Financial Accounting Glossary by Lie Dharma Putra [Part 3]

DIVIDEND PAYOUT RATIO – This ratio is computed by dividing total cash dividends for the year by the net income for the year. It’s simply the percent of annual net income distributed as cash dividends for the year.

DIVIDEND YIELD RATIO –  This ratio equals the cash dividends per share paid by a business over the most recent 12 months [called the trailing 12 months] divided by the current market price per share of the stock. This ratio is reported in the daily stock trading tables in the Wall Street Journal and other major newspapers.

 

EARNINGS BEFORE INTEREST AND INCOME TAX [EBIT] – This measure of profit equals sales revenue for the period minus cost of goods sold expense and all operating expenses—but before deducting interest and income tax expenses. It is a measure of the operating profit of a business before considering the cost of its debt capital and income tax.

EARNINGS PER SHARE [EPS] – See basic earnings per share; diluted earnings per share

 

EQUITY – This term refers to one of the two basic sources of capital to a business [the other being debt or borrowed money]. Most often it is called owners’ equity because it refers to the capital used by a business that “belongs” to the ownership interests in the business. Owners’ equity arises from two quite distinct sources: capital invested by the owners in the business, and profit [net income] earned by the business that has not been distributed to its owners [which is called retained earnings]. Owners’ equity in our highly developed and sophisticated economic and legal system can be very complex—involving stock options, financial derivatives of all kinds, different classes of stock, convertible debt, and so on.

EXTRAORDINARY GAINS AND LOSSES – No pun intended, but these gains and losses are extraordinarily important to understand. These are nonrecurring, one-time, unusual nonoperating gains or losses that are recorded by a business during the period. The amount of each of these gains or losses, net of the associated income tax effect, is reported separately in the income statement. Net income is reported before and after these gains and losses. These gains and losses should not be recorded very often; but, in fact, many businesses record them every other year or so, which causes much consternation to investors. In addition to evaluating the regular stream of sales and expenses that yield operating profit, investors also have to factor into their profit analysis these irregular gains and losses reported by a business.

 

FINANCIAL CONDITION, STATEMENT OF  [See balance sheet financial leverage] –  The equity [ownership] capital of a business serves as the basis for securing debt capital [borrowed money]. In this way a business increases the total capital available to invest in assets and can make more sales and more profit. The strategy is to earn operating profit, or earnings before interest and income tax [EBIT], on the capital supplied from debt that is more than the interest paid on the debt capital. A financial leverage gain equals the EBIT earned on debt capital minus the interest on the debt. A financial leverage gain augments earnings on equity capital. A business must earn a rate of return on its assets [ROA] that is greater than the interest rate on its debt to make a financial leverage gain. If the spread between its ROA and interest rate is unfavorable, a business suffers a financial leverage loss.

FINANCIAL REPORTS AND STATEMENTS – Financial means having to do with money and economic wealth. Statement means a formal presentation. Financial reports are printed, and a copy is sent to each owner and to each major lender of the business [unless the lender doesn’t want a copy]. Today, public corporations make their financial reports available on a Web site, so all or part of the financial report can be downloaded by anyone. Businesses prepare three primary financial statements: [1] the statement of financial condition, or balance sheet; [2] the statement of cash flows; and [3] the income statement. The income statement is often called a P&L [profit and loss] report, especially inside a business. These three key financial statements constitute the core of the periodic financial reports that are distributed outside a business to its shareowners and lenders. Financial reports also include footnotes to the financial statements and much other information. Financial statements are prepared according to generally accepted accounting principles [GAAP], which are the authoritative rules that govern profit measurement and the reporting of profit-making activities, financial condition, and cash flows. Internal financial statements, although based on the same profit accounting methods, report more information to managers for their decision making and control. Sometimes, financial statements are called simply financials.

 

FINANCING ACTIVITIES – This term refers to one of the three classes of cash flows reported in the statement of cash flows. This class includes borrowing money and paying debt, raising money from shareowners and the return of money to them, and dividends paid from profit.

FIRST-IN, FIRST-OUT [FIFO] – This is one of the two popular accounting methods to measure cost of goods sold during a period and the cost of ending inventory. It is both an expense measurement and an asset-valuation method; you can’t separate these two aspects. The first costs of purchasing or manufacturing products are the first costs charged out to record cost of goods sold expense. Thus, the most recent costs of acquisition remain in the inventories asset account [until the goods are sold sometime later]. To offer a simple example, suppose a business bought two units of a new product during the year. The first unit cost $100 and the second unit, which was purchased sometime later, cost $105. The business sold one of the two units. FIFO assigns $100 to cost of goods sold expense and $105 to the cost of ending inventory. See also last-in, first out [LIFO—which uses the same facts but gives different results].

 

FIXED ASSETS – This is an informal term used to refer to the variety of long-term operating resources used by a business—real estate, machinery, equipment, tools, vehicles, office furniture, computers, and so on. In balance sheets, these assets are typically labeled property, plant, and equipment. The term fixed assets captures the idea that the assets are relatively fixed in place and are not held for sale in the normal course of business. The cost of fixed assets, except land, is depreciated, which means the cost is allocated to expenses over the estimated useful lives of the assets.

FIXED COSTS – These are expenses or costs that remain relatively constant in amount, or fixed, over the short run. These costs do not vary with changes in sales volume or sales revenue or other measures of business activity. Over the long run, however, these costs are raised or lowered as the business grows or declines. Fixed operating costs provide capacity to carry on operations and to make sales. Fixed manufacturing overhead costs provide production capacity – Fixed expenses are a pivot point for analyzing profit behavior, especially in determining the breakeven point and in analyzing strategies for improving profit performance.

 

FREE CASH FLOW – Most often this term refers to cash flow from profit [cash flow from operating activities]. The underlying idea is that a business is free to do what it wants with its cash flow from profit. However, a business usually has many ongoing commitments and demands on this cash flow, so it may not actually be free in deciding what do with this source of cash. Caution: This term is not officially defined anyplace, and different people use the term with different meanings. Pay particular attention to how an author or a speaker is using the term. generally accepted accounting principles [GAAP] This term refers to the body of authoritative rules and standards for measuring profit and preparing financial statements that are included in financial reports by a business to its outside shareowners and lenders. The development of these standards has been an ongoing, evolving process for more than 70 years. Congress passed a law in 1934 that bestowed primary jurisdiction over financial reporting by publicly owned businesses to the Securities and Exchange Commission [SEC]. But the SEC has by and large left the development of GAAP to the private sector. Presently the Financial Accounting Standards Board [FASB] is the primary but not the only authoritative body that makes pronouncements on GAAP. One caution: GAAP are like a moveable feast. New rules are issued fairly frequently, old rules are amended from time to time, and some rules established years ago are discarded on occasion. Professional accountants have a heck of time keeping up with GAAP, that’s for sure. New GAAP rules sometimes have the effect of closing the barn door after the horse has left. Accounting abuses occur, and then, after the damage has been done, new rules are issued to prevent such abuses in the future.

GROSS MARGIN [ALSO CALLED GROSS PROFIT] – This first-line measure of profit equals sales revenue less cost of goods sold. This is profit before operating, interest, and income tax expenses are deducted. Financial reporting standards require that gross margin be reported in external income statements. Gross margin is a key variable in management profit reports for decision making and control. Gross margin doesn’t apply to service businesses that don’t sell products.

 

INCOME STATEMENT – This financial statement summarizes sales revenue and expenses for a period and reports one or more profit lines for the period. It also reports any other gains and losses for the period. It is one of the three primary financial statements of a business. The bottom-line profit figure is labeled net income or net earnings by most businesses. Externally reported income statements disclose less information than do internal management profit reports—but both are based on the same profit accounting principles and methods. Profit is not known until accountants complete the recording of sales revenue and expenses for the period [as well as determining whether any extraordinary gains and losses should be recorded]. Profit measurement depends on the reliability of a business’s accounting system, the choices of accounting methods by the business, and the end-ofperiod adjusting entries recorded by the business. Caution: A business may engage in certain accounting manipulations; managers may intervene in the normal course of operations for the purpose of improving the amount of profit recorded in the period, which is called massaging the numbers, earnings management, or income smoothing. internal accounting controls – This refers to forms and procedures established by a business [which go beyond what would be required for the record keeping function of accounting] that are designed to prevent accounting errors and fraud. Two common examples of internal controls are [1] requiring a second signature by someone higher in the organization to approve a transaction in excess of a certain dollar amount, and [2] giving customers printed receipts as proof of sale. Other examples of internal control procedures are restricting entry and exit routes of employees, requiring all employees to take their vacations and assigning another person to do their jobs while they are away, surveillance cameras, surprise counts of cash and inventory, and rotation of duties. Internal controls should be cost-effective; the cost of a control should be less than the potential loss that is prevented. The guiding principle for designing internal accounting controls is to deter and detect errors and dishonesty. The best internal controls in the world cannot prevent most fraud by high-level managers who take advantage of their positions of trust and authority.

INTERNAL RATE OF RETURN [IRR] – This term refers to the precise discount rate that makes the present value [PV] of the future cash returns from a capital investment exactly equal to the initial amount of capital invested. If IRR is higher than the company’s cost of capital rate, the investment is an attractive opportunity; if IRR is less, the investment is substandard from the cost of capital point of view.

 

Other glossaries:

[Financial Accounting Glossary Part 1 – ACCOUNTING]
[Financial Accounting Glossary Part 2 – CAPITAL]
[Financial Accounting Glossary Part 4 – INVENTORY TURNOVER RATIO]
[Financial Accounting Glossary Part 5 – PROFIT]

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

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