A R I Z O N A S T A T E
CFA Review
– Level 1
Prof. Phil Drake

• We have only two hours.
– Giddy up
• The emphasis is on review.
• You should know this material, but not at the depth you need to understand.
• Assume you know how the financial statements articulate.
• Review the balance sheet, then the income statement … you are on your own for cash flows.

• Cash, of course.
• Equivalents include money market instruments such as ST CDs, high quality commercial paper, Treasuries, money market funds that mature in three months or less.

Investments in Debt Securities
-

Held to Maturity
Requires ability and intent
-

Available for Sale
Cash Management
-

Trading
Intent to sell in the near term

Accounting for Debt Securities
Accounting & Valuation
-


Held to Maturity
Interest revenue, gain/loss on sale
Reported on balance sheet at amortized cost
-
-


Available for Sale
Interest revenue, gain/loss on sale
Fair value … with Unrealized Holding G/L to Comprehensive
Income (i.e., equity)


Trading
Interest Revenue, gain/loss on sale
Fair value … with Unrealized Holding G/L to Current Income
(i.e., Income Statement, then Retained Earnings)

Investments in Equity Securities
Accounting is based on level of influence
-

Minority, Passive (less than 20% ownership)
Fair Value Method
-

Minority, Active (20% - 50% ownership)
Equity Method
-

Majority, Active (more than 50% ownership)
Consolidation Method

Accounting for Equity Securities
-
-


Available for Sale
Dividend Income, gain/loss on sale to Income Statement
Fair value … with Unrealized Holding G/L to Comprehensive
Income (i.e., equity)


Trading
Dividend Income, gain/loss on sale to Income Statement
Fair value … with Unrealized Holding G/L to Current Income
(i.e., Income Statement, then Retained Earnings)

Accounting for Equity Securities
Record purchase at cost. Single line acquisition
If purchase price exceeds proportionate share of investee ’ s book value, identify fair values of underlying assets & liabilities.
Recognize proportionate share of investee ’ s income as an increase in the Investment
Recognize proportionate share of investee ’ s dividends as reduction in Investment

Valuation
Fair Value Method
Annual Adjustment
Trading – Unrealized Holding G/L in current income
Available for Sale – Unrealized Holding G/L in
Comprehensive Income (i.e., equity)
Equity Method
Annual Adjustment
Proportional Share of Income = Income
Proportional Share of income less Dividends = Investment
Adjustment

Valuation
The Fair Value Option
•
•
•
Held-to-maturity
Available-for-sale
Equity method
Report unrealized gains and losses through the income statement (not though comprehensive income)
Brand-new and not many takers yet.

Consolidations
Basic Idea:
The Parent company along with its Subsidiaries are a single economic unit.
–
–
Combine the financial results for Parent & all Subsidiaries, then
–
Eliminate Intercompany Payables
Eliminate Intercompany Sales
Eliminate double-counting of Investment
–
Eliminate double-counting of Income

Consolidations
– non-controlling Interests
Non-controlling Interest - (aka Minority Interests)
Occurs when the Parent does not own 100% of the subsidiary. The percentage of ownership not controlled by the Parent.
For the Balance Sheet , Non-controlling Interests represent the percent of net assets (assets less liabilities of the subsidiary). Appears between Liabilities & Equities
For the Income Statement , Non-controlling Interest is the percentage of subsidiary income held by the minority shareholders.

Consolidating
Foreign Subsidiaries
Companies often have international subsidiaries that must be consolidated with the Parent ’ s financial statements.
Typically, the subsidiaries accounts are maintained with local currency (and, sometimes, local GAAP). The amounts on the foreign subsidiaries financial statements must be translated in
U.S. dollars.
To translate a foreign subsidiary ’ s financial statements into
U.S. dollars, conversion is made with both Historical
Exchange Rates (those which existed at the time a transaction occurred) and Current Exchange Rates
(Exchange rates which exist as of the balance sheet date)

Consolidating
Foreign Subsidiaries
The use of different exchange rates means the resulting financial statements will not balance.
To force the statements to balance, an account called
“ Translation Adjustment ” is used.
Two approaches are used depending on the independence of the subsidiary from the Parent company.
-
Self-contained: All-current method (local currency is functional)
-
Extension of US Parent: Monetary-Nonmonetary method (US dollar is functional currency)
Subsidiaries in countries with hyperinflation (100+%) use the
U.S. dollar as the functional currency.

Accounts Receivable
Involves the application of two concepts –
Definition of an Asset & Matching
Definition of an asset:
-
-
-
Probable future economic benefit
Obtained or controlled by the entity
As a result of past transactions
What is the cost of extending credit?
-
Bad debts.

Accounts Receivable
Beg. Bal.
Sales
Acct Rec.
What I can
Collect
Allowance for Bad Debts
Beg. Bal.
Collections
Bad Debt
Expense
Write-Offs Write-Offs
End Bal.
End Bal.
What I expect to
Collect
Net Account Receivable

Accounts Receivable Example
Year 1
Sales
December 31, Year 1
Accounts Receivable
Allowance for Bad Debts
Accounts Receivable, net
$1,500,000
$175,000
(10,000)
$165,000
Goes to the
Balance Sheet

Accounts Receivable Example
December 31, Year 1
Bad Debt Expense $10,000
Allowance for Bad Debts $10,000
This entry applies the two important concepts:
- matching expenses with the related revenues
- recording the asset at its net realizable value (NRV)

Accounts Receivable Example
Year 2
Sales $5,000,000
Identified and wrote-off as uncollectible $21,500 of accounts receivable.
Allowance for Bad Debts $21,500
Accounts Receivable $21,500
Note, No impact of
Net A/R

Accounts Receivable Example
Year 2
December 31, Year 2
Accounts Receivable
Allowance for Bad Debts
Accounts Receivable, net
Based on
Analysis
$330,000
(25,000)
$305,000
Goes to the
Balance Sheet

Accounts Receivable Example
Allowance for Bad Debts
10,000 Beg. Balance
Write-Offs 21,500
36,500 Bad Debt Exp.
25,000 End Balance
December 31, Year 2
Bad Debt Expense
Allowance for Bad Debts
$36,500
$36,500

Inventory – Basic Approach
Beg. Inventory
+ Purchases
Cost of Goods Available for Sale
Sold
Cost of Goods Sold
(Income Statement)
Not Sold
End. Inventory
(Balance Sheet)

Inventory – Costing Methods
Beg. Inventory
Purchase
Sale
Purchase
Purchase
Sale
End Inventory
300 units @ $10 per unit
100 units @ $12 per unit
200 units @ $30 per unit
600 units @ $14 per unit
200 units @ $15 per unit
600 units @ $30 per unit
400 units
LIFO – Periodic
Cost of Goods Sold $11,400
Ending Inventory $ 4,200
LIFO – Perpetual
Cost of Goods Sold $10,800
Ending Inventory $ 4,800

Inventory – Costing Methods
Cost of Goods Sold
FIFO Periodic
FIFO Perpetual
$ 9,800
9,800
LIFO Periodic
LIFO Perpetual
$11,400
10,800
W/A Periodic $10,400
W/A Perpetual 10,200
FIFO Periodic
FIFO Perpetual
$ 5,800
5,800
LIFO Periodic
LIFO Perpetual
$ 4,200
4,800
W/A Periodic $ 5,200
W/A Perpetual 5,400

Inventory – Valuation (LCM)
•
After determining FIFO/LIFO/W-A Ending Inventory, must compare to market valuation.
–
Follows the definition of an asset
•
Report on the balance sheet, the lower of cost or market. Write-downs of inventory from cost to market are included in cost of goods sold.
–
Can establish a reserve account for obsolesce.

Inventory – LIFO Layers
As inventory levels increase, a LIFO layer is added.
Can result in very old costs embedded in inventory.
15 units at $20 per unit
20 units at $17 per unit
40 units at $13 per unit
100 units at $10 per unit

Inventory – LIFO Liquidations
Assume current costs are now $25 per unit.
Delay purchases to “ dip ” into the LIFO layers …
Instead of CGS at $25 per unit, now it is $20, then
$17, then $13 and eventually, $10 per unit
15 units at $20 per unit
20 units at $17 per unit
40 units at $13 per unit
100 units at $10 per unit

Inventory – LIFO Liquidations
LIFO Liquidations come at a very high cost – taxes!!
LIFO Conformity rule states that if you use LIFO accounting for your tax return, you use it for your financial statements as well.
It costs real money to dip into your LIFO Layers.

Inventory – Comparability
1.
2.
3.
4.
BI
F
BI
L
+ P – CGS
F
+ P – CGS
P = CGS
L
+ EI
L
L
= EI
= EI
– BI
Substitute 3 into 1
F
L
L
BI
F
+ (CGS
L
+ EI
Rearrange …
L
– BI
L
) – CGS
F
= EI
F
CGS
F
F
= CGS
L
- [(EI
F
- EI
L
L
) – (BI
F
- BI
E
L
)]
B
F
L

Inventory – Comparability
CGS
Income before taxes
Income taxes
Net Income
Cash Flow
Inventory Balance
LIFO
Higher
Lower
Lower
Lower
Higher
Lower
FIFO
Lower
Higher
Higher
Higher
Lower
Higher
Assume rising inventory costs and stable or
Increasing inventory levels.

Inventory - Summary
Beg. Bal.
Inventory
Cost of Goods Sold
Purchases
Obsolescence
End. Bal.

Long-Lived Assets
– Major Issues
•
Multi-period assets whose costs are matched to the revenues they help generate.
Smooths the impact on income
(Asset)
Capitalize
Allocate
Costs Expense
Impairment Issues
Based on the definition of an asset
Great opportunities to shift expenses from one period to another.

Long-lived Asset
Beg. Bal.
Disposals
Acquisitions
Impairments
Acc. Depreciation
Beg. Bal.
Disposals Depreciation
Expense
Impairments
End Bal.
End Bal.

Long-lived Assets – Acquisitions
Acquisition Cost – All the costs necessary to ready the asset for its intended use.
Specialized machinery for a manufacturer.
Invoice price
Taxes
Delivery charges
Speeding ticket during delivery
Installation costs (including repouring floor)
Repair work for damage during installation
Setup costs (labor and materials)

Long-lived Assets
– Depreciation
Depreciation – Allocating the cost of the asset over the period of benefit.
Accounting depreciation ≠ Economic Depreciation
Depreciable amount = Acquisition Cost less Residual Value
Cost
Residual Value
- $1,000,000
- $250,000
Depreciable Amount - $750,000
The amount to be expensed over the estimated useful life of the asset.

Long-lived Assets
– Depreciation Methods
Straight-Line: Simple and most pervasive.
Other methods:
Sum-of-the-years digits
Declining balance
Units of production
MACRS (tax return only)
Depreciation Expense Book Value

Long-lived Assets
– Betterments vs. Repairs
Betterment – Costs incurred after the asset has been placed in service. A betterment extends the asset ’ s useful life, increases the asset ’ s productive capacity, or increases the asset ’ s productive efficiency. Capitalize costs incurred.
Repairs – No increase in economic benefit or increased service potential. Expense costs as incurred.

Long-lived Assets
– Disposals & Exchanges
Disposal – Compare the asset ’ s book value to the value received from the sale. The difference is either a gain or loss.
Exchange – One productive asset (e.g., inventory) for another asset (e.g., equipment).
General rule: The new asset is recorded as the Fair market value (FMV) of the asset exchanged.
Exceptions for exchanges of similar assets or where
FMV is not ascertainable.

Long-lived Assets
– Change in market Value
Revaluation – Not with U.S. GAAP. However, IFRS and other countries allow revaluation up to market value.
Impairments – Decline in market value of an asset.
There are different kinds of tests for different kinds of long-lived assets.

Long-lived Assets
– Acquired Intangibles
Tangible Assets
Acquired Business
Identifiable Intangibles Other Balance Sheet
Marketing related
• Trademarks
• Trade names
• Marketing materials
• Style guide (unique color, shape or package design)
• Mastheads
• Domain names
Customer related
• Distributor relationships
• Retailer relationships
• Order or production backlog
• Contractual and noncontractual customer relationships
Technology related
• Trade secrets, such as secret formulas, processes or recipes
• Patented and unpatented technology
• Computer software
• Databases
Contract related
• Supply contracts
• Advertising, management & service contracts
• Licensing & royalty agreements
• Lease agreements
• Construction permits
• Franchise agreements
• Non-compete agreements

Goodwill
Goodwill arises when the purchase price paid for another business exceeds the fair market value of the acquired net assets of that business.
$10 million
$1 million - Goodwill
$1 million - Identifiable Intangibles
$3 million - Excess net asset FMV over BV
$5 million
Net asset book value
Consideration transferred
Allocation

Long-lived Assets
– Intangibles Amortization
Depends on the type of intangible asset it is.
• Limited Life intangible assets
– Amortize straight-line over estimated economic life.
• Indefinitive Life intangible assets
– Assets that the firm intends to maintain for an unknown period of time.
– No amortization.
• Goodwill
– No amortization.

Long-lived Assets
– Impairments
Property, Plant & Equipment and Limited Life Intangible
Assets (Category 1)
Two Step Impairment Test:
Step one: Compare future estimated undiscounted cash flows to book value. If cash flows are less than book value, the asset is impaired.
Step two: Write the asset down to either fair market value (FMV) or discounted future cash flows & recognize the impairment loss.

Long-lived Assets
– Impairments
Indefinite-Life Intangible Assets (other than Goodwill)
(Category 2)
One Step Impairment Test:
Step one: Write the asset down to either fair market value (FMV) or discounted future cash flows if below book value.

Long-lived Assets
– Impairments
Goodwill (Category 3)
Two Step Impairment Test:
Step one: Compare the fair value of the reporting unit to its book value including goodwill If fair value is below book value, then go to step two.
Step two: Determine the implied fair value of goodwill by comparing the fair value of the reporting to the fair value of net identifiable assets .
Write goodwill down if needed.

Long-lived Assets
– Impairments
The FASB added a new Step Zero for Intangibles and Goodwill.
–
Step zero is an optional, qualitative assessment.
–
If determined that it is more likely than not (i.e., a greater than 50% likelihood) that the fair value of a reporting unit exceeds its carrying value, then no further work required.

Liabilities – Major Issues
Fixed Payment
Dates & Amts.
Fixed Payment
Amts, Est. Dates
Est. Date
& Amount
Advances
& Unexecuted
Agreements
Mutually
Executed
Contracts
Contingent
Obligations
Note Payable
Interest Pay.
Bonds Pay.
Accounts Pay.
Taxes Pay.
Warranties
Payable
Rental Fees
Subscriptions
Insurance
Purchase
Employment
Commitments
Pending
Lawsuits
Off BS
Instruments
Recognized as Accounting Liabilities
Generally Not Recognized as Accounting Liability

Liabilities – Basic Definition
1. Probable future economic sacrifice,
2. The obligation belongs to the firm, and
3. Is the result of past transactions.
Parallels the definition of an asset.

Liabilities – Current
• Accounts payable
• Wages, salaries, and other payroll items
• Short-term notes and Interest payable
• Warranties – Matching concept.
• Estimate the warranty liability at the time of sale and record the expense.
• Reduce the liability based on actual costs incurred.

Bonds – Early retirement
Example:
The $100,000 bond is two years from maturing.
Originally issued at a market rate of 8%, now trades in the market at 12%.
Journal Entry
Reported in the Income
Statement
Bonds Payable
Cash
Gain on early retirement
$103,630
$ 96,535
7,095

Contingent Liabilities
When is a liability a liability? If there is uncertainty regarding the outcome of an event (e.g., litigation, possible assessments, expropriation of assets).
Disclosure or Recognize?
Two Criteria for Accruing a Liability:
-
-
“ Probable ”
“ Reasonably estimated ”

Liabilities
– Capital Leases Requirements
Must meet one of the four criteria:
1.
The lease transfers the ownership to the lessee at the end of the lease term.
2.
The lease contains an option to purchase substantially less than the expected fair market value at the end of the lease term.
3.
The lease term is equal to 75% or more of the estimated remaining economic life.
4.
At the beginning of the lease term, the present value of the minimum lease payments equals or exceeds 90% of the fair market value of the leased asset

Liabilities – Operating Leases
No entry at lease inception - executory contract
Lease Payment Journal Entry
Rent Expense $ xx
Cash $ xx
No asset nor liability recognized on the balance sheet.
Footnote disclosures are substantial including description and payment schedule.

Liabilities – Capital Leases
At Lease Inception
Leased Asset
Lease Liability
$ xx
Present value of
Minimum Lease
Payments
$ xx
Amortize the leased asset over the life of the lease.
Amortization Expense
Leased Asset
$ xx
$ xx
Lease payments follow Long-Debt GP
Interest Expense $ xx
Lease Liability
Cash
Difference $ xx
Second GP
$ xx

Leases
–
•
On Balance sheet or off?
Are investors really fooled?
–
•
•
•
Cash flows
Operating leases – Operating cash flows
Capital leases – Investing cash flows
Performance metrics

Pensions
– Defined Contribution Plans
Defined Contribution Plans are the dominate pension vehicle.
•
Transfers ownership of risks to employees
•
Easy accounting:
Pension Expense
Cash
$ XX
$ XX

Pensions
– Defined Benefit Plans
Rose in popularity following WWII.
•
Employer bear risks of funds market returns
•
Conceptual Underpinnings
–
–
–
Matching concept
Record expenses in period of benefit
Record liability
•
Management Incentives
–


Management prefers not to report a liability
Cost of Credit
Share price impact

Pensions
– Defined Benefit Plans
Three Concepts
Vested benefits
-
Legal issue with respect to employee right. If they leave the firm prior to achieving retirement conditions (e.g., age, years of service).
Accumulated Benefit Obligation (ABO)
-
-
-
Vest & non-vested benefits
Non-vested benefits are estimated
“ Actuarial ” net present value of benefits earned to date at today ’ s pay levels.

Pensions
– Defined Benefit Plans
Three Concepts
Projected Benefit Obligation (PBO)
-
PBO equals …

“ Actuarial ” net present value of benefits earned to date projected at future pay rates
-
The real liability conceptually
•
Best estimate of future payments

Pensions
– Defined Benefit Plans
Three Elements of Pension Accounting
Record liability for deferred cash flows
-
Increase for interest recognized over time
-
Decrease for cash payments
Record asset for invested funds
-
-
-
Recognize earnings on invested funds
Increase cash contributions to fund
Decrease for payments made to retirees
Record expense for “ service cost ”
-
NPV of incremental benefit earned for current year services

Pensions
– Defined Benefit Plans
Violations of FASB Conceptual Framework
Off-set Revenues and Expenses
Annual pension expense = Net of …



Interest expense
Service Cost expense
Investment Returns
Off-set Asset & Liabilities
Net Pension asset or Liability on Balance Sheet
The Plan is said to be either “ over-funded ” or “ underfunded ”

Pensions
– Components of Pension Exp.
1.
2.
3.
4.
5.
Service Cost – Increase in PBO because employees have worked another year.
Interest Cost – The PBO is the discounted present value of expected benefits to be paid to employees. As the payment date gets closer, interest cost must be recognized (2 nd general principle of long-term debt)
Expected Return on Plan Assets – The off-sets pension costs and makes pension expense smaller. The expected return is used rather than the actual return to avoid the effects of the stock market ’ s volatility.
Prior Year Service Cost – Adjustments to PBO for additional benefits granted to employees … “ sweeteners.
”
Amortization of Excessive Plan Gains & Losses – Due to changes in
Fund earnings experience or PBO assumptions.

Accounting for Dividends
Stock Dividend
Small (less than 20 – 25% of outstanding stock)
Retained Earnings $ FMV
Common Stock $ Par
Additional Paid-In Capital Difference
Large (more than 20 – 25% of outstanding stock)
Retained Earnings $ Par
Common Stock $ Par

Accounting for Dividends
Stock Split
Just like a stock dividend, increases the number of shares outstanding … without impacting Retained Earnings.
No entry is record. Par value and shares outstanding are adjusted to reflect the split.
PhilDrakeCo has 1,000,000 shares of $10 par common stock.
Following a 2 for 1 stock split, there are 2,000,000 shares outstanding with a par value of $5.

Treasury Stock
Purchase 10,000 shares of PhilDrakeCo at $11 per share.
Treasury Stock $ 110,000
Cash
Contra-Equity
Reissue Above Cost - $15 per share
Cash
$ 110,000
$ 150,000
Treasury Stock $ 110,000
Paid-In Capital – TS 40,000
Reissue Below Cost - $5 per share
Cash
Paid-In Capital – TS
$ 50,000
60,000
Treasury Stock $ 110,000

Convertible Securities
Convertible securities (debt and preferred stock) is the underlying security with an option to convert the security into common stock. Terms of conversion are typically fixed (i.e.,
50 shares common stock for each $1,000 bond).
For debt, the conversion feature reduces the interest rate due to the investor … lowers cost of borrowing.
When the security is converted, no gain or loss is recognized. Thus, the conversion is done at the convertible security ’s book value.

Revenue Recognition
The Securities and Exchange Commission (SEC) has issued authoritative statements in Staff Accounting
Bulletin (SAB) 104.
Revenue, generally, is realized or realizable and earned when all of the following criteria are meet:
1. There is persuasive evidence that an arrangement exists,
2. Delivery has occurred or services have been rendered*,
3. The seller ’ s price to the buyer is fixed or determinable, and
4. Collectability is reasonable assured.
*
Risk of loss is transfer or no future performance required

Research & Development
•
Companies engage in R&D with the expectation of producing profitable future goods and services. However, there is the risk that these expenditures will have no value for the firm.
•
The resulting assets typically have values unrelated to the R&D costs.
•
Expensed as incurred. Lacks the probable future economic benefit criteria of an asset.
•
Creditors generally do not lend on R&D projects.

Restructuring Activities
Most firms experience some type of restructuring.
It is a natural evolution of business.
Restructuring can include employee layoffs, lease terminations, asset write-downs, moving locations, closing operations and other reorganizations.
Following the commitment to a formal plan of restructuring, recognize a liability & expense.

Restructuring Activities
Provides management with a tool for earnings management. The Big Bath Theory.
As the restructuring unfolds, the liability & expense are updated for the new information.
This creates an incentive to front-load expenses.
Strangely, restructuring costs imposed by a merger as expensed as incurred. No liability is established due to past abuses.

Accounting for Income Taxes
GAAP
FASB, SEC
Tax law
Congress

The basics
Book Income
≠
Taxable Income
Timing differences
Permanent differences
A timing difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period.
A permanent difference results when a revenue (gain) or expense (loss) enters book income but never recognized in taxable income or vise versa.

Temporary Differences
Event
Installment Sales
Product Warranties
Book
Income
Tax
Income
Revenue Today Income Later
Expense Today Deduction Later
Bad Debt Expense Expense Today Deduction Later
Rent Rec ’d in Advance Revenue Later Income Today
Depreciation Expense
Prepaid Expenses
Straight-Line
Expense Later
Accelerated
Deduction Today
Def. Tax
Asset
X
X
X
Def. Tax
Liability
X
X
X
Deferred Tax Liability when Future Taxable Income > Future Book Income
Deferred Tax Asset when Future Taxable Income < Future Book Income

Permanent Differences
•
Permanent differences will not reverse in the future. Thus, book and tax will never equalize.
•
Common permanent differences:
–
–
Fines and Penalties
Meals and Entertainment
–
–
–
Political Contributions
Officers Life Insurance
Tax-exempt Interest
•
Permanent differences are ignored for financial accounting purposes.

Accounting for Taxes –
Mechanics
Income tax expense is the “ plug ” after determining the tax liability and changes in deferred taxes.
1.
Record the tax liability
2.
Record the changes in the deferred tax accounts
3.
Plug “ Income tax expense.
”
Unusual occurrence – Income tax expense when there is a net loss.

Deferred Tax Assets
Deferred tax assets must pass the definition on an asset … “ probable future economic benefit ”
If there is uncertainty realizing the deferred tax asset
( e.g., history of operating losses/profits, unsettled circumstances, presence of existing contracts or backlog ), then a valuation allowance (contra asset) must be establish.
The criteria for the valuation allowance is needed is whether the it is “ more likely than not ” that the tax benefits will be realized.

Net Operating Losses
The U.S. income Tax code allows firms reporting operating losses to offset those losses against past or future tax payments.

Valuation Allowance
When a valuation allowance is recognized, there is a corresponding increase in the income tax expense.
If it subsequently determined that the deferred tax benefit will be realized, then the entry that established the valuation allowance is reversed. This results in a decrease in income tax expense and an increase in net income. Some analysts call this cookie jar accounting.
Also reveals information about the long-term prospects of a firm ’s profitability. General Motors established a $38.6 billion valuation allowance in the 3 rd quarter, 2007.

Effective v. Marginal Tax Rates
•
Effective Tax Rate (ETR)
–
–
Income tax expense divided by pretax book income.
Provides information as to a firm ’s tax management.
•
Marginal Tax Rate
–
Income tax for the next dollar of taxable income.
–
For the U.S. companies, use a marginal federal rate of
35% plus estimated 5% state and local tax rate.
•
In conducting incremental analysis and after-tax effects (e.g., interest costs), use the marginal tax rate.

Foreign Currency Transactions
Amerco, a U.S. company, sells goods to a German customer at a price of 1 million Euros ( €) when the spot exchange rate is $1.50 per Euro.
If payment were received at the date of sale , Amerco would convert 1 million Euros into $1,500,000.
Instead, Amerco allows the German customer 30 days to pay .
At the end of 30 days, the euro had depreciated to $1.45 per
Euro and Amerco can convert the 1 million euros into
$1,450,000.
How should Amerco account for the $50,000 decrease in value?

Foreign Currency Transactions
Two-transaction perspective:
-
The export sale
-
The decision to extend credit
Date of Sale
Accounts Receivable $1,500,000
Sales
Goes to
Income Stmt
Date of Collection
Foreign Exchange Loss $ 50,000
Accounts Receivable
$1,500,000
$ 50,000
Cash
Accounts Receivable
$1,450,000
$1,450,000

Below the line components
Discontinued Operations & Extraordinary Items
- Reported net of tax
- Separate EPS calculations
Proctor & Gamble

Earnings Per Share
Very powerful … highly cited, moves markets, motivates people, affects M&As.
The most important single financial number.
Simple Capital Structure – No potential common stock
(e.g., NO convertible bonds, convertible preferred stock, stock warrants, stock options)
EPS
=
-

Earnings Per Share
Complex Capital Structure:
Dual Structure- Basic EPS, Diluted EPS
For Diluted EPS calculation include only dilutive securities, exclude antidilutive securities.

The “ if converted ” method:
• Assumes that all convertible bonds are exchanged for stock at the beginning of the reporting period.
• But conversion is unlikely if the stock price ($75) is substantially below the conversion price
($100).
• The resulting diluted EPS figure overstates likely dilution in this case and thus understates EPS.
The “ treasury stock ” method:
• Assumes that proceeds received on exercise of the options ($100 per share) are used to buy back shares at the average market price.
• If the average market price is below the exercise price, the options are not dilutive for EPS purposes.
• The resulting diluted EPS figure understates likely dilution and overstates diluted EPS.