Professional Documents
Culture Documents
Financial Accounting
Financial Accounting
-COGS
Gross profit = net sales less COGS
-Operating expenses
Income from operations (EBIT) = net sales less cogs and other operating expenses
+/- Nonoperating revenues/expenses and gains/losses
Income before income taxes (EBT=pretax earnings) = revenues all expenses except income tax
expense
-Income tax expense
Net Income
*nonoperating items: income, expenses, gains, and losses that do not relate to the cos primary
operations e.g) interest income/expense & gain and losses on the sale of fixed assets and
investments
Nonrecurring items
1. Discontinued operations
2. Extraordinary items
EPS( Earnings Per Share) = Net Income / Average number of shares of common stock outstanding
during the period
Statement of Cash Flows
CFO: ~ earning income
CFI: productive assets, investments in other companies
CFF: financing the business thru borrowing and repaying loans, stock issuances and repurchases and
dividend payment
ROA analysis
Return on Assets = Net Income/ Average Total Assets
Evaluate performance at any level within the organization (independent source financing -debt & equity)
ROA Profit Driver Analysis
Net Inc/Avg TA = NI/Net Sales * Net Sales/ Avg TA
Net profit margin
Low-cost strategy
*discontinued operations: result frm the disposal of a major component of the business and are
reported net of income tax effect -> separately disclosed in a note
*extraordinary items: are gains and losses that are both unusual in nature and infrequent in
occurrence; they are reported net of tax on the income statement -> report such items very rarely
Note disclosure is needed
*Form 10-K: annual report that publicly traded companies must file with the SEC
*Form 10-Q: quarterly report that publicly traded companies must file with the SEC
*Form 8-K: disclose any material event not previously reported that is important to investors
Gross Profit Percentage = Gross Profit / Net Sales ->How effective is management in selling goods
and services for more than the costs to purchase or produce them?
Measuring and reporting receivables
Classifying Receivables
A/R vs N/R
A/R: open accounts owed to business by trade customers
N/R: written promises that require another party to pay the business under specified conditions
(amount, time, interest)
Accounting for Bad Debts
Making the end-of-period adjusting entry to record estimated bad debt expense
Writing off specific accounts determined to be uncollectible during the period
*Bad Debt expense: expense associated with estimated uncollectible accounts receivable
Recording BDE estimates
A/R could not be credited in the journal entry b/c there is no way to know which customers A/R are
involved
Writing off specific uncollectible accounts
This journal entry did not affect any income statement accounts
X change the net book value of accounts receivable
When customer makes payment on account that has been written off, the journal entry to
write off the account is reversed
*Cash equivalents: ST investments with original maturities of three months or less that are readily
convertible to cash and whose value is unlikely to change
Internal control of cash
1. Separation of duties
*Lower of cost or market (LCM): valuation method departing frm the cost principle
-> It serves to recognize a loss when replacement cost or NRV is < Cost
When the goods remaining in ending inventory can be replaced with identical goods at a lower cost,
the lower replacement cost should be used as inv valuation
Damaged, obsolete, and deteriorated items should be assigned a unit cost that represents
their current estimated net realizable value (Sales price Costs to sell) (conservatism)
Holding loss: when the replacement cost of an item drops, rather than in the period the item is sold ->
purchase cost lower replacement cost is added to CGS
*LIFO Reserve: contra-asset for the excess of FIFO over LIFO inventory
FIFO CGS is lower, income b/4 income taxes would have been $8,000 higher
If tax rate is 35% -> increase in tax expense is $8000*0.35 = $2,800
b/c CGS was understated, income b/4 taxes would be overstated by $10,000 in the current year
It overstates beg inv and causes the overstatement of CGS in the nxt yr
So, clerical errors are inadvertently offset in the end
Demonstration case
When costs are rising, LIFO should be selecter b/c LIFO produces higher CGS, lower pretax income,
and lower income tax payments
-acquisition by construction
*capitalized interest: interest expenditures included in the cost of a self-constructed asset
-> recorded by debiting assets and crediting cash when the interest is paid
e.g) $60,000 labor, $1,300,000 supplies, $100,000 interest exp
Straight-line rate
Least and the latest rule: pay the lowest amt of tax that is legally permitted and at the latest possible
date
-MACRS (Modified Accelerated Cost Recovery System): similar to declining-balance method and applied
over relatively short asset lives to yield high dep exp in the early years ->reduces taxable income.
However, x acceptable for financial reporting purposes
Measuring Asset Impairment
Step 1) Test for impairment
If net book value > estimated future cash flows, then the asset is impaired
Step 2) Computation of Impairment Loss
Impairment Loss = Net Book Value Fair Value
e.g)
Disposal of Property, Plant, and Equipment
The disposal of a depreciable asset usually requires two journal entries:
1. adjusting entry to update the depreciation expense and accumulated depreciation accounts
2. entry to record the disposal -> cost of the asset & any accumulated dep of disposal must be
removed from the accounts
Difference b/t any resources received on disposal of an asset and its book value -> treated as a gain
or loss (gain I/S, x operating revenue, shown as a separate item on I/S)
-Indefinite Life: not amortized, -> tested at least annually for possible impairment
*Goodwill: the excess of the purchase price of a business over the fair value of the businesss assets
and liabilities
->The only way to report goodwill as an asset is to purchase another business
Goodwill to be reported = Purchase price Fair value of identifiable assets and liabilities
*Trademark: exclusive legal right to use a special name, image, or slogan
Valuable asset, but rarely seen on balance sheets b/c not recorded unless they are purchased
*Copyright: exclusive right to publish, use, and sell a literary, musical, or artistic work
*Technology: includes costs for computer software and web development
*Patent: granted by the federal government for an invention; it is an exclusive right given to the owner
to use, manufacture, and sell the subject of the patent
Patents are recorded at their purchase price or if developed internally -> recorded at registration and
legal costs (GAPP requires immediate expensing of R&D)
*Franchises: contractual right to sell certain products or services, use certain trademarks, or perform
activities in a geographical region
*Licenses and Operating Rights: obtained thru agreements with governmental units or agencies,
Payroll taxes
All payrolls are subject to a variety of taxes, including federal, state, and local income taxes
Notes Payable
*time value of money: interest that is associated with the use of money over time
Interest = Principal * Interest Rate * Time
Deferred revenues
*deferred revenues: revenues that have been collected but not earned; they are liabilities until the
goods or services have been provided
Estimated Liabilities Reported on the B/S
-the estimated amt of product that will be returned is reported as a reduction frm sales rev in the year
the sales are recorded
Estimated Liabilities Reported in the Notes
*Contingent Liability: potential liability that has arisen as the result of a past event; it is not an
effective liability until some future event occurs
-> may or may not become a recorded liability depending on future events
e.g) Lawsuits, environmental problems, and product warranties
1. Probable the chance that the future event or events will occur is high
2. Reasonably possible the chance that the future event or events will occur is more than remote but
less than likely
3. Remote the chance that the future event or events will occur is slight
1) a liability that is both probable and capable of being reasonably estimated must be recorded and
reported on the b/s
2) a liability that is reasonably possible must be disclosed in a note in the financial statements
whether it can be estimated or not
3) remote contingencies are not disclosed
Working Capital Management
*working capital: dollar difference b.t total current assets and total current liabilities
Working capital and Cash Flows
Long-Term Liabilities
*Long-term liabilities: all of the entitys obligations not classified as current liabilities (LT notes
payable over one year in the future)
-secured debt: liability supported by the ownership of the asset if liability is not satisfied
Long-Term notes payable and bonds
Private placement: raise long-term debt frm financial institutions -> notes payable having maturity date
-liability is recorded when the debt is incurred and interest expense is recorded with the passage of
time
Lease Liabilities
*Operating Lease: does not meet any of the four criteria established by GAAP and does not cause the
recording of an asset and liability
-ST basis, no liability is recorded when an operating lease is created -> records rent expense as it
uses the asset
e.g) rent five large trucks during Jan 2012 -> No liability is recorded in 2011 & rent exp is recorded
during January 2012 when trucks are actually used
*Capital Lease: meets at least one of the four criteria established by GAPP and results in the
recording of an asset and liability ->purchase and financing of an asset
1. The lease term is 75% or more of the assets expected economic life
2. Ownership of the asset is transferred to the lessee at the end of the lease term
3. The lease contract permits the lessee to purchase the asset at a price that is lower than its fair
market value
4. The present value of the lease payments is 90 percent or more of the fair market value of the asset
when the lease is signed
-most prefer to record lease as an operating lease -> co is able to report less debt on its B/S
*Indenture: bond contract that specifies the legal provisions of a bond issue
*trustee: independent party appointed to represent the bondholders
-bonds with ratings above Baa/BBB are investment grade
Reporting Bond Transactions
2 types of cash payment in the bond contract
1. Principal: single payment that is made when the bond matures = par value, face value
2. Cash interest payments: coupon rate
-to determine pv of bond, compute the pv of the principal and the pv of the interest payments -> add
two amts
*market interest rate: current rate of interest on a debt when incurred (=yield, effective interest rate) ,
rate that should be used in computing the pv of a bond
Coupon rate < Market rate -> discount
Coupon rate = market rate -> par
Coupon rate > market rate -> premium
when a bond pays interest rate less than the rate creditors demand, they will not buy it unless
its price is discounted
when a bond pays more than creditors demand, they will be willing to pay a premium to buy it
-corporations and creditors do not care whether a bond is issued at par, at a discount, or at a premium
b/c bonds are always priced to provide the mkt rate of interest
Bods Issued at Par
Bonds selling price is determined by the pv of its future cash flows, not the par value
-when bond is sold at a discount, B/P account is credited for the par amt, and discount is recorded as
a debit to Discount on B/P
-whil co received only $96,536 when it sold the bonds, it must repay $100,000 when the bonds
mature. (extra cash is an adjustment of interest expense to ensure that creditors earn the mkt rate of
interest)
-to adjust I/ Exp, borrower amortizes the bond discount to each interest period as increase in I/ Exp.
They use (1) straight line (2) effective interest
-Part A: Reporting Interest Expense on Bond Issued at a Discount Using Straight-Line Amortization
Straight-line amortization: simplified amt of amortizing a bond discount or premium that allocates an
equal dollar amt to each interest period
At the end of the 1st interest period -> book value of bonds increases to $97,402 (96,536+866)
each period, the book value of the bonds increase by $866 (amortizing)
At the maturity date of the bonds, the unamortized discount is zero
Part B: Reporting Interest Expense on Bonds Issued at a Discount Using Effective-Interest Amortization
*Effective-interest amortization: a method of amortizing a bond discount or premium on the basis of
the effective-interest rate; it is the theoretically preferred method
1) Compute interest expense
Current unpaid balance * mkt rate of interest (on the date of sold) * n/12
2) Compute amortization amount
Interest Expense Cash Interest
-the additional $792 was added to the principal of the bond and will be paid to bondholders when the
bond matures
-interest expense for 2H is calculated by multiplying the unpaid balance 96536+792 = 97.328
-interest expense increases each year b/c of the amortization of the bond discount
Part A: Reporting Interest Expense on Bonds issued at a premium using straight-line amortization
Part B: Reporting Interest Expense on Bonds Issued at a Premium Using Effective-Interest Amortization
Debt-to-Equity
Relationship b/t amt of capital provided by owners and the amt provided by creditors?
Debt-to-Equity = Total Liabilities / Stockholders Equity
Early Retirement of Debt
*Treasury stock: stock that has been bought back from issued company
Earnings per share (EPS)
-how well is a company performing?
EPS = NI / Avg number of common shares Outstanding
Common stock transactions
*common stock: basic voting stock issued by a corporation
*par value: nominal value per share of capital stock specified in the charter; serves as the basis for
legal capital
*legal capital: permanent amt of capital defined by state law that must remain invested in the
business; serves as a cushion for creditors
*no-par value stock: capital stock that has no par value specified in the corporate charter
Initial sale of stock
still being held by that corporation -> no voting, dividend, or other stockholder rights
Reason for acquiring-> existence of an employee bonus plan that provides workers with shares of
stocks
-it is less costly to give employees repurchased shares than to issue new ones b/c of regulations
Declaration and payment of a cash dividend reduce assets and S.E. -> two requires
1) sufficient retained earnings
2) Sufficient cash
Stock Dividends and Stock Splits
Stock Dividends
*stock dividends
-pro rata basis: each stockholder receives additional shares equal to the percentage of shares held
-when a stock dividend occurs, the company must transfer an additional amt frm the RE acct into C.S.
acct to reflect the additional shares issued
-the amt transferred depends on whether the stock dividend is classified as large or small
Large: distribution of additional shares is more than 20-25% currently outstanding shares
Small: distribution of additional shares is less than 20-25% currently outstanding shares
Stock Split
*Stock Split: increase in the total number of authorized shares by a specified ratio; it does not
decrease retained earnings
-stock split is accomplished by reducing the par or stated value per share of all authorized shares
(total par value is unchanged) .eg) 2-for-1
-stock split does not result in the transfer of a dollar amt to the C.S. acct
-> In both a stock dividend & a stock split, stockholder receives more shares of stock w/o having to
invest additional resources
-> dividend: journal entry O / split: no journal entry but disclosed in the notes
Preferred Stock
*Preferred Stock: stock that has specified rights over common stock
Differences
1) Preferred stock does not grant voting rights -> permit to raise funds w/o diluting common
stockholders control
2) Preferred stock is less risky: holders receive priority payment of dividends and distribution of assets
if the corp goes out of business
3) Preferred stock typically has a fixed dividend rate
Dividends on Preferred Stock
*current dividend preference: the feature of preferred stock that grants priority on preferred dividends
over common dividends
-declared dividends must be allocated to preferred stock first, then the remainder of the total dividend
can be allocated
Interest Earned
Principal at maturity
-If the bond investment must be sold b/4 maturity, (no intention b/4) any difference
b/t mkt value and net book value would be reported as a gain or loss on sale
Passive Investments: The Fair Value Method
-only passive investments in marketable securities are required to be reported using
fair value method on B/S
*fair value method: used to report securities at their current market value (amt that
would be received in an orderly sale)
1) why are passive investments reported at fair value on B/S ?
-Relevance / Measurability
2) when the investment account is adjusted to reflect changes in fair value, what
other account is affected when the asset account is increased or decreased?
*Unrealized holding gains or losses: amts associated with price changes of
securities that are currently held
-the value of the investments increases by $100,000 -> adjusting journal entry by
increasing investment account & unrealized holding gain
-the value of the investments decrease by $ 75,000 -> adjusting journal entry by
Year-End Valuation
-assume that fair value of per share is $8 (it was $10), and lost value is $2 per share
for the year -> x being sold , so the loss is unrealized loss
-Reporting the SAS investment at fair value requires asset Investments in SAS up or
down to fair value @ the end of each period -> Net Unrealized Losses/Gains
-reported in the S.E section of B/S under Other comprehensive Income (OCI)
-Only when the security I sold are any realized gains or losses included in net income
Sale of Securities
-Investments in SAS & Net Unrealized Losses/Gains (OCI) are eliminated
-assume that sold all of its SAS investments for $13 per share -> receive $195,000
Gain or loss on sale is computed as follows:
Proceeds frm sale Investment Cost = Gain if positive (Loss if negative)
-the book values on the acquired cos B/S are irrelevant unless they represent fair
value
-Goodwill is reported only if it is acquired in a merger or acquisition transaction
Reporting for the Combined Companies
-Consolidated financial statements must be presented
-treat the acquired A & L in the same manner as if they were acquired indiavidually