Generally Accepted Accounting Principles (GAAP) is the term used to refer to the standard framework of guidelines for financial accounting used in any given jurisdiction. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements. Overview
Financial accounting is information that must be assembled and reported objectively. Third-parties who must rely on such information have a right to be assured that the data are free from bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on certain standards or guides that are called "Generally Accepted Accounting Principles" (GAAP). Principles derive from tradition, such as the concept of matching. In any report of financial statements (audit, compilation, review, etc.), the preparer/auditor must indicate to the reader whether or not the information contained within the statements complies with GAAP.

Principle of regularity: Regularity can be defined as conformity to enforced rules and laws. Principle of consistency: This principle states that when a business has once fixed a method for the accounting treatment of an item, it will enter all similar items that follow in exactly the same way. Principle of sincerity: According to this principle, the accounting unit should reflect in good faith the reality of the company's financial status. Principle of the permanence of methods: This principle aims at allowing the coherence and comparison of the financial information published by the company. Principle of non-compensation: One should show the full details of the financial information and not seek to compensate a debt with an asset, a revenue with an expense, etc. (see convention of conservatism)

Principle of prudence: This principle aims at showing the reality "as is" : one should not try to make things look prettier than they are. Typically, a revenue should be recorded only when it is certain and a provision should be entered for an expense which is probable. Principle of continuity: When stating financial information, one should assume that the business will not be interrupted. This principle mitigates the principle of prudence: assets do not have to be accounted at their disposable value, but it is accepted that they are at their historical value (see depreciation and going concern). Principle of periodicity: Each accounting entry should be allocated to a given period, and split accordingly if it covers several periods. If a client pre-pays a subscription (or lease, etc.), the given revenue should be split to the entire timespan and not counted for entirely on the date of the transaction. Principle of Full Disclosure/Materiality: All information and values pertaining to the financial position of a business must be disclosed in the records.

Cash Flow
In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement,[1] is a financial statement that shows how changes in balance sheet and income accounts affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. The statement captures both the current operating results and the accompanying changes in the balance sheet.[1] As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 (IAS 7), is the International Accounting Standard that deals with cash flow statements. People and groups interested in cash flow statements include:
• • • •

Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses Potential lenders or creditors, who want a clear picture of a company's ability to repay Potential investors, who need to judge whether the company is financially sound Potential employees or contractors, who need to know whether the company will be able to afford compensation

Statement of Cash Flow - Simple Example for the period 01/01/2006 to 12/31/2006 Cash flow from operations $4,000 Cash flow from investing $(1,000) Cash flow from financing $(2,000) $1,000 The cash flow statement was previously known as the flow of funds statement.[2] The cash flow statement reflects a firm's liquidity. The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These noncash transactions include depreciation or write-offs on bad debts or credit losses to name a few.[3] The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities, and financing activities. Noncash activities are usually reported in footnotes.

The cash flow statement is intended to[4] 1. provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances 2. provide additional information for evaluating changes in assets, liabilities and equity 3. improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods 4. indicate the amount, timing and probability of future cash flows The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets.[5]

[edit] History and variations
Cash basis financial statements were common before accrual basis financial statements. The "flow of funds" statements of the past were cash flow statements. In the United States in 1971, the Financial Accounting Standards Board (FASB) defined rules that made it mandatory under Generally Accepted Accounting Principles (US GAAP) to report sources and uses of funds, but the definition of "funds" was not clear."Net working capital" might be cash or might be the difference between current assets and current liabilities. From the late 1970 to the mid-1980s, the FASB discussed the usefulness of predicting future cash flows.[6] In 1987, FASB Statement No. 95 (FAS 95) mandated that firms provide cash flow statements.[7] In 1992, the International Accounting Standards Board issued International Accounting Standard 7 (IAS 7), Cash Flow Statements, which became effective in 1994, mandating that firms provide cash flow statements.[8] US GAAP and IAS 7 rules for cash flow statements are similar. Differences include:
• • •

IAS 7 requires that the cash flow statement include changes in both cash and cash equivalents. US GAAP permits using cash alone or cash and cash equivalents.[9] IAS 7 permits bank borrowings (overdraft) in certain countries to be included in cash equivalents rather than being considered a part of financing activities.[10] IAS 7 allows interest paid to be included in operating activities or financing activities. US GAAP requires that interest paid be included in operating activities.

US GAAP (FAS 95) requires that when the direct method is used to present the operating activities of the cash flow statement, a supplemental schedule must also present a cash flow statement using the indirect method. The IASC strongly recommends the direct method but allows either method. The IASC considers the indirect method less clear to users of financial statements. Cash flow statements are most commonly prepared using the indirect method, which is not especially useful in projecting future cash flows.[12]

[edit] Cash flow activities
The cash flow statement is partitioned into three segments, namely: cash flow resulting from operating activities, cash flow resulting from investing activities, and cash flow resulting from financing activities. The money coming into the business is called cash inflow, and money going out from the business is called cash outflow.

[edit] Operating activities
Operating activities include the production, sales and delivery of the company's product as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product. Under IAS 7, operating cash flows include:[13]
• • • • • • •

Receipts from the sale of goods or services Receipts for the sale of loans, debt or equity instruments in a trading portfolio Interest received on loans Dividends received on equity securities Payments to suppliers for goods and services Payments to employees or on behalf of employees Interest payments (alternatively, this can be reported under financing activities in IAS 7, and US GAAP)

Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include:
• • • •

Depreciation (loss of tangible asset value over time) Deferred tax Amortization (loss of intangible asset value over time) Any gains or losses associated with the sale of a non-current asset, because associated cash flows do not belong in the operating section.(unrealized gains/losses are also added back from the income statement)

[edit] Investing activities
Examples of Investing activities are
• •

Purchase of an asset (assets can be land, building, equipment, marketable securities, etc.) Loans made to suppliers or customers

[edit] Financing activities
Financing activities include the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities which impact the long-term liabilities and equity of the company are also listed in the financing activities section of the cash flow statement. Under IAS 7,
• • • • •

Proceeds from issuing short-term or long-term debt Payments of dividends Payments for repurchase of company shares Repayment of debt principal, including capital leases For non-profit organizations, receipts of donor-restricted cash that is limited to long-term purposes

Items under the financing activities section include:
• • • •

Dividends paid Sale or repurchase of the company's stock Net borrowings Payment of dividend tax

Contents of Annual Report
An Annual report is a comprehensive report on a company's activities throughout the preceding year. Annual reports are intended to give shareholders and other interested persons information about the company's activities and financial performance. Most jurisdictions require companies to prepare and disclose annual reports, and many require the annual report to be filed at the company's registry. Companies listed on a stock exchange are also required to report at more frequent intervals (depending upon the rules of the stock exchange involved). Typically annual reports will include:
• • • • • • •

Chairman's report CEO's report Auditor's report on corporate governance Mission statement Corporate governance statement of compliance Statement of directors' responsibilities Invitation to the company's AGM

as well as financial statements including:
• • • • • • •

Auditor's report on the financial statements Balance sheet Statement of retained earnings Income statement Cash flow statement Notes to the financial statements Accounting policies

Financial Statement Analysis:
Learning Objectives:

1. Prepare and interpret financial statements in comparative and common-size 2. 3. 4.
form. Compute and interpret financial ratios that would be most useful to a common stock holder. Compute and interpret financial ratios that would be most useful to a shortterm creditor Compute and interpret financial ratios that would be most useful to long -term creditors.

Definition and Explanation of Financial Statement Analysis:

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis. Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.

Tools and Techniques of Financial Statement Analysis:
Following are the most important tools and techniques of financial statement analysis:

1. Horizontal and Vertical Analysis 2. Ratios Analysis

1. Horizontal and Vertical Analysis:
Horizontal Analysis or Trend Analysis: Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form. Click here to read full article. Trend Percentage: Horizontal analysis of financial statements can also be carried out by computing trend percentages. Trend percentage states several years' financial data in terms of a base year. The base year equals 100%, with all other years stated in some percentage of this base. Click here to read full article. Vertical Analysis: Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. Key financial changes and trends can be highlighted by the use of common size statements. Click here to read full article.

2. Ratios Analysis:
Accounting Ratios Definition, Advantages, Classification and Limitations:

The ratios analysis is the most powerful tool of financial statement analysis. Ratios simply means one number expressed in terms of another. A ratio is a statistical yardstick by means of which relationship between two or various figures can be compared or measured. Ratios can be found out by dividing one number by another number. Ratios show how one number is related to another. Click here to read full article.

Profitability Ratios:
Profitability ratios measure the results of business operations or overall performance and effectiveness of the firm. Some of the most popular profitability ratios are as under: • • • • • • • • • • • Gross profit ratio Net profit ratio Operating ratio Expense ratio Return on shareholders investment or net worth Return on equity capital Return on capital employed Dividend yield ratio Dividend payout ratio Earnings Per Share Ratio Price earning ratio

Liquidity Ratios:
Liquidity ratios These are the ratios which measure the short term solvency of financial position of a firm. These ratios are calculated to comment upon the short term paying capacity of a concern or the firm's ability to meet its current obligations. Following are the most important liquidity ratios. • • Current ratio Liquid / Acid test / Quick ratio

Activity Ratios:
Activity ratios are calculated to measure the efficiency with which the resources of a firm have been employed. These ratios are also called turnover ratios because they indicate the speed with which assets are being turned over into sales. Following are the most important activity ratios: • • • • • • • Inventory / Stock turnover ratio Debtors / Receivables turnover ratio Average collection period Creditors / Payable turnover ratio Working capital turnover ratio Fixed assets turnover ratio Over and under trading

Long Term Solvency or Leverage Ratios:
Long term solvency or leverage ratios convey a firm's ability to meet the interest costs and payment schedules of its long term obligations. Following are some of the most important long term solvency or leverage ratios. • • • • • • • Debt-to-equity ratio Proprietary or Equity ratio Ratio of fixed assets to shareholders funds Ratio of current assets to shareholders funds Interest coverage ratio Capital gearing ratio Over and under capitalization

Financial-Accounting- Ratios Formulas: A collection of financial ratios formulas which can help you calculate financial ratios in a given problem. Click here Limitations of Financial Statement Analysis: Although financial statement analysis is highly useful tool, it has two limitations. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios. Click here to read full article.

Advantages of Financial Statement Analysis:
There are various advantages of financial statements analysis. The major benefit is that the investors get enough idea to decide about the investments of their funds in the specific company. Secondly, regulatory authorities like International Accounting Standards Board can ensure whether the company is following accounting standards or not. Thirdly, financial statements analysis can help the government agencies to analyze the taxation due to the company. Moreover, company can analyze its own performance over the period of time through financial statements analysis.

Dear visitor! Do you like this article? If you like, then please bookmark this page and also share with your friends. Thank you for your support.

Method used by interested parties such as investors, creditors, and management to evaluate the past, current, and projected conditions and performance of the firm. Ratio analysis is the most common form of financial analysis. It provides relative measures of the firm's conditions and performance. Horizontal Analysis and Vertical Analysis are also

popular forms. Horizontal analysis is used to evaluate the trend in the accounts over the years, while vertical analysis, also called a Common Size Financial Statement discloses the internal structure of the firm. It indicates the existing relationship between sales and each income statement account. It shows the mix of assets that produce income and the mix of the sources of capital, whether by current or long-term debt or by equity funding. When using the financial ratios, a financial analyst makes two types of comparisons: (1) Industry comparison. The ratios of a firm are compared with those of similar firms or with industry averages or norms to determine how the company is faring relative to its competitors. Industry average ratios are available from a number of sources, including: (a) Dun & Bradstreet. Dun & Bradstreet computes 14 ratios for each of 125 lines of business. They are published in Dun's Review and Key Business Ratios. (b) Robert Morris Associates. This association of bank loan officers publishes Annual Statement Studies. Sixteen ratios are computed for more than 300 lines of business, as well as a percentage distribution of items on the balance sheet and income statement (common size financial statements). (2) Trend analysis. A firm's present ratio is compared with its past and expected future ratios to determine whether the company's financial condition is improving or deteriorating over time. After completing the financial statement analysis, the firm's financial analyst will consult with management to discuss plans and prospects, any problem areas identified in the analysis, and possible solutions. Given below is a list of widely used financial ratios.

English▼ English▼ Deutsch Español Français Italiano Tagalog
• •

Search unanswered questions...

Browse: Unanswered questions | Most-recent questions | Reference library

Enter question or phrase... Search: All sources Community Q&A Reference topics


Browse: Unanswered questions | New questions | New answers | Reference library 5min Related Video: Financial Statement Analysis

Top Business Encyclopedia: Financial Statement Analysis Top Home > Library > Business & Finance > Business Encyclopedia Financial statement analysis is the process of examining relationships among financial statement elements and making comparisons with relevant information. It is a valuable tool used by investors and creditors, financial analysts, and others in their decisionmaking processes related to stocks, bonds, and other financial instruments. The goal in analyzing financial statements is to assess past performance and current financial position and to make predictions about the future performance of a company. Investors who buy stock are primarily interested in a company's profitability and their prospects for earning a return on their investment by receiving dividends and/or increasing the market value of their stock holdings. Creditors and investors who buy debt securities, such as bonds, are more interested in liquidity and solvency: the company's short-and long-run ability to pay its debts. Financial analysts, who frequently specialize in following certain industries,

routinely assess the profitability, liquidity, and solvency of companies in order to make recommendations about the purchase or sale of securities, such as stocks and bonds. Analysts can obtain useful information by comparing a company's most recent financial statements with its results in previous years and with the results of other companies in the same industry. Three primary types of financial statement analysis are commonly known as horizontal analysis, vertical analysis, and ratio analysis. Horizontal Analysis When an analyst compares financial information for two or more years for a single company, the process is referred to as horizontal analysis, since the analyst is reading across the page to compare any single line item, such as sales revenues. In addition to comparing dollar amounts, the analyst computes percentage changes from year to year for all financial statement balances, such as cash and inventory. Alternatively, in comparing financial statements for a number of years, the analyst may prefer to use a variation of horizontal analysis called trend analysis. Trend analysis involves calculating each year's financial statement balances as percentages of the first year, also known as the base year. When expressed as percentages, the base year figures are always 100 percent, and percentage changes from the base year can be determined. Vertical Analysis When using vertical analysis, the analyst calculates each item on a single financial statement as a percentage of a total. The term vertical analysis applies because each year's figures are listed vertically on a financial statement. The total used by the analyst on the income statement is net sales revenue, while on the balance sheet it is total assets. This approach to financial statement analysis, also known as component percentages, produces common-size financial statements. Common-size balance sheets and income statements can be more easily compared, whether across the years for a single company or across different companies. Ratio Analysis Ratio analysis enables the analyst to compare items on a single financial statement or to examine the relationships between items on two financial statements. After calculating ratios for each year's financial data, the analyst can then examine trends for the company across years. Since ratios adjust for size, using this analytical tool facilitates intercompany as well as intracompany comparisons. Ratios are often classified using the following terms: profitability ratios (also known as operating ratios), liquidity ratios, and solvency ratios. Profitability ratios are gauges of the company's operating success for a given period of time. Liquidity ratios are measures of the short-term ability of the company to pay its debts when they come due and to meet unexpected needs for cash. Solvency ratios indicate the ability of the company to meet its long-term obligations on a continuing basis and thus to survive over a long period of time. In judging how well on a

company is doing, analysts typically compare a company's ratios to industry statistics as well as to its own past performance. Caveats Financial statement analysis, when used carefully, can produce meaningful insights about a company's financial information and its prospects for the future. However, the analyst must be aware of certain important considerations about financial statements and the use of these analytical tools. For example, the dollar amounts for many types of assets and other financial statement items are usually based on historical costs and thus do not reflect replacement costs or inflationary adjustments. Furthermore, financial statements contain estimates of numerous items, such as warranty expenses and uncollectible customer balances. The meaningfulness of ratios and percentages depends on how well the financial statement amounts depict the company's situation. Comparisons to industry statistics or competitors' results can be complicated because companies may select different, although equally acceptable, methods of accounting for inventories and other items. Making meaningful comparisons is also hampered when a company or its competitors have widely diversified operations. The tools of financial statement analysis, ratio and percentage calculations, are relatively easy to apply. Understanding the content of the financial statements, on the other hand, is not a simple task. Evaluating a company's financial status, performance, and prospects using analytical tools requires skillful application of the analyst's judgment.

An annual report is a statement prepared by a publicly traded company and distributed to employees, customers, shareholders, and the general community. A more detailed copy of an annual report, called a 10-K, is filed with the United States Securities and Exchange Commission (SEC), which has required companies to issue an annual report since 1934. The contents of an annual report provide information about how well the business is doing financially, upcoming changes projected for the next year, and the management staff of the company. Concerned parties, such as shareholders, can use an annual report to make important decisions. At a minimum, an annual report must include a balance sheet, a report from an independent auditor, an income statement, and a general report on company operations. Most companies, however, use the document as a marketing tool as well, and take time to

talk about the history of the industry the company is involved in along with emerging trends. Most annual reports include individual reports from the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of the company as part of a discussion of the company's direction, along with a “Letter to Stockholders” at the beginning of the report. In addition, the annual report lists pricing trends for the company's stock, and provides a list of major employees and board members along with their contact information. The SEC requires companies to provide annual reports so that consumers can decide whether or not investing in the company is a sound decision. Individuals with assets tied up in the company can also use the annual report to determine the security of the investment. Closely examining an annual report can provide clues into where the company is going, how well it is doing on the market, and how the company intends to grow its market position. It can take time to learn how to read an annual report properly, and many consumers prefer to leave analysis of annual reports to their stockbrokers or asset managers. In many cases, an annual report resembles a marketing brochure more than an official document. It is commonly printed on glossy paper, with numerous pictures and cutting edge typography to draw the eye. Some professional graphic design firms specialize in producing annual reports, and sometimes the slick nature of the annual report can be used to conceal important information. When looking at an annual report, seek out the numbers, rather than the company's spin on them. Because an annual report is an audited document, you should be able to trust the numbers to provide the information you need.

Assets and liabilities

Here are some words that you should understand

The Balance Sheet Words
Accounting Equation Is a useful rule which helps when assembling the balance sheet figures. The rule which is always true is that: Assets - Liabilities =Capital Fixed Assets + Current Assets -Current Liabilities - Long term Liabilities = Capital + profit - drawings This means that when preparing a balance sheet there will always be two figures which are the same and we refer to this state as the the balance sheet balancing Accounting ratios Used to help make sense of the figures and include the following categories:
• • • •

Profitability ratios , used to compare the profitability of one company with another or of one company over time. Liquidity ratios, used to compare the liquidity of one company with another or of one company over time. Investment ratios, used by potential investors when making investment decisions. Efficiency ratios, used to compare company efficiency with others or with itself from one year to another. Accounting ratios are only useful when used to compare:
o o


one company's results over a period of time. one company's results with another company. It is best to compare with the best ,such as a world class company, or to compare with the industry standard for that type of business. the company's results with those expected. It is useful to use budgets for this purpose.

Accrual An amount unaccounted for, yet still owed at the year end. The amount needs to be estimated and then added to the expenses deducted from the profit in the Profit and Loss account. The same amount also needs to be added to Trade Creditors in the Current Liabilities section of the Balance sheet Learn more about this Asset An item of value owned by the business Balance Sheet A financial statement that shows what the business is worth. This is a very simple definition as the valuation of a business is a very complex topic. It shows the

business assets and liabilities at one point in time and is sometimes referred to as the "snap shot". Bank & Cash Amounts held in the bank and in cash. Found in the Current Assets section of the Balance Sheet. If the amounts are in deficit, then the bank account is said to be an overdraft and will not appear in current assets but will be found in the Current Liabilities section of the balance sheet. Capital Items, usually cash or other assets introduced into the business by the owners. Sometimes referred to as Capital Introduced. For companies this is referred to as share capital and Capital Employed is the term given to the total of:
• • •

Share Capital (which comes in two varieties ordinary and preference) Loan capital (which is simply a grand name for long term loans) Reserves

Cash Money. Can be in the petty cash tin in the office or at the bank. Current Asset Assets which are expected to be used up and replaced within one year. Sometimes referred to as short term assets.They can be :

stocks of finished goods or raw materials or partially finished good known as work in progress. This amount is also referred to as closing stock and can be found in the Trading account section of the Profit and loss Account. It is important to remember that Closing stock appears both in the Balance sheet and in the Profit and Loss Account. amounts owed to the business from its customers and known as Debtors. Customers come in two varieties: o Cash customers which pay for goods at the time of sale o Credit customers which pay for goods at a later date. It is from these sales that debtors arises i.e. amounts owed from customers. This amount is usually shown net of Doubtful debts(which means having the amount of doubtful debts deducted from the total figure for debtors) The deduction for Doubtful debts is usually an estimate and is known as a Provision (meaning estimate) for doubtful debts. It represents amounts under dispute with customers or amounts which customers are having difficulty in paying because of cash flow problems. Income arising from these amounts is therefore considered doubtful.

amounts paid in advance (at the end of the accounting year) of goods and services received and referred to as Prepayments Prepayments are shown as added to debtors.

cash and bank

Current Liability Amounts owed (within one year) for goods and services purchased on credit terms. This means payment for goods and services is due at a date later than the date of sale. Current liabilities can be:
• • • • • •

Trade creditors, which is the name we give to amounts owed to suppliers. Accruals, which is the name we give to amounts still owed at the year end and not yet recorded in the books of account. Proposed items such as Dividends proposed, which means amounts the business promises to pay in the coming year. Payable items such as Tax payable which is payable within the coming year. Overdraft, which is amounts owed to the bank. Short term loans

Depreciation Is the measure of wearing out of a fixed asset. All fixed assets are expected to wear out, become less efficient and to get "tired". Depreciation is calculated as the estimate of this measure of wearing out and is a charge in the Profit and loss Account. Accumulated Depreciation is the total depreciation charges to date deducted from the cost of the fixed assets to show Net Book Value in the Balance Sheet learn more about depreciation Watch a car becoming more worn out over time When you have finished you need to press escape and return. Drawings Assets withdrawn from the business by the owners. These assets are usually cash but can be any asset withdrawn. In company accounts the withdrawal of assets by the owners is either called :
• •

salaries if it is payment for work done by the owner or dividendsif it is for a share of the profits

Fixed Assets

Assets used within the business and not acquired for the purposes of resale. Examples include:  Land and buildings  Plant and machinery, such as knitting machines and cup making machinery  Fixtures and fittings, such as light fittings and shelving  Motor vehicles, such as vans and cars. Fixed assets must be shown at original cost(purchase price) or valuation. Valuation is preferred in the case of assets which have changed significantly in value since original purchase. For example the current value of land and buildings can be quite different from the original cost. Accumulated Depreciation must also be shown, which is deducted from cost (or valuation) to give net book value Goodwill comes in two flavours:

Inherent goodwill, which is supposed to reflect the reputation and other positive characteristics of the business which are all difficult to put a value on. This type of goodwill should not appear on the Balance Sheet Purchased goodwill, which is the excess of purchase price over fair value of the net assets of the business acquired by the purchaser. learn more about goodwill

Legal framework The law controls what kinds of books, records and systems of internal controls that must be maintained by companies which are subject to an annual examination by external auditors. You will learn much more about these in your studies. Long term Liability Amounts owed to someone else which are payable after one year. Examples include:
• •

Long term loans Debentures , which are long term loans secured on the business assets. This means if the business fails to repay back the loan on time the business assets are at risk.

Net current assets Sometimes referred to as working capital, this is the difference between total current assets and total current liabilities and is what finances the business on a day to basis. Net Assets Is the difference between the total assets and total liabilities. Profit There are many types of profit:
• •

Cash surplus, which is the difference between receipts and payments. Taxable profit, which is the business profit adjusted for tax purposes.

Accounting profit, which is the difference between: o Income received or receivable and o Expenditure paid or payable within an accounting period Often referred to as NET Profit Accounting profit is calculated using the accruals or matching concept. Which means that the total income includes not only cash received but also amounts owed by credit customers (debtors) for sales made within the accounting period. The total costs incurred to achieve these sales include not just actual payments made , but also amounts still owing to suppliers. Accounting profit is normally referred to as Net Profit which is Gross profit less Expenses.

Reserves amounts retained in the business and not distributed to owners. Reserves can be:
• •

Profits made and not passed on to owners. These are some times known as retained earnings. Capital reserves which can not be passed on to owners and represent the perceived increase in valuation of some fixed assets.

Shares Amounts invested in a company by its owners. Owners of companies are called shareholders

The profit and loss account words
Accounting Period Is the period under examination and usually refers to a year. We therefore refer to a Profit and loss Account for the year ended so and so or a Balance Sheet as at so and so. Accruals or Matching concept Is the reason why net profit made is not the same as the cash surplus generated. This is a critical concept for you to understand. It is a fundamental concept upon which the accounts are prepared. You will learn in your studies that profit is not cash for a number of reasons:

because of applying the accruals concept to preparation of accounts. This is where we deduct from sales the amounts we have incurred to achieve those sales WHETHER WE HAVE PAID FOR THEM OR STILL OWE FOR THEM is irrelevant. In other words we count all costs incurred including those still owing to trade creditors at the end of the year. The costs deducted in the accounts will

therefore be greater than the actual cash payments made where amounts are still owed at the end of the year. Similarly the sales figure is not made up of cash received from customers but is made up of cash received together with that still to be received. because of accounting for depreciation which is a deduction against profits for the measure of wearing out of a fixed asset and therefore does not involve a cash payment because of the way we value closing stock which can be by using average unit costs, the last unit costs or the earliest unit costs. None of these methods reflect the actual flow of cash because they are all estimates only. You will learn that this is where we consider FIFO (first in first out) and LIFO (last in first out) valuations of closing stock. learn more about the matching concept learn more about stock valuation

Expenses Referred to as expenditure and including examples such as:  advertising  rent and rates  wages and salaries  travelling expenses  light and heat  Office Expenses  Miscellaneous Expenses  bank interest  loan interest  depreciation  Provision for doubtful debts . This represents an estimate of amounts customers have difficulty paying due to their cash flow problems. This figure will be deducted from the profit in the Profit and loss Account and will also be deducted from the Debtors figure in the Balance Sheet.  bad debts written off Amounts owed by customers that cannot afford to pay because they have gone into liquidation. These amounts need to be deducted from the profit in the Profit and Loss Account and also from the Debtors figure which is found in the Current Assets section of the Balance Sheet.  accruals and prepayments. Accruals are amounts unaccounted for yet still owing at the year end . Estimates need to be made and then added to the expenses deducted in the Profit and Loss account. This amount also needs to be added to Trade Creditors in the Current liabilities section of the Balance Sheet . Prepayments are amounts paid for by the business in advance of goods and services received. These amounts need to be deducted from expenses in the Profit and Loss account and will also appear in the Current Asset section of the Balance Sheet along with Debtors.

Gross Profit Is calculated by deducting Cost of Sales(sometimes referred to as Cost of goods sold) from sales. Cost Of Sales is calculated by taking:
• •

Opening stock, which is the value of stock which exists at the beginning of the accounting period Plus Purchases of goods for resale, made during the accounting period. One common mistake made by students is to confuse purchases with stocks. Purchases of stocks are dealt with through the purchases account and not through the Opening and closing stocks.

Less Closing stock, which is the value of stock which exists at the end of the accounting period In other words, it is the value of goods purchased during the year and in stock at the beginning of the year, less those items sold during the year. This is the figure which also appears in the balance sheet as stocks and can be found in the current assets section. learn more about cost of sales

Historic cost The method used for preparing accounts which estimates the actual purchase price of all items purchased. This is as opposed to the alternatives which could be to use instead the:
• •

cost of replacing items when they are sold or disposed of .Known as the Replacement cost or net realizable value income expected if items were sold. Known as the Realization cost

Net Profit Sales less cost of sales less expenses = net profit. Sales less cost of sales = gross profit. Therefore Net Profit = gross profit less expenses. In other words Net Profit represents the surplus of sales made over expenditure during the accounting period. If a deficit is made(i.e if expenditure is greater than sales) then this results in a net loss and not a net profit. Profit and Loss Account Shows what net profit or loss the business has made within an accounting period after deducting all expenditure from the income. A net profit is earned if total expenditure is less than the sales figure. A net loss is made if it is greater. Comes underneath the Trading Account

Sales Income received or receivable for the accounting period. Sometimes referred to as Turnover.It represents the sales value of goods and services made to customers during the year. Trading account Shows what Gross Profit the business has made within an accounting period It comes on top of the Profit and Loss Account

Reporting of assets

International Financial Reporting Standards
From Wikipedia, the free encyclopedia
Jump to: navigation, search


Key concepts Accountant · Bookkeeping · Trial balance · General ledger · Debits and credits · Cost of goods sold · Double-entry system · Standard practices · Cash and accrual basis · GAAP / IFRS Financial statements Balance sheet · Income statement · Cash flow statement · Equity · Retained earnings Auditing Financial audit · GAAS · Internal audit · Sarbanes-Oxley Act · Big Four auditors Fields of accounting Cost · Financial · Forensic · Fund · Management · Tax

This box: view • talk • edit

International Financial Reporting Standards (IFRS) are Standards,[1] Interpretations and the Framework[2][3] adopted by the International Accounting Standards Board (IASB). Many of the standards forming part of IFRS are known by the older name of International Accounting Standards (IAS). IAS were issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). On 1 April 2001, the new IASB took over from the IASC the responsibility for setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and SICs. The IASB has continued to develop standards calling the new standards IFRS.

• • •

• • •

• • •

1 Structure of IFRS 2 Framework 3 Role of Framework o 3.1 Objective of financial statements o 3.2 Underlying assumptions o 3.3 Qualitative characteristics of financial statements o 3.4 Elements of financial statements o 3.5 Recognition of elements of financial statements o 3.6 Measurement of the Elements of Financial Statements o 3.7 Concepts of Capital and Capital Maintenance o 3.8 Concepts of Capital  3.8.1 Concepts of Capital Maintenance and the Determination of Profit 4 Requirements of IFRS 5 IASB current projects 6 Adoption of IFRS o 6.1 Australia o 6.2 Canada o 6.3 European Union o 6.4 Russia o 6.5 Turkey o 6.6 Hong Kong o 6.7 Singapore o 6.8 United States and convergence with US GAAP o 6.9 India o 6.10 Japan 7 List of IFRS statements with full text links 8 List of Interpretations with full text links 9 Further reading

• • •

10 See also 11 References 12 External links

[edit] Structure of IFRS
IFRS are considered a "principles based" set of standards in that they establish broad rules as well as dictating specific treatments. International Financial Reporting Standards comprise:
• • • •

International Financial Reporting Standards (IFRS) - standards issued after 2001 International Accounting Standards (IAS) - standards issued before 2001 Interpretations originated from the International Financial Reporting Interpretations Committee (IFRIC) - issued after 2001 Standing Interpretations Committee (SIC) - issued before 2001

There is also a Framework for the Preparation and Presentation of Financial Statements which describes the principles underlying IFRS... IAS 8 Par. 11 "In making the judgement described in paragraph 10, management shall refer to, and consider the applicability of, the following sources in descending order: (a) the requirements and guidance in Standards and Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework."

[edit] Framework
The Framework for the Preparation and Presentation of Financial Statements states basic principles for IFRS.

[edit] Role of Framework
The IASB states: In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgement in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgement, IAS 8.11 requires management to consider the definitions, recognition

criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework. This elevation of the importance of the Framework was added in the 2003 revisions to IAS 8.[4]

[edit] Objective of financial statements
A framework is the foundation of accounting standards.
[edit] Underlying assumptions

The underlying assumptions used in IFRS are:

• •

Accrual basis - the effect of transactions and other events are recognized when they occur, not as cash is gained or paid. Going concern -an entity will continue for the foreseeable future.

[edit] Qualitative characteristics of financial statements

qualitative characteristics of financial statements as having

• • •




[edit] Elements of financial statements

The financial position of an enterprise is primarily provided in the Statement of Financial Position. The elements include:

1. Asset: An asset is a resource controlled by the enterprise as a result of past events, and from which future economic benefits are expected to flow to the enterprise.

2. Liability: A liability is a present obligation of the enterprise arising from the past events, the settlement of which is expected to result in an outflow from the enterprise' resources, i.e., assets.

3. Equity: Equity is the residual interest in the assets of the enterprise after deducting all the liabilities. Equity is also known as owner's equity.

The financial performance of an enterprise is primarily provided in an income statement or profit and loss account. The elements of an income statement or the elements that measure the financial performance are as follows:

4. Revenues: increases in economic benefit during an accounting period in the form of inflows or enhancements of assets, or decrease of liabilities that result in increases in equity. However, it does not include the contributions made by the equity participants, i.e., proprietor, partners and shareholders.

5. Expenses: decreases in economic benefits during an accounting period in the form of outflows, or depletions of assets or incurrences of liabilities that result in decreases in equity.

[edit] Recognition of elements of financial statements

An item is recognized in the financial statements when:

• • •

it is probable future economic benefit will flow to or from an entity and when the item has a cost or value that can be measured with reliability. stability

[edit] Measurement of the Elements of Financial Statements

Par. 99. Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement.

Par. 100. A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include the following:

(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.

(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.

(c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

(d) Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

Par. 101. The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. This is usually combined with other measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value, marketable securities may be carried at market value and pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets.[5]Muhammad Mohsin Bhatti

[edit] Concepts of Capital and Capital Maintenance

[edit] Concepts of Capital
Par. 102. A financial concept of capital is adopted by most entities in preparing their financial statements. Under a financial concept of capital, such as invested money or invested purchasing power, capital is synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as operating capability, capital is regarded as the productive capacity of the entity based on, for example, units of output per day. Par. 103. The selection of the appropriate concept of capital by an entity should be based on the needs of the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of financial statements are primarily concerned with the maintenance of nominal invested capital or the purchasing power of invested capital. If, however, the main concern of users is with the operating capability of the entity, a physical concept of capital should be used. The concept chosen indicates the goal to be attained in determining profit, even though there may be some measurement difficulties in making the concept operational.[7]

[edit] Concepts of Capital Maintenance and the Determination of Profit
Par. 104. The concepts of capital in paragraph 102 give rise to the following concepts of capital maintenance: (a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or money) amount of the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Financial capital maintenance can be measured in either Nominal monetary units or units of constant purchasing power. (b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive capacity (or operating capability) of the entity (or the resources or funds needed to achieve that capacity) at the end of the period exceeds the physical productive capacity at the beginning of the period, after excluding any distributions to, and contributions from, owners during the period. Par. 105. The concept of capital maintenance is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit because it provides the point of reference by which profit is measured; it is a prerequisite for distinguishing between an entity’s return on capital and its return of capital; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Hence, profit is the residual amount that remains after expenses (including capital maintenance adjustments, where appropriate) have been deducted from income. If expenses exceed income the residual amount is a loss.

Par. 106. The physical capital maintenance concept requires the adoption of the current cost basis of measurement. The financial capital maintenance concept, however, does not require the use of a particular basis of measurement. Selection of the basis under this concept is dependent on the type of financial capital that the entity is seeking to maintain. Par. 107. The principal difference between the two concepts of capital maintenance is the treatment of the effects of changes in the prices of assets and liabilities of the entity. In general terms, an entity has maintained its capital if it has as much capital at the end of the period as it had at the beginning of the period. Any amount over and above that required to maintain the capital at the beginning of the period is profit. Par. 108. Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They may not be recognised as such, however, until the assets are disposed of in an exchange transaction. When the concept of financial capital maintenance is defined in terms of constant purchasing power units, profit represents the increase in invested purchasing power over the period. Thus, only that part of the increase in the prices of assets that exceeds the increase in the general level of prices is regarded as profit. The rest of the increase is treated as a capital maintenance adjustment and, hence, as part of equity. Par. 109. Under the concept of physical capital maintenance when capital is defined in terms of the physical productive capacity, profit represents the increase in that capital over the period. All price changes affecting the assets and liabilities of the entity are viewed as changes in the measurement of the physical productive capacity of the entity; hence, they are treated as capital maintenance adjustments that are part of equity and not as profit. Par. 110. The selection of the measurement bases and concept of capital maintenance will determine the accounting model used in the preparation of the financial statements. Different accounting models exhibit different degrees of relevance and reliability and, as in other areas, management must seek a balance between relevance and reliability. This Framework is applicable to a range of accounting models and provides guidance on preparing and presenting the financial statements constructed under the chosen model. At the present time, it is not the intention of the Board of IASC to prescribe a particular model other than in exceptional circumstances, such as for those entities reporting in the currency of a hyperinflationary economy. This intention will, however, be reviewed in the light of world developments.[8]

[edit] Requirements of IFRS
Main article: Requirements of IFRS IFRS financial statements consist of (IAS1.8)

• • • • •

a Statement of Financial Position a comprehensive income statement either a statement of changes in equity (SOCE) or a statement of recognised income or expense ("SORIE") a cash flow statement or statement of cash flows notes, including a summary of the significant accounting policies

Comparative information is provided for the previous reporting period (IAS 1.36). An entity preparing IFRS accounts for the first time must apply IFRS in full for the current and comparative period although there are transitional exemptions (IFRS1.7). On 6 September 2007, the IASB issued a revised IAS 1 Presentation of Financial Statements. The main changes from the previous version are to require that an entity must:

• • •

present all non-owner changes in equity (that is, 'comprehensive income' ) either in one statement of comprehensive income or in two statements (a separate income statement and a statement of comprehensive income). Components of comprehensive income may not be presented in the statement of changes in equity. present a statement of financial position (balance sheet) as at the beginning of the earliest comparative period in a complete set of financial statements when the entity applies an accounting 'balance sheet' will become 'statement of financial position' 'income statement' will become 'statement of comprehensive income' 'cash flow statement' will become 'statement of cash flows'.

The revised IAS 1 is effective for annual periods beginning on or after 1 January 2009. Early adoption is permitted.

[edit] IASB current projects

. Much of its work is directed at convergence with US GAAP.

[edit] Adoption of IFRS
IFRS are used in many parts of the world, including the European Union, Hong Kong, Australia, Malaysia, Pakistan, GCC countries, Russia, South Africa, Singapore and Turkey. As of 27 August 2008, more than 113 countries around the world, including all of Europe, currently require or permit IFRS reporting. Approximately 85 of those countries require IFRS reporting for all domestic, listed companies.[10] For a current overview see IAS PLUS's list of all countries that have adopted IFRS.

[edit] Australia
The Australian Accounting Standards Board (AASB) has issued 'Australian equivalents to IFRS' (A-IFRS), numbering IFRS standards as AASB 1-8 and IAS standards as AASB 101 - 141. Australian equivalents to SIC and IFRIC Interpretations have also been issued, along with a number of 'domestic' standards and interpretations. These pronouncements replaced previous Australian generally accepted accounting principles with effect from annual reporting periods beginning on or after 1 January 2005 (i.e. 30 June 2006 was the first report prepared under IFRS-equivalent standards for June year ends). To this end, Australia, along with Europe and a few other countries, was one of the initial adopters of IFRS for domestic purposes. The AASB has made certain amendments to the IASB pronouncements in making AIFRS, however these generally have the effect of eliminating an option under IFRS, introducing additional disclosures or implementing requirements for not-for-profit entities, rather than departing from IFRS for Australian entities. Accordingly, for-profit entities that prepare financial statements in accordance with A-IFRS are able to make an unreserved statement of compliance with IFRS. The AASB continues to mirror changes made by the IASB as local pronouncements. In addition, over recent years, the AASB has issued so-called 'Amending Standards' to reverse some of the initial changes made to the IFRS text for local terminology differences, to reinstate options and eliminate some Australian-specific disclosure. There are some calls for Australia to simply adopt IFRS without 'Australianising' them and this has resulted in the AASB itself looking at alternative ways of adopting IFRS in Australia.

[edit] Canada
The use of IFRS will be required for Canadian publicly accountable profit-oriented enterprises for financial periods beginning on or after 1 January 2011. This includes public companies and other “profit-oriented enterprises that are responsible to large or diverse groups of shareholders.”[11]

[edit] European Union
All listed EU companies have been required to use IFRS since 2005. In order to be approved for use in the EU, standards must be endorsed by the Accounting Regulatory Committee (ARC), which includes representatives of member state governments and is advised by a group of accounting experts known as the European Financial Reporting Advisory Group. As a result IFRS as applied in the EU may differ from that used elsewhere. Parts of the standard IAS 39: Financial Instruments: Recognition and Measurement were not originally approved by the ARC. IAS 39 was subsequently amended, removing the option to record financial liabilities at fair value, and the ARC approved the amended

version. The IASB is working with the EU to find an acceptable way to remove a remaining anomaly in respect of hedge accounting.

[edit] Russia
The government of Russia has been implementing a program to harmonize its national accounting standards with IFRS since 1998. Since then twenty new accounting standards were issued by the Ministry of Finance of the Russian Federation aiming to align accounting practices with IFRS. Despite these efforts essential differences between national accounting standards and IFRS remain. Since 2004 all commercial banks have been obliged to prepare financial statements in accordance with both national accounting standards and IFRS. Full transition to IFRS is delayed and is expected to take place from 2011.

[edit] Turkey
Turkish Accounting Standards Board translated IFRS into Turkish in 2006. Since 2006 Turkish companies listed in Istanbul Stock Exchange are required to prepare IFRS reports.

[edit] Hong Kong
Starting in 2005, Hong Kong Financial Reporting Standards (HKFRS) are identical to International Financial Reporting Standards. While Hong Kong had adopted many of the earlier IAS as Hong Kong standards, some had not been adopted, including IAS 32 and IAS 39. And all of the December 2003 improvements and new and revised IFRS issued in 2004 and 2005 will take effect in Hong Kong beginning in 2005. Implementing Hong Kong Financial Reporting Standards: The challenge for 2005 (August 2005) sets out a summary of each standard and interpretation, the key changes it makes to accounting in Hong Kong, the most significant implications of its adoption, and related anticipated future developments. There is one Hong Kong standard and several Hong Kong interpretations that do not have counterparts in IFRS. Also there are several minor wording differences between HKFRS and IFRS. [12]

[edit] Singapore
In Singapore the Accounting Standards Committee (ASC) is in charge of standard setting. Singapore closely models its Financial Reporting Standards (FRS) according to the IFRS, with appropriate changes made to suit the Singapore context. Before a standard is enacted, consultations with the IASB are made to ensure consistency of core principles [13] .

[edit] United States and convergence with US GAAP
In 2002 at a meeting in Norwalk, Connecticut, the IASB and the US Financial Accounting Standards Board (FASB) agreed to harmonize their agenda and work towards reducing differences between IFRS and US GAAP (the Norwalk agreement). In February 2006 FASB and IASB issued a Memorandum of Understanding including a program of topics on which the two bodies will seek to achieve convergence by 2008. US companies registered with the United States Securities and Exchange Commission must file financial statements prepared in accordance with US GAAP. Until 2007, foreign private issuers were required to file financial statements prepared either (a) under US GAAP or (b) in accordance with local accounting principles or IFRS with a footnote reconciling from local principles or IFRS to US GAAP. This reconciliation imposed extra expense on companies which are listed on exchanges both in the US and another country. From 2008, foreign private issuers are additionally permitted to file financial statements in accordance with IFRS as issued by the IASB without reconciliation to US GAAP.[14] There is broad expectation among U.S. companies that the SEC will move to allow or require them to use IFRS in the near future and a growing acceptance of that scenario, according to Controllers' Leadership Roundtable survey data.[15] In August 2008, the SEC announced a timetable that would allow some companies to report under IFRS as soon as 2010 and require it of all companies by 2014.[16] The SEC received over 220 comment letters from a diverse group of constituents on its timetable. Some of the key points included: - The ultimate goal must be the worldwide use of a single set of high quality financial reporting standards - Most respondents support continuation of the convergence process - Users prefer a principles-based accounting framework that includes application of sound professional judgment coupled with clear and transparent disclosures about the economic substance of the transaction, the reasons for reaching that conclusion, and the related accounting for the transaction. Acknowledgment that the expected costs of IFRS adoption will be significant but the anticipated costs of not adopting will be much more significant to the U.S. Capital Markets - A clear commitment and adoption date is needed, regardless whether it is 2014, 2015 or 2016 (i.e., a “date certain”) Recommendation to require only one prior year comparative [17] Mary Schapiro, SEC Chair, provided an update on the SEC’s proposed roadmap during a meeting of the International Accounting Standards Committee Foundation (IASCF) on 6 July 2009. The SEC is continuing its detailed analysis of all comment letters and will readdress this issue in Fall 2009. [18]

[edit] India
The Institute of Chartered Accountants of India (ICAI) has announced that IFRS will be mandatory in India for financial statements for the periods beginning on or after 1 April,

2011. This will be done by revising existing accounting standards to make them compatible with IFRS. Reserve Bank of India has stated that financial statements of banks need to be IFRScompliant for periods beginning on or after 1 April, 2011.

[edit] Japan
The Accounting Standards Board of Japan has agreed to resolve all inconsistencies between the current JP-GAAP and IFRS wholly by 2011. [19]

Bank reconciliation
From Wikipedia, the free encyclopedia
Jump to: navigation, search Bank reconciliation is the process of comparing and matching figures from the accounting records against those shown on a bank statement. The result is that any transactions in the accounting records not found on the bank statement are said to be outstanding. Taking the balance on the bank statement adding the total of outstanding receipts less the total of the outstanding payments this new value should (match) reconcile to the balance of the accounting records. Bank reconciliation allows companies or individuals to compare their account records to the bank's records of their account balance in order to uncover any possible discrepancies. Discrepancies could include: cheques recorded as a lesser amount than what was presented to the bank; money received but not lodged; or payments taken from the bank account without the business's knowledge. A bank reconciliation done regularly can reduce the number of errors in an accounts system and make it easier to find missing purchases and sales invoices.

[edit] Accounting

A company needs to report depreciation accurately in its financial statements in order to achieve two main objectives: 1. matching its expenses with the income generated by means of those expenses, and 2. ensuring that the asset values in the balance sheet are not overstated. (An asset acquired in Year 1 is unlikely to be worth the same amount in Year 5.) Depreciation is an attempt to write-off the cost of Non Current Asset over its useful life. The word write-off means to turn it into an expense. For example, an entity may depreciate its equipment by 15% per year. This rate should be reasonable in aggregate (such as when a manufacturing company is looking at all of its machinery), and consistently employed. However, there is no expectation that each individual item declines in value by the same amount, primarily because the recognition of depreciation is based upon the allocation of historical costs and not current market prices. Accounting standards bodies have detailed rules on which methods of depreciation are acceptable, and auditors should express a view if they believe the assumptions underlying the estimates do not give a true and fair view.

[edit] Recording depreciation
For historical cost purposes, assets are recorded on the balance sheet at their original cost; this is called the historical cost. Historical cost minus all depreciation expenses recognized on the asset since purchase is called the book value. Depreciation is not taken out of these assets directly. It is instead recorded in a contra asset account: an asset account with a normal credit balance, typically called "accumulated depreciation". Balancing an asset account with its corresponding accumulated depreciation account will result in the net book value. The net book value will never fall below the salvage value, meaning that once an asset is fully depreciated, no further expenses will be taken during its life. Salvage value is the estimated value of the asset at the end of its useful life. In this way, total depreciation for an asset will never exceed the estimated total cash outlay (depreciable basis) for the asset. The exception to this is in many price-regulated industries (public utilities) where salvage is estimated net of the cost of physically removing the asset from service. (Decommissioning a nuclear power plant is a nontrivial expense.) If the expected cost of removal exceeds the expected raw (or gross) salvage, then the net of the two (called net salvage) may be negative. In this case, the depreciation recorded on the regulated books may exceed the depreciable basis. Companies have no obligation to dispose of depreciated assets, of course, and many fully depreciated assets continue to generate income. Recording a depreciation expense will involve a credit to an accumulated depreciation account. The corresponding debit will involve either an expense account or an asset account that represents a future expense, such as work in progress. Depreciation is recorded as an adjusting journal entry.

A write-down is a form of depreciation that involves a partial write off. Part of the value of the asset is removed from the balance sheet. The reason may be that the book value (accounted value) of the fixed asset has diverged from the market value and causes the company a loss. An example of this would be a revaluation of goodwill on an acquisition that went bad.

[edit] Methods of depreciation
There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

[edit] Straight-line depreciation
Straight-line depreciation is the simplest and most-often-used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life) and will expense a portion of original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value or residual value. Straight-Line Method:

For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 - $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided by the number of years of its useful life. This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation. Book Value = Original Cost - Accumulated Depreciation Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value. Book Value Beginning of Year $17,000 (Original Cost) $14,000 $11,000 $8,000 Depreciation Accumulated Book Value Expense Depreciation End of Year $3,000 $3,000 $14,000 $3,000 $6,000 $11,000 $3,000 $9,000 $8,000 $3,000 $12,000 $5,000




$2,000 (Scrap Value)

If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to depreciation recapture. In addition, this gain above the depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than the book value, the resulting capital loss is tax deductible. If the sale price were ever more than the original book value, then the gain above the original book value is recognized as a capital gain. If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.

[edit] Declining-Balance Method
Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years are called accelerated depreciation methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. One popular accelerated method is the declining-balance method. Under this method the Book Value is multiplied by a fixed rate. Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the double-declining-balance method. To illustrate, suppose a business has an asset with $1,000 Original Cost, $100 Salvage Value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) 20% per year. With double-declining-balance method, as the name suggests, double that rate, or 40% depreciation rate is used. The table below illustrates the double-declining-balance method of depreciation. Book Value at the beginning of the first year of depreciation is the Original Cost of the asset. At any time Book Value equals Original Cost minus Accumulated Depreciation. Book Value = Original Cost - Accumulated Depreciation Book Value at the end of year becomes Book Value at the beginning of next year. The asset is depreciated until the Book Value equals Salvage Value, or Scrap Value. Book Value Depreciation Depreciation Accumulated Book Value Beginning of Year Rate Expense Depreciation End of Year $1,000 (Original Cost) 40% $400 $400 $600 $600 40% $240 $640 $360

$360 $216 $129.60

40% $144 40% $86.40 $129.60 - $100 $29.60

$784 $870.40 $900

$216 $129.60 $100 (Scrap Value)

The Salvage Value is not considered in determining the annual depreciation, but the Book Value of the asset being depreciated is never brought below its Salvage Value, regardless of the method used. The process continues until the Salvage Value or the end of the asset's useful life, is reached. In the last year of depreciation a subtraction might be needed in order to prevent Book Value from falling below estimated Scrap Value. Since declining-balance depreciation does not always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life.

[edit] Activity depreciation
Activity depreciation methods are not based on time, but on a level of activity. This could be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired, its life is estimated in terms of this level of activity. Assume the vehicle above is estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated as: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the depreciation expense is then calculated by multiplying the rate by the actual activity level.

[edit] Sum-of-Years' Digits Method
Sum-of-Years' Digits is a depreciation method that results in a more accelerated write-off than straight line, but less than declining-balance method. Under this method annual depreciation is determined by multiplying the Depreciable Cost by a schedule of fractions. Depreciable Cost = Original Cost - Salvage Value Book Value = Original Cost - Accumulated Depreciation Example: If an asset has Original Cost $1000, a useful life of 5 years and a Salvage Value of $100, compute its depreciation schedule. First, determine Years' digits. Since the asset has useful life of 5 years, the Years' digits are: 5, 4, 3, 2, and 1. Next, calculate the sum of the digits. 5+4+3+2+1=15 Depreciation rates are as follows:

5/15 for the 1st year, 4/15 for the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year, and 1/15 for the 5th year. Book Value Total Depreciation Depreciation Beginning of Depreciable Rate Expense Year Cost $1,000 $300 ($900 * $900 5/15 (Original Cost) 5/15) $240 ($900 * $700 $900 4/15 4/15) $180 ($900 * $460 $900 3/15 3/15) $120 ($900 * $280 $900 2/15 2/15) $60 ($900 * $160 $900 1/15 1/15) Accumulated Depreciation $300 $540 $720 $840 $900 Book Value End of Year $700 $460 $280 $160 $100 (Scrap Value)

[edit] Units-of-Production Depreciation Method
Under the Units-of-Production method, useful life of the asset is expressed in terms of the total number of units expected to be produced. Annual depreciation is computed in three steps. First, a Depreciable Cost is computed. Depreciable Cost = Original Cost - Salvage Value. Second, Depreciation per Unit is computed. Depreciation charge per unit is computed by dividing Depreciable Cost by Total Units, expected to be produced during the useful life of the asset. Depreciation per Unit = Depreciable Cost / Total Units of production Third, annual depreciation, or Depreciation Expense, by another name, is computed. Depreciation Expense equals Depreciation per Unit multiplied by the number of units produced during the year. Depreciation Expense = Depreciation per Unit * Units produced during the Year. Book Value, as always, is calculated by subtracting Accumulated Depreciation from the Original Cost. Book Value = Original Cost - Accumulated Depreciation Suppose, an asset has Original Cost $70,000, Salvage Value $10,000, and is expected to produce 6,000 units.

Depreciable Cost = ($70,000-$10,000) $60,000 Depreciation per Unit = ($60,000 / 6,000) = $10 The table below illustrates the Units-of-Production depreciation schedule of the asset. Book Value Beginning of Year $70,000 (Original Cost) $60,000 $49,000 $37,000 $24,000 Units of Production 1,000 1,100 1,200 1,300 1,400 Depreciation Depreciation Accumulated Book Value Cost per Expense Depreciation End of Year Unit $10 $10 $10 $10 $10 $10,000 $11,000 $12,000 $13,000 $14,000 $10,000 $21,000 $33,000 $46,000 $60,000 $60,000 $49,000 $37,000 $24,000 $10,000 (Scrap Value)

Depreciation stops when Book Value is equal to the Scrap Value of the asset. In the end the sum of Accumulated Depreciation and Scrap Value equals to the Original Cost.

[edit] Units of time depreciation
Units of Time Depreciation is similar to units of production, and is used for depreciation equipment used in mine or natural resource exploration, or cases where the amount the asset is used is not linear year to year. A simple example can be given for construction companies, where some equipment is used only for some specific purpose. Depending on the number of projects, the equipment will be used and depreciation charged accordingly.

[edit] Group Depreciation Method
Group Depreciation method is used for depreciating multiple-asset accounts using straight-line-depreciation method. Assets must be similar in nature and have approximately the same useful lives. Historical Salvage Depreciable Depreciation Life Cost Value Cost Per Year Computers $5,500 $500 $5,000 5 $1,000 Asset

[edit] Composite Depreciation Method
The composite method is applied to a collection of assets that are not similar, and have different service lives. For example, computers and printers are not similar, but both are

part of the office equipment. Depreciation on all assets is determined by using the straight-line-depreciation method. Historical Salvage Depreciable Depreciation Life Cost Value Cost Per Year Computers $5,500 $500 $5,000 5 $1,000 Printers $1,000 $100 $ 900 3 $ 300 Total $ 6,500 $600 $5,900 4.5 $1,300 Asset Composite life equals the total Depreciable Cost divided by the total Depreciation Per Year. $5,900 / $1,300 = 4.5 years. Composite Depreciation Rate equals Depreciation Per Year divided by total Historical Cost. $1,300 / $6,500 = 0.20 = 20% Depreciation Expense equals the composite Depreciation rate times the balance in the asset account. (0.20 * $6,500) $1,300. Debit Depreciation Expense and credit Accumulated Depreciation. When an asset is sold, debit Cash for the amount received and credit the asset account for its original cost. Debit the difference between the two to Accumulated Depreciation. Under the Composite method no gain or loss is recognized on the sale of an asset. To calculate Composite Depreciation Rate, divide Depreciation Per Year by total Historical Cost. To calculate Depreciation Expense, multiply the result by the same total Historical Cost. The result, not surprisingly, will equal to the total Depreciation Per Year again. Common sense requires Depreciation Expense to be equal to total Depreciation Per Year, without first dividing and then multiplying total Depreciation Per Year by the same number. Creators of accounting rules sometimes are very creative, as was noted on the discussion forum of Accounting Coach at [1]

[edit] Taxes
Main article: Modified Accelerated Cost Recovery System When a company spends money for a service or anything else that is short-lived, this expenditure is usually immediately tax deductible in some countries, and the company enjoys an immediate tax benefit.[3] To be eligible for depreciation, an asset must have two features: 1. it has a useful life beyond the taxable year (essentially why it was capitalized in the first place), and

2. it wears out, decays, declines in value due to natural causes, or is subject to exhaustion or obsolescence. Therefore, when a company buys an asset that will last longer than one year, like a computer, car, or building, the company cannot immediately deduct the cost and enjoy an immediate large tax benefit. Instead, the company must depreciate the cost over the useful life of the asset, taking a tax deduction for a part of the cost each year. Eventually the company does get to deduct the full cost of the asset, but this happens over several years. In the US, the IRS's depreciation schedule for any given class of asset is fixed, and is related to typical durability. A computer may depreciate completely over five years; a nonresidential building, usually 39 years. The maximum allowable useful life under US income tax regulations is 40 years. Though the IRS does allow a small choice of permutations for depreciation life and acceleration, it does not allow a taxpayer to invent any arbitrary asset life. Other countries have other systems, many simply eliminate all choice altogether. In these jurisdictions accounting depreciation and tax depreciation are almost always significantly different numbers, as in many instances a form of "accelerated depreciation" can be used for tax purposes to lower (taxable) net income in a given period (or, in some instances, a fixed asset may be allowed to be expensed for tax purposes; Section 179 of the Internal Revenue Code allows for this treatment in some circumstances). Technically, these are not considered "tax reductions" but tax deferrals: lowering taxable income now by increasing expenses should increase future taxable income (and taxes) at a later date. Importantly, no depreciation deduction is allowed for inventories or other property held for sale to customers in the ordinary course of business (Treas. Reg. § 1.167(a)-2 and Thor Power Tool Company v. Commissioner). Land is also not depreciable (Treas. Reg. § 1.167(a)-2). However, improvements to land, including landscaping, are usually depreciable. In the US, there are generally five variables that a taxpayer must take into account when computing the correct depreciation deduction: 1. the depreciation base (the asset’s cost basis), 2. the asset’s class life (estimated life expectancy of the asset), 3. the applicable recovery period (the number of years the taxpayer can claim depreciation deductions), 4. the applicable depreciation method (see double declining balance method or straight-line method), and 5. the applicable convention (§ 168(d)(4) of the code—generally the half-year convention).

[edit] Economics
In economics, the value of a capital asset is equal to the present value of the flow of services the asset will generate in future, appropriately adjusted for uncertainty.

Economic depreciation over a given period is the reduction in the remaining value of future services. Under certain circumstances, such as an unanticipated increase in the price of the services generated by an asset, its value may increase rather than decline. Depreciation is then negative.

[edit] National accounts
In national accounts, depreciation represents the decline in the aggregate capital stock arising from the use of capital in production, also referred to as consumption of fixed capital. Hence, depreciation is equal to the difference between aggregate (gross) investment and net investment or between Gross National Product and Net National Product. Unlike depreciation in business accounting, depreciation in national accounts is, in principle, not a method of allocating the costs of past expenditures on fixed assets over subsequent accounting periods. Rather, fixed assets at a given moment in time are valued according to the remaining benefits to be derived from their use.

Preference shares

Hide links within definitionsShow links within definitions Definition Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preference shares represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, preference shares pay a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preference shares are that the investor has a greater claim on the company's assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock: cumulative preferred, noncumulative, participating, and convertible. also called preferred stock.

Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that resembles properties of both an equity and a debt instrument and generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common stock, but are subordinate to bonds.[1] Preferred stock usually carries no voting rights,[2] but may carry priority over common stock in the payment of dividends and upon liquidation. Preferred stock may carry a dividend that is paid out prior to any dividends being paid to common stock holders. Preferred stock may have a convertibility feature into common stock. Terms of the preferred stock are stated in a "Certificate of Designation". Similar to bonds, preferred stocks are rated by the major credit rating companies. The rating for preferreds is generally lower since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.[3]

• • • • •

• •

1 Rights 2 Types of preferred stock 3 Typical usage 4 Users 5 International perspectives o 5.1 Canada o 5.2 Germany o 5.3 United Kingdom o 5.4 United States o 5.5 Other countries 6 Notes 7 External links

[edit] Rights
Unlike common stock, preferred stock usually has several rights attached to it:

The core right is that of preference in the payment of dividends and upon liquidation of the company. Before a dividend can be declared on the common shares, any dividend obligation to the preferred shares must be satisfied. The dividend rights are often cumulative, such that if the dividend is not paid it accumulates from year to year. However, the directors must declare a dividend before the preferred shareholder has any right to it. In case of non-cumulative, the dividend right for the year is extinguished if it is not declared for that year.

Preferred stock may or may not have a fixed liquidation value, or par value, associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued.[4] Preferred stock has a claim on liquidation proceeds of a stock corporation, equivalent to its par or liquidation value unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim. Almost all preferred shares have a negotiated fixed dividend amount. The dividend is usually specified as a percentage of the par value or as a fixed amount. For example Pacific Gas & Electric 6% Series A preferred. Sometimes, dividends on preferred shares may be negotiated as floating i.e. may change according to a benchmark interest rate index such as LIBOR. Some preferred shares have special voting rights to approve certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, but most preferred shares provide no voting rights associated with them. Some preferred shares only gain voting rights when the preferred dividends are in arrears for a substantial time.

The above list, although including several customary rights, is far from comprehensive. Preferred shares, like other legal arrangements, may specify nearly any right conceivable. Preferred shares in the U.S. normally carry a call provision,[5] enabling the issuing corporation to repurchase the share at its (usually limited) discretion.

[edit] Types of preferred stock
In addition to the straight preferred, as just described, there is great diversity in the preferred stock market. Additional types of preferred stock include:

Prior Preferred Stock – Many companies have different issues of preferred stock outstanding at the same time and one of them is usually designated to be the one with the highest priority. If the company has only enough money to meet the dividend schedule on one of the preferred issues, it makes the dividend payments on the prior preferred. Therefore, prior preferred have less credit risk than the other preferred stocks but it usually offers a lower yield than the others. Preference Preferred Stock – Ranked behind the company's prior preferred stock (on a seniority basis), are the company's preference preferred issues. These issues receive preference over all other classes of the company's preferred except for the prior preferred. If the company issues more than one issue of preference preferred, then the various issues are ranked by their relative seniority. One issue is designated first preference, the next senior issue is the second and so on. Convertible Preferred Stock – These are preferred issues that the holders can exchange for a predetermined number of the company's common stock. This exchange can occur at any time the investor chooses regardless of the current market price of the common stock. It is a one way deal so one cannot convert the common stock back to preferred stock.

Cumulative preferred stock – If the dividend is not paid, it will accumulate for future payment. Exchangeable preferred stock – This type of preferred stock carries the option to be exchanged for some other security upon certain conditions. Participating Preferred Stock – These preferred issues offer the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. The investors who purchased these stocks receive their regular dividend regardless of how well or how poorly the company performs, assuming the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnings or profitability goals, the investors receive an additional dividend. Perpetual preferred stock – This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder, although there will always be redemption privileges held by the corporation. Most preferred stock is issued without a set redemption date. Putable preferred stock – These issues have a "put" privilege whereby the holder may, upon certain conditions, force the issuer to redeem shares. Monthly income preferred stock – A combination of preferred stock and subordinated debt. Non-cumulative preferred stock – Dividend for this type of preferred stock will not accumulate if it is unpaid. Very common in TRuPS and bank preferred stock, since under BIS rules, preferred stock must be non-cumulative if it is to be included in Tier 1 capital.[6]

[edit] Typical usage
Preferred stocks offer a company an attractive alternative to financing. In most cases, a company can defer dividends by going into arrears without much of a penalty or risk to their credit rating.[7] With traditional debt, payments are required and a missed payment would put the company in default. Occasionally companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a poison pill or forced exchange or conversion features that exercise upon a change in control. Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank checks" are often used as takeover defense (see also poison pill). These shares may be assigned very high liquidation value that must be redeemed in the event of a change of control or may have enormous supervoting powers.

Sometimes preferred shares can contain protective provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari-passu or junior relationship with other series issued by the same corporation.

[edit] Users
Preferred shares are more common in private or pre-public companies, where it is more useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may discourage or encourage the issuance of publicly traded preferred shares. In many countries banks are encouraged to issue preferred stock as a source of Tier 1 capital. On the other hand, the Tel Aviv Stock Exchange prohibits listed companies from having more than one class of capital stock.[citation needed] A single company may issue several classes of preferred stock. For example, a company may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock; such a company might have "Series A Preferred," "Series B Preferred," "Series C Preferred" and common stock. In the United States there are two types of preferred stocks: straight preferreds and convertible preferreds. Straight preferreds are issued in perpetuity (although some are subject to call by the issuer under certain conditions) and pay the stipulated rate of interest to the holder. Convertible preferreds—in addition to the foregoing features of a straight preferred—contain a provision by which the holder may convert the preferred into the common stock of the company (or, sometimes, into the common stock of an affiliated company) under certain conditions, among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share, or a certain price per share for the common. There are income tax advantages generally available to corporations that invest in preferred stocks in the United States that are not available to individuals. Some argue that a straight preferred stock, being a hybrid between a bond and a stock, bears the disadvantages of each of those types of securities without enjoying the advantages of either. Like a bond, a straight preferred does not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the common. But the bond has greater security than the preferred and has a maturity date at which the principal is to be repaid. Like the common, the preferred has less security protection than the bond. But the potential of increases of market price of the common and its dividends paid from future growth of the company is lacking for the preferred. One big advantage that the preferred provides its issuer is that the preferred gets better equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows financial institutions to satisfy regulatory requirements without diluting common

shareholders. Said another way, through preferred stock, financial institutions are able to put on leverage while getting Tier 1 equity credit. Suppose that an investor paid par ($100) today for a typical straight preferred. Such an investment would give a current yield of just over 6%. Now suppose that in a few years 10-year Treasuries were to yield 13+% to maturity, as they did in 1981; these preferreds would yield at least 13%, which would knock their market price down to $46, for a 54% loss. (In all probability, they would yield some 2% more than the Treasuries—or something like 15%, which would take the market price down to $40, for a 60% loss.)
[clarification needed]

The important difference between straight preferreds and Treasuries (or any investmentgrade Federal agency or corporate bond) is that the bonds would move up to par as their maturity date is approached, whereas the straight preferred, having no maturity date, might remain at these $40 levels (or lower) for a very long time. Advantages of straight preferreds posited by some advisers include higher yields and tax advantages (currently yield some 2% more than 10-year Treasuries, rank ahead of common stock in the case of bankruptcy, dividends are taxable at a maximum 15% rather than at ordinary income rates, as in the case of bond interest).

Sign up to vote on this title
UsefulNot useful