Introduction
It is not necessary to be a CPA to have a working knowledge of the "accounting model of the enterprise"
Transactions: This book describes a sequence of "transactions," and fake account "postings." Replicating practical experience.
Goals: You'll know how a balance sheet, income statement, and cash flow statement work.
Outline of objectives:
Section A will introduce special vocab for financial statements
Section B will show different business transactions, and how to report the financial impact of each on the Balance Sheet, Income Statement, and Cash Flow Statement.
Section C will subject the financial statement of this company to ratio analysis, and explain financial fraud
Section D will describe the strategic decisions that a fledgling company must make when it expands; "where will we get the money and how much will it cost?"
Section E will analyse business expansion alternatives and use NPV techniques.
Section A
Introduction
Terminology
Sales and revenue mean the "top line"
Profits, earnings and income mean the "bottom line"
Costs are money spent making a product; expenses are money spent to develop it, sell it, account for it, and so on.
Both costs and expenses become expenditures when money is actually sent to vendors to pay for them.
Orders are placed by customers and signify a request for future delivery; they don't impact the books until this happens, and they become shipments or sales.
Solvency means having enough money in the bank to pay your bills, whereas profitability means that your sales are greater than your costs and your expenses.
You can be profitable and insolvent at the same time; you are making money, but still do not have enough cash to pay all your bills.
After understanding vocabs, you can learn the 3 main financial statements:
Balance Sheet
Income Statement
Cash Flow Statement
Anki cards
Sales = revenue
Front
Sales means the same thing as…
Back
Revenue
Sales = revenue
Front
Revenue means the same thing as…
Back
Sales
Profit = earnings, and income
Front
Profit means the same thing as…
Back
Earnings and income
Profit = earnings, and income
Front
Earnings means the same thing as…
Back
Profit and income
Profit = earnings, and income
Front
Income means the same thing as…
Back
Profit and earnings
Revenue != income
Front
Revenue is not the same as…
Back
income
Costs != expenses
Front
Costs is not the same as…
Back
expenses
Expenses != expenditures
Front
Expenses is not the same as…
Back
Expenditures
Sales != orders
Front
Sales is not the same as…
Back
orders
Sales = shipments
Front
Sales is the same as…
Back
shipments
Profits != cash
Front
Profits are not…
Back
cash
Solvency != profitability
Front
Solvency is not…
Back
profitability
3 main financial statements
Front
The three main financial statements are
Back
Balance sheet, income statement, cash flow statement
Chapter 1
Terminology
The 12 "very" important accounting principles are as follows:
Accounting entity, which is the business unit for which hte financial statements are being prepared. There is a "business entity" seperate from its owners, a fictional corporate "person."
Going concern, i.e. the notion that the life of the business entity is infinitely long.
If during a review, an accountant believes a company may go bankrupt, he must issue a qualified opinion stating the potential of this.
Measurement, i.e., accounting only deals with things that can be measured; things that cannot be measured, like brand loyalty or swag, are not stated in books.
Accounting books only contain the difference between quantifiable assets and quantifiable liabilites, the difference between the two equalling equity.
Units of Measure correlate to the jurisdiction the company is based out of — U.S. companies measure everything in USD, and foreign subsidiaries have their values converted to USD for consolidative ease.
Historical Cost, i.e. what a company owns and owes are recorded as cost paid with no adjustment for inflation.
Even if this leads to undervaluing, it is the easiest thing to do.
Materiality refers to the relative importance of different financial information — all transactions must be reported if they would materially affect the financial condition of the company. This is different for the corner store and for IBM.
Estimates and judgements must often be made for financial reporting; often in the case of lack-of-info and lack-of-materiality. Accountants, however, should use the same guessing method for each period.
Consistency is important. Identical transactions can be accounted for differently using different accounting methods — each enterprise must choose a single method of reporting to mitigate value being mis-represented due to inconsistencies.
Conservatism is the general attitude towards valuation — value losses when they are likely to happen, but only value gains after they happen.
Periodicity is the notion that the life of a corporation can be divided into periods of time, for which profits and losses can be recorded. These are really just convenient periods; short enough to be within memory (and reasonably timely and useful), and long enough to have meaning and not just be random fluctuations.
These periods are called "fiscal periods" and may or may not align with actual calendar months/years.
Substance over Form, i.e. accountants report the economic "substance" of a transaction rather than just its form. One might be inclined to report a purchase as an equipment lease; but this is forbidden.
Accrual Basis of Presentation is very important to understand. Accountaints translate into dollars of profit or loss all the money-making activities that take place during a fiscal period.
In accrual accounting, if a business action in a period makes money, then all its product costs and its business expenses should be reported in that period
This is accomplished by matching for presentation
(a) the refenue received in selling product
(b) the costs to make the product sold
Key to accrual accounting is
Revenue recognition, i.e., recording a sale when all the necessary activities have been undergone. Revenue is generated when a product is shipped.
Matching principle — COGS (cost of goods sold) is recorded when the sale-revenue is
Allocation — Costs that cannot be associated with a product can be allocated to fiscal periods in a "reasonable fashion."
These rules are made by the FASB and they are called GAAP.
Anki Cards
Accounting entity
Front
Principle of accounting: an accounting entity is…
Back
the business unit for which hte financial statements are being prepared. There is a "business entity" seperate from its owners, a fictional corporate "person.
Going concern
Front
Principle of accounting: the going concern is…
Back
the notion that the life of the business entity is infinitely long
Measurement
Front
Principle of accounting: measurement is…
Back
accounting only deals with things that can be measured; things that cannot be measured, like brand loyalty or swag, are not stated in books
Units of measure
Front
Principle of accounting: units of measure…
Back
correlate to the jurisdiction the company is based out of — U.S. companies measure everything in USD, and foreign subsidiaries have their values converted to USD for consolidative ease.
Historical cost
Front
Principle of accounting: historical cost…
Back
what a company owns and owes are recorded as cost paid with no adjustment for inflation
Materiality
Front
Principle of accounting: materiality refers to…
Back
the relative importance of different financial information — all transactions must be reported if they would materially affect the financial condition of the company. This is different for the corner store and for IBM.
Estimates and judgements
Front
Principle of accounting: estimates and judgements…
Back
must often be made for financial reporting; often in the case of lack-of-info and lack-of-materiality. Accountants, however, should use the same guessing method for each period.
Consistency
Front
Principle of accounting: consistency is…
Back
important. Identical transactions can be accounted for differently using different accounting methods — each enterprise must choose a single method of reporting to mitigate value being mis-represented due to inconsistencies.
Conservatism
Front
Principle of accounting: conservatism is…
Back
the general attitude towards valuation — value losses when they are likely to happen, but only value gains after they happen.
Periodicity
Front
Principle of accounting: periodicity is…
Back
the notion that the life of a corporation can be divided into periods of time, for which profits and losses can be recorded. These are really just convenient periods; short enough to be within memory (and reasonably timely and useful), and long enough to have meaning and not just be random fluctuations.
Substance over Form
Front
Principle of accounting: substance over form means…
Back
accountants report the economic "substance" of a transaction rather than just its form. One might be inclined to report a purchase as an equipment lease; but this is forbidden.
Accrual Basis of Presentation
Front
Principle of accounting: accrual basis of presentation means means…
Back
Accountaints translate into dollars of profit or loss all the money-making activities that take place during a fiscal period.
Accrual accounting requires
Front
Accrual accounting requires:
Back
- Revenue recognition, i.e., recording a sale when all the necessary activities have been undergone. Revenue is generated when a product is shipped.
- Matching principle — COGS (cost of goods sold) is recorded when the sale-revenue is
- Allocation — Costs that cannot be associated with a product can be allocated to fiscal periods in a "reasonable fashion."
Who are these rules made by and what are they called?
Front
Who are these rules made by and what are they called?
Back
- FASB (Financial Accounting Standards Board)
- GAAP (Generally Accepted Accounting Principles)
Chapter 2 (Balance Sheet)
Terminology
The basic equation of accounting is Assets - Liabilities = Worth.
Worth, net worth, equity, owner's equity, and shareholder equity all mean the same thing.
The Balance Sheet restates the basic equation as Assets = Liabilities + Worth.
You must keep tabs on variables such that this always holds true
The balance sheet is a snapshot in time.
The balance sheet reports "has today = owes today + worth today"
Assets are everything you've got, in addition to certain "rights" you own; but they must be quantifiable.
Assets are grouped on the balance sheet according to their characteristics: first very liquid assets, productive assets, and finally assets for sale
Accounts receivable are a special type of asset group: the obligation of customers to pay a company for goods shipped to them
Assets are displayed in the asset section of the balance sheet; cash is the most liquid, fixed assets are the least liquid.
Current Assets are those assets that are expected to be converted into cash in less than 12 months.
Current Assets are also grouped by liquidity:
Cash
Accounts Receivable
Inventory
Prepaid Expenses
The money the company will use to pay its bills will come when its current assets are converted into cash (i.e. when inventory is sold, and accounts receivable are paid)
Cash is the ultimate liquid asset
Accounts Receivable is the total of the entity's rights to collect some money from a customer at a specified time in the future.
Inventory is both finished products ready-to-sell and raw materials which can be made into products.
A manufacturer has a three-part inventory consisting of:
Raw material inventory
Work-in-process inventory
Finished goods inventory
As finished goods inventory is sold, it becomes accounts receivable, and then cash.
Prepaid Expenses are bills the company has paid, but not received the resulting service — telephone, rent, etc.
Prepaid expenses cannot be turned into cash, but they are still assets because they will not require money in the future.
Current assets form a so-called current asset cycle, where cash becomes inventory which then becomes accounts receivable, which then becomes cash.
There are also non-current assets like other assets and fixed assets.
Fixed assets are often referred to as PP&E, or property, plant, and equipment.
Fixed assets are often reported as fixed assets at cost, i.e. at the original purchase price.
They are also shown as net fixed assets, which provides allowance for depreciation (but not appreciation due to inflation or market shifts.)
Depreciation is an accounting convention reporting the decline in useful value of a fixed asset due to time.
Depreciation charges do lower profits (since it is a liability) but do not affect cash.
Depreciation on a balance sheet may be uncorrelated with the real-life value of the asset entirely.
Other assets is a category that includes non-current assets which are unable to be classified, like patent-rights, trademarks, etc.
Liabilities are economic obligations of the enterprise; they are categorised based on to whom the debt is owed and whether the debt is to be paid within the year (current liabilities.)
Current liabilities are liabilities that must be paid within the year.
The current liabilities are grouped depending on to whom the debt is owed: accounts payable owed to suppliers, accrued expenses owed to employees and others for services, current debt owed to lenders, and income taxes payable owed to the government.
Accounts Payable are bills that the corporation must pay soon.
Accrued Expenses are monetary obligations similar to accounts payable, but for different creditors - salaries earned but not yet paid, lawyer's bills not yet paid, interest due but not yet paid.
Current Portion of Debt is the debt owed to a bank within the next 12 months.
Long Term Debt is debt owed outwith the next 12 months, for example, a mortgage.
There is a current portion of long-term debt, which is the portion of the long-term debts that is payable within the next 12 months.
Income Taxes Payable are taxes owed but not yet paid; every 3 months the company will send the government a cheque, but for the time between when the profit was made and the taxes were paid, they will occupy this spot.
Working capital: Current Assets - Current Liabilities = Working Capital. It is also called "net current assets" or "funds."
Working capital increases when current liabilities decrease or current assets increase.
Working capital can be used up when current assets decrease or current liabilities increase.
A company's total liabilities are just Current Liabilities + Long Term Debt
Shareholder's Equity is the company's value to its owners, i.e. liabilities minus assets, net worth, or book value.
Capital stock is the original money to start and any add-on money invested in the business.
Retained earnings are all profits that have not been returned to the shareholders as dividends; Retained Earnings = Sum of all profits - Sum of all dividends
Shareholder's Equity is also the sum of the investment made in the stock of the company, plus any profits minus any dividends that have been paid to shareholders.
The value of shareholder equity increases when the company
Makes a profit (increasing retained earnings)
Sells new stock (increasing capital stock)
The value of shareholder equity decreases when the company
Has a loss (decreasing retained earnings)
Pays dividends (decreasing retained earnings)
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TODO Anki Cards
Chapter 3 (Income Statement)
Terminology
The income statement gives the business's profitability
It does not tell the whole picture about a company's financial health; instead, it works in tandem with the balance sheet (which reports on assets, liabilities, and equity) and the cash flow statement (which reports on cash movements).
Income = Sales - COGS - Operating Expenses.
The second basic equation of accounting is this: Sales - (Costs & Expenses) = Income.
Sales are recorded on the income statement when products are actually shipped to customers
Orders are what sales are before they've actually been shipped; when a sale is made, income is generated on the income statement. Orders only increase the backlog of products to be shipped.
Costs are expenditures for raw materials, manufacturing, and labour - only when the goods are sold does cost move from the balance sheet to the income statement as COGS.
Gross margin is Sales - COGS; it is the manufacturing margin before other costs.
All other business expenditures that aren't costs are expenses. These are both a subset of expenditures.
Expenses are non-good expenditures, like paying legal fees, marketing, or R&D. They directly lower income on the income statement.
Operating expenses are those expenditures that a company makes for the purpose of generating income.
Operating expenses are sometimes called SG&A expenses, i.e., "sales, general, and administrative" expenses.
The income statement is often referred to as the profit and loss statement, P&L, or the earnings statement.
Income from operations refers to what is left over after both expenses and costs are subtracted from net sales.
Companies can also generate income from non-operating activities, i.e financial — e.g. the selling of securities.
Non-operating income includes categories like interest income, i.e. interest received on bank accounts.
Non-operating expenses include interest expense and income tax.
Remember that income is not cash, and so a company with lots of net income can still be insolvent, i.e., have no cash left to pay its bills.
Profit and income do mean the same thing.
Sales and revenue do mean the same thing.
If income is measured when cash is received, the business is operating on a cash basis.
If income and expenses are measured when the transactions occur — regardless of the physical flow of cash — the business is operating on a accrual basis.
With books on a cash basis, the income statement and the cash flow statement are the same.
In accrual basis accounting, the income statement does not reflect the movement of cash, but rather the generation of obligations ("payables") to pay cash in the future.
With accrual basis accounting, expenses occur when the company incurs the obligation to pay, not when it actually parts with the cash. Sales and costs are recorded when the goods are shipped and customers incur the obligation to pay, not when they actually pay.
If the enterprise's income sheet shows income, then retained earnings are increased on the balance sheet.
When retained earnings increase, the enterprise's assets must increase or the liabilities decrease for the balance sheet to remain in balance.
TODO Anki Cards
Chapter 4 (Cash Flow Statement)
Terminology
The Cash Flow Statement tracks the movement of cash through the business over a period of time.
A company's cash flow statement is just like a cheque register — recording all the company's transactions that use cash (cheques) or supply cash (deposits).
The cash flow statement shows Cash At Start + Cash Received - Cash Spent = Cash On-Hand
So-called cash transactions affect cash flow. For example, paying salaries, paying for equipment, paying off a loan.
Non-cash transactions are company activities where no cash moves into or out of the company's accounts; non-cash transactions have no effect on the cash flow statement, but they can effect the income statement and balance sheet.
A positive cash flow for a period means the company has more cash at the end of the period than at the beginning.
A negative cash flow means the company has less cash at the end of a period than at the beginning.
A continuing negative cash flow means the company is on the road to insolvency.
Cash comes into the business in two major ways:
1. Operating activities such as receiving payment from customers.
2. Financing activities such as selling stock or borrowing money.
Cash goes out of the business in four major ways:
1. Operating activities such as paying suppliers and employees.
2. Financial activities such as paying interest and principal, or paying dividends.
3. Making major capital investments in long-lived productive assets.
4. Paying income tax.
Cash from Operations, i.e. cash from the day-to-day "conventional" activities of a business (making and selling products), is shown separately from other cash flows.
Cash receipts are inflows of money coming from operating the business.
Cash disbursements are outflows of money coming from operating the business.
Cash from operations = Cash receipts - Cash disbursements.
Cash receipts, also called collections or simply receipts, come from collecting money from customers.
Cash receipts increase the amount of cash the company has on hand, but they are not profits.
Receiving cash from customers decreases the amount that is due the company as accounts receivable shown on the balance sheet.
Cash disbursements are, in effect, cheques written — whether to pay for inventory, supplies, or a worker's salary. They lower the amount of cash the company has on hand.
Cash disbursements to suppliers lower the amount the company owes as reported in accounts payable on the balance sheet.
Cash disbursements are also called payments or simply disbursements.
Cash from operations reports the flow of money into and out of the business from making and selling products, and as such is only one of the important elements of cash flow, alongside
Investment in fixed assets
Financial activities
Fixed Asset Purchases are money spent to buy property, plant and equipment — i.e. an investment in the long term capability of the company.
Paying for PP&E is not considered part of operations, and thus is not reported in cash disbursements from operations. Cash payments for PP&E (i.e. fixed asset purchases) are reported on a seperate line in the cash flow statement.
Needless to say, after purchasing PP&E the business has less cash, but cash flow is not affected at all by depreciation/amortisation.
Net Borrowings is the difference between any new borrowings in a period and the amount paid back, and is reported for the period on a seperate line in the Cash Flow Statement.
Income Taxes Paid is the income taxes paid — which is different than the income taxes owed, per the accrual-accounting practices of the balance sheet and income statement.
Sale of Stock is the new equity sold; when a company sells stock to investors, it receives money and increases the amount of cash it has on hand.
Ending Cash Balance is the cash-on-hand at the end of a given period.
Note that, while the cash flow statement is always unchanged in a transaction where no cash actually changes hands, a balance sheet or an income statement may be changed by a non-cash transaction.
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Chapter 5 (Connections)
Terminology
The fundamental reporting function of each of the three statements is as follows:
The income statement shows the manufacturoing and selling actions of the enterprise that show a profit or loss.
The cash flow statement details the movements of cash into and out of the coffers of the enterprise.
The balance sheet records what the company owns and what it owes, including the owner's stake.
Each statement views the enterprise's financial health from a different – and very necessary – perspective. Each statement relates to the other two in specific ways; they have these "natural connections"
The sales cycle
The expense cycle
The investment cycle
Asset purchase/depreciation
As you study the reporing of dollars and goods entering or leaving a business,
1. Watch the flow of cash money
2. Watch the flow of goods and services
Balance Sheet Connections
Structural connections
Ending cash balance on the cash flow statement for the period always equals cash at period end on the balance sheet
As the basic equation of accounting states, total assets always equals total liabilities + shareholder's equity on the balance sheet.
"Balancing" connections
To keep the balance sheet in balance, when a transaction is added to an asset account, an equal amount must be subtracted from another asset account
Likewise, for liability accounts. In both cases, total assets or total liabilities & shareholder equity do not change and maintain the balance on the balance sheet.
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