Cfa L1 Session07

Study Session 7 Accounting Basic Concepts
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Study Session 07
Basic Concepts

PreIiminary Readings

A. Measuring Business Income

a. explain why financial statements are prepared at the end of the regular accounting
period.

Major Financial Statements:
The balance sheet: provides a "snapshot" oI the Iirm's Iinancial condition.
The income statement: reports on the "perIormance" oI the Iirm.
The statement of cash flows: reports the cash receipts and cash outIlows classiIied
according to operating, investment and Iinancing activities.
The statement of stockholder's equity: reports the amounts and sources oI changes
in equity Irom transactions with owners.
The footnotes of the financial statements: allow uses to improve assessment oI the
amount, timing and uncertainty oI the estimates reported in the Iinancial statements.

The most accurate way to measure the results oI enterprise activity would be to measure
them at the time oI the enterprise's eventual liquidation. Business, government, investors,
and various other user groups, however, cannot wait indeIinitely Ior such inIormation. II
accountants did not provide Iinancial inIormation periodically, someone else would.

The periodicitv or time period assumption simply implies that the economic activities oI
an enterprise can be divided into artiIicial time periods. These time periods vary, but the
most common are monthly, quarterly, and yearly.

The inIormation must be reliable and relevant. This requires that inIormation must be
consistent and comparable over time and also be provided on a timely basis. The shorter
the time period, the more diIIicult it becomes to determine the proper net income Ior the
period. A month's results are usually less reliable than a quarter's results, and a quarter's
results are likely to be less reliable than a year's results. Investors desire and demand that
inIormation be quickly processed and disseminated; yet the quicker the inIormation is
released, the more it is subject to error. This phenomenon provides an interesting
example oI the trade-oII between relevance and reliability in preparing Iinancial data.
In practice, Iinancial reporting is done at the end oI the accounting period.
Accounting periods can be any length in time. Firms typically use the year as the
primary accounting period. The 12-month accounting period is reIerred to as the

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Iiscal year. Firms also report Ior periods less than a year (e.g. quarterly) on an
interim basis.
Accounting period must be oI equal length. Financial statements are prepared at
the end oI the regular accounting period to allow comparison across time.

b. explain why the accounts must be adjusted at the end of each period.

Why?

Most external transactions are recorded when they occur. The employment oI an accrual
system means that numerous adjustments are necessary beIore Iinancial statements are
prepared because certain accounts are not accurately stated.

Some external transactions might not even seem like transactions and are recognized
only at the end oI the accounting period. Examples include unrecorded revenues and
credit purchase.

Some economic activities do not occur as the result oI external transactions.
Examples include depreciation and the expiration oI prepaid expenses.

Timing: OIten a transaction aIIects the revenue or expenses oI two or more
accounting periods. The related cash inIlow or outIlow does not always coincide with
the period in which these revenue or expense items are recorded. Thus, the need Ior
adjusting entries results Irom timing diIIerences between the receipt or disbursement
oI cash and the recording oI revenue or expenses. For example, iI we handle
transactions on a cash basis, only cash transactions during the year are recorded.
Consequently, iI a company's employees are paid every two weeks and the end oI an
accounting period occurs in the middle oI these two weeks, neither liability nor
expense has been recorded Ior the last week. To bring the accounts up to date Ior the
preparation oI Iinancial statements, both the wage expense and the wage liability
accounts need to be increased.

A necessary step in the accounting process, then, is the adjustment oI all accounts to an
accrual basis and their subsequent posting to the general ledger. Adjusting entries are
thereIore necessary to achieve a proper matching oI revenues and expenses in the
determination oI net income Ior the current period and to achieve an accurate statement
oI the assets and equities existing at the end oI the period.

Adfustment principles
The revenue recognition principle
The matching principle


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What to adjust?

Each adjusting entry aIIects both a real account (assets, liability, or owner's equity) and a
nominal or income statement account (revenue or expense). The Iour basic types oI
adjusting entries are:

deIerred expenses that beneIits more than one period: Ior example, prepaid expenses
(e.g. prepaid insurance, rent) are expenses paid in advance and recorded as assets
beIore they are used or consumed. When these assets are consumed, expenses should
be recognized: a debit to an expense account and a credit to an asset account. Another
example is depreciation. The cost oI a long-term asset is allocated as an expense over
its useIul liIe. At the end oI each period depreciation expense is recorded through an
adjusting entry: a debit to a depreciation expense account and a credit to an
accumulated depreciation account (a contra account used to total the past
depreciation expenses on speciIic long-term assets).

accrued expenses that incurred but not yet paid or recorded: examples are employee
salaries and interest on borrowed money. At the end oI the accounting period, the
accrued expense is recorded through an adjusting entry: a debit to an expense account
(i.e. Salaries Expense) and a credit to a liability account (i.e. Salaries Payable).

accrued revenues that earned but not yet received or recorded: also called
unrecorded revenues. Examples include interest revenues, rent revenues, etc. Such
revenues accumulate with the passing oI time, but the Iirm may have not received the
payment or billed the client. An adjusting entry should be: a debit to an asset account
(i.e. Accounts Receivable) and a credit to a revenue account (i.e. Interest Revenue).

unearned revenues that are revenues received in cash beIore delivery oI
goods/services: examples are magazine subscription Iees, customer deposits Ior
services. These "revenues" are not earned yet and thus should be recorded as
liabilities. An adjusting entry should be: a debit to a liability account (i.e. Unearned
Revenue) and a credit to a revenue account (i.e. Revenue).

c. explain why the accrual basis of accounting produces more useful income
statements and balance sheets than the cash basis.

Revenue is something earned through the sale oI goods or services. Not all cash receipts
are revenues; Ior example, cash received through a loan is not revenue. Expenses are the
cost oI goods or services used to generate revenues. Not all cash payments are expenses;
Ior example, cash dividends paid to stockholders are not expenses. Net income is the
diIIerence between revenues and expenses. It is reported on the income statement, and is
the Iocus in evaluating a Iirm's proIitability.

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Most companies use the accrual basis accounting, recognizing revenue when it is
earned (the goods are sold or the services perIormed) and recognizing expenses in the
period incurred, without regard to the time oI receipt or payment oI cash.Net income is
revenue earned minus expenses incurred.

Under the strict cash basis accounting, revenue is recorded only when the cash is
received and expenses are recorded only when the cash is paid. Net income is cash
revenue minus cash expenses. The matching principle is ignored here, resulting
inconIormity with generally accepted accounting principles.

Today's economy is considerably more lubricated by credit than by cash. And the accrual
basis, not the cash basis, recognizes all aspects oI the credit phenomenon. Investors,
creditors, and other decision makers seek timely inIormation about an enterprise's Iuture
cash Ilows. Accrual basis accounting provides this inIormation by reporting the cash
inIlows and outIlows associated with earnings activities as soon as these cash Ilows can
be estimated with an acceptable degree oI certainty. Receivables and payables are
Iorecasters oI Iuture cash inIlows and outIlows. In other words, accrual basis accounting
aids in predicting Iuture cash Ilows by reporting transactions and other events with cash
consequences at the time the transactions and events occur, rather than when the cash is
received and paid. Accrual accounting generally provides a better indication oI
perIormance than cash basis oI accounting since it increases the comparability oI income
statements and balance sheets across periods.


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B. Financial Reporting and Analysis

a. define each asset and liability category on the balance sheet and prepare a classified
balance sheet.

Think oI the balance sheet as a photo oI the business at a speciIic point in time. It
presents the assets, liabilities, and the equity ownership oI a business entity as oI a
speciIic date.
Assets are the economic resources controlled by the Iirm.
Liabilities are the Iinancial obligations that the Iirm must IulIill in the Iuture.
Liabilities are typically IulIilled by payment oI cash. They represent the source oI
Iinancing provided to the Iirm by the creditors.
Equity Ownership is the owner's investments and the total earnings retained Irom
the commencement oI the Iirm. Equity represents the source oI Iinancing provided to
the Iirm by the owners.

Balance sheet accounts are classiIied so that similar items are grouped together to arrive
at signiIicant subtotals. Furthermore, the material is arranged so that important
relationships are shown.

The table below indicates the general Iormat oI balance sheet presentation:
Balance Sheet Classifications
Assets Liabilities and Owner's Equity
Current Assets Current liabilities
Long-term investments Long-term debt
Property, plan and equipment Owner's equity
Intangible assets Capital stock
Other assets Additional paid-in capital
Retained earnings

Current Assets:
They are cash and other assets expected to be converted into cash, sold, or consumed
either in one year or in the operating cycle, whichever is longer. The operating cycle is
the average time between the acquisition oI materials and supplies and the realization oI
cash through sales oI the product Ior which the materials and supplies were acquired. The
cycle operates Irom cash through inventory, production, and receivables back to cash.
Where there are several operating cycles within one year, the one-year period is used. II
the operating cycle is more than one year, the longer period is used.

Current assets are presented in the balance sheet in order oI liquidity. The Iive major
items Iound in the current asset section are:
Cash: valued at its stated value. Cash restricted Ior purpose other than payment oI
current obligations or Ior use in current operations should be excluded Irom the
current asset section.
Marketable securities: Also reIerred to as marketable securities. Valued at cost or
lower oI cost and market.

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Accounts receivables: amounts owed to the Iirm by its customers Ior goods and
services delivered. Valued at the estimated amount collectible.
Inventories: Products that will be sold in the normal course oI business.
Prepaid expenses: they are expenditures already made Ior beneIits (usually
services) to be received within one year or the operating cycle, whichever is
longer. Typical examples are prepaid rent, advertising, taxes, insurance policy,
and oIIice or operating supplies. They are reported at the amount oI un-expired or
unconsumed cost.

Long-Term Investments:
OIten reIerred to simply as investments, they are to be held Ior many years, and are not
acquired with the intention oI disposing oI them in the near Iuture. They normally consist
oI one oI Iour types:
Investments in securities such as bonds, common stock, or long-term notes that
management does not intend to sell within one year.
Investments in tangible Iixed assets not currently used in operations, such as land
held Ior speculation.
Investments set aside in special Iunds such as a sinking Iund, pension Iund, or
plant expansion Iund. The cash surrender value oI liIe insurance is included here.
Investments in non-consolidated subsidiaries or aIIiliated companies.

Property, Plant, and Equipment:
They are properties oI a durable nature used in the regular operations oI the business.
With the exception oI land, most assets are either depreciable (such as building) or
consumable.

Intangible Assets:
They lack physical substance and usually have a high degree oI uncertainty concerning
their Iuture beneIits. They include patents, copyrights, Iranchises, goodwill, trademarks,
trade names, secret processes, and organization costs. Generally, all oI these intangibles
are written oII (amortized) to expense over 5 to 40 years.

Other Assets:
They vary widely in practice. Examples include deIerred charges (long-term prepaid
expenses), non-current receivables, intangible assets, assets in special Iunds, and
advances to subsidiaries.

Current Liabilities:
They are obligations that are reasonably expected to be liquidated either through the use
oI current assets or the creation oI other current liabilities. They are not reported in any
consistent order. A typical order is: Notes payable, accounts payable, accrued items (e.g.
accrued warranty costs, compensation and beneIits) income taxes payable, current
maturities oI long-term debt, etc.

The excess oI total current assets over total current liabilities is reIerred to as working
capital. It represents the net amount oI a company`s relatively liquid resources; that is, it

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is the liquid buIIer, or margin oI saIety, available to meet the Iinancial demands oI the
operating cycle.

Long-Term Liabilities:
They are obligations that are not reasonably expected to be liquidated within the normal
operating cycle but, instead, at some date beyond that time. Bonds payable, notes payable,
deIerred income taxes, lease obligations, and pension obligations are the most common
long-term liabilities. Generally they are oI three types:
Obligations arising Irom speciIic Iinancing situations, such as issuance oI bonds,
long-term lease obligations, and long-term notes payable.
Obligations arising Irom the ordinary operations oI the enterprise such as pension
obligations and deIerred income tax liabilities.
Obligations that are dependent upon the occurrence or non-occurrence oI one or
more Iuture events to conIirm the amount payable, or the payee, or the date
payable, such as service or product warranties and other contingencies.

Owner's Equity:
The complexity oI capital stock agreements and the various restrictions on residual equity
imposed by state corporation laws, liability agreements, and boards oI directors make the
owner's equity section one oI the most diIIicult sections to prepare and understand. The
section is usually divided into three parts:
Capital stock: the par or stated value oI the shares issued.
Additional paid-in capital: the excess oI amounts paid in over the par or stated
value.
Retained earnings: the corporation's undistributed earnings.

b. define each component of a multi-step income statement and prepare a multi-step
income statement.

The income statement measures the success oI business operations Ior a given period oI
time. A single-step income statement groups revenues together and expenses together,
without Iurther classiIying each oI the groups. A multi-step income statement makes
Iurther classiIications to provide additional important revenue and expense data. These
classiIications make the income statement more inIormative and useIul. It is
recommended because:
it recognizes a separation oI operating transactions Irom non-operating transactions;
it matches costs and expenses with related revenues;
it highlights certain intermediate components oI income that are used Ior the
computation oI ratios used to assess the perIormance oI the enterprise.

Components:

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Operating section: a report oI the revenues and expenses oI the company's
principal operations.
Sales or revenue section: a subsection presenting sales, discounts,
allowances, returns, and other related inIormation, and to arrive at the net
mount oI sales revenue.
Cost oI goods sold section: a subsection that shows the cost oI goods that
were sold to product the sales.
Selling expense: a subsection that lists expenses resulting Irom the
company's eIIorts to make sales.
Administrative or general expenses: a subsection reporting expenses oI
general administration.
Non-operating section: a report oI revenues and expenses resulting Irom
secondary or auxiliary activities oI the company. In addition, special gains and
losses that are inIrequent or unusual, but not both, are normally reported in this
section. Generally these items break down into two main subsections:
Other revenues and gains: A list oI the revenues earned or gains incurred,
generally net oI related expenses, Irom non-operating transactions.
Other expenses and losses: A list oI the expenses or losses incurred,
generally net oI any related incomes, Irom non-operating transactions.
Income taxes: A short section reporting Iederal and state taxes levied on income
Irom continuing operations.
Discontinued operations: material gains or losses resulting Irom the disposition
oI a segment oI the business.
Extraordinary items: Unusual AND inIrequent material gains and losses.
Cumulative effect of a change in accounting principle.
Earnings per share.


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C. Short-Term Liquid Assets

a. describe how to choose the appropriate accounting method for investment securities
and explain how fair (market) value gains and losses on such investments are reported.

Short-term investments, also called marketable securities, ordinarily consist oI short-
term paper (certiIicates oI deposit, treasury bills, and commercial paper), marketable debt
securities (government and corporate bonds), and marketable equity securities (preIerred
and common stock) acquired with cash not immediately needed in operations.

They must be:
readily marketable: can be sold quite easily.
intended to be converted into cash as needed within one year or the operating cycle,
whichever is longer. Securities that are intended to be held Ior more than one year are
called long-term investments.

There are two types oI gains and losses:
Realized gains and losses: the diIIerence between the Iair market value and the cost
oI the securities when they are sold.
Unrealized holding gains and losses: the diIIerence between the Iair market value
and the cost oI the securities when they are still held by the Iirm. The gains and losses
are unrealized because securities have not been sold.

In general:
When securities are purchased, they are recorded at cost. The cost oI the securities
includes purchase price and any broker's Iees or Iees paid to acquire securities.
Interest and dividends generally are recognized as revenue when they are received.
When securities are sold, the cost is compared to the sales price, and the diIIerence is
recorded as a gain or a loss.
At the end oI each accounting period, the balance oI the controlling account is
adjusted to reIlect the current market value oI the securities owned.

However, diIIerent categories oI investment securities have diIIerent treatment on
unrealized holding gains and losses.

Held-to-maturity securities: Debt securities that management intends to hold to
their maturity date. At year end, they are reported at cost adjusted Ior the eIIect oI
interest (debit the securities account and credit interest income account), and
unrealized holding gains and losses are not recognized.

Trading securities: Debt and equity securities bought and held mainly Ior sale in the
near term to generate income on price changes. At year end, they are reported at their
Iair market value. Any unrealized holding gains or losses are recognized on the Iirm's
income statement as part oI the net income. When they are sold, the realized gains or
losses will also appear on the income statement. Realized gains and losses are not
aIIected by any unrealized gains or losses recognized beIore.

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Example:
1. 12/1/2002, 100 shares purchased at $80 per share Ior trading purposes:
Entry: Trading Securities 8000(Debit) , Cash 8000 (Credit)
2. 12/31/2002, the price is $60 per share.
Entry: Unrealized Loss on Investments 2000 (Debit) , Allowance to Adjust
Short-Term Investments to Market 2000 (Credit).
The allowance account is shown on the balance sheet as a contra-asset account:
Trading Securities (at cost) 8000
Allowance Account (2000)
Trading Securities (at market) 6000
The $2000 unrealized loss is reported in the income statement Ior 2002.
3. 06/12/2003, 100 shares sold at $120 per share.
Entry: Cash 12000 (Debit) , Trading Securities 8000 (Credit) , Realized Gain
on Investment 4000 (Credit)
The $4000 realized gain is reported in the income statement oI 2003.

Available-for-sale securities: Debt and equitv securities not classiIied as held-to-
maturity or trading securities. The unrealized gains and losses are reported in the
balance sheet as an adjustment to the shareholders' equity (in contrast, the unrealized
gains or losses oI trading securities are reported in the income statement as part oI the
net income). Other than that, they are accounted Ior in the same way as trading
securities.
Example:
1. 12/1/2002, 100 shares purchased at $80 per share Ior trading purposes:
Entry: Available-Ior-Sale Securities 8000(Debit) , Cash 8000 (Credit)
2. 12/31/2002, the price is $60 per share.
Entry: Unrealized Loss on Investments 2000 - Equity (Debit) , Allowance to
Adjust Short-Term Investments to Market 2000 (Credit).
The allowance account is shown on the balance sheet as a contra-asset account:
Available-Ior-Sale Securities (at cost) 8000
Allowance Account (2000)
Available-Ior-Sale Securities (at market) 6000
The $2000 unrealized loss is reported in the balance sheet Ior 2002 as a
component oI stockholder's equity.
3. 06/12/2003, 100 shares sold at $120 per share.
Entry: Cash 12000 (Debit) , Trading Securities 8000 (Credit) , Realized Gain
on Investment 4000 (Credit)
The $4000 realized gain is reported in the income statement oI 2003.

b. describe how to account for transactions with credit customers, including
accounting for bad debts under the allowance method or the direct write-off method.
Background

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Two measures are used to assess the eIIective oI a Iirm's credit policies:
1. Receivable turnover Net Sales / Average Net Account Receivable: it
shows how many times the receivables are turned over during the accounting
period.
2. Average days' sales uncollected 365 days / Average Net Accounts
Receivable: it shows how long it takes to collect accounts receivable.

Four ways to Iinance receivables:
1. Pledge accounts receivable as collateral Ior borrowing.
2. Sell or transIer accounts receivable to another entity. This practice is called
factoring. Factoring can be done with recourse (the seller is liable to the
buyer iI any receivable iI not collected: the seller has a contingent liability,
which can develop into a real liability iI the customer deIaults on the payment
oI the receivables.)or without recourse (the buyer oI the receivables bears any
losses Irom uncollected accounts).
3. Sell securities backed by receivables. This practice is known as securitization.
4. Sell notes receivable to a bank. This practice is known as discounting,
because the bank deducts the interest Irom the maturity value oI the notes and
then pay the remaining value to the seller.

Account Receivables arise Irom sales to customers who do not immediately pay cash.
There are always some customers who cannot or will not pay their debts. The accounts
owed by these customers are called uncollected accounts. ThereIore, accounts
receivables are valued and reported at net realizable value - the net amount expected to
be received in cash, which is not necessarily the amount legally receivable. The chieI
problem in recording uncollectible accounts receivable is establishing the time at which
to record the loss. Two methods are used to account Ior uncollected accounts:

Allowance Method:

Under the allowance method, the portion oI each period's credit sales expected to prove
uncollectible is estimated. This estimated amount is recorded by a debit to Uncollectible
Accounts Expense and a credit to the contra-asset account Allowance Ior DoubtIul
Accounts. When speciIic accounts are determined to be uncollectible, they are written oII
by debiting Allowance Ior DoubtIul Accounts and crediting Accounts Receivable.

Advocates oI the allowance method believe that bad debt expense should be recorded in
the same period as the sale to obtain a proper matching oI expenses and revenues and to
achieve a proper carrying value Ior accounts receivable. In practice, the estimate oI bad
debt is made either on the percentage oI sales basis (income statement approach) or
outstanding receivables basis (balance sheet approach).

II E. T. Elsner's Inc. had $20,000 oI credit sales and it collected $6,000 out oI it in the
year oI 2000.
Accounts Receivable 20,000

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Sales 20,000
Cash 6,000
Accounts Receivable 6,000

At year end it is estimated that oI the $14,000 balance in accounts receivable, $1,000 will
ultimately be uncollectible.
Bad Debt Expense 1,000
Allowance Ior DoubtIul Accounts 1,000

The bad debt expense decreased net income under the matching concept, and the
allowance Ior doubtIul accounts decreases the account receivable on the balance sheet to
its net realizable value oI $13,000.

In March 2001, it was learned the one customer who owed the Iirm $200 had declared
bankruptcy. No bad expense would be incurred by this accident since the Iirm had
already established allowance Ior it:
Allowance Ior DoubtIul Accounts 200
Accounts Receivable 200

There are two methods to estimate the uncollectible accounts:

Percentage of Net Sales Method: uncollectible accounts expense is estimated as a
percentage oI net sales during this period. In many businesses, net sales approximates
net credit sales. Note that any previous balance in the allowance account is irrelevant
in preparing the adjustment. This method matches costs with revenues because it
relates the expense to the period in which the sales is recorded.

Accounts Receivable Aging Method: the estimate is made Irom the total oI outstanding
receivables. It involves Iive steps:
1. List each customer's receivable account according to its due date.
2. IdentiIy the accounts that are past due, and categorize them on the basis oI
days past due.
3. For each category, estimate the percentage uncollectible, and then multiply the
percentage by the accounts past due to compute the uncollectible accounts.
4. Add up the uncollectible accounts in each category to determine the target
balance oI Allowance Ior Uncollectible Accounts.
5. Determine the amount oI adjustment Ior Allowance Ior Uncollectible
Accounts.

Note this method does not Iit the concept oI matching expenses and revenues.

Direct Write-Off Method:
Under this method, uncollectible accounts are charged to expense in the period that they
are determined to be worthless. No entry is made until a speciIic account has deIinitely
been established as uncollectible. Then the loss is recorded by crediting Accounts
Receivable and debiting Bad Debt Expense.

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Under this method the Iirm would only recognize bad debt expense in March 2001:
Bad Debt Expense 200
Accounts Receivable 200

This method is easy and convenient to apply. It is used Ior income tax calculations and by
Iirms with immaterial bad debts. However, it usually does not match costs with revenues
oI the period, nor does it result in receivables being stated at estimated realizable value on
the balance sheet. However, only the direct write-oII method may be used in income tax
returns.


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D. Inventories

a. describe how the choice of inventory system or method affects the financial
statements.

Inventories are considered a current asset because they are typically sold within one year
or one operating cycle. Two ratios are used to evaluate the level oI inventories:
Inventory turnover (Cost oI Goods Sold / Average Inventory) shows how many
times the average inventory is sold during the account period.
Average days' inventory on hand (365 days / Inventory Turnover) shows how long
it takes to sell the inventory on hand.

Two basic issues oI inventory accounting:
Determine the cost oI goods available Ior sale: Beginning Inventory Purchases.
Allocate the cost oI goods available Ior sale between two components: CPGS
Beginning Inventory Purchases - Ending Inventory. The ending inventory is
reported on the balance sheet and carried over to the next period.

The choice oI inventory system or method aIIects Iinancial numbers. For example, the
Iollowing is the comparison between LIFO and FIFO:
FIFO LIFO
Income Statement
COGS Lower Higher
Taxes Higher Lower
Net Income Higher Lower
Balance Sheet
Inventory Balance Higher Lower
Working Capital Higher Lower
Cash Flow Statement
Cash Flows Lower Higher

The advantages oI LIFO are:
Matching: current costs are matched against revenues and inventory proIits are
thereby reduced.
Tax benefits: they are the major reason why LIFO has become popular. As long
as the price level increases and inventory quantities do not decrease, a deIerral oI
income tax occurs. "Whatever is good Ior tax is good Ior Iinancial reporting".
Improved cash flow: It is related to the tax beneIits, because taxes must be paid
in cash.
Future earnings hedge: With LIFO, a company's Iuture reported earnings will
not be aIIected substantially by Iuture price declines. Since the most recent
inventory is sold Iirst, there isn't much ending inventory sitting around at high
prices vulnerable to a price decline.

The disadvantages oI LIFO:

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Reduced earnings: many managers just rather have higher reported proIits than
lower taxes. However, non-LIFO earnings are now highly suspect and may be
severely penalized by Wall Street.
Inventory understated: LIFO may have a distorting eIIect on a company's
balance sheet. It makes the working capital position oI the company appear worse
than it really is.
Physical flow: LIFO does not approximate the physical Ilow oI the items except
in peculiar situations.
Current cost income not measured: LIFO Ialls short oI measuring current cost
(replacement cost) income though not as Iar as FIFO. Using replacement cost is
reIerred to as the next-in, Iirst-out method, which is not acceptable Ior purposes oI
inventory valuation.
Inventory liquidation: II the base or layers oI old costs are eliminated, strange
results can occur because old, irrelevant costs can be matched against current
revenues. The income tax problem is particularly severe when the involuntary
liquidation results Irom a strike or a shortage oI materials: in these situations,
companies may incur high tax bills when they can least aIIord to pay taxes.
Poor buying habits: a company may attempt to manipulate its net income at the
end oI the year simply by altering its pattern oI purchases.

b. define inventory cost.

To determine inventory cost, we need to determine:
The physical goods to be included in inventory: who owns the goods?
Goods in transit: need to apply the "passage oI title" rule.
Consigned goods: they remain the property oI the consignor and must be
included in the consignor's inventory at purchase price or production cost.

The costs to be included in inventory: production costs, invoice price (net oI discount),
transportation costs, taxes, etc. In principle, costs Ior ordering, receiving and storing
should also be included in inventory cost. However, in practice it's diIIicult to allocate
these costs to speciIy inventory items. ThereIore, these costs are typically expensed in
the accounting period instead oI being considered inventory costs.

The cost Ilow assumption to be adopted: speciIic identiIication, average cost, FIFO,
LIFO, retail, etc. It may or may not reIlect the physical Ilow oI inventory.


CFACENTER.COM 16
c. calculate the cost of an inventory based on (1) the specific identification method, (2)
the average-cost method, (3) first in, first out (FIFO), and (4) last in, first out (LIFO).

In some cases, it's possible to speciIically identiIy which inventory items have been sold
and which remain. By the specific identification method, the actual costs oI the speciIic
units sold are transIerred Irom inventory to the cost oI goods sold. (Debit Cost oI Goods
Sold; credit Inventory.) This method achieves the proper matching oI sales revenue and
cost oI goods sold when the individual units in the inventory are unique. However, the
method becomes cumbersome and may produce misleading results iI the inventory
consists oI homogeneous items. In most cases, companies may be unable to determine
exactly which items are sold and which items remain in ending inventory.

The remaining three methods are Ilow assumptions, which should be applied only to an
inventory oI homogeneous items.

By the average-cost method, the average cost oI all units in the inventory is computed
and used in recording the cost oI goods sold: (beginning inventory purchases) / number
oI units in inventory. This is the only method in which all units are assigned the same
(average) per-unit cost.
Average cost (beginning inventory purchases) / units available Ior sale.
Ending inventory Average cost x Units oI ending inventory.
COGS Cost oI goods available Ior sale - ending inventory.

FIFO (first-in, first-out) is the assumption that the Iirst units purchased are the Iirst
units sold. Thus inventory is assumed to consist oI the most recently purchased units.
FIFO assigns current costs to inventory but older (and oIten lower) costs to the cost oI
goods sold.

LIFO (last-in, first-out) is the assumption that the most recently acquired goods are sold
Iirst. This method matches sales revenue with relatively current costs. In a period oI
inIlation, LIFO usually results in lower reported proIits and lower income taxes than the
other methods. However, the oldest purchase costs are assigned to inventory, which may
result in inventory becoming grossly understated in terms oI current replacement costs.

Note that the cost oI goods available Ior sale (beginning inventory purchases) is the
same Ior all inventory methods.

d. explain the effect of an overstatement or understatement of inventories on the
financial statements.

In the current year, an error in the costs assigned to ending inventory will cause an
opposite error in the cost oI goods sold and, thereIore, a repetition oI the original error in

CFACENTER.COM 17
the amount oI gross proIit. The error has exactly the opposite eIIects on the cost oI goods
sold and the gross proIit oI the Iollowing year, because the error is now in the cost
assigned to beginning inventory.

The Iollowing relationship is the key to work out the eIIects oI inventory errors:

Ending Inventory Beginning Inventory + Purchases - Cost of Goods Sold

Ending Inventory Misstated:
II some items are not included in ending inventory (understated ending inventory), we
would have the Iollowing eIIect on the Iinancial statements:
Balance Sheet:
Inventory: understated.
Working capital: understated.
Current ratio: understated.
Income Statement:
COGS: overstated.
Net income: understated.

Purchase and Inventory Misstated:
II certain goods that we own are not recorded as a purchase (assume this is a purchase on
account) and were not counted in ending inventory:
Balance Sheet:
Inventory: understated.
Accounts payable: understated.
Working capital: no eIIect.
Current ratio: overstated.
Income Statement:
Purchases: understated.
COGS: no eIIect.
Net Income: no eIIect.
Inventory (ending): understated.

The need Ior taking a physical inventory: ina perpetual inventory system, a physical
inventory is taken to adjust the inventory records Ior shrinkage losses. In a periodic
inventory system, the physical inventory is the basis Ior determining the cost oI the
ending inventory and Ior computing cost oI goods sold.

e. calculate the lower-of-cost-or-market amount of an inventory.

The lower-oI-cost-or-market rule:

CFACENTER.COM 18
II inventory declines in value below its original cost Ior whatever reason
(obsolescence, price-level changes, damaged goods, etc), the inventory should be
written down to reIlect this. The term market means the cost to replace the item
by purchase or reproduction. II the market price is lower than the cost, the ending
inventory is written down to the market price. The loss then is charged against
revenues in the period in which the loss occurs, not in the period in which it is
sold.

II the market price is higher than the cost, nothing is done. The increases in the
value oI the inventory are recognized only at the point oI sale.

This rule can be applied either directly to each inventory item, to each category,
or to the total oI the inventory. The most common practice is to price the
inventory on an item-by-item basis.

Shrinkage losses are recorded by removing Irom the Inventory account the cost oI the
missing or damaged units. The oIIsetting debit may be to Cost oI Goods Sold, iI the
shrinkage is normal in amount, or to a special loss account. II inventory is Iound to be
obsolete or un-sellable, it is written down to zero (or its scrap value, iI any).


CFACENTER.COM 19
E. Current Liabilities and the Time Value of Money

a. define liabilities, explain the difference between current and long-term liabilities,
and describe the uncertainties about the value of some liabilities.

Liabilities are probable Iuture payments oI assets (usually cash) or services (prepaid
revenue) that a Iirm is obligated to make as a result oI a past transaction.
Current liabilities are expected to be paid within one year or operating cycle,
whichever is longer, Irom the Iirm's existing current assets.
Long-term liabilities are obligations maturing more than one year in the Iuture
and shorter-term obligations that will be reIinanced or paid Irom non-current
assets. Such liabilities are used to Iinance long-term assets such as property, plant,
and equipment.

There are several uncertainties related to liabilities:
Payee is unknown: when a cash dividend is declared (dividend payable), the
stockholders at the Iuture date oI record are not known with certainty. Warranty
payables are recognized at the time oI sale, but the payees are not yet known.

Due date is unknown: Warranty payables and prepayment Ior goods and services
to be delivered at a Iuture unspeciIied date.

The amount is unknown: The value oI most oI the liabilities can be measured
exactly. For some liabilities, however, though the obligations are deIinite, the
amount oI the liabilities must be estimated. Such liabilities are called estimated
liabilities. They include warranty payables, expenses oI utilities, pensions, taxes
and employee beneIits are to be estimated at the end oI year.
Sony sells a computer with a one-year warranty. Under the warranty Sony
must provide parts and service during the year. The warranty is a Ieature
oI the product or service sold and thereIore should be recorded in the
period in which income is earned. Sony's obligation is deIinite but the
exact amount oI the obligation cannot be known and thus has to be
estimated. The estimates oI such liabilities are usually based on past
experience and the anticipated changes in the business environment.

The amount oI income taxes liability depends on the results oI operations,
which are oIten not known till aIter the end oI the year. However, at the
year-end the income taxes should be reported as an expense in the income
statement. ThereIore, an adjusting entry is needed to record the estimated
income tax liability at the end oI the year: Income Tax Expense (debit,
reported in income statement) -- Estimated Income Tax Payable (credit,
reported in balance sheet)..


CFACENTER.COM 20

b. describe how accountants record and report estimated liabilities (such as warranties
and income taxes) and contingent liabilities.

Warranty costs are a classic example oI a loss contingency: Although the Iuture cost
amount, due date and customer are not known Ior certain, a liability is probable and
should be recognized iI it can be reasonably estimated.

Denson Machinery Company sold 100 units oI a new machine at $5,000 each in 1998.
Each machine is under warranty Ior one year and Irom past experience the company
estimated that the warranty cost will probably average $200 per unit. Further, as a result
oI parts replacement and services rendered in compliance with machinery warranties, the
company incurred $4,000 in warranty costs in 1998 and $16,000 in 1999.

1. Sale oI 100 machines in 1998:
Cash or Accounts Receivable 500,000
Sales 500,000

2. Recognition oI warranty expense in 1998:
Warranty Expense 4,000
Cash, Inventory, or Accrued Payroll 4,000
Warranty Expense 16,000
Estimated Liability Under Warranties 16,000

The 1998 balance sheet would report Estimated Liability Under Warranties as a current
liability oI $16,000, and income statement would report Warranty Expense oI $20,000.

3. Warranty costs in 1999:
Estimated Liability Under Warranties 16,000
Cash, Inventory, or Accrued Payroll 16,000

A company must estimate interim (quarterly) income taxes:
Provision Ior income taxes (expenses) 600
Income Taxes Payable 600

When income tax is determined (e.g. at 650) and paid:
Income Taxes Payable 600
Provision Ior income taxes (expenses) 50
Cash 650

Contingent liabilities are obligations that are dependent upon the occurrence or non-
occurrence oI one or more Iuture events to conIirm either the amount payable, the payee,
the date payable, or its existence. For example, some toxic liquid Irom ABC Inc's plants
was Iound in the water supply oI a nearby town. The town has sued against ABC Ior
damages, but the extent oI ABC's responsibility and the nature and extent oI any harm are
still uncertain.

CFACENTER.COM 21

Contingent liabilities are potential liabilities, not existing liabilities. Disclosure depends
on the ability to estimate the liability and likelihood oI Iuture payment oI the liability.

II it is probable that a liability has been incurred at the date oI Iinancial
statements, and the amount oI the loss can be reasonably estimated, then the loss
(expense) and liability must be disclosed on the income statement and balance
sheet, respectively.

II the loss is either probable or estimable but not both, and iI there is at least a
reasonable possibility that a liability may have been incurred, then only Iootnote
disclosure is required.

II the loss is remote, then no disclosure is required.


CFACENTER.COM 22
F. Long-Term Assets

a. describe the difference between long-term assets and other kinds of assets.

ClassiIication oI Long-Term Assets:
Tangible Assets: long-term assets with physical substance. Examples are land,
PP&E, etc.
Natural Resources: long-term assets whose economic value is Irom the land and
can be used up. Examples are oil and gas Iields, mines, etc.
Intangible Assets: long-term assets without physical substance. Examples are
goodwill, patents, trademarks, etc.

The major characteristics oI PP&E (Property, Plant and Equipment) are:
They are acquired Ior use in operations and not Ior resale. This diIIerentiates them
Irom inventories and other interest or dividend generating investments.
Land held Ior speculative purposes should be classiIied as long-term
investments, not long-term assets.
A computer in Sony's warehouse is an inventory.
A computer in a Bank oI America's oIIice is a long-term asset.
They are long-term in nature (last Ior more than one year) and usually subject to
depreciation. This diIIerentiates them Irom current assets and other prepaid
expenses.
They possess physical substance. This diIIerentiates them Irom intangible assets.

The cash eIIects oI transactions involving plant assets:
Depreciation is a non-cash expense.
Cash expenditures Ior the acquisition oI plant assets are independent oI the
amount oI depreciation Ior the period.
Cash payments to acquire plant assets (and cash receipts Irom disposals) appear in
the statement oI cash Ilows, classiIied as investing activities.
Write-downs oI plant assets also are non-cash charges, which do not involve cash
payments.

b. calculate the cost, and record the purchase, of property, plant, and equipment.

There are three basic accounting issues during the useIul liIe oI a long-term asset:
At the time oI acquisition: what cost to capitalize?
While the asset is in use: how to allocate the cost oI the asset to the periods it
beneIits in?
At the time oI disposal: how to record the disposal oI the asset?

CFACENTER.COM 23
Plant assets are long-lived assets acquired Ior use in the business and not Ior resale to
customers. The matching principle oI accounting requires that we include in the plant and
equipment accounts those costs that will provide services over a period oI years. During
these years, the use oI the plant assets contributes to the earning oI revenues. The cost oI
a plant asset includes all expenditures reasonable and necessary in acquiring the asset and
placing it in a position and condition Ior use in the operations oI the business.

Historical cost is measured by the cash or cash equivalent price oI obtaining the asset
and bringing it to the location and condition necessary Ior its intended use.

Cost of Land:

Generally, land is part oI property, plant, and equipment. All expenditures made to
acquire land and to ready it Ior use should be considered as part oI the land cost. It
typically includes:
the purchase price and commissions to real estate agents.
closing costs such as title transIer, legal and recording Iees.
costs incurred in getting the land in condition Ior its intended use, such as grading,
Iilling, draining and clearing.
assumption oI any liens, mortgages or encumbrances on the property, and
any additional land improvements that have an indeIinite liIe.

When land has been purchased Ior the purpose oI constructing a building, all costs
incurred up to the excavation Ior the new building (including removal oI old building) are
considered land costs.

Cost of Buildings:

All costs incurred, Irom excavation to completion, are considered part oI the building
costs.

Cost of Equipment:

It includes purchase price (less cash discounts), Ireight and handling charges, insurance
on the equipment while in transit, assembling and installation costs, and costs oI
conducting trial runs.

Interest costs during construction:

II an asset is constructed by the Iirm, the costs includes all reasonable and necessary
expenditure such as materials, labor, part oI the overhead, and interest on borrowed Iunds
during the construction process. The actual interest costs incurred during construction
should be capitalized. The borrowing rate is applied to the portion oI weighted-average
accumulated expenditures that is less than the speciIic borrowing amount. The rest oI the
weighted-average accumulated expenditures should use a weighted average oI interest

CFACENTER.COM 24
rate. Capitalized interest cost should be written oII over the liIe oI the assets, not over the
term oI the debt.

The entry to record the purchase is straightIorward:
Land xxx
Building xxx
Equipment xxx
Cash xxxx

c. explain depreciation accounting (including the reasons for depreciation), calculate
depreciation using the straight-line and units-of-production methods, and calculate
depreciation after revising the estimated useful life of an asset.

Long-term assets are generally recorded at their carrying value: the unexpired part oI the
cost oI an asset. Also called book value.

All long-term assets except Ior land have a limited useIul liIe due to obsolescence and/or
physical deterioration. ThereIore, once the acquisition cost oI a long-term asset has been
determined, it must be allocated over its useIul liIe. Depreciation is deIined as the
accounting process oI allocating the cost oI tangible assets to expense in a systematic and
rational manner to those periods expected to beneIit Irom the use oI the asset.
The cost allocation Ior a natural resource is known as depletion.
The cost allocation Ior an intangible asset is known as amortization.

Note that:
Depreciation is not a matter oI valuation, but a means oI cost allocation.
The cost oI land is never allocated because land has unlimited useIul liIe.

Accounting Ior Depreciation:
At the end oI an accounting period, depreciation on an asset is recorded as:
Depreciation Expense (Debit) xxx
Accumulated Depreciation (Credit) xxx
The Accumulated Depreciation account is a contra-asset account used to total
the depreciation expense to date on the asset.

Depreciation expense is shown in the income statement oI the period.

The balance oI Accumulated Depreciation account is shown on the balance sheet
as a deduction Irom the original cost oI the asset.

Factors that aIIect the computation oI depreciation:

CFACENTER.COM 25
Depreciable cost: the total amount oI cost to be allocated over the useIul liIe oI
an asset. It equals the acquisition cost oI an asset less its residual value, which is
the estimated amount that will be received when the asset is sold or removed Irom
service at the end oI its useIul liIe. It is also called salvage value. Note that it is
depreciable cost, not acquisition cost, that is allocated over the useIul liIe oI an
asset.

Estimated useful life: it can be measured in terms oI years the asset is expected
to be used, or units expected to be produced, or hours oI service to be provided by
the asset.

Depreciation method: the approach to allocating the depreciable cost over the
estimated useIul liIe oI the asset.
Straight-line depreciation assigns an equal portion oI an asset's cost to
expense in each period oI the asset's liIe. It considers depreciation a
Iunction oI time instead oI a Iunction oI usage.
Depreciation charge Cost less salvage / estimated service liIe.
Declining-balance is an accelerated method. Each year, a Iixed (and
relatively high) depreciation rate is applied to the remaining book value oI
the asset. There are several variations oI declining-balance depreciation,
including MACRS.
Units of production method assumes the depreciation is a Iunction oI use
or productivity instead oI passage oI time.
Depreciation charge ((Cost less salvage) - output units oI this year) /
Total estimated output units.

d. describe how to account for the disposal of depreciable assets.

Sometimes a long-term asset may lose some oI its revenue generating ability prior to the
end oI its useIul like. II the expected cash Ilows Irom the asset are less than the carrying
value oI the asset, an asset impairment occurs and the carrying value should be written
down. The amount oI written-down is recorded as a loss.

When plant assets are disposed oI, depreciation should be recorded to the date oI disposal.
The cost is then removed Irom the asset account and the total recorded depreciation is
removed Irom the accumulated depreciation account. Normally an asset's market value at
the time oI sale or disposal will most likely be diIIerent than the asset's book value (its
original historical cost minus all accumulated depreciation on that asset). The sale oI a
plant asset at a price above or below book value results in a gain or loss to be reported in
the income statement.


CFACENTER.COM 26
Because diIIerent depreciation methods are used Ior income tax purposes, the gain or loss
reported in income tax returns may diIIer Irom that shown in the income statement. It is
the gain or loss shown in the Iinancial statement that is recorded in the company's general
ledger accounts.

e. identify assets that should be classified as natural resources or intangible assets and
prepare entries to account for such assets, including entries to record depletion and
amortization.

Natural resources, also known as wasting assets, include petroleum, minerals, mines, oil
Iields, and standing timber. Their cost is converted into inventory as the resource is
mined, pumped, or cut. This allocation oI the cost oI a natural resource to inventories is
called depletion. The cost can be divided into acquisition cost oI the deposit, exploration
costs and development costs. Companies may choose successIul eIIorts approach or Iull-
cost approach to deplete costs ( usually using units oI production method).
Depletion rate (Cost oI natural resource - residual value) / Estimated number oI
extractable units
Depletion expense Ior a speciIic accounting period Depletion rate x number oI
units extracted during the period

Recording depletion is very similar to recording depreciation. For exam, "oil deposit" and
its contra account "accumulated depletion" appear in balance sheet.

Intangible assets are assets owned by the business that have no physical substance, are
noncurrent, and are used in business operations. Examples include patents, copyrights,
Iranchises, goodwill, trademarks, trade names, secret processes, property rights, goodwill,
and organization costs. Generally, intangible assets are recorded only when purchased:
Purchased intangible assets are accounted Ior at acquisition costs.
The cost oI internally developed intangible assets are typically expensed when
incurred.

Among the most interesting intangible assets is goodwill. Goodwill is the present value oI
Iuture earnings in excess oI a normal return on net identiIiable assets. It stems Irom such
Iactors as a good reputation, loyal customers, and superior management. Any business
that earns signiIicantly more than a normal rate oI return actually has goodwill. But
goodwill is recorded in the accounts only iI it is purchased by acquiring another business
at a price higher than the Iair market value oI its net identiIiable assets.

Example:

CFACENTER.COM 27
Harcott Co. incurs $170,000 in legal costs on January 1, 1999 to successIully deIend a
patent. The patent has a useIul liIe oI 17 years, and is amortized on a straight-line basis.
At the end oI the year:
Patents 170,000
Cash 170,000
Patent Amortization Expense 10,000
Patents (or Accumulated Patent Amortization) 10,000

Note:
The straight-line method is typically used Ior amortization.
Intangible assets must be amortized over a period not exceeding 40 years.
A copyright is granted Ior the liIe oI the creator plus 50 years, but still need to be
amortized Ior a maximum oI 40 years!
Please make sure that R&D costs are not in themselves intangible assets!


CFACENTER.COM 28
G. Long-Term Liabilities

a. describe how to report the issuance of long-term debt.

The most common type oI long-term liabilities is long-term bonds. Other types oI long-
term liabilities include long-term notes, mortgages payable, long-term leases, pension
liabilities, and other postretirement beneIits.

The debt burden oI a Iirm can be evaluated using the interest coverage ration: (Income
BeIore Taxes Interest Expense) / (Interest Expense). It measures a Iirm's ability to
satisIy its obligations on interest payments.

Long-term debt is valued and recorded at the present value oI its Iuture cash Ilows, which
consists oI:
interest, and
principal.

The cash Ilows are discounted at the market rate oI interest at issuance (also known as
the effective interest rate). ThereIore, the value oI the bond depends on the market rate
oI interest. II the market rate oI interest is higher (lower) than coupon rate, the bond value
will be lower (higher) than its Iace value, and the bond will be issued at a premium
(discount). II the two rates are the same, then the bond will be issued at par.

1. Issued at par on Interest Date:
II $800,000 oI bonds were issued on January 1, 2000 at 100, the issuance would be
recorded as Iollows:
Cash 800,000
Bonds Payable 800,000

2. Issued at Discount on Interest Date:
Cash ($800,000 x 0.97) 776,000
Discount on Bonds Payable 24,000

3. Issued at Premium on Interest Date:
Cash ($800,000 x 1.03) 824,000

4. Issued Between Interest Dates:

CFACENTER.COM 29
II ten-year bonds oI a par value oI $800,00, dated January 1, 2000, and bearing interest oI
10, payable semi-annually on January 1 and July 1, are issued at par plus accrued
interest on March 1, 2000. The entry is:
Cash 813,333
Bond Interest Expense 13,333

5. The purchaser advances 2 month's interest:
On July 1, 4 months aIter the date oI purchase, 6 months' interest will be received Irom
the issuing company:
Cash 40,000

b. describe how to report interest expense and amortization associated with long-term
debt.

Understanding bond premium and discount:
A bond premium represents the amount over the Iace value oI the bond that the
issuer never has to return to the bondholders. In eIIect it reduces the higher-than-
market interest rate that the issuer is paying on the bond. It must be allocated over
the liIe oI the bonds as a reduction oI interest expense each period.
A bond discount represents the amount in excess oI the issue price that must be
paid by the issuer at the time oI maturity. In eIIect it increases the lower-than-
market interest rate the issuer is paying on the bond. It must be allocated over the
liIe oI the bond as an increase oI interest expense each period.

Bond interest expense is increased by amortization oI a discount and decreased by
amortization oI a premium.

Straight-line method: the discount or premium is amortized Ior a constant value over
the period oI time that the bonds are outstanding.

The proIession's preIerred procedure Ior amortization oI a discount or premium is the
effective interest method.
Bond interest expense is computed Iirst by multiplying the carrying value oI the
bonds at the beginning oI the period by the eIIective interest rate.
Interest Expense Beginning Carrying Value x Market Rate oI Interest

The bond discount or premium amortization is then determined by comparing the
bond interest expense with the interest to be paid. Note that: interest payment
Face Value x Coupon Rate x 1/2 (assume semiannual coupon payment).

CFACENTER.COM 30
The carrying value oI the bond at the end oI the period Beginning Carrying
Value - Amortization oI Bond Premium (or Amortization oI Bond Discount).

This method produces a periodic interest expense equal to a constant percentage oI the
carrying value oI the bonds. Since the percentage is the eIIective rate oI interest incurred
by the borrower at the time oI issuance, the eIIective interest method results in a better
matching oI expense with revenues than the straight-line method.

Evermaster Corporation issued $100,000 oI 8 term bonds on January 1, 1996, due on
January 1, 2001, with interest payable each July 1 and January 1. Since investors required
an eIIective interest rate oI 10, they paid $92,278 Ior the $100,000 oI bonds, creating a
$7722 discount.

1. To record the issuance:
Cash 92,278

2. To record the Iirst interest payment oI $4,000 on July 1, 1996:
Discount on Bonds Payable 614
Cash 4,000
Note: 92,278 x 0.10 x 0.5 4,614. Now the discount balance is 7,722 - 614 $7,108.

3. To record the second interest payment oI $4,000 on January 1, 1997:
Discount on Bonds Payable 645
Cash 4,000
Note: (100,000 - 7,108) x 0.10 x 0.5 4645. Now the discount balance is 7,108 - 645
6,463.
And so on.

The carrying value oI a premium (discount) bond decreases (increases) over time.

CFACENTER.COM 31
At the maturity date, the carrying value oI both a premium bond and a dicount
bond equals the Iace value.
The interest expense oI a discount (premium) bond increases (decreases) over
time due to the increasing (decreasing) carrying value.

Balance Sheet Disclosure of Bonds

Bonds payable and unamortized discounts or premiums are typically shown on the
balance sheet as long-term liabilities. Bond discount is reported as a direct deduction
Irom, and bond premium as a direct addition to, the Iace value oI the bond. II a bond
issue will mature within a year, it should be reported as a current liability iI the issue will
be retired using current assets. However, the issue should continue to be reported as a
long-term liability iI it is to be replaced with another bond issue, converted into stock, or
paid oII with non-current assets.

c. describe how to report the retirement of bonds and the conversion of bonds into
common stock.

When a bond reaches its maturity date, the Iinal interest payment is made and the
principal is paid in Iull. A key point is that at maturity, the market value oI the bond will
equal its book value. Any premium or discount and any issue costs will be Iully
amortized at the date oI bonds mature. This action reduces the cash account and long-
term liability. No gain or loss exists.

II a bond is retired prior to maturity, any diIIerence between the market and book value
oI the bond is treated as an extraordinary gain or loss and is shown on the income
statement (below the operating line, net oI tax).
Gain/Loss Carrying Value - Call Price

Upon retirement, the bond payable account and any related unamortized premium or
discount are brought to 0.

Assume that on January 1, 1987, General Bell Corporation issued at 97 bonds with a par
value oI $800,000 due in 20 years. Bond issue costs totaling $16,000 were incurred. Ten
years aIter the issue date, the entire issue is called at 101 and canceled. The loss on
redemption is computed as Iollows (straight-line amortization is used Ior simplicity):

Reacquisition price 808,000
Net carrying amount:
Face value: 800,000
Un-amortized discount: -12,000

CFACENTER.COM 32
Un-amortized issue cost: -8,000
Total: 780,000
Loss on redemption: -28,000

Un-amortized discount: 800,000 x (1 - 0.97)) x 10/20 -12,000.
Un-amortized issue cost: 16,000 x 10/20 -8,000.

To record this:
Loss on Redemption oI Bonds 28,000
Un-amortized Bond Issue Costs 8,000
Cash 808,000

Convertible bonds are debt securities that are convertible (exchangeable) into the
company's common stock. For example, iI Company X issues convertible bonds with a
10-to-1 conversion ratio, than each bond may be converted into 10 shares oI common
stock. Please note that upon conversion, the company must issue 10 new shares oI
common stock.

When the convertible debt is issued, the conversion Ieature (equity component) is
ignored and the entire proceeds oI the bond are treated as a long-term liability.
Upon conversion into equity, the bond issue is reclassiIied Irom debt into equity
on the balance sheet.
The bond payable account and any related unamortized premium or
discount is brought to 0.
Stockholders' equity increases by the carrying value oI the bond. The par
value oI the stock issued is recorded in the Common Stock account. The
diIIerence between the carrying value oI the bond and the par value oI the
stock is recorded in the Paid-in Capital account.
No gain or loss is recognized on the conversion.

Example: XYZ Inc. has a convertible bond issue with a Iace value oI $100,000 and un
unamortized premium oI $10,000. II the bonds are converted into 5000 shares oI $10 par
value common stock:
The carrying value oI the bond issue: $110,000.
The par value oI newly issued stock: $50,000.
Addition paid-in capital: $60,000

d. explain the basic features of such long-term liabilities as long-term leases,
mortgages payable, pensions, and other postretirement benefits.

CFACENTER.COM 33

Long-Term Leases:

A long-term lease commitment may be equivalent to an asset purchase using long-term
debt. Leases are oIten used to keep debt oII the balance sheet. All leases must be
classiIied as either operating leases or capital leases. See study session 10 Ior details.

Mortgage payable:

A mortgage is a long-term debt that is secured with real property. It is primarily used to
Iinance a real estate. In a typical mortgage, even payments are made at regular intervals
oI time and each payment represents both interest and principal repayment. The interest
component is based on the remaining principal oI the debt. As the principal oI the debt is
paid down, the interest component oI the payment declines, and more and more payments
are used to repay the principal.

Pensions:

A pension plan is an agreement whereby an employer provides beneIits (payments) to
employees aIter they retire Ior services they provided while employed. The beneIits
normally depend on certain requirements, such as age and number oI years oI service.
Many companies make contributions to a pension Iund, which invests the contributions
and pays pension beneIits to retirees as the beneIits become due.

The two most common types oI pension arrangements are:

defined contribution plans: Only the employer's contribution is deIined. No
promise is made regarding the ultimate beneIits paid out to the employees.
Employees are at risk. The accounting Ior a deIined contribution plan is
straightIorward: the employer's required contribution is recorded as pension
expense. An asset arises iI the actual contribution exceeds the required
contribution, while a liability arises iI the opposite happens.

defined benefit plans: It deIines the beneIits that the employee will receive at the
rime oI retirement. The Employer is at risk as it is responsible Ior the payment oI
the deIined beneIits, regardless oI what happens to the pension Iund. Accounting
Ior a deIined beneIit plan is rather complex, requiring a number oI assumptions.

Other post-retirement benefits:

Many employers may provide beneIits such as liIe insurance, medical care, eye care,
legal and tax services, tuition assistance, day care and housing assistance to retirees, their
spouses, dependents and beneIiciaries. As companies account those beneIits on accrual
basis (i.e. they are expensed when earned by the employees, not when paid aIter
retirement), those post-retirement beneIit promises are liabilities.


CFACENTER.COM 34
H. Contributed Capital

a. identify the components of contributed capital.

Contributed capital consists oI the par value oI any preIerred stock, the par value (iI
applicable) oI common stock, and paid-in capital in excess oI par value.

The par value oI a stock is an arbitrary amount. It has no relationship to its Iair market
value. At present, the par value associated with most capital stock issuances is very low
($1, $5, $1). This permits the original sale oI stock at low amounts per share and avoids
the contingent liability associated with stock sold below par. The product oI the par value
per share and the number oI shares issued is the legal capital oI the corporation.

When shares are originally issued, the accounts oI PreIerred Stock or Common Stock are
credited. No additional entries are made in these accounts unless additional shares are
issued or shares are retired.

Paid-in Capital in Excess of Par indicates any excess over par value paid in by
stockholders in return Ior the shares issued to them. Once paid in, the excess over par
becomes a part oI the corporation's additional paid-in capital, and the individual
stockholder has no greater claim on the excess paid in than all other holders oI the same
class oI shares.

Many states permit the issuance oI capital stock without par value. The exact amount
received represents the credit to common or preIerred stock.

Retained earnings are the Iirm's earnings since inception, less any losses, dividends, or
transIers to contributed capital. They are earnings reinvested in the Iirm.

b. explain the difference between common stock and preferred stock.

The rights oI stockholders are normally:
To share proportionately in proIits and losses.
To share proportionately in management (the right to vote Ior directors).
To share proportionately in corporate assets upon liquidation.
To share proportionately in any new issues oI stock oI the same class (called
preemptive rights). It protects an existing stockholder Irom involuntary dilution oI
ownership interest.

In an eIIort to appeal to all types oI investors, corporations may oIIer two or more classes
oI stock each with diIIerent rights or privileges.

CFACENTER.COM 35
Common stock is the residual corporate interest that bears the ultimate risks oI loss and
receives the beneIits oI success. It is guaranteed neither dividend nor assets upon
dissolution. In case oI liquidation, all other creditors and preIerred stockholders have a
higher claim on the Iirm's assets. Common stockholders generally control the
management oI the corporation and tend to proIit most iI the company is successIul.

Five diIIerent terms used to describe common stock:
Authorized shares: the number oI shares the Iirm can legally issue.
Issued shares: the number oI shares the Iirm has issued. Outstanding shares are
issued shares that are still in circulation. Treasury shares are issued shares that
are bought back and held by the Iirm.
Unissued shares: shares that have been authorized but are not yet issued.

Preferred stockholders are assured a dividend, usually at a stated rate, beIore any
amount may be distributed to the common stockholders. They have seniority over
common stockholders with respect to claims on income and assets. In return Ior these
preIerences the preIerred stock may sacriIice its right to a voice in management or its
right to share in proIits beyond the stated rate. The most common Ieatures are:

Cumulative: Dividends not paid in any year must be made up in a later year
beIore any proIits can be distributed to common stockholders. They are called
dividend in arrears. Note that preIerred dividends are generally not guaranteed:
they must be voted on by common shareholders.

Participating: they may partially or Iully participate proIit distributions beyond the
prescribed rate.

Convertible: The stockholders may at their option exchange their preIerred shares
Ior common stock at a predetermined ratio.

Callable: The issuing corporation can call or redeem at its option the outstanding
preIerred shares at speciIied Iuture dates and at stipulated prices.

c. describe how to account for stock issuance and treasury stock.

Stock Issuance:

Assume Colonial Corporation sold, Ior $110,000, one thousand shares oI stock with a par
oI $100 per share. The entry to record the issuance is:
Cash 110,000
Common Stock 100,000
Paid-in capital in Excess oI Par 10,000

CFACENTER.COM 36

II there was no per-share amount printed on the stock certiIicate, the entry should be:
Cash 110,000
Common Stock - No-Par Value 110,000

Stock Repurchase:

It is not unusual Ior companies to buy back their own shares. Once shares are reacquired,
they may either be retired or held in the treasury Ior reissue.

Please note that:
The transaction reduces both the assets and the stockholders' equity oI the Iirm.
The treasury shares are recorded at cost in a contra equity account called Treasury
Stock. Treasury stock is not an asset.
The cost oI the treasury stock is reported on the stockholders' equity section oI the
balance sheet as a deduction Irom the total contributed capital and retained
earnings.
The number oI shares issued remains the same, but the number oI shares
outstanding is decreased by the number oI shares repurchased.

When treasury stock is sold, the shares are taken out oI the Treasury Stock account.
II the shares are sold above cost, the gain is added to Paid-in Capital.
II the shares are sold below cost, the loss is deducted Irom Paid-in Capital. II the
Paid-in Capital account does not exist or is insuIIicient to cover the loss, Retained
Earnings is used to absorb the remaining loss.

Continue with the above example with par value oI $100.

1. Now one hundred shares oI common stock are reacquired at $112.
Treasury Stock 11,200
Cash 11,200

2. Ten shares oI treasury stock are reissued at $112.
Cash 1,120

Cash 1,300
Paid-in Capital Irom Treasury Stock 180

Cash 980
Paid-in Capital Irom Treasury Stock 140


CFACENTER.COM 37
Under the above cost method, the price received Ior the stock when originally issued does
not aIIect the entries to record the acquisition and re-issuance oI the treasury stock.

Retirement of Treasury Stock:

A company can retire the treasury shares iI it decides that those shares will not be
reissued. Retired treasury shares have the status oI authorized and un-issued shares.
When treasury shares are retired, all items related to those shares are removed Irom the
related capital accounts (i.e. Common Stock, Paid-in Capital, and Treasury Stock).II the
purchase price is less (greater) than the original contributed capital, the diIIerence is
added to Paid-in Capital (deducted Irom Retained Earnings).

Continue with the above example.

1. Ten shares oI treasury stock are retired (they were acquired at $112):
Common Stock 1,000
Paid-in Capital in Excess oI Par 100
Retained Earnings 20

2. However, iI the stocks were reacquired at $98:
Common Stock 1,000
Paid-in Capital in Excess oI Par 100
Paid-in Capital Irom Retirement oI Treasury Stock 120
Treasury Stock 980

In the Balance Sheet the cost is reported as an unallocated reduction oI the stockholders'
equity.

d. describe how to account for cash dividends.

Dividends are cash payments to stockholders that may be paid on a regular basis
(monthly, quarterly, semi-annually, or annually) or occasionally. They are paid out oI
retained earnings.

In most states dividends declared by a Iirm cannot exceed its retained earnings. In
essence, the excess oI a dividend over retained earnings represents part oI the contributed
capital returned to the stockholders. ThereIore, a dividend that exceeds retained earnings
is called a liquidating dividend, since it is usually paid when a company is going out oI
business or shrinking its operations.


CFACENTER.COM 38
A corporation is not required to pay cash dividends. The board oI directors votes on the
declaration oI dividends, and iI the resolution is properly approved, the dividend is
declared. A resolution approved at the January 10 (date of declaration) meeting oI the
board oI directors might be declared payable February 5 (date of payment) to all
shareholders oI record January 25 (date of record: iI a stockholder is listed as the owner
on this date, the stockholder receives the dividend.).

A declared cash dividend is a current liability. For example, Roadway Freight Corp. on
June 10 declared a cash dividend oI 50 cents a share on 1.8 million shares payable July
16 to all shareholders oI record June 24.

1. At date oI declaration (June 10):
Retained Earnings 900,000
Dividends Payable 900,000

2. At date oI record (June 24):
No entry.

3. At date oI payment (July 16):
Dividends Payable 900,000
Cash 900,000


CFACENTER.COM 39
I. The Corporate Income Statement and the Statement of Stockholders'
Equity

a. explain how to report the income effects of discontinued segments, extraordinary
items, and changes in accounting principles and estimates.

Non-operating items are not the results oI a Iirm's normal business operations. They may
dramatically inIluence the net income oI the Iirm. The gains (income) or losses net oI
taxes Irom non-operating items should be reported below the line, which means that the
item is presented below income Irom continuing operations on the income statement.
Above the line is just the opposite.

Examples oI non-operating items include:

Discontinued Operations

When a Iirm decides to discontinue a portion oI its diversiIied operations, the net income
associated with the discontinued operations and any gains or losses Irom its disposal are
separated Irom income Irom continuing operations. Please note that the eIIects are shown
net oI tax.

To qualiIy as discontinued operations, the assets, results oI operations, and activities oI a
segment oI a business must be clearly distinguishable, physically and operationally Irom
the other assets, results oI operations and activities oI the entity.

Disposal oI assets that do not qualiIy:
Disposal oI part oI a line oI business.
ShiIting production or marketing activities Ior a particular line oI business Irom
one location to another.
Phasing out oI a product line or class oI service.
Other changes due to a technological improvement.

Extraordinary Gains or Losses

They are both unusual in nature and inIrequent in occurrence. They are reported net oI
income taxes and separated Irom income Irom continuing operations.

Most gains and losses do not qualiIy. Examples are:
Write-down or write-oII receivables, inventories, equipment leased to others,
deIerred research and development costs, and other intangible assets.
Gains or losses Irom exchange or translation oI Ioreign currencies, including
those relating to major devaluations and revaluations.
Gains or losses on disposal oI a segment oI a business.
Other gains or losses Irom sale or abandonment oI property, plant, or equipment
used in the business.
EIIects oI a strike, including those against competitors and major suppliers.

CFACENTER.COM 40
Adjustment oI accruals on long-term contracts.

Changes in Accounting Principle

Changes in accounting principle occur Irequently in practice, because important events or
conditions may be in dispute or uncertain at the statement date. Examples are: changing
Irom FIFO to LIFO, Irom double declining to straight-line depreciation, or changing Irom
accounting Ior post-retirement beneIits only when they are paid to using accrual
accounting procedures. Those changes are recognized by including the cumulative eIIect
net oI tax in the current year's income statement based on a retroactive computation oI
changing to a new accounting principle.

Changes in Estimate

Adjustment that grow out oI the use oI estimates in accounting are not classiIied as prior
period adjustments and, thereIore, are used in the determination oI income Ior the current
period and Iuture period and not charged or credited directly to Retained Earnings.
Examples are: changes in the estimated lives oI Iixed assets, adjustment oI the costs,
reliability oI inventories believed to be obsolete in preceding years, reliability oI
receivables, estimated liability Ior warranty costs, income taxes, and salary payments, etc.

Changes in estimate are not handled retroactively, that is, carried back to adjust prior
years. They are not considered errors (prior period adjustments) or extraordinary items.

To illustrate a change in estimate that aIIects only the period oI change, assume that
DuPage Corp. has consistently estimated its bad debt expense at 1 oI credit sales. In
1997, however, DuPage's controller determines that the estimate Ior the last 2 years has
been to low and that an additional provision Ior bad debts oI $240,000 should be recorded
to reduce accounts receivable to net realizable value. The provision is recorded on
December 31, 1997 should be recorded as:
Bad Debt Expense 240,000
Allowance For DoubtIul Accounts 240,000

The entire change in estimate is included in 1997 income because no Iuture periods are
aIIected by the change.

b. describe stock dividends and stock splits and explain the effects of each on a
company's assets and stockholders' equity.

The statement of stockholders' equity reports the changes in the components oI the
stockholders' equity section oI the balance sheet. Columns Ior each component and total
stockholders' equity are usually presented in the statement. The ending balances on the

CFACENTER.COM 41
statement are transIerred to the stockholders' equity section oI the balance sheet. The
statement provides much more inIormation about the year's stockholders' equity
transactions. ThereIore, more and more companies are using the statement oI
stockholders' equity to replace the statement oI retained earnings.

Stock Dividends

Cash dividends reduce retained earnings at the time the company's board oI directors
declares the dividends. At that time, the dividends become a liability Ior the company.

II the management wishes to "capitalize" (i.e. reclassiIy amounts Irom earned to
contributed capital) part oI the earnings, and thus retain earnings in the business on a
permanent basis, it may issue a stock dividend.

In this case, not assets are distributed, and each stockholder has exactly the same
proportionate interest in the corporation and same total book value aIter the stock
dividend was issued as beIore it was declared. In other words, a stock dividend
does not change the Iirm's assets and liabilities.

Stock dividends generally are recorded by transIerring the market value oI the
additional shares to be issued Irom retained earnings to the appropriate paid-in
capital accounts.

The book value per share is lower because an increased number oI shares is held
(Stock dividends increase the number oI shares outstanding but do not change
total stockholders' equity).

Stock dividends oI less than 20 - 25 oI the common shares outstanding at the time oI
dividend declaration, they are oIten reIerred to as "small (ordinary) stock dividends".
The Iair market value oI the stock issued is required to be transIerred Irom retained
earnings. However, iI the stock dividend is large (greater than 20 - 25 oI the common
shares outstanding), the amount transIerred is the par value oI the additional shares.

To illustrate a small stock dividend, assume that a corporation has outstanding 1,000
shares oI $100 par value capital stock and retained earnings oI $50,000. II the corporation
declares a 10 stock dividend, it issues 100 additional shares to current stockholders. II it
is assumed that the Iair market value oI the stock at the time oI stock dividend is $130 per
share, the entry is:

1. at date oI declaration:
Retained Earnings 13,000
Common Stock Dividend Distributable 10,000
Paid-in capital in Excess oI Par 3,000

2. at date oI distribution:
Common Stock Dividend Distributable 10,000

CFACENTER.COM 42
Common Stock 10,000

Note that no asset or liability has been aIIected. The entries merely reIlect a
reclassiIication oI stockholder's equity.

Stock Split

The managements oI many corporations believe that Ior better public relations, wider
ownership oI the corporation stock is desirable. They wish, thereIore, to have a market
price suIIiciently low to be within range oI the majority oI potential investors. To reduce
the market value oI shares, the common device oI a stock split is employed.

From an accounting standpoint, no entry is recorded Ior a stock split; a
memorandum note, however, is made to indicate that the par value oI the shares
has changed, and the number oI shares has increased. A stock split does not
change the amount in any asset, liability or stockholders' equity account.

From a legal standpoint a stock split is distinguished Irom a stock dividend,
because a stock split results in an increase in the number oI shares outstanding
and a corresponding decrease in the par value per share. A stock dividend,
although it results in an increase in the number oI shares outstanding, does not
decrease the par value; thus it increases the total par value oI outstanding shares.


CFACENTER.COM 43
1. The Statement of Cash Flows

a. explain why cash flow information is important to investment decision making.

Please see reading section B los a as these two los are identical.

b. describe the information in a statement of cash flows and the methods used to
disclose non-cash account balances.

The beginning and ending cash balances on the statement oI cash Ilows tie directly to the
Cash and Cash Equivalents accounts listed on the balance sheets at the beginning and end
oI the period.

Net income diIIers Irom net operating cash Ilows Ior several reasons.

One reason is noncash expenses, such as depreciation and the amortization oI
intangible assets. These expenses, which require no cash outlays, reduce net
income but do not aIIect net cash Ilows.
Another reason is the many timing diIIerences existing between the recognition oI
revenue and expense and the occurrence oI the underlying cash Ilows.
Finally, nonoperating gains and losses enter into the determination oI net income,
but the related cash Ilows are classiIied as investing or Iinancing activities, not
operating activities.

Cash receipts and cash payments during a period are classiIied in the statement oI cash
Ilows into three diIIerent activities:

Operating activities involve the cash eIIects oI transactions that enter into the
determination oI net income and changes in the working capital accounts
(accounts receivable, inventory, and accounts payable). CFOs reIlect the Iirm's
ability to generate suIIicient cash Irom its continuing operations.

Investing activities include making and collecting loans and acquiring and
disposing oI investments (both debt and equity) and property, plant, and
equipment. In general, these items relate to the long-term asset items on the
balance sheet. Investing cash Ilows reIlect how the Iirm plans its expansions.

Financing activities involve liability and owner's equity items, and include (a)
obtaining capital Irom owners and providing them with a return on (and a return
oI) their investment and (b) borrowing money Irom creditors and repaying the
amounts oI borrowed. In general, the items in this section relate to the debt and

CFACENTER.COM 44
the equity items on the balance sheet. Financing cash Ilows reIlect how the Iirm
plans to Iinance its expansion and reward its owners.

Please note:
Interest paid on borrowed Iunds would be considered an operating cash Ilow
because interest is reported on the income statement, while dividends paid to
stockholders would be a Iinancing cash Ilow because dividends Ilow through the
retained earnings statement.
Interest and dividend income are considered operating cash Ilow.
How to remember these guidelines? An interest/dividend item is an operating
activity iI it appears on the income statement. For example, payments oI
dividends do not appear on the income statement, and thus are not classiIied as
operating activities.

All taxes paid are considered operating activities, even iI some may result Irom
investing or Iinancing activities.

Purchase oI debt and equity securities oI other entities (sale oI debt or equity
securities oI other entities), loans to other entities (collection oI loans to other
entities) are considered investing activities. However, issuance oI debt (bonds and
notes) and equity securities are Iinancing cash inIlows, and payment oI dividend,
redemption oI debt, and reacquisition oI capital stock are Iinancing cash outIlows.

Investing cash Ilows essentially deal with the items appearing on the lower leIt-
hand portion oI the balance sheet (Iixed assets and long-term investments), while
Iinancing cash Ilows deal with the lower right-hand portion oI the balance sheet
(long-term debt and equity).

Some investing and Iinancing activities do not Ilow through the statement oI cash Ilows
because they don't require the use oI cash:
Retiring debt securities by issuing equity securities to the lender.
Converting preIerred stock to common stock.
Acquiring assets through a capital lease.
Obtaining long-term assets by issuing notes payable to the seller.
Exchanging one non-cash asset Ior another non-cash asset.
The purchase oI non-cash assets by issuing equity or debt securities.

For example, iI a Iirm purchases $200,000 oI land by issuing a long-term bond, this
transaction is a noncash one as it does not involve direct outlays oI cash. ThereIore, it is
excluded Irom the statement oI cash Ilows. These types oI transactions should be
disclosed in a separate schedule as part oI the statement oI cash Ilows, or in the Iootnotes
to the Iinancial statements.

The direct and indirect methods are alternative Iormats Ior reporting net cash Ilows Irom
operating activities. The direct method shows the speciIic cash inIlows and outIlows
comprising the operating activities oI the business. Under the indirect method, the

CFACENTER.COM 45
computation begins with accrual-based net income and then shows adjustments necessary
to arrive at net cash Ilows Irom operating activities. Both methods result in the same
dollar amount oI net cash Ilows Irom operating activities.

Both the direct and indirect methods are acceptable Ior Iinancial reporting
purposes. However, the direct method discloses more inIormation about a Iirm.
Partly because Iirms want to limit inIormation disclosed, the indirect method is
more commonly used.

The reporting oI investing and Iinancing activities are the same Ior both direct and
indirect methods. Only the reporting oI CFO is diIIerent.

c. calculate, using the indirect method, the net cash provided or used by operating
activities.

Note: This illustrations combines los c and d.

Both the income statement and the CFP section oI the statement oI cash Ilows indicate a
Iirm's perIormance Irom its operating activities. The income statement is based on an
accrual basis. The CFO section presents the net cash Ilows Irom operating activities.

The major operating cash Ilows are (1) cash received Irom customers, (2) cash paid to
suppliers and employees, (3) interest and dividends received, (4) interest paid, and (5)
income taxes paid. These cash Ilows are computed by converting the income statement
amounts Ior revenue, cost oI goods sold, and expenses Irom the accrual basis to the cash
basis. This is done by adjusting the income statement amounts Ior changes occurring over
the period in related balance sheet accounts.

The indirect method uses net income (as reported in the income statement) as the starting
point in the computation oI net cash Ilows Irom operating activities. Adjustments to net
income necessary to arrive at net cash Ilows Irom operating activities Iall into three
categories: noncash expenses, timing diIIerences, and nonoperating gains and losses.
Adjustments reconcile net income (accrual basis) to net cash Ilows Irom operating
activities. In other words, the indirect method adjusts net income Ior items that aIIected
reported net income but did not aIIect cash.

The Iour step process:

Start with net income.

Add back noncash charges such as depreciation and amortization oI intangibles.
Cash payments Ior long-lived assets such as plant and intangibles occur when

CFACENTER.COM 46
they are purchased. Purchase oI these assets is reIlected as an investing activity at
that time. When depreciation expense is recognized in the current period, it
simply indicates the paper allocation oI original purchase cost to this period. As a
result, expenses increase without a corresponding cash outlay. Since depreciation
does not aIIect cash Ilow, it should be added back to net income to compute net
CFO.

Add back losses and subtract gains Irom investing or Iinancing activities.
Examples include gains/losses Irom sale oI property, plant and equipment
(investing activity), or gains/losses Irom early retirement oI debt (Iinancing
activity). Why? Let's use disposal oI Iixed assets to illustrate this. The gains and
losses Irom the disposal oI Iixed assets appear on the income statement. However,
disposal oI Iixed assets is an investing activity, so the entire cash receipt is shown
as an investing cash inIlow. ThereIore, the gains or losses should be removed
Irom net income so as to prevent double counting cash Ilows. Note that it is the
proceeds Irom disposal, not the gain or loss, that constitute the cash Ilow.

Adjust Ior changes in operating related accounts (current assets and current
liabilities other than cash, short-term borrowings and short-term investments). For
example, an increase in current asset ties up cash, thereby reducing operating cash
Ilow. An increase in current liabilities postpones cash payments, thereby Ireeing
up cash and increasing operating cash Ilows in the current period. Increase in
assets reduces cash, and should be deducted Irom net income. Increase in
liabilities increases cash, and should be added to net income.

Note that short-term investments are considered an investing activity, and short-
term borrowing is considered a Iinancing activity.

Selton Co.'s balance sheet and income statement are presented below:
Comparative Balance Sheet (December 31.)
Assets 2000 1999 Net Change
Cash 44,000 22,000 22,000
Accounts receivable 26,000 28,000 -2,000
Inventories 60,000 -0- 60,000
Prepaid expenses 4,200 6,200 -2,000
Land 10,000 30,000 -20,000
Buildings 150,000 150,000 -0-
Accumulated depreciation - buildings (40,000) (20,000) 20,000
Equipment 101,000 89,000 12,000
Accumulated depreciation - equipment (20,000) (12,000) 8,000
Totals 335,200 293,200
Liabilities and Stockholder's Equity
Accounts payable 33,000 30,000 3,000
Bonds payable 100,000 140,000 -40,000
Common stock ($1 par) 170,000 100,000 70,000
Retained earnings 32,200 23,200 9,000

CFACENTER.COM 47
Totals 335,200 293,200

Income Statement (December 31. 2000)
Revenue 800,000
Costs oI goods sold 475,000
Operating expenses 220,000
Interest expense 8,000
Loss on sale oI equipment 2,000
Income from operations 95,000
Income tax expense 38,000
Net income 57,000

Additional inIormation:
(a) Operating expenses include depreciation expense oI $34,000 and amortization oI
prepaid expenses oI $2,000
(b) Land was sold at its book value Ior cash.
(c) Cash dividend oI $48,000 were paid in 2000.
(d) Interest expense oI $8,000 was paid in cash.
(e) Equipment with a cost oI $36,000 was purchased Ior cash. Equipment with a cost oI
$24,000 and a book value oI $18,000 was sold Ior $16,000 Ior cash.
(I) Bonds were redeemed at their book value Ior cash.
(g) Common stock ($1 par value) was issued Ior cash.

Explanations oI the adjustments to net income oI $57,000 are as Iollows:
Accounts receivable: the decrease oI $2,000 should be added to net income to
convert Irom the accrual basis to the cash basis.
Inventories: the increase oI $60,000 represents an operating use oI cash Ior which
an expense was not incurred. This amount is thereIore deducted Irom net income
to arrive at cash Ilow Irom operations.
Prepaid expense: the decrease oI $2,000 represents a charge to the income
statement Ior which there was no cash outIlow in the current period. The decrease
should be added back to net income.
Accounts payable: when it increases, cost oI goods sold and expense on a cash
basis are lower than they are on an accural basis. The increase oI $3,000 should
be added back to net income.
Depreciation expense: the depreciation expense Ior the building is $20,000. Due
to the sale oI equipment the depreciation Ior equipment is (24,000 - 18,000)
20,000 - 12,000 $14,000. This amount plus $20,000 should be added back to net
income to determine net cash Ilow Irom operating activities.
Loss on sale oI equipment: the loss oI $2,000 on sale oI equipment should be
added back to net income since the loss did not reduce cash but it did reduce net
income.

Cash Ilows Irom investing and Iinancing activities:
Land: the sale oI land Ior $20,000 is an investing cash inIlow.

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Equipment: the purchase oI equipment Ior $36,000 is an investing cash outIlow,
and the sale Ior $16,000 is an investing cash inIlow.
Bonds payable: this Iinancing activity used cash oI $40,000.
Common stock: common stock oI $80,000 was issued as a Iinancing cash inIlow.
Retained earnings: the increase oI $11,000 is the result oI net income oI $57,000
Irom operations and the Iinancing activity oI paying cash dividends oI $46,000.

The statement oI cash Ilows is prepared as Iollows:
Statement of Cash Flows
Cash flows from operating activities
Net income 57,000
Depreciation expense 34,000
Decrease in accounts receivable 2,000
Increase in inventories -60,000
Decrease in prepaid expense 2,000
Increase in accounts payable 3,000
Loss on sale oI equipment 2,000 -17,000
Net cash provided by operating activities 40,000
Cash flows from investing activities
Sale oI land 20,000
Sale oI equipment 16,000
Purchase oI equipment -36,000
Net cash provided by investing activities -0-
Cash flows from financing activities
Redemption oI bond -40,000
Sale oI common stock 70,000
Payment oI dividends -48,000
Net cash provided by financing activities -18,000
Net increase in cash 22,000
Cash, January 1, 2000 22,000
Cash, December 31, 2000 44,000

d. prepare the statement of cash flows using the indirect method.

Please reIer to LOS c Ior the illustration.


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e. calculate, using the direct method, the net cash provided or used by operating
activities.

The principal advantage oI the indirect method is that it Iocuses on the diIIerences
between net income and net cash Ilow Irom operating activities. On the other hand, the
principal advantage oI the direct method is that it shows operating cash receipts and
payments.

Under the direct method, the statement oI cash Ilows reports net cash Ilows Irom
operations as major classes oI operating cash receipts and cash disbursements. This
method converts each item on the income statement to its cash equivalent. The net cash
Ilows Irom operations are determined by the diIIerence between cash receipts and cash
disbursements.

Assume that Bismark Company has the Iollowing balance sheet and income statement
inIormation:
Comparative Balance Sheet (December 31.)
Items 2000 1999
Cash 64,000 58,000
Receivables 50,000 58,000
Inventory 74,000 76,000
Prepaid expenses 6,000 5,000
Accounts payable 60,000 72,000
Taxes payable 10,000 5,000

Income Statement 2000
Sales 242,000
Costs oI goods sold (105,000)
Gross proIit 137,000
Selling and administrative expenses (58,000)
Income beIore income taxes 79,000
Income tax expense (30,000)
Net income 49,000

Additional inIormation:
(a) Receivables relate to sales and accounts payable relate to cost oI goods sold.
(b) Depreciation oI $5,000 and prepaid expense both relate to selling and administrative
expenses.

Direct Method:

Cash sales: sales on accural basis are $242,000. Since the receivables have
decreased by $8,000, the cash collections are higher than accural basis sales.
Sales $242,000
Add decrease in receivables 8,000
Cash sales $250,000

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Cash purchases: since inventory decreased by $2,000, goods purchased in prior
years were used as cost oI goods sold. Since accounts payable decreased by
$12,000, more cash was paid in 2000 Ior goods than is reported under accural
accounting.
Costs oI goods sold $105,000
Deduct decrease in inventories 2,000
Add decrease in accounts payable 12,000
Cash purchases $115,000

Cash selling and administrative expense: the selling and administrative expenses
include a non-cash charge related to depreciation oI $5,000. In addition, prepaid
expenses (assets) increased by $1,000 and should be added to the selling and
administrative expenses.
Selling and administrative expenses $58,000
Deduct depreciation expense 5,000
Add increase in prepaid expense 1,000
Cash selling and administrative expenses $54,000

Cash income taxes: income tax on the accrual basis are $30,000. Tax payable,
however, has increased by $5,000. This means a portion oI the taxes has not been
paid. As a result:
Income tax expense $30,000
Deduct increase in taxes payable 5,000
Income tax paid $25,000

The presentation oI the direct method Ior reporting net cash Ilow Irom operating
activities:
Statement of Cash Flows (Partial)Direct Method
Cash flow from operating activities
Cash received Irom customers $250,000
Cash paid to suppliers $115,000
Selling and administrative expenses paid 54,000
Taxes paid 25,000
Cash disbursed Ior operating activities $194,000
Net cash provided by operating activities $56,000


CFACENTER.COM 51
K. Framework for Financial Statement Analysis

a. explain the goals of financial reporting according to the FASB conceptual
framework.

Investors and creditors use Iinancial statements to make better economic decisions.
However, Iinancial statements are only an approximation oI economic reality. Economic
events and the corresponding entries diverge across three dimensions:

Timing: Economic events and accounting entries oIten occur at diIIerent time.
For example, management oIten writes down long-lived assets in an accounting
period diIIerent Irom when the impairment takes place.

Measurement: GAAP oIten permit diIIerent methods to be used to recognize
economic events. For example, a Iirm may choose the straight-line method Ior
depreciation oI Iixed assets, while another Iirm may choose the double-declining
balance method.

Recognition: Many economic events are not recognized in Iinancial statements.
For example, some contracts such as operating leases are disclosed only in
Iootnotes by some companies.

In addition, accounting treatments vary signiIicantly among countries in each oI
these dimensions.

Financial statements prepared according to GAAP are mainly used by users who are
external to the company.
Equity investors are primarily interested in the Iirm's long-term earning power,
growth, and ability to pay dividends.
Short-term creditors are more interested in the Iirm's immediate liquidity.
Long-term creditors are primarily concerned with the Iirm's long-term asset
position and earning power.
Government, regulatory and tax authorities.
The general public, and special interest groups.

The FASB has sought to establish a conceptual Iramework with the hope oI creating a
system oI consistent Iinancial reporting objectives and concepts. The Iramework is used
as a basis by the board to set accounting standards. According to the Iramework, the
goals oI Iinancial reporting are to provide inIormation Ior decision-making by creditors
and equity investors. Such inIormation includes inIormation on the amount, timing, and
uncertainty oI the Iirm's Iuture cash Ilows.

The Iramework deIines the qualitative characteristics oI accounting inIormation:


CFACENTER.COM 52
Relevance: to be relevant, accounting inIormation must be capable oI making a
diIIerence in a decision. Timeliness is a primary ingredient oI relevance as
inIormation loses value rapidly in the Iinancial world.

Reliability: to be reliable, accounting inIormation must be veriIiable, have
representational IaithIulness, and be reasonably Iree oI error and bias (this is
known as neutrality).
Note that relevance and reliability tend to be conIlicting qualities. For example,
inIormation on current market value may be highly relevant, but may have limited
reliability. Another example is historical cost: it is highly reliable but may have
little relevance.

Consistency: accounting inIormation is consistent iI the same accounting
principles are used Irom period to period. ThereIore, consistency allows
comparisons across diIIerent periods Ior the same company. It is aIIected by new
accounting standards, and voluntary changes in accounting principles and
estimates.

Comparability: accounting inIormation is comparable iI inIormation has been
measured and reported in a similar manner Ior diIIerent companies. ThereIore,
comparability allows comparisons among companies. Comparability is a common
problem in Iinancial analysis as Iirms may choose diIIerent accounting methods
and estimates. There are also real diIIerences between Iirms.

II you are interested, you may want to know more details presented below.

At the Iirst level oI the Iramework, the objectives identiIy the goals and purposes oI
accounting and are the building blocks Ior the conceptual Iramework. The objectives are
to provide inIormation that is
UseIul to those making investment and credit decisions who have a reasonable
understanding oI business and economic activities.
HelpIul to present and potential investors and creditors and other users in
assessing the amounts, timing and uncertainty oI Iuture cash Ilows.
About economic resources, the claims to those resources, and the changes in them.

The second level is about:
The qualitative characteristics oI accounting inIormation: relevance, reliability,
comparability and consistency.
Elements oI Iinancial statements: assets, liabilities, equity, etc.

The third level is about recognition and measurement concepts:
Assumptions: economic entity assumption, going concern assumption, monetary
unit assumption and periodicity assumption.
Principles: historical cost principle, revenue recognition principle, matching
principle, and Iull disclosure principle.

CFACENTER.COM 53
Constraints: cost-beneIit relationship, materiality, industry practices, conservatism.
The Iour basic types oI adjusting entries are made to (1) convert assets to
expenses, (2) convert liabilities to revenue, (3) accrue unpaid expenses, and (4)
accrue unrecorded revenue. OIten a transaction aIIects the revenue or expenses oI
two or more accounting periods. The related cash inIlow or outIlow does not
always coincide with the period in which these revenue or expense items are
recorded. Thus, the need Ior adjusting entries results Irom timing diIIerences
between the receipt or disbursement oI cash and the recording oI revenue or
expenses.

The concept oI materiality allows accountants to use estimated amounts and even
to ignore other accounting principles iI these actions will not have a material
eIIect on Iinancial statements. A material eIIect is one that might reasonably be
expected to inIluence the decisions made by users oI Iinancial statements. Thus
accountants may count Ior immaterial items and events in the easiest and most
convenient manner.

b. compare and contrast the Securities and Exchange Commission's (SEC's) and
FASB's role in developing and enforcing U.S. CAAP.

In the US, the Iorm and content oI the Iinancial statements oI companies whose securities
are publicly traded are governed by the SEC through its regulation S-X. The SEC
Iunctions as a highly eIIective enforcement mechanism Ior standards promulgated in the
private sector. Although the SEC has delegated much oI this responsibility to the FASB,
it Irequently adds its own requirements. In some areas SEC-required disclosures precedes
FASB action.

Since 1973, FASB has been the organization designated to establish authoritative
Iinancial accounting and reporting standards Ior businesses and other private-sector
organizations; it succeeded the Accounting Principles Board oI the AICPA as the
standards-setting body. FASB pronouncements are recognized as authoritative by the
SEC. The FASB is a non-governmental body. New FASB statements immediately
become part oI GAAP.

Foreign issuers may sell securities in the US by registering with the SEC. They are
subject to substantially the same reporting requirements as their US counterparts.

c. identify the accounting pronouncements that are considered authoritative for U.S.
CAAP purposes and the order of hierarchy of such accounting principles.

CFACENTER.COM 54

OIIicially established, authoritative accounting principles (also reIerred to as authoritative
literature or pronouncements):
FASB Statements oI Financial Accounting Standards (SFAS)
FASB Interpretations (FIN) which modiIy, extend, clariIy and elaborate on
existing SFAS, AICPA Accounting.
Principles Board Opinions and Accounting Research Bulletins
AICPA Opinions and their Interpretations which have not been superseded
AICPA Accounting Research Bulletins which have not been superseded

Examples:
Statement oI Financial Accounting Standards No. 131, Disclosures about
Segments oI an Enterprise and Related InIormation.
APB Opinion No. 18, The Equity Method oI Accounting Ior Investments in
Common Stock

d. discuss the roles of the International Organization of Securities Commissions
(IOSCO) and the International Accounting Standards Committee (IASC) in setting
and enforcing global accounting standards.

Accounting and reporting standards vary signiIicantly across countries. DiIIerences in
accounting and reporting standards make it diIIicult Ior creditors and investors to
compare domestic and Ioreign companies. Two organizations play a signiIicant role in
developing and enIorcing international accounting standards:

IOSCO is an organization oI securities regulators Irom more than 65 countries,
including the SEC Irom the US. Its Technical Committee investigates regulatory
issues related to international securities transactions and is charged with
developing solutions to problems in these areas. Its international accounting
standards can be recognized by IOSCO members Ior use in cross-border oIIerings
and global multiple listings. However, each country' regulatory agency would
have to approve these standards. It appears that enIorcement would also remain a
country-by-country matter.

The ISAC attempts to harmonize (conIorm) the accounting standards oI diIIerent
nations. It is a non-governmental body with representatives Irom national
accounting Iederations, stock exchanges, Iinancial institutions, and other groups.
The ISAC has largely 'caught up' with the FASB: the organization and
responsibility oI the ISAC is similar to those oI the FASB in the US. ThereIore,
ISAC has emerged as a rival source oI accounting standards.


CFACENTER.COM 55
e. define and explain the components of and relationships among the income statement,
balance sheet, and cash flow statement.

The balance sheet (statement oI Iinancial position) reports major classes and amounts oI
assets (resources owned or controlled by the Iirm), liabilities (external claims on those
assets), and stockholders' equity (owners' capital contributions and other internally
generated resources oI capital) and their interrelationships at speciIic points in time.

Assets Liabilities + Stockholders' Equity

Assets are probable Iuture economic beneIits obtained or controlled by a
particular entity as a result oI past transactions or events.
Liabilities are Iuture sacriIices oI economic beneIits arising Irom present
obligations oI a particular entity to transIer assets or provide services to other
entities in the Iuture as a result oI past transactions or events.
Stockholders' Equity is the residual interest in the net assets oI an entity that
remains aIter deducting its liabilities.

The changes in the balance sheet during a Iiscal year are explained by the statement oI
cash Ilows and the income statement.

The income statement (statement oI earnings) reports on the perIormance oI the Iirm,
the result oI its operating activities. It explains some but not all oI the changes in the
assets, liabilities and equity oI the Iirm between two consecutive balance sheet dates. Use
oI the accrual concept means that income and the balance sheet are interrelated.
Revenues are Ilows oI an entity Irom delivering or producing goods, rendering
services, or other activities that constitute the entity's ongoing major or central
operations.
Expenses are outIlows Irom delivering or producing goods, rendering services, or
carrying out other activities that constitute the entity's ongoing major or central
operations.
Gains and Losses are increases (decreases) in equity (net assets) Irom peripheral
or incidental transactions. They are non-operating events.

The statement oI cash Ilows reports cash receipts and payments in the period oI their
occurrence. The beginning and ending cash balances tie directly into the Cash accounts
listed on the balance sheets at the beginning and end oI a Iiscal year. The change in the
cash balance is due to operating, investing, and Iinancing activities.
Investing cash Ilows are those resulting Irom acquisition or sale oI property, plant
and equipment, oI a subsidiary or segment and purchase or sale oI investments in
other Iirms.
Financing cash Ilows are those resulting Irom issuance or retirement oI debt and
equity securities and dividends paid to stockholders.
Cash Irom operations includes the cash eIIects oI all transactions that are neither
investing nor Iinancing as deIined above.


CFACENTER.COM 56

f. discuss the additional sources of information accompanying the financial
statements including the Management Discussion and Analysis section and financial
footnotes.

Additional sources include:
Management Discussion and Analysis is required by the SEC. It provides the
management's assessment oI the Iirm's Iinancial perIormance and business
conditions. The MD&A is required to discuss:
Results of operations, including discussion oI trends in sales and
categories oI expense.
Capital resources and liquidity, including discussion oI cash Ilow trends.
Overlook based on known trends.
Note that the MD&A section is not audited.

Footnotes: they provide inIormation about the accounting methods, assumptions
and estimates used by management to develop the data reported in the Iinancial
statements. They are designed to allow users to improve assessments oI the
amounts, timing, and uncertainty oI the estimates reported in the Iinancial
statements. For example, Iootnotes provide additional disclosure in such areas as
Iixed assets, inventory methods, income taxes, pensions, debt, contingencies such
as lawsuits, sales to related parties, etc. Footnotes are an integral part oI the
Iinancial statements.

Supplementary Schedules: In some cases additional inIormation about assets
and liabilities oI a Iirm is provided as supplementary data outside the Iinancial
statements. Examples include oil and gas reserve reported by oil and gas
companies, the impact oI changing prices, sales revenue, operating income and
other inIormation Ior major business segments. Some oI the supplementary data
are unaudited.

Other sources: periodic "fact books" prepared by companies, corporate press
releases, trade publications, company web site, etc.

g. discuss the role of the auditor and the meaning of the audit opinion.

The auditor (independent certiIied public accountant) is responsible Ior seeing that the
Iinancial statements issued conIorm with generally accepted accounting principles. In
contrast, the Iirm's management is responsible Ior the preparation oI the Iinancial
statements. Thus, the auditor must agree that management's choice oI accounting

CFACENTER.COM 57
principles is appropriate and any estimates are reasonable. The auditor also examines the
company's accounting and internal control systems, conIirm assets and liabilities, and
generally tries to be sure that there are no material errors in the Iinancial statements.

Though hired by the management, the auditor is supposed to be independent and to serve
the stockholders and the other users oI the Iinancial statements.

An auditor's report (also called the auditor's opinion) is issued as part oI a Iirm's
audited Iinancial report. It tells us the Iollowing:
Whether the Iinancial statements are presented in accordance with generally
accepted accounting principles.
IdentiIy those circumstances in which such principles have not been consistently
observed in the current period in relation to the preceding period.
InIormative disclosures in the Iinancial statements are to be regarded as
reasonably adequate unless otherwise stated in the report.

The audit report should provide useIul inIormation to investors. One investment banker
noted, "probable the Iirst item to check is the auditor's opinion to see whether or not it is a
clean one" - in conIormity with generally accepted accounting principles' - or is qualiIied
in regard to diIIerences between the auditor and company management in the accounting
treatment oI some major item, or in the outcome oI some major litigation.


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A. Accounting Income and Assets: The Accrual Concept

a. describe the format of the income statement and describe the components of net
income.

The income statement lists income and expenses as they are directly related to the Iirm's
recurring income. The Iormat oI the income statement is not speciIied by US GAAP.
Actual Iormat vary across companies. The Iollowing is a generic sample:

Revenues Irom the sale oI goods and services
Other income and revenues
- Operating expenses
- Financing costs
/-Unusual or inIrequent items
Pretax earnings Irom continuing operations
- Income tax expense
Net income Irom continuing operations
/-Income Irom discontinued operations (net oI tax)
/-Extraordinary items (net oI tax)
/-Cumulative eIIect oI accounting changes (net oI tax)
Net income.

Operating income is listed Iirst to reIlect the importance oI gross profit (sales - costs oI
goods sold). The other components oI net income are introduced sequentially (other
income and revenues, Iinancing costs, unusual items and taxes) to enhance their
useIulness to the analyst in Iorming expectations oI the Iirm's Iuture income and cash
Ilow.

The goal oI income statement analysis is to derive an eIIective measure oI Iuture earnings
and cash Ilows. Analysts need data with predictive ability, hence income from
continuing (recurring) operations is considered to be the best indicator oI Iuture
earnings. As operating expenses does not include Iinancing costs such as interest expense,
income Irom continuing operations is independent oI the Iirm's capital structure.

In the typical income statement this means segregating the results oI normal, recurring
operations Irom the eIIects oI nonrecurring or extraordinary items to improve the
Iorecasting oI Iuture earnings and cash Ilows. The idea here is that recurring income is
persistent. II an item in the unusual or inIrequent component oI income Irom continuing
operations is deemed to not to be persistent, then recurring (pretax) income Irom
continuing operations should be adjusted. The adjusted net income Irom recurring
operations can be derived using the Iollowing equation:

Net income Irom recurring operations net income Irom continuing operations /-
|unusual or inIrequent items (1 - tax rate)|.

Some commonly used income terms:

CFACENTER.COM 59

Income or economic earnings equals net cash Ilow plus the change in the market
value oI the Iirm's assets. With a known interest rate, the market value equals the
present value oI cash Ilows, thereIore there exists a neat relationship between
economic income, cash Ilows and asset values.

Distributable earnings equal the amount oI earnings that can be paid out as
dividends without changing the value oI the Iirm.

Sustainable income is income that can be sustained in the Iuture given a Iirm's
capital investment.

Permanent income is the amount oI income that can be earned each period given
the Iirm's assets.

Accounting income is based on the accrual concept and deals with a Iirm's ability
to generate Iuture cash Ilows.

b. identify the requirements for revenue recognition to occur.

There are two revenue and expense recognition issues when accrual accounting is used to
prepare Iinancial statements:
Timing: when should revenue and expense be recognized?
Measurement: how much revenue and expense should be recognized?

Revenue is generally recognized when (1) realized or realizable and (2) earned.

The general rule Ior revenue recognition includes the "concept of realization". Two
conditions must be met Ior revenue recognition to take place:

1. Completion oI the earnings process.
The Iirm must have provided all or virtually all the goods or services Ior which it
is to be paid, and it must be possible to measure the total expected cost oI
providing the goods or services. No remaining signiIicant contingent obligation
should exist. This condition is not met is the Iirm has the obligation to provide
Iuture services (such as warranty protection) but cannot estimate the associated
expenses.

2. Assurance oI payment.
The quantiIication oI cash or assets expected to be received Ior the goods or
services provided must be reliable.

CFACENTER.COM 60
These conditions are typically met at time oI sale, but there are many exceptions.
Examples are:
during production such as long-term construction contracts.
end oI production but beIore the sale takes place such as mining oI certain
minerals Ior which, once the minerals is mined, a ready market at a standard price
exists.
receipt oI cash due to uncertainty oI collection such as installment sales.

The amount oI revenue recognized at any given point in time is measured as:

(Goods and services provided to date / Total goods and services to be provided) x Total
expected revenue

This equation measures the amount oI revenue recognized cumulativelv to date. Revenue
reported Ior the current period is the cumulative total less revenue recognized in prior
periods.

c. describe the matching principle for revenue and expense recognition.

The matching principle states that operating perIormance can be measured only iI
related revenues and expenses are accounted Ior during the same period ("let the expense
follow the revenues"). Expenses are recognized not when wages are paid, or when the
work is perIormed, or when a product is produced, but when the work (service) or the
product actually makes its contribution to revenue. Thus, expense recognition is tied to
revenue recognition.

Expenses incurred to generate revenues must be matched against those revenues in the
time periods when the revenues are recognized.
II the revenues are recognized in the current period, the associated expenses
should be recognized in the current period and appear in the income statement.
II revenues are expected to be recognized in Iuture periods, the associated
expenses are capitalized (appearing on the balance sheet oI the current period as
an asset). When the revenues are recognized in Iuture periods, the asset is
converted to expenses in those periods.

The problem oI expense recognition is as complex as that oI revenue recognition. For
costs that are not directly related to revenues, accountants must develop a "rational and
systematic" allocation policy that will approximate the matching principle. However, the
matching permits certain costs to be deIerred and treated as assets on the balance sheet
when in Iact these costs may not have Iuture beneIits. II abused, this principle permits the
balance sheet to become a "dumping ground" Ior unmatched costs.


CFACENTER.COM 61
The principle does not imply that cash is not important and relevant. Over time, cash Ilow
and income based on the accrual method converge. They diIIer only as to timing oI
recognition. Accrual accounting provides better Iorward-looking inIormation, but at the
same time it requires estimation and judgments, which are subject to management
manipulation.

Firms have strong incentives to use accounting methods that accelerate the recognition oI
revenues and postpone the recognition oI expenses. The special accounting issues in
revenue and expense recognition can be categorized as Iollows:

Revenue Recognition
Firms may use sales incentives to achieve revenue goals. Such incentives
include oIIering discounts, granting stock options to customers, and
providing rights oI return to customers.
Firms may provide goods or services to each other, and record the
revenues at "list prices" that are higher than the Iair market prices. Such
transactions are known as barter arrangements.
Firms may record license Iees or membership Iees when an arrangement is
signed, rather than over the term oI the arrangement.
Firms may record shipping and handling costs as revenues.
Firms may recognize all revenue Irom a contract beIore the customer
agrees that the project is Iully operational.
Firms acting as agents may record the gross amount billed to customers as
revenue. However, under GAAP the only amount they can record as
revenue is their commission income.
Many utility companies record "unbilled revenues" as sales, even when
bills have not been sent out.

Expense Recognition
Firms may deIer recognition oI marketing expenses and sales
commissions, thereby increasing reported earnings. DeIerred expenses
must be recognized sooner or later. For growth companies, however,
deIerral oI expenses may exceed the recognition oI previously deIerred
expenses over a long period oI time.
Firms may deIer the costs oI periodic major maintenance projects until
actually incurred.
Firms may change their estimate oI bad debts or warranty expenses to
smooth earnings and/or delay the reporting oI bad news.

Classification
Firms may distort analyses and comparison oI gross margin levels,
percentage, and growth rates by changing the classiIication oI revenue and
expenses. For example, Iirms may record discounts, marketing costs,
shipping and handling costs as operating expense rather than cost oI goods
sold. As a result, cost oI goods sold is underestimated, thereby boosting
gross margin levels and percentage without reducing operating income.

CFACENTER.COM 62

Note: Gross margin is equal to revenues less cost oI goods sold, and gross
margin percentage is the gross margin as a percentage oI sales.

d. discuss different revenue recognition methods and their implications for financial
analysis.

Sales basis method

Revenue is recognized at the time oI sale, where title oI the goods or services are
transIerred to the buyer, and the sale is Ior cash or accounts receivable which is
collectable. The earning process is typically complete here. II cash is received beIore
goods or services are provided, the revenue is not recognized until it is earned. As this
method is the general rule Ior revenue recognition, all other methods are compared with it.

Installment sales

This method is used iI the costs to provide goods or services are known, but the
collectibility oI sales proceeds cannot be reasonably determined. It recognizes both
revenue and associated cost oI goods sold only when cash is received. Gross proIit (sales
- costs oI goods sold) reIlects the proportion oI cash received. This method is sometimes
used to report income Irom sales oI noncurrent assets and real estate transactions.

Cost recovery

This method is similar to installment sales method but is more conservative. It is used iI
the costs to provide goods or services cannot be reasonably determined. Sometimes there
is also substantial uncertainty about the collectivity oI sales proceeds. Under this method,
sales are recognized when cash is received, but no gross proIit is recognized until all oI
the costs oI goods sold is collected. That is, it recognizes proIit only when cash
collections exceed the total cost oI the product sold.

For both installment and cost recovery methods, analysts may need to rely on the cash
Ilow statement to Iully reveal the Iirm's current and Iuture proIitability.

Percentage of completion
Revenues and expenses are recognized each period in proportion to the work completed.
It is used Ior a long-term project iI all oI the Iollowing conditions are met:
There is a contract.
There are reliable estimates oI revenues, costs, and progress towards completion.
The buyer can be expected to pay the Iull contract price on schedule.

CFACENTER.COM 63
It recognizes proIit corresponding to the percentage oI cost incurred to total estimated
costs associated with long-term construction contracts. It is the preIerred method because
it provides a better measure oI operating activities, and a more inIormative disclosure oI
the status oI incomplete contracts. It also Iacilitates Iorecast oI Iuture perIormance and
cash Ilows. This method highlights the relationship among the income statement
(revenues), the balance sheet (resulting receivables) and the cash Ilow statement (current
collections).

The percentage oI completion is equal to actual cost / estimated total cost, or it can be
determined by an engineering estimate. Using the Iirst approach:
Percent completed Costs incurred to date / Most recent estimate oI total costs
Revenue to be recognized to date Percent complete x Estimated total revenue
Current period revenue Revenue to be recognized to date - revenue recognized
in prior periods.

You may have noticed that the most recent estimate oI the total cost is used in computing
the progress toward completion. It means that iI cost estimates are revised as the project
progresses, that eIIect is recognized in the period in which the change is made. Costs and
revenues oI prior periods are not restated.

Completed contract

It does not recognize revenue and expense until the contract is completed and title is
transIerred. All proIits are recognized when the contract is completed. The completed
contract method is used when:
There is no contract; or
Estimates oI revenues, costs, or progress towards completion are unreliable; or
The ability to collect revenues Irom the buyer is uncertain.

This method is more conservative than the percentage-oI-completion method. Analysts
may need to rely on the statement oI cash Ilows to assess the contribution oI long-term
contracts to a Iirm's proIitability.

e. discuss ways that management can manipulate earnings by using discretion in
presenting financial statements.

Net income, also called the "bottom line", is very important in measuring a Iirm's
perIormance. Analysts have signiIicant interest in evaluating the quality oI net income,
also known as the quality of earnings. The quality oI earnings reIers to the substance
and sustainability oI earnings. It reIers to the use oI accounting methods and assumptions
that tend not to overstate reported revenues and earnings. It may be aIIected by two
Iactors:

CFACENTER.COM 64
The accounting methods and estimates chosen by the Iirm's management.
The nature oI non-operating items on the income statement.

Firms have considerable latitude in the choice oI accounting methods and estimates,
yielding diIIerent reported earnings. For example, Iirms can choose one oI Iour methods
(speciIic identiIication, FIFO, LIFO and average cost) to account Ior inventories. Firms
may also choose diIIerent estimates Ior estimated useIul lives and residual values oI
assets. Another example is the timing oI the occurrence and classiIication oI the item as
to ordinary, unusual or extraordinary income. As a result, two Iirms with comparable
earnings quantity may have very diIIerent earnings quality. Management typically
chooses the accounting methods and estimates to report the most Iavorable earnings
Iigure. In general, an accounting method or estimate that results in lower current
earnings is considered to produce a better qualitv of earnings.

Management manipulation can take one or more oI the Iollowing Iorms:

ClassiIication oI good and bad news: management preIers to report good news
"above the line" as part oI continuing operations and bad news "below the line" as
extraordinary or discontinued operations. Not everything in accounting is clear
cut. For example, sale oI an entire business segment is considered discontinued
operations and should be reported below the line. However, sale oI a portion oI a
business segment is considered as an unusual or inIrequent item and should be
reported above the line. In Iact, management has considerable discretion in
determining whether a transaction qualiIies as a sale oI a business segment.

Income smoothing: The purpose is to reduce earnings in good years and inIlate
earnings in bad years to repot stable earnings. The intertemporal smoothing reIers
to either timing expenditures or choosing accounting methods (e.g. capitalizing
expenditures in bad years while expensing them directly in good years) that
allocate the expenditure over time. Another example is to increase expenditures
such as repairs and marketing in good years, while to cut back these expenditures
in bad years. ClassiIication smoothing is to shiIt item "above or below the line" to
report a desired trend.

Big bath accounting: management may report additional losses in bad years in the
hope that by taking all available losses at one time, they will "clear the decks"
once and Ior all. The implicit assumption is that Iuture proIits will increase.

Accounting changes: the eIIect oI the accounting change tends to be in the
opposite direction oI Iorecast revisions made by analysts in the latter part oI the
Iiscal year.

Example 1: Sale oI equipment as unusual or even extraordinary and there by omit these
losses Irom persistent or recurring net income.


CFACENTER.COM 65
Example 2: "Under depreciating" an asset over it liIe will result in a loss when that assets
is sold or retired. This loss belongs to continuing operations and should not be hidden in
extraordinary items.

f. identify the appropriate revenue recognition method, given the status of completion
of the earning process and the assurance of payment.

Please reIer to los d as those two are quite similar.

g. describe the types and analysis of unusual or infrequent items, discontinued
operations, extraordinary items, and accounting changes.

The goal oI analyzing the income statement is to derive an eIIective indicator to predict
Iuture earnings and cash Ilows. Net income includes the impact oI non-recurring items,
which are transitory or random in nature. ThereIore, net income is not the best indicator
oI Iuture income. Recurring pretax income Irom continuing operations represents the
Iirm's sustainable income, and thereIore should be the primary Iocus oI analysis.

Net Income Irom Recurring Operations Recurring Pretax Income Irom Continuing
Operations x ( 1 - Tax Rate)

Segregating the results oI recurring operations Irom those oI non-recurring items
Iacilitates the Iorecasting oI Iuture earnings and cash Ilows. Generally, analysts should
exclude items that are non-recurring in nature when predicting a Iirm's Iuture earnings
and cash Ilows. However, this does not mean that every non-recurring item in the income
statement should be ignored. Management tend to label many items in the income
statement as "nonrecurring:, especially Ior those that reduce reported income. For the
purpose oI analysis, an important issue is to assess whether nonrecurring items are really
"nonrecurring", regardless oI their accounting labels.

There are Iour types oI nonrecurring items in the income statement.

Unusual or infrequent items

They are either unusual in nature or inIrequent in occurrence, but not both. They may be
disclosed separately (as a single-line item) as a component oI income Irom continuing

CFACENTER.COM 66
operations. They are reported pretax in the income statement and appear "above the line",
while the other three categories are reported on an aIter-tax basis and "below the line" and
excluded Irom "net income Irom continuing operations".

Common examples are:
Gains oI losses Irom disposal oI a portion oI a business segment.
Gains or losses Irom sales oI assets or investments in aIIiliates or subsidiaries.
Provisions Ior environmental remediation.
Impairment, write-oIIs, write-downs, and restructuring costs (such as those costs
related to the integration oI acquired companies).

Extraordinary items

They are unusual in nature and inIrequent in occurrence, and material in amount. They
must be reported separately (below the line), net oI income tax.

Common examples are:
Expropriations by Ioreign governments.
Gains or losses Irom the early retirement oI debt.
Uninsured losses Irom earthquakes, eruptions and tornadoes.

Discontinued operations

Reported in the same manner as extraordinary items, they are not a component oI
persistent or recurring net income Irom continuing operations. To qualiIy, the assets,
results oI operations, and investing and Iinancing activities oI a business segment must be
separable Irom those oI the Iirm. The separation must be possible physically and
operationally, and Ior Iinancial reporting purposes. Any gains or disposal will not
contribute to Iuture income and cash Ilows, and thereIore, can be reported only aIter
disposal, that is, when realized.

Subsidiaries and investees also qualiIy as separate components.
Disposal oI a portion oI a business component does not qualiIy as discontinued
operations. Instead they are recorded as unusual or inIrequent items.

Accounting changes

They can be either voluntary changes or changes mandated by new accounting standards.
They are reported in the same manner as extraordinary items and discontinued operations.
The cumulative impact on prior period earnings should be reported as a separate line item
on the income statement on an aIter tax basis. Generally, restatement oI prior periods'
Iinancial statements is not required, except in the Iollowing areas:

Change Irom LIFO to another inventory method.
Change to or Irom the Iull cost method.
Change to or Irom percentage oI completion method.

CFACENTER.COM 67
Change in accounting methods prior to an initial oIIering.
Be noted that a change Irom an incorrect to an acceptable accounting method is
treated as an error, and its impact is reported as a prior period adjustment.

Nonrecurring items should be scrutinized to assess whether they are truly "nonrecurring".
For example, gains or losses Irom the sale oI Iixed assets are classiIied as an unusual or
inIrequent item. However, Ior a car rental company that retires part oI its Ileet oI cars
annually, such gains or losses are rather recurring in nature. Some nonrecurring charges
are, in Iact, prior period expenses taken too late or Iuture expenses taken too early. For
example, asset write-downs may indicate that prior period depreciation or amortization
changes are insuIIicient. ThereIore, completely ignoring such nonrecurring items in
Iinancial analysis may result in an overestimation oI the Iirm's earning trend.

Nonrecurring items have diIIerent impact on cash Ilows. Some have no direct impact (i.e.
asset write-downs, accounting changes), some only aIIect the current period cash Ilows,
while others aIIects cash Ilows in Iuture periods. Even those nonrecurring items without
direct impact on cash Ilows can provide valuable inIormation about the Iirm's continuing
operations. For example, asset write-oIIs have no impact on cash Ilows since the cash
outlay occurred in the past. However, the write-oIIs can be used to Iorecast the Iirm's
Iuture sales, earnings and cash Ilows.

h. distinguish between U.S. CAAP and IAS CAAP with respect to the treatment of
nonrecurring items and discontinued operations.

IAS No. 35 (Discontinued Operations) standard is a presentation and disclosure standard,
and does not establish new recognition and measurement principles. Discontinued
operation is deIined as a relatively large component oI the enterprise - a business or
geographical segment. The deIinition diIIers slightly Irom the US deIinition, and allows
Ior diIIerent treatment oI the same item.

Required disclosures include:
A description oI the discontinued operation including the segment in which it is
reported
The date the plan was announced
The completion date
The net selling price and the carrying amount oI the assets and liabilities to be
disposed
Revenues expenses and proIit or loss oI the discontinued operation
Gain or loss on disposal oI the assets
Cash Ilows attributable to operating, Iinancial and inventing activities oI the
discontinue operation
FASB StaII Reaction

CFACENTER.COM 68

DiIIerences:
Unlike the US GAAP, IAS GAAP does not require the separate presentation oI
earnings Irom continuing operations, earnings Irom discontinued operations, and
income beIore extraordinary items.
For accounting changes, IAS GAAP permits either the cumulative change
method or the restatement oI prior periods. In general, the US GAAP requires the
cumulative change method.
Under IAS GAAP, errors can be corrected by either including the item in current
period results or restating prior periods.
IAS GAAP requires the estimated losses Irom a discontinued unit to be reported
as incurred. In contrast, the US GAAP requires it to be reported as accrued.
Under IAS GAAP, impairment losses associated with discontinued operations
may be reported as part oI the loss Irom continued operations, even iI
recognized prior to the announcement date. Under the US GAAP, these
impairment losses are reported as part oI the loss Irom discontinued operations.
The discontinuation date under IAS GAAP may be diIIerent Irom that under US
GAAP.

i. describe the format and the components of the balance sheet.

Please reIer to Preliminary Reading LOS 7.1.B.a. as it has a detailed explanation oI this
LOS.

j. describe the format, classification, and use of each component of the statement of
stockholders' equity.

The statement oI stockholders' equity reports ownership interests in order oI preIerence
upon liquidation and dividends. For example, the Iirst item listed gets paid oII Iirst aIter
creditors in the event oI liquidation. For each class oI shares, Iirm reports the number oI
shares authorized, issued, and outstanding at each balance sheet date.

Preferred stock receives dividends and any cash during liquidation beIore common
shareholders. They may have cumulative rights to dividends. Dividends might be Iixed,
variable (Iloating) or tied to dividends paid to common. They might be called by the Iirm

CFACENTER.COM 69
at a speciIic call price and perhaps convertible to common stock at a speciIied exchange
ratio.

Common stock represents residual ownership claims including voting rights and
dividends. Common stock is recorded at par value with the remaining amount invested
contained in additional paid in capital.

Additional paid-in capital.

Treasury stock arises when the Iirm buys back its own stock but does not retire it. It
decreases stockholder's equity.

Retained earnings is simply the total earnings oI the company since its inception less all
dividends paid out.

The statement may also report other items such as the minimum liability recognized Ior
under-Iunded pension plans, market value changes in non-current investments,
cumulative eIIect oI Ioreign exchange rate changes, and unearned shares issued to
employee stock ownership plans.

k. identify the appropriate income statement and balance sheet entries using the
percentage-of-completion method and the completed contract method.

The percentage-of-completion method is used when ultimate payment is assured and
revenue is earned as costs are incurred.

The completed contract method is used when a reliable estimate oI the total costs oI the
contract does not exist, or the amount oI the contract cannot be determined until the
contract is Iinished.

For a Iirm with constant revenues the two methods produce identical results. However,
since the business world is rarely in a steady state oI equilibrium, the percentage-oI-
completion method provides both a better measure oI operating activity and a more
inIormative disclosure oI the status oI incomplete contracts. It recognizes revenue and
income earlier than the second method, and is thus viewed as a better predictor oI trends
in earnings power.


CFACENTER.COM 70
l. describe and calculate the effects on cash flows and selected financial ratios that
result from using the percentage-of-completion method versus the completed contract
method.

Typically, long-term projects have a contract that would be legally enIorceable against
the buyer. ThereIore, the collection oI sales proceeds is reasonably assured by the
contracts. Revenues oI long-term projects are typically recognized prior to the time oI
sale, using either percentage-oI-completion method or completed contract method.

Cash Ilows

They are the same under both methods. Why? Pretax cash Ilows are not aIIected by
accounting policies.

Income statement

The two methods produce diIIerent patterns oI reported revenue, expense, and income,
although the total revenue, expense and income over the liIe oI the contract are identical
under both methods. There are no interim charges or credits to income statement accounts
Ior revenues, expenses and income as they are recognized at the completion oI the project.
Percentage-oI-completion method recognizes revenue, expense and income earlier, and
less volatile income level than the completed contract method.

Balance sheet

Under the completed contract method, expenditures prior to completion are reported as
inventory and cash receipts as advances Irom customers. Under the percentage-oI-
completion method, any diIIerence between cash received and revenue recognized is
treated as accounts receivable.

Most parts oI balance sheet are identical Ior both methods:
Amounts billed to customers are recorded as an asset (accounts receivable) or as a
liability (advance billings).
Cash received reduces accounts receivable.
Costs incurred are accumulated in an asset account titled construction-in-progress.
At the end oI contract period this account and advanced billings accounts are
eliminated.
At the end oI contract period the only remaining balance sheet amounts are cash
and retained earnings.
For Iinancial reporting purposes, construction-in-progress and advance billings
are netted, reducing large activities to relatively small net amounts.

The key diIIerent treatment is: the percentage-oI-completion method accumulates gross
proIit in the construction-in-progress account, but completed contract method does not.


CFACENTER.COM 71
The eIIect is: when there is an excess oI advanced billings over costs, reported total assets
are identical. When construction-in-progress exceeds billings, total assets will be higher
under the percentage-oI-completion method.

This diIIerent treatment leads to (under the percentage-oI-completion method):
Higher total assets.
Lower liabilities.
Higher stockholders' equity.
Lower liabilities-to-equity ratio.
Higher short-term assets (excess level oI construction-in-progress) but same long-
term assets.


CFACENTER.COM 72
B. Analysis of Cash Flows

a. explain the relevance of cash flows to analyzing business activities.

The balance sheet and income statement do not provide cash Ilow inIormation such as:
Where did the cash come Irom during the period?
What was the cash used Ior during the period?

The primary purpose oI the statement oI cash Ilows is to provide inIormation about an
entity's cash receipts and cash payments during a period.

Reporting the sources, uses and net increase or decrease in cash is useIul because
investors, creditors, and others want to know what is happening to a company's most
liquid resource. The inIormation can be used to determine:
The Iirm's ability to generate positive Iuture net cash Ilows.
The Iirm's ability to meet its obligations, its ability to pay dividends, and its needs
Ior external Iinancing.
The Iirm's ability to Iinance growth Irom internally generated Iunds, and to raise
cash to take advantage oI new business opportunities.
The eIIectiveness oI the Iirm's cash Ilow management.
The reasons Ior diIIerences between net income and associated cash receipts and
payments.
The eIIects on an enterprise's Iinancial position oI both its cash and non-cash
investing and Iinancing transactions during a period.

The statement oI cash Ilows is, thereIore, useIul because it provides answers to the
Iollowing simple but important questions:
Where did the cash come Irom during the period?
What was the cash used Ior during the period?
What was the change in the cash balance during the period?

The statement's value is that it helps users evaluate liquidity, solvency, and Iinancial
Ilexibility. Liquidity reIers to the "nearness to cash" oI assets and liabilities. Solvency
reIers to the Iirm's ability to pay its debts as they mature. Cash Ilows reIlect the Iirm's
liquidity and long-term solvency. Financial flexibility reIers to a Iirm's ability to respond
and adapt to Iinancial adversity and unexpected needs and opportunities. For example,
cash Ilow inIormation can be used to evaluate the eIIects oI major investment and
Iinancing decisions.

Unlike net income, cash Ilow is much less likely to be manipulated by management's
choice oI accounting policies and estimates. Trend oI cash Ilows can be compared to that
oI income to evaluate whether income inIormation is reliable. ThereIore, cash Ilow
inIormation allows the analysts to distinguish between the actual events and the results oI
accounting choices.


CFACENTER.COM 73
The statement oI cash Ilows is complementary to the balance sheet and income statement,
providing cash Ilow inIormation. For the purpose oI the statement oI cash Ilows, cash is
deIined to include both cash and cash equivalents. Cash equivalents are highly liquid
investments with original maturities oI 90 days or less. Examples include commercial
paper, US Treasury bills, etc. Note that short-term investments (or marketable securities)
are not considered cash equivalents.

b. describe the elements of operating cash flows.

Cash flows from operations (CFO) reIlect Ilows related to the normal operating
activities oI the business. It measures the amount oI cash generated or used by the Iirm as
a result oI its production and sales oI goods and services. In eIIect, cash Ilows Irom
operating activities are derived by converting the income statement Irom an accrual basis
to a cash basis. For most Iirms positive operating cash Ilows are essential Ior long-run
survival.

The major operating cash Ilows are (1) cash received Irom customers, (2) cash paid to
suppliers and employees, (3) interest and dividends received, (4) interest paid, and (5)
income taxes paid. These cash Ilows are computed by converting the income statement
amounts Ior revenue, cost oI goods sold, and expenses Irom the accrual basis to the cash
basis. This is done by adjusting the income statement amounts Ior changes occurring over
the period in related balance sheet accounts.

These items Ilow through the Iirm's income statement and working capital accounts. The
CFO is computed by adjusting net income Ior all:
Non-cash revenues and expenses.
Non-operating items included in net income.
Non-cash changes in operating assets and liabilities.

The above is the indirect method which has a signiIicant drawback: because oI the
indirect Iormat, it is not possible to compare operating cash inIlows and outIlows by
Iunctions with the revenue and expense activities that generated them, as is possible Irom
cash Ilow statements prepared using the direct method.

Special items to note:

Interest and dividend revenue, and interest expenses are considered operating
activities, but dividends paid are considered Iinancing activities. Excluding
interest payments Irom CFO it would make cash Ilow Irom operations
independent oI the Iirm's leverage decisions. Thus Ior analytical purposes you
might preIer to reclassiIy interest payments as CFF rather than CFO.

CFACENTER.COM 74
All income taxes are considered operating activities, even iI some arise Irom
Iinancing or investing.

c. describe the elements of investing cash flows.

Cash Ilows Irom investing and Iinancing activities are determined by examining the
entries in the related asset and liability accounts, along with any related gains or losses
shown in the income statement. Debit entries in asset accounts represent purchases oI
assets (an investing activity). Credit entries in asset accounts represent the cost oI assets
sold. The amount oI these credit entries must be adjusted by any gains or losses
recognized on these sales transactions.

Cash flows from investing activities reIlect investing activities such as making and
collecting loans and acquiring and disposing oI investments (both debt and equity) and
property, plant, and equipment. Investing cash Ilows essentially deal with the items
appearing on the lower leIt-hand portion oI the balance sheet (Iixed assets and long-term
investments).

Examples are:

Sale or purchase oI property, plant & equipment.
Investments in joint ventures and aIIiliates and long-term investments in securities.
Loans to other entities or collection oI loans Irom other entities.

In case oI the disposal oI an asset, the proceeds Irom the disposal constitute the cash Ilow.
Typically, the asset account is reduced by the cost oI the asset to reIlect the eIIect oI the
disposal. ThereIore, the change in the asset account should be adjusted accordingly. The
gain or loss Irom the disposal does not represent any cash Ilows -- they are merely
bookkeeping adjustments. The entire change in the account is considered investment cash
Ilows.

Note: when analyzing changes in Iixed assets and intangibles, only the gross amounts oI
these accounts are considered. The accumulated depreciation and amortization accounts
should not be considered because they are merely bookkeeping adjustments and do not
aIIect cash.

Trends in gross capital expenditures contain useIul insights into management plans.
Segment disclosures should be monitored Ior diIIerential investment patterns.


CFACENTER.COM 75

d. describe the elements of financing cash flows.

Financing activities involve liability and owner's equity items and include:
obtaining capital Irom owners and providing them with a return on (and a return
oI) their investment.
borrowing money Irom creditors and repaying the amounts oI borrowed. They
deal with the lower right-hand portion oI the balance sheet (long-term debt and
equity).

Examples are:
Dividends paid to stockholders (not interest paid to creditors!). Note that the cash
outIlow caused by dividends is determined by dividends paid, not dividends
declared. Dividends paid are not reIlected in the Retained Earnings account. The
amount is provided in the supplementary inIormation.
II inIormation about dividend payments is provided in the supplementary
data: eIIect on Iinancing cash outIlow dividends paid.
II no inIormation about dividend payments is available but there is a
Dividend Payable account in the balance sheet, it is assumed that dividend
declared have not been paid. Thus, dividends declared have no impact on
Iinancing cash Ilows. eIIect on Iinancing cash outIlow 0.
II no inIormation about dividend payments is available and there is not a
Dividend Payable account, the assumption would be that all dividends
declared have been paid: eIIect on Iinancing cash outIlow dividends
declared.

Issue or repurchase the company's stocks.

Issue or retire long-term debt (including current portion oI long-term debt).

e. classify a particular item as an operating cash flow, an investing cash flow, or a
financing cash flow.

This LOS is just a combination oI LOS b, c and d.

f. compute, explain, and interpret a statement of cash flows, using the direct method
and the indirect method.


CFACENTER.COM 76
Please reIer to Preliminary Reading J - c, d and e.

g. describe and compute free cash flow.

From an analyst's point oI view, cash Ilows Irom operation activities have two major
drawbacks:
CFO does not include charges Ior the use oI long-lived assets. Recall that
depreciation is added back to net income in arriving at CFO.
CFO does not include cash outlays Ior replacing old equipment.

Free cash flow (FCF) is intended to measure the cash available to the Iirm Ior
discretionary uses aIter making all required cash outlays. It accounts Ior capital
expenditures and dividend payments, which are essential to the ongoing nature oI the
business.

The deIinition oI Iree cash Ilow varies depending on how to deIine "required cash
outlays".

The basic deIinition is cash Irom operations less the amount oI capital expenditures
required to maintain the Iirm's present productive capacity. II historical cost depreciation
provided a good measure oI the use oI productive capacity, then FCF would equal CFO
less depreciation expense.
Free cash Ilow CFO - depreciation.

In many Iinance valuation models, required outIlows are deIined as operating cash Ilows
less capital expenditures to replace current operating capacity as well as capital
expenditures necessary to Iinance the Iirm's growth opportunities. Thus:
Free cash Ilow CFO - capital expenditure

Any excess cash Ilow can be Ior discretionary uses including: growth-oriented capital
expenditures and acquisitions; debt reduction; dividend payments and stock repurchases.
However, Iirms typically do not disclose the amount oI cash outlays required to maintain
the current level oI operation.

Valuation models diIIer as to whether FCF is measured by FCF available to the Iirm (all
providers oI equity and debt)) or FCF available to equity shareholders. The Iormer case
requires adjusting Ior interest on debt on a tax-adjusted basis to CFO. There are also
variations that subtract cash dividends.

h. distinguish between the U.S. CAAP and IAS CAAP classifications of dividends paid
or received and interest paid or received for statement of cash flow purposes.


CFACENTER.COM 77
DiIIerences in cash Ilow classiIication:
Interest and dividends received:
Under US GAAP, interest income and dividends received Irom investment
in other Iirms are classiIied as cash Ilows Irom operations.
Under IAS GAAP, interest and dividends received may be classiIied as
either CFO or cash Ilows Irom investing activities (CFI).

Interest paid:
Under US GAAP, interest paid is classiIied as cash Ilows Irom operations
(CFO).
Under IAS GAAP, interest paid may be classiIied as either CFO or cash
Ilow Irom investing activities (CFI).

Dividends paid:
Under US GAAP, dividends paid are classiIied as cash Ilows Irom
Iinancing activities (CFF).
Under IAS GAAP, dividends paid may be classiIied as either CFO or cash
Ilows Irom Iinancing activities (CFF).

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