WALL STREET PREP: ACCOUNTING CRASH COURSE ACTUAL EXAM QUESTIONS AND CORRECT ANSWERS GRADED A+ 2024

WALL STREET PREP: ACCOUNTING CRASH COURSE ACTUAL EXAM QUESTIONS AND CORRECT ANSWERS GRADED A+ 2024 “What is Accounting? - CORRECT ANSWER Accounting is the language of business; it is a standard set of rules for measuring a company's financial performance. Assessing a company's financial performance is important for: The firm's officers (managers and employees) Investors Lenders General public Standard financial statements serve as a "yardstick" of communicating financial performance to the general public." "Why is Accounting Important? - CORRECT ANSWER Enables managers to make corporate decisions Enables the general public to make investment decisions" "Who Uses Accounting? - CORRECT ANSWER Used by a variety of organizations - from the federal government to non-profit organizations to small businesses to corporations We will discuss accounting rules as they pertain to publicly-traded companies" "Accounting Regulations - CORRECT ANSWER Accounting attempts to standardize financial information and follows rules and regulations These rules are called Generally Accepted Accounting Principles (GAAP) In the US, the Securities and Exchange Commision (SEC) authorizes the Financial Accounting Standards Board (FASB) to determine accounting rules GAAP comes from the Statements of Financial Accounting Standards (SFAS) issued by the FASB" "Four Underlying Principles in Accounting - CORRECT ANSWER (1) Historical Cost (2) Accrual Accounting: Revenue Recognition (3) Accrual Accounting: Matching Principle (4) Full Disclosure" "Constraint 1: Estimates & Judgments - CORRECT ANSWER Certain measurements cannot be performed completely accurately, and must therefore utilize conservative estimates and judgments" "Constraint 2: Materiality - CORRECT ANSWER Inclusion and disclosure of financial transactions in financial statements hinge on their size and effect on the company performing them Note: Materiality varies across different entities" "Constraint 3: Consistency - CORRECT ANSWER Each company has to prepare financial statements using measurement techniques and assumptions which are consistent from one period to another" "Constraint 4: Conservatism - CORRECT ANSWER Financial statements should be prepared with a downward measurement bias Assets and revenues should not be overstated, while liabilities and expenses should not be understated" "Four Underlying Constraints in Accounting - CORRECT ANSWER (1) Estimates & judgments (2) Materiality (3) Consistency (4) Conservatism" "T/F: GAAP requires that firms show recorded values for acquired intangible assets such as patents and trademarks on their financial statements - CORRECT ANSWER True! GAAP requires that firms only show measurable activities, such as the value of acquired intangible assets Assets such as employee, customer loyalty, and internally-developed trademarks are not shown on financial statements" "CVS Revenue Exercise - CORRECT ANSWER Note: How much you collect in cash is irrelevant in revenue; it is how much you EARNED during the period" "Revenue Recognition - CORRECT ANSWER Accrual accounting dictates that revenue must be recorded only when it is earned and measurable In other words, until an order is shipped to a customer and collection from that customer is reasonably assured" "Revenue Recognition: Multiple Deliverables - CORRECT ANSWER For sales of bundled products, companies should assign individual values to each of the bundled components This is especially relevant in the software industry (see picture)" "Revenue Recognition: Long-Term Projects - CORRECT ANSWER Companies have some flexibility with long-term project revenue recognition (1) Percentage of Completion Method: Revenues are recognized on the basis of the percentage of total work completed during the accounting period (2) Completed Contract Method: Rarely used in the US; allows revenue recognition only once the entire project has been completed" "Matching Principle - CORRECT ANSWER Expenses should be "matched" to revenues The costs of manufacturing a product are matched to the revenue generated from that product during the same period" "Accrual Accounting - CORRECT ANSWER Revenues are recognized and recorded when an economic exchange occurs, while expenses are recognized when the associated revenues are recognized, not necessarily when cash is exchanged" "What would happen if we recognized expenses when they are incurred like revenue? - CORRECT ANSWER Shows an inaccurate depiction of a company's profitability" "Accrual vs. Cash Accounting - CORRECT ANSWER Although the benefits of the accrual method are apparent, it has the limitation that analysts cannot track objectively the movement of cash The cash flow statement allows analysts to reconcile these differences Cash accounting is more objective; accrual accounting is more subjective" "Cash Accounting - CORRECT ANSWER Not allowed under GAAP but used for tax reporting for certain businesses Objectively recognizes revenues when cash is received and records costs when cash is paid out" "Revenue Manipulation - CORRECT ANSWER Because of accrual accounting, revenue recognition can be subjective This "wiggle room" creates potential for manipulation in the form of shifting revenues from one period to another While revenue recognition methods are almost always explained in companies' 10K footnotes, when there is suspicion of "shenanigans," these should be read carefully" "Expense of Employee Salaries - CORRECT ANSWER The expense of employee salaries are embedded within the expense categories based on the employee's job function A corporate manger or sale person's salary will be in SG&A The salary of a software engineer will be in R&D The salary of a factory supervisor at a tire manufacturer will be in COGS" "Stock Based Compensation Expense - CORRECT ANSWER When a company compensates an employee with stock (like stock options or restricted stock), the value of that compensation is recognized as an expense in the same expense category as the employee's regular cash compensation during the period that that stock based compensation is actually earned Even though its recognized as an expense as an employee earns the SBC, remember that SBC is a non-cash form of compensation Note: Valuing stock based compensation is very difficult" "Where is SBC on the Income Statement? - CORRECT ANSWER Just like depreciation, you won't see a line item on the I/S specifically identifying SBC expense It is included within the operating expenses in which the employee is classified However, like depreciation, you will almost always find SBC expense identified separately on the cash flow statement" "Other Operating Expenses/Income - CORRECT ANSWER Companies will sometimes recognize expenses (or income) on the I/S that, while still related to operating activities, are a little less typical Includes: Gains/losses on sale of fixed assets, gains/losses from a legal settlement, restructuring expenses and severance costs, losses due to inventory spoilage (inventory write-down) On the I/S: They will often be embedded within larger operating expense categories like SG&A, or in a separate line item called "Other operating expenses" Companies sometimes provide a separate disclosure in their press releases where they have more freedom to detail these items (non-GAAP reconciliation) When the expense (or income) is large, it may be identified as its own separate line item" "Non Operating Income and Expenses - CORRECT ANSWER Everything below operating profit is not directly related to the operations of the business" "Above vs. Below the Line - CORRECT ANSWER Above the Line: Everything above Operating Income on the I/S that's tied to the core operations of a business Below the Line: Everything below Operating Income" "Interest Expense - CORRECT ANSWER Payments the company makes for its outstanding debt Corporations make regular interest payments on debt owed to banks or other lenders" "Interest Income - CORRECT ANSWER A company's income from its cash holdings and investments (stocks, bonds, and savings accounts)" "Net Interest Expense - CORRECT ANSWER Sometimes, interest income and expense are netted against one another when presented on the I/S" "Other Non-Operating Income / Expenses - CORRECT ANSWER INCOME Companies may generate income from non-operating activities: Increases in value and gains on sale on certain financial investments EXPENSES Represents expenses that are not tied to the core operations of the business or are unusual: Decreases in value and losses on sale on certain investments and debt, currency exchange losses Non-Operating Income and Expenses are often netted together on the I/S" "Tax Expense - CORRECT ANSWER Under US GAAP and IFRS, companies report tax expense as a separate line item usually right below a line item called 'Pretax Income' or 'Income before provision for income taxes' Tax expense doesn't equal the actual cash taxes paid! Because of the ability of companies to defer certain taxes, the tax expense recognized on the I/S does not equal actual cash taxes they have to pay for the same period" "Net Income - CORRECT ANSWER The final measure of profitability on the on the I/S Represents income after all expenses have been paid out AKA Net earnings, net profit, bottom line" "Shares Outstanding - CORRECT ANSWER Represent the number of shares of common stock outstanding One share of common stock represents one unit of ownership of a public company Shareholders are generally entitled to vote on the selection of directors and other matters and to receive dividends in proportion to the number of shares they own Shares Outstanding = Shares Issued - Treasury Stock" "What can companies do with profits? - CORRECT ANSWER Distribute dividends Reinvest in the business through new purchases, acquisition, etc. Pay down existing debt obligations or other liabilities Sit on it (grow a pile of cash)" "Dividend Presentation on the I/S - CORRECT ANSWER Common dividends are usually presented below net income and EPS on an income statement" "Earnings Before Interest and Taxes (EBIT) - CORRECT ANSWER Analysts often use operating income or EBIT to compare the performances of businesses" "Earnings Before Interest and Taxes, Depreciation, & Amortization (EBITDA) - CORRECT ANSWER An even more popular metric than EBIT for analyzing companies Why? (1) D&A is a huge noncash expense for fixed asset and intangible asset intensive businesses, and stripping out the biggest noncash expense provides a more accurate picture of "real" profits during the year (2) Since companies can use different useful life assumptions and even depreciation methods to calculate D&A this can skew the comparison of operating profitability Where is it? SInce D&A is not usually disclosed on the I/S, analysts have to go to the CFS to get D&A and add it back to EBIT Note: EBITDA is a blend of accrual and cash accounting. So be careful - it is not a perfect proxy for operating cash flows" "Income Statement Summary - CORRECT ANSWER " "Legal Expenses - CORRECT ANSWER While losses or gains from legal settlements are classified as non-operating expenses, regular recurring legal expenses are classified as an operating expense within SG&A" "Operating Income - CORRECT ANSWER Operating Income = Net Revenue - COGS - SG&A - Other Operating Expenses" "Is revenue recognized at the time of delivery of goods and services, regardless of when the cash is received? - CORRECT ANSWER Yes!" "Gross Profit Margin - CORRECT ANSWER Gross Profit / Net Sales (Revenue) The higher the margin, the better a company is at converting revenue into profits" "The Balance Sheet - CORRECT ANSWER Reports the company's resources (assets) and how these resources were funded (liabilities and shareholders' equity) on a particular date and time (end of the quarter or year) Fundamental Equation: Assets = Liabilities + Equity Historical Cost + Conservatism: The balance sheet does not report the true market value of a company - only its resources and funding at their historical cost" "Assets - CORRECT ANSWER Represent the company's resources Qualifications: (1) A company must own the resource (2) The resource must be valuable (3) The resource must have a quantifiable, measurable cost" "Marketable Securities / Short-Term Investments - CORRECT ANSWER Debt or equity securities held by the company that provide interest payments" "Accounts Receivable (A/R) - CORRECT ANSWER Payment owed to a business by its customers for products and services already delivered to them Sales that a company has made on credit Ex. Insurance companies resulting from pharmacy sales; banks for customer credit card transfers that take in excess of seven days to process Linked to revenues on the I/S" "Inventories - CORRECT ANSWER Any unfinished or finished goods that are waiting to be sold and the direct costs associated with the production fo these goods" "Assets Exercise - CORRECT ANSWER Note: Internally generated intangible assets are NOT considered assets on the B/S" "Liabilities & Equity - CORRECT ANSWER Represent the company's sources of funds (how it pays for assets) Liabilities: What the company owes to others (1) They must be measurable (2) Their occurrence is probable Equity: Sources of funds through... (1) Equity investment (2) Retained earnings (what the company has earned through operations since its inception)" "Accounts Payable (A/P) - CORRECT ANSWER A company's obligations to suppliers for services and products already purchased for them, but which have not been paid (unpaid bills for services obtained on credit from them) Current liability Note: No cash is used in the purchase of the inventory" "Accrued Expenses - CORRECT ANSWER Expenses like employee compensation that the company has incurred, but for which it has not yet paid Ex. Year-end bonus, earned wages owed to employees, insurance, rents, taxes, dividends, litigation costs, etc. Note: A company must recognize expenses on the I/S when the resources provided by those expenses were provided, not when the expense is due" "Short Term vs. Long Term Debt - CORRECT ANSWER Short Term Due within 12 months Long Term Due more than 1 year" "Preferred Stock - CORRECT ANSWER Stock that takes priority over common stock and has special rights (priority over dividends and claims on assets in bankruptcy) Often structured to include the possibility of conversion into common stock at a pre-set exchange rate, enabling investors to benefit from a set dividend, but participate in the upside if the company's common equity value increases" "Retained Earnings - CORRECT ANSWER Total company earnings / losses since its inceptions less all dividends Remember: The I/S is connected to the B/S through RE All income on the I/S increases retained earnings on the balance sheet (credits) All expenses on the I/S decrease retained earnings (debits) In addition, all common and preferred dividends decrease retained earnings (debits) Conceptually, RE represents the cumulative earnings that have been "retained" by the business, after taking into account all the dividend payments ever made" "Liabilities Exercise - CORRECT ANSWER Remember: The occurrence has to be probable and the impact must be measurable Dividends are not liabilities" "The Accounting Equation - CORRECT ANSWER Every transaction can be viewed as having two sides -- the source of funds, and the way the funds were used (use of funds) It is because of this equivalence sources and uses of funds that assets will always equal liabilities and equity by definition" "Double Entry Accounting - CORRECT ANSWER Records the two sides of every economic event - 1) The funding source; 2) How the funds are used Every transaction is recorded through the use of a "credit" (source of funds) and an offsetting "debit" (use of funds) such that total debits always equal total credits in value Double-entry accounting is depicted through the use of a "T account" to track each source and use of funds in a transaction Debit: Increases in assets, decreases in liabilities & equity - left side of T account Credit: Increases in liabilities & equity, decreases in assets - right side of T account" "Why is Double-Entry Accounting Important? - CORRECT ANSWER It facilitates understanding of the relationship between assets (resources) and liabilities/shareholders' equity (funding) of a company The I/S, B/S, and CFS are connected; the relationship among these three statements and their impact on one another can be initially "illustrated" through debits and credits" "Income Statement and Balance Sheet Connections - CORRECT ANSWER The I/S is linked to the B/S via retained earnings in shareholders' equity All income on the I/S (revenue, interest income, etc.) increases retained earnings on the balance sheet (credits) All expenses on the I/S (COGS, SG&A, tax, etc.) decrease retained earnings (debits)" "Income Statement Impact on the B/S: Revenue - CORRECT ANSWER If paid collected entirely in cash Increase cash (assets) Increased retained earnings (equity)" "Income Statement Impact on the B/S: COGS - CORRECT ANSWER Decrease retained earnings (Equity) Decrease cash, PP&E - depreciation, inventory (Assets)" "Income Statement Impact on the B/S: SG&A - CORRECT ANSWER Decrease retained earnings (Equity) Decrease inventory, cash, PP&E - depreciation (Assets)" "Income Statement Impact on the B/S: Net Interest Expense - CORRECT ANSWER (1) Interest Expense: Reduced retained earnings (equity) and cash (assets) (2) Interest Income: Increases retained earnings (equity) and cash (assets) Note: There was no impact to debt from the payment of cash interest - debt level stays the same" "Income Statement Impact on the B/S: Non-Operating Expenses - CORRECT ANSWER Retained earnings decreases (Equity) Cash decreases (Assets)" "Income Statement Impact on the B/S: Tax Expense - CORRECT ANSWER Retained earnings decreases (Equity) Cash decreases (Assets)" "Changes on the B/S that Don't Affect Retained Earnings - CORRECT ANSWER Raising money from investors: Cash increases, common equity increases" "Assets Presentation - CORRECT ANSWER Assets are presented in descending order of liquidity Cash is the most liquid asset - always first Usually followed by A/R and inventory - can be sold quickly Less liquid assets like PP&E and intangible assets are at the bottom Current Assets: Assets that can be converted to cash within 12 months; usually listed first on the B/S" "Liabilities Presentation - CORRECT ANSWER Liabilities are presented in the order of when they are to be paid Current Liabilities: Liabilities like short term debt and accounts payable to be paid within 12 months; listed first Long Term Liabilities: Liabilities like long term debt that are not due within the year; listed last" "Current vs. Non-Current B/S Exercise - CORRECT ANSWER " "Are interest payments on a loan a liability? - CORRECT ANSWER NO! Interest expense is recognized on the I/S with a corresponding reduction to cash. Only the principal of the loan is recognized as a liability." "How would you characterize a long-term bank loan due this year? - CORRECT ANSWER A current liability Long term debt migrates from a long term liability to a current liability on the B/S once it becomes due within 12 months" "Cash and equivalents - CORRECT ANSWER Cash equivalents are extremely liquid assets (ex. US treasury bills) You'll also see marketable securities included in this line item or broken out separately" "Prepaid Expenses - CORRECT ANSWER When a company prepays for things like utilities, insurance and rents, cash is reduced but the expense is not yet recognized on the I/S under the accrual concept Instead, they are recognized on the B/S as assets to reflect that the company now has the right to the future services" "Inventory - CORRECT ANSWER Represent goods waiting to be sold and direct and sometimes indirect costs associated with the production or procurement of these goods Merchandiser The products procured for resale Manufacturer Includes the costs of producing the finished inventory: raw materials, work-in-process (direct labor and factory overhead) Inventory cycles out of the B/S and into I/S as COGS Before inventory get expensed as COGS and are matched to the revenues they help generate (matching principle), they are part of the company's inventories on the B/S" "Inventory Exercise - CORRECT ANSWER " "Inventory Costing (LIFO vs. FIFO vs. Average Cost) - CORRECT ANSWER First In, First Out (FIFO): Cost of the inventory first purchased (first in) is the cost assigned to the first inventory to be sold (COGS - first out); remaining inventory reflect the latest costs Last In, First Out (LIFO): The items purchased last (last in) are the first to be sold (COGS - first out). Therefore, the cost of inventory most recently acquired (ending inventory - last in) is assigned to COGS (first out); ending inventory reflects cost of the first purchased inventories Average Cost: COGS and ending inventory are calculated as = COGS / Total number of goods" "Inventory Costing Exercise - CORRECT ANSWER " "Why do companies choose LIFO? - CORRECT ANSWER The tax benefit of LIFO is what makes it preferable for many US companies over FIFO accounting in periods of rising inventory prices Why? LIFO leads to lower net income, which leads to lower taxes" "LIFO Reserve - CORRECT ANSWER When companies use the LIFO method, their footnotes must disclose what the value of their inventories would have been under the FIFO method; this difference is called the LIFO Reserve The LIFO reserve allows comparison of inventories and COGS across both methods: LIFO Inventory + LIFO Reserve = FIFO Inventory FIFO COGS + LIFO Reserve = LIFO COGS In Practice: When comparing a LIFO company against a FIFO company, the LIFO reserve must be subtracted from the LIFO company's COGS to arrive at apples-to-apples profits comparisons" "Writing Down Inventories - CORRECT ANSWER The B/S shows assets like inventories at historical (acquisition) cost -- companies can't mark them up to market value under GAAP Can they be marked down if inventory is destroyed, deteriorates or becomes obsolete? Yes! Under US GAAP, the lower of cost-or-market (LCM) rule dictates that if the market value of inventory falls below historical cost, they must be written down to market value The loss must be recognized immediately on the Income Statement in COGS or 'Other operating (or non operating) expenses' or a separate line item On the Balance Sheet, there is a decrease in retained earnings (Equity) and inventory (Asset)" "Property, Plant & Equipment - CORRECT ANSWER Land, buildings, and machinery used in the manufacture of the company's services and products plus all costs (transportation, installation, other) necessary to prepare those fixed assets for their service PP&E cycles out of the B/S and into the I/S as depreciation, either in COGS, SG&A, or elsewhere PP&E is reported net of accumulated depreciation on the balance sheet, such that: Net PP&E = Gross PP&E - accumulated depreciation Where Gross PP&E is the historical cost of all PP&E" "Accumulated Depreciation - CORRECT ANSWER Netted away from gross PP&E to arrive at net PP&E on the balance sheet Accumulated depreciation is a contra account, which is an offsetting account to an asset (contra accounts also exist for liabilities and shareholders' equity) Increases in a contra account reduce the associated asset account" "Capital Expenditures - CORRECT ANSWER New purchases of PP&E (fixed assets)" "PP&E Exercise - CORRECT ANSWER " "PP&E Write Downs - CORRECT ANSWER Just like inventory, PP&E whose value declines needs to be written down to market value The loss is recognized immediately on the I/S (COGS, SG&A, 'Other operating (or non operating) expenses', or a separate line item) On the B/S, the loss is taken out of PP&E" "Asset Sales - CORRECT ANSWER If a company chooses to sell some of their PP&E, the associated gross PP&E balance (and accumulated depreciation) is removed from the balance sheet, offset by: (1) The cash received, and (when applicable) (2) Any gain/loss on sale on the I/S (usually as "other" operating or non-operating income, or within the expense category through which the asset was being depreciated - COGS or SG&A) Key Takeaway: Regardless of the sale price, only the net book value is removed from the PP&E line, and any excell gain (loss) is recognized on the I/S" "PP&E Balance During the Year - CORRECT ANSWER " "Intangible Assets - CORRECT ANSWER Comprised of non-physical acquired assets Tems that have value based on the rights belonging to the company Linked to amortization on the I/S Intangible assets are reduced on the B/S via amortization on the I/S" "Intangible Asset Balance During the Year - CORRECT ANSWER " "Goodwill - CORRECT ANSWER The amount by which the purchase price for a company exceeds its fair market value (FMV), representing the "intangible" value stemming from the acquired company's business name, customer relations, employee morale, etc. Effectively an accounting plug, created only if the purchase price exceeds the FMV of all the assets acquired" "Goodwill Impairment - CORRECT ANSWER Unlike finite life intangible assets, Goodwill is not amortized but is tested annually for loss of value (impairment) If the value of the previously acquired company declines, goodwill is reduced, with a corresponding reduction to RE via the income statement by the amount of the impairment (as a separate line item or within a broader category) Conceptually, goodwill write-downs imply that a company overpaid in the original acquisition" "Goodwill Balance During the Year - CORRECT ANSWER " "Liabilities - CORRECT ANSWER The company's obligations to others that will be met through the use of cash, goods, or services Qualifications: (1) Measurable (2) Probable occurrence (3) The transactions from which these obligations arise have taken place Categories: (1) Current Liabilities: Due within 1 year - reported in order of maturity, by amount, or in the event of liquidation (2) Long-term Liabilities: Not due within a year" "Deferred (Unearned) Revenue - CORRECT ANSWER Revenue received for services not yet provided by the company A sizeable liability for software companies and companies that sell long-term memberships A current liability if the revenus is expected to be recognized within the year; otherwise, a long-term liability" "Types of Current Liabilities - CORRECT ANSWER Short Term Debt: Owed by the company that are due within 1 year Current Portion of Long-Term Debt: Portion of long-term debt which is due within 1 year" "Long Term Debt - CORRECT ANSWER A long-term liability that is often a sizeable liability Note: Interest expense is a reduction to retained earnings and does not affect debt balance" "Leases - CORRECT ANSWER Many companies make lease payments for their equipment, office space, and retail locations Lease payments are defined contractually upfront between the lessee (the company making lease payments) and the lessor (the company collecting lease payments) Under IFRS, virtually all leases are accounted for as finance leases Under US GAAP, leases can be accounted for as operating leases or finance leases (see image) Basically, if the lease is basically a transfer of ownership, it is a finance lease" "Finance Leases - CORRECT ANSWER An accounting approach that recognizes the lease as debt and the underlying asset as PP&E on the lessee's balance sheet Lease as Debt: Like debt, leases are long-term obligations to make payments to another party. Unlike debt, lease payments don't usually include explicit interest payments; Instead, the interest fees are implied and baked into the total lease expense Initial Balance Sheet Impact: Finance leases initially are recognized as a liability on the B/S (just like debt) with the corresponding asset as PP&E Note: Unlike debt, companies have to estimate the initial liability as the present value of all future lease payments, using a discount rate assumption" "Finance Leases: Over the Life of the Lease - CORRECT ANSWER Conceptually, the asset is depreciated (or amortized) over its useful life (or lease term, if shorter), while the lease liability accrues interest during the year and is then reduced by lease payments (like principal payments with debt) On the I/S, both depreciation expense and an implied interest expense reduces net income Depreciation/Amortization Expense: The asset initially recognized is depreciated via straight-line depreciation over the term of the lease Interest Expense: The discount rate x The lease liability balance Main Takeaway: The B/S initially treats the finance lease as a debt-like liability and the underlying asset as an owned asset Over the life of the lease, the I/S impact does not capture the rent but wants us to break up the lease payments into two components: interest and depreciation fees Note: Compared to the lease expense, the overall depreciation + interest expense will be higher early in the lease and lower later in the lease because the interest expense is higher when the lease liability is high" "Operating Leases - CORRECT ANSWER Applies to leases where the lessee doesn't have economic ownership of the lease Initial B/S Impact: Same as finance leases; initially are recognized as a liability on the B/S (just like debt) with the corresponding asset as PP&E (Right of Use Assets) I/S Impact Over Lease Term: I/S is reduced by the rent ("lease") expense Straight-line Lease: If lease payments grow each year, the I/S will recognize an annual straight line expense - creates a disconnect between the cash outlay and the accrual-based expense recognized" "Operating Leases - Lease Liability - CORRECT ANSWER Lease liability is treated identically under operating and finance lease accounting (interest accruing and being reduced by lease payments) The lease asset is reduced by depreciation expense but the calculation is different Depreciation: The rent expense, net of the interest expense Note: The lease liability and lease asset may not be exactly equal but will be very similar" "Equity - CORRECT ANSWER A major source of funds via: (1) Preferred stock issuance (2) Equity investment (net of share repurchases "treasury stock") (3) Retained earnings (what the company has earned through operations since its inception)" "Common Stock - CORRECT ANSWER The primary way companies can raise money aside from debt Accounting involves splitting the value of a common share into two components: (1) Common Stock Par Value: Some nominal value to an issued share (ex. $0.10/share) (2) Additional Paid In Capital: The excess value of the share issued over par value Note: Due to the historical cost principle, common stock on the B/S of most companies grossly understates the true market value of their equity" "Common Stock & Treasury Stock on Financial Statements - CORRECT ANSWER Treasury stock is sometimes an even larger amount on the B/S than common stock & APIC due to the fact that common stock & APIC cannot be written up" "Other Comprehensive Income (OCI) - CORRECT ANSWER An equity line item on the B/S that captures the accumulation of income or loss that a company has recognized over time that is not recognized directly on the I/S and thus not captured in retained earnings Includes gains and losses from: Foreign currency transactions, unrealized gains and losses on available for sale securities, etc. Note: A full breakout of gains and losses categorized as OCI are often reported in a separate financial statement called 'Statement of Comprehensive Income'" "Common Stock & Stock Based Compensation - CORRECT ANSWER Equity issued to employees through stock based compensation (stock options and restricted stock) increases the common stock & APIC balance As the company recognizes stock based compensation on the I/S, it will recognize a corresponding increase in the common stock & APIC balance Note: There is no cash impact!" "How to Calculate Retained Earnings - CORRECT ANSWER Net income - Dividends" "Do collections of accounts receivable affect stockholders' equity? - CORRECT ANSWER No! They only affect cash and A/R" "When a customer takes advantage of a sales discount, what does the discount affect? - CORRECT ANSWER It increases operating expenses by the discount Also: Cash increases by the price paid by the customer but A/R decreases by the full price" "Is ending inventory greater than beginning inventory when purchases are less than COGS? - CORRECT ANSWER No! Ending inventory would be less than beginning inventory" "When inventories are overstated, what is the effect on net income? - CORRECT ANSWER Current assets are overstated COGS are understated Net income is overstated" "Is land held for investment part of PP&E? - CORRECT ANSWER No, it is reported on the B/S as an investment" "The Cash Flow Statement (CFS) - CORRECT ANSWER A required financial statement that provides insight that the I/S cannot - namely, exactly how much cash a company generates and from what activities Reconciles net income to a company's actual change in cash balance over a period in time (quarter or year) Thus, the CFS and I/S must both be used and fully understood by analysts" "Structure of the Cash Flow Statement - CORRECT ANSWER Companies have two options for reporting cash flows: (1) Direct Method (2) Indirect Method - Virtually all choose this one Both approaches requires cash flows to be classified into three components: (1) Cash from Operations (CFO): Uses net income as a starting point and converts accrual-based net income into cash flow from operations via a series of adjustments (i.e., non-cash and accrual) (2) Cash from Investing Activities (CFI): Capital expenditures / asset sales and purchases (3) Cash from Financing Activities (CFF): New borrowing / pay-down of debt / new issuance of stock / share repurchases; Issuance of dividends" "Cash from Operations - CORRECT ANSWER How much cash went into the company's pocket as a result of operations? Ignores non-cash income (credit sales, write-ups) and expenses (D&A, credit purchases) Start at net income and back all the non-cash expenses and income out of net income to get at "cash income" or "cash from operations"" "CFO: Depreciation - CORRECT ANSWER Often the biggest adjustment to get from net income to CFO is depreciation expense, because it is usually the largest noncash expense included within net income" "CFO: Working Capital - CORRECT ANSWER The other major adjustment from net income to CFO that is for a specific grouping of B/S line items Current assets like A/R, inventories, prepaid expenses are call "working capital" assets Current liabilities like A/P, accrued expenses, deferred revenue are called "working capital" liabilities Both represent assets and liabilities that are tied up in the ordinary course of operations Note: Increases in assets represent a usage of funds (cash outflow); increases in liabilities represent a source of funds (cash inflow)" "CFO: Increases in assets & liabilities - CORRECT ANSWER Increases in assets represent a usage of funds (cash outflow) Increases in liabilities represent a source of funds (cash inflow)" "CFO: Other Items - CORRECT ANSWER Asset write downs / impairments: Since write downs or asset impairments are recognized as an expense on the I/S, they represent a noncash expense that must be added back on the CFS within CFO" "Getting to Cash From Operations - CORRECT ANSWER Increases in A/R, inventory, prepaid expenses, other current assets should be subtracted from net income to get to CFO Increases in A/P, accrued expenses, other current liabilities should be added to net income to get to CFO" "Cash from Operations Exercise - CORRECT ANSWER " "Typical Line Items in the CFO - CORRECT ANSWER " "Cash from Investing Activities (CFI) - CORRECT ANSWER Tracks additions and reductions to fixed assets and investments during the year (corresponding primarily to long-term asset side of the balance sheet) Most Common Inflows/Outflows: Capital expenditures (outflow) Purchases of intangible assets (outflow) Asset sales (inflow) Purchases and sales of debt & equity securities (outflow/inflow)" "Cash from Financing Activities (CFF) - CORRECT ANSWER Tracks changes in the company's sources of debt and equity financing (corresponding primarily to the liabilities and shareholders' equity side of the B/S) Most Common Inflows/Outflows: Issuance / repayment of debt (inflow / outflow) Common stock issued / repurchased (inflow / outflow) Payment of common & preferred dividends (outflow)" "The CFS is a Magnifying Glass - CORRECT ANSWER The CFS is a magnifying glass on the cash line of the B/S CFS identifies the year-over-year change of every B/S line item that affects cash CFO captures the impact of RE, current assets, and current liabilities (and the D&A part of fixed assets and intangibles) CFI capture the impact of long-term assets CFF captures the impact of long-term liabilities and equity" "Would a decrease in utilities payable be added or subtracted from net income when determining cash flows from operating activities? - CORRECT ANSWER Subtracted! A decrease in utilities payable means that cash payments exceeded utilities expense for the period" "Would a gain on an asset sale be added or subtracted from net income when determining cash flows from operating activities? - CORRECT ANSWER Subtracted!" "Working Capital - CORRECT ANSWER A specific subset of balance sheet items Working capital = Current assets - Current liabilities" "Current Ratio - CORRECT ANSWER Current assets divided by current liability Designed to provide a measure of a company's liquidity > 1: A company is more liquid - has liquid assets that can presumably cover the upcoming short-term liabilities" "Quick Ratio (Acid Test) - CORRECT ANSWER Isolates only the most liquid assets (cash and receivables) to gauge liquidity" "Working Capital Presentation on the BS with the CFS - CORRECT ANSWER The B/S organizes items based on liquidity, but the CFS organizes items based on their nature (operating vs. investing vs. financing) Most current assets and liabilities are related to operating activities - inventory, A/R, A/P, accrued expenses, etc. are clustered under "changes in operating assets and liabilities" in CFO This section is generally referred to as "changes in working capital", but not all current assets and liabilities are in this section Ex. Marketable securities and short-term debt are not tied to operations - included in investing and financing activities instead" "Operating Items vs. Working Capital on the CFS - CORRECT ANSWER "Changes in operating assets and liabilities" commingles both current and long-term operating assets and liabilities Thus, it includes both working capital and other long-term assets and liabilities" "What Does Working Capital Tell Us? - CORRECT ANSWER Not much -- a negative balance can be good, bad, or something in between" "Operating Cycle - CORRECT ANSWER The time it takes, from start to finish, of buying or producing inventory, selling it, and collecting cash for it Includes cash, A/R, inventories, and A/P Conceptually: The amount of days that it takes between when a company initially puts up cash to get (or make) stuff and getting the cash back out after you sold the stuff" "Net Operating Cycle (Cash Conversion Cycle) - CORRECT ANSWER A related concept to the operating cycle that factors in credit purchases Operating cycle - payables payment period" "Formulas Required to Calculate the Operating Cycle - CORRECT ANSWER " "Managing Working Capital - CORRECT ANSWER Companies with significant working capital considerations must carefully and actively manage capital to avoid inefficiencies and possible liquidity problems Perfect Storm: (1) Retailer bought a lot of inventory on credit with short repayment terms (2) Economy is slow, customers aren't paying as fast as was expected (3) Demand for the retailer's product offerings change and some inventory flies off the shelves while other inventory isn't selling" "Working Capital Exercise - CORRECT ANSWER " "Financial Statement Ratio Analysis - CORRECT ANSWER Financial statement analysis relies on looking at relationships (ratios) between 2 or more financial statement accounts and seeing how those ratios change over time, and how they compare across companies or industries Categories of Ratios: (1) Liquidity ratios (2) Profitability ratios (3) Activity ratios (4) Solvency ratios (coverage)" "Activity Ratios - CORRECT ANSWER Measure how efficient a company is at using its assets" "Inventory Turnover - CORRECT ANSWER If you need $50 in inventory jto support $1,000 in COGS that means you carry very little inventory; can be advantageous because you do not need large amounts of cash for inventory requirements until a sale is actually made Had you needed large inventory purchases prior to the sale, you would have had to tap other financing sources like debt" "Receivable Turnover & DSO - CORRECT ANSWER Identical conceptually to inventory turnover If you collect very fast from customers, you immediately get cash If you wait a long time for customers to pay, cash that you need for other activities would have to come from somewhere else (like debt) Receivable turnover = Revenue / Average accounts receivable Another way to express the relationship between A/R and sales is days sales outstanding (DSO) = (AR/Credit sales) x days in period Note: You want DSO to be low" "AP Turnover and Payables Payment Period - CORRECT ANSWER Measures how quickly a company pays its vendors Generally, the longer credit terms provide a company with more flexibility If the average DSO is greater than the average PPP, cash from customers takes longer to collect than the term your vendors have provided you - implies that you cannot rely on receivables alone to fund your short term credit terms so you'll need to access other capital sources" "Activity Ratios Exercise - CORRECT ANSWER Exercise 3 = 46 days Note: DSO should be low; Inventory turnover should be high; PPP should be high" "Liquidity Ratios - CORRECT ANSWER Gauge the ability of a company to cover short term financing needs Rough Rule of Thumb: A current ratio > 1 is good; it implies that there are more liquid assets than short term liabilities, reflecting a healthier level of liquidity The Flip Side: Companies with very strong working capital management can operate effectively with lower liquidity ratios, enabling them to fund activities more efficiently" "Profitability Ratios - CORRECT ANSWER " "Operating Margin - CORRECT ANSWER Like GPM but captures operating (non-direct) expenses like SG&A Operating profit / Revenue Higher margin = better" "Net Profit Margin - CORRECT ANSWER Like GPM but captures all non-operating income/expenses Net income / Revenue Higher margin = better" "Asset Turnover - CORRECT ANSWER Revenue / Average assets A business with $500 in assets and $1,000 in revenue has a 2x asset turnover - could be far more capital intensive than a business that achieves the same sales with only $100 in assets Alternatively, it could just have a lot more cash" "Return on Assets (ROA) - CORRECT ANSWER Net income / Average assets Measures how effective a company is at converting assets into profits, as opposed to just revenue Higher return = Better Although, there are many possible scenarios that make this rule of thumb less than perfect" "Return on Equity (ROE) - CORRECT ANSWER Net income / Total equity One of the challenges with ROA is that it commingles a levered measure of profitability (net income is sensitive to leverage via interest expense) with an unlevered measure of assets (assets can be financed by a lot of leverage or no leverage at all) Thus, ROA makes a poor ratio to use when comparing companies with significantly different rates of leverage ROE solves this by factoring leverage into the denominator and calculates a return on just the equity value of the firm; this facilitates the analysis across companies with varying degrees of leverage" "Leverage and Solvency Ratios - CORRECT ANSWER Important to investors (especially lenders) as they try to determine whether borrowers have sufficient profits to make interest payments and sufficient equity to carry debt" "Debt to EBITDA - CORRECT ANSWER Debt / EBITDA Used to determine a company's debt capacity Ex. Lenders contemplating lending to a company with EBITDA of $100m restrict the loan amount to 5.0x the company's EBITDA" "Interest and Fixed Charge Coverage Ratios - CORRECT ANSWER Interest coverage ratio = EBIT / Interest expense Fixed charge coverage ratio = (EBIT + Lease charges) / (Lease charges + Interest expense) Analyze how much profit is available to satisfy interest expense Coverage ratios are often included in credit agreements whereby a borrower must maintain a certain ratio to be in good standing with the lender Note: Sometimes lenders adjust EBIT to better approximate cash profits because it captures many noncash items" "Debt to Equity Ratio - CORRECT ANSWER Total liabilities / Total equity Used to understand how levered a company is The higher to D/E, the more highly levered a firm is A measure of investor and credit risk Note: Since the book value of equity can seriously understate the market value of equity, a market value of equity should be used to better understand leverage" "An Overview of the SEC - CORRECT ANSWER A US federal agency established by the US Congress in 1934 Primary mission is "to protect investors and maintain the integrity of the securities markets" Division of Corporate Finance oversees FASB" "An Overview of FASB - CORRECT ANSWER Established in 1973 as an independent body to carry out the function of codifying accounting standards on the behalf of the SEC Composed of seven full-time members appointed for five years by the Financial Account Foundation (FAF) Decisions are influenced by:" "International Financial Reporting Standards (IFRS) - CORRECT ANSWER Over 100 countries, including the EU, UK, Canada, Australia, and Russia, have adopted a unified set of international accounting standards (IFRS) Although we have seen unprecedented convergence over the last few years between US GAAP and IFRS, some differences remain" "Assumption 1: Accounting Entity - CORRECT ANSWER A company is considered a separate "living" enterprise, apart from its owners In other words, a corporation is a "fictional" being" "Assumption 2: Going Concern - CORRECT ANSWER A company is considered a "going concern" for the foreseeable future; it is assumed to remain in existence indefinitely" "Assumption 3: Measurement - CORRECT ANSWER Financial statements can only show measurable activities of a corporation such as its quantifiable resources, its liability, amount of taxes it is facing, etc." "Assumption 4: Periodicity - CORRECT ANSWER Companies are required to file annual and interim reports In the US, quarterly and annual financial reports are required An accounting year (fiscal year) is frequently aligned with the calendar year" "Four Underlying Assumptions of Accounting - CORRECT ANSWER (1) Accounting Entity (2) Going Concern (3) Measurement (4) Periodicity" "Principle 1: Historical Cost - CORRECT ANSWER Financial statements report companies' resources at an initial historical cost Why? Represents the easiest measurement method without a need for appraisal and revaluation Marking resources up to fair value allows for management discretion and subjectivity, which US GAAP attempts to minimize by using historical cost Note: IFRS allows you to write up the asset to fair value, but most companies use historical value anyways" "Principles 2 and 3: Accrual Accounting (Revenue Recognition and Matching Principle) - CORRECT ANSWER Governs the company's timing in recording its revenues (i.e. sales) and associated expenses 2) Revenue Recognition: Accrual basis of accounting dictates that revenues must be recorded when earned and measurable 3) Matching Principle: Under the matching principle, costs associated with making a product must be recorded during the same period as revenue generated from that product Exercise Answer: 1) 1/4/15; 2) 1/4/15" "Why can't companies immediately record these revenues and expenses? - CORRECT ANSWER According to the revenue recognition principle, a company cannot record revenue until that order is shipped to a customer (only then, is the revenue actually earned) and collection from that customer is reasonably assured" "Why shouldn't a company record an expense when it actually buys the item? - CORRECT ANSWER According to the matching principle, costs associated with the production of the product should be recorded in the same period as the revenue from the product's sale" "US GAAP vs. IFRS Accrual Accounting - CORRECT ANSWER " "Principle 4: Full Disclosure - CORRECT ANSWER Companies must reveal all relevant economic information that they determine to make a difference to its users Such disclosure should be accomplished in the following sections of companies' reports: (1) Financial statements (2) Notes to financial statements (3) Supplementary information" "Summary of Accounting Assumptions, Principles, Constraints - CORRECT ANSWER Most important are the historical cost, revenue recognition, and matching principles" "Financial Reporting Overview - CORRECT ANSWER Presented in the companies' financial reports and standardized by accounting Companies must file periodic financial reports with the SEC" "Finding Financial Reports - CORRECT ANSWER On the website UK: Canada: Also, company websites and financial websites and services" "Form 10-K (Annual Filing) - CORRECT ANSWER Publicly traded companies must file the 10-K at the end of each fiscal year Includes a thorough overview of their businesses and finances, as well as their financial statements Must be filed within 60-90 days within year end, depending on filer's status (large accelerated (60)/accelerated/non-accelerated filer (90))" "Why is the 10-K important? - CORRECT ANSWER Required annual filing that provides the most detailed overview of companies' financial operations and regulations governing them" "Annual Report vs. 10-K - CORRECT ANSWER " "Form 10-Q (Quarterly) - CORRECT ANSWER At the end of each quarter of their fiscal year (for the first three quarters), publicly-traded companies file a report with the SEC which includes financial statements and non-financial data Must be filed within 40-45 days of quarter end" "10-K vs. 10-Q - CORRECT ANSWER " "Form 8-K - CORRECT ANSWER A required filing any time a company undergoes or announces a materially significant event such as an earnings press release Usually filed within 4 days of the event" "Form 14A (Proxy Statement) - CORRECT ANSWER A required filing prior to a company's annual shareholder meeting Contains detailed information about top officers and their compensations Often solicits shareholder votes (proxies) for Board nominees and other important matters" "Other Financial Reports - CORRECT ANSWER S-1, S-4, and 20-F" "Part 1 of the 10-K - CORRECT ANSWER " "Part 2 of the 10-K - CORRECT ANSWER The red meat of the 10-K" "Parts 3 and 4 of the 10-K - CORRECT ANSWER " "Where can you find the latest share count on a 10-K? - CORRECT ANSWER At the bottom of the cover page" "Business Section of the 10-K - CORRECT ANSWER Allows you to get to know a company Generally Includes: Company background, business strategy, product descriptions, markets and distribution, competition, distribution networks" "MD&A Section of the 10-K (Item 7) - CORRECT ANSWER Reviews what happened during the year, what their expectations are, etc." "Selected Financial Data of the 10-K (Item 6) - CORRECT ANSWER Includes the most important financial highlights" "Financial Statements Section of the 10-K (Item 8) - CORRECT ANSWER Includes: B/S, CFS, I/S, etc." "The Income Statement is designed to measure... - CORRECT ANSWER The profits of a firm over a period of time" "What is the Income Statement? - CORRECT ANSWER A financial report that depicts the operating performance of a company (i.e. revenues less expenses generated or profitability) over a specific period of time (quarter or year) AKA The Consolidated Statement of Earnings, Profit and Loss Statement (P&L), Statement of Revenues and Expenses" "Why is the Income Statement Important? - CORRECT ANSWER Facilitates the analysis of a company's growth prospects, cost structure, and profitability Analysts use it to identify the components and sources ("drivers") of net earnings" "Major Income Statement Line Items (Pt. I) - CORRECT ANSWER " "Major Income Statement Line Items (Pt. II) - CORRECT ANSWER " "Ways to Measure Profitability - CORRECT ANSWER EBITDA & Operating Profit (EBIT)" "Bottom Line - CORRECT ANSWER Net income on the Income Statement" "Revenue - CORRECT ANSWER Represents proceeds from the sale of goods and services produced or offered by a company Not all income is revenue Interest income earned from investments and income received from a legal settlement are not considered revenue AKA Sales, turnover, net sales, net revenues, top line" "Top Line - CORRECT ANSWER Revenues on the Income Statement" "Cost of Goods Sold / Cost of Sales - CORRECT ANSWER A company's direct cost of manufacture (for manufacturers) or procurement (for merchandisers) of a good or service that the company sells to generate revenue COGS do not include administrative costs such as corporate overhead, marketing and administrative expenses, R&D, and salaries of employees (included under Selling, General, & Administrative Expenses or other line items) For a Manufacturer Inventory, direct labor, factory overhead (indirect costs), shipping & delivery costs For a Merchandiser Inventory, shipping & delivery costs For a Service Provider Direct service costs" "COGS Exercise - CORRECT ANSWER Cashiers and management offices are a part of SG&A expenses R&D is its own line item" "Gross Profit - CORRECT ANSWER Represents profit after only direct expenses (COGS) have been accounted for: Gross Profit = Net Revenues - COGS In Exercise: $100M in revenues - $40M in inventories used up - $2M in shipping = $58M (Remember the matching principle!)" "Selling, General, & Administrative Expenses - CORRECT ANSWER Operating expenses that are not included in cost of goods sold are allocated to categories titled 'Selling, general & administrative expenses' (SG&A) but may also include terms like marketing and operating expenses in the title Represents the operating expenses not directly associated with the production or procurement of the product or service that the company sells to generate revenue" "SG&A Exercise - CORRECT ANSWER " "Research & Development (R&D) - CORRECT ANSWER R&D expenses stem from a company's activities that are directed at developing new products or procedures Research-intensive industries like healthcare, energy, and technology often identify R&D expenses separately because they are so large; other companies aggregate R&D expenses within Other Operating Expenses or SG&A Includes: Compensation for employees, equipment, and facilities engaged in the R&D process" "Depreciation Expense - CORRECT ANSWER Accrual accounting dictates that we spread the cost of an asset evenly over the useful life of the asset so that costs are matched to the period when revenue is earned as a result of using the asset The resulting annual expense is called depreciation Quantifies the wear and tear from the use and passage of time of the physical asset through a systematic decrease of the assets' book (historical) value" "Depreciation Exercise - CORRECT ANSWER " "Where is depreciation expense on the Income Statement? - CORRECT ANSWER You will not see a line item on the I/S specifically identifying depreciation expense Depreciation is included within COGS (asset is directly tied with manufacture or procurement) or SG&A (asset is not directly tied, like selling or marketing) Note: You can find depreciation expense identified separately on the cash flow statement" "Depreciation Expense is a Non-Cash Expense - CORRECT ANSWER Depreciation is a non-cash expense and can make up a significant portion of total expenses on a company's income statement That makes the income statement a poor tool for tracking a company's cash position -- I/S profits are reduced each year by depreciation, whereas actual cash profits are affected only when cash payments for purchases of assets are made" "Straight Line Depreciation Method - CORRECT ANSWER Under US GAAP and IFRS, most companies choose to depreciate assets evenly over their useful lives Under this method, the depreciable cost of an asset is spread evenly over the asset's estimated useful life Annual depreciation expense = (Original cost - salvage value) / Useful life Original Cost = Original cost of the asset Salvage (Residual) Value = The asset's estiamted salvage at the time of disposal Depreciable Cost = Original cost - Salvage value Useful Life = Total years the asset is expected to remain in service" "Balance Sheet & Depreciation - CORRECT ANSWER The balance sheet tracks the book value of a depreciable asset and the accumulated depreciation The ending book value is simply the salvage value, and it sits there until the asset is sold or retired" "Accelerated Depreciation Method - CORRECT ANSWER Methods that calculate a greater amount of depreciation in earlier years than later years Common Methods: Declining balance Sum of years digits Units of production" "Why do companies prefer straight line depreciation? - CORRECT ANSWER " "Amortization Expense - CORRECT ANSWER The allocation of the cost of intangible assets over the number of years that these assets are expected to help generate revenue for the company Conceptually similar to depreciation and often lumped in with depreciation as Depreciation & Amortization Like with fixed assets, when a company purchases an intangible asset from which it expects to generate benefits over future periods, the cost of the asset is spread over that particular asset's useful life in the form of amortization expense Note: Trademarks and goodwill are not amortized" "Amortization is a Non-Cash Expense - CORRECT ANSWER Amortization does not depict any actual cash outflow (payment), like depreciation The only difference between depreciation and amortization is that depreciation refers to fixed assets, while amortization refers to acquired intangible assets" "Internally-Generated Intangible Assets - CORRECT ANSWER Expenses associated with internally developing intangible assets like patents, customer lists, trademarks are expensed fully as they are incurred (no amortization) Since companies are not allowed to write up the value of intangible assets (historical cost and conservatism), companies with very valuable trademarks and patents (Coke, GE, Apple) do not recognize or amortize these assets Intangible assets on the balance sheet that are amortized are mostly acquired assets" "Amortization & Depreciation Exercise - CORRECT ANSWER Salaries are NOT depreciated! Trademarks that are ACQUIRED are never expensed, like land" "Treasury Stock - CORRECT ANSWER Shares that have been issued but subsequently repurchased by the company; they are no longer outstanding Why Repurchase Stock? Boost EPS (repurchase of shares reduces total shares outstanding) or change the company's capital structure (more debt/less equity) What Happens? The company either goes into the open market and buys the shares at the current share price, or through negotiation with specific shareholders Impact on Share Count: Basic shares outstanding are reduced; Basic shares outstanding = Total shares issued less shares repurchased Note: Treasury stock is a contra equity account to capture the value of common stock that was once issued but then repurchased by the company" "Shares Outstanding - Basic vs. Diluted - CORRECT ANSWER Basic includes only the actual shareholders Diluted includes the impact of potentially dilutive security holders that expand the share base, like stock option holders and preferred shareholders that can convert their preferred shares to common stock" "Dilutive Securities - CORRECT ANSWER Securities that can be converted into common stock Includes: Stock options & warrants (the right to buy shares at predetermined price); convertible preferred stock; convertible debt" "Earnings Per Share (EPS) - CORRECT ANSWER Common way to analyze profits by dividing net income