Essential Accounting Terms E - H: A Comprehensive Guide
Explore key accounting terms from E to H, crucial for Canadian Accounting Exams. Enhance your understanding with definitions, examples, and applications.
18.2 Key Accounting Terms E - H§
In this section, we delve into essential accounting terms beginning with the letters E through H. Understanding these terms is crucial for anyone preparing for Canadian accounting exams, as they form the foundation of many accounting principles and practices. This comprehensive guide will provide clear definitions, practical examples, and insights into how these terms are applied in the real world, particularly within the Canadian accounting context.
Earnings Per Share (EPS)§
Definition: Earnings Per Share (EPS) is a financial metric that indicates the portion of a company’s profit allocated to each outstanding share of common stock. It is a key indicator of a company’s profitability and is often used by investors to assess financial performance.
Formula:
Example: If a company has a net income of $1,000,000, preferred dividends of $100,000, and 450,000 average outstanding shares, the EPS would be calculated as follows:
Application: EPS is used by investors to gauge a company’s profitability on a per-share basis, making it easier to compare with other companies. It is also a critical component in calculating the Price-to-Earnings (P/E) ratio, which helps in investment decision-making.
Equity§
Definition: Equity represents the ownership interest in a company. It is the residual interest in the assets of the entity after deducting liabilities. In the context of financial statements, equity is often referred to as shareholders’ equity or owners’ equity.
Components of Equity:
- Common Stock: Represents ownership in a company and a claim on a portion of profits.
- Preferred Stock: A type of stock with a fixed dividend, having priority over common stock in dividend payments.
- Retained Earnings: Cumulative net income retained in the company rather than paid out as dividends.
- Additional Paid-In Capital: The excess amount paid by investors over the par value of stock.
Example: If a company has total assets of $500,000 and total liabilities of $300,000, the equity would be:
Application: Equity is a critical measure of a company’s financial health and is used by investors to assess the net worth of a business. It also plays a vital role in determining the company’s capital structure.
Expense§
Definition: An expense is the cost incurred in the process of generating revenue. Expenses are deducted from revenue to determine net income and are recorded on the income statement.
Types of Expenses:
- Operating Expenses: Costs related to the core operations of a business, such as rent, utilities, and salaries.
- Non-Operating Expenses: Costs not directly tied to core business operations, such as interest expenses and losses from asset sales.
Example: A company incurs $5,000 in rent, $2,000 in utilities, and $3,000 in salaries. These are recorded as operating expenses on the income statement.
Application: Understanding expenses is crucial for managing a company’s profitability. Accurate expense tracking helps in budgeting and financial planning, ensuring that resources are allocated efficiently.
Fair Value§
Definition: Fair value is the estimated price at which an asset or liability could be exchanged in an orderly transaction between market participants at the measurement date.
Application in Financial Reporting: Fair value is used in financial reporting to provide a more accurate reflection of an asset’s current worth. It is particularly important in the valuation of financial instruments, investment properties, and biological assets.
Example: A company owns a piece of land purchased for $100,000. The current market value of similar land is $150,000. The fair value of the land would be reported as $150,000 in financial statements.
Regulatory Framework: In Canada, fair value measurement is guided by International Financial Reporting Standards (IFRS), specifically IFRS 13, which provides a framework for measuring fair value and requires disclosures about fair value measurements.
Fixed Assets§
Definition: Fixed assets, also known as tangible assets or property, plant, and equipment (PP&E), are long-term assets used in the production of goods and services. They are not expected to be converted into cash within a year.
Examples of Fixed Assets:
- Land
- Buildings
- Machinery
- Vehicles
Depreciation: Fixed assets are subject to depreciation, which allocates the cost of the asset over its useful life.
Example: A company purchases machinery for $50,000 with an expected useful life of 10 years. The annual depreciation expense would be calculated using the straight-line method:
Application: Fixed assets are crucial for a company’s operations and are reported on the balance sheet. Proper management and valuation of fixed assets are essential for accurate financial reporting and tax compliance.
Going Concern§
Definition: The going concern principle assumes that a company will continue its operations into the foreseeable future and has no intention or need to liquidate its assets.
Implications for Financial Reporting: The going concern assumption affects the valuation of assets and liabilities. If a company is not considered a going concern, assets may need to be valued at liquidation value rather than historical cost.
Example: A company facing severe financial difficulties may not be considered a going concern, leading to adjustments in asset valuations and financial statement disclosures.
Regulatory Considerations: Auditors assess a company’s ability to continue as a going concern during the audit process. In Canada, this assessment is guided by the Canadian Auditing Standards (CAS) and International Standards on Auditing (ISA).
Goodwill§
Definition: Goodwill is an intangible asset that arises when a company acquires another business for a price higher than the fair value of its identifiable net assets. It represents the value of a company’s brand, customer relationships, and other intangible factors.
Calculation:
Example: A company acquires another company for $1,000,000. The fair value of the acquired company’s assets is $800,000, and liabilities are $200,000. The goodwill is calculated as follows:
Impairment Testing: Goodwill is subject to annual impairment testing to ensure its carrying value does not exceed its recoverable amount.
Application: Goodwill is reported on the balance sheet and is an important consideration in mergers and acquisitions. It reflects the premium paid for acquiring a business and its potential for future earnings.
Gross Profit§
Definition: Gross profit is the difference between revenue and the cost of goods sold (COGS). It represents the profit a company makes from its core business activities before deducting operating expenses, taxes, and interest.
Formula:
Example: A company generates $500,000 in revenue and incurs $300,000 in COGS. The gross profit is calculated as follows:
Application: Gross profit is a key indicator of a company’s operational efficiency and pricing strategy. It is used to assess the profitability of core business activities and is reported on the income statement.
Historical Cost§
Definition: Historical cost is the original monetary value of an asset or liability at the time of acquisition. It is a fundamental accounting principle that provides a consistent and reliable basis for financial reporting.
Application: Historical cost is used in the valuation of assets and liabilities on the balance sheet. It provides a stable measure of value, unaffected by market fluctuations.
Example: A company purchases equipment for $20,000. The historical cost of the equipment remains $20,000, regardless of changes in market value.
Limitations: While historical cost provides consistency, it may not reflect the current market value of an asset, leading to potential discrepancies in financial reporting.
Human Capital§
Definition: Human capital refers to the economic value of an employee’s skill set, knowledge, and experience. It is considered an intangible asset that contributes to a company’s productivity and competitive advantage.
Application: Human capital is not recorded on the balance sheet but is a critical factor in strategic planning and decision-making. Companies invest in training and development to enhance their human capital.
Example: A company invests in employee training programs to improve skills and increase productivity, thereby enhancing its human capital.
Relevance in Accounting: While not directly reported in financial statements, human capital is a key consideration in assessing a company’s long-term growth potential and sustainability.
