七 investment tools financial statement analysis basic concepts_removed

1、七 Investment Tools: Financial Statement Analysis: Basic Concepts1.A: Preliminary Reading Measuring Business Incomea: Explain why financial statements are prepared at the end of the regular accounting period, whyaccounts must be adjusted at the end of each period, and why the accrual basis of account

2、ing produces more useful income statements & balance sheets than the cash basis.To be relevant, information must be reliable. This means information must beconsistent and comparable over time and be provided on a timely basis. According to the relevancy principle, a firm needs to identify its activi

3、ties in a timely fashion within a specific period, such as a quarter or year.Normal accounting procedure is to record during the accounting period those economic events that occurred as the result of external transactions. At the end of the period after all the external transactions have been record

4、ed, several of the accounts in the ledger need to be updated before their balances can be posted to the financial statements.The adjusting process is consistent with two important accounting principles:1. The revenue recognition principle, which requires that revenue be reported in the income statem

5、ent only when it is earned, not before and not after.2. The matching principle reports expenses on the income statement in the same accounting period as the revenues that were earned as a result of theexpenses.Accrual basis accounting assigns revenues to the accounting period in which they are earne

6、d and matches expenses with the revenues generated by those expenses. The objective of the accrual basis is to report the economic effects of revenues and expenses when they are earned or incurred, not when cash is received or paid.Cash basis accounting recognizes revenues when cash is received and

7、expenses when cash is paid. Under the cash basis net income for the period is the difference between revenues received in cash and expenses paid with cash.Accrual accounting generally provides a better indication of performance than information based on the receipt and disbursement of cash. Accrual

8、accounting increases the comparability of income statements and balance sheets from one period to another period. The accrual basis reflects the understanding that the economic effect of revenue generally occurs when it is earned and not when cash is received. The revenue recognition principle is th

9、e basis for making adjusting entries that pertain to unearned and accrued revenues.Adjusting entries are necessary to better match revenues and expenses that occurred duringthe accounting period. Adjusting entries are used to record the effects of internal economic events.1.B: Preliminary Reading Fi

10、nancial Reporting and Analysisa: Define each asset and liability category on the balance sheet and prepare a classified balance sheet.Assets category on the balance sheetCurrent assets are assets which will be sold, collected, or consumed within one year or the firms operating cycle, whichever is lo

11、nger. The operating cycle is the average time between paying for inventory or the employees who perform services and receiving cash payment backfrom the firms customers.1.2.Cash is currency or demand deposits.Short-term investments are debt or equity investments for which a ready market existsand ma

12、nagement intends to sell within one year or operating cycle.3.Accounts receivable are amounts owed to the firm by its customers for goods andservices delivered.4.Notes receivable are amounts owed, usually by customers, which will not be collectedwithin the typical collection period.5.6.Inventory rep

13、resents products that will be sold in the normal course of business.Prepaid expenses (e.g., rent) are services paid for but not yet used.Investments are land, debt securities, or equity securities which management does not intendto sell within the year.1. Property, plant, and equipment: Land is the

14、real estate upon which the firms buildings sit.2. Intangible assets are economic resources lacking tangible existence such as patents, copyrights, trademarks, and goodwill.Liability categories on the balance sheetLiabilities are responsibilities (amounts owed) which must be met in the future, usuall

15、y by thepayment of cash. Current liabilities are those liabilities that will be paid within one year or operating cycle.1.Accounts payable are the amounts owed to suppliers for goods or services receivedbut not yet paid for.2.Wages, rent, etc. payables are the amounts owed to employees, landlord, et

16、c. forservices used but not yet paid for.3.4.5.Notes payable are the amounts owed creditors usually with explicit interest expense. Dividends payable are owed to owners for dividends declared but not yet paid.Current portion of long-term debt is that portion of long-term debt that will be paid withi

17、n the year. Long-term liabilities are the amounts owed creditors that will not bepaid within one year.Stockholders equity is the owners investment and the total earnings retained from the beginning of the business. Contributed capital (paid-in-capital) is the amount of the stockholders investment in

18、 the firms equity securities. Common stock is the portion of stockholders investment valued at par. Other paid-in-capital is the excess of the shareholders investment over the stocks par value. Retained earnings is the total net income less theamount distributed to the owners as dividends from the b

19、eginning of business.A classified balance sheetA balance sheet can be presented in many different ways. A classified balance sheet is one inwhich the accounts are orderedtypical classified balance sheet:ome logical manner, such as by liquidity or maturity. In a1.2.3.Assets are listed in order of liq

20、uidity, from most liquid to least liquid. Liabilities are listed in order of when they become due.Equity is generally presented with contributed or paid-in capital first and retainedearnings last.b: Define each component of a multistep income statement and prepare a multistep incomestatement.A multi

21、-step income statement is a statement that provides subtotals along the way to providing net income. The basic structure of the income statement is: sales less cost of goods sold equals gross margin (a.k.a. gross profit) less operating expenses equals Income from operations (a.k.a. operating income)

22、 add or subtract other revenues and expenses equalsincome before income taxes less income taxes equals net income.Gross sales or revenues are the total sales (cash and credit) during an accounting period. Net sales or net revenues are the gross amount less returns, allowances, anddiscounts.Cost of g

23、oods sold is the cost of sales for the goods sold during the period; that is, thecost of the merchandise (paid for or the cost to manufacture).Operating expenses are the costs of operating a business other than the cost of goodssold. Examples include selling expenses and administrative expenses.Othe

24、r revenues and expenses are non-operating items. Examples include interestexpense and interest income.Income taxes are the provision for income taxes for reporting purposes.1.C: Preliminary Reading Short-Term Liquid Assetsa: Describe how to choose the appropriate accounting method for investment sec

25、urities andexplain how fair (market) value gaand losses on such investments are reported.Short-term investments (a.k.a. marketable securities) are investments intended to be held only until cash is needed for the operations of the business. It is intended that these investments are to be held for le

26、ss than one year. Short-term investments are initially recorded at cost(cash price plus any acquisition costs such as brokerage fees).If management intends to hold short-term investments in debt securities to maturity, then theyare reported at their original cost. These are called investmentsecuriti

27、es held to maturity. Ifmanagement classifies a short-term investment as a trading investment (trading investmentsare always considered to be current assets), then the investment is reported on the balancesheet at its fair market value. Any unrealized holding gaor losses due to the appreciation ordep

28、reciation of the investment must be listed as a gain or loss on the income statement.b: Describe how to account for transactions with credit customers, including accounting for baddebts under the allowance method and the direct write-off method.Let SSS corporation have $10,000 of credit sales and $2

29、,000 of cash collections in itsaccounts receivable during the year:Accounts Receivable $10,000Sales Revenue$10,000CashAccounts Receivable$2,000$2,000Now assume it is year end. It is estimated that of the $8,000 balance in accounts receivable,$1,000 will ultimately turn out to be uncollectable.Bad De

30、bts ExpenseAllowance Accounts$1,000forDoubtful$1,000The bad debts expense decreases net income under the matching concept. And the allowancefor doubtful accounts decreases the accounts receivable on the balance sheet to its net realizable value.Balance Sheet:Accounts Receivable$8,000less Allowance f

31、or Doubtful Accounts( 1,000)Net realizable value$7,000To continue the example, in the following year, it is learned that customer ZZZ, who owed thefirm $100 has declared Chapter 7 bankruptcy. ZZZs account receivable will be written-off by reducing the allowance and the particular accounts receivable

32、.Allowance for doubtful accounts $100Accounts Receivable$100The direct write-off method is used for income tax calculations and by firms with immaterial bad debts. Here the firm does not use an allowance account (accounts receivable on the balance sheet is the amount owed by customers). It recognize

33、s bad debts expense only when a particular account is written-off as uncollectable. The write-off of the $100 of accountsreceivable from customer ZZZ declaring bankruptcy is:Bad Debts ExpenseAccounts Receivable$100$1001.D: Preliminary Reading Inventoriesa: Describe how the choice of inventory system

34、 or method affects the financial statements.LIFO results in:Higher COGS Lower taxes Lower net incomeLower inventory balancesLower working capital Higher cash flowsFIFO results in:Lower COGS Higher taxes Higher net incomeHigher inventory balancesHigher working capital Lower cash flowsb: Define invent

35、ory cost.The cost of inventory includes invoice price (less discounts), transportation costs, and taxes.Inventory includes not only the inventory on hand, but may include inventory items in transit.Goods are valued according to the assumed cost flow, which may or may not reflect thephysical flow of

36、inventory.The cost of ending inventory and, hence, cost of goods sold is determined by choosing one ofthe four generally accepted accounting principles (GAAP) alternatives.c: Calculate the cost of an invetory based on 1) the specific identification method, 2) theaverage-cost method, 3) first in, fir

37、st out (FIFO), and 4) last in, first out (LIFO).Specific identification: The units in ending inventory and listed as sold are valued at thespecific invoice price of those units sold.Weighted average: The units held in ending inventory and listed as sold are valued at theaverage cost of goods availab

38、le for sale (beginning inventory + purchases)/(number of units in inventory).FIFO: This is the FIRST IN (purchases) FIRST OUT (sales) cost flow assumption. Under FIFO,the unit cost of the one unit in beginning inventory and the first unit purchased are assigned as the M units sold to calculate the c

39、ost of goods sold.LIFO: This is the LAST IN (purchases) FIRST OUT (sales) cost flow assumption. It is theopposite of FIFO.d: Explain the effect of an overstatement or understatement of inventories on the financialstatements.In working out the effects of an overstatement (O) or understatement (U), it

40、 is necessary torealize that the ending inventory in one period is the beginning inventory of the next period. Then use the following relationships:Ending Inventory = Beginning Inventory + Purchases Cost of Goods Soldor Cost of Goods Sold = Beginning Inventory + Purchases Ending InventoryFor example

41、, let ending inventory in year 1 be overstated by $1,000 (e.g., $1,000 of inventory was accidentally or fraudulently double counted at the end of year 1). Therefore, in year 1 cost of goods sold will be understated, net income overstated, and inventory overstated all by$1,000. Later, assuming that i

42、nventory is properly accounted for at the end of year 2, beginning inventory (which is ending inventory in year 1) is overstated causing cost of goods sold to be overstated and net income understated by $1,000. Because ending inventory in year 2 is correct, inventory on the balance sheet of year 2 w

43、ould be correct. Hence, aninventory error washes out in year two.e: Calculate the lower-of-cost-or-market amount of aninventory.After inventory is valued using specific identification, weighted average, FIFO, or LIFO, that value is compared to the current replacement market price of each distinct pr

44、oduct in inventory. If the market price is higher than cost, then nothing is done. If the market price is lower thancost, then ending inventory is written-down to the lower replacement market price.Example: Suppose that Company X uses FIFO and that two items remain in inventory at year end. The orig

45、inal cost of these two items is $40 and their market value or replacement cost is$30. In this case, the inventory account would be written down to $30 and this $10 losswould be reflected on the income statement (i.e., the inventory account would fall andexpenses would increase).Alternatively, if the

46、 replacement cost of these units were $50, then no write-down or additionalexpense recognition would occur.1.E: Preliminary Reading Current Liabilities and the Time Value of Moneya: Define liabilities, explain the difference between current and long-term liabilities, and describe the uncertanties ab

47、out the value of some liabilities.Liabilities are probable future payments of assets (usually cash) or services (prepaid revenue) that a firm is obligated to make as a result of a past transaction. Current liabilities are expected to be paid within one year or operating cycle from the firms existing

48、 current assets. Long-termliabilities are obligations that will not be paid within the year or operating cycle.There are several uncertainties related to liabilities. Sometimes the payee is unknown. For example, when the board of directors declares a cash dividend (dividends payable) the stockholder

49、s at the future date of record are not known with certainty. Also, warranty payables are recognized at the time of sale but the payees are not yet known. Sometimes the due date is uncertain. Examples would be warranty payables and the prepayment for goods and services to be delivered at a future uns

50、pecified date. Finally, the amount may be uncertain. An example would be warranty payables. Also, at the end of the year a firm must estimate andrecognize some expenses like utilities, pensions, taxes, employee benefits.b: Describe how accountants record and report estimated liabilities (such as war

51、ranties and incometaxes) and contingent liabilities.ome cases, the precise amount of a liability is not known, but the liability can be reasonablyestimated.Warranties are recorded as:During period of sale:Warranty expense Estimated warranty payableXXXXWhen repairs made under warranty:Estimated warra

52、nty payable Parts inventoryCashIncome taxes are recorded as:XXXXXXA company must estimate interim (quarterly) income taxes (say 100):Provision for income taxes (expenses)Income taxes payable100100Then when taxes are determined (assumed to be greater than estimated, 115) and paid:Income taxes payable

53、100Provision for income taxes15Cash115A contingent liability exists when, as a result of a past event, a firm is obligated to pay only if a future event occurs. The most frequent source of contingent liabilities is lawsuits for which future cash payments depend upon the result of court action. Discl

54、osure depends on the abilityto estimate the liability and likelihood of future payment of the liability.If the future payment is probable and reasonably estimable, then the loss (expense) and liability must be disclosed on the income statement and balance sheet,respectively.If the future payment is

55、reasonably likely or not reasonably estimable, then only footnote disclosure is required.If future payment is remote, then no disclosure is required.1.F: Preliminary Reading Long-Term Assetsa: Describe the difference between long-term assets and other kinds of assets.A long-term asset is an asset th

56、at has a useful life that is more than one year, is acquired for use in operations, and is not intended for resale to customers. Long-term assets are generally reported at their carrying value or book value. If however, the asset has lost itsrevenue-generating ability, it may be written down.A plant

57、 asset is a tangible asset that is fixed or permanent. Property, plant, and equipment (PP&E) assets are long-lived tangible assets used in the production or sale of other assets. PP&E assets long lives distinguish them from prepaid expenses and other current assets.PP&E assets are used and not sold

58、(like inventory) during the businesss regular course of operations. Also, PP&E assets are not ultimately sold as would be done with interest or dividend generating investments. PP&E assets tangible physical existence differentiates themfrom intangible assets.PP&E versus other assets:The primary difference between plant assets an