Terms and Concepts

Five Accounting Concepts

1. The entity concept is the most basic accounting concept. It states that accounts are kept for
an entity as distinct from the people who own, run or do business with the entity.

2. The money measurement concept states that  nancial accounting deals only with things
that can be represented in monetary terms. This concept is so intuitive that it is usually taken
for granted. But, since it is so important, it is stated as a basic accounting concept.

3. Going concern is accounting's way of saying that an entity is expected to remain in operation
for the inde nite future. The going concern concept directs the accountant to explicitly make
this assumption in the absence of evidence to the contrary.

4. The consistency concept states that an entity should use the same accounting methods and
procedures from period to period unless it has a sound reason to change methods.

5. The materiality concept states that an entity need only apply proper accounting to items that
are material, i.e., signi cant to potential users of the nancial statements. This concept allows
the accountant to be practical in choosing the appropriate degree of precision in the
accounts.



Just what is material and not material is not made speci c in accounting. The general rule is
that, "An item is material if its disclosure would impact the decisions of the users of the
accounts." The application of this rule requires accountants to judge what users of nancial
statements would consider signi cant to their decisions. As in most matters requiring
judgments, reasonable people can di er. Determining materiality is no exception.

Relevance refers to the timeliness and usefulness of the information to its users. Reliability refers
to the objectivity and veri ability of the information. Di erent ways of recognizing, measuring and
recording an event may yield more or less reliable or more or less relevant account balances.

Often, judgment has to be used to make the trade-o between relevance and reliability, i.e., there
isn't a way to record a transaction that will maximize both these desirable properties. In such
cases, reliability is generally given precedence over relevance.

IFRS tends to be stated as in the form of broad principles. In contrast, much of GAAP tends to
be stated in the form of bright-line rules.

The distinction between the principle based and rule based accounting standards is important.
Under a principle standards model, the accounting for transactions is more likely to re ect the
substance of the transaction. Under a rule based standards model, the accounting for a
transaction is more likely to re ect the form of the transaction.

As GAAP and IFRS converge, it is anticipated that GAAP will become more principle based.

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 The Balance Sheet
To be recorded as an asset, an economic resource must meet four requirements:

• Acquired at measurable cost

• Obtained or controlled by the entity

• Expected to produce future economic bene ts

• Arises from a past transaction or event

To be recorded as a liability, an obligation must meet three requirements:

• It involves a probable future sacri ce of economic resources by the entity

• The economic resource transfer is to another entity

• The future sacri ce is a present obligation, arising from a past transaction or event

The dual-aspect concept formalizes the idea that there are two sides to every accounting
transaction. Recording both sides of each transaction is known as double-entry bookkeeping.

The historical cost concept, also known as the cost concept, provides guidance as to the
amount at which a transaction should be reported initially in the entity's accounts. It requires that
transactions be recorded in terms of their actual price or cost at the time the transaction occurred.

The current ratio, or ratio of current assets to current liabilities, is a measure of an entity's ability
to meet its maturing short-term obligations.

Financial statement users often employ the rule-of-thumb that a healthy business will have a
minimum current ratio of 2.

If nancial statement users notice that an entity has a current ratio that is signi cantly higher than
that of its peers, they may be concerned that the entity holds more cash or inventory than a
business needs. This may signal that it is locking up potentially productive capital. If, on the other
hand, an entity has current ratio that is signi cantly lower than that of its peers, nancial
statement users may question its ability to satisfy its current obligations in a timely manner.

Total debt to equity ratio is the ratio of total debt (capital that accrues interest and has to be
repaid to lenders) to equity capital (capital that does not demand interest and does not have to be
repaid). This ratio measures nancial leverage or the degree of the entity's indebtedness relative
to its equity funding.

If a company has a total debt to equity ratio that is signi cantly higher than that of its peers,
nancial statement users may be concerned about its ability to make the required payments to its
debt holders and the company's long-term solvency may be questioned.

If, on the other hand, a company has a total debt to equity ratio that is signi cantly lower than that
of its peers, nancial statement users may question whether the company is being aggressive
enough in pursuing pro table growth opportunities by raising debt when necessary to nance
those opportunities.

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The Income Statement
We calculated gross margin by subtracting from sales the cost of goods sold ("COGS"). Next we
subtract the entity's other expenses of running the business to determine net income.

Expenses of running the business listed below the gross margin are displayed in three categories:
operating expenses, interest expense and income tax expense.

Operating income (operating pro t) = gross margin - operating expenses

Income before income taxes = operating pro t - interest expense

Net income = income before income taxes - tax expense

The balance sheets at the beginning and end of an accounting period are linked, by the income
statement for the period, through the retained earnings account in the owners' equity section of
the balance sheets.

Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings

Realization is the process of converting assets, such as merchandise for sale, into cash, cash
equivalents, or good accounts receivable.

Realization plays an important role in determining when revenue is recognized. Two conditions
must be satis ed:

• First, the revenue must be earned, which typically means that the customer has received the
good or service.

• Second, the revenue must have been realized or realizable, implying that the customer has paid
or is expected to pay for the merchandise.

• IFRS recognizes revenue when the "risks and rewards of ownership are transferred."

• In contrast, GAAP, among other requirements, recognizes revenue when it is "earned."

Despite these di erences, in most cases the accounting for revenue transactions will be the same
under either concept.

IFRS recognizes revenue when all the following conditions have been satis ed:

• The seller has transferred to the buyer the signi cant risks and rewards of ownership of the
goods;

• The seller retains neither continuing managerial involvement to the degree usually associated
with ownership nor e ective control over the good sold;

• The amount of revenue can be measured reliably;

• It is probable that the economic bene ts associated with the transaction will ow to the seller;
and

• The costs incurred or to be incurred in respect of the transaction can be measured reliably.

The Matching concept indicates what expenses should be recognized when revenue is
recorded. The Matching concept stipulates that expenses should be recognized in the same
period as the relevant revenues are recognized.

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The Conservatism Concept goes one step further by recommending that prudence be exercised
in recording revenues and expenses. It says that revenues should be recognized only when
reasonably certain, but expenses should be recognized as soon as reasonably possible.

The conservatism concept also applies to the balance sheet. It suggests prudence in the
recording of assets (record when reasonably certain) and in the recording of liabilities (record as
soon as reasonably possible). Further, if two di erent estimates of a balance sheet amount were
equally acceptable, the conservatism concept would guide accountant to record the smaller
amount when measuring assets and the larger amount for liabilities.

The matching concept requires that the cost of each of the tangible non-current assets be spread
over its useful life, and in each accounting period an expense be recorded to re ect the reduction
in the useful life of the asset. This expense is called Depreciation Expense.

Net Book Value = Historical Cost - Accumulated Depreciation

The net book value of each long-lived asset is used to compute total assets on the balance sheet.

For nancial reporting purposes, land is assumed to have an inde nite life. As a result, its useful
life is assumed to remain undiminished during the passage of an accounting period. Therefore,
land is never depreciated.

For an intangible long-lived asset, we record a reduction in its remaining useful life by recording
an amortization expense that directly reduces the value of the asset on the balance sheet. Note
that amortization and depreciation expenses both re ect the diminishing useful lives of assets.
However, the e ect of each is recorded di erently on the balance sheet. Depreciation expense is
recorded for each depreciable tangible asset and it accumulates in a related contra-asset account
on the balance sheet. Amortization expense is recorded for each amortizable intangible asset, and
there is no associated contra-asset account: amortization expense directly reduces the
related intangible asset account on the balance sheet.

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Gross margin as a percentage of sales (GMP) is dollar gross margin divided by sales,
expressed as a percentage. Dollar gross margin is sales minus cost of goods sold. It represents
the mark up on the cost of the products sold by a company.

Return on sales percentage (ROS) is calculated as net income per dollar of sales, or net income
divided by sales, expressed as a percentage.

Because net income is a ected by interest and tax expense, unlike the gross margin percentage,
return on sales is a ected by the company's capital structure and its tax regime.

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Accounting Records
Journal Entries

Increase Decrease

Asset accounts Debit Credit

Liabilities and Owner’s Equity Credit Debit

accounts

Sales accounts Credit Debit

Expense accounts Debit Credit

Ledger -> T-accounts

The T-account is literally a large 'T' with an account name on top. The left side of the T-account is
the debit side. The right side of the T-account is the credit side. So, in nancial accounting, debit
means left side, and credit means right side.

Note that each permanent or balance sheet account has the August ending balance as its
September beginning balance; each temporary or income statement account starts this new
accounting period with a zero balance.

Adjusting entries do not involve any economic exchange with a third party.

A closing entry is made to close or reset all sales and expense accounts to zero.

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 The Statement of Cash Flows
The direct method statement of cash ows for an accounting period summarizes the
transactions that have been posted to the cash ledger account during the period. This information
is presented in three categories: operating, investing and nancing activities.

In the indirect method statement of operating cash ows, each adjustment to net income is the
sum of one or more de-accruals for the period.

The two statements di er in only one area: the format and information included in the cash ows
from operating activities section. The investing and nancing cash ows sections are exactly the
same in both types of statements of cash ows.

Usage of Indirect method:

• the operating section of the indirect method statement explains the di erence between the net
income and the operating cash ows of the period, it provides readers with information about
the extent to which and the means by which the entity's net income of the period has resulted in
operating cash ows.

• The Financial Accounting Standards Board requires entities that use the direct method in their
statement of cash ows to present a separate reconciliation of net income to operating cash
ows using the indirect method. As a result, most companies choose to present only the indirect
method statement of cash ows.

In practice, the indirect method statement of cash ows for an accounting period is constructed
using the period's net income, the period's depreciation and amortization expenses, di erences
between the period's beginning and ending current asset and liabilities accounts, excluding cash
and short-term debt.

For operating:

ADD
depreciation and amortisation

increase in payable

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 decrease in prepaid expense, receivable, inventory

SUBTRACT
(opposite)

Analysis

It is expected that a mature company's capital expenditures - its cash payments for non-current
assets -- meet or exceed the depreciation expense of the period. This would indicate that the
company is replacing long-lived assets at about the same or greater rate than their economic
bene ts are being consumed.

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 Revenues and Receivables
Sales Method

Earned: In most cases, revenue is earned when a sale has taken place, which is when:

• the customer has agreed to buy the goods and services;

• the goods or services have been delivered; and

• the seller has performed substantially all of its obligation to the buyer

Realizable: The realized or realizable criterion is satis ed if the seller has received payment or
reasonably expects to be paid.

Other methods - %age of Completion Method, Completed Contract Method, Instalment Method

Deferred revenue is future revenue that has already been collected but has yet to be earned. It is
shown in the liabilities section of the balance sheet, re ecting Global Grocer's obligation to
provide merchandise to the holder of the gift certi cate in the future.

Remember, this sales transaction must remain on the balance sheet and cannot go into the
income statement as revenue until it is both earned and realized.

Bad Debts (contra account)- Constant Percentage Method, Allowance Method, Direct Write-o
Method

Allowance for bad debts (contra account of accounts receivables) - on asset side - credit

Bad debt expense - on retained earnings side - debit

Refunds (liability account) - direct deduction from gross sales

Allowance for sales returns - on liability side - credit

Estimated sales refunds - on retained earnings side - debit

Prompt payment or cash discount (liability account)

Allowance for cash discounts - on liability side - credit

Estimated cash discounts - on retained earnings side - debit

Bad Debt Ratio =

(Bad debt allowance at the end of the period/Gross receivables at the end of the period)*100%

Analysts look to see if a company's bad debt ratio is increasing over time, or if it is signi cantly
greater than that of other companies in its industry. In either case, this might indicate that the
company is failing to properly screen potential clients before o ering them credit. It might also
mean that the company is pursuing less credit-worthy customers in an attempt to generate sales
which it is not getting elsewhere.

From a managerial perspective, the greater your company's bad debt ratio is, the more it costs
you to extend credit to your customers. If you are attempting to analyze the incremental
pro tability of a sale, the cost of providing credit to a customer is one of the costs elements to
include. An increase in the cost of extending credit means a decrease in net pro t from a sale.

Days Receivable Ratio or Days Sales Outstanding (DSO) ratio =

(Net accounts receivable/Total sales in the period)*(# of days in the period)

indicates the average number of days necessary for the company to collect its outstanding
accounts receivable. The days receivable ratio is sometimes called receivables turnover,
because it tells you how fast the receivable are turning over and being converted into cash.

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 Inventories and Cost of Sales
Bought merchandise inventories - purchased nished goods immediately ready for sale

Cost Of Goods Sold = Beginning inventory + purchases - ending inventory

Manufacturing inventories are recorded at the cost of production. The costs included are those
directly connected with purchasing and transporting materials to the production site and
converting them to a nished product. These are termed product costs.

All product-related costs remain in inventory until the goods are sold. Then, costs for the goods
sold are transferred to COGS at the end of the accounting period.

There are di erent kinds of product costs. The main ones are listed here:

• Labor: The compensation of all manufacturing labor that can be traced to the production of the
product.

• Materials: Acquisition costs of all materials that eventually become part of the product.

• Manufacturing Overhead: Manufacturing costs that are closely related to the making of the
product, but that are not speci cally production labor or materials. Depreciation on
manufacturing equipment is an example.

Selling expenses, and administrative expenses are not included in manufactured inventory costs
and/or COGS. They are considered to be operating expenses, not product costs, and are
expensed as incurred.

Examples are:

• Advertising costs for the product

• The cost of the running the purchasing department

• O ce cleaning expenses

Bought merchandise inventory is also not included in the manufactured inventory account. Their
costs are assigned to a separate inventory account.

The process by which costs such as those listed here are allocated to products or to di erent
activities within the company is known as cost accounting.

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 Beginning raw materials inventory + raw materials purchases - ending raw materials inventory =
raw materials transferred to work-in-process account

There are two approaches to keeping track of inventories:

• Under the perpetual method, the inventory account is adjusted as each addition and
withdrawal is made.

• The periodic method, as its name indicates, adjusts the inventory account periodically based
on actual inventory counts. For example, at the end of each accounting period, inventory on
hand is counted and valued. This amount becomes the ending inventory.

Inventory costing approaches - FIFO and LIFO

These cost assumptions do not necessarily re ect the actual physical  ow out of its physical
inventory, which may be very di erent altogether.

LIFO isn’t permitted under IFRS

The cost di erence between FIFO and LIFO inventory is called the LIFO reserve.

Other methods - speci c identi cation and average cost methods

Inventory write-down

Lower of cost or market rule - the inventory must be written down to its new selling price less
the cost of disposal

DEBIT: COGS

CREDIT: Inventory

Inventory turnover ratio - measures the average number of times inventory is sold during the
year

COGS/(Average Inventory)

Average Inventory = (Beginning Inventory + Ending Inventory)/2

Days inventory - converts the turnover ratio to its days equivalent

365/(Inventory turnover ratio)

Managers keep a close eye on inventory turnovers for signs of inventory build-ups which could
indicate obsolescence or anticipated sales growth in the next period.

Whether a company uses LIFO or FIFO has an impact on inventory ratios; if input costs are
increasing, days inventory for a company under LIFO will be lower than under FIFO. This can
make it di cult to compare the inventory ratios of companies when some use the LIFO method
and others the FIFO method. One way to overcome this problem is to convert a LIFO inventory
amount to its FIFO value equivalent by adding the LIFO reserve back to the LIFO inventory
amount and then using the LIFO inventory's FIFO equivalent to compute inventory ratios.

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 Depreciation and Non-Current Assets
Costs associated with the acquisition of the asset that are incurred in bringing the asset to its
intended location and to get it ready for use are "capitalized", i.e. included as part of the total
cost of the asset that appears on the balance sheet.

GAAP requires the depreciation method adopted be systematic and rational. IFRS requires the
depreciation method adopted re ect the pattern in which the asset's future economic bene ts are
expected to be consumed by the reporting entity. The main methods used in practice are:

• Straight-Line Depreciation
• Accelerated Depreciation

After several years of using an asset, a company may revise its estimates of the asset's useful life
and salvage value. It can change these estimates and re-estimate the depreciation expense for
the asset going forward. But it may not revise the depreciation expense or accumulated
depreciation recorded in prior years.

The most commonly-used accelerated depreciation method is the double-declining balance

(DDB) method. DDB depreciation does not directly allow for an asset's expected salvage value.
Instead, the asset continues to be depreciated until its book value equals its salvage value, at
which point no further depreciation expense is recorded.

The depreciation expense is charged to Work-Process Inventory as a product cost and

subsequently transferred to Finished Goods Inventory and eventually to Cost of Sales.

IFRS permitted property, plant and equipment after initially being recorded at cost to be measured
at its market value. Generally, any subsequent change in the asset's market value is recorded in
other comprehensive income (see glossary).

The cost of any improvements or "betterment" to an existing asset must be capitalized. A

betterment makes the existing asset better than it was when it was purchased and/or extends its
life. It is recorded as an increase in the value of the existing long-lived asset.

Repair and maintenance costs are recorded as an expense and cannot be capitalized.

At the time of sale, any di erence between the sales price and the book value of the asset is
recorded as either a gain or a loss, depending on whether the sales price is greater or less than
the book value at sale date. Unless their magnitude is signi cant enough to warrant listing as a
separate line item on the income statement, gains and losses on sale are generally included in the
line item "Other Income," shown below "Operating Expenses" or "General & Administrative
Expenses.”

Research and development activities often result in the creation of new products which are
expected to generate future revenues. However, these types of outlays are not capitalized. The
outcome of research and development is considered too uncertain to meet the de nition of an
asset for nancial reporting purposes. As a result, the costs of these activities cannot be
capitalized and must be expensed.

In contrast, once a new product has been discovered (and the research uncertainty has been
resolved), any legal costs of ling a successful patent are viewed as being an intangible asset and
are capitalized.

To re ect usage over time, for most intangible assets, a portion of their cost is written-o or
amortized each period. This expense associated with this usage is called Amortization Expense
and usually estimated using the straight-line method. No contra-asset account comparable to
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Accumulated Depreciation is created to record the cumulative amortization of intangibles. Instead,
the cumulative amortization charge is credited directly to the intangible asset account itself.

Long-lived Asset Turnover - Revenues/Average Long-Lived Assets

Liabilities and Financing Cost

Businesses frequently enter into contracts known in law as executory contracts. These are
contracts where each party has yet to perform their part of the contract. These contracts often
appear to obligate the parties. However, in general, accounting does not recognize obligations
under an executory contract as liabilities.

Zero coupon debt - The borrower agrees to pay the lender a xed amount in the future in return
for receiving an amount today that is less than the future payment. The borrower is also relieved
from having to make periodic interest payments to the lender.

Initially, zero coupon loans are recorded as a liability at the amount received. Then, in each
subsequent accounting period, interest is accrued at the rate implied by the arrangement. The
accrued interest is recorded as an expense and an addition to the loan liability balance.

A lease grants the lessee the use of property for a speci ed time in exchange for a series of
periodic rental payments to the owner of the leased property. The owner of the leased property is
called the lessor.

Capital lease accounting assumes the lessee has in substance nanced the acquisition of the
right to use the leased asset with an installment loan. Consequently, the lessee records initially the
present value of the lease payments as a liability along with an asset in the same amount.
Subsequently, the leased asset is depreciated like any similar owned asset and the liability is
accounted for as an installment loan.

Under GAAP, a lease arrangement is classi ed as a capital lease if one of the following criteria are
met:

• Ownership of the leased asset is transferred to the lessee at the end of the lease term.

• The lessee has an option to purchase the leased asset at a bargain purchase price.

• The term of the lease is 75 percent or more of the leased asset's economic life (i.e., its
productive life).

• The present value of the lease payments discounted by the lessee's borrowing cost is 90
percent or more of the fair value of the property.

The particular depreciation method applied to the leased asset depends on the basis for
classifying the lease as a capital lease:

• If the capital lease classi cation is based on the lease meeting either the 75 percent or 90
percent test, the asset is depreciated over the lease term and salvage value is not considered.

• In contrast, if the capital lease classi cation is based on the lease meeting either the bargain
purchase or ownership transfer test, the asset is depreciated over its useful life to the lessee
and salvage value is considered.

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In contrast, IFRS's capital lease accounting standard is "principle-based" accounting standard.
IFRS stipulates that if substantially all the "risks and rewards incident to ownership" lie with the
lessee, the lease is a capital lease. Otherwise, it is an "operating lease.”

If a lease is not a capital lease, it is classi ed as an operating lease. The accounting for an
operating lease is straightforward. The periodic lease payments are simply recorded as a lease
expense each year. Neither a liability nor an asset is recognized.

Operating Lease:

Rental Payment - operating cash ow

Capital Lease:

Rental Payment:

Interest portion - operating cash ow

obligation reduction - nancing cash ow

Since the capital lease obligation is viewed as a form of debt, when the obligation is displayed in
the balance sheet it must be presented in two parts:

• The next year's principal reduction portion in the next annual lease payment is shown as a
current liability in the current period's balance sheet.

• The obligation remaining after the current portion is deducted from the total end-of-period
obligation and is reported as a non-current liability.

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Loss contingency - the obligation involves uncertainty as to the possible cost which will only be
resolved by some future event that may or may not happen.

Opposite - Gain Contingency

Conservatism - gain contingencies aren’t recognised until they are realised

A loss contingency is recognized as a liability when both of the following conditions are met:

• Information available prior to the issuance of the nancial statements indicates that it is
probable that an asset has been impaired or a liability has been incurred (That is, the three
liability criteria have been met).

• The amount of the loss can be reasonably estimated.

IFRS refers to those contingent liabilities that GAAP recognizes on the balance sheet as
"provisions," not "contingent liabilities." The term "contingent liability" is reserved to describe
those unrecognized contingent liabilities that under GAAP and IFRS may or may not have to be
disclosed.

Debt rated triple B or better is considered to be of "investment grade." It is considered to be a

relatively safe investment.

Many unrated and less than investment grade debt are referred to as "junk bonds.”

Interest coverage ratios:

EBITDA Coverage Ratio = EBITDA/Total Interest Charges

Generally, the higher the EBITDA coverage ratio, the higher is a company's debt rating.

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 Investments and Investment Income
One rm controls another if it owns a majority (i.e. more than 50%) of its common equity. As noted
above, managers typically view controlling investments as long-term and strategic. These types of
investments are called business acquisitions or combinations and are accounted for using
the purchase method.

Investments in corporate debt or equity stakes of less than 20% are usually viewed as not
involving control. These types of investments arise when a rm is using the investment as a
convenient temporary place to park excess cash. These investments are called marketable
securities and are accounted for using either the cost or market method.

Investments in the equity of another company that are 20% or more, but less than majority
ownership are likely to provide the acquiring rm with some in-between level of control. These
types of investments are called equity investments or investments in associated
companies and accounted for using the equity method.

Marketable Securities are shown as current assets on the balance sheet. They are investments
that are

• Readily marketable

• Expected to be converted to cash within a year

• Have no control implications for the company whose securities are acquired

Popular marketable security investments include commercial paper and treasury bills:

• Commercial paper is the name given to a type of short-term interest bearing note issued by
corporations.

• Treasury bills are interest paying short-term obligations sold by the U.S. Treasury.

Other forms of marketable securities include the marketable common stock of other companies,
corporate promissory notes and corporate bonds.

Investments that are not marketable or that are going to be held for longer than a year, but which
do not provide the owner with any control rights, are listed as long-term investments rather than
marketable securities on the balance sheet. These investments are accounted for at their cost.

Accounting classi es an investor's intent in one of the following three categories. They are:

• Hold-to-maturity

• Trading

• Available-for-sale

Hold-to-maturity marketable securities are debt securities that the investor intends to hold to
maturity. These types of marketable securities are accounted for on the balance sheet at their
cost.

Trading securities are debt and equity securities that the holder intends to sell in the near term
as part of a plan to earn pro ts from short-term movements in the security's price. Trading
securities are accounted for at their market value. That is, at each balance sheet date they are
reported at their current market value. Any unrealized gain or loss since the last balance sheet
date is included in the income statement as investment income. When the security is eventually
sold, any additional gains or loss is also recorded in the income statement as investment income.

Available-for-sale securities are debt and equity securities that do not fall into either the hold-to-
maturity or trading security categories.

Like trading securities, available-for-sale securities are reported on the balance sheet at their
market value. However, unlike the case of trading securities, unrealized gains and losses on
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 available-for-sale securities are not shown as Investment Income. Instead they are directly
credited/debited to a special shareholders' equity account called Unrealized gains and losses on
Available-for-Sale Securities. When the security is sold and an actual gain or loss is realized, any
related unrealized gain or loss recognized to date is eliminated from owners' equity and the actual
gain or loss is recorded in the income statement.

Business acquisitions are recorded using the acquisition method of accounting. Under this
method, the acquiring company records on its balance sheet the fair value of the net assets
(that is the assets net of any liabilities) that it acquires. Fair value is the amount a willing buyer and
seller would exchange for an asset or liability in a current transaction, other than a forced or
liquidation sale.

If the purchase price is greater than the fair value of the net assets acquired, the excess purchase
price is recorded as an asset called goodwill, and is reported as an intangible asset on the
balance sheet. Net assets acquired is the di erence between the value of the acquired assets
excluding any goodwill and the value of the acquired liabilities.

Purchase Price = Fair value of assets acquired + Fair value of liabilities assumed + Goodwill

The accounting for goodwill di ers from that of most other intangibles since it is not amortized.
Instead, it is tested annually for impairment and, if impaired, the decline in the value of the asset
is re ected on the balance sheet and an expense for the amount of the impairment appears on
the income statement.

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 Deferred Taxes and Tax Expense
Standard setters have dealt with these accounting di erences by requiring that the tax expense
be based on Income Before Taxes in the nancial reporting books rather than Taxable Income in
the tax books. This leads to the creation of a deferred tax accrual to re ect the tax e ect of any
accounting method di erences that exist between the two sets of books. Consequently,
accountants refer to these accounting di erences as "temporary accounting di erences”.

Deferred tax accounting is used when the following three conditions hold:

• A transaction or event is accounted for di erently in an entity's nancial reports and income tax
returns.

• The accounting e ect of the di erence in accounting policies is temporary in that the early
period e ects of the di erence are reversed in later periods.

• The accounting di erence has tax consequences.

Permanent di erences occur when either revenue or expenses are recognized for tax return
purposes but never for nancial reporting purposes or expenses or revenues are recognized for
nancial reporting purposes but never for tax return purposes. In other words, permanent
di erences are accounting di erences that do not reverse in future periods.

Deferred Tax Liabilities - A deferred tax liability is the future tax consequences attributable to
temporary accounting di erences between nancial and tax accounting policies where the future
tax consequences result in higher future taxes.

It is an unusual liability. Unlike most liabilities, it is not a present obligation to transfer resources to
another entity.

Instead, it is little more than a balancing credit entry to the liability section of the balance sheet to
o set a debit entry made to the income statement. This debit entry is made so that the income
statement is not misleading.

Deferred Tax Assets - opposite of deferred tax liabilities. Deferred tax assets arise when
temporary di erences between a company's nancial and tax accounting result in future lower
taxes.

Deferred tax assets can arise also if there are no temporary di erences in reporting methods used
for tax and nancial reporting books, but the rm reports losses for tax purposes. The amount of
the past losses carried forward to o set future taxable income is called a "tax loss
carryforward.”

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 The US tax code also provides for "tax loss carrybacks." This provision of the codes permits
companies to use their current tax return losses to o set taxable income reported in prior periods.
This may result in a refund of prior period tax payments.

The tax expense in a rm's income statement can be divided into two components, the current
portion and the deferred portion.

• The current portion is the tax due to the tax authority that period.

• The deferred portion is the tax accrual required to re ect any temporary accounting di erences
between nancial and tax accounting policies.

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Bad Debt:

0.4*(22,000 - 57,000) = -14,000

creates Deferred tax asset

Depreciation:

0.4*(212,000 - 106,000) = 42,400

creates Deferred tax liability


 Owner’s Equity
The di erence between the issue amount and the par value is called Additional Paid-in Capital.
It also appears on the balance sheet in the owners' equity section.

The sum of the par value and additional paid-in capital for common stock is called Paid-in
Capital.

There are several important di erences between preferred stock and common stock:

• Preferred stock is less risky than common stock since it has higher priority in receiving dividend
payments and return of capital in the event of a liquidation of the company.

• Preferred stock does not have voting rights.

• Preferred stock is typically entitled to a xed dividend rate, comparable to xed interest debt. In
contrast, common stock is not entitled to any speci ed dividend payment.

There are many di erent types of preferred stock:

• Cumulative Preferred Stock: speci es that if the company is unable to pay the preferred
dividends in a given year, it cannot pay any common stock dividends until the preferred
dividends in arrears are fully paid.

• Convertible Preferred Stock: speci es that the preferred stock can be converted into common
stock at a de ned exchange rate at the option of the preferred stock owner.

• Redeemable Preferred Shares: specify that the issuing company must buy back the preferred
shares at a de ned price within a de ned time period.

Sometimes companies buy back their own common stock. This purchased stock is called
treasury stock.

If the company subsequently reissues treasury stock, any gain or loss is treated as an adjustment
to additional paid-in capital. A gain or loss on the sale of treasury stock is never included in the
determination of net income.

The stocks of rms that pay dividends are called income stocks, and tend to attract a di erent
class of investor than those that avoid dividends to focus on growth. Investors attracted to
income stocks include:

• Retired investors who want a steady stream of income, and

• Institutions that do not pay taxes on dividends.

Accounting for stock splits is straight-forward. If the rm's stock has a par value, a split changes
the par value of the stock but not the aggregate book value of paid-in capital. To record this
change, stock with the old par value need to be removed from the books and stock with the new
par value recorded along with an adjustment to the stock's par value.

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 Sometimes companies do not change the par value when they split their stock. In these cases, a
credit equal to the par value of the stock issued is made to common stock. A debit for the same
amount is made to retained earnings.

Stock splits that result in an issuance of new shares that in total are less than 20 - 25 percent of
the outstanding shares are called a stock dividend. In this case, a debit entry equal to the market
value of the shares issued is made to retained earnings. A compound credit entry is made to
common stock for the par value of the issued stock along with an entry to additional paid-in-
capital for the di erence between the stock's market value and its par value.

If a company grants a stock option to a manager, the manager has the right to buy the stock
from the company at a speci ed price, called the exercise or strike price, within a speci ed
period, called the exercise period.

The option is then said to be 'out-of-the-money' when the value of the stock is lower than the
option's exercise price.

Stock options granted to top management have a number of bene ts:

• They motivate the managers to make decisions that increase the value of the company's stock,
consistent with the interests of the company's shareholders.

• They are a non-cash form of compensation which can be bene cial for cash-constrained young
companies.

• Since stock options are typically forfeited if the manager leaves the company, stock options
provide a way to reduce management turnover.

• They attract managers who are entrepreneurial and risk-seeking.

However, stock options also can have costs for the organization:

• If the stock price falls signi cantly after stock options are granted, so that the options are well
'out-of-the-money' they are likely to have limited positive employee motivation bene t.

• Options have been linked to earnings management and fraud as managers at some companies
have sought to boost their rms' stock price.

Because the Income Statement does not include all changes in Owners' Equity, standard setters
now require rms to prepare a Comprehensive Income Statement to provide investors with
such a reconciliation.

The Comprehensive Income Statement shows changes in shareholders equity arising

from all changes other than new investments by or distributions to owners, and in the case of
Global Grocer includes:

• Net Income, and

• Unrealized gains and losses on available-for-sale securities

Return on Equity or ROE - This ratio is simply Net Income divided by Owners' Equity. Equity can
be beginning, ending or average.

A rm can improve its ROE by

(a) increasing net income margins though improved pricing or cost controls,

(b) increasing asset turnover, by reducing its working capital needs or making long-term
assets work more productively, or

(c) by increasing the rm's nancial leverage by taking on additional debt nancing.

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