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157 Cards in this Set
- Front
- Back
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What is the accounting equation? |
Assets = Liabilities + Equity |
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What is the net earnings/loss equation? |
Net earnings/loss = Revenues - Expenses |
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What are the 2 types of accounting users? |
1) Internal users -work for the company -managers, employees, and others who plan, organize, and run the company 2) External users -don't work for company -investors, lenders, and other creditors -customers, employees, labour unions -taxing authorities and regulators |
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What do most companies have in order to guide ethical behaviour? |
Codes of conduct |
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3 types of business ownership |
- Proprietorship - Partnership - Corporations |
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Proprietorship |
-owned by one person (proprietor) -simple to set up -owner has control over business -limited life -unlimited liability -income tax paid by owner
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Partnership |
-similar to proprietorship except owned by more than one person -formalized in a written agreement -limited life -each partner has unlimited liability -income tax paid by individual partner |
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Corporations |
-separate legal entity owned by shareholders -indefinite life; ease of raising capital -shareholders enjoy limited liability -corporation pays income tax -may be public or private |
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Explain what GAAP is |
- Generally Accepted Accounting Principles - Rules and practices for the preparation of financial statements - Public corporations use IFRS - Private corporations use ASPE - Proprietorships and partnerships generally follow ASPE but aren't required to follow either |
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3 types of business activities |
-Financing -Investing -Operating |
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Financing Activities |
-Obtaining (and repaying) funds to finance the operations of the business -forms of debt -eg. loans, shares, mortgages, bonds, leases, etc. |
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Investing Activities |
-Purchase or sale of long-lived assets needed to operate the company -eg. non-trading investments, property, plants, equipment, intangible assets |
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Operating Activities |
-Main day-to-day activities -eg. revenues, expenses, accounts receivable and accounts payable |
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4 Types of Financial Statements |
In this order:
-Income statement -Statement of changes in equity -Statement of financial position -Statement of cash flow |
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Income statement |
-Revenues -Expenses -Profit |
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Statement of Changed in Equity |
-Shows the changes in each component of shareholders' equity for the period
-Common shares -Retained earnings -Profit -Dividends |
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Statement of Financial Position |
-Assets -Liabilities -Shareholders' equity -Accounting equation |
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Statement of cash flows |
- Report on operating, financing, and investing activities - Shows net gain/loss in cash for the period |
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Current Assets |
-Assets expected to be converted to cash or used in the business within one year or one operating cycle (whichever is longer) -Listed in order of liquidity (or reverse) -eg. cash, trading investments, accounts receivable, merchandise inventory, and prepaid expneses
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Non-current assets |
-Assets NOT expected to be converted to cash or used within the business within one year or one operating cycle -eg. investments, property, plant, equipment, intangible assets, goodwill, etc |
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Long-term investments |
-Multi-year investments in: loans, notes, bonds, mortgages, shares of other companies -These assets are not usually intended to be sold (and converted to cash) within one year |
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Property, Plant, Equipment |
-Tangible assets with long useful lives -Used in operating the business -Listed in order of permanency -eg. land, buildings, equipment, furniture
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Depreciation |
-Allocation of the cost of property, plant, and equipment over their useful lives -Companies systematically assign a portion of the cost of an asset to an expense account each year -Assets with indefinite lives aren't depreciated (eg. land) - Intangible assets use amortization -ASPE often uses the word amortization |
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Accumulated depreciation |
-Shows the total amount of depreciation taken t date -The difference between the cost of the asset and its accumulated depreciation is reffered to as the carrying amount of the asset |
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Intangible Assets |
-non-current assets that do not have physical substance and represent a privilege or a right held by the company -generate a future value to the company -amortized if they don't have an indefinite life -eg. patents, copyrights, trademarks, licenses, goodwill |
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Current Liabilites |
-obligations that are to be paid within the coming year or one operating cycle -eg. bank indebtedness, accounts payable, unearned revenue, bank loan/notes payable, current maturities of long-term debt |
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Non-current liabilities |
-Debts aren't expected to be paid or settled after one year -Usually accompanied by extensive notes to the financial statements -eg. bank loans, notes payable, lease obligations, pension/benefit obligations, deferred income tax |
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Shareholder's equity |
-Share capital, investment of cash (or other assets) in the company by shareholders in exchange for preferred or common shares -Retained earnings, cumulative profits kept for use in the company |
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Liquidity Ratios (2) |
-Measure a company's short-term ability to pay its maturing obligations and to meet its unexpected needs for cash (higher is generally better) 1) Working capital = current assets - current liabilities 2) Current ratio = current assets / current liabilities |
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Solvency Ratio |
-Measure a company's ability to survive over a long period of time (lower is generally better)
1) Debt to total assets = total liabilities / total assets |
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Profitability Ratios (2) |
- Measure a company's operating success for a given period of time (higher in generally better) 1) Earnings per share = profit available to common shareholders / average number of common shares 2) Price-earnings ratio = market price per share / earnings per share |
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Qualitative characteristics of accounting information |
-Relevance, makes a difference in the users' decisions, have predictive/confirmatory value, materiality -Faithful representation, information should reflect economic reality, must be complete verifiable, and free from material error
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Enhancing qualities of useful information |
-Comparability, users can identify and understand similarities and differences among items -Verifiability, independent consensus that information is faithfully represented -Timeliness, available before it loses its usefulness in decision-making -Understandability, classified, characterized and presented clearly and concisely
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Cost constraint |
-Ensures that the value of the information provided by financial reporting is greater than the cost providing it -The benefits of financial reporting should justify the costs of providing and using it |
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Going Concern Assumption |
-The business will continue operating in the foreseeable future -The key assumption - provides a foundation for accounting -Provides justification for using cost as the value of certain assets |
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Generally accepted accounting principles |
-Historical Cost, assets and liabilities should be recorded at their cost when acquired, not only at the time of purchase but throughout the lifetime of each asset and liability -Fair value, certain assets and liabilities should be recorded and reported at fair value |
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Accounting Transactions |
-Accounting information system, the system of collecting and processing transaction data and communicating financial information -Are economic events that must be recorded in the financial statements (only those that change assets, liabilities, or equity) -Based on factors such as type of business, size of company, amount of data, information requests |
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Analyzing Transactions |
-Transaction analysis determines impact on the accounting equation -The accounting equation must ALWAYS balance, therefore each transaction has a duel effect on the equation |
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The T Account |
-An individual accounting record of increases and decreases in a specific asset, liability, or shareholders' equity item -3 parts: 1) The title of the account (eg. cash) 2) a left (debit) side 3) a right (credit) side |
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Debits and Credits |
-Describe where entries are made in the account (debiting or crediting) -If debit amounts exceed credit amounts, account has a debit balance -If credit amounts exceed debit amounts, account has a credit balance |
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Normal balances |
-Assets, expenses, dividends: debit for increase, credit for decrease
-Liabilities, equity, common shares, retained earnings, and revenues: debit for decrease, credit for increase |
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Steps in recording process |
1) analyze each transaction to determine its effect on accounts (if any) 2) record transaction (journalizing) as a journal entry in the general journal (or sales, purchases, cash receipts) 3) transfer information (posting) to appropriate accounts in general ledger (chart of accounts) 4) prepare a trial balance (lists all accounts and their balances at a specific time) |
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Timing Issues |
-Companies need immediate feedback on how well they are doing -Accounting divides the economic life of a business into artificial time periods: -Monthly, quarterly (3 months), a year (know as fiscal year), shorter periods are known as interim periods |
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Revenue Recognition |
-Revenue is earned (recognized) when: sales or performance efforts is substantially complete, amount is measurable, collection is assured -In a merchandising company when: merchandise is sold (point of sale) -In a service company when: the service is performed |
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Expense Recognition |
-Expenses are recognized when: due to ordinary activity, a decrease in future economic benefit occurs (a decrease in an asset or an increase in a liability), can be measured reliably. -Tied to changes in assets and liabilities -Often (but not always) coincides with revenue recognition (known as matching) |
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Cash Basis accounting |
-Revenue is recorded only when cash is received -Expenses are recorded only when cash is paid -Can lead to misleading information for decision-making (revenue and expenses can be manipulated by timing the receipt and payment of cash, can increase or decrease profit |
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Adjusting Entries |
-Entries made to adjust or update accounts at the end of the accounting period -Required because the trial balance may not contain complete and up-to-date data (not recorded daily/during accounting period) |
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Types of Adjusting Entries |
-Prepayments: prepaid expenses, unearned revenue -Accruals: accrued revenues, accrued expenses |
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Prepaid Expenses |
-Expenses paid in cash and recorded as assets before they are used -Expire with the passage of time or through use -Adjusting entry increases an expense account and decreases the asset (prepaid) account |
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Unearned revenue |
-Cash received and recorded as liabilities before revenue is earned -The opposite of prepaid expenses -Adjusting entry decreases the liability (unearned revenue) account and increases a revenue account |
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Accruals |
-Revenues that have been earned but not received in cash (accrued revenues) -Expenses that have been been incurred but not yet paid or recorded (accrued expenses) |
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Adjusting Trial Balances |
-Prepared after all adjusting entries have been journalized and posted -Shows the balances of all accounts at the end of the accounting period -Proves total debit balances and total credit balances are equal after the adjusting entries have been made -The main source for preparation of financial statements |
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Closing the books |
-Revenue and expense accounts are are subdivisions of retained earnings (temporary accounts) -Statement of financial position accounts carry forward into the future (permanent accounts) -Closing entries |
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Temporary and permanent accounts |
1) Temporary: all expenses, all revenues, and dividends accounts
2) Permanent: all assets, all liabilities, and all shareholders equity |
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The closing process (4 steps) |
1)Close revenue accounts: debit each revenue account for its balance and credit income summary 2)Close expense accounts: Debit income summary and credit each expense account for its balance 3)Close income summary: debit (or credit) income summary for the balance in the account and credit (or debit) retained earnings 4)Close dividends account: debit retained earnings and credit dividends account for the balance |
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Post-closing Trial Balance |
-Lists all permanent accounts and their balances -Proves that total debit balances and total credit balances are equal after the closing entries have been made |
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Difference between service and merchandising companies |
-Service companies perform services as their primary course of revenue -Merchandising companies buy and sell inventory |
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Operating Cycle |
-The time it takes to go from cash to cash in producing revenues -Longer for a merchandising company than for a service company |
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Income management process |
-Revenue: sales revenue (from the sale of merchandise), the main source -Expenses are divided into two categories: 1)cost of goods sold, total cost of merchandise sold in a period 2)operating expenses, incurred in the process of earning sales revenue -Gross profit = sales revenue - cost of goods sold |
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Inventory Systems |
-Flow of costs for a merchandising company -One of two systems is used to account for inventory and costs of goods sold: perpetual inventory system, periodic inventory system
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Perpetual System |
-Detailed records are kept for the cost of each product purchased and sold -These records are updated continuously (perpetually) for purchases and sales -A physical count is done at least once a year to adjust perpetual records to actual -This system enables the effective control of inventory which is an important asset |
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Periodic System |
-Detailed records merchandise are not kept throughout the period -Cost of goods sold is only determined at the end of the accounting period |
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Purchases of Merchandise |
-Purchases are recorded in the merchandise inventory account -includes all costs to get merchandise to place of business and ready for resale -credit purchases are supported by a purchase invoice |
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Sales taxes and freight |
-GST and HST paid does not form part of cost of goods (refunded) -Generally no PST on goods purchased for resale -FOB (free on board) = refers to where title or ownership of goods transfers -Freight paid by buyer (FOB shipping point) is part of the cost of merchandise purchased |
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FOB Destination |
-Ownership of the goods does not pass from the seller to the buyer until the goods are received by the buyer (i.e. destination point) |
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FOB shipping point |
-Ownership of the goods passes from the seller to the buyer as soon as the goods are shipped |
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Purchase Returns and Allowances |
-A purchaser returns the goods to the seller and receives a cash refund or credit -The buyer may choose to keep the merchandise if the seller is willing to give an allowance (deduction) from the purchase price -In both cases, the result is a decrease to the cost of goods purchased |
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Discounts |
-A quantity discount gives a price reduction according to the volume of the purchase -A purchase discount is offered to encourage early payment of balance due |
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Sales of Merchandise |
-Recording of sales (one to record sales price and one to record cost of sale) -Sales taxes are not recorded as revenue -When freight is FOB destination, seller records cost of freight as an expense -Sales returns and allowances are a contra revenue account to sales
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Gross Profit Marign |
= Gross profit / net sales
-Measures the gross profit expressed as a percentage of net sales -Higher is generally better |
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Profit Margin |
= Profit / net sales
-Measures the percentage of each dollar of sales that results in profit -Higher is generally better |
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Calculating cost of goods sold |
1) Calculate cost of goods purchased 2) Determine ending inventory 3) Calculate the cost of goods sold
Beginning inventory + cost of goods purchased - cost of goods available for sale - ending inventory = cost of goods sold |
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Taking Inventory |
-To ensure inventory is properly counted, companies must have a good system of internal control: -employees who perform the count should not have responsibility for custody or record-keeping -establishes validity of item -second count by someone else |
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Cost methods |
-Cost methods assume a flow of costs that may not be the same as the actual flow of goods -FIFO (First-in, first-out), cost of first item purchased is cost of first item sold -Average cost, is determined using a moving (weighted) average of the cost of the items purchased |
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FIFO |
-Merchandise inventory is recorded at most recent (current) cost in the current assets section of statement of financial position -cost of goods sold is recorded as an expense at oldest inventory cost on income statement -ending inventory and cost of goods sold under FIFO are the same for periodic and perpetual inventory systems |
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Average Cost |
-Used when physical flow of inventory cannot specifically be measured -Under a perpetual inventory system, a new weighted (called moving) average is calculated after each purchase |
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How to choose cost determination methods |
-Choose a method that best represents physical flow of goods, reports ending inventory at recent cost -use the same method for inventories of similar nature and usage |
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Inventory Errors |
-Incorrect counting or costing -Transfer of title not recognized -Errors effect both statement of financial position (through merchandise inventory) and income statement (through cost of goods sold) |
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Effects of errors |
-an error in ending inventory of the current period will have a reverse effect on profit in the next accounting period -an error in ending inventory affects retained earnings of the same period |
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LCNRV Rule and Application |
-The lower of cost and net realizable value rule -Apply rule to individual inventory items -Reduce inventory by creating it for the amount of write-down, debit is to cost of goods sold -Reverse write-down if value subsequently recover |
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Reporting Inventroy |
-In the statement of financial position -In the notes to the statements, total amount of inventory, cost of goods sold, cost of determination method, amount of write-downs or reversals |
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Inventory Ratios |
- Inventory Turnover = Cost of goods sold / average inventory (measures the number of times inventory is sold in a period) - Days in Inventory = 365 / inventory turnover -In general, the higher the inventory turnover and the lower the days in inventory ratios, the better |
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Internal control |
-The related methods and measures adopted within a company to help it achieve: reliable financial reporting, effective and efficient operations, compliance with relevant laws and regulations -Helps prevent and detect errors, which cause unintentional misstatements -An effective way to prevent and detect fraud |
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5 components of internal control systems |
-Control environment -Risk assessment -Control activities -Information and communication -Monitoring |
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Control activities |
-Authorization of transactions and activities -Segregation of duties -Documentation -Physical controls -Independent checks of performance -Human resource controls |
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Limitations of internal cost |
-Can only provide reasonable assurance that assets are safeguarded and records are reliable -Limitations include: -cost/benefit -human element -collusion -size of business |
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Fraud |
-An intentional act to steal assets or to misstate financial statements -many high profile collapses of companies due to fraud -eg. recording expenses as assets, overstating useful lives of assets -recording revenues that do not exist |
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Cash receipts |
-over-the-counter, mail-in, and electric funds transfer (EFT) receipts -internal control over cash receipts is more effective when cash receipts are deposited into the bank account daily or are made by electric funds transfer |
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Cash Payments |
-control activities over cash payments are more effective when payments are made by cheque or by EFT, rather than in cash -good controls include: -dual signatures on cheques -segregation of duties -use pre-numbered cheques and account for numerical continuity -pay electronically instead of by cheque |
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Benefits of using a bank |
-safeguards cash by using a bank as a depository and clearing house for cheques received and written -minimizes amount of currency that must be kept on hand -provides a second record of transactions |
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Differences between company records and bank statements |
-Time lags -Errors by either party in recording transactions |
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Reconciling the Bank account |
-This reconciles the balance per the company's bank account with the cash balance per the general ledger ("books") -Both the books and bank balance are reconciled to their adjusted (correct) cash balance -Do not journalize any entries on the bank side |
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Reporting Cash |
-Cash is recorded in both the statement of financial position and the statement of cash flows -Cash is the most liquid asset and is listed first in the current assets section of the statement of financial position -Can be combined with cash equivalents -Cash that is restricted (not available for general use) is reported separately as a current or non-current asset |
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Types of Receivables (3) |
-Amounts due to a business from its customers or other entities expected to be collected in cash 1) Accounts receivable: amounts owed by customers due to the sale of goods and services 2) Notes receivable: formal credit instrument (written promise to pay) 3) Other receivables, interest receivable, loans and advances to employees, recoverable sales tax, income tax receivable |
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Accounts Receivable |
-A receivable is recorded when service is provided on account or at point of sale of merchandise on account -A receivable is reduced when cash is collected, a sales discount is taken, or the merchandise is returned by the customer |
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Nonbank Credit Card Receivables |
-Bank credit card and debit card transactions recorded as cash -Nonbank (company) credit cards recorded as accounts receivable |
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Subsidiary Ledger |
-a group of accounts that share a common characteristic (i.e. all receivable accounts) -the subsidiary ledger for accounts receivable provides the details that support the total balance for accounts receivable in the general ledger (the single accounts receivable account in the general ledger is the control account) |
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Interest Revenue |
-If a customer doesn't pay in full within a specified period of time (usually 30 days), an interest (financing) charge may be added to the balance due |
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Recording Estimated Uncollectible Accounts |
-Some accounts receivable become uncollectable -Losses from these uncollectible accounts are debited to an account called bad debts expense -bad debts expense is recognized in the same period that the related sales revenue is generated |
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Allowance Method |
-estimates the uncontrollable accounts at the end of each period -the amount estimated is shown in the allowance for doubtful accounts (put below accounts receivable)
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Estimating the Allowance |
-Most companies use the percentage of receivables basis to determine the allowance -Once the appropriate estimate for uncollectible accounts is determined, an adjusting entry can be recorded -The amount of the adjusting entry is the difference between the required balance and the existing balance in the allowance account |
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Percentage of receivables basis |
-Estimate what percentage of receivables are likely to be uncollectible -Apply this percentage to total receivables, or to receivables classified according to the length of time they have been outstanding (called aging the accounts receivable) |
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Steps in allowance method |
1) recording estimated uncollectible accounts -any increase to the allowance is recorded as bad debt expense 2) recording the write-off of an uncollectible account -actual accounts are written off when they are determined to be uncollectible -this reduces the allowance 3) recording the recovery of an uncollectible account -if a written off account is later collected, the write-off is reversed and the collection is recorded |
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Notes Receivable |
• Stronger legal claim to assets than accounts receivable; written promise (promissory note) to repay • A credit instrument that normally – Requires the payment of interest – Extends for time periods greater than 30 days • Often accepted from – Customers who need to extend payment of an account receivable – High-risk customers |
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Formula for calculating intrest |
-Face value of note x annual interest rate x time in terms of one year = interest • The interest rate specified on the note is an annual rate of interest
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Derecognizing Notes Receivable |
• Honoured – Paid in full at maturity date – Collection recorded • Dishonoured – Not paid at maturity date; note no longer negotiable – Balance transferred to Accounts Receivable if eventual collection expected – Balance transferred to Allowance for Doubtful Notes if eventual collection not expected |
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Statement Presentation |
• Statement of Financial Position – Receivables reported in the current assets section – Following cash and short-term investments – Only required to disclose net realizable value, but helpful to disclose gross receivables and the allowance for doubtful accounts • Income Statement – Bad debts expense is reported as an operating expense – Interest revenue is non-operating |
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Managing Receivables |
• Determine to whom to extend credit • Establish a payment period • Monitor collections – Prepare and update an accounts receivable aging schedule • Evaluate the liquidity of receivables |
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Evaluating the liquidity of Receivables |
• Liquidity is measured by how quickly certain assets can be converted into cash – Receivables turnover – Average collection period |
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Receivable turnover |
• Is a measure of the liquidity of receivables -Receivable turnover = Net Credit Sales/Average Gross Receivables -Higher is better |
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Average Collection Period |
• Is the average amount of time that a receivable is outstanding -Average collection period = 365 days / receivables turnover -lower is better |
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Property, Plant, Equipment |
• Long-lived resources that – Are controlled by the company – Have physical substance – Are used in the operation of a business – Are not intended for sale to customers • Provide benefits over many years |
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Determining the cost of property, plant, and equipment |
• Recorded at cost, which includes – Purchase price, including non-refundable taxes and duties, less discounts or rebates – Expenditures necessary to bring asset to its intended location and make it ready for its intended use – Estimated cost of future obligations to dismantle, remove or restore the asset at the end of its useful life |
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Types of Expenditures |
• Operating expenditures – Benefit only the current period – Immediately charged as an expense • Capital expenditures – Capitalized as an asset – Benefit future periods – Increases a company’s investment in productive activity |
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Land |
• Cost of land includes – Purchase price – Closing costs such as title and legal fees – Additional costs to prepare land for its intended use (less any proceeds from salvage) • Land has an unlimited life, therefore it is not depreciated |
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Land Imporvements |
• The costs of structural additions made to land (such as paving, fencing, and sidewalks) • These decline in service potential over time – They are recorded separately from land – Depreciated over their useful lives • Not one-time costs of getting the land ready to use |
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Buildings |
• All expenditures related to the purchase or construction of a building • When a building is purchased such costs include – Purchase price – Closing costs (legal fees) – Costs required to make building ready for its intended use • When a building is constructed, its cost consists of – Contract price – Architect's fees – Building permits |
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Equipment |
• Costs include – Purchase price – Freight charges and insurance during transit paid by the purchaser – Assembling – Installing and testing |
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Buy of lease? |
• Advantages of leasing – Reduced risk of obsolescence – 100% financing – Income tax – “Off-balance sheet” financing • Terminology Lessor — owner of asset for lease (such as a landlord) Lessee — party leasing asset from owner (such as a tenant) |
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Types of lease |
• Operating lease – Treated as rental by lessee – Periodic payment (rent expense) • Finance lease – Treated as purchase by lessee (as an asset and corresponding liability) – Periodic payment (decrease liability and charge interest expense) |
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Depreciation |
• Systematic allocation of the cost of property, plant and equipment over the asset’s useful life • A process of cost allocation, not determining an asset’s fair value • Does not use or provide cash to replace the asset |
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Factors in calculating depreciation |
• Cost – Purchase price plus costs required to get the asset ready for use plus estimated asset retirement costs • Useful life – The period of time that the asset is expected to be available for use, or – The number of units that the asset is expected to produce • Residual value – Estimated amount to be received at the end of the asset’s useful life |
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Depreciation Methods |
• Straight-line – Used by the majority of Canadian publicly-traded companies • Diminishing-balance • Units-of-production • Management chooses the method that best reflects the pattern of use of the economic benefits from that asset |
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Straight-line method |
• Depreciation is constant for each year of the asset's useful life |
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Diminishing-Balance Method |
• Produces a decreasing annual depreciation expense over an asset’s useful life – Depreciation is calculated based on the asset’s carrying amount, which diminishes each year as accumulated depreciation increases • Annual depreciation expense is calculated by multiplying the carrying amount by the depreciation rate – Residual value is not included in the calculation • Can be applied using different rates – Depreciation rate = Straight-line rate x multiplier |
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Units of Production Method |
• Useful life is expressed in terms of total units of production or activity expected from the asset – Such as units produced or machine-hours worked • Useful for factory machinery, vehicles, airplanes |
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Depreciation Issues |
• Significant components – May be depreciated separately • Income tax • Impairments – Impairment loss occurs when carrying amount of asset exceeds its recoverable amount • Cost vs. revaluation model – Revaluation model allowed under IFRS; used on a limited basis |
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Revising Periodic Depreciation |
• Revisions needed if – Capital expenditures during useful life – Impairment losses – Change in estimated useful life or residual value – Change in the pattern in which the asset’s economic benefits are consumed • Accounted for as a change in estimate – Change made in current and future |
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Derecognition of property, plant, and equipment |
1. Update depreciation – Depreciation for the fraction of the year to the date of disposal must be recorded 2. Calculate carrying amount – Carrying amount = Cost – Accumulated depreciation 3. Calculate gain or loss – Proceeds – carrying amount = gain/loss 4. Record disposal – Remove cost of asset and accumulated depreciation. Record proceeds (if any) and gain or loss on disposition (if any)
Proceeds > carrying amount = Gain (Cr.) Proceeds < carrying amount = Loss (Dr.) |
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Intangible Assets and Goodwill |
• Do not have physical substance • Rights, privileges and/or competitive advantages – For example, intellectual property in a production process • Must be identifiable – Can be separated from company and sold; or – Based on contractual or legal rights |
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Accounting for Intangible Assets |
• Accounting for intangible assets parallels accounting for tangible assets – Recorded at cost including all costs to make asset ready for use • If intangible asset has a finite (limited) life, its cost must be systematically allocated over its useful life – For intangible assets, this is referred to as amortization rather than depreciation • Intangible assets with an indefinite (unlimited) life are not amortized |
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Aortization for intangibles |
• Amortize over shorter of – Estimated useful life – Legal life • Test for impairment |
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Intangibles with finite lives |
• Patents – Exclusive right to produce for 20 years • Research and development costs – All research costs are expensed – Development costs are capitalized only if associated with an identifiable, feasible product • Copyrights © – Protection for the life of the creator + 50 years |
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Intangibles with indefinite lives |
• Trademarks and trade names ™® – Word, jingle, symbol that distinguishes business • Franchises – Contractual agreement to sell products or services • Licences – Operating rights |
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Goodwill |
• Asset representing future economic benefits arising from the purchase of a business – Excess of cost over fair market value of net assets (assets less liabilities) acquired – Represents the extra value relating to a business when it is purchased – Only identified with the business as a whole • Not amortized, but subject to an annual test for impairment |
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Presentation of long-lived assets |
• Statement of Financial Position – Reported as • Property, Plant and Equipment • Intangible Assets • Goodwill – Disclose cost and accumulated depreciation (amortization) of each major class of assets either in statement or in notes – Disclose depreciation/amortization methods and useful lives or rates – IFRS also requires additional disclosures • Income Statement – Depreciation expense, gains and losses on disposal and impairment losses are included in the operating section • Statement of Cash Flows – Cash flows from the purchase and sale of longlived assets are reported in the investing section |
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Return on Assets |
• Measures overall profitability -Return on assets = Profit / average total assets -higher is better |
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Asset Turnover |
• Measures how efficiently a company uses its assets -Asset Turnover = Net sales/ Average Total assets -Higher is better |
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Profit Margin Revisited |
• Together, profit margin and asset turnover explain the return on assets ratio -Profit Margin x Asset Turnover = Return on assets |
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Purpose of the Statement of Cash flows |
• Helps users assess: – A company’s ability to generate cash – What the company did with the cash • This is useful in determining: – Company’s ability to generate future cash flows – Investing and financing transactions during the period, and effect upon capital structure – Making comparisons with other companies |
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Definition of Cash and Classification of Cash Flows |
• Cash may include cash equivalents – Short-term, highly liquid trading investments that are readily converted to cash within a short period of time (usually within three months) • Cash receipts and payments are classified into three categories: – Operating activities – Investing activities – Financing activities |
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Significant Noncash Activities |
• If it does not affect cash, do NOT report in statement of cash flows • Report in separate note to the financial statements • Examples: – Issue of debt to purchase assets – Issue of shares to purchase assets – Conversion of debt into equity – Exchange of property, plant, and equipment |
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Preparing the Statement of Cash Flows |
• Step 1: Prepare operating activities section • Step 2: Prepare investing activities section • Step 3: Prepare financing activities section • Step 4: Complete the statement of cash flows |
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Step 1: Operating activities |
• Determine the net cash provided (used) by operating activities by converting profit from an accrual basis to a cash basis • Conversion may be done by either the indirect method or the direct method – Both methods arrive at the same amount of net cash provided (used) by operating activities • Most companies favour the indirect method for the following reasons – Easier to prepare – Reveals less information to competitors |
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Convert Profit to Net Cash Used by operating activities -indirect method |
• Start with profit and add or deduct items not affecting cash to arrive at net cash provided (used) by operating activities + Noncash expenses such as depreciation and losses – Noncash revenues and gains + Decreases in noncash current asset accounts and increases in noncash current liability accounts – Increases in noncash current asset accounts and decreases in noncash current liability accounts |
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Direct method |
• Standard setters prefer the direct method but allow the use of either method • Details cash receipts and payments • Similar to indirect method: – Adjusts income statement from accrual basis to cash basis in order to arrive at net cash provided (used) by operating activities – However, whereas indirect method adjusts total profit, direct method adjusts each individual revenue and expense account |
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Cash Receipts from customers |
• The relationship among cash receipts from customers, revenues from sales, and changes in accounts receivable is: Cash receipts from customers = revenue (+decreases in accounts receivable or -increases in accounts receivable) • If other cash receipts (such as interest), these must be adjusted for any receivable amounts as was done above |
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Cash payments to suppliers |
-The relationship among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable is: -Cash payments to suppliers = cost of goods sold (+increase in inventory or -decrease in inventory, +decreases in accounts payable or -increases in accounts payable) |
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Cash Payments for operating expenses |
-The relationship among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable is: -Cash payments for operating expenses = operating expenses (+increase in prepaid expenses or -decrease in prepaid expense, +decreases in expenses payable or -increases in expenses payable) |
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Cash Payments for Income tax |
• The relationship among cash payments for income tax, income tax expense, and changes in income tax payable is: -Cash payments for income tax = income tax expense (+decreases in income tax payable or -increases in income tax payable) • A similar calculation would be made for cash payments for interest |
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Step 2: investing activities |
• Measure cash flows relating to non-current asset accounts; long-term investments; property, plant and equipment; intangible assets • Reported the same under both direct and indirect methods • Asset acquisitions are uses of cash; disposals are sources of cash (for the proceeds of disposition) – Depreciation expense is a noncash charge |
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Step 3: financing activities |
• Determine the net cash provided (used) by financing activities by analyzing changes in noncurrent liability and shareholders’ equity accounts • Changes to notes, loans, and bonds payable are analyzed to determine cause of change – Amortization of premium or discount (if any) are noncash charges and have no effect • Analyze share capital and retained earnings accounts for changes and their cause – Profit is reported in the operating activities section |
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Step 4: The statement of cash flows |
• Complete the statement of cash flows • Determine increase (decrease) in cash • Ensure ending cash balance agrees to that reported on statement of financial position • Identify any noncash disclosures |
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Using cash flows to evaluate a company |
• Liquidity – Cash current debt coverage ratio • Solvency – Cash total debt coverage ratio – Free cash flow |
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Cash current debt coverage ratio |
• Measures ability of company to repay obligations coming due within the next year -Net cash provided (used) by operating activities Average current liabilities -Higher is better |
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Cash total debt coverage ratio |
• Measures ability of company to repay its liabilities from operating activities -Net cash provided (used) by operating activities Average total liabilities -Higher is better |
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Free cash flow |
• Measures discretionary cash flow remaining from operating activities available to use to expand operations, reduce debt, go after new opportunities, or pay additional dividends, among other alternatives -Net cash provided (used) by operating activities – net capital expenditures – dividends paid -Higher is better |
