Financial Statement Analysis

Financial Statements - IntroductionINTRODUCTIONFinancial reporting is the method a firm uses to convey its financial performance to the market, its investors, and other stakeholders. The objective of financial reporting is to provide information on the changes in a firm’s performance and financial position that can be used to make financial and operating decisions. In addition to being a management aide, analysts use this information to forecast the firm’s ability to produce future earnings and as a means to assess the firm’s intrinsic value. Other stakeholders such as creditors will use financial statements as a way to evaluate the economic and competitive strength.

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.

Financial Statements - Financial Statement AnalysisA. Financial Statement AnalysisThe income statement is a statement of earnings that shows managers and investors whether the company made money over the period of time being reported. This statement details the revenues of the firm as well as the expenses incurred to achieve them, and transforms this into net income. The conclusion of the statement is to show the firm’s gains or losses for the period. The balance sheet reports the company’s financial position at a specific point in time. The balance sheet is made up of three parts: assets, liabilities and owners’ equity. Assets detail the firm’s economic resources that have been built up through the firm’s operations or acquisitions. Liabilities are the current or estimated obligations of the firm. The difference between assets and liabilities is known as net assets or net worth of the firm. The net assets of the firm are also known as owners’ equity, which is amount of assets that would remain once all creditors are paid. According to the accounting equation, owners’ equity equals assets minus liabilities

Assets – Liabilities = Owners’ Equity

The statement of cash flows reconciles the firm’s net income to its reports on the company’s cash inflows and outflows. It shows how changes in balance sheet accounts and income affect cash and cash equivalents. These cash receipts and payments are categorized as by operating cash flows, investing cash flows and financing cash flowsThe statement of changes in owners’ equity reports the sources and amounts of changes in owners’ equity over the period of time being reportedLet'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.

Accrual accounting requires that revenue is recorded when the firm earns it, and that expenses are taken when the firm incurs them regardless of when the cash is actually received or paid. If cash is received first then an unearned revenue or prepaid expense account is set up and decreased as the revenue and expense is recorded over time. If cash is received after goods are delivered then the revenue and expense is recorded and a receivables or payables account is set up and decreased as the cash is paid. Most accruals fall into one of four categories:

1. Accrued Revenues: A firm will usually earn revenue before it is actually paid for its goods or services. Typically the asset account for accounts receivable is increased until the customer actually pays for goods that have been invoiced. The company records the revenue when the goods are delivered and invoiced. The accounts receivable account is decreased when the customer pays the invoice in cash.

2. Unearned Revenue: Some firms collect income before goods are provided. Subscriptions are examples of goods that are prepaid, but the revenue is not recognized until the goods are delivered. In this situation the firm increases the asset account cash and a liability account for unearned income. Unearned income is decreased as revenue is earned over time.

3. Accrued Expenses: Most firms buy inventories and supplies on account and pay for them after they have been invoiced. When the goods are delivered and equal amount is recorded in the expense account and in accounts payable. When the invoice is paid, cash and the accounts payable account are decreased.

4. Prepaid Expenses: Some companies pay some expenses in advance. A prepaid expanse account is increased and the actual expense is not recorded until the actual goods or services are delivered.

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.

Financial Statements - Accounting Process

Accounting Process

Accounting systems take the cash and accruals from various transactions and generate financial

reports and statements. Information flows through an accounting system in four steps:

1. The first step is to create journal entries and adjusting entries. The general journal is list of each

transaction, the amount, and the accounts affected in chronological order. At the end of accounting

periods adjustments are made to record accruals not yet made.

2. The general ledger show the journal entries sorted by the accounts affected rather than in

chronological order. This can be useful for reviewing the activity in a specific account.

3. At the end of the accounting period an initial trial balance is prepared lists the ending balance of

each account on a given date. If needed, adjusting entries are recorded in an adjusted trial

balance.

4. The financial statements are prepared as a final product of the system, based on the totals from

an adjusted trial balance.

Security Analysis

In conducting security analysis, an analyst cannot solely rely on the financial statements. Financial

reporting is affected by the choice of accounting methods, and the estimates that management

uses to determine the value of assets. In order to get a good understanding of the earnings

potential of a business, an analyst must understand the accounting process used to produce the

financial statements to better understand the business and the results for the period.

Since much of the detail information on management's accruals, adjustments and estimates is

contained in the footnotes to the statements and Management's Discussion and Analysis, it is

imperative that the analyst review these sections of the financial statements. Using this

information an analyst should determine:

The various accruals, adjustments and assumptions that went into the financial statements.

The detailed information that underlies the company's accounting system.

How well the financial statements reflect the company's true performance.

How the data needs to be adjusted for the analyst's own analysis.

Because adjustments and assumptions are at the discretion of management, analysts should

always be on the lookout for possible financial statement manipulation and any situation that might

incent management to falsify or misrepresent the actual operations of the firm.

Financial Statements - 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

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

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.) 

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. 

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

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

Financial Statements - 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. 

Financial Statements - Income Statement: Non-recurring Items

INCOME 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 Items

Included 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 Items

Events 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 Operations

Sometimes 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 Changes

Accounting changes occur for two reasons:

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

2. 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 Adjustments

These 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.

Financial Statements - Balance Sheet Basics

I. Basics

Within this section we'll define each asset and liability category on the balance sheet, and prepare

a classified balance sheet

Balance Sheet Categories

The 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.

Balance Sheet Presentation Formats

Although there are no required reporting balance sheet designs there are two customary formats

that are used, the account format and the report format. The two formats follow the accounting

equation by subtotaling assets and showing that they equal the combination of liabilities and

shareholder’s equity. However, the report format presents the categories in one vertical column,

while the report format places assets in one column on the left hand side and places liabilities and

shareholder’s equity on the right. Both formats can be collapsed further into a classified balance

sheet that subtotals and shows only similar categories such as current assets, noncurrent assets,

current liabilities, noncurrent liabilities, etc.

Financial Statements - Balance Sheet Components - Assets

Total Assets

Total 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 by allowance 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.

The value of an identifiable intangible asset is based on the rights or privileges conveyed to its

owner over a finite period, and its value is amortized over its useful life. Identifiable intangible

assets include patents, trademarks and copyrights. Intangible assets that are purchased are

reported on the balance sheet at historical cost less accumulated amortization.

An unidentifiable intangible asset cannot be purchased separately and may have an infinite

life. Intangible assets with infinite lives are not amortized, and are tested for impairment annually,

at least. Goodwill is an example of an unidentifiable intangible asset. Goodwill is recorded when

one company acquires another at an amount that exceeds the fair market value of its net

identifiable assets. It represents the premium paid for the target company’s reputation, brand

names, customers, suppliers, human capital, etc. When computing financial ratios, goodwill and the

offsetting impairment charges are usually removed from the balance sheet.

Certain intangible assets that are created internally such as research and development costs are

expensed as incurred under U.S. GAAP. Under IFRS, a firm must identify if the R&D cost is in the

research and development stage. Costs are expensed in the research stage and capitalized during

the development stage.

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.

Financial Statements - Balance Sheet Components - Liabilities

Total Liabilities

Liabilities 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:

Bank indebtedness - This amount is owed to the bank in the short term, such as a bank

line of credit.

Accounts payable - This amount is owed to suppliers for products and services that are

delivered but not paid for.

Wages payable (salaries), rent, tax and utilities - This amount is payable to

employees, landlords, government and others.

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.

Notes payable (short-term loans) - This is an amount that the company owes to a

creditor, and it usually carries an interest expense.

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.

Dividends payable - This occurs as a company declares a dividend but has not of yet paid

it out to its owners.

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.

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.

Financial Statements - Balance Sheet Components - Marketable & Nonmarketable Instruments

Marketable & Nonmarketable Instruments

Financial instruments are found on both sides of the balance sheet. Some are contracts that

represent the asset of one company and the liability of another. Financial assets include

investment securities like stocks and bonds, derivatives, loans and receivables. Financial liabilities

include derivatives, notes payable and bonds payable. Some financial instruments are reported on

the balance sheet at fair value (marking to market), while others are reported at present value or

at cost. The FASB recently issued SFAS No. 159, “The Fair Value Option for Financial Assets and

Financial Liabilities,” which allows any firm the ability to report almost any financial asset or liability

at fair value. Marketable investment securities are classified as one of the following:

Held to Maturity Securities: Debt securities that are acquired with the intention of

holding them until maturity. They are reported at cost and adjusted for the payment of

interest. Unrealized gains or losses are not reported.

Trading Securities: Debt and equity securities that are acquired with the intention to

trade them in the near term for a profit. Trading securities are reported on the balance

sheet at fair value. Unrealized gains and losses before the securities are sold are reported in

the income statement.

Available for Sale Securities: are debt and equity securities that are not expected to be

held until maturity or sold in the near term. Although like trading securities, available for

sale securities are reported on the balance sheet at fair value, unrealized gains and losses

are reported as other income as part of stockholder’s equity.

With all three types of financial securities, income in the form of interest and dividends, as well as

realized gains and losses when they are sold, are reported in the income statement. 

The following are measured at fair value:

Assets LiabilitiesFinancial assets held for trading Financial assets held for tradingFinancial assets available for sale DerivativesDerivatives Non-derivative instruments hedged by

derivativesNon-derivative instruments hedged by derivatives

The following are measured at cost or amortized cost:

Assets LiabilitiesUnlisted instruments All other liabilities (accounts payable,

notes payable)Held-to-maturity investmentsLoans and receivables

Financial Statements - 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:

Preferred stock Common stock Issue of par value stock Additional paid-in capital Treasury stock repurchase Cumulative Translation Allowance (CTA) Retained earning

Financial Statements - Components of Stockholders' Equity

Within this section we'll identify the components that comprise the contributed capital part of

stockholders' equity.

Contributed Capital

Contributed 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: $105,000(15,000 x $7)

Common shares: $450,000(30,000 x $15)

Legal capital $555,000

Paid-in capital:

Preferred shares: $195,000 ($300,000-$105,000)

Common shares: $150,000   ($600,000-$450,000)

Paid-in capital$345,000

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.

Financial Statements - Accounting for Dividends

Dividends

Dividends 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:

1. Cash dividends - These are cash payments made to stockholders of record. Retained

earnings are reduced when dividends are declared. 

2. 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 Dividend

Let'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 Dividends

Stock 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 shares

XYZ 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 Split

Stock 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).

Financial Statements - Accounting for Equities

Preferred Stock Characteristics

Preferred 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. 

Attributes

In 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 Rights

Most 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 Issuance

The issuing company will normally receive cash in exchange for shares (stock). The shares may or

may 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 Repurchase

A 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:

Financial Statements - Revenue Recognition

I. What is Revenue Recognition?

The Matching Principle

The 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 Principles

SFAS 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 Payment

There 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.

Gross and Net Reporting of Revenue

Under gross revenue reporting, sales and the cost of goods sold are reported separately. With net

revenue reporting only the net revenue, calculated by subtracting cost of goods sold from gross

sales, is reported. Since the only the net revenue is reported, revenues will be less than under

gross revenue reporting.

Under U.S. GAAP, a firm using gross revenue reporting must be the primary party to any contract,

take on both inventory and credit risk, be able to choose its suppliers, and have the ability to set

price.

When analyzing the financial statements analysts should be aware of how aggressive or

conservative a firm's revenue recognition policies are. A firm's that has a very aggressive revenue

recognition policy runs the risk of over stating its revenues and its earnings performance. Analysts

should also be aware of any assumptions or judgments that are made in reporting revenues

Financial Statements - Revenue Recognition Methods and Implications

Sales-basis Methodo 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.

o 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.

o 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).

o Implication : This is themost accurate form of revenue recognition. Percentage-of-completion method

o This method is popular with construction and engineering companies, who may take years to deliver a product to a customer.

o 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.

o 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 contract2. It is possible to estimate the percentage of the project that is complete, its

revenues and its costs. o 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.) 

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

Completed-contract methodo Under this method, revenues and expenses are recorded only at the end of the

contract.o 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.) 

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

Cost-recoverability methodo Under the cost-recoverability method, no profit is recognized until all of the expenses

incurred to complete the project have been recouped.o 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.o 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.

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

Installment methodo If customer collections are unreliable, a company should use the installment method

of revenue recognition.o 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.

o 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. 

o 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

Instalment Method Yes Yes Yes No

Financial Statements - Revenue Recognition and Accounting Entries

Accounting Entries

The 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:$50M

Total Cost:$35M

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Cost 5,000,000 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 416,667 833,333 1,250,000 666,667 -

Percentage-of-Completed-Contract Method

We 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

Cost 5,000,000 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%

Revenue 7,142,857 5,714,286 14,285,714 14,285,714 8,571,429 50,000,000

Step 1:

Revenues to be declared

We 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 declared

Since 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 Entries

In 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.

o 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.

o 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.

o 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 Method

Under 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 Statements

Under 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.

o 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).

Financial Statements - Revenue Recognition Effects on Cash Flows and Financial Ratios

Both methods - the percentage-of-completion and completed-contract methods - produce the

same net cash flow effect. 

Cash Flow Effects

Percentage-of-completed contract method

o Net income (NI) will be higher in the first years and lower in the last year.

o Net Income will be less volatile.

o Total assets will be greater.

o Liabilities will be lower.

Completed contract method

o Net income will be nonexistent in the first years and higher in the last year.

o Net income will be very volatile.

o Total assets will be smaller.

o Liabilities will be higher (no recognition of retained earnings).

o Stockholders equity will be lower.

o Stockholders equity will be more volatile.

Impact on Financial Ratio

Ratio Formula% of Completion Method

Reason  Completed Method

Current Ratio

Current AssetsCurrent Liabilities

HigherConstruction in progress includes portion of estimated profits

Lower

RevenueTurnover

RevenuesAverage Receivables

Higher Revenues are reportedLower - Not measurable prior to completion

Assets to Equity

Total AssetsEquity

Higher Retained earnings are reportedLower - Not measurable prior to completion

Total Debt Ratio

Total LiabilitiesTotal Liabilities + Total Equity

LowerLiabilities are smaller and the denominator includes equity which is higher

Higher

Financial Statements - The Cash Flow Statement

I. Introduction

Components and Relationships Between the Financial Statements

It 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

Financial Statements - Cash Flow Statement Basics

Statement of Cash Flow

The 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:

1. How the company obtains and spends cash

2. Why there may be differences between net income and cash flows

3. If the company generates enough cash from operation to sustain the business

4. If the company generates enough cash to pay off existing debts as they mature

5. If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows

The 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: 

Cash inflow (+)

1. Revenue from sale of goods and services

2. Interest (from debt instruments of other entities)

3. Dividends (from equities of other entities) 

Cash outflow (-)

1. Payments to suppliers

2. Payments to employees

3. Payments to government

4. Payments to lenders

5. 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 (+)

1. Sale of property, plant and equipment

2. Sale of debt or equity securities (other entities)

3. Collection of principal on loans to other entities

Cash outflow (-)

1. Purchase of property, plant and equipment

2. Purchase of debt or equity securities (other entities)

3. 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 (+)

1. Sale of equity securities

2. Issuance of debt securities

Cash outflow (-)

1. Dividends to shareholders

2. Redemption of long-term debt

3. Redemption of capital stock

Reporting Noncash Investing and Financing Transactions

Information for the preparation of the statement of cash flows is derived from three sources: 

1. Comparative balance sheets

2. Current income statements

3. 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.

Financial Statements - Cash Flow Computations - Indirect Method

Under U.S. and ISA GAAP, the statement of cash flow can be presented by means of two ways:

1. The indirect method

2. The direct method

The Indirect Method

The 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 Operations

Here are the steps for calculating the cash flow from operations using the indirect method:

1. Start with net income.

2. Add back non-cash expenses.

o (Such as depreciation and amortization)

3. Adjust for gains and losses on sales on assets.

o Add back losses

o Subtract out gains

4. Account for changes in all non-cash current assets.

5. 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 Activities

Cash 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 Activities

Cash 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:

Financial Statements - Cash Flow Computations - Direct Method

The Direct Method

The 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 Operations

Under 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 6.7Cash 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 6.8Cash 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 - increase) 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 income taxes 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.

Financial Statements - Free 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.

Free Cash Flow to the Firm (FCFF)

Free cash flow to the firm is the cash available to all investors, both equity and debt holders. It can

be calculated using Net Income or Cash Flow from Operations (CFO).

The calculation of FCFF using CFO is similar to the calculation of FCF. Because FCFF is the cash flow

allocated to all investors including debt holders, the interest expense which is cash available to

debt holders must be added back. The amount of interest expense that is available is the after-tax

portion, which is shown as the interest expense multiplied by 1-tax rate [Int x (1-tax rate)]. .

This makes the calculation of FCFF using CFO equal to:

FCFF = CFO + [Int x (1-tax rate)] – FCInv 

Where:

CFO = Cash Flow from Operations

Int = Interest Expense

FCInv = Fixed Capital Investment (total capital expenditures)

This formula is different for firm’s that follow IFRS. Firm’s that follow IFRS would not add back

interest since it is recorded as part of financing activities. However, since IFRS allows dividends

paid to be part of CFO, the dividends paid would have to be added back.

The calculation using Net Income is similar to the one using CFO except that it includes the items

that differentiate Net Income from CFO. To arrive at the right FCFF, working capital investments

must be subtracted and non-cash charges must be added back to produce the following formula:

FCFF = NI + NCC + [Int x (1-tax rate)] – FCInv – WCInv 

Where:

NI = Net Income

NCC = Non-cash Charges (depreciation and amortization)

Int = Interest Expense

FCInv = Fixed Capital Investment (total capital expenditures)

WCInv = Working Capital Investments

Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived from FCFF. FCFE

equals FCFF minus the after-tax interest plus any cash from taking on debt (Net Borrowing). The

formula equals:

FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing

Financial Statements - Management Discussion and Analysis & Financial Statement Footnotes

I. 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:

o The revenues-recognition method used

o Depreciation methods and rates

Balance sheet and income statement breakdown of items such as:

o Marketable securities

o Significant customers (percentage of customers that represent a significant portion

of revenues)

o Sales per regions

o Inventory

o 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.

Supplemental schedules often detail disclosures required by audited statements, as well as the

accounting methods and assumptions used by management. Supplemental schedules can include

information such as natural resources reserves, an overview of specific business lines, or the

segmentation of income or other line items by geographical area or customer distribution.

Management’s Discussion and Analysis (MD&A) presents management’s perspective on the

financial performance and business condition of the firm. U.S. publicly-held companies must

provide MD&As that include a discussion of the operations of the company in detail by usually

comparing the current period versus prior period

Analyst Interpretation

As reporting standards continue to change and evolve, analysts must be aware of new accounting

approaches and innovations that can affect how businesses treat certain transactions, especially

those that have a material impact on the financial statements. Analysts should use the financial

reporting framework to guide them on how to determine the financial statement impact of new

types of products and business operations.

One way to keep up to date on evolving standards and accounting methods is to monitor the

standard setting bodies and professional organizations like the CFA Institute that publish position

papers on the subject.

Companies that prepare financial statements under IFRS or US GAAP must disclose their accounting

policies and estimates in the footnotes, as well as any policies requiring management's judgment in

the management's discussion and analysis. Public companies must also disclose their estimates for

the impact of newly adopted policies and standards on the financial statements.

Financial Statements - The Auditor and Audit Opinion

The Auditor

An 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 Responsibility

Auditors 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 standard auditor’s opinion contains three parts and states that:

• the preparation of the financial statements are the responsibility of management, and that the

auditor has performed an independent review.

• Generally accepted auditing procedures were followed, providing reasonable assurance that the

statements do not contain any material errors.

• The auditor is satisfied that the statements were prepared in accordance with accepted

accounting procedures and that any assumptions or estimates used are reasonable. 

An unqualified opinion indicates that the auditor believes that the statements are free from any

material errors or omissions

The Qualified Opinion

A 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.

An adverse opinion is issued if the statements are not presented fairly or do not conform to

generally accepted accounting procedures.

Internal Controls

Under U.S. GAAP, the auditor must provide its judgment about the company’s internal controls, or

the processes the company uses to ensure accurate financial statements. 

Under the Sarbanes-Oxley act, management is supposed to make a statement about its internal

controls including the following:

• A statement declaring that the financial statements are presented fairly;

• A statement declaring that management is responsible for maintaining and executing effectual

internal controls;

• A description of the internal control system and how it is evaluated;

• An analysis of how effective the internal controls have been over the last year;

• A statement declaring that the auditors have review management’s report on its internal controls

Financial Statements - Financial Reporting Objectives and Enforcement

I. Financial Reporting Objectives

There are six steps in completing the financial analysis framework:

1. The first step is to determine the scope and purpose of the analysis. When stating the objective

and context, definitive goals should be stated as well as what form the analysis will take and what

resources will be required to complete it.

2. In order to complete the analysis the analyst must gather data. In addition to the financial data,

a physical inspection should be completed and company stakeholders should be interviewed, if

applicable.

3. Analysts must then process the data and make adjustments to the financial statements, to

assumptions or estimates, and any other necessary calculations.

4. Once the data has been reviewed and updated then the analyst must analyze and interpret it to

determine if the analysis achieves the original goals that were set in the first step.

5. Once the analysis has been completed then the analyst must report the conclusions or

recommendations and communicate it to the appropriate audience.

6. Since the factors and assumptions made in the analysis are subject to change over time, the

analyst should update the analysis periodically, to see if the conclusions or recommendations

change.

Objectives of Financial Reporting

Objectives 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. 

The main barrier to convergence or one universally accepted set of financial standards is the fact

that the international boards that set standards cannot agree on the best way to deal with

particular issues or situations affecting the preparation of financial statements. Different local

issues often take priority over determining ways to deal with international accounting problems.

The political environment and the resultant political pressure on governmental standards

authorities also create an impediment to a global standards framework.

The major standard setting authorities such as the International Accounting Standards Board and

the U.S. Financial Accounting Standards Board, the International Organization of Securities

Commissions, the U.K. Financial Services Authority, and the U.S. Securities and Exchange

Commission all have their own projects to solve domestic financial accounting and performance

reporting issues. However, international convergence has become a greater priority as more

foreign companies become available for investment

II. Enforcing and Developing U.S. GAAP

FASB Role in Enforcing and Developing U.S. GAAP

The 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. GAAP

The 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 Authoritative

Accounting 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

Financial Statements - Accounting Qualities

1) 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 Analysts

Here 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. The following key SEC filings must be

reported:

• S-1: Filed prior to sale of new securities

• 10-K: Annual filing similar to annual report; 40-F for Canadians; 20-F for other foreign issuers

• 10-Q: Quarterly unaudited statements

• 8-k: Disclose material events such as asset acquisition and disposition, changes in management

or corporate governance

• DEF-14: Proxy statement

• 144: Issue of unregistered securities

• Beneficial and insider ownership of securities by company's officers and directors

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.

Financial Statements - Setting and Enforcing Global Accounting Standards

What is the International Organization of Securities Commissions (IOSCO)

Although the IFRS and GAAP frameworks are different, they usually agree in the overall structure

and principle and are working toward convergence. The two differ in the following ways:

• IFRS requires users to consider the general principles in the absence of specific standards.

• US GAAP distinguishes between objectives for business and non-business entities.

• The IASB framework gives more emphasis to the importance of the accrual and going concern

assumptions than FASB

• GAAP framework establish a hierarchy of qualitative financial statement characteristics;

• Some differences in how each defines, recognizes, and measures individual elements of financial

statements

• Companies reporting under standards other than GAAP that trade in USA must reconcile their

statements with GAAP.

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 Operations

Dividends 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.