F1 - M1 - Balance Sheet, Income Statement, and Comprehensive Income

Question 1

What do people normally use the balance sheet for? What can they calculate?

Answer 1

They normally look at it for financial risk, here are some of the things they calculate:

Short-term liquidity - This is the short term risk.

Long term solvency - The long term risk, along with performance in the future. For example, if assets go up, we can infer that sales will go up and vise versa. This is also called capital to produce.

Question 2

What are the two things that the income statement (statement of earnings) helps us determine?

Answer 2

Performance risk - Risk to preform. Can they turn assets in to revenue, and then can they make that revenue into a profit. Unlike the balance sheet, this is for a period of time.

Operating risk - This more looks at a companies sales from one period to the next and see if they are volatile. Or they look operating income and compare from one year to another. How is the operations compared to other years.

Question 3

What is the statement of comprehensive income? What is other comprehensive income (OCI)?

Answer 3

The statement of comprehensive income is a statement that includes both net income per the income statement, and other comprehensive income.

Other comprehensive income is gains or losses that do not go through equity via retained earnings. These items hit the equity account right away, and they skip hitting net income and then equity.

Question 4

What is the statement of cash flows? How this different than you net income on your income statement?

Answer 4

This is a statement that shows why cash changed hands. This simply records when the cash came in and when the cash came out. The difference with the income statement is simply timing. Income statement is on accrual basis, while statement of cash flows is the cash basis.

Statement of cash flows helps show why cash changed, indicates the quality of the earnings, and growth potential.

Question 5

What is the statement of owners equity?

Answer 5

This helps show why stockholder equity changed.

Could be a change in capital - Sold more shares of common stock, preferred stock, etc.

Could be a change in retained earnings - You got a net income or net loss.

Change in OCI - Gains or losses that went straight to equity.

Question 6

Are notes required for accrual basis financial statements?

Answer 6

YES

Question 7

What is the liquidity ratio?

Answer 7

current assets/current liabilities

Question 8

What is a classified balance sheet?

Answer 8

This is a balance sheet that breaks out the current assets from investments, other assets. Has current liabilities and long-term liabilities. What you think of when you see a traditional balance sheet.

Question 9

What is the liquidity ratio?

Answer 9

Current assets/current liabilities. This looks more at short term risk of distress.

Question 10

What is the solvency equation?

Answer 10

Long term Debt/Equity - This is more to see how the company raised money. Was it through debt or more through equity via earnings or contributions?

Question 11

Would an investor be impressed if you increased your equity because you sold shares of common or preferred stock?

Would an investor be impressed if you increased your capital via earned capital? Such as an increase in retained earnings or accumulated other comprehensive income?

Answer 11

Not really, when you issue stock to raise capital, your are normally adding more partners to the firm and that is diluting your earnings per share.

Yes, raising money by earned capital is impressive because that means you made money through you ordinary course of business.

Question 12

What is contra equity, and what is an example of this?

Answer 12

Contra equity is when you buy back your own stock because you think its a great investment and your shares will go up. This is called a treasury stock and is also reported in equity. Could be a sign of optimism.

This also reduces your equity account

Question 13

What are some of the ratios that are used to evaluate liquidity and long term solvency (balance sheet)?

Answer 13

Some examples include current ratio, quick ratio, degree of financial leverage, etc. There is a section later that covers these ratios and what they mean.

Question 14

Who has first claim to a companies assets?

Answer 14

The liabilities and then the equity.

Question 15

What are current assets on the balance sheet?

Answer 15

These include cash, receivables, prepaids, inventory, and short term investments. Things that we can covert to cash within one year.

Question 16

What are investments on the balance sheet? Are they current or non-current?

Answer 16

Investments are stocks/bonds in other companies and investments. They are non-current assets.

Question 17

Who gets paid first, common stockholders or preferred stock holders?

Answer 17

Preferred. The order goes creditors, preferred stockholders and then common stockholders.

Question 18

For equity, what accounts are contributed capital, and what accounts are earned capital?

Answer 18

Contributed capital - Preferred stock, common stock, and additional paid in capital.

Earned capital - Retained Earnings, accumulated other comprehensive income (residual interest).

Question 19

What are some of the limitations of the balance sheet?

Answer 19

The assets are not measured at FMV or the current value. They are measured at the NBV or historical cost. This makes the numbers more outdated for current value.

Some accounts can be calculated in different ways, making comparison hard. Like inventory is LIFO or FIFO, depreciation can be straight line or accelerated. This makes comparing your financials to a competitors difficult since different valuation methods can be used.

Some of the accounts are estimates such as allowance for bad debts, so it is hard for investors to know if the company is being aggressive or lenient in the their estimations.

Question 20

Who are some of the people that want to see the income statement?

Answer 20

External users such as investors, stockholders, common or preferred.

Lenders, looking at credit rating for loans.

Internal users - like managers of a company.

Question 21

What is the difference between operating and nonoperating on an income statement?

Answer 21

Operating - These are activities that the company does on their daily operations. Such as raising money or paying expenses for things they do in the normal course of business.

Nonoperating - This is income or expenses not in the normal course of business, such as gains or losses, interest revenue, and interest expense if not a bank.

Question 22

What is a period cost?

Answer 22

These are costs that we expense right away. They are normally reoccurring and include, selling, general research, and administrative.

Question 23

What is an unexpired cost?

Answer 23

These are costs that will be capitalized now and expensed in future periods. We think that these costs will generate revenue in the future. Some examples include:

You capitalize inventory, and when you sell it, you expense it at COGS.

You prepay something like insurance, and then you remove the prepaid as insurance expense.

You have fixed assets, and you depreciate them with depreciation expense.

Patents, you amortize those.

Question 24

What are some examples of non operating expenses.

Answer 24

These are unusual and/or infrequent. They include:

Sale of something other than inventory,

Write-down

Write offs

Sale of PP&E

Sale of an investment in another company

Unusual operating expense.

Question 25

What is income from continuing operations?

Answer 25

This is the sum of operating income + non operating income

Question 26

What is the difference between income from continued operations and income from discontinued operations?

Answer 26

Income from discontinued operations is the selling off of a product line, sperate division, or a segment of a company's operations. These are reported separately on the income statement and have their own line. They are reported after income from continuing operations, and they are net of tax.

Question 27

What is a single step income statement? What are the pros and cons of this?

Answer 27

This is when you take all of your income and gains - all of your expenses and losses and then take that amount minus you tax amount to get your net income amount. You sum up all income and expenses in one line. Benefits - Gives net income in one step due to its simple design, does not make one account appear more important than other. Cons - Does not distinguish between your core business and incidental business.

Question 28

What is a multiple-step income statement?

Answer 28

This is an income statement that has multiple steps and breaks out by each account. The biggest thing is that it separates business from operating and nonoperating. Provides information for ratio analysis.

Question 29

What are some of the limitations of the income statement?

Answer 29

It is subjective because it is based on accounting methods which include estimates. Revenues and expenses are booked on accrual basis. Management bias - You have choice of accounting estimates to improve your bottom line.

Question 30

What is the difference between aggressive and conservative?

Answer 30

Aggressive - Booking higher revenue and lower expense such as; booking revenue that should have been deferred capitalizing expenses that should have been expenses Conservative - booking lower revenue, but higher expense. deferring revenue instead of recognizing. booking expenses instead of capitalizing.

Question 31

What is an example of income smoothing with accrual basis?

Answer 31

For example, if you operate on cash basis, and you build a whole new building, you would have to expense all of that building in year 1 and that would make you look like a failure until year 5 when the building is complete. In accrual, you can capitalize the building and expense it over time, which makes your business look better. That is income smoothing.

Question 32

What is the con to income smoothing?

Answer 32

Sometimes companies take advantage of this. If in one year, they get 30% increase in revenue, they defer that amount for future years, so it looks more consistent. If they recognize all the revenue in year one, are they going to increase revenue by more than 30% in the next year? Probably not, so that is why it is a con, makes companies look better than they are. You record when earned or incurred to combat this.

Question 33

Difference between freight in and freight out?

Answer 33

Freight out is a is selling expense, freight in needs to be capitalized with inventory.

Question 34

What is classification shifting?

Answer 34

This is when a company puts their good non operating income on top of the income statement, and their bad operating losses on the bottom of the income statement. You cannot do this for income statement presentations, but people have done it.

Question 35

Are selling, general, and administrative expenses operating expenses?

Answer 35

Yes General and Administrative - These are expenses like insurance, officer salaries, legal fees, and accounting fees. Selling Expenses - These are expenses to help sell things for business, such as freight out, commissions, advertising, salaries for salespeople. Depreciation and Income tax expense have their own line item under a multi step income statement.

Question 36

When would you know when to report the discontinuing of operations?

Answer 36

Two areas, the year it has been disposed. So if you dispose of the business segment in 2022, that is when it is discontinued. Or when it is held for sale, if you hold it for sale in 2022, then that is when you report all the activity for that segment in discontinued.

Question 37

What are some of the ways you can identify discontinuing in operations?

Answer 37

Disposal in a major geographical area - Not doing business in Asia anymore. Disposal of a major equity method investment - You have significant influence over one company, and you sell your interest. You significant influence of another company (between 20% to 50%). Disposal of a major business line.

Question 38

Let's say you decide to sell a business segment in July but you are December year end businesses. For what period of time do you have report all of the business activity for that business segment in discontinued operations?

Answer 38

It does not matter when in the year you decide to sell that segment, if you decide before year end, then all the activity for the year needs to be reported in discontinued operations. For example, if you decide in July to do it, but you are December year end, all activity from January 1st to December 31st, need to be reported in the discontinued section.

Question 39

How does an impairment loss work for discontinued operations?

Answer 39

If you plan to discontinue operations you have to find the net realizable value, and compare it to the book value. If the net realizable value is less than the book value, then you write down the book value by the impairment loss. Once you do this, you can not reverse the amount written by more than what it was written down by. For example, the NRV is 8 but the book value is 10. You have an impairment loss of 2, so the new book value would be 8. Let's say next year the NRV increases to 11, and you want to record a gain of 3. You cannot do this because you can only increase the amount up to what the loss was.

Question 40

When the discontinued operations occurs for multiple years how does that work? How is it calculated?

Answer 40

For multiple years, like they listed it for sale, but sold it later, you need to: Record the impairment loss Results of operations need to be moved down to discontinuance. Do not report the gain or loss until the period in which it occurs.

Question 41

Do you still depreciate or amortize assets within the component or line that is being discontinued?

Answer 41

No you do not

Question 42

Are discontinued operations disclosed in the footnotes? If so, what needs to be disclosed?

Answer 42

Yes they do; What product line it was Why is this segment being sold How might this impact business in the future.

Question 43

If a company decides to discontinue operations in the middle of the year, when do they start reporting income and expenses in the discontinued section of the income statement?

Answer 43

It does not matter when they decide to discontinue in the year, all revenue and expenses for the whole year are reported in the discontinued section. Even if they elect April 1st, all revenue and expenses starting January 1st of the year will be reported.

Question 44

For foreign currency, what is the difference between import purchases and export sales?

Answer 44

Import purchases, this is accounts payable in a foreign currency Export Sales: Accounts receivable in foreign currency Depending on if the currency goes up or down, you could have a gain or loss to report.

Question 45

What is the difference between direct method and indirect method?

Answer 45

Direct method: the home currency is in the numerator, and foreign currency is in the denominator. For example $1.47/1 euro. This says that one euro gets you 1.47 dollars. Indirect method: This is where the home currency is in the denominator. For example, 1 euro/$1.47. These divided by each other are .68, which says that .68 euros buys one dollar.

Question 46

How does the value go up or down on foreign currency accounts receivable? What about accounts payable?

Answer 46

For Accounts Rec: If foreign currency goes up, the asset goes up, so you have a gain. If foreign currency goes down, the asset goes down, so you have a loss. For Accounts Payable: If foreign currency goes up, the liability goes up, that is a loss. If the foreign currency goes down, the liability goes down, that is a gain.

Question 47

What are the accounts that go direct to equity and do not hit the income statement? (PUFI)

Answer 47

Pension adjustment Unrealized gains and losses [Available for sale debt securities and hedges] Foreign Currency items Instrument specific credit risk

Question 48

What is the formula to calculate comprehensive income?

Answer 48

This would be your Net Income + Other Comprehensive Income

Question 49

How do pension adjustments work and what are they?

Answer 49

This is when an employer has gain or losses from a defined benefit pension plan that must be recognized in OCI the year the change occur. Good news if you owe less to your employees, bad news if you owe more to your employees These pension gains and losses get amortized over the service life of the employees and recognized as a pension expense.

Question 50

What are available for sale debt securities and hedges?

Answer 50

These are securities the entity does not want to sell yet, so they hold onto it until they finally sell. For each year they do not sell, they have to report unrealized gains and losses direct to OCI. This is covered more in M5 of the course.

Question 51

How do the foreign currency items work in PUFI?

Answer 51

This happens when a parent company owns a foreign subsidiary, and when the financials need to be consolidated, the currency that is used will be the parents currency. In that conversion, you will have either a gain or loss in currency conversion, and have to recognize that in OCI. Also, gains or losses in your foreign currency payables and receivables.

Question 52

What is instrument specific credit risk?

Answer 52

This is when you hold a security in a company, but the companies security that you are invested in, has their risk change. If the risk changes, that impacts the discount rate, which in turn, would either decrease or increase the value of the investment. If the risk goes up for the company, the FMW goes down which causes a gain for the company holding the security. If the risk goes down, the FMW goes up, which is a loss for the company holding the security.

Question 53

How are PUFI items moved out of other comprehensive income? What is this called?

Answer 53

Reclassification adjustments; When they can be recognized, these items are moved out of equity and into the income statement, which would roll into retained earnings just like any other normal net income amount.

Question 54

What is accumulated other comprehensive income?

Answer 54

Any gains and losses that go directly to equity that have been accumulating over time go to accumulated other comprehensive income. Once you can recognize these, they go on the income statement, and rolled into retained earnings.

Question 55

When would a statement of comprehensive income not be needed?

Answer 55

Non profit or you don't have any PUFI items.

Question 56

For the comprehensive income statement, how would you know if it is a single statement or multi statement approach?

Answer 56

For single statement - They start with revenue, work all the way down to net income, and then add or subtract their OCI amounts. For multi statement - You have a separate income statement and comprehensive income statement. It starts with net income.

Question 57

Can the PUFI items be presented net of tax or before tax?

Answer 57

Either way is fine

Question 58

What is the reporting requirement for comprehensive income?

Answer 58

Must be presented in the financial statements In interim periods (quarterly)

Question 59

It is required that the tax effect of each component of comprehensive income must be disclosed. How can this be disclosed?

Answer 59

Either on the face of the income statement of in the notes.

Question 60

Do you need to disclose any changes in the accumulated other comprehensive income amounts?

Answer 60

Yes, this can be additions, losses, reclassifications, etc. You can do this on the financial statements, or in the notes.

Question 61

What does equity comprise of?

Answer 61

Paid-in capital minus treasury stock earned capital (retained earnings); and ending accumulated other comprehensive income

Question 62

What are the two reasons a PUFI item was changed in the current fiscal year?

Answer 62

Could be due to two reasons; A current period gain or loss or reclassification adjustments. Have to be disclosed, either on the face of the financials or in the notes.

Question 63

Is recovery of accounts written off recorded in revenue?

Answer 63

No

Question 64

Where do you report foreign transaction gains and losses, and where do you report foreign translation gains and losses?

Answer 64

Transaction - Income Statement Translation - OCI

Question 65

What are some examples of selling expenses?

Answer 65

Advertising, freight out, office space for selling department, sales salaries and commissions.

Question 66

What are the two things that comprehensive income excludes on the financial statements?

Answer 66

Owner contributions and distributions.