CFA Level 1

AA

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Chapter 1 - 5 Chapter 6 - 10 6. Financial Statements 6.1 Introduction 6.2 Financial Statement Analysis 6.3 Accounting Process 6.4 Income Statement Basics 6.5 Income Statement Components 6.6 Income Statement: Non-recurring Items 6.7 Balance Sheet Basics 6.8 Balance Sheet Components - Assets 6.9 Balance Sheet Components - Liabilities 6.10 Balance Sheet Components - Marketable & Nonmarketable Instruments 6.11 Shareholders' (Stockholders') Equity Basics 6.12 Components of Stockholders' Equity 6.13 Accounting for Dividends 6.14 Accounting for Equities 6.15 Revenue Recognition 6.16 Revenue Recognition Methods and Implications 6.17 6.18 6.19 6.20 6.21 6.22 6.23 6.24 6.25 6.26 Revenue Recognition and Accounting Entries Revenue Recognition Effects on Cash Flows and Financial Ratios The Cash Flow Statement Cash Flow Statement Basics Cash Flow Computations - Indirect Method Cash Flow Computations - Direct Method Free Cash Flow Management Discussion and Analysis & Financial Statement Footnotes The Auditor and Audit Opinion Financial Reporting Objectives and Enforcement

6.27 Accounting Qualities 6.28 Setting and Enforcing Global Accounting Standards 7. Financial Ratios 8. Assets 9. Liabilities 10. Red Flags Chapter 11 - 15 Chapter 16 - 17

Financial Statements - Introduction

Introduction Financial reporting is the method a firm uses to convey its financial performance to the market, its investors, and other stakeholders. The objective of financial reporting is to provide information on the changes in a firm's performance and financial position that can be used to make financial and operating decisions. In addition to being a management aide, analysts use this information to forecast the firm's ability to produce future earnings and as a means to assess the firm's intrinsic value. Other stakeholders such as creditors will use financial statements as a way to evaluate the economic and competitive strength. The timing and the methodology used to record revenues and expenses may also impact the analysis and comparability of financial statements across companies. Accounting statements are prepared in most cases on the basis of these three basic premises: 1. The company will continue to operate (going-concern assumptions). 2. Revenues are reported as they are earned within the specified accounting period (revenues-recognition principle). 3. Expenses should match generated revenues within the specified accounting period (matching principle). Basic Accounting Methods: 1. Cash-basis accounting - This method consists of recognizing revenue (income) and expenses when payments are made (checks issued) or cash is received (deposited in the bank). 2. Accrual accounting - This method consists of recognizing revenue in the accounting period in which it is earned

(revenue is recognized when the company provides a product or service to a customer, regardless of when the company gets paid). Expenses are recorded when they are incurred instead of when they are paid. A. Financial Statement Analysis The income statement is a statement of earnings that shows managers and investors whether the company made money over the period of time being reported. This statement details the revenues of the firm as well as the expenses incurred to achieve them, and transforms this into net income. The conclusion of the statement is to show the firm's gains or losses for the period. The balance sheet reports the company's financial position at a specific point in time. The balance sheet is made up of three parts: assets, liabilities and owners' equity. Assets detail the firm's economic resources that have been built up through the firm's operations or acquisitions. Liabilities are the current or estimated obligations of the firm. The difference between assets and liabilities is known as net assets or net worth of the firm. The net assets of the firm are also known as owners' equity, which is amount of assets that would remain once all creditors are paid. According to the accounting equation, owners' equity equals assets minus liabilities Assets Liabilities = Owners' Equity The statement of cash flows reconciles the firm's net income to its reports on the company's cash inflows and outflows. It shows how changes in balance sheet accounts and income affect cash and cash equivalents. These cash receipts and payments are categorized as by operating cash flows, investing cash flows and financing cash flows The statement of changes in owners' equity reports the sources and amounts of changes in owners' equity over the period of time being reported Let's consider a practical example to fully understand the impact of Cash versus Accrual Accounting on XYZ Corporation's Income Statement and Balance Sheet. Cash Basis Accounting Taken as is, the financial statements in Figure 6.1 below indicate that XYZ Corporation is not doing well, with a net loss of $43,200, and may not be a good investment opportunity. Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting

Note: For simplicity the tax effect not considered. Accrual Basis Accounting Armed with some additional information, let's see what the income statement would look like if the accrual-basis accounting method was used. Additional Information: A1. June 12, 2005 - The company received a rush order for $80,000 of wood panels. The order was delivered to the customer five days later. The customer was given 30 days to pay. (With the cash-basis method, sales are not recorded in the income statement and not recorded in accounts receivables: no cash, no record). A2. June 13, 2003 - The company received $60,000 worth of wood panels to replenish their inventory, and $40,000

was related to the rush order. The company paid the invoice in full to take advantage of a 2% early-payment discount. (With the cash-basis method, this is recorded in full on the income statement, and there is no record of inventory on hand). A3. June 1, 2005 - The company launched an advertising campaign that will run until the end of August. The total cost of the advertising campaign was $15,000 and was paid onJune 1, 2005. Figure 6.2: XYZ Corporation's Restated Financial Statements using Accrual Basis Accounting

Note: tax effect not considered Adjustments: To obtain the figures in the restated financial statements in figure 6.2 above, the following adjusting entries were made: A1. Product sales and Accounts receivable - Even though the client has not paid this invoice, the company still made a sale and delivered the products. As a result, sales for the accounting period should increase by $80,000. Account s receivables (reported sales made but awaiting payment) should also increase by $80,000. Adjusting entries:

A2. June 13, 2003 - Since the entire $60,000 order was paid during the accounting period, the full amount was included in production costs under the cash-basis method. Only $40,000 of the order was related to product sales during that accounting period, and the rest was stored as inventory for future product sales. Adjusting entries:

A3. June 1, 2005 - Marketing expenses included in the income statement totaled $15,000 for a three-month advertising campaign because it was paid in full at initiation (cash-basis accounting). The reality is that this campaign will last for three months and will generate a benefit for the company every month. As a result, under accrual-basis accounting, the company should record in this accounting period only one-third of the cost. The remainder should be allocated to the next period and recoded as prepaid expenses on the assets side of the balance sheet. Adjusting entries:

Results: Under cash-basis accounting, this company was not profitable and its balance sheet would have been weak at best. Under accrual accounting, the financials tell us a very different story. Accrual accounting requires that revenue is recorded when the firm earns it, and that expenses are taken when the firm incurs them regardless of when the cash is actually received or paid. If cash is received first then an unearned revenue or prepaid expense account is set up and decreased as the revenue and expense is recorded over time. If cash is received after goods are delivered then the revenue and expense is recorded and a receivables or payables account is set up and decreased as the cash is paid. Most accruals fall into one of four categories: 1. Accrued Revenues: A firm will usually earn revenue before it is actually paid for its goods or services. Typically the asset account for accounts receivable is increased until the customer actually pays for goods that have been invoiced. The company records the revenue when the goods are delivered and invoiced. The accounts receivable account is decreased when the customer pays the invoice in cash. 2. Unearned Revenue: Some firms collect income before goods are provided. Subscriptions are examples of goods that are prepaid, but the revenue is not recognized until the goods are delivered. In this situation the firm increases the asset account cash and a liability account for unearned income. Unearned income is decreased as revenue is earned over time. 3. Accrued Expenses: Most firms buy inventories and supplies on account and pay for them after they have been invoiced. When the goods are delivered and equal amount is recorded in the expense account and in accounts payable. When the invoice is paid, cash and the accounts payable account are decreased. 4. Prepaid Expenses: Some companies pay some expenses in advance. A prepaid expanse account is increased and the actual expense is not recorded until the actual goods or services are delivered.

Look Out! Debit:An accounting term that refers to an entry that increases an expense or asset account, ordecreases an income, liability or net-worth account. Credit: An accounting term that refers to an entry that decreases an expense or asset account, orincreases an income, liability or net-worth account.

Look Out! Going forward, all statements will use accrual-basis accounting. Please note that on the exam, candidates should assume that all financial statements use accrualbasis accounting, unless it is specified that the cashbasis accounting method is used in the question.

Financial Statements - Accounting Process

Accounting Process Accounting systems take the cash and accruals from various transactions and generate financial reports and statements. Information flows through an accounting system in four steps: 1. The first step is to create journal entries and adjusting entries. The general journal is list of each transaction, the amount, and the accounts affected in chronological order. At the end of accounting periods adjustments are made to record accruals not yet made. 2. The general ledger show the journal entries sorted by the accounts affected rather than in chronological order. This can be useful for reviewing the activity in a specific account. 3. At the end of the accounting period an initial trial balance is prepared lists the ending balance of each account on a

given date. If needed, adjusting entries are recorded in an adjusted trial balance. 4. The financial statements are prepared as a final product of the system, based on the totals from an adjusted trial balance. Security Analysis In conducting security analysis, an analyst cannot solely rely on the financial statements. Financial reporting is affected by the choice of accounting methods, and the estimates that management uses to determine the value of assets. In order to get a good understanding of the earnings potential of a business, an analyst must understand the accounting process used to produce the financial statements to better understand the business and the results for the period. Since much of the detail information on management's accruals, adjustments and estimates is contained in the footnotes to the statements and Management's Discussion and Analysis, it is imperative that the analyst review these sections of the financial statements. Using this information an analyst should determine: The various accruals, adjustments and assumptions that went into the financial statements. The detailed information that underlies the company's accounting system. How well the financial statements reflect the company's true performance. How the data needs to be adjusted for the analyst's own analysis Because adjustments and assumptions are at the discretion of management, analysts should always be on the lookout for possible financial statement manipulation and any situation that might incent management to falsify or misrepresent the actual operations of the firm

Financial Statements - Income Statement Basics

I. Basics Within this basics section, we will define each component of a multi-step income statement, and prepare a multi-step income statement. Multi-Step Income Statement A multi-step income statement is a condensed statement of income as opposed to a single-step format, which is the more detailed format. Both single and multi-step formats conform to GAAP standards. Both yield the same net income figure. The main difference is how they are formatted, not how figures are calculated. Figure 6.3: Multi-Step Income Statement

Sales - These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns, allowances and discounts Cost of goods sold (COGS) - These are all the direct costs related to the product or rendered service sold and recorded during the accounting period. (Reminder: matching principle.) Operating expenses - These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling, marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent, computers, accounting fees, legal fees), research and development (R&D), depreciation and amortization, etc. Other revenues & expenses - These are all non-operating expenses such as interest earned on cash or interest paid on loans.

Financial Statements - Income Statement Components

Income taxes - This account is a provision for income taxes for reporting purposes.

Income Statement Format The following figure demonstrates which components are used to calculate a company's net income, which is the income available to shareholders. Figure 6.4: How Net Income is Derived on the Income Statement

The Components of Net Income: Operating income from continuing operations - This comprises all revenues net of returns, allowances and discounts, less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses.

Recurring income before interest and taxes from continuing operations - This component includes, in addition to operating income from continuing operations, all other income, such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets. To be included in this category, these items must be recurring in nature. This component is generally considered to be the best predictor of future earning. That said, it does assume that noncash expenses such as depreciation and amortization are a good indicator of future capital expenditures. Since this component does not take into account the capital structure of the company (use of debt), it is also used to value similar companies. Recurring (pre-tax) income from continuing operations - This component takes the company's financial structure into consideration as it deducts interest expenses. Pre-tax earning from continuing operations - This component considers all unusual or infrequent items. Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples are an employee-separation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc.

Net income from continuing operations - This component takes into account the impact of taxes from continuing operations. Non-Recurring Items Discontinued operations, extraordinary items and accounting changes are all reported as separate items in the income statement. They are all reported net of taxes and below the tax line, and are not included in income from continuing operations. In some cases, earlier income statements and balance sheets have to be adjusted to reflect changes. Income (or expense) from discontinued operations - This component is related to income (or expense) generated due to the shutdown of one or more divisions or operations (plants). These events need to be isolated so they do not inflate or deflate the company's future earning potential. This type of nonrecurring occurrence also has a nonrecurring tax implication and, as a result of the tax implication, should not be included in the income tax expense used to calculate net income from continuing operations. That is why this income (or expense) is always reported net of taxes. The same is true for extraordinary items and cumulative effect of accounting changes (see below).

Extraordinary items - This component relates to items that are both unusual and infrequent in nature. That means it is a one-time gain or loss that is not expected to occur in the future. An example is environmental remediation. Cumulative effect of accounting changes - This item is generally related to changes in accounting policies or estimations. In most cases, these are non cash-related expenses but could have an effect on taxes.

Financial Statements - Income Statement: Non-recurring Items

Within this section we will further our discussion on the non-recurring components of net income, such as unusual or infrequent items, discontinued operations, extraordinary items, and prior period adjustments. Unusual or Infrequent Items Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples of unusual or infrequent items: o Gains (or losses) as a result of the disposition of a company's business segment including: Plant shutdown costs Lease-breaking fees Employee-separation costs o Gains (or losses) as a result of the disposition of a company's assets or investments (including investments in subsidiary segments) including: Plant shut-down costs Lease-breaking fees o Gains (or losses) as a result of a lawsuit o Losses of operations due to an earthquake o Impairments, write-offs, write-downs and restructuring costs o Integration expenses related to the acquisition of a business Look Out! Accounting treatment is usually displayed aspre-tax. That means that they are displayed on the income statement after income from continuing operations gross of tax implication. Extraordinary Items Events that are both unusual and infrequent in nature are qualified as extraordinary expenses. Example of extraordinary items: o Losses from expropriation of assets o Gain (or losses) from early retirement of debt Look Out! Accounting treatment is usually displayed net of tax. That means that they are displayed on the income statement after income from continuing operations net of its tax implication. Discontinued Operations Sometimes management decides to dispose of certain business operations but either has not yet done so or did it in the current year after it had generated income or losses. To be accounted for as a discontinued operation, the business must be physically and operationally distinct from the rest of the firm. Basic definitions: Measurement date - The date when the company develops a formal plan for disposing. Phaseout period - Time between the measurement date and the actual disposal date The income or loss from discontinued operations is reported separately, and past income statements must be restated, separating the income or loss from discontinued operations. On the measurement date, the company will accrue any estimated loss during the phaseout period and estimated loss on the sale of the disposal. Any expected gain on the disposal cannot be reported until after the sale is completed (same rule applies to the sale of a portion of a business segment). Look Out! Important: Accounting treatment of income and losses from discontinued operations are reported net of tax after net income from continuing operations. Accounting Changes Accounting changes occur for two reasons: 1. As a result of a change in an accounting principle 2. As a result of a change in an accounting estimate. The most common form of a change in accounting principle is the switch from the LIFO inventory accounting method to another method such FIFO or average cost basis.

The most common form of a change in accounting estimates is a change in depreciation method for new assets or change in depreciable lives/salvage values, which is considered a change in accounting estimates and not a change in accounting principle. Note that past income does not need to be restated from the LIFO inventory accounting method to another method such FIFO or average cost basis. In general, prior years' financial statements do not need to be restated unless it is a change in: Inventory accounting methods (LIFO to FIFO) Change to or from full-cost method (This is used in oil & gas exploration. The successful-efforts method capitalizes only the costs associated with successful activities while the full-cost method capitalizes all the costs associated with all activities.) Change from or to percentage-of-completion method (look at revenue- recognition methods) All changes just prior to a company's IPO Prior Period Adjustments These adjustments are related to accounting errors. These errors are typically NOT reported in the income statement but are reported in retained earnings. (These can be found in changes in retained earnings.) These errors are disclosed as footnotes explaining the nature of the error and its effect on net income.

Financial Statements - Balance Sheet Basics

I. Basics Within this section we'll define each asset and liability category on the balance sheet, and prepare a classified balance sheet Balance Sheet Categories The balance sheet provides information on what the company owns (its assets), what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date. Total Assets = Total Liabilities + Shareholders' Equity

Assets are economic resources that are expected to produce economic benefits for their owner. Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the company's money or services. Examples include bank loans, debts to suppliers and debts to employees. Shareholders' equity is the value of a business to its owners after all of its obligations have been met. This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners have invested, plus any profits generated that were subsequently reinvested in the company. Look Out! Components of Total Assets on the balance sheet are listed in order of liquidity and maturity.

Balance Sheet Presentation Formats Although there are no required reporting balance sheet designs there are two customary formats that are used, the account format and the report format. The two formats follow the accounting equation by subtotaling assets and showing that they equal the combination of liabilities and shareholder's equity. However, the report format presents the categories in one vertical column, while the report format places assets in one column on the left hand side and places liabilities and shareholder's equity on the right. Both formats can be collapsed further into a classified balance sheet that subtotals and shows only similar categories such as current assets, noncurrent assets, current liabilities, noncurrent liabilities, etc.

Financial Statements - Balance Sheet Components - Assets

Total Assets Total assets on the balance sheet are composed of: 1. Current Assets - These are assets that may be converted into cash, sold or consumed within a year or less. These usually include: Cash - This is what the company has in cash in the bank. Cash is reported at its market value at the reporting date in the respective currency in which the financials are prepared. (Different cash denominations are converted at the market conversion rate.

Marketable securities (short-term investments) - These can be both equity and/or debt securities for which a ready market exist. Furthermore, management expects to sell these investments within one year's time. These short-term investments are reported at their market value.

Accounts receivable - This represents the money that is owed to the company for the goods and services it has provided to customers on credit. Every business has customers that will not pay for the products or services the company has provided. Management must estimate which customers are unlikely to pay and create an account called allowance for doubtful accounts.Variations in this account will impact the reported sales on the income statement. Accounts receivable reported on the balance sheet are net of their realizable value (reduced byallowance for doubtful accounts). Notes receivable - This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory notes" (usually a short term-loan that carries interest). Furthermore, the maturity of notes receivable is generally longer than accounts receivable but less than a year. Notes receivable is reported at its net realizable value (what will be collected). Inventory - This represents raw materials and items that are available for sale or are in the process of being made ready for sale. These items can be valued individually by several different means - at cost or current market value - and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets.

Prepaid expenses - These are payments that have been made for services that the company expects to receive in the near future. Typical prepaid expenses include rent, insurance premiums and taxes. These expenses are valued at their original cost (historical cost). 2. Long-term assets - These are assets that may not be converted into cash, sold or consumed within a year or less. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet. However, all items that are not included in current assets are long-term Assets. These are: Investments - These are investments that management does not expect to sell within the year. These investments can include bonds, common stock, long-term notes, investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in special funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are reported at their historical cost or market value on the balance sheet.

Fixed assets - These are durable physical properties used in operations that have a useful life longer than one year. This includes: o Machinery and equipment - This category represents the total machinery, equipment and furniture used in the company's operations. These assets are reported at their historical cost less accumulated depreciation. o Buildings (plants) - These are buildings that the company uses for its operations. These assets are depreciated and are reported at historical cost lessaccumulated depreciation. o Land - The land owned by the company on which the company's buildings or plants are sitting on. Land is valued at historical cost and is not depreciable under U.S. GAAP Other assets - This is a special classification for unusual items that cannot be included in one of the other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current receivables and advances to subsidiaries.

Intangible assets - These are assets that lack physical substance but provide economic rights and advantages: patents, franchises, copyrights, goodwill, trademarks and organization costs. These assets have a high degree of uncertainty in regard to whether future benefits will be realized. They are reported at historical cost net of accumulated depreciation. The value of an identifiable intangible asset is based on the rights or privileges conveyed to its owner over a finite period, and its value is amortized over its useful life. Identifiable intangible assets include patents, trademarks and copyrights. Intangible assets that are purchased are reported on the balance sheet at historical cost less accumulated amortization. An unidentifiable intangible asset cannot be purchased separately and may have an infinite life. Intangible assets with infinite lives are not amortized, and are tested for impairment annually, at least. Goodwill is an example of an unidentifiable intangible asset. Goodwill is recorded when one company acquires another at an amount that exceeds the fair market value of its net identifiable assets. It represents the premium paid for the target company's reputation, brand names, customers, suppliers, human capital, etc. When computing financial ratios, goodwill and the offsetting impairment charges are usually removed from the balance sheet. Certain intangible assets that are created internally such as research and development costs are expensed as incurred under U.S. GAAP. Under IFRS, a firm must identify if the R&D cost is in the research and development stage. Costs are expensed in the research stage and capitalized during the development stage. Look Out! These assets are listed in order of their liquidity and tangibility. Intangible assets are listed last since they have high uncertainty and liquidity.

Financial Statements - Balance Sheet Components - Liabilities

Total Liabilities Liabilities have the same classifications as assets: current and long-term. 3. Current liabilities - These are debts that are due to be paid within one year or the operating cycle, whichever is longer; further, such obligations will typically involve the use of current assets, the creation of another current liability or the providing of some service. Usually included in this section are: Bank indebtedness - This amount is owed to the bank in the short term, such as a bank line of credit.

Accounts payable - This amount is owed to suppliers for products and services that are delivered but not paid for. Wages payable (salaries), rent, tax and utilities - This amount is payable to employees, landlords, government and others. Accrued liabilities (accrued expenses) - These liabilities arise because an expense occurs in a period prior to the related cash payment. This accounting term is usually used as an all-encompassing term that includes customer prepayments, dividends payables and wages payables, among others. Notes payable (short-term loans) - This is an amount that the company owes to a creditor, and it usually carries an interest expense. Unearned revenues (customer prepayments) - These are payments received by customers for products and services the company has not delivered or started to incur any cost for its delivery. Dividends payable - This occurs as a company declares a dividend but has not of yet paid it out to its owners. Current portion of long-term debt - The currently maturing portion of the long-term debt is classified as a current liability. Theoretically, any related premium or discount should also be reclassified as a current liability. Current portion of capital-lease obligation - This is the portion of a long-term capital lease that is due within the next year. Look Out! Current liabilities above are listed in order of their due date.

4. Long-term Liabilities - These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Usually included are: Notes payables - This is an amount the company owes to a creditor, which usually caries an interest expense.

Long-term debt (bonds payable) - This is long-term debt net of current portion. Deferred income tax liability - GAAP allows management to use different accounting principles and/or methods for reporting purposes than it uses for corporate tax filings (IRS). Deferred tax liabilities are taxes due in the future (future cash outflow for taxes payable) on income that has already been recognized for the books. In effect, although the company has already recognized the income on its books, the IRS lets it pay the taxes later (due to the timing difference). If a company's tax expense is greater than its tax payable, then the company has created a future tax liability (the inverse would be accounted for as a deferred tax asset). Pension fund liability - This is a company's obligation to pay its past and current employees' postretirement benefits; they are expected to materialize when the employees take their retirement (definedbenefit plan). Valued by actuaries and represents the estimated present value of future pension expense, compared to the current value of the pension fund. The pension fund liability represents the additional amount the company will have to contribute to the current pension fund to meet future obligations. Long-term capital-lease obligation - This is a written agreement under which a property owner allows a tenant to use and rent the property for a specified period of. Long-term capital-lease obligations are net of current portion.

Look Out! The liabilities above are listed in order of their due date.

Financial Statements - Balance Sheet Components - Marketable & Nonmarketable Instruments

Marketable & Nonmarketable Instruments Financial instruments are found on both sides of the balance sheet. Some are contracts that represent the asset of one company and the liability of another. Financial assets include investment securities like stocks and bonds, derivatives, loans and receivables. Financial liabilities include derivatives, notes payable and bonds payable. Some financial instruments are reported on the balance sheet at fair value (marking to market), while others are reported at present value or at cost. The FASB recently issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," which allows any firm the ability to report almost any financial asset or liability at fair value. Marketable investment securities are classified as one of the following: Held to Maturity Securities: Debt securities that are acquired with the intention of holding them until maturity. They are reported at cost and adjusted for the payment of interest. Unrealized gains or losses are not reported. Trading Securities: Debt and equity securities that are acquired with the intention to trade them in the near term for a profit. Trading securities are reported on the balance sheet at fair value. Unrealized gains and losses before the securities are sold are reported in the income statement. Available for Sale Securities: are debt and equity securities that are not expected to be held until maturity or sold in the near term. Although like trading securities, available for sale securities are reported on the balance sheet at fair value, unrealized gains and losses are reported as other income as part of stockholder's equity. With all three types of financial securities, income in the form of interest and dividends, as well as realized gains and losses when they are sold, are reported in the income statement. The following are measured at fair value: Assets Financial assets held for trading Financial assets available for sale Derivatives Non-derivative instruments hedged by derivatives

Liabilities Financial assets held for trading Derivatives Non-derivative instruments hedged by derivatives

The following are measured at cost or amortized cost: Assets Liabilities Unlisted instruments All other liabilities (accounts payable, notes payable) Held-to-maturity investments Loans and receivables

Financial Statements - Shareholders' (Stockholders') Equity Basics

I. Basics Components of Shareholder's Equity Also known as "equity" and "net worth", the shareholders' equity refers to the shareholders' ownership interest in a company. Usually included are: Preferred stock - This is the investment by preferred stockholders, which have priority over common shareholders and receive a dividend that has priority over any distribution made to common shareholders. This is usually recorded at par value.

Additional paid-up capital (contributed capital) - This is capital received from investors for stock; it is equal to capital stock plus paid-in capital. It is also called "contributed capital". Common stock - This is the investment by stockholders, and it is valued at par or stated value. Retained earnings - This is the total net income (or loss) less the amount distributed to the shareholders in the form of a dividend since the company's initiation. Other items - This is an all-inclusive account that may include valuation allowance and cumulative translation allowance (CTA), among others. Valuation allowance pertains to noncurrent investments resulting from selective recognition of market value changes. Cumulative translation allowance is used to report the effects of translating foreign currency transactions, and accounts for foreign affiliates.

Look Out! These components are listed in the order of their liquidation priority. Figure 6.5: Sample Balance Sheet

Stockholders' Equity Statement Instead of presenting a detailed stockholders' equity section in the balance sheet and a retained earnings statement, many companies prepare a stockholders' equity statement. This statement shows the changes in each type of stockholders' equity account and the total stockholders' equity during the accounting period. This statement usually includes: Preferred stock Common stock Issue of par value stock Additional paid-in capital Treasury stock repurchase Cumulative Translation Allowance (CTA) Retained earning

Financial Statements - Components of Stockholders' Equity

Within this section we'll identify the components that comprise the contributed capital part of stockholders' equity. Contributed Capital Contributed capital is the total legal capital of the corporation (par value of preferred and common stock) plus the paid-in capital. Par value - This is a value of preferred and common stock that is arbitral (artificial); it is set by management on a per share basis. This artificial value has no relation or impact on the market value of the shares.

Legal capital of the corporation - This is par value per share multiplied by the total number of shares issued.

Additional paid-in capital (paid-in capital) - This is the difference between the actual value the company sold the shares for and their par value. Example: Company XYZ issued 15,000 preferred shares to investors for $300,000. Company XYZ issued 30,000 common shares to investors for $600,000. Par value of preferred shares is $7 per share.

Par value of common shares is $15 per share. Legal capital: Preferred shares: $105,000(15,000 x $7) Common shares: $450,000(30,000 x $15) Legal capital $555,000 Paid-in capital: Preferred shares: $195,000 ($300,000-$105,000) Common shares: $150,000 ($600,000-$450,000) Paid-in capital $345,000 Legal capital + Paid-in capital = Contributed Capital

Look Out! If issued common shares have no par value, the amount the stock is sold for constitutes common stock. Preferred stock is always sold with a stated par value.

Financial Statements - Accounting for Dividends

Dividends Dividends are payments to stockholders that can be made regularly (monthly, quarterly or annually) or occasionally. Companies are not required to issue a dividend to their common stockholders. Companies may have an obligation to issue a dividend to preferred shareholders (see definition and properties of preferred shareholders). A company's board of directors must approve of a dividend before it can be declared and issued. There are two basic dividend forms: 1. Cash dividends - These are cash payments made to stockholders of record. Retained earnings are reduced when dividends are declared. 2. Stock dividends - These are dividends paid in the form of additional stock of the issuing company to shareholders of record in proportion to their current holdings. A stock dividend does not increase the wealth of the recipient nor does it reduce the net assets of the firm. It is a permanent capitalization of retained earnings to contributed capital. Dividend Terminology Date of Declaration: This is the date the board approved and declared a dividend.

Date of record: This is thedate set by the issuer that determines who is eligible to receive a declared dividend or capital-gains distribution. Ex-dividend date: This is the first day of trading when the selling shareholder is entitled to the recently announced dividend payment. Shares purchased as of the ex-dividend date will not receive the previously declared dividend.

Date of payment: This is the date on which the company will pay the declared dividend to its stockholders of record as of the date of record. Accounting for a Cash Dividend Let's examine the payment process of a cash dividend. We'll use XYZ company again for this example. XYZ declares a dividend on Jan 1, 2005, for its common shareholders of $400,000 payable to shareholders of record on Feb 1, 2005, and payable on Feb 31, 2005. Accounting Impact on the Date of Declaration, Jan 1, 2005: Accounting Impact on the Date of Payment, Feb 31, 2005: Stock Dividends Stock dividends involve the issuance of additional shares of stock to existing shareholders on a proportional basis. Stock dividends are issued to stockholders of record as of the record date. The dividends are not paid in cash but are paid as additional shares.

Since a company does not pay out any cash when it declares a stock dividend, the company's cash account (current assets) is not affected. The only account that is affected is the company's contributed capital (paid-up capital). When a company issues a stock dividend, the company's retained earnings are reduced by the value of the stock dividend, and the company will increase its common stock and paid-up capital accounts. Note that the size of the dividend declared is important. If the company declares a 25% or less stock dividend (as a percentage of the company's previous total outstanding shares) then the value of the stock dividend declared is equal to the market value of the shares issued. (Common shares are increased to reflect value of dividend.) If the stock dividend is larger than 25%, the company will transfer 100% of the par or stated value of the common shares to the common-stock account. Examples: Stock dividends are best learned by considering an example of a situation where the stock dividend is 25% or less of previously outstanding shares, and where the stock dividend is 25% or more of the previously outstanding shares. Situation 1: Twenty-five percent or less of previous outstanding shares XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005, one share for every five shares will be paid to shareholders of records of Feb 1, 2005. XYZ shares have a market value of $10 and a par value of $40. The company has 2 million shares outstanding. What does this mean? A shareholder that has 100 shares of XYZ will receive 20 additional shares for a total of 120. Furthermore, the company will issue 400,000 additional stocks to stockholders. After the dividend is issued, the company will have 20% more shares outstanding. Accounting impact on date of declaration:

Accounting impact on date of issuance:

Situation 2: More than 25% of previous outstanding shares. XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005, three shares for every five shares will be paid to shareholders of records of Feb 1, 2005. XYZ shares have a market value of $10 and a par value of $40. The company has 2 million shares outstanding. What does this mean? A shareholder that has 100 shares of XYZ will receive 60 additional shares for a total of 160. Furthermore, the company will issue 1.2 million additional stocks to stockholders. After the dividend is issued, the company will have 60% more shares outstanding. Accounting impact on date of declaration:

Accounting impact on date of issuance:

Look Out! The most common mistake students make in this section is that they forget to calculate if the stock dividend is less than or higher than 25% of the shares outstanding and the reporting effect it will have. Stock Split Stock splits are events that increase the number of shares outstanding and reduce the par or stated value per share of the company's stock. For example, a two-for-one stock split means that the company stockholders will receive two shares for every share they currently own. This will double the number of shares outstanding and reduce by half the

par value per share. Existing shareholders will see their shareholdings double in quantity, but there will be no change in the proportional ownership represented by the shares (i.e. a shareholder owning 2,000 shares out of 100,000 would then own 4,000 shares out of 200,000). Most importantly, the total par value of shares outstanding is not affected by a stock split (i.e. the number of shares times par value per share does not change). Therefore, no journal entry is needed to account for a stock split. A memorandum notation in the accounting records indicates the decreased par value and increased number of shares. Stocks that are trading on the exchange will normally be re-priced in accordance to the stock split. For example, if XYZ stock was trading at $90 and the company did a 3-for-1 stock split, the stock would open at $30 a share. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (regular lot = 100 shares).

Financial Statements - Accounting for Equities

Preferred Stock Characteristics Preferred stock (preferred shares) is a hybrid between common stock and bonds. It provides a specific dividend that is paid before any dividend is paid to common stockholders. Dividends o Preferred stocks pay to stockholders a predefined dividend that is based on a specific amount, or is a percentage of the preferred stock's par value. o Like common stock, preferred stocks represent partial ownership in a company. o Preferred stockholders do not usually enjoy any of the voting rights of common stockholders or any additional net income distributions beyond the stated dividend payout, unless they are participating preferred stockholders. Superiority in the Event of Liquidation o Preferred stockholders have precedence over common stockholders in the event of liquidation. o Bondholders always have precedence over preferred stockholders from a dividend and liquidation point of view. o Unlike bondholders, preferred stockholders cannot force a company into bankruptcy. Classification o From an accounting point of view, preferred stock is classified as equity, and the dividend payments are classified in a similar fashion as common stock dividends. o Unlike interest paid on bonds, the fixed dividend paid out to preferred stockholders is not deductible from earnings before taxes (EBT) and is not tax deductible. Attributes In general, preferred stock can have several attributes; they can be: o Cumulative - This is preferred stock on which dividends accrue in the event that the issuer does not make timely dividend payments. Unpaid preferred dividends are called "dividends in arrears". Most preferred stocks are cumulative.

o o o o o o

Non-cumulative - This is preferred stock on which dividends do not accrue in the event that the issuer does not make timely dividend payments. Participating - This is preferred stock that, in addition to a regular dividend, pays a dividend when common stock dividends exceed a specified amount. Convertible - This is preferred stock that can be converted into a specified amount of common stock at the holder's option. Retractable - This is preferred stock that grants the stockholder the right to redeem the stock at specified future date(s) and price(s). Perpetual - These are preferred shares that have no maturity date.

Callable (Non-perpetual) - These are preferred shares that have a predetermined maturity date. At the maturity date, the company will buy back the preferred shares at their par value. Voting Rights Most preferred stock is non-voting. However, most of these securities also include a clause that would give holders a predetermined voting right if dividends are not paid for a certain period of time (in most cases, three years). Stock Issuance The issuing company will normally receive cash in exchange for shares (stock). The shares may or may not have a stipulated par value. If they do have a par value, the excess paid to the par value will be recorded in additional paid-in capital (paid-in capital) account. If the stock sold has no par value, the full amount will be recorded in the stock account.

Example: XYZ Company has issued 800,000 common shares at a price of $5 per share. With par value of $3 per share:

Without par value:

Stock Repurchase A program by which a company buys back its own shares from the marketplace, reducing the number of outstanding shares. This is usually an indication that the company's management thinks the shares are undervalued. Look Out! Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases earnings per share and tends to elevate the market value of the remaining shares. When a company does repurchase shares, it will usually say something along the lines of, "We find no better investment than our own company." With par value of $3 per share:

Without par value:

Financial Statements - Revenue Recognition

I. What is Revenue Recognition? The Matching Principle The matching principle of GAAP dictates that revenues must be matched with expenses. Thus, income and expenses are reported when they are earned and incurred, even if no cash transaction has been recorded. For example, say a company made a sale for $30,000 within an accounting period but has not received payment. Even though the company was not paid, the sale is recorded as revenue. This revenue has to be matched with the expenses that the company incurred in the accounting period to generate that revenue (revenues and expanses must match). If revenues were not matched with their related expenses, companies would produce financial statements that provide little information to the readers and themselves. (This is a fundamental principle of accrual-basis accounting) Revenue-Recognition Principles SFAS 5 specifies that two conditions must be met for revenue recognition to take place: 1. Completion of the Earnings Process This means the company has provided all or virtually all of the goods and services for which it is to be paid. Furthermore, it means the company can measure the total expected cost of providing the goods and services, and the company must have no significant remaining obligations to its customers. Both must be true for this condition to be met.

2. Assurance of Payment There must be a quantification of the cash or assets that will be received for realized goods and services. Furthermore, the company must be able to accurately estimate the reliability of payment. Both must be true for this requirement to be met. Gross and Net Reporting of Revenue Under gross revenue reporting, sales and the cost of goods sold are reported separately. With net revenue reporting only the net revenue, calculated by subtracting cost of goods sold from gross sales, is reported. Since the only the net revenue is reported, revenues will be less than under gross revenue reporting. Under U.S. GAAP, a firm using gross revenue reporting must be the primary party to any contract, take on both inventory and credit risk, be able to choose its suppliers, and have the ability to set price. When analyzing the financial statements analysts should be aware of how aggressive or conservative a firm's revenue recognition policies are. A firm's that has a very aggressive revenue recognition policy runs the risk of over stating its revenues and its earnings performance. Analysts should also be aware of any assumptions or judgments that are made in reporting revenues

Financial Statements - Revenue Recognition Methods and Implications

Sales-basis Method o Under the sales-basis method, revenue is recognized at the time of sale, which is defined as the moment when the title of the goods or services is transferred to the buyer. o The sale can be made for cash or credit. This means that, under this method, revenue is not recognized even if cash is received before the transaction is complete. o For example, a monthly magazine publisher that receives $240 a year for an annual subscription will recognize only $20 of revenue every month (assuming that it delivered the magazine). o Implication: This is the most accurate form of revenue recognition. Percentage-of-completion method o This method is popular with construction and engineering companies, who may take years to deliver a product to a customer. o With this method, the company responsible for delivering the product wants to be able to show its shareholders that it is generating revenue and profits even though the project itself is not yet complete. o A company will use the percentage-of-completion method for revenue recognition if two conditions are met: 1. There is a long-term legally enforceable contract 2. It is possible to estimate the percentage of the project that is complete, itsrevenues and its costs. o Under this method, there are two ways revenue recognition can occur: 1. Using milestones - A milestone can be, for example, a number of stories completed, or a number of miles built for a railway. 2. Cost incurred to estimated total cost- Using this method, a construction company would approach revenue recognition by comparing the cost incurred to date by the estimated total cost.) o Implication:This can overstate revenues and gross profits if expenditures are recognized before they contribute to completed work. Completed-contract method o Under this method, revenues and expenses are recorded only at the end of the contract. o This method must be used if the two basic conditions needed to use the percentage-of-completion method are not met (there is no long-term legally enforceable contract and/or it is not possible to estimate the percentage of the project that is complete, its revenues and its costs.) o Implication: This can understate revenues and gross profit within an accounting period because the contract is not accounted for until it is completed. Cost-recoverability method o Under the cost-recoverability method, no profit is recognized until all of the expenses incurred to complete the project have been recouped. o For example, a company develops an application for $200,000. In the first year, the company licenses the application to several companies and generates $150,000. o Under this method, the company recognizes sales of $150,000 and expenses related to the development of $150,000 (assuming no other costs were incurred). As a result, nothing would appear in net income until the total cost is offset by sales. o Implication: This can understate gross profits initially and overstate profits in future years. Installment method o If customer collections are unreliable, a company should use the installment method of revenue recognition. o This is primarily used in some real estate transactions where the sale may be agreed upon but the cash collection is subject to the risk of the buyer's financing falling through. As a result, gross profit is calculated only in proportion to cash received.

o o

For example, a company sells a development project for $100,000 that cost $50,000. The buyer will pay in equal installments over six months. Once the first payment is received, the company will record sales of $50,000, expenses of $25,000 and a net profit of $25,000. Implication: This can overstate gross profits if the last payment is not received.

Summary of Revenue Recognition Methods

First Condition: Completion of Earning Progress

Second Condition:Assurance of Payment

Method

Goods/Services Provided

Measurable Cost

Quantification

Reliability

Sales Basis

Yes

Yes

Yes

Yes

Percentage of Completion

Incomplete

Yes

Yes

Yes

Completed Contract

Incomplete

Yes or No

Yes/No

Yes/No

Cost Recoverability

Yes

Yes with Contingency

Yes/No

Yes/No

Installment Method

Yes

Yes

Yes

No

Financial Statements - Revenue Recognition and Accounting Entries

Accounting Entries The best way to identify the appropriate accounting entries is to consider an example: Construction Company ABC, has just obtained a $50 million contract to build a five-building resort in the Bahamas for Meridian Vacations. Company ABC estimates that each building will take a full year to build. Meridian Vacations has agreed to pay Company ABC according to the following schedule: $5m in year 1, $10m in year 2, $10m in year 3, $10m in year 4 and $15m in year 5. Company ABC has estimated that the total cost of this contact will be $35m, and will occur over the five years in this way; $5m in year 1, $4m in year 2, $10m in year 3, $10m in year 4 and $6m in year 5. Equal monthly payments will be made to ABC, and Meridian will have a 30-day grace period except for the last payment in year 5. Figure 6.6: Illustration of Construction Company ABC's expected figures Total Revenue: $50M Total Cost: Cost Payment Terms $35M Year 1 5,000,000 5,000,000 Year 2 4,000,000 10,000,000 Year 3 10,000,000 15,000,000 Year 4 10,000,000 8,000,000 Year 5 6,000,000 12,000,000 Total 35,000,000 50,000,000

Cash Received Accounts Receivable

4,583,333 416,667

9,583,333 833,333

14,583,333 1,250,000

8,583,333 666,667

12,666,667 -

50,000,000

Percentage-of-Completed-Contract Method We first need to estimate the revenues Company ABC will declare each year. Remember we are using the percentageof-completion method based on estimated cost.

Figure 6.7: Construction Company ABC's Estimated Revenues Year 1 Year 2 Year 3 Year 4 Year 5 Cost % of Completion Cumulative Revenue 5,000,000 14.29% 14.29% 7,142,857 4,000,000 11.43% 25.71% 5,714,286 10,000,000 28.57% 54.29% 14,285,714 10,000,000 28.57% 82.86% 14,285,714 6,000,000 17.14% 100% 8,571,429

Total 35,000,000 100% 50,000,000

Step 1: Revenues to be declared We first need to extrapolate how much each annual cost represents as a percentage of the total cost. Armed with this information we multiply the percentage of completion with the total expected revenue for the project for each period. Recall that one of the basic accounting principles is assurance of payment, and here is the formula used to determine amount of revenues to be recognized at any given point in time: Formula 6.4 (Services Provided to Date/Total Expected Services) x Total Expected Inflow This is basically the same formula used in the percentage-of-completion method. Step 2: Cost to be declared Since this is the basic assumption of this accounting methodology, the expenses remain the same as the ones that were estimated. Results: 1. Annual Income Statement Entries In each year, the revenues, expenses would be entered as seen on the following table. Note: For simplicity, taxes were not considered. Figure 6.8: Construction Company ABC's Income Statement (% of Completion Method)

2. Balance Sheet Statement Entries Figure 6.9: Construction Company ABC's Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries: Cash:It is the total cash Company ABC has on hand at the end of the year, and is defined as the total cash inflow minus the total cash outflow. If the result of this equation were negative, the company would have to borrow from its line of credit additional funds to cover its total expenses.

Accounts Receivable:The total amount billed less the cash received by Meridian. Net construction in progress (asset) and net advance billing (liability): These accounts offset each other and are composed of construction in progress less total billings. o If the result of this equation were negative, the company would have billed its client for more than what has delivered. This would have constituted a liability for the construction company, and would have been reported as net advance billings. o If this equation were positive, then the company would have built more than the client has paid for it, and the result of the equation would have constituted an asset and would be recorded as net construction in progress. o In most cases, companies only report net construction in progress or net advance billing on their balance sheet. Retained earnings -The cumulative shares of the total profit to date. This item is not shown on the balance sheet above. It normally appears after shareholders equity.

Formula 6.5 Construction in progress = the cumulative cost incurred since inception + (cumulative percentage of completion x total estimated net profit of the project) Less Total billings = cumulative amount billed to the client since inception

Look Out! Remember, if the result of the above equation is: Positive (asset) = net construction in progress Negative (liability) = net advance billings

Figure 6.10: Other Items on Company ABC's Balance Sheet (% of Completion Method)

Completed-Contract Method Under this accounting methodology, revenues and expenses are not recognized until the contract is completed and the title is transferred to the client. Annual Income Statements In this case, nothing would be reported on the annual income statements until Year 5. Figure 6.11: Company ABC's Income Statement (Completed Contract Method)

Balance Sheet Statements Under this method, the balance sheet entries are the same as the percentage-of -completion method, except for the Net Advance Billing account. Figure 6.12: Company ABC's Balance Sheet (Completed Contract Method)

Balance Sheet Entries Cash and accounts receivables stay the same under both the percentage of completion and completed contract methods. o This is normal because, no matter which method you use, you always know how mush cash you have in the bank, and you how much credit you have extended to your client. Net construction in progress (asset) / net advance billing - The basic concepts are the same, except that under this methodology, construction in progress does not include the cumulative effect of gross profits in the formula (i.e. excludes cumulative percentage of completion x total estimated net profit of the project).

Financial Statements - Revenue Recognition Effects on Cash Flows and Financial Ratios
Both methods - the percentage-of-completion and completed-contract methods - produce the same net cash flow effect. Cash Flow Effects

Percentage-of-completed contract method o Net income (NI) will be higher in the first years and lower in the last year. o Net Income will be less volatile. o Total assets will be greater. o Liabilities will be lower. Completed contract method o Net income will be nonexistent in the first years and higher in the last year. o Net income will be very volatile. o Total assets will be smaller. o Liabilities will be higher (no recognition of retained earnings). o Stockholders equity will be lower. o Stockholders equity will be more volatile. Impact on Financial Ratio % of Completion Reason Method Construction in progress includes portion of estimated profits Completed Method

Ratio

Formula

Current Ratio

Current Assets Current Liabilities

Higher

Lower

Revenue Revenues Turnover Average Receivables Assets to Total Assets Equity Equity Total Debt Ratio

Higher

Lower - Not Revenues are reported measurable prior to completion Lower - Not Retained earnings are measurable prior reported to completion Liabilities are smaller and the denominator Higher includes equity which is higher

Higher

Total Liabilities Total Liabilities + Total Equity

Lower

Financial Statements - The Cash Flow Statement

I. Introduction Components and Relationships Between the Financial Statements It is important to understand that the income statement, balance sheet and cash flow statement are all interrelated. The income statement is a description of how the assets and liabilities were utilized in the stated accounting period. The cash flow statement explains cash inflows and outflows, and will ultimately reveal the amount of cash the company has on hand; this is reported in the balance sheet as well. We will not explain the components of the balance sheet and the income statement here since they were previously reviewed. Figure 6.13: The Relationship between the Financial Statements

Financial Statements - Cash Flow Statement Basics

Statement of Cash Flow The statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period. The cash flow statement is designed to convert the accrual basis of accounting used in the income statement and balance sheet back to a cash basis. The cash flow statement will reveal the following to analysts: 1. How the company obtains and spends cash 2. Why there may be differences between net income and cash flows 3. If the company generates enough cash from operation to sustain the business 4. If the company generates enough cash to pay off existing debts as they mature 5. If the company has enough cash to take advantage of new investment opportunities Segregation of Cash Flows The statement of cash flows is segregated into three sections: 1. Operating activities 2. Investing activities 3. Financing activities 1. Cash Flow from Operating Activities (CFO) CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes. This includes: Cash inflow (+) 1. Revenue from sale of goods and services 2. Interest (from debt instruments of other entities) 3. Dividends (from equities of other entities) Cash outflow (-) 1. Payments to suppliers 2. Payments to employees 3. Payments to government 4. Payments to lenders 5. Payments for other expenses 2. Cash Flow from Investing Activities (CFI) CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed assets. This includes: Cash inflow (+) 1. Sale of property, plant and equipment 2. Sale of debt or equity securities (other entities) 3. Collection of principal on loans to other entities Cash outflow (-) 1. Purchase of property, plant and equipment 2. Purchase of debt or equity securities (other entities) 3. Lending to other entities

3. Cash flow from financing activities (CFF) CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, short-term or long-term debt for the company's operations. This includes: Cash inflow (+) 1. Sale of equity securities 2. Issuance of debt securities Cash outflow (-) 1. Dividends to shareholders 2. Redemption of long-term debt 3. Redemption of capital stock Reporting Noncash Investing and Financing Transactions Information for the preparation of the statement of cash flows is derived from three sources: 1. Comparative balance sheets 2. Current income statements 3. Selected transaction data (footnotes) Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash. Examples Include: Conversion of debt to equity Conversion of preferred equity to common equity Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities Though these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements.

Financial Statements - Cash Flow Computations - Indirect Method

Under U.S. and ISA GAAP, the statement of cash flow can be presented by means of two ways: 1. The indirect method 2. The direct method The Indirect Method The indirect method is preferred by most firms because is shows a reconciliation from reported net income to cash provided by operations. Calculating Cash flow from Operations Here are the steps for calculating the cash flow from operations using the indirect method: 1. Start with net income. 2. Add back non-cash expenses. o (Such as depreciation and amortization) 3. Adjust for gains and losses on sales on assets. o Add back losses o Subtract out gains 4. Account for changes in all non-cash current assets. 5. Account for changes in all current assets and liabilities except notes payable and dividends payable. In general, candidates should utilize the following rules: Increase in assets = use of cash (-) Decrease in assets = source of cash (+) Increase in liability or capital = source of cash (+) Decrease in liability or capital = use of cash (-) The following example illustrates a typical net cash flow from operating activities:

Cash Flow from Investment Activities Cash Flow from investing activities includes purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on loans. Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing Activities Cash Flow from financing activities includes issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not. Here's the calculation of the cash flows from financing using the indirect method:

Financial Statements - Cash Flow Computations - Direct Method

The Direct Method The direct method is the preferred method under FASB 95 and presents cash flows from activities through a summary of cash outflows and inflows. However, this is not the method preferred by most firms as it requires more information to prepare.

Cash Flow from Operations Under the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends, and deducting cash payments for purchases, operating expenses, interest and income taxes. We'll examine each of these components below: Cash collections are the principle components of CFO. These are the actual cash received during the accounting period from customers. They are defined as: Formula 6.7
Cash Collections Receipts from Sales = Sales + Decrease (or - increase) in Accounts Receivable

Cash payment for purchases make up the most important cash outflow component in CFO. It is the actual cash dispersed for purchases from suppliers during the accounting period. It is defined as: Formula 6.8
Cash payments for purchases = cost of goods sold + increase (or - decrease) in inventory + decrease (or - increase) in accounts payable

Cash payment for operating expenses is the cash outflow related to selling general and administrative (SG&A), research and development (R&A) and other liabilities such as wage payable and accounts payable. It is defined as: Formula 6.9
Cash payments for operating expenses = operating expenses + increase (or decrease) in prepaid expenses + decrease (or - increase) in accrued liabilities

Cash interest is the interest paid to debt holders in cash. It is defined as: Formula 6.10

Cash interest = interest expense - increase (or + decrease) interest payable + amortization of bond premium (or - discount)

Cash payment for income taxes is the actual cash paid in the form of taxes. It is defined as: Formula 6.11
Cash payments for income taxes = income taxes + decrease (or - increase) in income taxes payable

Look Out! Note: Cash flow from investing and financing are computed the same way it was calculated under the indirect method.

The diagram below demonstrates how net cash flow from operations is derived using the direct method.

Look Out! Candidates must know the following: Though the methods used differ, the results are always the same. CFO and CFF are the same under both methods. There is an inverse relationship between changes in assets and changes in cash flow.

Financial Statements - Free Cash Flow

Free Cash Flow (FCF) Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including net capital expenditures. Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating. Formula 6.12
Free cash flow = cash flow from operating activities - net capital expenditures (total capital expenditure - after-tax proceeds from sale of assets)

The FCF measure gives investors an idea of a company's ability to pay down debt, increase savings and increase shareholder value, and FCF is used for valuation purposes. Free Cash Flow to the Firm (FCFF) Free cash flow to the firm is the cash available to all investors, both equity and debt holders. It can be calculated using Net Income or Cash Flow from Operations (CFO). The calculation of FCFF using CFO is similar to the calculation of FCF. Because FCFF is the cash flow allocated to all investors including debt holders, the interest expense which is cash available to debt holders must be added back. The amount of interest expense that is available is the after-tax portion, which is shown as the interest expense multiplied

by 1-tax rate [Int x (1-tax rate)]. . This makes the calculation of FCFF using CFO equal to: FCFF = CFO + [Int x (1-tax rate)] FCInv Where: CFO = Cash Flow from Operations Int = Interest Expense FCInv = Fixed Capital Investment (total capital expenditures) This formula is different for firm's that follow IFRS. Firm's that follow IFRS would not add back interest since it is recorded as part of financing activities. However, since IFRS allows dividends paid to be part of CFO, the dividends paid would have to be added back. The calculation using Net Income is similar to the one using CFO except that it includes the items that differentiate Net Income from CFO. To arrive at the right FCFF, working capital investments must be subtracted and non-cash charges must be added back to produce the following formula: FCFF = NI + NCC + [Int x (1-tax rate)] FCInv WCInv Where: NI = Net Income NCC = Non-cash Charges (depreciation and amortization) Int = Interest Expense FCInv = Fixed Capital Investment (total capital expenditures) WCInv = Working Capital Investments Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived from FCFF. FCFE equals FCFF minus the after-tax interest plus any cash from taking on debt (Net Borrowing). The formula equals: FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing

Financial Statements - Management Discussion and Analysis & Financial Statement Footnotes
I. Management Discussion and Analysis The Securities Exchange Commission (SEC) requires this section to be included with the financial statements of a public company and is prepared by management This narrative section usually includes the following; A description of the company's primary business segments and future trends A review of the company's revenues and expenses Discussions pertaining to the sales and expense trends Review of cash flow statements and future cash flow needs including current and future capital expenditures A review of current significant balance sheet items and future trends, such as differed tax liabilities, among others A discussion and review of major transactions (acquisitions, divestitures) that may affect the business from an operational and cash flow point of view A discussion and review of discontinued operations, extraordinary items and other unusual or infrequent events Financial Statement Footnotes These footnotes are additional information provided to the reader in an effort to further explain what is displayed on the consolidated financial statements. Generally accepted accounting principles (GAAP) and the SEC require these footnotes. The information contained in these footnotes help the reader understand the amounts, timing and uncertainty of the estimates reported in the consolidated financial statements. Included in the footnotes are the following: A summary of significant accounting policies such as: o The revenues-recognition method used o Depreciation methods and rates Balance sheet and income statement breakdown of items such as: o Marketable securities o Significant customers (percentage of customers that represent a significant portion of revenues) o Sales per regions o Inventory

Fixed assets and Liabilities (including depreciation, inventory, accounts receivable, income taxes, credit facility and long-term debt, pension liabilities or assets, contingent losses (lawsuits), hedging policy, stock option plans and capital structure. Supplemental schedules often detail disclosures required by audited statements, as well as the accounting methods and assumptions used by management. Supplemental schedules can include information such as natural resources reserves, an overview of specific business lines, or the segmentation of income or other line items by geographical area or customer distribution.

Management's Discussion and Analysis (MD&A) presents management's perspective on the financial performance and business condition of the firm. U.S. publicly-held companies must provide MD&As that include a discussion of the operations of the company in detail by usually comparing the current period versus prior period Analyst Interpretation As reporting standards continue to change and evolve, analysts must be aware of new accounting approaches and innovations that can affect how businesses treat certain transactions, especially those that have a material impact on the financial statements. Analysts should use the financial reporting framework to guide them on how to determine the financial statement impact of new types of products and business operations. One way to keep up to date on evolving standards and accounting methods is to monitor the standard setting bodies and professional organizations like the CFA Institute that publish position papers on the subject. Companies that prepare financial statements under IFRS or US GAAP must disclose their accounting policies and estimates in the footnotes, as well as any policies requiring management's judgment in the management's discussion and analysis. Public companies must also disclose their estimates for the impact of newly adopted policies and standards on the financial statements.

Financial Statements - The Auditor and Audit Opinion

The Auditor An audit is a process for testing the accuracy and completeness of information presented in an organization's financial statements. This testing process enables an independent Certified Public Accountant (CPA) to issue what is referred to as "an opinion" on how fairly a company's financial statements represent its financial position and whether it has complied with generally accepted accounting principles. Look Out! Note: Only independent auditors (CPAs) can produce audited financial statements. That is, the company's board members, staff and their relatives cannot perform audits because their relationship with the company compromises their independence. The audit report is addressed to the board of directors as the trustees of the organization. The report usually includes the following: a cover letter, signed by the auditor, stating the opinion. the financial statements, including the balance sheet, income statement and statement of cash flows notes to the financial statements In addition to the materials included in the audit report, the auditor often prepares what is called a "management letter" or "management report" to the board of directors. This report cites areas in the organization's internal accounting control system that the auditor evaluates as weak. What Does the Auditor Do? The auditor will request information from individuals and institutions to confirm: bank balances contribution amounts conditions and restrictions contractual obligations monies owed to and by the organization. To ensure that all activities with significant financial implications is adequately disclosed in the financial statements the auditor will review: physical assets journals and ledgers board minutes In addition, the auditor will also: select a sample of financial transactions to determine whether there is proper documentation and whether the transaction was posted correctly into the books

interview key personnel and read the procedures manual, if one exists, to determine whether the organization's internal accounting control system is adequate

The auditor usually spends several days at the organization's office looking over records and checking for completeness. Auditor Responsibility Auditors are not expected to guarantee that 100% of the transactions are recorded correctly. They are required only to express an opinion as to whether the financial statements, taken as a whole, give a fair representation of the organization's financial picture. In addition, audits are not intended to discover embezzlements or other illegal acts. Therefore, a "clean" or unqualified opinion should not be interpreted as assurance that such problems do not exist. The standard auditor's opinion contains three parts and states that: the preparation of the financial statements are the responsibility of management, and that the auditor has performed an independent review. Generally accepted auditing procedures were followed, providing reasonable assurance that the statements do not contain any material errors. The auditor is satisfied that the statements were prepared in accordance with accepted accounting procedures and that any assumptions or estimates used are reasonable. An unqualified opinion indicates that the auditor believes that the statements are free from any material errors or omissions The Qualified Opinion A qualified opinion is issued when the accountant believes the financial statements are, in a limited way, not in accordance with generally accepted accounting principles. A qualified option may be issued if the auditor has concerns about the going-concern assumption of the company, the valuation of certain items on the balance sheet or some unreported pending contingent liabilities. An adverse opinion is issued if the statements are not presented fairly or do not conform to generally accepted accounting procedures. Internal Controls Under U.S. GAAP, the auditor must provide its judgment about the company's internal controls, or the processes the company uses to ensure accurate financial statements. Under the Sarbanes-Oxley act, management is supposed to make a statement about its internal controls including the following: A statement declaring that the financial statements are presented fairly; A statement declaring that management is responsible for maintaining and executing effectual internal controls; A description of the internal control system and how it is evaluated; An analysis of how effective the internal controls have been over the last year; A statement declaring that the auditors have review management's report on its internal controls

Financial Statements - Financial Reporting Objectives and Enforcement

I. Financial Reporting Objectives There are six steps in completing the financial analysis framework: 1. The first step is to determine the scope and purpose of the analysis. When stating the objective and context, definitive goals should be stated as well as what form the analysis will take and what resources will be required to complete it. 2. In order to complete the analysis the analyst must gather data. In addition to the financial data, a physical inspection should be completed and company stakeholders should be interviewed, if applicable. 3. Analysts must then process the data and make adjustments to the financial statements, to assumptions or estimates, and any other necessary calculations. 4. Once the data has been reviewed and updated then the analyst must analyze and interpret it to determine if the analysis achieves the original goals that were set in the first step. 5. Once the analysis has been completed then the analyst must report the conclusions or recommendations and communicate it to the appropriate audience. 6. Since the factors and assumptions made in the analysis are subject to change over time, the analyst should update the analysis periodically, to see if the conclusions or recommendations change. Objectives of Financial Reporting Objectives of financial reporting identified in SFAC 1 are to do the following:

They are to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (Note the FASB's emphasis on investors and creditors as primary users. However, this does not exclude other interested parties.) They are to provide information to help present and potential investors and creditors and other users in assessing the amounts, timing and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption or maturity of securities or loans. (Emphasize the difference between the cash basis and the accrual basis of accounting.)

They are to provide information about the economic resources of an enterprise, the claims on those resources and the effects of transactions, events and circumstances that change its resources and claims to those resources. The main barrier to convergence or one universally accepted set of financial standards is the fact that the international boards that set standards cannot agree on the best way to deal with particular issues or situations affecting the preparation of financial statements. Different local issues often take priority over determining ways to deal with international accounting problems. The political environment and the resultant political pressure on governmental standards authorities also create an impediment to a global standards framework. The major standard setting authorities such as the International Accounting Standards Board and the U.S. Financial Accounting Standards Board, the International Organization of Securities Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange Commission all have their own projects to solve domestic financial accounting and performance reporting issues. However, international convergence has become a greater priority as more foreign companies become available for investment II. Enforcing and Developing U.S. GAAP FASB Role in Enforcing and Developing U.S. GAAP The Financial Accounting Standards Board (FASB) is a nongovernmental body. This board sets the accounting standards for all companies that issue audited U.S. GAAP-compliant financial statements. Both the Securities Exchange Commission (SEC) and American Institute of Certified Public Accountants (AICPA) recognize that the Statement of Financial Accounting Standards (SFAS) statements as authoritative. GAAP comprises a set of principles that are patterned over a number of sources including the FASB, the Accounting Principles Board (APB) and the AICPA research bulletins. Prior to the creation of the FASB, the Accounting Principles Board (APB) set the accounting standards. As a result some of these standards are still in use. SEC Role in Enforcing and Developing U.S. GAAP The form and content of the financial statements of public companies are governed by the SEC. Even though the SEC delegates most of the authority to the FASB, it frequently adds its own requirements, such as the requirement for a company to provide a management discussion and analysis with its financial statements, quarterly financial statements (10-Q) and current reports (8-K). These discussions indicate things like changes in control, acquisition and divestitures, etc.) Accounting Pronouncements Considered Authoritative Accounting pronouncements are segmented into four categories. Category A is the most authoritative, and Category D is the least authoritative: Category (A) - FASB Standards and Interpretations - APB Opinions and Interpretations - CAP Accounting Research Bulletins Category (B) - AICPA Accounting and Audit Guides - AICPA Statements of Position - FASB Technical Bulletins Category (C) - FASB Emerging Issues Task Force - AICPA AcSEC Practice Bulletins Category (D) - AICPA Issues Papers - FASB Concepts Statements - Other authoritative pronouncements

Financial Statements - Accounting Qualities

1) Primary qualities of useful accounting information: - Relevance - Accounting information is relevant if it is capable of making a difference in a decision. Relevant information has: (a) Predictive value (b) Feedback value (c) Timeliness - Reliability - Accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent. Reliable information has: (a) Verifiability (b) Representational faithfulness (c) Neutrality 2) Secondary qualities of useful accounting information: Comparability - Accounting information that has been measured and reported in a similar manner for different enterprises is considered comparable. Consistency - Accounting information is consistent when an entity applies the same accounting treatment to similar accountable events from period to period. Accounting Qualities and Useful Information for Analysts Here is how these qualities provide analysts with useful information: Relevance- Relevant information is crucial in making the correct investment decision. Reliability - If the information is not reliable, then no investor can rely on it to make an investment decision. Comparability - Comparability is a pervasive problem in financial analysis even though there have been great strides made over the years to bridge the gap. Consistency - Accounting changes hinder the comparison of operation results between periods as the accounting used to measure those results differ. The following key SEC filings must be reported: S-1: Filed prior to sale of new securities 10-K: Annual filing similar to annual report; 40-F for Canadians; 20-F for other foreign issuers 10-Q: Quarterly unaudited statements 8-k: Disclose material events such as asset acquisition and disposition, changes in management or corporate governance DEF-14: Proxy statement 144: Issue of unregistered securities Beneficial and insider ownership of securities by company's officers and directors Look Out! Students should note that relevance and reliability tend to be opposite qualities. For example, an auditor may improve the quality of the audit but at the cost of timeliness. Relevance and reliability can also clash strongly in these ways: the market value of an investment can be highly relevant but may be accurate only to a certain extent. On the other hand, the historical cost, while reliable, may have little relevance.

Financial Statements - Setting and Enforcing Global Accounting Standards

What is the International Organization of Securities Commissions (IOSCO) Although the IFRS and GAAP frameworks are different, they usually agree in the overall structure and principle and are working toward convergence. The two differ in the following ways:

 IFRS requires users to consider the general principles in the absence of specific standards. US GAAP distinguishes between objectives for business and non-business entities. The IASB framework gives more emphasis to the importance of the accrual and going concern assumptions than FASB GAAP framework establish a hierarchy of qualitative financial statement characteristics; Some differences in how each defines, recognizes, and measures individual elements of financial statements Companies reporting under standards other than GAAP that trade in USA must reconcile their statements with GAAP. The International Accounting Standard Board (IASB) The IASB structure's main features are: - the IASC Foundation - which is an independent organization whose two main bodies are the Trustees and the IASB - a Standards Advisory Council - the International Financial Reporting Interpretations Committee The IASC Foundation Trustees appoint the IASB members, exercise oversight and raise the funds needed, but the IASB has sole responsibility for setting accounting standards. This organization was created to set international accounting standards in an effort to bridge the gap between the accounting standards of different nations. U.S. GAAP versus IAS GAAP Under U.S. GAAP, SFAS 95: - Dividends paid by a company to its shareholders are classified on the cash flow statement under cash flow from financing. - The dividends received by a company from its investments are classified as cash flow from operations. - All interests received and paid by or to a company are classified as cash flow from operations. Under IAS GAAP: - Dividends paid by a company to its shareholders, dividends received by a company from its investments and all interests received and paid by or to a company can be classified aseither cash flow from financing or cash flow from operations. These rules are summarized in the following chart: U.S. GAAP Dividends paid by a company to shareholders Dividends received by a company from investments Cash Flow from Financing Cash Flow from Operations

IAS GAAP Cash Flow from Financing or Operations Cash Flow from Financing or Operations Cash Flow from Financing or Operations

All interest received and paid by or to Cash Flow from Operations a company

Look Out! It is highly likely you will need to calculate a figure on a cash flow statement according to one of the two rules.

Financial Ratios - Introduction

INTRODUCTION Knowing how to calculate and use financial ratios is important for not only analysts, but for investors, lenders and more. Ratios allow analysts to compare a various aspect of a company's financial statements against others in its industry, to determine a company's ability to pay dividends, and more. The material presented in this section is extremely important to know for your exam. The majority of the questions you see on your exam, within the accounting section, will require you to have excellent knowledge on how to calculate and manipulate ratios. You also need to recognize how ratios are interrelated and how the results of two or more other ratios can be used to calculate other ratios. A. ANALYZING FINANCIAL STATEMENTS I. Common-Size Financial Statements

Common-size balance sheets and income statements are used to compare the performance of different companies or a company's progress over time. A Common-Size Balance Sheet is a balance sheet where every dollar amount has been restated to be a percentage of total assets. o Calculated as follows: Formula 7.1 % value of balance sheet account = Balance sheet account Total Assets A Common-Size Income Statement is an income statement where every dollar amount has been restated to be a percentage of sales. o Calculated as follows: Formula 7.2 % value of income statement account = Income statement account Total Sales (Revenues) Example: FedEx Common Size Balance Sheet and Income Statement At first glance, all numbers stated within FedEx's income statement in figure 7.1, and balance sheet in figure 7.2, can seem daunting. It requires close examination to determine whether operating expenses are increasing or decreasing, or which particular expense comprises the highest percentage total operating expenses. Figure 7.1: FedEx Consolidated Income Statements

However, if we consider the common-size statements in figures 7.2 and 7.4 below, you can tell at first glance how a company is performing in many areas. The common-size income statement informs us that salaries and other comprise the largest percentage of total operating expenses and their most recent net income comprises 3.39% of total 2004 revenues. Alternately, the common-size balance sheet in figure 7.4 quickly shows that receivables comprise a large percentage of current assets and are decreasing, and more.

Figure 7.2: FedEx Common-sized Income Statements

Figure 7.3: FedEx Consolidated Balance Sheets

Figure 7.4: FedEx Common-sized Consolidated Balance Sheets

II.Financial Ratios Classification of Financial Ratios Ratios were developed to standardize a company's results. They allow analysts to quickly look through a company's financial statements and identify trends and anomalies. Ratios can be classified in terms of the information they provide to the reader.

There are four classifications of financial ratios: 1. Internal liquidity - The ratios used in this classification were developed to analyze and determine a company's financial ability to meet short-term liabilities. 2. Operating performance - The ratios used in this classification were developed to analyze and determine how well management operates a company. The ratios found in this classification can be divided into 'operating profitability' and 'operating efficiency'. Operating profitability relates the company's overall profitability, and operating efficiency reveals if the company's assets were utilized efficiently. 3. Risk profile - The ratios found in this classification can be divided into 'business risk' and 'financial risk'. Business risk relates the company's income variance, i.e. the risk of not generating consistent cash flows over time. Financial risk is the risk that relates to the company's financial structure, i.e. use of debt. 4. Growth potential - The ratios used in this classification are useful to stockholders and creditors as it allows the stockholders to determine what the company is worth, and allows creditors to estimate the company's ability to pay its existing debt and evaluate their additional debt applications, if any.

5. Financial Ratios - Internal Liquidity Ratios

6. 1. Current Ratio This ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them. Formula 7.3 Current ratio = current assets current liabilities 7. 2. Quick Ratio The quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of. Formula 7.4 Quick ratio = (cash+ marketable securities + accounts receivables) current liabilities 8. 3. Cash Ratio The cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations. Formula 7.5 Cash ratio = (cash + marketable securities) current liabilities 9. 4. Cash Flow from Operations Ratio Poor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations. Formula 7.6 Cash flow from operations ratio = cash flow from operations current liability 10. 5. Receivable Turnover Ratio This ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated. Formula 7.7 Receivable turnover = net annual sales average receivables Where: Average receivables = (previously reported account receivable + current account receivables)/2 11. 6. Average Number of Days Receivables Outstanding (Average Collection Period) This ratio provides the same information as receivable turnover except that it indicates it as number of days.

Formula 7.8 Average number of days receivables outstanding = 365 days_ receivables turnover 12. 7. Inventory Turnover Ratio This ratio provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand. Formula 7.9 Inventory turnover = cost of goods sold average inventory Where: Average inventory = (previously reported inventory + current inventory)/2 13. 8. Average Number of Days in Stock This ratio provides the same information as inventory turnover except that it indicates it as number of days. Formula 7.10 Average number of days in stock = 365 inventory turnover 14. 9. Payable Turnover Ratio This ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful in credit checks of firms applying for credit. Payable turnover that is too small may negatively affect a company's credit rating. Formula 7.11 Payable turnover = Annual purchases Average payables Where: Annual purchases = cost of goods sold + ending inventory - beginning inventory Average payables = (previously reported accounts payable + current accounts payable) / 2 15. 10. Average Number of Days Payables Outstanding (Average Age of Payables) This ratio provides the same information as payable turnover except that it indicates it by number of days. Formula 7.12 Average number of days payables outstanding = 365_____ payable turnover 16. II. Other Internal-Liquidity Ratios 11. Cash Conversion Cycle This ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in process. Formula 7.13 Cash conversion cycle = average collection period + average number of days in stock - average age of payables 17. Cash conversion cycle = average collection period + average number of days in stock - average age of payables 12. Defensive Interval This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales. Formula 7.14 Defensive interval = 365 * (cash + marketable securities + accounts receivable) projected expenditures

Where: Projected expenditures = projected outflow needed to operate the company

Financial Ratios - Operating Profitability Ratios

Operating Profitability can be divided into measurements of return on sales and return on investment. I. Return on Sales 1. Gross Profit Margin This shows the average amount of profit considering only sales and the cost of the items sold. This tells how much profit the product or service is making without overhead considerations. As such, it indicates the efficiency of operations as well as how products are priced. Wide variations occur from industry to industry. Formula 7.15 Gross profit margin = gross profit net sales Where: Gross profit = net sales - cost of goods sold 2. Operating Profit Margin This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital and tax structure. Formula 7.16 Operating profit margin = operating income net sales Where: Operating income = earnings before tax and interest from continuing operations 3. EBITDA Margin This ratio indicates the profitability of current operations. This ratio does not take into account the company's capital, non-cash expenses or tax structure. Formula 7.17 EBITDA margin = earnings before interest, tax, depreciation and amortization net sales 4. Pre-Tax Margin (EBT margin) This ratio indicates the profitability of Company's operations. This ratio does not take into account the company's tax structure. Formula 7.18 Pre-tax margin = Earning before tax sales 5. Net Margin (Profit Margin) This ratio indicates the profitability of a company's operations. Formula 7.19 Net margin = net income sales 6. Contribution Margin This ratio indicates how much each sale contributes to fixed expenditures. Formula 7.20 Contribution margin = contribution sales Where: Contributions = sales - variable cost

Financial Ratios - Return on Investment Ratios

II. Return on Investment 1. Return on Assets (ROA)

This ratio measures the operating efficacy of a company without regards to financial structure Formula 7.21 Return on assets = (net income + after-tax cost of interest) average total assets OR Return on assets = earnings before interest and taxes average total assets Where: Average total assets = (previously reported total assets + current total assets) 2 2. Return on Common Equity (ROCE) This ratio measures the return accruing to common stockholders and excludes preferred stockholders. Formula 7.22 Return on common equity = (net income - preferred dividends) average common equity Where: Average common equity = (previously reported common equity + current common equity) / 2 3. Return on Total Equity (ROE) This is a more general form of ROCE and includes preferred stockholders. Formula 7.23 Return on total equity = net income average total equity Where: Average common equity = (previously reported total stockholders' equity + current total stockholders\' equity) / 2 4. Return on Total Capital (ROTC) Total capital is defined as total stockholder liability and equity. Interest expense is defined as the total interest expense excluding any interest income. This ratio measures the total return the company generates from all sources of financing. Formula 7.24 Return on total capital = (net income + interest expense) average total capital

Financial Ratios - Operating Efficiency Ratios

1. Total Asset Turnover This ratio measures a company's ability to generate sales given its investment in total assets. A ratio of 3 will mean that for every dollar invested in total assets, the company will generate 3 dollars in revenues. Capital-intensive businesses will have a lower total asset turnover than non-capital-intensive businesses. Formula 7.25 Total asset turnover = net sales average total assets 2. Fixed-Asset Turnover This ratio is similar to total asset turnover; the difference is that only fixed assets are taken into account. Formula 7.26 Fixed-asset turnover = net sales average net fixed assets 3. Equity Turnover This ratio measures a company's ability to generate sales given its investment in total equity (common shareholders and preferred stockholders). A ratio of 3 will mean that for every dollar invested in total equity, the company will generate 3 dollars in revenues. Formula 7.27

Equity turnover = net sales average total equity

Financial Ratios - Business Risk Ratios

Business Risk - This is risk related a company's income variance. There is a simple method and more complex method: I. Simple Method The following four ratios represent the simple method of business risk calculations. Business risk is the risk of a company making less money, or worse, losing money if sales decrease. In the declining-sales environment, a company would lose money mainly because of its fixed costs. If a company only incurred variable costs, it would never have negative earnings. Unfortunately, all businesses have a component of fixed costs. Understanding a company's fixed-cost structure is crucial in the determination of its business risk. One of the main ratios used to evaluate business risk is the contribution margin ratio. 1. Contribution Margin Ratio This ratio indicates the incremental profit resulting from a given dollar change of sales. If a company's contribution ratio is 20%, then a $50,000 decline in sales will result in a $10,000 decline in profits. Formula 7.28 Contribution margin ratio = contribution sales = 1 - (variable cost / sales) 2. Operation Leverage Effect (OLE) The operating leverage ratio is used to estimate the percentage change in income and return on assets for a given percentage change in sales volume. Return on sales is the same as return on assets. If a company has an OLE greater than 1, then operating leverage exists. If OLE is equal to 1 then all costs are variable, so a 10% increase in sales will increase the company's ROA by 10%. Formula 7.29 Operation leverage effect = contribution margin ratio return on sales (ROS) Where: ROS = Percentage change in income (ROA) = OLE x % change in sales 3. Financial Leverage Effect (FLE) Companies that use debt to finance their operations, thus creating a financial leverage effect and increasing the return to stockholders, represent an additional business risk if revenues vary. The financial leverage effect is used to quantify the effect of leverage within a company. Formula 7.30 Financial leverage effect = operating income net income If a company has an FLE of 1.33, an increase of 50% in operating income would result in a 67% shift in net income. 4. Total Leverage Effect (TLE) By combining the OLE and FLE, we get the total leverage effect (TLE), which is defined as: Formula 7.31 Total leverage effect = OLE x FLE In our previous example, sales increased by $50,000, the OLE was 20% and FLE was 1.33. The total leverage effect would be $13,333, i.e. net income would increase by $13,333 for every $50,000 in increased sales. II. Complex Method Business risk can be analyzed by simply looking at variations in sales and operating income (EBIT) over time. A more structured approach is to use some statistics. One common method is to gather a date set that's large enough (five to 10 years) to calculate the coefficient of variation. With this approach: - Business risk = standard deviation of operating income / mean of operating income - Sales variability = standard deviation of sales / sales mean

- Another source of variability of operating income is the difference between fixed and variable cost. This is referred to as "operating leverage". A company with a large variable structure is less likely to create a loss if revenues decline. The calculation of variability of operating income is complex and beyond CFA level 1. Look Out! Note that it is unlikely that the exam will ask you to calculate any ratios relating to business risk that utilize statistics.

Financial Ratios - Financial Risk Ratios

Financial Risk - This is risk related to the company's financial structure. I. Analysis of a Company's Use of Debt 1. Debt to Total Capital This measures the proportion of debt used given the total capital structure of the company. A large debt-to-capital ratio indicates that equity holders are making extensive use of debt, making the overall business riskier. Formula 7.32 Debt to capital = total debt total capital Where: Total debt = current + long-term debt Total capital = total debt + stockholders' equity 2. Debt to Equity This ratio is similar to debt to capital. Formula 7.33 Debt to equity = total debt total equity II. Analysis of the Interest Coverage Ratio 3. Times Interest Earned (Interest Coverage ratio) This ratio indicates the degree of protection available to creditors by measuring the extent to which earnings available for interest covers required interest payments. Formula 7.34 Times interest earned = earnings before interest and tax interest expense 4. Fixed-Charge Coverage Fixed charges are defined as contractual committed periodic interest and principal payments on leases and debt. Formula 7.35 Fixed-charge coverage = earnings before fixed charges and taxes fixed charges 5. Times Interest Earned - Cash Basis Adjusted operating cash flow is defined as cash flow from operations + fixed charges + tax payments. Formula 7.36 Times interest earned - cash basis = adjusted operating cash flow interest expense 6. Fixed-Charge Coverage Ratio - Cash Basis Formula 7.37 Fixed charge coverage ratio - cash basis = adjusted operating cash flow fixed charges 7. Capital Expenditure Ratio Provides information on how much of the cash generated from operations will be left after payment of capital expenditure to service the company's debt. If the ratio is 2, it indicates that the company generates two times what it

will need to reinvest in the business to keep operations going; the excess could be allocated to service the debt. Formula 7.38 Capital expenditure ratio = cash flow from operations capital expenditures 8. CFO to Debt Provides information on how much cash the company generates from operations that could be used to pay off the total debt. Total debt includes all interest-bearing debt, short and long term. Formula 7.39 CFO to debt = cash flow from operations total debt 1. Sustainable Growth Rate Formula 7.40 G = RR * ROE Where: RR = retention rate = % of total net income reinvested in the company or, RR = 1 - (dividend declared / net income) ROE = return on equity = net income / total equity Note that dividend payout is the residual portion of RR. If RR is 80% then 80% of the net income is reinvested in the company and the remaining 20% is distributed in the form of cash dividends. Therefore, Dividend Payout = Dividend Declared/Net Income
Look Out!

Students sometimes confuse retention rate with actual dividend declared. Students should read questions diligently.

Let's consider an example:

Segment Analysis Segment analysis requires conducting ratio analysis on any operating segment that accounts for more than 10% of a company's revenues or total assets, or that is easily distinguishable from the other company business in terms of products provided or the risk/return profile of the segment. Lines of business are often broken down into geographical segments, when the size or type of business differentiates them from other business lines. Since many segments have different risk profiles, they should be analyzed and valued separately from other parts of the business. Conducting ratio analysis, specifically profit margins, return on assets and other profitability measures can give analysts insight into how the segment affects overall financial performance. Both U.S. GAAP and IFRS require companies to report specific segment data, which is only a subset of the overall reporting requirements. Ratio Analysis Ratio analysis can be used to estimate future performance and allows analysts to create pro forma financial statements. Here is one example of how to estimate the future earnings potential of a firm. An analyst can first create a common-size income statement by dividing all accounting items by total sales. Using forecast assumptions the analyst then determines the amount of future sales. By multiplying the common-size percentages by the new sales

amount, the analyst prepares a pro forma income statement that estimates the future earnings potential based on the expectations of future sales. By using a range of values from the common-size statement and using a range of values for sales, the analyst can conduct a sensitivity analysis for each of the accounting items, such as cost of goods sold (COGS), profit margin and net income, to see how sensitive they are to changes in the amount of sales. By understanding how each of these items correlate to the changes in sales, an analyst can create a function that provides output for these measures for any potential sales amount in the future. Using this function an analyst can conduct scenario analysis by choosing assumptions for different market situations and create for example a base case, upside and downside scenario. Scenario analysis gives analysts an idea of the risks involved in operating a firm under different economic situations. To create an even more detailed probability distribution of potential values and risk, some analysts will conduct simulations that use a computer to produce many potential scenarios

Financial Ratios - Return on Equity and the Dupont System

DuPont System A system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the "DuPont Formula". The DuPont Formula shows the interrelationship between key financial ratios. It can be presented in several ways. The first is: Formula 7.41 Return on equity (ROE) = net income / total equity If we multiply ROE by sales, we get: Return on equity = (net income / sales) * (sales / total equity) Said differently: ROE = net profit margin * return on equity The second is: Formula 7.42 Return on equity (ROE) = net income / total equity If in a second instance we multiply ROE by assets, we get: ROE = (net income / sales) * (sales / assets) * (assets / equity) Said differently: ROE = net profit margin * asset turnover * equity multiplier Uses of the DuPont Equation By using the DuPont equation, an analyst can easily determine what processes the company does well and what processes can be improved. Furthermore, ROE represents the profitability of funds invested by the owners of the firm. All firms should attempt to make ROE as high as possible over the long term. However, analysts should be aware that ROE can be high for the wrong reasons. For example, when ROE is high because the equity multiplier is high, this means that high returns are really coming from overuse of debt, which can spell trouble. If two companies have the same ROE, but the first is well managed (high net-profit margin) and managed assets efficiently (high asset turnover) but has a low equity multiplier compared to the other company, then an investor is better off investing in the first company, because the capital structure can be changed easily (increase use of debt), but changing management is difficult. More Useful Dupont Formula Manipulations The DuPont formula can be expanded even further, thus giving the analyst more information. Formula 7.43 ROE = (net income / sales) * (sales / assets) * (assets / equity) If in a third instance we substituted net income for EBT * (1-tax rate), we get: ROE =(EBT/sales) * (sales / assets) * (assets / equity)* (1-tax rate)

Formula 7.44 ROE = (net income / sales) * (sales / assets) * (assets / equity) If in a forth instance we substituted EBT for EBIT - interest expense, we get: ROE = [EBIT / sales * sales / total assets - interest / total assets] * total assets / equity * [1 - tax / net before tax] Said differently: ROE = operating profit margin * asset turnover - interest expense rate * equity multiplier * tax retention

Financial Ratios - Uses and Limitations of Financial Ratios

Benchmarking Financial Ratios Financial ratios are not very useful on a stand-alone basis; they must be benchmarked against something. Analysts compare ratios against the following: 1.The Industry norm - This is the most common type of comparison. Analysts will typically look for companies within the same industry and develop an industry average, which they will compare to the company they are evaluating. Ratios per industry are also provided by Bloomberg and the S&P. These are good sources of general industry information. Unfortunately, there are several companies included in an index that can distort certain ratios. If we look at the food and beverage ratio index, it will include companies that make prepared foods and some that are distributors. The ratios in this case would be distorted because one is a capital-intensive business and the other is not. As a result, it is better to use a cross-sectional analysis, i.e. individually select the companies that best fit the company being analyzed. 2.Aggregate economy - It is sometimes important to analyze a company's ratio over a full economic cycle. This will help the analyst understand and estimate a company's performance in changing economic conditions, such as a recession. 3.The company's past performance - This is a very common analysis. It is similar to a time-series analysis, which looks mostly for trends in ratios. Limitations of Financial Ratios There are some important limitations of financial ratios that analysts should be conscious of: Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios. Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment. Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low. Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.). It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations. A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company. In general, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other hand, if used intelligently, ratio analysis can provide insightful information.

Financial Ratios - Basic Earnings Per Share

I. Introduction Simple and Complex Capital Structures A simple capital structure is one that contains no potential dilutive securities. A company with a simple structure will have only common stockholders, preferred stockholders and nonconvertible debt. Companies with simple capital structures only need to report basic EPS. A complex structure refers to one that contains potential dilutive securities. A company with a complex structure in addition to what is included in a company's simple capital structure will also include warrants and/or options and/or convertible debt instruments.

- Companies that have a complex capital structure must report earnings per share (EPS) on a basic and fully diluted basis. EPS is simply the net income that is attributable to common shareholders divided by the number of shares outstanding. If a company has a complex capital structure, it means that a portion of their dilutive securities may be converted to equity at some point in time. Since EPS basic does not take into account these dilutive securities, EPS basic will always be greater than EPS fully diluted. Basic Earnings Per Share (EPS) EPS basic does not consider potential dilutive securities. A company with a simple capital structure will calculate only a basic EPS, which is defined as: Formula 7.45

Basic EPS = (net income - preferred dividends)_____ weighted average number of shares outstanding

Since we are interested only in the net income that belongs to common stockholders, preferred dividends are subtracted. Dividends, whether paid in cash or stock, or the additional dividend that is attributable to participating preferred shares must also be deducted. Note: - Dividends declared to common stockholders are not subtracted from ESP as they belong to common stockholders. - Preferred stock dividends are the current year's dividend only. (a) If none are declared, then calculate an amount equal to what the current dividend would have been. (b) Don't include dividends in arrears. (c) If a net loss occurs, add the preferred dividend. - EPS is calculated for each component of income: income from continuing operations, income before extraordinary items or changes in accounting principle, and net income. Calculating the Weighted Average Number of Shares Outstanding The weighted average number of shares outstanding (WASO) is: Formula 7.46 The # of shares outstanding during each month, weighted by the # of months those shares were outstanding. Included are the impacts of all stock dividends and stock splits effective during the period and those announced after the end of the reporting period but before the financial statements are issued. Furthermore, all prior periods must be restated to facilitate comparative analysis.

Financial Ratios - Dilutive Effect of Splits and Dividends

Since in the Financial Statements section we described stock dividends and splits, here we will focus on their effects by considering an example. Example 1: Cash Dividend In 2004, Company ABC generated a net income of $12 million and paid a dividend of $1 million to preferred stockholders. Other information:

The first step is to average out the number of months the shares were outstanding:

Answer: Basic EPS = $12 million - $1 million / 3.8 million = $2.89 Example 2: Stock Splits and Dividends Stock splits and dividends are applied to all shares issued prior to the split and to the weighted average number of shares at the beginning of the period. In other words, if in this quarter a company declares a 2-to-1 stock split, then double the number of outstanding shares of prior months. Furthermore, if the company declares in Q3 a stock dividend of 10%, then increase the number of shares outstanding by 10% of prior months. Shares that are repurchased from treasury after the stock split and dividends should not be adjusted. Other information:

The first step is to account for the stock dividend in Q3:

The second step is average out the number of month the shares were outstanding:

Answer: Basic EPS = $12m -$1m/ 4.28m = $2.57

Financial Ratios - Dilutive Securities

Dilutive Securities are securities that are not common stock in form, but allow the owner to obtain common stock upon exercise of an option or a conversion privilege. The most common examples of dilutive securities are: stock options, warrants, convertible debt and convertible preferred stock. These securities would decrease EPS if exercised or if they were converted common stock. In other words, a dilutive security is any securities that could increase the weighted number of shares outstanding. If a security after conversion causes the EPS figure to increase rather than decrease, such a security is an anti-dilutive security, and it should be excluded from the computation of the dilutive EPS. For example, assume that the company XYZ has a convertible bond issue: 100 bonds, $1,000 par value, yielding 10%, issued at par for the total of $100,000. Each bond can be converted into 50 shares of the common stock. The tax rate is 30%. XYZ's weighted average number of shares, used to compute basic EPS, is 10,000. XYZ reported an NI of $12,000, and paid preferred dividends of $2,000. What is the basic EPS? What is the diluted EPS? 1) Compute basic EPS: i. Basic EPS = (12,000 - 2,000) / (10,000) = $1.00

2) Compute diluted EPS: i. Find the adjustment to the denominator: 100 * 50 = 5,000 ii. Find the adjustment to the numerator: 100 * $1000 * 0.1 * (1 - 0.3) = $7,000 3) Find diluted EPS: i. Diluted EPS = (12,000 - 2,000 + 7,000) / 10,000 + 5,000 = $1.13 If the fully dilused EPS > basic EPS, then the security is antidilutive. In this case, Basic EPS = $1.00 is less than the fully diluted ESP, and the security is antidilutive.

Financial Ratios - Calculating Basic and Fully Diluted EPS in a Complex Capital Structure

There are some basic rules for calculating basic and fully diluted ESP in a complex capital structure. The basic ESP is calculated in the same fashion as it is in a simple capital structure. Basic and fully diluted EPS are calculated for each component of income: income from continuing operations, income before extraordinary items or changes in accounting principle, and net income. To calculate fully diluted EPS: Diluted EPS = [(net income - preferred dividend) / weighted average number of shares outstanding - impact of convertible securities - impact of options, warrants and other dilutive securities] Other form: (net income - preferred dividends) + convertible preferred dividend + (convertible debt interest * (1-t)) Divided by weighted average shares + shares from conversion of convertible preferred shares + shares from conversion of convertible debt + shares issuable from stock options. To understand this complex calculation we will look at each possibility: If the company has convertible bonds, use the if-converted method: 1.Treat conversion as occurring at the beginning of the year or at issuance date, if it occurred during the year (additive to denominator). 2.Eliminate related interest expense, net of tax (additive to numerator). If the company has convertible preferred stock, use the if-converted method: 1. Eliminate preferred dividend from numerator (decrease numerator). 2. Treat conversion as occurring at the beginning of the year or at issuance date, if it occurred during the year (additive to denominator). Furthermore, use the most advantageous conversion rate available to the holder of the security. Options and warrants use the treasury-stock method: 1.Assume that exercise occurred at the beginning of the year or issue date, if it occurs during the year. 2.Assume that proceeds are used to purchase common stock for treasury stock. 3.If exercise price < market price of stock, dilution occurs. 4.If exercise price > market price, securities are anti-dilative and can be ignored in the diluted EPS calculation. Example: Company ABC has: - Net income of $2m and 2m weighted average number of shares outstanding for the accounting period. - Bonds convertible to common stock worth $50,000: 50 at $1,000, with an interest of 12%. They are convertible to 1,000 shares of common stock. - A total of 1,000 convertible preferred stock paying a dividend of 10% and convertible to 2,000 shares of common stock, with a par of $100 per preferred stock. - A total of 2,000 stock options outstanding, 1,000 of which were issued with an exercise price of $10 and the other 1,000 of which have an exercise price of $50. Each stock option is convertible to 10 common stocks. - A tax rate of 40%. - Stock whose average trading price is $20 per share. Calculate the fully diluted EPS

1.Convertible debt Assume conversion: If the debt is converted, the company would have to issue an additional 50,000 (50*1,000) common stock. As a result the WASO would increase to 2,050,000. Since the debt would be converted, no interest would have to be paid. Interest was $6,000 per annum. The interest expense would flow through to common stockholders but not before the IRS get a portion of it. So net of taxes the company would have generated an additional $3,600 [(6,000*(1-40%)] in net income. Adjusted WASO: 2,050,000 Adjusted net income: $2,003,600 2.Convertible preferred stock Assume conversion: If the stock is converted the company would have to issue an additional 2,000 shares of common stock. As a result the WASO would increase to 2,052,000. Since the preferred dividend would no longer be issued the company would not have to pay $1,000 dividends (100*1,000*10%). Since dividends are not tax deductible, there are no tax implications. So the company would have generated an additional $1,000 in net income attributable to common stockholders. Adjusted WASO: 2,050,000 Adjusted net income: $2,003,600 Preferred dividend is reduced to zero 3.Stock options If-converted method: Say there are 1,000 stock options in the money (exercise price < market price of stock). The holders of the stock option can convert their options into stock for a profit at any point and time. Say 1,000 stock options are out of the money (exercise price > market price of stock). The holders of the stock option would not convert their options, because it would be cheaper to purchase the stock on the open market. The out-of-the-money option can be ignored. The in-the-money options need to be accounted for. Here is how in-the-money options are accounted for: 1)Calculate the amount raised through the exercise of options: 1000 * 10 *$10 = $100,000 2)Calculate the number of the common shares that can be repurchased using the amount raised through the exercise of options (found in step #1): $100,000 / 20 = 5,000 3)Calculate number of common shares created by the exercise of the stock options: 1000 * 10 = 10,000 4)Find the net number by which the number of new common shares, created as result of the stock options exercised (found in step #3), exceed the number of common shares repurchased at the market price with proceeds received from the exercise of the options (found in step #2): 10,000 - 5,000 = 5,000 5) Find the total number of shares if the stock options are exercised: add weighted average number of shares to what you found in step #4: 2,052,000 + 5,000 = 2,057,000 Fully diluted EPS= 2,000,000 + 3,600 - 6,000 + 6,000 = 2,003,600 = 0.974

2,000,000 +50,000 + 2,000 +5,000 2,057,000 Presentation and disclosure Simple capital structure a. Basic EPS is presented for income from continuing operations, income before extraordinary items or change in accounting principle, and net income. b. Reported for all accounting periods presented c. Prior-period EPS is restated for any prior-period adjustments. d. Footnotes are required for stock splits and stock dividends. Complex capital structure a. Basic and fully diluted EPS are presented for income from continuing operations, income before extraordinary items or change in accounting principle, and net income. b. Reported for all accounting periods presented c. Prior-period EPS is restated for any prior-period adjustments. d. Footnotes are required for diluted EPS.

Assets - Introduction
LOS 29.a: Discuss the roles of financial reporting and financial statement analysis Chapter 8 focuses on the asset side of the balance sheet. We will discuss current and long term assets, including inventory analysis. We have provided many examples throughout the section that will aid your learning experience. Note how changes in these accounts affect the ratios - pay careful attention as to what constitutes a credit vs. debit. In Chapter 9 we will discuss the liability side of the balance sheet.

Assets - Choosing the Appropriate Accounting Method For Investment Securities

LOS 29.b: Discuss the role of key financial statements (income statement, balance sheet, statement of cash flows, and statement of changes in owners' equity) in evaluating a company's performance and financial position Classification & accounting treatment Trading securities - These are securities held by a company that it intends to buy and sell for a short-term profit. These securities are reported at their fair market value. Gains and losses will be included on the income statement. They are classified as unrealized holding gains or losses on the income statement, and the counter account on the balance sheet is allowance for adjusted short-term investments to market.

Available for sale - This is generally a default category. The accounting for available-for-sale securities looks quite similar to the accounting-for-trading securities. There is one big difference between the accounting-fortrading securities and available-for-sale securities. This difference pertains to the recognition of the changes in value. For trading securities, the changes in value are recorded in operating income. However, for availablefor-sale securities the changes in value go into a special account, which is called "unrealized gain/loss in other comprehensive income", which is located in stockholders' equity. The income statement will be unaffected. The counter account to unrealized gain/loss in other comprehensive income is short-term available-for-sales fair market adjustment. Held to maturity - These are securities held by a company that it intends to buy and hold to maturity. These securities are recorded at cost (Purchase price + communions or other fees) and gains or losses are only recognized after the company has sold the securities.

Accounting Impact Classification Trading Assessment Guidelines Intent to buy/sell for short-term profits Initially Record at fair market value Record at fair market value Subsequently Attribute gains and losses to operating income

Available for Sale

Default Category Intent to buy and hold until fixed future maturity date

Attribute gains and losses to stockholders' equity

Held to Maturity

Assets - Accounting for Credit Transactions

LOS 30.a: Explain the relationship of financial statement elements and accounts, and classify

accounts into the financial statement elements. NOTE: Determining the correct classification of investment securities can have important impacts on either the income statement or balance sheet, so the decision process should be consistent. An exam question or sample set can be impacted by your classification. Most businesses give customers a certain number of days (30 to 60 days) to pay for delivered products and services. This is referred to as "extending credit to customers". Under accrual accounting, sales made on credit are recorded on the income statement. The not-yet-collected money is recorded under accounts receivable. Unfortunately, some customers will not want or be able to pay (because of bankruptcy) the company. Company's can utilize two different approaches to account for these uncollectible accounts. The first is to account for them as they occur. Companies mostly use this method for income tax calculations and/or because its bad debts are immaterial. This method is called the "direct write-off method of accounting for bad debts". Once the company determines that an account is uncollectible, it will debit (which is an increase) the bad debt expense and credit accounts receivable (which is a decrease) The second method used by companies, which is more consistent with the matching accounting principle, is to estimate the bad debt on an ongoing basis. This is referred to as the "allowance method for bad debt", and it is accounted for in allowance for doubtful accounts. Accounting for Credit Sales 1) The direct write-off method ABC sells and delivers $200,000 in products to 3C, which has 30 days to pay. Here's the accounting record:

The 3C account has been overdue for six months and will most likely be uncollectible. The company decides to write it off:

2) Allowance method for bad debt ABC sells and delivers $200,000 in products to 3C, which has 30 days to pay. Accounting record:

The company estimates that 1% of accounts receivable will become uncollectible:

Unfortunately, 3C has declared Chapter 7 bankruptcy. The 3C account needs to be written off. Currently the Company has 400,000 in allowance for doubtful accounts:

Assets - Basics of Inventories

Inventory Processing Systems Inventory-processing systems relate to the timing of the assessment of inventory. They can be valued on a continuous basis (physical count of inventory will be done after each sale) or periodically (physical count of inventory will be done at the end of each period). For most businesses, continuous revaluation of their inventory is too expensive and generates little value. As a result, most companies evaluate their inventory periodically. The inventory-costing methods used relate to the way management has decided to evaluate the cost of their inventory, for example, specific identification, average cost, first in first out (FIFO), or last in first out (LIFO). The costing method will have an impact on the estimated value of the inventory on hand and the estimated cost of goods sold (COGS) reported on the income statement. The valuation method is the process by which the inventory is valued. GAAP requires inventory to be valued at the lower of cost to market (LCM) valuation. Market valuation is defined as replacement cost. The choices made by management with the inventory- processing systems, the inventory-costing method and the valuation method used will affect what is reported on a company's balance sheet, net income statement (profits) and cash flow statement. All these choices should be driven by the application of the matching principle. Unfortunately, these choices are sometimes driven by the owner/management tax implications (usually among private companies), or by the intention to artificially increase a company's profitability (usually among public companies). Inventory Cost Inventory cost is the net invoice price (less discounts) plus any freight and transit insurance plus taxes and tariffs. Inventory includes not only inventory on hand but also inventory in transit. Furthermore, inventory does not have to be a finished product to the included. The cost of inventory can be calculated 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) GAAP allows management to use four methods to evaluate inventory. We will use the following example to illustrate each of these methods. Example: Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

1) The Specific-identification Inventory Method Under this inventory method each unit purchased for resale is identified and accounted for by its invoice. Companies that use this method carry a small number of units. Cost of goods sold: $75 (ID: 102 and 103) Ending inventory: $55 (ID: 101 and 104) Gross profit: $300-$75 = $225 2) Average-cost Method Under this inventory method the units in inventory are considered as a whole and their cost is averaged out. Companies that use this method carry a large number of units. Total cost: $130 Average cost: $33 per unit (total cost / total number of units) Cost of goods sold: $66 ($33*2 units sold) Ending inventory: $66 ($33*2 units left) Gross profit: $300-$66 = $234 3) First-in, First-out (FIFO) Under this inventory method the units that were first purchased are assumed to be sold first. Cost of goods sold: $65 (ID: 101 and 102)

Ending inventory: $65 (ID: 103 and 104) Gross profit: $300-$65= $235 4) Last-in, First-out (LIFO) Under this inventory method the units that were last purchased are assumed to be sold first. Cost of goods sold: $65 (ID: 103 and 104) Ending inventory: $65 (ID: 101 and 102) Gross profit: $300-$65 = $235

Assets - Effects of Misstated Inventory

Overstating (O) or understating (U) inventory has an effect not only on the balance sheet but also on reported income and cash flow. O and U occur when the purchase price and value of inventory change over time. Let's take, for example, a company that trades scrap steel. The best way to illustrate O and U is to do it through an example. Basic concept: Formula 8.1 COGS = beginning inventory + purchases - ending inventory If the price of a company's inputs (such as steel, lumber, etc.) is rising: FIFO method COGS will be understated. Income will be overstated. The company will pay more income tax and have a lower cash flow. Assets on the balance sheet will be more reflective of the actual market value. Working capital and current ratio will be increased. LIFO method COGS will be more reflective of current market environment. Income will be lower. The company will pay less income tax and cash flow would be higher. Assets would be understated and not reflective of its market value. Working capital and current ratio will be decreased. Average-cost method Since it's an average, it would be in between LIFO and FIFO Specific identification method If this method is used, it is extremely hard to tell, since each product has been accounted for individually. Questions of the effect of prices are common in CFA exams as well as most basic accounting exams but often overlooked. This example of rising prices (inflationary environment) can be viewed in various ways: Under FIFO, while the company will pay more in taxes, investors may overlook this due to the increase in income and working capital. Under LIFO, the lower income scenario may be only temporary and reverse in the next reporting period when they sell the inventory that was acquired before the rising price scenario. Look Out!
In the past, exam questions typically focus on differences between LIFO and FIFO, but don't rely on the past.

Assets - Inventory Valuation

GAAP requires inventory to be valued at the lower of cost to market. LCM can be calculated by using the item-by-item method or the major-category method. 1. The item-by-item method - This methods will look at each item and determine the LCM. Example:

2. The major-category method - Under this method, each category is grouped and the lower of the cost to market is taken. Example - Assume that our prior example represents a category.

Under this method the LCM should be $850.

Assets - Inventory Analysis

Computing Inventory Balances In computing ending inventory balances under the various methods we will use the following example. Example: Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

1. Average-cost method - Under this inventory method the units in inventory are considered as a whole and their cost is averaged out. Companies that use this method carry large amount of units. Total cost: $130 Average cost: $33 per unit (total cost / total number of units) Cost of goods sold: $66 ($33*2 units sold) Ending inventory: $66 ($33*2 units left) Gross profit: $300-$66 = $234 2. First in first out - Under this inventory method, the units that were first purchased are assumed to be sold first. Cost of goods sold: $65 (ID: 101 and 102) Ending inventory: $65 (ID: 103 and 104) Gross profit: $300-$65 = $235

3. Last in first out - Under this inventory method the units that were last purchased are assumed to be sold first. Cost of goods sold: $65 (ID: 103 and 104) Ending inventory: $65 (ID: 101 and 102) Gross profit: $300-$65 = $235 Usefulness of Inventory Data When Prices Are Stable or Changing If the cost of purchasing inventory remains stable, the method used to calculate the cost of goods sold (by FIFO, LIFO or average cost) will yield similar results. On the other hand, in a changing environment this can distort the reported income, cash flow and inventory. I. Rising Price (Inflationary) Environment FIFO method COGS will be understated. Income will be overstated. The company will pay more income tax and have a lower cash flow. Assets on the balance sheet will be more reflective of the actual market value. Working capital and current ratio will be increased. Inventory turnover (COGS / average inventory) will worsen (decrease). LIFO method COGS will be more reflective of current market environment. Income will be lower. The company will pay less income tax and cash flow will be higher. Assets will be understated and not reflective of its market value. Working capital and current ratio will be decreased. Inventory turnover (COGS / average inventory) will improve (increase). Average-cost method Since it's an average, it would be in between LIFO and FIFO. II. Decreasing Price (Deflation) Environment FIFO method COGS will be more reflective of current market environment. Income will be lower. The company will pay less income tax, and cash flow would be higher. Assets will be understated and not reflective of its market value. Working capital and current ratio will be decreased. Inventory turnover (COGS / average inventory) will improve (increase). LIFO method COGS will be understated. Income will be overstated. The company will pay more income tax and have a lower cash flow. Assets on the balance sheet will be more reflective of the actual market value. Working capital and current ratio will be increased. Inventory turnover (COGS / average inventory) will worsen (decrease). Look Out! Make sure you understand this concept very well. It can make or break an entire sample set if you reverse the effects conceptually Analysts should be aware that companies that operate in a rising-price environment and utilize the LIFO method could manipulate their earnings. To manipulate the earnings management could simply stop purchasing new inventory and start dipping into their old and cheap inventory. This is call "LIFO liquidation". Most U.S. companies use LIFO as opposed to FIFO. Given the fact that the U.S. has seen cost of inventory rise over the last 30 years (inflation) these companies were able to save on taxes. One should know that the Internal Revenue Service (IRS) does not allow companies to report LIFO for tax purposes and then FIFO on their general-purpose statements. Analyzing the Financial Statements of Companies That Use Different Inventory Accounting Methods When comparing two companies, one must ensure that they are comparing apples with apples. If the first company uses the FIFO method and the other the LIFO method, then there is a problem. To make the comparison relevant, one must convert LIFO to FIFO or FIFO to LIFO.

Assets - Converting LIFO to FIFO

To make the conversion possible, U.S. GAAP requires companies that use LIFO to report a LIFO reserve (found in footnotes). The LIFO reserve is the difference between what their ending inventory would have been if they used FIFO. Formula 8.2 LIFO reserve = FIFO inventory - LIFO inventory Or FIFO inventory = LIFO inventory + LIFO reserve Recall: COGS = beginning inventory + purchases - ending inventory Or COGS = change in inventory levels So: Formula 8.3 COGS (FIFO) = COGS (LIFO) - change in LIFO reserve Or COGS (FIFO) = COGS (LIFO) - (LIFO reserve at the end of the period - LIFO reserve at the beginning of the period) Long Conversion A longer way to convert LIFO to FIFO is to calculate purchases, convert both beginning and ending inventory to FIFO levels, and then calculate COGS using the FIFO inventory levels and purchases. COGS = beginning inventory + purchases - ending inventory Rearrange the terms: Purchases = ending inventory - beginning inventory + COGS (LIFO) We also know that: Ending inventory (FIFO) = Ending inventory (LIFO) + ending period LIFO reserve Beginning inventory (FIFO) = Beginning inventory (LIFO) + Beginning LIFO reserve Example: Company ABC uses LIFO. Year-end inventory = $2m Beginning inventory = $3m LIFO reserve at year-end = $1m LIFO reserve at the beginning of the years = $500,000 COSG = $5m Simple way to convert LIFO to FIFO COGS (FIFO) = COGS (LIFO) - change in LIFO reserve COGS (FIFO) = $5m - ($1m - $0.5m) = $4.5m Complex way Purchases = ending inventory - beginning inventory + COGS (LIFO) Purchases = $2m - 3m + $5m = $4m Ending inventory (FIFO) = ending inventory (LIFO) + ending period LIFO reserve

Ending inventory (FIFO) = $2m + $1m = $3m Beginning inventory (FIFO) = beginning inventory (LIFO) + beginning LIFO reserve Beginning inventory (FIFO) = $3m + $0.5m = $3.5m COGS (FIFO) = purchases + beginning inventory (FIFO) - ending inventory (FIFO) COGS (FIFO) = $4m + $3.5m - $3m = $4.5m To make the two companies comparable, we need to do some additional adjustments. Under different methods COGS will vary and as a result net income should be adjusted.

If COGS under the LIFO was higher than the COGS under the FIFO method: o That would mean this company would have used the FIFO method, it would have declared a higher gross profit and hence a higher net income. But it would have also had to pay higher taxes and reduce its cash flow. A simple way to account for that is to take the positive difference in COGS and multiply it by (1-tax rate). o This difference would also be included in shareholders' equity. o The additional tax would be recorded in income tax liability. If COGS under the LIFO was lower than the COGS under the FIFO method: o That would mean this company would have used the FIFO method, it would have declared a lower gross profit and hence lower net income. But it would have also had to pay lower taxes and increase its cash flow. A simple way to account for that is to take the negative difference in COGS, divide the COGS by (1-tax rate). o This difference would also be included in shareholders' equity. o The additional tax would be recorded in income tax asset.

Assets - Converting FIFO to LIFO

There is no precise mathematical equation to convert FIFO accounting to LIFO because the equivalent of the FIFO reserve does not exist. Furthermore, there is little value in converting inventory under FIFO to LIFO, since LIFO inventory is not a reflection of the true economic value of inventory. Nonetheless, analysts can estimate what the inventory and COGS would have been if the company used the LIFO accounting method. Analysts would first need to estimate what the beginning inventory would have been under LIFO. Inventory can be affected by economic inflation, inflation of raw assets with a particular industry, among others. As a result, COGS (LIFO) can be estimated by using this formula: COGS (LIFO) = COGS (FIFO) + [beginning inventory (FIFO) * (adjustment or inflation rate)] Looking at a company within a similar industry that uses the LIFO method can also be done to derive the adjustment rate. Adjustment rate = LIFO reserve / beginning inventory (LIFO) Converting Average-cost Method to LIFO As stated previously, since the average-cost method is a simple average of COGS, COGS would be in between LIFO and FIFO.

Assets - Effects of Inventory Accounting

COGS (LIFO) = COGS (average) - * (beginning inventory (Average) * (adjustment or inflation rate)

A company's choice of inventory accounting will affect the company's income, cash flow and balance sheet. Income effect - Inventory and cost of goods sold are interdependent. As a result, if LIFO method is used in a rising-price and increasing-inventory environment, more of the higher-cost goods (last ones in) will be accounted for in COGS as opposed to FIFO. Under this scenario, net income will be lower compared to a company that used FIFO accounting.

Cash flow effect - If we lived in a tax-free world, there would be no cash flow difference between inventoryaccounting methods. Unfortunately, we do pay taxes. As a result, if a company uses the FIFO method in a rising-price and increasing-inventory environment, it will have to generate a lower COGS and a higher net taxable income, and pay higher taxes. Tax expenses are a real cash expense and lower a company's cash flow.

Working Capital - Working capital is defined as current assets minus current liabilities. If one method produces a higher inventory value in the income statement, the working capital will increase. Table 8.1 Summary of effects given a rising-prices environment and stable or increasing inventories

The Effects of the Inventory Method On Ratios Since the accounting method used to account for inventory has an effect on the income statement, balance sheet and cash flow statement, it will ultimately have an effect on the ratios used to measure and compare a company's profitability, liquidity, activity and solvency. While temporary, any significant changes in ratios can have effects on the company's stock price. While analysts may recognize that the changes in the ratios are sourced from the methods, in the world of rapid information dissemination, traders and investors often react before the news is fully digested. This is a table that is important to commit to memory. Keep in mind, one method is not necessarily better than the other and often reverse during the next reporting periods so the effects are dynamic in nature. Computing Profitability Effects In a rising-price and stable- or increasing-inventory environment,LIFO will have a higher COGS, but it will also be more representative of the current economic reality. As a result, profitability will be more accurate, and a better indicator of future profitability. FIFO will use the cost of the old stock to determine the COGS, making the profitability ratio less reflective of the current economic reality. As a general rule, in a rising-price and stable- or increasing-inventory environment,using profitability measures based on LIFO is better. Look Out! Most questions relating to the differences under LIFO and FIFO will include a descriptive effect on financial ratios. Students need to understand what each ratio is composed of.

Look Out! Before starting this section remember what changes: Inventory - current assets and total assets o COGS - profitability Income - stockholder equity Taxes - CFO and cash account on the balance sheet Liquidity Ratio Changes

Look Out! From an analytical perspective, in a rising-price and stable- or increasinginventory environment, it is better to use FIFO liquidity ratios because the LIFO ending inventory is composed of older, cheaper inventory. Activity ratios

From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, the LIFO inventory

turnover ratio will trend higher. On the other hand, if we use FIFO, the COGS does not represent the current economic reality. In this case the best thing to do is to use the COGS found under LIFO and divide it by the average inventory found in FIFO. This is called "current-cost method". Look Out! From an analytical perspective, in a rising-price and stable- or increasinginventory environment, it is better to use FIFO total asset turnover ratios because LIFO ending inventory is the older, cheaper inventory. Solvency ratios

From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, it is better to use LIFO debt-to-equity ratio because the retained earnings are more representative of the current economic reality. For the time, interest-earned ratio is more relevant to use LIFO because EBIT will be lower and more representative of future interest-coverage protection. If the company is currently using FIFO, it is better they use the CFO generated by FIFO because the company cannot change the fact that it will have to continue paying higher taxes under this method.

Assets - Causes of Decline in LIFO Reserve

LIFO reserves decline because a company is doing the following: liquidating its inventory (lower quantities / selling cheap/old stock) is purchasing inventory at lower prices (price decline) The liquidation of inventory is called "LIFO liquidation". This happens when a company is no longer purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. This can produce large increases in profitability (COGS abnormally low). This increase in profitability is temporary (paper profit). Once it runs out of cheap inventory, it will have to purchase new inventory at a mush higher cost base. This will also decrease a company's cash flow because it will have to pay more taxes. Profits from LIFO liquidation are non-operating in nature and should be excluded from earnings in an analysis. A decline in price reduces the COGS under LIFO, but though COGS is lower it is a better indication of the economic reality. So no adjustments are necessary on the income statement. That said, the ending inventory under LIFO is too high and is no longer representative of its true economic value. The ending inventory should be adjusted to FIFO. Look Out! Companies must report inventories at the lower of cost (determined by their LIFO, FIFO or other inventory accounting method) or market value. Market value is essentially the net realizable value of the assets.

Assets - Long Term Asset Basics

Distinguishing Features of Long Term Assets Long-term assets are assets that are typically used in the production process of a company and have a useful life of more then one year. Long-term assets typically include property, plant (building and land) and equipment ( PP&E). These assets are reported at cost (book value) at initiation, and are depreciated over time (except for land). Once an asset has started to depreciate, it is said to be reported at its carrying value. If an asset becomes obsolete before its time or it has lost its revenue-generating ability, it must be written off and this is referred to as asset impairment. Property, Plant and Equipment (PP&E) The cost of PP&E includes all costs related to their acquisition and all necessary expenses required to make them useful for the company. Example 1: Company ABC purchased a machine for $2m. To get this machine ready for use, it paid a total of $200,000 for transportation and insurance, brokerage fees, set-up costs and legal fees, among others. So the total cost is $2.2m. Journal entry:

Company ABC bought a piece of land for $2m and an additional $100,000 went to expenses resulting from the search for the land, real estate commission, title transfer, surveying and landscaping. Total cost is $2.1m. Journal entry:

Company ABC incurred a total of $20m in additional costs to build on this land. This included, among others, costs for materials, labor, construction plans and interest cost incurred during the construction phase. Journal entry:

Assets - Depreciation Accounting

Depreciation is defined as the reduction in the value of a product arising from the passage of time due to use or abuse, wear and tear. Depreciation is not a method of valuation but of cost allocation. This cost allocation can be based on a number of factors, but it is always related to the estimated period of time the product can generate revenues for the company (economic life). Depreciation expense is the amount of cost allocation within an accounting period. Only items that lose useful value over time can be depreciated. That said, land can't be depreciated because it can always be used for a purpose. Straight-line Depreciation The simplest and most commonly used method, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset, subtracting by the salvage value (value at which it can be sold once the company no longer needs it) and dividing by the total productive years for which the asset can be reasonably expected to benefit the company, or its useful life. Example: For $2m, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts. Formula 8.4 Depreciation expense = total acquisition cost - salvage value useful life

Look Out! Know that this method of depreciation produces a constant depreciation expense, and at the end of its useful life, this asset will be accounted for in the balance sheet at its salvage value. Unit-of-production Depreciation This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one must first determine the cost per one production unit and then multiply that cost per unit with the total number of units the

company produced within an accounting period to determine its depreciation expense. Formula 8.5 Depreciation expense = total acquisition cost - salvage value estimated total units Estimated total units = the total units this machine can produce over its lifetime Depreciation expense = depreciation per unit * number of units produced during an accounting period Example: Company ABC purchased a machine that can produce 300,000 products over its useful life for $2m. The company also estimates that this machine has a salvage value of $200,000.

Look Out! Know that this depreciation method produces a variable depreciation expense and is more reflective of production-to-cost (matching principle).

At the end of the useful life of the asset, its accumulated depreciation is equal to its total cost minus its salvage value. Furthermore, its accumulated production units equal the total estimated production capacity. One of the drawbacks of this method is that if the units of products decrease (slowing demand for the product), the depreciation expense also decreases. This results in an overstatement of reported income and asset value. Hours-of-service Depreciation This is the same concept as unit of production depreciation except that the depreciation expense is a function of total hours of service used during an accounting period.

Assets - Accelerated Depreciation

Accelerated depreciation allows companies to write off their assets faster in earlier years than the straight-line depreciation method and to write off a smaller amount in the later years. The major benefit of using this method is the tax shield it provides. Companies with a large tax burden might like to use the accelerated-depreciation method, even if it reduces the income shown on the financial statement. This depreciation method is popular for writing off equipment that might be replaced before the end of its useful life since the equipment might be obsolete (e.g. computers). Companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will seem more profitable in the later years. Companies that will be raising financing (via an IPO or venture capital) are more likely to use accelerated depreciation in the first years of operation and raise financing in the later years to create the illusion of increased profitability (higher valuation). The two most common accelerated-depreciation methods are the sum-of-year (SYD) method and doubledeclining-balance method (DDB): Sum-of-year Method: Depreciation in year i = (n-i+1) * (total acquisition cost - salvage value) n! Example: For $2m, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts.

n! = 1+2+3+4+5 = 15 n=5

Look Out! Know that this depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straightline depreciation. Double-declining-balance method The DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years. DDB in year i = 2 x (total acquisition cost - accumulated depreciation) n n = number of years Example For $2m, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years the company will be able to sell it for $200,000 for scrap parts.

Look Out! Know that this depreciation method produces a very aggressive depreciation schedule. The asset cannot be depreciated beyond its salvage value. Change in Useful life or Salvage Value All depreciation methods estimate both the useful life of an asset and its salvage value. As time passes the useful life of a company's equipment may be cut short (new technology), and its salvage value may also be affected. Once this happens there is asset impairment. Companies can do two things: 1) They can accelerate the asset's depreciation and fix the reduction in useful life or salvage value over time or 2) They can do the recommended thing, which is to recognize the impairment and report it on the income statement right away.

Look Out! Note that changes in useful life and salvage value are considered changes in accounting estimates, not changes in accounting principle. The result is this: no need to restate past financial statements. Sale, Exchange, or Disposal of Depreciable Assets Companies that are in the business of exploring and/or extracting and/or transforming natural resources such as timber, gold, silver, oil and gas, among other resources are known as "natural resource companies". The main assets these companies have are their inventory of natural resources. These assets must be reported at their cost of carry (or carrying cost). The carrying costs for natural resources include the cost of acquiring the lands or mines, cost of timber-cutting rights and the cost of exploration and development of the natural resources. These costs can be capitalized or expensed. The costs that are capitalized are included in the cost of carry. The cost of carry does not include the cost of machinery and equipment used in the extraction process. When a resource company purchases a plot of land, it not only pays for the physical asset but also pays a large premium because of what is contained in the plot of land. That said, once a company starts extracting the oil or natural resource from the land, the land loses value, because the natural resources extracted from a plot of land will never regenerate. That loss in value is called "depletion". That is why cost of carry is depleted over time. The depletion of these assets must be included in the income statement's accounting period. This is the only time land can be depleted. The carrying costs of natural resources are allocated to an accounting period by means of the units-of-production method. Example: A company acquired cutting rights for $1m. With these cutting rights, the company will be able to cut 5,000 trees. In its first year of operation, the company cut 200 trees. Journal entries:

Assets - Natural Resource Assets

Classification of Natural Resource Assets Intangible assets are identifiable non-monetary resources that have no physical substance but provide the company controlling them with a benefit. Intangible assets can be internally created or acquired from a third party. If intangible assets are acquired in an arm's length transaction, their recognition and measurement will be similar to those of tangible assets. Internally developed intangible assets are accounted for in a wide range of ways. Intangible assets include research and development costs, patents, trademarks and goodwill. Intangible assets are depreciated over their estimated life and they are done so by the use the straight-line depreciation method. Intangible assets cannot have an estimated life of more then 40 years. Unlike other intangible assets, goodwill is no longer an asset that can be depreciated. As of July 2001, the Financial Accounting Standards Board (FASB) adopted the Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, which sets new rules for goodwill accounting. SFAS 142 eliminates goodwill amortization and instead requires companies to identify reporting units and perform goodwill impairment tests. Example Company ABC acquires a company for $20m. The acquired company's fair market value was $18m. ABC has also acquired a patent for $2m that has an estimated remaining life of 10 years. Journal entries:

Assets - Effects of Capitalizing Vs. Expensing

Expenses can be expensed as they are incurred, or they can be capitalized. A company is able to capitalize the cost of acquiring a resource only if the resource provides the company with a tangible benefit for more than one operating cycle. In this regard, these expenses represent an asset for the company and are recorded on the balance sheet. Effects of Capitalization on Key Figures The decision to capitalize or expense some items depends on management. As such, this choice will have an impact on a company's balance sheet, income statement and cash flow statement. It will also have an impact on a company's financial ratios. Here is what the decision will have an impact on: Net income - Capitalizing costs and depreciating them over time will show a smoother pattern of reported incomes. Expensing firms have higher variability in reported income. In terms of profitability, in the early years, a company that capitalizes costs will have a higher profitability than it would have had if it expensed them. In later years, the company that expenses costs will have a higher profitability than it would have had if it capitalized them.

Stockholders' equity - Over a long time frame, the choice of expensing a cost or capitalizing it will have little effect on a shareholders' total equity. That said, expensing firms will have a lower stockholders' equity at first (less profit, thus smaller retained earnings). Cash flow from operations - A company that capitalizes its costs will display higher net profits in the first years and will have to pay higher taxes than it would've had to pay if it expensed all of its costs. That said, over a long period of time, the tax implications would be the same. But the choice for capitalizing over expensing have a much larger effect on the reported cash flow from operations and cash flow from investing. If a company expenses its cost it will be included in cash flow from operations. If it capitalizes, then it will be included in cash flow from investing (lower investment cash flow and higher cash flow from operations). Assets reported on the balance sheet - A company that capitalizes its costs will display higher total assets.

Financial ratios - A company that capitalizes its costs will display higher profitability ratios at the onset and lower ratios in the later stages. Liquidity ratios will experience little impact, except for the CFO ratio, which will be higher under the capitalization method. Operation-efficiency ratios such as total asset and fixed-asset turnover will be lower under the capitalization method, due to higher reported fixed assets. Furthermore, at the onset, equity turnover will be higher under the capitalization method (lower total equity due to lower net profit). Companies that capitalize their costs will initially report higher net income, lower equity and higher total assets. Remember that, on average, an equal dollar effect on a numerator and denominator will produce a higher net result. That said, on average, ROE & ROA will initially be higher for capitalizing firms. Solvency ratios are better for firms that capitalize their costs because they have higher assets, EBIT and stockholders' equity. Consider figure 8.2 below for an overview of the effect of capitalizing and expensing on key financial ratios. Figure 8.2 Impact of Assets, Profitability on Financial Ratios

Assets - Computing the Effects of Capitalizing vs. Expensing

If interest is capitalized, it is included in the cost of carry. Capitalizing interest is common in construction projects. The interest cost is included as an asset versus being expensed on the income statement for the period it occurred. In the U.S., SFAS 34 governs the capitalization of interest cost during an accounting period. SFAS 34 requires that the interest cost incurred during a construction period is accounted for as a long-lived asset. To be capitalized, the interest must be from borrowed money. If no specific borrowing is identified, interest can be estimated by means of a weighted average interest rate on outstanding debt for the amount invested. Example: A company built a building for $1m. It borrowed $500,000 at 5% to build the building. In this case the interest capitalized will amount to $25,000. Another company built a building for $1m. It borrowed $500,000 at 5% to build the building; it also had an outstanding debenture of $3m at 10% and a $1M mortgage at 15%. In this case, the interest capitalized will amount to: 500,000 * 5% = 25,000 500,000 * 10% = 50,000 Total 75,000 Interest to be expensed = total interest paid - capitalized interest = 25,000+300,000+150,000-75,000 = 400,000 The total capitalized interest is $75,000 because we assume the $500,000 balance was financed through the debenture. The reason we do not consider the mortgage is that it is already assigned to another identifiable asset. Some argue that the capitalization costs of self-financed assets should not be included. The decision to capitalize interest will have an effect on a company's:

Assets - Capitalizing Intangible Assets

Net income - In the current period earnings will be higher (overstated). CFO - In the current period, CFO will be higher (overstated) because the interest expense will be included in CFI. CFI - In the current period, CFI will be lower (understated). Assets - Total assets will be overstated because they include the capitalized interest. Solvency ratios - Since assets, EBIT and stockholders' equity will be higher, all solvency ratios will be overstated.

Intangible assets are identifiable non-monetary resources that have no physical substance but provide the company controlling them with a benefit and, as a result, have a higher degree of uncertainty regarding future benefits. When intangible assets are acquired through an arm's length transaction, they are recorded at cost. SFAS classifies intangible assets in different categories and provides a guideline in regards to their expense or capitalization. 1. Research and development costs SFAS requires virtually all R&D costs to be expensed in the period they were incurred and the amount to be disclosed. The main exception to the expensing rule is contract R&D performed for unrelated entities. 2. Software development SFAS requires all costs that were incurred in order to establish technological and/or economic feasibility of software to be viewed as R&D costs and expensed as they are incurred. ONCE economic feasibility has been established, subsequent costs can be capitalized (but are not required to be) as part of product inventory and amortized based on product revenues or on sales-per-license basis. Other Intangibles 1. Patents and copyrights All costs in developing these are expensed in conformity with the treatment of R&D costs (legal fees incurred in registering can be capitalized). Full acquisition costs are capitalized when purchased from other entities. 2. Brands and trademarks All costs in developing a brand or trademark are expensed in conformity with treatment of R&D costs (legal fees incurred in registering can be capitalized). Full acquisition costs are capitalized when brands and trademarks are purchased from other entities.

Assets - Depreciation

Depreciation Methods Identification of depreciation methods: Straight-line depreciation Per unit of production Per hour of service Declining balance Sinking-fund depreciation The only depreciation method that was not previously explained is the sinking-fund depreciation. The sinking-fund depreciation is rarely used and is prohibited in the U.S. and some other countries. Under this depreciation method, the amount of depreciation increases every year to maintain a fixed internal rate of return (IRR). Formula 8.6 Depreciation in year i = CF in year i - (IRR * book value at beginning of the year) CF is defined as the cash derived every year from a particular asset. Effect of depreciation on financial statements, ratios and taxes: Straight-line depreciation - This method will create a steady income stream, tax expense and ratios. Return on assets will increase over time if the equipment continues to generate the same products and price per unit remains constant. Per unit of production and per hour of service - These depreciation methods produce a variable depreciation expense. Net income will vary but it could be more reflective of production-to-cost (matching principle). One of the drawbacks of this method is that if units of products decrease (slowing demand for the product), depreciation expense also decreases, resulting in an overstatement of reported income and asset value. Declining balance - Income will be lower in the first years. As a result taxes will be lower and CFO will be higher. If production and selling prices of goods remain constant, ROA will be much higher in later years.

Sinking-fund depreciation - The only benefit of this method is that the income reported should reflect ROI earned by assets. Depreciable Life Depreciable life, whether it is defined by years of useful life or by production units, is the most significant estimate that must be made in the determination of the depreciation expense. The estimated salvage value of an asset is also important but not as significant. The role of depreciable life and salvage value is important because it is an estimation given by management. As such, management can use this estimation choice to manipulate current and future earnings. The most common form of manipulation is an overstatement in the write-down of assets during a restructuring process, which will be reported as an extraordinary item and will result in the inflation of future net profits. Changing Depreciation Methods Changes in depreciation methods can be done in three ways: 1. Change the depreciation method for all newly acquired assets. 2. Change the depreciation method for current and all new assets. 3. Change in depreciable life or salvage value. Changing the Depreciation Method for All Newly Acquired Assets The change in depreciation method will only affect future acquired assets. As a result, no past adjustment need to be made; the only thing that will change is future depreciation expense. That said, the change in depreciation expense will be gradual, and the change in ratios will also be gradual. Change the Depreciation Method for Current and All New Assets This is a much more complex change and will require all past assets to be restated to reflect the new depreciation accounting method. For all new assets it's not really a problem, but for the past assets the cumulative effect of the changes on past income statements must be reported (net of tax) on the current income statement. Furthermore, these changes must be included in net income from continuing operations. Example of effect: Say a company changes its depreciation method, the straight-line method, to one that would have previously created a larger depreciation expense, the double-declining method). This will cause past expenses to be higher and income to be lower. At the time of recognition, net income from continuing operations will decrease. Future depreciation expense will decrease (they would have already been expensed) but will increase in future years once all of the old assets are replaced. Look Out! ROE and ROA will decrease even though assets and equity will decrease; the larger impact will come from a large decrease in net income. Change in Depreciable Life or Salvage Value A change in depreciable life and/or salvage value is not considered an acting policy change; it is a change in estimate. As a result, a company is not required to restate it in financial statements. The only thing that will change is the current and future net income. For example, if an asset's life is shortened, this will increase the company's current and future depreciation expense, and decrease net income, ROA and ROE.

Assets - Fixed Asset Disclosures

The disclosure found in a company's footnote section of its financial statements provides useful information about the age and possible usefulness of the assets held by the company. Using the information contained in the footnote, an analyst can estimate the total age of the assets held by a company. There are three ways to estimate the average age of a company's fixed assets: 1. Average age = accumulated depreciation / current depreciation expense = X years 2. Relative age = accumulated depreciation / ending gross investment = % of age 3. Average depreciable life = ending gross investment / depreciation expense Look Out! Note: All these estimations are affected by what is included in fixed assets (asset mix). Relative age can be used only when the assets analyzed use a straight-line depreciation method.

Though not accurate, the estimated average age of a company's fixed assets is useful and allows an analyst to: Estimate if the company has old assets and will need to invest heavily in new equipment in the near future. If that is the case, the company would be currently reporting an overstated net income that is not reflective of future profitability. Reveal whether a company is losing its competitive advantage compared to another company that has invested heavily in new technology.

Assets - Asset Impairment

What is Impairment? Assets are said to be impaired when their net carrying value, (acquisition cost - accumulated depreciation), is greater than the future undiscounted cash flow that these assets can provide and be disposed for. Under U.S. GAAP impaired assets must be recognized once there is evidence of a lack of recoverability of the net carrying amount. Once impairment has been recognized it cannot be restored. Analysts must know that some foreign countries and the IASB allow companies to recognize increases in previously impaired assets. Asset impairment occurs when there are: Changes in regulation and business climate Declines in usage rate Technology changes Forecasts of a significant decline in the long-term profitability of the asset Once a company has determined that an asset is impaired, it can write down the asset or classify it as an asset for sale. Assets will be written down if the company keeps on using this asset. Write-downs are sometimes included as part of a restructuring cost. It is important to be able to distinguish asset write-downs, which are non-cash expenses, from cash expenses like severance packages. Write-downs affect past reported income. The loss should be reported on the income statement before tax as a component of continuing operations. Generally impairment recognized for financial reporting is not deductible for tax purposes until the affected assets are disposed of. That said, in most cases recognition of an impairment leads to a deferred tax asset. Impaired assets held for sale are assets that are no longer in use and are expected to be disposed of or abandoned. The disposition decision differs from a write-down because once a company classifies impaired assets as assets for sale or abandonment, it is actually severing these assets from assets of continuing operations as they are no longer expected to contribute to ongoing operations. This is the accounting impact: assets held for sales must be written down to fair value less the cost of selling them. These assets can no longer be depreciated. Assets Impairment - Effects on Financial Statements and Ratios Past income statements are not restated. The current income statement will include an impairment loss in income before tax from continuing operations. Net income will also be lower. On the balance sheet, long-term assets are reduced by the impairment. A deferred-tax asset is created (if there was a deferred tax liability it is reduced). Stockholders' equity is reduced as a result of the impairment loss included in the income statement. Current and future fixed-asset turnover will increase (lower fixed assets). Since stockholders' equity will be lower, debt-to-equity will be lower. Debt-to-assets will be higher. Cash flow based ratios will remain unaffected (no cash implications). Future net income will be higher as there will be lower asset value, and thus a smaller depreciation expense. Future ROA and ROE will increase. Past ratios that evaluated fixed assets and depreciation policy are distorted by impairment write-downs.

Liabilities - Introduction
This chapter will focus on the liability side of the balance sheet, particularly current and long-term liabilities including capital and operating leases. Pay close attention to the section concerning the classification of leases as capital vs. operating, and how each classification affects other accounts. This concept is tested heavily in the CFA Level 1 exam.

Liabilities - Current Liability Basics

Liabilities - These are obligations a company owes to outside parties. Liabilities represent others' rights to money or services of the company. Examples include bank loans, debts to suppliers and debts to employees. Current liabilities - These are debts that are due to be paid within one year or the operating cycle, whichever is longer; further, such obligations will typically involve the use of current assets, the creation of another current liability or the provision of some service.

Long-term liabilities - These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Uncertainties Regarding Liability Value In some cases the timing and/or the total liability may be difficult to estimate: 1. Some companies offer clients a warranty period. The company does not know at the time of the sale who the payee will be. Furthermore, the company does not know when this payment will occur. 2. At year-end some companies will estimate some expenses, and recognize some liabilities such as pension benefits. Recording and Reporting Estimated and Contingent Liabilities Liabilities whose timing and amount are known can easily be accounted for. But others - such as warranties, taxes, vacation-pay liability and contingent liabilities, among others - require some estimation. Warranties When a company sells a product, it sometimes offers its customers a warranty of a certain number of years. To be consistent with the matching principle, companies, at the time of the sale, must estimate an amount that must be allocated to the costs associated with the warranties. Most companies will use a historical or industry average to estimate its warranty cost. The estimated warranty cost or liability will be allocated to the estimated warranty liability. For example, say Company ABC sells 100 appliances at $100 and estimates that each appliance will carry a $10 warranty liability. Journal entry:

Taxes Due to timing differences, companies will report deferred income tax liabilities. These are taxes that have not yet been paid but are expected to be paid in the future. For example, say Company ABC estimates its tax bill will total $500. At year-end it has an actual tax bill of $600.

Vacation-pay Liability This liability arises when employees do not take their vacation during an accounting period. Even though they have not taken their vacation, they are still entitled to them, and the result is a future liability. For example, say an executive has three weeks of earned but unfulfilled vacation days, which have a total value to $10,000.

Contingent Liabilities Contingent liabilities are liabilities that will materialize if some future event occurs and are contingent on a specific outcome. The most frequent contingent liability is a pending lawsuit against the company, which will materialize only if the firm is found guilty. Pending lawsuits can be significantly large for some companies, especially those involved in large class action lawsuits with hundreds or even thousands of potential plaintiffs. Examples of these industries include pharmaceuticals, oil companies or any company that produces large amounts of products that can harm consumers. The disclosure and/or inclusion of contingent liabilities in a company's financial statements will depend on the company's ability to estimate the amount of the liability and the likelihood that it will occur. Rules for classifying liabilities: If the liability is probable and can be reasonably estimated, it must be included in the company's financial statements. The loss will be included in the financial statements, and the liability must be included on the balance sheet. If the liability is probable but cannot be reasonably estimated, then only a footnote disclosure is required. If the liability is not probable and cannot be reasonably estimated, then no disclosure is required.

Liabilities - Income Tax Terminology

Taxable vs. Financial Income Taxable Income versus Financial Income: 1. Taxable income is calculated in accordance with prescribed tax regulations and rules. 2. Financial income is measured and reported in accordance with generally accepted accounting principles. Differences between taxable income and financial income occur because tax regulations and GAAP are frequently different. This will create a temporary difference between the tax basis of an asset or liability and its reported amount in the financial statements. This difference will result in taxable amounts or deductible amounts in future years when the asset is recovered or the liability is settled. This is known as "deferred income taxes". Tax Terminology Basics Taxable income is the amount of income subject to income taxes over the company's reporting period. Tax payable refers to the tax liability recorded on the balance sheet as a result of taxable income. Tax payable is the amount of taxes that has not been paid but will be in the near term. Income tax paid is the actual taxes paid out of cash. This includes what was paid for this period and other periods during this accounting period. Tax-loss carry-forward occurs when a company has created a net loss within an accounting period that it cannot use to lower previous income taxes paid but can be used in the future to offset future taxable income. Terminology Found on the Income Statement Tax payable includes total taxes to be paid within the accounting period. Said differently, it is equal to the amount of income taxes paid or payable for the period. Deferred tax expenses represent the increase in the deferred tax-liability balance from the beginning to the end of the accounting period (noncash expense). Income tax expense includes tax payable and deferred income tax expenses. It is composed of cash and noncash items. Thus it is not the actual tax paid to the government within the accounting period. Terminology Found on the Balance Sheet Deferred tax asset represents the increase in taxes refundable (saved) in future years as a result of deductible temporary differences at the end of the current year. Deferred tax liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year. Other terminology: Valuation allowance represents that portion of the deferred tax asset that is more likely not to be realized. Types of Differences

Temporary difference is the difference between the book basis and tax basis of an asset or liability that is expected to reverse over time. Permanent difference is the difference between the book basis and tax basis of an asset or liability that is not expected to reverse over time. Look Out! Note: Temporary differences create deferred taxes, while permanent differences cause a firm's effective income tax rate (book income tax expense / pre-tax book income) to differ from the statutory tax rate.

Liabilities - Tax Deferred Liabilities

A deferred tax liability occurs when taxable income is smaller than the income reported on the income statements. This is a result of the accounting difference of certain income and expense accounts. This is only a temporary difference. The most common reason behind deferred tax liability is the use of different depreciation methods for financial reporting and the IRS. A deferred tax asset is the opposite of a deferred tax liability. Deferred tax assets are reductions in future taxes payable, because the company has already paid the taxes on book income to be recognized in the future (like a prepaid tax). Calculation: Deferred tax liability 1. Book basis - tax basis of asset or liability = cumulative temporary difference (cumulative temporary differences x enacted tax rate). 2. Scheduling of future taxable amounts. Deferred tax asset 1. Book basis - tax basis of asset or liability = cumulative temporary difference (cumulative temporary difference x enacted tax rate). 2. Scheduling of deductible amounts. The Liability Method of Accounting for Deferred Taxes. There are several different tax-allocation methods: Deferred Method The amount of deferred income tax is based on tax rates in effect when temporary differences originate. It is an income-statement-oriented approach. It emphasizes proper matching of expenses with revenues in the period when a temporary difference originates. Finally, it is not acceptable under GAAP. Asset-liability Method The amount of deferred income tax is based on the tax rates expected to be in effect during the periods in which the temporary differences reverse. It is a balance-sheet-oriented approach. It emphasizes the usefulness of financial statements in evaluating financial position and predicting future cash flows. Most importantly, it is the only method accepted by GAAP. Implications of Valuation Allocation A deferred tax asset is a reduction in future cash outflow (taxes to be paid). But, the asset has value only if the firm expects to pay taxes in the future. For example, an Net Operating Loss (NOL) carry-forward is worthless if the firm does not expect to have positive taxable income for the next 20 years. Since accounting is conservative, firms must reduce the value of their deferred tax assets by a deferred tax-asset valuation allowance. This is a contra-asset account CR (credit) balance on the balance sheet - just like accumulated depreciation or the allowance for uncollectible accounts) that reduces the deferred tax asset to its expected realizable value. Increasing the valuation allowance increases deferred income tax expense; decreasing the allowance does the opposite. Changes in the allowance affect income tax expense. Although the need for an allowance is subjective, its existence and magnitude reveals management's expectation of future earnings. Management can use changes in the allowance to "manipulate" NI by affecting income tax expense. Analysts should scrutinize these types of changes. Deferred Tax Liability Treatment If a tax asset or liability is simply the result of a timing difference that is expected to reverse in the future, it is best classified as an asset or liability. But if it is not expected to reverse in the future, it is best qualified as equity. Deferred tax liabilities that should be treated as equity in the following circumstances: 1. A company has created a deferred tax liability because it used accelerated depreciation for tax purposes and not for financial-reporting purposes. If the company expects to continue purchasing equipment indefinitely, it is unlikely that the reversal will take place, and, as such it should be considered as equity. But if the company stops growing its operations, then we can expect this deferred liability to materialize, and it should be considered a true liability.

2. An analyst determines that the deferred tax liability is unlikely to be realized for other reasons; the liability should then be reclassified as stockholders' equity. Look Out! In some cases the deferred tax liability should not be added to stockholders' equity, but should be ignored as a liability.

Liabilities - Permanent Vs. Temporary Items

Temporary (or timing) differences between book income versus taxable income are due to items of revenue or expense that are recognized in one period for taxes, but in a different period for the books. Book recognition can come before or after tax recognition. These revenue and expense items cause a timing difference between the two incomes, but over the "long run", they cause no difference between the two incomes. This is why they are temporary. When the difference first arises, it is called "an originating timing difference". When it later reverses it is called "a reversing timing difference". Here are two examples of temporary differences: (1) the calculation of depreciation expense by means of the straight-line method for books and by means of an accelerated method for taxes, and (2) the calculation of bad-debts expense by means of the allowance method for books and by means of the direct writeoff method for taxes. Over the life of the firm, total depreciation expense and bad debts expense are unaffected by the method. What is affected is how much expense is recognized in any given period. Temporary differences are said to "reverse" because if they cause book income to be higher (or lower) than taxable income in one period, they must cause taxable income to be higher (or lower) than book income in another period. Permanent differences are differences that never reverse. That is, they are items of book (or tax) revenue or expense in one period, but they are never items of tax (or book) revenue or expense. They are either nontaxable revenues (book revenues that are nontaxable) or nondeductible expenses (book expenses that are nondeductible). Examples of permanent differences are (nontaxable) interest revenue on municipal bonds and (nondeductible) goodwill (GW) amortization expense under the purchase method for acquisitions. A good example of GW amortization is when one company purchases another company or any asset at a price that exceeds its recorded book value. This would be recognized partially at the time of purchase and partially over a period of time using standard amortization schedules. These are often referred to non-cash items of expenses or revenues and again are heavily scrutinized by analysts. Calculating Income Tax Expense, Income Taxes Payable, Deferred Tax Assets, and Deferred Tax Liabilities We'll explain this concept by example: Company ABC purchased a machine for $2m with a salvage value of $200,000. It used the accelerated depreciation method for tax purposes and straight-line depreciation for reporting purposes. Tax rate is 40%.

Tax differential:

Make sure you know the following for your exam: 1. Total tax bill is the same. o Timing differences create a tax liability. Calculation: Income tax expense = reported income before tax * tax rate Income tax payable = IRS reported income * tax rate Deferred tax liability (asset) = income tax expense - income tax payable

Figure 9.1: Cumulative Effect of Total Taxes

Liabilities - Adjustments To Financial Statements From Tax Rate Changes

If the tax rate changes, then under the asset-liability (or balance sheet) method, all deferred tax assets and liabilities must be revaluated using the new tax rate that is expected to be in place at the time of the reversal. An increase in the expected tax rate at time of reversal will create a larger tax burden than expected for the company once the transaction is reversed. That said, the current tax expense also increases. This will have a negative impact on current net income and decrease stockholders' equity. A decrease in the tax rate will have the opposite effect. Example: Company ABC has an EBITDA of $50,000 in the first five years of operations. To generate this income it purchases a machine for $40,000, with no salvage value at the beginning of year 5. The equipment has a five-year life. For tax purposes the company uses the double-declining depreciation method and uses a straight-line depreciation for financial-reporting purposes. At the time of purchase, the estimated tax rate at time of reversal was 40%.

In year 2 the tax rate at time of reversal is estimated at 20%. Taxes payable = new tax rate x taxable income = 20% x $41,411= $8,222 Deferred taxes = new tax rate x (DDM-SL) = 20% x ($8,889-$13,333) = ($899) Benefit from tax rate in year 1 = [$42,500 x (40%-20%)] - [$30,000 x (40%-20%)] = $1,250 Tax expense = tax payable in year 2 - decrease in deferred taxes in year 2 - benefits from tax rate on year 1 taxes = $8,889 + $899-$2,667= $4,667

Liabilities - Long-Term Liability Basics

Reporting Debt Issues In addition to raising capital from stock issuance, many companies issue debt securities in the form of bonds to finance their operations. A bond is essentially an IOU or promise to pay a predetermined annual or semiannual interest payment and to pay back the principal (face value) when the bond matures. When a company issues a bond with coupon payments that are equal to the current market rate, the bond is said to be issued at par. From an accounting point of view this means that if a company issues a $1M bond at par the company will in return have raised $1M in capital for its efforts. When bonds are issued with coupon payments that are not equal to the current market interest rate they are considered to be issued at a "premium" or "discount" to or from par. Companies that are very active in bond issuance issue bonds at par more frequently than those companies that are not as active. Example of bonds issued at a discount: Company ABC issues a bond that will pay 9% a year for five years and similar bonds trading are paying currently paying 10%.While there are multiple market related factors that determine the issuing price (supply and demand, credit ratings, analysts' opinions, state of the economy and yield curve characteristics) in this simplistic example the

bonds would most like be issued at a discount to its par value to compensate for the lower coupon payments. The company will ultimately get less money for its bond than the stated par value and is said to sell at a discount. Example of bonds issued at a premium: Company ABC issues a bond that will pay 10% a year for five years and similar bonds are currently paying 9%. The only way the company will sell this bond to investors is if the company sells the bond at a premium to its par value (for more money) to compensate the company for the paying a higher coupon. The company will ultimately get more money for its bond than the stated par value, and the bond is said to sell at a premium. From an accounting standpoint, a company that sells a bond at a discount (or premium) will record on a cash basis a smaller interest payment but in reality will have a higher interest expense because it received fewer dollars for its bond. In accordance with the matching principle, premium and discounts must be amortized over the life of the bond. U.S. GAAP allows companies to amortize premiums or discounts by using a straight-line amortization or the effective interest rate method. Discount vs. Premium Pricing If coupon = to market rate, the bond is issued at par. If coupon > market rate, the bond is issued at a premium. The issuing company will get more money at initiation than it will pay to investors at maturity. In exchange it will pay a higher coupon than it would have to if the bond was issued at par. If coupon < market rate, the bond is issued at a discount. The issuing company will get less money at initiation than it will pay to investors at maturity. In exchange it will pay a lower coupon than it would have to if the bond was issued at par.

Liabilities - Journal Entries and Accounting Impact

We will now discuss the journal entries and accounting impact of bonds issued at par, a premium, or a discount. The market value of a bond is calculated as follows: Formula 9.1 Market value of a bond = PV of coupon payments + PV of principal

Par-value bonds Company ABC issues a $1m bond that will pay a 10% semiannual (coupon) for five years and similar bonds are paying 10%. Market value = $1m Face value or principal or book value = $1m

Bond issued at a Premium Company ABC issues a $1m bond that will pay a 11% semiannual (coupon) for five years and similar bonds are paying 10%. Bond premiums are amortized using straight-line depreciation.

Bond issued at a Discount Company ABC issues a $1m bond that will pay a 9% semiannual (coupon) for five years and similar bonds are paying 10%. Bond discounts are amortized using staring-line depreciation.

Liabilities - Total Interest Cost Components

Total interest expense, which is reported on the income statement, includes the total coupon payment plus a portion of the underappreciated discount or premium for the specified accounting period. U.S. GAAP allows companies to amortize premiums or discounts by utilizing a straight-line amortization or the effective interest rate method. Straight-line Depreciation Formula 9.2 Depreciation amount = premium or discount at issue payment periods Example Company ABC issues a $1m bond that will pay a 11% semiannual (coupon) for five years and similar bonds are paying 10%. Bond premiums are amortized using straight-line depreciation. The company issues at $1,038,609 and face value is $1m.

Interest expense = coupon payments - unamortized portion of bond premium for the period The carry value = total market value at time of issue - cumulative amortized premium or discount Unamortized portion of bond premium for every period (six months in this example) = $38,609 / (10 payment periods) = $3,860.9

Result Under this method the issuing company will recognize an equal amount of unamortized depreciation for every period. Effective Interest Rate Method Effective interest rate method results in an interest expense that is a constant percentage of the carrying value of the bonds; thus interest expense varies from period to period. In contrast, the straight-line method results in a constant interest expense from period to period. Formula 9.3 Interest expense = current interest rate at time of issue x carry value The carry value = total market value at time of issue - cumulative amortized premium or discount Formula 9.4 Amortized premium (discount) = coupon payment - interest expense Example Company ABC issues a $1m bond that will pay a 11% semiannual (coupon) for five years, and similar bonds are paying 10%. Bond premiums are amortized using the effective interest rate depreciation method. The company issues at $1,038,609 and face value is $1m.

Liabilities - Reporting The Retirement Or Conversion of Bonds

A company that retires its bond at maturity will issue to bondholders the last interest payments, if any, and the face value of the bond. At that time the book value of the bond will equal the face value. Journal entry

Retiring Bonds Prior to Maturity Sometimes bonds can be retired before they mature. They can be retired, or if they are convertible bonds, they can be converted to another form of securities such as common stock. If a company retires a bond prior to maturity, the stated book value (or carry value for a discount or premium bond) will most likely be the same as market value for which the company repurchased the bond. This difference creates an extraordinary gain or loss for the repurchasing company. This gain or loss is classified as extraordinary because it is non-recurring in nature. Extraordinary gains and losses are reported on the income statement below the operating

line net of taxes. Remember: carrying value is computed as: Formula 9.5 Bonds Payable at par Bonds Payable at par - Unamortized Discount + Unamortized Premium Carrying Value Carrying Value To compute the gain or loss, compare the carrying value of the bonds with the amount we pay to redeem the bonds. Formula 9.6 Carrying Value - cash paid to retire bonds = gain or loss on bond retirement

Look Out! If the carrying value is greater than the cash paid, there is a gain on the bond retirement. If the carrying value is less than the cash paid, there is a loss on the bond retirement. Journal entry: A company retires a bond with a $1m face value early for $1.2m and creates a loss of $200,000.

Converting Bonds Into Common Stock Some bonds can be converted or exchanged into common stock. Under SFAS 14 the convertible feature of a bond is completely ignored when the bond is issued, and it is considered only when it is converted into equity. The effect of a conversion of a bond into common stock is a decrease in liabilities for the carrying value of the bond and an increase in stockholders' equity for an amount equal to the bond carrying value. Gains or losses on bond conversion are not recognized. Any difference between the carrying value of the bond converted and the par value of the new shares issued is recorded in the account called "contributed capital in excess of par value". The market value of the common stock is ignored. Example: Bondholders converted $20,000 worth of convertible bonds into the issuer's $5-par common stock. Each $1,000 bond is can be converted into 10 shares of common stock. The carrying value of the bonds at the time of conversion is $21,500. 1. First we need to compute the carrying value of the bonds converted Carrying value = bonds payable + bond premium = $20,000 + $1,500 = $21,500 2. Then we calculate the number of bonds converted Number of bonds converted = $20,000/$1000 = 20 bonds 3. Then we calculate the number common shares to be issued? Number of common shares = 20 bonds * 10 shares = 200 common shares 4. Then we calculate the contributed capital in excess of par value Contributed capital in excess of par value = carrying value of the bond - par value of the new shares = 21,500 - (200*$5) = $20,500 Journal entry:

Liabilities - Accounting For Long-Term Liabilities

Mortgages payable A mortgage is a long-term debt secured by a real estate property such as a building or land. The mortgage is usually paid back in equal installments. These installments include a portion that is attributable to interest expense and the other to capital repayment.

Long-term leases Companies generally acquire the right to use an asset by purchasing it outright. But in some cases companies can lease an asset as opposed to an outright purchase. Leases can be classified as operating leases or capital leases. Operating leases are defined as short-term leases by which the company enters into an agreement with the lessor to use the asset for a portion of the asset's economic life. The lessee (the company leasing the equipment) will have no obligation to purchase the asset in the future. Capital leases, on the other hand, are long-term leases that create a long-term obligation for the lessee. If the asset qualifies as a capital lease, the asset is recorded on the balance sheet and the present value of the lease obligations are also recorded on the balance sheet. The asset is amortized over the life of the lease by using a straight-line depreciation method. Each rental payment includes a portion that is allocated to interest expenses and repayment of principal. Pensions A pension plan is a qualified retirement plan set up by a corporation, labor union, government or other organization for its employees. A pension plan is an agreement under which the employer agrees to pay monetary benefits to employees once their period of active service has come to an end. A third party frequently manages the pension plan. Look Out! The CFA institute concentrates on two types of pension plans: defined-benefit plans and defined-contribution plans.

A defined-benefit pension plan promises a specific benefit at retirement to its employees. Since the benefits are defined, the employer is responsible for accumulating sufficient funds. Such plans insulate employees from investments that perform poorly, but it also prevents them from enjoying the entire upside potential of the pension if it does well. That said, pension funds are governed by the Employee Retirement Income Security Act of 1974 (ERISA), a more conservative investment approach, and large gains are unlikely to occur. Corporations refrain from setting up these types of plans because they can create enormous pension liabilities for a company if the pension's portfolio does not perform well. Defined pension plans need to be revalued periodically by an actuary. Under SFAS 87, companies are required to use the same actuarial cost method and are required to disclose assumptions about the pension obligation and pension cost. The major issue with SFAS 87 is that a company may make pension contributions using different assumptions when valuing the present value of the underlying assets using capital market assumptions.

A defined-contribution pension plan, by contrast, specifies how much the employer will contribute annually. The actual amount the employee will receive at retirement will depend on the overall performance of the pension fund. With such a plan, investments that perform poorly mean lower income in retirement, and vice versa. Under this plan the company does not carry any risk and does not create any pension liabilities if it pays its annual contribution amount. Contributions made are simply expenses on an annual basis and are usually discretionary. Accounting for pension funds. To be able to pay their pension obligations, companies must accumulate funds known as the "plan assets". Plan assets are not formally recognized on the balance sheet, but are actively monitored in the employer's informal records. The plan assets can change due to returns on plan assets - such as dividends, interest, market-price appreciation and cash contributions - employer contributions and retiree benefits paid, which are benefits actually paid to retired employees. The composition of pension expenses is beyond this problem set. Look Out! Candidates should know that pension expenses are deducted from the income statement.

Though the pension plan assets and liabilities are not included in the financial statement, companies are required to include the following information in the footnotes: The components of the annual pension expense The projected benefit obligation (as well as the accumulated benefit obligation and vested benefit obligation) Other information that makes it possible for interested analysts to reconstruct the financial statements with pension assets and liabilities included.

Liabilities - Post-Retirement Obligations

Post-retirement benefits include all retiree health and welfare benefits other than pensions and can include: Medical Coverage Dental coverage Life insurance

 Group legal services These benefits are much more difficult to estimate than pension obligations. Under SFAS 106, employers have some latitude in making these estimates. The expected post-retirement benefit obligation is computed by taking the present value of expected post-retirement benefits.
Accounting for post-retirement benefits 1. Accounting for post-retirement benefits is, to the extent it is possible, the same as for pension benefits. 2. While the accounting methods are similar, the latitude described above is due to the dynamic nature of these types of benefits in general. For example, pension fund accounting uses industry standard actuarial assumptions, discount rates and long-term market assumptions. While the treatment of pension funds is quite mature, methods under SFAS 106 are evolving and the expected future costs of these benefits are more fluid. 3. The main difference from an accounting perspective is that post-retirement healthcare benefits usually are "all-or-nothing" plans in which a certain level of coverage is promised upon retirement, and the coverage is independent of the length of service beyond the eligibility date. Cost is unrelated to service and is attributed to the years from the employee's date of hire to the full-eligibility date. Elements of post-retirement benefit cost: Service cost Interest cost Return on plan assets Amortization and deferral Amortization of unrecognized prior service cost Amortization of transition asset and liability SFAS 106 permits the amortization of the transition liability over 20 years, versus the average remaining service period of active employment found under pension plans.

Liabilities - Effects Of Debt Issuance

Bonds Issued at Par - Effects On: Income statement - The income statement will include an interest expense equal to the bond's coupon payment attributable to the specified accounting period. Balance sheet - The balance sheet will include at all times a long-term liability equal to the face value of the bond until its maturity or redemption. Cash flow statement - Going forward, cash flow from operations will include the interest expense recorded on the income statement. As of the issuing date, the company will account in cash flow from financing the total amount received for the bond. Bonds Issued at a Premium - Effect On: Income statement - The income statement will include an interest expense equal to the bond's coupon payment minus the amortized portion of the premium received during the specified accounting period. Balance sheet - The balance sheet will include at all times a long-term liability equal to its carrying value. At initiation the carrying value will be equal to the face value of the bond plus the total unamortized premium. Every year the bond value recorded on the balance sheet will be reduced until the bond comes to maturity or is redeemed and the bond value displayed on the balance eventually reaches the bond's original face value. Cash flow statement - Going forward, cash flow from operations will include the actual coupon paid to the debt holder during the specified accounting period. Since this is a bond that was sold at a premium, it is paying out a larger coupon than is currently stated as an interest expense on the income statement. As a result, CFO will be understated relative to that of a company that sold its bond at par. The amortized portion of the bond premium will be included in cash flow from financing. This will cause the reported cash flow from financing to be overstated relative to that of a company that sold its bond at par. Bonds Issued at a Discount - Effect On: Income statement - The income statement will include an interest expense equal to the bond's coupon payment plus the amortized portion of the discount received during the specified accounting period. Balance sheet - The balance sheet will include at all times a long-term liability equal to its carrying value. At initiation the carrying value will be equal to the face value of the bond minus the total unamortized discount. Every year the bond value recorded on the balance sheet will be increased until the bond comes to maturity and the bond value displayed on the balance is equal to the bond's face value. Cash flow statement - Going forward, cash flow from operations will include the actual coupon paid to the debt holder during the specified accounting period. Since this is a bond that was sold at a discount, it is paying out a smaller coupon than is currently stated as an interest expense on the income statement. As a result CFO will be overstated relative to that of a company that sold its bond at par. The amortized portion of the bond discount will be included in cash flow from financing. This will cause the reported cash flow from financing to be understated relative to that of a company that sold its bond at par. Computation Company ABC issues a $1m bond that will pay a 10% semiannual (coupon) for three years; the company will generate $500,000 EBITDA over the next three years. Contract the effect if market rate at the time of issuance was 10%, 11% and 9%. (Straight-line depreciation is used for premiums and discounts). Taxes are not considered. Opening balance sheet:

Liabilities - Implications Of Debt Issuance

1) Income Statement

2) Cash Flow Statement

3) Balance Sheet

Effect on Reported Cash Flows from Zero-Coupon Debt Issuance Zero-coupon bonds are also referred to as "deep-discount bonds" or "pure-discount instruments". These bonds do not provide any periodic interest payments to the bondholders and are sold at deep discount to the stated par value. These bonds will have the same type of effect on a company's balance sheet, income statement and cash flow

statements as that of discount bonds; the only difference is that the effect will be more pronounced because they are issued well below par value as opposed to a slight discount.

Liabilities - Effect Of Changing Interest Rate On Debt Market Value

A company that issued debt prior to an increase (or decrease) in market rates experiences an economic gain (or loss) when the rates change. This economic gain or loss is not reflected in a company's financial statement. Market-value changes will not appear on the income statement or balance sheet. As a result, the book value of a company's debt will not be equal to its market value. From a company valuation point of view, the book value of equity (total assets liability) will not reflect the current economic reality. Furthermore, if an analyst compared two companies - one that issues $1m in debt at 10% and another that issues the same debt amount at 8% three months later - the debt-toequity ratio of both companies will be the same. However, the company that issued the debt at a lower rate will be in a much better financial position. Times interest earned and other ratios will enable an analyst to uncover these differences.

Liabilities - Capital And Operating Leases

Lease Classification Note: For clarity, the classification of a lease should be considered on an item by item basis and not grouped together. In addition, the classification should be determined at the time of the commitment or signing of the lease which may or may not coincide with the date that the lessee actually receives the physical asset. A lessee (the company leasing equipment) should classify a lease transaction as a capital lease if it is non-cancelable and if one or more of the four classification criteria are met: The agreement specifies that ownership of the asset transfers to the lessee. The agreement contains a bargain purchase option. The non-cancelable lease term is equal to 75% or more of the expected economic life of the asset. The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset. If none of these criteria are met, the lease can be classified as an operating lease. Choosing Capital and Operating Leases Most companies will want to classify their leases as operating leases because they can provide a company with the following: Tax incentive o The tax benefit of owning an asset (depreciation expense) can be exploited best by transferring it to a party that has a higher tax bracket. o A firm with a lower tax bracket will have incentives to classify a lease as an operating lease. o A firm with a higher tax bracket will be more likely to classify a lease as a capital lease. Non-tax incentives o If a lease is classified as an operating lease no assets or liabilities associated with the lease are recorded on the balance sheet. Since the company's asset base is reported lower the immediate benefit would be a higher ROA than it would display had it classified the lease as a capital lease requiring a higher asset base. It will also allow a company to display better solvency ratios such as debt-to-equity. o Operating leases create off-balance sheet financing because no liability is recorded on the balance sheet since no asset is recorded. The result is the company would display to its debt lenders better debt covenant ratios. o Some companies link management bonuses to specific ratios such as return on capital which creates even more incentives to lean towards operating classifications. While there are significantly more incentives to classify leases as operating, there are a few benefits to using capitalization: The lease expenses would reduce net income, thus potentially reducing a company's income tax expense and rates. Operating cash flow will be higher under a capital lease because there is no operating lease expense.

Liabilities - Effects Of Capital Vs. Operating Leases

Capital Leases - Effects On: Balance sheet - At the inception of a capital lease, the company leasing the equipment will record the equipment as an asset, and the company will also recognize a liability on the balance sheet, by an amount equal to the present value of the minimum lease payments. The discount rate used will be the lower of the following two rates: The lessor's (the rental company's) implied rate The lessee incremental borrowing rate

Going forward, the leased asset is depreciated in a manner consistent with the lessee's usual policy for depreciating its operational assets. It can be over the term of the lease (most common) or over the asset's useful life, if ownership transfers or a bargain purchase option is present.

Income statement - A capital-lease payment includes two components: one is the interest expense - which is included in the income statement but is not part of operating income (earnings before taxes from continuing operations) - and the second component is the principal payment, which is included in the income statement and operating income. The interest portion will be higher in the first few years of the lease, and is consistent with the interest expense of an amortized loan. Total income over the life of the leased assets will be the same for operating and capital leases.

Cash flow statement - Total cash flow statements remain unaffected by operating and capital leases. That said, cash flow from operations will include only the interest portion of the capital-lease expense. The principal payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO and understate CFF. Operating Leases - Effects On: Balance sheet - No assets or liabilities are recorded. Income statement - The operating-lease payment will be treated as an operating expense. Cash flow statement - Cash flow from operations will include the total lease payment for the specified accounting period. Comparison of Capital vs. Operating Leases Let's compare the differences between both lease options through an example. Option 1 Company Leasing has approached Company ABC to lease equipment from it for five years (non-cancelable lease). The annual payment would be $20,000. The discount rate implied in the lessor's implied rate is 6%. Company ABC has an incremental borrowing rate of 7%. After the five-year period, the asset will be transferred to the lessor, which it will sell for scrap. Option 2 Company L&R has also approached Company ABC to rent equipment from it. Under the term of the rental agreement, Company ABC will rent the equipment from Company L&R for an annual fee of $20,000. This equipment has an estimated useful life of 10 years. Classification If Company ABC accepts Company Leasing's offer, the lease agreement has to be classified as a capital lease because the non-cancelable lease term is equal to 75% or more of the expected economic life of the asset. (At the end the five years, the equipment is sold for scrap). The second option can be classified as an operating lease.

Liabilities - Determining The Value Of The Lease And The Lease Asset

The discount rate used will be 6% because it is the lesser of the lessor's implied rate and the lessee's incremental borrowing rate. 1) Balance Sheet Effect: Book Ending Value Of Beginning Interest Principal Lease Lease The Lease Expense (3) Payment value Depreciation Asset Value (1) (2) =(4)-(1) (4) (liability) (fixed = (1)*6% =(1)-(3) assets) 84,247 69,302 53,460 36,668 18,868 5,055 4,158 3,208 2,200 1,132 14,945 15,842 16,792 17,800 18,868 20,000 20,000 20,000 20,000 20,000 84,247 69,302 53,460 36,668 18,868 0 16,849 16,849 16,849 16,849 16,849 84,247 67,398 50,548 33,699 16,849 0

Year

0 1 2 3 4 5

Under the capital-lease method the asset will only equal the lease liability at initiation and at the end of the lease. In this example, the asset was depreciated using the straight-line depreciation method, or $16,849 ($84,247/5). On the other hand, the lease obligation is reduced by the principal-repayment amount during each specified accounting period. This interest component is determined by multiplying the beginning-period lease value with the discount rate used in the determination of the PV of the lease obligation. Since the lease obligation decreases with time, it is highest in the first year and declines over time. That said, the principal repayment on the lease liability is determined by subtracting the interest component for the specified period with the actual lease payment to the lessor. As a result, the principal-repayment amount increases with time and is lowest in the first year. Look Out! At the end of the lease, both the lease obligation will be eliminated and so will the asset value. 2) Income Statement Effect:

Under a capital lease, operating expenses include the depreciable portion of the leased asset, and the interest portion is classified as a non-operating expense and is included in earnings before tax. As noted earlier, the interest expense that emerges from capital leases is highest in the first years and decreases over time (unlike depreciation expense, which is constant). This creates a variation in a company's reported total expenses. In the earlier years, a company using a capital lease will report a lower net income than a company using an operating lease. This will also create a tax benefit for the company that uses a capital lease in the first years. This tax benefit will cancel out because in the later years, the interest component will decrease and reported income will increase. 3) Cash Flow Statement Impact:

Cash flow statements remain unaffected by the choice of classifying leases as operating or capital leases. That said, cash flow from operations will include only the interest portion of the capital-lease obligation. The principal repayment on the lease obligation payment will be included as a cash outflow from cash flow from financing activities. As a result, capital leases will overstate CFO by the amount included in CFF and understate CFF. Summary of Financial Effects:

Impacts on Key Financial Ratios:

Liabilities - Sale And Leaseback

A sale and leaseback constitutes an arrangement where the seller of an asset leases back the same asset from the purchaser. The lease arrangement is made immediately after the sale of the asset with the amount of the payments and the time period specified. Essentially, the seller of the asset becomes the lessee and the purchaser becomes the lessor in this arrangement. A leaseback arrangement is useful when companies need to untie the cash invested in an asset for other investments, but the asset is still needed in order to operate. Leaseback deals can also provide the seller with additional tax deductions. The lessor benefits in that they will receive stable payments for a specified period of time. Under both U.S. and IASB GAAP: When the lease is capitalized, SFAS 13 (US GAAP) and IAS 17 (IASB GAAP) require the lessee to defer any gain on the sale of the asset. The gain would then be recognized over the life of the lease. Under IAS 17 only: Gains on sale and leasebacks of assets are recognized immediately should the lease be classified as operating. Under SFAS 13 only: Gains on sale and leaseback of assets must by amortized over the life of the lease.

Liabilities - Types Of Off-Balance-Sheet Financing

Many economic transactions and events are not recognized in the financial statements because they do not qualify as accounting assets or transactions under GAAP standards. That said, these unreported assets and liabilities have real cash flow consequences. As a result, it is important to be able to identify and qualify these assets and liabilities. Operating lease - Classifying a lease as an operating lease provides a company with the opportunity to utilize the leased asset and assume a contractual obligation to pay the lessor during a specific period of time without having to report the asset and, more importantly, the liability. Take-or-pay contract - This is an agreement between a buyer and seller in which the buyer will still pay some amount even if the product or service is not provided. Companies use take-or-pay contracts to ensure that their vendor makes the materials, such as raw materials, that they need to sustain operations available to them. In the event that a company does not purchase the material from the vendor, the company will have to pay some amount to the vendor. This provides a company with the ability to acquire the use of an asset without having to record it as an asset and a liability. These arrangements are common in the natural-gas, chemical, paper and metal industry. Throughput arrangements - Natural-gas companies use throughput arrangements with pipelines or processors to ensure distribution or processing. The effects are the same as take-or-pay contracts.

Commodity-linked bonds - Natural-resource companies may also finance inventory purchases through commodity-indexed debt where interest and/or principal repayments are a function of the price of the underling commodity. The sale of accounts receivables - A company may sell its receivables to an unrelated third party to reduce its debt and improve its financial position. Most sales of receivables provide the buyer with a limited recourse to the seller. However, the recourse provision is generally well above the expected loss ratio on the receivables (allowance for doubtful accounts). The potential liability associated with the buyer-recourse provision is not displayed on the balance sheet. A more elaborate sale of account receivables is a parent company selling its receivables to a finance subsidiary where the parent owns less than 50% of the subsidiary. If the parent owns less than 50%, the financial asset and liability of the subsidiary are not included in the parent balance sheet; only the investment in the subsidiary is recorded as an asset. (If less than 50%, the equity method is used). Furthermore, the parent generally supports the subsidiary borrowings through extensive income-maintenance agreements and direct and indirect guarantees of debt. Joint ventures - Companies may enter into a joint venture with a supplier or other company. To obtain financing for such a venture, companies often enter into a take-or-pay or throughput contract with minimum payments designed to meet the venture's debt-service requirements. Furthermore, direct or indirect guarantees may be present. Generally, companies account their investments in joint ventures using the equity method since no single company holds a controlling interest. As a result, the balance sheet reports on the net investment in the venture. Investments - Some companies issue long-term debt that is exchangeable for common shares of another publicly-traded company. Since the debt is secured by another liquid asset, the interest expense on the loan is usually smaller. This issuance is also used by companies with a large capital-gain liability on stock held. The company's biggest concern in this case would be the large capital-gains tax liability they would have to pay should they default on the loan and have to exchange the debt for the securities it holds. Take-or-pay contracts and throughput agreements These types of agreements effectively allow companies to keep some operation assets and liabilities off the balance sheet. As a result, in the analysis of a company's financial statement, the balance sheet should be restated and include the present value of the minimum future payments to both the assets and liabilities section of the balance sheet. If this is not done, the debt-to-equity and asset-turnover ratio will be overstated. Sales of receivables Sales of receivables artificially reduce the receivables and short-term borrowing needs. Furthermore, they distort the pattern of cash flow from operations as the firm receives cash earlier than it would if the receivables had been collected in due course. In addition, the potential liability associated with the buyer-recourse provision is not displayed on the balance sheet. From an analytical point of view, the current-asset ratio, working capital and receivable turnover will be overstated. On the other hand, the leverage ratios such as debt-to-equity will be too high. The reported income will also be too high because if it did not sell its receivables, the company would have had to borrow the funds it acquired from the sale of the receivables to finance its current operations. Analysts should adjust the balance sheet by adding back the amount of accounts receivables sold and increase short-term borrowing by an equal amount. Furthermore, the income statement needs to be restated and include the interest expense that would have been incurred by the firm had it not sold its receivables and borrowed the money instead.

Liabilities - Effects Of Off-Balance Sheet Financing Transactions On Financial Ratios

Liabilities - Accounting For Leases

A lessor (the leasing company) can account for a lease in three ways: Operating lease Direct-financing lease Sales-type lease Lease capitalization, which includes the direct-financing lease and the sales-type lease, needs to be recognized when a lease meets any one of the four criteria specified for capitalization of leases and both of the following revenuesrecognition criteria: Collection of the monthly lease payments is reasonably predictable. Lessor's performance is substantially complete, or future costs are reasonably predictable. If the lease is accounted for as a capital lease, the lessor must determine if it classifies as a direct-finance lease or as a sales-type lease. To classify as a sales-type lease, the fair value of the asset must be greater than the lessor's book value. If not, it is accounted for as a direct-financing lease. Direct-Financing Lease As its name implies, a direct-financing lease is basically the coupling of a sale and financing transaction. In this case,

the lessor removes the leased asset from its books and replaces it with a receivable from the lessee. The only income recognized by the lessor is the interest received. The implied rate is taken by calculating IRR of the asset; cash inflow is equal to lease payments and cash outflow is equal to the book value of the lease asset. Sales-Type Lease A sales-type lease is accounted for like a direct-financing lease, except that profit on a sale is recognized upon inception of the lease, in addition to the interest income recognized during the lease term. The gross profit recognized at the inception of the lease is the PV of all lease payments minus the cost of the leased asset.