Accounting Basics
Key accounting concepts including amortization, SG&A, operating income, and capital allocation.
Amortization of Intangibles
The process of expensing the cost of an intangible asset over the projected life of the asset for tax or accounting purposes.
Intangible Asset: an identifiable non-monetary asset without physical substance, namely:
- Brands
- Goodwill - associated with the purchase of one company by another. Specifically, goodwill is the portion of the purchase price that is higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process. Can be comprised of things like:
- Having a good relationship with customers
- Having a good relationship with employees
- Having a solid customer base
- Trademarks
- Patents
- Knowledge
For intangible assets that are the result of contractual or legal rights, including patents, licenses, trademarks, franchise and servicing rights, CPAs should ask whether the company intends and is able to renew or extend the contract; whether there are substantial costs associated with renewal; and whether there will be any material modifications to existing contract terms. This will help determine whether the benefits of the asset for amortization purposes will continue beyond the contract period.
SG&A
Selling, General & Administrative Expenses
Include all everyday operating expenses of running a business that are not included in the production of goods or delivery of services.
Fiscal Year vs Calendar Year
A fiscal year does not necessarily follow the calendar year.
The United States government's FY starts on October 1 and ends on Sep 30.
A good practice of accounting principle suggests closing the FY at the low point of business activity. For example, agricultural companies often end their FY right after harvest season. Another example is consumer retail - they have their busiest season in December and January; therefore, they often have their FY end as of Jan 31.
In financial modeling, when performing company valuation, it's important to normalize financials on FY end. For this reason, analysts typically use a metric called Last Twelve Months (LTM). Likewise, Trailing 12 months is a term used to describe the past 12 consecutive months of a company's performance data.
Operating Income
A.k.a. operating profit or recurring profit.
Similar to EBIT (earnings before interest and taxes), but different because EBIT also includes non-operating income, such as dividend income, losses from investments, gains/losses incurred by foreign exchange and asset write-downs. This is important because a company can actually have done a poor job at turning its revenue into profit and conceal it with non-core business activities or could otherwise use profits from non-core business activities to inflate their ability to turn revenue into profit.
The profit realized from a business's operations, after deducting operating expenses such as wages and depreciations.
It takes a company's gross income (gross/total revenue minus COGS) and subtracts all operating expenses (office supplies, utilities).
Does not include one-off items like taxes that may skew the company's profit in a given year.
As opposed to Non-operating income (incidental or peripheral income) which comes from activities not related to the core business operation.
Asset Write-down
The reduction in the book value of an asset when its FMV has fallen below the carrying book value.
Expenses vs Expenditures
Expense - reduction in value of an asset as it is used to generate revenue
Expenditure - a payment or the incurrence of a liability in exchange for goods or services
Some expenditures are expenses and others aren't. A car, for instance, will depreciate for 10 years or so. So, each year the company incurs a depreciation expense. However, the expenditure for the capital for the car is paid in one year.
Put another way, the key difference between an expense and an expenditure is that an expense recognizes the consumption of a cost, while an expenditure represents the disbursement of funds.
As such, expenditures appear on the balance sheet, while expenses appear on the income statement.
OPEX & CAPEX
- CapEx - Capital expenditures (long term)
- OpEx - Operational expenditures (short term/day-to-day expenses)
Treasury Shares
A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market.
Capital Allocation
Where and how a corporation's CEO decides to spend the money that the company has earned. It's all about distributing and investing the company's financial resources in ways that will increase its efficiency and maximize its profits.
Options include (but not limited to):
- Dividends (returning cash to investors)
- Repurchasing shares of stock from investors
- Increasing R&D
- Sit on it/invest it externally
For example, Apple's capital allocation in 2015 (in order of magnitude):
- Corporate securities
- U.S. Treasury securities
- Mortgage- and asset-backed securities
- Cash
- Non-U.S. government securities
- U.S. agency securities
- Certificates of deposit and time deposits
- Commercial paper
- Mutual funds
- Money market funds
- Municipal securities