5 Financial Accounting-notes.doc

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9/22/2008Revision 0.1

Author: Philip Larson

Financial Accounting: ClassNotes


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Corporate Acquisitions: Class notes

Table of Contents

1. Lecture 1....................................................................................................................................3

Philip Larson Page 2


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1. Lecture 1

1.1 Financial Accounting -

- Aiyesha Dey- Class 1

o Three homework assignments

- Accountingo language of business

o Collection, processing and reporting of info about activities and events that affect the

organization- Three types of accounting users

o Financial Accounting and Reporting: recording financial transactions, position and results and

communicating it to outside stakeholderso Managerial Accounting and Reporting: communicating the position and results of firm

internally.o Tax Accounting and Reporting: recording and reporting financial position to IRS.

- Accounting Principleso Generally Accepted Accounting Principles (GAAP)

SEC has authority to set GAAP

SEC delegates this authority to the Financial Accounting Standards Board

(FASB)

FASB rules are called Statements of Financial Accounting Standards

(SFAS) currently over 150 rules

Attributes ofideal accounting system

Reliability verifiable by an independent party

Relevance it has to be timely, and havefeedback value andpredictive

ability to a certain extent (you may want to use the info to make futuredecisions)

Other important accounting concepts

Conservatism report bad news but not good news if there is uncertainty

Materiality if tracking an account is costly and reporting it doesnt change

decisions, it is not worth it.- Accounting Qualities

o Decision Usefulness

Relevance

Timely

Feedback value tells you about the past (evaluate the managers of the

firm); feedback on past performance and management performance

Predictive value

Reliability

Verifiability

Representational faithfulness

Neutral (compare firm across years and compare across firms) Comparability

Materialityo Understandability

- Assumptions Underlying Financial Accountingo Three Assumptions

Entity Concept parent company and any subsidiaries controlled by the parent;independent subsidiaries are not part of the firm

Arms length transaction



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Monetary measurement concept -

Going concern assumptiono Discretion accounting information is subject to discretion.

Accounting numbers = economic truth + measurement error + incentiveso Changes to Accounting Rules and Regulation can change due to lobbying, political

pressure, economics and technological change

- Principal Activities of a Firmo Sources of capital

Creditors

Ownerso Investing Activities

Inventory

PPEo Operating Activities

Creates valueo Value creation

Earnings, profits, etc.

How can a firm return value?

Dividends Reinvest earnings into investing activities of the firm

Repay your creditors

o FINANCIAL STATEMENTS PROVIDE INFORMATION ON EACH STEP

- Role of Financial Reportingo Who is interested in information about the firm?

S/Hs, potential S/Hs

Creditors

Suppliers

IRS

Analysts, other intermediarieso What types of information about the firm?

Performance

Revenue, expenses,

Ratios

Cash flow

Assets & liabilities

o Supply

Mandatory disclosures

Annual audited filings with the SEC (10Ks)

Quarterly unaudited SEC filings (10Qs)

Annual reports sent to shareholders- Key Players in Financial Reporting

o Preparers

SEC oversight role delegated to FASB

FASB rule-making body

GAAP set of rules created by FASB

Directors audit committee responsible for reporting of the firm

Auditors attest to the credibility of the financial reports

(Sarbanes-Oxley Act (SOX) July 30, 2002 in response to Enron, WorldCom,etc.)

o Users

Analysts/Media third party information providers



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Investors large institutions and individuals- International Financial Reporting Standards (IFRS)

o Set of global accounting standards for the preparation of public company financial statements

o Developed by the International Accounting Standards Board (IASB)

o IASB is an independent accounting standard-setting body based in London

o 12,000 companies in almost 100 nations have adopted IFRS. Many more will transition in

2011o FASB and IASB are working towards convergence of US GAAP and IFRS

o SEC Roadmap

2011: decision whether US Firms are required to use IFRS

2014: implementation year in case of positive decision- Financial Statements

o Basic Financial Statements

Balance Sheet

Income Statement

Statement of Cash Flowso Supplemental information about the financial condition of a company

Statement of Shareholders Equity

Notes to Financial Statements footnotes are very important

Auditors Report- The Balance Sheet

o Apoint in timesnapshotof the investing and financial activities of the firm

o Balance sheet identity

ASSETS = LIABILITIES + SHAREHOLDERS EQUITY

E.g.

Investments = financial arrangements

Resources = claims on resources

Owns = owes

- The Income Statement

o A schedule that presents the results of operations of a firm for a specific period of time.

o NET INCOME = REVENUES EXPENSES

Revenues inflows of assets from selling and providing goods or services

Expenses outflows of assets used in generating revenueso Note: there is nothing in these definitions that referto cash

o Balance Sheet vs. Income Statement

Income statement links the balance sheet at the beginning of the period with thebalance sheet at the end of the period

Retained Earnings (RE) is increased each period by the net income of the period anddecreased by any dividends declared during the period

RE (end of period) = RE (beginning of period) + NET INCOME

DIVIDENDS

- Statement of Cash Flowso A schedule that reports the details ofwhere cash came from and where cash wentfor a

period of time.o Cash flows are categorized into:

Operating: Providing goods and services

Investing: Choice of assets used to run operations

Financial: Raising capital to pay for assets- Financial Statements: The Link

o CASH + NONCASH ASSETS = LIABILITIES + CONTRIBUTED CAPITAL +

RETAINED EARNINGS- Other Financial Reporting Items



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o Statement of Shareholders Equity schedule that reconciles the change in S/Hs equity

accounts during a period of timeo Notes to financial statements

o Auditors opinion

o Financial highlights, including trends

o Managements Discussion and Analysis

o CEO/CFO Certification- CHAPTER 2- The Balance Sheet (p59-61 nice summary of balance sheet accounts)- Assets

o Definition: an asset is an economic resource that is expected to provide future economic value

(i.e. generate future cash inflows or reduce future cash outflows)

All assets are future benefits; however not all future benefits are accounting assets

Executory (uncompleted) contracts do not result in assets (must be an exchange)o An asset is included in the balance sheet (i.e. recognized) when:

Ownership the firm has acquired the right to use it in a past transaction orexchange

Measurable the value of its future benefits can be measured with a reasonabledegree of precision

o Examples Cash, Inventory, Accounts Receivable, PPE (property, plant, equipment)

Brand name or famous CEO (Warren Buffett) CANNOT be put on the balance sheet

Patents are intangible assets (R&D) GAAP requires that you expense the costs ofR&D. If you are generating it yourself, you can put a value to it. How can youverify the value? However, if you buy it from an outside party that establishes areliable value.

- Assets: Valuationo Three types

Acquisition or Historical Cost (adv: verifiable/reliable; disadv: may not reflecteconomic value)

Valued at the amount of resources paid to acquire it

Fair Market Value (adv: closer to market value; disadv: hard to measure)

Replacement cost entry price (valued at the cost of replacing the asset)

Net Realizable Value exit price (valued at the net cash received on selling

the asset)

Present value of expected future cash flows (adv: closer to economic value; disadv:reliance on assumptions that may not be accurate)

o GAAP on Valuation

Monetary assets an asset whose realization is fixed in terms of dollars

Use PV method

Examples: Cash, Accounts Receivable

Nonmonetary Asset all other assets

Historical Cost

Examples: PPE, inventory, etc.

Exception: marketable securities (valued at Net Realizable Value)

- Assets: Classificationo Current Assets: assets expected to be realized in cash within one operating cycle (typically

one year)

Examples: inventory, accounts receivableo Noncurrent assets: assets that are NOT expected to be realized in cash within one operating

cycle

Examples: PPE



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o Why is this relevant? Liquidity it is a measure of liquidity and how quickly you can get the

assets out of the firm.- Liabilities:

o Definition: a liability is a claim on assets by creditors that represents an obligation to make

future payment of cash, gods or services (i.e. consume resources)o All liabilities are obligations; not all obligations are accounting liabilities

o A liability is included in the balance sheet (i.e. recognized) when: The obligation is based on benefits or services received currently or in a past

transaction

The amount and timing of payment is reasonably certain (measurable)

Examples: accounts payable, notes payable, advances from customers(prepayment), warranties

Is a lawsuit a liability? No. It is not measurable. This is called a contingent

liability. You do have to disclose them in notes.- Liabilities: Valuation

o Monetary liabilities liability whose settlement is fixed in terms of dollars (i.e. by contract)

Examples: bonds payable

Most liabilities require a specific payment

Valuation: PV of expected future cash flowso Nonmonetary liabilities all others! Typically requires delivery of goods or rendering of

service rather than payment of cash

Examples: advance from customers, warranty liability

Valuation:

Atface value (amount of resources received (e.g. customer advances)

At expected costof providing service (e.g. warranty liabilities)

- Liabilities: Classificationo Current liability: obligation expected to be paid in cash within one operating cycle

Example: accounts payableo Non-current liability: obligation with an expected due date beyond one operating cycle

Ex: long-term debto Current ration: Current assets/Current Liabilities

o Working capital: CA-CLo Acid Test Ratio (Quick Ratio) = (Cash + Acct Receivable + Short term investment)/Current

Liabilities - this basically ignores inventory.

If ACID test ratio is less than Current Ratio Inventory is a big deal. How liquidreally is the firms inventory?

- FAS 159: Fair Value Option (FVO)o Firms can optionally elect to use fair values to measure eligible assets and liabilities in their

financial statements

Fair value is the amount a firm would receive if it sold an asset or would pay if itsettled a liability at the measurement date

Effective date: fiscal year beginning after November 15, 2007

Management has sufficient discretion in electing specific assets and liabilities, butonce FVO is elected it is irrevocable

Detailed requirements for applying fair value measurements to the calculation of netincome for specific assets and liabilities (e.g. bonds) are still not provided

The fair value option is still considered an interim step.o Inputs to Measuring Fair Value (FV)

Level 1: Observable quoted prices in active markets for identical assets/liabilities(MOST RELIABLE)

Level 2: Observable inputs other than quoted market prices within Level 1

Includes quoted prices for similar asses/liabilities in active market



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Includes quoted prices for identical asses/liability in markets that are not

active

Observable factors relevant to using present values of cash flows to measure

FV

Level 3: Unobservable inputs which reflect the reporting entitys own assumptions(Managements assumptions) about the assumptions market participants would use

in pricing an asset/liability. (LEAST RELIABLE)o Disclosures Related to the Fair Value Option (FVO)

Balance Sheet

Identify the financial assets/liabilities for which it used the FVO and

disclose the reasons for choosing to measure those items at FV

Income Statement exact rules not yet set

Notes to Financial Statements

Indicate which Level (1, 2 or 3) you used for measuring FV

For assets/liabilities valued using more than one of the leels, classify the

asset as coming from the lowest level

More disclosure around Level 3 management assumptions

- Shareholders Equityo Definition : shareholders equity is the residual claim on assets by owners after settling claims

of creditors

o Valuation : value of assets MINUS value of liabilities. (A=L+SE)

o Two basic components of S/Hs equity

Contributed capital: initial investment of S/Hs

Preferred stock first preference for dividends but no voting rights.

Common stock voting rights

Additional paid-in capital (APIC) (e.g. if you sell a $1 par value stock in the

market for $10 you have $1 common stock and $9 additoinal paid-in capital

Retained earnings: additional investment of S/Hs resulting from firms retention ofearnings that belong to owners

o Is S/Hs equity (i.e. book value of equity) = market value of equity?

Market value of equity (market cap)

- Market to Book Ratioo Ratio of the market value of equity to the book value of S/Hs equity

Market value of equity (also known as the market capitalization of the firm) =number of common shares outstanding X market price per share

Book value of equity = the accounting value of S/Hs equityo Why would these differ?

Market value reflects the economic valueso MV/BV examples

Dell: 12.5

Microsoft: 6.18

Bank of America: 1.03

NOTE: while BoA holds mainly financial assets that are recorded in the accounting,

MSFT and DELL have brand name, R&D, etc. that are not incorporated into thebalance sheet- Accounting Cycle

o Lots of transactions

o 1. Analyze Transactions

o 2. Create journal entires (two sides must balance)

o 3. Post to a ledger which is a collection of T-accounts unadjusted trial balance

o 4. Adjusting entries

o 5. Closing entries



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o END OF PERIOD three financial statements are created

- Double Entry Accounting Systemo Every economic event has two sides a give and a take

o Both sides of the transaction are to be recorded

o The basic accounting equation remains in balance

Assets = Liabilities + Shareholders Equity

1) Inv up $100k, Acct Payable up $100k 2) Cash up $3k, Accounts Receivable down $3k

3) PPE up $40M, Notes payable up $40M

4) Cash up $300M, Common stock up $300M

5) Cash down $20k, Accounts payable down $20ko Assets, Liabilities and S/Hs Equity are stored in accounts

T-accounts: easy way to keep track of activity and multiple transactions in anaccount

o Account balances

Ending balance = beginning balance + increases decreaseso Debit an entry which

Is made on the left side of the T-Account

Increases an asset account

Decreases a liability account

Decreases a S/Hs equity accounto Credit is an entry which

Is made on the right side of the T-Account

Decreases an asset account

Increases a liability account

Incrases a S/Hs equity accounto Every transaction must have at least one debit and at least one credit

o Sum of debits = sum of credits

E.g. Dr. Inv. 100k; Cr. Acct Pay 100k

Class 2 10/6/2008

- Balance Sheet Definitionso Assets: economic resourcecs with the ability to provide future benefits to a firm

o Liabilities: creditors claims on the assets of a firm and show some of the sources of the

funds the firm uses to acquire the assets.o Shareholders Equity: amount of funds owners have provided and, in parallel, their claims

on the assets of a firm.o Retained Earnings: source of funds a firm derives from its earnings that exceed the

dividends it has distributed to S/Hs since its formationo Current Liabilities: obligations a firm expects to pay in one year

o Current Assets: generally convert into cash within one year.

o Historical valuation: reflects the acquisition cost of assets or the amounts of funds originally

obtained from creditors or ownerso Current Valuation: reflects the current cost of acquiring assets or the current market value of

creditors and shareholders claims on a firm.- Income Statement Definitions

o Income Statement: attempts to answer question How profitable is the firm? by showing

net income or earnings for a periodo Net Income: revenues expenses (aka earnings)

o Revenues: measure of the inflows of assets (or reductions in liabilities) from selling goods

and providing services to customers.o Expenses: measure of outflows of assets (or increases of liabilities) used in generating

revenues.



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o Net Loss: when expenses for a period exceed revenues.

- Equationso Assets = Liabilities + Shareholders Equity

o Net Income = revenues expenses

- PROBLEM 2.29o 1) Issued for cash 80,000 shares of #10

$800,000 Cash: Debit 800,000

Common Stock: Credit 800,000

o 2)

o We are still recording for December, Yr 12 so the 25 yr useful life doesnt begin yet.

Dr. Land 50,000

Dr. Building 450000

Cr. Cash 500000

o 3)

Dr. Inventory 280,000

Cr. Accounts Payable 280,000

(Notes payable: borrowing money from a lender; Accounts payable: buyinginventory; Bonds payable: borrowing from a different kind of lender)

o 4)

Dr. Accounts Payable 250,000

Cr. Cash 245,000 (2% discount - .02*250k=5k)

Cr. Inventory 5,000 (adding to an asset is a credit)o 5)

Dr. Prepaid Insurance 12000

Cr. Cash 12000

o 6)

Dr. Cash 300,000

Cr. Loan Payable 300,000

o 7)

Dr. Equipment 80,000

Cr. Notes Payable 80,000

o A)

o Cash: Dr 343000

o Inventory: Dr 275000

o Prepaid Insurance: Dr. 12000

o Land 50000

o Buildings 400000

o Equipment 80000

o Accounts Payable: Cr 30000

o Notes Payable: Cr. 80000

o Loan payable: Cr. 300000

o Common stock: Cr. 800000- Assets

o Cash: 343000

- Total Current Assets: 630,000o Land 50000

o Building 450000

o Equipment 80000

- Total Assets: 1210000- Liabilities



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o Accounts Payable 30000

o Notes Payable 80000

o Total Current Liabilities 110000

o Loan Payable 300000

- Total Liabilities 410000- Shareholders Equity

o Common Stock at Par 800000o Total Shareholders Equity 800000

- Total Liabilities and Shareholders Equity 1210000

- Analyzing the Balance Sheeto Current Ratio: Current Assets/Current Liabilities = 630000/110000 ~ 6 (way over 1 good

sign)o Acid Test Ratio: 343000/1100000 ~ 3 (way over 1 good sign)

THE INCOME STATEMENT- Presents a moving picture of the operating results of a firm for a given period of time (e.g. quarter,

fiscal year)o Also known as Statement of Operations, Statement of Earnings

- Cash accountingo Cash Accounting method of accounting where revenues are recorded when cash is received

and expenses are recorded when cash is expended.

o Advantages

Provides reliable information about cash flows

Intuitive and easy to understand

Objective timing of transactions is clearo Disadvantages

Delay in recording revenues/expenses until cash changes hands

Poor matching of resources expended to benefits received

Subject to manipulation for example, firm can delay recording an expense bypostponing cash payment

o Accrual Accounting

Accrual Accounting: method of accounting where revenues and expenses arerecorded on an economic basis regardless of the actual flow of cash

Revenues recorded when benefits are earned

o When is revenue earned?

Expenses recorded when resources are expended to produce benefits.

Advantages

Better measurement of performance and matchingof benefits and costs of

transactions

Curtails manipulation of cash transactions

Disadvantages

More difficult conceptually (at what point is revenue earned?)

Cash is still king

Non-cash financial manipulation through discretion and choice in

accounting ruleso Earnings management: use of accounting discretion to distort

reported earningso Methods of Managing Earnings

1) Cookie Jar Reserves take hits during good periods(restructuring costs) to smooth out earnings numbers.



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2) Concentrate costs in one quarter so future quarters lookbetter. Take a onetime hit, look bad, but then look reallygood going forward.

3) Financing Arm of company

4) Cutting out R&D costs particularly pharmaceuticaland software companies (other discretionary expenses)

5) Earnings guidance to analysts manage analystexpectations so market doesnt expect something higher.

6) Pro forma earnings EBITDA (excludingnonrecurring expenses) be aware that interest, taxes,depreciation, amortization, etc. will continue.

- Measurement Principles of Accrual Accountingo Measurement involves both timing and amount of the recognition for both revenues and

expenses.

Timing of revenue recognition

Measurement of revenue

Timing of expense recognition

Measurement of expenseso Over the life of the firm:

Cash income = accrual income- Revenues

o Revenues: benefits (or increases in net assets) earned by a firm for providing goods and

services

Net Assets = assets liabilities = Shareholders Equityo Revenue recognition criteria

Firm has delivered the goods to the customer or performed all or most of the services(i.e. it has earned the revenue)

Collection of cash (or other benefits) is reasonably assured though some uncertaintymay remain (bad debts, warranties)

Cash (or other benefits) to be received is measurable- How much revenue is recognized in December?

o A) $500k because goods delivered sold on credit

o B) 0 this was already recorded in October

o C) $10k this is what was earned in December

o D) 0 revenue they would have advance from customers

o E) This is not an income statement item this would go into paid in capital

- Expenseso Definition: Decreases in net assets (not necessarily cash) that arise in the process of

generating revenue.o The underlying expense recognition concept is the matching principle: recognize costs and/or

assets used as expenses in the period in which they generate revenueo Expense recognition criteria expenses are recognized when either:

Product costs (costs associated with the production of goods: record in the periodwhen the related revenue is recognized

Period costs (cannot easily be matched with revenue: record in the period when thecost is incurred

- How much expense is recognized in December?o A) 0 revenue not matching to any revenue yet

o B) 0 revenue

o C) $8,000,000 expense matching to the $15,000,000 in revenue

o D) $180,000 expenses in December they did their marketing for that month hard to match

to futureo E) 25000 in December



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o F) this creates an asset, no revenue

o G) 0 dividends are NOT an expense it is not a part of generating revenues. DIVIDENDS

DO NOT GO INTO THE INCOME STATEMENT- Basic Accounting Equation with Revenues, Expenses and Dividends

o Assets = Liabilities + Shareholders Equity

o Shareholders Equity = Contributed Capital + Retained Earnings

o Retained Earnings = Retained Earnings Beginning + Net Income for Period Dividend forPeriod

o Net Income = Revenues for Period Expenses for Period

- Purpose and Use of Individual Revenue and Expense Accountso Revenue and expenses could be recorded directly to the Retained Earnings account

o It is more informative to collect revenues and expenses separately during the accounting

period.o At the end of the accounting period, revenues and expenses are cleared (reset to zero) for the

new accounting period. Their balances flow into Retained Earnings. This is closing theaccounts

o Revnues and expense accounts are temporary accounts. In contrast, the balance sheet

accounts (asset, liability and S/Hs equity) arepermanent accounts whose balances carry overeach period

- Double Entry Accounting Systemo Revenue: increases credit the account (increase an asset); Decreases debit the account

o Expenses: increases are debited; decreases are credited

o Closing revenue account

If you have a credit in revenue

Dr. Revenue by X

Cr. Retained Earnings by X

Expenses, if you have a balance of Y

Cr Expense Account by Y

Dr. Retained Earnings by Xo Shareholders Equity

Increases credited

Decreases

debited

EXAM: DIVIDENDS ARE NOT AN EXPENSE- PROBLEM 3.33 Moulton Corporation

o Accrual basis of accounting

o 1)purchased inventory on account costing $1,100,000 from various suppliers

Dr. Inventory 1,100,000

Cr. Accounts Payable 1,100,000

We start with a beginning balance of $343,000 for cash, etc.o 2) Sold merchandise to customers for 2,000,000 on account

Dr. Accounts Receivable 2,000,000 (this goes to balance sheet)

Cr. Revenue 2,000,000 (this goes to income statement)o 3) Cost of merchandise sold to customers totaled $1,200,000

Dr. Cost of Goods Sold 1,200,000

Cr. Inventory 1,200,000o 4) Collected $1,400,000 from customers for sales made previously on account

Dr. Cash 1,400,000

Cr. Accounts Receivable 1,400,000o 5) Paid merchandise suppliers $950,000 for purchases made previously on account

Cr. Cash 950,000

Dr. Accounts Payable 950,000o 6) Paid various suppliers of selling and administrative services $625,000. The firm consumed

all of the benefits of these services during Year 13.



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Cr. Cash 625,000 (balance sheet)

Dr. SGA (Selling, General, Administrative) Expense 625,000 (income statement)o 7) Firm acquired equipment costing $80k and signed a 6% note payable to the supplier. The

note is due on 6/30 Year 13. Equipment has estimated useful life of 5 years. In year 13, firmrepaid note payable to supplier with interest.

Dr. Interest Expense .06*80k*(1/2 half a year)=$2,400

Cr. Cash 2400 Dr. Notes Payable 80,000

Cr. Cash 80000o 8) The firm borrowed $300k from a bank. The loan bears interest at an annual rate of 8% and

is due in 5 yrs. The interest is payable on January 1 of each year, beginning January 1, Year14. On December 31, Year 13 the firm recognized interest on the loan.

The 300,000 was from year 12 so it should have already been reflected.

Dr. Interest Expense .08*300,000=24000 (on income statement)

Cr. Interests Payable 24,000 (liability on balance sheet)o 9)

Dr. Insurance Expense 12,000

Cr. Prepaid Insurance 12,000 (this reverses out the asset they had)o 10) Recognized depreciation expense for Year 13. In Year 12, the firm had purchased a

building costing $450,000 with an expected useful life of 25 years beginning on January 1,Year 13. Also, on December 31 it acquired equipment costing $80k which has an estimateduseful life of 5 years.

Dr. Depreciation Expense 18,000

Dr. Depreciation Expense 16,000

Cr. Accumulated Depreciation 34,000 (contra asset account this goes intobalance sheet and is written under the building or equipment you are depreciating. Itis still on the asset side of the balance sheet because it makes sense to have themtogether. It works like a liability because when it increases we credit.

o 11) 12/31 Year 13, recognized income tax expense and income tax payable for Year 13. The

income tax rate is 40%. Assume that income taxes for Year 13 are payable by March 15,Year 14.

Sales Revenue: 2,000,000

Expenses

Cost of Goods Sold: 1,200,000

SGA Expense: 625,000

Insurance: 12,000

Depreciation: 34,000

Interest: 26,400

Total Expenses: 1,897,400

Net Income Before Income Taxes: 102,600

Income Tax Expense at 40%: (41040)

Net Income: 61,560

Dr. Income Tax Expense 41,040

Cr. Tax Payable 41,040

o Closing transactions

Dr. Revenue 2,000,000 (because that zeros out the credit)

Cr. Retained Earnings 2,000,000

Cr. Cost of Goods Sold 1,200,000

Dr. Retained Earnings 2,000,000

Cr. SGA 625,000



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Dr. Retained Earnings 625,000

Cr. Insurance 12,000


Cr. Depreciation 34,000


Cr. Income Tax Expense 41040

Dr. Retained Earnings 41,040- Types of Journal Entries

o Transaction based entries: sale of product, purchase materials, pay salaries

o Adjusting journal entries:

Made at the end of an accounting periodto reflect non-cash economic events thatoccurred during the period or prior transactions that were improperly recorded duringthe period.

Usually involve both a balance sheet and an income statement account

Example

Dr. Unearned Revenue

Cr. Revenue

- Summary of the Double Entry Accounting Systemo Asset

+ debit

- credito Liability

- Debit

+ Credit

o Stockholders Equity

- Debit

+ Credito Contributed Capital

- Debit

+ Credito Retained Earnings

- Debit

+ Credito Expense

+ Debit

- Credit

o Revenue

- Debit

+ Credit- Analyses of overstatement/understatement

o A)

Actual Entry

Dr. Cash 1400

Cr. Revenue 1400 Correct Entry

Dr. Cash 1400

Cr. Advance from Customer 1400

Correcting Entry Needed

Dr. Revenue 1400

Cr. Advance from Customer 1400

Effect on Balance Sheet



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Assets not effected (cash correctly stated)

Liabilities (understated because they had an advance but they didnt state

the liability)

Shareholder Equity (Overstated by 1400 because revenues were overstated

by 1400)o B)

Actual Entry Dr. Cost of Goods Sold 5000

Cr. Cash 5000

Correct Entry

Dr. Equipment 5,000

Cr. Cash 5000

Dr. Depreciation 500 (5000*1/5 * )

Cr. Accumulated Depreciation (contra account)

Correcting Entry

Cr. Cost of Goods Sold 5000

Dr. Equipment 5,000

Dr. Depreciation 500 (5000*1/5 * )

Cr. Accumulated Depreciation 500 (contra account)

Effect on balance sheet

Assets understated by 4500 (5000-500)

Liabilities no effect

Shareholders Equity understated by 4500

Retained earnings understated by 4500

Expenses overstated by 4500

- Income Statement Classificationo Operating (related to core operations of firm)

Recurring (persist in future)

Product sales

SGA

COGS

Non-recurring (temporary charge)

Discontinued operations (closed unit)

o Peripheral (not related to core activity)

Recurring

Depreciation

Interest Expense/Revenue

Income Tax

Gains & Losses on Asset Sales

Non-recurring

Patent litigation

Natural disasters

o You want to look at these different categories so you can invest properly. Look at what is

likely to persist in the future.

EPS = (net income dividends)/avg common shares outstanding

If effect of dilution on EPS > 3% you must report both basic and diluted EPS.

CLASS 3- Revenue Recognition Principles

o Reasonably Certain that you will collect it from customers

o Delivered goods or provided the service at least most of the service or most of the goods



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o Measurable must be measurable or else we cant recognize it in financial statements

- Staples Example

o 1) Review the revenue recognition policies of Staples discussed in Note A (Summary

of Significant Accounting Policies). What are the types of revenue recorded byStaples? Discuss why the recognition policies for these revenue types are consistentwith the revenue recognition criteria discussed in class.

Revenue is recognized at the point of sale for the Companys retail operationsand at the time of shipment for its delivery sales .

This is consistent with the Revenue Recognition principles of GAAP

Sales of extended service plans are either administered by an unrelated third party orby the Company. The unrelated third party is the legal obligor in most of the areasthey administer and accordingly bears all performance obligations and risk of lossrelated to the service plans sold in such areas. In these areas, Staples recognizes anet commission revenue at the time of sale for the service plans. In certain areaswhere Staples is the legal obligor, the revenues associated with the sale are

deferred and recognized over the life of the service contract, which is typicallyone to five years.

This is consistent with GAAP.

o 2) What is Staples accounting policy for advertising expenditures? What percent of Staples

Sales are advertising and marketing expenses in fiscal 2005, 2004 and 2003? What percent ofOperating and Selling expenses are advertising and marketing expenses in fiscal 2005, 2004and 2003?

Staples expenses the production costs of advertising the first time the

advertising takes place, except for the cost of direct-response advertising, primarilycatalog production costs, which are capitalized and amortized over their expectedperiod of future benefits (i.e., the life of the catalog). Direct catalog production costsincluded in prepaid and other assets totaled $28.4 million at January 28, 2006 and$30.8 million at January 29, 2005. Total advertising and marketing expense was$588.2 million, $526.0 million and $492.7 million for fiscal years 2005, 2004 and2003, respectively.

This is consistent with GAAP.

They spend about 4% of sales on advertising in 2003, 2004 & 2005

Advertising over Operating and Selling costs is about 22% across the years.

If you are looking for a particular expense, sometimes you need to look at

the footnotes.o 3. Show the journal entry made by Staples to reflect the amount of dividends declared during

fiscal 2005. You may assume that there are no prior period adjustments that affect RetainedEarnings.

Retained Earnings

Credit Debit

2818163

Net Income 834409

Dividends ?? (123402)

Ending Balance 3529170 (this increases because of net income)

o Retained Earnings End Balance = RE Beginning Balance + Net Income Dividendso How write as a journal entry?

Dr. Retained Earnings 123402

Cr. Dividends Payable (or Cash) 123402o 4. What is the number of shares of common stock that have been issued as of January 28,

2006? Show how the accounting value for the Common Stock account in the Balance Sheeton this date was determined.

Issued vs. Authorized vs. Outstanding

Authorized # shares total number of shares a firm can issue over its life



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Issued # shares dont take away the number they purchased back

Repurchased shares (e.g. Treasury stock)

Outstanding # shares (e.g. float) shares issued shares repurchased

Issued: 829,695,100

Repurchased: 99,253,565

Outstanding = Issued Repurchased = 730441535

o REFERS TO GOOGLEo 5. What type of opinion did the auditors issue regarding Googles financial statements? What

types of opinion did the auditors issue regarding Googles internal controls?o 6. Compute the percentage change in revenue from fiscal 2003 to fiscal 2004 and from fiscal

2004 to fiscal 2005. Conduct similar calculations for income from operations. [Note: youshould exclude the one-time expense recorded in 2004 and 2005 related to the Yahoodispute settlement and the Google Foundation contribution, respectively]. Based on theseresults, did expenses grow at a faster or slower pace than revenues? Which expense categoriesappear to account for the differences in growth rates between revenues and income fromoperations?

o 7. What is the date of the financial statements? What is the date of the auditors report? When

did the stock market learn about Googles results?o 8. For this question, please read and review: the excerpt of the press release titled Googles

Fourth Quarter and Fiscal Year 2005 Results the Google stock market charts in the attachedpages and the Wall Street Journal article dated February 1, 2006.

o a) How would you characterize the Googles results for fiscal 2005?

o b) Review the stock market charts for the period January 1, 2005 through May 1, 2006 for

Google. Compare the fiscal 2005 performance for Google with Googles stock price (from thestock chart) over the same period. Compare Googles 2005 stock price performance with theperformance of the broader set of firms trading on the NASDAQ exchange.

o c) Based on the stock market chart, was the news in the press release perceived as good

news or bad news by the market? According to the Wall Street Journal article datedFebruary 1, 2006, what appears to be the rationale behind the markets reaction to the news inthe press release?

o d) The earnings press release includes information about non-GAAP financial measures (also

known as pro-forma earnings) for the fourth quarter 2005. Why do you think Googlecomputes and reports these non-GAAP numbers? How might they be used by marketparticipants? The last page of the press release includes a reconciliation from the GAAPincome statement measures to the non-GAAP measures discuss the 2 items that are reflectedin GAAP Income from Operation that are excluded from the non-GAAP equivalent whatdoes each item capture and why would Google exclude each in computing the non-GAAPmeasure?

CLASS 3- Review of Accrual Accounting

o Assets = Liabilities + Owners Equity (this is always balanced)

- Assets Increase by:o Borrowing (Liabilities increase)

o Owner investments (contributed capital increases)o Earnings Income (Retained Earnings increases)

- Net Income = Revenues Expenseso Revenues are inflows of assets

o Expenses are outflows of assets

o Revenues and expenses can be recognized even when cash does not chance hands. Revenue

recognition criteria and expense recognition- The Statement of Cash Flows



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o Reports changes in cash over a period of time (moving picture) between balance sheet dates

due to operating, investing, and financing activities. People want to know the sources anduses of cash (e.g. lenders, suppliers, etc.)

- Why do we need SCF?o Cash is important enough to warrant reconciliation

o Cash flow as an alternative performance measure bankruptcy risk depends more on cash

flows than on profitso Past cash flows serve as an aid to

Predict future cash flows

Evaluate managements effectiveness in generating and using cash

Assess liquidityo Net change in Cash = Net Cash from operations + net cash fromfinancing+ net cash from

investing

- Types of Activitieso Operating Activities

Transactsions related to providing goods and services to customers and to payingexpenses related to revenue generating activities (income statement transactions)

o Investing Activities

o Financing Activities

- How would you classify these? REVIEW THESE DECK 3, SLIDE 4o Payment of accounts payable - O,

o Proceeds from issuing common stock - F,

o Collection of accounts receivable - O,

o Purchase of land - I,

o F, O, O (interest on debt is operating parallels income statement, GAAP),, F, I, O (receipt

of dividends on that stock investment parallels income statement, GAAP, even though thisseems like an investment deal), NON-CASH TRANSACTION (not in statement of cashflows)

- Noteo Be careful about

payments of dividends vs. Interest and dividends collected (operating)

Interest and taxes paid (operating)- Methods of Presenting the Statement of Cash Flows

o Direct Method

Lists cash receipts and disbursements by source/use of funds

Always used for investing and financing activities

Rarely used for operating activitieso Indirect method

Only used for operating activities

Goal is to reconcile net income with cash from operations by removing noncashitems from net income

Net Income = Cash Revenue + NonCash Revenue Cash Expenses

Noncash expenses

Net Income (cash) = Cash Revenue Cash Expenses)

Almost every company uses this method for operating activities- Statement of Cash Flows: Indirect Method

o Well focus on indirect formatwhich is used by most firms

Involves reconciling net income to cash flow from operations by accounting for non-cash items embedded in net income

Net Income = Cash Revenue + Noncash Revenues Cash Expense

NonCash expense

Start with Net Income



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Cash Flows from Operations = Net Income Non-cash revenues +

noncash expenses

o Types of Adjustments between net income and cash from operations

Non-cash expenses (depreciation

Non-operating items in net income

Gains and losses on equipment sales

Accrual vs. cash flow differences in operating activities (sales vs. cash receipts)- Indirect Method: A Summary

o ??

- Statement of Cash Flows: Examples of Adjustmentso Depreciation is a non-cash expense why?

When you purchase a long-term asset you spend cash but do not expense the amountright away (matching principle)

Example

Revenue (Cash) = 100

Expenses, cash = (40)

Depreciation (20)

Net Income = 40

CFO = NI + Depreciation = 60

Note: Anything that is a noncash expense is added back in.

Example 2

Sales = 1400

Cash collections from customers = 1385

Accounts Receivable 100 115

Direct method: use 1385

Net Income = 1400

Change in AR 115-100 = Sales cash received;

subtract out this difference from net income and that gives us the cash theycollected. Receivables will go up by the difference in cash and noncashrevenues

Indirect method: 1400 15 = 1385 Example 3

Asset bought for $8 and depreciated $3

Net Book Value = $8-$3 = $5.

Sold it for $1

Journal entry

o Dr. Cash 1 (investing section of SCF)

o Dr. Acc Dep. 3

o Dr. Loss on Sale 4

o Cr. Asset 8

Whenever there is a gain or loss from property you have to adjust the

income statement.- Problem 4.30 from the text.

o A)

Dr. Cash 10,000

Dr. Acc. Dep 40,000

Dr. Loss on Sale 0 (goes to income statement)

Cr. Equipment 50,000

Cr. Gain on Sale 0 (goes to IS)

o B)



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Dr. Cash 12,000

Dr. Acc. Dep 40,000

Dr. Loss on Sale 0 (goes to IS)


Cr. Gain on Sale 2,000 (goes to IS)o C)

Dr. Cash 8,000 Dr. Acc. Dep 40,000

Dr. Loss on Sale 2,000 (goes to IS)


Cr. Gain on Sale 0 (goes to IS)o Note: In C we have a loss on sale of $2,000.

o What is the effect on the Cash Flow Statement?

Sell for $10000

Operations

o Income 100

o Depreciation 15

o Gain on sale 0

o Loss on sale 0o Changes in work cap (40)

o Cash flows from operations 75

Investing

o Acquisition of Buildings & Equipment (30)

o Proceeds from Sale of Equipment 10

o Cash flow from investing (20)

Financing

o Repayment of long-term Debt (40)

Net Change in Cash 15

Cash, Beginning of year 27

Cash, End of year 42

Sell for $12000 Operations

o Income 102

o Depreciation 15

o Gain on sale (2)

o Loss on sale 0

o Changes in work cap (40)


Investing


o Proceeds from Sale of Equipment 12

o Cash flow from investing (18)

Financing





Sell for $8000

Operations

o Income 98

o Depreciation 15



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o Gain on sale 0

o Loss on sale 2

o Changes in work cap (40)


Investing


o Proceeds from Sale of Equipment 8o Cash flow from investing (22)

Financing





- Accumulating Information for a SCFo A = L + S/E

o REVIEW: Deck 3, Slide 15

o Operating

Generally, all changes in current assets and current liabilities

Exceptions Marketable Securities investments section

Short-term borrowing Financing

Otherwise, changes in current assets and current liabilities go to operating

o Investing

Generally, changes in long-term assets (excluding depreciation which is not a cashtransaction)

o Financing

Generally, change in long-term liabilities and changes in contributed capital accounts- Problem 4-35

o If income statement is not provided, you will have the information required.

o Example

Net Income is given

Depreciation expense is given

o STEP 1: create T accounts and put in beginning and ending balances from balance sheet

o STEP 2: look at additional information given

Net Income for year was $568,000 and dividends declared were $60,000

Update Retained Earnings by increasing $568,000

Decrease RE by $60,000

Depreciation was $510,000

Accumulated Depreciation increases $510 (Cr)

$120 (plug) represents accumulated depreciation of sold equipment (Dr)

o They give you the $120,000 which you could have calculated.

How?

Machinery goes down (Cr) by $150,000

o They must have purchased new machinery and buildings

o Amount purchased is $118 (plug) purchased for year (Dr.)

Proceeds from sale was $25000

o What was net book value of machinery sold?

$150,000 (original cost) acc. Depreciation of $120,000= $30000. They sold for $25000. This is a loss of $5000.(remember this when making cash flow statement)

Retired bonds at book value



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o Retired $50k

Accounts receivable changed by 1052,000 946,000 = 106,000

Inventory: 204,000

Land: 36,000

Accounts Payable: 146,000

Taxes Payable: 16,000

Other payables: 138,000

Common Stock: 32,000

o STEP 3: Cash flow statement

Current assets/liabilities go to operations- START WITH NET INCOME AND ADD BACK IN DEPRECIATION

o Operating

Net Income is $568,000

Add back depreciation expense: $510,000

Accounts Receivable: subtract $106 because AR increased

Inventory: subtract 204 (inventory increased 204)

Loss on Machinery: $5,000

Accounts Payable: add back (accounts payable increased 146)

Tax Payable: add 16 (it increased and it is a liability) Other Payable: add 138

o Investing

Asset goes up (subtract from cash flow)

Land: subtract 36 (land went up 36)

Machinery: subtract 1018 (building and machinery increased)

Machinery: add 25,000 (put down the proceeds of the sale, not the book value) (whatis the corresponding adjustment in operating section? They made a loss. We addthat back.

Accumulated Depreciation: nothing left

Accounts Payable: increased by 146o Financing

Bonds Payable: went down 50 (subtract)

Common Stock: went up 32 (add it)

Dividends Paid to S/H: subtract 60 (subtract because dividends paid went up.- What can firms do to mislead investors regarding cash flows?

o Increase or decrease in assets that arent reflected.

o Working capital adjustments

changes in accounts payable, accounts receivable, etc. Companies can still followGAAP but they can delay paying suppliers, push customers to pay earlier which isntalways a good business practice. They can effect other business decisions to maketheir cash flow from operations look better.

o Classification

Most investors look at cash from operations. This is an important part of the SCF.Are they doing well in their operations.

Nortel had accounts receivable changes that were over a year old so they put them inthe investing section. The numbers still add up but the operating amount doesntchange.

Operating cash flow number may not be fool proof

o Depreciation expense method

Can affect the operating number because of the add back that can boost operating however, their net income will take a hit.

- Red flags watch out for if looking at companies

o Compare NI & CFO number if earnings and cash flow are going in different directions



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You want the company to recover the cash. If they are growing in differentdirections, they may be channel stuffing (bogus customers)

o Look at Receivables, Inventory Growth & Sales if inventory is growing but sales are not,

they may have a lot of inventory that they cant sell. If they are getting receivables but nocash, why?

o Free Cash flow number analysts look at this.

Free Cash Flow = Cash from operations Capital investments (PP&E, etc.) = CFO (cash flow operations CFI (cash flow from investments)

If you have negative free cash flow, look at days to flameout this is liquidresources of firm / cashflow per day.

Liquid resources = Cash + AR + Inv + Marketable Securities

Cash Flow/day = FCF/365

Days to flameout

- US Airways

o 5) Assume that the property sold by U.S. Airways during 2001 had an original cost of $100 million.

What was the entry to record the sale of the property?

Proceeds from Disposition of Property $53

They got Cash of $53

Accumulated Depreciation

What was the depreciation of the sold PP&E? How do we figure it out?

We know the gain was $3 (subtracted from operations)

We know that it cost $53, so we know accumulated depreciation was $50.

Dr. Cash 53

Dr. Acc Depre 50

Cr. Gain 3

Cr. PPE 100 (given)

o 6) As a result of the September 11 attacks, Congress passed legislation authorizing payments to airlines

to compensate them for 9/11 losses. How much did U.S. Airways receive in 2001 from these grants andhow much of this amount was in cash?

Dr. Cash 264

Dr Acc Rec 56 Cr Airline Grant 320

Cr.o 7) Why is the amount for Non-cash Charges an addition to net income in determining cash flow from

operations?

Because it is non-casho 8) Why are increases in Accounts Payable and Accrued expenses an addition to Net income in

determining cash flow from operations?

They are not cash. It is an expense for the period but not a cash expense. Therefore,you add it back because you only want to find the cash part of the period. Addanything that was a non-cash item.

Class 4: Class Notes for Chapter 6

- Accounts Receivable and Revenue Recognitiono Revenue is recognized when

1) firm has delivered the goods/services to the customer

2) Collection of cash is reasonably assured

3) Cash to be received is measurableo Accounting for bad debts from customers and other costs associated with accounts receivables

focuses on the last two criteriao Objective when reporting Revenue and corresponding A/R:



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Reflect balances at the net amount of cash expected to be received: this reflects thegross amount of Revenue and A/R net ofestimated uncollectible amounts.

Strict credit policy high quality customers but lower volume

Loose credit policy lower quality customers but higher volume

Trade-off as users of information, we want to know what the company expects tocollect.

- Accounting for Uncollectible Accounts: DIRECT WRITE-OFF METHODo Bad debt expense is recognized in the period in which a specific account is deemed

uncollectible.o Recognize Revenue at time of sale

CLASS 5- NOTES are ON CLASS NOTES- MIDTERM REVIEW- Balance Sheet

o Assets = Liabiliities + SH Equityo Assets

Debit balance: debit increases, credit decreaseso Liabilities

Credit balance: credit increases, debit decreases

o Shareholders Equity

Contributed capital (preferred stock, common stock, addl paid in capital), retainedearnings

SE accounts have a credit balance: credit increases, debit decreases- Income Statement

o Net Income = Revenue expenses + gains losseso Accrual accounting: record revenue when earned and match expenses corresponding

o Revenues/Gains: credit balance - debits decrease, credits increase

o Expenses/loss: debit balance - debits increase, credits decrease

o Temporary Accounts

Close income statement accounts to RE at end of operating period

REend = REbeg + Net Income Dividends Dividends are not declared as an expense!!

- Cash Flow Statemento Net change in cash = net cash from operations + net cash from investing + net cash from

financingo Cash flow from operations: Indirect Method

Net income

+ non-cash expenses (depreciation, bad cash expense)

- gains from sale of PPE

+ losses from sale of PPE

+ increases in operating current liab/decreases in operating current assets

32000 for insurance policy for 4 months. Cost/month $8000.

Close books every month. End of 1st month, no entry was recorded.

Correct entry

o Debit Insurance Expense 8000

o Debit Prepaid Insurance 24000

o Credit Cash 32000

+ 8000 NI (NI overstated should have had an expense of 8000)

+32000 overstatement in cash

- decreases in operating current liab/increases in operating current assets

= cash flow from operations



26/44


o Cash flow from investing (Dreict Method)

(Purchase/sale of PPE, land, investments)

Sale of PPE: net book value = acquisition cost accum.Depreciation

Proceeds of sale of PPE = net book value + gain on sale

Cash from investing includes theproceeds from the saleo Cash flow from financing (Direct Method)

Issue (+)/repurchase stock (-)

Dividends paid (-) (dividend revenue from investments is in cash flow fromoperations)

Debt issued/retired (interest payments are in cash flow from operations)o Non-cash transactions are not reported in the cash flow statement

- Accounts Receivableo At time of sale

Dr AR, Cr Revenue

Dr bad debt expense, Cr Allowance for uncollectible accounts (contra asset)

Bad debt expense: estimated using percentage of sales; aging of ARo When specific customers default

Dr. Allowance for Uncollectible Accounts, Cr. ARo When customers pay in cash

Dr. Cash, Cr. ARo Cash flow presentation

Net Income +- net AR

Net AR = Gross AR Net Allowance

Net Income + bad debt expense +/- net AR write-offs

o Income recognition before and after sale

o Ratio Analysis p237

- EXAMPLEo Suppose customer owing $5000 in prior period sales defaults. What is effect NI, CA and

CFO?

Before recording writeoff AR Gross is 100

Net Allowance is (25)

Net AR = 75

After recording

AR Gross is 95

Net Allowance (20)

Net AR is 75

Dr. Allowance Account 5000

Cr. Accounts Receivable 5000

NI is unaffected because the expense was already taken into account

CA no impact

CFO no impact- Inventory

o All costs related to acquisition included in inventory value (transportation, direct material,

packing/unpacking costs, etc.)o Manufacturing firms

Raw materials inventory, work-in-process (WIP) inventory, finished goods inventory

Product costs (direct and indirect) included in work in process inventory]

Dr WIP, Cr. Cash/salary payable/accum depr./insurance payable

RMend = beginning balance + purchased RM used



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WIPend = Beginning Balance +Raw materials being used + Direct Labor +

Overhead completed units value

Finaished Goodsend = Beginning balance + Completed Units COGS

o FIFO Inventory + LIFO Reserve (credit balance) = LIFO Inventory

Excess of FIFO over LIFO is the LIFO Reserve

11/10/08- GAP and AOL Case- Product Development Costs

o 1) Capitalize Costs

o 2) Amortize Costs

o 3) Expense when Technological Feasibility is not reached

- Journal Entreiso Capitalize

Dr. Product Development Cost 51

Cr. Cash/Payable 51o Amortize

Dr. Amortization Expense 36

Cr. Product Development Cost (Net)

Or

Cr. Accumulated Amortization 36o Expensing

Dr. Product Development Expense 95

Cr. Cash/Payable 95- Deferred Subscriber Acquisition Cost

o Beginning Balance

o Amount Capitalized

o Sold Net

o Amortization Expense

o Write-offs

o End Balance

- Fiscal Year 1996- Deferred Subscriber Acquisition Cost

o Beginning Balance: 6/30/95 77

o Costs Capitalized (cash flow) 363

o Amortization Expense (SCF) 126

o Writeoffs (SCF) 0

o

o End Balance: 6/30/96 314

- Journal Entrieso Capitalize

Dr. Deferred Subscriber Acquisition Cost 363

Cr. Cash/Payable 363o Amortization

Dr. Amortization Expense 126

Cr. Accumulated Amortization 126

Or

Cr. Deferred Subscriber Acquisition, Net 126o Writeoffs

Dr. Writeoff (Inc. Stmt) 0

Cr. Deferred Subscriber Acquisition, Net 0- Fiscal Year 1997



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o Beginning Balance: 6/30/96 314

o Costs Capitalized (cash flow) 130

o Amortization Expense (SCF) 59

o Writeoffs (SCF) 385

o End Balance: 6/30/97 0

- 11)

o No capitalization 1. No amortization Expense

2. No writeoffs

3. Full Expensing of all Capitalized Costs

Everything going to the asset on balance sheet should hit income statement

as expense.o EQUATION: As if Net Income if no capitalization = Net IncomeAsReported + amortization

expense + writeoffs costs capitalized

Source: Income Statement

1997 1996

Pretax Income: (499) 62

+ Amortization Expense 126 59

+ Writeoffs 0 385

- Capitalized Costs (363) (130)

____________________________________________

(175) (185)- LONG-TERM LIABILITIES

o A liability is a claim on assets by non-owners that represents an obligation to make future

payments of cash goods or serviceso A liability is recognized when

Obligation is based on benefits or services received currently or in the past

The amount of timing of payment is reasonably certaino Valuation

Monetary reflected at the PV of future cash payments

Nonmonetary at expected cost of providing service (e.g. warranties) or amount of

resources advanced (e.g. customer advance)o Current and Noncurrent classifications

Some obligations have both current and noncurrent portions- Contingent Liabilities

o Contingent liabilities are potential liabilities some event has occurred, but the certainty of an

obligation to the firm is not yet determinedo GAAP requires recognition of contingent liability if:

It isprobable (80-85%) that an asset has been impaired or a liability incurred, and

The amount of the loss can be reasonably estimatedo Most often, contingent liabilities are not recorded but are disclosed in footnotes

o New concept constructive liabilities

Arise not from an obligation, but from management intent (e.g. costs associated with

a planned restructuring activity) E.g. this is a signal to investors contentious because there are cookie jar things

where management takes a big hit in one period, and then go forward and reversethat charge. This is very dicey. Potential for earnings management.

Dr. Restructuring Charges (IS)

Cr. Restructuring Liability

- Long-term Liabilitieso Value at thepresent value of future cash payments



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o There are many types of long-term debt with differing types of timing of required future cash

flows of interest and principalo Common examples

Mortgages

Coupon bonds

Serial bonds

Zero coupon bondso Well illustrate using coupon bonds which have periodic payments of interest with the

principal amount repaid in one lump sum at the maturity of the bond.- Bonds

o Face or par value: the amount due at the maturity of an obligation

o Interest rate

Coupon interest rate stated rate in the bond contract that determines the amount ofthe periodic payments

Historical market interest rate/effective interest rate/yield to maturity the marketrate of interest at the date of issue of the bond

Determined by general market conditions and overall riskiness (e.g. credit

worthiness) of firm

Current market interest rate rate in the marketplace for a comparable piece of debt(maturity and risk)

o Coupon payments: annual/semi-annual interest payments determined by the face value of the

bond and the coupon interest rate contract

Total promised cash payments = annual/semi-annual interest payments and facevalue of bond due in full at maturity

- Bondso Dr. Interest Expense

o Dr. Bond Premium

o Cr. Cash

o Ending Balance of Bond Premium eventually becomes zero and Bond value goes down to

par value.o Balance Sheet

At Issue Date Bonds Payable: 8000000

Bond Premium: 1849208

Net Book Value of Bonds: 9849206

6 months later

Bonds Payable: 8000000

Bond Premium 1824682

Net Book Value of Bonds 9824682

1 yr after issue

Bonds Payable: 8000000

Bond Premium 1799422

Net Book Value of Bonds 9799422

- I NEED TO GET A PHOTOCOPY OF THE BONDS STUFF- Bonds

o More on Bonds

Example

Dr. Cash 6627309

Dr. Bond Discount 1372691 (plug)

Cr. Bonds Payable 8000000

Market Rate: 10%, period rate 5%

USE TABLE 2 and TABLE 4



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o Balance Sheet

Bonds Payable

LESS (Bond Discount)

NBV of Bondo Bond Amortization Table

1,2,3,4,5,6

Period, Liability at Beginning Amt Raised, Interest Expense (at 5%), CouponPayment (at 4%), Difference: decrease in book value, Liability at End of Period

Difference: decrease in book value = 3 4

EFFECTIVE INTEREST RATE METHODo Amount by which the bond discounts gets amortized every period. The liability amount is

changing every period.o How much is the liability changing? This is the same as how much the bond value is

changing.o Dr. Interest Expense

Cr. Bond Discount (amount gets subtracted from unamortized Bond Discount untilthe balance becomes zero after 40 periods. This amount is the difference betweenthe actual interest expense and the amount actual shelled out in cash.

Cr. Casho When you are finding out the book value or to compute interest expense, use the historical a

rate.o When you are going to retire a bond or want the present value, use the current rate.

o Gain = Net Book Value Cash Outflow to Retire the Bonds (MV)

If the cash you have to pay is less than the book value, you have a gain from retiringthe bond.

If the cash you have to pay is more than the book value, you are making a loss inretiring the bond.

-- TRIBUNE CASE

o 7. What is the amount of long-term debt that is scheduled to be paid by the Tribune Company

during fiscal 2002?

Note 10: 410,890

o 8. What was the adjusting entry recorded by The Tribune Co. on December 31, 2001 to

recognize fiscal 2001interest expense on the LYONs (Liquid Yield Options Notes)?

Look at Note 10 The percentage before the amount is a coupon rte. LYONs is azero coupon bond. YTM was 3.57% but the coupon rate was zero. What is theinterest expense every period? It is due in 15 years.

Typical journal entry

Dr. Interest Expense

Cr. Bond Discount

Cr. Cash

Find out the amount the bond is amortized and that is the same as the

interest expense because Cash is zero with a zero coupon bond.

Bond Discount Account (Unamortized bond discount)

o LYONs are zero coupon bonds interest expense = amount of

amortization of discounto Alternative: Change in net book value (NBV) of bond = 291,644

281,602 = 10,042.o Change in Bond Discount Account = Change in Net Book Value

(NBV) of bond. this is true even if it is not a zero coupon bond.o 217,498

o 207,456



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o Bond got discounted by $10,042. This is the amount the bond

discount changed.o 9. If The Tribune Co. does not retire any of the LYONs during 2002, what would be their

book value on December 31,2002?

NBV of Lyons as of 12/31/2002

NBV = Bond Value as of 12/31/2001 + Interest Expense during 2002

= 291644 + (historical rate * beginning liability) = 291644 + (.0357*291644) = 302,056

For a zero coupon, interest expense is the same as the amount the bond

discount changes which is how the net book value changes as well.

THIS IS VERY IMPORTANT FOR THE FINAL.o 10. Show the journal entry that was made by The Tribune Co. to retire the 6.65% notes,

including the final annual payment of interest) on their maturity date of October 1, 2001.

6.65% notes matured in October 2001, net of unamortized discount of $551

Company year end is 12/31 so this problem will be tricky.

Face Value = amount due at maturity

Face Value Bond Discount = Net Book Value (NBV) of Bond

NBV + Unamortized Discount = Face Value

Face Value = 199,449 + 551 = 200,000 Coupon Payment = Face Value * coupon rate

Coupon Payment = 200,000 * .0665 = $13,300

Oct 2000 Dec 2000 = 3 months of interest = 3/12 * 13,300 = $3325 (InterestPayable)

From Jan 1, 2001 = Oct 2001 = 9 monghts interest = 9/12 * 13300 = 9975

Only interest expense for 2001

Interest Expense

o Dr. Interest Expense 10,526 (plug)

o Cr. Bond Discount 551

o Cr. Cash 9975

Maturity Entry

o Dr. Bonds Payable 200,000

o Dr. Interest Payable 3325

o Dr Interest Expense 10526

o Cr. Bond Discount 551

o Cr. Cash 213300

o 11. What is the outstanding face amount of the 7.45% notes due 2009 at December 31, 2001?

At December 31, 2000?

Face Value = NBV + Unamortized Discount

Face Value 12/31/2001 = NBV12/31/2001 + Unamortized Discount(12/31/2001)

FV12/31/2001 = 394370 + 5630 = 400,000

FV12/31/2000 = 393649 + 6351 = 400,000

NOTE: face value will not change (unless they retire part of the bond)

Coupon Payments = .0745 * 400000 = $29800

Bond Discount Amortization = 6351 5630 = $721

Interest Expense = Interest Payable + Change in Unamortized Discount

Journal Entries

Dr Interest Expense 30521

Cr. Bond Discount 721

Cr. Cash/Interest Payable (in this case) 29800



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o 12. What adjusting journal entry was made on December 31, 2001 relating to the 7.45% notes

due 2009. You may assume that coupon interest payments are due annually on January 1.- LEASES

o Off balance sheet Financing: use of assets or services by a firm that obligates them to sacrifice

cash payments in the future, but the transaction is structured to avoid recording a liability onthe balance sheet

Example: operating lease of equipment Special Purpose Entities (SPE) can be considered off-balance sheet financing

o Goal of GAAP: assess whether the company using the assets (lessee) bears the risks of

ownership if so, the lessee will likely have to record the asset and the liability on itsbalance sheet

o Why might firms want to keep debt off the balance sheet?

Reduce perceived risk of firm

Increase access to new debt

Maintain slack in existing debt covenantso Lease

A lease is a contract in which an owner (lessor) grants the use of an asset to a secondparty (lessee) for a fixed period of time in exchange for a series of payments.

o Capital lease (financing lease)

Lessor transfers substantially all the risks and benefits of ownership to the lessee

Lessee purchases the asset

o Operating Lease

Lessor transfers property rights to the lessee for a period of time

Lessee returns property to lessor at the end of thte lease term

Lessee rents the asset

o Criteria to Determine Lease Accounting Treatment

Method of lease accounting is not a choice it is dictated by the structure of thelease. Of course, management has control over how a lease is structured.

Key issue which party enjoys the economic benefits and bears the economic risksof the lesae property

A firm must account for a lease as a capital lease if the lease meets any one of the

following four conditions 1. Lessortransfers ownership to the lessee at the end of the lease term

2. A bargain purchase option exists (lessee has a right to buy the asset at

the end of the lease for less than market value.

3. The lease term extends forat least 75% of the assets life

4. Thepresent value of the minimum lease payments is greater than or equal

to 90% of the fair value of the asset at the time the lease is signedo Accounting for Lessee: Operating Lease

Inception: No entry.

At end of each year: Periodic rent expense

Dr. Rent Expense

Cr. Cash

Future operating lease payments must be disclosed in footnoteso Accounting for Lessee: Capital Lease

Inception: record an asset and a liability at the present value of the lease payments

Dr. Capital Lease Asset

Cr. Capital Lease Liability

At end of year: record depreciation expense and record cash payments as interestexpense and reduction in liability

Dr. Depreciation Expense (generally straight line depreciation method)

Cr. Accumulated Depreciation



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Dr. Interest Expense (contract rate * book value of liability)

Dr. Capital Lease Liability (PLUG)

Cr. Cash (contract payment)

o Accounting for Lessor: Operating Lease

Inception: record transfer of the product from inventory to equipment (in the hands

of the lessee Dr. Equipment

Cr. Inventory

At the end of each year: record annual revenue and depreciation on the rentedequipment

Dr. Cash

Cr. Rent Revenue

Dr. Depreciation Expense

Cr. Accumulated Depreciation

o Accounting for Lessor: Capital Lease

Inception: record the sale of the equipment

Dr. Lease Receivable

Cr. Sales Revenue (PV of all future lease payments) Dr. COGS

Cr. Inventory (book value of the asset leased)

At the end of each year: record lease payment, interest on the receivable, andreduction in the lease receivable

Dr. Cash

Cr. Interest Revenue

Cr. Lease Receivable

SOUTHWEST CASE- 1. Refer to Note 8 of Southwests 2005 financial report. Record the journal entry to reflect scheduled

payments during 2006 for operating and capital leases in place at the end of 2005. Use this information

to infer an estimate of the average interest rate used by Southwest to determine the present value ofpayments on capital leases at the end of 2005.

o Journal Entries

Operating Lease

Dr. Rent Expense 332

Cr. Cash 332

Capital Lease

Dr. Interest Expense 5 (plug)

Dr. Lease Liability 11

Cr. Cash 16

o Calculate Average Interest Rate used by Southwest

Interest Expense = rate * Beginning liability

5 = rate * 74 Average Interest Rate = 6.8%

- 2. What would be the total amount of the obligation under capital leases included in the balance sheetat December 31, 2005 if Southwest used an implicit interest rate of 8% to determine the present valueof minimum lease payments on all capital leases? Assume that lease payments are made annually onDecember 31 and that payments after 2010 include 1 payment of $12 million at the end of 2011.

o Still on Note 8

Liability of a Capital Lease is the present value of future payments



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Obligation = 16/1.08 + 16/1.08^2 + 16/1.08^3 + 16/1.08^4 + 15/1.08^5 + 12/1.08^6= 70.76.

- 3. Compute the debt-to-equity (D/E) ratio, as defined in Chapter 5 in the text, for Southwest atDecember 31, 2005.

o D/E = Total liabilities/(Total Liabilities + Shareholders Equity) = Total Liabilities / Total

Assetso

= 7,543/14,218 = 53%- 4. Southwest has significant commitments under operating leases. If these agreements had been treated

as capital leases, what additional amount would be reported as a lease obligation on the balance sheetat December 31, 2005? What would be the impact on Southwests debt-to-equity ratio computed inquestion 3 above? Why may this type of analysis be useful in evaluating companies? The followingassumptions should be used to compute the present value of the minimum lease payments: 1) Theannual borrowing rate is 10%; Payments subsequent to 2010 ($1,164 million) are comprised of 5annual payments of $233 million; and Lease payments are made annually on December 31. Totalliabilities for purposes of the debt-to-equity ratio include all operating liabilities (current and long-term), long-term debt and obligations under capital leases and deferred credits.

o Capitalize the Operating Lease Payments Convert Existing Operating Lease

Commitments into Capital Leases

Discount the Operating Lease Payments

Year Payment Annuity Payment Discount Factor PV 2006 332 332 .9091 302

2007 309 309 .8264 255

2008 274 274 .7513 206

2009 235 235 .6830 161

2010 219 219 .6209 136

2011-2015 233 each year 3.79079 883 .6209 548

Present Value = 1608o Debt/Equity Ratio

There would be another Liability of 1608 on the balance sheet that is off balancesheet because they are using operating leases.

New D/E Ratio = (7543+1608)/(14218+1608) = 58%

This is an increase of about 10% just based on how the leases are structured.Therefore, adjusting the lease obligations can keep the debt/equity ratio lower.

DEFERRED TAXES- Introduction

o If you use LIFO for accounting, you must use it for taxes.

o You can get two separate forms of income depending on the rules. This difference, and how

it is reconciled, gives rise to deferred taxes.- Terminology

o Book Income

Income before income taxes (i.e. pre-tax income) for financial reporting purposeso Taxable Income

The amount of income on which taxes currently due is figured for tax reportingpurposes

o Differences between book and taxable income are of two types

Permanent differences: differences between book income and taxable income thatarise from the inclusion of revenues and expenses for financial reporting but not fortax reporting some revenues and expenses have special tax treatment

E.g. government bonds - interest revenue cannot include in tax

statements

Fines due to violation of laws cannot include in tax



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Timing Differences: differences between book income and taxable income that relateto the recognition of revenues and expenses in different periods for tax and financialreporting.

E.g. depreciation

o Book -- straight line for financial; Tax - MACRS

Bad debt expense

o Book Allowance Method; Tax Direct Write-off Method- Deferred Income Taxes

o Matching Principle says that tax expense recognized each period should be based on the

amount of book income regardless of the amount of taxes actually payable this period basedon taxable income.

Match income tax expense with the GAAP pre-tax income amount

This ignores timing differences while computing the tax expense.o Income tax Expense (also called Provision for Income Taxes)

= (Book income before income taxes +/- permanent differences) * Statutory tax rate

o Income tax expense is comprised of a current component and a deferred component

Current component reflects actual tax due

Deferred component reflects tax associated with current period timing differencesbetween book and tax income

o Deferred tax assets and liabilities record the difference between tax payable to tax authorities

and the tax expense recorded in the income statement

Dr. Income Tax Expense

Dr. Deferred Tax Asset these account for the differences Cr. Deferred Tax Liability these account for the differences Cr. Tax Payable

- Deferred Tax Liabilities (DTL)o DTL is something the company has not paid yet but will pay later.

o Taxes paid < cumulative income tax expense on I/S

If Taxes Paid < Tax Expense on I/S then Deferred Tax Liabilityo The difference is something the company needs to pay up in the future. Therefore, they get a

liability until they pay the liability in the future.

o Results from Expenses recognized faster for tax purposes

Examples

o MACRS for tax purposes but straight line for book purposes

Revenues recognized slower for tax purposes

Examples

o Sales on credit revenues recognized in book income, only cash

revenue recognized in tax income- Deferred Tax Assets (DTA)

o DRA is something the company paid early and does not have to pay later. Almost like

Prepaid taxes.

o Cumulative taxable income > cumulative book income taxes paid > cumulative income tax

expense on I/So Expenses recognized slower for tax purposes

Examples

Bad Debt Expense

Warranty Expense only recorded in tax when you do the service

o Revenues recognized faster for tax purposes

Not a very common occurrence.

Example: completed contract method- Deferred tax Assets and Liabilities



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o Note: Assume no permanent differences

o Recording Deferred Tax Liabilities

From temporary differences that will result in future taxable income and thus, futuretax payments (e.g. book income = $250, IRS income = $225)

Journal Entry

Dr. Income Tax Expense 100

Cr. Income Taxes Payable 90 Cr. Deferred Tax Liability 10

o DTL of $10 equals ($250-225)*40% tax rate = $10

Kodak Case- 1. According to its tax returns, what was Eastman Kodaks total income tax obligation to all

governmental entities in the year 2000?

o Tax obligation Tax Payable = 145 + 268 + 35 = 448

- 2. What entry was recorded by Eastman Kodak to record its income tax provision in the year 2000?

o Deferred Provision = Income Tax Provision - Income Tax Expense =

o Deferred Provision = 225+37+15 = 277

o Income Tax Expense

Journal Entry

Dr. Income Tax Expense (Provision) 725

Cr. Income Tax Payable 448

Cr. Deferred Taxes (NET) 277

- 3. Assume that the U.S. statutory tax rate of 35% was used to calculate deferred tax liabilities related todepreciation.Duringthe year ended December 31, 2000, which report included a greater amount ofdepreciation expense: the tax return or the financial accounting income statement? What was themagnitude of the difference?

o During the year not cumulative looking for the current period difference in timing

due to depreciationo Note 10

DTL regarding depreciation

Change in DTL = Current Period Timing Difference * Tax Rate

Change in DTL = 555 527 = 28 Current Period Timing Difference = 28/.35 = 80

How do you know if it is higher in tax or book?

Depreciation expense is higher in the tax books

DTL increased from 527 to 555. Therefore, liability is increasing making

the expense higher in the tax books because income is lower in tax books soyou paid less taxes and the liability therefore increases.

- 4. Assume that the U.S. statutory tax rate of 35% was used to calculate deferred tax liabilities related to

depreciation.As ofDecember 31, 2000, which system has recognized more depreciation expense: taxor financial accounting? What is the magnitude of the difference? What would be the percentagechange in Net properties on the balance sheet if tax depreciation had been used throughout theassets lives?

o Balance in DTL = Cumulative Timing Difference * Tax Rate

555 = Cumulative Timing Difference * .35

Cumulative Timing Difference = 555/.35 = 1586M

As of Dec 31, 2000, cumulatively, tax statement has recorded 1586 more ofdepreciation. Over the life of the total assets, they have recognized moredepreciation on the tax statement.

o Percentage Change in Net Properties if Tax Depreciation had been used throughout the assets

lives?



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Accumulated Depreciation = 7044 + 1586 = 8630

Net PPE = 5919 1586 = 4333- 5. What is the purpose of the valuation allowance which reduces the magnitude of deferred tax assets?

Which specific items(s) does the allowance relate to?

o What is the Valuation Allowance? The portion they dont think they can use in the future.

MARKETABLE SECURITIES AND LONGTERM INVESTMENTS- Investments

o Reasons to invest in other companies

Improve competitive position

To get a return in the form of dividends, interest or capital gainso Types of Investments

Minority Passive (less than 20% ownership) firm has no influence

Debt Securities hold until maturity

o Amortized historical cost

Trading Securities mark to market with unrealized gains/losses to income

o Market Value Method of Accounting

Available-for-sale Securities mark to market with unrealized gain/losses

to shareholders equityo Market Value Method of Accounting

o Not solely for purpose of speculation hold for longer term

Minority Active (Between 20% and 50%) can influence management

Equity Method of Accounting adjusted historical cost

Majority (More than 50% ownership) effective control

Full Consolidation purchase accounting

o M&A Course 30117

Lots of Equity Method and Full Consolidation-

Documents

5 Financial Accounting-notes.doc