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THE BIG PICTURE
Decision makers need information so they can make informed decisions. But whenever we make a decision, there is a risk that we will make a bad decision and face adverse consequences. The more good information we have, however, the better decisions we can make.
Irrespective of the Type of Business or the Forms of Business Ownership, accountants provide financial information to decision makers about the economic events of a company. Managers need this information to know how to run a company to achieve their financial objectives. Investors or creditors need this information to assess the risk and return on their investments.
We can view what companies do to create value for their investors and creditors in two ways
The transformation process
input (resources)àprocess(activities)àoutput(goods/services)àvalue(profits)
The business activities
FinancingàInvestingàOperatingàCreating value
To develop information about the transformation process or the business activities of a company, we need an accounting system.
Any accounting system, no matter how complex, has four basic steps
§ identify transactions,
§ record transactions, including adjustments
§ determine account balances
§ make reports.
So that this system produces reliable information, we have certain measurement rules for recording transactions and certain reporting rules for presenting the financial statements (GAAP). In addition, the financial statements of publicly traded companies undergo audits by CPAs to add credibility to the reporting process.
What to measure Financial Statement Elementsà
Assets, Liabilities, Owner's Equity, Revenues, Expenses, Gains, Losses
When to measure accrual basis versus cash basis
Revenue recognition
Matching principle
How to record
How to report
Basic Financial Statements Financial Statement Elements
Income Statement Revenues-Expenses Gains-Losses
Statement of Owner's Equity or Retained Earnings Statement Owners' Equity
Balance Sheet Assets = Liabilities + Owners' Equity
Cash Flow Statement Op Cash + Invest Cash + Fin Cash =∆ in Cash + Beginning Cash = Cash Bal
Now the investors can use financial statementsalong with other financial information--to analyze the information to make decisions.
THE DETAILS
Types of transactions
Financing
Equity---sales of stock, payment of dividends, purchase of treasury stock
Debtborrowing money, paying principal
Investing
PP&E
Investment in other companies
Operating
Purchases supplies, inventory, other goods and services including taxes, wages, interest, etc.
Sales of goods and services
Collection of receivables
Payment of Payables
End of period adjustmentsbad debts, depreciation, interest, wages, etc.
Anything else that is not investing or financing
Detailed Format of Financial Statements
Any CompanyIncome StatementFor the year ended 1/1/01 Revenues- Expenses Net IncomeEPS (Publicly traded) Any CompanyIncome StatementFor the year ended 1/1/01 Revenues- ExpensesIncome before taxes Income taxes Net IncomeEPS (Publicly traded)
Any CompanyIncome StatementFor the year ended 1/1/01 Net Sales - Cost of Goods Sold = Gross Profit - Operating Expenses (S, G & A) = Income from Operations + Other Revenues and Gains - Other Expenses and Losses = Income before Taxes - Income Tax Expense = Net Income (Net Loss) EPS (Publicly traded)
Any CompanyIncome StatementFor the year ended 1/1/01 Net Sales - Cost of Goods Sold = Gross Profit - Operating Expenses (S, G & A) = Income from Operations + Other Revenues and Gains - Other Expenses and Losses = Income before Taxes - Income Tax Expense = Net Income (Net Loss) Income from Continuing Operations +/- Discontinues Operation (net of tax) = Income before Extraordinary and Cumulative Effect +/- Extraordinary Gains or Loss(net of tax) +/- Cumulative Effect of Accounting Change(net of tax) = Net Income EPS (publicly traded companies)
Basic EPS = NI - Preferred Dividends [even undeclared if cumulative]
Weighted Average of Common Shares Outstanding
Fully net income adjusted for the effects of exercise or conversion
Diluted (wt avg shares os + effect of all dilutive securities)
Any CompanyRetained Earnings StatementFor the year ended 1/1/01 Beginning Retained Earning+ Net Income- Dividends= Ending Retained Earnings
Any CompanyStatement of Stockholders' EquityFor the year ended 1/1/01
Beg BalInvestmentPurchase TSNet IncomeDividendsOCI items 1 End Bal Common StockxyT (Treasury Stock)(x)(y)T Accumulated OCIX(z)z(z)T Retained Earningsxy(z)T
Any CompanyBalance Sheet1/1/01
AssetsCA Cash MES AR Inventory Supplies & Other PrepaidsTotal CANCA L-T Investments PP&E Intangibles OtherTotal NCA Total Assets Liabilities + Owners EquityCL AP NP, short term Accrued Payables Taxes InterestTotal CLL-T Liabilities NP, long-term Mortgage PayableTotal L- T LOwners Equity Contributed Capital Earned Capital OtherTotal OETotal Liabilities & OE
Any CompanyStatement of Cash FlowsFor the year ended 1/1/01 CASH FLOWS FROM OPERATIONS (direct or indirect) (detail) NET CASH PROVIDED/USED BY OPERATING ACTIVITIES _________ CASH FLOWS FROM INVESTING ACTIVITIES (details re inflows) (details re outflows) NET CASH PROVIDED/USED BY INVESTING ACTIVITIES _________ CASH FLOWS FROM FINANCING ACTIVITIES (details re inflows) (details re outflows) NET CASH PROVIDED/USED BY FINANCING ACTIVITIES _________ NET INCREASE/DECREASE IN CASH CASH AT BEGINNING OF THE YEAR _________ CASH AT END OF YEAR (= BALANCE SHEET)
Time value of Money
PV = what future cash flows are worth today. We are making decisions today and transacting business today. So we need to know $s today
Present Value of a Single Amount
Present value Future $'s
| | | /////// | | |
now
1 prd prd prd prd 10 prd
Present Value of an ordinary annuity
Present Value
. . . . . .
no $ $ $ $ $ $
r r1 r r r4 r5 r6
FV = what transactions and events grow to in the future. Used for planning.
future value of a single amount
today's future value
$ | | | /////// | //// |
1 prd prd prd 5 prd 0 prd
now
future value of an ordinary annuity
0 $
today future value
. . . . . .
no $ $ $ $ $ $
r r1 r r r4 r5 r6
Debt Financing
Here are a few tips to rememberPrice of a bond equals the present value of all the future cash flows, both principal and interest.At issue, mkt rate face rate, bond is less desirable to the bond buyer. So the bond sells at a discount.For the borrower, discounts à increase interest expense to marketFor the creditor, discounts à increase interest income to marketAt issue, the mkt rate face rate, the bond is more desirable to the bond buyer. So the bond sells at a premium.For the borrower, premiums à decrease interest expense to marketFor the creditor, premiums à decrease interest income marketThe face rate the face amount controls the cash amount of interest paid.The market rate the carrying value controls the amount of interest expense.
Equity Financing
Authorized, issued, outstanding
Preferred vs Common
Par, stated value, no par
Dividends, Stock Dividends, Stock Splits
Analysis
Current Ratio
Market to Book Value
Return on Equity = Return on Assets x Financial Leverage
Higher Leverage means higher risk
Investing Activities
PP&E
Types
Cost
Depreciation
Valuation
Investments in other companies
Equity Securitiestrading, available for sale, significant influence, control
Debt Secuirites-- trading, available for sale, held to maturity
Valuation
Analysis
Operating leverage
Asset Turnover
Profit Margin
Return on Assets
Effectiveness vs Efficiency
Operating
Revenues and Receivables
Revenue recognition
Returns and Discounts
Valuing--NRV
Inventory and Cost of Goods Sold
Matching principle
Merchandising vs Manufacturing
MeasuringFIFO, LIFO, Weighted Average
ValuingLCM
Other operating expenses
Matching principle
Special Itemsbelow the line
Anaylsis
Gross Profit
Operating Margin
Profit Margin
ROE
Inventory Turnover
Receivable Turnover
Cost Leadership
Product Differentiation
Miscellaneous Items
Limitations of financial statements
Limitations of financial statement analysis
Moral Hazard
Earnings Management
Internal Control
Minority Interest
Accumulated OCI
Deferred Compensation
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