CFA Level 1 - Section 6 Financial Statements

CFA Level 1 - Financial Statements

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6.1 - IntroductionINTRODUCTIONFinancial statements are a snapshot of a company's well being at a specific point in time. The length of time (the accounting period) that these financial statements represent varies; they can be annual (fiscal) or quarterly (every three months), among others. Fiscal year-end is normally defined as 12 months of operations. A company's year-end is defined by management and may not concur with the calendar year-end (Dec 31). When comparing the performance of different companies, one must be aware of these timing differences, if any. The timing and the methodology used to record revenues and expenses may also impact the analysis and comparability of financial statements across companies. Accounting statements are prepared in most cases on the basis of these three basic premises:

1.      The company will continue to operate (going-concern assumptions).

2.      Revenues are reported as they are earned within the specified accounting period (revenues-recognition principle).

3.      Expenses should match generated revenues within the specified accounting period (matching principle).

Basic Accounting Methods:

1.      Cash-basis accounting – This method consists of recognizing revenue (income) and expenses when payments are made (checks issued) or cash is received (deposited in the bank).

2.      Accrual accounting – This method consists of recognizing revenue in the accounting period in which it is earned (revenue is recognized when the company provides a product or service to a customer, regardless of when the company gets paid). Expenses are recorded when they are incurred instead of when they are paid.

6.2 - Cash Vs. Accrual AccountingA. ACCRUAL ACCOUNTINGWithin this section, we will review cash vs. accrual accounting methodologies. Note that the material set forth in this section is intended as a review and CFA Institute will most likely not ask a question directly based on this material.

However, we recommend a read of this section is you are unfamiliar with accounting as you will need this knowledge in order to succeed in future sections.

I. Cash vs. Accrual Accounting Within this section we will explain how income measurement issues are resolved, accrual accounting, and why the accrual basis of accounting produces more useful income statements and balance sheets than the cash basis.

Benefits of Cash Accounting

Benefits

It is easy to use and implement because the company records income only when it gets paid and records expenses only when it pays them.

If accepted by the IRS (limited cases only), the company is taxed when it has money in the bank. On average, fewer transactions will be recorded (bookkeeping).

Biggest Drawback

Cash accounting can distort a company's actual income and expenses, especially if it extends credit to its customers, purchases raw materials on credit from its suppliers or keeps inventory.  

Benefits of Accrual Accounting

Generally, it provides a clearer picture of the financial performance (income statement) and financial health (balance sheet).

It allows management to keep track of accounts receivables and payables more efficiently. It is more representative of the economic reality of the business. A service provider may not require

upfront payment for an annual service; this revenue will be recorded as it is performed, not when it is paid. Similarly, expenses that are paid in advance - such as property taxes, which are paid semiannually - will be recognized on a monthly basis.

It enhances comparability of performance (income statement) and financial stability (balance sheet) from one period to the next.

There is a smoother earning stream. There is enhanced predictability of future cash flow.

Let's consider a practical example to fully understand the impact of Cash versus Accrual Accounting on XYZ Corporation's Income Statement and Balance Sheet.

Cash Basis AccountingTaken as is, the financial statements in Figure 6.1 below indicate that XYZ Corporation is not doing well, with a net loss of $43,200, and may not be a good investment opportunity. Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting

 Note: For simplicity the tax effect not considered.

Accrual Basis AccountingArmed with some additional information, let's see what the income statement would look like if the accrual-basis accounting method was used.

Additional Information:

A1. June 12, 2005 – The company received a rush order for $80,000 of wood panels. The order was delivered to the customer five days later. The customer was given 30 days to pay. (With the cash-basis method, sales are not recorded in the income statement and not recorded in accounts receivables: no cash, no record).

A2. June 13, 2003 – The company received $60,000 worth of wood panels to replenish their inventory, and $40,000 was related to the rush order. The company paid the invoice in full to take advantage of a 2% early-payment discount. (With the cash-basis method, this is recorded in full on the income statement, and there is no record of inventory on hand).

A3. June 1, 2005 – The company launched an advertising campaign that will run until the end of August. The total cost of the advertising campaign was $15,000 and was paid on June 1, 2005.

Figure 6.2: XYZ Corporation's Restated Financial Statements using Accrual Basis Accounting

Note: tax effect not considered

Adjustments:To obtain the figures in the restated financial statements in figure 6.2 above, the following adjusting entries were made:

A1. Product sales and Accounts receivable – Even though the client has not paid this invoice, the company still made a sale and delivered the products. As a result, sales for the accounting period should increase by $80,000. Account s receivables (reported sales made but awaiting payment) should also increase by $80,000.

Adjusting entries:

A2. June 13, 2003 – Since the entire $60,000 order was paid during the accounting period, the full amount was included in production costs under the cash-basis method. Only $40,000 of the order was related to product sales during that accounting period, and the rest was stored as inventory for future product sales.

Adjusting entries:

A3. June 1, 2005 – Marketing expenses included in the income statement totaled $15,000 for a three-month advertising campaign because it was paid in full at initiation (cash-basis accounting). The reality is that this campaign will last for three months and will generate a benefit for the company every month. As a result, under accrual-basis accounting, the company should record in this accounting period only one-third of the cost. The remainder should be allocated to the next period and recoded as prepaid expenses on the assets side of the

balance sheet.

Adjusting entries:

Results:Under cash-basis accounting, this company was not profitable and its balance sheet would have been weak at best. Under accrual accounting, the financials tell us a very different story.

Look Out!

Debit:An accounting term that refers to an entry that increases an expense or asset account, or decreases an income, liability or net-worth account.

Credit: An accounting term that refers to an entry that decreases an expense or asset account, or increases an income, liability or net-worth account.

Look Out!

Going forward, all statements will use accrual-basis accounting. Please note that on the exam, candidates should assume that all financial statements use accrual-basis accounting, unless it is specified that the cash-basis accounting method is used in the question.

6.3 - Income Statement BasicsI. BasicsWithin this basics section, we will define each component of a multi-step income statement, and prepare a multi-step income statement.

Multi-Step Income StatementA multi-step income statement is a condensed statement of income as opposed to a single-step format, which is the more detailed format. Both single and multi-step formats conform to GAAP standards. Both yield the same net income figure.

The main difference is how they are formatted, not how figures are calculated.

Figure 6.3: Multi-Step Income Statement

1. Sales – These are defined as total sales (revenues) during the accounting period. Remember these sales are net of returns, allowances and discounts 

2. Cost of goods sold (COGS) – These are all the direct costs related to the product or rendered service sold and recorded during the accounting period. (Reminder: matching principle.)  

3. Operating expenses – These include all other expenses that are not included in COGS but are related to the operation of the business during the specified accounting period. This account is most commonly referred to as "SG&A" (sales general and administrative) and includes expenses such as selling, marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent, computers, accounting fees, legal fees), research and development (R&D), depreciation and amortization, etc.  

4. Other revenues & expenses – These are all non-operating expenses such as interest earned on cash or interest paid on loans.

5. Income taxes – This account is a provision for income taxes for reporting purposes.

6.4 - Income Statement ComponentsIncome Statement FormatThe following figure demonstrates which components are used to calculate a company's net income, which is the income available to shareholders.

Figure 6.4: How Net Income is Derived on the Income Statement

 The Components of Net Income:

Operating income from continuing operations – This comprises all revenues net of returns, allowances and discounts, less the cost and expenses related to the generation of these revenues. The costs deducted from revenues are typically the COGS and SG&A expenses. 

Recurring income before interest and taxes from continuing operations – This component includes, in addition to operating income from continuing operations, all other income, such as investment income from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets. To be included in this category, these items must be recurring in nature. This component is generally considered to be the best predictor of future earning. That said, it does assume that noncash expenses such as depreciation and amortization are a good indicator of future capital expenditures. Since this component does not take into account the capital structure of the company (use of debt), it is also used to value similar companies.

Recurring (pre-tax) income from continuing operations – This component takes the company's financial structure into consideration as it deducts interest expenses.

Pre-tax earning from continuing operations – This component considers all unusual or infrequent items. Included in this category are items that are either unusual or infrequent in nature but cannot be both. Examples are an employee-separation cost, plant shutdown, impairments, write-offs, write-downs, integration expenses, etc.

Net income from continuing operations – This component takes into account the impact of taxes from continuing operations.

Non-Recurring ItemsDiscontinued operations, extraordinary items and accounting changes are all reported as separate items in the income statement. They are all reported net of taxes and below the tax line, and are not included in income from continuing operations. In some cases, earlier income statements and balance sheets have to be adjusted to reflect changes.

Income (or expense) from discontinued operations – This component is related to income (or expense) generated due to the shutdown of one or more divisions or operations (plants). These events

need to be isolated so they do not inflate or deflate the company's future earning potential. This type of nonrecurring occurrence also has a nonrecurring tax implication and, as a result of the tax implication, should not be included in the income tax expense used to calculate net income from continuing operations. That is why this income (or expense) is always reported net of taxes. The same is true for extraordinary items and cumulative effect of accounting changes (see below).

Extraordinary items - This component relates to items that are both unusual and infrequent in nature. That means it is a one-time gain or loss that is not expected to occur in the future. An example is environmental remediation.

Cumulative effect of accounting changes - This item is generally related to changes in accounting policies or estimations. In most cases, these are non cash-related expenses but could have an effect on taxes. 

6.5 - Income Statement: Non-recurring ItemsINCOME STATEMENT: NONRECURRING ITEMS

Within this section we will further our discussion on the non-recurring components of net income, such as unusual or infrequent items, discontinued operations, extraordinary items, and prior period adjustments.

Unusual or Infrequent ItemsIncluded in this category are items that are either unusual or infrequent in nature but cannot be both.

Examples of unusual or infrequent items: o Gains (or losses) as a result of the disposition of a company's business segment including:

Plant shutdown costs Lease-breaking fees Employee-separation costs

o Gains (or losses) as a result of the disposition of a company's assets or investments (including investments in subsidiary segments) including:

Plant shut-down costs Lease-breaking fees

o Gains (or losses) as a result of a lawsuit o Losses of operations due to an earthquake o Impairments, write-offs, write-downs and restructuring costs o Integration expenses related to the acquisition of a business

Look Out!

Accounting treatment is usually displayed as pre-tax. That means that they are displayed on the income statement after income from continuing operations gross of tax implication.

Extraordinary ItemsEvents that are both unusual and infrequent in nature are qualified as extraordinary expenses.

Example of extraordinary items:

o Losses from expropriation of assets o Gain (or losses) from early retirement of debt

Look Out!

Accounting treatment is usually displayed net of tax. That means that they are displayed on the income statement after income from continuing operations net of its tax implication.

Discontinued OperationsSometimes management decides to dispose of certain business operations but either has not yet done so or did it in the current year after it had generated income or losses. To be accounted for as a discontinued operation, the business must be physically and operationally distinct from the rest of the firm. Basic definitions:

Measurement date - The date when the company develops a formal plan for disposing. Phaseout period - Time between the measurement date and the actual disposal date

The income or loss from discontinued operations is reported separately, and past income statements must be restated, separating the income or loss from discontinued operations. On the measurement date, the company will accrue any estimated loss during the phaseout period and estimated loss on the sale of the disposal. Any expected gain on the disposal cannot be reported until after the sale is completed (same rule applies to the sale of a portion of a business segment).

Look Out!

Important: Accounting treatment of income and losses from discontinued operations are reported net of tax after net income from continuing operations.

Accounting ChangesAccounting changes occur for two reasons:

As a result of a change in an accounting principle As a result of a change in an accounting estimate.

The most common form of a change in accounting principle is the switch from the LIFO inventory accounting method to another method such FIFO or average cost basis.

The most common form of a change in accounting estimates is a change in depreciation method for new assets or change in depreciable lives/salvage values, which is considered a change in accounting estimates and not a change in accounting principle. Note that past income does not need to be restated from the LIFO inventory accounting method to another method such FIFO or average cost basis.

In general, prior years' financial statements do not need to be restated unless it is a change in:

Inventory accounting methods (LIFO to FIFO) 

Change to or from full-cost method (This is used in oil & gas exploration. The successful-efforts method capitalizes only the costs associated with successful activities while the full-cost method capitalizes all the costs associated with all activities.)

Change from or to percentage-of-completion method (look at revenue- recognition methods) All changes just prior to a company's IPO

Prior Period AdjustmentsThese adjustments are related to accounting errors. These errors are typically NOT reported in the income statement but are reported in retained earnings. (These can be found in changes in retained earnings.) These errors are disclosed as footnotes explaining the nature of the error and its effect on net income.

6.6 - Balance Sheet BasicsI. BasicsWithin this section we'll define each asset and liability category on the balance sheet, and prepare aclassified balance sheet

Balance Sheet CategoriesThe balance sheet provides information on what the company owns (its assets), what it owes (its liabilities) and the value of the business to its stockholders (the shareholders' equity) as of a specific date.

Total Assets = Total Liabilities + Shareholders' Equity

Assets are economic resources that are expected to produce economic benefits for their owner. Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the

company's money or services. Examples include bank loans, debts to suppliers and debts to employees. Shareholders' equity is the value of a business to its owners after all of its obligations have been met.

This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the owners have invested, plus any profits generated that were subsequently reinvested in the company.  

Look Out!

Components of Total Assets on the balance sheet are listed in order of liquidity and maturity.

6.7 - Balance Sheet Components - AssetsTotal AssetsTotal assets on the balance sheet are composed of:

1. Current Assets – These are assets that may be converted into cash, sold or consumed within a year or less. These usually include:

Cash – This is what the company has in cash in the bank. Cash is reported at its market value at the reporting date in the respective currency in which the financials are prepared. (Different cash

denominations are converted at the market conversion rate.

Marketable securities (short-term investments) – These can be both equity and/or debt securities for which a ready market exist. Furthermore, management expects to sell these investments within one year's time. These short-term investments are reported at their market value.

Accounts receivable – This represents the money that is owed to the company for the goods and services it has provided to customers on credit. Every business has customers that will not pay for the products or services the company has provided. Management must estimate which customers are unlikely to pay and create an account called allowance for doubtful accounts.Variations in this account will impact the reported sales on the income statement. Accounts receivable reported on the balance sheet are net of their realizable value (reduced byallowance for doubtful accounts).

Notes receivable – This account is similar in nature to accounts receivable but it is supported by more formal agreements such as a "promissory notes" (usually a short term-loan that carries interest). Furthermore, the maturity of notes receivable is generally longer than accounts receivable but less than a year. Notes receivable is reported at its net realizable value (what will be collected).

Inventory – This represents raw materials and items that are available for sale or are in the process of being made ready for sale. These items can be valued individually by several different means - at cost or current market value - and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings and assets.

Prepaid expenses – These are payments that have been made for services that the company expects to receive in the near future. Typical prepaid expenses include rent, insurance premiums and taxes. These expenses are valued at their original cost (historical cost).

2. Long-term assets – These are assets that may not be converted into cash, sold or consumed within a year or less. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet. However, all items that are not included in current assets are long-term Assets. These  are:

Investments – These are investments that management does not expect to sell within the year. These investments can include bonds, common stock, long-term notes, investments in tangible fixed assets not currently used in operations (such as land held for speculation) and investments set aside in special funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are reported at their historical cost or market value on the balance sheet.

Fixed assets – These are durable physical properties used in operations that have a useful life longer than one year. This includes:

o Machinery and equipment – This category represents the total machinery, equipment and furniture used in the company's operations. These assets are reported at their historical cost less accumulated depreciation.

o Buildings (plants) – These are buildings that the company uses for its operations. These assets are depreciated and are reported at historical cost less accumulated depreciation.

o Land – The land owned by the company on which the company's buildings or plants are sitting on. Land is valued at historical cost and is not depreciable under U.S. GAAP

Other assets – This is a special classification for unusual items that cannot be included in one of the other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current

receivables and advances to subsidiaries.

Intangible assets – These are assets that lack physical substance but provide economic rights and advantages: patents, franchises, copyrights, goodwill, trademarks and organization costs. These assets have a high degree of uncertainty in regard to whether future benefits will be realized. They are reported at historical cost net of accumulated depreciation.

Look Out!

These assets are listed in order of their liquidity and tangibility. Intangible assets are listed last since they have high uncertainty and liquidity.

Look Out!

In July 2001, the Financial Accounting Standards Board (FASB) adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets", which sets new rules for goodwill accounting. SFAS 142 eliminates goodwill amortization and instead requires companies to identify reporting units and perform goodwill impairment tests.

6.8 - Balance Sheet Components - LiabilitiesTotal LiabilitiesLiabilities have the same classifications as assets: current and long-term.

3. Current liabilities – These are debts that are due to be paid within one year or the operating cycle, whichever is longer; further, such obligations will typically involve the use of current assets, the creation of another current liability or the providing of some service.

Usually included in this section are:

1. Bank indebtedness – This amount is owed to the bank in the short term, such as a bank line of credit.

2. Accounts payable – This amount is owed to suppliers for products and services that are delivered but not paid for.

3. Wages payable (salaries), rent, tax and utilities – This amount is payable to employees, landlords, government and others.

4. Accrued liabilities (accrued expenses) - These liabilities arise because an expense occurs in a period prior to the related cash payment. This accounting term is usually used as an all-encompassing term that

includes customer prepayments, dividends payables and wages payables, among others.

5. Notes payable (short-term loans) – This is an amount that the company owes to a creditor, and it usually carries an interest expense.

6. Unearned revenues (customer prepayments) – These are payments received by customers for products and services the company has not delivered or started to incur any cost for its delivery.

7. Dividends payable – This occurs as a company declares a dividend but has not of yet paid it out to its owners.

8. Current portion of long-term debt - The currently maturing portion of the long-term debt is classified as a current liability. Theoretically, any related premium or discount should also be reclassified as a current liability.

9. Current portion of capital-lease obligation – This is the portion of a long-term capital lease that is due within the next year.

Look Out!

Current liabilities above are listed in order of their due date.

4. Long-term Liabilities – These are obligations that are reasonably expected to be liquidated at some date beyond one year or one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Usually included are:

Notes payables – This is an amount the company owes to a creditor, which usually caries an interest expense.

Long-term debt (bonds payable) – This is long-term debt net of current portion.

Deferred income tax liability – GAAP allows management to use different accounting principles and/or methods for reporting purposes than it uses for corporate tax fillings (IRS). Deferred tax liabilities are taxes due in the future (future cash outflow for taxes payable) on income that has already been recognized for the books. In effect, although the company has already recognized the income on its books, the IRS lets it pay the taxes later (due to the timing difference). If a company's tax expense is greater than its tax payable, then the company has created a future tax liability (the inverse would be accounted for as a deferred tax asset).

Pension fund liability – This is a company's obligation to pay its past and current employees' post-retirement benefits; they are expected to materialize when the employees take their retirement (defined-benefit plan). Valued by actuaries and represents the estimated present value of future pension expense, compared to the current value of the pension fund. The pension fund liability represents the additional amount the company will have to contribute to the current pension fund to meet future obligations.

Long-term capital-lease obligation – This is a written agreement under which a property owner allows a tenant to use and rent the property for a specified period of. Long-term capital-lease obligations are net of current portion.

Look Out!

The liabilities above are listed in order of their due date.

6.9 - Shareholders' (Stockholders') Equity BasicsI. Basics

Components of Shareholder’s EquityAlso known as “equity” and “net worth”, the shareholders’ equity refers to the shareholders’ ownership interest in a company.

Usually included are: Preferred stock – This is the investment by preferred stockholders, which have priority over common

shareholders and receive a dividend that has priority over any distribution made to common shareholders. This is usually recorded at par value.

Additional paid-up capital (contributed capital) – This is capital received from investors for stock; it is equal to capital stock plus paid-in capital. It is also called “contributed capital”.

Common stock – This is the investment by stockholders, and it is valued at par or stated value.

Retained earnings – This is the total net income (or loss) less the amount distributed to the shareholders in the form of a dividend since the company’s initiation.

Other items – This is anall-inclusive account that may include valuation allowance and cumulative translation allowance (CTA), among others. Valuation allowance pertains to noncurrent investments resulting from selective recognition of market value changes. Cumulative translation allowance is used to report the effects of translating foreign currency transactions, and accounts for foreign affiliates.

Look Out!

These components are listed in the order of their liquidation priority.

Figure 6.5: Sample Balance Sheet

Stockholders’ Equity StatementInstead of presenting a detailed stockholders’ equity section in the balance sheet and a retained earnings statement, many companies prepare a stockholders’ equity statement.

This statement shows the changes in each type of stockholders’ equity account and the total stockholders’ equity during the accounting period. This statement usually includes:

1. Preferred stock 2. Common stock 3. Issue of par value stock 4. Additional paid-in capital 5. Treasury stock repurchase 6. Cumulative Translation Allowance (CTA) 7. Retained earning

6.10 - Components of Stockholders' EquityWithin this section we’ll identify the components that comprise the contributed capital part of stockholders’ equity.

Contributed CapitalContributed capital is the total legal capital of the corporation (par value of preferred and common stock) plus the paid-in capital. 

Par value – This is a value of preferred and common stock that is arbitral (artificial); it is set by management on a per share basis. This

artificial value has no relation or impact on the market value of the shares. 

Legal capital of the corporation – This is par value per share multiplied by the total number of shares issued.

Additional paid-in capital (paid-in capital) – This is the difference between the actual value the company sold the shares for and their par value.

Example: Company XYZ issued 15,000 preferred shares to investors for $300,000.Company XYZ issued 30,000 common shares to investors for $600,000.Par value of preferred shares is $7 per share.Par value of common shares is $15 per share.

Legal capital:Preferred shares: $300,000(15,000 x $20)Common shares: $450,000(30,000 x $15)Legal capital       $750,000

Paid-in capital:Preferred shares: $           0 ($300,000-$300,000)Common shares: $150,000($600,000-$450,000)Paid-in capital     $150,000

Legal capital + Paid-in capital = Contributed Capital

Look Out!

If issued common shares have no par value, the amount the stock is sold for constitutes common stock. Preferred stock is always sold with a stated par value.

6.11 - Accounting for DividendsDividendsDividends are payments to stockholders that can be made regularly (monthly, quarterly or annually) or occasionally.

Companies are not required to issue a dividend to their common stockholders. Companies may have an obligation to issue a dividend to preferred shareholders (see definition and

properties of preferred shareholders). A company’s board of directors must approve of a dividend before it can be declared and issued.

There are two basic dividend forms:

Cash dividends – These are cash payments made to stockholders of record. Retained earnings are reduced when dividends are declared.

Stock dividends – These are dividends paid in the form of additional stock of the issuing company to shareholders of record in proportion to their current holdings. A stock dividend does not increase the wealth of the recipient nor does it reduce the net assets of the firm. It is a permanent capitalization of retained earnings to contributed capital.

Dividend Terminology

Date of Declaration: This is the date the board approved and declared a dividend.

Date of record: This is thedate set by the issuer that determines who is eligible to receive a declared dividend or capital-gains distribution.

Ex-dividend date: This is the first day of trading when the selling shareholder is entitled to the recently announced dividend payment. Shares purchased as of the ex-dividend date will not receive the previously declared dividend.

Date of payment: This is the date on which the company will pay the declared dividend to its stockholders of record as of the date of record.

Accounting for a Cash DividendLet’s examine the payment process of a cash dividend. We’ll use XYZ company again for this example.

XYZ declares a dividend on Jan 1, 2005, for its common shareholders of $400,000 payable to shareholders of record on Feb 1, 2005, and payable on Feb 31, 2005.

Accounting Impact on the Date of Declaration, Jan 1, 2005:

Accounting Impact on the Date of Payment, Feb 31, 2005:

Stock DividendsStock dividends involve the issuance of additional shares of stock to existing shareholders on a proportional basis.   Stock dividends are issued to stockholders of record as of the record date. The dividends are not paid in cash but are paid as additional shares.

Since a company does not pay out any cash when it declares a stock dividend, the company’s cash account (current assets) is not affected. The only account that is affected is the company’s contributed capital (paid-up capital). When a company issues a stock dividend, the company’s retained earnings are reduced by the value of the stock dividend, and the company will increase its common stock and paid-up capital accounts.

Note that the size of the dividend declared is important. If the company declares a 25% or less stock dividend (as a percentage of the company’s previous total outstanding shares) then the value of the stock dividend declared is equal to the market value of the shares issued. (Common shares are increased to reflect value of

dividend.) If the stock dividend is larger than 25%, the company will transfer 100% of the par or stated value of the common shares to the common-stock account.

Examples:Stock dividends are best learned by considering an example of a situation where the stock dividend is 25% or less of previously outstanding shares, and where the stock dividend is 25% or more of the previously outstanding shares.

Situation 1: Twenty-five percent or less of previous outstanding sharesXYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005, one share for every five shares will be paid to shareholders of records of Feb 1, 2005. XYZ shares have a market value of $10 and a par value of $40. The company has 2 million shares outstanding. What does this mean? A shareholder that has 100 shares of XYZ will receive 20 additional shares for a total of 120. Furthermore, the company will issue 400,000 additional stocks to stockholders. After the dividend is issued, the company will have 20% more shares outstanding.

Accounting impact on date of declaration:

Accounting impact on date of issuance:

Situation 2: More than 25% of previous outstanding shares.XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005, three shares for every five shares will be paid to shareholders of records of Feb 1, 2005. XYZ shares have a market value of $10 and a par value of $40. The company has 2 million shares outstanding. What does this mean? A shareholder that has 100 shares of XYZ will receive 60 additional shares for a total of 160. Furthermore, the company will issue 1.2 million additional stocks to stockholders. After the dividend is issued, the company will have 60% more shares outstanding.

Accounting impact on date of declaration: 

Accounting impact on date of issuance:

Look Out!

The most common mistake students make in this section is that they forget to calculate if the stock dividend is less than or higher than 25% of the shares outstanding and the reporting effect it will have.

Stock SplitStock splits are events that increase the number of shares outstanding and reduce the par or stated value per share of the company’s stock. For example, a two-for-one stock split means that the company stockholders will receive two shares for every share they currently own. This will double the number of shares outstanding and reduce by half the par value per share. Existing shareholders will see their shareholdings double in quantity, but there will be no change in the proportional ownership represented by the shares (i.e. a shareholder owning 2,000 shares out of 100,000 would then own 4,000 shares out of 200,000).

Most importantly, the total par value of shares outstanding is not affected by a stock split (i.e. the number of shares times par value per share does not change). Therefore, no journal entry is needed to account for a stock split. A memorandum notation in the accounting records indicates the decreased par value and increased number of shares. 

Stocks that are trading on the exchange will normally be re-priced in accordance to the stock split. For example, if XYZ stock was trading at $90 and the company did a 3-for-1 stock split, the stock would open at $30 a share.

Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (regular lot = 100 shares).

6.12 - Accounting for EquitiesPreferred Stock CharacteristicsPreferred stock (preferred shares) is a hybrid between common stock and bonds. It provides a specific dividend that is paid before any dividend is paid to common stockholders.

 Dividends o Preferred stocks pay to stockholders a

predefined dividend that is based on a specific amount, or is a percentage of the preferred stock’s par value.

o Like common stock, preferred stocks represent partial ownership in a company. o Preferred stockholders do not usually enjoy any of the voting rights of common stockholders or

any additional net income distributions beyond the stated dividend payout, unless they are participating preferred stockholders.

Superiority in the Event of Liquidation o Preferred stockholders have precedence over common stockholders in the event of liquidation.

o Bondholders always have precedence over preferred stockholders from a dividend and liquidation point of view.

o Unlike bondholders, preferred stockholders cannot force a company into bankruptcy.

Classification o From an accounting point of view, preferred stock is classified as equity, and the dividend

payments are classified in a similar fashion as common stock dividends. o Unlike interest paid on bonds, the fixed dividend paid out to preferred stockholders is not

deductible from earnings before taxes (EBT) and is not tax deductible. 

AttributesIn general, preferred stock can have several attributes; they can be:

o Cumulative - This is preferred stock on which dividends accrue in the event that the issuer does not make timely dividend payments. Unpaid preferred dividends are called “dividends in arrears”. Most preferred stocks are cumulative.

o Non-cumulative - This is preferred stock on which dividends do not accrue in the event that the issuer does not make timely dividend payments.

o Participating - This is preferred stock that, in addition to a regular dividend, pays a dividend when common stock dividends exceed a specified amount.

o Convertible - This is preferred stock that can be converted into a specified amount of common stock at the holder's option.

o Retractable - This is preferred stock that grants the stockholder the right to redeem the stock at specified future date(s) and price(s).

o Perpetual - These are preferred shares that have no maturity date.

o Callable (Non-perpetual) – These are preferred shares that have a predetermined maturity date. At the maturity date, the company will buy back the preferred shares at their par value.

Voting RightsMost preferred stock is non-voting. However, most of these securities also include a clause that would give holders a predetermined voting right if dividends are not paid for a certain period of time (in most cases, three years).

Stock IssuanceThe issuing company will normally receive cash in exchange for shares (stock). The shares may or many not have a stipulated par value. If they do have a par value, the excess paid to the par value will be recorded in additional paid-in capital (paid-in capital) account. If the stock sold has no par value, the full amount will be recorded in the stock account.

Example: XYZ Company has issued 800,000 common shares at a price of $5 per share.

With par value of $3 per share:

Without par value:

Stock RepurchaseA program by which a company buys back its own shares from the marketplace, reducing the number of outstanding shares. This is usually an indication that the company's management thinks the shares are undervalued.

Look Out!

Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases earnings per share and tends to elevate the market value of the remaining shares.

When a company does repurchase shares, it will usually say something along the lines of, "We find no better investment than our own company."

With par value of $3 per share:

Without par value:

6.13 - Revenue RecognitionI. What is Revenue Recognition?

The Matching PrincipleThe matching principle of GAAP dictates that revenues must be matched with expenses. Thus, income and expenses are reported when they are earned and incurred, even if no cash transaction has been recorded.

For example, say a company made a sale for $30,000 within an accounting period but has not received payment. Even though the company was not paid, the sale is recorded as revenue. This revenue has to be matched with the expenses that the company incurred in the accounting period to generate that revenue (revenues and expanses must match).

If revenues were not matched with their related expenses, companies would produce financial statements that provide little information to the readers and themselves. (This is a fundamental principle of accrual-basis accounting)

Revenue-Recognition PrinciplesSFAS 5 specifies that two conditions must be met for revenue recognition to take place:

1. Completion of the Earnings Process This means the company has provided all or virtually all of the goods and services for which it is to be paid. Furthermore, it means the company can measure the total expected cost of providing the goods and services, and the company must have no significant remaining obligations to its customers. Both must be true for this condition to be met.

2. Assurance of PaymentThere must be a quantification of the cash or assets that will be received for realized goods and services. Furthermore, the company must be able to accurately estimate the reliability of payment. Both must be true for this requirement to be met.

The amount of revenues to be recognized at any given point in time is measured as:

                                                     Formula 6.3

(Services Provided to Date/Total Expected Services) x Total Expected Inflow

6.14 - Revenue Recognition Methods and Implications

1. Sales-basis Method 1. Under the sales-basis method, revenue is

recognized at the time of sale, which is defined as the moment when the title of the goods or services is transferred to the buyer.

2. The sale can be made for cash or credit. This means that, under this method, revenue is not recognized even if cash is received before the transaction is complete.

3. For example, a monthly magazine publisher that receives $240 a year for an annual subscription will recognize only $20 of revenue every month (assuming that it delivered the magazine).

4. Implication : This is themost accurate form of revenue recognition.

2. Percentage-of-completion method 1. This method is popular with construction and engineering companies, who may take years to

deliver a product to a customer.

2. With this method, the company responsible for delivering the product wants to be able to show its shareholders that it is generating revenue and profits even though the project itself is not yet complete.

3. A company will use the percentage-of-completion method for revenue recognition if two conditions are met:

1. There is a long-term legally enforceable contract 2. It is possible to estimate the percentage of the project that is complete, its revenues and

its costs.

4. Under this method, there are two ways revenue recognition can occur: 1.  Using milestones - A milestone can be, for example, a number of stories completed, or a

number of miles built for a railway. 2. Cost incurred to estimated total cost- Using this method, a construction company would

approach revenue recognition by comparing the cost incurred to date by the estimated total cost.)

5. Implication :Thiscan overstate revenues and gross profits if expenditures are recognized before they contribute to completed work.

3. Completed-contract method 1. Under this method, revenues and expenses are recorded only at the end of the contract. 2. This method must be used if the two basic conditions needed to use the percentage-of-

completion method are not met (there is no long-term legally enforceable contract and/or it is not possible to estimate the percentage of the project that is complete, its revenues and its costs.)

3. Implication : Thiscan understate revenues and gross profit within an accounting period because the contract is not accounted for until it is completed.

4. Cost-recoverability method 1. Under the cost-recoverability method, no profit is recognized until all of the expenses incurred to

complete the project have been recouped. 2. For example, a company develops an application for $200,000. In the first year, the company

licenses the application to several companies and generates $150,000. 3. Under this method, the company recognizes sales of $150,000 and expenses related to the

development of $150,000 (assuming no other costs were incurred). As a result, nothing would appear in net income until the total cost is offset by sales.

4. Implication : Thiscan understate gross profits initially and overstate profits in future years.

5. Installment method 1. If customer collections are unreliable, a company should use the installment method of revenue

recognition. 2. This is primarily used in some real estate transactions where the sale may be agreed upon but the

cash collection is subject to the risk of the buyer's financing falling through. As a result, gross profit is calculated only in proportion to cash received.

3. For example, a company sells a development project for $100,000 that cost $50,000. The buyer will pay in equal installments over six months. Once the first payment is received, the company will record sales of $50,000, expenses of $25,000 and a net profit of $25,000.

4. Implication : This can overstate gross profits if the last payment is not received.

Summary of Revenue Recognition Methods

Method

First Condition: Completion of Earning Progress

Second Condition: Assurance of Payment

Goods/Services Provided

Measurable Cost

Quantification

Reliability

Sales BasisYes Yes Yes Yes

Percentage of Completion

Incomplete Yes Yes Yes

Completed Contract

Incomplete Yes or No Yes/No Yes/No

Cost Recoverability

YesYes with Contingency

Yes/No Yes/No

Installment Method

Yes Yes Yes No

6.15 - Revenue Recognition and Accounting EntriesAccounting EntriesThe best way to identify the appropriate accounting entries is to consider an example:

Construction Company ABC, has just obtained a $50 million contract to build a five-building resort in the Bahamas for Meridian Vacations. Company ABC estimates that each building will take a full year to build. Meridian Vacations has agreed to pay Company ABC according to the following schedule: $5m in year 1, $10m in year 2, $10m in year 3, $10m in year 4 and $15m in year 5. Company ABC has estimated that the total cost of this contact will be $35m, and will occur over the five years in this way; $5m in year 1, $4m in year 2, $10m in year 3, $10m in year 4 and $6m in year 5. Equal monthly payments will be made to ABC, and Meridian will have a 30-day grace period except for the last payment in year 5. 

Figure 6.6: Illustration of Construction Company ABC’s expected figures

Total Revenue:$50MTotal Cost: $35M

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Cost5,000,000

4,000,000

10,000,000

10,000,000

6,000,000

35,000,000

Payment Terms

5,000,000

10,000,000

15,000,000

8,000,000

12,000,000

50,000,000

Cash Received

4,583,333

9,583,333

14,583,333

8,583,333

12,666,667

50,000,000

Accounts Receivable

416,667 833,3331,250,000

666,667 -

Percentage-of-Completed-Contract MethodWe first need to estimate the revenues Company ABC will declare each year. Remember we are using the percentage-of-completion method based on estimated cost.

Figure 6.7: Construction Company ABC’s Estimated Revenues

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Cost5,000,000

4,000,000

10,000,000

10,000,000

6,000,000

35,000,000

% of Completion

14.29% 11.43% 28.57% 28.57% 17.14% 100%

Cumulative

14.29% 25.71% 54.29% 82.86% 100%  

Revenue7,142,857

5,714,286

14,285,714

14,285,714

8,571,429

50,000,000

Step 1:Revenues to be declaredWe first need to extrapolate how much each annual cost represents as a percentage of the total cost. Armed with this information we multiply the percentage of completion with the total expected revenue for the project for each period.

Recall that one of the basic accounting principles is assurance of payment, and here is the formula used to determine amount of revenues to be recognized at any given point in time:                                                     Formula 6.4

(Services Provided to Date/Total Expected Services) x Total Expected Inflow

This is basically the same formula used in the percentage-of-completion method.

Step 2:Cost to be declaredSince this is the basic assumption of this accounting methodology, the expenses remain the same as the ones that were estimated.

Results:1. Annual Income Statement EntriesIn each year, the revenues, expenses would be entered as seen on the following table.

Note: For simplicity, taxes were not considered.

                                                     Figure 6.8: Construction Company ABC’s Income Statement (% of Completion Method)

2. Balance Sheet Statement Entries

Figure 6.9: Construction Company ABC’s Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries:

Cash:It is the total cash Company ABC has on hand at the end of the year, and is defined as the total cash inflow minus the total cash outflow. If the result of this equation were negative, the company would have to borrow from its line of credit additional funds to cover its total expenses.

 Accounts Receivable:The total amount billed less the cash received by Meridian.

 Net construction in progress (asset) and net advance billing (liability): These accounts offset each other and are composed of construction in progress less total billings.

1.  If the result of this equation were negative, the company would have billed its client for more than what has delivered. This would have constituted a liability for the construction company, and would have been reported as net advance billings.

2. If this equation were positive, then the company would have built more than the client has paid for it, and the result of the equation would have constituted an asset and would be recorded as net construction in progress.

3. In most cases, companies only report net construction in progress or net advance billing on their balance sheet.

Retained earnings –The cumulative shares of the total profit to date. This item is not shown on the balance sheet above. It normally appears after shareholders equity.

                                                     Formula 6.5

Construction in progress = the cumulative cost incurred since inception + (cumulative percentage of completion x total estimated net profit of the project)

Less

Total billings = cumulative amount billed to the client since inception

Look Out!

Remember, if the result of the above equation is:Positive (asset) = net construction in progressNegative (liability) = net advance billings

                                                            Figure 6.10: Other Items on Company ABC’s Balance Sheet (% of Completion Method)

Completed-Contract MethodUnder this accounting methodology, revenues and expenses are not recognized until the contract is completed and the title is transferred to the client.

Annual Income Statements

In this case, nothing would be reported on the annual income statements until Year 5.

                                                                   Figure 6.11: Company ABC’s Income Statement (Completed Contract Method)

Balance Sheet StatementsUnder this method, the balance sheet entries are the same as the percentage-of –completion method, except for the Net Advance Billing account.

Figure 6.12: Company ABC’s Balance Sheet (Completed Contract Method)

Balance Sheet Entries

Cash and accounts receivables stay the same under both the percentage of completion and completed contract methods.

1. This is normal because, no matter which method you use, you always know how mush cash you have in the bank, and you how much credit you have extended to your client.

Net construction in progress (asset) / net advance billing – The basic concepts are the same, except that under this methodology, construction in progress does not include the cumulative effect of gross profits in the formula (i.e. excludes cumulative percentage of completion x total estimated net profit of the project).

6.16 - Revenue Recognition Effects on Cash Flows and Financial RatiosBoth methods - the percentage-of-completion and completed-contract methods - produce the same net cash flow effect.

Cash Flow Effects

Percentage-of-completed contract method 1. Net income (NI) will be higher in the

first years and lower in the last year. 2. Net Income will be less volatile. 3. Total assets will be greater. 4. Liabilities will be lower. 

1. Completed contract method 1. Net income will be nonexistent in the

first years and higher in the last year. 2. Net income will be very volatile. 3. Total assets will be smaller. 4. Liabilities will be higher (no

recognition of retained earnings). 5. Stockholders equity will be lower. 6. Stockholders equity will be more

volatile.

Impact on Financial Ratio

Ratio

Formula

% of Completion Method

Reason Completed Method

Current Ratio

Current AssetsCurrent Liabilities

Higher

Construction in progress includes portion of estimated profits

Lower

RevenueTurnover

 RevenuesAverage Receivables

Higher

Revenues are reported

Lower - Not measurable prior to compl

etion

Assets to Equity

Total AssetsEquity

HigherRetained earnings are reported

Lower - Not measurable prior to completion

Total Debt Ratio

Total LiabilitiesTotal Liabilities + Total Equity

Lower

Liabilities are smaller and the denominator includes equity which is higher

Highe

6.17 - The Cash Flow StatementI. Introduction

Components and Relationships Between the Financial StatementsIt is important to understand that the income statement, balance sheet and cash flow statement are all interrelated.

The income statement is a description of how the assets and liabilities were utilized in the stated accounting period. The cash flow statement explains cash inflows and outflows, and will ultimately reveal the amount of cash the company has on hand; this is reported in the balance sheet as well.

We will not explain the components of the balance sheet and the income statement here since they were previously reviewed.

Figure 6.13: The Relationship between the Financial Statements

6.18 - Cash Flow Statement BasicsStatement of Cash FlowThe statement of cash flow reports the impact of a firm's operating, investing and financial activities on cash flows over an accounting period. The cash flow statement is designed to convert the accrual basis of accounting used in the income statement and balance sheet back to a cash basis.

The cash flow statement will reveal the following to analysts:

How the company obtains and spends cash Why there may be differences between net

income and cash flows If the company generates enough cash from

operation to sustain the business If the company generates enough cash to pay

off existing debts as they mature If the company has enough cash to take

advantage of new investment opportunities

Segregation of Cash FlowsThe statement of cash flows is segregated into three sections:

1. Operating activities 2. Investing activities 3. Financing activities

1. Cash Flow from Operating Activities (CFO)CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes.

This includes:

1. Cash inflow (+) o Revenue from sale of goods and services o Interest (from debt instruments of other entities) o Dividends (from equities of other entities)

2. Cash outflow (-) o Payments to suppliers o Payments to employees o Payments to government o Payments to lenders o Payments for other expenses

2. Cash Flow from Investing Activities (CFI)CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed

assets.

This includes:

Cash inflow (+) o Sale of property, plant and equipment o Sale of debt or equity securities (other entities) o Collection of principal on loans to other entities

Cash outflow (-) o Purchase of property, plant and equipment o Purchase of debt or equity securities (other entities) o Lending to other entities

3. Cash flow from financing activities (CFF)CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional shares, short-term or long-term debt for the company's operations. This includes:

Cash inflow (+) o Sale of equity securities o Issuance of debt securities

Cash outflow (-) o Dividends to shareholders o Redemption of long-term debt o Redemption of capital stock

Reporting Noncash Investing and Financing TransactionsInformation for the preparation of the statement of cash flows is derived from three sources:

Comparative balance sheets Current income statements Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow because they do not require the use of cash.

Examples Include:

Conversion of debt to equity Conversion of preferred equity to common equity Acquisition of assets through capital leases Acquisition of long-term assets by issuing notes payable Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities

Though these items are typically not included in the statement of cash flow, they can be found as footnotes to the financial statements.

6.19 - Cash Flow Computations - Indirect MethodUnder U.S. and ISA GAAP, the statement of cash flow can be presented by means of two ways:

The indirect method The direct method

The Indirect MethodThe indirect method is preferred by most firms because is shows a reconciliation from reported net income to cash provided by operations.

Calculating Cash flow from OperationsHere are the steps for calculating the cash flow from operations using the indirect method:

Start with net income. Add back non-cash expenses.

o (Such as depreciation and amortization) Adjust for gains and losses on sales on assets.

o Add back losses o Subtract out gains

Account for changes in all non-cash current assets. Account for changes in all current assets and liabilities except notes payable and dividends payable.

In general, candidates should utilize the following rules:

Increase in assets = use of cash (-) Decrease in assets = source of cash (+) Increase in liability or capital = source of cash (+) Decrease in liability or capital = use of cash (-)

The following example illustrates a typical net cash flow from operating activities:

Cash Flow from Investment ActivitiesCash Flow from investing activities includes purchasing and selling long-term assets and marketable securities (other than cash equivalents), as well as making and collecting on loans.

Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing ActivitiesCash Flow from financing activities includes issuing and buying back capital stock, as well as borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this category, but the repayment of accounts payable or accrued liabilities is not.

Here's the calculation of the cash flows from financing using the indirect method:

6.20 - Cash Flow Computations - Direct MethodThe Direct MethodThe direct method is the preferred method under FASB 95 and presents cash flows from activities through a summary of cash outflows and inflows. However, this is not the method preferred by most firms as it requires more information to prepare.

Cash Flow from OperationsUnder the direct method, (net) cash flows from operating activities are determined by taking cash receipts from sales, adding interest and dividends, and deducting cash payments for purchases, operating expenses, interest and income taxes. We'll examine each of these components below:

Cash collections are the principle components of CFO. These are the actual cash received during the accounting period from customers. They are defined as:                                                 Formula 6.7

Cash Collections Receipts from Sales= Sales + Decrease (or - increase) in Accounts Receivable

Cash payment for purchases make up the most important cash outflow component in CFO. It is the actual cash dispersed for purchases from suppliers during the accounting period.

It is defined as:                                                 Formula 6.8

Cash payments for purchases = cost of goods sold + increase (or - decrease) in inventory + decrease (or - increase) in accounts payable

Cash payment for operating expenses is the cash outflow related to selling general and administrative (SG&A), research and development (R&A) and other liabilities such as wage payable and accounts payable.

It is defined as:

                                                      Formula 6.9Cash payments for operating expenses = operating expenses + increase (or - decrease) in prepaid expenses + decrease (or - decrease) in accrued liabilities

Cash interest is the interest paid to debt holders in cash.

It is defined as:

                                                      Formula 6.10Cash interest = interest expense – increase (or + decrease) interest payable + amortization of bond premium (or - discount)

Cash payment for incometaxes is the actual cash paid in the form of taxes. It is defined as:

                                                      Formula 6.11Cash payments for income taxes= income taxes + decrease (or - increase) in income taxes payable

Look Out!

Note: Cash flow from investing and financing are computed the same way it was calculated under the indirect method.

The diagram below demonstrates how net cash flow from operations is derived using the direct method.

Look Out!

Candidates must know the following:

Though the methods used differ, the results are always the same. CFO and CFF are the same under both methods. There is an inverse relationship between changes in assets and changes in cash flow.

Free Cash Flow (FCF)Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including net capital expenditures. Net capital expenditures are what a company needs to spend annually to acquire or upgrade physical assets such as buildings and machinery to keep operating.

                                                      Formula 6.12Free cash flow = cash flow from operating activities – net capital expenditures (total capital expenditure - after-tax proceeds from sale of assets)

The FCF measure gives investors an idea of a company's ability to pay down debt, increase savings and increase

shareholder value, and FCF is used for valuation purposes.

6.21 - Management Discussion and Analysis & Financial Statement FootnotesI. Management Discussion and Analysis

The Securities Exchange Commission (SEC) requires this section to be included with the financial statements of a public company and is prepared by management

This narrative section usually includes the following;

A description of the company's primary business segments and future trends

A review of the company's revenues and expenses Discussions pertaining to the sales and expense trends Review of cash flow statements and future cash flow needs including current and future capital

expenditures A review of current significant balance sheet items and future trends, such as differed tax liabilities,

among others A discussion and review of major transactions (acquisitions, divestitures) that may affect the business

from an operational and cash flow point of view A discussion and review of discontinued operations, extraordinary items and other unusual or infrequent

events

Financial Statement Footnotes

These footnotes are additional information provided to the reader in an effort to further explain what is displayed on the consolidated financial statements.

Generally accepted accounting principles (GAAP) and the SEC require these footnotes. The information contained in these footnotes help the reader understand the amounts, timing and uncertainty of the estimates reported in the consolidated financial statements.

Included in the footnotes are the following:

A summary of significant accounting policies such as: The revenues-recognition method used Depreciation methods and rates

Balance sheet and income statement breakdown of items such as: Marketable securities Significant customers (percentage of customers that represent a significant portion of revenues) Sales per regions Inventory Fixed assets and Liabilities (including depreciation, inventory, accounts receivable, income

taxes, credit facility and long-term debt, pension liabilities or assets, contingent losses (lawsuits), hedging policy, stock option plans and capital structure.

6.22 - The Auditor and Audit OpinionThe AuditorAn audit is a process for testing the accuracy and completeness of information presented in an organization's financial statements. This testing process enables an independent Certified Public Accountant (CPA) to issue what is referred to as "an opinion" on how fairly a company's financial statements represent its financial position and whether it has complied with generally accepted accounting principles.

Look Out!

Note: Only independent auditors (CPAs) can produce audited financial statements. That is, the company's board members, staff and their relatives cannot perform audits because their relationship with the company compromises their independence.

The audit report is addressed to the board of directors as the trustees of the organization. The report usually includes the following:

a cover letter, signed by the auditor, stating the opinion.

the financial statements, including the balance sheet, income statement and statement of cash flows

notes to the financial statements

In addition to the materials included in the audit report, the auditor often prepares what is called a "management letter" or "management report" to the board of directors. This report cites areas in the organization's internal accounting control system that the auditor evaluates as weak.

What Does the Auditor Do?The auditor will request information from individuals and institutions to confirm:

bank balances

contribution amounts

conditions and restrictions

contractual obligations

monies owed to and by the organization.

To ensure that all activities with significant financial implications is adequately disclosed in the financial statements the auditor will review:

physical assets

journals and ledgers

board minutes

In addition, the auditor will also:

select a sample of financial transactions to determine whether there is proper documentation and whether the transaction was posted correctly into the books

interview key personnel and read the procedures manual, if one exists, to determine whether the organization's internal accounting control system is adequate

The auditor usually spends several days at the organization's office looking over records and checking for completeness.

Auditor ResponsibilityAuditors are not expected to guarantee that 100% of the transactions are recorded correctly. They are required only to express an opinion as to whether the financial statements, taken as a whole, give a fair representation of the organization's financial picture. In addition, audits are not intended to discover embezzlements or other illegal acts. Therefore, a "clean" or unqualified opinion should not be interpreted as assurance that such problems do not exist.

The Qualified OpinionA qualified opinion is issued when the accountant believes the financial statements are, in a limited way, not in accordance with generally accepted accounting principles. A qualified option may be issued if the auditor has concerns about the going-concern assumption of the company, the valuation of certain items on the balance sheet or some unreported pending contingent liabilities.

6.23 - Financial Reporting Objectives and EnforcementI. Financial Reporting Objectives

Objectives of Financial ReportingObjectives of financial reporting identified in SFAC 1 are to do the following:

They are to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. (Note the FASB's emphasis on investors and creditors as primary users. However, this does not exclude other interested parties.)

They are to provide information to help present and potential investors and creditors and other users in assessing the amounts, timing and uncertainty of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption or maturity of securities or loans. (Emphasize the difference between the cash basis and the accrual basis of accounting.)

They are to provide information about the economic resources of an enterprise, the claims on those resources and the effects of transactions, events and circumstances that change its resources and claims to those resources. 

II. Enforcing and Developing U.S. GAAP

FASB Role in Enforcing and Developing U.S. GAAPThe Financial Accounting Standards Board (FASB) is a nongovernmental body. This board sets the accounting standards for all companies that issue audited U.S. GAAP-compliant financial statements. 

Both the Securities Exchange Commission (SEC) and American Institute of Certified Public Accountants (AICPA) recognize that the Statement of Financial Accounting Standards (SFAS) statements as authoritative. 

GAAP comprises a set of principles that are patterned over a number of sources including the FASB, the Accounting Principles Board (APB) and the AICPA research bulletins.   

Prior to the creation of the FASB, the Accounting Principles Board (APB) set the accounting standards. As a result some of these standards are still in use.

SEC Role in Enforcing and Developing U.S. GAAPThe form and content of the financial statements of public companies are governed by the SEC. Even though the SEC delegates most of the authority to the FASB, it frequently adds its own requirements, such as the requirement for a company to provide a management discussion and analysis with its financial statements, quarterly financial statements (10-Q) and current reports (8-K). These discussions indicate things like changes in control, acquisition and divestitures, etc.) 

Accounting Pronouncements Considered AuthoritativeAccounting pronouncements are segmented into four categories. Category A is the most authoritative, and Category D is the least authoritative:

Category (A) - FASB Standards and Interpretations - APB Opinions and Interpretations - CAP Accounting Research Bulletins

Category (B) - AICPA Accounting and Audit Guides - AICPA Statements of Position - FASB Technical Bulletins

Category (C)- FASB Emerging Issues Task Force- AICPA AcSEC Practice Bulletins

Category (D)- AICPA Issues Papers- FASB Concepts Statements- Other authoritative pronouncements

6.24 - Accounting Qualities1) Primary qualities of useful accounting information:

- Relevance - Accounting information is relevant if it is capable of making a difference in a decision. 

Relevant information has:(a) Predictive value(b) Feedback value(c) Timeliness

- Reliability - Accounting information is reliable to the extent that users can depend on it to represent the economic conditions or events that it purports to represent. 

Reliable information has:(a) Verifiability(b) Representational faithfulness(c) Neutrality

2) Secondary qualities of useful accounting information:

Comparability - Accounting information that has been measured and reported in a similar manner for different enterprises is considered comparable.

Consistency - Accounting information is consistent when an entity applies the same accounting treatment to similar accountable events from period to period.

Accounting Qualities and Useful Information for AnalystsHere is how these qualities provide analysts with useful information:

Relevance– Relevant information is crucial in making the correct investment decision.

Reliability – If the information is not reliable, then no investor can rely on it to make an investment decision.

Comparability – Comparability is a pervasive problem in financial analysis even though there have been great strides made over the years to bridge the gap.

Consistency – Accounting changes hinder the comparison of operation results between periods as the accounting used to measure those results differ.   

Look Out!

Students should note that relevance and reliability tend to be opposite qualities. For example, an auditor may improve the quality of the audit but at the cost of timeliness. Relevance and reliability can also clash strongly in these ways: the market value of an investment can be highly relevant but may be accurate only to a certain extent. On the other

hand, the historical cost, while reliable, may have little relevance. 

6.25 - Setting and Enforcing Global Accounting StandardsWhat is the International Organization of Securities Commissions (IOSCO)

IOSCO is an international association of securities regulators that was created in 1983. The objective of this organization is to create a co-operative environment between different countries by aiming to do the following:

- Promoting high standards of regulation in order to maintain just, efficient and sound markets- Exchanging information on respective experiences in order to promote the development of domestic markets- Uniting efforts to establish standards and effective surveillance of international securities transactions- Providing mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offences.

The International Accounting Standard Board (IASB)The IASB structure's main features are:

- the IASC Foundation - which is an independent organization whose two main bodies are the Trustees and the IASB- a Standards Advisory Council- the International Financial Reporting Interpretations Committee

The IASC Foundation Trustees appoint the IASB members, exercise oversight and raise the funds needed, but the IASB has sole responsibility for setting accounting standards. This organization was created to set international accounting standards in an effort to bridge the gap between the accounting standards of different nations. 

U.S. GAAP versus IAS GAAP

Under U.S. GAAP, SFAS 95:- Dividends paid by a company to its shareholders are classified on the cash flow statement under cash flow from financing. - The dividends received by a company from its investments are classified as cash flow from operations. - All interests received and paid by or to a company are classified as cash flow from operations.

Under IAS GAAP:- Dividends paid by a company to its shareholders, dividends received by a company from its investments and all interests received and paid by or to a company can be classified as eithercash flow from financing or cash flow from operations. 

These rules are summarized in the following chart:

U.S. GAAP IAS GAAPDividends paid by a company to shareholders

Cash Flow from Financing

Cash Flow from Financing or

OperationsDividends received by a company from investments

Cash Flow from Operations

Cash Flow from Financing or Operations

All interest received and paid by or to a company

Cash Flow from Operations

Cash Flow from Financing or Operations

Look Out!

It is highly likely you will need to calculate a figure on a cash flow statement according to one of the two rules.

6.26 - Future FASB ChangesFUTURE FASB CHANGES

FASBFASB's agenda is determined through recent developments in financial reporting, requests for action on various practices, and through correspondence with many organizations such as the CFA Institute and the IASB.

For a list of completed past projects (up to date as of January 2006), we recommend a read of the following page on FASB's website:

FASB Website: Completed/Past Agenda Projects

http://www.fasb.org/project/completed_past_projects.shtml 

The Norwalk Agreement was formulated between FASB and the IASB in October of 2002. This

agreement, also known as a "Memorandum of Understanding" marked both organizations commitment to converging US GAAP and IASP GAAP.

For more on the Norwalk Agreement, the following link will direct you to the actual document formulated in 2002:

The Norwalk Agreementhttp://www.fasb.org/news/memorandum.pdf 

Projects on the FASB Agenda Related to International Convergence

1. Business Combinations

- FASB and IASB's aim is to eliminate inconsistencies related to guidance for assets acquired and liabilities assumed.- Determination of which transactions, assets and liabilities should be included in the acquisition method.

For more on the history, background, and decisions made since FASB and IASB's last meeting, check out the following document online:

Applying the Acquisition Methodhttp://www.fasb.org/project/bc_acquisition_method.shtml

2. Revenue Recognition

Essentially, FASB's aim is to eliminate inconsistencies, improve guidance, and establish a single rule.

Full details regarding this agenda can be found at the following weblink:

Revenue Recognitionhttp://www.fasb.org/project/revenue_recognition.shtml 

Projects on FASB's Short Term Agenda Related to International Convergence

The following projects are on FASB's agenda to be solved in the short term:

Inventory costs

Asset Exchanges

Accounting Changes

Earnings per Share

Balance Sheet Classification

As of May 22, 2006, FASB has issued Statements on inventory costs, asset exchanges, and accounting changes have issued an exposure draft regarding Earnings Per Share.

Read more on these tentative decisions in the following weblink:

Short-Term International Convergencehttp://www.fasb.org/project/short-term_intl_convergence.shtml

Guidance Rules for Revenue Recognition: FASB vs. IASBIn general, the IASB has one major standard on Revenue Recognition: IAS 18. Consequently, there is limited guidance on the various types of transactions that generate revenue. On the other hand, FASB does not have any one standard, but has over 100 pronouncements on specific topics related to revenue recognition.

1) Sale and Leaseback – An arrangement where the seller of an asset leases back the same asset from the purchaser. We will discuss this arrangement further in the Liabilities section.

Under IASB rule IAS 17, gains on sale and leaseback of assets is recognized immediately if the lease is classified as operating.

Under FASB rule SFAS 13, gains on sale and leaseback of assets is amortized over the life of the lease, regardless if the lease is operating or capitalized.

2)Revenue Recognition When Right of Return Exists - According to SFAS No. 48, when a customer has a right to return the product, revenue is only recognized if the following conditions are met:

- Persuasive evidence of an arrangement exists- Delivery or service has been completed- Fee for product or service is determinable- Collectibility of monies owed from buyer is reasonably assured

In addition, revenue must be reduced to take into account estimated returns. According to IAS 18.14, revenue can be if the buyer has assumed a substantial portion of the risks and rewards of ownership. In addition to the above requirements, revenue is also recognized when the cost or future costs of the transactions is determinable. This is one example where FASB has a specific guidance for these situations, whereas IASB has broad guidance on revenue recognition as a whole.

ConclusionYou have now completed the first section on Financial Statement Analysis. Within this section we have discussed accrual accounting benefits; income statement, balance sheet and shareholders' equity basics and components; revenue recognition, the cash flow statement, other items and GAAP.

The material outlined in this section is important to know as it lays the foundation for effectively learning and understanding the material presented in the following two sections.