FADM

1. Introduction to Financial Reporting

1. A. The Balance Sheet Equation
Assets = Liabilities + Owner’s Equity
Assets = Liabilities + (Shareholders’ Equity + Retained Earnings)
Retained Earnings = Revenues – Expenses – Dividends + Op. Retained Earnings

1. B. Financial Statements
 Performance over a given period: Income Statement & Cash Flows
 Financial Condition on a given day: Balance Sheet

2. The Accounting Process

2. A. Income Measurement
Matching Expenses
 Expenses related to earning revenue must be matched so that income can be determined. Period
costs are added as the period finishes – e.g. rent, depreciation
 Recognition of expired assets – e.g. inventory used for the sale. Product Cost

2. B. Basic Assumptions
 Going concern
 Accrual basis of accounting
 Consistency
3. Accrual Process
3. A. Accrued Expenses (L)
Cash paid after services received. Expense comes first

3. B. Accrued Revenues (A)

Cash received after services rendered, revenue recognition comes first

3. C. Deferred Expenses (A)

Cash paid before services received. E.g. Prepaid insurance

3. D. Deferred Revenues (L)

Cash received before services are rendered. E.g. unearned revenue / advances

3. E. Expiration of unexpired costs

Part consumed during operations is converted to expense (comes in Income Statement). The
unexpired portion remains as an asset in the Balance Sheet.
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3. F. Earning of unearned revenues

Part earned is converted to income in Income Statement. Unearned portion remains as a liability in
the Balance Sheet.

3. G. Capitalizing versus Expensing

i. Firms capitalize expenses when the benefit incurred is across multiple years. Asset is created in the
Balance Sheet – amortized/depreciated over years.
ii. Expense implies that the benefit from expenditure expires within one year. Expense recorded in the
Income Statement
iii. Development costs are capitalized – however not research costs (Under IFRS).
iv. If there is an uncertainty as to whether there are future benefits, expenditure is recorded as an expense.
v. Accumulated Depreciation is a contra-asset

Effects

Capitalizing Expensing

Income Statement Income increases Income Decreases

Balance Sheet Assets increase Shareholders Equity decreases

4. Revenue Recognition
4. A. Recognition Criterion
 Persuasive evidence of an arrangement (Contract)
 Delivery has occurred or services have been provided (earning process is complete)
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 Seller’s price to buyer is fixed

 Collection is reasonably assured
 Has nothing to do with cash collection
 At Point of Sale – costs are inventoried till delivery is made
 Industry and Transaction specific

4. B. Expenses
Outflows or consumption of assets or incurrence of a liability from activities that constitute the major operations

 Product Costs
o Directly related to goods or services
o Raw materials
o Labor
o Recognized when related revenue is recognized
 Period Costs
o Not directly related to production
o Recognized over the period they are expensed.

5. Accounts Receivables
5. A. Working Capital
Current Assets less Current Liabilities (also known as Net worth)

5. B. Estimating Bad Debts

 Percent of Credit Sales – use historical data to determine ratio.
 Aging Method – A/R is likely to differ as a function of how long the accounts have been outstanding.
Older have higher %.

6. Stock Re-purchases
 Increases Earnings per Share
 Provides stock for reissuance in employee stock option schemes
 Profit / Loss while dealing with own stock does not come in the income statement

7. Cash Flow Statements

7. A. Cash Flow from Operating Activities
 (+) Receipts from Customers
 (-) Payments to Suppliers
 (-) Payments to Employees
 (-) Payments for Rent, Utilities, Insurance
 (-) Taxes Paid
 (+) Interest and Dividends Received
 (-) Interest Paid

7. B. Cash Flow from Investing Activities

 (-) Purchases of Tangible Fixed Assets
 (+) Sales of Tangible Fixed Assets
 (-) Purchases of Intangible Assets
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 (+) Sales of Intangible Assets

 (-) Purchases of Securities, incl. M&A
 (+) Sales of Securities
 (-) Loans made to other companies
 (+) Repayments of loans made to other companies
7. C. Cash Flows from Financing Activities
 (+) Proceeds from New Borrowing
 (-) Retirement of Debt
 (+) Proceeds from New Issues of Stock
 (-) Repurchases of Stock
 (-) Dividends Paid to Shareholders

7. D. Indirect Method of Cash Flow

 Start with Net Income
 Subtract any non-cash and non-operating transactions
8. Inventory Accounting

Total Inventory = Balance of (Raw material + WIP + Finished Goods)

9. Leasing vs. Buying

Balance Sheet & Income Statement Effects:
Borrowing / Buying Leasing

Substantially Greater Debt reported in BS

Higher Leverage ratios: Lower Leverage ratios

L+New Borrowing/E L/E

L+New Borrowing/A L/A

Lower returns on assets as assets increase in BS

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Borrowing / Buying Leasing

Income decreases in first year due to depreciation – In subsequent years as depreciation becomes less Income decreases by a constant
than rent the decrease in income also becomes less amount (rent)

Reduction in Taxes as rent is an

Taxed as an asset – depreciation
expense

9. A. Capital Lease
Treats leases as a debt-financed purchase of the asset.

Criteria to trigger Capital Lease:

 Ownership transfer at end of lease term

 Bargain purchase option
 Lease term exceeds 75% of asset life
 Present value of lease payments exceed 90% of asset’s fair value
10. Employee Stock Options
The Intrinsic Value Method: No action was taken at the stock option’s grant date if the option’s
exercise price was greater than or equal to the firm’s stock price on the grant date. Companies
recognized no compensation expense at any time.

Expense over the vesting period: At the grant date, the company computes the economic value of the
options using the Black-Scholes model, or equivalent. This value is systematically recognized as an
expense over the options’ vesting period.

11. Financial Ratios

Profitability Ratios
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Liquidity Ratios

Leverage Ratios

Activity Ratios
Inventory turnover = Cost of Goods Sold / Average Inventory

Accounts receivable turnover = Sales on credit/ Average Accounts receivable

Accounts payable turnover = Cost of Goods Sold/ Average Accounts payable

Number of Days Inventory = 365/ Inventory Turnover

Number of Days Receivables = 365/ Receivables Turnover

Number of Days Payable = 365/ Payables Turnover

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Operating Cycle (Also known as Cash Conversion Cycle)

= Number of Days Receivables + Number of Days Inventory - Number of Days payables

DuPont Analysis
ROE (Net Income/Equity) = (Profit margin)*(Asset turnover)*(Equity multiplier)

= (Net Income/Sales)*(Sales/Assets)*(Assets/Equity)

 Operating efficiency (measured by profit margin)

 Asset use efficiency (measured by asset turnover)

 Financial leverage (measured by equity multiplier)

DuPont 5 – Part decomposition

 The company's tax burden is (Net profit ÷ pretax profit). This is the proportion of the company's profits
retained after paying income taxes. [NI/EBT]
 The company's interest burden is (Pretax profit ÷ EBIT). This will be 1.00 for a firm with no debt or
financial leverage. [EBT/EBIT]
 The company's operating profit margin or return on sales (ROS) is (EBIT ÷ Sales). This is the
operating profit per dollar of sales. [EBIT/Sales]
 The company's asset turnover ratio is (Sales ÷ Assets).
 The company's leverage ratio is (Assets ÷ Equity), which is equal to the firm's debt to equity ratio +
1. This is a measure of financial leverage.