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Review of Accounting

1. Review of Accounting
1. Accounting is the language of finance. A financial manager must understand the basic concepts of accounting in order to use the tools the accountants provide. These tools are the ____, ____ and ____ (Critical Concept ) and the line item accounts that compose each.
2. The Income Statement
1. The income statement measures firm performance as ____ (Critical Concept). The time period usually is stated "for the period ended [date]" on the typical income statement. The income statement defines performance as profitability. The income statement defines profitability as ____ ( Key Term ) To develop an income statement, you begin with the gross sales revenue for the firm and subtract out all expenses.
2. Expenses include operating expenses and non-operating expenses. Operating expenses are generally ____ and ____( Critical Concept ). Non-operating expenses are interest expense, taxes and preferred stock dividends. Common stock dividends are subtracted out after net income is calculated, as they are not a tax-deductible expense.
3. There are three sources of capital for the business firm indicated by the income statement. These sources of capital are ____, ____ and ____( Critical Concept ). Bondholders are paid interest expense. Preferred stockholders are paid preferred dividends, before taxes. Common stockholders are paid common dividends, after taxes.
4. Net income can either be retained by the firm or paid out to the common shareholders as dividends. Firms that are growing tend to retain more earnings such as high technology firms as retained earnings are used for growth. More mature firms with slower growth rates pay more dividends.
5. Income statements are used to calculate a firm's earnings per share (EPS). EPS is defined as ____( Key Term ) When you hear, on the financial news, that a company has issued an earnings warning, that means that its EPS for a particular time period will not be what it originally anticipated.
6. Price-earnings ratio is used after EPS is calculated to determine the value of the firm's common stock. A firm's price/earnings ratio (P/E ratio) is a valuable tool for financial analysis. The P/E ratio is ____( Key Term ) P/E ratios higher than the market average generally mean that a firm is expected to provide returns greater than the market return with the same or less risk. It can be misleading if the firm's earnings are dropping and the stock price is not dropping as rapidly. See P/E Ratio (46.0K)
7. The income statement has limitations. Accounting convention says that income and expenses are actual transactions that occur within a given time period rather than events that reflect changes in the value of the firm. See Income Statement (54.0K)
3. The Balance Sheet
1. The balance sheet is a picture of a firm's financial position at a point in time. Where the income statement indicates firm profitability over a given time period, the balance sheet indicates ____ ( Critical Concept ) A balance sheet lists firm assets in the order of their liquidity. Current assets are ____( Key Term ). The most liquid current asset is cash and the least liquid is inventory.
2. Fixed assets are those that will not be converted to cash during one year such as long-term investments or plant and equipment. The accumulated depreciation on a balance sheet is the sum of the depreciation line item year by year from the income statement.
3. The sum of current and fixed assets is total assets. Total assets are financed with either debt or equity financing. The financing for assets, which is shown on the right-hand side of the balance sheet, equals total assets.
4. Assets can be purchased with debt financing. Debt financing may be either short-term, with a year or less to maturity, or long-term, with more than a year to maturity. Short-term debt financing, or current liabilities, may be accounts payable or accruals. Long-term debt financing includes ____ and ____( Critical Concept ). Equity financing can also be used to purchase assets. Stockholder's equity is equivalent to the total contribution and ownership interest of preferred and common stockholders. The net worth of the firm is ____ Key TermLike the income statement, the balance sheet has limitations. Balance sheet figures are based on historical costs instead of current market values. See Slide Balance Sheet (44.0K)
4. Statement of Cash Flows
1. The Statement of Cash Flows allows the financial manager to track the actual cash position of the firms. The accrual method of accounting is used for both the income statement and balance sheet. In other words, revenue and expenses are recognized when they occur rather than when cash changes hands. The statement of cash flows recognizes ____( Critical Concept ) and reveals the firm's actual cash position. See Slide 2 (53.0K)
2. There are three sections of the statement of cash flows. These are the ____, ____ and ____( Critical Concept ). When the results of each are added together, the net increase or decrease in cash is calculated.
3. Cash flows from operations are calculated by adding together net income and depreciation and the sources and uses of cash for the firm. Increases in current assets are a use of funds and decreases are a source of funds. When a current liability ____, that is a ____ of funds( Critical Concept ). When it decreases, that is a use of funds. This portion of the cash flow statement shows us exactly how the firm uses and pays for its current assets.
4. Depreciation is a source of funds for the firm. Depreciation is the attempt to allocate the cost of an asset over its useful life. It is a noncash expense that must be added back to net income to determine the actual amount of cash on hand even though it is an accounting entry and not a cash transaction.
5. Cash flows from investing activities are the result of changes in long-term investments and plant and equipment. Increases in investments and plant and equipment are a use of funds and decreases are a source of funds.
6. Cash flows from financing activities show us the effects of the use of debt and equity financing on the business firm. Increases in long-term debt or bonds are a source of funds while payment of dividends is a use of funds.
7. The sum of the three sections of the cash flow statement

should equal the change in the cash account on the firm's balance sheet. The statement of cash flows is an excellent financial analysis tool as it can help the financial manager red flag any large increases or decreases in income statement and balance sheet accounts that might be a problem for the firm. The Motley Fool, a website full of financial information, discusses the statement of cash flows for Microsoft Corporation.

5. Other Accounting Considerations
1. Free cash flow is the amount of cash available for special financial activities. Free cash flow is defined as____(Key Term) . Free cash flow has become a popular financial analysis tool in the 1990s.
2. Income tax considerations impact a firm's financial decision- making. Both depreciation and interest expense shield a portion of the firm's income from taxes since they are tax-deductible expenses. Dividends on common stock are not tax-deductible.