Managers don’t require general financial statement since they have direct access to the business

Financial statements are made for business entities which isn’t the same as a business person

Incorporation is a fictional entity, responsible for the formation of a new company, making it a
legal entity, since they own assets, loan/borrow money, sue/become sued, etc

Accounting information has to be for a time period

Fiscal year: period of 12 months where financial statements are prepared. There needs to be a
monetary period too (currency)

If a business owns assets, where do they come from?

Assets = Equity + Liabilities (this equation has to be balanced)
↑ Debit = ↑ Credit ↑ Credit (vice versa too)
Debit:
● Revenues (If revenue increases, it should be credit)
● Expenses (If expenses increases, equity decreases, so debit increases)
Cash is credit (when revenue increases)
When we make sales on account, sales increases, and it is considered as debit

Cash + 5000 = ___ + Loan 5000

Profit = Revenue - Costs
Profit Margin = Profit / Sales
Loans are considered a liability
Negative accountancy are shown in brackets

Return in Equity = Profit / Total Amount

Journalizing = ensuring debit and credit are equal

Interest is considered as expense

Retained earnings: cumulative net income (from year to year)

Liquidity: order in which it will be written in the journal entry

● Current
● Non-current (long term / fixed)
○ Fixed
■ Current
■ Long-term

If you think your asset is going to be converted into cash within 12 months, it will be considered
current (inventory, products to be sold). Even if loans are paid within 12 months (or due within
12 months) it is current.

Five Step Process to recognize Revenue:

1. Identify the contracts with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognize the revenue when the entity satisfies a performance obligation

Identify the performance obligations in the contract:

A promised good or service is distinct only if the following conditions are met:
● The seller’s promise to transfer the good/service to the customer is separately identified
from other promises in the contract
● The customer can benefit from the good or service either on its own or together with
other resources that are readily available to the customer
Determine the transaction price:

The following should be considered in determining the transaction price:

● Variable payment(s)
● Constraining estimates of variable payment
● Existence of a significant financing component
● Any non cash payment
● Any payment payable to the customer
● Customer credit risk is not considered when determining the transaction price

Recognize the revenue when the entity satisfies a performance obligation:

1. The seller has a present right to payment for the asset
2. The customer has legal title to the asset
3. The seller has transferred physical possession of the asset
4. The customer has significant risks and rewards of ownership to the asset
5. The customer has accepted the asset

Depreciation is the process of allocating the cost of a long-lived asset over its useful life. A
non-cash expense that reflects the decline in the value of an asset as time goes on, due to wear
and tear and other factors.

There are two methods of depreciation:

1. Straight-line depreciation: Depreciable value is allocated equally across an asset’s useful
life. Depreciation expense is constant across years and is equivalent to the asset’s
depreciable cost divided by its useful life.
2. Accelerated depreciation: Depreciation charges are front-loaded with lower charges in
later years. Two common methods for calculating accelerated depreciation are
double-declining balance depreciation and sum-of-the-years’-digits depreciation.

Impairment is a decrease in the value of an asset that is not recoverable and exceeds its fair
value. An asset is considered impaired when its carrying value (net book value) exceeds the
amount of future economic benefits expected to be generated by the asset. Impairment can occur
due to various reasons, including:
● Obsolescence: The asset is no longer useful or relevant due to changes in technology or
market conditions
● Physical damage: The asset has been damaged or destroyed, reducing its value
● Changes in legal or regulatory environment: Changes in laws or regulations may render
the asset obsolete or reduce its value
● Economic factors: Changes in economic conditions, such as a recession or changes in
interest rates, may reduce the value of the asset
● Changes in business operations: Changes in a company's business operations may render
the asset obsolete or reduce its value

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date. In simple terms, fair
value represents the amount that an asset could be sold for or a liability could be settled for in a
typical transaction between willing buyers and sellers.

Item 1: Business

Description of the company’s business → main products and services → what subsidiaries it
owns → what markets it operates in → recent events → competition the company faces →
regulations that apply to it → labor issues → special operating costs, or seasonal factors

Item 2: Properties: Company’s significant properties, like plants, mines and other important
physical properties

Item 3: Legal Proceedings

GAAP: General Accepting Accounting Principles

Marketing-related intangible assets:

● Trademarks, trade names
● Service marks, collective marks, certification marks
● Trade dress
● Newspaper mastheads
● Internet domain names
● Non-competitive agreements

Artistic related:
● Plays, ballets
● Books
● Songs, musical works
● Photos
● Motion pictures

Features of intangible assets:

● Sunkenness: once money has been spent, it can’t be recovered
● Spillover: once money is used to create a brand, that brand can spill over to other
products
● Scalability: once a brand is created, regardless of the number of customers, the brand
shouldn’t be recreated again
● Synergies: once a brand is created, an associated brand can be created

Earnings management is a method of employing accounting techniques to improve the

appearance of the company’s financial position.

The most significant reason a business would window dress its financial reports is to ensure they
don't lose investor interest. Investors and lenders make up a large portion of a company's
fund-raising efforts. Lenders use these reports to make lending decisions, and investors use them
for investing decisions.

Earnings smoothing is the act of using accounting methods to level out fluctuations in net
income from different reporting periods. The process of income smoothing involves moving
revenues and expenses from one accounting period to another.

Vesting: the conveying to an employee of unconditional entitlement to a share in a pension fund

Earnings = Cash + Accounting Accruds

In an income statement, if there is no cash flow, there is no way to determine if the company is a
successful one

Sources and uses of cash:

1. Cash inflows
a. Operating
i. From sale of products
ii. From providing services
b. Investing
i. From sale of property, plant and equipment
ii. From sale of investments
c. Financing
i. From issuing long term liabilities
ii. From issuing stock
2. Cash outflows
a. Operating
i. To purchase inventory
ii. To pay employees
iii. To pay taxes
b. Investing
 i. To buy property, plant and equipment
ii. To purchase investments
c. Financing
i. To pay dividends to shareholders
ii. To repurchase common stock (treasury stock)
iii. To repay long-term liabilities

Fewer investments and large disposal of assets can lead to shrinking of capacity and business

Issue of shares is the result of new investors

Other Comprehensive Income (OCI) includes revenues, expenses, gains and losses that have yet
to be realized and are excluded from net income on an income statement.

Reasons for Passive Investment:

1. Trading
2. Available for sale

Two ways to calculate fair value:

1. Market approach: this approach makes use of actual transaction of identical assets and
liabilities and tries to put an amount as close as possible
2. Income approach: this approach uses future cash flows. Adjustments are made to the cash
flows for the time value of money

3 levels to get to the fair value

1. Quoted prices in an active market for identical assets/liabilities
2. Observable inputs other than quoted prices
3. Unobservable inputs

New investments lead to increase in equity. It can also increase when there is more income
Other comprehensive income: FUPIE
F: foreign currency translation gains or losses
U: unrealized holding gains/losses on available for sale securities
P: Pension gains or losses
I: Instrument specific credit risk
E: Effective portion of cash flow hedges

Balance sheet effects: investment balance report as end-of-period fair value

Higher income means higher taxes. Prices are changed based on the income rate, tax rate or how
much a person is willing to pay

Tax liability is higher or lower according to tax authorities than the actual one. Tax liability is a
difference that is either permanent or temporary.

When there is a temporary difference, the difference results in tax liability and this is known as
deferred tax. It’s called that because the tax will be paid but at a later date. For example, if one
pays less tax now, they will pay more tax later and vice versa.
Why is market value greater than book value?
● Some assets are not on the balance sheet
● Some assets are worth more than the value on the balance sheet
● Some liabilities can be discharged for a lower value
● Some assets may be worth more when combined

How do acquirers pay for a target?

● Stocks
● Cash

How to determine purchase price allocation valuation?

Step 1: determine the fair value of the consideration paid
Step 2: revalue all existing assets and liabilities to their acquisition date fair values
Step 3: identify the intangible assets acquired
Step 4: determine the fair value of identifiable intangible assets acquired
Step 5: allocate the remaining consideration to goodwill and assess conclusion

Goodwill is part of a company’s value that we can’t measure directly, such as its customers'
loyalty and reputation. They’re intangible assets that are not separately identifiable. Goodwill
comes from acquiring a company.

Impairment testing: impairment is a permanent reduction in the value of a company asset. It’s
either a fixed asset or an intangible asset. When testing an asset for impairment, the total profit,
cash flow, or other benefits that can be generated by the asset is compared with its actual value.
Impairment is recorded as an expense.

Consolidated financial statements: the aggregated financial reports

The parent company is combined with a subsidiary to form consolidated P&L (Profit & Loss).
All parent companies need to prepare subsidiaries.

Goodwill is recorded usually when an asset is bought. Assets priced by market that are typically
not reported on the balance sheet

Net sales - cost of goods sold = gross profit

Gross profit - operating expenses = income from operations (or operating profit or EBIT)
Income from operations - interest = income before income tax (or EBT)
Income before income tax - income tax expense = net income (or earnings/profits)

Cost of sales is what remains of gross margin, percentage wise. If gross margin is 80%, cost of
sales is 20%

SG&A = Selling, General & Administrative Expenses, is a major non-production cost presented
in an income statement (statement of profit or loss). If the cost of goods sold (COGS) is going
downwards, SG&A is going upwards. That is the cost pattern between those two. In a bar graph,
COGS is usually way higher than SG&A (but this hasn’t been happening as the years go on)

High fixed costs in creating a protocol, standard, platform, or path-breaking idea. Most of these
initial costs, such as R&D, marketing, and information technology are intangible in nature.

Investments are considered expenses in accounting. The more the company invests in building its
future, the higher its reported losses.

There is potential to earn large monopolistic profits once a company becomes the market leader.
Firm is willing to use penetration pricing to attract customers and establish its own product or
network as the de facto standard

Accounting cannot account for this strategy:

● Customer relationships become valuable asset
● Cost of creating relationship, however, booked as expenses
● Company willing to incur losses to generate relationships
● Earning accounting profits becomes a secondary motive for the company
 EXAM PREPARATION

Assets = Liabilities + Equity

If revenue increases, it is considered credit

Recognize the revenue when the entity satisfies a performance obligation:

1. The seller has a present right to payment for the asset
2. The customer has legal title to the asset
3. The seller has transferred physical possession of the asset
4. The customer has significant risks and rewards of ownership to the asset
5. The customer has accepted the asset

Arguments against revenue recognition:

● Rights of return exist
● Consignment sales
● Continuing involvement by seller
● Contingency sales

Realized revenue means that goods/services have been received by the customer but payment for
it is expected later. Earned revenue accounts for goods or services that have been provided.

Unearned revenue: deposits or advance payments are not recorded as revenue until the company
performs the services owed or delivers the goods

Depreciation is the process of allocating the cost of a long-lived asset over its useful life. A
non-cash expense that reflects the decline in the value of an asset as time goes on, due to wear
and tear and other factors.
There are two methods of depreciation:
1. Straight-line depreciation: Depreciable value is allocated equally across an asset’s useful
life. Depreciation expense is constant across years and is equivalent to the asset’s
depreciable cost divided by its useful life.
2. Accelerated depreciation: Depreciation charges are front-loaded with lower charges in
later years. Two common methods for calculating accelerated depreciation are
double-declining balance depreciation and sum-of-the-years’-digits depreciation.

Impairment is a decrease in the value of an asset that is not recoverable and exceeds its fair
value. An asset is considered impaired when its carrying value (net book value) exceeds the
amount of future economic benefits expected to be generated by the asset. Impairment can occur
due to various reasons, including:
● Obsolescence: The asset is no longer useful or relevant due to changes in technology or
market conditions
● Physical damage: The asset has been damaged or destroyed, reducing its value
● Changes in legal or regulatory environment: Changes in laws or regulations may render
the asset obsolete or reduce its value
● Economic factors: Changes in economic conditions, such as a recession or changes in
interest rates, may reduce the value of the asset
● Changes in business operations: Changes in a company's business operations may render
the asset obsolete or reduce its value

The auditor’s report is a document containing the auditor’s opinion on if a company’s financial
statements comply with GAAP (General Accepting Accounting Principles) and are free from
material misstatement. It is generated as a result of an external audit, which is an examination of
a company’s financial statements by an independent auditor (an external auditor or a team of
them). The main purpose of it is to provide assurance to stakeholders, including shareholders,
investors and creditors about the reliability and credibility of the financial statements, which can
help build confidence in the financial information presented by the company.
Intangible assets:
● Knowledge
● Patent
● Brands
● Goodwill

Features of intangible assets

● Sunkenness
● Spillover
● Scalability
● Synergies

Indefinite intangible assets is an asset that’ll stay with an owner indefinitely. Definite ones have a
limited time (with no plans of extending it)

Intangible assets appear as long-term assets on corporate balance sheets. The value is determined
based on the purchase price along with their amortization schedules. Some assets, like goodwill,
don’t appear on sheets because their value can’t be spread out over time.

Accounting policies are procedures that a company uses to prepare financial statements. Unlike
accounting procedures, which are rules, accounting policies are standards for following the rules.
They can be used to manipulate earnings legally. They need to adhere to the GAAP. They are
usually made by the Chief Financial Officer and meant to be implemented.

These policies allow for:

● Consistency in financial reporting
● Contribute to the transparency of financial statements
● Guide management in making informed accounting decisions
● Ensure compliance within accounting standards and regulations
Examples:
● Depreciation
● Revenue recognition
● Lease accounting
● Financial instruments
● Inventory valuation

How should a CEO’s performance be measured in the future? (Don’t memorize all)
Customer metrics:
● Customer satisfaction score
● Churn rate
● Return rate
Employee metrics:
● Engagement ratings
● Turnover rates
Relative performance compared to competitors or the industry:
● Brand recognition
● Reputation
● Returns
● Profitability

Cash flow is the movement of money in and out of a company. Cash received signified inflows
and cash spent is outflows. Cash flow statement is a financial statement that reports a company’s
sources and use of cash over time. It’s categorized into 3 categories: operating, investing and
financing activities, all of which can have a +ve or -ve cash flow.

Companies can invest in another through:

● Equity investments: purchasing shares of another company provides ownership, which’ll
allow for the investing company to gain from target company’s success
● M&A
● Joint ventures
 ● Debt investments: providing loans to another for interest payments is a form of
investment

It’s hard to determine where a company might be headed, even if the cash flow is +ve.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date. In simple terms, fair
value represents the amount that an asset could be sold for or a liability could be settled for in a
typical transaction between willing buyers and sellers. It can be found in financial statements,
real estate transactions, private company transactions, business combinations.

3 levels to get to the fair value

1. Quoted prices in an active market for identical assets/liabilities
2. Observable inputs other than quoted prices
3. Unobservable inputs

Net income is calculated as revenues minus expenses, interest and taxes. It is used to calculate
earnings per share. Gross income is the total amount earned. Net income is gross income minus
expenses, interest and taxes. Net income reflects the actual profit.

A deferred tax liability is an obligation to pay taxes in the future. The obligation originates when
a company or individual delays an event that would cause it to also recognize tax expenses in the
current period. When there is a difference between reported income tax and income tax payable

Organic growth is the growth of a business through internal processes, relying on its own
resources. Measuring it is done by comparing revenues yearly and comparable store sales.
Benefits of it include:
● Control
 ● Preservation of company culture
● Lower financial risks
● Sustainable long term success
● Capital efficiency

Benefits of M&A:
● Market expansion
● Synergies (combining resources)
● Access to new technology
● Enhanced market share
● Diversification

Incentives and motives behind M&A:

● Profit maximization
● Strategic growth
● Competitive advantage
● Access to talent
● Financial engineering

Book value of a company represents the total value of a company’s assets minus its liabilities. It
is the accounting value of a company’s equity and provides a measure of the company’s net
worth according to its financial statements.

Book value = total assets - total liabilities

Market value of a company is the total value of a company’s outstanding shares of stock in the
open market. It is the price an asset has in the market and is commonly used to refer to market
capitalization.

Market value = current market price per share x number of outstanding shares
Purchase price allocation is a process that occurs when a company acquires another company.
During an acquisition, the acquiring company allocates the purchase price to the assets and
liabilities of the target company. This is needed for financial reporting purposes and it helps
determine the fair value of the acquired assets and liabilities.

Differences in the values of assets and liabilities in the market compared to their book values are
because of reasons like market perceptions, accounting principles, intangible assets, negotiations
and economic dynamics.

Goodwill is part of a company’s value that we can’t measure directly, such as its customers'
loyalty and reputation. They’re intangible assets that are not separately identifiable. Goodwill
comes from acquiring a company. There is no useful life of goodwill. It also represents the
excess of the purchase price paid for an acquired company over fair value of its identifiable net
assets. It represents the premium an acquiring company is willing to pay for the acquired
company, over and above the fair value of its tangible and intangible assets.

Factors that lead to goodwill impairment include:

● Market conditions
● Economic downturns
● Increased competition

Financial statements are written records that convey the financial activities of a company.
Financial statements are often audited by government agencies and accountants to ensure
accuracy and for tax, financing, or investing purposes. They do it to assess the financial health of
a company. Liquidity ratio measures a company’s ability to meet short-term obligations. It can be
big, small, +ve or -ve.

DuPont Analysis is used to calculate the ROE (return on equity). It’s 3 labors are:
● Net profit margin (NPM)
● Asset turnover (AT)
● Equity multiplier (EM)
ROE = NPM x AT x EM

NPM = Net income / Revenue

AT = Revenue / Average Total Assets
EM = Average Total Assets / Average Shareholder’s Equity

ROE = Net Income / Average Total Equity