Financial Accounting Final Review A transaction must have financial impact and be able to reliably recorded We use low cost of market because of conservatism. We are not allowed to overstate our economic resources. When we offer warranty, we must put potential effect on our income statement Bonds can be issued at par, premium, or discount. 4 point criteria of operating leases: 1. Operating lease is on balance sheet. Goodwill = purchase price – book value of assets Intro to Business Activities and Financial Accounting Overview I. II. III. IV. 4 main principles of a business a. Establishing goals and strategies b. Obtaining financing c. Making investments d. Conducting operations 4 key financial statements a. Balance sheet i. At a fixed moment in time ii. Lists assets, liabilities, and stockholder’s equity iii. Assets are listed in order of liquidity iv. Liabilities are listed in order of maturity b. Income statement i. Sales revenues and expenses c. Statement of Cash Flows i. Over a period of time ii. Inflows and outflows d. Stockholder’s Equity i. Changes to each stockholder’s equity during acct year Footnotes a. Help to fully explain certain items in the financial statements. b. Significant accounting policies and practices – Companies are required to disclose the accounting policies that are most important to the portrayal of the company’s financial condition and results. These often require management’s most difficult, subjective or complex judgments. c. Income taxes – The footnotes provide detailed information about the company’s current and deferred income taxes. The information is broken down by level – federal, state, local and/or foreign, and the main items that affect the company’s effective tax rate are described. d. Pension plans and other retirement programs – The footnotes discuss the company’s pension plans and other retirement or post-employment benefit programs. The notes contain specific information about the assets and costs of these programs, and indicate whether and by how much the plans are over- or under-funded. e. Stock options – The notes also contain information about stock options granted to officers and employees, including the method of accounting for stock-based compensation and the effect of the method on reported results. 3-5 external users of financial statements and why they sue them a. Managers and Employees i. Compensation and bonus contracts ii. Financial condition, profitability, and prospects of their companies V. VI. VII. VIII. IX. iii. Competing companies iv. Business opportunities b. Stockholders and Directors i. Fundamental analysis uses financial information to estimate company value and form buy sell stock strategies ii. Investment decisions c. Creditors and Suppliers i. Help determine loan terms, loan amounts, interest rates, and required collateral. d. Customers and Strategic Partners i. To assess a company’s ability to provide products or services as agreed ii. Assess company’s staying power or reliabity e. Investment Analysts and Information Intermediaries i. Future profitability and ability to generate cash Preparation and Oversight of Financial Statements a. Quantity and quality of accounting information that companies supply are determined by manager’s benefits and costs of disclosure b. Both regulation and bargaining power affect disclosure costs and benefits c. In the US, we use the SEC SEC: Securites Exchange Commision a. Two main compulsory SEC filings i. Form 10-K 1. The audited annual report that includes the four financial statements, with explanatory notes and the management’s discussion and analysis of financial results ii. Form 10-Q 1. The unaudited quarterly report that includes summary versions of the four financial statements and limited additional disclosures FASB: Financial Accounting Standards Board a. FASB’S conceptual framework states that accounting should be: i. Relevant & reliable ii. Comparable & consistent b. Sets US financial accounting standards c. An independent body owned by a foundation d. Published over 150 accounting standards i. GAAP: Generally Accepted Accounting Principles 1. FASB’s rules 2. prefers accrual accounting so that transactions are recorded on an economic basis IASB: International Accounting Standards Board Accounting Equation a. Assets = Liability + Owner’s Equity Balance Sheet and Income Statement I. II. III. IV. Accrual Basis Accounting vs. Cash Basis Accounting a. Accrual Accounting i. Revenues and Expenses are recognized on an economic basis, without regard for the actual flow of cash ii. GAAP’s accouting system to prepare all GAAP related expenses iii. GAAP (Generally Accepted Accounting Principles) requires accrual-based accounting because it more accurately reflects a company's financial position. iv. Revenue is earned when products are delivered or services are provided v. Foundation of accrual accouting 1. Revenue Recognition Principle: recognize revenues when earned 2. Matching Principle: recognize expenses when incurred a. must match at time they occured b. Cash Basis i. Revenues are recognized ONLY when cask is received ii. Expenses are recognized when cash is paid iii. On the cash basis, only cash received and paid out is recorded. This method ignores any income the company has earned but has not yet received and any expenses the company owes but has not yet paid. Transaction a. Every transaction must have financial impact on at least 2 accounts i. Must keep equation balanced b. Every transaction must be easily documented Steps in the Accouting Cycle a. For each transaction: 1. a Journal Entry is recorded showing the impacted accounts using the rules of Debits & Credits 2. A summary of the account is shown in a T-account 3. Further summary is the creation of a Trial Balance 4. From the Trial Balance, Financial Statements are born! Current vs long term assets a. Current assets i. Cash—currency, bank deposits, and investments with an original maturity of 90 days or less (called cash equivalents); ii. Marketable securities—short-term investments that can be quickly sold to raise cash; iii. Accounts receivable, net—expected amounts due to the company from customers arising from the sale of products and services on credit; iv. Inventory—goods purchased or produced for sale to customers; v. Prepaid expenses—costs paid in advance for rent, insurance, advertising or other services. b. Long term assets i. Property, plant and equipment (PPE), net—land, buildings, warehouses, machinery, motor vehicles, office equipment and other items used in operating activities V. VI. VII. VIII. IX. ii. Long-term investments—investments that the company does not intend to sell in the near future; iii. Intangible and other assets—assets without physical substance, including patents, trademarks, franchise rights, goodwill and other costs the company incurred that provide future benefits. c. Except for land, we depreciate our long term assets d. We amortize our intangibles, we deplete our natural resources. Ability to identify and classify accounts a. Everything on the left side of the accounting equation we debit i. Asset accounts b. Everything on the right side are credit accounts i. Therefore, assets are debited, liabilities and owner's equity are credited Liquidity a. The balance sheet lists assets in order of decreasing liquidity, which refers to the ease of converting non cash assets into cash. b. The most liquid assets are called current assets and they are listed first Relevance and reliability a. Most assets are reported at their original acquisition costs, or historical costs b. The controversy arises because of the tradeoff between the relevance or current market values for many business decisions and the reliability of historical cost measures GAAP’s book value a. Stockholder’s equity is the value of the company determined by GAAP and is commonly referred to as the book value. b. We use low cost of market because of conservatism. We are not allowed to overstate our economic resources. c. This value is different than the market value which is computed by multiplying the number of outstanding common shares by the per share market value. i. GAAp generally reports assets and liabilities at historical costs, whereas the market attempts fair market values ii. GAAP excludes resources that cannot be reliably measured like talented mgmt, employee morale, recent innovations and successful marketing, whereas the market attempts to value there. iii. GAAP does not consider market differences in which companies operate such as competitive conditions and expected changes, whereas the market attempts to factor in these differences in determining value. iv. GAAP does not report expected future performance, whereas the market attempts to predict and value future performance. Matching Principles a. Expenses are matched to the revenues that they generate b. Since the firm expends assets (causing expenses) in anticipation of revenue, fair measurement of net income calls for matching those expenses against revenue. c. Expenses are recognized in the period in which the revenue is recognized/when incurred Receivables and Revenue Recognition I. Revenue Recognition a. For revenue to be recorded on the financial statement, it must be: i. Realized or reliable ii. Earned b. We do not recognize revenue in these situations: i. Rights of return exist: We can return it at anytime ii. Consignment sales: Being the middle man iii. Continuing involvement by seller and product resale(when seller retains possession of the product until it is resold) iv. Contingency sales: when product sales are contingent on product performance 1. There is persuasive evidence that a sales agreement exists 2. Delivery has occurred or services have been rendered 3. Seller’s price to the buyer is fixed or determinable 4. Collectability is reasonably assured. X. R&D Expenses: a. Expense all R&D costs as incurred unless those assets have alternative future uses (in other R&D projects or otherwise). b. For example, a general research facility housing multi-use lab equipment is capitalized and depreciated like any other depreciable asset. c. However, project-directed research buildings and equipment with no alternate uses must be expensed. d. We are not allowed to capitalize Research and Development because of GAAP, this means instead of the income statement, it must go on the balance sheet. e. XI. Extraordinary Items a. Refer to events that are both unusual and infrequent b. GAAP’s criteria for what is extraordinary i. Unusual nature ii. Infrequency of occurrence c. These are NOT recorded as extraordinary items i. Gains or losses on retirement of debt ii. Write down or write off of operating or nonoperating assets iii. Foreign currency gains and losses iv. Gains and losses from disposal of specific assets or business segment v. Effects of a strike vi. Accrual adjustments related to LT contracts vii. Costs of a takeover defense d. Recorded separately (net of tax) and below income from continuing operations on the income statement XII. Accounts Receivable a. When companies sell to other companies, they offer credit terms, which are called sales on credit (or credit sales or sales on account). b. Accounts receivable are reported on the balance sheet of the seller at net realizable value, which is the net amount the seller expects to collect. c. The Allowance for Doubtful (or Uncollectible) Accounts is a contra-asset account. It is deducted from Accounts Receivable on the balance sheet as follows: Accounts receivable: XX Less: Allowance for D.A. XX Accounts receivable, net XX XIII. Allowance for doubtful accounts a. Accounts Receivable b. When companies sell to other companies, they offer credit terms, which are called sales on credit (or credit sales or sales on account). c. Accounts receivable are reported on the balance sheet of the seller at net realizable value, which is the net amount the seller expects to collect. d. The Allowance for Doubtful (or Uncollectible) Accounts is a contra-asset account. It is deducted from Accounts Receivable on the balance sheet as follows: Accounts receivable: XX Less: Allowance for D.A. XX Accounts receivable, net XX XIV. The accounts receivables turnover (ART) rate: a. ART = Sales / Avg Accounts Receivable b. The accounts receivable turnover rate reveals how many times receivables have turned (been collected) during the period. c. More turns indicate that receivables are being collected quickly d. A companion ratio is the Average Collection Period: Average Collection Period = Accounts Receivable / Avg Daily Sales e. Example: Suppose that sales are $1,000 ending accounts receivable are $230 average accounts receivable are $200. f. How to calculate allowance for doubtful accounts Inventories, Long Term Assets I. Inventory a. The cost of inventories is on the balance sheet as the price of goods purchased from other companies or the costs to manufacture those goods, if internally produced. b. Inventory costs either are reported on the balance sheet (ending inventory) or they are transferred to the income statement as an expense (cost of goods sold) to match against sales revenues. c. Based on conservatism, ending inventory is valued at cost or market value, whichever is lower. i. Problems: 1. can create hidden reserves 2. Recognizes price decreases immediately 3. Defers price increase recognition until sold II. Cost Flow Assumptions for Inventory a. First-In. First-Out (FIFO). i. This method assumes that the first units purchased are the first units sold. ii. FIFO benefits: Because of inflation, it is common for beginning companies to use FIFO for reporting the value of merchandise to bolster their balance sheet. As the older and cheaper goods are sold, the newer and more expensive goods remain as assets on the company's books. iii. FIFO limitations: Companies may switch to LIFO to reduce the amount of taxes they pay to the government. b. Last-In, First-Out (LIFO). i. The LIFO inventory costing method assumes that the last units purchased are the first to be sold. ii. LIFO limitations: Since prices generally rise over time because of inflation, this method records the sale of the most expensive inventory first and thereby decreases profit and reduces taxes. iii. LIFO benefits: LIFO better matches current cost against current revenue. It also defers paying taxes on phantom income arising solely from inflation. LIFO is attractive to business in that it delays a major detrimental effect of inflation, namely higher taxes. c. Specific Identification: i. III. IV. Inventory valuation method in which the actual cost of the purchased and issued (used or sold) items is identified by purchase date or a serial number. ii. Benefits of Specific Identification: relates the ending inventory goods directly to the specific price they were brought. iii. Limitations of Specific Identification: allows management to easily manipulate ending inventory cost, since they can choose to report that the cheaper goods were sold first, hence increasing ending inventory cost and lowering Cost of Goods Sold. This will increase the income. Alternatively, management can choose to report lower income, to reduce the taxes they needed to pay. d. Average Cost: i. Computes cost of goods sold as an average of the cost of purchase. Company divides total cost of goods available for sale by the number of units available for sale. ii. The average cost method assumes that the units are sold without regard to the order in which they are purchased. Instead, it computes COGS and ending inventories as a simple weighted average. Long Lived Assets and Cost Allocation a. Long-lived asset: one whose future benefit is expected for a number of years; also called long-term asset. It includes such non-current assets as building, equipment, and intangibles. b. Cost Allocation: Capitalization of Asset Costs i. Companies capitalize asset costs as an asset on the balance sheet only if that asset possesses both of the following characteristics: 1. The asset is owned or controlled by the company 2. The asset provides future expected benefits ii. Companies can only capitalize asset costs that are directly linked to future cash inflows iii. R&D activities are expensed because companies cannot reliably estimate future cash flows from R&D activities iv. Once the cost of PPE is capitalized on the balance sheet as an asset, it must be systematically transferred from the balance sheet to the income statement as depreciation expense to match the asset's cost to the revenues it generates Depreciation requires the following estimates: a. Useful life – period of time over which the asset is expected to generate cash inflows b. Salvage value – Expected disposal amount for the asset at the end of its useful life c. Depreciation rate – an estimate of how the asset will be used up over its useful life. d. A company can depreciate different assets using different depreciation rates (and different useful lives). e. The using up of an asset generally relates to physical or technological obsolescence. f. Depreciation Methods i. Straight line method - Method of computing depreciation in which the depreciable cost (historical or purchase price) of a tangible capital asset is reduced by an equal amount in each accounting period (usually a year) over the asset's estimated useful life. ii. Double Declining Balance Method - Method that records more depreciation in the early years of an asset's useful life and less depreciation in later years Liabilities(Non-Owner Financing) I. II. Current operating liabilities a. Accounts payable - obligations to other companies for amounts owed on purchases of goods and services. These are usually non-interest-bearing. b. Accrued liabilities - obligations for which there is no related external transaction in the current period. These accruals are made to properly reflect the liabilities owed and expenses incurred by the company as of the statement date. c. Short-term interest-bearing loans: short-term bank borrowings expected to mature in whole or in part during the upcoming year, together with accrued interest. d. Current maturities of long-term debt: long-term liabilities that are scheduled to mature in whole or in part during the upcoming year. e. Accounts payable turnover i. Reflects mgmt success in using trade credit to finance purchases of goods and services ii. APT = Cost of Goods Sold/Average Accounts Payable Accounting for Contingent Liabilities: If the loss is remote: Ignore If the loss is reasonably possible: Disclose in footnotes If the loss is probable: Is the loss estimable? No -> Disclose in footnotes Yes -> Accrue and disclose a. Contingent liabilities are potential liabilities. b. The more probable the potential to become a legal obligation, the greater the rationale for recognizing it as a liability. c. Probability of a potential liability is very difficult to measure. d. In general, an obligation should be recognized as a liability if it is probable that the firm will have made future sacrifices of resources. e. Of course, the word “probable” is also difficult to measure. f. FASB and IASC require the recognition of a loss and a contingent liability (i.e. an accrual) when: III. IV. I. II. i. It is probable that an asset has been impaired or a liability incurred ii. The amount of the loss can be reasonably estimated. Bond Ratings Bonds are ranked on the basis of the degree of risk associated with timely payment of their interest and principle. Bond rating agencies (such as Standard & Poor's) use a grading system as follows a. (1) AAA: highest quality (called 'gilt edged'). b. (2) AA: high quality. c. (3) A: upper medium grade. d. (4) BBB: medium grade. e. (5) BB: has speculative elements. f. (6) B: speculative. g. (7) CCC: speculative with possibility of default. h. (8) CC: most speculative. i. (9) C: lowest gradable quality. j. (10) DDD: in default with possibility of recovery. k. (11) DD: in default and arrears. l. (12) D: in default, with little or no value. Bonds rated 'BBB' or higher are considered investment grade suitable for financial institutions with fiduciary responsibilities. Bonds rated below 'B' are considered speculative grade and are called high yield or junk bonds which, due to greater likelihood of their default, must pay higher interest rates to attract investors. A company's credit rating is related to default risk. Companies that want to obtain bond financing from the capital markets normally first seek a rating on their proposed debt issuance from one of several rating agencies. Definition of Off-Balance Sheet Financing a. Off-balance sheet financing means that either assets or liabilities (or both) are kept off of the face of the balance sheet. There still is disclosure though. Examples include: leases, pensions, variable interest entities, and derivatives. Why is Off-Balance Sheet Financing Used a. It lowers the cost of borrowing if lenders are not aware of the unrecorded liabilities. b. Sometimes this rationale assumes that lenders can be fooled by off-balance-sheet methods. c. Standard-setting bodies have required increased disclosures of such methods in recent years. d. Companies desire to present a balance sheet with sufficient liquidity, and less indebtedness…therefore looking their “best”. It avoids violating some “debt covenants”, such as restrictions specified in the debt agreement to protect the III. IV. lender. These restrictions are sometimes stated in the form of financial ratios which may be affected by whether or not the liability is recorded. e. To help finance new ventures (could be within the company’s current product offering or a new line). f. These separate legal entities could be privately held partnerships or publicly traded spin-offs. Remember, our risk may be someone else’s opportunity. g. When misused, off-balance-sheet vehicles have been used to pump up financial results. Off-balance-sheet financing falls into one of two categories that accounting does not currently recognize as liabilities a. 1. Executory contracts are promises to pay at a future date for future benefits These may be legally binding and give both parties valuable rights. Standard accounting would recognize a liability as benefits are received, not when the contract is signed. b. 2. Contingent obligations are obligations that arise only if a specified set of conditions are met. Standard accounting would recognize a liability as the contingent events occur rather than when the contract is signed. General understanding of “Window-Dressing” a. A company is concerned that its liquidity may not be perceived as sufficient… What may they do? • Prior to the end of its financial reporting period it takes out a short-term loan from its bank in order to increase its reported cash balance. The same result can also be obtained by delaying payment of accounts payable. • In both cases, the company’s cash and current assets have been increased. • Even though current liabilities are also higher, the liquidity of the balance sheet has been improved and the company appears somewhat stronger from a liquidity point of view. b. A company’s level of accounts receivable are perceived to be too high, thus indicating possible collection problems and a reduction in liquidity… • What may they do? • Prior to the statement date, the company offers customers an additional discount in order to induce them to pay the accounts more quickly. • Although the profitability on the sale has been reduced by the discount, the company reduces its accounts receivable, increases it’s reported cash balance and presents a somewhat healthier financial picture to the financial markets. c. A company may face the maturity of a long-term liability, such as the scheduled maturity of a bond. The amounts coming due will be reported as a current liability (current maturities of long-term debt), thus reducing the net working capital of the company… • What may they do? • V. VI. Prior to the end of its accounting period, the company renegotiates the debt to extend the maturity date of the payment or refinances the indebtedness with longer-term debt. • The indebtedness is, thus, reported as a long-term liability and net working capital has been increased. d. The company’s financial leverage is deemed excessive, resulting in lower bond ratings and a consequent increase in borrowing costs… • What may they do? • To remedy the problem, the company issues new common equity and utilizes the proceeds to reduce the indebtedness. • The increased equity provides a base to support the issuance of new debt to finance continued growth. Capital Leases vs. Operating Leases a. Capital lease method - both the lease asset and the lease (present value) liability are reported on the balance sheet. The leased asset is depreciated like any other long-term asset. The lease liability is amortized like a note, where lease payments are separated into interest expense and principal repayment. b. Operating lease method - neither the lease asset nor the lease liability is on the balance sheet. Lease payments are recorded as rent expense when paid. c. Criteria to show as Capital Lease Requirements of SFAS No. 13 - record as capital lease for the lessee if any one of the following is present in the lease: • Title transfers at the end of the lease period, • The lease contains a bargain purchase option, • The lease life is at least 75% of the useful life of the asset, or • The lessee pays for at least 90% of the fair market value of the lease. d. Leases • Operating leases i. Lessee assumes no risk of ownership. ii. Recognize rent expense as each payment made. iii. At end of lease term, right to use the property reverts to the owner. • Capital leases i. Effectively an installment purchase. ii. Lessee assumes rights and risks of ownership. iii. Treated as asset purchased with related liability and depreciation. Pensions -There are generally two types of plans: a. Defined contribution plan. This plan has the company make periodic contributions to an employee’s account (usually with a third party trustee like a bank), and many plans require an employee matching contribution. Following retirement the employee makes periodic withdrawals from that account. A taxadvantaged 401(k) account is a typical example. b. Defined benefit plan. This plan has the company make periodic payments to an employee after retirement. Payments are usually based on years of service and/or the employee’s salary. The company may or may not set aside sufficient funds to make these payments. As a result, defined benefit plans can be overfunded or underfunded. VII. Accounting for Defined Benefit Plans a. Defined benefit plans are more problematic due to the fact that the company retains the pension investments and the pension obligation is not satisfied until paid. b. Account balances, income and expenses, therefore, need to be reported in the company’s financial statements. • If cumulative pension expenses exceed cumulative pension funding, a pension liability appears on the balance sheet, else a pension asset is recognized. • If the PV of pension commitments to employees exceeds the assets of the fund, a pension liability would also have to be recognized. VIII. Special Purpose Entities (SPEs) – Asset Securitization a. A sponsoring company forms a subsidiary that is capitalized entirely with equity; this creates a bankruptcy remote transaction, which reduces the likelihood of bankruptcy for subsequent investors). b. The subsidiary purchases assets from the sponsoring company and sells them to a securitization (off-balance-sheet) trust (the SPE), which purchases the assets using borrowed funds. c. Cash flows from the acquired assets are used by the SPE to repay its debt. IX. Rationale for SPE Financing a. Lower cost of capital. SPEs can provide lower cost financing for a company. b. Liquidity. Securitization of assets provides a consistent cash flow source. c. Nonconsolidation. SPEs can provide a mechanism for off-balance-sheet financing if unconsolidated with the sponsoring company I. II. III. Intercorporate Investments- why this is important includes: a. ST Investment of excess cash b. Alliances for strategic purposes c. Market penetration or expansion d. Coming attractions regarding significant influence: e. Prelude to acquisition f. Again, strategic alliance g. Pursuit of R & D For the purposes of valuation after acquisition, there are three classes of marketable securities: a. Debt held to maturity b. Trading securities c. Securities available for sale Debt Held to Maturity IV. V. VI. VII. a. Debt securities for which a firm has both the positive intent & ability to hold to maturity. b. Shown on the balance sheet at the amortized acquisition cost. c. Amortized acquisition cost means that the securities are amortized like a mortgage or bond. d. The acquisition cost is assumed to be the present value. The maturity value and maturity date are known from the bond certificate. An internal rate of return can be calculated using PV Equity Investments a. Equity investments represent ownership of another company’s outstanding common stock. b. Marketable equity investments are actively traded on a public stock exchange. c. By owning shares of common stock, the investor “owns” a part of the company, represented by the percentage ownership. d. There are different accounting rules for: Less than 20 percent ownership. Between 20 and 50 percent ownership. greater than 50 percent ownership Less than 20 % ownership a. Deemed to be a “passive” investment… b. If marketable securities, use the mark-to market method. c. Carries securities on balance sheet at market value. d. Revaluation at the end of each period based on new market price e. Unrealized gains (or losses) are recognized as the investment is valued up (or down). f. Treatment of the Unrealized +/- depends on classification of security: Trading securities…income statement Available-for-sale securities…equity section Trading Investments a. Trading investments held for the short term, with purpose of selling securities for profit. b. At purchase - record at cost to acquire. c. Activity during the year - record declaration of cash dividends, and recognize “Dividend Income” on the Income Statement: Dividends Receivable xx Dividend Income xx d. For securities on hand at the end of the accounting period - revalue to market value and record “Unrealized Gain/Loss” on Income Statement. e. When sold - recognize “Realized Gain/Loss on Sale” on Income Statement for any balance since the last revaluation. Available-for-sale Securities a. Available-for-sale (AFS) securities may be held for the short term or for long term, depending on management’s intentions. b. At purchase - record at cost to acquire. c. Activity during the year - record declaration of cash dividends, and recognize “Dividend Income” on the Income Statement: VIII. IX. X. XI. XII. Dividends Receivable xx Dividend Income xx d. For securities on hand at the end of the accounting period - revalue to market value and record “Unrealized Gain/Loss” on Balance Sheet (as part of Other Comprehensive Income in Stockholders’ Equity). e. When sold - recognize “Gain/Loss on Sale” on Income Statement for total difference between original cost and selling price. From 20% to 50% Investment a. Because investment represents significant influence of investor, we cannot account for investments the same way as Trading or AFS. b. Specifically, we cannot recognize “Dividend Income” as dividends are declared, because the investor could “dictate” income to be recognized from the investee (investor could have investee declare a dividend to investor). c. Must use the Equity Method of accounting d. The equity method increases the investment account and recognizes investor’s portion of income as investee earns it (reports income to investor). e. The equity method decreases the investment account as investee declares dividends to the investor. Greater than 50% Investment a. If an investor has majority control, the investment is recorded using the consolidation method, and a parent/subsidiary relationship is established. b. At the end of the period, the financials of the parent and subsidiary must be combined, or consolidated, for external financial reporting. c. Goodwill is recognized as a separate asset in the consolidation. Consolidation of Purchased Subsidiaries Recognition of Minority Interest a. If the subsidiary is less than 100% owned (but still greater than 50%), the parent still adds all of the subs assets and liabilities, and all of the subs revenues and expenses in the consolidation. b. The parent must then recognize that part of the subsidiary belongs to a “Minority Interest” when reporting the results to the parent’s shareholders. Acquired Intangible Assets a. The purchase price is allocated to acquired identifiable intangible assets, which include the following: b. Marketing-related assets i.e. trademarks and internet domain names c. Customer-related assets i.e. customer lists, production backlog, and customer contracts d. Artistic-related assets i.e. plays, books, and video e. Contract-based assets i.e. licensing and royalty agreements, lease agreements, franchise agreements, and servicing contracts f. Technology-based assets i.e. patents, computer software, databases and trade secrets Limitations of Consolidated Financial Statements a. Consolidation income does not imply that cash is received by the parent company b. Comparisons across companies are often complicated by the mix of subsidiaries included in the financial statements c. Segment profitability can be affected by intercorporate transfer pricing and allocation of overhead XIII. XIV. XV. Minority Interest a. The equity claim of a shareholder owning less than a majority or controlling interest in the company. Goodwill a. The value that derives from a firm’s ability to earn more than a normal rate of return on the fair market value of its specific, identifiable net assets; computed as the residual of the purchase price less the fair market value of the net tangible and intangible assets acquired. Goodwill = Purchase Price – Fair Market Value of net assets Fair Market value of Net assets= FMV assets – FMV liabilities Cash Flows Assets - + Liabilities + - * We keep things at historical cost, very rarely do we branch out A/D = accumulated depreciation. We need to know how much cash was received from the equipment in its historical cost Ending plant equipment=Book Value of assets sold + gain on the sale (Historical cost – A/D) Proceeds from sale of equipment=Book value of assets sold + Gain on the sale Proceeds from issue of common stock=Increase in common stock+Increase in additional common stock paid in capital Dividends= Beginning retained earnings + Net income – ending retained earnings Cash flows from operating activities: Net Income Non cash items +(Depreciation expense from income statement) -(Premium on Bonds payable) Avoid double counting gains/losses –(Gains on sale) Changes in current assets and L Accounts receivable Inventory Prepaid Insurance Accounts Payable Cash Flows from Investing Activities: Proceeds from sale of PE Purchased plant equipment Cash Flows from Financing Activities Equity: Beginning retained earnings +/- Net income (loss) - Dividends _____________________ =Ending retained earnings Proceeds from issuing bonds Common Stock Additional P-I-C Paid in Capital Payment of dividends