Intermediate Accounting


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  • ISBN: 978-0324592375
  • My Rating: 6/10

What is it about?

Intermediate Accounting is a book about accounting, with a focus on U.S. GAAP.

My impression

I found Intermediate Accounting an informative and comprehensive book. However, the writing style is dry and boring, and sometimes I had to fight against falling asleep. And it took me a very long time to finish it. Some of the content is probably outdated, because the book was published in 2009. And it's a little embarrassing to admit that I have confused this book with a newer book with the same title (and the same edition).

My notes

Foundations of Financial Accounting

Financial Reporting

[...] the intricacies of accounting often result in differences of opinion as to what accounting methods are appropriate and the level of disclosure that should be required of companies. Arguments over appropriate accounting are facts of life because accounting involves judgment. Even in cases that don't involve financial statement scandal, the management of a company is likely to have some accounting disagreements with the independent auditor before the company's financial statements are released.

The purpose of financial reporting is to aid interested parties in evaluating a company's past performance and in forecasting its future performance. The information about past events is intended to improve future operations and forecasts of future cash flows.

The overall objective of accounting is to provide information that can be used in making economic decisions.

Management accounting (sometimes referred to as managerial or cost accounting) is concerned primarily with financial reporting for internal users. Internal users, especially management, have control over the accounting system and can specify precisely what information is needed and how the information is to be reported.

Financial accounting focuses on the development and communication of financial information for external users.

[...] two groups of external users, creditors and investors, have been identified as the principal external users of financial information. Creditors need information about the profitability and stability of the company to decide whether to lend money to the company and, if so, what interest rate to charge. Investors (both existing stockholders and potential investors) need information concerning the safety and profitability of their investment.

The general-purpose financial statements are the centerpiece of financial accounting. These financial statements include the balance sheet, income statement, and statement of cash flows.

The balance sheet reports, as of a certain point in time, the resources of a company (the assets), the company's obligations (the liabilities), and the net difference between its assets and liabilities, which represents the equity of the owners. The balance sheet addresses these fundamental questions: What does a company own? What does it owe?

The income statement reports, for a certain interval, the net assets generated through business operations (revenues), the net assets consumed (expenses), and the difference, which is called net income.

The statement of cash flows reports, for a certain interval, the amount of cash generated and consumed by a company through the following three types of activities: operating, investing, and financing. The statement of cash flows is the most objective of the financial statements because it is somewhat insulated from the accounting estimates and judgments needed to prepare a balance sheet and an income statement.

Accounting estimates and judgments are outlined in the notes to the financial statements. In addition, the notes contain supplemental information as well as information about items not included in the financial statements.

Auditors, working independently of a company's management and internal accountants, examine the financial statements and issue an auditor's opinion about the fairness of the statements and their adherence to proper accounting principles. The opinion is based on evidence gathered by the auditor from the detailed records and documents maintained by the company and from a review of the controls over the accounting system.

By defining which accounting methods to use and how much information to disclose, accounting standards save time and money for accountants. Users also benefit because they can learn one set of accounting rules to apply to all companies.

The Financial Accounting Standards Board (FASB) sets accounting standards in the United States.

The Securities and Exchange Commission (SEC) was created to protect the interests of investors by ensuring full and fair disclosure. The SEC was also given specific legal authority to establish accounting standards for companies desiring to publicly issue shares in the United States.

Because business is increasingly conducted across national borders, companies must be able to use their financial statements to communicate with external users all over the world. As a result, divergent national accounting practices are converging to an overall global standard.

The International Accounting Standards Board (IASB) is an international body that releases financial reporting standards. IASB standards have become the accepted worldwide standard.

The accounting standards produced by the IASB are referred to as International Financial Reporting Standards (IRSs) and International Accounting Standards (IASs). The difference between these two sets of standards is merely one of timing; the IASB standards issued before 2001 are called IAS and those issued since 2001 are called IFRS. In practice, the entire body of IASB standards is referred to simply as IFRS.

The conceptual framework allows for the systematic adaptation of accounting standards to a changing business environment. The FASB uses the conceptual framework to aid in an organized and consistent development of new accounting standards.

The conceptual framework outlines the objectives of financial reporting and the qualities of good accounting information, precisely defines commonly used terms such as asset and revenue, and provides guidance about appropriate recognition, measurement, and reporting.

The overall objective of financial reporting is to provide information that is useful for decision making.

Financial reports cannot and should not be so simple as to be understood by everyone. Instead, the objective of understandability recognizes a fairly sophisticated user of financial reports, that is, one who has a reasonable understanding of accounting and business and who is willing to study and analyze the information presented.

Although there are many potential users of financial reports, the objectives are directed primarily toward investors and creditors.

[...] financial reporting should provide information that is useful in assessing amounts, timing, and uncertainty (risk) of prospective cash flows.

Financial reporting should also provide information about a company's assets, liabilities, and owners' equity to help investors, creditors, and others evaluate the financial strengths and weaknesses of the enterprise and its liquidity and solvency. Such information will help users determine the financial conditions of a company, which, in turn, should provide insight into the prospects of future cash flows.

One way to report financial information is to boil down all the estimates and judgments into one number and then use that one number to make a journal entry. This is called recognition. The key assumptions and estimates are then described in a note to the financial statements. Another approach is to skip the journal entry and just rely on the note to convey the information to users. This is called disclosure.

Disclosure is preferable to recognition in situations in which relevant information cannot be reliably measured.

Closely related to recognition is measurement. Five different measurement attributes are currently used in practice.

  1. Historical cost is the cash equivalent price exchanged for goods or services at the date of acquisition. (Examples of items measured at historical cost: land, buildings, equipment, and most inventories.)
  2. Current replacement cost is the cash equivalent price that would be exchanged currently to purchase or replace equivalent goods or services. (Example: some inventories that have declined in value since acquisition.)
  3. Fair value is the cash equivalent price that could be obtained by selling an asset in an orderly transaction. (Example: many financial instruments.)
  4. Net realizable value is the amount of cash expected to be received from the conversion of assets in the normal course of business. (Example: accounts receivable.)
  5. Present (or discounted) value is the amount of net future cash inflows or outflows discounted to their present value at an appropriate rate of interest. (Examples: long-term receivables, long-term payables, and long-term operating assets determined to have suffered an impairment in value.)

A Review of the Accounting Cycle

[...] the accounting process (or accounting cycle) consists of two interrelated parts, (1) the recording phase and (2) the reporting phase. The recording phase is concerned with collecting information about economic transactions and events and distilling that information into a form useful to the accounting process. For most businesses, the recording function is based on double-entry accounting procedures. In the reporting phase, the recorded information is organized and summarized using various formats for a variety of decision-making purposes.

Accurate financial statements can be prepared only if the results of business events and activities have been properly recorded. Certain events, termed transactions, involve the transfer or exchange of goods or services between two or more entities. Examples of business transactions include the purchase of merchandise or other assets from suppliers and the sale of goods or services to customers. In addition to transactions, other events and circumstances can affect the assets, liabilities, and owners' equity of the business. Some of those events and circumstances also must be recorded. Examples include the recognition of depreciation on plant assets or a decline in the market value of inventories and investments.

With double-entry accounting, each transaction is recorded in a way that maintains the equality of the basic accounting equation: Assets = Liabilities + Owners' equity.

The recording phase begins with an analysis of the documentation showing what business activities have occurred. Normally, a business document, or source document, is the first record of each transaction. Such a document offers detailed information concerning the transaction. The business documents provide support for the data to be recorded in the journals.

Once the information provided on business documents has been analyzed, transactions are recorded in chronological order in the appropriate journals. [...] Most business enterprises [...] maintain various special journals designed to meet their specific needs as well as a general journal. A special journal is used to record a particular type of frequently recurring transaction. Special journals are commonly used, for example, to record each of the following types of transactions: sales, purchases, cash disbursements, and cash receipts. A general journal is used to record all transactions for which a special journal is not maintained.

An account is used to summarize the effects of transactions on each element of the expanded accounting equation. For example, the cash account is used to provide detail for all transactions involving the inflow (debit) and outflow (credit) of cash. A ledger is a collection of accounts maintained by a business.

After all transactions for the period have been posted to the ledger accounts, the balance for each account is determined. Every account will have either a debit, credit, or zero balance. A trial balance is a list of all accounts and their balances.

[...] a trial balance that does not balance indicates that we needn't go further into the reporting phase of the accounting process. An error exists somewhere and must be detected and corrected before proceeding.

Although the majority of accounts are up to date at the end of an accounting period and their balances can be included in the financial statements, some accounts require adjustment to reflect current circumstances. In general, these accounts are not updated throughout the period because it is impractical or inconvenient to make such entries on a daily or weekly basis. At the end of each accounting period, in order to report all asset, liability, and owners's equity amounts properly and to recognize all revenues and expenses for the period on an accrual basis, accountants are required to make any necessary adjustments prior to preparing the financial statements. The entries that reflect these adjustments are called adjusting entries.

For most transactions, the revenue or expense recognition and the flow of cash occur in the same accounting period. For those transactions, no adjustments are necessary as the entire transaction is accounted for in one accounting period. In some instances, the recognition of revenues and expenses and the flow of cash may occur in different accounting periods. In those instances, an adjusting entry is required to ensure that the proper amount of revenue and/or expense is recorded in each accounting period.

In accordance with the revenue recognition principle of accrual accounting, revenues should be recorded when earned, regardless of when the cash is received. If revenue is earned but not yet collected in cash, a receivable exists. To ensure that all receivables are properly reported on the balance sheet in the correct amounts, an analysis should be made at the end of each accounting period to see whether there are any revenues that have been earned but have not yet been collected or recorded. These unrecorded receivables are earned and represent amounts that are receivable in the future; therefore, they should be recognized as assets.

Just as assets are created from revenues being earned before they are collected or recorded, liabilities can be created by expenses being incurred prior to being paid or recorded. These expenses, along with their corresponding liabilities, should be recorded when incurred, no matter when they are paid. Thus, adjusting entries are required at the end of an accounting period to recognize any unrecorded liabilities in the proper period and to record the corresponding expenses.

Payments that a company makes in advance for items normally charged to expense are known as prepaid expenses. An example would be the payment of an insurance premium for three years.

An expense is the using up of an asset. For example, when supplies are purchased, they are recorded as assets; when they are used, their cost is transferred to an expense account. The purpose of making adjusting entries for prepaid expenses is to show the complete or partial consumption of an asset. If the original entry is to an asset account, the adjusting entry reduces the asset to an amount that reflects its remaining future benefit and at the same time recognizes the actual expense incurred for the period.

Amounts received before the actual earning of revenues are known as unearned revenues. They arise when customers pay in advance of the receipt of goods or services. Because the company has received cash but has not yet given the customer the purchased goods or services, the unearned revenues are in fact liabilities. That is, the company must provide something in return for the amounts received.

Charges to operations for the use of buildings, furniture, and equipment must be recorded at the end of the period. In recording asset depreciation, operations are charged with a portion of the asset's cost, and the carrying value of the asset is reduced by that amount. A reduction in an asset for depreciation is usually recorded by a credit to a contra account, Accumulated Depreciation. A contra account (or offset account) is set up to record subtractions from a related account.

Invariably, when a business allows customers to purchase goods and services on credit, some of the accounts receivable will not be collected, resulting in a charge to income for bad debt expense. Under the accrual concept, an adjustment should be made for the estimated expense in the current period rather than when specific accounts actually become uncollectible in later periods. This practice produces a better matching of revenues and expenses and therefore a better income measurement. Using this procedure, operations are charged with the estimated expense, and receivables are reduced by means of a contra account, Allowance for Bad Debts.

Accrual accounting recognizes revenues as they are earned, not necessarily when cash is received. Expenses are recognized and recorded when they are incurred, not necessarily when cash is paid. Accrual accounting provides for a better matching of revenues and expenses during and generally results in financial statements that more accurately reflect a company's financial position and results of operations.

The Balance Sheet and Notes to the Financial Statements

A balance sheet is a listing of an organization's assets and liabilities as of a certain point in time. The difference between assets and liabilities is called equity. Equity can be thought of as the amount of the assets that the owners of the organization can really call their own, the amount that would be left if all the liabilities were paid.

Assets include financial items such as cash, receivables, and investments in financial instruments. Assets also include costs that are expected to provide future economic benefits. For example, expenditures made for inventories, equipment, and patents are expected to help generate revenues in future periods. Most assets are measured in terms of historical cost.

Liabilities include obligations with amounts denominated in precise monetary terms, such as accounts payable and long-term debt. The amounts of other liabilities must be estimated based on expectations about future events. These types of liabilities include warranties, pension obligations, and environmental liabilities.

Owners' equity equals the net assets of a company, or the difference between total assets and total liabilities. Owners' equity arises from investment by owners and is increased by net income and decreased by net losses and distributions to owners.

Balance sheet items are generally classified as current (or short-term) items and noncurrent (or long-term) items. How long is current? For most companies, current means one year or less.

[...] the difference between current assets and current liabilities [...] is referred to as the company's working capital – the liquid buffer available in meeting financial demands and contingencies of the near future.

The reported amounts for current assets are measured in a variety of ways. Cash and receivables are reported at their net realizable values. Thus, current receivable balances are reduced by allowances for estimated uncollectible accounts. Investments in debt and equity securities are reported, in most cases, at current market value. Inventories are reported at cost (FIFO, LIFO, etc.) or on the lower-of-cost-or-market basis. Prepaid expenses are reported at their historical costs.

If management intends to use an asset for a noncurrent purpose, that asset should be classified as noncurrent in spite of the usual classification.

When an investment in another company represents majority ownership of that company, no single investment amount is reported in the balance sheet. Instead, all of the individual assets and liabilities of the other company are included, or consolidated, in the balance sheet.

Properties of a tangible and relatively permanent character that are used in the normal business operations are reported under Property, Plant, and Equipment or other appropriate headings, such as Land, Buildings, and Equipment.

If an asset, such as land, is being held for speculation, it should be classified as an investment rather than under the heading Property, Plant, and Equipment.

Tangible properties, except land, are normally reported at cost less accumulated depreciation.

The long-term rights and privileges of a nonphysical nature acquired for use in business operations are often reported under the heading Intangible Assets. Included in this class are items such as goodwill, patents, trademarks, franchises, copyrights, formulas, leaseholds, and customer lists.

Some intangible assets are depreciated, or amortized, in the same way as tangible assets. However, many intangible assets, including goodwill, are not amortized on a systematic basis. Instead, these intangible assets are regularly tested to determine whether their value has been impaired.

In addition to accounts payable and short-term borrowing, current liabilities also include amounts for accrued expenses. Common accruals include salaries and wages, interest, and taxes. The Current Liabilities section also includes amounts representing the portion of the long-term obligations due to be satisfied within one year.

Classification problems can arise when an obligation is callable by a creditor because it is difficult to determine exactly when the obligation will be paid. A callable obligation is one that is payable on demand and thus has no specified due date.

A loan can become callable because the debtor violates the provisions of the debt agreement. Loan agreement clauses that identify specific deficiencies (e.g., missing two consecutive interest payments) that can cause a loan to be immediately callable are referred to as objective acceleration clauses. If these specific deficiencies exist as of the balance sheet date, the associated liability should be classified as current unless the lender has agreed to waive the right to receive immediate payment or the deficiency has been fixed (e.g., an interest payment made) by the time the financial statements are issued.

Long-term debt is reported at its discounted present value, which is initially measured by the proceeds from the debt issuance. When the amount borrowed is not the same as the amount ultimately required to be repaid, called the maturity value, a discount or premium is included as an adjustment to the maturity value to ensure that the debt is reported at its discounted present value.

Almost all large companies include a deferred income tax liability in their balance sheets. This liability can be thought of as the income tax expected to be paid in future years on income that has already been reported in the income statement but which, because of the tax law, has not yet been taxed. The liability is valued using the enacted income tax rates expected to prevail in the future when the income is taxed.

In a corporation, the difference between assets and liabilities is referred to as stockholders' (shareholders') equity or owners' equity. In presenting the owners' equity on the balance sheet, a distinction is made between the equity originating from the stockholders' investments, referred to as contributed capital or paid-in capital, and the equity originating from earnings, referred to as retained earnings.

When one company owns controlling interest (more than 50%) of the common stock of one or more other companies, the financial results of this group of companies are combined into a set of consolidated financial statements. The objective of consolidated financial statements is to reflect in one set of financial statements the results of all companies owned or controlled by the parent corporation. In the consolidated balance sheet, minority interest is the amount of equity investment made by outside shareholders to consolidated subsidiaries that are not 100% owned by the parent.

A financial statement number, in isolation, tells you very little. To really understand the financial statements, you must look at relationships among the numbers.

In general, relationships between financial statement amounts are called financial ratios.

The relationship between current assets and current liabilities can be used to evaluate the liquidity of a company. Liquidity is the ability of a firm to satisfy its short-term obligations.

A common indicator of the overall liquidity of a company is the current ratio. The current ratio is computed by dividing total current assets by total current liabilities. [...] Historically, the rule of thumb has been that a current ratio below 2.0 suggests the possibility of liquidity problems. However, advances in information technology have enabled companies to be much more effective in minimizing the need to hold case, inventories, and other current assets. As a result, current ratios for successful companies these days are frequently less than 1.0. Note that this is just a rule of thumb; proper evaluation of a company's liquidity involves comparing the current year's current ratio to current ratios in prior years and comparing the company's current ratio to those for other companies in the same industry.

Another ratio used to measure a firm's liquidity is the quick ratio, also known as the acid-test ratio. This ratio is computed as total quick assets divided by total current liabilities, where quick assets are defined as cash, investment securities, and net receivables. [...] The quick ratio indicates how well a firm can satisfy existing short-term obligations with assets that can be converted into cash without difficulty.

A common characteristic of almost all financial ratios is that a ratio that deviates too much from the norm, either above or below, indicates a possible problem.

A current ratio that is too high can also indicate trouble. Excess current assets, resulting in a high current ratio, can represent an inefficient use of resources.

One frequently used measure of leverage is the debt ratio, computed as total liabilities divided by total assets. The debt ratio is frequently used as an indicator of the overall ability of a company to repay its debts. [...] The higher the debt ratio, the higher the likelihood that some of the debt might not be repaid. The general rule of thumb is that debt ratios should be below 50%. Again, this varies widely from one industry to the next. A bank, for example, could easily have a debt ratio in excess of 95%.

As a general rule, companies in mature industries have a higher amount of debt than in newer industries because the proven track records of the companies make lenders willing to provide more debt financing.

A financial ratio that gives an overall measure of company efficiency is called asset turnover and is computed as [sales divided by total assets]. [...] The higher the asset turnover ratio, the more efficient the company is at using its assets to generate sales.

Two financial ratios used to assess a firm's overall profitability are return on assets and return on equity. [...] Return on assets is computed as [net income divided by total assets]. [...] Return on equity (ROE) measures the percentage return on the actual investment made by stockholders and is computed as [net income divided by stockholder's equity]. [...] As a rule of thumb, companies with return on equity significantly below 15% are doing poorly. Companies with return on equity consistently above 15% are doing well.

The Income Statement

Income is measured as the difference between resource inflows (revenues and gains) and outflows (expenses and losses) over a period of time. Revenues are recognized when (1) they are realized or realizable and (2) they have been earned through substantial completion of the activities involved in the earning process. Expenses are matched against revenues directly, in a systematic or rational manner, or are immediately recognized as a period expense.

The key problem in recognizing and measuring income using the transaction approach is deciding when an "inflow or other enhancements of assets" has occurred and how to measure the "outflows or other 'using up' of assets". The first issue is identified as the revenue recognition problem, and the second issue is identified as the expense recognition, or expense-matching problem.

Put in simple terms, revenues are recognized when the company generating the revenue has provided the bulk of the goods or services it promised (substantial completion) for the customer and when the customer has provided payment or at least a valid promise of payment (realizable) to the company.

Relating expenses to specific revenues is often referred to as the matching process. For example, the cost of goods sold is clearly a direct expense that can be "matched" with the revenues produced by the sale of goods and reported in the same time period as the revenues are recognized. Similarly, shipping costs and sales commissions usually relate directly to revenues.

The cost of assets such as buildings, equipment, patents, and prepaid insurance are spread across the periods of expected benefit in some systematic and rational way. Generally, it is difficult, if not impossible, to relate these expenses directly to specific revenues or to specific periods, but it is clear that they are necessary if the revenue is to be earned. Examples of expenses that are included in this category are depreciation and amortization.

Many expenses are not related to specific revenues but are incurred to obtain goods and services that indirectly help to generate revenues. Because these goods and services are used almost immediately, their costs are recognized as expenses in the period of acquisition. Examples include most administrative costs, such as office salaries, utilities, and general advertising and selling expenses.

The general format of an income statement is to subtract cost of goods sold and operating expenses from operating revenues to derive operating income. Gains and losses are then included to arrive at income from continuing operations. Irregular and extraordinary items are reported separately to determine net income.

Income from continuing operations includes all revenues and expenses and gains and losses arising from the ongoing operations of the firm.

Revenue reports the total sales to customers for the period less any sales returns and allowances or discounts.

For most merchandising and manufacturing companies, cost of goods sold is the most significant expense on the income statement. Because of its size, firms pay particular attention to changes in cost of goods sold relative to changes in sales. Gross profit is the difference between revenue from net sales and cost of goods sold; gross profit percentage, computed by dividing gross profit by revenue from net sales, provides a measure of profitability that allows comparisons for a firm from year to year.

Operating expenses may be reported in two parts: (1) selling expenses and (2) general and administrative expenses.

Operating income measures the performance of the fundamental business operations conducted by a company and is computed as gross profit minus operating expenses. A general rule of thumb is that all expenses are operating expenses except interest expense and income tax expense. Accordingly, another name for operating income is earnings before interest and taxes (EBIT).

A common irregular item involves the disposition of a separately identifiable component of a business either through sale or abandonment. [...] The size of the discontinued activity is not the factor that determines whether it is reported as a discontinued operation. Instead, to qualify as discontinued operations for reporting purposes, the operations and cash flows of the component must be clearly distinguishable from other operations and cash flows of the company, both physically and operationally, as well as for financial reporting purposes.

Frequently, the disposal of a business component is initiated during the year but not completed by the end of the fiscal year. To be classified as a discontinued operation for reporting purposes, the ultimate disposal must be expected within one year of the period for which results are being reported.

Income or loss from continuing operations combined with the results of discontinued operations and extraordinary items provides users a summary measure of the firm's performance for a period: net income or net loss.

In order to compare this period's results with prior periods or with the performance of other firms, net income is divided by net sales to determine the return on sales.

An individual shareholder is interested in how much of a company's net income is associated with his or her ownership interest. As a result, the income statement reports earnings per share (EPS), which is the amount of net income associated with each common share of stock.

Companies often disclose two earnings-per-share numbers. Basic EPS reports earnings based solely on shares actually outstanding during the year. [...] Diluted earnings per share reflects the existence of stock options or other rights that can be converted into shares in the future.

Earnings per share is often used to calculate a firm's price-earnings (P/E) ratio. This ratio expresses the market value of common stock as a multiple of earnings and allows investors to evaluate the attractiveness of a firm's common stock.

Comprehensive income is the number used to reflect an overall measure of the change in a company's wealth during the period. In addition to net income, comprehensive income includes items that, in general, arise from changes in market conditions unrelated to the business operations of a company. These items are excluded from net income because they are viewed as yielding little information about the economic performance of a company's business operations. However, they are reported as part of comprehensive income because they do impact the value of assets and liabilities reported in the balance sheet.

Statement of Cash Flows and Articulation

When a company reports large noncash expenses, such as write-offs, depreciation, and provisions for future obligations, earnings may give a gloomier picture of current operations than is warranted. [...] In such cases, cash flow from operations is a better indicator of whether the company can continue to honor its commitments to creditors, customers, employees, and investors in the near term.

Rapidly growing firms use large amounts of cash to expand inventory. In addition, cash collections on the growing accounts receivable often lag behind the need to pay creditors. In these cases, reported earnings may be positive, but operations are actually consuming rather than generating cash. [...] The lesson is this: For high-growth companies, positive income is no guarantee that sufficient cash flow is there to service current needs.

Accounting assumptions are the heart of accrual accounting. For companies entering phases in which it is critical that reported earnings look good, those assumptions can be stretched – sometimes to the breaking point. Such phases include just before making a large loan application, just before the initial public offering of stock [...], and just before being bought out by another company. In these cases, cash flow from operations, which is not impacted by accrual assumptions, provides an excellent reality check for reported earnings.

A statement of cash flows explains the change during the period in cash and cash equivalents. A cash equivalent is a short-term, highly liquid investment that can be converted easily into cash.

In the statement of cash flows, cash receipts and payments are classified according to three main categories:

  • Operating activities
  • Investing activities
  • Financing activities

Operating activities include those transactions and events associated with the revenues and expenses that enter into the determination of net income. Cash receipts from selling goods or from providing services are the major cash inflows for most businesses. [...] Major cash outflows include payments to purchase inventory and to pay wages, taxes, interest, utilities, rent, and similar expenses. The net amount of cash provided or used by operating activities is the key figure in a statement of cash flows.

Whether an activity is an operating activity depends upon the nature of the business. The purchase of machinery is an investing activity for a manufacturing business, but it is an operating activity for a machinery sales business.

The primary investing activities are the purchase and sale of land, buildings, equipment, and other assets not generally held for resale.

Financing activities include transactions and events whereby cash is obtained from or repaid to owners (equity financing) and creditors (debt financing).

Two methods may be used in calculating and reporting the amount of net cash flow from operating activities: the indirect method and the direct method.

The direct method is essentially a reexamination of each income statement item with the objective of reporting how much cash was received or disbursed in association with the item. For example, for the item sales in the income statement, there is a corresponding item in the cash flow statement called cash collected from customers. For cost of goods sold, the corresponding item is cash paid for inventory. To prepare the Operating Activities section using the direct method, one must adjust each income statement item for the effects of accruals.

The indirect method begins with net income as reported on the income statement and adjusts this accrual amount for any items that do not affect cash flow. The adjustments are of three basic types:

  • Revenues and expenses that do not involve cash inflow or outflow
  • Gains and losses associated with investing or financing activities
  • Adjustments for changes in current operating assets and liabilities that indicate noncash sources of revenues and expenses

Perhaps the most important cash flow relationship is the relationship between cash from operations and reported net income. The cash-flow-to-net-income ratio reflects the extent to which accrual accounting assumptions and adjustments have been included in computing net income. The formula is cash from operations divided by net income.

In general, the cash-flow-to-net-income ratio has a value more than 1.0 because of the existence of significant noncash expenses (such as depreciation) that reduce reported net income but have no impact on cash flow. For a given company, the cash-flow-to-net-income ratio should remain fairly stable from year to year. A significant increase in the ratio [...] indicates that accounting assumptions were instrumental in reducing reported net income.

[...] a cash cow is a business that is generating enough cash from operations to completely pay for all new plant and equipment purchases with cash left over to repay loans or to distribute to investors. The cash flow adequacy ratio, computed as cash from operations divided by expenditures for fixed asset additions and acquisitions of new businesses, indicates whether a business is a cash cow.

In an accounting context, articulation means that the three primary financial statements are not isolated lists of numbers but are an integrated set of reports on a company's financial health. The statement of cash flows contains the detailed explanation for why the balance sheet cash amount changed from beginning of year to end of year. The income statement, combined with the amount of dividends declared during the year, explains the change in retained earnings shown in the balance sheet. Cash from operations in the statement of cash flows is transformed into net income through the accounting adjustments applied to the raw cash flow data.

Earnings Management

Because accounting numbers are so important in so many decisions, there is a predictable tendency of managers to try to manipulate the reported numbers to be as favorable as possible. And because financial accounting involves so many judgments and estimates, such manipulation is possible.

Four factors typically motivate managers to manage reported earnings: attempts to meet internal targets, to meet external expectations, to smooth reported income, and to window dress the financial statements in advance of an IPO or a loan application.

Internal earnings targets represent an important tool in motivating managers to increase sales efforts, control costs, and use resources more efficiently. As with any performance measurement tool, however, it is a fact of life that the person being evaluated will have a tendency to forget the economic factors underlying the measurement and instead focus on the measured number itself.

Financial analysts are a very important set of external financial statement users. In addition to making buy and sell recommendations about shares of a company's stock, financial analysts also generate forecasts of company earnings. Extensive research has shown that announcing net income less than the income forecast by analysts results in a drop in stock price. As a result, companies have an incentive to manage earnings to make sure that the announced number is at least equal to the earnings expected by analysts.

The practice of carefully timing the recognition of revenues and expenses to even out the amount of reported earnings from one year to the next is called income smoothing. By making a company appear to be less volatile, income smoothing can make it easier for a company to obtain a loan on favorable terms and easier to attract investors.

Through awareness of the benefits of consistently meeting earnings targets or of reporting a stable income stream, a company can make extra efforts to ensure that certain key transactions are completed quickly or delayed so that they are recognized in the most advantageous quarter.

Companies frequently change accounting estimates respecting bad debts, return on pension funds, depreciation lives, and so forth. [...] Although such changes are a routine part of adjusting accounting estimates to reflect the most current information available, they can be used to manage the amount of reported earnings. Because the impact of such changes is fully disclosed, any earnings management motivation could be detected by financial statement users willing to do a little detective work.

An interesting twist in the practice of earnings management is the reporting of pro forma earnings. A pro forma earnings number is the regular GAAP earnings number with some revenues, expenses, gains, or losses excluded. The exclusions are made because, companies claim, the GAAP results do not fairly reflect the company's performance. [...] The concern with pro forma earnings is that companies can abuse the practice and report pro forma earnings merely in an effort to make their results seem better than they actually were.

The key question with respect to pro forma earnings is whether the number helps financial statement users better understand a company or whether it is a blatant attempt to cover up poor performance. [...] For many companies [...] the pro forma earnings number is in fact a better reflection of the underlying economic performance than is GAAP net income. Thus, a manager can use the flexibility of pro forma earnings reports to reveal additional, useful information. On the other hand, there is also evidence that some managers use a pro forma earnings release in an attempt to hide poor operating performance.

Excessive earnings management almost always begins with a downturn in business. When operating results are consistently good, the need for earnings management is not as great.

The cost of capital is the cost a company bears to obtain external financing. The cost of debt financing is simply the after-tax interest cost associated with borrowing the money. The cost of equity financing is the expected return (both as dividends and an increase in the market value of the investment) necessary to induce investors to provide equity capital. A company often computes its weighted-average cost of capital, which is the average of the cost of debt and equity financing weighted by the proportion of each type of financing.

A company's cost of capital is critical because it determines which long-term projects are profitable to undertake. In a capital budgeting setting, the cost of capital can be thought of as the discount rate or hurdle rate used in evaluating long-term projects. The higher the cost to obtain funds, the fewer long-term projects are profitable for the company to undertake.

A key factor in determining a company's cost of capital is the risk associated with the company. For a very risky company, lenders and investors are going to require a higher return to induce them to provide capital to the company. Thus, the more risk associated with a company, the higher its cost of capital. One risk factor is the information risk associated with uncertainty about the company's future prospects. A company produces financial statements to better inform lenders and investors about its past performance; they can then use this information to make better forecasts of the company's future performance. Consequently, good financial statements reduce the uncertainty of lenders and investors so that they will provide financing at a lower cost. However, when the financial statements lose their credibility, they do nothing to reduce the information risk surrounding a company, and the company's cost of capital is higher.

Module: Time Value of Money Review

Making correct financial decisions requires that the time value of money be taken into account. This means that dollars to be received or paid in the future must be "discounted" or adjusted to their present value. Alternatively, current dollars may be "accumulated" or adjusted to their future values so that comparisons of dollar amounts at different time periods can be meaningful.

Money, like other commodities, is a scarce resource, and a payment for its use is generally required. This payment (cost) for the use of money is interest.

Generally, interest is specified in terms of a percentage rate for a period of time, usually a year. For example, interest at 8% means the annual cost of borrowing an amount of money, called the principal, is equal to 8% of that amount.

Most transactions [...] involve compound interest. This means that the amount of interest earned for a certain period is added to the principal for the next period. Interest for the subsequent period is computed on the new amount, which includes both principal and accumulated interest.

An annuity consists of a series of equal payments over a specified number of equal time periods.

Annuities are of two types: ordinary annuities (annuities in arrears) and annuities due (annuities in advance). The periodic receipts or payments for an ordinary annuity are made at the end of each period, and the last payment coincides with the end of the annuity term. The periodic receipts or payments for an annuity due are made at the beginning of the period, and one period of the annuity term remains after the last payment.

Module: Fair Value

Fair value is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants."

[...] with the increasing use of fair values in financial reporting, all accountants, auditors, and financial statement users should understand the key concepts used in defining and estimating fair values. These key concepts are as follows:

  • The hypothetical transaction
  • The principal (or most advantageous) market
  • Market participants
  • Highest and best use
  • Valuation techniques
  • Inputs to valuation techniques

Fair value is based on the price that would be received to sell an asset (or paid to transfer a liability) in a hypothetical transaction on the date of the measurement. This hypothetical transaction is assumed to be an orderly one meaning that it is not a forced or hasty sale. In addition, this hypothetical transaction is assumed to occur between two unrelated, informed market participants.

[...] the hypothetical transaction is an orderly market transaction. Well, a natural question is: Which market? For some assets, there is a principal market in which that asset is typically traded. This principal market would be associated with the largest trading volume for the asset in question. [...] If there is no one principal market in which a company could sell the asset, then the fair value should be determined using the price that could be obtained in the most advantageous market of those available.

[...] the price of the hypothetical transaction used to determine the fair value of an asset is the price that would occur between two unrelated, informed market participants. Specifically, the hypothetical market participants are knowledgeable about the asset in question, have the financial resources to buy and sell the asset, and are interested in buying or selling the asset.

A key assumption in appraising an asset is that in an unconstrained market with ample time given for market participants to consider whether they want to buy an asset, the asset will be sold to the market participant who will use that asset in the most valuable way and who will pay the highest price for the asset. In shorthand terms, it is assumed that the asset in question will be put to its "highest and best use".

When the highest and best use of an asset is "in use", in determining the fair value of the asset, it is assumed that the hypothetical market participant who would purchase the asset also owns the related assets that would allow it to maximize the "in use" value of the purchased asset.

In the field of asset appraisal, there are three primary asset valuation techniques: the market approach, the income approach, and the cost approach.

The market approach uses data from market prices for identical or similar assets.

The income approach is the general heading given to valuation techniques based directly or indirectly on discounted cash flow analysis.

The cost approach is based on the replacement cost of the asset. Often, the replacement cost is estimated based on what it would cost to replace the asset new, and then an adjustment is made for wear and tear to reflect the fact that the asset is used.

All of the valuation techniques outlined above require data inputs in estimating a fair value. Some data inputs are independently verifiable such as market prices for shares of stock or selling prices for comparable pieces of commercial real estate. These are called observable inputs. In the absence of observable inputs based on market data, a company must use its own assumptions to generate reasonable estimates of the cash flow forecasts, discount rate assumptions, or other valuation inputs that would be used by market participants. These are called unobservable inputs.

[...] the present value of future cash flows can be used to estimate fair value in one of two ways. In the traditional approach, which is often used in situations in which the amount and timing of the future cash flows are determined by contract, the present value is computed using a risk-adjusted interest rate that incorporates expectations about the uncertainty of receipt of the future contractual cash flows. In the expected cash flow approach, a range of possible outcomes is identified, the present value of the cash flows in each possible outcome is computed (using the risk-free interest rate), and a weighted-average present value is computed by summing the present value of the cash flows in each outcome, multiplied by the estimated probability of that outcome.

In using valuation techniques to generate fair values, the FASB requires companies to maximize the use of observable inputs and minimize the use of unobservable inputs. The FASB has refined this observable/unobservable dichotomy into a 3-way "fair value hierarchy", as follows:

  • Level 1 inputs - quoted prices in active markets for identical assets (or liabilities)
  • Level 2 inputs - observable inputs other than quoted prices in active markets for identical assets (or liabilities)
  • Level 3 inputs - unobservable inputs

Clearly, a fair value generated with Level 1 inputs is more reliable and involves less uncertainty than a fair value generated with Level 3 inputs. Accordingly, [...] a company is required to provide quantitative disclosure about the source of the inputs into its fair value computations.

Routine Activities of a Business

The Revenue/Receivables/Cash Cycle

The normal operating cycle of a business involves purchasing inventory (using either cash or credit), which is then sold, often on account. Once the receivable is collected, the cycle begins again.

The recognition of revenue is generally related to the recognition of accounts receivable. Because revenues are generally recorded when the earning process is complete and a valid promise of payment (or payment itself) is received, it follows that a receivable arising from the sale of goods is generally recognized when title to the goods passes to a bona fide buyer. The point at which title passes may vary with the terms of the sale; therefore, it is normal practice to recognize the receivable when goods are shipped to the customer. It is at this point in time that the revenue recognition criteria are normally satisfied.

Receivables for services to customers are properly recognized when the services are performed.

In classifying receivables, an important distinction is made between trade and nontrade receivables. Trade receivables, generally the most significant category of receivables, result from the normal operating activities of a business, that is, credit sales of goods or services to customers. [...] Accounts receivable represent an extension of short-term credit to customers. [...] Nontrade receivables include all other types of receivables. They arise from a variety of transactions, such as (1) the sale of securities or property other than inventory; (2) deposits to guarantee contract performance or expense payment; (3) claims for rebates and tax refunds; and (4) dividends and interest receivable.

Receivables are generally recorded at their gross amounts, without regard to any cash discount offered. If payment is received within the discount period, Sales Discounts (a contra account to Sales) is debited for the difference between the recorded amount of the receivable and the total cash collected. This method [is] called the gross method [...]. The net method of accounting for sales discounts records the sale and the receivable net of the discount. [...] If payment is not made within the discount period, the additional amount paid by the customer through failure to take the sales discount would be recorded in a revenue account.

In the normal course of business, some goods will be returned by customers and some allowance will have to be made for factors such as goods damaged during shipment, spoiled or otherwise defective goods, or shipment of an incorrect quantity or type of goods. When an allowance is necessary, net sales and accounts receivable are reduced.

Theoretically, all receivables should be valued at an amount representing the present value of the expected future cash receipts. Because accounts receivable are short term, usually being collected within 30 to 90 days, the amount of interest is small relative to the amount of the receivable. Consequently, the accounting profession has chosen to ignore the interest element for these trade receivables.

Instead of valuing accounts receivable at a discounted present value, they are reported at their net realizable value, that is, their expected cash value. This means that accounts receivable should be recorded net of estimated uncollectible items. The objective is to report the receivables at the amount actually expected to be collected in cash.

When using the allowance method, the amount of receivables estimated to be uncollectible is recorded by a debit to Bad Debt Expense and a credit to Allowance for Bad Debts. [...] The allowance for bad debts account is a contra asset account that is offset against Accounts Receivable, resulting in the Accounts Receivable balance being reported at its net realizable value.

When positive evidence is available concerning the partial or complete worthlessness of an account, the account is written off by a debit to the allowance account, which was previously established, and a credit to Accounts Receivable. Positive evidence of a reduction in value is found in the bankruptcy, death, or disappearance of a debtor, failure to enforce collection legally, or barring of collection by the statute of limitations.

The estimate for uncollectible accounts may be based on sales for the period or the amount of receivables outstanding at the end of the period.

When a sales basis is used, the amount of uncollectible accounts in past years relative to total sales provides a percentage of estimated uncollectibles. This percentage may be modified by expectations based on current experience.

Instead of using a percentage of sales to estimate bad debts, companies may base their estimates on a percentage of total accounts receivable outstanding. [...] The most commonly used method for establishing an allowance based on outstanding receivables involves aging receivables. Individual accounts are analyzed to determine those not yet due and those past due. Past-due accounts are classified in terms of the length of the period past due. [...] Overdue balances can be evaluated individually to estimate the collectibility of each item as a basis for developing an overall estimate.

Many companies agree to provide free service on units failing to perform satisfactorily or to replace defective goods. When these agreements, or warranties, involve only minor costs, such costs may be recognized in the periods incurred. When these agreements involve significant future costs and when experience indicates that a definite future obligation exists, estimates of such costs should be made and matched against current revenues.

Average receivables are sometimes expressed in terms of the average collection period, which reflects the average number of days that elapse between the time that a sale is made and the time that cash is collected. Average receivables outstanding divided by average daily sales gives the average collection period.

Accounts receivable turnover is determined by dividing net sales by the average trade accounts receivable outstanding during the year.

Cash is the most liquid of current assets. To be reported as "cash", an item must be readily available and not restricted for use in the payment of current obligations. A general guideline is whether an item is acceptable for deposit at face value by a bank or other financial institution.

Items that are classified as cash include coin and currency on hand and unrestricted funds available on deposit in a bank, which are often called demand deposits, because they can be withdrawn upon demand. Demand deposits include amounts in checking, savings, and money market deposit accounts.

In addition, many companies report investments in very short-term, interest-earning securities (such as 3-month U.S. Treasury securities) as cash equivalents in the balance sheet.

A comparison of the bank balance with the balance reported on the books is usually made monthly by means of a summary known as a bank reconciliation. A bank reconciliation is prepared to disclose any errors or irregularities in either the records of the bank or those of the business unit.

Certain banks, dealers, and finance companies purchase receivables from companies. In many cases, these purchases are done without recourse, meaning that the purchaser assumes the risks associated with the collectibility of the receivables. If the terms of the sale are with recourse, then if the receivables are not collected, the purchaser has the right to collect from the company that originally sold the receivable. A sale of accounts receivable without recourse is commonly referred to as accounts receivable factoring, and the buyer is referred to as a factor.

Packaging and transfer of receivables is sometimes called securitization.

A promissory note is an unconditional written promise to pay a certain sum of money at a specified time. [...] Notes usually involve interest, stated at an annual rate and charged on the face amount of the note. Most notes are negotiable notes that are legally transferable by endorsement and delivery.

Actually, two possibilities are associated with a decrease in receivables: Customers pay or customers never pay and the account is written off. Thus, a decrease in receivables may reflect a receipt of cash, or it may reflect the writing off of an account.

Revenue Recognition

Recognition refers to the time when transactions are recorded on the books. [...] Revenues and gains are generally recognized when:

  1. They are realized or realizable.
  2. They have been earned through substantial completion of the activities involved in the earnings process.

Both of the criteria generally are met at the point of sale, which most often occurs when goods are delivered or when services are rendered to customers. Usually, assets and revenues are recognized concurrently. Thus, a sale of inventory results in an increase in Cash or Accounts Receivable and an increase in Sales Revenue. However, assets are sometimes received before these revenue recognition criteria are met. For example, if a client pays for consulting services in advance, an asset, Cash, is recorded on the books even though revenue has not been earned. In these cases, a liability, Unearned Revenue, is recorded. When the revenue recognition criteria are fully met, revenue is recognized and the liability account is reduced.

A bill-and-hold arrangement is exactly what the label implies: The seller bills the buyer for a purchase but holds the goods for later shipment. In general, revenue should not be recognized in a bill-and-hold arrangement until the seller has transferred both legal ownership, evidenced by the buyer taking title to the goods, and economic ownership, meaning that the buyer accepts responsibility for the safeguarding and preservation of the goods.

Under U.S. GAAP, the most common occurrence of revenue recognition before final delivery is when the construction period of the asset being sold or the period of service performance is relatively long, that is, more than one year. In these cases, if a company waits until the production or service period is complete to recognize revenue, the income statement may not report meaningfully the periodic achievement of the company. Under this approach, referred to as the completed-contract method, all income from the contract is related to the year of completion, even though only a small part of the earnings may be attributable to effort in that period. Previous periods receive no credit for their efforts; in fact, they may be penalized through the absorption of selling, general and administrative, and other overhead costs relating to the contract but not considered part of the inventory cost.

Percentage-of-completion accounting, an alternative to the completed-contract method, was developed to relate recognition of revenue on long-term construction-type contracts to the activities of a firm in fulfilling these contracts. Similarly, the proportional performance method has been developed to reflect revenue earned on service contracts under which many acts of service are to be performed before the contract is completed.

Various methods are currently used in practice to measure the earnings process. They can be conveniently grouped into two categories: input and output measures.

Input measures are made in relation to the costs or efforts devoted to a contract. They are based on an established or assumed relationship between a unit of input and productivity.

Perhaps the most popular of the input measures is the cost-to-cost method. Under this method, the degree of completion is determined by comparing costs already incurred with the most recent estimates of total expected costs to complete the project.

The efforts-expended methods are based on some measure of work performed. They include labor hours, labor dollars, machine hours, or material quantities. In each case, the degree of completion is measured in a way similar to that used in the cost-to-cost approach: the ratio of the efforts expended to date to the estimated total efforts to be expended on the entire contract.

Output measures are made in terms of results achieved. Included in this category are methods on units produced, contract milestones reached, and values added.

Collection of receivables is usually routine, and any future warranty costs can be reasonably estimated. In some cases, however, the circumstances surrounding a revenue transaction are such that considerable uncertainty exists as to whether payments will indeed be received. This can occur if the sales transaction is unusual in nature or involves a customer in such a way that default carries little cost or penalty. Under these circumstances, the uncertainty of cash collection suggests that revenue recognition should await the actual receipt of cash. There are at least three different approaches to revenue recognition that depend on the receipt of cash: installment sales, cost recovery, and cash.

Traditionally, the most commonly applied method for dealing with the uncertainty of cash collections has been the installment sales method. Under this method, profit is recognized as cash is collected rather than at the time of sale.

Under the cost recovery method, no income is recognized on a sale until the cost of the item sold is recovered through cash receipts. All cash receipts, both interest and principal portions, are applied first to the cost of those items sold. Then all subsequent receipts are reported as revenue. Because all costs have been recovered, the recognized revenue after cost recovery represents income. This method is used only when the circumstances surrounding a sale are so uncertain that earlier recognition is impossible.

If the probability of recovering product or service costs is remote, the cash method of accounting could be used. [...] the cash method might be appropriate for service contracts with high initial costs and considerable uncertainty as to the ultimate collection of the contract price. Under this method, all costs are charged to expense as incurred, and revenue is recognized as collections are made.

Inventory and Cost of Goods Sold

The objective of inventory valuation is to divide the total cost of goods available for sale during the period into two categories: the cost associated with goods that were sold (cost of goods sold) and the cost associated with goods that still remain (ending inventory).

The term inventory designates goods held for sale in the normal course of business and, in the case of a manufacturer, goods in production or to be placed in production.

The term inventory (or merchandise inventory) is generally applied to goods held by a merchandising firm, either wholesale or retail, when such goods have been acquired in a condition for resale. The terms raw material, work in process, and finished goods refer to the inventories of a manufacturing enterprise.

Raw materials are good acquired for use in the production process. Some raw materials are obtained directly from natural sources. More often, however, raw materials are purchased from other companies and represent the finished products of the suppliers.

Although the term raw materials can be used broadly to cover all materials used in manufacturing, this designation is usually restricted to materials that will be physically incorporated in the products being manufactured. Because these materials are used directly in the production of goods, they are frequently referred to as direct materials. The term indirect materials is then used to refer to auxiliary materials, that is, materials that are necessary in the production process but are not directly incorporated in the products.

Although indirect materials may be summarized separately, they should be reported as a part of a company's inventories since they ultimately will be consumed in the production process. Supplies purchased for use in the delivery, sales, and general administrative functions of the enterprise should not be reported as part of the inventories, but as selling and administrative supplies.

Work in process, alternately referred to as goods in process, consists of materials partly processed and requiring further work before they can be sold. This inventory includes three cost elements.

  1. Direct materials – the cost of materials directly identified with goods in production
  2. Direct labor – the cost of labor directly identified with goods in production
  3. Manufacturing overhead – the portion of factory overhead assignable to goods in production

Finished goods are the manufactured products awaiting sale. As products are completed, the costs accumulated in the production process are transferred from Work in Process to the finished goods inventory account.

When goods are in transit from the seller to the buyer, who owns them? The answer depends on the terms of the sale. When terms of sale are FOB (free on board) shipping point, title passes to the buyer with the loading of goods at the point of shipment. [...] When terms of a sale are FOB destination, legal title does not pass until the goods are received by the buyer. [...] To summarize, when goods are shipped FOB shipping point, they belong to the buyer while they are in transit and should normally be included in the buyer's inventory while in transit. When goods are shipped FOB destination, they belong to the seller while in transit and are normally included in the seller's inventory.

Keep in mind that the shipping terms related to inventory are only an issue at the end of an accounting period. For most shipments, the goods will be shipped by the seller and received by the buyer in the same accounting period, thereby presenting no accounting problems.

Goods are frequently transferred to a dealer or customer on a consignment basis. The shipper retains title and includes the goods in inventory until their sale or use by the dealer or customer.

Inventory cost consists of all expenditures, both direct and indirect, relating to inventory acquisition, preparation, and placement for sale. In the case of raw materials or good acquired for resale, cost includes the purchase price, freight, receiving, storage, and all other costs incurred to the time goods are ready for sale.

At the end of an accounting period, total inventory cost must be allocated between inventory still remaining (to be reported on the balance sheet as an asset) and inventory sold during the period (to be reported on the income statement as the expense "cost of goods sold"). Numerous methods have evolved to make this allocation between cost of goods sold and inventory. The most common methods are as follows:

  • Specific identification
  • Average cost
  • First-in, first-out (FIFO)
  • Last-in, first-out (LIFO)

Costs may be allocated between goods sold during the period and goods on hand at the end of the period according to the actual cost of specific units. This specific identification method requires a way to identify the historical cost of each individual unit of inventory. With specific identification, the flow of recorded costs matches the physical flow of goods.

The average cost method assigns the same average cost to each unit. This method is based on the assumption that goods sold should be charged at an average cost, with the average being weighted by the number of units acquired at each price.

The first-in, first-out (FIFO) method is based on the assumption that the units sold are the oldest units on hand.

The last-in, first-out (LIFO) method is based on the assumption that the newest units are sold.

Notice that each year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending inventory. As long as inventory continues to grow, a new LIFO layer is created each year and the old LIFO layers remain untouched. The creation of LIFO layers illustrates one of the drawbacks of LIFO in that after a few years, the LIFO assumption results in ending inventory containing old inventory at old prices.

The difference between the LIFO ending inventory amount and the amount obtained using another inventory valuation method (like FIFO or average cost) is called the LIFO reserve.

One of the traditional concepts of accounting is conservatism, sometimes summarized as "when in doubt, recognize all unrealized losses, but don't recognize any unrealized gains". When applied to asset valuation, conservatism results in the rule of lower of cost or market (LCM), meaning that assets are recorded at the lower of their cost or their market value. LCM has the effect of recognizing unrealized decreases in the value of assets but not unrealized increases. In applying the lower-of-cost-or-market rule, the cost of the ending inventory [...] is compared with market value at the end of the period. If market is less than cost, an adjusting entry is made to record the loss and restate ending inventory at the lower value.

The term market in "lower of cost or market" is interpreted as meaning replacement cost [...]. Replacement cost, sometimes referred to as entry cost, includes the purchase price of the product or raw materials plus all other costs incurred in the acquisition or manufacture of goods.

Extreme fluctuations in the price of inventory purchases can expose a company to excessive risk. Of the different ways to manage this risk, the simplest is a purchase commitment that locks in the inventory purchase price in advance.

Investments in Noncurrent Operating Assets - Acquisition

Noncurrent operating assets are recorded initially at cost [...].

The cost of property includes not only the original purchase price or equivalent value but also any other expenditures required in obtaining and preparing the asset for its intended use. Any taxes, freight, installation, and other expenditures related to the acquisition should be included in the asset's cost. Postacquisition costs – costs incurred after the asset is placed into service – are usually expensed rather than added to the acquisition cost.

Classification of an asset as a noncurrent operating asset depends on how management intends to use the asset. For example, land held for long-term investment purposes is not an operating asset; land held for resale within a year is a current asset.

Because land is a nondepreciable asset, costs assigned to it should be those costs that directly relate to land's unlimited life. Together with clearing and grading costs, costs of removing unwanted structures from newly acquired land are considered part of the cost to prepare the land for its intended use and are added to its purchase price.

The cost of purchased buildings includes any reconditioning costs necessary before occupancy.

Equipment costs include freight and insurance charges while the equipment is in transit and any expenditures for testing and installation. Costs for reconditioning purchased used equipment are also part of the asset cost.

Intangible assets are defined as those assets (not including financial assets) that lack physical substance. Many intangible assets arise from contractual or governmental rights. A well-known example of this type of intangible asset is the right to operate a taxicab in a metropolitan area [...]. Other intangible assets are not created by a specific contract or legal right. The existence of these intangibles is evidenced by the fact that they are bought, sold, or licensed, either separately or in conjunction with a broader assortment of assets. A good example of this type of intangible is a customer list.

The most important distinction in intangible assets for accounting purposes is between those intangible assets that are internally generated and those that are externally purchased. This distinction is important because the transfer of externally purchased intangible assets in an arm's-length market transaction provides reliable evidence that the intangibles have probable future economic benefit. Such reliable evidence does not exist for most internally generated intangibles. Accordingly, most costs associated with generating and maintaining internally generated intangibles are expensed as incurred. Only the actual legal and filing costs are included as part of the intangible asset cost for these internally developed items.

A trademark is a distinctive name, symbol, or slogan that distinguishes a product or service from similar products or services.

When a business obtains a franchise, the recorded cost of the franchise includes any sum paid specifically for the franchise right as well as legal fees and other costs incurred in obtaining it. Although the value of a franchise at the time of its acquisition may be substantially in excess of its cost, the amount recorded should be limited to actual outlays. [...] However, if a franchise right is included when one company purchases another company, presumably the entire value is included in the purchase price, and the fair value attributable to the franchise right is recorded as an intangible asset in the acquirer's books.

To some companies, especially capital equipment manufacturers, the order backlog is a key economic asset. The order backlog is the amount of orders the company has received for equipment that has not yet been produced or delivered. Note that these orders do not constitute sales because they do not satisfy the revenue recognition requirement that the product be completed and shipped. However, this order backlog does represent future valuable economic activity, and the contractual right to these backlogged orders constitutes an important intangible asset.

In essence, goodwill is a residual number, the value of all of the synergies of a functioning business that cannot be specifically identified with any other intangible factor. Goodwill is recognized only when it is purchased as part of the acquisition of another company. In other words, a company's own goodwill, its homegrown goodwill, is not recognized.

When an asset is purchased for cash, the acquisition is simply recorded at the amount of cash paid, including all outlays relating to its purchase and preparation for intended use. Assets can be acquired under a number of other arrangements, however, some of which present special problems relating to the cost to be recorded.

In some purchases, a number of assets may be acquired in a basket purchase for one lump sum. [...] To account for the assets on an individual basis, the total purchase price must be allocated among the individual assets. When part of a purchase price can be clearly identified with specific assets, such a cost assignment should be made and the balance of the purchase price allocated among the remaining assets. When no part of the purchase price can be related to specific assets, the entire amount must be allocated among the different assets acquired. Appraisal values or similar evidence provided by a competent independent authority should be sought to support the allocation.

This cost allocation of a basket purchase price is not merely a theoretical exercise. Some assets in the group may be depreciable, others nondepreciable. Depreciable assets may have different useful lives. Periodic depreciation expense can be significantly impacted by the proportion of the purchase price that is allocated to assets with relatively long useful lives.

The acquisition of real estate or other property frequently involves deferred payment of all or part of the purchase price. The buyer signs a note or a mortgage that specifies the terms of settlement of the obligation. The debt contract may call for one payment at a given future date or a series of payments at specified intervals. Interest charged on the unpaid balance of the contract should be recognized as an expense.

If the fair value of the asset varies from the contract price because of delayed payments, the difference should be recorded as a discount (contra liability) and amortized over the life of the contract using the implicit or effective interest rate.

A lease is a contract whereby one party (the lessee) is granted a right to use property owned by another party (the lessor) for a specified period of time for a specified periodic cost. Most leases are similar in nature to rentals. These leases are called operating leases. However, other leases, referred to as capital leases, are economically equivalent to a sale of the leased asset with the lessor allowing the lessee to pay for the asset over time with a series of "lease" payments. In these circumstances, the lease payments are exactly equivalent to mortgage payments. In such cases, the leased property should be recorded as an asset on the books of the company using the asset (the lessee), not on the books of the company that legally owns the asset (the lessor). The capital lease asset is recorded at the present value of the future lease payments.

In some cases, an enterprise acquires a new asset by exchanging or trading existing nonmonetary assets. Generally, the new asset should be valued at its fair value or at the fair value of the asset given up, whichever is more clearly determinable.

A company may acquire certain property by issuing its own bonds or stocks. When a fair value for the securities can be determined, that value is assigned to the asset; in the absence of a fair value for the securities, the fair value of the asset acquired would be used.

Like purchased assets, [self-constructed assets] are recorded at cost, including all expenditures incurred to build the asset and make it ready for its intended use.

Property acquired through donation should be appraised and recorded at its fair value. A donation is recognized as a revenue or gain in the period in which it is received.

Sometimes, the act of acquiring a long-term operating asset legally obligates a company to incur restoration costs in the future when the asset is retired. [...] Proper accounting for this obligation requires that it be recognized, at its estimated fair value, at the time that it is incurred and that the fair value of the obligation be added to the cost of acquiring the long-term operating asset.

The decision as to whether a given expenditure is an asset or an expense is one of the many areas in which an accountant must exercise judgment. Conceptually, the issue is straightforward: If an expenditure is expected to benefit future periods, it is an asset; otherwise, it is an expense. In practice, the capitalize-or-expense question is much more difficult.

The difficulty with making capitalize-or-expense decisions is that many expenditures have some probability of generating future economic benefit, but uncertainty surrounds that benefit. Research and development expenditures are a good example. Companies spend money on research and development because they expect to reap future benefits. However, there is no guarantee that the benefits will materialize.

Expenditures to maintain plant assets in good operating condition are referred to as maintenance. [...] Maintenance expenditures are ordinary, recurring, and do not improve the asset or add to its life; therefore, they are recorded as expenses when they are incurred.

Expenditures to restore assets to good operating condition upon their breakdown or to restore and replace broken parts are referred to as repairs. These are ordinary and recurring expenditures that benefit only current operations; thus, they also are charged to expense immediately.

Expenditures for overhauling plant assets are frequently referred to as renewals. These amounts should be expensed as incurred.

Substitutions of parts or entire units are referred to as replacements. If a part if removed and replaced with a different part, the cost and accumulated depreciation related to the replaced part should be removed from the accounts, and the remaining book value of the replaced part is added to depreciation expense for the period. If the replacement component has a useful life different from the remaining useful life of the large plant asset of which it is a component, its cost should be accounted for as a separate depreciable asset.

Enlargements and extensions of existing facilities are referred to as additions. Changes in assets designed to provide increased or improved services are referred to as betterments. If the addition or betterment does not involve a replacement of component parts of an existing asset, the expenditure should be capitalized by adding it to the cost of the asset, or, if the new component has a useful life different from the larger asset of which it is a component, establishing a separate asset account for the component.

[...] all [software development] costs incurred up to the point where technological feasibility is established are to be expensed as research and development. These include costs incurred for planning, designing, and testing activities. In essence, the uncertainty surrounding the future benefits of these costs is so great that they should be expensed. After technological feasibility has been established, uncertainty about future benefits is decreased to the extent that costs incurred after this point can be capitalized.

Two methods of accounting have been developed to account for oil and gas exploratory costs. Under the full cost method, all exploratory costs are capitalized, the reasoning being that the cost of drilling dry wells is part of the cost of locating productive wells. Under the successful efforts method, exploratory costs for dry holes are expensed, and only exploratory costs for successful wells are capitalized.

Most of the intangible assets [...] arise from contracts or other legal rights. Examples are trademarks, patents, copyrights, and franchise agreements. An intangible asset that is based on contractual or legal rights should be recognized as a separate asset, even if the right is inseparably connected with another asset.

Some intangible assets arise as companies establish and maintain relationships of trust with their customers. These relationships are not imposed by legal right or contract but are voluntary and are based on past positive experiences. Companies are increasingly recognizing the value in these relationships and are even learning how to sell or rent these relationships. One example is the sale (exclusive use) or rental (nonexclusive use) of a customer database to another company. The fact that there is a market for these databases is taken as evidence that intangibles of this sort are reliably measurable assets that should be recognized as a separate asset when acquired by a company.

The most difficult part of recording an amount for an intangible asset is not in identifying the asset but in estimating its fair value. The objective in estimating the fair value is to duplicate the price at which the intangible asset would change hands in an arm's-length market transaction. If there is a market for similar intangible assets, the best estimate of fair value is made with reference to these observable market prices. In the absence of such a market, present value techniques should be used to estimate the fair value.

Goodwill is best thought of as a residual amount, the amount of the purchase price of a business that is left over after all other tangible and intangible assets have been identified. As such, goodwill is that intangible something that makes the whole company worth more than its individual parts. In general, goodwill represents all of the special advantages, not otherwise separately identifiable, enjoyed by an enterprise, such as a high credit standing, reputation for superior products and services, experience with development and distribution processes, favorable government relations, and so forth.

After it is recognized, goodwill is left on the books at its originally recorded amount unless there is evidence that its value has been impaired.

Because goodwill is recorded on the books only when another company is acquired, one must be careful in interpreting a company's reported goodwill balance. The reported goodwill balance does not reflect the company's own goodwill but the goodwill of other companies it has acquired.

Occasionally, the amount paid for another company is less than the fair value of the net identifiable items of the acquired company. This condition can arise when the existing management of a company is using the assets in a suboptimal fashion. When this bargain purchase exists, the acquiring company should first review all of the fair value estimates to make sure that they are reliable. If after doing this there is still an excess of identifiable net fair value over the purchase price, any remaining excess is recognized as a gain.

Fixed asset turnover ratio is computed as sales divided by average property, plant, and equipment (fixed assets) and is interpreted as the number of dollars in sales generated by each dollar of fixed assets. This ratio is also called PP&E turnover.

Investments in Noncurrent Operating Assets - Utilization and Retirement

Three different terms are used to describe the process of allocating the cost of long-lived assets to periodic expense. The allocation of tangible property costs is referred to as depreciation. For minerals and other natural resources, the cost allocation process is called depletion. For intangible assets, such as patents and copyrights, the process is referred to as amortization. Sometimes amortization is used generically to encompass all three terms.

Depreciation is not a process through which a company accumulates a cash fund to replace its long-lived assets. Depreciation is also not a way to compute the current value of long-lived assets. Instead, depreciation is the systematic allocation of the cost of an asset over the different periods benefited by the use of the asset. Accumulated depreciation is not an asset replacement fund but is the sum of all the asset cost that has been expensed in prior periods.

Similarly, the book value of an asset (historical cost less accumulated depreciation) is the asset cost remaining to be allocated to future periods but is not an estimate of the asset's current value.

Four factors are taken into consideration in determining the appropriate amount of annual depreciation expense.

  • Asset cost
  • Residual or salvage value
  • Useful life
  • Pattern of use

The cost of property less the expected residual value, if any, is the depreciable cost or depreciation base, that is, the portion of asset cost to be expensed in future periods.

The residual (salvage) value of property is an estimate of the amount for which the asset can be sold when it is retired. The residual value depends on the retirement policy of the company as well as market conditions and other factors. If, for example, the company normally uses equipment until it is physically exhausted and no longer serviceable, the residual value, represented by the scrap or junk value that can be salvaged, may be quite small. If, however, the company normally replaces its equipment after a short period of use, the residual value, represented by the selling price or trade-in value, may be relatively high.

Noncurrent operating assets other than land have a limited useful life as a result of certain physical and functional factors. The physical factors that limit the service life of an asset are (1) wear and tear, (2) deterioration and decay, and (3) damage or destruction. [...] The primary functional factor limiting the useful lives of assets is obsolescence.

To match asset cost against revenues, periodic depreciation charges should reflect as closely as possible the pattern of use. If the asset produces a varying revenue pattern, the depreciation charges should vary in a corresponding manner.

The most common methods of cost allocation are related to the passage of time. A productive asset is used up over time, and possible obsolescence due to technological changes is also a function of time. Of the time-factor depreciation methods, straight-line depreciation is by far the most popular. The use of accelerated depreciation methods is based largely on the assumption that there will be rapid reductions in a depreciable asset's efficiency, output, or other benefits in the early years of that asset's life. [...] The most commonly used accelerated method is the declining-balance method [...].

Straight-line depreciation relates depreciation to the passage of time and recognizes equal depreciation in each year of the life of the asset. The simple assumption behind the straight-line method is that the asset is equally useful during each time period, and depreciation is not affected by asset productivity or efficiency variations. In applying the straight-line method, an estimate is made of the useful life of the asset, and the depreciable asset cost (the difference between the asset cost and residual value) is divided by the useful life of the asset in arriving at the periodic depreciation amount.

When assets are acquired or disposed of in the middle of a year, depreciation for the partial year should be recognized.

The sum-of-the-years'-digits depreciation method yields decreasing depreciation in each successive year. The computations are done by applying a series of fractions, each of a smaller value, to depreciable asset cost. The numerator of the fraction is the number of years remaining in the asset life as of the beginning of the year. The denominator of the fraction is the sum of all the digits from one to the original useful life. There is no great conceptual insight behind this method; it is merely a clever arithmetic scheme that gives decreasing depreciation each year and results in the entire depreciable cost being allocated over the asset's useful life.

The declining-balance depreciation methods provide decreasing charges by applying a constant percentage rate to a declining asset book value. The most popular rate is two times the straight-line rate, and this method is often called double-declining-balance depreciation. [...] Residual value is not used in the computations under this method; however, it is generally recognized that depreciation should not continue once the book value is equal to the residual value.

Use-factor depreciation methods view asset exhaustion as related primarily to asset use or output and provide periodic charges varying with the degree of such service. Service life for certain assets can best be expressed in terms of hours of service but for others in terms of units of production.

Service-hours depreciation is based on the theory that the purchase of an asset represents the purchase of a number of hours of direct service. This method requires an estimate of the life of the asset in terms of service hours. Depreciable cost is divided by total service hours in arriving at the depreciation rate to be assigned for each hour of asset use. The use of the asset during the period is measured, and the number of service hours is multiplied by the depreciation rate in arriving at the periodic depreciation charge.

Productive-output depreciation is based on the theory that an asset is acquired for the service it can provide in the form of production output. This method requires an estimate of the total unit output of the asset. Depreciable cost divided by the total estimated output gives the equal charge to be assigned for each unit of output. The measured production or a period multiplied by the charge per unit gives the charge to be made against revenue.

From a practical standpoint, it often makes sense to compute depreciation for an entire group of assets as if the group were one asset. Group cost allocation procedures are referred to as group depreciation when the assets in the group are similar (e.g., all of a company's delivery vans) and composite depreciation when the assets in the group are related but dissimilar (e.g., all of a company's desks, chairs, and computers).

Natural resources, also called wasting assets, are consumed as the physical units representing these resources are removed and sold. [...] Depletion expense is a charge for the "using up" of the resources. The computation of depletion expense is an adaptation of the productive-output method of depreciation. Perhaps the most difficult problem in computing depletion expense is estimating the amount of resources available for economical removal from the land.

Developmental costs, such as costs of drilling, sinking mine shafts, and constructing roads, should be capitalized and added to the original cost of the property in arriving at the total cost subject to depletion.

Only one factor in determining the periodic charge for depreciation, amortization, or depletion is based on historical information: asset cost. Other factors – residual value, useful life or output, and the pattern of use or benefit – must be estimated. The question frequently facing accountants is how adjustments to these estimates, which arise as time passes, should be reflected in the accounts. A change in estimate is reported in the current and future periods rather than as an adjustment of prior periods.

Conducting an impairment review of every asset at the end of every year would be unlikely to provide sufficiently improved financial information to justify the cost of the reviews. Instead, companies are required to conduct impairment tests whenever there has been a material change in the way an asset is used or in the business environment. In addition, if management obtains information suggesting that the market value of an asset has declined, an impairment review should be conducted.

After an impairment loss is recognized, no restoration of the loss is allowed even if the fair value of the asset recovers.

In accounting for an intangible asset after its acquisition, a determination first must be made as to whether the intangible asset has a finite life. If no economic, legal, or contractual factors cause the intangible to have a finite life, then its life is said to be indefinite, and the asset is not to be amortized until its life is determined to be finite. An indefinite life is one that extends beyond the foreseeable horizon.

Intangible assets are to be amortized by the straight-line method unless there is strong justification for using another method.

[...] an intangible with an indefinite life is evaluated at least annually to determine (1) whether the end of the useful life is now foreseeable and amortization should begin and/or (2) whether the intangible is impaired. The impairment test is a very simple one: The fair value of the intangible is compared to its book value, and if the fair value is less than the book value, an impairment loss is recognized for the difference.

Generally, when an asset is disposed of, any unrecorded depreciation or amortization for the period is recorded at the date of disposition. A book value as of the date of disposition can then be computed as the difference between the cost of the asset and its accumulated depreciation. If the disposition price exceeds the book value, a gain is recognized. If the disposition price is less than the book value, a loss is recorded.

Often a plan is made to dispose of an asset before the actual sale takes place. Special accounting is required if the following conditions are satisfied:

  • Management commits to a plan to sell a long-term operating asset.
  • The asset is available for immediate sale.
  • An active effort to locate a buyer is underway.
  • It is probable that the sale will be completed within one year.
If these criteria are satisfied, two uncommon accounting actions are required. During the interval between being classified as held for sale and actually being sold
  1. No depreciation is to be recognized, and
  2. The asset is to be reported at the lower of its book value or its fair value (less the estimated cost to sell).

The rationale behind this approach is that because the asset is now designated for disposal, the key accounting point is no longer long-term cost allocation using depreciation but is instead proper current valuation of the asset.

Additional Activities of a Business

Debt Financing

The distinction between current and noncurrent liabilities is important because of the impact on a company's current ratio. This fundamental measurement of a company's liquidity is computed by dividing total current assets by total current liabilities. The current ratio is a measure of an entity's ability to meet current obligations.

A reasonable margin of current assets over current liabilities suggests that a company will be able to meet maturing obligations even in the event of unfavorable business conditions or losses on such assets as securities, receivables, and inventories.

[...] items that resemble liabilities but are contingent upon the occurrence of some future event are not recorded until it is probable that the event will occur. Even though the amount of the potential obligation may be known, the actual existence of a liability is questionable because it is contingent upon a future event for which there is considerable uncertainty. An example of a contingent liability is a pending lawsuit. Only if the lawsuit is lost or is settled out of court will a sacrifice of economic benefits be necessary.

[...] liabilities that have been classified as current are typically not discounted, that is, they are not reported at their present value. Instead, they are reported on the balance sheet at their face value.

The term account payable usually refers to the amount due for the purchase of materials by a manufacturing company or merchandise by a wholesaler or retailer. Other obligations, such as salaries and wages, rent, interest, and utilities, are reported as separate liabilities in accounts descriptive of the nature of the obligation. Accounts payable are not recorded when purchase orders are placed but instead when legal title to the goods passes to the buyer.

Companies often borrow money on a short-term basis for operating purposes other than for the purchase of materials or merchandise involving accounts payable. Collectively, these obligations may be referred to as short-term debt. In most cases, such debt is evidenced by a promissory note, a formal written promise to pay a sum of money in the future, and is usually reflected on the debtor's books as Notes Payable.

Because the "current" classification is reserved for those obligations that will be satisfied with current assets within a year, a short-term obligation that is expected to be refinanced on a long-term basis should not be reported as a current liability. [...] Similarly, it should no be assumed that a short-term obligation will be refinanced and therefore classified as a noncurrent liability unless the refinancing arrangements are secure. Thus, to avoid potential manipulation, the refinancing expectation must be realistic, not just a mere possibility.

A line of credit is a negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowing. When a company finds itself in need of money, an established line of credit allows the company access to funds immediately without having to go through the credit approval process.

The line of credit itself is not a liability. However, once the line of credit is used to borrow money, the company has a formal liability that will be reported as either a current or long-term liability, depending on the repayment terms of the agreement.

In reporting long-term debt obligations, the emphasis is on reporting what the real economic value of the obligation is today, not what the total debt payments will be in the future.

The long-term financing of a corporation is accomplished either through the issuance of long-term debt instruments, usually bonds or notes, or through the sale of additional stock. [...] There are, however, certain limitations and disadvantages of financing with long-term debt securities. Debt financing is possible only when a company is in satisfactory financial condition and can offer adequate security to creditors. Furthermore, interest obligations must be paid regardless of the company's earnings and financial position. If a company has operating losses and is unable to raise sufficient cash to meet periodic interest payments, secured debt holders may take legal action to assume control of company assets.

Often, companies in poor financial condition can still obtain financing. However, the terms of the debt are typically very restrictive and the interest rate is very high. Bonds issued by high-risk companies are often classified as junk bonds.

Borrowing by means of bonds involves the issuance of certificates of indebtedness. Bond certificates, commonly referred to simply as bonds, are frequently issued in denominations of $1,000, referred to as the face value, par value, or maturity value of the bond, although in some cases bonds are issued in varying denominations. The group contract between the corporation and the bondholders is known as the bond indenture. The indenture details the rights and obligations of the contracting parties, indicates the property pledged as well as the protection offered on the loan, and names the bank or trust company that is to represent the bondholders.

Bonds that mature on a single date are called term bonds. When bonds mature in installments, they are referred to as serial bonds. Serial bonds are much less common than term bonds.

Bonds issued by private corporations may be either secured or unsecured. Secured bonds offer protection to investors by providing some form of security, such as a mortgage on real estate or a pledge of other collateral. [...] A collateral trust bond is usually secured by stocks and bonds of other corporations owned by the issuing company. Such securities are generally transferred to a trustee, who holds them as collateral on behalf of the bondholders and, if necessary, will sell them to satisfy the bondholders' claim.

Unsecured bonds are not protected by the pledge of any specific assets and are frequently termed debenture bonds, or debentures. Holders of debenture bonds simply rank as general creditors along with other unsecured parties. The risk involved in these securities varies with the financial strength of the debtor.

Registered bonds call for the registry of the owner's name on the corporation books. Transfer of bond ownership is similar to that for stock. When a bond is sold, the corporate transfer agent cancels the bond certificate surrendered by the seller and issues a new certificate to the buyer. Interest checks are mailed periodically to the bondholders of record. Bearer bonds, or coupon bonds, are not recorded in the name of the owner; title to these bonds passes with delivery. Each bond is accompanied by coupons for individual interest payments covering the life of the issue. Coupons are clipped by the owner of the bond and presented to a bank for deposit or collection.

In recent years, some companies have issued long-term debt securities that do not bear interest. Instead, these securities sell at a significant discount that provides an investor with a total interest payoff at maturity. These bonds are known as zero-interest bonds or deep-discount bonds.

Bonds may provide for their conversion into some other security at the option of the bondholder. Such bonds are known as convertible bonds. The conversion feature generally permits the owner of bonds to exchange them for common stock.

Bond indentures frequently give the issuing company the right to call and retire the bonds prior to their maturity. Such bonds are termed callable bonds.

The amount of interest paid on bonds is a specified percentage of the face value. This percentage is termed the stated rate, or contract rate.

The bond premium or the bond discount is the amount needed to adjust the stated rate of interest to the actual market rate of interest or yield for that particular bond. Thus, the stated rate adjusted for the premium or the discount gives the actual rate of return on the bonds, known as the market, yield, or effective interest rate.

Bond prices are quoted in the market as a percentage of face value. For example, a bond quotation of 96.5 means the market price is 96.5% of face value [...].

When debt is retired, or "extinguished", prior to the maturity date, a gain or loss must be recognized for the difference between the carrying value of the debt security and the amount paid to satisfy the obligation.

Cash for the retirement of a bond issue is frequently raised through the sale of a new issue and is referred to as bond refinancing, or refunding. Bond refinancing may take place when an issue matures, or bonds may be refinanced prior to their maturity when the interest rate has dropped and the interest savings on a new issue will more than offset the cost of retiring the old issue.

A major issue facing the accounting profession today is how to deal with companies that do not disclose all their debt in order to make their financial position look stronger. This is often referred to as off-balance-sheet financing. Traditionally, leasing has been one of the most common forms of off-balance-sheet financing.

A lease is merely a seller-sponsored technique through which a buyer can finance the use of an asset. For accounting purposes, leases are considered to be either rentals (called operating leases) or asset purchases with borrowed money (called capital leases). A company using a leased asset tries to have the lease classified as an operating lease in order to keep the lease obligation off the balance sheet. The proper accounting treatment depends on whether the lease contract transfers effective ownership of the leased asset. Capital leases are accounted for as if the lease agreement transfers ownership of the leased asset from the lessor (the owner of a leased asset) to the lessee (the user of the leased asset).

The objective of consolidated financial statements is to show the net assets that are owned or controlled by a company and its subsidiaries. For accounting purposes, a controlling interest in a subsidiary's net assets is presumed to exist when ownership by the parent company exceeds 50%. [...] Under current accounting rules, companies are able to avoid recognizing debt associated with subsidiaries that are less than 50% owned by the company.

The term leverage refers to the relationship between a firm's debt and assets or its debt and stockholders' equity. A firm that is highly leveraged has a large amount of debt relative to its assets or equity. A common measure of a firm's leverage is the debt-to-equity ratio, calculated by dividing total liabilities by total stockholders' equity.

Another measure of a company's performance relating to debt is the number of times interest is earned. This measure compares a company's interest obligations with its earnings ability. Times interest earned is calculated by adding a company's income before income taxes and interest expense and then dividing by the interest expense for the period.

Equity Financing

Owner investments are reported in the Equity section of the balance sheet. For example, when a corporation issues new shares of stock to the public, the proceeds are recorded in the Equity section. These invested funds are called contributed, or paid-in, capital. Owners also contribute funds to a company by allowing profits to be reinvested. In a corporation, these reinvested profits are called retained earnings.

The term preferred stock is somewhat misleading because it gives the impression that preferred stock is better than common stock. Preferred stock isn't better – it's different. In fact, a useful way to think of preferred stock is that preferred stockholders give up many of the rights of ownership in exchange for some of the protection enjoyed by creditors.

The cash dividends received by preferred stockholders are usually fixed in amount. Therefore, if the company does exceptionally well, preferred stockholders do not get to share in the success. As a result of this cap on dividends, the market value of preferred stock does not typically vary with the success of the company as does the price of common stock. Instead, the market value of preferred stock varies with changes in interest rates, in much the same way as bond prices change.

Preferred stockholders are entitled to receive their full cash dividend before any cash dividends are paid to common stockholders.

If the company goes bankrupt, preferred stockholders are entitled to have their investment repaid, in full, before common stockholders receive anything.

When a corporation fails to declare dividends on cumulative preferred stock, such dividends accumulate and require payment in the future before any dividends may be paid to common stockholders. [...] Dividends on cumulative preferred stock that are passed are referred to as dividends in arrears. Although these dividends are not a liability until declared by the board of directors, this information is important to stockholders and other users of the financial statements. The amount of dividends in arrears is disclosed in the notes to the financial statements.

With noncumulative preferred stock, it is not necessary to provide for passed dividends. A dividend omission on preferred stock in any one year means it is irretrievably lost.

Preferred stock is convertible when it can be exchanged by its owner for some other security of the issuing corporation. Conversion rights generally provide for the exchange of preferred stock into common stock.

Many preferred issues are callable, meaning they may be called and canceled at the option of the corporation. The call price is usually specified in the original agreement and provides for payment of dividends in arrears as part of the repurchase price.

Redeemable preferred stock is preferred stock that is redeemable at the option of the stockholder or upon other conditions not within the control of the issuer (e.g., redemption on a specific date or upon reaching a certain level of earnings).

When a company's own stock is reacquired and held in the name of the company, it is referred to as treasury stock. Treasury shares may subsequently be reissued or formally retired.

A corporation may issue rights, warrants, or options that permit the purchase of the company's stock for a specified period (the exercise period) at a certain price (the exercise price). Although the terms rights, warrants, and options are sometimes used interchangeably, a distinction may be made as follows:

  • Stock rights – issued to existing shareholders to permit them to maintain their proportionate ownership interests when new shares are to be issued.
  • Stock warrants – sold by the corporation for cash, generally in conjunction with the issuance of another security.
  • Stock options – granted to officers or employees, usually as part of a compensation plan.

When announcing rights to purchase additional shares of stock, the directors of a corporation specify a date on which the rights will be issued. All stockholders of record on the issue date are entitled to receive the rights. Thus, between the announcement date and the issue date, the stock is said to sell rights-on. After the rights are issued, the stock sells ex-rights, and the rights may be sold separately by those receiving them from the corporation. An expiration date is also designated when the rights are announced, and rights not exercised by this date are worthless.

Warrants may be sold in conjunction with other securities as a "sweetener" to make the purchase of the securities more attractive. [...] Warrants issued with other securities may be detachable or nondetachable. Detachable warrants are similar to stock rights because they can be traded separately from the security with which they were originally issued.

In the field of finance, a debt claim is one that entitles the debt holders to a fixed payment when company assets are sufficient to meet that payment; if company assets are below that amount, the debt holders get all of the assets. An equity claim is one that entitles the equity holders to all company assets in excess of the debt holders's portion.

Minority interest is the amount of equity investment made by outside shareholders to consolidated subsidiaries that are not 100% owned by the parent.

The primary source of retained earnings is the net income generated by a business. The retained earnings account is increased by net income and is reduced by net losses from business activities.

Most dividends involve reductions in retained earnings. Exceptions include some large stock dividends, which involve a reduction in additional paid-in capital, and liquidating dividends, which represent a return of invested capital to stockholders and call for reductions in contributed capital.

Three dates are essential in the recognition and payment of dividends: (1) date of declaration, (2) date of record, and (3) date of payment. Dividends are made payable to stockholders of record as of a date following the date of declaration and preceding the date of payment. The liability for dividends payable is recorded on the declaration date and is canceled on the payment date.

A corporation may distribute to stockholders additional shares of the company's own stock as a stock dividend. A stock dividend involves no transfer of cash or any other asset to shareholders. In essence, a stock dividend results in the same pie (the company) being cut up into more pieces (shares outstanding), with each shareholder owning the same proportion of the pieces as before the stock dividend. From a shareholder's standpoint, receipt of a stock dividend is an economic nonevent.

The foreign currency translation adjustment arises from the change in the equity of foreign subsidiaries (as measured in terms of U.S. dollars) that occurs as a result of changes in foreign currency exchange rates.

The unrealized gains and losses from market value fluctuations in trading securities are included in the income statement, but the unrealized gains and losses from market value fluctuations in available-for-sale securities are shown as a direct adjustment to equity.

Investments in Debt and Equity Securities

Held-to-maturity securities are debt securities purchased by a company with the intent and ability to hold those securities until they mature.

Debt securities that are not being held until maturity and are not classified as trading securities are considered, by default, to be "available-for-sale" securities. Available-for-sale securities are also equity securities that are not considered trading securities and are not accounted for using the equity method.

Trading securities are debt and equity securities purchased with the intent of selling them in the near future. Trading involves frequent buying and selling of securities, generally for the purpose of "generating profits on short-term differences in price".

Equity method securities are equity securities purchased with the intent of being able to control or significantly influence the operations of the investee. As a result, a large block of stock (presumed to be at least 20% of the outstanding stock unless there exists evidence to the contrary) must be owned to be classified as an equity method security.

Securities classified as trading securities are reported at their fair value on the balance sheet with any unrealized holding gains or losses being reported on the income statement as part of net income. Securities classified as available-for-sale securities are also reported on the balance sheet at fair value. However, any unrealized holding gains and losses associated with these securities are reported as other comprehensive income and are accumulated as a separate component of stockholders' equity; these unrealized gains and losses do not affect reported net income for the period. Held-to-maturity securities are reported on the balance sheet at their amortized cost and are not reported at fair value. [...] Equity method securities are not reported at their fair value on the balance sheet. Instead, the investment account is increased or decreased as the net assets of the investee increase and decrease.


A lease is a contract specifying the terms under which the owner of property, the lessor, transfers the right to use the property to a lessee.

[...] there are three primary advantages to the lessee of leasing over purchasing.

  • No down payment. Most debt-financed purchases of property require a portion of the purchase price to be paid immediately by the borrower. This provides added protection to the lender in the event of default and repossession. Lease agreements, in contrast, frequently are structured so that 100% of the value of the property is financed through the lease. This aspect of leasing makes it an attractive alternative to a company that does not have sufficient cash for a down payment or wishes to use available capital for other operating or investing purposes.
  • Avoid risks of ownership. There are many risks accompanying the ownership of property. These risks include casualty loss, obsolescence, changing economic conditions, and physical deterioration. If the market value of a leased asset decreases dramatically, the lessee may terminate the lease, although usually with some penalty. On the other hand, if you own the asset, you are stuck with it when the market value declines.
  • Flexibility. Business conditions and requirements change over time. If assets are leased, a company can more easily replace assets in response to these changes.

Advantages of the lease to the lessor include the following:

  • Increased sales. [...] customers may be unwilling or unable to purchase property. By offering potential customers the option of leasing its products, a manufacturer or dealer may significantly increase its sales volume.
  • Ongoing business relationship with lessee. When property is sold, the purchaser frequently has no more dealings with the seller of the property. In leasing situations, however, the lessor and lessee maintain contact over a period of time, and long-term business relationships often can be established through leasing.
  • Residual value retained. In many lease arrangements, title to the leased property never passes to the lessee. The lessor benefits from economic conditions that may result in a significant residual value at the end of the lease term. The lessor may lease the asset to another lessee or sell the property and realize an immediate gain.

For accounting purposes, leases are separated into two groups, capital leases and operating leases. Capital leases are accounted for as if the lease agreement transfers ownership of the asset from the lessor to the lessee. [...] Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease.

[...] most companies using assets under lease agreements go to great lengths to ensure that they can account for the bulk of their leases as operating leases because it allows them to keep both the asset and the associated liability off the balance sheet. Keeping the asset off the balance sheet improves financial ratio measures of efficiency, and keeping the liability off the balance sheet improves measures of leverage.

Some leases are noncancelable, meaning that these lease contracts are cancelable only on the outcome of some remote contingency or that the cancellation provisions and penalties of these leases are so costly to the lessee that, in all likelihood, cancellation will not occur. All cancelable leases are accounted for as operating leases; some, but not all, noncancelable leases are accounted for as capital leases.

Leases often include a provision giving the lessee the right to purchase leased property at some future date. If the specified purchase option price is expected to be considerably less than the fair value at the date the purchase option may be exercised, the option is called a bargain purchase option. [...] Noncancelable leases with bargain purchase options are accounted for as capital leases.

An important variable in lease agreements is the lease term, that is, the time period from the beginning to the end of the lease. The beginning of the lease term occurs when the leased property is transferred to the lessee. The end of the lease term is more flexible because many leases include provisions allowing the lessee to extend the lease period. For accounting purposes, the end of the lease term is defined as the end of the fixed noncancelable lease period plus all renewal option periods that are likely to be exercised.

The market value of the leased property at the end of the lease term is referred to as its residual value.

Some lease contracts require the lessee to guarantee a minimum residual value. If the market value at the end of the lease term falls below the guaranteed residual value, the lessee must pay the difference.

The rental payments required over the lease term plus any amount to be paid for the residual value either through a bargain purchase option or a guarantee of the residual value are referred to as the minimum lease payments. Lease payments sometimes include charges for items such as insurance, maintenance, and taxes incurred for the leased property. These are referred to as executory costs, and they are not included as part of the minimum lease payments.

If a lease involves a transfer of ownership, a bargain purchase option, a lease term greater than or equal to 75% of the economic life of the leased asset, or minimum payments with a present value of at least 90% of the fair value of the leased asset, then the lease is accounted for as a capital lease. Otherwise, the lease is accounted for as an operating lease.

Accounting for operating leases involves the recognition of rent expense over the term of the lease. The leased property is not reported as an asset on the lessee's balance sheet, nor is a liability recognized for the obligation to make future payments for use of the property. Information concerning the lease is limited to disclosure in notes to the financial statements.

Accounting for a capital lease essentially requires the lessee to report on the balance sheet the present value of the future lease payments, both as an asset and a liability. The asset is amortized as though it had been purchased by the lessee. The liability is accounted for in the same manner as would be a mortgage on the property.

Direct financing leases involve a lessor who is primarily engaged in financing activities, such as a bank or finance company. The lessor views the lease as an investment. The revenue generated by this type of lease is interest revenue. Sales-type leases, on the other hand, involve manufacturers or dealers who use leases as a means of facilitating the marketing of their products. Thus, there are two different types of revenue generated by this type of lease: (1) an immediate profit or loss, which is the difference between the cost of the property being leased and its sales price, or fair value, at the inception of the lease and (2) interest revenue earned over time as the lessee makes the lease payments that pay off the lease obligation plus interest.

A common type of lease arrangement is referred to as a sale-leaseback transaction. Typical of this type of lease is an arrangement whereby one party sells the property to a second party, and then the first party leases the property back.

Income Taxes

[...] corporations in the United States compute two different income numbers: financial income for reporting to stockholders and taxable income for reporting to the Internal Revenue Service (IRS).

Accounting for deferred income taxes focuses on temporary differences between financial accounting income and taxable income.

[...] a deferred tax liability [...] requires a payment in the future (hence the word deferred) as a result of a past transaction (the past transaction is the earning of the income). This liability can be thought of as the expected income tax on income earned but not yet taxed.

Income taxes payable is an existing legal liability that the IRS fully expects to collect [...]. Deferred tax liability is not an existing legal liability; as far as the IRS is concerned, it doesn't exist.

[...] a deferred tax asset [...] represents the expected benefit of a tax deduction for an expense item that has already been incurred and reported to the shareholders but is not yet deductible according to IRS rules.

Some differences between financial and taxable income are permanent differences. These differences are caused by specific provisions of the tax law that exempt certain types of revenues from taxation and prohibit the deduction of certain types of expenses. Nontaxable revenues and nondeductible expenses are never included in determining taxable income, but they are included in determining financial income under GAAP. Permanent differences are created by political and social pressures to favor certain segments of society or to promote certain industries or economic activities.

A deferred tax asset represents future income tax benefits. But the tax benefits will be realized only if there is sufficient taxable income from which the deductible amount can be deducted.

If you were profitable in prior periods and, as a result, paid taxes, you can get a refund of some or all those tax payments in the period in which you incur an operating loss. A net operating loss (NOL) carryback is applied to the income of the two preceding years in reverse order, beginning with the second year and moving to the first year. If unused net operating losses are still available, they may be carried forward up to 20 years to offset any future income.

Employee Compensation - Payroll, Pensions, and Other Compensation Issues

The basic purpose of all employer pension plans is the same: to provide retirement benefits to employees. A principal issue concerning pension plans is how to provide sufficient funds to meet the needs of retirees.

Some pension plans are funded entirely by the employer and are referred to as noncontributory pension plans. In other cases, the employee also contributes to the cost of the pension plan, referred to as a contributory pension plan.

Under [defined contribution pension] plans, the employer pays a periodic contribution amount into a separate trust fund, which is administered by an independent third-party trustee. The contribution may be defined as a fixed amount each period, a percentage of the employer's income, a percentage of employee earnings, or a combination of these or other factors. As contributions to the fund are made, they are invested by the fund administrator. When an employee retires, the accumulated value in the fund is used to determine the pension payout to the employee. The employee's retirement income therefore depends on how the fund has been managed. If investments have been made wisely, the employee will fare better than if the investments have been managed poorly. In effect, the investment risk is borne by the employee. The employer's obligation extends only to making the specified periodic contribution.

Under defined benefit plans, the employee is guaranteed a specified retirement income often related to his or her number of years of employment and average salary over a certain number of years. The periodic amount of the employer's contribution is based on the expected future benefits to be paid to employees and is affected by a number of variables. Because the benefits are defined, the contributions (funding) must vary as conditions change.

Under defined benefit plans, the investment risk is, in substance, borne by the employer.

A pension fund may be viewed essentially as funds set aside to meet the employer's future pension obligation just as funds may be set aside for other purposes, for example, to retire bonds at maturity. One major difference, however, is that a future obligation to retire bonds is a definite amount, while the employer's future obligation for retirement benefits is based on many estimates and assumptions.

Other Dimensions of Financial Reporting

Earnings per Share

If a company has only common stock, or common and nonconvertible preferred stock outstanding and there are no convertible securities, stock options, warrants, or other rights outstanding, it is classified as a company with a simple capital structure. Earnings per share is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period.

Even if convertible securities, stock options, warrants, or other rights do exist, the capital structure may be classified as simple if there is no potential dilution to EPS from the conversion or exercise of these items. Potential EPS dilution exists if the EPS would decrease or the loss per share would increase as a result of the conversion of securities or exercise of stock options, warrants, or other rights based on the conditions existing at the financial statement date. A company with potential earnings per share dilution is considered to have a complex capital structure.

To summarize, the basic EPS computation uses the results of actual transactions and events to compute an EPS figure. Diluted EPS involves making assumptions about transactions relating to a company's stock that, based on information available now, will likely occur in the future. In other words, diluted EPS provides financial statement users a "worst-case" estimate as to EPS with the computations made by assuming that all events relating to the exercising of existing options or the conversion of existing securities that will likely occur in the future have in fact already occurred.

The basic EPS computation presents no problem when only common stock has been issued and the number of shares outstanding has remained the same for the entire period. The numerator is the net income (loss) for the period, and the denominator is the number of shares outstanding for the entire period.

The weighted-average number of shares can be computed by determining "month-shares" of outstanding stock and dividing by 12 to obtain the weighted average for the year. [...] The same answer can be obtained by applying a weight to each period equivalent to the portion of the year since the last change in shares outstanding [...].

When the number of common shares outstanding has changed during a period as a result of a stock dividend, a stock split, or a reverse split, a retroactive recognition of this change must be made in determining the weighted-average number of shares outstanding.

Dilution occurs if inclusion of a potentially dilutive security reduces the basic EPS or increases the basic loss per share.

The two major types of potentially dilutive securities are (1) common stock options, warrants, and rights and (2) convertible bonds and convertible preferred stock. Because the purpose of a diluted EPS figure is to disclose how an exercise or conversion would affect future EPS, all computations of diluted EPS are made as if the exercise or conversion took place at the beginning of the company's fiscal year or at the issue date of the stock option or convertible security, whichever comes later.

If the price for which stock can be acquired (exercise price) is lower than the ending market price for the period, the options, warrants, or rights probably would be exercised and their effect would be dilutive. If the exercise price is higher than the ending market price, no exercise would take place; thus, there is no potential dilution from these securities.

To compute diluted EPS when convertible securities exist, adjustments must be made both to net income and to the number of shares of common stock outstanding. These adjustments must reflect what these amounts would have been if the conversion had taken place at the beginning of the current year or at the date of issuance of the convertible securities, whichever comes later.

Derivatives, Contingencies, Business Segments, and Interim Reports

A derivative is a financial instrument or other contract that derives its value from the movement of the price, foreign exchange rate, or interest rate on some other underlying asset or financial instrument.

Most firms use derivatives as a tool for managing risk.

Price risk is the uncertainty about the future price of an asset. [...] Firms can be exposed to price risk with existing assets, such as financial securities or inventory, or with assets to be acquired in the future, such as equipment to be purchased next month.

Credit risk is the uncertainty that the party on the other side of an agreement will abide by the terms of the agreement. The most common example of credit risk is the uncertainty over whether a credit customer will ultimately pay his or her account.

Interest rate risk is the uncertainty about future interest rates and their impact on future cash flows as well as on the fair value of existing assets and liabilities.

Exchange rate risk is the uncertainty about future U.S. dollar cash flows arising when assets and liabilities are denominated in a foreign currency.

A swap is a contract in which two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate. A common type of swap is an interest rate swap. In an interest rate swap, two parties agree to exchange future interest payments on a given loan amount; usually, one set of interest payments is based on a fixed interest rate and the other is based on a variable interest rate.

A forward contract is an agreement between two parties to exchange a specified amount of a commodity, security, or foreign currency at a specified date in the future with the price or exchange rate being set now.

A futures contract is a contract, traded on an exchange, that allows a company to buy or sell a specified quantity of a commodity or a financial security at a specified price on a specified future date. A futures contract is very similar to a forward contract with the difference being that a forward contract is a private contract negotiated between two parties, whereas a futures contract is a standardized contract that is sponsored by a trading exchange and can be traded among different parties many times in a single day. So, with a forward contract, you know the party with whom you will be exchanging cash to settle the contract; with a futures contract, all these cash settlements are handled through the exchange and you never know, or care, who is on the other side of the contract.

An option is a contract giving the owner the right, but not the obligation, to buy or sell an asset at a specified price any time during a specified period in the future. Options come in two general types: call options and put options. A call option gives the owner the right to buy an asset at a specified price, and a put option gives the owner the right to sell an asset at a specified price. In exchange for the rights inherent in the option, the owner of the option pays an amount in advance to the party on the other side of the transaction, who is called the writer of the option.

Broadly defined, hedging is the structuring of transactions to reduce risk.

A fair value hedge is a derivative that offsets, at least partially, the change in the fair value of an asset or a liability.

A cash flow hedge is a derivative that offsets, at least partially, the variability in cash flows from forecasted transactions that are probable.

Derivatives should be reported in the balance sheet at their fair value as of the balance sheet date.

When a derivative is used to hedge risk, the gains and losses on the derivative should be reported in the same income statement in which the income effects on the hedged item are reported.

[...] the appropriate treatment of changes in the fair value of a derivative depends on whether the derivative serves as a hedge and, if so, the type of hedge, as follows:

  • No hedge. All changes in the fair value [...] are recognized as gains or losses in the income statement in the period in which the value changes.
  • Fair value hedge. Changes in the fair value [...] are recognized as gains or losses in the period of the value change. These derivative gains or losses are offset (either in whole or in part) by the recognition of gains or losses on the change in fair value of the item being hedged.
  • Cash flow hedge. Changes in the fair value [...] are recognized as part of the accumulated other comprehensive income account. In effect, this treatment defers recognition of the gain or loss and classifies the deferred item as an equity adjustment. These deferred derivative gains and losses are recognized in net income in the period in which the hedged cash flow transaction was forecasted to occur.

If the occurrence of an event that would create a liability is probable and if the amount of the obligation can be reasonably estimated, the contingency should be recognized as a liability.

If a contingent liability is reasonably possible, defined as more than remote but less than likely, it should be disclosed in a note to the financial statements. Possible gains are often not disclosed to avoid any misleading implications about the likelihood that the gain will eventually be realized.

If a contingent item is remote, that is, the chance of occurrence is slight, there is no requirement that it be disclosed unless it is a contingent liability under a guarantee arrangement such as guaranteeing, or co-signing, the loan of another party.

If revenues from any one customer are more than 10% of total revenue, this fact must be disclosed (although the name of the customer isn't disclosed) along with the amount of the revenue and the names of the operating segments in which the revenue is reported.

Publicly traded firms must file quarterly financial statements with the SEC in a 10-Q filing within 40 days of the end of the quarter for large firms and 45 days for smaller firms.

Accounting Changes and Error Corrections

[...] accounting data often must be based on estimates of future events. The financial statements incorporate these estimates, which are based on the best professional judgment given the information available at that time. At a later date, however, additional experience or new facts sometimes make it clear that the estimates need to be revised to more accurately reflect the existing business circumstances. When this happens, a change in accounting estimate occurs.

[...] all changes in estimates should be reflected either in the current period or in current and future periods. No retroactive adjustments or pro forma (as-if) statements are to be prepared for a change in accounting estimate. Changes in estimates are considered to be part of the normal accounting process, not corrections or changes of past periods.

A change in accounting principle involves a change from one generally accepted principle or method to another.

The effect of a change from one accepted accounting principle to another is reflected by retrospectively adjusting the financial statements for all years reported, and reporting the cumulative effect of the change in the income for all preceding years as an adjustment to the beginning balance in retained earnings for the earliest year reported. For example, in a standard set of financial statements presenting balance sheets for two years and income statements and statements of cash flows for three years, all of the statements would be redone using the new accounting principle. In addition, the statement of stockholders' equity that is typically included with the financial statements would reflect the cumulative effect on income in prior years with an adjustment to beginning retained earnings in the first of the three years reported.

A business combination can substantially alter the size and mix of the operations reported in a single set of financial statements. [...] The combined company is required to disclose pro forma results for the year of the combination as if the combination had occurred at the beginning of the year. In addition, the same pro forma disclosure is required for the preceding year, as if the business combination had occurred at the beginning of that year. At a minimum, a company must include revenue and net income for the respective periods in this pro forma disclosure.

Accounting errors made in prior years are corrected from a reporting standpoint by restating the financial statements for all years presented and, if needed, by reporting an adjustment to the beginning retained earnings for the earliest year reported. Basically, errors in the financial statements are fixed in subsequent years by releasing corrected financial statements and providing note disclosure of the line-by-line impact of the errors.

If an error (either accidental or intentional in nature) is subsequently discovered that affected a prior period, the nature of the error, its effect on previously issued financial statements, and the effect of its correction on current period's net income and EPS should be disclosed in the period in which the error is corrected. In addition, any comparative financial statements provided must be corrected.

Statement of Cash Flows Revisited

The following 6-step process outlines a systematic method that can be used in analyzing the income statement and comparative balance sheets in preparing a statement of cash flows.

  1. Compute how much the cash balance changed during the year. The statement of cash flows is not complete until the sum of cash from operating, investing, and financing activities exactly matches the total change in the cash balance during the year.
  2. Convert the income statement from an accrual-basis to a cash-basis summary of operations. This is done in three steps.
    1. Eliminate expenses that do not involve the outflow of cash, such as depreciation expense.
    2. Eliminate gains and losses associated with investing or financing activities to avoid counting these items twice.
    3. Adjust for changes in the balances of current operating assets and operating liabilities (usually, but not always, current) because these changes indicate cases in which the operating cash flow associated with an item does not match the revenue or expense reported for that item.
    The final result of these adjustments is that net income is converted into cash flow from operating activities.
  3. Analyze the long-term assets to identify the cash flow effects of investing activities. Changes in property, plant, and equipment as well as in long-term investments could indicate that cash has either been spent or been received.
  4. Analyze the long-term debt and stockholders' equity accounts to determine the cash flow effects of any financing transactions. These transactions include borrowing or repaying debt, issuing or buying back stock, and paying dividends. Also examine changes in short-term loan accounts; borrowing and repaying under short-term arrangements are also classified as financing activities.
  5. Make sure that the total net cash flow from operating, investing, and financing activities is equal to the net increase or decrease in cash as computed in step 1. Then prepare a formal statement of cash flows by classifying all cash inflows and outflows according to operating, investing, and financing activities.
  6. Prepare supplemental disclosure, including the disclosure of any significant investing or financing transactions that did not involve cash. [...] In addition, supplemental disclosure of cash paid for interest expense and taxes is required.

[...] the computation of accrual net income involves reporting revenues and expenses when economic events occur, not necessarily when cash is received or paid. The timing differences between the receipt or payment of cash and the earning of revenue or the incurring of an expense are reflected in the shifting balances in the current operating assets and liabilities.

When a current operating asset increases, cash that otherwise would have been available for buying equipment or paying dividends is tied up in the form of that current operating asset. Thus, the current operating asset increase means a decrease in the cash generated by operations.

In short, current operating assets represent cash tied up in noncash form; an increase in current operating assets means more cash tied up, and a decrease means cash has been freed for other purposes.

In the case of operating liabilities (current and noncurrent), an increase means that more cash is available to the business because the cash was not used to pay the liability.

Accounting in a Global Market

[...] ratio comparisons can yield misleading implications if the ratios come from companies with differing accounting practices.

There are two methods for converting foreign currency financial statements: translation and remeasurement. Translation is used when the foreign subsidiary is a relatively self-contained unit that is independent from the parent company's operations. Remeasurement is appropriate when the subsidiary does not operate independently of the parent company. The translation process simply converts the foreign currency financial statements into U.S. dollars for consolidation with the parent company's statements; remeasurement involves remeasuring the financial statements as though the transactions had been originally recorded in U.S. dollars.

Double-entry accounting works the same for foreign subsidiaries as it does for U.S. companies: When a local currency trial balance is prepared, debits equal credits. However, as a result of the translation process, debits in the translated U.S. dollar trial balance typically will not equal credits. The balancing figure is called a translation adjustment and is recognized as part of the U.S. parent company's stockholders' equity.

[...] the translation adjustment is shown as a separate item in [the] Equity section as part of accumulated other comprehensive income. The translation adjustment is recognized as a deferred gain (or loss) rather than as an income statement gain or loss because the only way the foreign currency gain can be realized is through liquidation of all the assets and liabilities of the foreign subsidiary.

Analysis of Financial Statements

Financial statement analysis is the examination of both the relationships among financial statement numbers and the trends in those numbers over time. One purpose of financial statement analysis is to use the past performance of a company to predict its future profitability and cash flows. Another purpose of financial statement analysis is to evaluate the performance of a company with an eye toward identifying problem areas.

[...] the informativeness of financial ratios is greatly enhanced when they are compared with past values and with values for other firms in the same industry.

[...] if a company is of medium size in its industry, how can its financial statements be compared to those of the larger firms? The quickest and easiest solution to this comparability problem is to divide all financial statement numbers for a given year by sales for the year. The resulting financial statements are called common-size financial statements, with all amounts for a given year being shown as a percentage of sales for that year.

[...] financial statement analysis may not give you all the final answers, but it can guide you toward the questions you should be asking.

The DuPont framework [...] provides a systematic approach to identifying general factors causing ROE to deviate from normal. The DuPont system also provides a framework for computing financial ratios to yield more in-depth analysis of a company's areas of strength and weakness.

The insight behind the DuPont framework is that ROE can be decomposed into three components [...]. For each of the three ROE components – profitability, efficiency, and leverage – one ratio summarizes a company's performance in that area. These ratios are as follows:

  • Return on sales is computed as income divided by sales and is interpreted as the number of pennies in profit generated from each dollar of sales.
  • Asset turnover is computed as sales divided by assets and is interpreted as the number of dollars in sales generated by each dollar of assets.
  • Assets-to-equity ratio is computed as assets divided by stockholders' equity and is interpreted as the number of dollars of assets a company is able to acquire using each dollar invested by stockholders.

[...] the return on sales gives an overall indication of whether a firm has a problem with the profitability of each dollar of sales; the common-size income statement can be used to pinpoint exactly which expenses are causing the problem.

The appropriateness of the level of receivables may be evaluated by computing the accounts receivable turnover. This ratio is computed by dividing sales by the average accounts receivable for the year. [...] Receivables turnover represents the average number of sales/collection cycles completed by the firm during the year. The higher the turnover, the more rapid is a firm's average collection period for receivables.

The inventory position and the appropriateness of its size may be evaluated by computing the inventory turnover. The inventory turnover is computed by dividing cost of goods sold by average inventory.