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US vs. International accounting boards and rules
US: FASB creates GAAP
International: IASB creates IFRS
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Where are gains/losses on asset disposal reported?
Income statement
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What is the accounting equation
assets = liabilities + owner's equity
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What are the types of cash flows
- operating: result from "normal" business of the firm
- investing: acquisition/sale of PPE, of a subsidiary or segment, of securities, and investment in other firms
- financing: issuance/retirement of firm debt/equity and dividends to stockholders
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Types of audit opinions
- unqualified: statements are free from material errors/omissions
- qualified: explain reasonably made exceptions to accounting principles
- adverse: statements not presented fairly or are materially nonconforming
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Six steps of FSA
- State the objective and context
- Gather data
- Process the data (make appropriate adjustments)
- Analyze and interpret the data
- Report the conclusions/recommendations
- Update the analysis
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What 2 things make up owner's equity
contributed capital + retained earnings
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Chart for indirect method of going from IS to CF statement
- Assets increase = outflow
- Assets decrease = inflow
- Liabilities increase = inflow
- Liabilities decrease = outflow
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Classification of dividends and interest as a cash flow
- FASB: Dividends paid are financing, dividends received are operating, and interest either paid or received is operating.
- IASB: All situations can be either financing or operating cash flows
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FASB vs IASB on purposes of the framework, objectives of financial statements, assumptions, qualitative characteristics, and financial statement elements
- Purposes of the framework: IASB requires management to consider the framework if no explicit standard exists. FASB does not
- Objectives: FASB presents different objectives for business and non business reports. IASB does not.
- Assumptions: IASB places more emphasis on going concern assumption
- Qualitative characteristics: FASB only lists relevance and reliability. IASB has those and comparability and understandability
- Financial statement elements:
- 1) IASB lists income and expenses as performance crucial. FASB also includes revenue, expenses, gains, losses, and comprehensive income.
- 2) FASB says asset is a future economic benefit. IASB says its a resource from which a future economic benefit is expected
- 3) FASB does not allow the value of most assets to be adjusted upward
- 4) FASB uses the word "probable" to define assests and liabilities
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General IS format
- Revenue
- (COGS)
- = Gross Profit
- (GSA)
- (Depreciation expense)
- = Operating Profit
- (Interest expense)
- =Income before tax
- (Tax)
- = Income from continuing operations
- Earnings (loss) from discontinued operations net of tax
- = Net income
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Explain two methods for recognizing long-term contracts
Percentage-of-completion: Recognize same % of final revenue as the % of final cost that has occurred. Ex. if have completed 50% of project in Q1 (based on cost), recognize 50% of the sale price
in year 2, calculate revenue recognized by: TOTAL costs incurred/total estimated costs * total expected revenue - revenue already recognized
if costs exceed projections, recognize remaining revenue only, and income may be a loss
Completed-contract: recognition of all revenue and expense occurs upon completion
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Installment sale recognition methods
- Normal recognition: if collectibility is certain or can be reasonably estimated, revenue is recognized at the time of sale
- Installment method: profit is recognized as cash is collected. Profit = cash collected * total expected profit/total sales
- Cost recovery method: revenue = expenses = cash collected until all costs are accounted for, then the rest is considered profit
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Gross revenue reporting vs net revenue reporting
- Gross: revenue and cogs are recognized separately
- Net: only the difference in sales and cogs is reported
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Criteria for using gross method
- be the primary obligor under the contract
- bear the inventory risk and credit risk
- be able to choose supplier
- have reasonable latitude to establish the price
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What is the matching principle?
expenses to generate revenue are recognized in the same period as the revenue
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Period costs, what are they and when are they expensed
- cannot be tied directly to revenue generation (ex. admistrative)
- expensed in the period incurred
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Straight line depreciation
SL depreciation expense = (cost - residual value)/useful life
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Double declining balance depreciation method (DDB)
- DDB depreciation = (2/useful life)*(cost - accumulated depreciation)
- Depreciation continues until residual value is reached since it's not explicitly used in the formula
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Beginning -> ending inventory
Beginning inventory + Purchases - COGS = Ending Inventory
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Periodic vs perpetual inventory systems
- Periodic: inventory purchased during the accounting period is recorded in a Purchases account. At the end of the period, Purchases and Sales are used to reconcile the Inventory and COGS accounts
- Perpetual: Inventory and COGS are updated continuously. A purchases account is unneccessary.
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Does LIFO or FIFO provide a better measure of ending inventory? Why?
Which is most appropriate for inventory whose value deteriorates quickly?
FIFO does because ending inventory (beginning + purchases - COGS) is made of the most recent purchases, which better reflects current market prices and therefore current economic value.
FIFO is most appropriate for deteriorating inventory
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Inventory write-down rules for IFRS and GAAP
IFRS: inventory is recorded as lower of net realizable value (sales price - selling cost) and original cost. Allowed both write-ups and write-downs.
GAAP: inventory is recorded as lower of market and cost. Market must be less than NRV and greater than NRV - Normal profit margin. Write-ups not allowed.
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FIFO and LIFO allowances under GAAP and IFRS
GAAP allows both, IFRS only allows FIFO
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Capitalizing vs. Expensing on: total assets, shareholder's equity, net income (first year), net income (subsequent years), cash flow from operations, cash flow from investing, Debt ratio and Debt/equity ratio, investment coverage (first year), investment coverage (subsequent years)
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Common size ratios (BS, IS, CF)
- Balance sheet: All balances as percentage of assets
- Income statement: All items as percentage of sales
- Cash flow statement: All items as a percentage of total inflows (outflows if overall negative) or as a percentage of net revenue
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Free cash flow
- measure cash available for discretionary purposes
- operating cash flow - net capital expenditures - change in working capital
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Liquidity ratios (current, quick, cash, defensive interval)
- current: current assets/current liabilities
- higher implies more liquid (greater ability to meet short term obligations)
- quick: (cash + marketable securities + receivables)/current liabilities
- similar to current, but more conservative because it includes only the most liquid assets
- cash: (cash + marketable securities)/current liabilities
- represents liquidity in crisis situations (could be unreliable since mrkt sec lose value quickly in these situations)
- defensive interval: (cash + marketable securities + receivables)/daily cash expenditures
- measures how long the firm can continue to pay its expenses from its existing liquid assets assuming no cash flows
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Cash conversion cycle ratios: receivables turnover, inventory turnover, payables turnover ratio, days of sales outstanding, days of inventory on hand, number of days of payables, cash conversion cycle
- receivables turnover: annual sales/average receivables
- high ratio can indicate highly efficient credit and collection. Alternatively, high could also indicate too stringent of collection policies, competitor's policies may be more attractive
- days of sales outstanding (DSO): 365/receivables turnover
- number of days between sale and collection
- inventory turnover: COGS/average inventory
- high ratio may indicate effective inventory management or company may not carry adequate inventory, damaging sales
- days of inventory on hand (DOH): 365/inventory turnover
- number of days inventory is held
- payables turnover ratio: purchases/average trade payables
- purchases = COGS + ending inventory - beginning inventory or approximated as simply COGS
- high ratio indicates either company is not taking advantage of available credit facilities or is taking advantage of early payment discounts
- number of days of payables: 365/payables turnover ratio
- number of days the company takes to pay its suppliers
- Cash Conversion Cycle: DOH + DSO - number of days of payables
- indicates the amount of time that elapses from the point when a company invests in working capital until the company collects cash
- shorter cycle indicates higher liquidity and implies that firm only needs to finance its inventory and A/R for a short period of time
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Total asset, fixed asset, working capital, working capital turnover
- total asset turnover: revenue/average total net assets
- fixed asset turnover: revenue/average net fixed assets
- working capital: current assets - current liabilities
- working capital turnover: revenue/working capital
- indicates how efficiently the firm generates revenue with its working capital
- 4.0 indicates $4 revenue for every $1 working capital
- if near 0 or negative, this number can't be interpreted
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Gross margin, operating margin, net margin
- gross margin: gross profit/revenue
- operating margin: operating profit/revenue = EBIT/net sales
- net margin: net income/revenue
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Debt-to-equity, debt-to-assets (total-debt), debt-to-capital, leverage, interest coverage, fixed charge coverage
- debt-to-equity: total debt/total shareholder's equity
- high means low solvency
- ratio of 1 implies debt to capital of 50%
- book value or market value of equity
- debt-to-assets: total debt/total assets
- indicates percentage of assets financed with debt
- debt-to-capital: total debt/(total debt + total shareholder's equity)
- high indicates higher risk and weaker solvency
- leverage: average total assets/average total equity
- total assets supported with 1 unit of equity
- interest coverage: EBIT/interest payments
- number of times a firm's ebit could cover its interest payments
- "times interest earned"
- fixed charge coverage: (EBIT + lease payments)/(interest payments + lease payments)
- same as interest coverage but includes leases
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Growth rate
- retention rate(b) * ROE
- b = 1 - dividends declared/operating income after taxes
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Return on assets, return on equity
- Net income/average total assets
- interest expense added back: (net income + interest expense[1-tax rate])/average total assets
- Pre-interest and pre-tax ROA aka operating ROA: EBIT/average total assets
- ROE: net income/average total equity
- return on common equity: (net income - preferred dividends)/average common equity
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Dupont analysis - regular and extended
- regular: ROE = (net income/sales)*(sales/assets)*(assets/equity)
- aka - ROE = net profit margin * asset turnover * equity multiplier
- extended: ROE = (net income/EBT)*(EBT/EBIT)*(EBIT/revenue)*(revenue/average total assets)*(average total assets/average equity)
- aka - ROE = tax burden * interest burden * EBIT margin * asset turnover * leverage
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Basic EPS, diluted EPS
basic EPS: (net income - preferred dividends)/weighted average number of common shares outstanding[WACSO]
diluted EPS: [(net income - preferred dividends) + convertible preferred dividends + convertible debt interest*(1-tax rate)]/[WACSO + shares from conversion of convertible preferred shares + shares from conversion of convertible debt + shares issuable from stock options]
convertible instruments issued during the year are also time weighted in the average
Average annual share price is used as denominator for converting options
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Captializing vs expensing
- capitalizing: lowers income variability, increases near term profits, increases assets, increases equity
- expensing: opposite effects
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depreciation - straight line, double declining balance, units of production
- straight line: (cost - residual value)/useful life
- double declining balance: (2/useful life)*(net book value)
- units of production: (cost - salvage value)/useful life in units * output units
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Held-to-maturity vs available for sale vs trading assets
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WACC
WACC = wdKd(1-t) + wpsKps + wcsKce
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Kd, Kps, Kce
- Kd = Current YTM on firm's debt
- Kps = preferred dividends/market price of ps
- Kce = (CAPM) rf + B(E[Rm] - rf), (Dividend Discount) Price =
, (Bond) kce = bond yield + risk premium,
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BETA asset, BETA project
- BETA asset (use other firm's info that does only the specific project's business) = BETA equity *
 - BETA project (use subject firms information) = BETA asset * 1+((1-t)*Debt/Equity)
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Country risk premium (CRP)
- revised Kce = Rf + Beta[Rmkt - Rf + CRP]
- CRP = sovereign yield spread * annualized standard deviation of developing country / annualized standard deviation of sovereign bond market in terms of developed market currency
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Flotation costs
treated as an initial outflow, not part of ROE
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Degree of Leverage (DOL)
- Q = Units sold
- P = Price per unit
- V = Variable cost per unit
- F = Fixed Costs
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Degree of Financial Leverage (DFL)
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Degree of Total Leverage
DOL*DFL
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IFRS Framework: 4 characteristics that enhance 2 characteristics
FS should have: timeliness, comparability, verifiability, and understandability
To enhance: relevance, faithful representation
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what is convergence?
the effort of creating one global accounting standard
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Forms 8-K, DEF-14A, 144
8-K: Filed to disclose material events to shareholders (M&A, management changes, etc.)
DEF-14A: statement that must be filed with the SEC when the company holds a shareholder proxy vote
144: an announcement to the SEC that the company is going to issue unregistered securities
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components of contributed capital
Common shares + additional paid-in capital
additional paid-in capital: happens when shares are purchased for more (or less) than their par value
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financial statements required by IAS No. 1
- balance sheet
- statement of comprehensive income
- cash flow statement
- statement in changes of owner's equity
- explanatory notes that include accounting policies
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The flow of information in an accounting system is
journal entries, general ledger, trial balance, financial statements
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How do warrants increase number of shares outstanding
number promised - number of shares cash flow from conversion will buy at current market prices
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IFRS vs GAAP on projects where costs cannot be reasonably estimated
GAAP: contract completion method - recognize everything at the end
IFRS: if can assume costs will be recovered, revenue = costs (cost recovery method)
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accounting principle changes vs accounting estimates changes
accounting principles changes must be applied retroactively, accouning estimates changes must only be applied going forward
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simple capital structure
no securities exist that can dilute eps
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what amount do companies receive on stock issuance
par + additional paid in capital
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warranty expense, bad debt expense
warranty expense: held as a liability, decreases NI, increases liabilities
bad debt expense: expensed on the spot, decreases NI, decreases Assets via uncollectable account for A/R
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which method is used in the hypothetical conversion of warranties?
treasury stock method - it is assumed the firm uses money paid to first purchase shares in the open market, then creates any shares still needed from the conversion
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Average inventory
(beginning inventory - ending inventory)/2
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valuation allowance
under GAAP, this is required if there is doubt that a deferred tax asset will be recovered
under IFRS, the DTA is written down directly
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bad debt expense and taxes
bad debt expense cannot be deducted from taxable income until the A/R is deemed worthless
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interest expense on income statement = ?
book value of the bond at the beginning of the period * market rate at issuance
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asset impairment
undiscounted future cash flows < asset carrying value
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finance lease payments are split into _____
- principal, which is CFF
- interest, which is CFO
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defined benefit option
PV of future pension benefits earned to date
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tax loss carryforward
net taxable loss that can be used to reduce taxable income in the future
NI was negative, so that can be applied to a positive NI later to curve taxes
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tax expense =
tax rate * taxable income + DTL
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effective and statutory tax rates difference are caused by:
tax credits, non-deductible income, and differences between capital gains and operating taxes
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revaluation model
under IFRS, assets can be adjusted for their fair value on the BS. any adjustment below original cost hits, IS, and others only go on BS under Assets and Equity (Revaluation Surplus)
firms must state finite or infinite life and disclose the carrying value under the historical cost model
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software development costs: GAAP vs IFRS
- GAAP: developed for in house, all expensed.
- developed for sale, expensed until feasible, then capitalized
- purchased, capitalized
- IFRS: all expensed until feasible, then capitalized
- purchased, capitalized
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when is a current liability expected to be settled?
within one year or one operating cycle, whichever is greater
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net income vs comprehensive income
NI = Rev - COGS - Operating expenses +- sale of equipment - taxes paid
Comprehensive income = unrealized gains/losses from available for sale securities, unrealized gains/losses from cash flow hedging derivatives, unrealized gains/losses from currency translation
Dividends are not included in either
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calculate goodwill
purchase price - fair market value (assets - liabilities
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leverage vs financial leverage
Debt/Equity vs Assets/Equity
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treasury stock: voting rights and cash dividends
no and no
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Notes payable is CF_
Financing
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Treasury shares treatment on balance sheet
Treasury shares are a reduction in shareholder's equity, not an asset
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Reinvestment ratio
CFO/cash paid for long-term investments
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Financial reporting vs Tax reporting terminology
- FR: Pretax income, tax expense
- tax expense = tax payable + DTL - DTA (DT must be based on future tax rates, which creates a difference between tax expense and (pretax income * tax rate)
TR: Taxable income, tax payable, tax basis of asset (cost - depreciation)
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component depreciation
depreciating different components of an asset separately
IFRS requires component depreciation, GAAP does not
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Capitalized interest costs
treated as part of the cost of the constructed capital asset
CFI
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effective tax rate
weighted average taxes. tax exempt items do weigh in at 0
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LIFO conformity rule
in the U.S., under GAAP, if a firm uses LIFO for tax purposes, it must also use LIFO for financial reporting
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