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Exam 1 Notes (Libby Libby Short Chapters 2, 3, 4)

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New York University
Yiwei Dou

Kevin Jin 1 ACCT-UB 1 Pre-Exam 1 Notes Basics  Financial accounting: identifying, measuring, recording, and communicating economic events in value terms in order to provide information for decision-making purposes to stakeholders outside the firm, primarily through financial statements  Owners (investors, stockholders, shareholders) want capital gains and dividends o Their returns grow with the company but they can also fall  Creditors want interest over a length of time o Returns are fixed but (risk of default) < (risk of equity)  All corporations must file financial reports, whereas proprietorships (one owner) and partnerships do not because the owners better understand how the business is doing o Monitoring (agency theory)  Owners hire agents (managers) with skill to run firm  Without monitoring (financial reports) and incentives (executive compensation), agents will not act in best interests of owners  10-Q quarterly, 10-K annually; SEC enforces compliance and finds fraud o Contracting o Valuation  Mandatory reports (basic financial statements) detail current financial status of firm and changes during reported time period o Balance sheet (owned i.e. assets, owed i.e. liabilities, remainder i.e. equity)  Snapshot at end of report period  What is the company’s financial position at the end of the period? o Income statement  Revenues and expenses during the report period  How well did the company perform during the period? o Cash flow statement  Change in cash during the report period  How much cash did the company generate and spend during the period? o Statement of stockholder’s equity  Change in stockholder’s equity during the report period  Why did the company’s retained earnings change during the period?  Financial statement relationships (BOY = beginning, EOY = ending) Cash flows statement Income statement Beginning balance sheet Ending balance sheet Retained Earnings o Retained earnings = beginning retained earnings + net income  Retained earnings depends on income statement (net income) Kevin Jin 2 ACCT-UB 1 Pre-Exam 1 Notes  Retained earnings depends on beginning balance sheet (BOY RE) o Cash = beginning cash + cash from operations + cash from investing + cash from financing  Cash flows statement depends on beginning balance sheet (BOY cash)  Ending balance sheet depends on cash flows statement (EOY cash) o Ending retained earnings = retained earnings  Ending balance sheet depends on retained earnings (EOY RE)  Mandatory reports are prepared by financial accountants (firm side, under CFO, e.g. comptroller), and auditor (independent agent, e.g. CPA firm, to assess and attest to quality of financial reports)  Mandatory reports include o Footnotes for details o MD&A for management’s analysis of prior period and future expectations o Audit opinion for outside party’s opinion on trustworthiness  Unqualified: compliant with Generally Accepted Accounting Principles  GAAP is enforced by SEC and auditors, amended by FASB  Qualified: some issues  Adverse: high probability of material errors in financial statements o Voluntary disclosures (forecasts) for signaling Tracking account balances  Debit (Dr): left o Increase in total assets (balance sheet)  Because contra-assets are subtracted from assets, a decrease in these accounts actually is a debit too o Decrease in total liabilities, total equity (balance sheet)  Because losses, expenses, dividends, and treasury stock are subtracted from equity, an increase in these accounts actually is a debit too o Increase in expenses (income statement) o Decrease in revenues (income statement) o Contains beginning balance for assets (except contra assets), losses, expenses, dividends, treasury stock  Credit (Cr): right o Decrease in total assets (balance sheet)  Because contra-assets are subtracted from assets, an increase in these accounts actually is a credit too o Increase in total liabilities, total equity (balance sheet)  Because losses, expenses, dividends, and treasury stock are subtracted from equity, a decrease in these accounts actually is a credit too o Decrease in expenses (income statement) o Increase in revenues (income statement) Kevin Jin 3 ACCT-UB 1 Pre-Exam 1 Notes o Contains beginning balance for contra-assets, liabilities, equity (except losses, expenses, dividends, treasury stock)  A balanced balance sheet will also have sum of debits equal sum of credits  T-account: account title on top, debit column on left, credit column on right o Beginning balance is first entry under column that represents increase o Each entry in the column is a dollar amount o Last row has normal balance under column that represents increase  Journal: debit entries left aligned, credit entries indented from left o Each entry contains the account title and dollar amount Balance sheet: Assets = liabilities + stockholders’ equity  i.e. economic resources = sum of claims to economic resources from { creditors, investors }  Secondary offerings and IPOs ↑ S.E., ↑ assets (cash)  Borrowing ↑ liabilities, ↑ assets (cash)  Paying off a loan ↓ liabilities, ↓ assets (cash)  Buying inventory or equipment ↑ assets (e.g. inventory or PP&E), ↓ assets (cash)  Conduct operations ↓ assets (e.g. inventory), ↑ assets (cash) (Revenue? Expenses?)  Working capital: current assets - current liabilities o ≈ inventories + accounts receivable - accounts payable o Excludes long term assets and liabilities o Better for it to be a smaller positive number as this signifies efficiency and less waste in inventory (perfect amount of product created and delivered) o Negative number means company faces bankruptcy  Balance sheet T-accounts are permanent in that their beginning balance for the period is always carried over from the previous period rather than starting at 0  Assets = current assets + long term assets - contra-assets + … o Future economic benefits or rights that are owned or controlled by firm o E.g. other: new CEO hire o Most asset accounts follow “Historical Cost Principle” to be conservative  Exchange price (market/fair value) at time of transaction (acquisition)  Except: net inventory (by subtracting depreciation contra-asset), long term asset impairments, marketable securities (fair value)  These are even more conservative than historical cost o Current assets = cash + receivables + inventory + prepaid expenses + …  E.g. other: cash equivalents, marketable securities (debt and equity stakes in other companies)  Will be converted to cash, sold, or consumed within 12 months  To investors: total value of items with low risk (can be quickly liquidated)  Accounts receivable: promise for future receipt from a customer  Performed services on account: ↑ accounts receivable  Collected on account: ↓ accounts receivable Kevin Jin 4 ACCT-UB 1 Pre-Exam 1 Notes  Notes receivable: written pledge that a customer or executive will pay a fixed amount of money by a date  Involves interest  Can also be long term depending on expiration date  Inventory: e.g. finished goods/merchandise ready to be sold, raw materials, work-in-process  Prepaid expenses: e.g. rent, insurance, advertising  Paid in advance and will be benefited from over a time period o Long term assets = PP&E + Intangibles + Long term investments + …  Any non-current assets  Property, plant, and equipment (fixed assets): e.g. land; buildings; equipment, furniture, and fixtures; leasehold improvements  Intangible assets: e.g. trademarks, copyrights, patents, goodwill  Long term investments  Liabilities = current liabilities + long term liabilities + long term debt + … o Fixed and unavoidable obligations to transfer cash or another good/service to an outside party at some future time o E.g. debt, pending lawsuits o Current liabilities = payables + accrued liabilities + …  E.g. other: short term debt  Due within 12 months  Accounts payable: promise to pay a vendor (from credit purchases)  Purchased on account: ↑ accounts payable  Paid on account: ↓ accounts payable  Accrued liabilities/expenses: expenses that are owed but not yet paid  E.g. interest payable, salary payable, taxes payable  Notes/bonds payable: amounts that must be paid on promissory notes  More typically is long term  E.g. loans from creditors, banks  Deferred/unearned revenue: obligation from receiving cash in advance of providing product or service  E.g. deposits or advances, unredeemed gift cards (recognized as revenue when redeemed by customer or deemed expired/lost)  Capital lease obligations o Long term liabilities  Any non-current liabilities o Long term debt  Stockholders’ equity = contributed capital - treasury stock + retained earnings o Money invested in firm by owners either directly (secondary offerings and IPOs) or indirectly when they allow firm to give less dividends and retain more profit Kevin Jin 5 ACCT-UB 1 Pre-Exam 1 Notes o Book value (on accounts) is different than market cap/value because books are based on subtracting liabilities from assets, but market cap is determined by investors  Market > book is the case for most companies  Market < book means company is undervalued or has problems o Contributed capital  i.e. amount invested in company by its owners  Paid-in capital: shares sold directly by company to owners (rather than secondary market, e.g. stock market) o Treasury stock: shares repurchased by company, i.e. capital withdrawal  Alternative way to give money back to investors than paying dividends  Company feels shares are undervalued on stock exchanges  Fewer shares means higher price per share o Retained earnings = beginning retained earnings+ net income - dividends  Cumulative reinvested profits  Net income = earnings + gains - losses  Earnings = income = profits = revenue - expenses  Revenue (sales): money generated from assets (operational) o Increase in retained earnings due to delivering goods or services (selling product) o Assets acquired or obligations o Liabilities satisfied by the firm in exchange for the goods or services sold by the firm to others  Expenses: money used to generate revenue (operational) o Decrease in retained earnings from operations o Assets used or liabilities incurred to generate revenue o E.g. cost of goods sold; marketing, R&D, interest, income taxes  Gains: increases in value of assets (tangential) o Selling equipment when market price has gone above depreciation  Losses: decreases in value of assets (tangential) o Selling equipment when market price has gone below depreciation  Dividends: decrease in retained earnings due to payments to shareholders Cash flow statement  Describes flow of cash in and out of the firm during the period over three categories: o Operating: activities carried out on a day to day basis to meet the goals of the company  E.g. revenue (inflow), expenses (outflow) o Investing: activities carried out periodically that alter the firm’s infrastructure, enabling it to carry out the operating activities  E.g. new equipment (outflow), sell equipment (inflow) Kevin Jin 6 ACCT-UB 1 Pre-Exam 1 Notes o Financing: activities carried out to obtain (and repay) funds used in the other activities  E.g. contributed capital (inflow), dividends (outflow), treasury stock (in
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