Accounting 2 Exam Terms

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1. Amortisation vs depreciation vs

impairment

Amortisation is:

1. a routine decrease in value of an intangible asset, or the process of paying off a debt over time through regular payments.

2. Recorded as a reduction in book value of the intangible asset (Balance Sheet) & as an expense (Income Statement).

A corresponding concept for tangible assets is known as depreciation which is:

1.When a company spreads the cost of an asset over the period of its 'useful life'.

Impairment: If the undiscounted future cash flows from the asset (including the sale amount) are less than the asset's carrying amount, an impairment loss must be reported. If the impairment loss must be reported, the amount of the impairment loss is measured by subtracting the asset's fair value from its carrying value.

Loss of value of a company's capital stock (fixed assets & intangibles). Reduces value on company books and usually perceived as negative

2. Associate company vs subsidiary

Associate: a company whose parent company only possesses a minority stake in the ownership of the company. (In which another company owns a significant portion of voting shares, usually 20–50%.) In this case, an owner does not consolidate the associate company's financial statements.

Subsidiary: a company whose parent is a majority shareholder. A company whose voting stock is more than 50% controlled by another company, usually referred to as the parent company or holding company. A subsidiary is a company that is partly or completely owned by another company that holds a controlling interest in the subsidiary company

3. Average collection/payment period

The approximate amount of time that it takes for a business to receive payments owed, in terms of receivables, from its customers and clients.

Calculated as: Days x AR / Credit Sales

Where:

Days = Total amount of days in period

AR = Average amount of accounts receivables

Credit Sales = Total amount of net credit sales during period

4. Big bath

Earnings management technique whereby a one-time charge is taken against income in order to reduce assets, which results in lower expenses in the future. The write-off removes or reduces the asset from the financial books and results in lower net income for that year.The strategy of manipulating a company's income statement to make poor results look even worse.

The big bath is often implemented in a bad year to enhance artificially next year's earnings.

The big rise in earnings might result in a larger bonus for executives. New CEOs sometimes use the big bath so they can blame the company's poor performance on the previous CEO and take credit for the next year's improvements.

5. Consolidated

Combined financial statements of a parent company & it's susidiaries. Allows shareholders to see how well an entire enterprise is performing

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1. Creative accounting; earnings management;

off balance sheet financing; window-dressing

Accounting practices that follow required laws and regulations, but deviate from what those standards intend to accomplish. Creative accounting capitalizes on loopholes in the accounting standards to falsely portray a better image of the company. Although creative accounting practices are legal, the loopholes they exploit are often reformed to prevent such behaviors.

Off Balance Sheet Financing - A form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low

Operating leases are one of the most common forms of off-balance-sheet financing. In these cases, the asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset.

2. Credit risk

Before offering credit to a borrower, financial institutions assess the borrower's ability to repay the loan on time. Credit scores & bond ratings measure such risk.

3. Currency risk

Currency risk is the potential risk of loss from fluctuating foreign exchange rates when an investor has exposure to foreign currency or in foreign-currency-traded investments.

4. Current ratio (vs. Liquid/quick/acid test

ratio)

The current ratio is a financial ratio that shows the proportion of current assets to current liabilities. The current ratio is used as an indicator of a company's liquidity.

5. Defined benefit (vs defined contribution)

pension scheme

Traditional pension plan funded & managed entirely by the company that calculates retirement benefits based on Years of service + Salary History, rather than depending directly on individual investment returns.

Not as portable (cannot be transferred if you change jobs) or flexible as a Defined Contribuition Plan (401K).

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1. Dividend cover

Net Profit divided by required dividend payments: Measures a company's ability to pay off its required dividend payments.

A healthy company will have a high coverage ratio, indicating that it has little difficulty in paying off its dividend requirements.

2. Fair value (vs historic cost, replacement

cost)

Fair value: a rational and unbiased estimate of the potential market price of a good, service, or asset

Historic Cost: the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company

Replacement Cost: the cost to replace the assets of a company or a property of the same or equal value.

3. Finance lease (vs operating lease)

A lease considered to have the economic characteristics of asset ownership.

A financial lease would be considered a purchased asset for accounting purposes. An operating lease, on the other hand, would be handled as a true lease, or rental, for accounting purposes. The choice of lease classification will have important results on a firm's financial statements. Both types of leases provide specific advantages and disadvantages to financial statements. For example, companies wishing to show a higher return on asset ratios would choose an operating lease, as the balance sheet would not account for the item as an asset, thus reducing the denominator in the ratio.

4. Gearing/leverage

Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds.

5. Gearing ratio

This is a ratio that compares some form of owner's equity (or capital) to borrowed funds.

A company with high gearing (high leverage) is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is seen as a measure of financial strength.

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1. Impairment

A company's asset that is worth less on the market than the value listed on the company's balance sheet.

2. (In)solvent

Insolvency: the value of a company's liabilities exceeds its assets

When an individual or organization can no longer meet its financial obligations with its lender or lenders as debts become due.

Insolvency can lead to insolvency proceedings, in which legal action will be taken against the insolvent entity, and assets may be liquidated to pay off outstanding debts.

Solvency: having enough funds or liquid assets to pay all of one's debts

3. Leasing

One party agrees to rent property from another party.

A lease guarantees the lessee (the renter) use of an asset and guarantees the lessor (the property owner) regular payments from the lessee for a specified number of months or years. Both the lessee and the lessor must uphold the terms of the contract for the lease to remain valid.

4. Limited liability

If a business owner has "limited liability," it means that he or she is not personally responsible for business debts and obligations of the corporation.

In other words, if the corporation is sued, only the assets of the business are at risk, not the owners' (shareholders) personal assets, such as their houses or cars.

5. Liquidity

A business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets (cash). OR an asset's ability to be sold without causing a significant movement in the price & w/ min loss of value.

6. Liquidity risk

Liquidity risk is the risk that a company or bank may be unable to meet short term financial demands. This usually stems from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss.

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1. Loan (vs hire purchase, vs lease, vs overdraft)

Loan: The act of giving money, property or other material goods to a another party in exchange for future repayment of the principal amount along with interest.

Hire Purchase: A method of buying goods through making installment payments over time. The term hire purchase originated in the U.K., and is similar to what are called "rent-to-own" arrangements in the United States. Under a hire purchase contract, the buyer is leasing the goods and does not obtain ownership until the full amount of the contract is paid.

Lease: The lessee is guaranteed use of an asset in exchange for giving the lessor regular payments for a specified number of months or years.

Overdraft: An extension of credit from a lending institution when an account reaches zero.

2. Mark to market

Refers to accounting for the value of an asset or liabiliy based on the current market price instead of book value. Mark to market aims to provide a realistic appraisal of a company's current financial situation.

3. Off balance sheet finance

An asset or liability that does not appear on a company's balance sheet. Items that are considered off balance sheet are generally ones in which the company does not have legal claim or responsibility for.

4. Provision

A provision is the amount of an expense that an entity elects to recognize now, before it has precise information about the exact amount of the expense. Money is put aside in the accounts to cover a future liability.

5. Times interest earned

A metric used to measure a company's ability to meet its debt obligations. It is calculated by taking EBIT and dividing it by the total interest payable (bonds & debt). It is usually quoted as a ratio and indicates how many times a company can cover its interest charges on a pretax basis. Failing to meet these obligations could force a company into bankruptcy.