FINANCIAL ACCOUNTING
– 8TH EDITION, HARRISON & HORNGREN, 2011
Chapter 1 – The Financial Statements
Accounting is the language of business
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Accounting is an information system
o It measures business activities, processes data into reports, communicates
results to people
Financial statements report information about a business entity
o They measure performance
Bookkeeping is a mechanical part of accounting
Who uses accounting information?
• Individuals (how much money available)
• Investors and Creditors (how much income is expected of an investment)
• Taxing authorities (taxes are based on accounting data)
• Nonprofit organizations (how much money available)
Two kinds of accounting: Financial accounting and Management accounting
• Financial accounting: for external users (investors, bankers, government agencies,
public); information must meet standards of relevance and reliability
• Management accounting: internal users (managers)
Organizing a business
Proprietorship
• Single owner
• Proprietor personal liable for all business debts
• For accounting a proprietorship is distinct from its proprietor
• Business records do not include proprietors personal finances
Partnership
• 2 or more owners
• Each partner is personally liable for all partnership debts
• Limited-liability partnership: each partner is only for his or her own actions and those
under his or her control liable
• Limited-liability partnership (LLP)
o Business, not the owner, is liable for the company’s debt
o Each partner is only liable for partnership debts up to the extent of his
investment in the partnership, plus his proportionate share of the liabilities
o Each LLP must have one general partner with unlimited liability for all
partnership debts
Corporation
• Business owned by the stockholders, or shareholders
• Own stocks, which represent shares of ownership in corporation
• Formed under state law; legally distinct from its owners
o Corporation possesses many rights that a person has
• Stockholders are not liable for debts
• Corporation pays a corporate income tax
• Shareholders elect the board of directors which sets policy & appoints officers
• Board elects chairperson (CEO), holds most power in the corporation
1 Accounting Principles and Concepts
• Generally accepted accounting principles (GAAP)
o In US the Financial Accounting Standards Board (FASB) formulates GAAP
o GAAP designed to meet primary objective of financial reporting
o Information must be relevant, reliable, comparable, and consistent
• But: IFRS is now constructed by the IASB to simplify cross-border operations
The conceptual framework
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It lays the foundation for resolving the big issues in accounting
IFRS Framework for the Preparation of Presentation of financial statements
o Prescribes nature, function and boundaries within which f. accounting operates
IFRS focus: general purpose financial statements which are at least annually
directed to the common information needs
What makes accounting information useful?
• Qualitative characteristics:
• Understandability
• Relevance
o Degree of relevance may be influenced by nature and materiality of the info
o Materiality means that the Information must be Important enough so that the
information being wrong would make a difference to the users
o Immaterial items are not required to be disclosed separately and may be
combined with other information
• Reliability
• Comparability
o Comparability does not mean uniformity, nor continuing to use the same
accounting principles when more relevant & reliable alternatives exist
What constraints do we face in providing useful information?
• Timeliness, balance between qualitative characteristics, benefits vs. costs
• Accounting information is costly to produce and the cost should not exceed the
expected benefits to users
What are our assumptions in financial reporting?
• we prepare our financial statements on an accrual basis
• we assume that the entity will continue to operate long enough to use assets
 called going concern assumption
What exactly are we accounting for?
• Assets
• Liabilities
• Equity
o Share capital + retained earnings
• income
o Separated into revenue and gains
• Expenses
o Losses are usually not from usual business operations
• When to recognize:
a) When it is possible that any future economic benefit associated with the
item will flow to or from the entity
b) When the item has a cost or value that can be measured with reliability
2 The Accounting Equation
The basic accounting equation shows the relationship among assets, liabilities and equity
Assets = liabilities + owners' equity
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Assets: economic resources that are expected to produce a benefit in the future
Liabilities: outsider claims = debts that are payable to outsiders called creditors
Stockholders' equity/capital: insider claims: equity = ownership, stockholders equity
is the stockholders interest in the assets of the corporation
A second accounting equation relates to the calculation of profits earned by an entity during a
financial period. Profit is simply Income less Expenses
Total Revenue and Gains – Total Expenses and Losses = Net Income (or loss)
The Financial Statements
3 The Income statement shows a company’s financial performance
Revenues – expenses = net income/net loss
Revenues and gains (e.g. net sales)
Expenses and losses
 Cost of goods sold (COGS)
 Depreciation
 Non-recurring income and expenses
 Finance expenses (finance costs)
 Income tax expenses
 Net income is the single most important item in the financial statements
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The Statement of Changes in Equity shows a company’s transactions with its owners
Beg. Equity + Total Income – Dividends +/- Capital Transactions with owners = End. Equity
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The Equity is the owner’s residual interest in the entity after deducting liabilities.
Profits that a company generates ultimately belong to the owners of the company.
Retained earnings is the portion of net income the company kept
o Net income increases retained earnings
o Net losses & dividends decrease retained earnings
Dividends are distributions to stockholders of assets generated by income.
o They are not expenses and never affect income, but deducted from net income.
o There is no obligation to pay dividends, instead the board decides whether to
pay dividends or not
o Most companies in the stages of growth do not pay dividends, but reinvest.
The Balance Sheet shows a company’s financial position
Assets = liabilities + owners' equity
The Balance sheet (statement of financial position) reports three groups of items: assets,
liabilities and shareholders equity. It shows the financial position at a specific point of time
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Assets are economic resources that are expected to produce a benefit in the future.
Current assets are assets expected to be turned into cash, sold or consumed within the
next 12 months or within the business’ operating cycle. Typically current assets are
presented in some order of liquidity
o Current assets
 Cash
 Accounts receivable
 Notes receivable
 Merchandise inventory
 Prepaid expenses
o Non-current assets
 Property, plant, equipment (PPE)
• Accumulated depreciation
 Intangibles (patents, trademarks)
 Plant assets or fixed assets
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Liabilities are outsider claims, thus debts that are payable to outsiders called creditors.
Current liabilities are obligations or debts payable within 12 months or within the
business’ operating cycle.
o Current Liabilities
 Accounts payable
 Notes payable (short-term borrowings)
 Tax payable
 Salaries/wages payable
o Non-current liabilities
 Long-term debt (payable beyond 1 year)
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Stockholders' equity are insider claims, thus stockholders equity is the stockholders
interest in the assets of the corporation
o Stockholders equity has 2 main subparts:
• Paid-in capital is the amount the stockholders have invested in
a corporation
• Retained earnings is the amount earned by income-producing
activities and kept for use in the business. It is affected by
revenues and expenses
 Proprietorship and partnerships don’t identify paid-in capital and
retained earnings;
• single heading: capital
The statement of Cash flows shows a company’s cash receipts and payments
Companies engage in three basic types of activities
1. operating activities
o Companies operate by selling goods/services to customers
 Results in net income or net loss, thus increasing or deceasing cash
2. investing activities
o Companies invest in non-current assets such as PPE. Both purchases and sales
of non-current assets are investing cash flows
3. financing activities
o Companies need money for financing.
 Financing comes from both equity owners and borrowings
 Includes issuance of shares, repurchases of shares and proceeds &
repayments of borrowings
Ethics in accounting: Standards of professional conduct
• Relevant information: able to affect decisions
• Reliable: verifiable and free of error and bias
• A company’s real performance may differ from what gets reported to the public
• Need to have an annual audit by independent accountants
• Protect public by ensuring that data is relevant and reliable
• Business Ethics Leadership Alliance (BELA) aims at reestablishing ethics as the
foundation of everyday business practices. Its members agree to embrace und uphold
four core values
1. Legal compliance
2. Transparency
3. Conflict Identification
4. Accountability
5 Chapter 2 – Transaction Analysis
Transactions
Transaction is any event that has a financial impact on the business and can be measured
reliably
• It provides objective information about the financial impact on a company
• Two sides: you give something and you receive something
The Account
An account is the record of all the changes in a particular asset, liability, or shareholder’
equity during a period
Assets
• Cash
• Accounts Receivable
• Notes Receivable
• Inventory
• Prepaid expenses (asset because it provides an future benefit for business)
• Land
• Buildings
• Equipment, Furniture, Fixtures (Most companies report these non-current assets under
the heading Property, Plant and Equipment PPE)
Liabilities
• Accounts payable
• Notes Payable,
• Accrued Liabilities (liability for an expense you have not yet paid; interest payable,
salary payable, income tax payable)
Stockholders equity (SE)
• Share Capital (owners investment in the corporation)
• Retained Earnings (cumulative net income - cumulative net losses and dividends)
• Dividends
• Revenues
• Expenses
Transactions and Financial Statements (page 65)
• Income statement data appear as revenues and expenses under retained earnings
• Balance sheet data are composed of ending balances of the assets, liabilities, and
stockholders equity
• Statement of changes in equity reconciles movements in equity for the period.
• Statement of cash flows are aligned under cash account
Double-Entry Accounting
Dual effects of the entity: each transaction affects at least two accounts
The T-Account
• Left side of each account is called the debit side, right side is called the credit side
• Every transaction involves both a debit and a credit
Cash
Debit
Credit
(Left Side) (Right Side)
6 Increases and Decreases in the Accounts: the Rules of debit and credit
• Increases in assets are recorded on the left (debit) side, decreases of assets are
recorded on the right (credit) side
• Conversely, increases in liabilities and stockholders equity are recorded by credits and
decreases are recorded by debits
• Amount remaining in an account is called its balance
Summary of debit and credit
Assets:
• A debit increases an asset account
• A credit decreases an asset account
Liabilities and shareholders’ equity:
• A credit increases liability, as well as SE
• A debit decreases liability as well as SE
Additional Stockholders equity accounts: revenues and expenses
• Revenues are increases in shareholders’ equity that result from delivering goods or
services to customers
• Expenses are decreases in shareholders’ equity due to the cost of operating business
7 Recording transactions
Chronological record of transactions is called: journal
1. Specify each account affected and classify each account by type (asset, liability,
stockholders equity, revenue, expense)
2. determine whether account is increased or decreased: rules of debit and credit
3. record transaction in journal, brief explanation
Copying information (posting) from the journal to the ledger (page 80)
• Journal does not indicate how much cash or accounts receivable the business has
• Ledger is a grouping of all the T-Accounts, with their balances
• Data must be copied to the ledger called posting
• The phrase keeping the books refers to keeping the accounts in the ledger
The Trial Balance
The Trial balance
• Lists all accounts with their balances- assets first, then liabilities and SE
• Summarizes all the account balances for the financial statements and shows whether
total debits equal total credits
Analyzing accounts
You can figure at missing entries in T-Accounts by calculating e.g.:
Cash
Beginnig balance
Cash receipts
Ending balance
33,000
8,000
35,000
Cash payments
X = 6,000
Correcting Accounting errors
In case of errors you can compute the difference between total debits and total credits
1. Search the records for a missing account
2. Divide the out-of-balance amount by 2
3. Divide the out-of-balance amount by 9 (slide or transposition)
Chart of accounts
Used to list all accounts and account number. Ledger contains accounts grouped as follows:
1. Balance sheet accounts: assets, liabilities, shareholders equity
2. Income statement accounts: revenues and expenses
The normal balance of an account
• Normal balance falls on the side of the account where increases are recorded
o Normal balance of assets is on debit side, so assets are debit-balance accounts
o Normal balance of liabilities and SE is on credit side, so these are
credit-balance accounts
8 Chapter 3 – Accrual Accounting and Income
Accrual accounting versus cash-basis accounting
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Accrual accounting records the impact of a business transaction as it occurs
o When business performs service, makes sales, incurs an expense, transaction
will be recorded even if it receives or pays no cash
Cash-basis accounting records only cash transactions
o Cash receipts (treated as revenues)
o Cash payments (handled as expenses)
IAS1 requires accrual accounting
Basic limitation of cash basis accounting is that the cash basis ignores the underlying
economic activities (i.e. earning revenue and incurring expenses necessary to earn the
revenue)  makes the financial statements purely a record of cash inflows and
outflows
Balance-Sheet Impact of cash-basis accounting
· No account receivable will be recorded
· Account receivable is an asset; if it is not there, assets are understated on balance sheet
Income statement Impact of cash-basis accounting
· Sale on account provides revenue that increases company’s wealth
· Ignoring sale understates revenue and net income
Accrual Accounting and cash flows
Accrual accounting records cash transactions and non-cash transactions
• Cash: Cash from customers, cash from interest earned, paying salaries, rent other
expenses, borrowing money, paying off loans, issuing stocks
• Non-cash: Sales on account, purchases of inventory on account, accrual of expenses
incurred but not yet paid, depreciation, usage of prepaid rent, insurance, supplies,
earning of revenue when cash was collected in advance
The time-period concept
The Time-period concept ensures that accounting information is reported at regular
intervals
• Basic accounting period is one year
• Calendar year from January 1 to December 31
• Fiscal year ends on date other than December 31
The revenue recognition principle
The revenue recognition principle states that, under accrual accounting, revenue should be recognized when it’s earned, so it requires that… a. The entity has transferred to the buyer the significant risks and rewards of ownership of the goods b. The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold c. The amount of revenue can be measured reliably d. It is probable that the economic benefits associated with the transaction will flow to the entity e. The costs incurred or the be incurred in respect of the transaction can be measured reliably 9 Matching Principle This the basis for recording and recognizing expenses. Matching principle includes two steps:
1. Identify all expenses incurred during accounting period
2. Measure the expenses, match expenses against revenues earned
 Subtract expenses from revenues: net income or net loss
Updating the Accounts: the adjusting process
Process of reporting the financial statements begins with the trial balance
Which accounts need to be updated (adjusted)?
Unadjusted means not completely up to date
• Cash, equipment, accounts payable, common stock, and dividends are up-to-date:
because day-to-day transactions provide all data for these accounts
• Accounts receivable, supplies, prepaid insurance… are not yet up-to-date because
certain transactions have not yet been recorded
• Supplies as asset and Supplies expense during an entire month are recorded on the end
Categories of adjusted entries
Adjustments fall into three basic categories
• Deferrals
o Deferral is an adjustment for an item that the business paid or received cash in
advance
o During the period some supplies are used up and become expenses. At the end
of the period an adjustment is needed to decrease the supplies account for the
supplies used up and record the supplies expense
o Prepaid rent, prepaid insurance, and all other prepaid expenses require deferral
adjustments
o Also liabilities require deferral adjustments:
 If company receives cash up front it has an obligation to deliver the
product  called unearned sales revenue.
 When the company delivers the product it decreases the liability and
increases the revenue for the revenue earned
• Depreciation
o Depreciation allocates cost of a plant asset to expense over useful life of asset
 Accounting adjustment: record depreciation expense and decrease
asset’s book value
o Long-term deferral process is identical to deferral-type adjustment, only
difference is the type of asset involved
• Accruals
o Accrual is the Opposite of a deferral
 For an Accrued expense, expenses are recorded before paying cash
 For an Accrued revenue, record revenue before collecting cash
o Other Accruals: Salary expense, interest expense, income tax expense
o Accrued revenue is revenue that business has earned and will collect next year
Prepaid Expenses
Prepaid expense, an expense paid in advance (assets, because provide future benefit)
• Prepaid Rent
o One asset increases (prepaid rent) and another decreases (cash)  asset swop
o After one month, prepaid rent (asset) is credited & rent expense is debited (SE)
 Asset and stockholders equity both decrease
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Supplies
o Supplies are another type of prepaid expense
o Cost of using supplies are expenses
Depreciation of PPE
PPE are long-lived tangible assets (land, buildings, furniture, equipment)
• Assets decline in usefulness and the decline is an expense. When the asset is used a
portion of the assets costs is transferred to depreciation expense
• Accounting matches expense against revenue: matching principle
• Accumulated depreciation account
o Is credited to preserve the original cost of the asset
o Shows the sum of all depreciation expense from using the asset (balance
increases over lifetime of asset)
o Is a contra account: asset account with a normal credit balance
 Contra account:
1. has always companion account
2. normal balance is opposite of that of the companion account
• Book Value (carrying value)
o Is the net amount of plant asset (cost minus accumulated depreciation)
Accrued Expenses and accrued Revenues
• Accrued expense refers to a liability that arises from an expense that’s not yet been paid
o Example: interest expense on a note payable
 an accrued expense increases liabilities and decreases shareholders equity
• Accrued revenue is revenue that has been earned but not yet collected
o Accounted for all accrued revenues: debit a receivable and credit a revenue
Unearned revenues
Collect cash from customers before earning revenue creates a liability = Unearned revenue
o Revenue is earned if job is completed
o One company’s prepaid expense is the other company’s unearned revenue
Summary of adjusting process
Two Purposes of the adjusting process are to:
• Measure income and
• Update the balance sheet
Therefore every adjusting affects at least one of the following:
• Revenue or expense  to measure income
• Asset or liability  to update the balance sheet
Preparing Financial Statements
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The income statement lists the revenue and expense accounts
The statement of changes in equity shows the changes in various equity components
The balance sheet reports asssets, liabilities and SE
Why is income statement prepared first and balance sheet last?
1. The income statement reports net income or net loss, the result of revenues minus
expenses. Revenues and expenses affect SE, so net income is transferred to
retained earnings, which is a part of SE.
2. The statement of changes in equity reflects the increase in retained earnings from the
IS and records payments of dividends. An additional capital contribution would be
also reflected in this statement. The ending balance of equity is carried to the BS
11 Which accounts need to be closed?
• Closing the books means prepare the accounts for next periods transactions
• Closing entries set the revenue, expense, and dividends balances back to zero at
end of
the period
 Remember the Income statement reports only one period’s income
• Temporary Accounts
o Revenues, expenses and dividends because they relate to a limited period
o Closing process applies only to temporary accounts
• Permanent accounts
o Assets, liabilities and SE are not closed, because they carry over to next period
o The ending balances become beginning balances of next period
How to close the books
Closing balances transfer revenue, expense, and dividends to retained earnings
1. Debit each revenue account for amount of its credit balance. Credit retained earnings
for sum of revenues. Now the sum of revenue is in retained earnings
2. Credit each expense account for amount of its debit balance. Debit retained earnings
for sum of expenses
3. Credit the dividends account for amount of debit balance, debit retained earnings;
dividends are no expenses, they never affect income
Retained Earnings
Beg Bal
Exp Revenues
Div
End Bal
Classifying assets and liabilities based on their liquidity
Liquidity means how quickly an item can be converted to cash
• Cash is most liquid asset
• Accounts receivable relatively liquid
• Inventory less liquid than accounts receivable because company must sell the goods
• PPE is even less liquid because these assets are held for use and not for sale
 Balance sheet lists assets and liabilities in order of relative liquidity
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Current assets
o Current assets are the most liquid assets
o IAS1 requires that an entity classify an asset as current when:
 It expects to realize the asset, intends to sell or consumes it within its
normal operating cycle (business cycle)
 It holds the asset primarily for the purpose of trading
 It expects to realize the asset within 12 months after reporting period
 The asset is cash or a cash equivalent unless the asset is restricted from
being exchanged or used to settle a liability for at least 12 months after
the reporting period
 All other assets are considered non-current assets
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Current liabilities
o Current liabilities are obligations that must be paid within the next 12 months
o IAS1 requires that an entity classify an asset as current when:
 It expects to settle the liability within its normal operating cycle
 It holds the liability primarily for the purpose of trading
 The liability is due to be settled within 12 months after reporting period
 The entity does not have an unconditional right do defer settlement of
the liability for at least 12 months after the reporting period
 All other assets are considered non-current assets.
 Some notes payable are paid in installments with first installment due
within one year, second within second year etc.
• First installment: current liability
• Reminder of note payable: non-current liability
Reporting Assets and liabilities:
A Classified balance sheet separates current assets from long-term assets and current
liabilities from long-term liabilities
Formats for the financial statements
Balance Sheet formats
Small companies use the Report formats
• lists asset at the top, followed by liabilities and shareholders equity
Most companies use the Account format
• lists assets on the left and liabilities and shareholders equity on the right
Income Statement formats
IAS1 requires an entity to present an analysis of expenses recognized in the income statement
using a classification based on either their nature of their function within the entity. The
choice depends on historical and industry factors and the nature of the entity.
• Nature of expenses format: an entity aggregates its expenses according to their nature
o Easy to prepare
• function of expenses format: classify expenses as part of cost of sales, marketing costs,
distribution costs, or other functional groupings
o more reliable and relevant
Using Accounting Ratios
Current ratio
current ratio =
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Total current assets
Total current liabilities
Measures ability to pay current liabilities with current assets
Increasing current ratio from period to period indicates improvement in financial
position
Strong current ratio is 1.50 (€1,50 current assets for every €1 current liabilities)
current ratio of 1.00 is considered quite low
Most companies operate between 1.20 and 1.50
13 Debt ratio
debt ratio =
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€
Total liabilities
Total assets
Indicates proportion of a company’s asset that is financed with debt
Measures business ability to pay both current and long-term debts (total liabilities)
Low debt ratio is safer than high debt ratio (0.5 is considered low)
Most bankruptcies result from high debt ratios
When company fails to pay its debts, creditors can take the company away from its
owners
How do transactions affect the ratios?
Lending agreements exists, in which companies have to take care that the current ratio does
not fall below a certain level and that the debt ratio may not rise above a threshold
• The issuance of shares improves the current ratio and the debt ratio
• A cash purchase of a building decreases the current ratio. Debt ratio is unaffected
• A sale on account improves the current ratio and the debt ratio
 see further examples on page 173
14 Chapter 4 – Internal Control and Cash
Fraud and its Impact
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Fraud is an intentional misrepresentation of facts, made for the purpose of persuading
another party to act in a way that causes injury or damage to that party
o Fraud is a huge global problem (e.g. 75% of businesses surveyed had
experiences fraud)
o Fraud has “exploded” with the expansion of e-commerce via the internet
o Most common types of fraud are: insurance fraud, forgery
(Urkundenfälschung), credit card fraud, identity theft
o Two most common types of fraud that impact financial statements are:
 Misappropriation of Assets: Committed by employees of an entity who
steal money from company and cover it up through erroneous entries in
the books (most common)
 Fraudulent Financial Reporting: Committed by company managers
who make false and misleading entries in the books, making statements
look better than they are (most expensive)
• The fraud triangle includes the elements that make up every event. All three elements
of the triangle must be present and take over your decision-making process for fraud
to occur:
o Pressure (or Motive): Critical need or greet for something of the committer
o Opportunity to commit a fraud often arises through weak internal control
o Rationalization: Perpetrator engages in distorted thinking, such as: “I deserve
this; no one will ever know”
 Fraud is defined by state, federal, and international law as illegal
 Fraud is the ultimate unethical act in business
Internal Control
· Internal control is a plan of organization and a system of procedures implemented by
company management and the board of directors to accomplish the following five objectives:
1. Safeguard assets (company must safeguard its assets against waste, inefficiency,
and fraud)
2. Encourage employees to follow company policy
3. Promote operational efficiency
4. Ensure accurate, reliable accounting records
5. Comply with legal requirements
 Public companies are required to maintain a system of internal controls
15 The Sarbanes-Oxley Act (SOX)
• In 2002 the US Congress passed the Sarbanes-Oxley Act with these provisions:
1. Issue an internal control report, which is evaluated by outside auditor
2. Public company accounting oversight board oversees auditors of companies
3. An accounting firm may not both audit a public client and also provide certain
consulting services
4. Stiff penalties await violators (up to 25 years in prison for people with black beards)
The Components of Internal Control
• Can be broken down in 5 components:
 Control environment: owner and top managers must behave honorably to set a
good example for company employees; demonstrate controls importance;
corporate code of ethics modeled by top management
 Risk assessment: company must identify its risks; establish procedures for dealing
with those risks to minimize impacts on the company
 Information system: need of accurate information to keep track of assets and
measure profits and losses
 Control procedures: procedures to ensure that business goals are achieved
(assigning responsibilities, separating duties, using security devices to protect
assets from theft)
 Monitoring of Controls: hire auditors to monitor their controls; internal audits
monitor company controls to safeguard its assets; external auditors monitor the
controls to ensure that accounting records are accurate
Internal Control Procedures
Every major class of transactions needs to have the following internal control procedures:
Smart Hiring Practices and Separation of Duties
• Each person in the information chain is important. The chain should start with hiring
including background checks of the applicants
• Employees should be competent, reliable, and ethical
• Proper training and supervision plus paying competitive salaries
• Clear position descriptions and responsibilities
• Chief accounting officer is called the controller
• Person in charge of writing checks is called the treasurer
• Three key duties are separated:
 Asset handling
 Record keeping
 Transaction approval
• The accounting department should be separated from the operating departments
• Separate the custody of assets from accounting (treasurer of a company should handle
cash, controller should account for the cash; neither should have both jobs)
• If companies are too small for a proper separation it should get the owner involved
Comparison and Compliance Monitoring
• No person or department should be able to completely process a transaction from
beginning to end without being cross-checked by another person or department
• Effective tools to for monitoring compliance with management’s policies is the use of
operating budgets and cash budgets
 Budget is a quantitative financial plan that helps control day-to-day management
 It is prepared for a certain period and further checked with the current numbers
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 Variances need to be explained by managers  exception reporting
To validate accounting records and monitor compliance with company policies, most
companies have an audit
 Audit is an examination of the company’s financial statements and its accounting
system, including its controls
 Internal auditors who are employees of the company
 External auditors who are completely independent and are hired to determine the
company’s financial statements agreement with accounting standards
Adequate Records
• Accounting Records provide the details of business transactions and are generally
supported by hardcopy documents or electronic records
Limited Access
• Company policy should limit access to assets only to persons or departments that have
custodial responsibilities (Cash=lock-box system in treasure’s department)
Proper Approval
• No transaction should be processed without management’s general or specific approval
• The bigger, the more specific should be the approval ; examples:
 Sales to customers on account should all be approved by a separate credit
department
 Personnel decision should be handled by a separate human resources department
• Easy way to remember basic control procedures SCALP:
 Smart hiring practices and segregation of duties
 Comparisons and compliance monitoring
 Adequate records
 Limited access to both assets and records
 Proper approvals for each class of transaction
Information Technology
• Accounting systems are almost entirely relying on IT for record keeping, asset handling,
approval, and monitoring, as well as physically safeguarding the assets
• Basic attributes of internal control (SCALP) do not change, but procedures by which these
attributes are implemented change
 e.g. segregation of duties = segregation of computer departments + restricting
access
Safeguard Control
• Fireproof Vaults for important documents, security cameras to safeguard property
• Employees who handle cash are in a tempting position; companies use fidelity bonds on
cashier as an insurance
 fidelity bonds insure companies against any losses due to employee theft
• Mandatory vacations and job rotations improve internal control  improves morale
Internal Controls for E-Commerce
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E-commerce pitfalls include:
 Stolen Credit-card numbers
 Computer viruses and Trojan horses
o Computer virus is a malicious program
o Trojan Horse hides inside a legitimate program and works like a virus
17 
Phishing expeditions
o Thieves phish by creating bogus websites that sound familiar to the
original websites to trick visitors; thiefs obtain account numbers/passwords
Limitations of Internal Control – Costs and Benefits
• Most internal controls can be overcome by collusion – two or more people work together
• Other ways are: management override, human limitations such as fatigue and negligence,
and gradual deterioration due to neglect
The Bank Account as a Control Device
•
•
•
Cash is most liquid asset because it’s the medium of exchange
 Specific controls for cash, because its most easily stolen
Keeping cash in a bank account helps control cash because banks have established
practices for safeguarding customers money
Documents used to control a bank account:
 Signature Card
o Each person authorized to sigh on an account provides a signature card
o Protects against forgery
 Deposit Ticket
o Banks supply standard forms such as deposit tickets
o Customer fills in amount of each deposit, and keeps deposit receipt
 Cheque
o Depositor can write a cheque to pay cash
o There are three parties to a cheque; the maker (signs), the payee (to whom
it is paid), and the bank (on which the cheque is drawn)
o A cheque has two parts:
• cheque itself and
• remittance advice (optional attachment, tells the payee reason for
payment used for documentation
 Bank statement
o Monthly statements to customers
o Bank statement reports what the bank did with customers cash
o Accounts beginning, ending balances, cash receipts and payments
o Electronic funds transfer (EFT) moves cash by elect. communication
Bank reconciliation
• There are two records of a business’s cash:
1. Cash account in company’s general ledger
2. Bank statement, which shows the cash receipts and payments transacted through
the bank
• Books and bank statement usually show different cash balances; differences because of
time lag in recording transactions
 e.g. a Cheque is immediately deducted in your checkbook; but check is paid a few
days later
• For accuracy - Updating of cash records creates a bank reconciliation, which you must
prepare
 It explains all differences between you cash records and you bank balance
 Person who prepares bank reconciliation should have no other cash duties
18 Preparing Bank Reconciliation (see page 250)
• Items that appear on a bank reconciliation are the following. They all cause differences
between the bank balance and the book balance:
• Bank side of the reconciliation
1. Items shown on bank side of bank reconciliation
a. Deposits in transit (outstanding deposits): you have recorded them but
bank not; add them on bank reconciliation
b. Outstanding cheques: you have recorded but bank has not yet paid them;
subtract outstanding checks
c. Bank errors: correct all bank errors
•
Book side of the reconciliation
2. Items shown on book side of bank reconciliation
a. Bank collections: cash receipts that bank has recorded for your account, but
you haven’t recorded the cash receipt yet; customers often pay directly to
bank = lock-box system which reduces theft
b. Electronic funds transfer: bank receives or pays cash on your behalf; add
EFT receipts and subtract EFT payments
c. Service charge: banks fee for processing you transactions
d. Interest revenue on you checking account: earn interest if you keep enough
cash in account
e. Nonsufficient funds (NSF) cheques: earlier cash receipts that have turned
out to be worthless; treated as cash payments on bank reconciliation
f. Cost of printed cheques: cash payment is handled like a service charge
g. Book error: correct all book errors on book side of reconciliation
Journalizing Transactions from the Bank Reconciliation
• Bank reconciliation does not account for transactions in the journal and is a total separate
tool from journals and ledgers
• To get transactions into accounts, must make journal entries and post to the ledger
• All items on book side of bank reconciliation require journal entries
Online Banking
• With online banking you can reconcile transactions at any time and keep you account
current whenever you wish
• Account history lists deposits, checks, EFT payments, ATM withdrawals, and interest
earned on your bank balance; it does not show the beginning balance
Using the Bank Reconciliation to Control Cash
• Bank reconciliations can be used as a control device, especially in small companies
Internal control over cash receipts
Cash requires some specific internal controls because it is relatively easy to steal
Cash receipts over the counter
• Point of sale terminal (cash register) provides control over cash receipts
 A receipt is issued to ensure that each sale is recorded
 At end of day manager proves the cash by comparing the cash in the drawer
against the machines record of sales
19 Cash receipts by Mail
•
•
•
Many companies receive cash per mail
Controller compares bank deposit amount from the treasurer with debit to cash from
accounting department  cash should equal the amount deposited in the bank
Lock-box system: customers sent checks directly to bank account; internal control is tight
Internal Control over Cash Payments
Companies make most payments by check
Controls over payment by check
• Controls over purchase and payment
1. Purchase order (to other company)
2. Merchandise inventory (send order + fax invoice back)
3. Receiving inventory; preparing receiving report
4. Sending cheque
• For internal control, purchasing agent should not receive inventory or approve payment
• Split purchasing goods: receiving / approving / paying for goods
• Before signing check, controller and treasurer examine packet to prove that all the
documents agree (Purchase order, invoice, receiving report)
 Then the company knows that it received the goods ordered and pays only for
goods received
• Companies keep a petty cash fund on hand to pay minor amounts (executive’s taxi fare)
 Petty cash is opened with particular amount of cash: check for this amount is then
issued to petty cash
 For each petty cash payment, custodian prepares a petty cash ticket to list the item
 Maintaining the petty cash account at its opening balance, supported by the fund
(cash plus ticket), is how an imprest system works
Using a budget to manage cash
• Budget is a financial plan that helps coordinate business activities; cash is budgeted most
often
• Cash budget helps a company or an individual manage cash by planning receipts and
payments during a future period
• Determine how much cash will be needed and then decide whether or not operations will
bring the needed cash; managers proceed as follows:
1. cash balance at the beginning of the period
2. add budgeted cash receipts and subtract the budgeted cash payments
3. beginning balance plus receipts minus payments equals expected cash
balance at end of period
4. compare cash available before new financing to budgeted cash balance at
end of period
20 Reporting Cash on the Balance Sheet
• Most companies usually combine all cash amounts into a single account called:
 Cash equivalents include liquid assets (time deposits and certificates of deposit;
interest bearing accounts that can be withdrawn with no penalty)
Compensating Balance Agreements
• Non of cash balance is restricted in any way
 any restricted amount of cash should not be reported as cash on the balance sheet
• Cash pledged as collateral is reported separately because that cash is not available for
day-to-day business
• Cash pledged as security (collateral) for a loan is less liquid
• Banks often lend money under a compensating balance agreement
 The borrower agrees to maintain an minimum balance in a checking account with
the bank at all time
 The minimum balance becomes long-term assets and is not cash in normal sense
21 Chapter 5 - Short-term Investments & Receivables
Short-term Investments
Trading Securities
Trading securities is common term for short-term investments and marketable securities
• official term Fair Value through Profit or Loss
• Purpose: hold it for short time and then sell it for more than its costs
• Time hold by company: one year or less  current assets
• Next-most-liquid after cash
Unrealized Gains and Losses
· Market value is amount the owner can sell securities for (could increase or decrease)
· Gain when market value is greater than cost of security (has same effect as revenue)
· Unrealized gain/loss (if security has not yet been sold)
· Trading securities are reported on the balance sheet at their current market value
Unrealized Loss on Investments
Investment in Corp
Adjusted investment to market value
5 000
5 000
· A loss has the same effect as an expense
Reporting on the Balance Sheet and the Income Statement
The Balance Sheet
· Short-term investments are current assets
· Appear directly after cash because short-term investments are almost as liquid as cash
 Report trading securities at their current market value
Income Statement
· Investments in debt and equity securities earn interest revenue and dividend income
· Creates gains and losses
 Reported on income statement as Other revenue, gains, and (losses)
22 Realized Gains and Losses
· Gains or Losses are realized when the investor sells the investment
· Gain or loss is different from the unrealized gain or loss
· Realized gain = sales price greater than investment carrying amount
· Realized loss = sales price less than investment carrying amount
Cash
Loss on Sale of Investment
Investment in Corp
Sold investment at a loss
98 000
4 000
102 000
· Report gain or loss on sale of investments among the other items of the income statement
· Gain (or loss) is understood to be a realized gain (or loss) arising from a sale transaction
· Unrealized gains and losses are clearly labeled as unrealized
Accounts and Notes Receivable
Receivables are the third most liquid assets
Types of Receivables
· Receivables (also called debtors) are monetary claims against others
 Selling goods and services  accounts receivables
 Lending money  notes receivable
· Classified as current assets
· Accounts receivable account in the general ledger serves as a control account that
summarizes the total amount receivable from all customers
· Companies keep a subsidiary record of accounts receivable with a separate account for each
customer
· Notes receivable (also called promissory notes) are more formal contracts
 Borrower signs written promise to pay lender at maturity date
 may require the borrower to pledge security for the loan (collateral)
· Other receivables is a miscellaneous category for all receivables other than accounts
receivable and notes receivable (e.g. loans to employees and related companies)
Internal Controls over Cash Collections on Account
· Internal control over collections on account is important
 Separation of cash-handling and cash-accounting duties
· Bookkeepers should not be allowed to handle cash
· Keep accounts away from the supervisor
· Use bank lockbox
How do we manage the risk of not collecting?
· By selling on credit
 Benefit: customers who cannot pay cash immediately can buy on credit  sales &
profit increase
 Cost: company cannot collect from all customers (uncollectible-account expense,
doubtful-account expense, bad-debt expense)
23 Accounting for Uncollectible Receivables
· Allowance for doubtful receivables is an amount that is not expected to be collected
· Net amount of receivables is an amount expected to be collect
 net realizable value because it’s the amount of cash the company expects to realize in
cash receipts
· Uncollectible-account expense is an operating expense along with salaries etc
Allowance Method
· The best way to provide for bad debts is by the allowance method
 IAS: loans and receivables are impaired if, and only if, there is objective and evidence
of impairment as a result of one or more "loss events" that occurred after their initial
recognition. Loss events are
o Significant financial difficulty of a specific debtor (possible bankruptcy)
o A breach of a specific debtor such as default to make interest payments
o Adverse changes in the number of delayed payments by debtor in general
o Economic conditions that correlate with defaults by debtor in general
 The allowance method records collection losses based on estimates developed from
company’s collections experience and information about debtors
 Companies don't wait until people don't pay. Therefore they…
 Record estimated amount as uncollectible-account expense
 Set up allowance for uncollectible receivables (allowance for doubtful receivables,
allowance for receivables impairment)
o Contra account to accounts receivable
o Allowance shows amount of receivables the business expects not to collect
· Aging-of-receivables is popular method for estimating uncollectibles
 It is a balance-sheet approach because it focuses on accounts receivable
 Individual receivables from specific customers are analyzed based on how long they
have been outstanding
o Simplified versions of aging methods would simply list the status or age of the
receivables for the receivables, classified into age groups ("Not yet due", "1-30
days overdue", etc.)
o The goal is to estimate the chance of accounts not being collectible (not yet
due=1%, 1-30=5%)
Uncollectible-Account Expense
Allowance for doubtful receivables
Recorded bad debt expense for the year
151
151
Writing off Uncollectible Accounts
Allowance for Doubtful receivables
Accounts Receivable
Wrote off uncollectible receivables
12
12
· Writing off uncollectible accounts has no effect on total assets, current assets, net accounts
receivable and net income
· Net income is unaffected because the write-off of uncollectible accounts affects no expense
account
24 Adjusting Ending Allowance for Doubtful Receivables
Beginning Allowance -
Receivables Write-­‐offs +
Uncollectible for Doubtful receivables
Allowance for doubtful receivables
Recorded bad debt expenses for the year
Bad Debt Expense Ending Allowance =
22
22
Recovery of Previously Written-Off Receivables
· After accounts have been written-off some can be partially recovered
· Can be treated in one of two ways
1. Reverse the write-off entry
2. Decrease bad debt expense, by the amount recovered
 Both will eventually result In same bad debt expense at the end of the period when new
allowance is calculated
Direct Write-Off Method
· Direct writ-off method, company waits until specific customers receivable proves
uncollectible  less preferable
Uncollectible Account Expense
Accounts Receivable
Wrote off bad debts by direct write-off method
12
12
· Considered defective because it doesn't take into account the possibility of impairment
(minderung) of the receivables at balance sheet date
• As result receivables are always reported at full amount (more than business expects
to receive)  Assets are overstated
Computing Cash Collections from Customers
· Company earns revenue and then collects cash from customers
· Mostly there is a time lag between earning the revenue and collecting the cash
Notes Receivable
· Some notes receivable are collected in installments. The portion due within one year is a
current asset and remainder is a long term asset
• Creditor (to whom money is owed) also called lender
• Debtor (borrower of money) maker of the note or borrower
• Interest (cost of borrowing money) stated as annual percentage rate
• Maturity date (date on which debtor must pay note)
• Maturity value (sum of principal plus interest on note)
• Principal (amount of money borrowed to debtor)
• Term (length of time from when note was signed by debtor to when he must pay note)
• Both Creditor and Debtor have a note payable
25 Accounting for Notes Receivable

Example for a company collecting a note receivable:
Cash
Note Receivable
Interest Receivable
Interest Revenue (1000 x 0,09 x 2/12)
Collected note at maturity
1 045
1 000
30
15
· If the company collects the note receivable it will only state the interest revenue in its
financial statements because the note and interest receivable zero out, when the note is
collected. Three aspects of interest computation are important:
1. Interest rates are always for an annual period, unless stated otherwise
2. Time element always stated per year (use fractions, e.g. 4/12)
3. Interest is often completed for a number of days if you have a period of 90 days, take
90/365
· If a company received a note receivable from a customer whose account receivable is past
due: debit note receivable and credit account receivable
How to Speed up Cash Flow
Credit Card or Bankcard Sales
· If merchants allow paying with credit card or bankcard, then, e.g. 2%, go to
VISA for use of their system
· Credit-card discount expense is an operating expense similar to interest expense
Selling (factoring) Receivables
· If sales are made on account  debit accounts receivable and credit Sales Revenue  A
Company can sell these accounts receivables to another business, called a factor
· Factors earn revenue by paying a discounted price for the receivable and then hopefully
collecting the full amount from the customer
 Benefit for 1st company: fast cash receipt
 Benfit for 2nd company: Make surplus if amount can be collected
· Financing expense is an operating expense
· Discounting a note receivable is similar to selling an account receivable
Cash
Financing Expense
Accounting Receivable
Sold accounts receivable
95 000
5 000
100 000
Reporting on the Statement of Cash Flows
· Receivables and short-term investments are on balance sheet as assets
· Receivable and investment transactions affect cash, must be reported on statement of cash
flows
· Receivables bring in cash: transactions reported as operating activities on statement of cash
flows because results from sales
· Investment transactions show up as investing activities on statement of cash flows
26 Using two Key Ratios to Make Decisions
Measure liquidity
Acid-Test (or Quick) Ratio
· Balance sheet lists asset in order of relative liquidity
1. Cash and cash equivalents
2. Short-term investments
3. Accounts (notes) receivable
 The acid-test ratio is a more stringent measure than the current ratio to measure the ability
to pay current liabilities with current assets
acid − test ratio =
cash + shortterm investments + net current receivables
Total current liabilites
· The acid-test ratio is considered "Safe" when > 1
· Acceptance of this depends on the industry
€
Days’ Sales in Receivables
· After a credit sale, the next step is collecting receivables. The Days’ sales in receivables,
also called the collection period, tells a company how long it takes to collect its average
level of receivables
 The longer the period, the less cash is available to pay bills and expand
1. Receivable Turnover =
Sales
Average Receivables *
2. Days sales in inventory =
365
Receivables Turnover
* Average net receivables =
Beg. net receivables + End. net receivables
2
€
€
€
27 Chapter 6 - Inventory & Cost of Goods Sold
Accounting for Inventory
· IAS- Inventory: assets that are
a) Held for sale In the ordinary course of business
b) In the process of production for such sale
c) In the form of materials or suppliers to be consumed in the production process or in
the rendering of services
 Inventory cost shifts from asset to expense when seller delivers goods to the buyer
Sale Price vs. Cost of Inventory
Note the difference between sale price of inventory and the cost of inventory
• Sales revenue is based on the sale price of inventory sold
• Cost of goods sold is based on the cost of the inventory sold
• Inventory on balance sheet is based on the cost of inventory still on hand
· Gross profit (gross margin) is the excess of sales revenue over cost of goods sold. It is called
gross profit because operating expenses have not yet been subtracted
Inventory
=
(Balance sheet)
Number of units of
inventory on hand
x
Cost per unit
of inventory
Cost of goods sold =
(Income Statement)
Number of units of
inventory sold
x
Cost per unit
of inventory
Number of Units of Inventory
· Number of Inventory units on hand determined from accounting records, backed up by a
physical count of the goods at year end
 Doesn't include any goods in own inventory held on consignment because those goods
belong to another company
 Does include own inventory that is out on consignment and held by another company
· Shipping term, FOB (free on board or freight on board) indicates who owns the good at
particular time and, therefore, who must pay for it
 FOB shipping point purchaser legally owns good when inventory leaves seller's place
of business
o Purchaser owns goods while they are in transit & must pay transportation costs
o Purchaser must include goods in transit from suppliers as units in inventors as
of the year end
 FOB destination title to the goods does not pass from seller to purchaser until goods
arrive at purchaser's receiving dock
o Goods are not counted in year-end Inventory of purchasing company
o Goods included in inventory of the seller until goods reach destination
28 Cost per Unit of Inventory
· Challenge because companies purchase goods at different prices throughout the year
Accounting for Inventory in the Perpetual System
· Two types of inventory accounting systems:
 Periodic inventory system: used for inexpensive goods
o Doesn't keep running record of all goods bought, sold and on hand
o Count inventory periodically to determine the quantities on hand
 Perpetual inventory system: uses computer software to keep a running record of
inventory on hand
o Control over goods; used by most business
o still inventory is counted on hand annually to check for correct amount
How the Perpetual System Work
· Clerk scans the bar code on the labels of the item bought
· Computer records the sale and updates the inventory records
Recording Transactions in the Perpetual System
· When company makes a sale, 2 entries are needed in perpetual system
 The company records the sale (debits cash or accounts receivable and credits sales
revenue for the sale price of the goods)
 Debits cost of goods sold and credits inventory for the cost of the sold inventory
 Cost of inventory is the net amount of the purchases
· Freight-In is the transportation cost paid by buyer and is accounted for as part of the cost of
inventory
· Purchase return is decrease in cost of inventory because the buyer returned goods to the
seller (vendor)
· Purchase allowance (decreases costs of inventory) buyer gets allowance (deduction) from
amount owed
· Debit memorandum: accounts payable are reduced (debited) for the amount of the return
· Purchase discount a decrease in buyer's cost of inventory earned by paying quickly
 Example for payment terms: 2/10 n/30: 2% paid within 10 days, rest within 30 days
 Common credit term is net 30 which tells customer to pay full amount within 30 days
Net purchases = Purchase price of inventory
- Purchase return and allowances
- Purchase discounts
+ Freight-in
Net sales =
Sales revenue
- Sales return and allowances
- Sales discounts
 Freight-out paid by seller is not part of the cost of inventory but is a delivery expense
29 Inventory Costing
What goes into Inventory Cost?
· IAS- Inventories:
 cost of inventories shall compromise all costs of purchase, conversion and other costs
incurred in bringing the inventories to their present location and condition
 cost of purchase of inventories thus compromise the purchase price, import duties and
other taxes, and other costs (transport, handling) directly attributable to the acquisition
of finished goods, materials and services
 Advertising, sales commission, and delivery costs are expenses and not included as cost of
inventory
The Various Inventory Costing Methods
· IAS-Inventory:
 Cost of inventory items that are not ordinarily interchangeable shall be assigned by
using specific identification
 Costs of other inventories that are ordinarily interchangeable are determined using
common cost formulas:
o First-in, first-out (FIFO) method
o Last-in, last-out (LIFO) method
o Average cost method
 The retail inventory method is used by retailers for measuring inventories of large
numbers of rapidly changing items with similar margins
 The IAS prohibits the use of LIFO cost formula (although allowed in the US)
Specific Identification
· For businesses that deal in unique inventory items
 Businesses cost their inventories at the specific cost of the particular unit
· Method too expensive to use for inventory items that have common characters
· Other methods (FIFO etc.) assume different flows of inventory costs
· Big accounting questions:
1. What is the cost of goods sold for the income statement?
2. What is the cost of the ending inventory for the balance sheet?
FIFO Cost
· First costs into inventory are first costs assigned to cost of goods sold
· Under FIFO, the cost of ending inventory is always based on the latest cost incurred
LIFO Cost
· Las costs into inventory go immediately to cost of goods sold
· Under LIFO, the cost of ending inventory is always based on oldest cost:
 from beginning inventory plus the early purchases of the period
Average Cost
· The Average-cost method is based on the average cost of inventory during the period
Average cost per unit = Cost of goods available*/Number of units available
*Goods available = Beginning Inventory + Purchases
30 The Effects of FIFO, LIFO and Average Cost on Cost of Goods Sold, Gross Profit, and
Ending Inventory
· When inventory costs change, the various Inventory methods produce different cost-ofgoods sold figures
· When inventory costs are increasing:
FIFO
LIFO
Costs of Goods Sold
FIFO COGS is lowest because it's
based on the oldest costs, which are
low. Gross profit is the highest.
LIFO COGS is highest because it's
based on the most recent costs, which
are high. Gross profit Is the lowest.
Ending Inventory
FIFO ending inventory is highest
because it's based on the most recent
costs, which are high.
LIFO ending inventory is lowest
because it's based on the oldest costs,
which are low.
 Opposite when inventory costs are decreasing
 IAS requires entities to use the same cost formula unless the nature of the inventories is
dissimilar
Comparison of the Inventory Methods
1. Measuring cost of goods sold
a. LIFO results in most realistic net income figure because it assigns the most
recent inventory cost to expense
b. FIFO matches old inventory cost against revenue  poor measure of expense
c. FIFO income is less realistic than LIFO income
2. Measuring ending inventory
a. Most up-to-date inventory cost on balance sheet: FIFO
b. LIFO can value inventory at very old cost because LIFO leaves oldest prices in
ending inventory
Accounting Principles Related to Inventory
Comparability Principle
· Comparability principle states that businesses should use the same accounting methods and
procedures from period to period
 Consistency enables investors to compare a financial statement from period to next
 Switch from LIFO to FIFO increases income dramatically
 Company making an accounting change must disclose the effect of the change on net
income
Net Realizable Value
· IAS requires inventories to be measured at lower cost and net realizable value (NRV)
 Once costs are determined inventory must be compared to its NRV
NRV = estimated selling price - estimated costs of completion - estimated costs of sale
Cost of Goods Sold
Inventory
Wrote Inventory down to realizable value
600
600
31 Inventory and the Financial Statements
Analyzing Financial Statements
Ratios are used to evaluate a business:
Gross Profit Percentage
Gross profit = Sales - Costs of Goods Sold
· Key indicator of a company's ability to sell inventory at a profit
· Merchandisers strife to increase gross profits/margin percentage
 A mark-up stated as a percentage of sales
Gross profit percentage = Gross profit/Net sales revenue
 e.g. 49%: Each dollar of sales generates about 49 cents of gross profit
 Changes little from year to year, so a small downturn may signal trouble
Inventory Turnover
· The faster the sales, the higher the income, and vice-versa for slow-moving goods
 Ideally operate with zero inventory
· Inventory turnover is the ratio of COGS to average inventory (how rapidly inventory is sold)
Inventory turnover = COGS/Average inventory
Additional inventory Issues
Using the Cost-Of-Goods-Sold Model
· Is used by all companies, regardless of accounting system
· Captures all the inventory information for an entire accounting period
Cost of Goods Sold
Beginning Inventory
+ Purchases
= Goods Available
- Ending Inventory
= Cost of Goods Sold
1 200
6 300
7 500
(1 500)
6 000
 Most important question (if perpetual inventory accounting system is used)
 What merchandise should be offered to customers? (marketing question)
 How much inventory should company hold? (accounting question)
 Rearrange formula of cost of goods sold to come to purchase amount
Estimating Inventory by Gross Profit Method
· Often businesses must estimate value of its goods
· Gross profit method is used to estimate ending inventory
 For gross profit method, rearrange ending inventory and cost of goods sold
Cost of Goods Sold
Beginning Inventory
+ Purchases
= Goods Available
- Cost of Goods Sold
= Ending Inventory
1 200
6 300
7 500
(6 000)
1 500
 Using the actual gross profit rate, you can estimate the cost of goods sold
 Subtract cost of goods sold from goods available to estimate ending inventory
32 Effects of Inventory Errors
· Example: overstated Ending inventory  understated COGS
· Without any further errors, inventory errors counterbalance in two consecutive periods
 Period 1's ending inventory becomes period 2's ending amount
 Error carries over to period 2, resulting in overstated COGS and understated gross
profit in period 2
 Beginning inventory and ending inventory have opposite effects on cost of goods sold
(beginning inventory is added, ending inventory is subtracted)
33 Chapter 7 – PPE & Intangibles
Types of Assets
•
•
•
•
PPE (fixed assets)
o Long-lived assets that are tangible (land, buildings, equipment), held for use in
the production or supply of goods etc.
 associated expense: depreciation (land is not expensed over time),
amount so far allocated: accumulated depreciation
Construction In Progress
o Placeholder for assets that are being constructed, when finished moves to PPE
or intangible assets account
Intangible assets:
o Identifiable non-monetary assets that have no physical form, but are still
identifiable: (patents, copyrights, trademarks, goodwill)
 associated expense: amortization (similar to depreciation)
Investment properties
o Specially designated class of properties held to earn rentals or for capital
appreciation
 PPE and Intangibles are subject to impairment tests - ensures that stated amounts
do not exceed fair values
Initial Recognition and Measurement of PPE
•
Cost of any asset is the sum of all the costs incurred to bring the asset to its intended
use: Purchase price, plus taxes, commissions
o IAS16 directly attributable costs:
 costs of employee benefits
 costs of site preparation
 initial delivery and handling costs
 installation and assembly costs
 testing costs
 professional fees
o What should not be included in PPE costs:
 Costs of opening a new facility
 Costs of Introducing a new product or service
 Costs of conducting business in a new location
 Overhead costs
Land and Land Improvements:
• Cost of land:
o Includes: purchase price (cash plus any note payable given), brokerage
commission, survey fees, legal fees, back property tax; expenditures for
grading and clearing land and for removing unwanted buildings
o Not includes: land Improvements which are subject to depreciation
 cost of leasehold improvements should be depreciated over the term of lease,
(often called amortization)
34 Buildings, Machinery, and Equipment
The cost of building inclues architectural fees, building permits, contractors charges, and
payments for material, labor and overhead
 If company constructs its own building: costs include the cost on interest on money
borrowed
 If company purchases existing building: costs include purchase price, brokerage
commission, sales and other taxes paid, all expenditures to repair and renovate
Lump-Sum (or Basket) Purchases of Assets
Businesses often purchase assets as a group or basket, for a single lump-sum amount
 Must identify the cost of each asset
 Total cost is divided among the assets to their relative sales (market) value
 Relative-sales-value method: Ratio of each assets market value to total market value
Subsequent Costs (Capital Expenditure vs. Immediate Expenses)
• Expenditures that increase the assets capacity or extend its useful life are called capital
expenditures
• add the costs to the asset account
• Costs that do not extend the assets capacity or its useful life, but merely maintain the asset
or restore it to working order, are recorded as expenses
 Expense that should have been capitalized: overstate expenses and understates net income
 Capitalize a cost that should have been expensed: understate expenses and overstates net
income
Measuring Depreciation on PPE
•
•
•
Carrying amount of an item (Book value) of PPE = cost – accumulated depreciation
Depreciation:
o Allocate an asset's cost to expense over its useful life
o Matches asset expense against revenue to measure income (matching principle)
o Depreciation expense is reported on income statement
Physical wear and tear: physical deterioration
Obsolescence: asset can become obsolescent before they deteriorate (obsolete if another
asset can do job more efficiently)  useful life may be shorter than physical life
1. depreciation is not a process of valuation: not based on changes in market value
2. depreciation does not mean setting aside cash to replace assets as they wear out
How to allocate depreciation
• Things which have to be known:
1. Cost
2. Estimated useful life
3. Estimated residual value
• Estimated useful life:
o expected usage of the asset, expected physical wear and tear, technical or
commercial obsolescence, legal or similar limits on the use of the asset (e.g. expiry
dates)
• Estimated residual value (scrap value or salvage value):
o expected cash value of an asset at end of its useful life (it is not depreciated)
Depreciable Amount = Assets cost – Estimated residual value
35 Depreciation methods
There are three methods
• Straight-line
o Straight-line (SL) method: An equal amount of depreciation is assigned to each
year of asset use  Determine annual depreciation expense
o As an asset is used in operations, accumulated depreciation increases and the book
value of the asset decreases  decreases assets and equity
o Assets final book value is the residual value
• Units-of-production
o Units-of-production (UOP) method: A fixed amount of depreciation is assigned to
each unit of output, or service, produced by asset
•
Double-declining-balance
o An Accelerated depreciation method writes off a larger amount of the assets cost
near the start of its useful life than the straight-line method does
o Double-declining-balance (DDB) depreciation computes annual depreciation by
multiplying the assets declining book value by a constant percentage, which is 2
times the straight-line depreciation rate
1. Compute straight-line depreciation rate per year
2. Multiply straight-line rate by 2 to compute DDB rate
3. Multiply DDB rate by periods beginning asset book value (cost less
accumulated depreciation)
• Ignore the residual value of the asset in computing depreciation, expect
during last year
4. Determine the final years’ depreciation amount to reduce asset book value to
its residual value
• Residual value should not be depreciated but should remain on the books
until disposed off
o DDB differs from other depreciation methods in 2 ways:
1. Residual value is ignored initially, depreciation computed on full costs
2. Depreciation expense in the final year is the Plug amount needed to
reduce the assets book value to the residual amount
 All methods result in same total amount of depreciation (depreciable cost), but
allocate different amounts to each period
Comparing Depreciation Methods
· Total depreciable cost is same
• Straight-line best fits for plant asset that generates revenue evenly over time
• Units-of-production best fits those assets that wear out because of physical use
rather than obsolescence
• DDB applies best to assets that generate more revenue earlier in lives
 For reporting in the financial statements, straight-line depreciation is most popular
36 Other Issues in Accounting for PPE
•
•
•
•
Choice of depreciation method may affect income taxes; a different depreciation method
may be used for financial reporting vs. tax purposes
PPE have long lives, and subsequent better information may change estimates of useful
life of assets and residual values
Alternative models for measurement of PPE subsequent to initial recognition
Companies that have gains or losses when they sell PPE
Depreciation for Tax Purposes
• DBB is most popular for income-tax purposes  It's legal, ethical and allowed
• Accelerated depreciation provides fastest tax deductions, thus decreasing immediate tax
payments  Reinvest tax savings
• Since depreciation is an expense, it decreases net income, therefore decreases the tax
amount payable
Depreciation for partial years
Companies also purchase Equipment during a year and not at the beginning
How to compute it:
1. Compute depreciation for a full year
2. Multiply full-year depreciation by fraction of the year that you held the asset
o If bought on 18th, many businesses record no monthly depreciation on assets
purchased after 15th of month but record a full month's depreciation on asset
bought before 15th
o Depreciation is often automatically updated  by computer systems
Changes in estimates of useful lives or residual values
• Recalculate depreciation on basis of new useful life
• Spread remaining depreciable book value over assets remaining life
Impairment of PPE
• Asset is Impaired when its carrying value is higher than Its recoverable amount
o Recoverable amount is the higher of fair value less cost to sell and value in use
• Assets (factory) and equity (through the loss account) decrease
Measurement subsequent to initial recognition
• IAS16: entity elects one out of two measurement models for each class of property 
grouping of assets of similar nature and use in an entity's operations
o Cost model: an item of PPE shall be carried at its cost, less any accumulated
depreciation and any accumulated impairment losses
o Revaluation model: an item of PPE whose fair value can be measured reliably
shall be carried at a revalued amount
 Revaluations shall be made with sufficient regularity to ensure that the
carrying amount does not differ materially from that which would be
determined using fair value at the balance sheet dates
Fully Depreciated Assets
Fully Depreciated Assets are Asset that reached the end of its estimated useful life
• Equipment may be usable for longer time, but company will not record any more
depreciation on a fully depreciated asset
• When equipment is disposed, assets costs and its accumulated depreciation will be
removed from the books
37 Accounting for disposal of PPE
Before accounting for disposal of an asset, business should bring depreciation up to date
o Measure assets final book value
o Record the expense up to the date of sale
• To account disposal: remove asset and its related accumulated depreciation from books
o There is no gain or loss on the disposal, no effect on assets, liabilities or equity
• If assets are junked before being fully depreciated, company incurs a loss on the disposal
o Loss decreases assets and equity
o Loss is reported as other income (expense) on the income statement
 Losses decrease income as expenses do; gains increase as revenues do
Selling PPE
• First update depreciation until the date of the sale
o There is a gain on sale if sale price is higher than book value
o Entry: cash and accumulated depreciation debited, equipment and gain on sale
of equipment credited
 Total assets as well as equity increase
Exchanging PPE
• Trade old assets for new ones
o Transfer the book value of the old asset plus any cash payment into new asset
account
o Cost of new asset is then purchase price plus book value of old asset
o Debit new asset and debit accumulated depreciation, credit cash plus old asset
 No effect on total assets, liabilities or equity because there was no gain or
loss on the exchange
•
Accounting for Natural Resources
•
Assets of special type (iron, oil etc.) expensed through depletion
o Depletion expense is that portion of the cost of a natural resource that is used
up in a particular period
 Same way as units-of-production depreciation
 Entry is almost identical to a depreciation entry
Accounting for intangibles
•
•
•
They are recorded at its acquisition cost
They are the most valuable assets of high-tech companies and those that depend on
research and development
Intangible assets fall into two categories:
1. Intangibles with finite lives that can be measured reliably
a. Expense is called amortization for these intangibles which works like
depreciation, usually on straight-line basis
b. The residual value for most intangibles is zero
2. Intangibles with indefinite lives:
a. Record no amortization
b. Check them annually for any loss in value, and record a loss when it
occurs (Impairment)
c. Good example is Goodwill
38 Accounting for Specific intangibles
Patents
• Patents are federal government grants that give the holder the exclusive right for a number
of years to produce and sell an invention
o Invention may be a product or a process
o Patent must be purchased
o Amortization: credit patent account and debit Amortization Expense
 Decreases both assets and equity
Copyrights
• Copyrights are exclusive rights to reproduce and sell a book, musical composition, film or
other work of art and computer software
o Issued by federal government, extend 70 years beyond the authors life
o Cost of obtaining copyright from government is low, but a company may pay a
large sum to purchase an existing copyright from owner
Trademarks and Trade names
• Trademarks and trade names (brand names) are distinctive identification of a product or
service
o Some have definite useful life set by contract
o Amortize this trademarks cost over its useful life, but they may have an
indefinite life that cannot be fully amortized
Franchises and Licenses
• Franchises and licenses are privileges granted by a private business or a government to
sell a product or service in accordance with specified conditions
o Useful life of many franchises and licenses are indefinite and, therefore, are
not amortized
Goodwill
• Goodwill is defined as the excess of the cost of purchasing another company over the sum
of the market value of the acquired company’s net assets
o Willing to pay for goodwill if company has abnormal earning power
• Goodwill in accounting has special features
1. Goodwill is recorded only when it is purchased in the acquisition of another
company (never record goodwill for own business)
2. Unlike other intangibles with finite useful lives, goodwill Is not amortized but
subject to strict impairment tests
Accounting for the Impairment of an intangible asset
• Impairment testing applies to intangible assets as it does for PPE
• Some intangibles have indefinite life: goodwill, licenses etc.  no amortization
o But all intangible assets are subject to a write-down when their value decreases
called Impairment
• If goodwill decreases in value, record an Impairment loss on goodwill and write down the
book value of the goodwill  Assets and equity decrease
• Unlike tangible assets, once goodwill is impaired, IFRS prohibit any reversal of the
impairment
39 Accounting for research and development costs
• Account for R&D is most difficult issue
• Under IAS38, the accounting treatment for R&D expenditures Is literally split in the
middle between research and development:
• Costs associated with the creation of intangible assets are classified into research
phase costs and development phase costs
1. Research phase costs are always expensed
2. Development phase costs are capitalized when all of the following criteria can
be demonstrated:
 The technical feasibility of completing the intangible asset
 The intention to complete the intangible asset
 The ability to use or sell the intangible asset
 The future economic benefits
 The availability of adequate resources to complete development of the
asset
 The ability to reliably measure the expenditure attributable to the
Intangible asset during its development
 It requires judgment, supported by objective evidence
Reporting PPE Transactions on the Statement of cash flows
There are three main types of PPE transactions
1. Acquisition
2. Sales
3. depreciation (including amortization and depletion)
• Acquisition and disposal of PPE are investing activities
o Payment for equipment and buildings are investing activities that appear on the
statement of cash flows
o Sale of PPE results in a cash receipt (see p. 441)
• Depreciation appears on cash-flow statement, but it does not affect cash
o Depreciation decreases net income, but does not affect cash; is therefore added
back to net income to measure cash flow from operations
 It helps to reconcile net income (on accrual basis) to cash flow from operations (Indirect
method)
40 Chapter 8 Current Liabilities •
•
Obligation due within 1 year or within company’s normal operating life cycle if longer than 1 year Current liabilities are of 2 kinds: o Known amounts o Estimated amounts Current Liabilities of Known Amounts Accounts payable, short-­‐term notes payable, sales tax payable, accrued liabilities, payroll liabilities, unearned revenues, current portion of long-­‐term debt • Accounts Payable owed for products and services purchased on account • Short-­term notes payable, common form of financing payable within 1 year o Like short-­‐term borrowings o Interest expense and interest payable is accrued • Sale Tax Payable is collected by retailers from customers and owed to the tax authority • Accrued Liabilities (Accrued Expenses) results from an expense the business has incurred but not yet paid o Salary and wages payable o Interest payable o Income taxes payable  Every expense accrual has same effect: liabilities increase; equity decreases • Payroll liabilities, also called employee compensation, is a major expense for service organizations, just as COGS for merchandising company o Salary is employee pay stated at a monthly or yearly rate o Wage is employee pay stated at an hourly rate o Sales employees earn a commission = percentage of the respective sales o Bonus is an amount over and above regular compensation o Salary expenses represents gross pay (employee pay before subtractions for taxes and other deductions) • Unearned Revenues also called deferred revenues, revenues collected in advance o Company has an obligation, to provide goods or services to customers • Current Portion of Non-­Current (or long-­term) debt o Some long-­‐term debt must be paid in installments. The Current portion of long-­term debt (also called current maturity or current installment) is the amount of the principal that is payable within one year. At end of year, company reclassifies (from long-­‐term to current liability) the amountof its long-­‐term debt that must be paid next year Current Liabilities that must be estimated • Provision for warranty repairs o Companies guarantee their products under warranty agreements o Whatever warranty’s life, the matching principle demands that the company record the warranty expense in the same period that the business records sales revenue o Exact amount of warranty expense cannot be known with certainty  estimate warranty expense and related liability 41 Contingent Liabilities Contingent liability is not an actual liability, but a disclosure item in the notes to the financial statement. Contingent Liabilities arise when… • There is a possible obligation to be confirmed by a future event that is outside the control of the entity • A present obligation may, but probably will not, require an outflow of resources • A sufficiently reliable estimate of the amount of a present obligation cannot be made  Examples of contingent liabilities are future obligations that may arise because of lawsuits, tax disputes, or alleged violations of environmental protection laws  There is no need to report a contingent loss that is unlikely to occur  The new IFRS is likely to demand more disclosures of quantitative & qualitative information for contingent liabilities than are presently required Are all your liabilities reported on the balance sheet? • If a company fails to report a large debt it understates its liabilities and debt ratio and probably overstate its net income • Contingent liabilities are easy to overlook because they are not actual debts Summary of the Current Liabilities On the income statement a company would report • Expenses related to some of the current liabilities (salary, interest, income tax, warranty) • Revenue related to unearned revenue Long-­term liabilities: Bonds and notes payable •
Bonds payable are groups of notes payable issued to multiple lenders called bondholders. o Benefit for company (issuer): raising cash o Benefit for bondholder: possibility to diversify risk by holding different bonds Bonds • Characteristics o Principal (face value, maturity value): typically stated in units of $1000 o Maturity date: specific future time when the issuer pays the principal o Interest expense: rental fee on borrowed money o Underwriter: usually a bank which purchases the bonds from the issuing company and resells them to its clients (and probably earns a commission) • Types of Bonds o Term bonds mature at the same time o Serial bonds mature in installments over a period of time o Secured or mortgage bonds give the bondholder the right to take specific assets of the issuer if the company defaults o Unsecured bonds (debentures) are backed only by the good faith of the borrower and usually carry a higher rate of interest • Bond Prices o Investors may buy and sell bonds trough bond markets o Bond prices are quoted at a percentage of their principal 42 •
Bond premium and Bond discount Bond premium Bond discount •
Issued above face value Issued below face value Credit balance Premium decreases toward face value Discount increases toward face value Debit balance Bond Interest Rates determine Bond Prices o Bonds are sold at their market price = bond’s PV = PV of the principal payment + PV of future cash interest payments (usually paid semi-­‐annually) o Price of the bond is determined by two interest rates  Stated interest rate (coupon rate) is the interest rate printed on the bond certificate  Market interest rate (effective interest rate) is the rate investors demand for loaning their money. This rate can fluctuate after issuance of the bond. Issuing bonds at par value • Issuing the bond: debit cash, credit bonds payable  increase assets & liabilities • Interest payment: debit interest expense, credit cash  decrease assets & SE • Accrue interest expense and interest payable at year end for interest payment on January 1st : debit interest expense, credit interest payable  increase liabilities, decrease SE • Interest payment: debit interest payable, credit cash  swop assets • Pay off the bond: debit bonds payable, credit cash  decrease assets & liabilities Issuing bonds at discount 43 What is the Interest Expense on These bonds payable? • The interest payment is set by the bond contract and therefore remains the same • The interest expense… o Increases for a discount bond as the bonds march toward maturity o Decreases for premium bond as the bonds march toward maturity • The effective-­interest method of amortization… o Determines the periodic interest expense o Shows the bond carrying amount Interest Expense on bonds issued at discount and premium • For a discount bond holds = issuing value < maturity value. The difference is an additional interest expense that amortizes the bonds carrying value to its maturity value. Thus the bonds carrying value in increasing • For a premium bond holds = issuing value > maturity value. The difference is a premium that reduces the interest expense that amortizes the bonds carrying value to its maturity value. Thus the bonds carrying value in decreasing. • For partial-­period Interest amounts and further information see page 485-­‐492 The straight-­line amortization method • also called effective interest amortization method • Divides a bond discount or premium into equal periodic amounts. The amount of interest expense is therefore the same each period • Calculation: + = •
Cash interest payment amortization of account ((maturity value – issuing value)/number of payments Estimated interest expense This method is called quick and dirty because it simplifies the amortization. It is not allowed under the IFRS Should we retire bonds payables before maturity? • Sometimes companies retire bonds early because… o Of the pressure of making high interest payments o The company may be able to borrow at a lower interest rate • If a bond is callable the issuer may call or pay off the bond at a prearranged price stated in a percentage points above the par value (e.g. 101%) • The alternative is to purchase the bonds back in the open market at their current market price Convertible bonds and notes • Corporate bonds and notes that can be converted into the issuing company’s share capital are called convertible bonds (convertible notes) • For investors the benefits are o The safety of assured receipt of interest and principal on the bonds o The opportunity for gains on the shares • This feature may be so attractive that investors accept lower interest rates on the bonds. When the share price get’s high enough the bondholders convert the bonds into shares 44 Financing operations with bonds or shares? There are three ways for a company to finance operations 1. By retained earnings: a. Advamtage: low-­‐risk 2. By issuing shares: a. Advantage: creates no liabilities or interest expense and is less risky. Dividend payments can be omitted b. Disadvantage: low EPS 3. By issuing bonds: a. Advantage: gives no control of the corporation to other people. High EPS b. Disadvantage: increases debt and therefore risk  see Exhibit 8-­‐10 on page 495 for an example The times-­interest-­earned ratio • The debt ratio measures the effect of debt on the company’s financial position but says nothing about the ability to pay interest expense • The times-­interest-­earned ratio (interest-­coverage ratio) relates income to interest expense and measures the number of times that operating income can cover interest expense • A high times-­‐interest-­‐earned ratio indicates ease in paying interest expense; a low value suggests difficulty Operating Income
• Formula: Times − interest - earned ratio =
Interest Expense
Non-­current liabilities: Leases and Pensions €
•
•
Lease: This is a rental agreement in which tenant (lessee) agrees to make rent payments to property owner (lessor) in exchange for the use of asset There are two types of leases o Operating leases:  rental agreement between the lessor and the lessee, who pays the lessor to make use of the leased assets  Many operating leases are non-­‐cancellable.  The lessor retains the usual risks and rewards of owing the leased assets  Neither leased assets nor future payments are recorded on the balance sheet. Instead imposes disclosure requirement. o Capital leases: Leases are recognized as capital leases if they meet any of the following conditions  Lease transfers substantially all risks and rewards of asset to leesse  Lease transfers ownership of asset to lessee at the and of the lease  Lease term represents substantial part of asset’s useful life  PV of lease payments represents substantial part of fair value of asset 45 o Capital leases:  The lessee enters the asset into long-­‐term assets and records a long-­‐term liability at beginnig of lease turm  The lessee capitalizes the asset but may never take legal title to the ownership.  The lessee will record the PV of its lease payment on its books. The original entry is a debit lease assets and credit lease liabilities. As the asset is being used it is depreciated. When lease payments are made it is first made against lease interest expense, and remaining balance reduces outstanding lease payments  companies prefer operating leases over capital leases because operating leases do not increase debt and therefore do not affect the debt-­‐ratio Pensions and Post-­retirement Liabilities There are two basic schemes for employees’ post-­‐retirement liabilities • Defined contribution o Employers contribute a fixed amount on money (provident, superannuation) to an employee’s pension fund o Employers obligation ends one the contribution has been made o Members of the pension fund are able to use, invest or withdraw the contribution accumulated according to the fund’s rules & regulations • Defined benefit plan o Employee is promised some post-­‐retirement benefits (pensions) o Companies may provide other benefits e.g. medical insurance o Companies record pension and retirement-­‐benefits while employees work for the company • At the end of each period the company compares o Fair market value of assets in the retirement plans (cash & investment) o With the plans accumulated benefit obligation, which is the PV of promised future payments to retirees  Plan is overfunded if: assets > accumulated benefit obligation  report in the notes to the financial statements  Plan is underfunded if: assets < accumulated benefit obligation  report excess liability amount as long-­‐term liability on balance sheet Reporting the fair market value of long-­term debt • The IFRS requires companies to report fair market value of their financial liabilities • Fair market values of publicly traded debt are based on quoted market prices and can therefore exceed or be less than their carrying amounts 46 Chapter 9 – Shareholders’ Equity
What’s the best way to organize a business?
Separate legal Entity
• Corporation is formed under state law
• It is a distinct entity that exists apart from its owners (shareholders)
• Has many rights that a person has: buy, own, sell property
• Assets and liabilities belong to corporation and not to its owners
Continuous life and transferability of ownership
• Companies have Continuous life regardless of changes in their ownership
• Proprietorships and partnerships terminate when ownership changes
Limited Liability
• Stockholders have limited liability for corporation’s debt
• Most they could lose, cost of the investment
• Enables corporation to raise more capital
• Proprietors and partners are personally liable for all the debts of their businesses
Separation of ownership and management
• Stockholders own, but the board of directors appoints officers to manage the business
• Managements goal is to maximize the firm’s value for the stockholders
• Agency problem
Corporate Taxation
• Proprietorships and partnerships pay no business tax, but their owners
• Corporation are separate taxable entities which pay corporate tax
o sometimes also federal and state income taxes
• Corporations pay income taxes on their corporate income
Government Regulation
• To protect a corporations creditors and stockholders, federal and state governments
monitor corporations
o Ensure that they disclose information: accounting
• Big listed companies will be subject to more regulatory oversight than a private
company with a small number of shareholders
Advantages (of a Corporation)
1. Can raise more capital than a
proprietorship
2. Continuous life
3. Ease of transferring ownership
4. Limited liability to shareholders
Disadvantages
1. Separation of ownership and
management
2. Corporate taxation
3. Government regulation
47 Organizing a Corporation
•
•
•
•
Organizers apply for registration as a company with the relevant authority
Typically required are a constitution, charter, or memorandum of association
Stockholders elect a board of directors; set company policy and appoint officers;
The Board elects a chairperson CEO and sometimes also a chief operating officer
COO (day-to-day operations)
Stockholders Rights
• Ownership of shares gives shareholders four basic rights:
1. Vote: participate in management; 1 vote per share; usually at the annual
general meeting (AGM)
2. Dividends
3. Liquidation: receive a proportionate share of any assets remaining after paying
the corporations’ liabilities (liquidation = go out of business)
4. Preemption: right to maintain one’s proportionate ownership in the corporation
 in you hold 5% of all shares and new shares are issued, you must be offered
to buy 5% of the new shares = preemptive right
Stockholders Equity
Stockholders equity:
o Paid-in capital, contributed capital, share capital: amount of equity that
stockholders have contributed to corporation; includes stock accounts and any
additional paid-in capital
o Retained earnings: earned through profitable operations and has not used for
dividends
• Most states prohibit declaration of cash dividends from paid-in capital; cash dividends
are declared from retained earnings
• Owners equity of corporation is divided into shares of stock
o Corporation issues stock certificates to its owners when the company receives
their investment in business
o Stock in the hands of a stockholder is said to be outstanding
o Total number of shares of stock outstanding represents 100% ownership of the
corporation
Classes of Shares
Corporations issue different types of shares to appeal to a variety of investors
• ordinary shares or preference shares
• with or without par values
Ordinary Shares:
• An ordinary share is the basic form of capital share
• Common stockholders have the four basic rights
• They take most risk by investing
• Called common stock in the USA
Preferred Shares:
• Gives its owners certain advantages over ordinary shareholders
• Receive dividends before the common shareholders and they also receive assets before
ordinary shareholders if corporation liquidates
• Also have four basic rights
48 •
•
•
•
Company may issue different classes of preferred stock (each different account)
Most preferred shareholders can expect to earn a fixed dividend
Hybrid between ordinary share and long-term debt: it pays a fixed dividend, but the
dividend is not required to be paid unless board of directors declares the dividend
There is no obligation to pay back preferred share unless it is an redeemable
preference share: It must be paid back by the corporation and is a covered liability
o Rarely used (7% of corporations)
Par-Value and No-Par Shares
• Share may be par-value or no-par share
• Par value is an arbitrary amount assigned by a company to a share of its share
• Most companies set par value of their common share low to avoid legal difficulties
from issuing share below par
Voting rights
• Companies may have different classes of shares with different voting rights
• special shares are often hold by a government
Issuing Share
•
•
Corporations may sell shares directly to shareholders or use the service of an
underwriter (brokerage firms like UBS or Goldman Sachs)
Companies often advertise the issuance of their share to attract investors
o Advertisements are called tombstones
Ordinary Shares
Ordinary Shares at Par
• Assets and shareholders equity increase by the same amount
Ordinary Shares above par
• Most corporations set par value low and issue ordinary shares for a price above par
o Difference between issue price and par value is share premium, additional
paid-in capital or capital in-excess of par
o Par value of share and additional amount are part of paid-in capital
• A company neither earns a profit nor incurs a loss when it sells its share to, or buys its
share from, its own shareholders
•
No-Par Shares with stated value get accounted in the same way
Ordinary Shares with No-Par Values
• Debit asset received or cash and credit share capital for the cash value of asset
received
• Company with true no-par shares has no additional paid-in capital account
Ordinary Share Issued for Assets Other than Cash
• Record assets at current market value and credits share and additional paid-in capital
accounts accordingly
49 Ordinary Shares Issued for Services
• Sometimes a corporation issue shares in exchange for services, either by employees or
outsiders
o No cash is exchanged
o Transaction is recognized at fair market value
o Corporation recognizes an expense for the fair market value of the service
rendered
 Retained earnings are decreased and paid-in capital increased
Share Issuance for Other than Cash can Create an Ethical Challenge
• Accounting standards require companies to record its shares at the fair market value of
whatever the corporation receives in exchange for the share
o Value of asset can create an ethical challenge
o Assets and equity may be overstated if asset is not worth that much
o Some accounting values are more solid than others
o Not all financial statements mean exactly what they say
Preference Shares
• Credit preference share capital at its par value, with any excess credited to paid-in
capital excess of par-preferred
o Separate account from paid-in-capital in excess of par-common
• Accounting for no-par preference follows pattern for no-par common share
• convertible preference share: preferred share is convertible into companies ordinary
share
Authorized, Issued, and Outstanding Shares
There are three different numbers of company’s shares:
1. Authorized Shares: maximum number of shares company can issue under its
present constitution
2. Issued Shares: already issued to shareholders
3. Outstanding Shares: number of shares that shareholders own
Outstanding shares = issued shares – treasury shares
Treasury Shares
An own share that was issued and later reacquired is called treasury share
• Corporations purchase their own shares for several reasons
1. When offering employees share option compensation or share ownership plan
it does not have to issue new shares but buys shares from the market and pass
them further to the employees
2. Management wants to avoid a takeover by an outside party
3. Management wants to increase its reported earnings per share (EPS)
How is Treasury Share Recorded
• Buying treasury share shrinks assets (e.g. cash) and equity by an amount equal to the
cost of treasury share
o Effect: Cash is credited and treasury shares is debited
• Remember Issuing shares grows assets and equity
50 Resale of Treasury Shares
• Selling treasury share: grows assets and equity by an amount equal to the sale price of
the treasury share sold
• If treasury shares are sold at a higher price than they were bought, the share capital
account gets credited
• If treasury shares are sold at a lower price than they were bought, the share capital
account gets debited
 Company never gains or losses on transactions involving its own treasury shares
Issuing Treasury Shares as Compensation
• Probably most common use of treasury shares
• Effect: Debit share option compensation account and credit treasury shares
Retiring Treasury Shares
• Corporation may purchase its own shares and retire it by canceling the shares
o Retired shares cannot be reissued
o Effect: Debit share capital account and credit treasury shares
Retained Earnings, Dividends, and Splits
The retained earnings account carries the balance of the business’s net income, less its net
losses and less any declared dividends that have been accumulated over the company’s
lifetime
• Retained earnings account is not a reservoir of cash for paying dividends to the
shareholders
• Cash and retained earnings are two entirely separate accounts with no particular
relationship
o Credit balance in retained earnings is normal
o A debit balance in retained earnings arises when a corporations lifetime losses
and dividends exceed lifetime earnings  called a deficit, this amount is
subtracted to determine total shareholders equity (17% of companies)
Should the Company Declare and pay cash dividends?
A dividend is a corporations return to its shareholders of benefits of earnings and can take
three forms:
• Cash
• Share
• Noncash assets (noncash dividends are rare)
 For noncash asset dividend, debit retained earnings and credit the asset for the current
market value of the asset given
Cash Dividends
Most dividends are cash dividends
• Company must have
o Enough retained earnings to declare the dividend and
o Enough cash to pay the dividend
• Typically, dividends are paid after the AGM and the shareholders must decide on its
payment  final dividend
• Dividends paid during the year are interim dividends and are declared by the board
and become payable immediately
51 •
There are three relevant dates
1. declaration date: board announces dividend; declaration creates liability (if
interim)  debit retained earnings and credit dividends payable
2. date of record: corporation announces record date; follows declaration by a few
weeks  shareholders on the record date will receive the dividend
3. payment date: payment of dividend follows record date by a week or 2  debit
dividends payable, credit cash
Dividends on Preference Shares
• Preferred shareholders receive dividend first
• Common shareholders only receive dividends if total dividend is large enough to pay
preference shareholders first
• Two ways to express the dividend rate on preferred share:
1. Dividends on preferred share either stated as percentage of par value
 6% preferred: annual dividend equal to 6% of shares par value
2. Or dollar amount per share  3 dollar preferred: annual dividend of 3 per
share regardless of par value (on no-par preferred share)
Dividends on Cumulative and Noncumulative Preference Shares
• If corporations fail to pay a dividend to preferred shareholders the corporatin is
passing the dividend;
o passed dividends are said to be in arrears
• Owners of cumulative preferred share must receive all dividends in arrears plus the
current years dividend before any dividends go to common shareholders
• Mostly preference shares are cumulative unless specifically labeled as noncumulative
Share Dividends
• Share dividend is a proportional distribution by a corporation of its own share to its
shareholders
o increase share account and decrease retained earnings; total equity unchanged;
no asset or liability affected
o Distributed in proportion to number of shares they already own
• There are two reasons for paying dividends:
1. To continue dividends but conserve cash
2. To reduce the per-share market price of its share (shares market price falls
due to increased supply of shares  attracts more investors)
Stock Splits
• Stock split is an increase in the number of shares of share authorized, issued, and
outstanding  coupled with reduction in the shares par value
o Share split, like a large share dividend, decreases the market price of the share
o A 2-for-1 share split means that: company will have twice as many shares of
share authorized; issued, and outstanding; each shares par value is cut in half
 All account balances are the same after the share split as before
 Only par value per share, shares authorized and shares issued change
Measuring the Value of Share
The business community measures share values in various ways, depending on the purpose of
the measurement. These values include market value, redemption value, liquidation value,
and book value
52 Market, Redemption, Liquidation, and Book Value
• Shares market value, or market price, is the price a person can buy or sell 1 share of
the share
o Varies with corporations net income, financial position and future prospects
and general economic conditions
o Shareholders are more concerned about market value than any other
• Market Capitalization (number of shares times share price)
• Redeemable preference share require the company to redeem the preference share at a
set price
o Company is obligated to redeem (pay to retire) the preference share
o Redeemable preference share is not SE, but a liability
• Redemption value is the price the corporation agrees on to pay for share. It is set when
the share is issued
o Preference shares often have a specified redemption value
o The preference component of equity is its redemption value plus any
cumulative preference dividends in arrears
• Liquidation value is the amount that a company must pay a referred shareholder in the
event the company liquidates (goes out of business)
• Book value per share of common share is amount of owners equity on company’s
books for each share of its share
o If only ordinary share  book value = total ordinary shares outstanding
• Outstanding shares: Total issued shares – Treasury shares
•
Book value of ordinary shares =
Total SE − Preference Equity
Number of ordinary shares outstanding
 Investors may search for shares whose market price is below book value
€ Relating Profitability to a Company Share
To compare companies of different size, investors use standard profitability measures:
Return on Assets
• Rate of return return on assets (ROA) measures a company’s use of its assets to earn
income for the 2 groups who finance the business:
1. Creditors to whom corporation owes money: they want interest
2. Shareholders who own corporation share: want net income
• 10% is considered strong in most industries
ROA =
Net Income + Interest expense
Average total assets
Return on Equity
• Rate of return on equity (ROE) shows the relation between net income available to
€
average ordinary SE because the return to preference shareholders is a specified
dividend
• Used to compare companies; 15% is a good return
ROE =
Net income − Preference dividends
Average ordinary SE
 ROE is always higher than ROA because shareholders take a lot more investment risk than
bondholders
€
53 Chapter 10 – Long-­Term Investments & International Operations Share Investments: an Overview •
•
Entity that owns the share of a corporation is the investor Corporation that issued the share is the investee Reporting Investments on the Balance Sheet • Short-­term investments in marketable securities are current assets. Classified as o Trading o held-­to-­maturity o available for sale • Long-­term investments are a category of noncurrent assets o Include shares & bonds that investor expect to hold for longer than 1 year • Assets are listed in order of liquidity • Accounting rules for investments in share depend on the percentage of ownership by the investors Percentage Ownership by the Investor Accounting Treatment Up to 20% (when classified Available-­‐for-­‐Sale) Fair Market Value Up to 20% (when classified as Held-­‐to-­‐Maturity) Amortized Cost Between 20-­‐50% Equity Method Greater than 50% Consolidation • Investment up to 20% is casual ("passive investments") because the investor has usually almost no influence on investee • Available-­for-­sale investments are share investments other than trading securities o Usually are shown as non-­‐current or long-­‐term assets, except if intended to be sold within 12 months • Held-­to-­Maturity investments are accounted for using amortized cost o Accounted as non-­‐current if maturity date is beyond the next fiscal year • Ownership between 20 and 50% have a significant influence investee o Investees are called: associates or equity affiliates • Above 50% lots of influence; control o Investees are called subsidiaries of the parent company Available-­for-­Sale Investments •
•
•
•
•
Accounted for at fair market value because the company expects to sell the investment at its market price Cost is used only as the initial amount for recording the investment Investments are reported on balance sheet at current fair market value Unrealized gains and losses on available-­for-­sale securities are recognized in equity until the financial asset is sold Receipt of a share dividend is different from a receipt of a cash dividend o For share dividend, no dividend revenue is recorded o Investor makes memorandum entry in accounting records to denote new number of shares held o Cost per share decreases with increasing number of shares 54 Which Value of an Investment is Most Relevant? • Available-­for-­sale investments are measured at fair value o if the value cannot be measured reliably, the investment is carried at cost • Fair market value is the amount that a seller would receive on the sale of an investment on a given date • On the balance sheet we adjust available-­for-­sale investments from their last carrying amount to fair market value Market Value Adjustment (46,500-­44,000) 2,500 (MVA) Unrealized Gain on Investment 2,500 • Debit MVA to market value, credit unrealized gain on investment • MVA is a companion account to long-­‐term investment • Unrealized gains and losses result from changes in the market value, not from sale of investment and are reported in 2 places in financial statements o Comprehensive income: income statement below net income o Other comprehensive income: separate section of shareholders equity, below retained earnings on balance sheet Selling an Available-­for-­Sale investment • Results in realized gain or loss, which measure the difference between the amount received from sale and its cost Cash 43,000 Loss on Sale of 1,000 Investment Long-­‐Term Investment (cost) 44,000 When should we sell an investment? • Companies control when they sell investments, that helps them control when they record gains and losses • Cost principle of accounting provides this opportunity to manage earnings Equity-­Method Investments •
•
The equity method is used to account for investments where the investor owns 20 to 50% of the investee’s shares It is a method of accounting whereby the investment is initially recognized at cost and adjusted thereafter for the post-­‐acquisition change in the investor’s share of net assets of the investee Buying a Large Stake in Another Company • Investor may affect dividend policy, product lines, and other important matters Accounting for Equity-­Method Investments • Investments are initially accounted as cost: Long-­‐Term Investment 400 Cash 400 55 Investors Percentage on Investee Income • The Investor applies its percentage of ownership (20%) in recording its share of the investee’s net income and dividends Long-­‐Term Investment (Net Income of 250*0.2) 50 Income from Associates 50 Receiving Dividends under the Equity Method • Investment account is decreased for the receipt of a dividend on an equity-­‐
method investment because dividend decreases investees owners equity and thus investors investment Cash (Dividends of 100*0.2) 20 Long-­‐Term Investment 20 • Gain or loss on the sale of an equity-­‐method investment is measured as the difference between sale proceeds and the carrying amount of the investment Cash (Sale proceeds of 425) 425 Loss in Sale of Investment 5 Long-­‐Term Investment 430 Consolidated Subsidiaries Why buy another company? • Controlling (majority) interest is the ownership of more than 50% of the investee’s voting share o Investor is called the parent company o Investor can elect the majority of the members of board of directors and thus control the investee Consolidation Accounting • Consolidation accounting is a method of combining the financial statements of all the companies controlled by the same shareholders • Consolidated statements combine the balance sheet, income statements, and cash-­‐
flow statements of the parent company with those of the subsidiary o Assets, liabilities, revenues, and expenses of each subsidiary are added to the parents accounts  Investors gain a better perspective on total operations than they could by examining the reports of the parent and the individual subsidiary The Consolidated balance sheet and the related work · Parent company uses a worksheet to prepare the consolidated statements 1. Investment & Equity a. Credit the parent’s investment account for the investment in the subsidiary b. Debit both share capital and retained earnings of the investee that comes from the parent company 2. Eliminate the notes receivables for each other 56 Goodwill and Non-­Controlling Interest • … are two accounts that only a consolidated entity can have • Goodwill arises when a parent company pays more to acquire the subsidiary company than the market value of the subsidiary’s net assets o It is an intangible asset and reported on balance sheet • Non-­controlling (or minority) interest arises when a parent company owns less than 100% of the share of a subsidiary o the remainder of the subsidiaries’ shares is non-­‐controlling interest to the parent company o It reported as a separate account on the SE section Income of a Consolidated Entity • If the subsidiary is 100% owned, then all the subsidiary’s net income belongs to the shareholders for the parent • Income of the consolidated entity equals net income of the parent plus the parent’s proportion of the subsidiaries net income (Check Exhibit: 10-­‐10) Long-­Term Investments in Bonds • Major investors in bonds are financial institutions like: mutual funds and insurance companies o Investments in bonds are rarely short-­‐term and recorded as costs o Long-­‐term investments in bonds are called held-­to-­maturity investments  Held-­‐to-­‐maturity investments are reported by the amortized cost method, which determines the carrying amount  Consider the following held-­to-­maturity example: o Bond bought at discount (95.2%) with semi-­‐annual payments (April 1st & October 1st) with 6% interest payments o The holding company must amortize the carrying amount of 9,520 up to 10,000 over their term of maturity o Quick and dirty (I like) straight-­line method: Long-­‐Term Investment in Bonds Cash Long-­‐Term Investment in Bonds (10,000*0.952) 9,520 Cash (10,000*0.06*6/12) Interest Interest Revenue ((10,000-­9,520)/48)*6 Amortization 300 60 9,520 300 Interest Revenue 6ß 57 •
This amortization entry (last one) has two effects: o It increases the Long-­‐term Investment account on its march toward maturity value o It records the interest revenue earned from the increase in the carrying amount of the investment Accounting for International Operations Many companies earn revenues beyond their national boundaries. Accounting for business activities involves foreign currencies and exchange rates Foreign Currencies and Exchange Rates • Two main factors affect the price (exchange rate) of a particular currency: 1. The ratio of a country’s imports to its exports: the more foreign demand for a country’s goods, the more currency is demanded  currency appreciates 2. The rate of return available in the country’s capital markets: if rates of returns in a stable country are high, people buy shares, bonds, or real estate in that country which increases the demand for the currency  currency appreciates • Exchange rate of a strong currency is rising relative to other nations’ currency • Exchange rate of a weak currency is falling relative to other nations’ currency Accounting for Foreign Currency Transactions • Functional currency is the currency of the primary economic environment in which a business operates o In most cases it is the local currency o All foreign currency items are translated into the functional currency at initial recognition using transaction-­‐date exchange rates • Example of an American firm “Dr. Doolittle” purchasing on account little tigers from a German zoo, paying 4,000 dollars (exchange rate is 0.5€/$): Accounts Receivable – Dr. (4,000*0.5= 2000€) 2,000 Doolittle Sales Revenue 2,000 • When the final payment is conducted the amount can vary from the initial amount recorded due to exchange rate fluctuations o Either a translation gain or translation loss • Let’s assume the dollar has appreciated to 0.7€/$: Cash (4,000*0.7= 2800€) 2,800 Translation Gain 800 Accounts Receivable – Dr. 2,000 Doolittle Reporting Gains Losses in the Income Statement • The net amount of the gains and losses are reported on the income statement as Other Revenues and Gains, or Other Expenses and Losses 58 Should We Hedge Our Foreign-­Currency-­Transaction Risk? • One way to avoid foreign-­‐currency transaction losses is to insist that international transactions be settled in the local currency • Another way to protect itself from exchange rate fluctuations is by hedging o Hedging means to engage in a counter-­‐balancing transaction: engage in future contracts, which promises to receive a certain amount of foreign currency for a fixed amount at a future date (vice versa) Consolidation of Foreign Subsidiaries • An entity may also operate through a foreign operation, which can be a subsidiary, associate, joint venture or branch of a reporting entity • A company with a foreign subsidiary must consolidate the financial statement into its own, which consequences two special challenges: 1. Some foreign countries may require accounting treatments that differ from the reporting entity’s accounting principles 2. The subsidiary’s statements may be expressed in a foreign currency different from the parent’s currency • Process of translating a foreign subsidiary’s financial statement into parent’s currency creates a foreign-­currency translation adjustment o Is reported as part of “other comprehensive income” on the income statement and as part of SE on the consolidated balance sheet: • A translation adjustment arises due to changes in the foreign exchange rate over time. In general, the foreign operation’s: o Monetary assets and liabilities are translated into the parent’s currency at the current exchange rate on the date of the statements o Non-­‐monetary assets and liabilities carried at historical cost (such as PPE) continue to be measured using the historical transaction-­‐date exchange rates o Shareholders’ equity is translated into the parent’s currency at older historical exchange rates  paid-­in capital accounts are translated at the historical rate when the subsidiary was acquired  retained earnings is translated at the average rate of the period earned  The foreign-­currency translation adjustment is the balancing amount that brings the dollar amount of liabilities and equity of a foreign subsidiary into agreement with the dollar amount of total assets  After the adjustment total liabilities and equity equal total assets 59 Chapter 11 Evaluating the Quality of Earnings Corporations net income (including EPS) is most important on financial statements and gives information to… o Shareholders: the larger net income, the greater likelihood of dividends o Creditors: the larger net income, the better the ability to pay debts • Earnings quality: the higher the current EQ compared to the past, the higher the likelihood to generate healthy earnings in future. Components of EQ are 1. Proper revenue and expense recognition 2. High and recurring gross, operating and net profit ratios 3. Absence of changes in accounting policies, assumptions and estimates to boost earnings Revenue recognition The first component of EQ and top of line of the IS is proper recognition of net revenue • The revenue recognition principle states that, under accrual accounting, revenue should be recognized when it’s earned, so it requires that… a. The entity has transferred to the buyer the significant risks and rewards of ownership of the goods b. The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold c. The amount of revenue can be measured reliably d. It is probable that the economic benefits associated with the transaction will flow to the entity e. The costs incurred or the be incurred in respect of the transaction can be measured reliably Cost of goods sold, gross profit, operating profit and net profit After revenue the next two important components in EQ are COGS and gross profit • Cost of goods sold (COGS): represent the direct cost of goods sold. Steadily decreasing COGS as percentage of net sales  a sign of increasing EQ • Gross profit (gross margin): represents = net sales – COGS. Steadily increasing gross profit  a sign of increasing EQ. Other revenue (e.g. interest revenue) should be excluded from gross profit calculations because there are not directly related to merchandise operations • Operating expenses: represent ongoing expenses incurred by the entity (e.g. salaries, supplies). Steadily decreasing OE  a sing of increasing EQ o Function of expense method: This method groups expenses into functional categories (e.g. marketing-­‐, administrative expense) • Operating profit: Gross profit -­‐ Operating expense + Other operating income +/-­‐ Exceptional items = Operating profit o Exceptional items: represent the financial effect of unusual happenings like an attack of sharks with leaser weapons attached to their heads. The IFRS prohibits the use of this category, even though it may be allowed by GAAP 60 •
Net profit: + -­‐ -­‐ + = Operating profit Finance income (interest revenue) Finance cost (interest expense) Tax expense Profit from discontinued operations Net profit o Profit on discontinued operations: this item is generally not included because it will not continue to generate income for the company Which income number predicts future profits? To estimate value of common share, financial analysts determine the PV of the stream of future income. • This is done by discounting future income with the Investment Capitalization Rate, which is based on the risk that the company might not be able to earn its expected income in future Estimated annual income in future
• Estimated value of shares =
Investment Capitalization Rate
• To estimate whether shares are over-­‐ or undervalued we have to compare the Estimated value of company to the current value of the company • Current market value = shares outstanding × current market price per share €
• The Investment rule may be the following… If the estimated Value €
Of the company: Decision: Exceeds   Buy share because P↑ Current market Equals  Value of the  Hold share because P= company Is less than   Sell share because P↓ Accounting changes Companies sometimes change account methods for e.g. depreciation or inventory. This makes it difficult to compare one period with preceding periods. Therefore account policies should only be changed if… • This is required by the accounting authority • The new policy results in more reliable and more relevant information There are three types of accounting changes, which are relevant for us 1. Changes due to new accounting standards or pronouncements 2. Changes in account estimates (change estimated life of a building) 3. Changes in account principles (e.g. from FIFO to LIFO) a. Then the company has to report figures for all periods presented in the income statement –past as well as current– on the new basis Watch out for voluntary accounting changes that increase reported income • Managers may change the accounting principles in order to increase reported income and to look better  quick and dirty way 61 Correcting retained earnings • Sometimes a company fails to properly record an element of financial statement. All material prior-­‐period errors require retrospective restatement by either…or… o Restating the opening balances of assets, liabilities and equity for the earliest prior-­‐period presented in a set of financial statements o If impractical, trough a prior-­period adjustment to the beginning retained earnings in the statement of changes in equity Reporting Comprehensive Income Comprehensive income is the company’s change in total shareholders equity from all sources other than from the owners of the business. It includes net income or loss plus the following, yet elsewhere unrecognized items: • Changes in revaluation surplus • Actuarial gains and losses on defined benefit plans • Gains and losses arising from translating the financial statements of foreign operation • Gains and losses on re-­‐measuring available-­‐for-­‐sale financial assets • The effective portion of gains and losses on hedging instruments in a cash flow hedge  These items do not enter the determination of net income or earnings per share Companies can state comprehensive income in two ways: • Single statement • Two statements. First a separate income statement followed by comprehensive income statement Earnings per share (EPS) Earnings per share (EPS) is the amount of a company’s net income per share of its outstanding common share and a key measure of business success EPS =
•
€
•
Net income − preferred dividends
Average number of ordinary shares oustanding
There are two EPS computations o Basic: the currently outstanding shares o Diluted: adjusted for an potential increase in outstanding shares Effect of preference dividends on earnings per share o EPS accounts for ordinary shares. But holders of preference shares have first claim on dividends. Therefore, preference dividends must be subtracted from net income to compute EPS Earning from operations versus cash flow from operations The two key figures used in financial analysis are: • Net income (income from continuous operations) • Cash flow from operations  Those two figures may differ, because net income recognizes revenues and expenses when they occur (revenue recognition principle), but the cash flow is based solely on cash receipts and cash payments 62 Accounting for corporate income taxes To account for income tax the corporation measures: • Income tax expense, an expense on the income statement. Income tax expense is used in determining net income • Income tax payable, a current liability on the balance sheet. Income tax payable is the amount of tax to pay the government in the next period •
•
•
The income statement and income tax return are entirely separate documents: o The income statement reports the results of operations o The income tax return is filed with the tax authority to measure how much tax to pay the government in the current period For most companies, tax expense and tax payable differ. Some revenues and expenses affect income differently for accounting and for tax purposes. One the most common differences between accounting income and taxable income occurs when a corporation uses straight-­‐line depreciation in its financial statements and accelerated depreciation for the tax return For a given year, Income tax payable can exceed income tax expense. This occurs when because of differences in revenue and expenses for book and tax purposes, taxable income exceeds book income. When that occurs, the company debits a deferred tax asset. Analyzing the statement of changes in equity The statement of changes in equity reports the reasons for all the changes in the shareholders’ equity section of the balance sheet during a period Responsibility for the financial statements Managements Responsibility • Management issues a report on internal control over financial reporting, along with financial statements • Management declares its responsibility for the internal controls over financial reporting. Moreover it states that is has monitored the effectiveness of these controls including assurances from both internal and external auditors Audit Report Respective jurisdiction’s corporation or company law legally places the requirement for audit of financial statements. Companies engage external auditors who are certified public accountants to examine their financial statements • Addressed to board of directors and shareholders of the company • Audio report contains four sections 1. Section identifies audited financial statements as well as the company being audited 2. Section outlines responsibility of management and auditor 3. Section describes how the audit was performed in accordance with the accounting standards 4. Section expresses the auditor’s combined opinion on the financial statements. Unqualified option is the highest statement of assurance 63 Chapter 12 – The Statement of Cash Flow
Basic Concepts: The Statement of Cash Flows
• Statement of cash flows reports cash flows (cash receipts and cash payments)
• Statement covers a span of time; dated at year end
• Purposes of cash flow statement:
1. Predicts future cash flows
2. Evaluates management decisions (how managers got cash and how they used it)
3. Shows the relationship of net income to cash flows (usually high net income leads
to an increase in cash, and vice versa)
• Cash includes cash in bank but also cash equivalents thus highly liquid short-term
investments that can be converted into cash immediately (money market accounts,
investments in US government securities)
How’s your cash flow? Telltale signs of financial difficulty
• Net income measures success and companies need cash to pay bills
• Net income generates cash but sometimes they take different paths
• Indicators of trouble:
o Too little cash (current, acid-test ratio)
o Too low inventory turnover (inventory turnover ratio)
o Too long time to collect cash (accounts receivable turnover ratio)
• you need net income as wells as strong cash flow to succeed in business
Operating, Investing, and Financing Activities
• Operating activities: create revenues, expenses, gains, and losses = net income, which
is a product of accrual-basis accounting)
o A successful business must generate most of its cash from operating activities!
o Most important of these three categories
• Investing activities: increase and decrease long-term assets (land, buildings,
equipment, investments in other companies); purchases and sales of these assets
• Financing activities: obtain cash from investors and creditors (issue share, borrow
money, buy and sell treasury share, pay cash dividends, paying off loan); relate to
long-term liabilities and shareholders equity; least important
Technical Update:
· IAS7 allows for alternatives classifications:
o Interest paid, usually categorized as an operating cash flow item, may be
classified as financing cash flow Items
o Interest and dividends received, usually classified as operating cash flow
items, may be classified as investing cash flow items
o Dividends paid, usually categorized as a financing cash flow item, may be
classified as cash flow from operations
64 Two formats for operating activities
• Indirect method: reconciles from net income to net cash provided by operating
activities
• Direct method: reports all cash receipts and cash payments from operating activities
 The computations are different but they produce the same figure for cash from
operating activities. They do not affect investing or financing activities
 IAS7 actually advocated for the direct method because it provides Information which
may be useful in estimating future cash flows
Preparing the Statement of Cash flows: indirect method
•
•
Operating activities are related to the transactions that make up net income
Begins with net income taken from income statement an makes adjustments to
reconcile net income to net cash provided by operating activities
•
•
Step 1: Start with net income from the income statement
Step 2: From the income statement add back depreciation, depletion and amortization
expense and remove any gains (or add back losses) on the sale of long-term assets
Step 3: Examine the balance sheet identify changes in current assets and current
liabilities except for cash and cash equivalents
Step 4: Deduct increases in current assets other than cash and add decreases in current
assets other than cash
Deduct decreases in current liabilities and add increases in current liabilites
•
•
•
Depreciation, Depletion, and Amortization Expenses
• Depreciation has no effect on cash but like all other expenses, it decreases net income
• Therefore add depreciation back to net income (cancels earlier deductions)
65 Gains and Losses on the Sale of an Asset
• The proceeds from sale of long-term assets are reported in the cash flow from
investing activities
o Resulting gains (or losses) from the sale are included in net income
o To avoid double counting
 Losses are added back to net income
 Gains are deducted from net income
Changes in the Current Asset and Current Liability Accounts
• Most current assets and current liabilities result from operating activities (accounts
receivables from sales, inventory relates to COGS)
• Changes in current accounts are adjustments to net income on the cash flow statement
1. An increase in another current asset decreases cash. Suppose you make a sale
on account. Accounts receivables are increased and thus is net income, but
cash is not collected yet.
2. A decrease in another current asset increases cash. Cash receipts cause
accounts receivable to decrease, so add decreases in accounts receivable
3. A decrease in a current liability decreases cash. The payment of a liability
decreases both cash and the liability
4. An increase in a current liability increases cash. Suppose your accounts
payable increased. Than can occur only when cash was not spend to pay this
debt. Thus increase cash
Evaluating Cash Flows from Operating Activities
• Net cash flow should exceed net income because of the add-back of depreciation
Preparing Cash Flows from Investing Activities
•
Cash flows from investing activities basically revolve around the cash inflows and
outflows related to long-term assets of the entity
•
•
Computing Purchases and Sales of PP
Computing Purchases and Sales of Investments, and Loans and Collections
Receipts
From sale of PPE
From sale of
investments
Beginning
PPE, net
Cash received
+
Acquisition cost
-
Depreciation
=
Book value of
assets sold
Gain on sale
Beginning
investments
+
Purchase cost
of investments
+
or
-
Cash received
=
Cost of
Investments
sold
+
or
-
Loss on sale
Cost of
investments
sold
Gains on sale
-
Book value of
assets sold
=
Ending
investments
Ending
PPE, net
=
Ending
PPE, net
Loss on sale
From collection
of notes
receivable
Payments
For acquisition
of PPE
For purchase of
investment
Beginning
notes
receivable
+
New loans
made
-
Collections
=
Ending notes
receivable
Beginning
PPE, net
Beginning
investments
+
Acquisition cost
-
Depreciation
-
+
Purchase cost
of investments
-
=
For new loans
made
Beginning
notes
receivable
+
New loans
made
-
Cost of
investments
sold
Collections
Book value of
assets sold
Ending
investments
=
=
Ending notes
receivable
66 Preparing Cash Flows from Financing activities
•
Financing activities affect liabilities and shareholders equity (notes payable, bonds
payable, long-term debt, common share, paid-in capital in excess of par, retained
earnings)
•
•
•
Computing Issuance and Payments of long-term debt
Computing Issuance of Share and Purchases of Treasury Shares
Computing Dividend Declarations and Payments
Receipts
From
Borrowing Issuance of
long-term
debt
From
issuance of
share
Payments
Of longterm debt
To purchase
treasury
share
Of dividends
Beginning
long-term
debt
+
Cash received from
issuance of long-term
debt
-
Payment of debt
=
Ending long-term debt
Beginning
share capital
+
Cash received from
issuance of new shares
-
Share cancellations
=
Ending share capital
Beginning
long-term
debt
Beginning
treasury
share
Beginning
retained
earnings
+
Cash received from
issuance of long-term
debt
Purchase cost of
treasury share
-
Payment of debt
=
Ending long-term debt
=
Ending treasury share
Net Income
-
=
Ending retained
earnings
+
+
Dividend payment
Noncash investing and financing activities
• Investments that do not require cash
• Financing other than cash
o Issue common share to acquire a warehouse
o Would not be recorded as cash payment; no cash paid
 Noncash investing and financing activities can be reported in a separate schedule
Preparing the Statement of Cash Flows: Direct method
•
•
•
IAS7 advocated the direct method of reporting operating cash flows because it
provides clearer information about the sources and uses of cash
But very few use it because takes more computations than the indirect method
Investing and financing cash flows are unaffected by the operating cash flows
67 •
SEE BOOK FOR COMPUATIONS UNDER DIRECT METHOD (p. 735-738)
Measuring Cash adequacy: free cash flow
•
•
•
How much cash can a company “free up” for new opportunities?
Free cash flow is amount of cash available from operations after paying for planned
investments in plant asset
A large amount of FCF is generally preferable because it means that a lot of cash is
available for new investments
Examining Cash Flow Patterns
• Company's cash flows should be examined over a period of time, not just at the end of
one financial year:
o Simple but insightful cash flow analysis is to simply plot the cash flow patterns
over a number of years
68 Chapter 13 - Financial Statement Analysis
Horizontal Analysis
•
•
Horizontal analysis is the study of percentage changes from year to year
Two steps
o Compute amount of change from period to period
o Divide amount of change by base-period amount
Trend percentages
• Trend percentages indicate the direction a business is taking
o Computed by selecting base year whose amounts are set equal to 100%. The
amount for each following year is stated as a percentage of the base amount.
To compute a trend percentage divide an item for a later year by the base-year
amount
Trend % =
€
Any periods amount
Base periods amount
Vertical analysis
•
Vertical analysis shows the relationship of financial-statement items relative to a total,
which is the 100% figure
o All items are reported as a percentage of the base
o For the income statement total revenue is usually the base
Vertical Analysis % =
Each income statment item
Total revenue
Benchmarking
•
€
•
Benchmarking simply means comparing on entity to the other
o usually direct competitors are selected for benchmarking
most important aspect is that it gives you context in which you could interpret one
data
Common-size statement
• When comparing financial statements side-by-side this is called Common-size
statement
o All amounts are stated in percentages
 Size and currency differences are eliminated
69 Using ratios to make business decisions
Limitations of ratio analysis
· Only signals that something is wrong but does not identify the problem
o Analyze figures to learn what caused ratio to fall
o Analyze ratios over period of years to consider all relevant factors
Financial ratios
1. Ability to pay current liabilities
2. Cash conversion cycle
3. Ability to pay long-term debt
4. Profitability
5. Analyze shares as an investment
70 Other Issues in Financial Statement Analysis
Economic Value added (EVA)
• Is used to evaluate operating performance
• All amounts except the cost of capital come the financial statements
o Cost of capital is the weighted average of the returns demanded by the
company’s shareholders and lenders
• Idea behind EVA is that the returns to the company’s shareholders and to its creditors
should exceed the company’s capital charge
o capital charge is the amount that shareholders and lenders charge a company
for the use of their money
71 Red Flags in Financial Statement Analysis
• The following conditions may mean a company is very risky
o Earnings problems
o Decreased cash flow
o Too much debt
o Inability to collect receivables
o Buildup of inventories
o Trends of sales, inventory, receivables should move together
Efficient Markets
• An efficient capital market is one in which market prices fully reflect all information
available to the public.
 Share prices reflect all publicly accessible data
72