Financial Accounting
Chapter 1 –
4 Business Activities: plan, finance invest, and operate
2 Main Compulsory SEC Filings:
- 10-K: Annual audited report with 4 financial statements with explanatory notes and a
manager’s discussion and analysis (MD&A) of results.
o File within 60 (90) days of the year end for larger (smaller) companies
- 10-Q: quarterly unaudited report including summary versions of the four financial
statements and limited additional disclosures.
o File within 40 (45) days of the quarter end for larger (smaller) companies.
Required Financial Statements: Balance Sheet, Income Statement, Statement of Cash Flows,
Statement of Stockholder Equity, and a set of explanatory footnotes.
- Balance sheet reports on a financial position at a point in time.
- Income, Stockholder’s Equity and cash flows show financial position over a period of
time.
Balance Sheet reports assets/resources (what company owns) and sources of asset financing.
- 2 ways a company can finance assets: owner financing (equity) and non-owner financing
(liabilities/debt)
Investing = Nonowner Financing + Owner Financing
Assets = Liabilities + Equity
Return on Assets (ROA) = profitability (PM: Profit Margin) x productivity (AT: Asset
Turnover)
-orROA = Net Income/Average Assets
- ROA measures return from the perspective of the entire company. To earn a high
return, companies must both be profitable and manage assets to minimize the assets
invested
- Increase ROA by increasing profitability or by reducing assets invested to generate a
certain level of profitability
PM = Net Income/Sales
AT: Sales/Average Assets
Return on Equity (ROE) = Net Income/Average Stockholder’s Equity
- One measurement of how effective management has been in its role as stewards of the
capital invested by shareholders.
- Takes perspective of company’s shareholders and measures rate of return on
shareholder’s investment. Reflects both performance and how assets are financed.
- ROE is higher where there is more debt and less equity. Higher ROE = higher risk for
company.
Financial Accounting
5 factors that influence financial statements and determine competitive intensity:
- Industry competition – competition and rivalry raise the cost of doing business as
companies must hire and train workers, advertise products, r&d products, etc.
- Buyer power – buyers with strong bargaining power can extract price concessions and
demand a higher level of service and delayed payment terms; this reduces profits from
sales and the operating cash flows to sellers.
- Supplied power – suppliers with strong bargaining power can demand higher prices and
earlier payments, yielding adverse affects on profits and cash flow to buyers
- Product substitutes – as substitutes increase, sellers have less power to raise prices
and/or pass on costs to buyers; accordingly, threat of substitution places downward
pressure on profits of sellers.
- Threat of entry – new market entrants increase competition, to mitigate the threat,
companies expend money on activities such as new technologies, promotion, and
human development to erect barriers to entry and to create economies of scale
Retained Earnings = Cumulative Net Income – Dividends Paid Out
Dividend Paid Out = Net Income – Change in Retained Earnings Over Period
Computation of dividends
Beginning retained earnings, 2014............
$ 18,832
+ Net income...................................................
1,384
– Cash dividends.............................................
(?)
= Ending retained earnings, 2015.................
$ 18,861
CHAPTER 2
Expenses go on the Income Statement.
Balance Statement
When company manufactures good, it goes on balance sheet as an asset called inventory. When
the inventory is sold, it is transferred to income statement as an expense as cost of goods sold.
For equipment, as it’s used it depreciates. Equipment is an asset on the balance statement.
Depreciation goes on the income statement as an expense.
If a cost has a future benefit, it’s considered capitalized and goes on as an asset until it is
completely used, in which case, it is then expensed to the income statement. If no future benefit
(i.e. Advertising, Salaries, Fuel Charge), than it is not capitalized and immediately expensed to
the income statement.
To report an asset in the balance sheet, it must be owned/controlled by the company and it must
confer expected future economic benefits that result from a past transaction or event.
Financial Accounting
-
Current asset – assets used up or converted within one year
Long Term asset – assets used up or converted to cash over more than one year (ex:
property)
Assets listed in liquidity. So most liquid to least liquid.
Liabilities listed in order of maturity.
Net Working Capital = Current Assets – Current Liabilities
Cash Conversion Cycle is the number of days the company has its cash tied up in receivables and
inventories less the number of days of trade credit provided by company suppliers.
Cash Conversion Cycle = Avg. Days Sales Outstanding + Avg. Days Inventory Outstanding –
Avg. Days Payable Outstanding
Equity is also referred to as residual interest. Stockholder’s Equity:
- Contributed capital: common stock, additional paid-in capital, preferred stock, treasury
stock.
o Treasury Stock: amount the company paid to reacquire its common stock from
shareholders.
o Common stock has more ownership rights than preferred stock.
- Earned capital: Retained earnings, accumulated other comprehensive income or loss
o Retained earnings – accumulated net income that has not been distributed to
stockholders as dividends.
o Earned capital – cumulative net income (loss) that has been retained by the
company
Retained Earnings = beginning retained earnings + net income (or loss) – dividends = ending
retained earnings
Book value – the “value” of the company determined by GAAP.
Market value – market capitalization or market cap
- Book estimates at historic costs vs. Market estimates at current market prices
- GAAP excludes sources that cannot be reliably measured whereas market tries to value
these (morale, successful marketing, etc)
Market Value = number of outstanding common stock x stock price
Market-to-Book Ratio = market value / book value to total equity. -or- stock price per share /
book value or equity per share
Income Statement
Structure:
Revenues
Financial Accounting
-Cost of Goods Sold
Gross Profit
-Operating Expenses
Operating Profit
-Nonoperating expenses (+ nonoperating revenues)
-Income tax expense
Income from continuing operations
+/- discontinued operations, net of tax
= Net Income
Operating expenses include COGS, selling expenses, depreciation, and r&d
Non-operating expenses include interest expense, interest or dividend income, and gains or
losses from the sale of securities.
Revenue recognition principle – recognize revenues for goods and services provided to
customers at an amount expected to be received.
Expense recognition (matching) principle – recognize expenses when incurred.
Discontinued operations has 2 components: (1) net income (loss) from the segment’s business
activities prior to sale and (2) any gain or loss on the actual sale of the business.
Gross profit margin = gross profit / sales. Ex: buy product for $6, sell for $10. GPM = 10-6/10
= 40%
Margins for operating expenses = operating expense / sales
Statement of cash flows reports cash inflow and outflow from 3 primary activities: cash flows
from operating activities, cash flows from investing activities, and cash flows from financing
activities.
Chapter 3
Four Step Accounting Cycle – (1) record transactions in the accounting records. (2) prepare
accounting adjustments, which recognize a number of events that have occurred but that have not
yet been recorded. (3) prepare financial documents (4) close books in anticipation of a new
accounting cycle
T-Account – used to reflect the increases and decreases to individual accounts.
Journal Entries – also capture the effects of transactions. Journal entries reflect the increases and
decreases to accounts using the language of debits and credits. Debits on the left, credits on the
right.
4 types of accounting adjustments:
- Prepaid Expenses: reflect advance cash payments that will ultimately be expenses
Financial Accounting
-
Unearned Revenues: cash received from customers before any services are provided.
Accrued Expenses: expenses that incurred and cognized on the income statement even
when they are not yet paid in cash. Ex: wages owed
Accrued Revenues: revenues earned and recognized on the income statement even
though cash is not yet received. Ex: sales on credit and revenue earned under a long
term contract.
Order of preparing financial statements: (1) prepare income statement using income statement
accounts. It then uses the net income number and dividend information to update the retained
earnings account. (2) it prepares the balance sheet using the updated retained earnings account
along with the remaining balance sheet accounts. (3) it prepares the statement of stockholder’s
equity (4) it prepares the statement of cash account (and other sources).
Closing Process – also known as closing the books or zeroing out the temporary accounts by
transferring their ending balances to retained earnings.
Temporary accounts balances do not carry over to the next period. Temporary accounts include:
- Income statement accounts, revenues and expenses accounts, and dividend account
Permanent = balance sheet accounts that carry over
4 basic processes in the accounting cycle: (1) analyze transactions and prepare (and post) entries.
(2) prepare (and post) accounting adjustments (3) prepare financial statements (4) perform the
closing process
Chapter 4
Financial Leverage – second component of ROE, measures the degree to which the company
finances it assets with debt vs equity. Measured as the ratio of its assets with deb to vs equity.
- Increase in this ratio = increase in relative level of debt.
- Financial Leverage = average assets / average equity
ROCE (Return on Common Equity) = (net income – preferred dividends) / (avg. stockholder’s
equity – avg. preferred equity)
- For preferred stock adjustments. Preferred stock dividends and equity subtracted from
top and bottom of equation.
Adjusted ROA = (net income + [net interest expense x (1-statutory tax rate)]) / avg. total assets
ROE = ROA (PM x AT) x FL
Profitability accounts: gross profit margin, operating expense margin, profit margin
Productivity: accounts receivable turnover, inventory turnover, accounts payable turnover, cash
conversion cycle, PPE turnover.
Financial Leverage: total liabilities to equity, times interest earned.
Gross Profit Margin = price sold – price purchased / price sold
Financial Accounting
Operating Expense Margin, also known as SG&A measures the general operating costs for each
sales dollar. These costs include all costs other than those to make or buy the company’s
products.
- Tend to judge lower SG&A as favorable but caution advised. Sometimes tried to mitigate
declining profits by reducing R&D, marketing, or compensation costs which can result in
short term improvements at long term costs.
Productivity = sales / total assets.
All turnover ratios have Sales in the Numerator and the balance sheet account in the
denominator. Ex:
- A/R turnover = sales / avg. A/R
- Inventory turnover = COGS / Avg. inventories
Better to use days as a measurement for working capital accounts:
Days sales outstanding ……………….. 365 x avg. A/R / sales
+ Days inventory outstanding………… 365 x avg. inventory / COGS
- Days Payable outstanding………………365 x avg. A/P / COGS
= Cash conversion cycle…………………..A/R days + Inventory days – A/P days
- Measures the avg. time in says to sell inventories, collect receivables from sale and pay
payables, and return to cash.
- (-) cash conversion cycle viewed favorably – allows to generate profit from sale and
profit from investing cash
Sales per day = Sales / 365
COGS per day = COGS / 365
To generate cash generated by changes in measures, multiply change in AR by sales per day and
changes in inventory and AP by COGS per day. Ex:
Annual Amount in Days
$ millions
2015
2014
Days sales
outstanding
+ days inventory
outstanding
- Days payable
outstanding
= cash conversion
cycle
60.6
59.7
Chan
ge
(.9)
X Sales (COGS)
per day
108.2
=
Cash Savings
125.5
128.4
2.9
40.9
118.6
63
53.3
9.7
40.9
396.7
123.1
124.8
(97.4)
417.9
Most useful analysis of turnover for PPE assets (sales / Avg. PPE assets).
- Lower levels of PPE turnover indicate a higher level of capital intensity.
Financial Accounting
-
b/c PPE assets is often a large portion of the balance sheet, improvement in plant asset
turnover can greatly impact the company’s return on assets and cash flow
Total Liabilities to equity ratio = total liabilities / stockholders equity
Times interested earned ratio = earnings before interest and taxes / interest expense.
ROE = operating return + non-operating return
- non-operating return from financing and investing activities
Return on net operating assets RNOA = NOPAT / NOA
NOPAT = Net operating profit after tax
- NOPAT = net operating profit before tax – tax on operating profit
- Tax on operating profit = tax expense + (pretax net nonoperating expense x statutory
tax rate)
NOA = avg. net operating assets
NOA = operating assets – operating liabilities
- balance sheet operating items:
o [Current Assets] AR, Inventories, prepaid expenses, deferred income tax assets,
other current assets.
o [Long Term Assets] property plant and equp. net, capitalized lease assets, natural
resources, equity method investments, goodwill and intangible assets, deferred
income tax assets, other long term assets
o [Current liabilities] AP, accrued liabilities, unearned deferred revenue, deferred
income tax liabilities
o [Long term liabilities] pension and other post employment liabilities, deferred
income tax liabilities
- Operating assets exclude short term and long term investments in marketable securities
Non-operating assets include cash and cash equivalents and investments in marketable securities.
Non-operating liabilities include all interest-bearing debt, both short and long term. Lease
liabilities are treated as nonoperating. Derivatives are classified as non-operating liabilities.
NOA = net operating obligations (NNO) + Stockholders equity (SE)
NNO = non operating liabilities – nonoperating assets.
- Current nonoperating assets + long term non operating assets = total nonoperating
assets
- Current nonoperating liabilities + long term non operating liabilities = total nonoperating
liabilities
Equity = NOA – NNO
- Total assets – total liabilities and equity
On Income Statement, operating items:
Financial Accounting
-
-
Revenues, COGS, Gross profit
Operating expenses: SG&A, depreciation and amortization expenses, restricting
expense, R&D, asset impairment expense, gains and losses on asset disposal, total
operating expenses
Operating income, income from equity method investments
Net Operating Profit Margin (NOPM) reveals how much operating profit the company earns
from each sales dollar. Higher is usually better.
- Affected by the level of gross profit the company earns on its products (revenue minus
COGS). Also affected by the level of operating expenses the companies requires to
support its products or services.
NOPM = net operating profit after tax / sales
Net operating asset turnover (NOAT) measures the productivity of the company’s net operating
assets. This metric reveals the level of sales the company realizes from each dollar invested in
net operating assets. Higher is preferable.
- Can be increased by either increasing sales for a given level of investment in operating
assets or by reducing he amount of operating assets necessary to generate a dollar of
sales, or both.
NOAT = sales / avg. net operating assets
Calculating non-operating return for next year, use ROE – RNOA.
Noncontrolling Interest Ratio = (net income attributable to controlling interest / net income) /
(average equity attributable to controlling interest / average total equity)
Or ROE = [RNOA + (FLEV X Spread)] X NCI ratio.  calculate as percentages (don’t change to decimal).
- ROE, RNOA, and Spread should be in percentages.
Chapter 5 –
Financial Accounting
Revenue Recognition – we record revenues from product sales when the goods are shipped and
the title passes to the customer. At the time of sale, we also record estimates for a variety of
revenue deductions such as rebates, chargebacks, sales allowances, and sales returns.
- Recognized when good or service is provided to customer.
- Not necessary to receive cash to recognize revenue.
Non-refundable fees, bill-and-hold fees recognized as revenue when item reaches customers
hands.
For consignment units, if the seller is an agent, they recognize commission fees.
Variable consideration: if a good or service has been transferred to the customer and the payment
is likely and can be reasonably estimated, the seller should estimate the expected amount to be
received and recognize that amount in current revenue.
Cost-to-cost Method – companies typically use the percentage of projected contract costs that
have been incurred to estimate the contract’s percentage of completion.
Ex: Bayer signed $10 million dollar contact to build building. Time to build = 2 years. Cost to
build = $7.5 million. Gross profit = 10-7.5 = 2.5 mil
Year 1: construction cost = 4.5 mil -> 4.5/7.5 = .6. 10 mil x .6 = $6 mil revenue
Year 2: construction cost = 4 mil -> 3/7.5 = .4. 10 mil x .4 = $4 mil revenue
So year 1, reported revenue = $6 mil. 6 mil – 4.5 = $1.5 mill gross profit. Year 2, reported
revenue is $4 mil. 4 mil – 3 mil = $1 mil gross profit.
Accounts receivable turnover ratio = sales / avg. AR
- Increase = good
Accounts receivable as a percentage of sales = avg. AR / sales
Days sales outstanding (DSO) = 365 x avg. AR / sales
- Lower DSO, a higher percentage of accounts receivables to sales, and a lengthening of
DSO all provide a signal that AR has grown quicker than sales = NOT FAVORABLE b/c:
o Company = more lenient in granting credit to customers and credit quality is
deteriorating.
Deductions from income:
- Cost of sales
- SG&A expense – includes salaries and benefits, rent and utilities, marketing and selling
expenses, IT legal and accounting expenses, depreciation for assets used for admin
purposes.
- R&D expense
o Expensed as they occur
o Analysis is measured in $ and as a percentage of total revenue
- Amortization of intangible assets
- Restructuring charges
Financial Accounting
-
Provision for taxes on income
Discontinued operations
Income attributable to noncontrolling interest
Regulation G – reconciling non-GAAP info to GAAP numbers.
Operating and Non-Operating Expenses:
Net sales and revenue
Net sales
Finance and interest income
Other income
Total
$25,775.2
2,381.1
706.5
Operating
Operating
Operating
28,862.8
Costs and expenses
Cost of sales
20,143.2
Research and development expenses
1,425.1
Selling, administrative and general expenses
2,873.3
Interest expense
Other operating expenses
Total
Income of consolidated group before income taxes
Provision for income taxes
Income of consolidated group
Equity in income of unconsolidated affiliates
Net income
Less: Net income attributable to noncontrolling interests
Net income attributable to Deere & Company
--
680.0
961.1
Operating
Operating
Operating
Non-Operating
Operating
26,082.7
2,780.1
840.1
Operating
1,940.0
0.9
1,940.9
0.9
Operating
Financial Accounting
Advertising expenses
b. Compensation and benefit costs for headquarters employees
c. Compensation and benefit costs for store employees
SG&A
SG&A
SG&A
COS
d. Compensation and benefits costs for distribution center employees
COS
e. Distribution center costs
f. Freight expenses associated with moving merchandise from our vendors to our distribution centers and our
retail stores
COS
COS
g. Freight expenses associated with moving merchandise among our distribution and retail stores
COS
h. Import costs
COS
i.
Inventory shrink and theft
j.
Litigation and defense costs and related insurance recovery
SG&A
Cos
k. Markdowns on slow moving inventory
l.
Occupancy and operating costs for headquarters facilities
SG&A
SG&A
m. Occupancy and operating costs of retail locations
COS
n. Outbound shipping and handling expenses associated with sales to our guests
COS
o. Payment term cash discounts to our vendors
SG&A
p. Pre-opening costs of stores and other facilities
q. U.S. credit cards servicing expenses
SG&A
Financial Accounting
r.
Vendor reimbursement of specific, incremental, and identifiable advertising costs
SG&A
CHAPTER 6 –
Capitalization – cost is recorded on the balance sheet and is not immediately expensed to the
income statement. Once a cost is capitalized, they remain on the balance sheet as assets until they
are used up, at which time they are transferred from the balance sheet to the income statement as
expense.
- If costs are capitalized rather than expenses, then assets, current income, and current
equity are all higher.
- For purchased inventories, the cost capitalized is the purchase price.
- For manufacturers: manufacturing costs:
o Cost of direct (raw materials), cost of direct labor, and manufacturing overhead.
 Direct costs are easy. Overhead is everything other than direct materials
and labor. Overhead goes into inventory.
When inventory is sole, their costs are transferred from the balance sheet to the income statement
as COGs. COGs is then deducted from sales to yield gross profit.
- Gross Profit = Sales – COGS
Inventory Flow:
Beginning inventory (prior period balance sheet)
+ Inventory purchased and/or produced
Cost of goods available for sale
-Ending inventory (current period balance sheet)
Cost of goods sold (current period income statement)
Beginning inventory + inventory acquired = Cost of goods available = ending inventory + cost of
goods sold
FIFO (First in, First Out) – transferring inventory in the order they were initially recorded.
- FIFO yields higher frost profit than do LIFO or average costs methods
- In an inflationary economy, FIFO results in higher taxable income, and consequently,
higher taxes paid.
FIFO Inventory = LIFO inventory + LIFO reserve
FIFO COGS = LIFO COGS – Increase in LIFO Reserve (or + decrease)
LIFO (Last in, First Out) – transferring inventory from most recent first.
- In periods of rising costs, LIFO inventories are markedly lower than under FIFO. As a
result, LIFO does not accurately represent the cost that a company would incur to
replace its current investment in inventories.
- Using LIFO in an inflationary economy, pretax profit is lower and so are taxes paid,
which increases operating cash flow.
Financial Accounting
-
To adjust for LIFO on the balance sheet:
o Increase inventories by the LIFO reserve
o Increase tax liabilities by the tax rate applied to the LIFO reserves (take the LIFO
reserve x tax rate)
o Increase retained earnings for the difference (Take LIFO reserve – Tax liabilities)
LIFO liquidation – increase in gross profit resulting from a reduction of inventory in the
presence of rising costs.
Average Cost – computes the cost of goods sold as an average of the costs to purchase or
manufacture all of the inventories available for sale during the period.
Retail to inventory method (RIM) – retailers know the cost of inventories purchased and their
retail selling price. They can compute the Cost-to-retail percentage and applies the cost of the
inventory still available at year-end (the ending inventory):
Purchase Cost
Beg. Inventory
100,000
+purchases during per.
300,000
=COG avail. For sale
400,000
(cost-to-retail %: 400k/660k = 60.6%)
Retail Selling Price
160,000
500,000
660,000
Sales
(420,000)
Est. end inv @ retail prices
240,000 double line
Est. end inv @ cost (60.6% x 240k retail) (145,440)
=COGS
254,560 <- double line
Lower of Cost or Market (LCM) – compares the market value with current value in inventory
using FIFO/LIFO/AVG. Writes down whichever is lower in books.
- Inventory book value is written down to current market value (replacement costs),
reducing inventory and total assets.
- Inventory write-down is reflected as an expense (part of COGS) on the income
statement, reducing current period gross profit, income and equity.
- Written in as COGS on income statement, and as write down in balance sheet.
Gross profit margin (GPM) = gross profit / sales.
- Percentage often used instead of dollar amount b/c allows for comparisons across
companies and time.
o Some reasons for decline (concern):
 Product line is stale, new competitors enter the market, general decline
in economic activity, inventory is overstocked, manufacturing costs have
increased, changes in product mix.
Average days inventory outstanding (DIO) = 365 x avg. inventory / COGS
Financial Accounting
-
Important b/c inventory quality. Fewer days = better b/c products are salable, and asset
utilization (right amount of inventory)
Advertising expense = SG&A (operating expense)
Days payable outstanding (DPO) = 365 x avg. AP / COGS
- Better to have longer days but be careful b/c can damage relationships
Cash Conversion Cycle:
Days sales outstanding (accounts receivables)
+ days inventory outtsanding
-days payable outstanding
= cash conversion cycle
Better = shorter cash cycle b/c increases cash flow. Inventories are recognized on the balance
sheet when received at the distribution center and the days inventories outstanding clock starts at
that moment. Stops when it hits stores.
Change in cash = change in days inventory outstanding x (COGS/365)
PPE Property, plant and equipment are the largest assets for most companies and depreciation is
often second in expenses to COGS on the income statement.
- When required, it is recorded at cost on the balance sheet (called capitalization).
Expenditures for PPE are called CAPEX. The amount capitalized on the balance sheet
includes all costs to put the assets into service. This includes transportation, duties, tax,
and necessary costs to install and test the assets.
- Companies often use leases to increase operational flexibility or to take advance of
attractive financing terms. If the lease convey the “risks and rewards” of ownership, the
equipment is capitalized just like other tangible assets. Called Capital lease.
- Once capitalized, the cost of plant and equipment is recognized as expense over the
period of time that the assets produce revenues (Directly or indirectly) through
depreciation.
Depreciation – recognizes using up of asset over its useful life. Only assets that have a useful life
are depreciated. Land does not depreciate. To determine depreciation expense, companies make
3 estimates:
- Useful life, salvage value, and depreciation method.
- Companies use a depreciation rate to systematically decrease the value on the balance
sheet (called carrying value) such that, at the end of its useful life, the assets carrying
value = salvage value.
o When the asset is sold, the difference between the sales proceeds and its book
value is recorded as a gain or loss on sale in the income statement.
- Most common depreciation methods: straight line depreciation, declining-balance
method.
Straight line depreciation – asset depreciation recognized evenly over period of useful life.
Financial Accounting
Depreciation base = cost – salvage value
Depreciation rate = 1/estimated useful life
Straight line depreciation = depreciation base x depreciation rate
- Goes into deduction in non-cash assets and addition to expenses.
Ex: machine at cost
Less accumulated depre
Machine, net (end yr 1)
100,000
18,0000
82,000
Accumulated depreciation – is the sum of all depreciation expense that has been recorded to date.
Net book value (NBV) – or carrying value, is cost less accumulated depreciation.
Net book value = cost – accumulated depreciation
Ex: machine, at cost
Less accumulated depre
Machine, net (end yr 2)
$100,000
36,000
64,000
Double-declining-balance method (DDB) – accelerated method of depreciation. Records more
depreciation in the beginning years of useful life and less later. 2 x the straight line depreciation.
Ex: machine, at cost
DDB depreciation
Machine, net (end yr 1)
$100,000
$40,000 <- 2 x SL= 2 x 20% = 40%
60,000
Machine, at cost
Less acum. Depre
Machine, net (end yr 2)
$100,000
64,000 <- (60,000 x 40% = 24,000 + 40,000 (from yr 1))
36,000
Companies typically use SL for financial reporting purposes and accelerated depreciation
method for tax return b/c in early years, SL yields higher income on financial statements,
whereas accelerated yields lower taxable income. Tax companies prefer to have tax savings
sooner so that cash savings can be invested to produce earnings.
- The reversal may never occur if depreciable assets are growing at a fast enough rate, the
additional first year’s depreciation on newly acquired assets more than offsets the lower
deprecation expense on older assets, yielding a “permanent” reduction in taxable
income and taxes paid.
R&D facilities and equipment are not immediately expensed.
- If they are general use in nature, costs are capitalized on the balance sheet and
depreciated over its useful life like other depreciable assets.
- Only those that are specifically purchased for single projects and have no alternative use
are expensed immediately.
Financial Accounting
-
With exceptions of facilities and equipment, R&D costs are not capitalized. Those are
expensed in the income statement as they are incurred.
Gain or loss on asset sale = proceeds from sale – NBV of asset sold
An asset’s NBV = its acquisition cost – accumulated depreciation.
- When an asset is sold, its acquisition cost and related accumulated depreciation are
both removed from the balance sheet and any gain or loss is reported in income from
continuing operations.
Impairment – if market values of PPE assets decrease (market value lower than acquisition cost),
companies must write off the impaired cost and recognize losses on those assets.
- Determined by comparing the asset’s NBV to the sum of the asset’s expected future
(undiscounted) cash flows.
o If sum of expected cash flow > NBV, no impairment. If sum of expected cash
flow < NBV, deemed impaired and it is written down to its current fair value.
Restructuring costs include 3 components: employee severance or relocation costs, asset writedowns, other restricting costs.
PPE Turnover (PPET) = sales / avg. PPE, net
- Higher PPE preferred, higher turnover increases profitability because the company
avoids asset carrying costs and because the freed-up assets can generate operating cash
flow.
Average Useful life = depreciable asset costs / depreciation expense
- Assuming SL depreciation and 0 salvage value
- Compute depreciable assets costs by adding up all except land and construction in
progress.
Percent used up = accumulated depreciation / depreciable asset cost
- Estimating proportion of a company’s depreciable assets that have already been
transferred to the income statement. This ratio represents depreciable assets that are
no longer productive.
CHAPTER 7 –
Non-operating liabilities: short term debt and long term debt scheduled to mature within one
year.
Accrued liabilities are incurred in the current period, therefore, must be recognized in the current
period. They fall into two broad categories:
- Accruals for routine contractual liabilities: wages company is obligated to pay but not
yet paid, interest due in current period on borrowed money not yet paid, income taxes
Financial Accounting
-
owed but not yet paid as a result of profit earned in period, other operating liabilities
that have been incurred but not yet paid for in current period (rent, utilities, etc).
Accruals for contingent liabilities: liabilities that depend on a future occurrence of a
future uncertain event to determine whether the liability exists. Ex: law suit or warranty
liabilities for products sold
Accruals for wages payable:
+75 to liabilities wages payable (balance) AND +75 to wages expense (income) = -75 to retained
earnings
Period 2: -75 cash = - 75 wages payable
Accruals for contingent liabilities: warranty
+1000 liabilities warranty payable (balance) AND + 1000 to warranty expense (income) = -1000
retained earnings
Period x: -1000 inventory = -1000 warranty payable
Short term debt – falls under current liability b/c pay back within next year. Ex:
Jan 1: +1000 cash = +1000 liabilities note payable
Mar 31: +30 interest payable AND +30 interest expense (Income) = - 30 retained earnings
Apr 1: -30 cash = -30 interest payable
Current maturities of long-term debt – principal payments that must be made during the
upcoming 12 months on long-term debt are reported as current liabilities
Coupon rate – contract or stated rate in the contact. Used to compute interest rate. Fixed prior to
issuance of bond.
Market rate – yield or effective rate. The interest rate investors expect to earn on the investment
in this debt security. This rate is used to price the bond.
Bond holders normally expect to receive two different types of cash flow:
- Periodic interest payments – usually semi annual during the bonds life. Payments are
called an annuity because they are equal in amount and made at regular intervals.
- Single payment – of the face (principal) amount of the bond at maturity. Called a lumpsum because it occurs only once.
Ex: bong sold at part with face value 10 mil, 6% annual coupon rate payable semiannually, and a
maturity of 10 years.
So semiannual rate is 3%.
Semiannual interest payments = 10 years x 2 (# of pmts) = 20. Dollars per payment = 10
mil x 3% = 300k. Total cash flows = 6 mil. Principal pmt at maturity is 1 x 10 mil = 10 mil.
Total = 16 mil.
- So bond states borrower must make 20 semiannual payments of 300k each and at
maturity, repay back principal (10 mil)
Financial Accounting
The bond price is the present value of the periodic interest payments (annuity) plus the present
value of the principal payment (lump sum).
Excel Formula = PV (annual market rate / interest pmts per year, years to maturity x int pmts per
year, -face value*annual coupon rate/int pmt per year, -face value, 0)
Because a bond carries a coupon rate lower than what investors demand, the bond is less
desirable and sells at a discount.
Coupon rate > market rate -> bond sells at a premium (above face amount)
Coupon rate = market rate -> bond sells at par (at face amount)
- When sold at par, the cost to the issuing company is the cash interest paid (= the
effective cost)
Coupon rate < market rate - > bond sells at discount (below face amount)
Effective cost of debt is reflected in the amount of interest expense reported in the issuer’s
income statement.
Excel = rate (years to maturity*int pmts per year, -par value*annual coupon rate/int pmts per
year, issue price, -par value, 0)
Par bonds issued =
+10 mil cash asset = +10 mil long-term debt liabilities (Balance sheet)
Discount bonds issued – when sold, cash proceeds and net bond liability recorded at the amount
of the proceeds received, not the face of the bond. Ex: 10 mil bond with investors demanding 4%
semiannual return for the 3% semiannual coupon bond)=
+8640999 cash = +8640999 long term debt liabilities (balance sheet)
- Bonds payable, face = 10 mil – bond discount (1359001) = 8640999
For discount bonds, bonds reported on balance sheet net discount. However, when bond matures,
company is obligated to repay the face amount. Accordingly, bond payable account at maturity
must read 10 mil.
Amortization – reduction of the discount over the life of the bond. Must become 0 at maturity.
Amortization causes the effective interest expense to be greater than the periodic cash interest
payments.
- Amount of interest that is reported on the income statement each year represents its
effective cost of debt including both interest paid plus a portion of the additional
borrowing costs (or less a portion of the benefit of the premium).
Premium bonds – cash proceeds and net bond liability recorded at the amount of the proceeds
received (not face value). Ex: 10 mil bond where investors demand 2% semiannual return for 3%
semiannual coupon bond =
+11635129 cash asset = +11635129 long term debt liabilities (balance)
- Bond payables, face = 10 mil +bond premium 1635129 = bonds payable, net 11635129
Financial Accounting
-
Premiums are benefits and reduce interest expense on the income statement
AMMORTIZATION OF DISCOUNT
EX: face amount 600k, 3% annual coupon rate payable semiannually (1.5% semiannual rate),
maturity of years (6 semiannual payments. Market yield rate of 4% annual (2% semiannual).
Bond issue price is $583,196.
Period
0
1
2
3
4
5
6
(A)
(B)
([E] x market%) (Face x
Interest Exp.
coupon%)
Cash Int. Paid
11,664
11,717
11772
11827
11884
11940
70,804
9000
9000
9000
9000
9000
9000
54,000
©
([A]-[B])
Discount
Amortization
2664
2717
2772
2827
2884
2940
16,804
(D)
(Prior Bal –
[C])
Discount
Balance
16,804
14140
11423
8651
5824
2940
0
(E )
(Face – [D])
Bond
Payable, Net
583,196
585,860
588,577
591,349
594,176
597,060
600,000
AMMORTIZATION OF PREMIUM
Ex: face amount 600k, 3% annual coupon rate payable semiannually (1.5% semiannual rate),
maturity of years (6 semiannual payments. Market yield rate of 2% annual (1% semiannual).
Bond issue price is $617,386.
Period
0
1
2
3
4
5
6
(A)
(B)
([E] x market%) (Face x
Interest Exp.
coupon%)
Cash Int. Paid
6,174
6,146
6,117
6,088
6,059
6,030
36,614
9000
9000
9000
9000
9000
9000
54,000
©
([A]-[B])
Premium
Amortization
2826
2854
2883
2912
2941
2970
17,386
(D)
(Prior Bal –
[C])
Discount
Balance
17,386
14,560
11,706
8,823
5,911
2,970
0
(E )
(Face – [D])
Bond
Payable, Net
617,386
614,560
611,706
608,823
605,911
602,970
600,000
If bonds are at premium, that means that your promises are worth more = more profitable
because paying less interest overall.
Gain or loss on Bond Repurchase = net bonds payable – repurchase payment
- Net bonds payable also referred to as book value
Financial Accounting
-
Gains and losses of bond repurchases are transitory in nature and do not have economic
effects. They are offset by the present value of the future cash flow implications of the
repurchase.
Yield rate = risk free rate + risk premium
- Risk premium = spread
Default – nonpayment of interest and principal and/or the failure to adhere to the various terms
and conditions of the bond indenture.
- Business risk: industry characteristics, competitive position (marketing, tech, efficiency,
regulation), management
- Financial risk: financial characteristics, financial policy, profitability, capital structure,
cash flow protection, financial flexibility
Profitability Ratios:
- EBITA / Average Assets
- EBITA Margin = EBITA / Net Revenue
- EBITA / Interest Expense
- Operating Margin = Operating Profit / Net Revenue
Cash Flow Ratios:
- (FFO + Int Exp)/Int Exp
- FFO / Debt = FFO / (Short term + long term debt)
- Net Debt = (FFO – Preferred Dividends – Common Dividends – Minority Dividends) /
(Short term + long term debt)
Solvency Ratios:
- Debt / EBITDA = (Short term + long term debt) / EBITDA
- Debt / Book Capitalization = (Short term + long term debt) / (Short term + long term
debt + deferred taxes + minority interest + book equity)
- CAPEX / Depreciation Exp
- Revenue Volatility = standard deviation of trailing 5 years of net revenue growth
Future Value = present value x interest rate x time
- Ex: present value of $100 with a 10% interest rate inclusive = 10% inclusive = 1.1.
100/1.1 = 90.91. To check 90.91 x 1.1 = 100
Present values decline as interest rates increase and present values decline as the time lengthens.
- Present Value = FV / (1 + i)^n
Present Value of Original Annuity = PVoa = PMT [(1 - (1 / (1 + i)^n)) / i]
Ordinary Annuity – when annuity amounts occur at the END of each period.
Financial Accounting
Excel PV = (rate, nper, pmt, fv, type)
Excel FV = (rate, nper, pmt, pv, type)
- Nper – number of compounding or discounting periods.
Chapter 9
Intercorporate investments – when one company purchases the stock of another company.
3 levels of influence or control:
- Little or no influence (passive investment) – investor’s goal is to realize dividend income
and capital gain. Generally 20% or less ownership. Use of fair value method of
accounting.
o Income statement effect: dividend and capital gains included in income, interim
changes in fair value effect income, sale of investment yields capital gain or loss.
Cash flow effects: dividends and sale proceeds are cash inflows from investing
activities. Purchases are cash outflows from investing activities.
- Significant influence – usually ownership between 20% to 50%. Use of equity method of
accounting.
o Income statement effect – dividends reduce investment account, investor
reports income equal to percent owned of investee income. Sale or investment
yields gains or losses. Cash flow effects – dividends and sale proceeds are cash
inflows from investing activities. Purchases are cash outflows from investing
activities. Balance sheet effect – investment account equals percent owned of
investee company’s equity.
- Control – owns more than 50%. Ability to control strategic decisions. Consolidation
accounting type.
o Balance sheet effects – balance sheets of investor and investee are combined.
Income statement effects – income statements are combined. Sales of investee
yields capital gain or loss. Cash flow effects – cash flows combined and retain
original classification (operating, investing, or financing). Sale and purchase of
investee are investing cash flows.
Marketable equity securities = stocks. Marketable debt securities = bonds.
Gain or loss on sale = proceeds from sale – book value of investment sold
- Usually reported under other income.
Ex: Google buys 1000 shares at $20 per share. Sells 400 shares for $23.
-20000 cash + 20000 marketable securities (balance)
+9200 cash -8000 marketable securities = +1200 gain on sale = +1200 net income = +1200
Retained Earnings
Passive investments in marketable securities are the only assets that are reported at fair value
instead of historical value. Other assets including inventory, PPE and goodwill are recorded at
Financial Accounting
fair value when it is lower than historical costs, but not when fair value exceeds historical cost.
This is because the prices for marketable securities can be easily observed and measured.
- The market price results from numerous transactions between buyers and sellers. It
provides an unbiased estimate of fair value.
Fair value adjustments ex: Google’s 600 shares purchased at $20 per share. Shares increase to
$25 per share at year end.
- The investment account must be adjusted to fair value to reflect the $3000 unrealized
gain ($5 increase for 600 shares).
+3000 marketable securities = +3000 retained earnings (balance). +3000 unrealized gain =
+3000 net income (income).
Non-marketable equity securities – stock of privately held companies with no public stock.
Required to be reported as fair market value of at cost plus or minus changes resulting from
observable price changes in orderly transactions for an identical or similarly investment of the
same issuer.
Held-to-maturity (HTM) debt securities – uses cost method. Changes in fair value of HTM
securities to not affect either the balance sheet or the income statement because it is presumed
that these investments will be held to maturity, at which time, their market value will be exactly
equal to their face value.
- Any interest received is recorded in current income.
- Interest reported as other income in income statement. IF sold before maturity, any
gain or loss on sale is reported in income statement.
Equity method – reports the investment on the balance sheet at an amount equal to the
percentage of the investee’s equity owned by the investor. In equity method, investments
increase (decrease) with increases (decreases) in the investee’s stockholders’ equity.
- Investments recorded at purchase cost. Dividends received are treated as a recovery of
the investment and thus reduce the investment balance (dividends are not reported as
income).
- Investor reports income equal to its percentage share of the investee’s reported net
income; the investment account is increased by the percentage share of the investee’s
income or creased by the percentage share of any loss.
- Changes in fair value to not affect the investment’s carrying value.
Ex: Google buys 30% stage in Mitel. At acquisition date, Mitel’s balance sheet shows $1000
stockholder’s equity. So google’s purchase is $300 (30%). At year end, Mitel reports profits of
$100 and pays $20 in cash dividends to its shareholders ($6 to google).
-300 cash + 300 investment in mitel.
+30 investment in mitel = +30 retained earnings (balance). +30 equity income = +30 net income
(income). <- Mitel reports $100 income (Google = $30).
+6 cash -6 cash in Mitel <- dividend pay out
Ending balance of Google’s investment account = 324 (+300 +30-6)
Financial Accounting
With equity method, NOPM for investee’s sales are not included in the NOPM denominator.
NOAT – investee’s sales are excluded from the NOAT numerator and NOA in excess of the
investment balance are excluded from the denominator. FLEV is understated due to the absence
of investee liabilities in the numerator.
- Although ROE components are affected, ROE is unaffected by the equity method
because the correct amount of investee net income and equity is included in the ROE
numerator and denominator respectively. Analysis would use an overstated NOPM and
an understated FLEV because the numbers are based on the net balance sheet and net
income statement numbers.
Variable interest entity (VIE) – when investor is the primary beneficiary. The investor has the
ability to influence the investee’s decision making, can influence the investee’s financial results
through contractual rights and obligations, the investor is exposed to variable returns (absorbing
losses and gains), investor has the right to receive residual returns.
- All VIEs must be consolidated.
- Alternatively if VIE test not met, if investor has 50% control of voting stock, they have
economic power and investment must be consolidated.
Investments purchased AT book value:
When a subsidiary wholly-owned, the consolidated stockholders’ equity equals the equity of the
parent company.
The consolidated net income equals the net income of the parent company because the equity
income the parent reports equals the net income of the subsidiary when the subsidiary is wholly
owned.
Table of consolidated and adjusting for wholly owned subsidiary on page 9-17.
When a subsidiary is not wholly-owned, we account for the equity interest of noncontrolling
shareholders in addition to that of the parent stockholders. This affected the income and balance
sheet.
- Reflected in new account on balance sheet titled noncontrolling interest.
Investments purchase ABOVE book value:
Account for goodwill. Usefulness of assets will be amortized across their life.
Consolidation of Foreign Subsidiaries (Cumulative Translation Adjustment):
Gain/loss on foreign transaction adjustments are added to stockholder’s equity in a line called
cumulative translation adjustment. Also known as accumulated other comprehensive income
(AOCI).
- Changes in foreign exchange have no effect on the cash flow.
- Changes in translation adjustment are not reflected in net income. The fluctuations
remain in stockholder’s equity as long as the parent owns the foreign subsidiary.
Financial Accounting
o If the company is sold, any remaining amount of AOCI that relates to the foreign
subsidiary is removed from stockholders equity and reported in net income.
Comprehensive income = net income + other comprehensive income.
In consolidated statements, the process eliminates all intercompany investments including
intercompany sales and receivables. All intercompany transactions are eliminated in both the
income statement and the balance sheet to avoid double counting.
Subsidiary stock issuance – influx of cash can reduce parent company’s percentage of
ownership. Accounted in parent company as an increase of paid-in capital. Has no effect on
income statement.
When the parent company sells a subsidiary, accounted for as discontinued operations IF the sale
represents a strategic shift or will have a major effect on a company’s financial results.
Chapter 10 –
Owner of the contract – lessor
Party desiring to use that asset in the contract – lessee
Lease – the contract between the lessor and lessee
Advantages of leasing to bank financing:
- Leases require less equity investment by the lessee compared to bank financing.
- Leases usually require the first least payment be made at the inception of the lease. For
a 60 month least, this amounts to a 1/60 (1.7%) investment by the lessee, compared to
a bank that typically requires 20-30% investment by the borrower.
- Because leases are contracts between 2 parities their terms can be structed to meet
both parties’ needs. Ex: allowing variable payments to match cash flow
Pre-2019 standards for leases:
Capital lease method – requires that both the lease asset and the lease liabilities be reported on
the balance sheet. The lease asset is depreciated like any other long term asset. The lease liability
is amortized like debt, where lease payments are separated into interest expense and principal
repayment.
- Operating cash flows are greater when a lease is classified as a operating cash flow
because of the differentiation between principal repayment and interest repayment.
Classifying leases as operational has 4 financial consequences for the lessee:
- The lease asset is not reported on the balance sheet. This means that asset turnover is
higher because reported assets are lower and revenues are unaffected.
- The lease liability is not reported on the balance sheet. This means that the balance
sheet measures of financial leverage are improved.
Financial Accounting
-
Without analytical adjustments, the portion or ROE derived from operating activities
appears higher, which improves the perceived quality of the company’s ROE.
During the early years of the lease term, rent expense reported on operating lease is
less than the depreciation and interest expense reported for a capital lease. This means
that net income is higher in the early years with an operating lease. If a company is
growing and continuing to add operating lease assets, the level of profits will continue
to remain higher during the growth period.
Operating lease method – under this method, neither the lease asset not the lease liability is
reported on the balance sheet. Lease payments are recorded as rent expense by the lessee.
- The cash outflows (payments to the lessor) per the lease contract are included in the
operating section of the statement of cash flows.
Lease Type
Capital
Operating
Assets
Lease asset
reported
Lease asset not
reported
Liabilities
Lease liability
reported
Lease liability not
reported
Expenses
Deprecation and
interested expense
Rent expense (by
lessee)
Cash Flows
Payments per
lease contract
Payments per
lease contract
New lease accounting rules:
All lease assets and liabilities must be reported on balance sheet at an amount equal to the
present value of the lease payments.
Companies classify all capitalized leases as either a:
- finance lease (where lease transfers control of the lease asset to a lessee and is
effectively like purchasing the asset) or an
o 2 parts: amortization of the lease asset (included with other depreciation and
amortization expenses) and interest expense on the lease obligation.
- operating lease (the lessee controls only the use of the lease asset but not the asset
itself).
o Classification for operating lease affects how leases are determined and where it
appears in the income statement.
o Lease expense for operating leases is simply the amortization on a straight line
basis of the lease asset cost (the sum of the lease payments)
o Operating lease expense included in COGS, R&D expense, or SG&A depending on
the nature of the lease asset.
Lease expense for finance leases is generally higher in the early years of the lease and lower in
the later years. Conversely, operating lease expense is generally the same amount each year.
To assess whether a finance lease:
- Lease term comprises a “major part” of the remaining economic life of the lease (vs.
strict 75% under pre-2019 rules)
- Present value of the lease payments comprises “substantially all” of the fair value of the
lease asset (vs. strict 90% under the pre-2019 rules)
Financial Accounting
-
Lease transfers ownership of the underlying asset to the lessee by the end of the lease
term.
Lease grants the lessee an option to purchase the lease asset hat the lessee is
reasonably certain to exercise.
All leases not classified as finance are operating leases and now reflected on the balance sheet.
The lease asset is now commonly called a “right of use” or ROU asset.
Footnote disclosures of leases:
Under pre-2019, disclosures of expected payments for leases are required for both operating and
capital leases.
Capitalization of operating leases:
Failure to capitalize operational lease assets and liabilities:
- Operational profit margin is understated.
o Operating cash flow is higher with capital leases since depreciation is added back
in and the reduction of the capital lease obligation is classified as a financing
outflow. Operating cash flows are lower with operating leases than with capital
leases because only depreciation expense is included in operating profit as
interest is a non-operating expense.
- Asset turnover is overstated due to nonreporting of lease assets
- Financial leverage is understated by the omitted lease liabilities.
Lease disclosures under the pre-2019 rules allow for constructive capitalization (capitalizing
operating leases for analysis purposes). Capitalization process is 3 steps:
- Step 1: Determine the discount rate
- Step 2: Compute the present value of future lease payments
- Step 3: Adjust the balance sheet to include the present value from step 2 as both a lease
asset and a lease liability. Adjust the income statement to include depreciation and
interest in lieu of rent expense.
Step 1: determine the discount rate.
- If a company discloses capital leases, we can infer an implicit rate of return: a rate that
yield the present value computed by the company given the future capital lease
payments.
- Use the rate that corresponds to the company’s credit rating or the rate from any recent
borrowings involving intermediate-term secured obligations. Companies typically
disclose these details in their long-term debt footnote.
Example using financial calculator and present value tables in Appendix 10A.
Step 2: compute the present value of future operating lease payments using the discount rate.
Financial Accounting
-
The present value of the operating lease payments equals the sum of the present values
for each of the lease payments Y1 through Y5 and the present value of the lease
payments after Y5. (SEE Example on Pg. 10-7). Two step computation:
o Present values for Y1 through Y5. Use the PV function in excel
o Present values for Y6 and thereafter: make an assumption that the company
continues to make lease payments at the Y5 level for the remainder of the lease
term. Remaining lease term = total payments for Y6 and thereafter / Y5 lease
payment. Use annuity formula in excel to determine present value of remaining
lease payments. However, what we seek is the present value of the remaining
payments at the beginning of Y1. So multiply by the PV of a lump sum.
 Last payment x (1-(1/(1+ discount rate)^remaining life)/discount rate) x
(1 / (1+discount rate)^previous years)
Step 3: use the computed present value of future operating lease payments to adjust the balance
sheet, income statement, and financial ratios.
Financial statement adjustments: failure to capitalize operating leases affects ratio analysis.
- In step 2, you quantified the assets and liabilities missing from the balance sheet. To
adjust the balance, we add that number to both assets and liabilities.
- On the income statement, had the leases been capitalized, you would have recognized
depreciation expense relating to the lease assets and interest expense on the lease
obligations. Adjustments to the income statement replaces the rent expense with
depreciation and interest expense, leaving net income unaffected. Because net income
is unaffected, stockholder’s equity is also unaffected.
ROE and Disaggregation Effects: using the year end (reported and adjusted) data, the adjusted
ROA is lower than the reported (SEE EXAMPLE Pg 10-9). Adjusted ROAY decreases because
the adjusted total asset turnover is lower owing to the recognition of the lease assets.
Analyzing ROE by disaggregating it into operating and non-operating components. Constructive
capitalization affects both operating and non-operating items and requires that we adjust the
balance sheet and income statement.
- To adjust balance sheet – add PV of the operating lease payments from step 2 to
operating assets (PPE). Add PV of operating lease payments from Step 2 to nonoperating liabilities (long-term debt).
- To adjust income statement – add depreciation expense from the lease assets to
operating expense (PV / total life of asset). Add interest expense from the lease
obligation as a non-operating expense (PV x discount rate). Remove rent expense from
operating expenses. Computed as sum of depreciation + interest expense.
Because only depreciation is an operating expense, NOPAT is higher when a lease is classified
as a capital lease. The increase in NOPAT however, is offset by the increase in non-operating
expense, which leaves net income unaffected.
Pensions:
Financial Accounting
Defined contribution plan: requires company to make periodic contributions to an employee’s
account and many plans require a matching contribution by the employee. Ex: 401k plan
- When company is liable to make contribution, accrues liability and related expense.
Later when the company makes a payment, its cash and liability are reduced.
Defined benefit plan: requires company to make periodic payments to a third party, which then
makes payments to the beneficiary after retirement. Payments are usually based on years of
service and the employee’s salary. The company may or may not set aside enough funds to cover
this obligation. Ex: gov high 3 plan
- The accounting for defined benefit plans considers the following:
o Companies estimate pension liability, the PV o the projected benefit obligations.
o Companies required by law to set aide funds to make the estimated payments.
Usually called pension plan assets. Each year a portion of the assets is liquidated
to make annual payments to retirees. When benefits are paid, pension assets
and pension liability (PBO) are reduced in equal amounts, similar to the payment
of cash for wages payable.
o Balance sheet reporting – difference between the fair value of the pension plan
assets and the PBO is called the funded status. Companies report the funded
status on the balance sheet as an asset (if fair value > PBO) or as a liability (PBO <
fair assets). Companies do not report both the pension plan assets and the PBO
separately on the balance sheet. Only net amount is reported.
o Income statement reporting – an increase in the funded status (other than
company contributions) decreases pension expense and a decrease in the
funded status increases pension expense. Pension expense will increase as the
company estimates more benefits to be paid (similar to recording a liability for
wages payable) And pension expense will decrease as the pension assets earn
investment income.
Balance sheet effects:
Pension plan assets – pension plan assets consisted of investments in stocks and bonds. The fair
value of the plan assets change each period from actual returns, company contributions, and
benefit payments.
Pension plan assets, beg balance
+ actual returns on investments (interest, dividends, gains and losses)
+ company contributions to pension plan
-benefits paid to retirees
= pension plan assets, ending balance
Pension plan liabilities – the amount of the projected benefit obligation increases and decreases
due to service cost, interest cost, actuarial losses (and gains), and benefits paid to retirees.
- Service cost PBO increases when more employees are hired, wage rates increase, and
years of service to the company increase.
Financial Accounting
Projected benefit obligation, beginning balance
+ service cost
+ interest cost
+/- actuarial losses (gains)
-benefits paid to retirees
= projected benefit obligation, ending balance
Pension plan funded status – the difference between the fair value of the pension assets and the
computed PBO at the end of the year is called the funded status and it is reported on the balance
sheet as an asset (if pension assets > PBO) and a liability (if PBO < pension assets).
Pension plan assets (at market value)
-projected benefit obligation (PBO)
= funded status
Income statement effects:
Pension expense on the income statement consists of service costs, interest costs, expected return
n pension assets, and amortization of deferred amounts.
- Amortization of deferred amounts – difference between the expected and the actual
return on pension assets, along with any actuarial gains/losses in the computation of the
PBO are deferred and reported in AOCI. If the deferred amount exceeds certain limits,
the excess is amortized and recorded as an expense on the income statement. Can be
positive or negative amount.
As pension assets increase (other than from company contributions), pension expense decreases
and as the PBO increases, pension expense increases.
Service cost
+ interest cost
-expected return on pension plan assets
+/- amortization of deferred amounts, if any
=net pension expense
Pension expense includes amortization of deferred amounts that arise from changes in actuarial
assumptions and unexpected returns on pension plan assets.
Fair value accounting for pensions: recognizing the actual returns from pension assets and gains
and losses of actuarial costs in current earnings. – more volatility than if you used deferred and
long term expected in AOCI.
Footnote disclosure – Future cash flows:
Companies annual pension plan contributions come from operating cash flows or borrowed
funds. Better economies can result in additional growth in assets and vise versa.
Financial Accounting
Interest cost = discount rate x PBO. Discount rate is set by the company.
Expected dollar return on pension assets = pension plan asset balance x expected long-run rate
of return on the investment portfolio. Rate also set by the company.
PBO affected by rate of wage inflation, termination and mortality rates – all estimated by the
company.
Rates used to determine and sheet affected:
- Discount rate used to determine benefit obligation (BS)
- Discount rate used to determine net periodic benefit cost (IS)
- Rate of increase in future compensation levels used to determine benefit obligation (BS)
- Rate of increase in future compensation levels used to determine net periodic benefit
cost (IS)
- Expected long term rate of return on assets (IS)
Assumption
Change
Discount rate
increase
Probable effect on
pension expense
Up or down
Investment
return increase
down
Wage inflation
increase
up
Reason for effect
Higher discount rate reduces PBO, lower PBO is
multiplied by higher rate when computing interest
component of expense. Net effect is indeterminate.
Dollar amount of expected return on plan assets = plan
assets balance x expected long term return on plan
assets, thus reducing pension expense.
Expected rate of wage inflation affects future wage
levels that determine expected pension payments.
Increased wages increase PBO, which increases the
service and interest cost components of pension exp.
Other post-employment benefits (OPEB): additional health care and insurance benefits to retired
employees. Becomes a liability known as accumulated post-employment benefit obligation
(APBO) since most are pay as you go. Largely unfunded account.
- GAAP requires that the unfunded APBO liability net or unrecognized amounts be
reported in the balance sheet and the annual service costs and interest costs be accrued
as expenses each year.
Income taxes: companies use the Internal Revenue Code (IRC) to prepare financial statements.
- Companies try to report less income for tax purposes.
- In GAAP, use straight-line depreciation but often in IRC, use accelerated depreciation (so
pay more initially).
Pg. 10-25 - Deferred tax liability: Y1 using financial reporting and tax reporting
-50 cash asset = +10 deferred tax liability -10 retained earnings (BS)
0 + 60 tax expense = -60 net income (IS)
Y2 using financial reporting and tax reporting
Financial Accounting
-70 cash = -10 deferred tax liability -60 retained earnings (BS)
0 – (+60 tax expense) = -60
Deferred tax assets – arise when the tax payment is greater than the tax expense for financial
reporting purposes.
Tax loss carry forwards – another common deferred tax asset. When a company reports a loss for
tax purpose, it can carry back that loss for up to two years to recoup previous taxes paid. Any
unused losses can be carried forward for up to twenty years to reduce future taxes. This creates a
benefit (asset) for tax reporting for which there is no corresponding financial reporting asset so
company reports a deferred tax asset but only if the company is more likely than not able to use
the loss to reduce future taxes.
Valuation allowance for deferred tax assets: companies must establish a valuation allowance for
deferred tax assets if the future realization of the tax benefits is uncertain. The allowance reduces
reported assets, increases tax expense, which reduces equity. Once established, it can be reduced
/ reversed by 2 events:
- Company writes off a deferred tax asset. Asset reduced to 0 and amount is subtracted
from the deferred tax valuation allowance. No effect on income from this write off.
- Company determines that the deferred tax assets will be realized. If company
determines that assets likely to be realized, it can reverse the deferred tax asset
valuation allowance. The deferred tax asset valuation allowance is reduced and tax
expense is reduced by the same amount, increasing net income.
Deferred tax expense is the effect on tax expense from changes in deferred tax liabilities and
deferred tax assets.
Effective tax rate = tax expense / pretax income
An increase in deferred tax liabilities indicates that a company is reporting higher GAAP income
relative to taxable income and indicate the company is managing earnings upwards.
A decrease in the valuation allowance is often triggered by the write-off of deferred tax assets,
typically relating to net operating loss carryforwards. These carry forwards allow companies to
offset current losses against future income for up to 20 years.
The reconciliation of effective and statutory tax rates can reveal transitory items that might
impact future forecast of tax rates.
USING HP Financial Calculator for present value and for discount rate – PG 10-32
Future Value = Present x (1+r)^n . r = discount rate, n = number of interest periods
P = F / (1+ r)^n
Financial Accounting