature of operations, size, and
accounting policies. There are no global standards in this.

A ratio analysis knows several limitations:

- Quality of financial statements is uncertain

- Inflation
- The restricted vision of ratios
- The basis for comparison
- Balance sheet ratios

21
Lecture 12

Cash flow statement

A positive cash flow permits to pay dividends to owners, expand company operations, and replace
needed assets.

An example for a cash flow statement is given below:

As can be seen, a cash flow statement consists of three parts: operating activities, investing activities,
and financing activities.

- Operating activities are cash inflows and outflows directly related to earnings from normal
activities.
- Investing activities are cash inflows and outflows related to the acquisition or sales of
productive facilities and investments in the securities of other companies.
- Financing activities are cash inflows or outflows related to external sources of financing
(owners and creditors) for the enterprise.

US GAAP and IFRS differ in the cash flow statement treatment of interest received and interest paid.

- For GAAP interest is only received and paid for operating activities.
- For IFRS interest is received and paid for operating activities, investing activities, and
financing activities.

22
Direct vs Indirect method

Operating activities can be calculated through the direct method, and the indirect method.

For the indirect method:

Assets = Liabilities + Equity

Cash + Noncash assets = Liabilities + Equity
Cash = Liabilities + Equity – Noncash Assets
∆Cash = ∆Liabilities + ∆Equity - ∆Noncash assets

Deducting net cash flow from operating activities:

➔ Direct method: Analysis of cash records of the business for the period all payments and
receipts related to operating activities.
➔ Indirect method: Idea: Revenues raise cash inflows, expenses raise cash outflows. It uses
information from the income statement as starting point for operating cash flows.

23
Book summaries
Chapter 1 - Financial Statements and Business Decisions

Managers (often called internal decision makers) need information about the company’s business
activities to manage the operating, investing, and financing activities of the firm. Stockholders and
creditors (often called external decision makers) need information about these same business
activities to assess whether the company will be able to pay back its debts with interest and pay
dividends. Developing accounting information for internal decision makers, called managerial or
management accounting, is the subject of a separate accounting course. Financial accounting is
accounting for external decision makers.

Business activities include:

- Financing activities: borrowing or paying back money to lenders and receiving additional
funds from stockholders or paying them dividends.
- Investing activities: buying or selling items such as plant and equipment used in the
production of beverages.
- Operating activities: the day-to-day process of purchasing raw tea and other ingredients
from suppliers, manufacturing beverages, delivering them to customers, collecting cash from
customers, and paying suppliers.

The four basic financial statements

Four financial statements are normally prepared by profit-making organizations for use by investors,
creditors, and other external decision makers.

- The balance sheet

- The income statement
- The statement of stockholders’ equity
- The statement of cash flows

The purpose of the balance sheet is to report the financial position (amount of assets, liabilities, and
stockholders’ equity) of an accounting entity at a particular point in time. The heading of this
statement consists of 4 parts:

1.) Name of the entity,

2.) Title of the statement,

24
 3.) Specific date of the statement,
4.) Unit of measure.

The balance sheet follows the basic accounting equation which is as follows:

Assets are the economic resources owned by the entity. Liabilities indicate the amount of financing
provided by creditors. They are the company’s debts or obligations. Stockholders’ equity indicates the
amount of financing provided by owners of the business and reinvested earnings

The income statement reports the revenues less the expenses of the accounting period. The time
period covered by the financial statements (one year in this case) is called an accounting period. The
income statement equation that describes their relationship is:

The statement of stockholders’ equity reports the way that net income and the distribution of
dividends affected the financial position of the company during the accounting period. The
statement starts with the beginning balances in the stockholders’ equity accounts, lists the increases
and decreases, and reports the resulting ending balances.

The statement of cash flows reports inflows and outflows of cash during the accounting period in the
categories of operating, investing, and financing. The cash flow statement equation describes the
causes of the change in cash reported on the balance sheet from the end of the last period to the
end of the current period:

Cash flows from operating activities are cash flows that are directly related to earning income. It lists
the amounts collected as cash collected from customers. Cash flows from investing activities include
cash flows related to the acquisition or sale of the company’s plant and equipment and investments.
Cash flows from financing activities are cash flows directly related to the financing of the enterprise
itself. They involve the receipt or payment of money to investors and creditors

25
Responsibility for the accounting communication process

Generally accepted accounting principles, or GAAP is the name given to the measurement and
disclosure rules used to develop the information in financial statements. They are of great interest to
the companies that must prepare financial statements, their auditors, and the readers of the
statements. Companies incur the cost of preparing the statements and bear the major economic
consequences of their publication, which include, among others,

- Effects on the selling price of a company’s stock.

- Effects on the amount of bonuses received by management and employees.
- Loss of competitive information to other companies.

Companies should take three important steps to assure investors that the company’s records are
accurate: (1) they should maintain a system of controls over both the records and the assets of the
company, (2) they should hire outside independent auditors to audit (examine) the fairness of the
financial statements, and (3) they should form a committee of the board of directors to oversee the
integrity of these other safeguards.

26
Chapter 2 - Investing and Financing Decisions and the Accounting
System

Overview of accounting concepts

The primary objective of financial reporting to external users is to provide financial information about
the reporting entity that is useful to existing and potential investors, lenders, and other creditors in
making decisions about providing resources to the entity. Most users are interested in information to
help them assess the amount, timing, and uncertainty of a business’s future cash inflows and
outflows.

For accounting information to be useful, it must be relevant and be a faithful representation.

Relevant information is capable of influencing decisions by allowing users to assess past activities
and/or predict future activities. Faithful representation requires that the information be complete,
neutral, and free from error. Comparability, verifiability, timeliness, and understandability are
qualitative characteristics that enhance the usefulness of information that is relevant and faithfully
represented.

Three important assumptions and a measurement concept that underlie accountants’ definitions:

- Separate entity assumption states that business transactions are separate from the
transactions of the owners.
- Going concern assumption states that businesses are assumed to continue to operate into
the foreseeable future (also called the continuity assumption).
- Monetary unit assumption states that accounting information should be measured and
reported in the national monetary unit without any adjustment for changes in purchasing
power.
- The mixed-attribute measurement model is applied to measuring different assets and
liabilities of the balance sheet.

Assets are probable future economic benefits owned or controlled by an entity as a result of past
transactions or events. In other words, they are the economic resources the entity acquired to use in
operating the company in the future. On a balance sheet, these are placed in order of liquidity (how
soon an asset is expected to be turned into cash). Current assets are assets that will be used or
turned into cash within one year. Inventory is always considered a current asset regardless of the
time needed to produce and sell it.

Liabilities are defined as probable future sacrifices of economic benefits arising from present
obligations of a business to transfer cash or other assets or to provide services as a result of past
transactions or events. Liabilities are usually listed on the balance sheet in order of maturity (how
soon an obligation is to be paid). Current liabilities are short-term obligations that will be paid in cash
(or other current assets) within the current operating cycle or one year, whichever is longer.

Stockholders’ equity is the financing provided by the owners and the operations of the business.
Retained earnings are cumulative earnings of a company that are not distributed to the owners and
are reinvested in the business.

27
What business activities cause changes in financial statement amounts?

Accounting focuses on certain events that have an economic impact on the entity. Those events that
are recorded as part of the accounting process are called transactions. The first step in translating
the results of business events to financial statement numbers is determining which events to include.
Transactions include two types of events:

- External events: These are exchanges of assets, goods, or services by one party for assets,
services, or promises to pay (liabilities) from one or more other parties.
- Internal events: These include certain events that are not exchanges between the business
and other parties but nevertheless have a direct and measurable effect on the entity.

To accumulate the dollar effect of transactions on each financial statement item, organizations use a
standardized format called an account. To facilitate the recording of transactions, each company
establishes a chart of accounts, a list of all account titles and their unique numbers.

How do transactions affect accounts?

Transaction analysis is the process of studying a transaction to determine its economic effect on the
entity in terms of the accounting equation (also known as the fundamental accounting model). The
two principles underlying the transaction analysis process follow:

➔ Every transaction affects at least two accounts; correctly identifying those accounts and the
direction of the effect (whether an increase or a decrease) is critical.
➔ The accounting equation must remain in balance after each transaction

Par value is the nominal value per share of capital stock as specified in the corporate charter. Also,
another name for bond principal, or the maturity amount of a bond. Common stock is the basic
voting stock issued by a corporation. Additional paid-in capital/contributed capital is the amount of
contributed capital less the par value of the stock.

How do companies keep track of account balances?

The accounting cycle is the process used by entities to analyse and record transactions, adjust the
records at the end of the period, prepare financial statements, and prepare the records for the next
cycle. These formal records are based on two very important tools used by accountants: journal
entries and T-accounts.

A journal entry is an accounting method for expressing the effects of a transaction on accounts in a
debits-equal-credits format. An example can be seen below:

A T-account is a tool for summarizing transaction effects for each account, determining balances, and
drawing inferences about a company’s activities. Finally, a trial balance is a list of all accounts with
their balances to provide a check on the equality of the debits and credits

28
Chapter 3 - Operating Decisions and the Accounting System

How do business activities affect the income statement?

The long-term objective for any business is to turn cash into more cash. If a company is to stay in
business, this excess cash must be generated from operations. Companies (1) acquire inventory and
the services of employees and (2) sell inventory or services to customers. The operating (cash-to-
cash) cycle begins when a company receives goods to sell, pays for them, and sells to customers; it
ends when customers pay cash to the company.

Decision makers require information periodically about the company’s financial condition and
performance. To measure income for a specific period of time, accountants follow the time period
assumption, which assumes that the long life of a company can be reported in shorter time periods,
such as months, quarters, and years.

Revenues are increases in assets or settlements of liabilities from the major or central ongoing
operations of the business. These are used as the first and primary account in the income statement.
Operating income, in an income statement, are the net-sales less cost of goods sold and other
operating expenses. An example of an income statement can be seen below:

How are operating activities recognized and measured?

Cash basis accounting records revenues when cash is received and expenses when cash is paid.
Accrual basis accounting records s revenues when earned and expenses when incurred, regardless of
the timing of cash receipts or payments. The two basic accounting principles that determine when

29
revenues and expenses are recorded under accrual basis accounting are the revenue recognition
principle and the expense recognition principle (also called the matching principle).

The core revenue recognition principle specifies both the timing and amount of revenue to be
recognized during an accounting period. It requires that a company recognize revenue:

1.) When the company transfers promised goods or services to customers

2.) In the amount it expects to receive.

The expense recognition principle (also called the matching principle) requires that costs incurred to
generate revenues be recognized in the same period—a matching of costs with benefits.

30
Chapter 4 - Adjustments, Financial Statements, and the Quality of
Earnings

Adjusting revenues and expenses

Accounting systems are designed to record most recurring daily transactions, particularly those
involving cash. As cash is received or paid, it is recorded in the accounting system. How does the
accounting system record revenues and expenses when one transaction is needed to record a cash
receipt or payment and another transaction is needed to record revenue when it is earned or an
expense when it is incurred? The solution to the problem created by such differences in timing is to
record adjusting entries at the end of every accounting period. These are entries necessary at the
end of the accounting period to measure all revenues and expenses of that period. This is important
so that:

- Revenues are recorded when they are earned (the revenue recognition principle),
- Expenses are recorded when they are incurred to generate revenue (the expense recognition
principle),
- Assets are reported at amounts that represent the probable future benefits remaining at the
end of the period,
- Liabilities are reported at amounts that represent the probable future sacrifices of assets or
services owed at the end of the period.

When a customer pays for goods or services before the company delivers them, the company
records the amount of cash received in a deferred (unearned) revenue account. These are previously
recorded liabilities (from collecting cash from customers in the past) that need to be adjusted at the
end of the period to reflect the amount of revenue earned by providing goods or services over time
to customers. This unearned revenue is a liability representing the company’s promise to perform or
deliver the goods or services in the future. Recognition of (recording) the revenue is postponed
(deferred) until the company meets its obligation.

Accrued revenues are previously unrecorded revenues that need to be adjusted at the end of the
accounting period to reflect the amount earned and its related receivable account. Deferred
expenses are previously acquired assets that need to be adjusted at the end of the accounting period
to reflect the amount of expense incurred in using the asset to generate revenue.

Closing the books

The ending balance in each of the asset, liability, and stockholders’ equity accounts becomes the
beginning account balance for the next period. These accounts, called permanent (real) accounts, are
not reduced to a zero balance at the end of the accounting period. The only time a permanent
account has a zero balance is when the item it represents is no longer owned or owed.

Revenue, expense, gain, and loss accounts are used to accumulate data for the current accounting
period only; they are called temporary (nominal) accounts. The final step in the accounting cycle,
closing the books, is done to prepare income statement accounts for the next accounting cycle.
Therefore, at the end of each period, the balances in the temporary accounts are transferred, or
closed, to the Retained Earnings account by recording a closing entry.

31
The closing entries have two purposes:

1.) To transfer the balances in the temporary accounts (income statement accounts) to Retained
Earnings.
2.) To establish a zero balance in each of the temporary accounts to start the accumulation in
the next accounting period.

In this way, the income statement accounts are again ready for their temporary accumulation
function for the next period.

After the closing process is complete, all income statement accounts have a zero balance. These
accounts are then ready for recording revenues and expenses in the new accounting period. As an
additional step of the accounting information processing cycle, a post-closing trial balance should be
prepared as a check that debits still equal credits and that all temporary accounts have been closed.

32
Chapter 5 - Communicating and Interpreting Accounting
Information

Players in the accounting communication process

The mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors and
maintain the integrity of the securities markets. As part of this mission, the SEC oversees the work of
the Financial Accounting Standards Board (FASB), which sets generally accepted accounting
principles (GAAP), and the Public Company Accounting Oversight Board (PCAOB), which sets auditing
standards for independent auditors (CPAs) of public companies.

A company’s board of directors is elected by the shareholders to represent their interests; its audit
committee is responsible for maintaining the integrity of the company’s financial reports.

Institutional investors are managers of pension, mutual, endowment, and other funds that invest on
the behalf of others. These institutional stockholders usually employ their own analysts. Most small
investors own stock in companies such as Apple indirectly through mutual and pension funds. Private
investors include large individual investors who purchase shares in companies. Lenders, or creditors,
include suppliers, banks, commercial credit companies, and other financial institutions that lend
money to companies. Lending officers and financial analysts in these organizations use the same
public sources of information.

Financial statements also play an important role in the relationships between suppliers and
customers. Customers evaluate the financial health of suppliers to determine whether they will be
reliable, up-to-date sources of supply.

The disclosure process

For privately held companies, annual reports are relatively simple documents photocopied on white
bond paper. They normally include only the following:

1.) . Four basic financial statements: income statement, balance sheet, stockholders’ equity or
retained earnings statement, and cash flow statement.
2.) Related notes (footnotes).
3.) Report of Independent Accountants (Auditor’s Opinion) if the statements are audited.

A closer look at the financial statement formats and notes

A company’s gross profit can be described as the net sales less the cost of goods sold. Operating
Income (also called Income from Operations)—is computed by subtracting operating expenses from
gross profit. Income before income taxes (EBIT) is calculated as revenues minus all expenses except
income tax expense.

33
Return on assets analysis: a framework for evaluating company performance

Evaluating company performance is the primary goal of financial statement analysis. Company
managers, as well as competitors, use financial statements to better understand and evaluate a
company’s business strategy. Analysts, investors, and creditors use these same statements to judge
company performance when they estimate the value of the company’s stock and its
creditworthiness.

Return on assets (ROA) are measured by the key rations below:

- Net profit margin = Net Income ÷ Net Sales. It measures how much of every sales dollar is
profit
- Total asset turnover = Net Sales ÷ Average Total Assets. It measures how many sales dollars
the company generates with each dollar of assets (efficiency of use of assets).

or

34
Chapter 6 - Reporting and Interpreting Sales Revenue, Receivables,
and Cash

Accounting for net sales revenue

On the company’s books, credit card discounts, sales discounts, and sales returns and allowances are
accounted for separately to allow managers to monitor the costs of credit card use, sales discounts,
and returns. Net sales refers to the top line reported on the income statement. Net Sales = Sales
Revenue - (Credit card discounts + Sales discounts + Sales returns and allowances).

Sales returns and allowances are reductions of sales revenues for return of or allowances for
unsatisfactory goods .

Measuring and reporting receivables

Receivables may be classified in three common ways. First, they may be classified as either an
account receivable or a note receivable.

- An account receivable is created by a credit sale on an open account.

- A note receivable is a promise in writing (a formal document) to pay (1) a specified amount of
money, called the principal, at a definite future date known as the maturity date and (2) a
specified amount of interest at one or more future dates. The interest is the amount charged
for use of the principal.

Second, receivables may be classified as trade or nontrade receivables. A trade receivable is created
in the normal course of business when a sale of merchandise or services on credit occurs. A nontrade
receivable arises from transactions other than the normal sale of merchandise or services.

Third, in a classified balance sheet, receivables also are classified as either current or noncurrent
(short term or long term), depending on when the cash is expected to be collected.

The allowance method bases bad debt expense on an estimate of uncollectible accounts. Two
primary steps in employing the allowance method are:

1.) Making the end-of-period adjusting entry to record estimated bad debt expense.
2.) Writing off specific accounts determined to be uncollectible during the period.

Here, bad debt expense (doubtful accounts expense, uncollectible accounts expense, provision for
uncollectible accounts) is the expense associated with estimated uncollectible accounts receivable. It
is included in the category “Selling” expenses on the income statement.

The bad debt expense amount recorded in the end-of-period adjusting entry often is estimated
based on either (1) a percentage of total credit sales for the period or (2) an aging of accounts
receivable. Both methods are acceptable under GAAP and are widely used.

➔ The percentage of credit sales method bases bad debt expense on the historical percentage
of credit sales that result in bad debts. The average percentage of credit sales that result in
bad debts can be computed by dividing total bad debt losses by total credit sales.

35
 ➔ The aging of accounts receivable method relies on the fact that, as accounts receivable
become older and more overdue, it is less likely that they will be collected.

Reporting and safeguarding cash

Cash is defined as money or any instrument that banks will accept for deposit and immediate credit
to a company’s account, such as a check, money order, or bank draft. Cash equivalents are
investments with original maturities of three months or less that are readily convertible to cash and
whose value is unlikely to change. . Effective cash management involves more than protecting cash
from theft, fraud, or loss through carelessness. Other cash management responsibilities include:

- Accurate accounting so that reports of cash flows and balances may be prepared.
- Controls to ensure that enough cash is available to meet (a) current operating needs, (b)
maturing liabilities, and (c) unexpected emergencies.
- Prevention of the accumulation of excess amounts of idle cash. Idle cash earns no revenue.
Therefore, it is often invested in securities to earn a return until it is needed for operations.

The term internal controls refers to the process by which a company safeguards its assets and
provides reasonable assurance regarding the reliability of the company’s financial reporting, the
effectiveness and efficiency of its operations, and its compliance with applicable laws and
regulations. Internal control procedures should extend to all assets. Effective internal control of cash
should include the following:

- Separation of duties
- Prescribed policies and procedures

A bank reconciliation is the process of comparing (reconciling) the ending cash balance in the
company’s records and the ending cash balance reported by the bank on the monthly bank
statement. A bank reconciliation should be completed at the end of each month.

36
Chapter 7 - Reporting and Interpreting Cost of Goods Sold and
Inventory

Nature of inventory and cost of goods sold

Inventory is tangible property that is (1) held for sale in the normal course of business or (2) used to
produce goods or services for sale. Inventory is reported on the balance sheet as a current asset
because it normally is used or converted into cash within one year or the next operating cycle.
Merchandise inventory are goods (or merchandise) held for resale in the normal course of business.
The goods usually are acquired in a finished condition and are ready for sale without further
processing. Manufacturing businesses hold three types of inventory:

➔ Raw materials inventory: Items acquired for processing into finished goods. These items are
included in raw materials inventory until they are used, at which point they become part of
work in process inventory.
➔ Work in process inventory: Goods in the process of being manufactured but not yet
complete. When completed, work in process inventory becomes finished goods inventory.
➔ Finished goods inventory: Manufactured goods that are complete and ready for sale.

Two other components of manufacturing cost, direct labor and factory overhead, are also added to
the work in process inventory when they are used. Direct labor cost represents the earnings of
employees who work directly on the products being manufactured. Factory overhead costs include
all other manufacturing costs. There are three stages to inventory cost flows for both merchandisers
and manufacturers. The first involves purchasing and/or production activities. In the second stage,
these activities result in additions to inventory accounts on the balance sheet. In the third stage, the
inventory items are sold and the amounts become cost of goods sold expense on the income
statement.

Cost of goods sold (CGS) expense is directly related to sales revenue. Cost of goods sold is the
number of units sold multiplied by their unit costs. During the accounting period, new purchases (P)
are added to inventory. The sum of the two amounts is the goods available for sale during that
period. What remains unsold at the end of the period becomes ending inventory (EI) on the balance

37
sheet. The portion of goods available for sale that is sold becomes cost of goods sold on the income
statement.

In a perpetual inventory system, purchase transactions are recorded directly in an inventory account.
When each sale is recorded, a companion cost of goods sold entry is made, decreasing inventory and
recording cost of goods sold. In a perpetual inventory system, a detailed record is maintained for
each type of merchandise stocked, showing (1) units and cost of the beginning inventory, (2) units
and cost of each purchase, (3) units and cost of the goods for each sale, and (4) units and cost of the
goods on hand at any point in time.

Under the periodic inventory system, no up-to-date record of inventory is maintained during the
year. An actual physical count of the goods remaining on hand is required at the end of each period.
The number of units of each type of merchandise on hand is multiplied by unit cost to compute the
dollar amount of the ending inventory. Cost of goods sold is calculated using the cost of goods sold
equation.

Inventory costing methods

When the specific identification method is used, the cost of each item sold is individually identified
and recorded as cost of goods sold. This method requires keeping track of the purchase cost of each
item.

The first-in, first-out method, frequently called FIFO, assumes that the earliest goods purchased (the
first ones in) are the first goods sold, and the last goods purchased are left in ending inventory.

The last-in, first-out method, often called LIFO, assumes that the most recently purchased goods (the
last ones in) are sold first and the oldest units are left in ending inventory.

The average cost method (weighted average cost method) uses the weighted average unit cost of the
goods available for sale for both cost of goods sold and ending inventory.

Valuation at lower of cost or market (net realizable value)

When the net realizable value (sales price less costs to sell) of goods remaining in ending inventory
falls below cost, these goods must be assigned a unit cost equal to their current estimated net
realizable value. This rule is known as measuring inventories at the lower of cost or market (LCM or
lower of cost or net realizable value).

Under LCM, companies recognize a “holding” loss in the period in which the net realizable value of an
item drops, rather than in the period the item is sold. The holding loss is the difference between the
purchase cost and the lower net realizable value. It is added to the cost of goods sold for the period.

LIFO reserve refers to a contra-asset for the excess of FIFO over LIFO inventory.

Control of inventory

A number of control features focus on safeguarding inventories and providing up-to-date information
for management decisions. Key among these are: 1. Separation of responsibilities for inventory
accounting and physical handling of inventory. 2. Storage of inventory in a manner that protects it

38
from theft and damage. 3. Limiting access to inventory to authorized employees. 4. Maintaining
perpetual inventory records (described earlier in this chapter). 5. Comparing perpetual records to
periodic physical counts of inventory.

39
Chapter 8 - Reporting and Interpreting Property, Plant, and
Equipment; Intangibles; and Natural Resources

Acquisition and maintenance of plant and equipment

The resources that determine a company’s productive capacity are often called long-lived assets.
These assets, which are listed as noncurrent assets on the balance sheet, may be either tangible or
intangible and have the following characteristics:

1. Tangible assets have physical substance; that is, they can be touched. The three kinds of
long-lived tangible assets are land, building/fixtures/equipment, and natural resources.
2. Intangible assets are long-lived assets without physical substance that confer specific rights
on their owner. Examples are patents, copyrights, franchises, licenses, and trademarks.

Under the cost principle, all reasonable and necessary expenditures made in acquiring and preparing
an asset for use should be recorded as the cost of the asset.

Acquisition cost is the net cash equivalent amount paid or to be paid for an asset.

In some cases, a company may construct an asset for its own use instead of buying it from a
manufacturer. When a company does so, the cost of the asset includes all the necessary costs
associated with construction, such as labor, materials, and, in most situations, a portion of the
interest incurred during the construction period, called capitalized interest.

Most assets require substantial expenditures during their lives to maintain or enhance their
productive capacity. These expenditures include cash outlays for ordinary repairs and maintenance,
major repairs, replacements, and additions. Expenditures that are made after an asset has been
acquired are classified as follows:

1. Ordinary repairs and maintenance are expenditures that maintain the productive capacity of
the asset during the current accounting period only. These expenditures are recurring in
nature, involve relatively small amounts at each occurrence, and do not directly increase the
productive life, operating efficiency, or capacity of the asset.
2. Improvements are expenditures that increase the productive life, operating efficiency, or
capacity of the asset. These capital expenditures are added to the appropriate asset
accounts.

Use, impairment, and disposal of plant and equipment

Depreciation is the process of allocating the cost of buildings and equipment (but not land) over their
productive lives using a systematic and rational method. The amount of depreciation recorded during
each period is reported on the income statement as Depreciation Expense. Net book value is the
acquisition cost of an asset less accumulated depreciation, depletion, or amortization. Residual value
represents management’s estimate of the amount the company expects to recover upon disposal of
the asset at the end of its estimated useful life. The residual value may be the estimated value of the
asset as salvage or scrap or its expected value if sold to another user.

Depreciation knows 3 separate methods:

40
 - Straight-line: Method that allocates the depreciable cost of an asset in equal periodic
amounts over its useful life.
- Units-of-production: Method that allocates the depreciable cost of an asset over its useful life
based on the relationship of its periodic output to its total estimated output.
- Declining-balance: Method that allocates the net book value (cost minus accumulated
depreciation) of an asset over its useful life based on a multiple of the straightline rate, thus
assigning more depreciation to early years and less depreciation to later years of an asset’s
life.

Intangible assets and natural resources

The most common types of intangible assets are the following:

- Goodwill (recognized in a business combination): For accounting purposes, the excess of the
purchase price of a business over the fair value of the acquired business’s assets and
liabilities.
- Trademarks: An exclusive legal right to use a special name, image, or slogan.
- Copyrights: Exclusive right to publish, use, and sell a literary, musical, or artistic work.
- Technology: Includes costs for computer software and Web development.
- Patents: Granted by the federal government for an invention; gives the owner the exclusive
right to use, manufacture, and sell the subject of the patent.
- Franchises: A contractual right to sell certain products or services, use certain trademarks, or
perform activities in a geographical region.
- Licenses and operating rights: Obtained through agreements with governmental units or
agencies; permit owners to use public property in performing their services
- Others, including customer lists/relationships, noncompete covenants, and contracts and
agreements

Amortization is a systematic and rational allocation of the acquisition cost of an intangible asset over
its useful life. It is similar to depreciations.

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Chapter 9 - Reporting and Interpreting Liabilities

Liabilities defined and classified

Accountants formally define liabilities as the probable future sacrifice of economic benefits that arise from
past transactions. When a liability is first recorded, it is measured in terms of its current cash equivalent, which
is the cash amount a creditor would accept to settle the liability immediately. Many current liabilities have a
direct relationship to the operating activities of a business. In other words, specific operating activities are
financed, in part, by a related current liability.

Accrued liabilities are expenses that have been incurred before the end of an accounting period but have not
been paid. These expenses include items such as rent, utilities, and salaries. When a company collects cash
before the related revenue has been earned, the cash is called deferred revenues, or, occasionally, unearned
revenues. When a company borrows money, it normally signs a formal written contract with a bank and reports
the amount borrowed as a note payable.

A contingent liability is a potential liability that has arisen as the result of a past event; it is not a definitive
liability until some future event occurs. Whether a contingent liability is reported on the balance sheet, in the
footnotes, or not at all depends on two factors: (1) the probability of a future economic sacrifice and (2) the
ability of management to estimate the amount of the liability.

Long-term notes payable and bonds

Companies can raise capital directly from a number of financial service organizations including banks, insurance
companies, and pension plans. Raising capital from one of these organizations is known as a private placement.
The resulting liability is often called a note payable, which is a written promise to pay a stated sum at one or
more specified future dates called the maturity date(s).

In many cases, a company’s need for capital exceeds the financial ability of any single bank or other creditor. In
these situations, the company may issue publicly traded debt called bonds.

When a company leases an asset, it enters into a contractual agreement with the owner of the asset. In the
language of contracts (and accounting), the party that owns the asset is referred to as the lessor. The party that
pays for the right to use the asset is referred to as the lessee. The terms of an operating lease are similar to a
short-term rental and therefore do not require companies to recognize a lease asset or a lease liability on their
balance sheets. In contrast, the terms of a capital lease resemble the financing and outright purchasing of an
asset and therefore require companies to recognize both a lease asset and a lease liability on their balance
sheets

Computing present values

Present value is the current value of an amount to be received in the future; a future amount discounted for
compound interest. Future value is the sum to which an amount will increase as the result of compound
interest.

Instead of a single amount, many business problems involve multiple cash payments over a number of periods.
An annuity is a series of consecutive payments characterized by

1.) An equal dollar amount each period.

2.) Interest periods of equal length (year, half a year, quarterly, or monthly).
3.) The same interest rate each period.

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Chapter 10 - Reporting and Interpreting Bond Securities

Characteristics of band securities

Companies issue both stock and bonds to raise capital. Several reasons why a company might choose
to issue bonds instead of stock include:

- Stockholders maintain control

- Interest expense is tax deductible
- Issuing bonds can increase the return to shareholders

Disadvantages are:

- Risk of bankruptcy
- Negative impact on cash flows

A bond usually requires the payment of interest over its life with repayment of principal on the
maturity date. The bond principal is (1) the amount a company must pay to bondholders at the
maturity date and (2) the amount used to compute the bond’s periodic cash interest payments. The
bond principal is also called the face value, par value, or maturity value. A bond always specifies a
coupon rate (also called the stated rate, contract rate, or nominal rate) and the frequency of periodic
cash interest payments. These interest payments are sometimes called coupon payments.

Convertible bonds are bonds that may be converted to other securities of the issuer (usually common
stock). A Debenture is an unsecured bond; no assets are specifically pledged to guarantee repayment.
Callable bonds are bonds that may be called for early retirement at the option of the issuer.

An indenture is a legal document that describes all the details of a debt security to potential buyers.
A prospectus is a regulatory filing that describes all the details of a debt or equity security to potential
buyers. The prospectus also describes any covenants designed to protect the creditors. Typical
covenants include limitations on new debt that the company might issue in the future, limitations on
the payment of dividends to shareholders, or requirements that the company maintain certain
minimum accounting ratios, such as the current ratio or the debt-to-equity ratio.

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When a bond is issued to an investor, the person receives a bond certificate. All bond certificates for
the same bond issuance, whether an actual paper certificate or an electronic certificate, contain the
same information. The certificates show the same maturity date, coupon rate, interest dates, and
other characteristics. An independent party, called the trustee, is usually appointed to represent the
bondholders. A trustee’s duties are to ascertain whether the issuing company has fulfilled all
provisions of the bond contract.

Reporting bond transactions

The relationship between the market interest rate and the bond’s coupon rate determines whether
the bond is issued at par, at a premium, or at a discount. When the market interest rate equals the
coupon rate, the bond sells at par; when the market interest rate is greater than the coupon rate, the
bond sells at a discount; and when the market interest rate is less than the coupon rate, the bond
sells at a premium.

Effective-interest amortization: A method of amortizing a bond discount or bond premium that

reflects the effective interest rate a company pays bondholders over the life of a bond.

Straight-line amortization: An alternative method of amortizing bond discounts and premiums that
allocates an equal dollar amount to each interest period. It is only permitted by GAAP under specific
circumstances.

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Chapter 11 - Reporting and Interpreting Stockholders' Equity

Ownership of a corporation

The corporation is the only business form the law recognizes as a separate entity. As a distinct entity,
the corporation enjoys a continuous existence separate and apart from its owners. It may own
assets, incur liabilities, expand and contract in size, sue others, be sued, and enter into contracts
independently of its stockholder owners.

When you invest in a corporation, you are known as a stockholder or shareholder. As a stockholder,
you receive shares of stock that you subsequently can sell on established stock exchanges. Owners of
common stock receive a number of benefits:

- A voice in management
- Dividends
- Residual claim

Authorized number of shares refers to the maximum number of shares of stock a corporation can
issue as specified in its charter. The Issued shares is the total number of shares of stock that have
been sold. For a number of reasons, a company might want to buy back shares that have already
been sold to the public. Shares that have been bought back are called treasury stock. Shares held as
treasury stock are considered issued shares but not outstanding shares.

Common stock transactions

Common stock is held by investors who are the “owners” of a corporation. Though stockholders are
owners and have the right to vote and share in the profitability of the business through dividends,
they do not actively participate in managing the business.

Depending on state law, a company’s common stock may be required to have a par value, a nominal
value per share established in the corporate charter. Legal capital refers to the permanent amount of
capital defined by state law that must remain invested in the business; serves as a cushion for
creditors. No-par value stock is capital stock that has no par value as specified in the corporate
charter.

Dividends on common stack

Investors buy common stock because they expect a return on their investment. This return can come
in two forms: stock price appreciation and dividends. The declaration and payment of a dividend
involve several key dates such as:

1. Declaration date: The date on which the board of directors officially approves a dividend.
2. Record date: The date on which the corporation prepares the list of current stockholders
who will receive the dividend when paid.
3. Payment date: The date on which a cash dividend is paid to the stockholders of record.

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Stock dividends and stock splits

Unless stated otherwise, the term dividend means a cash dividend. Though cash dividends are by far
the most common type of dividend, companies can also distribute additional shares of stock as a
dividend. A stock dividend is a distribution of additional shares of a company’s own stock to its
stockholders on a pro rata basis at no cost to the stockholder. The phrase pro rata basis means that
each stockholder receives additional shares equal to the percentage of shares held.

In a stock split, a company commits to giving stockholders a specified number of additional shares for
each share that they currently hold. When a company initiates a stock split, it also reduces the par
value of its stock so that the total dollar amount in the Common Stock account remains unchanged.

Preferred stock transactions

Preferred stock is stock that has specified rights over common stock. The journal entries required to
record the issuance and repurchase of preferred stock are the same as the journal entries required to
record the issuance and repurchase of common stock. Preferred stock, however, differs from
common stock in a number of ways. The most significant differences are:

- Preferred stock typically does not have voting rights

- Preferred stock is less risky
- Preferred stock typically has a fixed dividend rate

The current dividend preference requires a company to pay current dividends to preferred
stockholders before paying dividends to common stockholders. This preference is always a feature of
preferred stock. After the current dividend preference has been met and if no other preference is
operative, dividends can be paid to the common stockholders.

The cumulative dividend preference requires any unpaid dividends on preferred stock to accumulate.
This cumulative unpaid amount, known as dividends in arrears, must be paid before any common
dividends can be paid. Of course, if the preferred stock is noncumulative, dividends can never be in
arrears, and therefore any dividend that is not declared is permanently lost. Preferred stock is usually
cumulative.

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Chapter 12 - Statement of Cash Flows

Classification of the statement of cash flows

the statement of cash flows explains how the amount of cash on the balance sheet at the beginning
of the period has become the amount of cash reported at the end of the period. For purposes of this
statement, the definition of cash includes cash and cash equivalents. Cash equivalents are short-
term, highly liquid investments that are both:

- Readily convertible to known amounts of cash;

- So near to maturity there is little risk that their value will change if interest rates change.

The statement of cash flows reports cash inflows and outflows in three broad categories: (1)
operating activities, (2) investing activities, and (3) financing activities. Together, these three cash
flow categories explain the change in cash from the beginning balance to the ending balance on the
balance sheet.

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Cash flows from operating activities (cash flows from operations) are the cash inflows and outflows
that relate directly to revenues and expenses reported on the income statement. There are two
alternative approaches for presenting the operating activities section of the statement:

➔ The direct method: A method of presenting the operating activities section of the statement
of cash flows that reports components of cash flows from operating activities as gross
receipts and gross payments.
➔ The indirect method: A method of presenting the operating activities section of the
statement of cash flows that adjusts net income to compute cash flows from operating
activities.

Cash flows from investing activities are cash inflows and outflows related to the purchase and
disposal of long-lived productive assets and investments in the securities of other companies.

Cash flows from financing activities include exchanges of cash with creditors (debtholders) and
owners (stockholders).

Preparing and interpreting the cash flow statement requires an analysis of the balance sheet and
income statement accounts that relate to the three sections of the cash flow statement. To prepare
the statement of cash flows, they need the following data:

- Comparative balance sheets

- A complete income statement
- Additional details concerning selected account where the total change amount in an account
balance during the year does not reveal the underlying nature of the cash flows.

Reporting and interpreting cash flows from operating activities

The operating activities section of the cash flow statement focuses attention on the firm’s ability to
generate cash internally through operations and its management of current assets and current
liabilities (also called working capital). A common rule of thumb followed by financial and credit
analysts is to avoid firms with rising net income but falling cash flow from operations. Rapidly rising
inventories or receivables often predict a slump in profits and the need for external financing.

Reporting and interpreting cash flows from financing activities

Financing activities are associated with generating capital from creditors and owners. This section of
the cash flow statement reflects changes in two current liabilities, Notes Payable to Financial
Institutions and Current Maturities of Long-Term Debt, as well as changes in long-term liabilities and
stockholders’ equity accounts.

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Chapter 13 - Analysing Financial Statements

The investment decision

In considering an investment in stock, investors should evaluate the company’s future income and
growth potential on the basis of three factors:

1.) Economy-wide factors

2.) Industry factors
3.) Individual company factors

Understanding a company’s strategy

Financial statement analysis involves more than just “crunching numbers.” Before you start looking
at numbers, you should know what you are looking for. While financial statements reflect
transactions, each of those transactions is the result of a company’s operating decisions as it
implements its business strategy.

Businesses can earn a high rate of return by following different strategies. There are two
fundamental strategies:

- Product differentiation
- Cost differentiation

Financial statement analysis

There are two general methods for making financial comparisons. The first compares a company to
itself in prior years. The second compares a company to other companies at a point in time.

1. Comparing across time: In this type of analysis, which is often referred to as “time-series
analysis,” information on a single company is compared over time
2. Comparing across companies: In this type of analysis, which is often referred to as “cross-
sectional analysis,” information for multiple companies is compared at a point in time. We
have seen that financial results are often affected by industry and economy-wide factors. By
comparing a company with other companies in the same line of business, an analyst can gain
better insight into its performance.

Component percentages and ratio analysis

All analysts use various tools to analyze a company’s financial statements. Two popular tools are
component percentages and ratio analysis. Component percentages express each item on a financial
statement as a percentage of a single base amount. For example: the base amount on the income
statement is net sales. To compute component percentages on the income statement, each amount
reported is divided by net sales.

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Ratio analysis is an analytical tool that measures the proportional relationship between two financial
statement amounts.

Profitability is a primary measure of the overall success of a company. Profitability ratios focus on net
income and how it compares to other amounts reported on the financial statements. Return on
equity is a widely used measure of profitability. Below is an sheet with some widely used accounting
ratios:

Asset turnover ratios focus on capturing how efficiently a company uses its assets. For example,
acquiring and selling inventory is a key activity for many companies. The inventory turnover ratio
helps analysts evaluate a company’s ability to sell its inventory

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Liquidity refers to a company’s ability to meet its short-term obligations. Because most short-term
obligations will be paid with current assets, liquidity ratios focus on the relationship between current
assets and current liabilities. The ability to pay current liabilities is an important factor in evaluating a
company’s short-term financial strength.

Solvency refers to a company’s ability to meet its long-term obligations. Solvency ratios measure this
ability and include the times interest earned, cash coverage, and debt-to-equity ratios.

Several ratios, often called market ratios, relate the current price per share of a company’s stock to
the return that accrues to stockholders. Analysts find these ratios helpful because they are based on
the current value of an owner’s investment in a company.

Interpreting ratios and other analytical considerations

Understanding the broader economic environment in which a company operates is important when
interpreting its ratios. Some things that analysts commonly consider are:

1.) Rapid growth

2.) Uneconomical expansion
3.) Subjective factors

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Appendix A - Reporting and Interpreting in Other Corporations

Types of investments and accounting methods

The accounting methods used to record investments are directly related to how much is owned and
how long management intends to hold the investments. The investment categories and the
appropriate measuring and reporting methods are summarized as follows.

- Passive investments are made to earn a return on funds that may be needed for future short-
term or long-term purposes. This category includes both investments in debt.
- Significant influence is the ability to have an important impact on the operating, investing,
and financing policies of another company. Significant influence is presumed if the investing
company owns from 20 to 50 percent of the outstanding voting shares of the other company.
- Control is the ability to determine the operating and financing policies of another company
through ownership of voting stock. Control is presumed when the investing company owns
more than 50 percent of the outstanding voting stock of the other company.

Debt held to maturity

When management plans to hold a debt security until its maturity date, it is reported in an account
appropriately called held-to-maturity investments. Debt securities should be classified as held-to-
maturity investments if management has the intent and the ability to hold them until maturity. These
investments in debt instruments are listed at cost adjusted for the amortization of any discount or
premium (amortized cost method), not at their fair value.

Passive investments: the fair value method

When the investing company owns debt securities or less than 20 percent of the outstanding voting
stock of another company, the investment is considered passive. Among the assets and liabilities on
the balance sheet, only passive investments in marketable are required to be reported using the fair
value method on the date of the balance sheet.

passive investments at fair value may be classified as trading securities or available-for-sale

securities.

- Trading securities are all investments in stocks or bonds that are held primarily for the
purpose of active trading (buying and selling) in the near future (classified as short term).
- Available-for-sale securities are all passive investments other than trading securities and debt
held to maturity (classified as either short term or long term).

Investments for significant influence: equity method

The equity method must be used when an investor can exert significant influence over an affiliate. On
the balance sheet these long-term investments are classified as investments in affiliates. That is,
investments in stock held for the purpose of influencing the operating and financing strategies of the
entity for the long term.

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Under the equity method, the investor’s 20 to 50 percent ownership of a company presumes
significant influence over the affiliate’s process of earning income. As a consequence, the investor
reports its portion of the affiliate’s net income as its income and increases the investment account by
the same amount.

Controlling interests: mergers and acquisitions

The following are some of the reasons for acquiring control of another corporation:

➔ Vertical integration: In this type of acquisition, a company acquires another at a different

level in the channels of distribution.
➔ Horizontal growth: These acquisitions involve companies at the same level in the channels of
distribution.
➔ Synergy: The operations of two companies together may be more profitable than the
combined profitability of the companies as separate entities.

The simplest way to understand the statements that result from the purchase of another company is
to consider the case of a simple merger, where one company purchases all of the assets and liabilities
of another and the acquired company goes out of existence as a separate corporation. The
acquisition method is the only method allowed by U.S. GAAP and IFRS for recording a merger or
acquisition.

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Practice test based on the lectures

1.) What is the difference between financial accounting and management accounting?
2.) What are the main criteria for the revenue recognitions principle?
3.) Through several transactions cash is both gained and lost. In 3 separate transaction $25.000,
$2.000, and $900 were obtained. In 3 other transactions $20.000, $100, and $1.500 were
lost. Make a T-account for the asset ‘Cash’.
4.) What are deferred (prepaid) expenses?
5.) And accrued revenues?
6.) Footlocker returns $500 of shoes originally purchased on account from Nike. Make the
journal entry for this transaction.

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Answers to the practice test

1.) Financial accounting provides info for external decision makers, while management
accounting provides info for internal users.
2.) The following are main criteria
- Services had been rendered
- Ownership and control of the item should pass to the buyer
- Amount of revenue can be measured reliably
- It is probable that the economic benefits will be received
3.)

4.) Deferred (prepaid) expenses are costs that have been incurred, but which has not yet been
consumed.
5.) Accrued revenue is revenue that has been earned by providing a good or service, but for
which no cash has been received.
6.)

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