Key Accounting Principles and Financial Ratios
Accounting information helps users evaluate the amount, timing, and uncertainty.
Key Accounting Principles
- Relevance: Pertinent to the decision at hand.
- Predictive Value: Information is useful in predicting the future.
- Confirmatory Value: Information confirms expectations.
- Materiality: Concerns the relative size of an item and its effect on decisions.
- Faithful Representation: Agreement between the measure and the phenomenon it purports to represent.
- Completeness: Includes all information necessary for faithful representation.
- Neutrality: Implies that financial accounting standards are free from bias.
- Free from Error: Information has no errors or omissions (not excluding anything).
- Comparability: Important for making inter-firm comparisons.
- Consistency: Applying the same accounting practices over time.
- Verifiability: Implies consensus among different measures.
- Timeliness: Information is available prior to the decision.
- Understandability: Users understand information in the context of the decision being made.
- Cost Effectiveness: Benefits exceed costs of sharing information with external users.
Key Accounting Concepts
- Recognition: Process of admitting information into statements.
- Comprehensive Income: Change in equity from non-owner transactions.
- Distribution to Owners: Decrease in equity resulting from transfers to owners.
- Earnings Quality: Ability of reported earnings to predict a company’s future earnings.
- Permanent Earnings: Anticipated/expected income over a long time period.
- Transitory Earnings: Unexpected income fluctuations (e.g., lottery).
- Discontinued Operations: Operating segment that either has been disposed of or is classified as held for sale and represents a major business line or geographical area of operations.
Key Financial Ratios
- Basic EPS: (Net Income – Preferred Dividends) / Weighted Average Number of Common Shares Outstanding for Period
- Diluted EPS: (Net Income – Preferred Dividends) / (Weighted Average Number of Common Shares Outstanding for Period + Diluted Securities)
- Net Profit Margin: Net Income / Revenue
- Gross Profit Margin: Gross Profit / Revenue
- Operating Profit Margin: Operating Profit / Revenue
- Pretax Profit Margin: Pretax Profit / Revenue
- Cash Ratio: (Cash + Marketable Securities) / Current Liabilities
- Quick/Acid Test: (Cash + Marketable Securities + Receivables) / Current Liabilities
- Current Ratio: Current Assets / Current Liabilities
- ROE: Net Income/ Average Equity = Net Income / Average Assets x Average Assets / Average Equity = ROA x Leverage
- ROA: Net Income / Average Assets = Net Income / Revenue x Revenue / Average Assets
- Inventory Turnover: COGS/ Average Inventory
- Receivables Turnover: Revenue/ Average Receivables
- Payables Turnover: (COGS + Net Change in Inventory) / Average Trades Payables
- Days of X: 365/ X Ratio
- Cash Conversion/Net Operating Cycle: Days Receivables + Days Inventory Held – Days of Payables
Four Approaches to Expense Recognition
- Based on exact cause and effect relationships (e.g., COGS).
- Associating an expense with revenues recognized in a specific time period (e.g., salaries).
- By a systematic and rational allocation to specific time periods (e.g., depreciation and amortization).
- In the period incurred, without regard to related expenses (e.g., advertising).
Five Types of Measurement
- Historical Costs: Original transaction value.
- Net Realizable Value: Estimated amount of cash into which the asset/liability will be converted (e.g., A/R).
- Current Cost: Cost that would be incurred to purchase or reproduce the asset (e.g., inventories are valued at lower of cost or market).
- Present Value: Discounted future cash flows (e.g., bonds).
- Fair Value: Current market value (e.g., trading securities).
*If market value is not available, use a) value of similar assets or b) derived value based on pricing models.
GAAP vs. IFRS
-GAAP hierarchy is Congress, SEC, private sector (CAP, APB, now FASB).
