FINANCIAL ACCOUNTING

– 8TH EDITION, HARRISON & HORNGREN, 2011

Chapter 1 – The Financial Statements

Accounting is the language of business
• Accounting is an information system
o It measures business activities, processes data into reports, communicates
results to people
• Financial statements report information about a business entity
o They measure performance
• Bookkeeping is a mechanical part of accounting

Who uses accounting information?

• Individuals (how much money available)
• Investors and Creditors (how much income is expected of an investment)
• Taxing authorities (taxes are based on accounting data)
• Nonprofit organizations (how much money available)

Two kinds of accounting: Financial accounting and Management accounting

• Financial accounting: for external users (investors, bankers, government agencies,
public); information must meet standards of relevance and reliability
• Management accounting: internal users (managers)

Organizing a business
Proprietorship
• Single owner
• Proprietor personal liable for all business debts
• For accounting a proprietorship is distinct from its proprietor
• Business records do not include proprietors personal finances
Partnership
• 2 or more owners
• Each partner is personally liable for all partnership debts
• Limited-liability partnership: each partner is only for his or her own actions and those
under his or her control liable
• Limited-liability partnership (LLP)
o Business, not the owner, is liable for the company’s debt
o Each partner is only liable for partnership debts up to the extent of his
investment in the partnership, plus his proportionate share of the liabilities
o Each LLP must have one general partner with unlimited liability for all
partnership debts
Corporation
• Business owned by the stockholders, or shareholders
• Own stocks, which represent shares of ownership in corporation
• Formed under state law; legally distinct from its owners
o Corporation possesses many rights that a person has
• Stockholders are not liable for debts
• Corporation pays a corporate income tax
• Shareholders elect the board of directors which sets policy & appoints officers
• Board elects chairperson (CEO), holds most power in the corporation

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Accounting Principles and Concepts
• Generally accepted accounting principles (GAAP)
o In US the Financial Accounting Standards Board (FASB) formulates GAAP
o GAAP designed to meet primary objective of financial reporting
o Information must be relevant, reliable, comparable, and consistent
• But: IFRS is now constructed by the IASB to simplify cross-border operations

The conceptual framework

• It lays the foundation for resolving the big issues in accounting
• IFRS Framework for the Preparation of Presentation of financial statements
o Prescribes nature, function and boundaries within which f. accounting operates
• IFRS focus: general purpose financial statements which are at least annually
directed to the common information needs

What makes accounting information useful?

• Qualitative characteristics:
• Understandability
• Relevance
o Degree of relevance may be influenced by nature and materiality of the info
o Materiality means that the Information must be Important enough so that the
information being wrong would make a difference to the users
o Immaterial items are not required to be disclosed separately and may be
combined with other information
• Reliability
• Comparability
o Comparability does not mean uniformity, nor continuing to use the same
accounting principles when more relevant & reliable alternatives exist

What constraints do we face in providing useful information?

• Timeliness, balance between qualitative characteristics, benefits vs. costs
• Accounting information is costly to produce and the cost should not exceed the
expected benefits to users

What are our assumptions in financial reporting?

• we prepare our financial statements on an accrual basis
• we assume that the entity will continue to operate long enough to use assets
 called going concern assumption

What exactly are we accounting for?

• Assets
• Liabilities
• Equity
o Share capital + retained earnings
• income
o Separated into revenue and gains
• Expenses
o Losses are usually not from usual business operations
• When to recognize:
a) When it is possible that any future economic benefit associated with the
item will flow to or from the entity
b) When the item has a cost or value that can be measured with reliability

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The Accounting Equation
The basic accounting equation shows the relationship among assets, liabilities and equity
Assets = liabilities + owners' equity
• Assets: economic resources that are expected to produce a benefit in the future
• Liabilities: outsider claims = debts that are payable to outsiders called creditors
• Stockholders' equity/capital: insider claims: equity = ownership, stockholders equity
is the stockholders interest in the assets of the corporation

A second accounting equation relates to the calculation of profits earned by an entity during a
financial period. Profit is simply Income less Expenses
Total Revenue and Gains – Total Expenses and Losses = Net Income (or loss)

The Financial Statements

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The Income statement shows a company’s financial performance
Revenues – expenses = net income/net loss
• Revenues and gains (e.g. net sales)
• Expenses and losses
 Cost of goods sold (COGS)
 Depreciation
 Non-recurring income and expenses
 Finance expenses (finance costs)
 Income tax expenses
 Net income is the single most important item in the financial statements

The Statement of Changes in Equity shows a company’s transactions with its owners
Beg. Equity + Total Income – Dividends +/- Capital Transactions with owners = End. Equity
• The Equity is the owner’s residual interest in the entity after deducting liabilities.
Profits that a company generates ultimately belong to the owners of the company.
• Retained earnings is the portion of net income the company kept
o Net income increases retained earnings
o Net losses & dividends decrease retained earnings
• Dividends are distributions to stockholders of assets generated by income.
o They are not expenses and never affect income, but deducted from net income.
o There is no obligation to pay dividends, instead the board decides whether to
pay dividends or not
o Most companies in the stages of growth do not pay dividends, but reinvest.

The Balance Sheet shows a company’s financial position

Assets = liabilities + owners' equity
The Balance sheet (statement of financial position) reports three groups of items: assets,
liabilities and shareholders equity. It shows the financial position at a specific point of time

• Assets are economic resources that are expected to produce a benefit in the future.
Current assets are assets expected to be turned into cash, sold or consumed within the
next 12 months or within the business’ operating cycle. Typically current assets are
presented in some order of liquidity
o Current assets
 Cash
 Accounts receivable
 Notes receivable
 Merchandise inventory
 Prepaid expenses
o Non-current assets
 Property, plant, equipment (PPE)
• Accumulated depreciation
 Intangibles (patents, trademarks)
 Plant assets or fixed assets

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 • Liabilities are outsider claims, thus debts that are payable to outsiders called creditors.
Current liabilities are obligations or debts payable within 12 months or within the
business’ operating cycle.
o Current Liabilities
 Accounts payable
 Notes payable (short-term borrowings)
 Tax payable
 Salaries/wages payable
o Non-current liabilities
 Long-term debt (payable beyond 1 year)

• Stockholders' equity are insider claims, thus stockholders equity is the stockholders
interest in the assets of the corporation
o Stockholders equity has 2 main subparts:
• Paid-in capital is the amount the stockholders have invested in
a corporation
• Retained earnings is the amount earned by income-producing
activities and kept for use in the business. It is affected by
revenues and expenses
 Proprietorship and partnerships don’t identify paid-in capital and
retained earnings;
• single heading: capital

The statement of Cash flows shows a company’s cash receipts and payments
Companies engage in three basic types of activities
1. operating activities
o Companies operate by selling goods/services to customers
 Results in net income or net loss, thus increasing or deceasing cash
2. investing activities
o Companies invest in non-current assets such as PPE. Both purchases and sales
of non-current assets are investing cash flows
3. financing activities
o Companies need money for financing.
 Financing comes from both equity owners and borrowings
 Includes issuance of shares, repurchases of shares and proceeds &
repayments of borrowings

Ethics in accounting: Standards of professional conduct

• Relevant information: able to affect decisions
• Reliable: verifiable and free of error and bias
• A company’s real performance may differ from what gets reported to the public
• Need to have an annual audit by independent accountants
• Protect public by ensuring that data is relevant and reliable
• Business Ethics Leadership Alliance (BELA) aims at reestablishing ethics as the
foundation of everyday business practices. Its members agree to embrace und uphold
four core values
1. Legal compliance
2. Transparency
3. Conflict Identification
4. Accountability

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Chapter 2 – Transaction Analysis
Transactions
Transaction is any event that has a financial impact on the business and can be measured
reliably
• It provides objective information about the financial impact on a company
• Two sides: you give something and you receive something

The Account
An account is the record of all the changes in a particular asset, liability, or shareholder’
equity during a period
Assets
• Cash
• Accounts Receivable
• Notes Receivable
• Inventory
• Prepaid expenses (asset because it provides an future benefit for business)
• Land
• Buildings
• Equipment, Furniture, Fixtures (Most companies report these non-current assets under
the heading Property, Plant and Equipment PPE)
Liabilities
• Accounts payable
• Notes Payable,
• Accrued Liabilities (liability for an expense you have not yet paid; interest payable,
salary payable, income tax payable)
Stockholders equity (SE)
• Share Capital (owners investment in the corporation)
• Retained Earnings (cumulative net income - cumulative net losses and dividends)
• Dividends
• Revenues
• Expenses

Transactions and Financial Statements (page 65)

• Income statement data appear as revenues and expenses under retained earnings
• Balance sheet data are composed of ending balances of the assets, liabilities, and
stockholders equity
• Statement of changes in equity reconciles movements in equity for the period.
• Statement of cash flows are aligned under cash account

Double-Entry Accounting
Dual effects of the entity: each transaction affects at least two accounts

The T-Account
• Left side of each account is called the debit side, right side is called the credit side
• Every transaction involves both a debit and a credit

Cash
Debit Credit
(Left Side) (Right Side)

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Increases and Decreases in the Accounts: the Rules of debit and credit
• Increases in assets are recorded on the left (debit) side, decreases of assets are
recorded on the right (credit) side
• Conversely, increases in liabilities and stockholders equity are recorded by credits and
decreases are recorded by debits
• Amount remaining in an account is called its balance

Summary of debit and credit

Assets:
• A debit increases an asset account
• A credit decreases an asset account

Liabilities and shareholders’ equity:

• A credit increases liability, as well as SE
• A debit decreases liability as well as SE

Additional Stockholders equity accounts: revenues and expenses

• Revenues are increases in shareholders’ equity that result from delivering goods or
services to customers
• Expenses are decreases in shareholders’ equity due to the cost of operating business

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Recording transactions
Chronological record of transactions is called: journal
1. Specify each account affected and classify each account by type (asset, liability,
stockholders equity, revenue, expense)
2. determine whether account is increased or decreased: rules of debit and credit
3. record transaction in journal, brief explanation
Copying information (posting) from the journal to the ledger (page 80)
• Journal does not indicate how much cash or accounts receivable the business has
• Ledger is a grouping of all the T-Accounts, with their balances
• Data must be copied to the ledger called posting
• The phrase keeping the books refers to keeping the accounts in the ledger

The Trial Balance

The Trial balance
• Lists all accounts with their balances- assets first, then liabilities and SE
• Summarizes all the account balances for the financial statements and shows whether
total debits equal total credits
Analyzing accounts
You can figure at missing entries in T-Accounts by calculating e.g.:
Cash
Beginnig balance 33,000
Cash receipts 8,000 Cash payments X = 6,000
Ending balance 35,000

Correcting Accounting errors

In case of errors you can compute the difference between total debits and total credits
1. Search the records for a missing account
2. Divide the out-of-balance amount by 2
3. Divide the out-of-balance amount by 9 (slide or transposition)
Chart of accounts
Used to list all accounts and account number. Ledger contains accounts grouped as follows:
1. Balance sheet accounts: assets, liabilities, shareholders equity
2. Income statement accounts: revenues and expenses
The normal balance of an account
• Normal balance falls on the side of the account where increases are recorded
o Normal balance of assets is on debit side, so assets are debit-balance accounts
o Normal balance of liabilities and SE is on credit side, so these are
credit-balance accounts

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Chapter 3 – Accrual Accounting and Income

Accrual accounting versus cash-basis accounting

• Accrual accounting records the impact of a business transaction as it occurs
o When business performs service, makes sales, incurs an expense, transaction
will be recorded even if it receives or pays no cash
• Cash-basis accounting records only cash transactions
o Cash receipts (treated as revenues)
o Cash payments (handled as expenses)
• IAS1 requires accrual accounting
• Basic limitation of cash basis accounting is that the cash basis ignores the underlying
economic activities (i.e. earning revenue and incurring expenses necessary to earn the
revenue)   makes the financial statements purely a record of cash inflows and
outflows

Balance-Sheet Impact of cash-basis accounting

· No account receivable will be recorded
· Account receivable is an asset; if it is not there, assets are understated on balance sheet

Income statement Impact of cash-basis accounting

· Sale on account provides revenue that increases company’s wealth
· Ignoring sale understates revenue and net income

Accrual Accounting and cash flows

Accrual accounting records cash transactions and non-cash transactions
• Cash: Cash from customers, cash from interest earned, paying salaries, rent other
expenses, borrowing money, paying off loans, issuing stocks
• Non-cash: Sales on account, purchases of inventory on account, accrual of expenses
incurred but not yet paid, depreciation, usage of prepaid rent, insurance, supplies,
earning of revenue when cash was collected in advance

The time-period concept

The Time-period concept ensures that accounting information is reported at regular
intervals
• Basic accounting period is one year
• Calendar year from January 1 to December 31
• Fiscal year ends on date other than December 31

The revenue recognition principle

The  revenue  recognition  principle  states  that,  under  accrual  accounting,  revenue  should  
be  recognized  when  it’s  earned,  so  it  requires  that…  
a. The  entity  has  transferred  to  the  buyer  the  significant  risks  and  rewards  of  
ownership  of  the  goods  
b. The  entity  retains  neither  continuing  managerial  involvement  to  the  degree  
usually  associated  with  ownership  nor  effective  control  over  the  goods  sold  
c. The  amount  of  revenue  can  be  measured  reliably  
d. It  is  probable  that  the  economic  benefits  associated  with  the  transaction  will  
flow  to  the  entity  
e. The  costs  incurred  or  the  be  incurred  in  respect  of  the  transaction  can  be  
measured  reliably  

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Matching Principle  
This the basis for recording and recognizing expenses. Matching principle includes two steps:
1. Identify all expenses incurred during accounting period
2. Measure the expenses, match expenses against revenues earned
 Subtract expenses from revenues: net income or net loss

Updating the Accounts: the adjusting process

Process of reporting the financial statements begins with the trial balance

Which accounts need to be updated (adjusted)?

Unadjusted means not completely up to date
• Cash, equipment, accounts payable, common stock, and dividends are up-to-date:
because day-to-day transactions provide all data for these accounts
• Accounts receivable, supplies, prepaid insurance… are not yet up-to-date because
certain transactions have not yet been recorded
• Supplies as asset and Supplies expense during an entire month are recorded on the end

Categories of adjusted entries

Adjustments fall into three basic categories
• Deferrals
o Deferral is an adjustment for an item that the business paid or received cash in
advance
o During the period some supplies are used up and become expenses. At the end
of the period an adjustment is needed to decrease the supplies account for the
supplies used up and record the supplies expense
o Prepaid rent, prepaid insurance, and all other prepaid expenses require deferral
adjustments
o Also liabilities require deferral adjustments:
 If company receives cash up front it has an obligation to deliver the
product  called unearned sales revenue.
 When the company delivers the product it decreases the liability and
increases the revenue for the revenue earned
• Depreciation
o Depreciation allocates cost of a plant asset to expense over useful life of asset
 Accounting adjustment: record depreciation expense and decrease
asset’s book value
o Long-term deferral process is identical to deferral-type adjustment, only
difference is the type of asset involved
• Accruals
o Accrual is the Opposite of a deferral
 For an Accrued expense, expenses are recorded before paying cash
 For an Accrued revenue, record revenue before collecting cash
o Other Accruals: Salary expense, interest expense, income tax expense
o Accrued revenue is revenue that business has earned and will collect next year

Prepaid Expenses
Prepaid expense, an expense paid in advance (assets, because provide future benefit)
• Prepaid Rent
o One asset increases (prepaid rent) and another decreases (cash)  asset swop
o After one month, prepaid rent (asset) is credited & rent expense is debited (SE)
 Asset and stockholders equity both decrease

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 • Supplies
o Supplies are another type of prepaid expense
o Cost of using supplies are expenses

Depreciation of PPE
PPE are long-lived tangible assets (land, buildings, furniture, equipment)
• Assets decline in usefulness and the decline is an expense. When the asset is used a
portion of the assets costs is transferred to depreciation expense
• Accounting matches expense against revenue: matching principle
• Accumulated depreciation account
o Is credited to preserve the original cost of the asset
o Shows the sum of all depreciation expense from using the asset (balance
increases over lifetime of asset)
o Is a contra account: asset account with a normal credit balance
 Contra account:
1. has always companion account
2. normal balance is opposite of that of the companion account
• Book Value (carrying value)
o Is the net amount of plant asset (cost minus accumulated depreciation)

Accrued Expenses and accrued Revenues

• Accrued expense refers to a liability that arises from an expense that’s not yet been paid
o Example: interest expense on a note payable
 an accrued expense increases liabilities and decreases shareholders equity
• Accrued revenue is revenue that has been earned but not yet collected
o Accounted for all accrued revenues: debit a receivable and credit a revenue

Unearned revenues
Collect cash from customers before earning revenue creates a liability = Unearned revenue
o Revenue is earned if job is completed
o One company’s prepaid expense is the other company’s unearned revenue

Summary of adjusting process

Two Purposes of the adjusting process are to:
• Measure income and
• Update the balance sheet
Therefore every adjusting affects at least one of the following:
• Revenue or expense  to measure income
• Asset or liability  to update the balance sheet

Preparing Financial Statements

• The income statement lists the revenue and expense accounts
• The statement of changes in equity shows the changes in various equity components
• The balance sheet reports asssets, liabilities and SE
Why is income statement prepared first and balance sheet last?
1. The income statement reports net income or net loss, the result of revenues minus
expenses. Revenues and expenses affect SE, so net income is transferred to
retained earnings, which is a part of SE.
2. The statement of changes in equity reflects the increase in retained earnings from the
IS and records payments of dividends. An additional capital contribution would be
also reflected in this statement. The ending balance of equity is carried to the BS
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Which accounts need to be closed?
• Closing the books means prepare the accounts for next periods transactions
• Closing entries set the revenue, expense, and dividends balances back to zero at
end of
the period
 Remember the Income statement reports only one period’s income
• Temporary Accounts
o Revenues, expenses and dividends because they relate to a limited period
o Closing process applies only to temporary accounts
• Permanent accounts
o Assets, liabilities and SE are not closed, because they carry over to next period
o The ending balances become beginning balances of next period

How to close the books

Closing balances transfer revenue, expense, and dividends to retained earnings
1. Debit each revenue account for amount of its credit balance. Credit retained earnings
for sum of revenues. Now the sum of revenue is in retained earnings
2. Credit each expense account for amount of its debit balance. Debit retained earnings
for sum of expenses
3. Credit the dividends account for amount of debit balance, debit retained earnings;
dividends are no expenses, they never affect income

Retained Earnings
Beg Bal
Exp Revenues
Div
End Bal

Classifying assets and liabilities based on their liquidity

Liquidity means how quickly an item can be converted to cash
• Cash is most liquid asset
• Accounts receivable relatively liquid
• Inventory less liquid than accounts receivable because company must sell the goods
• PPE is even less liquid because these assets are held for use and not for sale
 Balance sheet lists assets and liabilities in order of relative liquidity

• Current assets
o Current assets are the most liquid assets
o IAS1 requires that an entity classify an asset as current when:
 It expects to realize the asset, intends to sell or consumes it within its
normal operating cycle (business cycle)
 It holds the asset primarily for the purpose of trading
 It expects to realize the asset within 12 months after reporting period
 The asset is cash or a cash equivalent unless the asset is restricted from
being exchanged or used to settle a liability for at least 12 months after
the reporting period
 All other assets are considered non-current assets

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 • Current liabilities
o Current liabilities are obligations that must be paid within the next 12 months
o IAS1 requires that an entity classify an asset as current when:
 It expects to settle the liability within its normal operating cycle
 It holds the liability primarily for the purpose of trading
 The liability is due to be settled within 12 months after reporting period
 The entity does not have an unconditional right do defer settlement of
the liability for at least 12 months after the reporting period
 All other assets are considered non-current assets.
 Some notes payable are paid in installments with first installment due
within one year, second within second year etc.
• First installment: current liability
• Reminder of note payable: non-current liability

Reporting Assets and liabilities:

A Classified balance sheet separates current assets from long-term assets and current
liabilities from long-term liabilities

Formats for the financial statements

Balance Sheet formats

Small companies use the Report formats
• lists asset at the top, followed by liabilities and shareholders equity
Most companies use the Account format
• lists assets on the left and liabilities and shareholders equity on the right

Income Statement formats

IAS1 requires an entity to present an analysis of expenses recognized in the income statement
using a classification based on either their nature of their function within the entity. The
choice depends on historical and industry factors and the nature of the entity.
• Nature of expenses format: an entity aggregates its expenses according to their nature
o Easy to prepare
• function of expenses format: classify expenses as part of cost of sales, marketing costs,
distribution costs, or other functional groupings
o more reliable and relevant

Using Accounting Ratios

Current ratio

Total current assets

current ratio =
Total current liabilities
• Measures ability to pay current liabilities with current assets
• Increasing current ratio from period to period indicates improvement in financial
€ position
• Strong current ratio is 1.50 (€1,50 current assets for every €1 current liabilities)
• current ratio of 1.00 is considered quite low
• Most companies operate between 1.20 and 1.50

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 Debt ratio

Total liabilities
debt ratio =
Total assets

• Indicates proportion of a company’s asset that is financed with debt

• Measures business ability to pay both current and long-term debts (total liabilities)
€ • Low debt ratio is safer than high debt ratio (0.5 is considered low)
• Most bankruptcies result from high debt ratios
• When company fails to pay its debts, creditors can take the company away from its
owners

How do transactions affect the ratios?

Lending agreements exists, in which companies have to take care that the current ratio does
not fall below a certain level and that the debt ratio may not rise above a threshold
• The issuance of shares improves the current ratio and the debt ratio
• A cash purchase of a building decreases the current ratio. Debt ratio is unaffected
• A sale on account improves the current ratio and the debt ratio
 see further examples on page 173

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Chapter 4 – Internal Control and Cash
Fraud and its Impact

• Fraud is an intentional misrepresentation of facts, made for the purpose of persuading

another party to act in a way that causes injury or damage to that party
o Fraud is a huge global problem (e.g. 75% of businesses surveyed had
experiences fraud)
o Fraud has “exploded” with the expansion of e-commerce via the internet
o Most common types of fraud are: insurance fraud, forgery
(Urkundenfälschung), credit card fraud, identity theft
o Two most common types of fraud that impact financial statements are:
 Misappropriation of Assets: Committed by employees of an entity who
steal money from company and cover it up through erroneous entries in
the books (most common)
 Fraudulent Financial Reporting: Committed by company managers
who make false and misleading entries in the books, making statements
look better than they are (most expensive)
• The fraud triangle includes the elements that make up every event. All three elements
of the triangle must be present and take over your decision-making process for fraud
to occur:

o Pressure (or Motive): Critical need or greet for something of the committer
o Opportunity to commit a fraud often arises through weak internal control
o Rationalization: Perpetrator engages in distorted thinking, such as: “I deserve
this; no one will ever know”
 Fraud is defined by state, federal, and international law as illegal
 Fraud is the ultimate unethical act in business

Internal Control

· Internal control is a plan of organization and a system of procedures implemented by

company management and the board of directors to accomplish the following five objectives:
1. Safeguard assets (company must safeguard its assets against waste, inefficiency,
and fraud)
2. Encourage employees to follow company policy
3. Promote operational efficiency
4. Ensure accurate, reliable accounting records
5. Comply with legal requirements
 Public companies are required to maintain a system of internal controls

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The Sarbanes-Oxley Act (SOX)
• In 2002 the US Congress passed the Sarbanes-Oxley Act with these provisions:
1. Issue an internal control report, which is evaluated by outside auditor
2. Public company accounting oversight board oversees auditors of companies
3. An accounting firm may not both audit a public client and also provide certain
consulting services
4. Stiff penalties await violators (up to 25 years in prison for people with black beards)

The Components of Internal Control

• Can be broken down in 5 components:
 Control environment: owner and top managers must behave honorably to set a
good example for company employees; demonstrate controls importance;
corporate code of ethics modeled by top management
 Risk assessment: company must identify its risks; establish procedures for dealing
with those risks to minimize impacts on the company
 Information system: need of accurate information to keep track of assets and
measure profits and losses
 Control procedures: procedures to ensure that business goals are achieved
(assigning responsibilities, separating duties, using security devices to protect
assets from theft)
 Monitoring of Controls: hire auditors to monitor their controls; internal audits
monitor company controls to safeguard its assets; external auditors monitor the
controls to ensure that accounting records are accurate

Internal Control Procedures

Every major class of transactions needs to have the following internal control procedures:

Smart Hiring Practices and Separation of Duties

• Each person in the information chain is important. The chain should start with hiring
including background checks of the applicants
• Employees should be competent, reliable, and ethical
• Proper training and supervision plus paying competitive salaries
• Clear position descriptions and responsibilities
• Chief accounting officer is called the controller
• Person in charge of writing checks is called the treasurer
• Three key duties are separated:
 Asset handling
 Record keeping
 Transaction approval
• The accounting department should be separated from the operating departments
• Separate the custody of assets from accounting (treasurer of a company should handle
cash, controller should account for the cash; neither should have both jobs)
• If companies are too small for a proper separation it should get the owner involved

Comparison and Compliance Monitoring

• No person or department should be able to completely process a transaction from
beginning to end without being cross-checked by another person or department
• Effective tools to for monitoring compliance with management’s policies is the use of
operating budgets and cash budgets
 Budget is a quantitative financial plan that helps control day-to-day management
 It is prepared for a certain period and further checked with the current numbers

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  Variances need to be explained by managers  exception reporting
• To validate accounting records and monitor compliance with company policies, most
companies have an audit
 Audit is an examination of the company’s financial statements and its accounting
system, including its controls
 Internal auditors who are employees of the company
 External auditors who are completely independent and are hired to determine the
company’s financial statements agreement with accounting standards

Adequate Records
• Accounting Records provide the details of business transactions and are generally
supported by hardcopy documents or electronic records

Limited Access
• Company policy should limit access to assets only to persons or departments that have
custodial responsibilities (Cash=lock-box system in treasure’s department)

Proper Approval
• No transaction should be processed without management’s general or specific approval
• The bigger, the more specific should be the approval ; examples:
 Sales to customers on account should all be approved by a separate credit
department
 Personnel decision should be handled by a separate human resources department
• Easy way to remember basic control procedures SCALP:
 Smart hiring practices and segregation of duties
 Comparisons and compliance monitoring
 Adequate records
 Limited access to both assets and records
 Proper approvals for each class of transaction

Information Technology
• Accounting systems are almost entirely relying on IT for record keeping, asset handling,
approval, and monitoring, as well as physically safeguarding the assets
• Basic attributes of internal control (SCALP) do not change, but procedures by which these
attributes are implemented change
 e.g. segregation of duties = segregation of computer departments + restricting
access
Safeguard Control
• Fireproof Vaults for important documents, security cameras to safeguard property
• Employees who handle cash are in a tempting position; companies use fidelity bonds on
cashier as an insurance
 fidelity bonds insure companies against any losses due to employee theft
• Mandatory vacations and job rotations improve internal control  improves morale

Internal Controls for E-Commerce

• E-commerce pitfalls include:

 Stolen Credit-card numbers
 Computer viruses and Trojan horses
o Computer virus is a malicious program
o Trojan Horse hides inside a legitimate program and works like a virus
  17  
  Phishing expeditions
o Thieves phish by creating bogus websites that sound familiar to the
original websites to trick visitors; thiefs obtain account numbers/passwords

Limitations of Internal Control – Costs and Benefits

• Most internal controls can be overcome by collusion – two or more people work together
• Other ways are: management override, human limitations such as fatigue and negligence,
and gradual deterioration due to neglect

The Bank Account as a Control Device

• Cash is most liquid asset because it’s the medium of exchange

 Specific controls for cash, because its most easily stolen
• Keeping cash in a bank account helps control cash because banks have established
practices for safeguarding customers money
• Documents used to control a bank account:
 Signature Card
o Each person authorized to sigh on an account provides a signature card
o Protects against forgery
 Deposit Ticket
o Banks supply standard forms such as deposit tickets
o Customer fills in amount of each deposit, and keeps deposit receipt
 Cheque
o Depositor can write a cheque to pay cash
o There are three parties to a cheque; the maker (signs), the payee (to whom
it is paid), and the bank (on which the cheque is drawn)
o A cheque has two parts:
• cheque itself and
• remittance advice (optional attachment, tells the payee reason for
payment used for documentation
 Bank statement
o Monthly statements to customers
o Bank statement reports what the bank did with customers cash
o Accounts beginning, ending balances, cash receipts and payments
o Electronic funds transfer (EFT) moves cash by elect. communication

Bank reconciliation
• There are two records of a business’s cash:
1. Cash account in company’s general ledger
2. Bank statement, which shows the cash receipts and payments transacted through
the bank
• Books and bank statement usually show different cash balances; differences because of
time lag in recording transactions
 e.g. a Cheque is immediately deducted in your checkbook; but check is paid a few
days later
• For accuracy - Updating of cash records creates a bank reconciliation, which you must
prepare
 It explains all differences between you cash records and you bank balance
 Person who prepares bank reconciliation should have no other cash duties

  18  
Preparing Bank Reconciliation (see page 250)
• Items that appear on a bank reconciliation are the following. They all cause differences
between the bank balance and the book balance:
• Bank side of the reconciliation
1. Items shown on bank side of bank reconciliation
a. Deposits in transit (outstanding deposits): you have recorded them but
bank not; add them on bank reconciliation
b. Outstanding cheques: you have recorded but bank has not yet paid them;
subtract outstanding checks
c. Bank errors: correct all bank errors

• Book side of the reconciliation

2. Items shown on book side of bank reconciliation
a. Bank collections: cash receipts that bank has recorded for your account, but
you haven’t recorded the cash receipt yet; customers often pay directly to
bank = lock-box system which reduces theft
b. Electronic funds transfer: bank receives or pays cash on your behalf; add
EFT receipts and subtract EFT payments
c. Service charge: banks fee for processing you transactions
d. Interest revenue on you checking account: earn interest if you keep enough
cash in account
e. Nonsufficient funds (NSF) cheques: earlier cash receipts that have turned
out to be worthless; treated as cash payments on bank reconciliation
f. Cost of printed cheques: cash payment is handled like a service charge
g. Book error: correct all book errors on book side of reconciliation

Journalizing Transactions from the Bank Reconciliation

• Bank reconciliation does not account for transactions in the journal and is a total separate
tool from journals and ledgers
• To get transactions into accounts, must make journal entries and post to the ledger
• All items on book side of bank reconciliation require journal entries

Online Banking
• With online banking you can reconcile transactions at any time and keep you account
current whenever you wish
• Account history lists deposits, checks, EFT payments, ATM withdrawals, and interest
earned on your bank balance; it does not show the beginning balance

Using the Bank Reconciliation to Control Cash

• Bank reconciliations can be used as a control device, especially in small companies

Internal control over cash receipts

Cash requires some specific internal controls because it is relatively easy to steal

Cash receipts over the counter

• Point of sale terminal (cash register) provides control over cash receipts
 A receipt is issued to ensure that each sale is recorded
 At end of day manager proves the cash by comparing the cash in the drawer
against the machines record of sales

  19  
Cash receipts by Mail

• Many companies receive cash per mail

• Controller compares bank deposit amount from the treasurer with debit to cash from
accounting department  cash should equal the amount deposited in the bank
• Lock-box system: customers sent checks directly to bank account; internal control is tight

Internal Control over Cash Payments

Companies make most payments by check

Controls over payment by check

• Controls over purchase and payment
1. Purchase order (to other company)
2. Merchandise inventory (send order + fax invoice back)
3. Receiving inventory; preparing receiving report
4. Sending cheque
• For internal control, purchasing agent should not receive inventory or approve payment
• Split purchasing goods: receiving / approving / paying for goods
• Before signing check, controller and treasurer examine packet to prove that all the
documents agree (Purchase order, invoice, receiving report)
 Then the company knows that it received the goods ordered and pays only for
goods received
• Companies keep a petty cash fund on hand to pay minor amounts (executive’s taxi fare)
 Petty cash is opened with particular amount of cash: check for this amount is then
issued to petty cash
 For each petty cash payment, custodian prepares a petty cash ticket to list the item
 Maintaining the petty cash account at its opening balance, supported by the fund
(cash plus ticket), is how an imprest system works

Using a budget to manage cash

• Budget is a financial plan that helps coordinate business activities; cash is budgeted most
often
• Cash budget helps a company or an individual manage cash by planning receipts and
payments during a future period
• Determine how much cash will be needed and then decide whether or not operations will
bring the needed cash; managers proceed as follows:
1. cash balance at the beginning of the period
2. add budgeted cash receipts and subtract the budgeted cash payments
3. beginning balance plus receipts minus payments equals expected cash
balance at end of period
4. compare cash available before new financing to budgeted cash balance at
end of period

  20  
Reporting Cash on the Balance Sheet
• Most companies usually combine all cash amounts into a single account called:
 Cash equivalents include liquid assets (time deposits and certificates of deposit;
interest bearing accounts that can be withdrawn with no penalty)

Compensating Balance Agreements

• Non of cash balance is restricted in any way
 any restricted amount of cash should not be reported as cash on the balance sheet
• Cash pledged as collateral is reported separately because that cash is not available for
day-to-day business
• Cash pledged as security (collateral) for a loan is less liquid
• Banks often lend money under a compensating balance agreement
 The borrower agrees to maintain an minimum balance in a checking account with
the bank at all time
 The minimum balance becomes long-term assets and is not cash in normal sense

  21  
Chapter 5 - Short-term Investments & Receivables

Short-term Investments

Trading Securities
Trading securities is common term for short-term investments and marketable securities
• official term Fair Value through Profit or Loss
• Purpose: hold it for short time and then sell it for more than its costs
• Time hold by company: one year or less  current assets
• Next-most-liquid after cash

Unrealized Gains and Losses

· Market value is amount the owner can sell securities for (could increase or decrease)
· Gain when market value is greater than cost of security (has same effect as revenue)
· Unrealized gain/loss (if security has not yet been sold)

· Trading securities are reported on the balance sheet at their current market value

Unrealized Loss on Investments 5 000

Investment in Corp 5 000
Adjusted investment to market value

· A loss has the same effect as an expense

Reporting on the Balance Sheet and the Income Statement

The Balance Sheet

· Short-term investments are current assets
· Appear directly after cash because short-term investments are almost as liquid as cash
 Report trading securities at their current market value

Income Statement
· Investments in debt and equity securities earn interest revenue and dividend income
· Creates gains and losses
 Reported on income statement as Other revenue, gains, and (losses)

  22  
Realized Gains and Losses
· Gains or Losses are realized when the investor sells the investment
· Gain or loss is different from the unrealized gain or loss
· Realized gain = sales price greater than investment carrying amount
· Realized loss = sales price less than investment carrying amount

Cash 98 000
Loss on Sale of Investment 4 000
Investment in Corp 102 000
Sold investment at a loss

· Report gain or loss on sale of investments among the other items of the income statement
· Gain (or loss) is understood to be a realized gain (or loss) arising from a sale transaction
· Unrealized gains and losses are clearly labeled as unrealized

Accounts and Notes Receivable

Receivables are the third most liquid assets

Types of Receivables
· Receivables (also called debtors) are monetary claims against others
 Selling goods and services  accounts receivables
 Lending money  notes receivable
· Classified as current assets
· Accounts receivable account in the general ledger serves as a control account that
summarizes the total amount receivable from all customers
· Companies keep a subsidiary record of accounts receivable with a separate account for each
customer
· Notes receivable (also called promissory notes) are more formal contracts
 Borrower signs written promise to pay lender at maturity date
 may require the borrower to pledge security for the loan (collateral)
· Other receivables is a miscellaneous category for all receivables other than accounts
receivable and notes receivable (e.g. loans to employees and related companies)

Internal Controls over Cash Collections on Account

· Internal control over collections on account is important
 Separation of cash-handling and cash-accounting duties
· Bookkeepers should not be allowed to handle cash
· Keep accounts away from the supervisor
· Use bank lockbox

How do we manage the risk of not collecting?

· By selling on credit
 Benefit: customers who cannot pay cash immediately can buy on credit  sales &
profit increase
 Cost: company cannot collect from all customers (uncollectible-account expense,
doubtful-account expense, bad-debt expense)

  23  
Accounting for Uncollectible Receivables

· Allowance for doubtful receivables is an amount that is not expected to be collected

· Net amount of receivables is an amount expected to be collect
 net realizable value because it’s the amount of cash the company expects to realize in
cash receipts
· Uncollectible-account expense is an operating expense along with salaries etc

Allowance Method
· The best way to provide for bad debts is by the allowance method
 IAS: loans and receivables are impaired if, and only if, there is objective and evidence
of impairment as a result of one or more "loss events" that occurred after their initial
recognition. Loss events are
o Significant financial difficulty of a specific debtor (possible bankruptcy)
o A breach of a specific debtor such as default to make interest payments
o Adverse changes in the number of delayed payments by debtor in general
o Economic conditions that correlate with defaults by debtor in general
 The allowance method records collection losses based on estimates developed from
company’s collections experience and information about debtors
 Companies don't wait until people don't pay. Therefore they…
 Record estimated amount as uncollectible-account expense
 Set up allowance for uncollectible receivables (allowance for doubtful receivables,
allowance for receivables impairment)
o Contra account to accounts receivable
o Allowance shows amount of receivables the business expects not to collect

· Aging-of-receivables is popular method for estimating uncollectibles

 It is a balance-sheet approach because it focuses on accounts receivable
 Individual receivables from specific customers are analyzed based on how long they
have been outstanding
o Simplified versions of aging methods would simply list the status or age of the
receivables for the receivables, classified into age groups ("Not yet due", "1-30
days overdue", etc.)
o The goal is to estimate the chance of accounts not being collectible (not yet
due=1%, 1-30=5%)

Uncollectible-Account Expense 151

Allowance for doubtful receivables 151
Recorded bad debt expense for the year

Writing off Uncollectible Accounts

Allowance for Doubtful receivables 12

Accounts Receivable 12
Wrote off uncollectible receivables

· Writing off uncollectible accounts has no effect on total assets, current assets, net accounts
receivable and net income
· Net income is unaffected because the write-off of uncollectible accounts affects no expense
account

  24  
Adjusting Ending Allowance for Doubtful Receivables

Beginning   - Receivables   + Bad  Debt   = Ending  

Allowance   Write-­‐offs   Expense   Allowance  

Uncollectible for Doubtful receivables 22

Allowance for doubtful receivables 22
Recorded bad debt expenses for the year

Recovery of Previously Written-Off Receivables

· After accounts have been written-off some can be partially recovered
· Can be treated in one of two ways
1. Reverse the write-off entry
2. Decrease bad debt expense, by the amount recovered
 Both will eventually result In same bad debt expense at the end of the period when new
allowance is calculated

Direct Write-Off Method

· Direct writ-off method, company waits until specific customers receivable proves
uncollectible  less preferable

Uncollectible Account Expense 12

Accounts Receivable 12
Wrote off bad debts by direct write-off method

· Considered defective because it doesn't take into account the possibility of impairment
(minderung) of the receivables at balance sheet date
• As result receivables are always reported at full amount (more than business expects
to receive)  Assets are overstated

Computing Cash Collections from Customers

· Company earns revenue and then collects cash from customers
· Mostly there is a time lag between earning the revenue and collecting the cash

Notes Receivable

· Some notes receivable are collected in installments. The portion due within one year is a
current asset and remainder is a long term asset
• Creditor (to whom money is owed) also called lender
• Debtor (borrower of money) maker of the note or borrower
• Interest (cost of borrowing money) stated as annual percentage rate
• Maturity date (date on which debtor must pay note)
• Maturity value (sum of principal plus interest on note)
• Principal (amount of money borrowed to debtor)
• Term (length of time from when note was signed by debtor to when he must pay note)
• Both Creditor and Debtor have a note payable

  25  
Accounting for Notes Receivable

 Example for a company collecting a note receivable:

Cash 1 045
Note Receivable 1 000
Interest Receivable 30
Interest Revenue (1000 x 0,09 x 2/12) 15
Collected note at maturity

· If the company collects the note receivable it will only state the interest revenue in its
financial statements because the note and interest receivable zero out, when the note is
collected. Three aspects of interest computation are important:
1. Interest rates are always for an annual period, unless stated otherwise
2. Time element always stated per year (use fractions, e.g. 4/12)
3. Interest is often completed for a number of days if you have a period of 90 days, take
90/365
· If a company received a note receivable from a customer whose account receivable is past
due: debit note receivable and credit account receivable

How to Speed up Cash Flow

Credit Card or Bankcard Sales

· If merchants allow paying with credit card or bankcard, then, e.g. 2%, go to
VISA for use of their system
· Credit-card discount expense is an operating expense similar to interest expense

Selling (factoring) Receivables

· If sales are made on account  debit accounts receivable and credit Sales Revenue  A
Company can sell these accounts receivables to another business, called a factor
· Factors earn revenue by paying a discounted price for the receivable and then hopefully
collecting the full amount from the customer
 Benefit for 1st company: fast cash receipt
 Benfit for 2nd company: Make surplus if amount can be collected
· Financing expense is an operating expense
· Discounting a note receivable is similar to selling an account receivable

Cash 95 000
Financing Expense 5 000
Accounting Receivable 100 000
Sold accounts receivable

Reporting on the Statement of Cash Flows

· Receivables and short-term investments are on balance sheet as assets
· Receivable and investment transactions affect cash, must be reported on statement of cash
flows
· Receivables bring in cash: transactions reported as operating activities on statement of cash
flows because results from sales
· Investment transactions show up as investing activities on statement of cash flows

  26  
 Using two Key Ratios to Make Decisions
Measure liquidity

Acid-Test (or Quick) Ratio

· Balance sheet lists asset in order of relative liquidity
1. Cash and cash equivalents
2. Short-term investments
3. Accounts (notes) receivable
 The acid-test ratio is a more stringent measure than the current ratio to measure the ability
to pay current liabilities with current assets

cash + shortterm investments + net current receivables

acid − test ratio =
Total current liabilites

· The acid-test ratio is considered "Safe" when > 1

· Acceptance of this depends on the industry
€
Days’ Sales in Receivables
· After a credit sale, the next step is collecting receivables. The Days’ sales in receivables,
also called the collection period, tells a company how long it takes to collect its average
level of receivables
 The longer the period, the less cash is available to pay bills and expand

Sales
1. Receivable Turnover =
Average Receivables *

365
2. Days sales in inventory =
Receivables Turnover
€
Beg. net receivables + End. net receivables
* Average net receivables =
€ 2

  27  
Chapter 6 - Inventory & Cost of Goods Sold
Accounting for Inventory

· IAS- Inventory: assets that are

a) Held for sale In the ordinary course of business
b) In the process of production for such sale
c) In the form of materials or suppliers to be consumed in the production process or in
the rendering of services
 Inventory cost shifts from asset to expense when seller delivers goods to the buyer

Sale Price vs. Cost of Inventory

Note the difference between sale price of inventory and the cost of inventory
• Sales revenue is based on the sale price of inventory sold
• Cost of goods sold is based on the cost of the inventory sold
• Inventory on balance sheet is based on the cost of inventory still on hand
· Gross profit (gross margin) is the excess of sales revenue over cost of goods sold. It is called
gross profit because operating expenses have not yet been subtracted

Inventory = Number of units of x Cost per unit

(Balance sheet) inventory on hand of inventory

Cost of goods sold = Number of units of x Cost per unit

(Income Statement) inventory sold of inventory

Number of Units of Inventory

· Number of Inventory units on hand determined from accounting records, backed up by a
physical count of the goods at year end
 Doesn't include any goods in own inventory held on consignment because those goods
belong to another company
 Does include own inventory that is out on consignment and held by another company
· Shipping term, FOB (free on board or freight on board) indicates who owns the good at
particular time and, therefore, who must pay for it
 FOB shipping point purchaser legally owns good when inventory leaves seller's place
of business
o Purchaser owns goods while they are in transit & must pay transportation costs
o Purchaser must include goods in transit from suppliers as units in inventors as
of the year end
 FOB destination title to the goods does not pass from seller to purchaser until goods
arrive at purchaser's receiving dock
o Goods are not counted in year-end Inventory of purchasing company
o Goods included in inventory of the seller until goods reach destination

  28  
Cost per Unit of Inventory
· Challenge because companies purchase goods at different prices throughout the year

Accounting for Inventory in the Perpetual System

· Two types of inventory accounting systems:
 Periodic inventory system: used for inexpensive goods
o Doesn't keep running record of all goods bought, sold and on hand
o Count inventory periodically to determine the quantities on hand
 Perpetual inventory system: uses computer software to keep a running record of
inventory on hand
o Control over goods; used by most business
o still inventory is counted on hand annually to check for correct amount

How the Perpetual System Work

· Clerk scans the bar code on the labels of the item bought
· Computer records the sale and updates the inventory records

Recording Transactions in the Perpetual System

· When company makes a sale, 2 entries are needed in perpetual system
 The company records the sale (debits cash or accounts receivable and credits sales
revenue for the sale price of the goods)
 Debits cost of goods sold and credits inventory for the cost of the sold inventory
 Cost of inventory is the net amount of the purchases
· Freight-In is the transportation cost paid by buyer and is accounted for as part of the cost of
inventory
· Purchase return is decrease in cost of inventory because the buyer returned goods to the
seller (vendor)
· Purchase allowance (decreases costs of inventory) buyer gets allowance (deduction) from
amount owed
· Debit memorandum: accounts payable are reduced (debited) for the amount of the return
· Purchase discount a decrease in buyer's cost of inventory earned by paying quickly
 Example for payment terms: 2/10 n/30: 2% paid within 10 days, rest within 30 days
 Common credit term is net 30 which tells customer to pay full amount within 30 days

Net purchases = Purchase price of inventory

- Purchase return and allowances
- Purchase discounts
+ Freight-in

Net sales = Sales revenue

- Sales return and allowances
- Sales discounts

 Freight-out paid by seller is not part of the cost of inventory but is a delivery expense

  29  
Inventory Costing

What goes into Inventory Cost?

· IAS- Inventories:
 cost of inventories shall compromise all costs of purchase, conversion and other costs
incurred in bringing the inventories to their present location and condition
 cost of purchase of inventories thus compromise the purchase price, import duties and
other taxes, and other costs (transport, handling) directly attributable to the acquisition
of finished goods, materials and services
 Advertising, sales commission, and delivery costs are expenses and not included as cost of
inventory

The Various Inventory Costing Methods

· IAS-Inventory:
 Cost of inventory items that are not ordinarily interchangeable shall be assigned by
using specific identification
 Costs of other inventories that are ordinarily interchangeable are determined using
common cost formulas:
o First-in, first-out (FIFO) method
o Last-in, last-out (LIFO) method
o Average cost method
 The retail inventory method is used by retailers for measuring inventories of large
numbers of rapidly changing items with similar margins
 The IAS prohibits the use of LIFO cost formula (although allowed in the US)

Specific Identification
· For businesses that deal in unique inventory items
 Businesses cost their inventories at the specific cost of the particular unit
· Method too expensive to use for inventory items that have common characters
· Other methods (FIFO etc.) assume different flows of inventory costs
· Big accounting questions:
1. What is the cost of goods sold for the income statement?
2. What is the cost of the ending inventory for the balance sheet?

FIFO Cost
· First costs into inventory are first costs assigned to cost of goods sold
· Under FIFO, the cost of ending inventory is always based on the latest cost incurred

LIFO Cost
· Las costs into inventory go immediately to cost of goods sold
· Under LIFO, the cost of ending inventory is always based on oldest cost:
 from beginning inventory plus the early purchases of the period

Average Cost
· The Average-cost method is based on the average cost of inventory during the period
Average cost per unit = Cost of goods available*/Number of units available

*Goods available = Beginning Inventory + Purchases

  30  
The Effects of FIFO, LIFO and Average Cost on Cost of Goods Sold, Gross Profit, and
Ending Inventory
· When inventory costs change, the various Inventory methods produce different cost-of-
goods sold figures
· When inventory costs are increasing:

Costs of Goods Sold Ending Inventory

FIFO FIFO COGS is lowest because it's
based on the oldest costs, which are
low. Gross profit is the highest.
LIFO LIFO COGS is highest because it's
based on the most recent costs, which
are high. Gross profit Is the lowest.
FIFO ending inventory is highest
because it's based on the most recent
costs, which are high.
LIFO ending inventory is lowest
because it's based on the oldest costs,
which are low.

 Opposite when inventory costs are decreasing

 IAS requires entities to use the same cost formula unless the nature of the inventories is
dissimilar

Comparison of the Inventory Methods

1. Measuring cost of goods sold
a. LIFO results in most realistic net income figure because it assigns the most
recent inventory cost to expense
b. FIFO matches old inventory cost against revenue  poor measure of expense
c. FIFO income is less realistic than LIFO income
2. Measuring ending inventory
a. Most up-to-date inventory cost on balance sheet: FIFO
b. LIFO can value inventory at very old cost because LIFO leaves oldest prices in
ending inventory

Accounting Principles Related to Inventory

Comparability Principle
· Comparability principle states that businesses should use the same accounting methods and
procedures from period to period
 Consistency enables investors to compare a financial statement from period to next
 Switch from LIFO to FIFO increases income dramatically
 Company making an accounting change must disclose the effect of the change on net
income

Net Realizable Value

· IAS requires inventories to be measured at lower cost and net realizable value (NRV)
 Once costs are determined inventory must be compared to its NRV
NRV = estimated selling price - estimated costs of completion - estimated costs of sale

Cost of Goods Sold 600

Inventory 600
Wrote Inventory down to realizable value

  31  
Inventory and the Financial Statements

Analyzing Financial Statements

Ratios are used to evaluate a business:

Gross Profit Percentage

Gross profit = Sales - Costs of Goods Sold
· Key indicator of a company's ability to sell inventory at a profit
· Merchandisers strife to increase gross profits/margin percentage
 A mark-up stated as a percentage of sales
Gross profit percentage = Gross profit/Net sales revenue
 e.g. 49%: Each dollar of sales generates about 49 cents of gross profit
 Changes little from year to year, so a small downturn may signal trouble

Inventory Turnover
· The faster the sales, the higher the income, and vice-versa for slow-moving goods
 Ideally operate with zero inventory
· Inventory turnover is the ratio of COGS to average inventory (how rapidly inventory is sold)
Inventory turnover = COGS/Average inventory

Additional inventory Issues

Using the Cost-Of-Goods-Sold Model
· Is used by all companies, regardless of accounting system
· Captures all the inventory information for an entire accounting period
Cost of Goods Sold
Beginning Inventory 1 200
+ Purchases 6 300
= Goods Available 7 500
- Ending Inventory (1 500)
= Cost of Goods Sold 6 000
 Most important question (if perpetual inventory accounting system is used)
 What merchandise should be offered to customers? (marketing question)
 How much inventory should company hold? (accounting question)
 Rearrange formula of cost of goods sold to come to purchase amount

Estimating Inventory by Gross Profit Method

· Often businesses must estimate value of its goods
· Gross profit method is used to estimate ending inventory
 For gross profit method, rearrange ending inventory and cost of goods sold
Cost of Goods Sold
Beginning Inventory 1 200
+ Purchases 6 300
= Goods Available 7 500
- Cost of Goods Sold (6 000)
= Ending Inventory 1 500
 Using the actual gross profit rate, you can estimate the cost of goods sold
 Subtract cost of goods sold from goods available to estimate ending inventory

  32  
Effects of Inventory Errors
· Example: overstated Ending inventory  understated COGS
· Without any further errors, inventory errors counterbalance in two consecutive periods
 Period 1's ending inventory becomes period 2's ending amount
 Error carries over to period 2, resulting in overstated COGS and understated gross
profit in period 2
 Beginning inventory and ending inventory have opposite effects on cost of goods sold
(beginning inventory is added, ending inventory is subtracted)

  33  
Chapter 7 – PPE & Intangibles
Types of Assets
• PPE (fixed assets)
o Long-lived assets that are tangible (land, buildings, equipment), held for use in
the production or supply of goods etc.
 associated expense: depreciation (land is not expensed over time),
amount so far allocated: accumulated depreciation
• Construction In Progress
o Placeholder for assets that are being constructed, when finished moves to PPE
or intangible assets account
• Intangible assets:
o Identifiable non-monetary assets that have no physical form, but are still
identifiable: (patents, copyrights, trademarks, goodwill)
 associated expense: amortization (similar to depreciation)
• Investment properties
o Specially designated class of properties held to earn rentals or for capital
appreciation
 PPE and Intangibles are subject to impairment tests - ensures that stated amounts
do not exceed fair values

Initial Recognition and Measurement of PPE

• Cost of any asset is the sum of all the costs incurred to bring the asset to its intended
use: Purchase price, plus taxes, commissions
o IAS16 directly attributable costs:
 costs of employee benefits
 costs of site preparation
 initial delivery and handling costs
 installation and assembly costs
 testing costs
 professional fees
o What should not be included in PPE costs:
 Costs of opening a new facility
 Costs of Introducing a new product or service
 Costs of conducting business in a new location
 Overhead costs

Land and Land Improvements:

• Cost of land:
o Includes: purchase price (cash plus any note payable given), brokerage
commission, survey fees, legal fees, back property tax; expenditures for
grading and clearing land and for removing unwanted buildings
o Not includes: land Improvements which are subject to depreciation
 cost of leasehold improvements should be depreciated over the term of lease,
(often called amortization)

  34  
Buildings, Machinery, and Equipment
The cost of building inclues architectural fees, building permits, contractors charges, and
payments for material, labor and overhead
 If company constructs its own building: costs include the cost on interest on money
borrowed
 If company purchases existing building: costs include purchase price, brokerage
commission, sales and other taxes paid, all expenditures to repair and renovate

Lump-Sum (or Basket) Purchases of Assets

Businesses often purchase assets as a group or basket, for a single lump-sum amount
 Must identify the cost of each asset
 Total cost is divided among the assets to their relative sales (market) value
 Relative-sales-value method: Ratio of each assets market value to total market value

Subsequent Costs (Capital Expenditure vs. Immediate Expenses)

• Expenditures that increase the assets capacity or extend its useful life are called capital
expenditures
• add the costs to the asset account
• Costs that do not extend the assets capacity or its useful life, but merely maintain the asset
or restore it to working order, are recorded as expenses
 Expense that should have been capitalized: overstate expenses and understates net income
 Capitalize a cost that should have been expensed: understate expenses and overstates net
income

Measuring Depreciation on PPE

Carrying amount of an item (Book value) of PPE = cost – accumulated depreciation
• Depreciation:
o Allocate an asset's cost to expense over its useful life
o Matches asset expense against revenue to measure income (matching principle)
o Depreciation expense is reported on income statement
• Physical wear and tear: physical deterioration
• Obsolescence: asset can become obsolescent before they deteriorate (obsolete if another
asset can do job more efficiently)  useful life may be shorter than physical life
1. depreciation is not a process of valuation: not based on changes in market value
2. depreciation does not mean setting aside cash to replace assets as they wear out

How to allocate depreciation

• Things which have to be known:
1. Cost
2. Estimated useful life
3. Estimated residual value
• Estimated useful life:
o expected usage of the asset, expected physical wear and tear, technical or
commercial obsolescence, legal or similar limits on the use of the asset (e.g. expiry
dates)
• Estimated residual value (scrap value or salvage value):
o expected cash value of an asset at end of its useful life (it is not depreciated)

Depreciable Amount = Assets cost – Estimated residual value

  35  
Depreciation methods
There are three methods
• Straight-line
o Straight-line (SL) method: An equal amount of depreciation is assigned to each
year of asset use  Determine annual depreciation expense
o As an asset is used in operations, accumulated depreciation increases and the book
value of the asset decreases  decreases assets and equity
o Assets final book value is the residual value
• Units-of-production
o Units-of-production (UOP) method: A fixed amount of depreciation is assigned to
each unit of output, or service, produced by asset

• Double-declining-balance
o An Accelerated depreciation method writes off a larger amount of the assets cost
near the start of its useful life than the straight-line method does
o Double-declining-balance (DDB) depreciation computes annual depreciation by
multiplying the assets declining book value by a constant percentage, which is 2
times the straight-line depreciation rate
1. Compute straight-line depreciation rate per year
2. Multiply straight-line rate by 2 to compute DDB rate
3. Multiply DDB rate by periods beginning asset book value (cost less
accumulated depreciation)
• Ignore the residual value of the asset in computing depreciation, expect
during last year
4. Determine the final years’ depreciation amount to reduce asset book value to
its residual value
• Residual value should not be depreciated but should remain on the books
until disposed off
o DDB differs from other depreciation methods in 2 ways:
1. Residual value is ignored initially, depreciation computed on full costs
2. Depreciation expense in the final year is the Plug amount needed to
reduce the assets book value to the residual amount
 All methods result in same total amount of depreciation (depreciable cost), but
allocate different amounts to each period
Comparing Depreciation Methods
· Total depreciable cost is same
• Straight-line best fits for plant asset that generates revenue evenly over time
• Units-of-production best fits those assets that wear out because of physical use
rather than obsolescence
• DDB applies best to assets that generate more revenue earlier in lives
 For reporting in the financial statements, straight-line depreciation is most popular

  36  
Other Issues in Accounting for PPE
• Choice of depreciation method may affect income taxes; a different depreciation method
may be used for financial reporting vs. tax purposes
• PPE have long lives, and subsequent better information may change estimates of useful
life of assets and residual values
• Alternative models for measurement of PPE subsequent to initial recognition
• Companies that have gains or losses when they sell PPE

Depreciation for Tax Purposes

• DBB is most popular for income-tax purposes  It's legal, ethical and allowed
• Accelerated depreciation provides fastest tax deductions, thus decreasing immediate tax
payments  Reinvest tax savings
• Since depreciation is an expense, it decreases net income, therefore decreases the tax
amount payable

Depreciation for partial years

Companies also purchase Equipment during a year and not at the beginning
How to compute it:
1. Compute depreciation for a full year
2. Multiply full-year depreciation by fraction of the year that you held the asset
o If bought on 18th, many businesses record no monthly depreciation on assets
purchased after 15th of month but record a full month's depreciation on asset
bought before 15th
o Depreciation is often automatically updated  by computer systems

Changes in estimates of useful lives or residual values

• Recalculate depreciation on basis of new useful life
• Spread remaining depreciable book value over assets remaining life

Impairment of PPE
• Asset is Impaired when its carrying value is higher than Its recoverable amount
o Recoverable amount is the higher of fair value less cost to sell and value in use
• Assets (factory) and equity (through the loss account) decrease

Measurement subsequent to initial recognition

• IAS16: entity elects one out of two measurement models for each class of property 
grouping of assets of similar nature and use in an entity's operations
o Cost model: an item of PPE shall be carried at its cost, less any accumulated
depreciation and any accumulated impairment losses
o Revaluation model: an item of PPE whose fair value can be measured reliably
shall be carried at a revalued amount
 Revaluations shall be made with sufficient regularity to ensure that the
carrying amount does not differ materially from that which would be
determined using fair value at the balance sheet dates

Fully Depreciated Assets

Fully Depreciated Assets are Asset that reached the end of its estimated useful life
• Equipment may be usable for longer time, but company will not record any more
depreciation on a fully depreciated asset
• When equipment is disposed, assets costs and its accumulated depreciation will be
removed from the books

  37  
Accounting for disposal of PPE
• Before accounting for disposal of an asset, business should bring depreciation up to date
o Measure assets final book value
o Record the expense up to the date of sale
• To account disposal: remove asset and its related accumulated depreciation from books
o There is no gain or loss on the disposal, no effect on assets, liabilities or equity
• If assets are junked before being fully depreciated, company incurs a loss on the disposal
o Loss decreases assets and equity
o Loss is reported as other income (expense) on the income statement
 Losses decrease income as expenses do; gains increase as revenues do
Selling PPE
• First update depreciation until the date of the sale
o There is a gain on sale if sale price is higher than book value
o Entry: cash and accumulated depreciation debited, equipment and gain on sale
of equipment credited
 Total assets as well as equity increase
Exchanging PPE
• Trade old assets for new ones
o Transfer the book value of the old asset plus any cash payment into new asset
account
o Cost of new asset is then purchase price plus book value of old asset
o Debit new asset and debit accumulated depreciation, credit cash plus old asset
 No effect on total assets, liabilities or equity because there was no gain or
loss on the exchange

Accounting for Natural Resources

• Assets of special type (iron, oil etc.) expensed through depletion
o Depletion expense is that portion of the cost of a natural resource that is used
up in a particular period
 Same way as units-of-production depreciation
 Entry is almost identical to a depreciation entry

Accounting for intangibles

• They are recorded at its acquisition cost
• They are the most valuable assets of high-tech companies and those that depend on
research and development
• Intangible assets fall into two categories:
1. Intangibles with finite lives that can be measured reliably
a. Expense is called amortization for these intangibles which works like
depreciation, usually on straight-line basis
b. The residual value for most intangibles is zero
2. Intangibles with indefinite lives:
a. Record no amortization
b. Check them annually for any loss in value, and record a loss when it
occurs (Impairment)
c. Good example is Goodwill

  38  
Accounting for Specific intangibles
Patents
• Patents are federal government grants that give the holder the exclusive right for a number
of years to produce and sell an invention
o Invention may be a product or a process
o Patent must be purchased
o Amortization: credit patent account and debit Amortization Expense
 Decreases both assets and equity
Copyrights
• Copyrights are exclusive rights to reproduce and sell a book, musical composition, film or
other work of art and computer software
o Issued by federal government, extend 70 years beyond the authors life
o Cost of obtaining copyright from government is low, but a company may pay a
large sum to purchase an existing copyright from owner
Trademarks and Trade names
• Trademarks and trade names (brand names) are distinctive identification of a product or
service
o Some have definite useful life set by contract
o Amortize this trademarks cost over its useful life, but they may have an
indefinite life that cannot be fully amortized
Franchises and Licenses
• Franchises and licenses are privileges granted by a private business or a government to
sell a product or service in accordance with specified conditions
o Useful life of many franchises and licenses are indefinite and, therefore, are
not amortized
Goodwill
• Goodwill is defined as the excess of the cost of purchasing another company over the sum
of the market value of the acquired company’s net assets
o Willing to pay for goodwill if company has abnormal earning power
• Goodwill in accounting has special features
1. Goodwill is recorded only when it is purchased in the acquisition of another
company (never record goodwill for own business)
2. Unlike other intangibles with finite useful lives, goodwill Is not amortized but
subject to strict impairment tests

Accounting for the Impairment of an intangible asset

• Impairment testing applies to intangible assets as it does for PPE
• Some intangibles have indefinite life: goodwill, licenses etc.  no amortization
o But all intangible assets are subject to a write-down when their value decreases
called Impairment
• If goodwill decreases in value, record an Impairment loss on goodwill and write down the
book value of the goodwill  Assets and equity decrease
• Unlike tangible assets, once goodwill is impaired, IFRS prohibit any reversal of the
impairment

  39  
Accounting for research and development costs
• Account for R&D is most difficult issue
• Under IAS38, the accounting treatment for R&D expenditures Is literally split in the
middle between research and development:
• Costs associated with the creation of intangible assets are classified into research
phase costs and development phase costs
1. Research phase costs are always expensed
2. Development phase costs are capitalized when all of the following criteria can
be demonstrated:
 The technical feasibility of completing the intangible asset
 The intention to complete the intangible asset
 The ability to use or sell the intangible asset
 The future economic benefits
 The availability of adequate resources to complete development of the
asset
 The ability to reliably measure the expenditure attributable to the
Intangible asset during its development
 It requires judgment, supported by objective evidence

Reporting PPE Transactions on the Statement of cash flows

There are three main types of PPE transactions
1. Acquisition
2. Sales
3. depreciation (including amortization and depletion)
• Acquisition and disposal of PPE are investing activities
o Payment for equipment and buildings are investing activities that appear on the
statement of cash flows
o Sale of PPE results in a cash receipt (see p. 441)
• Depreciation appears on cash-flow statement, but it does not affect cash
o Depreciation decreases net income, but does not affect cash; is therefore added
back to net income to measure cash flow from operations
 It helps to reconcile net income (on accrual basis) to cash flow from operations (Indirect
method)

  40  
Chapter  8  
 
Current  Liabilities  
• Obligation  due  within  1  year  or  within  company’s  normal  operating  life  cycle  if  
longer  than  1  year  
• Current  liabilities  are  of  2  kinds:  
o Known  amounts  
o Estimated  amounts  
 
Current  Liabilities  of  Known  Amounts  
Accounts  payable,  short-­‐term  notes  payable,  sales  tax  payable,  accrued  liabilities,  payroll  
liabilities,  unearned  revenues,  current  portion  of  long-­‐term  debt  
• Accounts  Payable  owed  for  products  and  services  purchased  on  account  
• Short-­term  notes  payable,  common  form  of  financing  payable  within  1  year  
o Like  short-­‐term  borrowings  
o Interest  expense  and  interest  payable  is  accrued  
• Sale  Tax  Payable  is  collected  by  retailers  from  customers  and  owed  to  the  tax  
authority  
• Accrued  Liabilities  (Accrued  Expenses)  results  from  an  expense  the  business  has  
incurred  but  not  yet  paid  
o Salary  and  wages  payable  
o Interest  payable    
o Income  taxes  payable  
  Every  expense  accrual  has  same  effect:  liabilities  increase;  equity  decreases  
• Payroll  liabilities,  also  called  employee  compensation,  is  a  major  expense  for  
service  organizations,  just  as  COGS  for  merchandising  company  
o Salary  is  employee  pay  stated  at  a  monthly  or  yearly  rate  
o Wage  is  employee  pay  stated  at  an  hourly  rate  
o Sales  employees  earn  a  commission  =  percentage  of  the  respective  sales  
o Bonus  is  an  amount  over  and  above  regular  compensation  
o Salary  expenses  represents  gross  pay  (employee  pay  before  subtractions  
for  taxes  and  other  deductions)  
• Unearned  Revenues  also  called  deferred  revenues,  revenues  collected  in  advance  
o Company  has  an  obligation,  to  provide  goods  or  services  to  customers  
• Current  Portion  of  Non-­Current  (or  long-­term)  debt  
o Some  long-­‐term  debt  must  be  paid  in  installments.  The  Current  portion  of  
long-­term  debt  (also  called  current  maturity  or  current  installment)  is  the  
amount  of  the  principal  that  is  payable  within  one  year.  At  end  of  year,  
company  reclassifies  (from  long-­‐term  to  current  liability)  the  amountof  its  
long-­‐term  debt  that  must  be  paid  next  year  
 
Current  Liabilities  that  must  be  estimated  
• Provision  for  warranty  repairs  
o Companies  guarantee  their  products  under  warranty  agreements  
o Whatever  warranty’s  life,  the  matching  principle  demands  that  the  
company  record  the  warranty  expense  in  the  same  period  that  the  
business  records  sales  revenue  
o Exact  amount  of  warranty  expense  cannot  be  known  with  certainty    
estimate  warranty  expense  and  related  liability  

  41  
Contingent  Liabilities  
Contingent  liability  is  not  an  actual  liability,  but  a  disclosure  item  in  the  notes  to  the  
financial  statement.  Contingent  Liabilities  arise  when…  
• There  is  a  possible  obligation  to  be  confirmed  by  a  future  event  that  is  outside  the  
control  of  the  entity  
• A  present  obligation  may,  but  probably  will  not,  require  an  outflow  of  resources  
• A  sufficiently  reliable  estimate  of  the  amount  of  a  present  obligation  cannot  be  
made  
  Examples  of  contingent  liabilities  are  future  obligations  that  may  arise  because  of  
lawsuits,  tax  disputes,  or  alleged  violations  of  environmental  protection  laws  
  There  is  no  need  to  report  a  contingent  loss  that  is  unlikely  to  occur  
  The  new  IFRS  is  likely  to  demand  more  disclosures  of  quantitative  &  qualitative  
information  for  contingent  liabilities  than  are  presently  required  
 
Are  all  your  liabilities  reported  on  the  balance  sheet?  
• If  a  company  fails  to  report  a  large  debt  it  understates  its  liabilities  and  debt  ratio  
and    probably  overstate  its  net  income  
• Contingent  liabilities  are  easy  to  overlook  because  they  are  not  actual  debts  
 
Summary  of  the  Current  Liabilities  
On  the  income  statement  a  company  would  report  
• Expenses  related  to  some  of  the  current  liabilities  (salary,  interest,  income  tax,  
warranty)  
• Revenue  related  to  unearned  revenue  
 
Long-­term  liabilities:  Bonds  and  notes  payable  
• Bonds  payable  are  groups  of  notes  payable  issued  to  multiple  lenders  called  
bondholders.    
o Benefit  for  company  (issuer):  raising  cash  
o Benefit  for  bondholder:  possibility  to  diversify  risk  by  holding  different  
bonds  
 
Bonds  
• Characteristics  
o Principal  (face  value,  maturity  value):  typically  stated  in  units  of  $1000  
o Maturity  date:  specific  future  time  when  the  issuer  pays  the  principal  
o Interest  expense:  rental  fee  on  borrowed  money  
o Underwriter:  usually  a  bank  which  purchases  the  bonds  from  the  issuing  
company  and  resells  them  to  its  clients  (and  probably  earns  a  commission)  
• Types  of  Bonds  
o Term  bonds  mature  at  the  same  time  
o Serial  bonds  mature  in  installments  over  a  period  of  time  
o Secured  or  mortgage  bonds  give  the  bondholder  the  right  to  take  specific  
assets  of  the  issuer  if  the  company  defaults  
o Unsecured  bonds  (debentures)  are  backed  only  by  the  good  faith  of  the  
borrower  and  usually  carry  a  higher  rate  of  interest  
• Bond  Prices  
o Investors  may  buy  and  sell  bonds  trough  bond  markets  
o Bond  prices  are  quoted  at  a  percentage  of  their  principal  
 

  42  
 • Bond  premium  and  Bond  discount  
Bond  premium   Issued  above  face   Credit  balance   Premium  decreases  
value   toward  face  value  
Bond  discount   Issued  below  face   Debit  balance   Discount  increases  
value   toward  face  value  
• Bond  Interest  Rates  determine  Bond  Prices  
o Bonds  are  sold  at  their  market  price  =  bond’s  PV  =  PV  of  the  principal  
payment  +  PV  of  future  cash  interest  payments  (usually  paid  semi-­‐annually)  
o Price  of  the  bond  is  determined  by  two  interest  rates  
 Stated  interest  rate  (coupon  rate)  is  the  interest  rate  printed  on  the  
bond  certificate  
 Market  interest  rate  (effective  interest  rate)  is  the  rate  investors  
demand  for  loaning  their  money.  This  rate  can  fluctuate  after  
issuance  of  the  bond.    

 
Issuing  bonds  at  par  value  
• Issuing  the  bond:  debit  cash,  credit  bonds  payable    increase  assets  &  liabilities  
• Interest  payment:  debit  interest  expense,  credit  cash    decrease  assets  &  SE  
• Accrue  interest  expense  and  interest  payable  at  year  end  for  interest  payment  on  
January  1st  :  debit  interest  expense,  credit  interest  payable    increase  liabilities,  
decrease  SE  
• Interest  payment:  debit  interest  payable,  credit  cash    swop  assets  
• Pay  off  the  bond:  debit  bonds  payable,  credit  cash    decrease  assets  &  liabilities  
 
Issuing  bonds  at  discount  
 

  43  
What  is  the  Interest  Expense  on  These  bonds  payable?  
• The  interest  payment  is  set  by  the  bond  contract  and  therefore  remains  the  same  
• The  interest  expense…  
o Increases  for  a  discount  bond  as  the  bonds  march  toward  maturity  
o Decreases  for  premium  bond  as  the  bonds  march  toward  maturity  
• The  effective-­interest  method  of  amortization…  
o Determines  the  periodic  interest  expense  
o Shows  the  bond  carrying  amount  
 
Interest  Expense  on  bonds  issued  at  discount  and  premium  
• For  a  discount  bond  holds  =  issuing  value  <  maturity  value.  The  difference  is  an  
additional  interest  expense  that  amortizes  the  bonds  carrying  value  to  its  
maturity  value.  Thus  the  bonds  carrying  value  in  increasing  
• For  a  premium  bond  holds  =  issuing  value  >  maturity  value.  The  difference  is  a  
premium  that  reduces  the  interest  expense  that  amortizes  the  bonds  carrying  
value  to  its  maturity  value.  Thus  the  bonds  carrying  value  in  decreasing.  
• For  partial-­period  Interest  amounts  and  further  information  see  page  485-­‐492  
 
The  straight-­line  amortization  method  
• also  called  effective  interest  amortization  method  
• Divides  a  bond  discount  or  premium  into  equal  periodic  amounts.  The  amount  of  
interest  expense  is  therefore  the  same  each  period  
• Calculation:  
Cash  interest  payment  
+   amortization  of  account  ((maturity  value  –  issuing  value)/number  of  payments  
=   Estimated  interest  expense    
• This  method  is  called  quick  and  dirty  because  it  simplifies  the  amortization.  It  is  
not  allowed  under  the  IFRS  
Should  we  retire  bonds  payables  before  maturity?  
• Sometimes  companies  retire  bonds  early  because…  
o Of  the  pressure  of  making  high  interest  payments  
o The  company  may  be  able  to  borrow  at  a  lower  interest  rate  
• If  a  bond  is  callable  the  issuer  may  call  or  pay  off  the  bond  at  a  prearranged  price  
stated  in  a  percentage  points  above  the  par  value  (e.g.  101%)  
• The  alternative  is  to  purchase  the  bonds  back  in  the  open  market  at  their  current  
market  price  
 
Convertible  bonds  and  notes  
• Corporate  bonds  and  notes  that  can  be  converted  into  the  issuing  company’s  
share  capital  are  called  convertible  bonds  (convertible  notes)  
• For  investors  the  benefits  are  
o The  safety  of  assured  receipt  of  interest  and  principal  on  the  bonds  
o The  opportunity  for  gains  on  the  shares  
• This  feature  may  be  so  attractive  that  investors  accept  lower  interest  rates  on  the  
bonds.  When  the  share  price  get’s  high  enough  the  bondholders  convert  the  
bonds  into  shares  
 
 
 

  44  
Financing  operations  with  bonds  or  shares?  
There  are  three  ways  for  a  company  to  finance  operations  
1. By  retained  earnings:    
a. Advamtage:  low-­‐risk  
2. By  issuing  shares:    
a. Advantage:  creates  no  liabilities  or  interest  expense  and  is  less  risky.  
Dividend  payments  can  be  omitted  
b. Disadvantage:  low  EPS  
3. By  issuing  bonds:    
a. Advantage:  gives  no  control  of  the  corporation  to  other  people.  High  EPS  
b. Disadvantage:  increases  debt  and  therefore  risk  
  see  Exhibit  8-­‐10  on  page  495  for  an  example  
 
The  times-­interest-­earned  ratio  
• The  debt  ratio  measures  the  effect  of  debt  on  the  company’s  financial  position  but  
says  nothing  about  the  ability  to  pay  interest  expense  
• The  times-­interest-­earned  ratio  (interest-­coverage  ratio)  relates  income  to  
interest  expense  and  measures  the  number  of  times  that  operating  income  can  
cover  interest  expense  
• A  high  times-­‐interest-­‐earned  ratio  indicates  ease  in  paying  interest  expense;  a  
low  value  suggests  difficulty  
Operating Income
• Formula:     Times − interest - earned ratio =  
Interest Expense
 
 
Non-­current  
€ liabilities:  Leases  and  Pensions  
• Lease:  This  is  a  rental  agreement  in  which  tenant  (lessee)  agrees  to  make  rent  
payments  to  property  owner  (lessor)  in  exchange  for  the  use  of  asset  
• There  are  two  types  of  leases  
o Operating  leases:    
 rental  agreement  between  the  lessor  and  the  lessee,  who  pays  the  
lessor  to  make  use  of  the  leased  assets  
 Many  operating  leases  are  non-­‐cancellable.    
 The  lessor  retains  the  usual  risks  and  rewards  of  owing  the  leased  
assets  
 Neither  leased  assets  nor  future  payments  are  recorded  on  the  
balance  sheet.  Instead  imposes  disclosure  requirement.  
o Capital  leases:  Leases  are  recognized  as  capital  leases  if  they  meet  any  of  
the  following  conditions  
 Lease  transfers  substantially  all  risks  and  rewards  of  asset  to  leesse  
 Lease  transfers  ownership  of  asset  to  lessee  at  the  and  of  the  lease  
 Lease  term  represents  substantial  part  of  asset’s  useful  life  
 PV  of  lease  payments  represents  substantial  part  of  fair  value  of  
asset  
 
 
 
 
 

  45  
 o Capital  leases:    
 The  lessee  enters  the  asset  into  long-­‐term  assets  and  records  a  
long-­‐term  liability  at  beginnig  of  lease  turm  
 The  lessee  capitalizes  the  asset  but  may  never  take  legal  title  to  the  
ownership.    
 The  lessee  will  record  the  PV  of  its  lease  payment  on  its  books.  The  
original  entry  is  a  debit  lease  assets  and  credit  lease  liabilities.  As  
the  asset  is  being  used  it  is  depreciated.  When  lease  payments  are  
made  it  is  first  made  against  lease  interest  expense,  and  remaining  
balance  reduces  outstanding  lease  payments  
  companies  prefer  operating  leases  over  capital  leases  because  operating  leases  do  not  
increase  debt  and  therefore  do  not  affect  the  debt-­‐ratio  
 
 
Pensions  and  Post-­retirement  Liabilities  
There  are  two  basic  schemes  for  employees’  post-­‐retirement  liabilities  
• Defined  contribution  
o Employers  contribute  a  fixed  amount  on  money  (provident,  
superannuation)  to  an  employee’s  pension  fund  
o Employers  obligation  ends  one  the  contribution  has  been  made  
o Members  of  the  pension  fund  are  able  to  use,  invest  or  withdraw  the  
contribution  accumulated  according  to  the  fund’s  rules  &  regulations  
• Defined  benefit  plan  
o Employee  is  promised  some  post-­‐retirement  benefits  (pensions)  
o Companies  may  provide  other  benefits  e.g.  medical  insurance  
o Companies  record  pension  and  retirement-­‐benefits  while  employees  work  
for  the  company  
• At  the  end  of  each  period  the  company  compares  
o Fair  market  value  of  assets  in  the  retirement  plans  (cash  &  investment)  
o With  the  plans  accumulated  benefit  obligation,  which  is  the  PV  of  promised  
future  payments  to  retirees  
 Plan  is  overfunded  if:  assets  >  accumulated  benefit  obligation    
report  in  the  notes  to  the  financial  statements  
 Plan  is  underfunded  if:  assets  <  accumulated  benefit  obligation    
report  excess  liability  amount  as  long-­‐term  liability  on  balance  
sheet  
 
Reporting  the  fair  market  value  of  long-­term  debt  
• The  IFRS  requires  companies  to  report  fair  market  value  of  their  financial  
liabilities  
• Fair  market  values  of  publicly  traded  debt  are  based  on  quoted  market  prices  and  
can  therefore  exceed  or  be  less  than  their  carrying  amounts  

  46  
Chapter 9 – Shareholders’ Equity

What’s the best way to organize a business?

Separate legal Entity

• Corporation is formed under state law
• It is a distinct entity that exists apart from its owners (shareholders)
• Has many rights that a person has: buy, own, sell property
• Assets and liabilities belong to corporation and not to its owners

Continuous life and transferability of ownership

• Companies have Continuous life regardless of changes in their ownership
• Proprietorships and partnerships terminate when ownership changes

Limited Liability
• Stockholders have limited liability for corporation’s debt
• Most they could lose, cost of the investment
• Enables corporation to raise more capital
• Proprietors and partners are personally liable for all the debts of their businesses

Separation of ownership and management

• Stockholders own, but the board of directors appoints officers to manage the business
• Managements goal is to maximize the firm’s value for the stockholders
• Agency problem

Corporate Taxation
• Proprietorships and partnerships pay no business tax, but their owners
• Corporation are separate taxable entities which pay corporate tax
o sometimes also federal and state income taxes
• Corporations pay income taxes on their corporate income

Government Regulation
• To protect a corporations creditors and stockholders, federal and state governments
monitor corporations
o Ensure that they disclose information: accounting
• Big listed companies will be subject to more regulatory oversight than a private
company with a small number of shareholders

Advantages (of a Corporation) Disadvantages

1. Can raise more capital than a 1. Separation of ownership and
proprietorship management
2. Continuous life 2. Corporate taxation
3. Ease of transferring ownership 3. Government regulation
4. Limited liability to shareholders

  47  
Organizing a Corporation

• Organizers apply for registration as a company with the relevant authority

• Typically required are a constitution, charter, or memorandum of association
• Stockholders elect a board of directors; set company policy and appoint officers;
• The Board elects a chairperson CEO and sometimes also a chief operating officer
COO (day-to-day operations)

Stockholders Rights
• Ownership of shares gives shareholders four basic rights:
1. Vote: participate in management; 1 vote per share; usually at the annual
general meeting (AGM)
2. Dividends
3. Liquidation: receive a proportionate share of any assets remaining after paying
the corporations’ liabilities (liquidation = go out of business)
4. Preemption: right to maintain one’s proportionate ownership in the corporation
 in you hold 5% of all shares and new shares are issued, you must be offered
to buy 5% of the new shares = preemptive right

Stockholders Equity
Stockholders equity:
o Paid-in capital, contributed capital, share capital: amount of equity that
stockholders have contributed to corporation; includes stock accounts and any
additional paid-in capital
o Retained earnings: earned through profitable operations and has not used for
dividends
• Most states prohibit declaration of cash dividends from paid-in capital; cash dividends
are declared from retained earnings
• Owners equity of corporation is divided into shares of stock
o Corporation issues stock certificates to its owners when the company receives
their investment in business
o Stock in the hands of a stockholder is said to be outstanding
o Total number of shares of stock outstanding represents 100% ownership of the
corporation

Classes of Shares
Corporations issue different types of shares to appeal to a variety of investors
• ordinary shares or preference shares
• with or without par values

Ordinary Shares:
• An ordinary share is the basic form of capital share
• Common stockholders have the four basic rights
• They take most risk by investing
• Called common stock in the USA

Preferred Shares:
• Gives its owners certain advantages over ordinary shareholders
• Receive dividends before the common shareholders and they also receive assets before
ordinary shareholders if corporation liquidates
• Also have four basic rights

  48  
 • Company may issue different classes of preferred stock (each different account)
• Most preferred shareholders can expect to earn a fixed dividend
• Hybrid between ordinary share and long-term debt: it pays a fixed dividend, but the
dividend is not required to be paid unless board of directors declares the dividend
• There is no obligation to pay back preferred share unless it is an redeemable
preference share: It must be paid back by the corporation and is a covered liability
o Rarely used (7% of corporations)

Par-Value and No-Par Shares

• Share may be par-value or no-par share
• Par value is an arbitrary amount assigned by a company to a share of its share
• Most companies set par value of their common share low to avoid legal difficulties
from issuing share below par

Voting rights
• Companies may have different classes of shares with different voting rights
• special shares are often hold by a government

Issuing Share

• Corporations may sell shares directly to shareholders or use the service of an

underwriter (brokerage firms like UBS or Goldman Sachs)
• Companies often advertise the issuance of their share to attract investors
o Advertisements are called tombstones

Ordinary Shares
Ordinary Shares at Par
• Assets and shareholders equity increase by the same amount

Ordinary Shares above par

• Most corporations set par value low and issue ordinary shares for a price above par
o Difference between issue price and par value is share premium, additional
paid-in capital or capital in-excess of par
o Par value of share and additional amount are part of paid-in capital
• A company neither earns a profit nor incurs a loss when it sells its share to, or buys its
share from, its own shareholders

• No-Par Shares with stated value get accounted in the same way

Ordinary Shares with No-Par Values

• Debit asset received or cash and credit share capital for the cash value of asset
received
• Company with true no-par shares has no additional paid-in capital account

Ordinary Share Issued for Assets Other than Cash

• Record assets at current market value and credits share and additional paid-in capital
accounts accordingly

  49  
Ordinary Shares Issued for Services
• Sometimes a corporation issue shares in exchange for services, either by employees or
outsiders
o No cash is exchanged
o Transaction is recognized at fair market value
o Corporation recognizes an expense for the fair market value of the service
rendered
 Retained earnings are decreased and paid-in capital increased

Share Issuance for Other than Cash can Create an Ethical Challenge
• Accounting standards require companies to record its shares at the fair market value of
whatever the corporation receives in exchange for the share
o Value of asset can create an ethical challenge
o Assets and equity may be overstated if asset is not worth that much
o Some accounting values are more solid than others
o Not all financial statements mean exactly what they say

Preference Shares
• Credit preference share capital at its par value, with any excess credited to paid-in
capital excess of par-preferred
o Separate account from paid-in-capital in excess of par-common
• Accounting for no-par preference follows pattern for no-par common share
• convertible preference share: preferred share is convertible into companies ordinary
share

Authorized, Issued, and Outstanding Shares

There are three different numbers of company’s shares:

1. Authorized Shares: maximum number of shares company can issue under its
present constitution
2. Issued Shares: already issued to shareholders
3. Outstanding Shares: number of shares that shareholders own
Outstanding shares = issued shares – treasury shares

Treasury Shares

An own share that was issued and later reacquired is called treasury share
• Corporations purchase their own shares for several reasons
1. When offering employees share option compensation or share ownership plan
it does not have to issue new shares but buys shares from the market and pass
them further to the employees
2. Management wants to avoid a takeover by an outside party
3. Management wants to increase its reported earnings per share (EPS)

How is Treasury Share Recorded

• Buying treasury share shrinks assets (e.g. cash) and equity by an amount equal to the
cost of treasury share
o Effect: Cash is credited and treasury shares is debited
• Remember Issuing shares grows assets and equity

  50  
Resale of Treasury Shares
• Selling treasury share: grows assets and equity by an amount equal to the sale price of
the treasury share sold
• If treasury shares are sold at a higher price than they were bought, the share capital
account gets credited
• If treasury shares are sold at a lower price than they were bought, the share capital
account gets debited
 Company never gains or losses on transactions involving its own treasury shares

Issuing Treasury Shares as Compensation

• Probably most common use of treasury shares
• Effect: Debit share option compensation account and credit treasury shares

Retiring Treasury Shares

• Corporation may purchase its own shares and retire it by canceling the shares
o Retired shares cannot be reissued
o Effect: Debit share capital account and credit treasury shares

Retained Earnings, Dividends, and Splits

The retained earnings account carries the balance of the business’s net income, less its net
losses and less any declared dividends that have been accumulated over the company’s
lifetime
• Retained earnings account is not a reservoir of cash for paying dividends to the
shareholders
• Cash and retained earnings are two entirely separate accounts with no particular
relationship
o Credit balance in retained earnings is normal
o A debit balance in retained earnings arises when a corporations lifetime losses
and dividends exceed lifetime earnings  called a deficit, this amount is
subtracted to determine total shareholders equity (17% of companies)

Should the Company Declare and pay cash dividends?

A dividend is a corporations return to its shareholders of benefits of earnings and can take
three forms:
• Cash
• Share
• Noncash assets (noncash dividends are rare)
 For noncash asset dividend, debit retained earnings and credit the asset for the current
market value of the asset given

Cash Dividends
Most dividends are cash dividends
• Company must have
o Enough retained earnings to declare the dividend and
o Enough cash to pay the dividend
• Typically, dividends are paid after the AGM and the shareholders must decide on its
payment  final dividend
• Dividends paid during the year are interim dividends and are declared by the board
and become payable immediately

  51  
 • There are three relevant dates
1. declaration date: board announces dividend; declaration creates liability (if
interim)  debit retained earnings and credit dividends payable
2. date of record: corporation announces record date; follows declaration by a few
weeks  shareholders on the record date will receive the dividend
3. payment date: payment of dividend follows record date by a week or 2  debit
dividends payable, credit cash

Dividends on Preference Shares

• Preferred shareholders receive dividend first
• Common shareholders only receive dividends if total dividend is large enough to pay
preference shareholders first
• Two ways to express the dividend rate on preferred share:
1. Dividends on preferred share either stated as percentage of par value
 6% preferred: annual dividend equal to 6% of shares par value
2. Or dollar amount per share  3 dollar preferred: annual dividend of 3 per
share regardless of par value (on no-par preferred share)

Dividends on Cumulative and Noncumulative Preference Shares

• If corporations fail to pay a dividend to preferred shareholders the corporatin is
passing the dividend;
o passed dividends are said to be in arrears
• Owners of cumulative preferred share must receive all dividends in arrears plus the
current years dividend before any dividends go to common shareholders
• Mostly preference shares are cumulative unless specifically labeled as noncumulative

Share Dividends
• Share dividend is a proportional distribution by a corporation of its own share to its
shareholders
o increase share account and decrease retained earnings; total equity unchanged;
no asset or liability affected
o Distributed in proportion to number of shares they already own
• There are two reasons for paying dividends:
1. To continue dividends but conserve cash
2. To reduce the per-share market price of its share (shares market price falls
due to increased supply of shares  attracts more investors)

Stock Splits
• Stock split is an increase in the number of shares of share authorized, issued, and
outstanding  coupled with reduction in the shares par value
o Share split, like a large share dividend, decreases the market price of the share
o A 2-for-1 share split means that: company will have twice as many shares of
share authorized; issued, and outstanding; each shares par value is cut in half
 All account balances are the same after the share split as before
 Only par value per share, shares authorized and shares issued change

Measuring the Value of Share

The business community measures share values in various ways, depending on the purpose of
the measurement. These values include market value, redemption value, liquidation value,
and book value

  52  
 Market, Redemption, Liquidation, and Book Value
• Shares market value, or market price, is the price a person can buy or sell 1 share of
the share
o Varies with corporations net income, financial position and future prospects
and general economic conditions
o Shareholders are more concerned about market value than any other
• Market Capitalization (number of shares times share price)
• Redeemable preference share require the company to redeem the preference share at a
set price
o Company is obligated to redeem (pay to retire) the preference share
o Redeemable preference share is not SE, but a liability
• Redemption value is the price the corporation agrees on to pay for share. It is set when
the share is issued
o Preference shares often have a specified redemption value
o The preference component of equity is its redemption value plus any
cumulative preference dividends in arrears
• Liquidation value is the amount that a company must pay a referred shareholder in the
event the company liquidates (goes out of business)
• Book value per share of common share is amount of owners equity on company’s
books for each share of its share
o If only ordinary share  book value = total ordinary shares outstanding
• Outstanding shares: Total issued shares – Treasury shares
Total SE − Preference Equity
• Book value of ordinary shares =
Number of ordinary shares outstanding
 Investors may search for shares whose market price is below book value

€ Relating Profitability to a Company Share

To compare companies of different size, investors use standard profitability measures:

Return on Assets
• Rate of return return on assets (ROA) measures a company’s use of its assets to earn
income for the 2 groups who finance the business:
1. Creditors to whom corporation owes money: they want interest
2. Shareholders who own corporation share: want net income
• 10% is considered strong in most industries
Net Income + Interest expense
ROA =
Average total assets

Return on Equity
• Rate of return on equity (ROE) shows the relation between net income available to
€ average ordinary SE because the return to preference shareholders is a specified
dividend
• Used to compare companies; 15% is a good return
Net income − Preference dividends
ROE =
Average ordinary SE
 ROE is always higher than ROA because shareholders take a lot more investment risk than
bondholders
€
  53  
Chapter  10  –  Long-­Term  Investments  &  International  
Operations  
 
Share  Investments:  an  Overview  
• Entity  that  owns  the  share  of  a  corporation  is  the  investor  
• Corporation  that  issued  the  share  is  the  investee  
 
Reporting  Investments  on  the  Balance  Sheet  
• Short-­term  investments  in  marketable  securities  are  current  assets.  Classified  as  
o Trading  
o held-­to-­maturity  
o available  for  sale  
• Long-­term  investments  are  a  category  of  noncurrent  assets  
o Include  shares  &  bonds  that  investor  expect  to  hold  for  longer  than  1  year  
• Assets  are  listed  in  order  of  liquidity  
• Accounting  rules  for  investments  in  share  depend  on  the  percentage  of  
ownership  by  the  investors    
 
Percentage  Ownership  by  the  Investor   Accounting  Treatment  
Up  to  20%  (when  classified  Available-­‐for-­‐Sale)   Fair  Market  Value  
Up  to  20%  (when  classified  as  Held-­‐to-­‐Maturity)   Amortized  Cost  
Between  20-­‐50%   Equity  Method  
Greater  than  50%   Consolidation  
 
• Investment  up  to  20%  is  casual  ("passive  investments")  because  the  investor  has  
usually  almost  no  influence  on  investee  
• Available-­for-­sale  investments  are  share  investments  other  than  trading  securities  
o Usually  are  shown  as  non-­‐current  or  long-­‐term  assets,  except  if  intended  
to  be  sold  within  12  months  
• Held-­to-­Maturity  investments  are  accounted  for  using  amortized  cost  
o Accounted  as  non-­‐current  if  maturity  date  is  beyond  the  next  fiscal  year  
• Ownership  between  20  and  50%  have  a  significant  influence  investee  
o Investees  are  called:  associates  or  equity  affiliates    
• Above  50%  lots  of  influence;  control  
o Investees  are  called  subsidiaries  of  the  parent  company  
 
Available-­for-­Sale  Investments  
• Accounted  for  at  fair  market  value  because  the  company  expects  to  sell  the  
investment  at  its  market  price  
• Cost  is  used  only  as  the  initial  amount  for  recording  the  investment    
• Investments  are  reported  on  balance  sheet  at  current  fair  market  value  
• Unrealized  gains  and  losses  on  available-­for-­sale  securities  are  recognized  in  
equity  until  the  financial  asset  is  sold  
• Receipt  of  a  share  dividend  is  different  from  a  receipt  of  a  cash  dividend  
o For  share  dividend,  no  dividend  revenue  is  recorded    
o Investor  makes  memorandum  entry  in  accounting  records  to  denote  new  
number  of  shares  held  
o Cost  per  share  decreases  with  increasing  number  of  shares  
 

  54  
Which  Value  of  an  Investment  is  Most  Relevant?  
• Available-­for-­sale  investments  are  measured  at  fair  value    
o if  the  value  cannot  be  measured  reliably,  the  investment  is  carried  at  cost  
• Fair  market  value  is  the  amount  that  a  seller  would  receive  on  the  sale  of  an  
investment  on  a  given  date  
• On  the  balance  sheet  we  adjust  available-­for-­sale  investments  from  their  last  
carrying  amount  to  fair  market  value  
 
Market  Value  Adjustment   (46,500-­44,000)   2,500    
(MVA)  
  Unrealized  Gain  on  Investment       2,500  
 
• Debit  MVA  to  market  value,  credit  unrealized  gain  on  investment  
• MVA  is  a  companion  account  to  long-­‐term  investment  
• Unrealized  gains  and  losses  result  from  changes  in  the  market  value,  not  from  
sale  of  investment  and  are  reported  in  2  places  in  financial  statements  
o Comprehensive  income:  income  statement  below  net  income  
o Other  comprehensive  income:  separate  section  of  shareholders  equity,  
below  retained  earnings  on  balance  sheet  
 
Selling  an  Available-­for-­Sale  investment  
• Results  in  realized  gain  or  loss,  which  measure  the  difference  between  the  
amount  received  from  sale  and  its  cost  
 
Cash     43,000    
Loss  on  Sale  of     1,000    
Investment  
  Long-­‐Term  Investment  (cost)     44,000  
 
When  should  we  sell  an  investment?  
• Companies  control  when  they  sell  investments,  that  helps  them  control  when  
they  record  gains  and  losses  
• Cost  principle  of  accounting  provides  this  opportunity  to  manage  earnings  
 
Equity-­Method  Investments  
 
• The  equity  method  is  used  to  account  for  investments  where  the  investor  owns  20  
to  50%  of  the  investee’s  shares  
• It  is  a  method  of  accounting  whereby  the  investment  is  initially  recognized  at  cost  
and  adjusted  thereafter  for  the  post-­‐acquisition  change  in  the  investor’s  share  of  
net  assets  of  the  investee  
 
Buying  a  Large  Stake  in  Another  Company  
• Investor  may  affect  dividend  policy,  product  lines,  and  other  important  matters  
 
Accounting  for  Equity-­Method  Investments  
• Investments  are  initially  accounted  as  cost:  
 
Long-­‐Term  Investment     400    
  Cash     400  

  55  
Investors  Percentage  on  Investee  Income  
• The  Investor  applies  its  percentage  of  ownership  (20%)  in  recording  its  share  of  
the  investee’s  net  income  and  dividends  
 
Long-­‐Term  Investment     (Net  Income  of  250*0.2)   50    
  Income  from  Associates     50  
 
Receiving  Dividends  under  the  Equity  Method  
• Investment  account  is  decreased  for  the  receipt  of  a  dividend  on  an  equity-­‐
method  investment  because  dividend  decreases  investees  owners  equity  and  
thus  investors  investment  
 
Cash   (Dividends  of  100*0.2)   20    
  Long-­‐Term  Investment       20  
 
• Gain  or  loss  on  the  sale  of  an  equity-­‐method  investment  is  measured  as  the  
difference  between  sale  proceeds  and  the  carrying  amount  of  the  investment  
 
Cash   (Sale  proceeds  of  425)   425    
Loss  in  Sale  of  Investment     5    
  Long-­‐Term  Investment       430  
 
Consolidated  Subsidiaries  
 
Why  buy  another  company?  
• Controlling  (majority)  interest  is  the  ownership  of  more  than  50%  of  the  
investee’s  voting  share  
o Investor  is  called  the  parent  company  
o Investor  can  elect  the  majority  of  the  members  of  board  of  directors  and  
thus  control  the  investee  
 
Consolidation  Accounting  
• Consolidation  accounting  is  a  method  of  combining  the  financial  statements  of  all  
the  companies  controlled  by  the  same  shareholders  
• Consolidated  statements  combine  the  balance  sheet,  income  statements,  and  cash-­‐
flow  statements  of  the  parent  company  with  those  of  the  subsidiary  
o Assets,  liabilities,  revenues,  and  expenses  of  each  subsidiary  are  added  to  
the  parents  accounts  
  Investors  gain  a  better  perspective  on  total  operations  than  they  could  by  examining  
the  reports  of  the  parent  and  the  individual  subsidiary  
 
The  Consolidated  balance  sheet  and  the  related  work  
·  Parent  company  uses  a  worksheet  to  prepare  the  consolidated  statements  
1. Investment  &  Equity  
a. Credit  the  parent’s  investment  account  for  the  investment  in  the  
subsidiary    
b. Debit  both  share  capital  and  retained  earnings  of  the  investee  that  
comes  from  the  parent  company    
2.  Eliminate  the  notes  receivables  for  each  other    
 

  56  
  
Goodwill  and  Non-­Controlling  Interest  
• …  are  two  accounts  that  only  a  consolidated  entity  can  have  
• Goodwill  arises  when  a  parent  company  pays  more  to  acquire  the  subsidiary  
company  than  the  market  value  of  the  subsidiary’s  net  assets  
o It  is  an  intangible  asset  and  reported  on  balance  sheet  
• Non-­controlling  (or  minority)  interest  arises  when  a  parent  company  owns  less  
than  100%  of  the  share  of  a  subsidiary    
o the  remainder  of  the  subsidiaries’  shares  is  non-­‐controlling  interest  to  the  
parent  company  
o It  reported  as  a  separate  account  on  the  SE  section  
Income  of  a  Consolidated  Entity  
• If  the  subsidiary  is  100%  owned,  then  all  the  subsidiary’s  net  income  belongs  to  
the  shareholders  for  the  parent    
• Income  of  the  consolidated  entity  equals  net  income  of  the  parent  plus  the  
parent’s  proportion  of  the  subsidiaries  net  income  (Check  Exhibit:  10-­‐10)  
 
Long-­Term  Investments  in  Bonds  
• Major  investors  in  bonds  are  financial  institutions  like:  mutual  funds  and  
insurance  companies  
o Investments  in  bonds  are  rarely  short-­‐term  and  recorded  as  costs  
o Long-­‐term  investments  in  bonds  are  called  held-­to-­maturity  investments  
 Held-­‐to-­‐maturity  investments  are  reported  by  the  amortized  cost  
method,  which  determines  the  carrying  amount  
  Consider  the  following  held-­to-­maturity  example:  
o Bond  bought  at  discount  (95.2%)  with  semi-­‐annual  payments  (April  1st  &  
October  1st)  with  6%  interest  payments  
o The  holding  company  must  amortize  the  carrying  amount  of  9,520  up  to  
10,000  over  their  term  of  maturity  
o Quick  and  dirty  (I  like)  straight-­line  method:  
Long-­‐Term  Investment  in   (10,000*0.952)   9,520    
Bonds  
  Cash     9,520  
Cash   (10,000*0.06*6/12)  Interest   300    
  Interest  Revenue     300  
Long-­‐Term  Investment  in   ((10,000-­9,520)/48)*6  Amortization   60    
Bonds  
  Interest  Revenue     6ß  
  57  
 • This  amortization  entry  (last  one)  has  two  effects:  
o It  increases  the  Long-­‐term  Investment  account  on  its  march  toward  
maturity  value  
o It  records  the  interest  revenue  earned  from  the  increase  in  the  carrying  
amount  of  the  investment  
 
Accounting  for  International  Operations  
Many  companies  earn  revenues  beyond  their  national  boundaries.  Accounting  for  
business  activities  involves  foreign  currencies  and  exchange  rates  
 
Foreign  Currencies  and  Exchange  Rates  
• Two  main  factors  affect  the  price  (exchange  rate)  of  a  particular  currency:  
1. The  ratio  of  a  country’s  imports  to  its  exports:  the  more  foreign  demand  for  a  
country’s  goods,  the  more  currency  is  demanded    currency  appreciates  
2. The  rate  of  return  available  in  the  country’s  capital  markets:  if  rates  of  returns  
in  a  stable  country  are  high,  people  buy  shares,  bonds,  or  real  estate  in  that  
country  which  increases  the  demand  for  the  currency    currency  appreciates  
• Exchange  rate  of  a  strong  currency  is  rising  relative  to  other  nations’  currency    
• Exchange  rate  of  a  weak  currency  is  falling  relative  to  other  nations’  currency  
 
Accounting  for  Foreign  Currency  Transactions  
• Functional  currency  is  the  currency  of  the  primary  economic  environment  in  
which  a  business  operates  
o In  most  cases  it  is  the  local  currency  
o All  foreign  currency  items  are  translated  into  the  functional  currency  at  
initial  recognition  using  transaction-­‐date  exchange  rates  
• Example  of  an  American  firm  “Dr.  Doolittle”  purchasing  on  account  little  tigers  
from  a  German  zoo,  paying  4,000  dollars  (exchange  rate  is  0.5€/$):  
 
Accounts  Receivable  –  Dr.   (4,000*0.5=  2000€)   2,000    
Doolittle  
  Sales  Revenue       2,000  
 
• When  the  final  payment  is  conducted  the  amount  can  vary  from  the  initial  
amount  recorded  due  to  exchange  rate  fluctuations  
o Either  a  translation  gain  or  translation  loss  
• Let’s  assume  the  dollar  has  appreciated  to  0.7€/$:  
 
Cash   (4,000*0.7=  2800€)   2,800    
  Translation  Gain     800  
  Accounts  Receivable  –  Dr.     2,000  
Doolittle  
 
Reporting  Gains  Losses  in  the  Income  Statement  
• The  net  amount  of  the  gains  and  losses  are  reported  on  the  income  statement  as  
Other  Revenues  and  Gains,  or  Other  Expenses  and  Losses  
 
 
 
 

  58  
Should  We  Hedge  Our  Foreign-­Currency-­Transaction  Risk?  
• One  way  to  avoid  foreign-­‐currency  transaction  losses  is  to  insist  that  
international  transactions  be  settled  in  the  local  currency  
• Another  way  to  protect  itself  from  exchange  rate  fluctuations  is  by  hedging  
o Hedging  means  to  engage  in  a  counter-­‐balancing  transaction:  engage  in  
future  contracts,  which  promises  to  receive  a  certain  amount  of  foreign  
currency  for  a  fixed  amount  at  a  future  date  (vice  versa)  
 
Consolidation  of  Foreign  Subsidiaries  
• An  entity  may  also  operate  through  a  foreign  operation,  which  can  be  a  
subsidiary,  associate,  joint  venture  or  branch  of  a  reporting  entity  
• A  company  with  a  foreign  subsidiary  must  consolidate  the  financial  statement  
into  its  own,  which  consequences  two  special  challenges:  
1. Some  foreign  countries  may  require  accounting  treatments  that  differ  from  
the  reporting  entity’s  accounting  principles  
2. The  subsidiary’s  statements  may  be  expressed  in  a  foreign  currency  different  
from  the  parent’s  currency  
• Process  of  translating  a  foreign  subsidiary’s  financial  statement  into  parent’s  
currency  creates  a  foreign-­currency  translation  adjustment  
o Is  reported  as  part  of  “other  comprehensive  income”  on  the  income  
statement  and  as  part  of  SE  on  the  consolidated  balance  sheet:  
 
• A  translation  adjustment  arises  due  to  changes  in  the  foreign  exchange  rate  over  
time.  In  general,  the  foreign  operation’s:  
o Monetary  assets  and  liabilities  are  translated  into  the  parent’s  currency  at  
the  current  exchange  rate  on  the  date  of  the  statements  
o Non-­‐monetary  assets  and  liabilities  carried  at  historical  cost  (such  as  PPE)  
continue  to  be  measured  using  the  historical  transaction-­‐date  exchange  
rates  
o Shareholders’  equity  is  translated  into  the  parent’s  currency  at  older  
historical  exchange  rates  
 paid-­in  capital  accounts  are  translated  at  the  historical  rate  when  
the  subsidiary  was  acquired  
 retained  earnings  is  translated  at  the  average  rate  of  the  period  
earned  
  The  foreign-­currency  translation  adjustment  is  the  balancing  amount  that  
brings  the  dollar  amount  of  liabilities  and  equity  of  a  foreign  subsidiary  into  
agreement  with  the  dollar  amount  of  total  assets  
  After  the  adjustment  total  liabilities  and  equity  equal  total  assets  
 
 
 
 
 
 
 
 

  59  
Chapter  11  
 
Evaluating  the  Quality  of  Earnings  
Corporations  net  income  (including  EPS)  is  most  important  on  financial  statements  and  
gives  information  to…  
o Shareholders:  the  larger  net  income,  the  greater  likelihood  of  dividends  
o Creditors:  the  larger  net  income,  the  better  the  ability  to  pay  debts  
• Earnings  quality:  the  higher  the  current  EQ  compared  to  the  past,  the  higher  the  
likelihood  to  generate  healthy  earnings  in  future.  Components  of  EQ  are  
1. Proper  revenue  and  expense  recognition  
2. High  and  recurring  gross,  operating  and  net  profit  ratios  
3. Absence  of  changes  in  accounting  policies,  assumptions  and  estimates  to  
boost  earnings  
 
Revenue  recognition  
The  first  component  of  EQ  and  top  of  line  of  the  IS  is  proper  recognition  of  net  revenue  
• The  revenue  recognition  principle  states  that,  under  accrual  accounting,  revenue  
should  be  recognized  when  it’s  earned,  so  it  requires  that…  
a. The  entity  has  transferred  to  the  buyer  the  significant  risks  and  rewards  of  
ownership  of  the  goods  
b. The  entity  retains  neither  continuing  managerial  involvement  to  the  degree  
usually  associated  with  ownership  nor  effective  control  over  the  goods  sold  
c. The  amount  of  revenue  can  be  measured  reliably  
d. It  is  probable  that  the  economic  benefits  associated  with  the  transaction  will  
flow  to  the  entity  
e. The  costs  incurred  or  the  be  incurred  in  respect  of  the  transaction  can  be  
measured  reliably  
 
Cost  of  goods  sold,  gross  profit,  operating  profit  and  net  profit  
After  revenue  the  next  two  important  components  in  EQ  are  COGS  and  gross  profit  
• Cost  of  goods  sold  (COGS):  represent  the  direct  cost  of  goods  sold.  Steadily  
decreasing  COGS  as  percentage  of  net  sales    a  sign  of  increasing  EQ  
• Gross  profit  (gross  margin):  represents  =  net  sales  –  COGS.  Steadily  increasing  
gross  profit    a  sign  of  increasing  EQ.  Other  revenue  (e.g.  interest  revenue)  
should  be  excluded  from  gross  profit  calculations  because  there  are  not  directly  
related  to  merchandise  operations  
• Operating  expenses:  represent  ongoing  expenses  incurred  by  the  entity  (e.g.  
salaries,  supplies).  Steadily  decreasing  OE    a  sing  of  increasing  EQ  
o Function  of  expense  method:  This  method  groups  expenses  into  functional  
categories  (e.g.  marketing-­‐,  administrative  expense)    
 
• Operating  profit:     Gross  profit  
-­‐   Operating  expense  
+   Other  operating  income  
+/-­‐   Exceptional  items    
=   Operating  profit  
o Exceptional  items:  represent  the  financial  effect  of  unusual  happenings  like  an  
attack  of  sharks  with  leaser  weapons  attached  to  their  heads.  The  IFRS  
prohibits  the  use  of  this  category,  even  though  it  may  be  allowed  by  GAAP  

  60  
 • Net  profit:         Operating  profit  
+   Finance  income  (interest  revenue)  
-­‐   Finance  cost  (interest  expense)    
-­‐   Tax  expense  
+   Profit  from  discontinued  operations  
=   Net  profit  
o Profit  on  discontinued  operations:  this  item  is  generally  not  included  
because  it  will  not  continue  to  generate  income  for  the  company  
 
Which  income  number  predicts  future  profits?  
To  estimate  value  of  common  share,  financial  analysts  determine  the  PV  of  the  stream  of  
future  income.    
• This  is  done  by  discounting  future  income  with  the  Investment  Capitalization  
Rate,  which  is  based  on  the  risk  that  the  company  might  not  be  able  to  earn  its  
expected  income  in  future  
Estimated annual income in future
• Estimated value of shares =  
Investment Capitalization Rate
• To  estimate  whether  shares  are  over-­‐  or  undervalued  we  have  to  compare  the  
Estimated  value  of  company  to  the  current  value  of  the  company  
€ • Current market value = shares outstanding × current market price per share  
• The  Investment  rule  may  be  the  following…  
 
If  the  estimated  Value  
€ Of  the  company:               Decision:  
    Exceeds               Buy  share  because  P↑  
           Current  market    
    Equals               Value  of  the        Hold  share  because  P=  
         company  
    Is  less  than               Sell  share  because  P↓  
 
Accounting  changes  
Companies  sometimes  change  account  methods  for  e.g.  depreciation  or  inventory.  This  
makes  it  difficult  to  compare  one  period  with  preceding  periods.  Therefore  account  
policies  should  only  be  changed  if…    
• This  is  required  by  the  accounting  authority  
• The  new  policy  results  in  more  reliable  and  more  relevant  information  
There  are  three  types  of  accounting  changes,  which  are  relevant  for  us  
1. Changes  due  to  new  accounting  standards  or  pronouncements  
2. Changes  in  account  estimates  (change  estimated  life  of  a  building)  
3. Changes  in  account  principles  (e.g.  from  FIFO  to  LIFO)  
a. Then  the  company  has  to  report  figures  for  all  periods  presented  in  the  
income  statement  –past  as  well  as  current–  on  the  new  basis  
Watch  out  for  voluntary  accounting  changes  that  increase  reported  income  
• Managers  may  change  the  accounting  principles  in  order  to  increase  reported  
income  and  to  look  better    quick  and  dirty  way  
 
 
 

  61  
 Correcting  retained  earnings  
• Sometimes  a  company  fails  to  properly  record  an  element  of  financial  
statement.  All  material  prior-­‐period  errors  require  retrospective  restatement  
by  either…or…  
o Restating  the  opening  balances  of  assets,  liabilities  and  equity  for  the  
earliest  prior-­‐period  presented  in  a  set  of  financial  statements  
o If  impractical,  trough  a  prior-­period  adjustment  to  the  beginning  
retained  earnings  in  the  statement  of  changes  in  equity  
 
Reporting  Comprehensive  Income  
Comprehensive  income  is  the  company’s  change  in  total  shareholders  equity  from  all  
sources  other  than  from  the  owners  of  the  business.  It  includes  net  income  or  loss  plus  
the  following,  yet  elsewhere  unrecognized  items:  
• Changes  in  revaluation  surplus  
• Actuarial  gains  and  losses  on  defined  benefit  plans  
• Gains  and  losses  arising  from  translating  the  financial  statements  of  foreign  
operation  
• Gains  and  losses  on  re-­‐measuring  available-­‐for-­‐sale  financial  assets  
• The  effective  portion  of  gains  and  losses  on  hedging  instruments  in  a  cash  
flow  hedge  
  These  items  do  not  enter  the  determination  of  net  income  or  earnings  per  share  
Companies  can  state  comprehensive  income  in  two  ways:  
• Single  statement  
• Two  statements.  First  a  separate  income  statement  followed  by  comprehensive  
income  statement  
 
Earnings  per  share  (EPS)  
Earnings  per  share  (EPS)  is  the  amount  of  a  company’s  net  income  per  share  of  its  
outstanding  common  share  and  a  key  measure  of  business  success  
Net income − preferred dividends
EPS =  
Average number of ordinary shares oustanding
• There  are  two  EPS  computations  
o Basic:  the  currently  outstanding  shares  
€ o Diluted:  adjusted  for  an  potential  increase  in  outstanding  shares  
• Effect  of  preference  dividends  on  earnings  per  share  
o EPS  accounts  for  ordinary  shares.  But  holders  of  preference  shares  have  
first  claim  on  dividends.  Therefore,  preference  dividends  must  be  
subtracted  from  net  income  to  compute  EPS  
 
Earning  from  operations  versus  cash  flow  from  operations  
The  two  key  figures  used  in  financial  analysis  are:  
• Net  income  (income  from  continuous  operations)  
• Cash  flow  from  operations  
  Those  two  figures  may  differ,  because  net  income  recognizes  revenues  and  expenses  
when  they  occur  (revenue  recognition  principle),  but  the  cash  flow  is  based  solely  on  
cash  receipts  and  cash  payments  
 
 
 

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Accounting  for  corporate  income  taxes  
To  account  for  income  tax  the  corporation  measures:  
• Income  tax  expense,  an  expense  on  the  income  statement.  Income  tax  expense  is  
used  in  determining  net  income  
• Income  tax  payable,  a  current  liability  on  the  balance  sheet.  Income  tax  payable  is  
the  amount  of  tax  to  pay  the  government  in  the  next  period    

 
• The  income  statement  and  income  tax  return  are  entirely  separate  documents:  
o The  income  statement  reports  the  results  of  operations  
o The  income  tax  return  is  filed  with  the  tax  authority  to  measure  how  much  
tax  to  pay  the  government  in  the  current  period  
• For  most  companies,  tax  expense  and  tax  payable  differ.  Some  revenues  and  
expenses  affect  income  differently  for  accounting  and  for  tax  purposes.  One  the  
most  common  differences  between  accounting  income  and  taxable  income  occurs  
when  a  corporation  uses  straight-­‐line  depreciation  in  its  financial  statements  and  
accelerated  depreciation  for  the  tax  return  
• For  a  given  year,  Income  tax  payable  can  exceed  income  tax  expense.  This  occurs  
when  because  of  differences  in  revenue  and  expenses  for  book  and  tax  purposes,  
taxable  income  exceeds  book  income.  When  that  occurs,  the  company  debits  a  
deferred  tax  asset.  
 
Analyzing  the  statement  of  changes  in  equity    
The  statement  of  changes  in  equity  reports  the  reasons  for  all  the  changes  in  the  
shareholders’  equity  section  of  the  balance  sheet  during  a  period  
 
Responsibility  for  the  financial  statements  
Managements  Responsibility  
• Management  issues  a  report  on  internal  control  over  financial  reporting,  along  
with  financial  statements  
• Management  declares  its  responsibility  for  the  internal  controls  over  financial  
reporting.  Moreover  it  states  that  is  has  monitored  the  effectiveness  of  these  
controls  including  assurances  from  both  internal  and  external  auditors  
Audit  Report  
Respective  jurisdiction’s  corporation  or  company  law  legally  places  the  requirement  for  
audit  of  financial  statements.  Companies  engage  external  auditors  who  are  certified  
public  accountants  to  examine  their  financial  statements  
• Addressed  to  board  of  directors  and  shareholders  of  the  company  
• Audio  report  contains  four  sections  
1. Section  identifies  audited  financial  statements  as  well  as  the  company  
being  audited  
2. Section  outlines  responsibility  of  management  and  auditor  
3. Section  describes  how  the  audit  was  performed  in  accordance  with  the  
accounting  standards  
4. Section  expresses  the  auditor’s  combined  opinion  on  the  financial  
statements.  Unqualified  option  is  the  highest  statement  of  assurance  

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Chapter 12 – The Statement of Cash Flow
Basic Concepts: The Statement of Cash Flows
• Statement of cash flows reports cash flows (cash receipts and cash payments)
• Statement covers a span of time; dated at year end
• Purposes of cash flow statement:
1. Predicts future cash flows
2. Evaluates management decisions (how managers got cash and how they used it)
3. Shows the relationship of net income to cash flows (usually high net income leads
to an increase in cash, and vice versa)
• Cash includes cash in bank but also cash equivalents thus highly liquid short-term
investments that can be converted into cash immediately (money market accounts,
investments in US government securities)

How’s your cash flow? Telltale signs of financial difficulty

• Net income measures success and companies need cash to pay bills
• Net income generates cash but sometimes they take different paths
• Indicators of trouble:
o Too little cash (current, acid-test ratio)
o Too low inventory turnover (inventory turnover ratio)
o Too long time to collect cash (accounts receivable turnover ratio)
• you need net income as wells as strong cash flow to succeed in business

Operating, Investing, and Financing Activities

• Operating activities: create revenues, expenses, gains, and losses = net income, which
is a product of accrual-basis accounting)
o A successful business must generate most of its cash from operating activities!
o Most important of these three categories
• Investing activities: increase and decrease long-term assets (land, buildings,
equipment, investments in other companies); purchases and sales of these assets
• Financing activities: obtain cash from investors and creditors (issue share, borrow
money, buy and sell treasury share, pay cash dividends, paying off loan); relate to
long-term liabilities and shareholders equity; least important

Technical Update:
· IAS7 allows for alternatives classifications:
o Interest paid, usually categorized as an operating cash flow item, may be
classified as financing cash flow Items
o Interest and dividends received, usually classified as operating cash flow
items, may be classified as investing cash flow items
o Dividends paid, usually categorized as a financing cash flow item, may be
classified as cash flow from operations

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Two formats for operating activities
• Indirect method: reconciles from net income to net cash provided by operating
activities
• Direct method: reports all cash receipts and cash payments from operating activities
 The computations are different but they produce the same figure for cash from
operating activities. They do not affect investing or financing activities
 IAS7 actually advocated for the direct method because it provides Information which
may be useful in estimating future cash flows

Preparing the Statement of Cash flows: indirect method

• Operating activities are related to the transactions that make up net income
• Begins with net income taken from income statement an makes adjustments to
reconcile net income to net cash provided by operating activities

• Step 1: Start with net income from the income statement

• Step 2: From the income statement add back depreciation, depletion and amortization
expense and remove any gains (or add back losses) on the sale of long-term assets
• Step 3: Examine the balance sheet identify changes in current assets and current
liabilities except for cash and cash equivalents
• Step 4: Deduct increases in current assets other than cash and add decreases in current
assets other than cash
• Deduct decreases in current liabilities and add increases in current liabilites

Depreciation, Depletion, and Amortization Expenses

• Depreciation has no effect on cash but like all other expenses, it decreases net income
• Therefore add depreciation back to net income (cancels earlier deductions)

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Gains and Losses on the Sale of an Asset
• The proceeds from sale of long-term assets are reported in the cash flow from
investing activities
o Resulting gains (or losses) from the sale are included in net income
o To avoid double counting
 Losses are added back to net income
 Gains are deducted from net income

Changes in the Current Asset and Current Liability Accounts

• Most current assets and current liabilities result from operating activities (accounts
receivables from sales, inventory relates to COGS)
• Changes in current accounts are adjustments to net income on the cash flow statement
1. An increase in another current asset decreases cash. Suppose you make a sale
on account. Accounts receivables are increased and thus is net income, but
cash is not collected yet.
2. A decrease in another current asset increases cash. Cash receipts cause
accounts receivable to decrease, so add decreases in accounts receivable
3. A decrease in a current liability decreases cash. The payment of a liability
decreases both cash and the liability
4. An increase in a current liability increases cash. Suppose your accounts
payable increased. Than can occur only when cash was not spend to pay this
debt. Thus increase cash

Evaluating Cash Flows from Operating Activities

• Net cash flow should exceed net income because of the add-back of depreciation

Preparing Cash Flows from Investing Activities

• Cash flows from investing activities basically revolve around the cash inflows and
outflows related to long-term assets of the entity

• Computing Purchases and Sales of PP

• Computing Purchases and Sales of Investments, and Loans and Collections
Receipts
From sale of PPE Beginning + Acquisition cost - Depreciation - Book value of = Ending
PPE, net assets sold PPE, net
Cash received = Book value of + Gain on sale
assets sold or
- Loss on sale
From sale of Beginning + Purchase cost - Cost of = Ending
investments investments of investments investments investments
sold
Cash received = Cost of + Gains on sale
Investments or
sold - Loss on sale
From collection Beginning + New loans - Collections = Ending notes
of notes notes made receivable
receivable receivable
Payments
For acquisition Beginning + Acquisition cost - Depreciation - Book value of = Ending
of PPE PPE, net assets sold PPE, net
For purchase of Beginning + Purchase cost - Cost of = Ending
investment investments of investments investments investments
sold
For new loans Beginning + New loans - Collections = Ending notes
made notes made receivable
receivable

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Preparing Cash Flows from Financing activities
• Financing activities affect liabilities and shareholders equity (notes payable, bonds
payable, long-term debt, common share, paid-in capital in excess of par, retained
earnings)
• Computing Issuance and Payments of long-term debt
• Computing Issuance of Share and Purchases of Treasury Shares
• Computing Dividend Declarations and Payments
Receipts
From Beginning + Cash received from - Payment of debt = Ending long-term debt
Borrowing - long-term issuance of long-term
Issuance of debt debt
long-term
debt
From Beginning + Cash received from - Share cancellations = Ending share capital
issuance of share capital issuance of new shares
share
Payments
Of long- Beginning + Cash received from - Payment of debt = Ending long-term debt
term debt long-term issuance of long-term
debt debt
To purchase Beginning + Purchase cost of = Ending treasury share
treasury treasury treasury share
share share
Of dividends Beginning + Net Income - Dividend payment = Ending retained
retained earnings
earnings

Noncash investing and financing activities

• Investments that do not require cash
• Financing other than cash
o Issue common share to acquire a warehouse
o Would not be recorded as cash payment; no cash paid
 Noncash investing and financing activities can be reported in a separate schedule
Preparing the Statement of Cash Flows: Direct method
• IAS7 advocated the direct method of reporting operating cash flows because it
provides clearer information about the sources and uses of cash
• But very few use it because takes more computations than the indirect method
• Investing and financing cash flows are unaffected by the operating cash flows

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• SEE BOOK FOR COMPUATIONS UNDER DIRECT METHOD (p. 735-738)

Measuring Cash adequacy: free cash flow

• How much cash can a company “free up” for new opportunities?
• Free cash flow is amount of cash available from operations after paying for planned
investments in plant asset
• A large amount of FCF is generally preferable because it means that a lot of cash is
available for new investments

Examining Cash Flow Patterns

• Company's cash flows should be examined over a period of time, not just at the end of
one financial year:
o Simple but insightful cash flow analysis is to simply plot the cash flow patterns
over a number of years

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 Chapter 13 - Financial Statement Analysis
Horizontal Analysis
• Horizontal analysis is the study of percentage changes from year to year
• Two steps
o Compute amount of change from period to period
o Divide amount of change by base-period amount

Trend percentages
• Trend percentages indicate the direction a business is taking
o Computed by selecting base year whose amounts are set equal to 100%. The
amount for each following year is stated as a percentage of the base amount.
To compute a trend percentage divide an item for a later year by the base-year
amount

Any periods amount

Trend % =
Base periods amount

Vertical analysis
€
• Vertical analysis shows the relationship of financial-statement items relative to a total,
which is the 100% figure
o All items are reported as a percentage of the base
o For the income statement total revenue is usually the base

Each income statment item

Vertical Analysis % =
Total revenue

Benchmarking
€ • Benchmarking simply means comparing on entity to the other
o usually direct competitors are selected for benchmarking
• most important aspect is that it gives you context in which you could interpret one
data

Common-size statement
• When comparing financial statements side-by-side this is called Common-size
statement
o All amounts are stated in percentages
 Size and currency differences are eliminated

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Using ratios to make business decisions

Limitations of ratio analysis

· Only signals that something is wrong but does not identify the problem
o Analyze figures to learn what caused ratio to fall
o Analyze ratios over period of years to consider all relevant factors

Financial ratios
1. Ability to pay current liabilities
2. Cash conversion cycle
3. Ability to pay long-term debt
4. Profitability
5. Analyze shares as an investment

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Other Issues in Financial Statement Analysis

Economic Value added (EVA)

• Is used to evaluate operating performance
• All amounts except the cost of capital come the financial statements
o Cost of capital is the weighted average of the returns demanded by the
company’s shareholders and lenders
• Idea behind EVA is that the returns to the company’s shareholders and to its creditors
should exceed the company’s capital charge
o capital charge is the amount that shareholders and lenders charge a company
for the use of their money

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Red Flags in Financial Statement Analysis
• The following conditions may mean a company is very risky
o Earnings problems
o Decreased cash flow
o Too much debt
o Inability to collect receivables
o Buildup of inventories
o Trends of sales, inventory, receivables should move together

Efficient Markets
• An efficient capital market is one in which market prices fully reflect all information
available to the public.
 Share prices reflect all publicly accessible data

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