Chapter 3 - Learning Objectives

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Chapter 3 - Learning Objectives

Discuss generally accepted accounting principles (GAAP) and their importance to the economy

GAAP are a set of authoritative guidelines that define accounting practices at a particular point in time. The principles determine the rules for how a company maintains its accounting system and how it prepares financial statements. Accounting standards are important because without them each firm could develop its own unique accounting practices. This would make it difficult for anyone to monitor the firm's true performance or compare the performance off different firms. The result would be a loss of confidence in the accounting system and the financial reports it produces. Fundamental accounting principles include that transactions are arm'-length, the cost principle, the realisation principle, the matching principle, and the going concern assumption.

Explain the balance sheet identity and why a balance sheet must balance

A balance sheet provides a summary of a firm's financial position at a particular point in time. It identifies the productive resources (assets) that a firm uses to generate income, as well as the sources of funding from creditors (liabilities) and owners (stockholders' equity) that were used to buy the assets. The balance sheet identity is Total assets = Total liabilities + Total stockholders' equity. Stockholders' equity represents ownership in the firm and is the residual claim of the owners after all other obligations to creditors, employees, and vendors have been paid. The balance sheet must always balance because the owners get what is left over after all creditors have been paid - that is, Total stockholders' equity = Total assets - Total liabilities

Describe how market-value balance sheets differ from book-value balance sheets

Book value is the amount a firm paid for its assets at the time of purchase. The current market value of an asset is the amount that a firm wold receive for the asset if it were sold on the open market (not in a forced liquidation). Most managers and investors are more concerned about what a firm's assets can earn in the future than about what the assets cost in the past. Thus, marked-to-market balance sheets are more helpful in showing a company's true financial condition than balance sheets based on historical costs. Of course, the reason that marked-to market balance sheets are not commonly used is that it is difficult to estimate market values for some assets and liabilities

Identify the basic equation for the income statement and the information it provides

An income statement presents a firm's profit or loss for a period of time, usually a month, quarter, or year. The income statement identifies the major sources of revenues generated by the firm and the corresponding expenses needed to generate those revenues. The equation for the income statement is Net Income = Revenues - Expenses. If revenues exceed expenses, the firm generates a net profit for the period. If expenses exceed revenues, the firm generates a net loss. Net profit or net income is the most comprehensive accounting measure of a firm's performance

Understand the calculation of cash flows from operating, investing, and financing activities required in the statement of cash flows

Cash flows from operating activities in the statement of cash flows are the net cash flows that are related to a firm's principal business activities. The most important items are the firm's net income, depreciation and amortization expense, and working capital accounts (other than cash and short-term debt obligations, which are classified elsewhere). Cash flows from long-term investing activities related to the buying and selling of long-term assets. Cash flow from financing occur when cash is obtained from or repaid to creditors or owners (stockholders). Typical financing activities involve cash received from the issuance of common or preferred stock, as well as cash from bank loans, notes payable, and long-term debt. Cash payments of dividends to stockholders and cash purchases of treasury stock reduce a company's cash position

Explain how the four major financial statements discussed in this chapter are related

The four financial statements discussed in the chapter are the balance sheet, e income statement, the statement of cash flows, and the statement of retained earnings. The key financial statement that ties together the other three statements is the statement of cash flows, which summarises changes in the balance sheet from the beginning of the year to the end. These changes reflect the information in the income statement and in the statement of retained earnings

Identify the cash flow to a firm's investors using its financial statements

Cash flow to investors is the cash flow that a firm generates in a given period (cash receipts less cash payments and investments)excluding cash inflows from new equity sales or long-term debt issues. Cash flow to investors is the cash flow in a given period that is used to meet the firm's obligations to its debt holders and that is distributed to its equity investors, which in turn defines the value of their investments in the firm over time. The cash flow to investors is calculated as the cash flow to investors from operating activity, minus the cash flow invested in net working capital, minus the cash flow invested in long-term assets

Discuss the difference between average and marginal tax rates

The average tax rate is computed by dividing the total taxes by taxable income. It takes into account the taxes paid at all levels of income and will normally be lower that the marginal tax rate, which is the rate that is paid on the last dollar of income earned. However, for very high income earners, these two rates can be equal. When companies are making financial investment decisions, they use the marginal tax rate because new projects are expected to generate additional cash flow, which will be taxed at the firm's marginal tax rate