Accounting – Textbook Notes

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Condensed main accounting topics explained. Textbook covered is Financial Accounting: An Introduction to Concepts, Methods, and Uses by Clyde P. Stickney and Roman L. Weill, Seventh Edition.
Source: Financial Accounting: An Introduction to Concepts, Methods, and Uses by Clyde P. Stickney and Roman L. Weill, Seventh Edition (The Dryden Press, Harcourt Brace College Publishers, 1994)
Subject: Accounting

Chapters 1-4, 6

Objectivity refers to the ability of several independent measures to come to the same conclusion about the valuation of an asset (objectivity helps increase the reliability and comparability of financial information).

Conservatism = many accounts believe that financial statements will less likely mislead users if the balance sheet reports assets at lower than higher amounts.

The matching principle suggests that expenses be matched directly with respective revenues.

Working capital = current assets less current liabilities.

Net book value = owner’s equity.

Revenues measure an inflow in assets (or a reduction in liabilities).

Current valuation reflects the current cost of acquiring assets or the current market value of creditor’s and owner’s claim on a firm. The application of accrual accounting requires the accountant to address both timing issues and measurement issues. Timing issues relates to when a firm recognizes revenue.

Timing issues relates to when a firm recognizes revenue (The firm must have provided all or a substantial portion of the services it expects to perform, and be able to measure the cash inflows and outflows with reasonable precision).

Measurement issues relate to the amount of revenue and expense recognized (Revenues must equal the present value of the amount of cash a firm expects to receive and expenses must equal the amount of cash a firm has expended).

Earnings persistence is the degree to which the financial statements can be used to predict the timing and amount of future cash flows.

Quality of earnings is the latitude and judgment management has in arriving at the numbers reported in the financial statements (this subjectivity affects the extent to which net income reflects the true economic earnings).

Depreciation = cost – salvage value/life. Classified income statements help users better assess the persistence of earnings and the risk related to various components of net income.

Gains are increases in equity (net assets) from peripheral or incidental transactions.

The rate of return on assets (ROA) is a profitability measure, and measures a firm’s performance in using assets to generate earnings independent of the financing of those activities. ROA = (net income plus interest expense net of income taxes savings)/average total assets (for every dollar of assets used, xx dollars was earned).

The rate of return on owner’s equity (ROE) is a profitability measure, and measures a firm’s performance in using assets to generate earnings. ROE = (net income less dividends paid on preferred stock)/average shareholder’s equity.

Earnings per share (EPS) is a profitability measure.
EPS = (net income – preferred stock and dividends declared)/weighted average of the number of common shares outstanding during the period.
Primary earnings per share = adjust the denominator for securities that are nearly the same as common stock (e.g. common stock equivalents, convertible bonds, convertible preferred stock).
Fully diluted earnings per share is the maximum possible dilution that would occur if the owners of all options, warrants, and convertible securities outstanding exchanged them for stock.
ROA = profit margin ratio x total assets turnover ratio.

The total asset turnover ratio measures a firm’s ability to generate sales from a particular level of investment in assets.
Total asset turnover ratio = sales/average total assets.

The accounts receivable turnover ratio indicates how soon the company will collect cash on accounts receivable and is net sales on account/average accounts receivable. To get the average number of days that receivables are outstanding, divide 365 by the accounts receivable turnover ratio.

The inventory turnover ratio indicates how frequently firms sell inventory items, and is cost of good sold/average inventory. To get the average number of days that inventory is outstanding, divide 365 by the inventory turnover ratio.
The plant asset turnover ratio measures the relation between sales and the investment in PP&E. The plant asset turnover ratio = sales/average plan assets (each dollar invested in plant assets generated xx in sales).

The leverage ratio indicates the extent to which common shareholder’s versus creditors and preferred shareholders provide capital. The leverage ratio = average total assets/average common shareholder’s equity.

Financing with debt and preferred stock to increase the potential return to the residual common shareholder’s equity is referred to as financial leverage. As long as the firm earns rate of return on assets that is higher than the rate it paid for the capital used to acquire the assets, the rate of return to shareholder’s will increase.

The current ratio is a short term liquidity ratio which measures the ability to cover current debts with current assets and equals current assets/current liabilities.

Quick ratio = highly liquid assets/current liabilities.

The accounts payable turnover ratio = purchases/average accounts payable for the period. To get the average number of days that accounts payable is outstanding, divide 365 by the accounts payable turnover ratio.

The long-term debt ratio reports the portion of the firm’s long term capital that debt holders furnish.
The long term debt ratio = total long-term debt/(total long term debt plus shareholder’s equity).

The debt to equity ratio = total liabilities/total liabilities plus shareholder’s equity.

Chapters 5, 7-10

Activity in the accounts receivable account is generally related to sales and collections made in the ordinary course of business. If a company has a net increase in accounts receivable, it collected less cash from customers during the year than it generated in net credit sales. Because sales are positively related to net income, the excess of sales over cash collections will be subtracted from net income to determine cash flows from operations.

The Statement of Cash Flows shows how cash was affected by the three primary business activities – operating, investing and financing; it shows only the cash actually received and paid. There are two methods to creating the Statement of Cash Flows – direct and indirect. The methods differ only in the cash flows from operating activities section. Some things you would see in the operating activities section of a direct method Statement of Cash Flows are cash received from customers, cash paid to suppliers, cash paid for interest, cash paid for taxes. Interest and dividend revenues are operating activities. The purchase and sale of investments in securities is investing activities. Interest expense is operating activity. Issue or redemption of debt is financing activity. The change in cash is calculated by DC = DL + DSE – DNCA. Compensatory balances should not be included as cash.

A note sold without recourse grants no further liability to the transferor (original holder of the note). A transfer with recourse places a potential or contingent liability on the transferor if the maker fails to pay the note a maturity.

The LIFO method of valuing inventory leads to lower balance sheet methods for valuing inventory, and higher income statement values for the cost of goods sold, and no DIRECT difference on the statement of cash flows. However, the statement of cash flows is indirectly impacted under LIFO because taxable income is lower using the LIFO method, and income tax payments are lower. Assets in the 3-year, 5-year, 7-year and 10-year classes use the 200-percent declining balance method. Assets in the 15-year and 20-year classes use the 150-percent declining balance method. Assets in the 27.5-year and 31.5-year classes must use the straight-line (cost less salvage value/estimated life in years or estimated number of uses) basis.

Adjustments to accounts receivable are sales discounts, sales return, and sales allowances. Adjustments to inventory are purchase discounts, freight-in, purchase returns, purchase allowances. 2/10, net 30 means seller offers a 2% discount if the buyer makes a payment within 10 days, otherwise the full price is due within 30 days. Direct write-off method for uncollectible accounts debits bad debt and credits account receivable. The direct write-off method (1) does not recognize the loss from uncollectible accounts in the period in which the sale occurs and the firm recognizes revenue; (2) provides a firm with an opportunity to manipulate earnings by deciding when a particular customer’s accounts are uncollectible; (3) the accounts receivable does not reflect the amount a firm expects to collect in cash; (4) not allowed for financial accounting, but required for tax accounting. The allowance method for uncollectible accounts debits bad debt expense and credits and allowance for uncollectible accounts. When the exact amount is known, it debits the allowance for uncollectible accounts and credits the accounts receivable. The allowance method for uncollectible accounts (1) matches against sales revenue the amount the firm does not expect to collect in cash arising from that period’s sales and (2) does a better job of matching revenues and expenses.

The inventory equation is beginning inventory + additions – withdrawals (cost of goods sold) = ending inventory.

Goods available for sale is the sum of beginning inventory and additions.

Five valuation methods for inventory (assigning a dollar amount) are acquisition cost, replacement cost (entry value), net realizable value (exit value), lower-of-cost-or-market-basis and standard cost. Lower-of-cost-or-market-basis is required by GAAP, and is a conservative accounting policy because (1) it recognizes losses from decreases in market value before the firm sells the good, but not before the sale takes place; and (2) inventory figures on the balance sheet are never greater, but may be less, than acquisition cost.

Unrealized holding losses appear in financial statements, but unrealized holding gains do not appear until a firm sells the good.

The periodic inventory system: Beginning Inventory (known) + Purchases (known) – Ending Inventory (counted) = Cost of Goods Sold (solved for). With the periodic inventory system, any loss from shrinkage is counted in the cost of goods sold.

The perpetual inventory system: Beginning Inventory (known) + Purchases (known) – Withdrawals (recorded) = Ending Inventory (solved for).

Realized holding gains = COGS (based on acquisition cost) – COGS (on replacement basis).
Unrealized holding gains = Ending Inventory (based on acquisition cost) – Ending Inventory (on replacement basis).

Natural resources are wasting assets.

Depletion refers to the amortization of wasting assets.

Depreciation refers to the amortization of plant assets. Land is never depreciated. Depreciation methods are straight line (time); production use (straight-line use); accelerated depreciation; declining or double declining balance; and sum-of-the-years-digits. In choosing a depreciation policy, management is choosing how to allocate the cost of the asset to its useful life. This entails an estimate of the useful life of the asset and a decision of how best to match the initial cost to the periods the asset will be used. Under the straight line (time) method, annual depreciation = (cost less salvage value)/estimated life in years. Under the production use (straight-line use), per unit depreciation = (cost less estimated salvage value)/estimated number of units. Under the double declining balance method, depreciation = (2 x 1/asset life) x net book value. Under the sum-of-the-years-digits method, add the sum of the years (e.g. 5 years = 1+2+3+4+5=15). Depreciation for year one would equal 5/15 x acquisition cost. Depreciation for year two would equal 4/15 x acquisition cost. To record a loss on sale of plant assets, credit PP&E, debit cash, debit accumulated depreciation, and debit loss on sale of fixed asset. Repairs and maintenance do not extend the service life of an asset, but improvements do.

If a patent is purchased, it may be capitalized. If a patent is developed internally, it must be expensed. GAAP allows capitalizing and amortizing of advertising, but the common practice by most companies is to expense these.

Goodwill is the difference in the amount paid for an acquired company as a whole and the sum of the individual assets and liabilities. Goodwill is amortized.

A gain on a retirement of PP&E is a subtraction from net income in the operating activities section of the Statement of Cash Flows. A loss on the retirement of PP&E is an addition to net income in the operating activities section of the Statement of Cash Flows. Accounting does not recognize executory contracts as liabilities.

Current liabilities are recorded at the amount to be paid, and long-term liabilities are recorded at the present value.

Under GAAP, a contingency must be accrued at the financial statement date if two conditions are met (1) if it is highly probable (as opposed to remotely or reasonably probable) that a liability has been incurred; and (2) The amount of the loss can be reasonably estimated. GAAP requires that contingent gains, such as damages from the lawsuit, not be recorded until realized (i.e., when they are no longer contingent on a future event occurring or failing to occur). GAAP further requires that contingent gains that are highly probable be disclosed in the footnotes. This is evidence of the conservative nature of accrual accounting.

Convertible bonds can be exchanged or converted to common stock at the discretion of the holder. Subordinated bonds are less senior than other debt issued. Debentures bonds are unsecured. To record bonds issued at a discount, debit Cash, debit Discount on Bonds Payable and credit Long-Tern Debt or Bonds Payable.

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