Classified Balance Sheet (11-14) – snapshot of accts on a particular date

1. Assets:

1. current assets

1. used within 1 yr

2. e.g. marketable securities, notes receivables, accts receivables, inventories, prepaid expenses

2. long-term investments

1. longer than 1 yr

2. stocks and bonds held onto; notes receivables and accts receivables which cannot be collected within 1 yr; prepaid expenses that cover more than 1 yr

3. fixed assets

1. land, equipment, furniture

4. intangible assets

1. patents, goodwill

2. Liabilities (12)

1. current

1. less than 1 yr must be paid

1. notes payable: money borrowed under promissory notes due within one yr

2. accts payable

3. accrued liabilities or wages: services already performed

4. unearned revenues: amts which co will have to refund if it does not perform the services

2. long-term

1. lease; mortgage due in more than 1 yr

3. liabilities get priority when liquidation occurs, so listed before SH’s equity

1. secured claims: co has pledged one or more assets as collateral comes next during liquidation

3. SH’s Equity

Income Statement (28) – how much net worth (equity) has changed over a period

1. gives a summary of earnings or losses btw balance sheet dates

2. Revenues: increase in assets, decrease in liabilities from services central to operations

1. gains: increase in assets, decrease in liabilities from incidental txns not involving investments by owners

2. professional income

3. Expenses: decrease in assets, increase in liabilities from services central to operations

1. losses: decrease in assets, increase in liabilities from incident txns which do not involve distributions to owners

4. Net Income = proprietorship

Statement of Changes in Owner’s Equity (49)

1. Drawings: dividends or distributions

2. SH’s Equity – 3 components (53) – used by accounts

1. capital stock: common stock, preferred stock

2. additional paid in capital/capital surplus: capital contributed in excess of par

3. retained earnings – track all undistributed profits that remain invested in the corp.

3. SH’s Equity – 3 components (61) – used by attys

1. stated capital

2. capital surplus

3. earned surplus

4. Legal Capital or Stated Capital (54)

1. stated capital = issued shares X par value

1. e.g. 1000 shares at $1 par but sold for $20

1. stated capital = $1,000

2. capital surplus = $19,000

2. Capital Surplus = the amt of the shares sold that exceeds the stated par value

1. capital surplus is recorded as “additional paid in capital”

3. stated capital + capital surplus = the total capital that SH’s contribute to a corp. (Look to lawful dividends section for restrictions)

4. treasury shares (repurchases shares) = issued shares – outstanding shares

5. required par value bc ensure investors that all SHs purchased their shares for equivalent amts (cannot purchase for less than par value)

1. but corps don’t have to bear any specified par value (p.56)

6. can’t distribute when paying dividends more than stated capital

1. very nominal par value minimized the contributed capital that CANNOT be distributed to the SHs.

5. Shares with Par Value (57)

1. capital stock + add’l paid in capital = corp’s total contributed capital

2. TO FIND ISSUED SHARES – look on balance sheet and also the Capital Stock Footnote (p.59 for e.g.)

6. No Par Shares (60)

1. stated value = the amt allocated to stated capital with no par amt (directors come up with this number)

7. Earned Capital (61)

1. reinvested earnings by the co: repurchase shares; pay dividends

2. Retained Earnings/earned surplus: earnings that remain invested in the co.

1. In legal Capital system it is called “Earned surplus”

STATEMENT OF CASH FLOWS (122)

1. Cash flow: refers to the movement of cash into and out of the enterprise, can det the co’s financial success

3. must have access to cash to meet “recurring expenses” → payroll, rent, pay accts payable, pay outstanding debt

2. Revenue form operations provide primary source of cash, but some txns not reflected in the income statement (borrowing money, paying cash dividends, purchasing long-lived assets) may significantly increase or decrease cash.

3. a number of txns (borrowing, issuing new stock, or buying capital assets) greatly affect cash but do not appear in the income statement for the period and emerge on the balance sheet at the end of the period.

4. Common Cash Inflows:

1. sales for cash

2. collection of accts receivable

3. short and long-term borrowings

4. sale of property, plant and equipment

5. issuance of stock for cash

5. Common Cash Outflows:

1. operating expense

2. acquisition of property, plant, equipment or other long-term assets

3. repayment of short and long-term debt

4. distributions to owners

6. Statement of Cash Flows: reports the changes in cash and cash equivalents during acctg period and explains those changes.

1. Purpose: (listed on p124)

2. assess ability to generate positive future net cash flows

3. ability to mt obligations, pay dividends, needs for external financing

4. reasons for diff btw net income and associated cash receipts and payments

5. asses the effects on co’s financial position of both cash and noncash investing and financing txns during the period

2. cash and cash equivalents: short-term, highly liquid investments

1. cash equivalents must mt 2 requirments:

1. co msut be able to convert the equivalents to cash readily

2. equivalents orig maturity dates must not exceed 3 months so that changes in interest rates do not threaten to affect adversely their value

2. e.g. of cash equivalents: US Treasury bills, commercial paper, money mkt funds

3. must incl defn of cash equivalents in a related disclosure to its statement of cash flows

7. Classification of Statement of Cash Flows (126)

1. 3 categories:

1. operating activities:

1. acquiring and selling the co’s products and services

2. cash inflows from op activities incl interest and dividends form loans to and ownership investment in other co’s

3. cash outflows incl cash interest payments to lenders and creditors

4. Direct method:

1. report major classes of cash payments and receipts

1. 7 classes listed on p127

2. acctg stds require that co’s that use the direct method of reporting net cash flows form op to incl an indirect operating section in its financial statements

5. Indirect method:

1. reconcile net income, prepared under accrual acctg to net cash from operations

2. co’s that use indirect method must also disclose the amts of interests and income taxes paid during that period either on the face of the statements of cash flows or in the notes to the financial statements

3. indirect op section must also report changes in inventory, receivables and payables

2. investing activities:

1. incl acquiring and disposing of long-term investments and long-lived assets

2. cash expenditures to acquire other co’s through merger or stock acquisition

3. Capital expenditure: manufacturing co’s spend most on property, plan and equipement

4. DOES NOT incl interest and dividends form long-term investments

3. financing activities

1. incl obtaining of resources form owners and providing them with a return on their investment.

2. issuance and retirement of short and long-term debt from creditors

3. Cash outflows incl cash dividends or other distributions to owners

2. statement of cash flows must reconcile the total change in cash for the period with beginning and ending balances which appear on the current and prior balance sheets.

3. NONCASH INVESTING AND FINANCING ACTIVITIES (128)

1. does not fall into any of the 3 categories bc does not involve cash transfer

1. e.g. xchange stock for assets of another co, converting debt to equity, acquiring assets by assuming related liabilities, exchanging noncahs assets for other noncash assets

2. not required to report on the statement of cash flows → but must disclose in the footnotes

8. DISCLOSURES

1. disclose policy for determining which items are cash equivalent, if change policy and must disclose that

9. CONSOLIDATED FINANCIAL STATEMENTS (132)

1. defn: aggregate financial data for a parent co and its majority and wholly owned subs as if the parent and subs constitute a sgl acctg entity.

2. SUMMARY on p.136

3. “intra-family” obligations/liabilities do not belong on the composite picture, an accountant would eliminate any liabilities btw X and Y in the consolidation process by canceling the receivable in one corp’s accts agst the payable on the other corp’s books. (135)

4. retained earnings is the same after txn bc it is the parent’s retained earnings (parent is in effect buying Y’s net assets incl the retained earnings)

5. eliminate parent’s investment in the sub, substituting instead the sub’s assets and liabilities. Also eliminate the sub’s equity accts and any intercompany txns → avoid duplication and premature revenue recognition

1. e.g. must subtract from parent’s cash account (or asset account) the sub’s total assets bc that is how much the parent invested in the sub. On the consolidated balance sheet, an add’l account for “investments” would be added. (133 – look at example)

2. after subtracting from cash account, on the consolidated balance sheet, must once again reflect the sub’s ind cash and plant account and add to parent’s accounts to get net amt.

6. common stock reflects the common stock of the parent (it does not change)

1. each share of capital stock in a corp is a proportionate interest in the equity of the corp

7. consolidating financial statements incl not only consolidated financial statements, but also the financial statements of the consolidated group’s ind components in diff columns plus column for any eliminations (p.136)

8. combined financial statements aggregate accts of commonly controlled co.s that do not share a corp parent

1. e.g. an ind may own shares in both X corp and Y corp

2. present no only combined statements but also the sep financial statements for each member of the combined grp plus a sep column for any eliminations

9. STEPS: subtract investment from cash of parent, then get = Investment – (total assets of sub – liabilities of sub) and add to parent’s cash, also add the cash of sub to get total cash for consolidated balance sheet.

The Need for Accounting Principles (141-146)

1. So users can compare one enterprise to another, and from successive periods.

2. Managers may not be the most objective reporters of their own performance

3. Indep Auditor:

10. check on underlying facts represented in fin stmts

11. review of principles applied in portraying the info

4. SEC has authority to estb acctg principles but has deferred to acctg profession

1. Congress has implicitly retained the power to mandate acctg principles

2. registrant: 500 or more owners and $10M

How do Acctg Principles Become Generally Accepted? (p.167)

1. GAAP Hierarchy (168)

3. Category a: officially promulgated by a body that the AIPCA Council has designated to establish such principles under Rule 203 of AICPA Code of Professional Conduct

1. SEC’s rules and interpretative release carry similar status for SEC registrants

1. SEC registrants place SABs and EITF here.

2. e.g. FASB statements, FASB interpretations

3. ARBs that are not superseded.

4. APB Opinions and interpretations that FASB has not superseded

5. CAP

4. Category b: pronouncements from bodies of expert accountants that deliberate acctg issues in public forums

1. pronouncement must meet two conditions

1. relevant body must have exposed pronouncement for public comment

2. body which qualifies to establish Category a principles (category a organizations) must have cleared the pronouncement

1. category a orgs can’t object

2. FASB Technical Bulletins

3. AICPA Industry Audit and Acctg Guides

5. Category c:

1. pronouncements from bodies of expert accountants that category a formed and discuss acctg issues in public forums

2. pronouncements that would otherwise qualify in category b EXCEPT was not exposed to public comment.

3. e.g. EITF consensus positions (is raised to category a status by the SEC – look in book) and AcSEC Practice Bulletins

6. Category d:

1. knowledgeable application of generally accepted pronouncements to specific circumstances

2. practices that accountants acknowledge as enjoying general acceptance.

7. Other accounting literature (p.170)

Who Selects Among Generally Accepted Acctg Principles? (173)

1. Mgmt chooses

8. mgmt selects an indep auditor

9. opinion shopping: mgmt can put pressure on auditor by threatening to fire

1. SEC requires full disclosure of changes in auditors → reduce pressure

2. Auditor can influence by threatening to issue a qualified opinion.

1. Qualified Opinion: can change a co’s financial status

2. Adverse opinon

3. Clean Opinion: acceptable GAAP stds. but even an unqualified opinion does not guarantee accuracy bc only takes a sample (5% or less of annual txns)

1. bc test sample txns→ observed deviations may indicate larger problems → internal control plays a factor

Generally accepted auditing stds (180) – auditing procedure chosen by the auditor

1. Overview:

4. Auditing Stds:

2. require an auditor to opine whether the financial statements fairly rep the enterprise’s financial position and results of operations and cash flows in conformity with GAAP.

3. make sure no material misstatements or omissions

5. Need for audit:

1. Information risk: principle (SH) lack access to info of agents (Mgmt), need indep monitor to reduce info risk

1. if monitoring reduces info risk to principal, then cost of capital drops for the agent bc principal will accept lower return.

2. various users of financial statements (owners, creditors, potential investors, lenders, regulatory bodies) want assurances

6. Auditor seeks to verify the underlying txn and events reported in the financial statements to test the application of GAAP

1. SEC has power to estb auditing stds but has only occasionally done so, as a result, acctg profession through the AICPA’s Auditign Stds Board has det

2. Independent Auditor’s Role (182)

1. can’t audit co if CPA’s firm owns a direct or material indirect financial interest in the registrant

2. auditors can be held personally liable.

3. The Audit Process (200)

1. audit gathers evid abt 5 categories of assertions made by financial statements

1. reported assets and liabilities exist and that recorded txns occurred during the particular acctg period

2. that financial statement present all tranxns and accounts

3. listed assets represent the enterprise’s rights and the reported liabilities show the business’s obligations

4. appropriate recording of assets, liabilities, revenues, and expenses

5. enterprise has properly classified, described and disclosed the financial statements’ components

4. 3 phases:

1. planning audit and assessing internal control (203)

1. must assess client’s internal control before developing an audit program

1. investigate the client’s business and accounting policies

2. info on conditions in the industry

3. business products and services

4. sales trends

5. major customrs

6. production and mktg techniques

7. characteristics of mgmt, personnel

8. budgeting and acctg systems

9. affiliations with outside influences

2. will review prior years audit results

3. internal control: means systems, procedures and policies that co employs to help assure that organization proper execution and recording of txns

1. can be administrative controls

1. plan of organization, procedures, records that lead up to mgmt’s aurthorization of txns

2. or acctg controls

1. plan, procedures and records which co uses to safeguard assets and produce reliable financial records

3. e.g. cash registers that display prices and totals, that total all txns during a shift to discourage clerks in pocketing money

4. conduct some compliance tests to det if internal controls function → then decide whether to rely on some to reduce the need to test actual txns

5. VOUCHING: selects a txn recorded in the books to det whether underlying data supports the recorded entry

6. TRACING: choosing a particular item and follow through the accounting books to det whether co has properly recorded and accounted for the data

7. FCPA (Foreign Corrupt Practices Act) – made professional auditing stds an explicit statutory requirment

1. antibribery provision

1. 13b2B: required to maintain internal accounting controls (look on p205 for list of conditions that must be met)

2. accounting requirements

1. 13b2A: federally mandated minimum record-keeping and internal controls stds for all co.s

3. 1988 amendment: defn reasonable detail

2. implementing audit program

8. Audit program: plan that sets forth the detailed procedures that auditor will perform to text txns (defn on p215)

9. based on initial info gathered from internal control, auditor makes a prelim materiality judgment and risk assessment which determine the nature, timing, and extent of the procedures

10. TYPICAL AUDIT:

4. verify tangible assets

5. observe business activities

6. confirm account balances

1. e.g. accts receivable: money that customers owe client → might select customers randomly and confirm outstanding balance

7. check math computations and seek confirmation from mgmt and outside counsel

11. AUDIT WORKING PAPERS:

1. documentation of procedures and findings

2. e.g. schedules, memos, analyses and corresponding results

3. reporting the results

12. must have “reasonable basis” to express and opinion

13. report states 4 things:

3. financial statements remain mgmt’s responsibility

4. express an opinion on the financial statements based on audit

5. auditor conducted the audit in accordance with generally accepted auditing stds which require the auditor to plan and perform the audit to obtain reasonable assurance that the financial statements do not contain material misstatements

6. financial statements present fairly in all material respects, the financial position, the results of operations and cash flows in conformity with GAAP.

5. Incentives for estb strong internal controls (213)

1. Sentencing Guidelines

1. reduced penalties: offers leniency to wrongdoers that can show they have estb a strong internal control

2. enormous losses due to inadequate internal controls

1. derivatives: financial contracts that base their value on some underlying asset, such as bonds or foreign currencies

1. properly used derivatives offer co.s the ability to manage and transfer risk but at the same time, can provide a recipe for financial disaster

6. Establishing Generally accepted auditing stds:

1. SEC deferred to acctg profession on auditing stds→ acctg profession turned responsibility to develop and promulgate GAAP to FASB, but the corresponding duty to set auditing stds still lie with the AICPA through the ASB (auditing stds board)

7. Regulations S-X and S-B (sml business): (220)

1. address accountants qualifications, provide rules regarding the form and content for financial statements

1. can’t audit if CPA or CPA’s firm or member of the firm owns financial interest with co or subsidiaries

2. can impose disciplinary sanctions

8. GENERALLY ACCEPTED AUDITING STANDARDS (10 statements fall into 3 grps) (225) – very broad stds and does not estb specific procedures

1. General Standards:

1. auditor must possess adequate technical training and proficiency

2. auditor must maintain indep mental attitude in all matters relating to the assignment

3. auditor must exercise due professional care

2. Standards of Field Work:

1. adequately plan the work and properly supervise any assistants

2. properly study and evaluate the exiting internal controls to assess whether can rely on

3. obtain sufficient competent evid, through inspection, observation, inquiries, or confirmation to form reasonable basis

3. Reporting Standards:

1. report must express whether comply with GAAP or expln why must disclaim an opinion

2. Change in practice must be reported along with why: report must id circumstances in which the co has not consistently observed those principles in the current period in relation to preceding period

3. profession regards info disclosure in financial statements as reasonably adequate unless the audit report specifically states otherwise

4. express and opinion regarding financial statements as a whole or expln why must disclaim an opinion.

9. AUDITING PROCEDURES: (226)

1. e.g. reconciling cash amts in ledger with the balances reflected in statements from financial institutions

2. observing physical inventories

3. price testing inventories

4. confirming assets and liabilities

5. txnal testing involving expenses, purchases, sales and payroll

6. performing cut-off tests btw acctg periods

7. reading minutes of SH and director mtgs

8. obtaining representation letters form mgmt and attys

10. EXPECTATION GAP (227) – diff expectations between what investors and other users of financial statements expect and that which auditors provide

9. auditor assess the risk that errors and fraud may cause the financial statements to contain material misstatements.

1. auditor must design audit plan that will detect material misstatements

10. General Rule: → rejected by the SEC however (SEC adopted a case by case analysis)

1. any amt under 5% of income before taxes as immaterial, any amt over 10% of income before taxes as material

2. material has different meaning to different co.s

11. Qualitative factors to consider when determining “materiality”

1. sml omission could nevertheless qualify as material if:

1. arises from an item capable of precise measurement

2. masks a change in earnings or other trends

3. hides a failure to mt analysts’ consensus expectations for the co

4. changes a loss into income or vice versa

5. list continues (229)

11. “PRESENT FAIRLY” (230)

1. in addition to complying with GAAP, also requires auditor to assess whether:

1. whether acctg principles selected by mgmt enjoy general acceptance

2. acctg principles are appropriate in the circumtnaces

3. financial statements and related notes provide info abt those matters that may affect their use, understanding and interpretation

4. FS classify and summarize info, neither providing too much detail nor too few specifics

5. FS reflect underlying txns that presents the financial position, results of op and cash flows stated within acceptable limits that co can reasonably attain

12. IN CASE OF FRAUD AND OTHER ILLEGAL ACTS (231)

1. Private Securities Litigation Reform Act – Reporting requirements

1. if uncover illegal act, auditor must investigate and assess effects on the FS.

2. unless “clearly unconsequential” then auditor must inform mgmt and audit board

3. if mgmt does not take remedial measures and auditor reasonably believes failure to do so would warrant either departure form auditor’s std report or resignation form the audit engagement → then must report to board of directors

4. client/registrant must then notify SEC within one business day and the auditor, if auditor doesn’t receive in one b day then report to SEC

13. STANDARD AUDIT REPORT (will generally compare present with previous yrs) (234)

1. Components:

1. General Elements:

1. contain a title that includes the word “independent”

2. id a specific addressee

3. auditing firm’s manual or printed signature will appear at the bottom

4. date the report → usually rep the last day that the auditor performed field work

2. Introductory Paragraph:

1. id the financial statements that the indep auditor examined and states auditor audited those docs

2. state the various parties that are responsible for financial statement (mgmt) and opinion on the statements based on audit (auditor)

3. Scope Paragraph:

1. state auditor performed in accordance with GAAS

2. state GAAS require the auditor to plan and perform the audit to obtain reasonable assurance that FS don’t contain material misstatements

3. state scope describe an audit and that it includes 3 steps

4. state whether auditor believes the audit provides a rsnble basis for the audit opinion

4. Opinion Paragraph:

1. whether FS present fairly in all material respects a co’s financial position as of the balance sheet date, plus the results of its op and its cash flows in accordance with GAAP

2. unqualified opinion: yes, FS do present fairly…

2. 4 other kinds of reports: (236)

5. unqualified opinion with explanatory language (necessary in the following circumstances)

3. using another auditor’s work

4. change in acctg principles or in the way application has materially affected the comparability of FS btw acctg periods

5. FS must depart from promulgated acctg principles to avoid misleading presentation

6. qualified opinion notes exceptions in the FS which do not conform to GAAP

6. EXCEPT (always contain this word) for the effects of the matter to which the qualification relates, the FS present fairly in all material respects, the co’s financial picture

7. prevention of full audit bc lack of acctg records

7. adverse opinion: that statements do not fairly present the financial position, op results, or cash flows

8. states that FS do not present fairly…in conformity with GAAP

9. should expln the deviations

8. disclaimer of opinion: opinion that states auditor can not express any opinion

1. e.g. auditor has not performed an exam sufficient in scope to enable to form an opinion bc co. failed to make account of certain things.

14. ALTERNATIVES TO AUDITS (240) - privately owned co.s do not need to file audited FS with the SEC

3. Two kinds:

9. Review: limited examination by accountant, and limited assurance

2. only give accountant rsnble basis for expressing limited assurance that FS do not require any material changes to conform to GAAP, OR another basis of acctg such as cash method.

3. consists mostly of inquiries with co personnel and analytical procedures applied to financial data → discuss co’s ops with mgmt to det any changes in business

4. does not require accountant to become familiar with the internal controls

10. Compilation: does not express opinion or assurance, accountant converts info that mgmt has provided in the form of FS

1. accountant takes info that remains representations of the mgmt into the form of FS.

2. accountant prepares FS without expressing any assurance that the statements fairly present the co’s financial condition or accordance with GAAP

3. should have general understanding of business

4. need not be indep, but must disclose if not indep

4. GAAS do not govern either, AICPA’s Statements on Standards for Attestation Engagements govern these two procedures

5. Other services provided by accountants

1. special report on specific elements

15. PUBLISHED SOURCES OF GAAP, GAAS (243)

1. GAAP

1. FASB publishes annually “ Original Pronouncements” → contain the most authoritative sources of GAAP

2. FASB also publishes EITF abstracts

3. CCH Inc (Commerce Clearing House) publishes info abt SEC and fed securities laws

2. GAAS

1. AICPA (American Institute of Certified Pubic Accountants) publishes two sets containing various auditing stds

1. first volume contains US auditing stds incl SASs and related Auditing Interpretations and attestation stds

2. 2nd volume contains the stds applying to reviews and compilations

TIME VALUE OF MONEY (a dollar today is always worth more than a dollar tomorrow)

1. Overview:

3. For borrower: time value of money refers to the interest expense of borrowing money over a period of time

4. For lender: refers to the interest earned from lending or investing money

5. P: a lawyer rep P should remember to request prejudgment interest

6. D: lawyer rep D in a lawsuit seeking future lost profits, should ask the court to reduce any such award to present value.

2. INTEREST (276)

1. Overview:

2. formula: interest = rate over a specified period of time

3. Interest = Principal x Rate x Time

3. Borrowers: pay interest when benefit they receive from spending the money outweighs the interest they pay to borrow

4. Lenders and investors: lend money when they believe that the interest income they will earn in the future outweighs the opportunity cost of spending today.

2. Factors Determining Interest Rates

1. pure rate of interest: rate which lenders would charge and borrowers would pay if the risks did not exist. (usually btw 2-3% each yr)

1. e.g. US Treasury obligations → risk free interest rate

2. inflation premium: compensates the lender for inflation expected over the loan’s term

1. inflation risk: general loss in purchasing power that rising prices cause, when inflation increases → interest rates ↑, when price level declines → interest rates ↓

3. maturity premium: offsets the risks associated with committing funds for longer periods.

1. long term interest rates have exceeded short term interest rates for investments presenting similar risks.

4. default premium: risk that the borrower will default on the loan and that lender will lose the loan principal and any accrued interest.

1. US Treasury obligations (bonds) do not incl a default premium.

2. e.g. diff rates btw bonds with similar maturities in diff risk categories (US Treasury bonds – high grade corp bonds – below investment grade bonds “junk bonds”) reflect the default premium.

5. illiquidity premium: compensates the lender for lack of marketability and the resulting price concession that lender may have to grant if unexpected circum force lender to sell the debt instrument

3. SIMPLE INTEREST CALCULATION (279)

1. Interest = Principal x Rate x Time

1. Interest = dollar amt of interest

2. Principal = amt of money debtor borrows

3. Rate = cost of borrowing $1 per unit of time (interest rate)

4. Time = # of periods, look on table (1049) # of units of time that principal remains unpaid (1 yr = 1 unit)

2. Simple interest: borrower pays interest on the original principal amt only regardless of any interest that has accrued in the past.

4. COMPOUND INTERST CALCULATION

3. borrower pays interest on the unpaid interest of past periods as well as the orig principal.

4. Lenders and investors prefer more frequent compounding bc compounding produces higher interest

5. Borrowers prefer simple interest or compound interest with less frequent compounding

6. 2 yr term compounded annually with a principal of 10,000 @ 8%

1. 10,000 x .08 x 1 = 800 after first yr

2. 10,800 x .08 x 1 = 864 after the second yr

7. APPENDIX B – contains four tables of shortcuts for 4 diff types of compound interest calculations (1049)

1. FV of an amt

2. FV of a series of equal amts

3. PV of an amt

4. PV of a series of equal amts

8. FUTURE VALUE (FV)

1. defn: sum to which an amt or series of periodic and equal amts will grow at the end of a certain time, invested at a particular compound interest rate.

2. FV = amt which current principal (p) will grow at the end of (n) periods, invested at (i) compound interest rate.

3. FV of a sgl amt compounded interest annually

1. Example 5 (281)

1. 40,000 invested from 1901-2000 @ 5% compounded annually

2. 40,000 x .05 x 99

1. first find factor for 50 periods = 11.46740, which tells us that one dollar will grow to abt 11.47 if invested at 5% compound interest for 50 yrs → 458,696

1. 40,000 x 11.46740 = 458,696

2. next find factor for 40 yrs = 7.03999

1. 458,696 x 7.03999 = 3,229215.25 (the 458,696 @ the end of 90 yrs)

3. finally take the factor for 9 periods = 1.55133

1. 3,229215.25 x 1.55133 = 5,009578.49 after 99 yrs

4. FV of sgl amt compound semiannually

1. 10,000 @ 8% compounded semiannually, how much at the end of 10 yrs?

1. in 10 yrs will be compounded 20 times, every six months earn 4% interest

2. find 4% interest for 20 periods = 2.19112

3. 10,000 x 2.19112 = 21,911.20

2. 10,000 @ 8% compounded quarterly, how much at the end of 10 yrs?

1. at end of 10 yrs will have compounded 40 times, every 3 months earn 2% interest

2. find 2% interest for 40 periods using Table I = 2.20804

3. 10,000 x 2.20804 = 22,080.40

5. Rule of 72s or Doubling an Investment (283)

1. dividing 72 by t.he interest rate gives us the approximate number of yrs in which an investment will dbl at compound interest

2. e.g. if 8%, 72/8 = 9, look at table and it tells you that 8% in 9 periods will = 1.99900 (close to dbl)

3. e.g. for 25 yr old to get 1M by 65 (p.284)

6. annuity: (285)

1. refers to a sequence of periodic and equal amts at regular time intervals

2. Ordinary annuity (annuity in arrears): investor start making payments at the end rather than at the beginning of the first period

1. e.g. if investor contributes 1,000 at the end of each yr for 4 yrs at 5% compounded annually

1. the first payment will compound 3 times at the end of 4 yrs

2. 2nd payment will compound 2 times

3. 3rd payment will compound once

4. and 4th payment does not earn any interest

2. Table II (uses future value factors from Table I for sgl amts to calc the FV factors for an ordinary annuity) → shortcut to the above calc bc will give you the same number just by looking at the number of payments and the interest rate.

3. FV of an ordinary annuity (example 8, p287) – look at Table II

1. 2,000 at end of each yr for 15 yrs @ 6% = 2,000 x 23.27597 = 46,551.94

3. Annuity Due (annuity in advance): investor makes payments at he beginning of each period.

1. one more period than the payment would under an ordinary annuity

2. produce greater amt if pay at the beginning of the yr → one more period of interest accrual

3. Table II does not contain amts for annuity due

4. Formula for Annuities Due using Table II:

1. Future value factor of an annuity due for (n) payments = fv factor of an ordinary annuity for ((n) +1 payments) – 1.

2. n = no of payments for ordinary annuity, then add one add’l payment and find the factor for that

5. Example 9

1. 2000 at the beginning of each yr for 15 yrs @ 6% compounded annually

1. total of 16 payments to an ordinary annuity

2. 2000 x (25.6725 – 1) = 49,345.06

1. 25.6725 reflects the n +1 payment factor, n would equal 15 in ordinary annuity but must add one payment and find the factor for 16 payments

9. PRESENT VALUE (PV) (290) –Table III → shows the PV of $1 at the end of (n) periods discounted at (r) compound interest

1. defn: how much a given future sum or annuity is worth today

1. PV = amt that will grow to a larger sum a the end of (n) periods of time in the future at (r) compound interest rate.

2. discounted: bc we start with a larger known amt in the future and det the lower PV

2. Single amounts:

1. principal that a dollar is worth more today than a dollar tomorrow bc you can invest that dollar today and earn interest tomorrow

2. Example 10

1. A promised to give D 10000 on his 22 birthday (D is 12). What is the PV discounted at 8% annually?

2. PV = 10000 x .46319 (which is the 8% for 10 yrs) = 4631.90

1. can verify by using Table I to find FV factor for 10 periods at 8% which is 2.15892, then multiply 4631.90 x 2.16 = 9,999.90

3. Example 11: PV interest compounded semiannually

1. A promised D 10000 on 22 birthday @ 8% but will compound semiannually.

2. PV = 10000 x .45639 (which is PV factor for 20 yrs since compounded twice a yr at 4%)

3. take half of the orig interest per yr → 4%

4. Example 12: PV interest compounded quarterly

1. A promised D 10000on 22 b-day @ 8% but will compound quarterly

1. 10 yrs compounded 4 times a yr = 40 periods at 2% each period

2. 10000 x .45289 = 4,528.90

5. the more frequently we compound interest the lower the present value drops, bc more frequent compounding produces higher effective rate of interest, a higher effective rate of interest means that we can invest less now, which means a lower present value, to arrive at a given sum in the future.

3. Annuities (292)

1. someone promises to make a series of equal payments

2. Ordinary Annuity: Use Table VI → PV of Annuity

1. withdrawal at the end of the yr

2. e.g. S promises to pay 1000 at the end of each yr for 4 yrs. S can earn 8% on his investments, how much would S have to invest now to meet his promise?

1. could use Table III and calc each year separately and add the factors together to get 3.31213 (4 periods)

2. OR use Table VI for PV of annuity

3. example 13: PV of ordinary annuity

1. 1,000,000 payable 100,000 at the end of each yr for 10 yrs at 7% compounded annually, what is the PV of the sweepstakes payments?

2. 100,000 x 7.02358

3. Annuity Due (295)

1. do not discount the first withdrawal bc at the beginning of the yr and investor withdraws at the same time as the investment

2. receiving payment at the beginning of each yr will result in larger amt

3. using the sgl amt Table III:

1. if 4 withdraws at the beginning:

1. 1st withdrawal: no periods/no discount = 1.0

2. 2nd withdrawal: 1 period = .92593

3. 3rd withdrawal: 2 periods = .85734

4. 4th withdrawal: 3 periods = .79383

= 3.57710

4. Using Table VI for ordinary annuities to calc annuities due

2. PV factor of annuity due for (n) withdrawals = PV factor of ordinary annuity for n – 1 withdrawals, plus 1

5. Example 14: PV of Annuity Due

1. payable 100,000 at the beginning of each yr for 10 yrs with 7% interest compounded annually.

5. 100,000 x (6.51523 +1) = 751,523

6. instead of 10 periods, you would subtract one period to get 9 and find the PV factor for 9 at 7%

4. Calculating Amt of Annuity Payment (297)

1. Ordinary Annuity e.g. J borrows 100,000 for 5 yrs at 10%. Lender requires payment of the loan through equal annual payments at the end of each yr for 5 yrs. Lender will credit each payment to accrued interest first then to principal. What annual payment will lender require J to make?

2. “beginning in one yr”

1. 100,000 = 3.79079 x P ( P = amt of payment)

1. P = 26,379 per yr

2. credit interest first

1. 1st payment: interest = 10% interest x 100000 of orig→ 10,000, so 10,000 credited to interest and remaining 16,379 to principal = 83,620 outstanding balance

2. 2nd payment at end of 2nd yr: interest for that yr = 8,362 or 10% of outstanding, so credit 8,362 from 26,379 payment ot interest and 18,017 to outstanding balance

3. so forth and so forth

3. Annuity Due e.g. N borrow 50,000, bank charge 10% compounded annually, N wants to pay the debt and interest in 5 annual installments beginning immediately, what equal installments will pay the debt and interest?

1. 50,000 = [(n – 1 withdrawal period) +1 ]x P

2. P = 50,000/ (3.16987+1)

1. P = 11,990

3. Credit to interest first

1. beginning of 1st yr: bank credits entire payment to principal bc no interest has been earned yet, outstanding balance = 50,000 – 11,990→ 38,010

2. at end of first yr: 10% of 38,010 is the interest for 1st yr = 3,801, when N pays 11,990, 3801 will go to interest and rest go to principal = 8189, outstanding principal = 29,821

3. beginning of 3rd yr: N pays another 11,990, 10% of 29821 = 2981 and credited toward interest, and so forth and so forth

5. Perpetual Annuities (299) – permanent payment

1. investor intends the annuity to continue forever, the investor may only withdraw the interest earned and cannot withdraw principal

2. principal = interest x P (which is the amt of payment)

3.  

10. CHOOSING AMONG DIFF OPTIONS (300)

1. immediate cash payment of 200,000

2. deferred payment of 400,000 payable in 10 yrs at 7%

1. PV = 400,000 x .50835 = 203,340

3. 5 yr annuity beginning one yr after the signing of agreement, which will pay 50,000 annually at 7%

1. ordinary annuity bc beginning one yr so not at the beginning of the annuity → 4.10020 (5 periods at 7%)

2. PV = 50,000 x 4.10020 = 205, 010

4. option 3 has the highest PV

11. CALCULATING the MARKET VALUE OF BONDS (302)

1. Bonds give owner two rights:

1. rt to periodic interest payments

1. gives rise to an annuity

2. r tot repayment of principal at the bond’s maturity

1. represents a sgl amt

2. e.g. bonds at 10% payable semiannually, after issuing bond interest rates ↑ to 12%, if bonds will mature in 3 yrs, how much would a rsnbl investor pay for such a bond with 10,000?

1. 5% of 10,000 each half yr = interest payment of 500 → fixed by contract

2. value of the bond = sum of PV of each rt discounted at the mkt interest rate of 12% compounded semiannually → but the PV changes according to the market interest rate

3. USING Table VI → 500 x 4.91732 (which is PV factor for 6 payments of 6% interest ) = 2,458.66 PV of the interest payments

4. USING Table III→ NEXT, turn to the PV of principal, 10,000 of 6% for 6 periods = 10,000 x .70496 = 7,049.60

5. Investor should pay 2,458.66 + 7,049.60 = 9,508.26

3. Value of bonds varies inversely with the current mkt interest rate. When the mkt interest rate rise → value of bonds ↓, when market interest rate ↓ → the value of bonds increase.

12. RETIRMENT PLANNING

1. e.g. if at 35 wantes to make equal annual payments at the end of each yr until 65 so can withdraw 60,000 per yr for 20 yrs staring one yr after he retirement, what annual payment must you make assuming 8% interest compounded annually?

1. must calc ordinary annuity of 60,000 for 20 yrs at 8% = 9.81815 x 60,000 = 589,089 PV at retirement

2. 589,089 = P x 113.2832 (which is the FV of annuity for 30 yrs at 8%)

1. P = 5,200.14

Chapter 4: Intro to Financial Stmt Analysis and Financial Ratios

1. Analytical Tools and Techniques (310)

13. Generally:

2. watch for missing financial stmts or disclosures

3. carefully examine footnotes

4. pay attn to report of the indep accountant or auditor

5. prefer financial stmts covering more than one accounting period

14. A set of Financial Stmts will include:

1. balance sheet

2. incomes stmt

3. stmt of cash flows

4. info abt the changes in owner’s equity (can be separate stmt or as part of income stmt or in notes of financial stmt)

5. notes/footnotes to the financial stmt: explain the accounting policies that he co has adopted and contain add’l disclosures abt impt matters affecting the financial stmts

3. notes also disclose commitments: quantifiable trxns that mgmt has affirmative entered into on the co’s behalf (e.g. capital expenditures to expand operating facilities)

4. contingencies: uncertain future events (litigation) that may adversely affect the co.

15. Annual Reports (313):

1. quorum necessary: in order for corp to have any valid axn

1. proxy or in person

2. must send annual report with proxies

3. 8 things required in annual report:

1. audited financial stmts

2. quarterly financial data

3. historical summary of selected financial data for the most recent 5 yrs or the registrant’s life if < 5

4. description of the business

5. business segment info (if applicable)

6. info abt executive officers and directors

7. historical data abt the mkt prices

8. mgmt’s discussion and analysis of co’s financial condition

4. Required disclosure in the following forms:

1. Business Profile: contains mission stmt

2. Financial Highlights: quantitative info on sales and revenues, income or loss per ownership unit, balance sheet items, financial ratios.

2. presented in the light most favorable to co condition

3. nonrecurring or unusual items may have caused fluctuations that will not be reflected here.

3. Letter to the Owners: chair or BOD write letter to SH

4. Operational Overview: summarizes the co’s normal business fxns → co’s products, mkts and key financial data

5. Historical Summary of Financial Data: 5 yrs

6. Mgmt’s Analysis: mgmt’s predictions regarding the results of operations, capital resources, and liquidity

7. Mgmt’s Report: says that mgmt assumes responsibility for

1. preparation, fairness and integrity of co’s financial stmts

2. the maintenance of a system of internal controls

3. estbment of an indep audit committee to oversee

16. Analytical Procedures of Financial Stmts (316) –allows analysts to assess whether changing general econ or industry conditions such as interest rates, inflation, or vacillating consumer confidence will affect the enterprise.

1. Trend Analysis: comparing financial stmts for a co over several periods.

1. where a co generated and spent its resources over a period.

2. Common-Sized Analysis: reducing a financial stmt, such as the income stmt to a series of percentages of a given base amt, such as net sales for the period.

1. can compare the base percentages to similar businesses or to prior yrs.

3. Financial Ratios: 4 groupings (co may defn these ratios differently so must make sure that K or loan doc incl defn)

1. Liquidity ratios: provide info on co’s ability to cover its anticipated operating expenses and mt short term debt obligations

2. Leverage or coverage ratios: also provide info on co’s ability to cover its anticipated operating expenses (like payroll) and mt debt obligations in short and long term.

1. coverage ratios: also measure the relative claims that creditors and owners hold on the co’s assets

3. Activity ratios: provide info abt how effectively using its assets

4. profitability ratios: assess how effectively the business operates

2. Analytical Terms and Ratios (321)

1. Working Capital: excess of current assets over current liabilities

1. current ratio: compares current liabilities to current assets

2. formula: current assets – current liabilities

2. Financial Ratios: (323)

1. Liquidity Ratios: ability to pay short term debt

1. Current ratio: a current ratio of <1 may suggest a problem, 2 or abv suggest satisfactory liquidity. Too high may also suggest a problem that business is not replacing long-lived assets.

1. Equation: current assets / current liabilities

2. e.g. 25000000 (current assets) / 20000000 (current liabilities = 1.25

3. e.g. 10,000,000 (current assets) / 5,000,000 (current liabilities) = 2.0

4. must qualify to type of industry, seasonal business etc. (e.g. banks usually need greater liquidity)

2. Acid Test: short term, considers only cash including cash equivalents (like mkt securities or accounts receivable)

1. equation: (cash and equivalents + short term investments + receivables) / current liabilities

2. ignores prepaid expenses and inventories

3. ratio of 1 will be satisfactory

4. assumption in this test is that the co will not be able to sell any more inventory

2. Leverage Ratios: debt to equity, debt to total assets to assess the overall ability to pay its debts (long-term analysis)

1. Leverage: the greater the proportion of debt, the more highly leveraged the co.

2. Debt to Equity ratio:

1. formula: total liabilities/total owners’ equity

2. debt to equity ratio provide lenders with some indication abt he likelihood that the business will repay a loan.

3. creditors get paid before SHs in any liquidation

3. Debt to Total Assets: (p.326) compare debt to sum of debt and equity

1. formula: total liabilities / total assets

1. total assets = liabilities - assets

2. defn of debt can vary

3. Net Book Value: the difference btw the co’s assets and its liabilities as reflected in the co’s acctg records, usually expressed as an amt per outstanding common share or other ownership interest. (326)

1. formula: net book value attributable to common shares/common shares outstanding

2. net book value per common share (which has issued preferred stock): subtract preferred stock’s liquidation preference

3. Cautions (326)

1. balance sheet not stated at mkt value, so the ratios are only as good as the balance sheet

2. business’ net book value does not reflect what a buyer might pay for the business.

4. Income Stmt (330) – can use this to predict how the co will perform in the future

1. Results of Operations (331) – states the operating results for a particular period

1. should pay attn to unusual or nonrecurring items which affect the income stmt in one period but which will not affect subsequent periods. (e.g. mergers)

2. txns that do not directly relate to operations:

1. e.g. selling a manufacturing plant → should co create “Extraordinary Item” account for this unusual txn in the income stmt for the current period?

2. including it on the income stmt may lead some investors who only look at net income to falsely reach conclusions abt a co. when comparing to previous yrs’ operations.

3. prior period adjustment (334): bypasses the income stmt connoting the fact that a direct entry to Retained Earnings adjusts the results from a prior period bc an item which the co realized currently really belongs in a prior period. This process presents a problem: may cloud the accuracy of a particular income stmt by excluding such an item from the entire series of income stmts.

1. GAAP limited prior period adjustments to corrections of errors in financial stmts for a previous period. Must correct as soon as discovered cannot amortize over some period of time.

1. co debits or credits the appropriate asset or liability accts and records a corresponding adjustment directly to the beginning balance in the Retained Earnings account.

2. such treatment does not affect income stmt

2. e.g. yr 1 = improper recognition of 100,000 revenue in txns on open acct which included a rt of return. If only expenses incl: 60,000 in cost of goods sold, 15,000 in sales commissions which were prepaid, co must eliminate the 25,000 profit from retained earnings.

Inventory 60,000

Prepaid Sales Commission 15,000

Retained Earnings 25,000

Accts Receivable 100,000

4. Discontinued Operations (335): distinct business that a co decides to sell or eliminate (e.g. sub, division, dept or joint venture). Getting rid of the whole line of business.

3. to qualify:

1. co must clearly distinguish component’s assets

2. operating results and activities from the co’s other assets

3. operating results and activities (not only physically but operationally, but also financially)

4. must report in 2 sep components before income from “extraordinary items”

1. income or loss from discontinued operations: incl

1. segment’s operating income or loss less applicable incomes taxes for the period from the beginning of current yr to date.

2. gain or loss on disposal:

1. reflects the income or loss from divesting the segment less applicable income taxes.

1. must estimate if will not occur until after the end of the yr to the disposal date.

5. If co expects loss from disposal: co must incl estimated loss in the net income for the yr

6. If co expects gain from disposal: co must wait until it realizes the income which usually occurs at the closing of the disposal date to recognize revenue.

7. Activities that do not qualify:

1. asset disposal incident to a co’s evolution such as eliminating a line of business

2. transferring production or mkting activites from one location to antoher

3. phasing out a product line or service

4. other changes that technological improvements may occasion.

5. Extraordinary Items (336): gains or losses from txns other than the sale, abandonment of a business segment that qualify as both unusual in nature and infrequent in occurrence.

1. To qualify:

1. must possess a higher degree of abnormality and not relate to or only incidentally relate to a co’s ordinary activities.

2. infrequent reqmt: co must not rsnbly expect the txn to recur in the foresseable future.

3. must consider the nature of the business to det infrequency or unusualness.

2. GAAP: says gains and loses from extinguishing debt is extraordinary items without regard to frequency and other reqmts.

3. “extraordinary items” appear in a sep section on the income stmt after discontinued operations and following the caption “ Income before Extraordinary Items”

6. Changes in Acctg Principles and Estimates (337)

1. acctg principle: incl not only accounting principles and practices, but the methods that a co uses to apply them.

1. e.g. from first in, first out → last in, last out when acctg for inventories.

2. acctg estimates:

1. e.g. changes in estimtates that arise in connection with the depreciation or amortization of any asset over a # of yrs.

2. the estimate of useful life may not be as long as predicted.

3. APB Opinion Require account for changes in estimates in either:

1. period of change, if change affects that period only

2. OR period of change and future periods if the change affects both.

4. Change in acctg principle requires: (list on 338)

1. disclosure: must disclose the change

1. report its effect on income, net of income taxes, and expln why the new acctg method qualifies as “preferable”

2. concern abt consistency, so can only change if the new principle is more “preferable”

3. present financial stmts for prior periods incl for comparative purposes

4. cumulative effect that retroactively changing to new acctg principle has on the amt of retained earnings at the beginning of the period.

5. effect on income before extraordinary items

6. show income before extraordinary items and net income as if the co had applied the newly adopted acctg principle during all periods affected.

5. GAAP may also issue a pronouncement that will require co.s to change their acctg principles:

1. creates a new accounting principle

2. interprets an existing principle

3. expresses a preference for a particular principle

4. rejects a specific principle

7. Ratio Analysis (an erroneous income stmt or balance sheet can produce misleading financial ratios) (p.340)

1. Coverage Ratios: measures the extent to which income (usually determined before interest and taxes) covers certain payments related to an enterprise’s long-term debt.

1. Times Interest Earned: ratio of earnings to interest charges

1. provides indication abt how much the co’s earnings can decline without endangering the interest payments.

2. add back to net income interest charges and income taxes.

3. e.g. if co has net income before taxes 500,000 and interest charge of 250,000, it would cover its interest 3 times

1. (500,000 + 250,000) / 250,000

2. Debt Coverage: det how many times a co can cover both interest and current portion of long-term debt.

1. e.g. previous example debt coverage = 1.5

1. (500,000 income before taxes + 250,000 interest) / (250,00 interest + 250,000 principal of debt)

3. Dividend Coverage: ratio of net income after interest charges and taxes to regular dividends.

1. tells you how much the co’s net income can ↓ without jeopardizing the regular dividend payments.

2. e.g. 200,000 net income / (10,000 shares * $4 per share) = 5.0 times

8. Profitability Ratio (341) – how effectively is the co operating.

1. Earnings Per Share: probably the most impt comparison btw current acctg period and that in a prior period. (goes on the income stmt) – footnote 1 usually tells you how computed.

1. the ratio “net income per common share” shows the net income attributable to co common shares.

2. to compute: (net income – preferred stock dividends) /common shares outstanding

3. FASB issued SFAS No. 128 Earnings per Share to simplify the stds for computing and to conform to int’l stds.

1. “basic earnings per share” now replaces the “primary earnings per share”

1. describes the amt of earnings for the period available to each share of common stock outstanding during the period.

2. income / common shares outstanding

2. “diluted earnings per share” replaces “fully diluted earnings per share”

1. amt of earnings available to both each share of common stock outstanding and each share that would have been outstanding

2. dilutive potential common shares: such as options, warrants and convertible securities, give the holder the rt to acquire common shares either during or after the end of the reporting period.

2. Price Earnings Ratio (343)

1. compares the mkt price of the common shares to the earnings per share.

2. mkt price / earnings per share

3. Return on Sales

1. net income / sales

2. gives indication of efficiency

3. the higher the return on sales, the more profitably and efficiently the co sells goods.

4. Gross Profit Percentage

1. reflects the profitability form selling products, ignoring operating expenses.

2. gross profit = sales – cost of goods sold

3. GPP = gross profit / sales

5. Return on Assets

1. net income / avg assets

2. higher the return of assets, the better mgmt uses its resources in the business.

6. Return on Equity

1. how successfully is mgmt utilizing owner’s capital.

2. total SH equity – net income = SH equity at the beginning of the yr.

3. (SH equity at beginning of yr + SH equity at the end of yr) / 2 = avg equity.

4. net income / avg equity = Return on Equity

9. Activity Ratios (345) – compare amts from balance sheet and the income stmt to see how effectively the co utilizes its resources. (impt in asset-based lending)

1. Receivables Turnover:

1. ratio of credit sales to avg accts receivable provides some measure of the liquidity of the accts receivable.

2. credit sales / avg accts receivable

3. e.g. if co gives customers 30 days to pay their bills, but receivables turnover indicates that on avg co collects its receivables every 50 days → suggest inefficiencies in the co’s collection process

2. Inventory Turnover:

1. cost of goods sold / avg inventory

2. avg inventory = simply avg the opening and closing inventories

3. Asset Turnover:

1. sales / avg assets

2. indicates how many of dollars of sales the co generates for each dollar of assets that the co owns

5. Ratio Analysis (352) – with rowing reliance on borrowing, creditors and investors have to rely increasingly on ratios based on cash flow info.

- debt to equity ration and current ratio most impt, 3rd is the cash flow to current maturities of long term debt. Cash flow to total debt ranked 9th.

2. Liquidity and Coverage – help assess a co’s ability to mt its debt obligations in the short and long run, pay dividends, cover anticipated operating expenses.

10. cash interest coverage: assess co’s ability to generate enough cash from operations to pay its interest payments.

11. debt service coverage: ability of co to mt and retire its debt obligations.

12. Cash dividend coverage: demonstrates the co’s ability to pay dividends with cash generated from ops after payment of taxes and interest

13. Cash flow from ops to capital expenditures ratio: co’s ability to purchase its current capital assets with cash flows from ops.

3. Profitability – info abt ability of co to provide its investors with a return on their investment.

1. cash return on investment: inof on cash-generating ability of co’s assets.

2. cash flow per common share: most impt for closely held co., info abt how much cash the co generated fro every share of common stock outstanding

4. like earnings per share based on accrual acctg (so can’t disclose in the financial stmts to avoid confusion)

4. Quality of Income (354) – ability of a co to generate cash from the amt it reports as income from ops. How quickly can convert net income to cash.

1. cash quality of income ratio: a co that takes a long time to receive cash from its sales and promptly pays its expenses would generate low ratio.

2. cash quality of income before interest, taxes and depreciation: more accurately reflects the effects of interest, taxes and depreciation on net income.

6. Mgmt’s Discussion and Analysis (356) – MD & A – disclosure in narrative form the events and contingencies affecting their co in both historical and prospective views

1. Regulation S-K: std instructions for filing forms under fed securities laws

1. item 303: require registrants to discuss their financial condition and results of ops in both the annual report sent to SHs and periodic reports filed with SEC

2. Regulation S-B: similar disclosure req’ments for sml businesses (fall below $25M in revenue)

1. item 303: similar req’ments for sml businesses.

3. Purposes of Required Disclosure

1. allows investors to know the registrant’s prospects for the future.

2. Prospective info:

1. Required disclosure: on currently known trends AND rsnbly likely to have material effect

3. known trends or any known demands, commitments etc that will result in or “rsnbly likely result” in liquidity ↑ or ↓.

4. focus on “material events and uncertainties known to mgmt that would cause reported financial stmt not to be indicative of future condition.”

2. voluntary disclosure: involves anticipating a future trend etc.

1. such trends that will rsnbly lead to material impact or net sales, revenue or income from continuing ops

3. if mgmt can’t make a det whether rsnbly likely to occur → mgmt must evaluate what the conseq of event will be on the assuming that it will come to fruition

1. disclosure req’d unless mgmt det that material effect not rsnbly likely to occur

7. In re Catepillar (360) –

1. facts: failure to disclose info abt 1989 earning of Caterpillar Brasil (sub). A number of nonoperating items contributed to greater than usual overall profit.

1. annual reports (10-K) and quarterly reports (10-Q) required

2. Catepillar’s forecast tied to sub’s forecast. But sub’s future performance was difficult to predict.

Chapter 5 – Legal Issues Involving SH’s Equity and The Balance Sheet (375)

1. accountants divide SH’s equity into 3 components:

3. capital stock accounts (stated capital)

1. common

2. preferred stock

4. add’l paid-in stock (capital surplus)

5. retained earnings (earned surplus)

2. Limitations on the Issuance of Shares (377)

1. Legal Capital System: sought to provide minimal protection to a corp’s creditors

1. prohibits corps from issuing shares for less than par value (which is an arbitrary amt made in art of incrop)

1. this requirement ensures that creditors could readily ascertain the amt of resources that the orig SHs committed ot the business and that would offer some “cushion” to creditors

2. ensure that corp would charge each SH at leas a minimal equal amt when issuing stock.

2. water stock: if a corp issued shares for less than par value

1. corp stat may impose liability on SHs that do not pay at least par value for their shares.

2. some juris permitted creditors to recover ONLY if the issuance of watered stock amted to misrep (those who relied on can recover)

3. Lawyers devised ways to circumvent the legal capital system

1. can issue shares with low par values

3. Distributions and Legal Restrictions (381)

1. in every state, statutes limit corp’s ability to distribute assets to SHs (protect residual SHs)

1. restrictive covenants to protect creditors’ interest agst specified distributions that would deplete the corp’s net worth and ability to pay its debts.

2. Dividends and Redemptions (382)

1. Distribution (both dividends and repurchases) of co assets in 2 ways:

1. if directors det that co has more assets than necessary to op the business, may declare dividends

2. when corp redeems or purchases its own stock from SHs

1. repurchases shares = treasury stock

2. cost to acquire treasury stock reduces Sh’s equity and appears as a reduction to Sh’s equity on balance sheets.

3. authorized but unissued stock ≠ asset

4. isn’t recognized as revenue, gain or loss from selling and repurchasing or reselling its own stock.

2. from creditors perspective, the paying of dividends and the repurchasing of stock is the same - will result in the expenditure of same amt of cash from the co’s assets.

3. companies prefer redeeming shares over distribution of dividends bc of tax reasons

1. SH must report as income when dividend

2. redemption: capital gains tax (only pay tax on any gain at a statutory rate not exceeding 20%)

3. Stock Dividends and Stock Split (383)

1. involves issuance of shares to existing SHs without consideration

2. not considered as distribution bc not distributing corp asset (no cash or other property being transferred)

1. issuance of add’l shares that were unissued is not considered corp asset bc a corp cannot own itself.

3. neither txn will affect a SH’s proportionate stake in the corp

4. neither txn will affect the total value of the corp

5. increases the number of outstanding shares, reduces mkt price of ea share so increases the shares marketability → maintain liquid mkt

6. in both:

1. stock dividend increases # of shares outstanding BUT par value of ea share drops.

2. stock split increases # of shares outstanding BUT decreases the par or stated value per share.

7. Accounting treatment (386):

1. Stock Split:

1. e.g. 3 for 1 stock split means if corp has 500 outstanding shares → will now be 1500.

1. if shares worth 300 originally, would each be worth 100 now.

2. e.g. if 100,000,000 shares issued at $1 par and is currently traded for $20, if corp declare a 2 for 1 stock split

1. # of outstanding shares = 200,000,000

2. par value = .50

2. Stock Dividends: txns in which add’l shares are distributed to SHs, nothing changes in corp assets or SH’s proportionate interests → misconception that this is distribution of corp earnings.

1. 200% stock dividend means if 500 outstanding shares → will now be 1500.

2. transfer of retained earnings account to contributed capital (common stock or preferred stock, add’l paid in capital) an amt equal to the newly issued shares’ fair mkt value.

1. e.g. if 100,000,000 shares issued at $1 par and is currently traded for $20, if corp declares a 10% stock dividend (will increase the outstanding shares to 110,000,000)

Retained earnings 200,000,000

(10,000,000 newly issued

shares at $20)

common stock, $1 par 10,000,000

additional paid in capital 190,000,000

(to record the 10% stock dividend)

3. ARB 43: allows corps which issue add’l shares exceeding 25% of the number of previously outstanding shares to transfer only the amt which applicable corp stat requires from retained earnings to the appropriate capital stock acct.

2. e.g. if 50% stock dividend → no need to make transfer to add’l paid in capital acct, only needs to put 50,000,000 to the common stock acct.

8. TREATMENT UNDER THE LEGAL CAPITAL SYSTEM (388)

1. stated capital must always = or exceed the # of issued shares times the par value per share.

2. stock dividend

1. must transfer from available surplus to stated capital the amt necessary to reflect the add’l shares issued.

2. 10% stock dividend scenario at $1 per share (100,000,000 → 110,000,000)

1. 10,000,000 must be added to the stated capital and subtracted from surplus

3. stock split: nothing needs to be done

1. do not require any transfers under the legal capital system bc the change in par value offsets the add’l shares that the corp issues.

2. this gives the BOD almost unfettered discretion to effectuate a stock split.

4. RESTRICTIONS ON CORP DISTRIBUTIONS (391)

1. Restrictive covenants (often contained in loan agreements): may preclude corps from declaring dividends entirely or under certain circum

2. Statutory Restrictions

1. corporate law statutes and creditor’s rts statutes(392) – 4 categories, most states apply a combo of the 4 and there are diff stats for redemptions, will make directors liable for amt that corp unlawfully distributed UNLESS show defense. (p.394 for example)

1. Surplus Statutes: limit distributions to surplus (total SH’s equity that exceeds stated capital) – 2 categories:

1. Any surplus: a corp may distribute amts to SHs any time the corp’s surplus (capital or earned) exceeds the proposed distribution

1. distribution can’t be more than the net assets (add’l paid in capital + retained earnings)

1. add’l paid in capital = capital surplus

2. reduction surplus to declare dividends which exceed the net assets: can increase or decrease stated capital by changing the par value thereby changing it to surplus which goes into the retained earnings account allowing for more distribution (must amend the charter)

2. Earned Surplus: can distribute any time earned surplus exceeds the contemplated distribution

1. assets remaining must at least = to stated capital + capital surplus

2. exceptions:

1. if no earned surplus exists: can distribute from capital surplus

2. second situation allows if satisfy 4 conditions (listed on 395)

2. income stmt tests

3. insolvency limitations

4. financial ratios

2. creditors’ rights statutes

1. protect creditors from distributions which leave corp

1. more liabilities than assets

2. not enough liquid resources to pay bills

3. an unrsnbly small amount of capital for continuing ops

4. Consolidated Financial Stmts (521), also CH. 1 (132-137)

1. if co owns 20% but not more than 50%- GAAP presumes that co can exercise significant influence and treats as “active” investments.

1. cost method: treat each txn at cost

1. only reports income when investor (sub) declares a dividend

1. p.526 X would have to wait for Y to declare a dividend before reflecting any of Y’s post-acquisition earnings on X’s fin stmts.

2. debit to cash, credit to dividend revenue (reported at fair mkt value)

2. just use equity method to account for investments (524): intermediate method bc X’s balance sheet only shows its investment in Y rather than Y’s net assets, however will reflect subsequent earnings or losses whether or not Y declares any dividends.

1. bc does not own majority, when adding to investment the sub’s post-acquisition earnings, can only add half of the earnings.(526)

2. initially record at cost, then adjust to recognize the investing co (sub’s) share of the investee’s (parent) earnings or losses after the acquisition date. (investor’s share of the periodic net income of the investee is recorded as an increase in the investment acct and as revenue for the period)

1. pro rata method

3. investing co (sub) also adjusts the investment in the investee to reflect its share of changes in the investee’s capital. (investor’s share of cash dividends from the investee is recorded as an increase in cash acct and a decrease in the investment acct)

2. if co owns more than 50% - must prepare consolidated fin stmts.

3. combine financial data for a parent co and its majority owned subs as if the parent and subs rep a sgl acctg entity.

4. How a parent co should reflect a sub’s earning subsequent to acquisition:

1. look at examples on p522. (must add sub’s retained earnings to the parent’s retained earnings)

2. common stock account does not change → always reflect the common stock of the parent co.

3. after consolidated stmt → any payment from sub to parent or parent to sub would not affect the consolidated balance sheet. (can only reflect txns to outside enterprises)

1. e.g. if Y (sub) paid a dividend to X (parent), the increase in X’s net assets and retained earnings from the dividend would offset the corresponding decrease in Y’s net assets and retained earnings.

5. applies only when a parent co owns at least a majority of the voting interest in a sub (majority of shares)

1. minority interest: does not belong to parent

6. if no majority interest:

1. deduct minority interest’s share of the sub’s net income for a particular acctg period in determining consolidated net income

5. Revenue Recognition (Chap. 6)

1. Right of Return and Buy Back Arrangements (534)

1. If co sells a product in one acctg period, but buyer can return in the next, what is the acctg treatment bc the seller has retained the risks of ownership? (3 alternatives):

1. not record a sale until all return privileges have expired

2. recognize and record the sale BUT subtract estimated future returns from recorded sales

3. recognize and record the sale without subtracting estimated future returns, and treat any returns as occurring in the accounting period in which they actually occur.

2. FAS no. 48 – Revenue Recognition When Right of Return Exists

1. a seller can recognize revenue immediately only if the surrounding circumstances satisfy 6 conditions: (534)

1. price fixed or determined to the buyer on the date of sale

2. buyer paid seller OR agreement obligates the buyer to pay the seller whether or not the buyer resells the product

3. product’s theft, physical destruction or damage will NOT change the buyer’s obligation

4. buyer acquiring the product for resale has economic substance apart from any resources that the seller has provided.

5. agreement does not impose significant obligations on the seller for future performance

6. seller can rsnbly estimate future returns.

1. factors to consider if can rsnbly estimate:

1. product’s susceptibility to external factors

2. relatively long return period

3. no similar sales or products experience

4. changing circum such as change in mkting

5. inadequate volume of relatively homogeneous txns

2. if all 6 satisfied → FAS requires seller to report the sales revenue and cost of sales in the income stmt and reduce those amts to reflect estimated returns.

6. INVENTORY (689) – appear on the balance sheet as a current asset, also (104-112)

1. NET INCOME = (Sales – sales returns) – ((Opening Inventory + Purchases) – Closing Inventory) – Expenses (including tax))

2. Conservatism Principle: inventory should be carried on the books at a rsnble value (a value that co will likely recover).

1. when a co needs to reduce the value of the products it is bc they can’t recover the value that it was carried on the books at. (742-748)

3. Importance to Lawyers

1. inventory acctg presents another deferral issue

2. total inventory/costs incurred = costs allocable to current period + costs deferred to later periods

1. problem is don’t know costs allocable to current period and costs deferred to later periods at this pt

3. list of reasons (691)

1. acctg for inventory may affect taxes → understate closing inventory to keep taxable income low; overstate to show high earnings

2. loan agreements may require ratio of current assets to current liabilities, inventory is part of current asset.

3. inventory can affect how much co can distribute to owners

4. int’l trade involving antidumping

4. most businesses use Periodic Inventory Method – attempt to ascertain “costs deferred to later periods” by taking inventory at the end of the acctg period

1. serves 2 fxns:

1. calc the amt that co should defer as ending inventory to match agst revenues in some later period.

2. det what amt of the total inventory costs for the period the co should treat as an expense of the current period to match agst current revenues.

5. ACCTG PRINCIPLES RELEVANT TO INVENTORY ACCTG

1. Matching (693):

1. which costs and goods to incl in inventory?

2. flow assumption to value those goods which remain in inventory

1. Specific ID

2. Avg Cost (722)

3. Last in, First Out (724)

4. Retail Method (725)

5. Std Costs (726)

6. Combination (726)

2. Conservatism Principle: should not carry inventory or other asset at any amt greater than the asset’s current realizable value.

3. Consistency Principle: co should consistently apply the same acctg treatment from period to period and properly disclose

4. Disclosure

6. Cost of Goods Sold (104-112)

1. Gross Profit = net sales – cost of goods sold (p.107)

1. net sales = sales – (sales returns + sales allowances)

2. cost of goods sold = (opening inventory + purchases) – closing inventory

2. Net Income = gross profit – total expenses

3. Sales Allowances: seller grants a deduction in price to the customer (maybe for a defect etc)

4. Gross Profit and Multi step Income (p.107)

1. co.s derive revenues and incur expenses from normal operating activities while gains and losses flow from peripheral or incidental txns

1. non-op section: e.g. rental income, interest income, fire damage etc.

2. in Multi Step Income – shows non-op immediately after the co’s op income and nets the non-op items.

3. in Sgl step Income – 2 categories

1. revenues (both op revenues and gains)

2. expenses (cost of goods sold, op expenses and losses)

5. Periodic Inventory (109) – taking inventory at the end of a period

1. cost of goods sold is an expense:

1. so debit means increase in account (since on the rt side of T account) and credit means decrease in the account

2. whatever is left unsold is debited to inventory and credited to cost of goods sold (this is really deferral bc this is an overstmt that hasn’t been realized yet)

1. deferral: the cost of merchandise remaining should not be incl as an expense of the current period but rather deferred to later periods.

2. closing inventory = deferred cost of goods sold expense (p.111)

6. Total inventory/costs incurred – Costs deferred to later period = costs allocable to current period

7. helps co to det the expense for goods actually sold during an acctg period

1. add opening inventory and purchases for the period (debit side of the cost of goods sold acct)

2. Cost of Goods Sold 2,100

(beginning inventory =

number of items * cost per item)

Inventory 2,100

Cost of Goods Sold 8,400

Purchases (of new inventory) 8,400

beginning inventory + purchases = cost of goods available for sale

cost of goods avail for sale – closing inventory (unsold inventory) = cost of goods sold during the period

Inventory 3,500

Cost of Goods Sold 3,500

3. can refer to ending inventory acct as “deferred cost of goods sold expense” bc cutting down the expense applicable to current period but creating an asset to defer a portion of an expense for later period.

8. direct relationship btw ending inventory and net income:

1. as we defer more costs to later periods → ending inventory ↑ and cost of goods sold ↓ which ↑ the net income for the period.

2. allocate more costs to current period and ↑ the cost of goods sold, ending inventory ↓ and net income ↓.

9. Overstating and Understating Effects: (690)

1. e.g. overstating or understating ending inventory 10,000 on cost of goods sold and net income.

2. if overstate ending inventory → net income will be overstated, and beginning inventory will also be overstated → which means the cost of goods sold will be overstated on next period→ which will produce lower earnings.

3. understate ending inventory → net income will be understated and beginning inventory will be understated → which means that cost of goods sold will be understated on next period → which will reduce net income next period.

7. CONTINGENCIES (611) – Chap. 7

1. conditional gains or losses: may or may not occur and how to deal with such a txn in terms of the matching principle bc requires co to match expenses with the revenues that they helped to produce.

1. could create a special “contingent liability”

2. if do not record in the present period and there is a refund, refund does not qualify as a “prior period adjustment”

3. if based on “previous experience” co knows that there will ultimately bc some refunds, then should estimate the amt and record in current period. (612)

2. Diff from “unliquidated liability: that is where the co has incurred an expense or loss attributable to the current period, but uncertain as to the amt.

1. must estimate the likely amt

2. if can’t estimate, disclose in the footnote

3. Unasserted Claims (630):

1. must first assess the probability of the assertion.

2. if assertion seems probable, then must proceed in the same manner as loss contingency.

4. GAAP and MD&A may estb diff stds:

1. if MD&A rules impose a higher std, co can comply with GAAP stds but still be found liable under MD&A.

5. Table (630) – acctg treatment for asserted claims

6. FASB 5: acctg rules on contingencies (617)

1. estimates are required for on-going and recurring activities

1. e.g. depreciation is an estimate but does not make this a contingency

2. GAIN CONTINGENCY (631):

1. your client expects to receive a reward but you don’t book gained contingencies due to conservative principle

2. co should disclose gain contingencies but should not overstate the likelihood of the contingency to materialize.

3. LOSS CONTINGENCY (618): (1)if there has been a loss or impairment of an asset or the incurrence of liability OR it’s probable that there will be a loss or incurrence of liability and you can (2)rsnbly estimate the amt, and (3) the event occurred on or prior to the date of the fin stmts, the co must accrue an amt for this loss and also disclose it.

1. event has to occur prior to the date of fin stmts = date that fin stmts are being examined (619)

1. if the event/discovery of event occurred after the date of fin stmts but prior to stmts being issued, then must disclose and put in footnote

2. atty has to make assessment as to likeliness, if probable then see if able to estimate an amt

1. if all these conditions are met, then must book the liability (FASB rule says that co should at least book the low range of the liability)

2. if can’t estimate an amt, then just disclose (doesn’t matter when the event occurred)

1. disclosure shall indicate the nature of the contingency, and give an estimate of the possible loss or range of loss or state that such an estimate cannot be made.

3. Likeliness (FAS defn) (618)

1. Probable: the future event is likely to occur.

2. Reasonably Possible: chance of event occurring is more than remote but less than likely.

3. Remote: change of event occurring is slight.

4. ABA defn (652) – diff from FAS

1. probable: an unfavorable outcome for the client is probable if the prospects of the claimant not succeeding are judged to be extremely doubtful and the prospects for success by the client in its defense are judges to be slight

2. remote: unfavorable outcome is remote if the prospects for the client not succeeding in its defense are judged to be extremely doubtful and the prospects of success by the claimant are judged to be slight.

5. Examples of loss contingencies: when co has loss contingencies, they set up reserves.

1. collectibility of receivables

2. obligations related to product warranties and product defects

3. risk of loss or damage of co’s property by fire, explosion or other hazards.

4. threat of expropriation of assets

5. pending or threatened litigation

6. actual or possible claims and assessments

7. guarantees of indebtedness of others.

7. acctg profession and legal profession got together to deal with what auditors need in terms of evid from lawyers (648)

1. rule that is in both the FASB and ABA: atty acknowledges to the auditor, that whatever the atty becomes aware of the atty is obligated to inform their client.

2. atty agrees to tell client, and the auditor looks to the client, way of dealing with the issue so that atty doesn’t have go directly to the auditor that something has to get disclosed, concerned with confidentiality issues.

3. Difference btw acctg profession and legal profession (654):

1. conflicting interests

2. diff terms with diff defns

3. std for unasserted claims is diff:

1. FAS 5: if probable (likely to occur) must accrue, disclose or both.

2. ABA stmt: considers an unasserted claim “probable only when the prospects of its being asserted seem rsnbly certain and the prospects of non-assertion seem slight.

8. Auditor responsibilities:

1. request info and representations from co’s mgmt abt contingencies

2. request corroborating evid from the co’s outside counsel (client send audit inquiry letter)

3. auditor can face liability if issues an “unqualified” opinion when fin stmts do not appropriately treat contingencies. (614)

9. Audit Inquiries and Relevant Professional Stds (647)

1. mgmt letters: any co requiring audited fin stmts must provide to info re legal claims ags the co to its autditors.

2. audit inquiry letters: co will request atty to send letter to co’s auditor re asserted and unasserted claims.

3. ABA stmt on audit inquiry (648)

1. Letter:

1. defines the period of the audit (usually one yr)

2. when public co file offering docs → stmts are incl in the docs are usually 3 yrs of annual stmts AND quarterly financial stmts on a comparative basis.

1. when offering docs are filed with SEC → atty’s letters are requested and sent prior to the docs are filed with the SEC and sent again prior to time co plans to go effective with their offering.

2. lawyer’s professional responsibility (653) – specific lang that is in the inquiry letter and also in the response by the atty confirming the fact that the atty will inform the client of things that need to be disclosed.

3. it is a problem when lawyers don’t use the magic words from FAS 5.

8. INTANGIBLE ASSETS (808) – GAAP divides into 2 categories (Chart on 809)

10. Identifiable: intellectual property (patents, trademarks, assets for deferred expenses like training costs; computer software development costs; etc)

4. has definable and measurable relation to the business’s operations.

5. can sell these rts and property interests apart from its other assets

6. costs can be treated either as an expense or capitalize the costs to develop specific identifiable intangibles and amortize

7. amortizable costs incl:

4. purchase price

5. any directly related expenditures (atty fees to transfer and perfect title, cost to defend rt to asset)

6. registering trademark etc.

8. estimating an intangible’s useful life (810) - factors

11. Unidentifiable: inherent in a business, attached to business as a whole (going concern value; goodwill – the amt by which a business’s purchase price exceeds the sum of the fair values of its identifiable net assets.

1. goodwill does not need to be amortized under new rule bc indefinite life (new rule already in effect) (p.808)

2. the costs are treated as “current expense”

3. can’t purchase or sell separately

4. going concern value: add’l value that attaches to properties which constitute an ongoing business

5. e.g. txn of 800,000 that includes plant and inventory in an unspecified amt, the allocation matters bc the amt allocated to inventory will turn into cost of goods sold expense, while the co will expense the cost assigned to the plant much more slowly.

1. will allocate to stated capital or capital surplus

2. if get 100,000 add’l in good will then must incl as “good will” on balance sheet and amortize that amt.

3. acquiring such an asset would require you to add amt to may be the “long term asset” and have to amortize by adding to “depreciation expense”

6. e.g. if txn is made by transfer of stock

1. must try to det fair mkt value of shares

12. GAAP: requires co to record the costs to acquire intangible (identifiable or unidentifiable) as an ASSET and to amortize costs over the intabigles’ estimated useful life (may not exceed 40 yrs)

13. financial stmt should disclose how co treats intangibles and what amortization method and which periods.

14. Business Combinations (811)

1. Purchase method (816): assumes that the acquiring co “purchased” the net assets of the other co, bringing together 2 previously sep businesses into a sgl accounting entity

1. acquiring co adds to its own assets the target’s assets (valued at the acquisition cost)

2. if the purchase price exceeds the fair value of the assets, record the excess as “goodwill” and amortize (but under new rule does not need to be amortized) see p.808

3. if the purchase price exceeds the sum of the fair mkt values of the specific and sep identified assets, the acquiring co records the excess as goodwill.

1. goodwill needs to be amortized

4. negative goodwill: fair value of assets acquired may exceed the consideration paid to acquire the co.

2. Pooling Method: treats the combination as a continuation of the previous ownership interests

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