Accounting 202 Notes

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Chapter 13
Dealing with Current Liabilities
Current Liabilities
1. Liabilities that will be satisfied within the year or the operating cycle, whichever
is longer
Cash to Cash Cycle
The average amount of time it takes a company to buy and sell inventory, collect
Accounts Receivable and turn the AR into cash
It normally takes 3-4 months to sell average inventory and another couple of months to
collect money
The whole cycle is usually around 4-7 months
Operating cycle is usually shorter than the year
Yardstick for current liabilities will, therefore, usually be the year, but not always
2. Liabilities that will be paid off by the use of current assets
Accounts Payable
When do you use an AP? If you owe interest its called interest payable?
When we buy inventory on credit that is the most common time to use AP
Sometimes are referred to as trade accounts payable you have an AP because of the
trade or business that you happen to be in
Notes Payable
(Short term)
Written agreement to borrow money with interest. If you hold a note, that is an indication
that the note has not yet paid
If you borrow $1,000 at 6% on NP from 3/1 to 9/1 this is a 6-month note so its a CL:
CASH 1000
SHORT TERM NP 1000
Pay up:
STNP
INT EXPENSE
CASH

1000
30

(1000*.06*(6/12) = 30)
1030

9/1-3/1:
12/31 Adj. Entry:
INT EXP
20
INT PAYABLE
3/1:

(1000*.06*(4/12))
20

STNP
1000
INT PAY
20
INT EXP
10
CASH

1030

02/04/15
Current Maturity of Long-Term Debt
If you borrow money from a bank with principle due in 5 years long-term liability for
now, but when we get to the end of year 4, beginning of year 5, the liability will be due
within the year so we will have to convert the long-term liability into a short-term
liability
Debit long-term NP and Credit short-term NP
LONG-TERM NP
SHORT-TERM NP
This gets rid of the long-term note and creates a short-term note
If you borrow money from a bank with the principle not due all at once in 5 years, but
rather the principle is due a little bit each year (on top of the yearly interest)
If you borrow 1,000 on a 5-year note, each year you must pay 1/5 of the principle (plus
the interest)
$200 will be short-term, but the rest of the $800, is still long-term
At the end of year 1, you must pay the next $200 at the end of year 2, etc.
Debit LTNP and Credit STNP
Short-Term Obligations Expected to be refinanced
If you have a CL that needs to be paid sometime this year. Its Feb and the debt is due in
May. If you renegotiate with the bank and say that instead of paying the liability, you get
an extension on the principle for 2 years in return for an increased interest rate from 2%
to 3%.
What criteria must be met in order for GAAP to allow this?
Refinancing Criteria
1. Must be intent to refinance on a long-term basis
2. Must demonstrate ability to refinance
Intent is easy to demonstrate, but how do you show an ability to refinance?
Ability to Refinance
a. Actually refinancing demonstrates the ability to do so (sit down with the bank and
go through the details and sign the docs that allow the CL to be refinanced)
b. Entering into financing agreement (if you havent worked out all the details, a few
that are still being negotiated, but the fact that youve entered into the agreement,
that demonstrates the ability to refinance)
Debit STNP and Credit LTNP
Cash Dividends Payable
Companys board declares dividend in Dec and usually takes 4-6 weeks before dividend
is actually paid, so it will be paid toward the end of January

Youre going to hit 12/31 so youll have a short-term liability that hasnt yet been paid
If you havent yet declared the dividend then there is no liability. The liability is created
when the Board declares the dividend
Customer Advances
If you go to a carpenter and ask him to construct something and he asks for 50% now and
50% at completion
From the perspective of the carpenter, the customer advance (the 50% that he accepts)
creates the obligation to perform services and therefore a current liability
Unearned Revenue
You receive revenue in advance of earning it this creates a liability
If a landlord lets someone rent an apartment, but you have to pay every 3 months in
advance
Always have 3 months rent in advance and it hasnt been earned so the landlord has
unearned revenue and a CL
As every day/month passes, the revenue is being earned
This and customer advances are pretty much exactly the same
Sales Tax Payable
If you buy something that sells for $100, but at the register youre charged $108
including sales tax
Selling Price (SP) = $100
Tax = 8%
From perspective of business:
CASH
108
SALES
100
S.T. PAY
8
Income Tax Payable
The assumption is that we are talking about a corporation
Sole proprietorship one owner
Partnership two or more owners
The previous two dont pay taxes
This doesnt mean that the owners dont pay taxes. This just means that the business itself
isnt taxed
On these income statements there are never any lines for income tax of the business
Corporation a separate legal entity that must pay taxes
There is really a double taxation because the company is taxed and then any dividends
distributed to shareholders will be held as personal income, which everyone must pay
taxes on
There is almost even a triple tax because when you sell the shares at a profit there will be
a capital gain, which people will be taxed on as well
Employee-Related Liabilities
Most of this we wont discuss just one issue that we will talk about

From the employers perspective:

There are people working for she/he that will create liabilities related to them
There are deductions taken out of the check like:
FICA (Federal Insurance Contribution Act):
1. Social Security money is taken out of employees pay check in order to go to SS
so that when the individual is 62/65 he will be entitled to government payments
2. Medicare a subsidy that the government gives employees when they reach 65 to
pay for doctors and medication, etc.
Also there are federal and state tax plus union dues (if one is part of a union) and pension
plans
The employer must deduct for various items, resulting in CL
All of these deductions represent liabilities from the employers point of view because
they have the money on hand, but must send it to the necessary list of FICA-related
institutions
Not only is money taken out of employees check, but the employer also must deduct from
his own pocket whatever is taken out of the employees check (dollar-for-dollar) and pay
to the FICA system
The employer must also pay unemployment insurance out of his own money to the
federal and state government so that if the employee becomes unemployed he will be
entitled to unemployment insurance
These are a lot of CL and that is the connection to these chapters
The only issue we will go into depth about is
Compensated Absences
Because my employee has worked for me for a certain period of time, he can be absent
from work for certain reasons and I, the employer, will have to pay them regardless
What kind of absences?
Holidays, vacation days, and sick days
At the end of the year, should the employer recognize the fact that employees may be
absent and will still be paid?
GAAP says yes if the following 4 conditions exist:
1. The employees right to be compensated must be related to services already
rendered the employee must have already worked for the company and rendered
services for a certain period of time because in order for there to be a liability
there must be a past transaction or event
2. The rights either vest or accumulate
Rights that vest the employee has this right even if they decide to quit tomorrow
Rights that accumulate rights that accumulate from year to year if you dont use your
vacation days in one year, they will roll over to the next year and have extra vacation/sick
days
Some companies have the use it or lose it policy so you arent for sure going to be paid
3. Payment is probable
4. Payment amount can be reasonably estimated
3 and 4 are conditions that are relevant to every single liability, so of course here
Were up to contingencies

02/09/15

Contingencies
o Contingent Gain: gain that is contingent on some future outcome or
event. If hurt by a product and in the midst of suing gain is contingent on
the court case. Gain is recognized when case is settled.
o Contingent Losses: loss that is contingent on some future outcome or
event. My Product hurts a customer; in the middle of being sued loss is
contingent on the court case.
Probable: highly likely that law suit is going to be lost and amount
should be able to be reasonably estimated; loss is recognized before the
suit is over. If loss is a given range ie: $3-5, take most reasonable number
within range, indicate it can go as high as $5 in footnotes. If no way to
estimate within the range recognize the lower of the range and indicate in
the footnotes the higher of the range
LOSS FROM LWSUIT
LIABILITY PAYBLE
Reasonably Possible: No accrual or journal entry; however must be
indicated in footnotes either the possible amount or range
Remote: unlikely that you will lose, do not need to have any disclosure
Chapter 14
Bond issued by a Corporation
Bond indenture: contract between two parties, issuer and buyer.
Indicates the terms of the bonds, payment date, penalties, bond related
funds
Types of bonds
o Secured: backed by a pledge of some sort of collateral.
o Unsecured: Debenture un-backed bonds, usually issued by a company
that has minimal risk and offers a higher interest rate. More risk and higher
return.
o Term: bond that reaches maturity at the end of a certain term at which
point the principal is due
o Serial bond: interest and some of the principle is paid of at every period
o Callable Bond: corporation that issued the bond can call the bond back
before maturity
o Convertible: if bond holder wishes to give bond back, they can convert
to common stock during window of opportunity
o Commodity-Backed: Asset-Linked linked to a commodity such as oil or
silver, when bond reaches maturity it is payable in either the commodity or
cash; whichever is higher

o Deep-Discount: sold at a discount so that the total interest payoff is

received at maturity.
02/11/15
Par Value for Stock
Minimum legal issuance price of the stock and the least amount one can recover from a
stock
Par Value for bonds (Stated Value, Face Value or Maturity Value)
Maturity value of the bond the amount of principle the company will have to pay when
the bond matures
A stock cant be issued below par value, at what price can a bond be issued?
1. At Par: $1,000 pv @ 100 (this means @100% of its par value)
2. Discount below par: $1,000 pv @ 97 (this means @97% or $970)
3. Premium above par: $1,000 pv @ 102
Why would a bond be issued at either one of these? Well discuss later, but for now, we
know that issuing at a discount or a premium is not a question of who gets the better deal
(good or bad), but its a question about equilibrium, which well discuss later
There are 2 different interest rates that are associated with a bond:
1. Stated Rate of Interest (Face Rate, Coupon Rate, or Contract Rate) this is
the interest rate that will dictate how much interest will be paid during the period
(this may not be the same as the interest expensed)
It is called this because it is stated on the bond certificate that this will be the rate and is
called the face rate because the rate is engraved on the certificate. Its also called coupon
rate because the older bonds had a bunch of coupons around the certificate and the
bondholder would detach a coupon and send it to the company in return for interest
2. We may discuss later
BONDS PAYABLE IS ALWAYS RECORDED AT PV
Bonds can be issued at any time when buyers are willing to purchase the bonds (it can
be in between interest payment dates too)
Bond issued at par and on an interest payment date:
$100,000 PV
Stated R 6%
Semiannual 6/30 and 12/31
Issued on 1/1/1 (dont be so concerned that 12/31 is one day off)
5-year bond
1/1/1
CASH 100,000
BONDS PAYABLE
6/30/1
INT EXP

3,000

100,000

CASH
3,000
(F*F) = .06*100,000*(1/2)
Make sure to multiply by because it is semiannual
12/31/1
INT EXP
3,000
CASH
3,000
If issued at:
100,000 par
Stated R, 6%
3/1 and 9/1
Issued at 3/1/1
3/1/1
CASH 100,000
BP
100,000
9/1/1
INT EXP
3,000
CASH
3,000
12/31/1 Adjusting Entry
INT EXP
2,000
INT PAY
2,000
(F*F) = .06*100,000*(4/12)
3/1/2
INT PAY
2,000
INT EXP
1,000
CASH
3,000
Issued at par between interest payment dates:
RULE: whoever bought this bond should pay in the accrued interest and then on the
following interest payment date, the full six months will be paid back this will make the
accounting much simpler
100,000 PV
Stated r = 6%
3/1 and 9/1
Issued at 4/1/1
5-year bond:
3/1/1
NO ENTRY
4/1/1

CASH

100,500
BP
100,000
INT PAY
500
Face rate*face value = (f*f) = .06*100,000*(1/12)
9/1/1
INT PAY
500
INT EXP
2,500
CASH
3,000
12/31/1 adjusting entry
INT EXP
2,000
INT PAY
2,000
3/1/2
INT PAY
2,000
INT EXP
1,000
CASH
3,000
Bonds Issued at Discount
Handout
2/23/15
When it comes to paying interest, the interest rate you use is the stated rate
Interest expense means the true cost of the bond
So, in the case of a premium, the interest expense will be less than the interest paid
In a discount, the relationship is just the opposite
Buying a Bond vs. Buying shares in a corporation
If you buy a bond, you are a creditor
If you buy stock, you are an owner/investor
Rights of Shareholders
As a shareholder you have many rights, but there are 4 main ones for this course:
1. Right to share in profits This doesnt mean that you can walk into corporate
headquarters and take a check out of 4% of the earnings of the company the
corporation will put most of the earnings back into the corporation the
distribution of dividends will be what the shareholder will share in the earnings
2. Right to share in management They own the company so they should make
the decisions since they dont have the expertise to do so, so they arent
involved in day-to-day decisions but they can vote in and out the Board of
Directors who hire the upper level management who hire people to work in the
company takes place at the annual shareholders meeting if you dont want to
go there you can vote by proxy sometimes the board will hold a vote on certain
company decisions, but not on a day-to-day basis

3. Preemptive Right
4. Liquidation should the company liquidate, you have a right to get back what
you invested into the company, but if this happens, the creditors have priority
the shareholders are at the back of the line the creditors themselves have higher
and lower level priorities
2/25/15
Preferred Stock Vs. Common Stock
A minority of companies issue preferred stock, but most companies do issue common
stock
Preferred Stock
1. It is preferred as to dividends the preferred shareholders must receive their
required dividend before common shareholders can receive any dividends
2. Upon liquidation, these shares have preference over the common stock as far as
the rights to receiving compensation from the liquidation of a company
Required Dividend
If there is a 5% PS, PV of $100, 1,000 shares issued and outstanding, 5,000 shares
authorized
PS will pay $5 dividend per share, 5*1,000 = $5,000 in required dividends before any of
the common stock shareholders can receive any dividend
Par Value or Legal Consequence
The minimum legal issuance price of the stock
State law governs corporations (therefore, the laws vary from state to state)
Downside to PS
1. Market price of the PS is relatively stable over time and therefore you wont have
much capital gains like you would have with CS
Cumulative PS
If at any point, the directors dont declare the dividends for the year, the dividends will
accumulate for the next year, but the dividends must eventually be paid
This is how PS is normally sold
If in a HW problem it doesnt specify what type of PS, we assume that it is cumulative
Non-Cumulative PS
The dividends dont accumulate from period to period. If BOD doesnt declare a dividend
for the year, there is simply no dividend
IF:
Dividend In Arrears (DIA) 0
Board declares $45,000 dividend
PS gets 5,000, CS gets 40,000

SUPPOSE:
2 years DIA
PS gets $15,000 (10,000 from previous two years and 5,000 from this year)
CS will get $30,000
Callable Preferred Stock
If the corporation wishes, they could call back the PS
A company may do this if interest rates in the market are going down. The corporation
may rather borrow money at lower interest rates
Convertible Preferred Stock
If the preferred shareholders want, they can give back their shares and convert it into CS
at a rate specified by the company in advance
There is usually a window of opportunity to do this (and after that time they can no
longer do this)
A preferred shareholder may do this because the price of PS is relatively stuck at its price
and gets the same percentage dividend if the preferred shareholder believes that the
company is in good health, a PS wont help them so they may want to convert it into CS
so that they can benefit from capital gains + larger dividends
Fully Participating Preferred Stock
The preferred and common shareholders share in any dividends at the same rate (not
necessarily the same amount)
Suppose:
5% PS, par $100
1,000 shares issued and outstanding
CS $2 Par
100,000 shares I and O
If:
DIA = 0 , $45,000 dividend
PS gets 5% or $5,000
CS gets 5% of $2 = $10,000
Then you look at the PV relationship (theres $300,000 worth total, CS is 2/3 of it and PS
is 1/3 of it)
PS will get 1/3 total of 45,000 = 15,000 (so they get another 10,000)
CS will get 2/3 total of 45,000 = 30,000 (so they get another 20,000)
If:
DIA = 3,000
PS gets 5%, which is 5,000 plus 3,000 in arrears
CS gets 5%, which is 10,000
Then there is 27,000 left to divide
PS gets 9,000 (9% of 100,000) and CS gets 18,000 (9% of 200,000)

Both CS and PS participated in the full dividend

Partially Participating Preferred Stock
Preferred and CS share up to a point, but after that point PS is out and CS takes over
Every company will specify beforehand what that point is
Suppose:
PS can participate up to 8%
Same details as fully participating PS
DIA = 0
Dividends = 45,000
PS gets 5% =5,000
CS gets 10,000
PS gets another 3% of par = 3,000
CS gets 3% of par = 6,000
So far we gave out $24,000
The rest of the 21,000 is divided among the CS holders
If:
$20,000 dividend
PS gets 5% = 5,000
CS gets 5%= 10,000
PS gets 3% of par = 3,000
CS gets 3% of par = 6,000*, but the problem is that we cant give the CS holders 6,000
because there isnt enough left in the dividend
So CS holders will get the remaining $2,000 instead of their 3%
PS isnt Mutually Exclusive
You can have PS that is both cumulative and callable
Assume there are also dividends in arrears
The corporation may want to call back the PS and get out of paying any of the DIA, but
this isnt allowed
It will not work when the PS are called, the DIA must be paid
Even if the company only calls back some of their stock, they have to pay back all of the
PS holders DIA
HW Questions/Exercises/Problems:
Chapter 13
In syllabus
Chapter 14
Exercises 1,6,7,
03/4/15
4 Types of Preferred Stocks

Issuance of Stock
CS, par %
1,000 shares issued and outstanding
at $10
Issued stock at par:
CASH 10,000
CS
10,000
Issued stock above par at $12:
CASH 12,000
CS
10,000
APIC 2,000
No par value CS:
Issuance price $8
Stated value $5 (legally not the same as par value, but it replaces it as far as journal
entries)
CASH 8,000
CS
5,000
APIC 3,000
True No Par CS no par CS, no stated value:
Issued at $9
CASH 9,000
CS
9,000
3/09/15
Property Dividend
We will be giving an asset as a dividend, but not cash
If a warehouse has inventory thats not popular anymore they may send those to their
shareholders to appease them
A more realistic story would be:
If company A owns stock in company Z, which is an asset for the company called
Investment in Company Z that was purchased for $10,000
If there is an investment gain of 8,000, the account will now be valued at $18,000
INVESTMENT IN Z
GAIN
The company may distribute these shares as a dividend

RE
INVESTMENT IN Z
This does meet the definition of a dividend
Liquidating Dividend
The company is going out of business (liquidating)
The creditors are at the head of the line and the shareholders are at the back of the line
Usually the shareholders will end up with zero
But what if the company can pay the shareholders back what they invested in the
company?
The company will have to get rid of the CS and the APIC that was created when they
purchased shares
CS
X
APIC X
CASH X
This doesnt meet the definition of a dividend because there is no distribution of earnings
(even though we call it a dividend because the shareholders are getting something)
Stock Split
Before SS:
SE:
CS $10 par
10,000
1,000 shares issued and outstanding
APIC-CS
8,000
RE
62,000
TSE 80,000
Lets assume a 2:1 stock split (2 new for every one old)
In a stock split there is no JE
After SS:
SE:
CS $5 par
2,000 shares issued and outstanding 10,000
APIC-CS
8,000
RE
62,000
TSE
80,000
Main reason for stock split
When the market price of the stock is overpriced
By going through a split and flooding the market with more shares, the market price will
fall dramatically

Comprehensive Income
1. Equity changes because of everything that shows up on the income statement
2. Equity changes because of other comprehensive items that never show up on
income statement, but show up directly in the stockholders equity section
All the reasons why equity changes
Exam will be likely 2 weeks from today
03/16/15
Exam will be in one week from today exam will be on Monday
For next exam:
One other topic
Convertible PS we will do
Stock Warrants we will skip
Page 899 we will do computing EPS
All of the HW that was assigned will be on EPS, but the first two topics will be on that
exam too
Test #2
Convertible Bond
Bondholders have the right to convert their bonds into CS of the corporation
What methods do GAAP allow for the conversion of bonds into CS? What would be the
affect on the companys financial statements?
GAAP Allows 2 Approaches:
1. Book Value Method
2. Market Value Approach
We will go to brief exercise #2 to explain
If we have 2,000 bonds and each can be converted into 50 shares, we would have
100,000 shares after conversion
BV approach:
The amount of equity well exchange for these bonds will be based on BV of bonds
Converting the bond into CS:
BP
2,000,000
(2,000*1,000 PAR)
DISCOUNT
30,000
CS
1,000,000
APIC
970,000
We gave out 1,970,000 because that was the book value of the bonds (taking into account
the discount)
MV Approach:

We give out equity based on the market value of the stock

BP
2,000,000
LOSS
130,000
DISCOUNT
30,000
CS
1,000,000
APIC-CS
1,100,000

(loss on conversion of BP)

($11 value of stock over par*100,000 shares)

Convertible PS
Preferred shareholders can convert their preferred shares into CS
What does GAAP have to say about the JEs?
There is only 1 allowed method under GAAP the BV Approach
Brief Exercise #3
BV of PS is 60,000 so this is how much CS we must give out
PS
50,000
APIC-PS
10,000
CS
20,000
APIC CS
40,000
Two types of Capital Structures:
Simple Capital Structure
One that doesnt have any potentially dilutive securities
You must compute Basic EPS
Complex Capital Structure
One that does have potentially dilutive security
You must compute Basic EPS and Diluted EPS
Potentially Dilutive Security
A security that is not yet in the form of CS, but through conversion or exercise could
become CS, and should it become CS, could potentially dilute EPS
Basic EPS
(Net Income PS Dividends) / # of weighted average CS outstanding
Weighted Average CS Outstanding
Suppose at beginning of year, company issues 1,000 shares of CS
In ten months they offer another 1,000 CS
At year end, these shares cant just be added together because half the shares have been
earning for 12 months while the other half has only earned for 3 months
Therefore, we need to take the weighted average
1/1-9/1
1,000 * (9/12) = 750
10/1-12/31
2,000 * (3/12) = 500

1,250 WACS
(Handout on calculating WACS outstanding)
Potentially Dilutive Securities
Convertible PS
Can be converted into CS
What if it was converted, how would that affect EPS?
There is an increase in the numerator and the denominator
If the denominator effect is stronger, EPS will go down
Therefore, convertible PS is potentially dilutive
Convertible Bonds
If these were converted to CS, what would be the affect?
The denominator goes up because there are more shares and the numerator goes up
because there will be no more interest expense on the bonds so NI will increase
If the denominator effect will be the stronger of the two, EPS would go down
Therefore, convertible bonds are potentially dilutive
Stock Options or Stock Warrants
In a stock option, select employees of a company have the option to buy more stock at a
favorable price
In a stock warrant, current shareholders have the right to buy more stock
If exercised, the denominator will go up and EPS will fall, making it a potentially dilutive
security
With all of these items, none have yet become CS, but they might
GAAP says to show the potential reduction now make believe as if the dilutive security
became CS and show the reduction to EPS now
3/25/15
The Wed before the break and the Mon after the break he wont be here so well have to
make it up during free hour
Chapter 17
There are 2 investments we need to discuss
1. Debt securities/bonds
2. Investments in equities securities/stock
Weve discussed this from the perspective of the corporation thats issuing the bond
Now well be talking about the party that is buying the bond and lending money to the
issuer same story with stock
An investment is an asset
If you buy a bond youre a creditor
If you buy stock youre and owner

All dependent on FASB 115

3 types of bonds one can purchase:
1. Held-to-Maturity Security
2. Trading Security
3. Available for Sale Security
On day 1 you must decide which of the 3 youre buying because the rules under GAAP
are different for each type
Held to Maturity
When you buy the bond you have the intent and ability to hold on to the bond until it
matures
They may mature in 20 years so you must be able to hold on for that long
Held to Maturity bonds are long-term investments
We dont recognize an unrealized gain or loss on the investment
Valued at amortized cost (CV or BV; historical cost less amortization)
Trading Security
When you buy the bond, you buy it to trade it within a very short period of time (3
months)
When you buy it, its recorded at historical cost
If you still have it at the end of the period its valued at fair (market) value
If FV is above original cost we have a gain, if FV is below we have a loss
It would be an unrealized gain or loss not a true gain or loss because we havent yet
sold the security
This gain or loss should be recognized on the income statement
This is a short-term investment
Available for Sale
Plan to sell it, but not within 3 months
Must be able to hold it for whatever that time is
Similar rules to trading securities
It starts off at historical cost
At the end of the period its adjusted to FV (same as trading securities)
Also results in unrealized gain or loss
This gain or loss should show up on the balance sheet as part of other comprehensive
income
This can be either short- or long-term
If its within the year, its short-term
If its longer, its a long-term
Chart on page 953
Valuation doesnt mean finding valuation on the day you bought it because it always
starts at historical cost
Valuation means at the end of the period
Amortized Cost
HTM Bond
Bought on 1/1/1

Par
Discount

10,000
(1,000)
9,000
SL amortization for 10 years
12/31/1
Discount = 900
12/31/2
Discount = 800
Therefore, the CV of the bond (BV) is increasing:
10,000-900=9,100
10,000-800=9,200
This CV can also be called amortized cost
(Handout)
Data:
Trading Securities
Monthly basis
4/10 HC
10,000
4/30 FV
12,000
5/31 FV
9,000
4/10
DEBT INV 10,000
CASH
10,000
4/30 ADJ
FV ADJ
2,000
UNR GAIN 2,000
This will be recorded on the income statement
The new account FV ADJ is an asset account so the two assets (investment and FV Adj.
will add up to the FV)
Unrealized gain is an income statement account and will be closed out at the end of the
period (in this case the month) so the T-account will go back down to zero
FV Adj. doesnt get closed out because it is a balance sheet account
5/30
UNR LOSS
3,000
FV ADJ
3,000
Now that the FV ADJ T-account has a credit balance, it becomes a contra-asset account
Available-for-Sale Securities
Same data
4/10
DEBT INV

10,000

CASH

10,000

4/30 Adjusting Entries

FV ADJ
2,000
UNR GAIN
2,000
Over here, the unrealized gain will be brought to the balance sheet, not the income
statement, and therefore, it will not be closed out at the end of the period
5/31
UNR LOSS
3,000
FV ADJ
3,000
The unrealized gain/loss T-account will now have a debit balance of 1,000 because it
wasnt closed out in the prior period and will not be closed out now
Buying Stock in a Company
Charts on page 961
First Chart APB 18
Parent-Subsidiary
50%-100% stock in a company
Legally a parent and subsidiary are two separate companies, but from an accounting
perspective, the two companies are one economic entity
One company owns 50-100% of a company
Consolidation Only prepare one set of financial statements
This story of consolidation is the essence of advanced accounting so we just have to
know what GAAP says, but not how to consolidate financial statements
20%-50% stock in a company
Usually do have a lot of influence and you used the equity method to prepare statements
Significant influence example able to buy fabrics from a company at a significant
discount
The percentage is really not that important
Whats important is whether or not you have significant influence
If you own 30% of a company and another shareholder owns 70%, you dont have
significant influence
If you own 15% and the other million shareholders have around 1%, you do have
significant influence and should use the equity method
The percentage is just a guideline
Up to 20% of a company
Used the cost method to prepare financial statements according to APB 18
The book says to use fair value method, which is the current correct thing to do according
to the more recent FASB 115
Second Chart FASB 115

Holding less than 20%

1. AFS Security On day one, its valued at HC. At the end of the period its valued
at fair value resulting in unrealized gains or losses. This will show up on the
balance sheet in the stockholders equity section as part of other comprehensive
income
2. Trading Security When you buy the stock its recorded at HC. At the end of the
period it is adjusted to fair value resulting in unrealized gains or losses. This will
be recognized on the income statement.
For these we use the FV Method
Transfers Between Categories (974)
Always picked up in the new category at FV on the day of the transfer
If a bond was AFS and then changed to Held-to-Maturity, the investment will show up in
HTM at FV on the date of transfer
If it was HTM bonds and transferred to AFS, the investment will show up in AFS at FV
on the date of transfer
4/15/15
Chapter 17 deals with investments in the 3 types of bonds and also investment in equity
securities (3 range possibilities in how much you own)
Whats the basic difference between the FV approach and the Equity approach?
Page 965 illustrates the differences
Equity Method
Every time something happens to the equity section of the company invested in, there
will be an affect to the asset (an adjustment)
End of Chapter 17
4/20/15
BEGINNING OF NOTES FOR FINAL EXAM
Chapter 22
Accounting Changes
4 that we need to be familiar with:
1. Change in an Accounting Principle
2. Change in an Accounting Estimate
3. Change Due to an Error
4. Change in a Reporting Entity
Change in a Reporting Entity
Example:

If company A owns 51% or more of stock of company B

This will be a parent-subsidiary relationship because they are the majority shareholder
and are in control
A is parent, B is subsidiary
For this, we will use a method called consolidation to combine together the financial
statements of the two entities onto one set of financial statements and treat them as if
theyre one economic entity
Suppose this is how it was reported for the last ten years between this parent and
subsidiary
What if this year, company A bought 51% or more of company C
Now it will be parent A and subsidiary B and C (consolidated)
This change from just A and B to A, B and C is an example of a change in a reporting
entity
What does GAAP say you should do about this change? How will we ever compare the
financial statements of the new entity with the old financial statements?
We must handle this change retrospectively
We go back and make believe that this reporting entity wasnt just A and B for the last ten
years, but rather, as if it was a combination of A, B and C Change all of the financial
statements of the last 10 years
All of the NI will change because we add another entity this means that we need an
adjustment to RE
On top of that, we will need footnote disclosure indicating what is going on here with the
companies and the changing of the statements
Change in an Accounting Principle
Suppose weve been in business for 10 years and weve been using FIFO to value our
inventory
Now, we have a strong justification to switch to LIFO (you normally cant switch, but
sometimes theyll allow it)
We have a switch from GAAP to GAAP both are acceptable methods, were just
switching based on a strong justification
How does GAAP say we should handle this change? For the last few years weve been
using FIFO so it wont be comparable to the newer statements that are using LIFO?
Retrospectively change all of the old statements to LIFO so that well be able to
compare the statements
This means that all of the NI from the previous years will change, which means that there
will need to be an adjustment to RE
On top of this, well need footnote disclosure to indicate to the readers the nature of what
occurred
Change in an Accounting Estimate
We know that very often in accounting we have to estimate
For example, when we depreciate, we dont know exactly how long the object is going to
last
Same with bad debt expense, we dont actually know how many accounts are going to go
bad

In these situations we make estimates, but the odds are that somewhere along the line,
well realize that the original estimate wasnt correct
What should we do in this situation?
Suppose:
We acquire a truck thats HC is
20,000
SV of the truck is
0
Estimated life is 10 years
We will use SL
After 6 years:
HC is
AD is
BV is

20,000
12,000
8,000

This is only if my original estimate turns out to be correct

But what if after 6 years we determine that the SV is actually 500 and the Life is 9 years
We handle this change prospectively whatever you did until now you leave alone
because you estimated the best that you could just change things for the current and
future years
HC
20,000
AD
12,000
BV
8,000
SV
(500)
7,500 / 3 = 2,500 per year
When we were talking about a change in accounting principle, we talked about FIFO to
LIFO
What if we were talking about changing the method of depreciation from doubledeclining balance to SL or vice versa is this change from GAAP to GAAP?
This isnt what GAAP says depreciation isnt a change in an accounting principle, this
is a change in an accounting estimate
The reason why youre switching depreciation isnt because youre changing a principle,
its because you erred in your estimate the estimate is whats causing you to switch your
method of depreciation and therefore its a change in an accounting estimate
This is a big deal because it will be handled prospectively and not retrospectively
4/22/15
Change Due to an Error
Suppose in the middle of April we determine that we made a mistake on a previous
income statement
The fact that an error was found is a little odd because the statements are usually checked
so many times, but well assume thats what happened
3 Types of Errors
1. Arithmetic Mistake pushed the wrong keys on the computer when computing
the numbers

2. Mistake in Estimate An estimate is way off theres no exact definition to

this, but when you see it youll know
3. Usage of an accounting method thats unacceptable under GAAP this isnt a
change in accounting principle because that is GAAP to GAAP while this is nonGAAP to GAAP
Retrospectively You must go back and correct the error whenever the error took place
This will cause a change in the NI of the period and we will need an adjustment to RE
and a footnote of the adjustment
Example:
If we made an error in our calculation of depreciation expense
DEPRECIATION EXP
40,000 O
IBT
40,000 U
TAX EXP (40%)
16,000 U (these two errors will have negating effects)
NI
24,000 U
The beginning RE of the next year will be understated 24,000
Prior Period Adjustment (net of tax) We will have to add back 24,000
BEG RE ADJ
24,000
The main point is that there will be an adjustment to this periods RE not in the gross
amount of the error, but rather the error net of tax
Read the second half of chapter 22 on the light-side because it will not be the main part
of the course the first part will need the most studying
End of Chapter 22
Exam on Monday will start a quarter to 11:00am and go until 12:30pm
Exam is on 16 and 17
30 questions, we wont have to do all of them
(908) 591-5929 evenings are the best time to call
Chapter 23 Statement of Cash Flows
This chapter will have a very important role on final exam and it deals with the Statement
of Cash Flows
All this time weve focused on income statement and the balance sheet
This statement is not trying to tell us how much cash changed over the period because
then we wouldnt need the statement; wed just use the beginning and ending balance
sheet cash accounts
Statement of Cash Flows tries to tell us why cash changed
3 Activities that Cause Cash to Change
1. Operating Activities
2. Investing Activities
3. Financing Activities
Although this is the order in which they should appear, we will deal with operating
activities last in this class because it is the most difficult

Investing Activities
The change in cash due to the change in certain assets
As certain assets change, cash will either go up or down
For instance, if we buy a truck, youre buying an asset so the truck account goes up, but
the cash account goes down
When you sell the truck, you have less truck, but more cash
5 Categories of Assets that Affect Investing Activities:
1. Plant Property and Equipment
2. Investments
3. Intangibles
4. Natural Resources
5. Notes Receivable
PP&E
You buy a truck or you sell a truck
Investments
When you buy an investment (like a security), the asset will go up and the cash will go
down
If you sell an investment, vice versa
Intangibles
Trademarks, patents and copyrights
If you buy a copyright from another company, your intangible account will go up, but
cash will go down
Vice versa
Natural Resources
Oil fields, coalmines and timberlands
As asset changes, cash changes
Notes Receivable
There are many reasons why this account can change
The most basic reason is if we lend money cash goes down, but NR goes up
We have a right to get paid back when we receive the money, NR will goes down and
cash will go up
We will receive both principle and interest which one is the investing activity?
The principle is the part that is an investing activity
We will talk about the interest later
Financing Activities
The change in cash due to the change in certain liabilities and stockholder equity
accounts
1. Short- and Long-Term Notes Payable (liability)
2. Bonds Payable (liability)
3. Issuance of Stock (equity)
4. Treasury Stock Reacquisitions (equity)
5. Cash Dividends Paid (equity)
If we borrow money, our NP goes up while cash goes down and if we pay it back, the NP
will go down

Same with bonds

If we issue stock our cash goes up and SE goes up and vice versa with TS (buying back
stocks)
Cash Dividends
Causes SE to go down and cash to go down
Investing deals with Assets and Financing deals with Liabilities and Equity together,
they make up all the changes that take place on the balance sheet
Operating activities represent changes that take place on the income statement
Revenues will cause cash to go up and expenses will cause cash to go down
Operating Activities
Deals with changes that take place on the income statement
Income statement must be prepared using the accrual basis (recognized when earned)
On SCF, operating activities, the income statement must be done on a cash basis
Our job is to convert the income statement from an accrual to cash basis
GAAP Allows 2 Methods for this Conversion:
1. Direct Method* (preferred method)
2. Indirect Method (most companies use this method)
Because most companies use the indirect method, this will be the method that well
discuss in class even though the direct method is the preferred method
Look at chart on 1227 illustration 23-7
Chart shows that you start with NI, which is the bottom line of accrual basis and go
through additions and subtractions to get it to cash basis
DEPRC EXP X
AD
X
This is was prepared on the accrual basis
Since it was a noncash expense that we subtracted from NI, we will have to add it back
AMORT EXP X
PATENT
X
This was subtracted from NI, but is noncash
We will add this back to NI
INT EXP
X
DISC
X
This is a noncash expense so it will be added back to NI
We would do the opposite if it were the amortization of a bond premium
LOSS ON INV
X
EQU INV
X
Loss of Company As stock that we own using the equity method (significant influence)
If that company posted a loss, we would represent it as our own as a loss
The loss, however, is noncash for us so we must add it back to NI in order to get to the
cash basis
Conversely, if we had income on investment using the equity method, we will subtract
this noncash gain from NI

4/29/15
Notes were deleted because this laptop sucks
We did chapter 23, statement of cash flows
5/04/15
Leases
Companies often have to choose between buying or leasing an asset:
If you buy, in the long-run it will be cheaper, but you have to live with all of the problems
of the asset even when it stops working as well
If you lease the asset, you dont really own it, well make payments every period in order
to be able to use the asset. If there are any problems with the asset, its the owners
problem to fix it. In the long-run its probably more expensive
Since you keep renewing leases the asset is always relatively new
Lessor the one who legally owns the asset and this asset is initially on the lessors
books (they depreciate it)
Lessee leases the asset and makes payments to the lessor every period
Different types of Leases:
Operating Lease
The risks and benefits of ownership remain with the lessor
The lessor, from an accounting point of view, still owns the asset
The lessee is simply renting the asset under this lease
Therefore, the lessor depreciates the asset
Capital Lease
From an accounting point of view, the risks and benefits of ownership pass over to the
lessee
We view this as if the lessee bought the asset, from an accounting point of view
Therefore, the lessee will capitalize this onto the lessees books as if he bought the asset
Therefore, the lessee depreciates the asset on his books
Sales-Type
Direct Financing
Page 1274 in the text
Accounting for leases from the lessees point of view
4 Criteria for Capital Lease
1275, important chart capitalization criteria in blue box there are 4 criteria that if the
lessee meets any one, it is a capital lease from the lessees point of view
PV of minimum lease payments
Minimum Lease Payments (MLP)
Includes:

1. Annuity Payment that lessee has to pay PV of OA = A(F4); PV of AD = A(F(n1)+1)

2. PV Bargain Purchase Option (BPO) PV = FV(F2)
3. PV Guaranteed Residual Value (GRV) PV = FV (F2)
These are the only 3 we need to know about for our purposes even though book has more
Executory Costs
1. Insurance Costs
2. Property Taxes
3. Repairs and Maintenance
Even if lessee is responsible for these three payments, they are not included in the PV of
the payments in order to determine whether or not its a capital lease from POV of lessee
Discount Rate
The lessee should use the Lessees Incremental Borrowing Rate (LIBR)
This rate will be used to calculate the PV (its the R factor that you look up in the table)
LIBR
The lessee isnt really buying the asset, theyre just leasing it
But what if they did buy it and it cost $1M, what interest rate would the bank charge for
the lessee to borrow this money?
Because the lessee already borrowed for the lease, they will be charged an even higher
interest rate on the new borrowing to purchase the asset
However, theres one exception to the lessees usage of LIBR
If lessee knows that lessors implicit rate of return is less than the lessees incremental
borrowing rate, then lessee should use the lessors implicit rate of return
If LIRR < LIBR and lessee is aware of this, lessee should use LIRR
LIRR
Whatever asset were talking about, the lessor made an investment to purchase that asset
and are expecting a certain rate of return known as the LIRR
Part of any money that the lessor makes is used to cover the original investment
Depreciation Period
Assuming capital lease and its on the lessees books, the lessee must depreciate the asset
2 Possible Periods to Depreciate:
1. Lease Term criteria #3 and #4
2. Economic Life criteria #1 and #2
It depends on which of the 4 criteria made this into a capital lease which one you
depreciate over
Effective Interest Method
If every month, the mortgage payment is $1,000
In this payment, part is toward the principle and part is interest
When you first borrow the money, most of the payment will be interest, but as time
passes on, the interest portion will go down while the principle portion goes up
As time goes on, interest portion goes down, principle portion of payments goes up

Depreciation Concepts
The point is that if this is a capital lease from the lessees POV, the asset must be
capitalize on lessees books and lessee must depreciate the asset
We will be receiving a handout for numerical example of lessees capital lease
5/06/15
Handout on lease payments and journal entries
Sales-Type Capital Lease
BV doesnt equal FV at the inception of the lease there is an automatic gain or loss at
the start of the lease
Direct Financing Capital Lease
Book Value and the FV are equal there is no automatic gain/loss at the start of the lease