Who am I
Chapter 1: Accounting: The Language of Business Including Balance Sheet Transactions
Accounting is an information and measurement system designed to meet the needs of a diverse set of users ( managers, owners, customers and lenders ( in this competitive business environment. The goal of the accounting system is to provide relevant, reliable and comparable information about various business entities and opportunities and to improve decisions.
Accounting reports include specific tables or statements comparing the current period to past periods and explanatory text such as footnotes (notes) and other commentary.
Prospective users of accounting reports include investors, potential investors, creditors, suppliers, employees, regulators and other groups.
Accounting reports follow generally accepted accounting procedures (GAAP), an accepted set of rules designed to describe companies.
GAAP is an amalgam of rules determined by the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), and the American Institute of Certified Accountants (AICPA).
1 The SEC administers laws governing the securities markets and can determine the information available to public constituencies. Although the SEC retains oversight, the authority to develop specific standards has been delegated to the private sector.
2 The FASB is a private body that holds public hearings before determining accepted accounting procedures. Many of the board's pronouncements reflect controversial and new issues and may undergo revision in future. The board has accepted many AICPA procedures as part of generally accepted accounting procedures.
Accounting reports include:
1 A management discussion includes a commentary describing the company's recent performance and major issues affecting that performance.
2 Required tables or statements include a balance sheet (describing the company's current financial position), an income statement and a cash flow statement (each describing the company's recent performance (in different ways)), and a statement of shareholders' equity (describing the ownership of the company).
3 Notes to the financial statement clarify some items reported in the financial statements, adding details, and report on some items not included in the financial statements.
4 Reports by management asserting that company data are reliable and conforming to GAAP, and the independent auditors, indicating that the accounting audit has followed generally accepted procedures are also included in the report.
Basic Accounting Information
1 Companies report using consolidated financial statements. These statements combine the activities and position of the parent company and those of the subsidiaries the company owns or controls.
2 Cash basis accounting focuses on the cash flows as they affect the company. Events that may affect cash flows in the future are ignored.
3 Fair value accounting focuses on the market values of items the company owns or can use (assets) and on the market values of the obligations that the company must cover (liabilities).
1 Accrual accounting assumes that assets will generate future flows even if they do not generate cash flows today. Events that are expected to generate future cash flows are included in the company's statements.
2 Statements may report on the past for periods of a quarter or a year, but they provide inputs for decision making about the firm's future.
1 The Balance Sheet (Statement of Financial Position) provides a summary report of the firm's assets and liabilities. The leftover represents the residual or ownership position.
Assets ( Liabilities = Owners' Equity or A ( L = OE
This can be restated as A = L + OE or
Assets = liabilities + Owners' Equity
2 The Income Statement summarizes one period's activities generating inflows (revenues) and outflows (expenses) associated with the sale of the company's products or services. The excess of revenues over expenses is the company's net income for the period. The focus is on accrual accounting.
Revenues ( Expenses = Net income or R ( E = NI
Net income during a period is an addition to owners' equity. If there are no other changes, then OE0 + NI1 = OE1 or owners' equity at time 0 plus net income during time 1 = owners' equity at time 1.
3 The Statement of Cash Flows summarizes one period's activities as they affect the company's cash inflows and outflows.
The Balance Sheet: Fundamental Concepts
1 Balance sheets report the entity’s accounting-recognized assets, liabilities and owners’ equity as of a specific point in time. Balance sheets are for fiscal years, not calendar years.
2 Assets = Liabilities + Owners’ Equity - (A = L + OE).
3 Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. (Concept Statement 6 (Con6), para 25). Economic assets may differ from accounting-recognized assets.
4 The common characteristic possessed by all assets is a “future economic benefit” defined as an eventual cash inflow or benefit to the entity.
5 To recognize an accounting asset, two conditions must be met.
1 A: An exchange must take place. This means that there must be a formal commitment. This precludes all promises and future contracts as being assets. A signed contract doesn’t generate an asset, but the purchase of supplies does.
2 B: The future benefit must be quantifiable. This establish the value of the asset to be reported on the balance sheet. This precludes, for example, most R&D expenses and patent-related within the firm since the amount of the future benefit is sufficiently uncertain.
6 If the entity is no longer able to receive the benefit, then the asset ceases to be.
7 Liabilities are probable future sacrifices of economic benefits arising from the present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. (Con6, para 35). The amounts and timing of the economic resources are known and estimable.
8 To recognize a liability, two conditions must be met.
A: A past transaction must take place. This creates a commitment to complete an agreement. This precludes all promises and future contracts as liabilities unless the firm has received some service or asset in the past.
B: The amount to be sacrificed must be quantifiable and probable. This provides precision to the amount of the obligation. This precludes unsettled lawsuits since the firm does not know if it will win or lose the suit.
9 There are four types of liabilities, relating past benefits and future sacrifices.
A: Cash in leads to Cash out
B: Goods or service in leads to Cash out
C: Cash in leads to Goods or service out
D. Goods or service in leads to Goods or service out
10 (Owners’) Equity is the residual interest in the assets that remains after deducting its liabilities (Con6, para 49). Owners’ Equity (Also known as shareholders’ equity and stockholders’ equity) is divided into contributed capital (the amount invested directly by shareholders to the entity) and retained earnings. Contributed capital is divided into Par Value and Additional Paid-In Capital (also known as paid-in-capital in excess of par value).
Example of Par Value and Additional Paid-in-Capital (APIC)
Assume a firm sells 100 shares of stock for $10 apiece. Its par value is $1 per share. The accounting would show:
Cash +1,000 (Asset) 100 times $10
Par Value + 100 (SE) 100 times $ 1
Additional Paid-in Capital +900 (SE) 100 times $ 9
Note that Par Value + APIC = Market Value on Transaction date
Some Balance Sheet Facts
11 Current Assets are assets that are expected to be turned into cash within one year. Cash and Inventory are examples.
12 Noncurrent (Long-term) Assets are assets that are expected to be turned into cash after one year or over a period of several years. Property and machinery are examples.
13 Current Liabilities are liabilities that are expected to be settled within one year. Wage and tax obligations are examples.
14 Noncurrent (Long-term) Liabilities are liabilities that are expected to be settled after one year. Borrowings due to be repaid after several years are examples.
15 Retained Earnings is the amount earned by the entity and not yet distributed to shareholders.
16 Valuation (Adjunct, adjustment or contra) accounts can be used to ‘adjust’ the value of an asset, liability or equity. Accumulated depreciation is an example.
17 Every transaction affects the balance sheet in two ways, via debits and credits.
18 Transactions may affect two (or more) asset accounts, two (or more) liability accounts, two (or more) owners’ equity accounts or some combination of these accounts.
19 The balance sheet reported each year is a ‘cumulative’ document reflecting the net impact of all past activities.
20 Many entities also provide quarterly balance sheets which are abbreviated versions of the fiscal year-end balance sheet.
21 (Among other things) the balance sheet can be used to help assess current (short-term) and long-term risk.
22 Ratios such as the current ratio are used to estimate short-term risk.
23 Ratios such as the debt-to-asset ratio are used to estimate long-term financial risk.
24 Balance sheet fiscal years can differ from calendar years. Most go from a given month-end to the same month-end in the following year. They may also have 52 week (periodically 53 week) fiscal years.
25 Companies can change their fiscal years.
26 The Securities and Exchanges Commission (SEC) requires the issuance of a 10-K form which includes the entity’s financial statement plus additional information. Some entities use the 10-K form as the annual report.
Chapter 2: Measuring Income to Assess Performance
The Income Statement: Fundamental Concepts
Operating Cycle – The pattern of events to move an asset through the company’s accounts as part of the company’s normal day-to-day business. On example is the ‘cash cycle’ whereby a company’s cash is followed through the firm. The cash is converted into inventory. The inventory is then sold thereby creating a receivable. The receivable is paid and the company again has cash.
Net Income = Revenues – Expenses
Net Income = Revenues – Expenses + Gains – Losses (More comprehensive)
Revenues represent actual or expected cash inflows that have occurred or will occur as a result of the entity’s ongoing major operations. (Con6 par. 79)
Expenses are outflows from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major operations. (Con6 par. 80)
Gains are increases in equity from peripheral or incidental transactions of an entity. (Con6 par. 82)
Losses are decreases in equity from peripheral or incidental transactions of an entity. (Con6 par. 83)
Revenue Recognition has three parts. All three must happen for revenues to be recognized.
1 Earned: The company must have completed (pretty much) its obligations to the customer.
2 Realization: Cash collection must be reasonably certain.
3 Legal Transfer of Risk: Seller retains only ordinary business risks that can be estimated with reasonable accuracy
Revenues can come before cash (Accounts Receivable) (credit card sales), be contemporaneous with cash (Cash) (cash sales), or can follow cash (Advances from Customers) (insurance, subscriptions).
Expenses are divided into several categories:
1 Product Costs are linked to revenues. Cost of goods sold is the major type of product cost. These expenses are matched to the sale of goods.
2 Period Costs are expensed over time. Examples of period costs are interest expense, depreciation, rent, income taxes, and salary expense. These expenses are matched to the time period in which the resources are deemed to be used.
3 Some costs do not fit either category perfectly. Examples are advertising and research expenses. They may be linked to revenues in the long-term, but may not be in the short-term and may vary substantially without regard to a specific time frame.
Expenses can be divided into direct and indirect expenses.
1 Direct expenses have a clear and immediate association with the revenue earning outputs of the entity. An example is the material required to produce a salable good.
2 Indirect expenses do not have a clear and direct association with the revenue earning outputs of the entity. examples include plant maintenance, security and general systems support.
Expenses can come before cash (for example, Salaries Payable), be contemporaneous with cash (Cash) or can follow cash (for example, Prepaid Rent).
Retained Earnings are increased by revenues and gains. Retained Earnings are decreased by expenses and losses. Retained Earnings are also decreased by dividends declared. Dividends declared create an obligation to be paid at a later date.
Retained Earnings is entirely separate from cash. A company can get cash without earning income or increasing retained earnings. Increases in retained earnings reflect new income, but, there may be no impact on cash (or cash may even decrease).
Interest is a period return to debt holders. They are expensed.
Common stock dividends are voluntary returns to shareholders distributed by the entity. They are never expensed.
Fundamental Accounting Concepts for the Income Statement
Accounting transactions are events that affect the balance sheet. So, how does income recognition affect the balance sheet?
Answer: Through the retained earnings account.
1 Revenues and gains increase retained earnings (shareholders’ equity). This means that revenues and gains appear as an increase to shareholders’ equity.
2 Expenses and losses decrease retained earnings (shareholders’ equity). This means that expenses and losses appear as a decrease to shareholders’ equity.
3 Remember, double-entry accounting means that every transaction has a left (debit) and a right-(credit) handed side. Therefore, if revenues increase shareholders’ equity, then there must be a corresponding entry to keep the balance sheet equation in balance.
4 For example, suppose the firm sells an item on account (before receiving cash).
Assets = Liabilities + Shareholders’ Equity
+ (A/R) + (Retained Earnings)
5 Suppose the firm sells an item for cash.
Assets = Liabilities + Shareholders’ Equity
+ (Cash) + (Retained Earnings)
6 Suppose the firm delivers an item after receiving cash.
Assets = Liabilities + Shareholders’ Equity
- (Advances) + (Retained Earnings)
7 Similarly, if expenses decrease shareholders’ equity, then there must be a corresponding entry to keep the balance sheet in balance.
8 For example, suppose the firm recognizes a salary expense but has not paid its employees yet.
Assets = Liabilities + Shareholders’ Equity
+ (Salaries/P) - (Retained Earnings)
9 Since revenues and expenses are part of shareholders’ equity (retained earnings), we can use T-accounts for each revenue or expense. Or, we can open up an income account with both revenues and expenses. The key concept is to remember that the revenue, expense, or income account is really just a part of the retained earnings account.
Retained Earnings
| | |Beg. Bal. | |
| |- |+ | |
| | |Net Income | |
| | | | |
| | |End. Bal. | |
Retained Earnings
| | |Beg. Bal. | |
| |- |+ | |
| |Expense |Revenue | |
| | | | |
| | |End. Bal. | |
10 Many revenues and expenses are taken over time. Basically, revenues shown over time come from advances from customers, also called unearned revenue, deferred revenue or unearned credit. Expenses shown over time are typically expenses based on time (period expenses), such as interest, depreciation, wages, and taxes.
11 Advances from customers arise when the firm receives cash first. However, they cannot show the revenues until the firm provides the product or the service.
Example: The firm receives $1,000 on April 1 for services to be performed on April 8. On April 8, the firm performs the services.
On April 1: Cash + 1,000
Advances from Customers (L) + 1,000
On April 8: Advances from Customers (L) –1,000
Revenues + 1000
12 As time goes by, firms also show expenses based on the time expired. For example, suppose on January 1 the firm buys an insurance policy covering one year for $1,200. (Recognition of the expense after payment).
On January 1: Prepaid Insurance (A) +1,200
Cash - 1,200
On January 31: Insurance Expense + 100
Prepaid Insurance - 100
13 Another example of a period expense is taxes. Suppose the firm owes $12,000 in taxes at the end of the first quarter (March 31)
March 31: Tax Expense +12,000
Taxes/P + 12,000.
When the firm pays the taxes (let’s assume it’s on April 15) (Recognition of the expense before payment).
April 15: Taxes/P - 12,000
Cash - 12,000.
14 Note that cash flows can (and frequently do) occur at different times from the expense or revenue recognition. It can either come before or after the revenue or expense recognition.
Some Income Statement Facts
15 The gross margin is revenues less cost of goods sold.
16 Operating expenses are day-to-day expenses associated with the business (not financial) end of the firm.
17 The income statement is a period statement starting anew at zero each year.
18 Income can be negative (a loss). Losses can be due to normal operations or unusual events.
19 Cash and income associated with the same activity can occur in different fiscal years.
20 Some firms do more business in some parts of the year than in other parts of the year so that revenues, expenses and income rise and fall seasonally.
21 Several different income measures can be used as estimates of performance. Some include operating income, income before tax and income after tax.
22 Dividends and income do not have to be related in a given period.
23 Some expenses are sometimes called provisions. These are actually estimates of expenses, such as the provision for taxes and the provision for bad debts.
24 Interest expense is not an operating expense for most firms, but interest expense is an operating expense for firms such as banks.
25 Financial ratios that are associated with earnings and dividends include the earnings per share ratio (EPS), the dividend yield ratio (dividend/price per share), dividend payout ratio (dividend/earnings per share) and the price-earnings ratio (PE).
Chapter 3: Recording Transactions
The recording process has several steps. Some occur immediately. Some take place at the end of the period.
Events are recorded immediately in a journal – called journalizing. The journal events are then listed in the ledger, a listing of accounts – called posting.
At the end of the period a trial balance is created. It is a report of the balances in each account and the sum of those balances. Any necessary adjustments are then made (for example, events occurring, but not reported during the period). This leads to the adjusted trial balance.
The income statement account is created when the revenue and expense accounts are now closed. The income number then is added to the retained earnings account and the remaining accounts are rearranged to create the balance sheet.
Each account is merely a cumulative record of business events that have the same set of fundamental characteristics. All events are recorded in two basic ways; hence, accounting is called a double entry system.
Accounts are summarized into three categories, assets, liabilities and owners’ equity.
The relationship Assets = Liabilities + Owners' Equity ALWAYS holds.
A = L + OE
If you buy a good for resale you add an asset to your inventory of goods to be sold and you, simultaneously, accept a liability (obligation) to pay for it. If you add a $5,000 asset to your inventory you must commit to pay $5,000 for it. This can be recorded in a journal as
Inventory $5,000
Accounts payable $5,000
The top (left side) line is called a debit in this case. The indented (right side) line is called a credit.
T-accounts can be set up for each asset, liability, or shareholders’ equity account. Placing the events in the appropriate T-accounts reflects posting the journal entries into a ledger.
Assets Liabilities Shareholders’ Equity
|Beg. Bal. | | | |Beg. Bal. | | |Beg. Bal. |
|+ |( | = |( |+ | + |( |+ |
| | | | | | | | |
| | | | | | | | |
|End. Bal. | | | |End. Bal. | | |End. Bal. |
Left-hand side entries are debits.
Right-hand side entries are credits.
Assets Liabilities Shareholders’ Equity
|+debit |(credit | |(debit |+credit | |(debit |+credit |
Revenues Expenses Net Income
|(debit |+credit | |+debit |(credit | |(debit |+credit |
Inventory Accounts Payable
|Beg. Bal. | | | |Beg. Bal. |
|+5,000 |( | |( |+5,000 |
| | | | | |
|h | | | |End. Bal. |
Adjusting Entries occur at the end of an accounting period. They are used to recognize events that have occurred during the period but have not been recorded.
For example, if you borrow money, you do not have to pay every day, but the amount you owe increases each day despite the non-payment. If there has been no payment, then there has been no event to force recording. At the end of the period, you recognize the increased obligation even though no payment has occurred.
Another example is depreciation expense. (This is designed to represent a rough estimate of the aging or use of an asset such as a building or machinery.) While no specific event creates a depreciation entry machinery will wear down to some degree and be partially used up during the period.
The Adjusted Trial Balance contains the revised balances in each account. Debits are on the left side and credits are on the right side.
Closing the accounts removes the accounts that have been opened only for the period and which will be replaced by new accounts for next period. These are the revenue and expense accounts. The difference between the revenues and expenses (and gains and losses) is income (creating the income statement) and is transferred to the retained earnings account.
The balance sheet is the summary of the remaining accounts, summarized as assets, liabilities and owners’ equity (as adjusted by contra accounts); NOT as debits and credits.
Some Transactions Related Facts
1 Debits = credits and assets = liabilities + owners’ equity but debits do NOT equal assets and credits do NOT equal liabilities plus owners’ equity.
2 Errors can be made even if debits equal credits in a given journal entry.
3 Many journal entries will have multiple debits and/or multiple credits.
4 T-accounts representing ledgers of balance sheet accounts may have non-zero beginning balances (if the firm is not a start-up firm).
5 T-accounts representing ledgers for income statement accounts have zero beginning balances.
6 All t-accounts can be represented algebraically as beginning balance + inflows – outflows = ending balance.
7 The cash t-account can also be called a direct method cash flow statement.
Chapter 4: Using Financial Statements
Making adjustments to the trial balance
Gets to adjusted trial balance
Many transactions are explicit – specific transfers
Many events are implicit
1 Events based on time
Interest, rent, leases, insurance & depreciation
2 Adjusting entries
May be time based
Restate information due to change in accounting or estimate
3 Expenses previously unrecorded
Wages earned but not recorded
Taxes due but not yet recorded
4 Revenues previously unrecorded
Cash received before it is earned as revenue
Finally earned this period
Accrual of Unrecorded expenses
Wages
Wage expense
Accrued wage payable
Accrual of interest
Interest expense (No cash paid)
Accrued interest payable
Principal * interest rate * fraction of year = expense
(straight-line approximation used)
Provision for taxes
Estimated expense
Income before tax * effective tax rate
Tax expense
Accrued tax payable
Accrual of unrecorded revenues
Accrual of Interest
Accrued interest receivable
Interest revenue
Recognition of services previously paid and now rendered
(such as rental income)
Unearned revenue
Revenue
Correction of miscellaneous errors
Debits do not equal credits
Wrong accounts used
Creating the income statement and the balance sheet
1 Revision of the adjusted trial balance
Leads to income statement
Leads to balance sheet
2 Statements presented to outsiders
can take many forms
can have many similar, but different labels
3 Most companies use classified balance sheets
1 Separate assets into current assets and long-term assets
Current assets expected to be used within next year or longer operating cycle
Long-term assets expected to be useful for longer period
Report may combined debits & credits in some accounts such as
property, plant and equipment less accumulated depreciation
2 Liabilities separated the same way
3 Owners’ equity distinct from liabilities
4 Related financial ratios
Designed to review short-term ability to cover debts – solvency
Working capital = current assets – current liabilities
Current ratio
Good ratios a function of industry
Higher usually better
Higher may represent waste of assets
Ratio generally falling in recent decade
4 The income statement presented to outsiders
1 Single step format
All revenues
All expenses
Income after tax
2 Multiple step format
Sales less cost of goods sold to get gross profit
Additional operating expenses
Result is operating income or operating profit
Other revenues and expenses before tax
Income before tax
Tax expense
Income after tax
3 Public companies use a version of multiple step format
Tax expense is separated out
Other revenues might be included with sales
4 Related financial ratios
These focus on profitability
Gross profit margin = gross profit/sales
Return on sales = net income/sales
5 Ratio mixing income statement and balance sheet
Return on owners’ equity = Net income/avg. owners’ equity
When a ratio mixes an income statement number and a balance sheet number, the ratio is more accurate if an average is used for the balance sheet number.
Some Financial Statement Facts
5 Companies use Generally Accepted Accounting Procedures (GAAP) when creating reports for public distribution.
6 GAAP is an amalgam of regulations. The basic rules come from the Financial Accounting Standards Board (FASB). The rules incorporation opinions of the American Institute of Certified Accountants (AICPA) and interpretations on emerging issues.
7 The company has the ability to make several accounting choices while staying within the set of rules and regulations.
8 Accounting rules and regulations are reviewed continuously so that rules may changes and new ones may be added over time.
Chapter 5: Accounting for Sales
Accounts Receivable
This is the amount owed by customers for sales made on credit. If the amount is owed within one year, it is a current asset. If the amount is owed more than one year after the books are closed, it may be reported as a non-current asset.
The journal entry that gives rise to an account receivable is:
Accounts Receivable (Gross) Debit
Sales Credit.
Cash Collected from Customers
We can solve for cash collected from customers if we know the other information in the accounts receivables (gross) account. Specifically, we need to know the beginning and ending balances of the gross accounts receivables account, the total sales of the firm for the period, and the net write-offs taken for the period. The beginning and ending balances come from the balance sheet (or perhaps the footnote on accounts receivables). The sales are in the income statement. We can ascertain the write-offs through two possible ways: (1) it may be disclosed in the footnotes of the financial statements or (2) if we solve for it through the contra account.
Long-term Projects
Some contracts take more than one year to complete. Examples include building and airplane construction projects. In this case, the percentage of completion method is likely to be used. Revenues are reported based on the estimated completion of the project. The estimate is typically based on the total of costs already incurred as a percent of the estimated total project costs. This approach generates a constant profit margin.
Adjustments to Sales
1 Some merchandise is returned. This will reduce sales. Since a sale generates a debit to accounts receivable and a credit to sales, a return generates a debit to sales returns and a credit to accounts receivable (reducing the accounts receivable accounts). While a debit to sales could be substituted for the debit to sales returns the company would have less information.
2 Trade discounts and cash discounts are adjustments similar to the adjustment for sales returns. Each is a reduction to sales for a specific reason. Trade discounts are for special customers and cash discounts (or prompt payment discounts) are due to the low cost associated with collecting any cash connected with the sale.
3 2/10,n/30 is an example of a prompt payment discount. Purchasers can get a 2% discount if they pay within 10 days, but have to pay the full amount within 30 days.
4 A credit card sale using VISA, Master Card or Discover is essentially a cash sale at a discount. Cash received is the reduced amount. Sales recorded is the gross amount of the sale. Discounts for credit card sales is debited for the difference.
Dealing with Uncollectible Accounts
Some receivables are not going to be collected by the firm. Firms know this, but in the real world, it is often difficult to do business without extending credit to one’s customers. Therefore, firms need to adjust their assets (accounts receivables) and their income statement (revenues or expenses) to reflect the fact that not all receivables will be turned into cash.
The GAAP accounting way of doing this is by estimating the amount of the uncollectibles during the period in which the sales are made. This is called the allowance method, since the firm is estimating an allowing for uncollectible accounts. This method is a three-part process.
Step 1: Recognize the gross revenues over the period. The journal entry is:
Accounts Receivable (Gross) Debit
Sales Credit.
Step 2: Estimate the expected uncollectibles at the end of the period.
The amount to be recognized is recorded as an expense (a debit to bad debt expense) and a reduction to the accounts receivables (a credit to net accounts receivables).
Because we like to keep track of the uncollectibles, open up a contra account called Allowance for Uncollectible Accounts. It is contra to the gross accounts receivables account, and therefore acts as a reduction to that account. The journal entry is:
Bad Debt Expense Debit
Allowance for Uncollectible Accounts Credit.
This entry is called an adjusting entry because we make it only once -- when the books are closed. Remember, it is just an estimate of future write-offs.
Step 3: Next period, write off the actual accounts as it becomes apparent to us who will not pay. This is merely a “bookkeeping” entry, in that it identifies the estimated account from Step 2. The journal entry is:
Allowance for Uncollectible Accounts Debit
Accounts Receivables (Gross) Credit.
Step 4: Sometimes, a specific account that has previously been written off subsequently turns out to be collectible. To account for this, just reverse step 3. The journal entry is:
Accounts Receivables (Gross) Debit
Allowance for Uncollectible Accounts Credit
Note: Sometimes steps 3 and 4 are combined in the 10-K filing and is called “net write-offs.”
One important thing to remember is that Net Accounts Receivables (the amount that appears on the balance sheet) is equal to Accounts/Receivables (Gross) minus Allowance for Uncollectibles.
Using T-accounts:
Accounts/R (Gross) Allowance for Uncollectible Accounts (XA)
| |Beg. Bal. |. | | |Beg. Bal. |
| |+ |- | |- |+ |
| |(1) Sales |(3) Write-off | |(3) Write-off |(2) Bad Debt Expense |
| | |Cash Collected from | | | |
| | |Customer | | | |
| |(4) Reinstatement | | | |(4) Reinstatement |
| | | | | | |
| |End. Bal |. | | |End. Bal. |
Methods for Dealing with Uncollectibles
9 Specific Write-Off Method – Ignore the uncollectibles account and write off specific accounts as they fail. This ignores recognition of the expected results associated with sales when they are originally recorded.
10 Percentage of Sales method – Estimate bad debt expense (a credit to the allowance for uncollectibles) as x% of sales and record the bad debt expense during the period that the sales occur.
11 Percentage of Accounts Receivable Method – Determine the amount that should be reported as the credit balance in the allowance for uncollectibles account as x% of accounts receivable. Bad debt expense is the difference between this amount the amount currently in the account.
12 Aging of Accounts Receivable Method – This is the same as the percent of accounts receivable method except that different percents are applied to accounts based on how long the accounts have been outstanding. As the period gets longer the likelihood of non-payment increases.
Some Sales and Receivables Facts
13 Some companies expect more uncollectible accounts when the economy is weak.
14 Some companies extend credit to relatively poor credit risks expecting more uncollectible accounts.
15 Companies with aggressive collection policies are likely to have high accounts receivable turnover ratios. This ratio is sales divided by average accounts receivable.
16 National credit cards allow companies to convert new receivables to cash immediately while the credit card issuers accept the credit risks. In turn, the companies accept discounts on the receivables (factoring) and may have less contact with their customers.
17 Cash and sales are closely connected. However, the connection occurs over a long period, not over short periods as any given sale does not necessarily lead immediately to cash or to the same magnitude of cash. Also, this statement excludes cash that may come from outside funding.
Chapter 6: Inventories and Cost of Goods Sold
Inventory is the dollar amount of goods the firm has available for sale. Merchandising and manufacturing firms tend to have large amounts of inventories.
The first and most important accounting item related to inventories is:
Inventories
| |Beginning Balance |. | | | |
| |+ | | | | |
| |Purchases |COGS | | | |
| |or | | | | |
| |Manufactured Goods | | | | |
| | | | | | |
| |Ending Balance |. | | | |
That is: beginning inventories + purchases COGS = ending inventories. Since beginning inventories are given from last period and purchases are just the dollar amount of inventories purchased, this equation implies that COGS and the ending balance of inventories are co-determined.
Three Major Items to be Learned
1. Inventory Valuation
2. Cost Flow Assumptions (How do we count?)
3. Periodic vs. Perpetual Inventory Systems (When do we count?)
Inventory Valuation
For merchandise inventory, the purchase price is the price paid + or - certain adjustments. The positive adjustments include transportation costs, warehousing costs, and costs of handling. The negative adjustments include purchase discounts and returns to supplier.
For manufacturing inventory, there are three inventory accounts.
Raw materials is the raw materials used for production. For example, for General Motors, raw materials will be steel, tires, electrical units, etc.
Work in Process (Progress) is the value of the product during production. It consists of raw materials used, direct labor, and manufacturing overhead. For General Motors, it is the unfinished cars still in the factory.
Finished Goods is the value of the goods of the completed goods. For General Motors, it is the finished cars not yet shipped to the dealers
Cost Flow Assumptions (When do we count?)
There are four cost flow assumptions: Specific Identification Method, FIFO, LIFO, and Weighted-Average Cost. The firm must choose its cost flows assumptions ahead of time. It can use different assumptions for different types of inventories – however, the same assumption must be used for the same type of inventories.
1. Specific Identification
This method generally is not GAAP. It can only be used when the items sold are very different from each other or are made to order products; for example, paintings, houses, jewelry. Under this method, the cost of the good sold is matched to the specific item sold.
2. FIFO
FIFO is short for first-in first-out. As the name implies, FIFO assumes that items are
sold in the order that they are purchased. For example, assume on March 1, the firm buys 100 items at $50 apiece and on March 10, the firm buys 200 items at $60 apiece. If the firm sells 140 items on March 12 (assume no other purchases or inventories), the cost of goods sold is (100 times $50) + (40 times $60) = $7,400. Note that there are now 60 items remaining in inventory. Using the FIFO assumption, these 60 items are the latest purchases, which means that ending inventory is (160 times $60) = $9,600.
3. LIFO
LIFO is the flip side of FIFO. LIFO stands for last-in first-out. As its name implies, LIFO assumes that items are sold in the reverse order that they are purchased. Using the example from above, the 140 items sold on March 12 will consist of 140 items purchased most recently, i.e., on March 10. Thus, COGS is (140 times $60) = $8,400. The ending inventory is what is left, which are the older items. Thus, ending inventory is (100 times $50) + (60 times $60) = $8,600.
4. Weighted-average Cost
Under the weighted-average cost, a weighted-average cost per unit is calculated and then that cost per unit is used to calculate both the COGS and the ending inventory. The weighted-average cost per unit is total acquisition cost divided by total number of units. In the above example, the weighted average cost is ($5000 + $12,000)/300 items = $56.67 per unit. Thus, COGS is ($56.67 times 140) = $7,934. The ending inventory is ($56.67 times 160) = $9,067.
A “fifth” method is the lower of cost or market (LCM). This is really not different in that cost is one of the four methods described above. Under LCM, inventories are shown on the balance sheet at the lower of the cost method used or the market value. Market value is defined as replacement cost. So, if the inventory items lose their value due to perhaps a flood, fire, or just a change in taste, the amount shown under inventories in the balance must be written down to show this loss. For example, suppose the firm is on FIFO. Using the above example, its ending inventory is $9,600. Now, suppose the replacement cost is deemed to be $9,400. The journal entry would be:
Loss on write down of inventory 200
Inventory 200.
Note that ending inventory is now $9,600 minus $200 = $9,400.
Periodic vs. Perpetual Inventory Systems (When do we count?)
There are two ways to count inventories and COGS. The perpetual inventory method keeps a running total of COGS on a day-to-day basis. The periodic method counts inventory once a period (hence the name).
Under the perpetual method, the firm keeps a running tab of COGS throughout the period. Thus, at the end of the period, we know:
Beginning Inventory + Purchases – COGS. This gives us a theoretical ending inventory, which can be checked by the firm by taking a physical inventory count. The difference between the theoretical ending inventory and actual ending inventory is called shrinkage and is taken as an expense by the firm.
The following example applies the perpetual LIFO inventory method:
Date Purchase Sale Remaining Inventory
December 10 100 @ 50
December 15 100 @ 60
December 20 130 units 70 @ 50
December 31 100 @ 70 70 @ 50 & 100 @ 70
Under the periodic method, the firm closes down its operations once a period (at the end) and takes a physical count of the inventory. Thus, at the end of the period, we know:
Beginning Inventory + Purchases – Ending Inventory. This gives us COGS for the period. This means that under the periodic method, COGS is a derived number. COGS actually includes shrinkage from any source as the periodic count cannot distinguish among the reasons for the loss of inventory.
The following example applies the periodic LIFO inventory method:
Date Purchase Sale Remaining Inventory
December 10 100 @ 50
December 15 100 @ 60
December 20 130 units Not calculated
December 31 100 @ 70 100 @ 50 & 70 @ 60
Changing from LIFO to FIFO
To do comparisons across firms, analysts will change all inventory numbers to reflect as if the firm used FIFO for all its inventories.
Definition: LIFO Reserve
LIFO Reserve is the difference in inventories between LIFO (as is) and FIFO (as if).
1. To change LIFO inventory to FIFO inventory: take the actual inventory and add the LIFO Reserve.
2. To change COGS from as is to as if, take the actual COGS and subtract the difference between ending and beginning LIFO reserves.
3. To change pretax earnings from as is to as if, take the actual pretax earnings and add the difference between ending and beginning LIFO reserves.
4. To change net income from as is to as if, take the actual net income and add (1-tax rate) times the difference between ending and beginning LIFO reserves.
Note: The LIFO reserve can increase or decrease from year to year.
Some Inventory Facts
18 Inventory turnover is measured as cost of goods sold divided by average inventory
19 Some companies combine a high inventory turnover rate with a low profit per item to generate income. Others use a low turnover rate and high profit per item to generate income.
20 LIFO inventory accounting usually leads to higher turnover rates than FIFO inventory accounting.
21 Service companies and internet companies have different business models from manufacturing companies. These models have impacts on the whether the company has inventory and the amount of held inventory.
22 In an inflationary environment LIFO accounting gives a more ‘up-to-date’ expense (and income) statement while FIFO gives a more ‘up-to-date’ balance sheet.
23 Companies in the computer industry use FIFO accounting.
24 Tax accounting for inventory must be approximately the same as the inventory accounting procedure used by management for financial reporting.
25 Many companies, including international companies, use LIFO for some inventory and FIFO for other inventory
26 Replacement cost is the cost at which an inventory item can be acquired today. This may be different from the original cost of the inventory. The difference is either a holding gain or a holding loss.
27 Companies that use LIFO inventory can manipulate inventory levels at year end to increase or decrease reported cost of goods sold and decrease or increase reported income.
Chapter 7: Long-Lived Assets and Depreciation
The Basics
Noncurrent assets are assets that the company expects to keep for more than one year. In almost all cases, the assets are placed on the books at their acquisition cost and then are expensed in a systematic way over some long time frame. The expensing is either called depreciation or amortization or depleted, depending upon the asset that is being expensed. Conceptually, there is no difference between depreciation and amortization. In both cases, the company needs to specify a time period over which to expense and then picks an allowable method of expensing. The company can change its method or time period any time it wishes. As we’ll see, the accounting for changing assumptions yields interesting results.
Tangible vs. Intangible Assets
Tangible noncurrent assets include land, property, buildings, plant, equipment, and leased equipment. Intangible long-lived assets include patents, franchises, copyrights, and goodwill. Tangible assets are depreciated; intangible assets are amortized. Natural resources are depleted.
Major exceptions to depreciation and amortization are land and goodwill. Land is not depreciated. Goodwill is not amortized. Instead, it must be reviewed periodically for possible decreases in value. If there has been a decrease, then it is written down in value. Goodwill comes about from purchases of other companies. It is equal to (roughly) the difference between the purchase price of the net assets and the book (accounting) value of the net assets.
Capitalization vs. Expensing
In accounting, the firm can either capitalize or expense cash expenditures related to noncurrent assets. Capitalizing means that the expenditure is added to the value of the asset and then expensed over time. Expensing means that the expenditure is expensed immediately. Generally, the rule is as follows: if the expenditure enhances the value of the assets, then it is capitalized. Otherwise, it is expensed. Repairs generally are expensed. Additions or renovations generally are capitalized.
Acquisition Costs of Tangible Assets
All costs necessary to get a machine or building ready to be operational should be included in the original cost of the building and should be part of the depreciation basis when the asset is used. These costs can include labor costs, installation costs, materials costs, repair costs prior to use and construction related interest costs.
Depreciation Methods
There are many ways that a firm can depreciate its assets. First, we need to know three terms:
Depreciable Cost (Basis): This is the amount that will be depreciated.
Salvage or Residual Value: This is the amount that the firm expects to receive at the end of its useful life. It could be a positive or negative number.
Useful or Economic Life: This is the amount of time over which the asset will be depreciated.
Four Depreciation Methods
The book covers four depreciation methods. These are a small subset of allowable methods.
Method Depreciable Basis Rate
Straight-line Acquisition Cost - Salvage Value 1/Useful Life
DDB Net Book Value (AC - Acc. Dep.) 2/Useful Life
Sum-of-the-years’ digits Acquisition Cost – Salvage Value Life Left/( Yrs of Life
Physical Units Acquisition Cost - Salvage Value N/Total Units
Note: N is the total units used for the year. AC is acquisition cost. Acc. Dep. is accumulated depreciation
Changes in Depreciable Estimates
Firms can change their assumptions about depreciation. Most common changes are salvage value or the economic life of the asset. The firm can also change its depreciation method. The rules for making a change are as follow:
1. Changes are assumed to take place at the beginning of reporting period.
2. The new depreciable basis is the net book value of the asset as of the beginning of the period minus any applicable salvage value.
3. The new rate is taken over the remaining new life of the asset.
For example, suppose the firm uses straight-line depreciation. It originally acquired an asset for $100,000. It originally assumed a salvage value of $10,000 and an economic life of three years. Now, suppose that in the middle of the third year, the firm changes its salvage value to $15,000.
1. We assume that the change takes place at the beginning of year 3.
2. For years one and two, the firm already depreciated $60,000 of the asset. Thus, the net book value is $100,000 minus $60,000 = $40,000. The new depreciable basis is the net book value minus the new salvage value which is $40,000 minus $15,000 = $25,000.
3. The new rate is the same. It is 1/1 year remaining.
Thus, the depreciation expense for year 3 is $25,000/1 = $25,000. Note that without the change, the depreciation expense would have been $30,000.
Gains and Losses on Sale of Fixed Assets
This is one of the more complicated journal entries in accounting. It is a four part entry.
(1) Cash Debit
(2) Accumulated Depreciation Debit
(3) PP&E- Gross Credit
(4a) Loss Debit or
(4b) Gain Credit.
Item (1) is the amount of cash received from the sale. Items (2) and (3) together comprise the net book value of the PP&E sold. (3) is the original acquisition price of the PP&E; (2) is the accumulated depreciation to date. The amount of accumulated depreciation needs to be updated to the date of sale. Item (4a) or (4b) is a “plug.” It is the left over number that makes the left and right sides of the journal entry equal to each other. Note that items (1) and (3) are (or were) determined by the market. Item (2), however, depends on the depreciation method used by the firm. Therefore, the gain or loss (4) shown by the firm will also depend on how the firm depreciated the asset.
Intangible Assets
Intangible Assets refer to “certain long-lived legal and competitive advantages developed or acquired by a business enterprise” (see page 510). Four major intangible assets are patents, trademarks, franchises, and goodwill.
Like tangible assets, intangible assets must be amortized over time. The time period should be it “useful economic life.” In reality, this is difficult to compute due to obsolescence, patent infringement, legal considerations, and illiquid markets.
Some Long-Term Asset Facts
1 Companies with depreciating noncurrent assets can increase reported income by estimated a longer useful life.
2 Companies with natural resource assets use depletion rather than depreciation or amortization. Depletion is based on use of natural resources versus total natural resources available (like physical units).
3 Depreciation is shown (as an ‘add-back’) in an indirect cash flow statement, but is not reported in a direct cash flow statement. (It is reported as supplemental information in this case.)
4 Gains or losses on the sale of noncurrent assets can be viewed as corrections of the errors associated with using standardized accounting procedures and estimates for specific assets.
5 An intangible asset (such as a patent or trademark) may have a nominal value if generated internally, but if acquired externally the intangible asset will be reported at the cost of acquisition.
6 Companies can use multiple depreciation methods simultaneously.
7 Companies use the modified accelerated cost recovery system (MACRS) for tax purposes irrespective of the system they use for financial reporting. This system is approximately a double declining balance system using a short (government determined) life span and a zero salvage value. This method also assumed that the asset was acquired mid-year irrespective of its actual acquisition date.
Chapter 8: Liabilities and Interest
Liabilities: The Basics
Liabilities are probable future sacrifices of assets or services where the amounts and timing of the economic resources are known and estimable.
Current Liabilities are those obligations that are to be repaid or performed within one year. Current Liabilities generally are shown in nominal terms, not present value terms. Examples of current liabilities are accounts payable, accrued expenses payable, unearned revenues, and warrant liability. Monetary current liabilities such as loans and commercial paper may be shown at present values or, if due shortly, at face value. Some liabilities such as advances from customers can only be resolved by the provision of a service. Some liabilities such as warranty obligations and travel credit related obligations can only be estimated.
Noncurrent Liabilities are those obligations that are to be repaid or performed past one year. All monetary noncurrent liabilities are shown at present values. Examples are bonds, leases, and mortgages. Other noncurrent liabilities shown at present values are pensions and post retirement benefits. One noncurrent liability that is not shown at present value is deferred income taxes. Portions of long-term liabilities that are due within the current fiscal year are included in the current liabilities section of the balance sheet.
Contingent Liabilities are not liabilities. Contingencies differ from liabilities in that the future obligation is possible (not probable) and/or the amounts of the resources to be given out is not estimable. Contingencies are shown in footnotes to the financial statements. Examples of contingencies are pending lawsuits and being designated an environmental PRP (potentially responsible parties) by the EPA.
Commitments are contingent liabilities in which the amount to be paid is known but there has been no exchange or accounting transaction. Examples of commitments are options to buy future planes, unused credit lines and operating leases. Commitments generally are shown in a footnote to the financial statements.
Accounting for Selected Long-term Liabilities
Loans that require regular equal payments
If a company borrows money with the promise to make equal payments to repay the loan, then the borrower’s payments will total more than the amount of the loan. Each payment will include a payment of interest and an extra amount to repay part of the loan. (As the amount of unrepaid loan decreases, the amount of interest due decreases. Therefore, if payments remain the same, the portion remaining to reduce the outstanding debt increases each period.) In any given period the entry will be
Interest expense Y
Loan liability X-Y
Cash or Accrued payable X
Accounting for Bonds
Bonds are financial instruments in which the company or government borrows money and agrees to pay back the money at the end of a set time period. To borrow, the company or government agrees upon an interest rate to be paid over the life of the bond. With bonds, interest is paid twice a year. Thus, the interest is going to be compounded semi-annually.
There are several important terms to know:
8 Principal is the amount that the firm pays back at the end of the bond. Other names are maturity value and terminal value.
9 Coupon rate is the stated interest rate on the bond. It is the amount of interest that the firm agrees to pay on its bond. Another term is the nominal interest rate.
10 Interest payments are equal to the principal times the coupon rate divided by 2. It is the dollar amount of interest paid every six months.
11 Market interest rate is the true borrowing rate of the firm. It may or may not be equal to the coupon rate. Another name is the effective interest rate.
12 Term to maturity is the set time period that the bond will be outstanding
If a bond is issued at par (face value) then the borrower receives cash equal to the denomination of the bond and the bond is priced at 100. 100 means 100% of face value or par value. In this case, if the size of the issue is X, then the bond issue entry is:
Cash X
Bonds payable X
If the interest rate is r% per year, then the interest entry every six months is:
Interest expense .5rX
Cash or Interest payable .5rX
At maturity the debt is retired by
Bond payable X
Cash X
Additional bond terms
13 Covenant – A provision that protects lenders by limiting management flexibility. For example, dividend payments may be restricted or the company may be required to maintain a high current ratio.
14 Call provision – A bond provision permitting management to redeem a bond before its maturity. A penalty payment may be required.
15 Sinking fund – A provision designed to protect bondholders by requiring that management set aside assets to assure that the bond can be repaid at maturity.
16 Convertible bonds – A provision allowing bondholders to convert their bonds into other securities such as common stock.
Deferred Taxes
Tax accounting is different form financial accounting. The goal of financial accounting is a reasonable representation of the company’s financial condition. The goal of tax accounting is tax assessment and the reallocation of resources in accord with government policies. Income and taxes reported for financial purposes will generally differ from income and taxes reported for tax purposes. The difference is called deferred taxes. Taxes can be deferred permanently or temporarily.
Taxes are deferred permanently if income reported for financial purposes is not taxed. An example is income on municipal bonds. (No deferrals are recorded in this case). Differences between reported depreciation for financial reporting and tax reporting creates temporary tax deferrals. In this case, deferrals are recorded as:
Tax expense X
Accrued taxes payable Y
Deferred taxes payable X-Y
Selected Debt Ratios
Debt to Equity ratio = Total liabilities/Owners’ equity
Long-term-debt to Total capital ratio = Long-term debt/(Owners’ equity + Long-term debt)
Debt to Total assets ratio = Total liabilities/Total assets
Interest coverage ratio = (Pretax income + Interest expense)/Interest expense or Operating income/Interest expense
Some Liability and Bond Facts
17 Most liabilities are monetary liabilities. That is, they can be discharged by paying a certain amount of cash, irrespective of price levels.
18 Current monetary liabilities, such as commercial paper, which the company intends to refinance and is currently capable of refinancing can be called long-term liabilities.
19 Footnotes contain information about the firm’s annual future debt payment obligations for the next five years and thereafter.
20 Current monetary liabilities usually exceed the company’s cash and marketable securities. These companies are borrowing their operating funds.
21 Companies can ‘manipulate’ their current ratios by paying down their liabilities at an unusual rate toward the end of their fiscal year.
22 Financial risk ratios sometimes include current liabilities and/or noncurrent liabilities other than debt and lease liabilities in addition to the debt and lease liabilities
23 If (potential) debt holders feel that the firm may have trouble paying its debt obligations, then they may be able to impose operating and financial restrictions on the firm. They can do so by requiring that the firm’s activities be limited if the firm fails to report certain financial or accounting results, frequently expressed as financial ratios.
Chapter 9: Valuing and Accounting for Bonds and Leases
Compound Interest, Future Value and Present Value
Understanding present value is one of the most important topics in business school. With present value, we can figure out savings and retirement plans, price bonds and stocks, evaluate investment projects and, in general, understand the all important risk-return relationship of investing.
Present value calculations are used for monetary assets and liabilities -- assets and liabilities denominated in dollar terms. Examples are bonds, leases, pensions, and mortgages. In this class, we will concentrate on bonds and leases. However, the intuition and calculations are the same for all types of monetary assets and liabilities.
There is only one formula to remember. Every other formula is just an offshoot of the one formula:
(1) FV(n) = PV(0) (1+r)n ,
where FV(n) is the future value of an investment at time n, PV(0) is the present (today’s) value at time 0, time 0 is today, r is the interest rate, and n is n periods in the future.
For example, suppose I invest $1,000 today at an interest rate of 10%, compounded annually. Using formula (1), the $1,000 will be worth:
Year 1 $1,000 (1.10)1 = $1,100.
Year 2 $1,000 (1.10)2 = $1,210 or $1,100 (1.10)1.
Year 3 $1,000 (1.10)3 = $1,331 or $1,210 (1.10)1.
Note that I am compounding annually. This means that at the end of each year, I receive 10% interest on my entire amount, not just on the original $1,000 interest. The 10% received as interest is then treated as part of the investment. Thus, in year 1, the interest is $100 and the year-end investment (for the beginning of next year) becomes $1,100; in year 2, the interest is $110 (10% of $1,100); and in year 3, the interest is $121 (10% of $1,210).
These calculations are called future values, since it specifies the amount I expect to receive at some future date.
Present Value
Present value is just the inverse of future value. It translates future values into today’s prices. Using equation (1):
(2) PV(0) = FV(n)/ (1+r)n or = FV(n) (1/ (1+r)n)
where 1/(1+r)n is the discount factor. Using the example from before, I assumed an interest rate of 10%, compounded annually. Using formula (2), I can calculate present values as:
Investment in Year n Present Value PV(0) Discount Factor
Year 1 $1,100 $1,100 / (1.10)1 = $1,000 0.9091
Year 2 $1,210 $1,210 / (1.10)2 = $1,000 0.8264
Year 3 $1,331 $1,331 / (1.10)3 = $1,000. 0.7513
Note that in all cases, the present value is $1,000. What the above calculations mean is that $1,000 today, if compounded at 10% annually is equivalent to $1,100 in one year. Put differently, I can “price” a financial instrument that gives me $1,100 one year from now as $1,000 today. Similarly, a financial instrument that gives me $1,210 in two years from now can be priced at $1,000 today, assuming an interest rate of 10%, compounded annually.
Annuities
An annuity is a series of equal cash flows over n periods, in which each cash flow is one period apart. For example, a five year annuity of $1,000 means that 5 payments of $1,000 are made at the end of each of the next five years. The present value of an annuity can be quickly calculated due to the fact that each payment is the same (in this example, $1,000). To calculate the present value of the annuity, I need to know the annuity factor, which is just the sum of the discount factors for the period (in this example, 3 periods).
The present value is $1,000 times the (Annuity Factor, n=3, r=10%). In this case, it is = $1,000 (2.4869) = $2,487. (0.9091+0.8264+0.7513=2.4869 [difference due to rounding]) Annuity factors are printed in tables.
Compounding over smaller intervals
Thus far, I have assumed a compounding rate of once a year. However, financial instruments usually compound over smaller intervals of time, for example, semi-annually, quarterly, daily, and even continuously. To do this:
1. Convert the annual interest rate into the appropriate time interval. Assume a 12% annual interest rate. To convert this to a semi-annual rate, divide the annual rate by 2: 12%/2 = 6%. To convert the annual interest rate to a quarterly rate, divide it by 4: 12%/4 = 3%; monthly compounding is 12%/12 = 1%; daily compounding is 12%/365 = .33%. Thus, the conversion formula is annual rate/number of times compounded during the year.
2. Convert the number of periods into appropriate number. Compounding means that I am collecting interest on my total principal + interest. When we compound yearly, we collect interest once a year. When I compound semi-annually, I collect interest twice a year. When I compound quarterly, I collect interest four times a year. When I compound monthly, I collect interest twelve times a year. Thus, I need a new n, call it n*, equal to n times the number of times we compound per year.
Example: Assume an annual interest rate of 12%, compounded quarterly. What is the future value of $1,000 invested over 3 years?
FV(n) = PV(0) (1+r)n ,
With yearly compounding, n = 3 and r = .12. With quarterly compounding, n* = 3*4 = 12 and r* (the newly converted interest rate) = .12/4 =.03 = 3%.
Thus, the future value is 1,000 (1.03)12 = $1,425.80.
If the compounding period were a year, the future value is 1,000 (1.12)3 = $1,404.93.
The same types of conversions are done with present values and annuities.
Accounting for Bonds – A Broader View
When a firm issues a bond, it receives cash equal to the present value of the bond. This becomes the net bond payable that appears under the liability section of the balance sheet.
PV(bond) = I (Annuity factor, n=n*, r=r*) + Principal (PV factor, n=n*, r=r*),
where I is the interest payments, n* is the number of interest payments made, r* is the semi-annual market interest rate, and principal is the amount the firm has to pay back at the end of the bond’s life. The important thing to note is that the bond is discounted at the market interest rate, not the coupon rate.
Assume a ten year bond, with a coupon rate of 10%, and a principal payment of $100,000. Assume that interest is paid and compounded on a semi-annual basis.
In this example, the principal is $100,000; the interest payments are $5,000; n* = 20.
To get the present value, we need to know the market interest rate.
Case 1: market interest rate = 10%.
PV = $5,000 (Annuity factor n*=20, r*=5%) + $100,000 (PV factor n*=20, r*=5%) = $100,000. This bond is issued at par.
Case 2: market interest rate = 8%.
PV = $5,000 (Annuity factor n*=20, r*=4%) + $100,000 (PV factor n*=20, r*=4%) = $113,592. This bond is issued at a premium. (The coupon rate exceeds the market interest rate.)
Case 3: market interest rate = 12%.
PV = $5,000 (Annuity factor n*=20, r*=6%) + $100,000 (PV factor n*=20, r*=6%) = $88,530. This bond is issued at a discount. (The coupon rate is less than the market interest rate.)
Accounting for the Issuance of Bonds
Case 1: Cash 100,000
Bond/P 100,000. Net Bond/P = $100,000
Case 2: Cash 113,592
Bond/P 100,000
Premium 13,592. Net Bond/P = $113,592
Case 3: Cash 88,530
Discount 11,470
Bond/P 100,000 Net Bond/P = $88,530.
Accounting for the Interest Expense and Interest Payment
The key is to understand the difference between interest expense and interest payment for the bond.
Interest Expense = Present Value of Bond * market interest rate
Interest Payment = Principal of Bond * coupon interest rate.
For a par bond, interest expense = interest payment.
For a discount bond, interest expense > interest payment
For a premium bond, interest expense < interest payment.
Three other key points:
1 Interest payments do not change over the life of the typical bond
2 Interest expense always changes over the life of the bond for bonds issued at either discounts or premiums. Interest expense stays the same (as the interest payment) over the life of the bond that was issued at par.
3 For the premium and discount bond, the difference between the interest expense and interest payment gets debited to the premium or credited to the discount.
Example from above:
Case 1: Par Bond
Interest expense = 100,000 * .05 = $ 5,000
Interest payment = 100,000 * .05 = $5,000
Case 2: Premium Bond
Interest expense = 113,592 * .04 = $ 4,544
Interest payment = 100,000 * .05 = $ 5,000
Premium = 5,000 - 4,544 = $456
Note: The premium is netted out against the old premium of 13,592. Thus, the new premium is 13,592 - 456 = 13,136. Thus, the new present value or book value of the bond is $113,136. The premium continues to decline and the present value of the bond decreases until it reaches par at maturity.
Case 3: Discount Bond
Interest expense = 88,530 * .06 = $ 5,312.
Interest payment = 100,000 * .05 = $ 5,000.
Discount = 5,312 - 5000 = $ 312
Note: The discount is netted out against the old discount of $ 11,470. Thus, the new discount is 11,470 - 312 = $ 11,158. Thus the new present value or book value of the bond is $ 88,842. The discount continues to decline and the present value of the bond increases until it reaches par at maturity.
Early Extinquishment of Bonds
There are three ways a firm can retire a bond before its maturity date: open market purchase, calling the bond (hey bond!), or defeasance of a bond. We will concentrate on the first two ways.
Open Market Purchase
If a firm purchases its bond on the open market, it will pay the current price for the bond. The current price of the bond is just the present value of the bond at the firm’s current market interest rate. The journal entry is:
Net Bond/P = book value of the bond which is PV(n=n* and r=r*)
Cash = market value of the bond which is PV(n=n* and r=r**)
Loss or Gain = the difference between the first two entries.
where n* is the number of periods left on the bond, r* is the firm’s original borrowing rate and r** is the firm’s current borrowing rate.
Calling a bond
Sometimes a bond has a call provision. A call provision specifies that the firm can repurchase its bond at a set price prior to its maturity. For example, suppose the firm has a ten year bond due on April 1, 2002. Further suppose the bond has a call provision starting on April 1, 1999 at 102. This means from April 1, 1999 to April 1, 2002 the firm can repurchase the bond for $102 for every $100 of principal.
For example, suppose the current book value of the bond is $10,500. The principal is $10,000. Assume a call price of 102. If the firm calls the entire issue:
Bond/P 10,500
Cash 10,200
Gain 300
One final point: The gain or loss from the extinguishing of the bond is an extraordinary gain or loss. It appears in a separate section on the income statement.
The Basics of Leasing: The Lessee
A lease is a financing agreement linked to a specific asset. Firms that lease noncurrent assets and get related financing from other firms are called lessees. For accounting purposes, leases are classified as operating leases or capital leases. SFAS 13 (paragraph 7) covers the conditions in which a firm must classify its lease as a capital lease. All other leases are operating leases.
Basically, capital leases transfer the risks and benefits of ownership to the lessee. Operating leases are considered rentals. Cancelability of the lease is irrelevant.
If the lease at inception meets one or more of the following four criteria, it must be classified as a capital lease.
1. The lease transfers ownership of the property to the lessee by the end of the lease term.
2. The lease contains a bargain purchase option. A bargain purchase option is an option by the lessee to purchase the leased property for a price, which is “sufficiently lower than the expected fair value of the property.” (paragraph 5(d)).
3. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. Estimated economic life is the estimated remaining period which the property is expected to be economically usable by one or more users, with normal repairs and maintenance. (paragraph 5(g)).
4. The present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property. Minimum lease payments are the minimum rental payments and guaranteed residual lease payments (par. 5(e)). Fair value of the leased property is the price, which the property could be sold in an arm’s length transaction between unrelated parties (par. 5(c)).
Accounting for an Operating Lease
Balance Sheet: No entry
Income Statement: Debit Rental Expense
Credit Cash
Statement of Cash Flows: Rental payments are operating outflows
Accounting for a Capital Lease
Balance Sheet: Debit Leased Asset
Credit Capital Lease Liability
Note: Leased asset and lease liability equal the present value of the minimum lease payments. The lessee uses its “incremental borrowing rate,” defined as the rate it would have incurred to borrow over a similar term the funds necessary to purchase the leased asset (paragraph 5(l)).
Note: Leased assets and the Capital lease liability must be shown separately in the balance sheet or in the footnotes.
Income Statement: Amortization expense for the leased asset
Interest expense on the lease liability
Note: The leased asset is amortized over the life of the lease or the economic life of the asset.
Note: The cash payment to the lessor is allocated into two pieces:
Debit Interest Expense
Debit Reduction of the capital lease liability
Credit Cash
Statement of Cash Flows: The amortization expense (as an ‘add-back’ assuming the use of the indirect method) and interest expense are in the operating section. The reduction of the capital lease liability is in the financing section.
Some Bond and Lease Facts
24 Some bonds are issued without associated coupon payments. These ‘zero coupon’ bonds are issued at a discount from par, require no intermediate interest payments, but generate intermediate interest expenses and a terminal payment at par.
25 International companies may issue bonds denominated in several different currencies. They get converted into dollars for reporting purposes.
26 Some bonds are issued so that portions of the issue reach maturity in a serial fashion. Then portions of the bond issue become current liabilities even though other portions of the issue remain noncurrent liabilities.
27 Retailers frequently lease store locations. Capital lease and operating lease obligations for retailers may include a minimum payment obligation plus an additional payment obligation if retail sales at the leased location exceed a predetermined amount.
28 Leasees may sublease their space to others. However, they remain ultimately responsible for the entire lease payment.
29 Footnotes contain information about the firm’s annual future operating and capital lease payment obligations for the next five years and thereafter.
30 Lessees using capital leases will report more assets and liabilities than lessees using operating leases.
31 If the capital lease liability requires annuity payments, then capital lease liabilities (and mortgages) are amortized slowly at first, then more quickly as the lease ages. This amortization is slower than straight-line amortization. (The larger initial lease liability requires a larger allocation of any lease payment to interest than occurs in later years.)
Chapter 10: Statement of Cash Flows
The statement of cash flows is one of the main financial statements. It shows how the firm’s cash account in the balance sheet changes from its beginning balance to its ending balance.
The statement of cash flows divides cash flow into three components: cash from operations, cash from investing, and cash from financing. There are inflows (cash in) and outflows (cash out) from all three components.
Cash Inflows Cash Outflows
Operations
Collections from Customers Payments to suppliers and employees
Dividends and Interest Received Interest Paid
Other Taxes Paid
Other
Investing
Sale of PP&E Purchase of PP&E
Sale of Marketable Securities Purchase of Marketable Securities
Selling of Businesses Purchase of Business
Collection of Financial Assets Creation of Financial Assets
Financing
Borrowing Money Repaying of Amount Borrowed
Issuing Equities Repurchasing Equities
Paying Dividends
There are two ways of showing the cash flow statement: direct and indirect. The direct way shows the cash flow statement as above. The indirect statement is the same except for the operating section. For the indirect statement, cash flow from operations are shown in a “derived” way -- that is net income after tax from the income statement is converted into cash from operations.
Cash Flows from Operations
There are two ways to estimate cash flows provided by operations
1: Direct Method
To estimate cash flows from operations using the direct method, we need to convert the accrual accounting into cash based accounting.
1. Cash from customers = Sales - (Accounts/R + (Advances from Customers
2. Cash paid to suppliers = COGS + (Inventories - (Accounts/P
3. Cash paid to employees = Wage Expense + (Prepaid Wages - (Wages/P
4. Approximation: Cash paid for interest = Interest Expense + (Prepaid Interest
- (Interest/P
5. Approximation: Cash paid for taxes = Tax Expense + (Prepaid Taxes
- (Taxes/P.
2: Indirect Method
This is method connects net income to cash from operations
1. Net Income
2. Add non-operating losses or subtract non-operating gains
3. Add depreciation and amortization expense
4. Add tax expense for financial purposes, but not tax expense for tax reporting
purposes. This is indicated by the deferred tax entry in the cash flow
statement.
5. Add amortization of bond discount and subtract bond amortization
6. Subtract changes in operating assets. (Increases in operating assets use
available cash.)
7. Add changes in operating liabilities. (Increases in operating liabilities save
cash.)
Cash Flows from Investing
These are direct cash flows. They come from transactions affecting PP&E, marketable securities and financial assets. Acquisitions and divestitures affecting cash are also considered investing events. Acquisitions and divestitures for stock or other non-cash considerations are excluded from the cash statement. Instead, information supplemental to the cash statement describes these activities. Inflows and outflows are usually disaggregated from each other.
Cash Flows from Financing
These are direct cash flows. They come from cash transactions affecting non-operating liabilities such as Bonds/P, Loans/P. Common and preferred stock issues and retirements are included here. Dividend payments (not dividends declared) are also included here. With the exception of short-term borrowings, inflows and outflows are usually disaggregated from each other.
Idiosyncrasies of the Cash Flow Statement Relative to the Income Statement
Cash flows from operations differ from operating income. The cash statement number is based on real flows. Operating income is based on an accrual concept and includes many estimates.
Cash flows form operations include interest and dividend cash receipts, interest payments and tax payments. Operating income is reported before interest expense and tax expense. Interest income and dividend income is sometimes reported after operating income as other income.
Transactions Affecting Cash Flows
Transaction Change in Cash
Operating Activities
Sales of goods and services for cash +
Sales of goods and services on credit 0
Receive dividends or interest +
Collection of accounts receivable +
Recognize cost of goods sold 0
Purchase inventory for cash -
Purchase inventory on credit 0
Pay trade accounts payable -
Accrue operating expenses 0
Pay operating expenses -
Accrue taxes 0
Pay taxes -
Accrue interest 0
Pay interest -
Prepay expenses for cash -
Write off prepaid expenses 0
Charge depreciation or amortization 0
Investing Activities
Purchase fixed assets for cash -
Purchase fixed assets by issuing debt 0
Sell fixed assets +
Purchase securities that are not cash equivalents -
Sell securities that are not cash equivalents +
Make a loan -
Financing Activities
Increase long-term or short-term debt +
Reduce long-term or short-term debt -
Sell common or preferred shares +
Repurchase and retire common or preferred shares -
Purchase treasury stock -
Pay dividends -
Convert debt to common stock 0
Reclassify long-term debt to short-term debt 0
Some Cash Statement Facts
32 Most companies use the indirect cash flow method.
33 Cash from operations can fall even as income rises and vice versa.
34 Most operating assets and operating liabilities are current assets and current liabilities. However, some operating assets and liabilities are noncurrent assets and liabilities.
35 Some current assets and liabilities are not operating assets or liabilities such as marketable securities and loans payable.
36 Interest paid is an operating cash outflow, but dividends paid is a financing cash outflow.
37 Interest paid is an operating cash outflow, but is not an operating expense for non-financial firms.
38 Taxes paid is an operating cash outflow, but is a non-operating expense based on the company’s operating and non-operating activities.
39 Non-cash transactions such as the acquisition of a firm for stock do not appear on the cash flow statement.
40 ‘Operations’ as used in the cash statement includes different things from ‘operations’ as used in the income statement. Interest expense and tax expense are not included in operations in the income statement, but interest paid and taxes paid are included as part of operations in the cash flow statement. This is seen most clearly when the direct cash flow statement method is used.
Chapter 11: Stockholders’ Equity
Definitions:
1. Owners’ Equity: That which belongs to the shareholders of the firm after all liabilities are paid off.
2. Contributed Capital: Capital Stock of Company
3. Retained Earnings: Cumulative earnings less cumulative dividends declared
4. Par Value: Legal value required by some incorporation commissions.
5. Paid-in Capital in Excess of Par Value (Excess Capital, Capital Surplus, Additional Paid-in Capital): Consideration Received by Company (usually cash) minus par value
6. Common Stock: Basic equity security, usually with voting rights. There can be various classes of common stock.
7. Preferred Stock: Type of stock. Preference is to liquidation rights and dividend rights. Frequently, preferred stockholders have no voting rights.
8. Convertible Preferred Stock: Type of stock. Preferences like preferred stock, but can be converted into common stock at a given price or ratio either today or some time in the future.
9. Dividends: Distribution to shareholders. Can be in stock or in cash.
10. Dividend Declaration Date: Date firm commits to paying dividends.
11. Dividend Record Date: Shareholders on this date receive the dividend.
12. Dividend Payment Date: Date firm pays dividends to shareholders of record.
13. Treasury Stock: Outstanding stock held by the company. Treasury stock cannot be voted, cannot receive dividends, and is not used in earnings per share calculations.
14. Employee Stock Options: Gives employees the right to purchase X number of shares at a fixed exercise price, $ E, per share some time the future.
Stock Warrant: Security that enables the holder to purchase X number of shares at a fixed price some time in the future.
Company Stock
Companies are authorized to issue up to a given amount of shares. They cannot issue more shares (either for cash or through stock splits) unless authorized by current shareholders. Companies can issue to the authorized number of shares (for cash, splits or acquisitions) without a shareholders’ vote. The company may also buy shares back to be retired or to be held in the corporate treasury for future use. Therefore authorized shares exceed issued shares which, in turn, exceed outstanding shares.
Accounting Transactions for Owners’ Equity
Sale of Common Stock
Debit Cash or Organizational Costs or Other Asset
Credit Capital Stock at Par Value
Credit Paid-in Capital in Excess of Par Value
Note: Capital Stock Par Value is an artificial, stated number. It is determined by the shareholders, usually at incorporation. Paid-in Capital in Excess of Par Value is the difference between the debit and Capital Stock at Par Value.
Note: Debit is equal to stock price times number of shares issued.
Cash Dividends
On Declaration: Debit Retained Earnings
Credit Dividends Payable
On Record Date: No journal entry
On Payment Date: Debit Dividends Payable
Credit Cash
Note: Dividends are a voluntary distribution to shareholders. They are never, never, never expensed.
Stock Dividend
The firm can also give a stock dividend. If this is a small stock dividend (less than 20%), then it is valued at market. There is a journal entry at the declaration date. It is:
Debit Retained Earnings
Credit Capital Stock at Par Value
Credit Paid-in Capital in Excess of Par Value.
A large stock dividend is valued at par.
Debit Retained earnings
Credit Capital stock at Par Value
Purchase of Treasury Stock
Debit Treasury Stock
Credit Cash
Note: Treasury Stock is a contra account to shareholders’ equity
Reissuance of Treasury Stock
Debit Cash
Credit Treasury Stock
plus Debit or Credit Paid-in Capital in Excess of Par Value for the difference between the purchase and reissue.
Employee Stock Options
On issuance: no journal entry
A footnote in the annual report summarizes stock options issued to employees including the exercise price of the option and the date of possible exercise.
On exercise: Debit Cash
Credit Common Stock at Par Value
Credit Paid-in Capital in Excess of Par Value
Note: Cash is equal to exercise price times number of shares exercised.
Stock Warrants
On sale: Debit Cash
Credit Paid-in Capital in Excess of Par Value
On exercise: Debit Cash
Credit Common Stock at Par Value
Credit Paid-in Capital in Excess of Par Value
Stock Split
No journal entry. However, the firm usually splits its par value. Or, it can transfer the par value amount out of paid-in capital in excess of par value and into par value.
Comprehensive Income
This income number includes net income after tax from the income statement and adds the wealth effects associated with events that the company cannot control.. The two major events included here are the impact of changes in the value of some of the company’s financial investments (selected common stocks and bonds are typical investments) and changes in the value of the company’s assets that are denominated in foreign currencies. These assets must be converted into dollar amount for reporting purposes each year, but the company has no control over the current foreign exchange rates nor do they have any interest in actually converting the foreign investments into dollars.
Some Financial ratios related to Owners’ Equity
Rate of return on common equity = (Net income-Preferred dividends)/Average common equity
Book value of coomon sock = (Owners’ equity – Book value of preferred stock)/ Shares outstanding
Market to book ratio = Market price per share/ Book value per share
Some Owners’ Equity Facts
1 When the stock splits all company per share information is restated.
2 The number of shares outstanding throughout the year changes due to stock issues and buybacks. The year-beginning and year-end numbers of outstanding shares may vary from the average number of shares outstanding during the year. (Earning per share in any part of the year is based on the average number of shares outstanding during that part of the year.)
3 Par value or stated value has little economic meaning today and is frequently nominal. When shares are initially issued by the firm at least this par value must be paid. Long ago this was the basis for fraud where share with high par values were offered to the unwary at ‘bargain’ prices. Then the difference between the par value and the ‘bargain’ was demanded.
4 Comprehensive income is net income plus non-stock events affecting owners’ equity. Two major elements include unrealized returns to marketable securities available-for-sale and the impact of selected unrealized changes in value because of changes in the value of foreign currencies relative to the dollar.
5 There can be restrictions of the use of retained earnings. If preferred dividends are in arrears, the ocmpany cannot pay common stock dividend. Covneants associated with debt issues can require that the firm retain a minimum amount of retained earnings.
Chapter 12: Intercorporate Investments and Consolidations
Overview
There are three ways that the company can account for its investments in other companies. The ways are defined by the amount of control that the parent company has over the investee (or subsidiary).
1. Minority, Passive Investment: Market Value Method
2. Minority, Active Investment Equity Method
3. Control: Consolidation Accounting
Generally, the amount of control is determined by the percent of common shares of the investee that the parent.
1. Minority, Passive Investment: Less than 20%.
2. Minority, Active Investment 20% but less than 50%
3. Control: 50% or greater.
However, what really matters is real control or influence. So, if for example, the parent owns greater than 50% of common stock but can only vote 35%, then the parent should use the equity method instead of consolidating.
Market Value Method
Market value accounting is used for all minority, passive equity holdings and for all debt instruments holdings. Short-term minority, passive investments are called marketable securities. Long-term minority, passive investments generally are called investments. Generally speaking, marketable equity securities have to have liquid markets. Examples of marketable equity securities are common stock, preferred stock, warrants, and stock options. Marketable debt securities can either be traded (e.g., government bills and bonds, some corporate bonds), or, if not traded (e.g., mortgage-backed securities, commercial paper) have objective valuations.
Marketable securities are divided into three categories:
1. Held to maturity: These are debt instruments that the firm intends to hold until maturity.
2. Trading securities: These are debt or equity securities that the firm intends to sell in the near future.
3. Available-for-sale securities: These are debt or equity securities that the firm intends to hold for the long term (but not to maturity).
The valuation of the securities (e.g., what number appears on the balance sheet) and the treatment and placement of holding gains and losses depend on how the security is classified.
| |Balance Sheet Valuation |Where do unrealized holding gains or losses go? |
|Held to maturity |Shown as cost or amortized cost |Usually in a footnote |
|Trading securities |Market value on closing date |Income Statement |
|Available-for-sale securities |Market value on closing date |Shareholders’ Equity (appears as an adjsutment |
| | |account) |
| | |Shown net of taxes |
Changes in the adjustment account associated with available-for-sale securities are included in comprehensive income.
The Equity Method:
The equity method generally is used for equity holdings between 20 and less than 50%. The parent includes the investment in a one line account in the noncurrent asset section of its balance sheet.
The accounting for the investment is:
|Investment in Affiliate |
|Beginning Balance | |
| | |
|Plus Equity in Earnings of Affiliate |Less Dividends Received by Parent |
| | |
| |Less Goodwill Amortization Expense |
|Ending Balance | |
Beginning balance is equal to the market price paid. It is equal to two pieces: (1) the percentage of the affiliate’s shareholder equity account plus (2) market price minus (1). For example, suppose the firm buys 25% of the affiliate’s shares for $100. Suppose that the affiliate’s entire shareholder equity account is equal to $300. 25% of $300 is $75. Thus, the beginning balance of the investment in equity account is equal to $100 = $ 75 + $25. The $25 is an implicit goodwill; that is, it is amortized as goodwill but does not appear on the balance sheet as goodwill.
Equity in Earnings of Affiliate is the percentage of ownership times the total earnings of the affiliate. It increases the investment account of the parent and also appears in the parent’s income statement.
Dividends Received by Parent is the percentage of ownership times the total dividends paid by the affiliate. It decreases the investment account of the parent and also appears in the parent’s cash flow statement.
Goodwill Amortization Expense is an expense based on the implicit goodwill of the investment. It decreases the investment account of the parent and also appears in the parent’s income statement.
Consolidation Accounting: The Basics
Generally, when the parent owns 50% or more of the common voting shares of the subsidiary, it consolidates the subsidiary’s financial statements with its own. This is called purchase accounting.
Purchase accounting requires that the net assets acquired be recorded at their current market value. The combination is viewed as a group purchase of net assets. The total price paid for the firm must be allocated to the individual assets, using their estimated market values as a guide. If the price paid exceeds the total market values of the identifiable assets, the excess is viewed as a payment for intangible future benefits and is captioned goodwill on the balance sheet. Goodwill is reevaluated periodically after the consolidation. If it has declined in value, then it is written down reducing income for the period.
Mechanics of Purchase Accounting
Purchase Consolidation is a three step operation.
1. Financing Step: Issue cash or a combination of cash and securities in exchange for Net Assets of Subsidiary
For Example:
Dr. Investment in Affiliate Market Value of Net Assets
Cr. Cash Market Value of Net Assets
2. Eliminate the Investment in Affiliate account, eliminate the subsidiary’s common stock, mark up or down assets and liabilities of sub to market values, create goodwill
For Example:
Dr. Subsidiary’s Common Equity Book Value of Net Assets of sub
Dr. Land of Sub Difference between market value and book value of land
Dr. Goodwill Difference between Cash Paid and first two lines
Cr. Investment in Affiliate Market Value of Net Assets
Note: Investment in Affiliate = sub’s common equity + mark ups (or downs) + goodwill
3. Consolidate
Assets(consolidated co.) = Assets(parent) + Assets(sub)
Liabilities(consolidated co.) = Liabilities(parent) + Liabilities(sub)
SE(consolidated co.) = SE(parent)
Note: Don’t forget to include the financing part of the deal.
Some Intercorporate Investments and Consolidations Facts
1 Coca-Cola owns over 40% of several bottlers and uses equity accounting. Yet it supplies the product for the bottles and controls the advertising and other elements of the bottlers’ operations.
2 Consolidation rather than equity accounting leads to higher reported assets and liabilities.
3 In the year of acquisition, a company that purchases another it can only report the income of the investee from the time of the acquisition through the end of that fiscal year.
4 If a company crosses one of the thresholds for investment reporting it must use the new reporting procedure at that time and thereafter.
5 Acquisitions that are less than complete lead to minority interest accounts.
6 Companies sometimes provide pro forma statements that show what a company and its acquisition might have looked like in combination if the acquisition had been made previously. These statements are only general guides. They are unaudited and accompanying statements indicate that the actual results might have been different had the companies actually been able to work together.
Chapter 13: Financial Statement Analysis
Types of analysis
1 Cross-sectional analysis – the comparison of one company to other companies or an industry at one point in time
2 Time series analysis – the comparison of a company this period to its performance or an industry’s performance at other times
3 In either case, accounting describes the company’s past and present and can be used as a basis to estimate the future.
Dimensions of an analysis
1 Profitability – the ability of a company to generate a return on investment.
Some ratios include:
1 Rate of return on assets
2 Rate of return on common shareholders’ equity
3 Rate of return on sales
4 Total assets turnover
2 Risk – the obligations and uncertainties a company must face as it generates a profit.
Some ratios include:
1 Current ratio
2 Long-term debt ratio
3 Debt to equity ratio
4 Interest coverage ratio
Some Financial Statement Analysis Facts
3 The ratios can include forecasted information rather than just historical information.
4 Many ratios are unnamed.
5 Ratios eliminate corporate size from an analysis. It must be included separately.
6 Some ratios can be combined to form other ratios. In reverse this allows the user to disaggregate some ratios for additional information.
7 Some ratios are not meaningful if the company suffers a loss.
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