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FINANCIAL ACCOUNTING

Chapter 11

Advanced PP&E Issues/Natural


Resources/Intangibles

Chapter 12 Current Liabilities and Employer Obligations


Chapter 13 Long-term Obligations
Chapter 14 Corporate Equity Accounting

UNDERSTANDING/USING ACCOUNTING
INFORMATION
Chapter 15 Financial Reporting and Concepts
Chapter 16

Financial Analysis and the Statement of Cash


Flows

Costs Subsequent To Asset Acquisition


Most items of PP&E require substantial ongoing costs to keep them in good order. The accounting rules
for such costs treat them as capital expenditures if future economic benefits result from the
expenditure. Future economic benefits occur if the service life of an asset is prolonged, the quantity of
services expected from an asset is increased, or the quality of services expected from an asset is
improved. Expenditures not meeting at least one of these criteria should be accounted for as
a revenue expenditure and be expensed as incurred. Judgment is required in applying these rules. A
literal reading might lead one to believe that routine maintenance would be capitalized. After all,
fueling a car does extend its service life. But, that interpretation would miss the intent of the rule. It is
implied that routine costs to maintain normal operating condition be expensed as incurred. The
capitalization criteria are instead focused on nonrecurring
costs.

RESTORE AND IMPROVE


A truck may have an engine that is in need of replacement. The replacement of the
engine represents a restoration of some of the original condition (akin to
undepreciating). Restoration and improvement type costs are considered to meet the conditions for
capitalization. This entry records the restoration:

Notice that the preceding debit is to Accumulated Depreciation. The effect is to increase the net book
value of the asset by reducing its accumulated depreciation on the balance sheet. This approach is
perfectly fine for restoration expenditures. However, if one is improving the asset beyond its
original condition (sometimes termed a betterment), the costs would instead be capitalized by
debiting the asset account directly.

Disposal Of PP&E
Over time the productive assets in use by a company may no longer be needed and a decision is made
to dispose of those assets. Disposal may occur by abandonment, sale, or exchange. In any case, it is
necessary to update depreciation calculations through the date of disposal. Then, and only then, would
the asset disposal be recorded.
If the asset is being scrapped (abandoned), the journal entry entails the
elimination of the cost of the asset from the books, removal of the related accumulated depreciation,
and potentially recording a loss to balance. This loss reflects the net book value that was not
previously depreciated:

On the other hand, an asset may be disposed of by sale, in which case the journal entry would need to
be modified to include the proceeds of the sale. Assume the above asset was sold for $10,000. The
entry would be as follows:

While the journal entry alone might be sufficient to demonstrate the loss calculation, one might also
consider that an asset with a $25,000 net book value is being sold for $10,000. This gives rise to the
loss of $15,000.
Conversely, what if this asset were sold for $30,000? In that case, the asset having a $25,000 net
book value is converted to $30,000 cash. This triggers a $5,000 gain. Simply stated a $30,000 asset
replaces an asset that was reported at $25,000. Following is the entry for that scenario:

Accounting For Asset Exchanges


Sometimes a new car purchase is accompanied by a trade in of an old car. This would be a
classic exchange transaction. In business, equipment is often exchanged (e.g., an old copy machine
for a new one). Sometimes land is exchanged. Exchanges can be motivated by tax rules because
neither company may be required to recognize a taxable event on the exchange. The result could be
quite different if the asset was sold for cash. Whatever the motivation behind the transaction, the
accountant is pressed to measure and report the event.

COMMERCIAL SUBSTANCE
Exchanges that have commercial substance (future cash flows are expected to change) should be
accounted for at fair value. Various scenarios are illustrated in the following examples. Recognize that
some exchanges may lack commercial substance. For example, two companies may swap inventory
and neither expects a significant change in cash flows because of the trade. Gains are not recorded on
exchanges lacking commercial substance and are typically illustrated in more advanced courses.

FAIR VALUE APPROACH


The fair value approach for exchanges having commercial substance will ordinarily result in recognition
of a gain or loss because the fair value will typically differ from the recorded book value of a swapped
asset. There is deemed to be a culmination of the earnings process when assets are exchanged. In
other words, one productive component is liquidated and another is put in its place. The following
examples illustrate exchange transactions for scenarios involving both losses and gains.
EXAMPLE A: LOSS IMPLIED
Company A gives an old truck ($1,000,000 cost, $750,000 accumulated depreciation) for a
boat. The fair value of the old truck is $150,000 (which is also deemed to be the fair value
of the boat).

The boat should be recorded at fair value. Because this amount is less than the net book value of the
old truck, a loss is recorded for the difference:

EXAMPLE B: GAIN IMPLIED


Company A gives an old truck ($1,000,000 cost, $750,000 accumulated depreciation) for a
boat. The fair value of the old truck is $350,000 (which is also deemed to be the fair value
of the boat).

The boat should be recorded at fair value. Because this amount is more than the net book value of the
old truck, a gain is recorded for the difference:

BOOT
Exchange transactions are oftentimes accompanied by giving or receiving boot. Boot is the term used
to describe additional monetary consideration that may accompany an exchange transaction. Its
presence only slightly modifies the preceding accounting by adding one more account (typically Cash)
to the journal entry.
EXAMPLE C: BOOT GIVEN
Company A gives an old truck ($1,000,000 cost, $750,000 accumulated depreciation) and
$50,000 cash for a boat. The fair value of the old truck is $100,000. The fair value of the
boat is $150,000.

Notice that the following entry has an added credit to Cash reflecting the additional consideration. The
loss is $150,000. The loss is the balancing amount, and reflects that $300,000 of consideration (cash
($50,000) and an old item of equipment ($1,000,000 - $750,000 = $250,000)) was swapped for an
item worth only $150,000. Had boot been received, Cash would have instead been debited (and a
smaller loss, or possibly a gain, would be recorded to balance the entry).

Asset Impairment
When the carrying amount of a long-lived asset (or group of assets) is not recoverable from expected
future cash flows, an impairment has occurred. The owner of the asset no longer expects to be able
to generate returns of cash from the asset sufficient to recapture its recorded net book value. A loss is
recognized for the amount needed to reduce the asset to its fair value (i.e., debit loss and credit the
asset). The downward revised carrying value will be depreciated over its
remaining estimated life.
Measurements of impairment involve subjective components and judgment. These factors should be
taken into consideration: significant decrease in market value, physical condition has declined

unexpectedly, the asset is no longer used as intended, legal or regulatory issues have impeded the
asset, the overall business seems threatened by unsuccessful performance, and so forth. In addition,
the specific methods for determining if an impairment has occurred vary globally. While the USA
approach focuses first on cash recovery, global standards look to a more restrictive fair value test.

Natural Resources
Oil and gas reserves, mineral deposits, thermal energy sources, and standing timber are just a few
examples of natural resource assets that a firm may own. There are many industry-specific
accounting measurements attributable to such assets.
As a general rule, natural resources are initially entered in
the accounting records at their direct cost plus logically related items like legal fees,
surveying costs, and exploration and development costs. Once the cost basis is
properly established, it must be allocated over the periods benefited through a
process known as depletion. Think of it this way: depletion is to a natural resource
as depreciation is to property, plant, and equipment.

DEPLETION
The cost of a natural resource (less expected residual value) is divided by the estimated units in the
resource deposit; the resulting amount is depletion per unit. If all of the resources extracted during a
period are sold, then depletion expense equals depletion per unit times the number of units extracted
and sold. If a portion of the extracted resources are unsold resources, then their cost (i.e., number of
inventory units times depletion per unit) should be carried on the balance sheet as inventory.
Assume that a mine site is purchased for $9,000,000, and another $3,000,000 is spent on developing
the site for production. Assume the site is estimated to contain 5,000,000 tons of the targeted ore. At
completion of the operation, the site will be water flooded and sold as a recreational lake site for an
estimated $2,000,000. The depletion rate is $2 per ton, as the following calculations show:

If 1,000,000 tons of ore are extracted in a particular year, the assigned cost would be $2,000,000. But
where does that cost go? If 750,000 tons are sold and the other 250,000 tons are simply held in
inventory of extracted material, then $1,500,000 would go to cost of goods sold and the other
$500,000 would go to the balance sheet as inventory. A representative entry follows:

EQUIPMENT USED TO EXTRACT NATURAL RESOURCES


Property, plant, and equipment used to extract natural resources must be depreciated over its useful
life. Sometimes the useful life of such PP&E is tied directly to the natural resource life, even though its
actual physical life is much longer. For example, if a train track is built into a mine, the track is of no
use once the mine closes (even though it could theoretically still carry a train for a much longer
period). As a result, the track would be depreciated over the life of the mine. Conversely, the train that
runs on the track can be relocated and used elsewhere; as such it would likely be depreciated over the
life of the train rather than the life of the mine.

Intangibles
The defining characteristic of an intangible asset is the lack of physical existence. Nevertheless, such
assets contribute to the earnings capability of a company. Examples include patents, copyrights,
trademarks, brands, franchises, and similar items.
A company may develop such items via ongoing business processes.
Globally, some internally developed intangibles are recognized where future benefits are clear and
measurable. The USA is far more restrictive, and self-created intangibles seldom appear on a balance
sheet.
On the other hand, intangibles may be purchased from another party. For example, one company may
need to utilize technology embedded in a patent right belonging to someone else. When intangibles
are purchased, the cost is recorded as an intangible asset. When a purchased intangible has
an identifiable economic life, its cost is amortized over that useful life (amortization is the term to
describe the allocation of the cost of an intangible, just as depreciation describes the allocation of the
cost of PP&E).
Some intangibles have an indefinite life and those items are not amortized. Instead, they are
periodically evaluated for impairment. If they are never found to be impaired, they will permanently
remain on the balance sheet. The unamortized/unimpaired cost of intangible assets is positioned in a
separate balance sheet section immediately following Property, Plant, and Equipment.

EXAMPLE
Assume that Mercury Pharmaceutical purchased a patent for $50,000, estimating its useful life to be
five years. The appropriate entries are:

Unlike PP&E, notice that the preceding annual amortization entry credits the asset account directly.
There is usually not a separate accumulated amortization account for intangible assets.

SOME SPECIFIC INTANGIBLES


Patents give their owners exclusive rights to use or manufacture a particular product. The cost of
obtaining a patent should be amortized over its useful life (not to exceed its legal life of 20 years). The
amount included in the Patent account includes the cost of a purchased patent and/or incidental costs
related to the registration and protection of a patent.
Copyrights provide their owners with the exclusive right to produce or sell an artistic or published
work. A copyright has a legal life equal to the life of the creator plus 70 years; the economic life is
usually shorter. The economic life is the period of time over which the cost of a copyright should be
amortized.
Franchises give their owners the right to manufacture or sell certain products or perform certain
services on an exclusive or semi-exclusive basis. The cost of a franchise is reported as an intangible
asset, and should be amortized over the estimated useful life.
Trademarks/brands/internet domains are another important class of intangible assets. Although these
items have fairly short legal lives, they can be renewed over and over. As such, they have indefinite
lives.
Goodwill is a unique intangible asset that arises out of a business acquisition. It reflects the excess of
the fair value of an acquired entity over the net of the amount assigned to assets acquired and
liabilities assumed. Such excess may be paid because of the acquired companys outstanding
management, earnings record, or other similar features. Goodwill is deemed to have an indefinite life,
but should be evaluated for impairment at least annually.

Current Liabilities
The current liabilities section of the balance sheet contains obligations that are due to be satisfied in
the near term, and includes amounts relating to accounts payable, salaries, utilities, taxes, short-term
loans, and so forth. This casual description is inadequate for all situations, so accountants have
developed a very specific definition to deal with more issues.

Current liabilities are debts that are due to be paid within one year or the operating
cycle, whichever is longer; further, such obligations will typically involve the use of
current assets, the creation of another current liability, or the providing of some
service.
This enhanced definition is expansive enough to capture less obvious obligations
pertaining to items like customer prepayments, amounts collected for and payable to
third parties, the portion of long-term debt due within one year or the operating cycle
(whichever is longer), accrued liabilities for expenses incurred but not yet paid, and
contingent liabilities. However, the definition is not meant to include amounts not yet
incurred. For example, salary to be earned by employees next year is not a current liability (this
year) because it has yet to be incurred. Investors, creditors, and managers should pay close
attention to current liabilities as they reflect imminent demands on resources.

THE OPERATING CYCLE


Remember from Chapter 4 that the operating cycle is the length of time it takes to turn cash back into
cash. That is, a business starts with cash, buys inventory, sells goods, and eventually collects the sales
proceeds in cash. The length of time it takes to do this is the operating cycle. Take careful note of how
the operating cycle is included in the above definition of current liabilities: one year or the operating
cycle, whichever is longer.
For most businesses, the operating cycle is less than one year, but not always. A furniture
manufacturer may have to buy and cure wood before it can be processed into a quality product. This
could cause the operating cycle to go beyond one year. If that is the case, then current liabilities might
include obligations due in more than one year.

TYPICAL CURRENT OBLIGATIONS


Accounts Payable are the amounts due to suppliers relating to the purchase of goods and services.
This is perhaps the simplest and most easily understood current liability. Although an account
payable may be supported by a written agreement, it is more typically based on an informal working
relation where credit has been received with the expectation of making payment in the very near
term.
Notes Payable are formal short-term borrowings usually evidenced by specific written promises to pay.
Bank borrowings, equipment purchases, and some credit purchases from suppliers involve such
instruments. The party who agrees to pay is termed the maker of the note. Properly constructed,
a note payable becomes a negotiable instrument, enabling the holder of the note to transfer it to
someone else. Notes payable typically involve interest, and their duration varies. When a note is due
in less than one year (or the operating cycle, if longer), it is commonly reported as a current liability.
The Current Portion of Long-term Debt is another frequently encountered current obligation. When a
note or other debt instrument is of long duration, it is reported as a long-term liability. However, the
amount of principal which is to be paid within one year or the operating cycle, whichever is longer,
should be separated and classified as a current liability. For example, a $100,000 long-term note may
be paid in equal annual increments of $10,000, plus accrued interest. At the end of any given year, the
$10,000 principal due during the following year should be reported as a current liability (along with
any accrued interest), with the remaining balance shown as a long-term liability.
Accrued Liabilities (sometimes called accrued expenses) include items like accrued salaries and wages,
taxes, interest, and so forth. These items relate to expenses that accumulate with the passage of time
but will be paid in one lump-sum amount. For example, the cost of employee service accrues gradually
with the passage of time. The amount that employees have earned but not been paid is termed
accrued salaries and should be reported as a current liability. Likewise, interest on a loan is based on
the period of time the debt is outstanding; it is the passage of time that causes the interest payable to

accrue. Accrued but unpaid interest is another example of an accrued current liability. The reported
accrued liabilities only relate to amounts already accumulated and not to
amounts that will arise later.
Prepayments by Customers arise from transactions such as selling magazine
subscriptions in advance, selling gift-cards, selling tickets well before a
scheduled event, and other similar items where the customer deposits money
in advance of receiving the expected good or service. These items represent
an obligation on the part of the seller to either return the money or deliver a service in the future. As
such, the prepayment is reported as unearned revenue within the current liability section of the
balance sheet. Recall, from earlier chapters, that the unearned revenue is removed and revenue is
recognized as the goods and services are provided.
Collections for Third Parties arise when the recipient of some payment is not the beneficiary of the
payment. As such, the recipient has an obligation to turn the money over to another entity. At first,
this may seem odd. But, consider sales taxes. The seller of merchandise must collect the sales tax on
transactions, but then has a duty to pass those amounts along to the appropriate taxing entity. Such
amounts are appropriately reflected as a current liability until the funds are remitted to the rightful
owner.
Obligations to be Refinanced deserve special consideration. A long-term debt
may have an upcoming maturity date within the next year. Ordinarily, this
note would be moved to the current liability section. However, companies
often renew such obligations, in essence, borrowing money to repay the
maturing note. Should currently maturing long-term debt that is subject to
refinancing be shown as a current or a long-term liability? To resolve this issue, accountants have
developed very specific rules. A currently maturing long-term obligation is to be shown as a current
liability unless (1) the company intends to renew the debt on a long-term basis and (2) the company
has the ability to do so (ordinarily evidenced by a firm agreement with a competent lender).

Notes Payable
Long-term notes will be considered in the next chapter. For the moment, focus on the appropriate
accounting for a short-term note. A common scenario would entail the borrowing of money in
exchange for the issuance of a promissory note payable. The note will look
something like this:

The preceding illustration should not be used as a model for constructing a legal document; it is
merely an abbreviated form to focus on the accounting issues. A correct legal form would typically be
far more expansive and cover numerous things like what happens in the event of default, who pays
legal fees if there is a dispute, requirements of demand and notice, and so forth. In the preceding
note, Oliva has agreed to pay to BancZone $10,000 plus interest of $400 on June 30, 20X8. The
interest represents 8% of $10,000 for half of a year (January 1 through June 30).
The amount borrowed is recorded by debiting Cash and crediting Notes Payable:

When the note is repaid, the difference between the carrying amount of the note and the cash
necessary to repay that note is reported as interest expense. The journal entry follows:

Had the above note been created on October 1, the entries would appear as follows:

In the preceding entries, notice that interest for three months was accrued at December 31,
representing accumulated interest that must be paid at maturity on March 31, 20X9. On March 31,
another three months of interest was charged to expense. The cash payment included $400 for
interest, half relating to the amount previously accrued in 20X8 and half relating to 20X9.
Next, consider how the preceding amounts would appear in the current liability section of the balance
sheet at December 31, 20X8. Observe the inclusion of two separate line items for the note and related
interest:

In examining this illustration, one might wonder about the order in which specific current obligations
are to be listed. One scheme is to list them according to their due dates, from the earliest to the
latest. Another acceptable alternative is to list them by maturity value, from the largest to the
smallest.

INTEREST CALCULATION
Some short-term borrowing agreements may stipulate that a year is assumed to have 360 days,
instead of the obvious 365 days. In the old days, before calculators, this could perhaps be justified to
ease calculations. In modern days, it may be that a lender is seeking to prey on unsuspecting
borrowers. For example, interest on a $100,000, 8% loan for 180 days would be $4,000 assuming a

360-day year ($100,000 X .08 X 180/360), but only $3,945 based on the more correct 365-day year
($100,000 X .08 X 180/365). It becomes apparent that one should be alert to the stated assumptions
intrinsic to a loan agreement.
Next, be aware of the rule of 78s. Some loan agreements stipulate that prepayments will be based
on this tricky technique. A year has 12 months, and 12 + 11 + 10 + 9 + . . . + 1 = 78; somehow
giving rise to the rule of 78s. Assume that $100,000 is borrowed for 12 months at 8% interest. The
annual interest is $8,000, but, if the interest attribution method is based on the rule of 78s, it is
assumed that 12/78 of the total interest is attributable to the first month, 11/78 to the next, and so
forth. If the borrower desired to prepay the loan after just two months, that borrower would be very
disappointed to learn that 23/78 (12 + 11 = 23) of the total interest was due (23/78 X $8,000 =
$2,359). If the interest had been based simply on 2 of 12 months, the amount of interest would come
to only $1,333 (2/12 X $8,000 = $1,333).
Compounding is another concept that should be understood. So far in this text, simple interest has
been used in the illustrated calculations. This merely means that Interest = Loan X Interest Rate X
Time. But, at some point, it is fair to assume that the accumulated interest will also start to accrue
interest. Some people call this interest on the interest. In the next chapter, this will be examined in
much more detail. For the moment, just take note that a loan agreement will address this by stating
the frequency of compounding. Compounding can occur annually, quarterly, monthly, daily, and even
continuously (which requires a bit of calculus to deduce). The narrower the frequency, the greater the
amount of total interest that will be calculated.
One last item is to note that a lender might take their interest up front. The note may be issued with
interest included in the face value. For example, $9,000 may be borrowed, but a $10,000 note is
established (interest is not separately stated). At maturity, $10,000 is repaid, representing a $9,000
repayment of borrowed amounts and $1,000 interest. Note that the interest rate may appear to be
10% ($1,000 out of $10,000), but the effective rate is much higher ($1,000 for $9,000 = 11.11%).
The journal entry to record a note with interest included in face value (also known as a note issued at
discount), is as follows:

Observe that the $1,000 difference is initially recorded as a discount on note payable. On a balance
sheet, the discount would be reported as contra liability. The $1,000 discount would be offset against
the $10,000 note payable, resulting in a $9,000 net liability.
Discount amortization transfers the discount to interest expense over the life of the loan. This means
that the $1,000 discount should be recorded as interest expense by debiting Interest Expense and
crediting Discount on Note Payable. In this way, the $10,000 paid at maturity (credit to Cash) can be
offset with a $10,000 reduction in the Note Payable account (debit).
The entries to record at maturity are as follows:

Be aware that discount amortization occurs not only at the date of repayment, but also at the end of
an accounting period. If the preceding example had a maturity date at other than the December 31
year-end, the $1,000 of interest expense would need to be recorded partially in one period and
partially in another.

TRUTH IN LENDING
The preceding discussion about unique interest calculations sheds light on the mechanics that lenders
can use to tilt the benefit of a lending agreement to their advantage. As a result, statutes have
increasingly required fuller disclosure (truth in lending) and, in some cases, outright limits on certain
practices.
Borrowers should be careful to understand the full economics of any agreement, and lenders should
understand the laws that define fair practices. Lenders who overcharge interest or violate laws can
find themselves legally losing the right to collect amounts loaned.

Contingent Liabilities
Some events may eventually give rise to a liability, but the timing and amount is not presently sure.
Such uncertain or potential obligations are known as contingent liabilities. There are numerous
examples of contingent liabilities. Legal disputes give rise to contingent liabilities, environmental
contamination events give rise to contingent liabilities, product warranties give rise to contingent
liabilities, and so forth.
Do not confuse these firm specific contingent liabilities with general
business risks. General business risks include the risk of war, storms, and the like that are presumed
to be an unfortunate part of life for which no specific accounting can be made in advance.

ACCOUNTING FOR CONTINGENT LIABILITIES


A subjective assessment of the probability of an unfavorable outcome is required to properly account
for most contingences. Rules specify that contingent liabilities should be recorded in the accounts
when it is probable that the future event will occur and the amount of the liability can bereasonably
estimated. This means that a loss would be recorded (debit) and a liability established (credit) in
advance of the settlement.

An example might be a hazardous waste spill that


will require a large outlay to clean up. It is probable
that funds will be spent and the amount can likely
be estimated. If the estimated loss can only be
defined as a range of outcomes, the USA approach
generally results in recording the low end of the
range. International accounting standards focus on
recording a liability at the midpoint of the estimated
unfavorable outcomes.
On the other hand, if it is only reasonably possible that the contingent liability will become a real
liability, then a note to the financial statements is required. Likewise, a note is required when it is
probable a loss has occurred but the amount simply cannot be estimated. Normally, accounting tends
to be very conservative (when in doubt, book the liability), but this is not the case for contingent
liabilities. Therefore, one should carefully read the notes to the financial statements before investing
or loaning money to a company.
There are sometimes significant risks that are simply not in the liability section of the balance sheet.
Most recognized contingencies are those meeting the rather strict criteria of probable and
reasonably estimable. One exception occurs for contingencies assumed in a business acquisition.
Acquired contingencies are recorded based on an estimate of actual value.
What about remote risks, like a frivolous lawsuit? Remote risks need not be disclosed; they are viewed
as needless clutter. What about business decision risks, like deciding to reduce insurance coverage
because of the high cost of the insurance premiums? GAAP is not very clear on this subject; such
disclosures are not required, but are not discouraged. What about contingent assets/gains, like a
companys claim against another for patent infringement? Such amounts are almost never recognized
before settlement payments are actually received.

TIMING OF EVENTS
If a customer was injured by a defective product in Year 1 (assume the company anticipates a large
estimated loss from a related claim), but the company did not receive notice of the event until Year 2
(but before issuing Year 1s financial statements), the event would nevertheless impact Year 1 financial
statements. The reason is that the event (the injury itself) giving rise to the loss arose in Year 1.
Conversely, if the injury occurred in Year 2, Year 1s financial statements would not be adjusted no
matter how bad the financial effect. However, a note to the financial statements may be needed to
explain that a material adverse event arising subsequent to year end has occurred.

WARRANTY COSTS
Product warranties are presumed to give rise to a probable liability that can be estimated. When goods
are sold, an estimate of the amount of warranty costs to be incurred on the goods should be recorded
as expense, with the offsetting credit to a Warranty Liability account. As warranty work is
performed, the Warranty Liability is reduced and Cash (or other resources used) is credited. In this
manner, the expense is recorded in the same period as the sale (matching principle). Following are
illustrative entries for warranties. In reviewing these entries, note the accompanying explanations:

The warranty calculations can require consideration of beginning balances, additional accruals, and
warranty work performed. Assume Zeff Company had a beginning-of-year Warranty Liability account
balance of $25,000. During the year Zeff sells $3,500,000 worth of goods, eventually expecting to
incur warranty costs equal to 2% of sales ($3,500,000 X 2% = $70,000). The 2% rate is an estimate
based on the best information available. Such rates vary considerably by company and product.
$80,000 was actually spent on warranty work. How much is the end-of-year Warranty Liability? The Taccount reveals an ending warranty liability
of $15,000.
Many costs are similar to warranties.
Companies may offer coupons, prizes,
rebates, air-miles, free hotel stays, free
rentals, and similar items associated with
sales activity. Each of these gives rise to
the need to provide an estimated liability.
While the details may vary, the basic
procedures and outcomes are similar to those applied to warranties.

Payroll
Many services are provided to a business by other than employees. These services may include
janitorial support, legal services, air conditioner repairs, audits, and so forth. An independent
contractor is one who performs a designated task or service for a company. The company has the
right to control or direct only the result of the work done by an independent contractor. In contrast,
an employee is defined as a person who works for a specific business and whose activities are
directed by that business. The business controls what will be done and how it will be done. The
distinction is very important, because the payroll tax and record keeping requirements differ for
employees and independent contractors. As a general rule, amounts paid to independent contractors
do not involve any tax withholdings by the payer. However, the payer may need to report the
amount paid to the Internal Revenue Service (IRS) on a Form 1099, with a copy to the independent
contractor. But, the obligation for paying taxes rests with the independent
contractor.
The employers handling of payroll to employees is another matter entirely. Begin by considering the
specifics of a paycheck. Paychecks are usually reduced by a variety of taxes, possibly including federal
income tax, state income tax, social security taxes, and medicare/medicaid. Additional reductions can

occur for insurance, retirement savings, charitable contributions, special health and child care
deferrals, and other similar items. Employers may also pay costs related to social security,
medicare/medicaid, unemployment taxes, workers compensation insurance, matching contributions to
retirement programs, and other items.

GROSS VS. NET EARNINGS


The total earnings of an employee is the gross pay. For hourly employees, it is the number of hours
worked multiplied by the hourly rate. For salaried employees, it is the flat amount for the period, such
as $3,000 per month. Gross pay might be increased for both hourly and salaried employees based on
applicable overtime rules. Employers are well advised to monitor statutes relating to overtime; by law,
certain employees must be paid for overtime. Gross earnings less all applicable deductions is the net
pay.

DEDUCTIONS
Income taxes are required to be withheld by federal, state (when applicable), and city (when
applicable) governments. The withheld income taxesmust be remitted periodically to the government
by the employer. In essence, the employer becomes an agent of the government, serving to collect
amounts for the government. Withheld amounts that have yet to be remitted to the government are
carried as a current liability on the employers books (recall the earlier mention of amounts collected
for third parties). The level of withholdings is based on the employees level of income, the frequency
of pay, marital status, and the number of withholding allowances claimed (based on the number of
dependents). Employees claim withholding allowances by filing a form W-4 with their employer.
Social Security/Medicare Taxes are also known as FICA. FICA stands for Federal Insurance
Contributions Act. This Act establishes a tax that transfers money from workers to aged retirees (and
certain other persons who are in the unfortunate position of not being able to fully provide for
themselves due to disability, loss of a parent, or other serious problem). The social purpose of the tax
is to provide a modest income stream to the beneficiaries. This component is the social security tax.
Another component of the Act is the medicare/medicaid tax, which provides support for health care
costs incurred by retirees (and designated others).
The social security tax is presently a designated percentage of income, up to a certain maximum level
of annual income per employee. For illustrative purposes, assume a 6% social security tax, on an
annual income of $100,000. In the following pay stub, note that I. M. Fictitious paid $180 in social
security tax for the month (6% X $3,000). Since Fictitious has not yet exceeded $100,000 in gross
income for the year-to-date, the annual maximum has not been reached. If Fictitious exceeds the
annual limit, the tax would cease to be withheld for the remainder of the calendar year. The
employees amount must be matched by the employer. Thus, the burden associated with this tax is
actually twice what is apparent to most employees.
The medicare/medicaid tax is also a designated percentage of income. Unlike the social security tax,
there is no annual maximum. This tax is levied on every dollar of gross income, without regard to an
employees total earnings. In the following illustration, the assumed rate is 1.5% (1.5% X $3,000 =
$45). This is another tax the employer must match dollar-for-dollar.
Other Employee Deductions can occur for employee cost sharing in health care insurance programs,
employee contributions to various retirement or other savings plans, charitable contributions,
contributions to tax-advantaged health and child care savings programs, and so forth. In each case,
the employer is acting to collect amounts from the employee, with a resulting fiduciary duty to turn
the monies over to another entity. A representative paycheck and the attached stub follows. Examine
the check and notice that I. M. Fictitious earned $3,000 during the month but took home only
$1,834.

JOURNAL ENTRY FOR PAYROLL


The journal entry to record I.M. Fictitious's pay would be as follows. Carefully match the amounts in
the journal entry to the amounts on the pay stub.

Although not illustrated, as the company remits the withheld amounts to the appropriate entities (i.e.,
taxes to the government, retirement contributions to an investment trust, etc.), it would debit the
related payable and credit Cash.

EMPLOYER COSTS
Recall that the amount of social security and medicare/medicaid tax must be matched by employers.
In addition, the employer must pay federal and state unemployment taxes. These taxes are levied to
provide funds that are paid to workers who are actively seeking but unable to find regular
employment.
The bulk of unemployment tax is usually levied at the state level since most states choose to
administer their own unemployment programs (which is encouraged by the federal government via a
system of credits to the federal tax rate). The specific rates will depend on the particular state of
employment and each individual employers history. Employers who rarely lay off or fire employees get
a favorable rate, but those who do not maintain a stable labor pool will find their rates adjusted to a
higher level.
Like social security, the unemployment tax stops each year once a certain maximum income level is
reached. In this text, assume the federal rate is one-half of one percent (0.5%), and the state rate is
three percent (3%), on a maximum income of $10,000 per employee. Thus, assume the federal
unemployment tax (FUTA) is capped at $50 per employee and the state unemployment tax (SUTA) is
capped at $300.
Many employers will carry workers compensation insurance. The rules for this type of insurance
vary from state to state. Generally, this type of insurance provides for payments to workers who
sustain on-the-job injuries and shields the employer from additional claims. But, for companies that do
not carry such insurance, the employer may have an unlimited exposure to claims related to work
place injuries. The cost of this insurance can be very high for risky work, like construction.
Many employers will provide health care insurance and retirement plan contributions. These amounts
can also be substantial, perhaps even exceeding the amounts contributed by employees on their own
behalf.
Obviously, the employers cost of an employee goes well beyond the amount reported on the pay
check. For many companies, the total cost of an employee can be 125% to 150% of the gross
earnings. Of course, these added costs also need to be entered in the accounting records.

In preparing the entry it is assumed that (a) FUTA and SUTA bases had already been exceeded earlier
in 20XX (hence the related amounts are zero), (b) the employer exactly matched employee
contributions to insurance and retirement programs, and (c) the employer incurred workers'
compensation insurance of $300. Following is the entry for I. M. Fictitious:

ANNUAL REPORTS
Shortly after the conclusion of a calendar year, an employer must review its employee records and
prepare a summary wage and tax statement (commonly called a W-2). This information is furnished
to each employee and the government. It helps employees accurately prepare their own annual
federal and state income tax returns and allows the government to verify amounts reported by those
individual taxpayers.

ACCURATE PAYROLL SYSTEMS


Accuracy is vital in payroll accounting. Oftentimes, a business may hire an outside firm that specializes
in payroll management and accounting. The outside firm manages the payroll, recordkeeping,
government compliance, timely processing of tax deposits, and the like.
When a business manages its own payroll, very accurate data must be maintained. Most firms will set
up a separate payroll journal or database that tracks information about each employee, as well as in
the aggregate. In addition, it is quite common to open a separate payroll bank account into which the
gross pay is transferred and from which paychecks and tax payments are disbursed. This system
provides an added control to make sure that employee funds are properly maintained, processed, and
reconciled.
It is very important to know that the employers obligation to protect withheld taxes and make certain
they are timely remitted to the government is taken very seriously. Employers who fail to do so are
subject to harsh penalties for the obvious reason that the funds do not belong to the employer.
Likewise, employees who participate in, or are aware of misapplication of such funds can expect
serious legal repercussions. The government has made it very simple for employers to remit withheld
amounts, as most commercial banks are approved to accept such amounts from employers. Online
systems also allow easy funds transfer. The frequency of the required remittance is dependent upon
the size of the employer and the total payroll.

Other Components Of Employee Compensation

Paid vacations are another element of compensation that many employees receive. In addition to paid
vacations, employers may provide for other periods of compensated absences. Examples include
sick leave, holidays, family emergency time, jury duty time, military reserve time, and so forth.
Sometimes, these benefits accumulate with the passage of time, so that the benefit is a function of
tenure with the company. To illustrate, a company may stipulate that one half-day of sick leave and
one day of vacation time is accrued for each month of
employment.
Because the cost of periods of compensated absence can become quite significant, it
is imperative that such amounts be correctly measured and reported. Accounting
rules provide that companies expense (debit) and provide a liability (credit) for such
accumulated costs when specified conditions are present. Those conditions are that
the accumulated benefit (1) relates to services already rendered, (2) is a right that
vests or accumulates, (3) is probable to be paid to the employee, and (4) can be
reasonably estimated. Vacation pay typically meets these conditions for accrual, while
other costs depend upon the individual companys policies and history.

PENSION PLANS
It is common for a company to offer some form of retirement plan for its employees. Begin by noting
that there are two broad types of pensions: defined contribution plans and defined benefit plans.
With a defined contribution plan, an employer promises to make a periodic contribution (usually a
set percentage of the employees salary with some matching portion also provided by the employee)
into a separate pension fund account. After a minimum vesting period, the funds become the property
of the employee for his or her benefit once they enter retirement. Prior to withdrawal, the funds might
be invested in stocks, bonds, or other approved investments. The employee will receive the full benefit
of the funds and the investment returns, usually withdrawing them gradually
after retirement.
Defined contribution plans offer an important desirable feature for
employers, in that their obligation is known and fixed. Further, the employer
ordinarily gets a tax deduction for its contribution, even though the
employee does not recognize that contribution as taxable income until
amounts are withdrawn from the pension many years later. The company expenses the required
periodic contribution as incurred. No further accounting on the corporate books is necessitated. The
pension assets and obligations are effectively transferred to a separate pension trust, greatly
simplifying the recordkeeping of the employer.
In stark contrast are defined benefit plans. With these plans the employers promise becomes more
elaborate and its cost far more uncertain. For example, a company may offer annual pension
payments equal to 2% per year of service times the final annual salary. So, a person who works 30
years and then retires may be eligible for continuing pay at 60% of his or her annual salary. These
plans are fraught with uncertainty. How long will retirees live and draw benefits, how many years will
employees work, how much will the annual salary be, and so on?
Actuaries are persons trained and skilled to make assessments about life expectancy and related
workforce trends. They prepare estimates that are used by accountants to calculate annual pension
expense for a defined benefit plan. Matching concepts expense this cost during the periods of active
employee service, rather than periods of retirement. Some or all of the annual expense is funded by a
transfer of money into a pension trust fund. Those funds are invested and eventually disbursed to
retirees, but the company remains obligated for any shortfalls in the pension trust. If a company has
failed to fund all the amounts expensed to date, or if the pension fund is underfunded relative to
outstanding pension promises made, a pension liability is reported on the balance sheet. But, the bulk
of the pension assets and obligations are carried on the books of the separate pension trust fund.
Because of reporting complexities and actuarial risks, defined benefit pension plans are becoming less
common.

OTHER POST-RETIREMENT BENEFITS


Some companies provide retirees with health care coverage, prescription benefits, and life insurance.
Matching principles again dictate that such costs be expensed during the period of time during which
the employee is actively working to have these rights vest. As a result, companies will expense the
estimated cost of post-retirement benefits over many years, creating an offsetting liability on the
balance sheet.

Long-Term Notes
Prior chapters illustrated notes payable of short duration. However, a borrower may desire a longer
term for a loan. It would be common to find two-, three-, five-year, and even longer term notes.
These notes may evidence a term loan, where interest only is paid during the period of borrowing
and the balance of the note is due at maturity. To illustrate, assume that a $10,000, five-year, 8%
term note, is issued on October 1, 20X3 :

Interest on the note must be accrued each December 31, with payment following on September 30.

The following entry is needed at maturity on September 30, 20X8:

OTHER TYPES OF NOTES


With the term note illustration, it is easy to calculate interest of $800 per year, and observe the
$10,000 balance due at maturity. Other loans may require level payments over their terms, so that
the interest and principal are fully paid by the end of the loan. This type of arrangement is commonly
used for real estate financing. The payment of the note is usually secured by the property, allowing
the lender to take possession for nonpayment. Real estate notes thus secured are called mortgage
notes. How are payments calculated? The first step is to learn about future value and present value
calculations.

FUTURE VALUE
Begin by thinking about how invested money can grow with interest. What will be the future value of
an investment? If $1 is invested for one year, at 10% interest per year, it will grow to $1.10. This is
calculated by multiplying the $1 by 10% ($1 X 10% = $0.10) and adding this $0.10 to the original
dollar.
And, if the resulting $1.10 is invested for another year at 10%, it will grow to $1.21. That is, $1.10 X
10% = $0.11, which is added to the $1.10 value from the end of the first year. This process will
continue year after year. The annual interest each year is larger than the year before because of
compounding.
Compounding simply means that the investment is growing with accumulated interest and earning
interest on previously accrued interest. The contrast to compound interest is simple interest.
Simple interest does not provide for compounding, such that $1 invested for two years at 10% would
only grow to $1.20.
The preceding observations lead to this compound interest calculation:

(1+i)n
Where i is the interest rate per period and n is the number of periods
This calculation reveals
invested for 5 years at
$1,000 was invested for
the derived factor times
aptly termed the future

how much an investment of $1 will grow to after n periods. If $1 was


6%, then it would grow to about $1.34 [(1.06) 5 = 1.33823]. Of course, if
5 years at 6%, it would grow to $1,338.23; this is determined by multiplying
the amount invested at the beginning of the 5-year period. This calculation is
value of a lump sum amount.

Future value amounts can always be calculated using the preceding formulation. However, spreadsheet
software and business calculators frequently include built-in routines to return appropriate values.
Another useful tool is a future value table (see principlesofaccounting.com supplements). These tables
include values corresponding to various rates and periods. Use a table, spreadsheet, or business

calculator to verify the 1.33823 factor for a 5-period, 6% investment. Likewise, determine that
$5,000, invested for 10 years, at 4%, will grow to $7,401.20 ($5,000 X 1.48024).

PRESENT VALUE
Present value is the opposite of future value, as it reveals how much a dollar to be received in the
future is worth today. The math is simply the reciprocal of future value calculations:

1/(1+i)n
Where i is the interest rate per period and n is the number of periods
For example, $1,000 to be received in 5 years, when the interest rate is 7%, is presently worth
$712.99 [$1,000 X (1/(1.07)5)]. Stated differently, if $712.99 is invested today, it will grow to $1,000
in 5 years. Present value amounts are also determinable from spreadsheets, calculators, or tables.
Verify that the present value of $50,000 to be received in 8 years at 8% is $27,013.50 ($50,000 X .
54027).

ANNUITIES
Streams of level payments (i.e., the same amount each period) occurring on regular intervals are
termed annuities. For example, if one invests $1 at the beginning of each year at 5% per annum,
after 5 years it would accumulate to $5.80. This can be painstakingly calculated by summing the
future value amount associated with each individual payment, as shown in the following calculations.

But, it is much easier to use spreadsheets, calculators, or annuity future value tables. The annuity
table is simply the summation of individual factors. Verify the 5.80 factor from the 5% row, 5-year
column of a table. These calculations are useful in financial planning. For example, one may wish to
have a target amount accumulated by a certain age, such as with a retirement account. These factors
help calculate the amount that must be set aside each period to reach the goal.
Conversely, one may be interested in the present value of an annuity which reveals the current worth
of a level stream of payments to be receivedat the end of each period. Use a table, calculator, or
spreadsheet to find the present value of $1,000 to be received at the end of each year for 5 years, if
the interest rate is 8% per year. The 5-year column, 8% row of the appropriate table shows a factor of
3.99271, indicating that the present value of the annuity is $3,992.71.

NOTE PAYMENTS

How does one compute the payment on a typical loan that involves level periodic payments, with the
final payment satisfying the remaining balance due? The answer to this question is found in the
present value of annuity calculations. Remember that an annuity involves a stream of level payments,
just like many loans. The payments on a loan are a series of level payments that cover both the
principal and interest. The present value of those payments is the amount borrowed, in essence
discounting out the interest component. This concept may still be a bit abstract, but can be further
clarified with some equations:

Present Value of Annuity = Payments X Annuity Present


Value Factor
A loan that is paid off with a series of equal payments is also an annuity, therefore:

Loan Amount = Payments X Annuity Present Value Factor


Thus, to determine the annual payment to satisfy a $100,000, 5-year loan at 6% per annum:

$100,000 = Payment X 4.21236 (from table)


Payment = $100,000 / 4.21236 = $23,739.64
The five payments of $23,739.64 will exactly pay off the $100,000 loan plus all interest. Simply
stated, the payments on a loan are just the loan amount divided by the appropriate present value
factor. To fully prove this point, look at the following typical loan amortization table. This table shows
how each payment is applied to first satisfy the accumulated interest for the period, and then reduce
the principal. Note that the final payment will extinguish the remaining principal.

The journal entries associated with the preceding loan would flow as follows:

A FEW FINAL COMMENTS ON FUTURE AND PRESENT VALUE


Note that some scenarios may involve payments at the beginning of each period, while other scenarios
might require end-of-period payments. Later chapters of this book include additional future and
present value calculations for alternatively timed payment streams (e.g., present value of an annuity
with payments at the beginning of each period).
Also note that payments may occur on other than an annual basis. For example, a $10,000, 8% per
annum loan may involve quarterly payments over two years. The quarterly payment would be
$1,365.10 ($10,000/7.32548). The 7.32548 present value factor is reflective of 8 periods (4 quarters
per year for 2 years) and 2% interest per period (8% per annum divided by 4 quarters per year). This
type of modification applies to annuities and lump-sum amounts. For example, the present value of $1

invested for 5 years at 10% compounded semiannually can be determined by referring to the 5% row,
10-period factor.
As previously noted, spreadsheet software normally includes functions to help with fundamental
present value, future value, and payment calculations. Following is a screen shot of one such routine:

Bonds Payable
Bonds payable result when a borrower splits a large loan into many small units. Each of these units
(or bonds) is essentially a note payable. Investors will buy these bonds, effectively making a loan to
the issuing company. Bonds were introduced, from an investors perspective,
in Chapter 9.
The terms of a bond issue are specified in a bond indenture. In addition to making representations
about the interest payments and life of the bond, the indenture may also address questions such as:

Are the bonds secured by specific assets pledged as collateral to insure payment? If not, the
bonds are said to be debenture bonds, meaning they do not have specific collateral but are
only as good as the general faith and credit of the issuer.

What is the preference in liquidation in the event of failure? Agreements may provide that
some bonds are paid before others.

To whom and when is interest paid? In the past, some bonds were coupon bonds, and those
bonds literally had detachable interest coupons that could be stripped off and cashed in on
specific dates. One reason for coupon bonds was to ease the record keeping burden on bond
issuers. Companies merely issued coupons that were turned in for redemption.
However, in recent times, most bonds are registered to an owner. Computerized information
systems now facilitate tracking bond owners, and interest payments are commonly

transmitted electronically to the registered owner. Registered bonds are in contrast


to bearer bonds,where the holder of the physical bond instrument is deemed to be the owner
(bearer bonds are rare in todays economy).

Must the company maintain a required sinking fund? A sinking fund bond may sound bad,
but it is actually not. In the context of bonds, a sinking fund is a required account into which
monies are periodically transferred to insure that funds will be available at maturity to satisfy
the obligation.

Some companies will issue serial bonds. Rather than the entire issue maturing at once,
portions of the serial issue will mature on select dates spread over time.

Can the bond be converted into stock? Convertible bonds enable the holder to exchange the
bond for a predefined number of shares of corporate stock. The holder may plan to be paid the
interest plus face amount of the bond, but if the companys stock explodes upward in value,
the
holder
may
benefit
by
trading
the
bonds
for
appreciated
stock.
Why would a company issue convertibles? First, investors may prefer these securities and are
usually willing to accept lower interest rates than must be paid on bonds that are not
convertible. Another factor is that the company may contemplate its stock going up; by
initially borrowing money and later exchanging the debt for stock, the company may actually
get more money for its stock than it would have had it issued the
stock on the earlier date.

and

can

Is the company able to call the debt? Callable bonds provide a


company with the option of buying back the debt at a prearranged
price before its scheduled maturity. If interest rates go down, the
company may not want to be saddled with the higher cost obligations
escape
the
obligation
by
calling
the
debt.

Sometimes, bonds cannot be called. For example, suppose a company is in financial distress
and issues high interest rate debt (known asjunk bonds) to investors who are willing to take
a chance to bail out the company. If the company is able to manage a turn-around, the
investors who took the risk and bought the bonds dont want to have their high yield
stripped away with an early payoff before scheduled maturity.

Bonds that cannot be paid off earlier are sometimes called nonredeemable. Be careful not to
confuse nonredeemable with nonrefundable.Nonrefundable bonds can be paid off early, so
long as the payoff money is coming from operations rather than an alternative borrowing
arrangement. Some specialized securities may be legally structured as equity instruments, but
nonetheless possess mandatory redemption features. These attributes make the securities
more like long-term debt and the accounting should mirror this economic substance.
Note that convertible bonds will almost always be callable, enabling the company to force a
bond holder to either cash out or convert. The company will reserve this call privilege because
they will want to stop paying interest (by forcing the holder out of the debt) once the stock
has gone up enough to know that a conversion is inevitable.

Bonds are potentially complex financial instruments. Who enforces all of the requirements for a
companys bond issue? Within the bond indenture agreement should be a specified bond trustee. This
trustee may be an investment company, law firm, or other independent party. The trustee is to
monitor compliance with the terms of the agreement and has a fiduciary duty to intervene to protect
the investor group if the company runs afoul of its covenants.

Accounting For Bonds Payable


A bond payable is just a promise to pay a series of payments over time (the interest component) and
a fixed amount at maturity (the face amount). Thus, it is a blend of an annuity (the interest) and lump
sum payment (the face). To determine the amount an investor will pay for a bond, therefore, requires
present value computations to determine the current worth of the future payments. Assume that
Schultz Company issues 5-year, 8% bonds. Bonds frequently have a $1,000 face value and pay
interest every six months. Using these assumptions, consider the following
three alternative scenarios:

The following table shows calculations of the price of the bond under different scenarios:

To further explain, the interest amount on the $1,000, 8% bond is $40 every six months. Because the
bonds have a 5-year life, there are 10 interest payments (or periods). The periodic interest is an
annuity with a 10-period duration, while the maturity value is a lump-sum payment at the end of the
tenth period. The 8% market rate of interest equates to a semiannual rate of 4%, the 6% market rate
scenario equates to a 3% semiannual rate, and the 10% rate is 5% per semiannual period.
The present value factors are taken from the present value tables (annuity and lump-sum,
respectively). Take time to verify the factors by reference to the appropriate tables, spreadsheet, or
calculator routine. The present value factors are multiplied by the payment amounts, and the sum of
the present value of the components would equal the price of the bond under each of the three
scenarios.
Note that the 8% market rate assumption produced a bond priced at $1,000, the 6% assumption
produced a bond priced at $1,085.30 (which includes an $85.30 premium), and the 10% assumption
produced a bond priced at $922.78 (which includes a $77.22 discount).
These calculations are not only correct theoretically, but are very accurate financial tools. However,
one point is noteworthy. Bond pricing is frequently to the nearest 1/32nd. That is, a bond might trade
at 103.08. One could easily misinterpret this price as $1,030.80. But, it actually means 103 and 8/32.
In dollars, this would amount to $1,032.50 ($1,000 X 103.25). Having learned the financial mechanics
of bonds, it is now time to examine the correct accounting.

BONDS ISSUED AT PAR


If Schultz issued 100 of its 5-year, 8% bonds at par, the following entries would be required :

BONDS ISSUED AT A PREMIUM


One simple way to understand bonds issued at a premium is to view the accounting relative to
counting money! If Schultz issues 100 of the 8%, 5-year bonds when the market rate of interest is
only 6%, then the cash received is $108,530 (see the previous calculations). Schultz will have to
repay a total of $140,000 ($4,000 every 6 months for 5 years, plus
$100,000 at maturity).
Thus, Schultz will repay $31,470 more than was borrowed ($140,000 - $108,530). This $31,470 must
be expensed over the life of the bond; uniformly spreading the $31,470 over 10 six-month periods
produces periodic interest expense of $3,147 (not to be confused with the actual periodiccash
payment of $4,000).
Another way to illustrate this problem is to note that total borrowing cost is reduced by the $8,530
premium, since less is to be repaid at maturity than was borrowed up front. Therefore, the $4,000
periodic interest payment is reduced by $853 of premium amortization each period ($8,530 premium
amortized on a straight-line basis over the 10 periods), also producing the periodic interest expense of
$3,147 ($4,000 - $853).
This topic is inherently confusing, and the journal entries are actually clarifying. Notice that the
premium on bonds payable is carried in a separate account (unlike accounting for investments in
bonds covered in a prior chapter, where the premium was simply included with the Investment in
Bonds account).

Study the following illustration, and observe that the Premium on Bonds Payable is established at
$8,530, then reduced by $853 every interest date, bringing the final balance to zero at maturity.

On any given financial statement date, Bonds Payable is reported on the balance sheet as a liability,
along with the unamortized Premium balance (known as an adjunct account). To illustrate, the
balance sheet disclosures would appear as follows on December 31, 20X3 and 20X4:

The income statement for all of 20X3 would include $6,294 of interest expense ($3,147 X 2). This
method of accounting for bonds is known as the straight-line amortization method, as interest
expense is recognized uniformly over the life of the bond. Although simple, it does have one
conceptual shortcoming. Notice that interest expense is the same each year, even though the net book
value of the bond (bond plus remaining premium) is declining each year due to amortization.
As a result, interest expense each year is not exactly equal to the effective rate of interest (6%) that
was implicit in the pricing of the bonds. For 20X1, interest expense can be seen to be roughly 5.8% of
the bond liability ($6,294 expense divided by beginning of year liability of $108,530). For 20X4,
interest expense is roughly 6.1% ($6,294 expense divided by beginning of year liability of $103,412).
Accountants have devised a more precise approach to account for bond issues called the effectiveinterest method. Be aware that the more theoretically correct effective-interest method is actually the
required method, except in those cases where the straight-line results do not differ materially.
Effective-interest techniques are introduced in a following section of this chapter.

BONDS ISSUED AT A DISCOUNT


If Schultz issues 100 of the 8%, 5-year bonds for $92,278 (when the market rate of interest is 10%),
Schultz will still have to repay a total of $140,000 ($4,000 every 6 months for 5 years, plus $100,000
at maturity). Thus, Schultz will repay $47,722 ($140,000 - $92,278) more than was borrowed.
Spreading the $47,722 over 10 six-month periods produces periodic interest expense of $4,772.20
(not to be confused with the periodiccash payment of $4,000).
Another way to consider this problem is to note that the total borrowing cost is increased by the
$7,722 discount, since more is to be repaid at maturity than was borrowed initially. Therefore, the
$4,000 periodic interest payment is increased by $772.20 of discount amortization each period
($7,722 discount amortized on a straight-line basis over the 10 periods), producing periodic interest
expense that totals $4,772.20.
Like bond premiums, discounts are also carried in a separate account. The following entry is needed to
record the initial bond issuance:

The following entries reflect periodic interest and repayment at maturity:

Carefully study this illustration, and observe that the Discount on Bonds Payable is established at
$7,722, then reduced by $772.20 on every interest date, bringing the final balance to zero at
maturity. On any given financial statement date, Bonds Payable is reported on the balance sheet as a
liability, along with the unamortized Discount that is subtracted (known as a contra account). The
illustration below shows the balance sheet disclosure as of June 30, 20X3. Note that the unamortized
discount on this date is determined by calculations revealed in the table that follows:

Each yearly income statement would include $9,544.40 of interest expense ($4,772.20 X 2). The
straight-line approach suffers from the same limitations discussed earlier, and is acceptable only if the
results are not materially different from those resulting with the effective-interest technique.

Effective-Interest Amortization Methods


The theoretically preferable approach to recording amortization is the effective-interest method.
Interest expense is a constant percentage of the bonds carrying value, rather than an equal dollar
amount each year. The theoretical merit rests on the fact that the interest calculation aligns with the
basis on which the bond was priced.
Interest expense is calculated as the effective-interest rate times the bonds
carrying value for each period. The amount of amortization is the difference between the cash paid for
interest and the calculated amount of bond interest expense.

PREMIUM EXAMPLE
Recall that when Schultz issued its bonds to yield 6%, it received $108,530. Thus, effective interest
for the first six months is $108,530 X 6% X 6/12 = $3,255.90. Of this amount, $4,000 is paid in cash
and $744.10 ($4,000 - $3,255.90) is premium amortization. The premium amortization reduces the
net book value of the debt to $107,785.90 ($108,530 - $744.10). This new balance would then be
used to calculate the effective interest for the next period. This process would be repeated each
period, as shown in the following table:

The initial journal entry to record the issuance of the bonds, and the final journal entry to record
repayment at maturity would be identical to those demonstrated for the straight-line method.
However, each journal entry to record the periodic interest expense recognition would vary and can be
determined by reference to the preceding amortization table.

The following entry would record interest on June 30, 20X3:

The following balance sheet disclosure would be appropriate as of June 30, 20X3:

DISCOUNT EXAMPLE
Recall that when Schultz issued its bonds to yield 10%, it received only $92,278. Thus, effective
interest for the first six months is $92,278 X 10% X 6/12 = $4,613.90. Of this amount, $4,000 is paid
in cash, and $613.90 is discount amortization. The discount amortization increases the net book value
of the debt to $92,891.90 ($92,278.00 + $613.90). This new balance would then be used to calculate
the effective interest for the next period. This process would repeat each period as shown:

Each journal entry to record the periodic interest expense recognition would vary, and can be
determined by reference to the preceding amortization table. For instance, the following entry would
record interest on June 30, 20X3, and result in the balance sheet disclosure below:

Bonds Issued Between Interest Dates, Bond Retirements, And Fair


Value
Bonds issued between interest dates are best understood in the context of a specific example.
Suppose Thompson Corporation proposed to issue $100,000 of 12% bonds, dated April 1, 20X1.
However, despite the April 1 date, the actual issuance was slightly delayed, and the bonds were not
sold until June 1. Nevertheless, the covenant pertaining to the bonds specifies that the first 6-month
interest payment date will occur on September 30 in the amount of $6,000 ($100,000 X 12% X 6/12).
In effect, interest for April and May has already accrued at the time the bonds are actually issued
($100,000 X 12% X 2/12 = $2,000). To be fair, Thompson will collect $2,000 from the purchasers of
the bonds at the time of issue, and then return it within the $6,000 payment on September 30. This
effectively causes the net difference of $4,000 to represent interest expense for June, July, August,
and September ($100,000 X 12% X 4/12). The resulting journal entries are:

YEAR-END INTEREST ACCRUALS


Notice that interest was paid in full through September 30. Therefore, the December 31 year-end
entry must reflect the accrual of interest for October through December:

When the next interest payment date arrives on March 31, the actual interest payment will cover the
previously accrued interest, and additional amounts pertaining to January, February, and March:

If these bonds had been issued at other than par, end-of-period entries would also include
adjustments of interest expense for the amortization of premiums or discounts relating to elapsed
periods.

BONDS RETIRED BEFORE SCHEDULED MATURITY


Early retirements of debt may occur because a company has generated sufficient cash reserves from
operations, and the company wants to stop paying interest on outstanding debt. Or, interest rates may
have changed, and the company wants to take advantage of more favorable borrowing opportunities
by refinancing.
Whether the debt is being retired or refinanced in some other way, accounting rules dictate that the
extinguished obligation be removed from the books. The difference between the old debts net
carrying value and the amounts used for the payoff should be recognized as a gain or loss.
For instance, assume that Cabano Corporation is retiring $200,000 face of its 6% bonds payable. The
last semiannual interest payment occurred on April 30, and the bonds are being retired on June 30,
20X5. The unamortized discount on the bonds at April 30, 20X5, was $6,000, and there was a 5-year
remaining life on the bonds as of that date. Further, Cabano is paying $210,000, plus accrued interest
to date ($2,000), to retire the bonds; this early call price was stipulated in the original bond
covenant. The first step to account for this bond retirement is to bring the accounting for interest up
to date:

Then, the actual bond retirement can be recorded, with the difference between the up-to-date
carrying value and the funds utilized being recorded as a loss (debit) or gain (credit). Notice that

Cabanos loss relates to the fact that it took more cash to pay off the debt than was the debts
carrying value ($194,200 ($200,000 minus $5,800)).

THE FAIR VALUE OPTION


Be aware that bonds can change in value. Remember that the value of a bond is a function of the
bonds stated rate of interest in relation to the going market rate of interest. If market interest rates
rise, look for a market value decline (reflecting a lower present value based on the higher discount
rate) and vice versa. Companies are permitted, but not required, to recognize changes in value of
such liabilities. Entities that opt for this approach are to report unrealized gains and losses in earnings
at each reporting date, and the balance sheet will be revised to reflect the fair value of the obligation.
Specific rules dictate the process and judgment for determining fair value. If a company's debt is
traded in a public market, the valuation would be based on its observable price ("Level 1"). If the debt
does not have a clearly determinable market, pricing would be tied to similar securities ("Level 2").
Management may develop their own pricing models in the rare case where the value is not otherwise
observable ("Level 3").

Analysis, Commitments, And Leases


Careful analysis is essential to judge an entitys financial health. One form of analysis is ratio analysis
where certain key metrics are evaluated against one another. The debt to total assets ratio shows
the percentage of total capitalization that is provided by the creditors of a
business:

Debt to Total Assets Ratio = Total Debt / Total Assets


A related ratio is debt to equity that compares total debt to total equity:

Debt to Equity Ratio = Total Debt / Total Equity


The debt to asset and debt to equity ratios are carefully monitored by investors, creditors, and
analysts. The ratios are often seen as signs of financial strength when small, or signs of vulnerability
when large. Of course, small and large are relative terms. Some industries, like the utilities, are
inherently dependent on debt financing but may, nevertheless, be very healthy. On the other hand,
some high-tech companies may have little or no debt but be seen as vulnerable due to their intangible
assets with potentially fleeting value. In short, one must be careful to correctly interpret a companys
debt-related ratios. One must also be careful to recognize the signals and trends that may be revealed
by careful monitoring of these ratios.

Another ratio, the times interest earned ratio, demonstrates how many times the income of a
company is capable of covering its unavoidable interest obligation.

Times Interest Earned Ratio = Income Before Income Taxes and Interest /
Interest Charges
If this number is relatively small, it may signal that the company is on the verge of not generating
sufficient operating results to cover its mandatory interest obligation. While ratio analysis is an
important part of evaluating a companys financial health, one should be careful to not place undue
reliance on any single evaluative measure.

CONTRACTS
A company may enter into a variety of long-term agreements. For example, a company may agree to
buy a certain quantity of supplies from another company, agree to make periodic payments under a
lease for many years to come, or agree to deliver products at fixed prices in the future. There is
effectively no limit or boundary on the nature of these commitments and agreements. Oftentimes,
such situations do not result in a presently recorded obligation, but may give rise to an obligation in
the future.
This introduces a myriad of accounting issues, and a few generalizations are in order. First, footnote
disclosures are generally required for the aggregate amount of committed payments that must be
made in the future (with a year by year breakdown). Second, changes in the value of such
commitments may require loss recognition when a company finds itself locked into a future transaction
that will have negative economic effects. These observations should make it clear that an evaluation of
a company should not be limited to just the numbers on the balance sheet.

CAPITAL LEASES
A previous chapter introduced the idea of a "capital lease." Such transactions enable the lessee to
acquire needed productive assets, not by outright purchase, but by leasing. It may be helpful to
review the discussion in Chapter 10. The economic substance of capital leases, in sharp contrast to
their legal form, is such that the lessee effectively assumes the risks and rewards of owning the asset.
Further, the accompanying obligation for lease payments is akin to a note payable. That is, the lessee
is under contract to make a stream of payments over time that substantively resembles the stream of
payments that would have occurred had the lessee purchased the asset by a promissory note.
Accounting rules attempt to track economic substance ahead of legal form. When an asset is acquired
under a capital lease, the initial recording is to establish both the asset and related obligation on the
lessee's balance sheet.
Assume that equipment with a five-year life is leased on January 1, 20X1, and the lease agreement
provides for five end-of-year lease payments of $23,739.64 each. At the time the lease was initiated,
the lessees incremental borrowing rate (the interest rate the lessee would have incurred on similar
debt financing) is assumed to be 6%. The accountant would discount the stream of payments using
the 6% interest rate and find that the present value of the fixed noncancelable lease payments is
$100,000. Therefore, the following entry would be necessary to record the lease:

After the initial recording, the accounting for the asset and obligation take separate paths. Essentially,
the leased asset is accounted for like any other owned asset of the company. The asset is typically
depreciated over the lease term (or useful life, depending on a variety of conditions). The depreciation
method might be straight-line or an accelerated approach. The Obligation Under Capital Lease liability
is accounted for like a note payable. In the lease example, the amounts correspond to those illustrated
for the mortgage note introduced earlier in the chapter. The first lease payment would be accounted
for as follows:

Notice that this entry results in recording interest expense, not rent. This scheme would be applied for
each successive payment, until the final payment extinguishes the Obligation Under Capital Lease
account. The accounting outcome is virtually identical to that associated with the mortgage note
illustrated earlier in the chapter.

The Corporate Form Of Organization


A corporation is a legal entity having existence separate and distinct from its owners (i.e.,
stockholders). Corporations are artificial beings existing only in contemplation of law. A corporation is
typically created when one or more individuals file articles of incorporation with a Secretary of State
in a particular jurisdiction. The articles of incorporation generally specify a number of important
features about the purpose of the entity and how
governance will be structured.
After reviewing the articles of incorporation, the Secretary of State will issue a charter
(or certificate of incorporation) authorizing the corporate entity. The persons who
initiated the filing (the incorporators) will then collect the shareholders initial
investment in exchange for the stock of the corporation (the stock is the financial
instrument evidencing a persons ownership interest). Once the initial stock is issued,
a shareholders meeting will be convened to adopt bylaws and elect a board of
directors. These directors appoint the corporate officers who are responsible for
commencing the operations of the business. In a small start-up venture, the initial incorporators may
become the shareholders, then elect themselves to the board, and finally appoint themselves to
become the officers. This leads one to wonder why go to all the trouble of incorporating?

ADVANTAGES
The reasons for incorporating can vary, but there are certain unique advantages to this form of
organization that have led to its popularity. One advantage of the corporate form of organization is
that it permits otherwise unaffiliated persons to join together in mutual ownership of a business entity.
This objective can be accomplished in other ways like a partnership, but the corporate form of
organization is arguably one of the better vehicles. Large amounts of venture capital can be drawn
together from many individuals and concentrated into one entity under shared ownership. The stock of
the corporation provides a clear and unambiguous point of reference to identify who owns the
business and in what proportion. Further, the democratic process associated with shareholder voting
rights (typically one vote per share of stock) permits shareholder say so in selecting the board of
directors. In addition to electing the board, shareholders may vote on other matters such as selection

of an independent auditor, stock option plans, and corporate mergers. The voting ballot is usually
referred to as a proxy.
Corporate stock has the benefit of transferability of ownership. It is easily transferable from one
person to another. Transferability provides liquidity to stockholders as it enables them to quickly enter
or exit an ownership position in a corporate entity. As a corporation grows, it may bring in additional
shareholders by issuing even more stock. At some point, the entity may become sufficiently large that
its shares will become listed on a stock exchange. An IPO is the initial public offering of the
stock of a corporation. Rules require that such IPOs be accompanied by regulatory registrations and
filings, and that potential shareholders be furnished with a prospectus detailing corporate
information. Publicly traded corporate entities are subject to a number of continuing regulatory
registration and reporting requirements that are aimed at ensuring full and fair
disclosure.
Another benefit of a corporation is perpetual existence. A corporate entity is
typically of unlimited duration enabling it to effectively outlive its shareholders.
Changes in stock ownership do not cause operations to cease. What would cause a
corporation to cease to exist? At some point, a corporation may be acquired by
another and merged in with the successor. Or, a corporation may fail and cease
operations. Finally, some businesses may find that liquidating operating assets and
distributing residual monies to the creditors and shareholders is a preferable
strategy to continued operation.
Not to be overlooked in considering why a corporation is desirable is the feature of limited liability for
stockholders. Stockholders normally understand that their investment can be lost if the business fails.
However, stockholders are not liable for debts and losses of the company beyond the amount of their
investment. There are exceptions to this rule. In some cases, shareholders may be called upon to sign
a separate guarantee for corporate debt. And, shareholders in closely held companies can
inadvertently be drawn into having to satisfy corporate debts when they commingle their personal
finances with those of the company or fail to satisfy the necessary legal procedures to maintain a valid
corporate existence.

DISADVANTAGES
Corporations are not without certain disadvantages. Most corporations are taxable entities, and their
income is subject to taxation. This income tax is problematic as it oftentimes produces double
taxation. This effect occurs when shareholders receive cash dividends that they must include in their
own calculation of taxable income. Thus, a dollar earned at the corporate level is reduced by corporate
income taxes (at a rate that is likely about 35%); to the extent the remaining after-tax profit is
distributed to shareholders as dividends, it is again subject to taxes at the shareholder level (at a rate
that will vary in the 15% to 35% range). So, as much as half or more of the profits of a dividendpaying corporation are apt to be shared with governmental entities.
Governments are aware that this double-taxation outcome can limit corporate investment and be
potentially damaging to an economy. Various measures of relief are sometimes available, depending
on the prevailing political climate (including dividends received deductions for dividends paid
between affiliated companies, lower shareholder tax rates on dividends, and S-Corporation provisions
that permit closely held corporations to attribute their income to the shareholders thereby avoiding
one level of tax). Some countries adopt tax holidays that permit newer companies to be exempt
from income taxes, or utilize different approaches to taxing the value additive components of
production by an entity.
Another burden on the corporate form of organization is costly regulation. In the USA, larger (usually
public) companies are under scrutiny of federal (The Securities and Exchange Commission (SEC) and
other public oversight groups) and state regulatory bodies. History shows that the absence or failure
of these regulators will quickly foster an environment where rogue business persons will launch all
manner of stock fraud schemes. Worse, these frauds quickly corrupt public confidence without which

investors become unwilling to join together to invest in new ideas and products. Therefore, it seems
almost unavoidable that governmental regulation must be a part of the corporate scene. However, the
cost of compliance with such regulation is heavy. Public companies must prepare and file quarterly and
annual reports with the SEC, along with a myriad of other documents. And, many of these documents
must be certified or subjected to independent audit. Further, requirements are in place that require
companies to have strong internal controls and even ethical training.

Common And Preferred Stock


Companies may issue different types of stock. For example, some companies have multiple classes of
common stock. A family business that has grown very large and become a public company may be
accompanied by the creation of Class A stock (held by the family members) and Class B stock (held by
the public), where only the Class A stock can vote. This enables raising needed capital but preserves
the ability to control and direct the company. While common stock is the most typical, another way
to gain access to capital is by issuing preferred stock. The customary features of common and
preferred differ, providing some advantages and disadvantages for each. The following tables reveal
general features that can be modified on a company by company basis.

TYPICAL COMMON STOCK FEATURES

POSSIBLE PREFERRED STOCK FEATURES

A comparative review of the preceding tables reveals a broad range of potential attributes. Every
company has different financing and tax considerations and will tailor its package of features to match
those issues. For instance, a company can issue preferred that is much like debt (cumulative,
mandatory redeemable), because a fixed periodic payment must occur each period with a fixed
amount due at maturity. On the other hand, some preferred will behave more like common stock
(noncallable, noncumulative, convertible).

WHAT IS PAR?

In the preceding discussion, there were several references to par value. Many states require that
stock have a designated par value (or in some cases stated value). Thus, par value is said to
represent the legal capital of the firm. In theory, original purchasers of stock are contingently liable
to the company for the difference between the issue price and par value if the stock is issued at less
than par. However, as a practical matter, par values on common stock are set well below the issue
price, negating any practical effect of this latent provision.
It is not unusual to see common stock carry a par value of $1 per share or even $.01 per share. In
some respects, then, par value is merely a formality. But, it does impact the accounting records,
because separate accounts must be maintained for par and paid-in capital in excess of par.
Assume that Godkneckt Corporation issues 100,000 shares of $1 par value stock for $10 per share.
The entry to record this stock issuance would be:

Occasionally, a corporation may issue no-par stock, which is recorded by debiting Cash and crediting
Common Stock for the issue price. A separate Paid-in Capital in Excess of Par account is not needed.
Sometimes, stock may be issued for land or other tangible assets, in which case the debit in the
preceding entry would be to the specific asset account (e.g., Land instead of Cash). When stock is
issued for noncash assets, the amount of the entry would be based upon the fair value of the asset (or
the fair value of the stock if it can be more clearly determined).

A CLOSER LOOK AT CASH DIVIDENDS


Begin by assuming that a company has only common shares outstanding. There is no mandatory
dividend requirement, and the dividends are a matter of discretion for the board of directors to
consider. To pay a dividend the company must have sufficient cash and a positive balance in retained
earnings (companies with a deficit (negative) Retained Earnings account would not pay a dividend
unless it is part of a corporate liquidation action). Many companies pride themselves in having a longstanding history of regular and increasing dividends, a feature that many investors find appealing.
Other companies view their objective as one of continual growth via reinvestment of all earnings; their
investors seem content relying on the notion that their investment value will gradually increase due to
this earnings reinvestment activity. Whatever the case, a company has no obligation to pay a
dividend, and there is no liability for dividends until such time as they are actually declared. A
declaration is a formal action by the board of directors to indicate that a dividend will be paid at
some stipulated future date. On the date of declaration, the following entry is needed on the corporate
accounts:

DIVIDEND DATES

In observing the preceding entry, it is imperative to note that the declaration on July 1 establishes a
liability to the shareholders that is legally enforceable. Therefore, a liability is recorded on the books at
the time of declaration. Recall (from earlier chapters) that the Dividends account will directly reduce
retained earnings (it is not an expense in calculating income; it is a distribution of income)! When the
previously declared dividends are paid, the appropriate entry would entail a debit to Dividends Payable
and a credit to Cash.
Some shareholders may sell their stock between the date of declaration and the date of payment. Who
is to get the dividend? The former shareholder or the new shareholder? To resolve this question, the
board will also set a date of record; the dividend will be paid to whomever the owner of record is on
the date of record. In the preceding illustration, the date of record might have been set as August 1,
for example. To further confuse matters, there may be a slight lag of just a few days between the time
a share exchange occurs and the company records are updated. As a result, the date of record is
usually slightly preceded by an ex-dividend date.
The practical effect of the ex-dividend date is simple: if a shareholder on the date of declaration
continues to hold the stock at least through the ex-dividend date, that shareholder will get the
dividend. But, if the shareholder sells the stock before the ex-dividend date, the new shareholder can
expect the dividend. In the illustrated timeline, if one were to own stock on the date of declaration,
that person must hold the stock at
least until the green period to be
entitled to receive payment.

THE
PRESENCE
PREFERRED STOCK

OF

Recall that preferred dividends are expected to be paid before common dividends, and those dividends
are usually a fixed amount (e.g., a percentage of the preferreds par value). In addition, recall that
cumulative preferred requires that unpaid dividends become dividends in arrears. Dividends in
arrears must also be paid before any distributions to common can occur. Another illustration will likely
provide the answer to questions about how these concepts are to be implemented.
To develop the illustration, begin by looking at the equity section of Embassy Corporations balance
sheet. Note that this section of the balance sheet is quite extensive. A corporations stockholders
equity (or related footnotes) should include rather detailed descriptions of the type of stock
outstanding and its basic features. This will include mention of the number of
shares authorized (permitted to be issued), issued (actually issued), and outstanding (issued minus
any shares reacquired by the company). In addition, be aware of certain related terminology: legal
capital is the total par value ($20,400,000 for Embassy), and total paid-in capital is the legal
capital plus amounts paid in excess of par values ($56,400,000 for Embassy).

Note that the par value for each class of stock is the number of shares issued multiplied by the par
value per share (e.g., 200,000 shares X $100 per share = $20,000,000). The preferred stock
description makes it clear that the $100 par stock is 8% cumulative. This means that each share will
receive $8 per year in dividends, and any missed dividends become dividends in arrears.
If the notes to the financial statements appropriately indicate that Embassy has not managed to pay
its dividends for the preceding two years, and Embassy desired to pay $5,000,000 of total dividends
during the current year, how much would be available to the common shareholders?
The answer is only $200,000 (or $0.50 per share for the 400,000 common shares). The reason is that
the preferred stock is to receive annual dividends of $1,600,000 ($8 per share X 200,000 preferred
shares), and three years must be paid consisting of the two years in arrears and the current year
requirement ($1,600,000 X 3 years = $4,800,000 to preferred, leaving only $200,000 for common).

Treasury Stock
Treasury stock is the term that is used to describe shares of a companys own stock that it has
reacquired. A company may buy back its own stock for many reasons. A frequently cited reason is a
belief by the officers and directors that the market value of the stock is unrealistically low. As such,
the decision to buy back stock is seen as a way to support the stock price and utilize corporate funds
to maximize the value for shareholders who choose not to sell back stock to
the company.
Other times, a company may buy back public shares as part of a reorganization that contemplates the
company going private or delisting from some particular stock exchange. Further, a company might
buy back shares and in turn issue them to employees pursuant to some employee stock award plan.
Whatever the reason for a treasury stock transaction, the company is to account for the shares as a
purely equity transaction, and gains and losses are ordinarily not reported in income. Procedurally,
there are several ways to record the debits and credits associated with treasury stock, and the
specifics can vary globally. The cost method is generally acceptable. Under this approach,
acquisitions of treasury stock are accounted for by debiting Treasury Stock and crediting Cash for the
cost of the shares reacquired:

The effect of treasury stock is very simple: cash goes down and so does total equity by the same
amount. This result occurs no matter what the original issue price was for the stock. Accounting rules
do not recognize gains or losses when a company issues its own stock, nor do they recognize gains
and losses when a company reacquires its own stock. This may seem odd, because it is certainly
different than the way one thinks about stock investments. But remember, this is not a stock
investment from the companys perspective. It is instead an expansion or contraction of its own
equity.
Treasury Stock is a contra equity item. It is not reported as an asset; rather, it is subtracted from
stockholders equity. The presence of treasury shares will cause a difference between the number of
shares issued and the number of shares outstanding. Following is Embassy Corporations equity
section, modified (see highlights) to reflect the treasury stock transaction portrayed by the entry.

If treasury shares are reissued, Cash is debited for the amount received and Treasury Stock is credited
for the cost of the shares. Any difference may be debited or credited to Paid-in Capital in Excess of Par.

Stock Splits And Stock Dividends


Stock splits are events that increase the number of shares outstanding and reduce the par or stated
value per share. For example, a 2-for-1 stock split would double the number of shares outstanding
and halve the par value per share. Existing shareholders would see their shareholdings double in
quantity, but there would be no change in the proportional ownership represented by the shares (i.e.,
a shareholder owning 1,000 shares out of 100,000 would then own 2,000 shares out of 200,000).

Why would a company bother with a stock split? The answer is not in the
financial statement impact, but in the financial markets. Since the same
company is now represented by more shares, one would expect the market
value per share to suffer a corresponding decline. For example, a stock that is subject to a 3-1 split
should see its shares initially cut in third. But, holders of the stock will not be disappointed by this
share price drop since they will each be receiving proportionately more shares; it is very important to
understand that existing shareholders are getting the newly issued shares for no additional
investment. The benefit to the shareholders comes about, in theory, because the split creates more
attractive opportunities for other future investors to ultimately buy into the larger pool of lower priced
shares.
Rapidly growing companies often have share splits to keep the per share price from reaching
stratospheric levels that could deter some investors. In the final analysis, understand that a stock split
is mostly cosmetic as it does not change the underlying economics of the firm.
Importantly, the total par value of shares outstanding is not affected by a stock split (i.e., the number
of shares times par value per share does not change). Therefore, no journal entry is needed to
account for a stock split. A memorandum notation in the accounting records indicates the decreased
par value and increased number of shares. If the initial equity illustration for Embassy Corporation was
modified to reflect a four-for-one stock split of the common stock, the revised presentation would
appear as follows (the only changes are underlined):

By reviewing the changes, one can see that the par has been reduced from $1.00 to $0.25 per share,
and the number of issued shares has quadrupled from 400,000 shares to 1,600,000 (be sure to note
that $1.00 X 400,000 = $0.25 X 1,600,000 = $400,000). None of the account balances have changes.
Splits can come in odd proportions: 3 for 2, 5 for 4, 1,000 for 1, and so forth depending on the
scenario. A reverse split (1 for 5, etc.) is also possible and will initially be accompanied by a reduction
in the number of issued shares along with a proportionate increase in share price.

STOCK DIVIDENDS
In contrast to cash dividends discussed earlier in this chapter, stock dividends involve the issuance
of additional shares of stock to existing shareholders on a proportional basis. Stock dividends are very
similar to stock splits. For example, a shareholder who owns 100 shares of stock will own 125 shares
after a 25% stock dividend (essentially the same result as a 5 for 4 stock split). Importantly, all

shareholders would have 25% more shares, so the percentage of the total outstanding stock owned by
a specific shareholder is not increased.
Although shareholders will perceive very little difference between a stock dividend and stock split, the
accounting for stock dividends is unique. Stock dividends require journal entries. Stock dividends are
recorded by moving amounts from retained earnings to paid-in capital. The amount to move depends
on the size of the distribution. A small stock dividend (generally less than 20-25% of the existing
shares outstanding) is accounted for at market price on the date of declaration. A large stock
dividend (generally over the 20-25% range) is accounted for at par value.
To illustrate, assume that Childers Corporation had 1,000,000 shares of $1 par value stock
outstanding. The market price per share is $20 on the date that a stock dividend is declared and
issued:
Small Stock Dividend: Assume Childers Issues a 10% Stock Dividend

Large Stock Dividend: Assume Childers Issues a 40% Stock Dividend

It may seem odd that rules require different treatments for stock splits, small stock dividends, and
large stock dividends. There are conceptual underpinnings for these differences, but it is primarily
related to bookkeeping. The total par value needs to correspond to the number of shares outstanding.
Each transaction rearranges existing equity, but does not change the amount of total equity.

Statement Of Stockholders Equity


Remember that a company must present an income statement, balance sheet, statement of retained
earnings, and statement of cash flows. However, it is also necessary to present additional information
about changes in other equity accounts. This may be done by notes to the financial statements or
other separate schedules. However, most companies will find it preferable to simply combine the
required statement of retained earnings and information about changes in other equity accounts into a
single statement of stockholders equity. Following is an example of such
a statement.

Note that the company had several equity transactions during the year, and the retained earnings
column corresponds to a statement of retained earnings. Companies may expand this presentation to
include comparative data for multiple years. Under international reporting guidelines, the preceding
statement is sometimes replaced by a statement of recognized income and expense that includes
additional adjustments for allowed asset revaluations (surpluses). This format is usually
supplemented by additional explanatory notes about changes in other equity accounts.

Special Reporting Situations


The accounting profession uses an all inclusive approach to measuring income. Virtually all
transactions, other than shareholder related transactions like issuing stock and paying dividends, are
eventually channeled through the income statement. However, there are certain situations where the
accounting rules have evolved in sophistication to provide special disclosures. The reason for the
added disclosure is to make it easier for users of financial statements to sort out the effects that are
related to ongoing operations versus those that are somehow unique. The following discussion will
highlight the correct handling of special situations.

CORRECTIONS OF ERRORS
Errors consist of mathematical mistakes, incorrect reporting, omissions,
oversights, and other things that were simply handled wrong in a previous
accounting period. Once an error is discovered, it must be corrected.
The temptation is to simply force the books into balance by making a compensating error in the
current period. For example, assume that a company failed to depreciate an asset in 20X4, and this
fact is discovered in 20X5. Why not just catch up by double depreciating the asset in 20X5, and then
everything will be fine, right? Wrong! While it is true that accumulated depreciation in the balance
sheet would be back on track at the end of 20X5, income for 20X4 and 20X5 would now both be
wrong. It is not technically correct to handle errors this way.
Instead, USA generally accepted accounting principles dictate that error corrections (if material) must
be handled by prior period adjustment. This means that the financial statements of prior periods
must be subjected to a restatement to make them correct. In essence, the financial statements of

prior periods are redone to reflect the correct amounts. Global GAAP follows a similar approach but
provides an exception for adjustments that are impractical to determine.
The following 20X5 entry reveals the method of adjusting the general ledger for failure to record
depreciation in 20X4. The debit to Retained Earnings reflects the expense that would have been
recorded and closed to Retained Earnings in the prior year, while the credit to Accumulated
Depreciation provides a catch up adjustment to reflect the accounts correct balance.

Importantly, if comparative financial statements (i.e., side-by-side financial statements, for two or
more years) are presented for 20X4 and 20X5, depreciation would be reported at the correct amounts
in each years statements (along with a note indicating that the prior years data have been revised for
an error correction). If an error related to prior periods for which comparative data are not presented,
then the statement of retained earnings would be amended as follows:

DISCONTINUED OPERATIONS
A company may decide to exit a unit of operation by sale to some other company, or by outright
abandonment. For example, a computer maker may sell its personal computer manufacturing unit to a
more efficient competitor and instead focus on its server and service business. Or, a chemical
company may decide to close a unit that has been producing a specialty product that has become an
environmental liability.
When an entity disposes of a complete business component, it will invoke the unique reporting rules
related to discontinued operations. To trigger these rules requires that the disposed business
component have operations that are clearly distinguishable operationally and for reporting purposes.
This would typically relate to a separate business segment, unit, subsidiary, or group of assets.
Following is an illustrative income statement for Bail Out Corporation. Bail Out distributes farming
implements and sporting goods. During 20X7, Bail Out sold its sporting equipment business and began
to focus only on farm implements.

In examining this illustration, be aware that revenues and expenses only relate to the continuing
farming equipment. All amounts relating to operations of the sporting equipment business, along with
the loss on the sale of assets used in that business, are removed from the upper portion of the income
statement and placed in a separate category below income from continuing operations. If material, a
company may separate the operating gain/loss from the gain/loss on the actual disposal of assets
within this section.

If a company disposes of a facility or some other set of assets that is not a separate business
component, then discontinued operations reporting isnot invoked. Suppose Sail Out sold its facility in
Georgia, but continued to distribute the same products at other locations. This would not constitute a
discontinued operation because the company will continue to operate in the same line of business. The
income statement might include a separate line item for the gain or loss on the sale of the location,
but it would not constitute a discontinued operation:

Look again at Bail Out and note that income taxes were split between continuing operations and
discontinued operations. This method of showing tax effects for discontinued operations is mandatory
and is called intraperiod tax allocation. Intraperiod tax allocation is applicable to other items
reported below continuing operations (and some prior period and selected equity adjustments), but
only one income tax number is attributed to income from continuing operations.

EXTRAORDINARY ITEMS
A business may experience a gain or loss that results from an event that is both unusual in nature and
infrequent in occurrence. When these two conditions are both met, the item is deemed to be
an extraordinary item. Under US GAAP, it is reported net of tax in a separate category below income
from continuing operations:

What type of event is both unusual in nature and infrequent in occurrence? UFO Corporation was hit
by a meteorite. It is rare for a meteor to hit a specific business. It is unlikely that UFO would sustain
this type of loss again. On the other hand, flood losses for businesses located along a river,
earthquakes for businesses in the Pacific Rim, and the like can give rise to losses that are not unusual
in nature and/or may be expected to reoccur. Accounting requires professional judgment, and there is
sometimes room for debate, and perhaps more than one possible solution. International accounting
standards do not provide for a separate extraordinary item category.

COMPREHENSIVE INCOME
The Long-term Investments chapter introduced other comprehensive income. OCI arose from changes
in the fair value of investments classified as available for sale. OCI can also result from certain
pension plan accounting adjustments and translation of the financial statements of foreign
subsidiaries. OCI does not enter into the determination of net income or retained earnings, but it does
enter into the determination of a broader concept of income. When OCI is present, it may be
presented as a separate component in a statement of comprehensive income. Alternatively, a
company may present a reconciliation of net income to total comprehensive income.
It is highly unlikely that a company would experience all of the previously discussed items within the
same year. However, were that the case, its statement of comprehensive income might expand to look
something like the following:

Take note that net income or earnings is income from continuing operations plus/minus discontinued
operations and extraordinary items.Comprehensive income is net income plus other comprehensive
income. OCI is closed to the Accumulated Other Comprehensive Income account that is presented
within stockholders' equity (similar to, but separate from, retained earnings).

CHANGES IN ACCOUNTING METHODS


A company may adopt an alternative accounting principle. Such accounting changes relate to
changes from one acceptable method to another. For instance, a company may conclude that it wishes
to adopt FIFO instead of average cost. Such changes should only occur for good cause (not just to
improve income), and flip-flopping is not permitted. When a change is made, the company must make
a retrospective adjustment. This means that the financial statements of prior accounting periods
should be reworked as if the new principle had always been used.
Disclosures that must accompany a change in accounting principle are extensive. Notes must indicate
why the newly adopted method is preferable. In addition, a substantial presentation is required
showing amounts that were previously presented versus the newly derived numbers, with a clear

delineation of all changes. And, the cumulative effect of the change that relates to all years prior to
the earliest financial data presented must be disclosed.
Do not confuse a change in accounting method with a change in accounting estimate. Changes in
estimate are handled prospectively. This type of change was illustrated in the Property, Plant, and
Equipment chapter. If a change in principle cannot be separated from a change in estimate, the
adjustment would be handled as a change in estimate. Similar treatment is required for any change in
depreciation method.

EBIT AND EBITDA


Investors may discuss a companys earnings before interest and taxes (EBIT) and earnings before
interest, taxes, depreciation, and amortization (EBITDA). These numbers can be calculated from
information available in the statements. Some argue that EBIT (pronounced with a long E sound and
bit) and EBITDA (pronounced with a long E sound and bit and dah) are important and relevant
to decision making, because they reveal the core performance before considering financing costs and
taxes (and noncash charges like depreciation and amortization).
These numbers are sometimes used in evaluating the intrinsic value of a firm, in that they reveal how
much the business is producing in earnings without regard to how the business is financed and taxed.
These numbers should be used with great care, as they can provide an overly simplistic view of
business performance.

Earnings Per Share And Other Indicators


How is one to meaningfully compare the net income of a large corporation that has millions of shares
outstanding to smaller companies that may have less than even one million shares? The larger
company is probably expected to produce a greater amount of income. But, the smaller company
might be doing better per unit of ownership. To adjust for differences in size, public companies must
supplement their income reports with a number that represents earnings on a per common share
basis.
Earnings per share, or EPS, is a widely followed performance measure.
Corporate communications and news stories will typically focus on EPS, but care should be taken in
drawing any definitive conclusions. Nonrecurring transactions and events can positively or negatively
impact income. Companies that present an income statement that segregates income from continuing
operations from other components of income must also subdivide per share data (e.g., EPS from
continuing operations, discontinued operations, etc.).

BASIC EPS
Basic EPS may be thought of as a fraction with income in the numerator and the number of common
shares in the denominator. Expanding this thought, consider that income is for a period of time (e.g., a
quarter or year), and during that period of time, the number of shares might have changed because of
share issuances or treasury stock transactions. Therefore, a more correct characterization is income
divided by the weighted-average number of common shares outstanding.
Further, consider that some companies have both common and preferred shares. Dividends on
common and preferred stock are not expenses and do not reduce income. However, preferred
dividends do lay claim to a portion of the corporate income stream. Therefore, one more modification
is needed to correctly portray the Basic EPS fraction:

Basic EPS = Income Available to Common / Weighted-Average Number of


Common Shares Outstanding
The Basic EPS calculation entails a reduction of income by the amount of preferred dividends for the
period. To illustrate, assume that Kooyul Corporation began 20X4 with 1,000,000 shares of common
stock outstanding. On April 1, 20X4, Kooyul issued 200,000 additional shares of common stock, and
120,000 shares of common stock were reacquired on November 1. Kooyul reported net income of
$2,760,000 for the year ending December 31, 20X4. Kooyul also had 50,000 shares of preferred stock
on which $500,000 in dividends were rightfully declared and paid during 20X4. Kooyul paid $270,000
in dividends to common shareholders. Therefore, Kooyuls Basic EPS is $2 per share
($2,260,000/1,130,000), as discussed in the following paragraph.
Income available to Kooyuls common shareholders is $2,260,000. This amount is calculated as the
net income ($2,760,000) minus the preferred dividends ($500,000). Dividends on common stock do
not impact the EPS calculation. Weighted-average common shares outstanding during 20X4 are
1,130,000. The following table illustrates this calculation:

DILUTED EPS
Some companies must report an additional Diluted EPS number. The Diluted EPS is applicable to
companies that have complex capital structures. Examples include companies that have issued
stock options and warrants that entitle their holders to buy additional shares of common stock from
the company, and convertible bonds and preferred stocks that are exchangeable for common shares.
These financial instruments represent the possibility that more shares of common stock will be issued
and are potentially dilutive to existing common shareholders.
Companies with dilutive securities take the potential effect of dilution into consideration in
calculating Diluted EPS. These calculations require a series of assumptions about dilutive securities
being converted into common stock.
The hypothetical calculations are imaginative; even providing guidelines about how assumed money
generated from assumed exercises of options and warrants is assumed to be reinvested. Diluted EPS
provides existing shareholders a measure of how the companys income is potentially to be shared
with other interests.

PRICE/EARNINGS RATIO

Financial analysts often incorporate reported EPS information into


the price/earnings ratio (P/E). This is simply the stock price per share
divided by the annual EPS:

the

calculation

of

Price Earnings Ratio = Market Price Per Share / Earnings Per Share
For example, a stock selling at $15 per share with $1 of EPS would have a P/E of 15. Other companies
may have a P/E of 5 or 25. Wouldnt investors always be drawn to companies that have the lowest
ratios since they may represent the best earnings generation per dollar of required investment?
Perhaps not, as the E in P/E is past earnings. New companies may have a bright future, even if
current earnings are not great. Other companies may have great current earnings, but no room to
grow.
A related ratio is the PEG ratio. This is the P/E ratio divided by the companys growth rate. For
example, a company with a P/E of 20 that is experiencing average annual increases in income of 20%
would have a PEG of 1. If the same company instead had annual earnings increases of 10%, then the
PEG would be 2. Lower PEG numbers sometimes help identify more attractive investments.

BOOK VALUE PER SHARE


Another per share amount that analysts frequently calculate is the book value per share. This refers
to the amount of reported stockholders equity for each share of common stock. Book value is not the
same thing as market value or fair value. Book value is based on reported amounts within the balance
sheet.
Many items included in the balance sheet are based on historical costs which can be well below fair
value. On the other hand, do not automatically conclude that a company is worth more than its book
value, as some balance sheets include significant intangibles that cannot be easily converted to value.
For a corporation the has only common stock outstanding, the calculation of book value per share is
simple. Total stockholders equity is divided by common shares outstanding at the end of the
accounting period.
To illustrate, assume that Fuller Corporation has the following stockholders equity, which results in a
$24 book value per share ($12,000,000/500,000 shares):

A company with preferred stock must allocate total equity between the common and preferred shares.
The amount of equity attributable to preferred shares is generally considered to be the call price (i.e.,
redemption or liquidation price) plus any dividends that are due. The remaining amount of common
equity (total equity minus equity attributable to preferred stock) is divided by the number of common
shares to calculate book value per common share:

Book Value Per Share = "Common" Equity / Common Shares Outstanding

Assume that Muller Corporation has the following stockholders equity:

Mike Kreinhop is a financial analyst for an investment fund, and is evaluating the merits of Muller
Corporation. Pursuant to this task, he has diligently combed through the notes to the financial
statements and found that the preferred dividends were not paid in the current or prior year. He notes
that the annual dividend is $600,000 (6% X $10,000,000) and the preferred stock is cumulative in
nature. Although Muller has sufficient retained earnings to support a dividend, it is presently cash
constrained due to reinvestment of all free cash flow in a new building and expansion of inventory.
Kreinhop correctly prepared the following book value per share calculation:

DIVIDEND RATES AND PAYOUT RATIOS


Many companies do not pay dividends. One explanation is that the company is not making any money.
Hopefully, the better explanation is that the company needs the cash it is generating from operations
to reinvest in expanding a successful concept. On the other hand, some profitable and mature
businesses can easily manage their growth and still have plenty of cash left to pay a reasonable
dividend to shareholders. In evaluating the dividends of a company, analysts calculate the dividend
rate (also known as yield).

The dividend rate is the annual dividend divided by the stock price:

Dividend Rate = Annual Cash Dividend / Market Price Per Share


If Pustejovsky Company pays dividends of $1 per share each year, and its stock is selling at $20 per
share, it is yielding 5% ($1/$20). Analysts may be interested in evaluating whether a company is
capable of sustaining its dividends and will compare the dividends to the earnings:

Dividend Payout Ratio = Annual Cash Dividend / Earnings Per Share


If Pustejovsky earned $3 per share, its payout ratio is .333 ($1/$3). On the other hand, if the earnings
were only $0.50, giving rise to a dividend payout ratio of 2 ($1/$0.50), one would begin to question
the safety of the dividend.

RATES OF RETURN
Some financial statement analysts will compare income to assets, in an attempt to assess how
effectively assets are being utilized to generate profits. The specific income measure that is used in
the return on assets ratio varies with the analyst, but one calculation is:

Return on Assets Ratio = (Net Income + Interest Expense) / Average Assets


These calculations of ROA attempt to focus on income (excluding financing costs) in relation to
assets. The point is to demonstrate how much operating income is generated by the deployed assets
of the business. This can prove useful in comparing profitability and efficiency for companies in similar
industries.
The return on equity ratio evaluates income for the common shareholder in relation to the amount
of invested common shareholder equity:

Return on Equity Ratio = (Net Income - Preferred Dividends) / Average


Common Equity
ROE enables comparison of the effectiveness of capital utilization among firms. What it does not do
is evaluate risk. Sometimes, firms with the best ROE also took the greatest gambles. For example, a
high ROE firm may rely heavily on debt to finance the business, thereby exposing the business to
greater risk of failure when things dont work out. Analysts may compare ROE to the rate of interest
on borrowed funds. This can help them assess how effective the firm is in utilizing borrowed funds
(leverage).

Objectives And Qualities Of Accounting Information


Of what value is accounting? Why is so much time and money spent on the development of accounting
information? To fairly answer these questions, one must think broadly. Investors and creditors have
limited resources and seek to place those resources where they will generate the best returns.
Accounting information is the nexus of this capital allocation decision process. Without good
information, misallocation of capital would occur and result in inefficient
production and shortages.

Most organizations devote a fair amount of time and effort to considering their goals and objectives.
The accounting profession is no different. Foremost among the objectives of accounting and reporting
is to provide useful information for investors, creditors, analysts, governments, and others.
Accounting information is general purpose and should be designed to serve the information needs of
all types of interested parties. To be useful, information should be helpful in assessing an entity's
economic resources, claims against resources, and what causes changes in resources and claims. Such
assessments are generally benefited by accrual accounting, coupled with consideration of cash flows.
Care must be taken to differentiate between resource changes resulting from economic performance
and other factors (e.g., earnings vs. issuing additional shares of stock). The following qualities help to
make accounting useful.

Be aware of the growing complaint that accounting has become too complex. Many persons within and
outside the profession protest the ever growing number of rules and their level of detail. The debate is
generally couched under the heading principles versus rules. Advocates of aprinciplesbased approach argue that general concepts should guide the judgment of individual accountants.
Others argue that the world is quite complex, and accounting must necessarily be rules-based. They
believe that reliance on individual judgment may lead to wide disparities in reports that could render
meaningful comparisons impossible.

Development Of GAAP
Generally accepted accounting principles, or GAAP, encompass the rules, practices, and procedures
that define the proper execution of accounting. It is important to note that this definition is quite
broad, taking in more than just the specific rules issued by standard setters. It encompasses the longstanding methodologies and assumptions that have become engrained within the profession through

years of thought and development. Collectively, GAAP form the foundation of accounting by providing
comprehensive guidance and a framework for addressing most accounting
issues.

THE FASB, IASB, AND SEC


The Financial Accounting Standards Board (FASB) has been the primary USA accounting rule maker
since the early 1970s. Its many rulings are available via an online codification of standards (at
FASB.org). Prior to its creation, rules were set by the Accounting Principles Board (APB). The APB
was created in 1959 by the American Institute of Certified Public Accountants (AICPA). The
AICPA is a large association of professional accountants who seek to advance the practice of
accounting. Before 1959, the duty of standard development fell on the shoulders of an AICPA
committee known as the Committee on Accounting Procedure (CAP).
The International Accounting Standards Board (IASB) is the global counterpart to the FASB. The
standards of the IASB are oftentimes referred to as IFRS (International Financial Reporting
Standards). The FASB and IASB are working harmoniously to converge toward a single set of
accounting standards. This project is receiving considerable interest from financial institutions,
investors, and governmental units around the world. Convergence of accounting standards is seen as
an important tool in the facilitation and coordination of international commerce and the global
economy.
In a 1930s-era effort to bring credibility to capital markets, the U.S. Congress created the Securities
and Exchange Commission (SEC). The SEC was charged with the administration of laws that
regulate the reporting practices of companies with publicly traded stock. Today, U.S. public companies
must register and report to the SEC on a continuing basis. Although the SEC has ultimate authority to
set accounting rules, it has elected to operate under a tradition of cooperation and largely defers to
the private sector for most specific accounting rules.

THE AUDIT FUNCTION


To provide a measure of integrity, financial reports of public companies are required to be audited by
independent CPAs. Auditors evaluate the systems and data that lead to the reported financial
statements. The auditor will usually issue an opinion letter on the fairness of the reports. This letter is
rather brief and to the point and includes a paragraph similar to the following:

Note that the auditor is expressing an opinion about the conformity of the financial statements with
generally accepted accounting principles. Thus, conformity with GAAP is the key to obtaining the
desired audit opinion. Being alert to the detection of potential fraud is important, but it is not the
primary mission of a financial statement audit.
The U.S. Congress created the Sarbanes-Oxley Act of 2002 (SOX). It imposed stringent financial
statement certification requirements on corporate officers, raised the fiduciary duty of corporate
boards, imposed systematic ethics awareness, and placed a greater burden on auditors.

In addition, Section 404 of the Act requires public companies to implement a robust system of internal
control; an independent auditor must issue a separate report on the effectiveness of this control
system. The Act also created the Public Company Accounting Oversight Board (PCAOB). The
PCAOB is a private-sector, non-profit corporation, charged with overseeing the auditors of public
companies.

Key Assumptions
Many associate accounting with math in terms of absolute precision. However, accounting is actually
more like art and social science and depends on certain fundamental
assumptions.

ENTITY
Accounting information should be presented for specific and distinct reporting units. In other words,
the entity assumption requires that separate transactions of owners and others not be commingled
with the reporting of economic activity for a particular business. On one hand, an individual may
prepare separate financial statements for a business he or she owns even if it is not a separate legal
entity. On the other hand, consolidated financial statements may be prepared for a group of entities
that are economically commingled but are technically separate legal units.

GOING-CONCERN
In the absence of contrary evidence, accountants base measurement and reporting on the goingconcern assumption. This means that accountants are not constantly assessing the liquidation value
of a company in determining what to report, unless of course liquidation looks like a possibility. This
allows for allocation of long-term costs and revenues based on a presumption that the business will
continue to operate into the future. Accountants are typically conservative (when in doubt, select the
lower asset/revenue measurement choice and the higher liability/expense measurement choice) but
not to the point of introducing bias based on an unfounded fear for the future.

PERIODICITY
Accountants assume they can divide time into specific measurement intervals (i.e., months, quarters,
years). This periodicity assumption is necessitated by the regular and continuing information needs of
financial statement users. More precision could be achieved if accountants had the luxury of waiting
many years to report final results, but users need timely information. For instance, a health club may
sell lifetime memberships for a flat fee, not really knowing how long its customers will utilize the club.
But, the club cannot wait years and years for their customers to die before reporting any financial
results. Instead, methods are employed to attribute portions of revenue to each reporting period. This
is justified by the periodicity assumption.

MONETARY UNIT
The monetary unit assumption means that accounting measures transactions and events in units of
money. This assumption overcomes the problems that would arise by mixing measures in the financial
statements (e.g., imagine the confusion of combining acres of land with cash). The monetary unit
assumption is core and essential to the double-entry, self-balancing accounting model.

STABLE CURRENCY

Inflation can wreak havoc on the usefulness of financial data. For example, suppose a power plant that
was constructed in 1970 is still in operation. Accounting reports may show a profit by matching
currently generated revenues with depreciation of old (cheap) construction costs. A different picture
might appear if one reconsidered the value of the power plant that is being used up in generating
the current revenue stream. Inflation can distort performance measurement. Inflation also has the
potential to limit the usefulness of the balance sheet by reporting amounts at costs that differ greatly
from current value. Accountants have struggled with this issue for many years, and even
experimented with supplemental reporting requirements. However, accounting generally operates
under the stable currency assumption, going along as though costs and revenues incurred in
different time periods need not be adjusted for changes in the value of the
monetary unit over time.

Issues In Global Commerce


Understand that international trade no longer simply means importing and exporting. Companies have
added subsidiaries in many countries, formed cooperative alliances, listed shares on multiple stock
exchanges around the globe, engaged in global cross-border debt financing, and set up service centers
that utilize technology to provide seamless customer support around the world. Companies engaging
in global business face some specific reporting challenges. Two of those challenges are (1) how to
consolidate global subsidiaries and (2) how to account for global transactions denominated in
alternative currencies.

GLOBAL SUBS
When a parent corporation has a subsidiary outside of its home country, the financial statements of
that subsidiary may be prepared in the local currency of the country in which it operates. But, the
parents financials are prepared in the reporting currency of the country in which it is domiciled.
Thus, to consolidate the parent and sub first requires converting the subs financial information into
the reporting currency. Facts and circumstances will dictate whether the conversion process occurs by
a process known as the functional currency translation approach or an alternative approach known
as remeasurement.

GLOBAL TRADING
Many firms buy goods from foreign suppliers and/or sell goods to foreign customers. The terms of the
transaction will stipulate how payment is to occur and the currency for making settlement. If the
currency is foreign, then some additional thought must be given to the bookkeeping. Suppose
Bentleys Bike Shop purchases bicycles from GiroCycle of Switzerland. On July 1, 20X6, Bentley
purchased bicycles, agreeing to pay 20,000 Swiss francs within 60 days. Bentley is in Cleveland, Ohio,
and the U.S. dollar is its primary currency. On July 1, Bentley will record the purchase by debiting
Inventory and crediting Accounts Payable. But, what amount should be debited and credited? If
20,000 were used, the accounts would cease to be logical. The total Inventory balance would be
illogical since it would include this item, and all other transactions in other currencies. Total Accounts
Payable would become unintelligible as well. Therefore, Bentley needs to measure the transaction in
dollars. On July 1, assume that the current exchange rate (i.e., the spot rate) is 0.90 U.S. dollars to
acquire 1 Swiss franc. The correct entry would be:

By the August 29 settlement date, assume that the dollar has weakened and the spot rate is $0.95.
Bentley will have to pay $19,000 (20,000 X $0.95) to buy the 20,000 francs needed to settle the
obligation. The following entry shows that the difference between the initially recorded payable
($18,000) and the cash settlement amount ($19,000) is to be recorded as a foreign currency
transaction loss:

If the exchange rate had gone the other way, a foreign currency transaction gain (credit) would have
been needed to balance the payable and required cash disbursement.
It is important to know that foreign currency payables and receivables that exist at the close of an
accounting period must also be adjusted to reflect the spot rate on the balance sheet date. Suppose
Vigeland Corporation sold goods to a customer in England, agreeing to accept payment of 100,000
British pounds in 90 days. On the date of sale, December 1, 20X1, the spot rate for the pound was
$1.75. Vigeland prepared financial statements at its year end on December 31, 20X1, at which time
the spot rate for the pound was $1.90. The foreign currency receivable was collected on February 28,
20X2, and Vigeland immediately converted the 100,000 pounds to dollars at the then current
exchange rate of $1.70. The following illustrates Vigelands sale, year-end adjustment, and
subsequent collection:

Some companies may wish to avoid foreign currency exchange risks like those just illustrated. The
simplest way is to convince a trading partner to make or take payment in the home currency. In the
alternative, various financial agreements can be structured with banks or others to hedge this risk.

Financial Statement Analysis


Anyone wishing to study this textbook can learn valuable insights about accounting. Does the mere
fact that this book exists mean that everyone knows about accounting principles? Obviously not. By
analogy, the same can be said about financial information. Many companies spend substantial
amounts of money preparing and presenting financial statements that are readily available (the
reports for USA public companies can be found at www.sec.gov). Does this mean that everyone has
in-depth knowledge about these companies? Again, no. Some degree of study is required to benefit
from the information.
It is important to know that CPAs and the SEC
provide safeguards to protect the integrity of reported information, but this is
entirely different than suggesting that reporting companies are necessarily
good investments. For example, a company could report that its revenue
stream is in decline, expenses are on the rise, and significant debt is coming
due without a viable plan for making the payments. The financial statements may fully report this
predicament. But, if financial statement users choose to ignore that report, only they are to blame.
Investors must be very thorough in examining the financial statements of companies in which they are
considering making an investment. Sometimes, the evaluation of complex situations can be assisted
by utilization of key metrics or ratios. For example, a doctor will consider a patients health by taking
measurements of blood pressure, heart rate, cholesterol level, and so forth. Likewise, consideration of
a companys health can be measured with certain important ratios.

DETAILED EXAMPLE
This book has introduced financial statement ratios and analysis techniques throughout many of the
previous chapters. The following tables include a recapitulation of those ratios, including cross
references back to chapters where the ratios were first introduced. If any of the ratios are unclear, it
may prove helpful to refer back to the earlier chapters for more detail on the calculation and
interpretation of the ratios. The right hand column of the tables include specific calculations for
Emerson Corporation. Comprehensive financial statements for Emerson follow the tables. Be sure to
verify each ratio calculation to the data included in those financial statements.

BALANCE SHEET

ADDITIONAL FACTS FOR EMERSON


No dividends were due or paid on the $300,000 of preferred stock which was issued in exchange for a
building in late 20X5. Average common equity is assumed to be $2,095,000 ((($2,910,000 $300,000) + $1,580,000)/2). Assume most other balance sheet items change uniformly throughout

the year (e.g., average receivables = ($600,000 + $850,000)/2 = $725,000, etc.). The year-end
market value of the common stock was $10 per share, and the cash dividend was paid on shares
outstanding at the end of the year ($50,000/910,000 shares = $0.055 per share).
It appears that Emerson is doing fairly well. Its liquidity suggests no problem in meeting obligations,
the debt is manageable, receivables and inventory appear to be turning well, and profits are good.

STATEMENT OF RETAINED EARNINGS

INCOME STATEMENT

TREND ANALYSIS
Analysts often reproduce financial statement data in percentage terms. For example, Emersons cash
is 17% of total assets ($700,000/$4,100,000). These data provide investors and managers with a
keen sense of subtle shifts that can foretell changes in the business environment. This approach is
sometimes called common size financial statements, as applied to the balance sheet data below:

Cash Flow And The Statement Of Cash Flows


Accounting is based upon accrual concepts that report revenues as earned and expenses as incurred,
rather than when received and paid. Accrual information is perhaps the best indicator of business
success or failure. However, one cannot ignore the importance of cash flows.
For example, a rapidly growing successful business can be profitable and still
experience cash flow difficulties in trying to keep up with the need for expanded facilities and
inventory. On the other hand, a business may appear profitable, but may be experiencing delays in
collecting receivables, and this can impose liquidity constraints. Or, a business may be paying
dividends, but only because cash is produced from the disposal of core assets. Sophisticated analysis
will often reveal such issues.
Rather than depending upon financial statement users to do their own detailed cash flow analysis, the
accounting profession has seen fit to require another financial statement that clearly highlights the
cash flows of a business entity. This required financial statement is appropriately named
theStatement of Cash Flows.
One objective of financial reporting is to provide information that is helpful in assessing the amounts,
timing, and uncertainty of an organizations cash inflows and outflows. As a result, the statement of
cash flows provides three broad categories that reveal information about operating activities, investing
activities, and financing activities. In addition, businesses are required to reveal significant noncash
investing/financing transactions.

OPERATING, INVESTING, AND FINANCING ACTIVITIES


Cash inflows from operating activities consist of receipts from customers for providing goods and
services, and cash received from interest and dividend income (as well as the proceeds from the sale
of trading securities). Cash outflows consist of payments for inventory, trading securities, employee
salaries and wages, taxes, interest, and other normal business expenses. To generalize, cash from
operating activities is generally linked to those transactions and events that enter into the
determination of income. However, another way to view operating cash flows is to include anything
that is not an investing or financing cash flow.
Cash inflows from investing activities result from items such as the sale of longer-term stock and
bond investments, disposal of long-term productive assets, and receipt of principal repayments on

loans made to others. Cash outflows from investing activities include payments made to acquire plant
assets or long-term investments in other firms, loans to others, and similar items.
Cash inflows from financing activities include proceeds from a companys issuance of its own stock
or bonds, borrowings under loans, and so forth. Cash outflows for financing activities include
repayments of amounts borrowed, acquisitions of treasury stock, and dividend distributions.
There are potential distinctions between US GAAP and international accounting standards. IFRS
permits interest received (paid) to be disclosed in the investing (financing) section of a cash flow
statement. The global viewpoint also provides more flexibility in the classification of dividends received
(and paid). Additionally, international standards encourage disclosures of cash flows that are
necessary to maintain operating capacity, versus cash flows attributable to increasing capacity.

NONCASH INVESTING AND FINANCING ACTIVITIES


Some investing and financing activities occur without generating or consuming cash. For example, a
company may exchange common stock for land or acquire a building in exchange for a note payable.
While these transactions do not entail a direct inflow or outflow of cash, they do pertain to significant
investing and/or financing events.
Under US GAAP, the statement of cash flows includes a separate section reporting these noncash
items. Thus, the statement of cash flows is actually enhanced to reveal the totality of investing and
financing activities, whether or not cash is actually involved. The international approach is to present
such information in the notes to the financial statements.

Direct Approach To The Statement Of Cash Flows


Spend just a few moments reviewing the preceding balance sheet, statement of retained earnings,
and income statement for Emerson Corporation. Then, examine the following statement of cash flows.
Everything within this cash flow statement is derived from the data and additional comments
presented for Emerson. The tan bar on the left is not part of the statement; it is to facilitate the line
by line explanation that follows.

OPERATING ACTIVITIES
Notice that Line 01 appears as follows:

Emersons customers paid $3,000,000 in cash. Emersons information system could be sufficiently
robust that a database query could produce this number. On the other hand, one can infer this
amount by reference to sales and receivables data found on the income statement and balance sheet:

Cash Received From Customers


=

Total Sales Minus the Increase in Net Receivables (or, plus a decrease in net
receivables)
=
$3,250,000 - ($850,000 - $600,000)
=
$3,000,000
Accounts receivable increased by $250,000 during the year ($850,000 - $600,000). This means that
of the total sales of $3,250,000, a net $250,000 went uncollected. Thus, cash received from
customers was $3,000,000. If net receivables had decreased, cash collected would have exceeded
sales.

Emerson paid $1,050,000 of cash for inventory. Bear in mind that cost of goods sold is the dollar
amount of inventory sold. But, the amount of inventory actually purchased will be less than this
amount if inventory on the balance sheet decreased. This would mean that some of the cost of goods
sold came from existing stock on hand rather than having all been purchased during the year. On the
other hand, purchases would be greater than cost of goods sold if inventory increased.

Inventory Purchased
=
Cost of Goods Sold Minus the Decrease in Inventory (or, plus an increase in
inventory)
=
$1,160,000 - ($220,000 - $180,000)
=
$1,120,000
Inventory purchased is only the starting point for determining cash paid for inventory. Inventory
purchased must be adjusted for the portion that was purchased on credit. Notice that Emersons
accounts payable increased by $70,000 ($270,000 - $200,000). This means that cash paid for
inventory purchases was $70,000 less than total inventory purchased:

Cash Paid for Inventory


=

Inventory Purchased Minus the Increase in Accounts Payable (or, plus a


decrease in accounts payable)
=
$1,120,000 - ($270,000 - $200,000)
=
$1,050,000

Emerson paid $480,000 of cash for wages during the year. Emersons payroll records would indicate
the amount of cash paid for wages, but this number can also be determined by reference to wages
expense in the income statement and wages payable on the balance sheet:

Cash Paid for Wages


=
Wages Expense Plus the Decrease in Wages Payable (or, minus an increase in
wages payable)
=
$450,000 + ($50,000 - $20,000)
=
$480,000
Emerson not only paid out enough cash to cover wages expense, but an additional $30,000 as
reflected by the overall decrease in wages payable. If wages payable had increased, the cash paid
would have been less than wages expense.

Emersons cash payments for these items equaled the amount of expense in the income statement.
Had there been related balance sheet accounts (e.g., interest payable, taxes payable, etc.), then the
expense amounts would need to be adjusted in a manner similar to that illustrated for wages.
Overall, operations generated net positive cash flows of $800,000. Notice that two items within the
income statement were not listed in the operating activities section of the cash flow statement:

Depreciation is not an operating cash flow item. It is a noncash expense. Remember that
depreciation is recorded via a debit to Deprecation Expense and a credit to Accumulated
Depreciation. No cash is impacted by this entry (the investing cash outflow occurred when
the asset was purchased), and

The gain on sale of land in the income statement does not appear in the operating cash flows
section. While the land sale may have produced cash, the entire proceeds will be listed in the
investing activities section; it is a nonoperating item.

INVESTING ACTIVITIES
The next major section of the cash flow statement is the cash flows from investing activities. This
section can include both inflows and outflows related to investment-related transactions. Emerson
Corporation had one example of each; a cash inflow from sale of land, and a cash outflow for the
purchase of equipment. The sale of land requires some thoughtful analysis. Notice that the statement
of cash flows for Emerson reports the following line item:

This line item reports that $750,000 of cash was received from the sale of land during the year. In
actuality, it would be possible to look up this transaction in the companys journal. The journal entry
would appear as follows:

But, it is not necessary to refer to the journal. Notice that land on the balance sheet decreased by
$600,000 ($1,400,000 - $800,000), and that the income statement included a $150,000 gain.
Applying a little forensic accounting allows one to deduce that $600,000 in land was sold for
$750,000, to produce the $150,000 gain.

Emerson purchased equipment for $150,000 during the year. Notice that equipment on the balance
sheet increased by $150,000 ($1,050,000 - $900,000). One could confirm that this was a cash
purchase by reference to the journal; such is assumed in this case.

FINANCING ACTIVITIES

This line reveals that $80,000 was received from issuing common stock. This cash inflow is suggested
by the $10,000 increase in common stock ($910,000 - $900,000) and $70,000 increase in additional
paid-in capital ($370,000 - $300,000).

The statement of retained earnings reveals that Emerson declared $50,000 in dividends. Since there is
no dividend payable on the balance sheet, one can assume that all of the dividends were paid.

The balance sheet reveals a $900,000 decrease in long-term debt ($1,800,000 - $900,000). This
represented a significant use of cash.

CASH FLOW RECAP

Emerson had a $530,000 increase in cash during the year ($800,000 from positive operating cash
flow, $600,000 from positive investing cash flow, and $870,000 from negative financing cash flow).
This change in cash is confirmed by reference to the beginning and ending cash balances.

NONCASH INVESTING/FINANCING ACTIVITIES

The noncash investing and financing section reports that preferred stock was issued for a building.

RECONCILIATION
The statement of cash flows just presented is known as the direct approach. It is so named because
the cash items entering into the determination of operating cash flow are specifically identified. In
many respects, this presentation of operating cash flows resembles a cash basis income statement.
An acceptable alternative is the indirect approach. Before moving on to the indirect approach, be
aware that companies using the direct approach must supplement the cash flow statement with a
reconciliation of income to cash from operations. This reconciliation may be found in notes
accompanying the financial statements:

Notice that this reconciliation starts with the net income, and adjusts to the $800,000 net cash from
operations. Some explanation may prove helpful:

Depreciation is added back to net income, because it reduced income but did not consume any
cash.

Gain on sale of land is subtracted, because it increased income, but is not related to
operations (remember, it is an investing item and the gain is not the sales price).

Increase in accounts receivable is subtracted, because it represents uncollected sales included


in income.

Decrease in inventory is added, because it represents cost of sales from existing inventory
(not a new cash purchase).

Increase in accounts payable is added, because it represents expenses not paid.

Decrease in wages payable is subtracted, because it represents a cash payment for something
expensed in an earlier period.

This can become rather confusing. Most can probably see why depreciation is added back. But, the
gain may be fuzzy. It must be subtracted because one is trying to remove it from the operating
number; it increased net income, but it is viewed as something other than operating, and that is why
it is backed out. Conversely, a loss on such a transaction would be added. Remember, the full proceeds
of an asset sale are reported within investing activities, regardless of whether the sale produced a gain
or loss.
The following drawing is useful in simplifying consideration of how changes in current assets and
current liabilities result in reconciliations of net income to operating cash flows. Begin by thinking
about a reconciling item that is fairly easy to grasp. Emersons accounts receivable increased on the
balance sheet, but the amount of the increase was subtracted in the reconciliation (again, this
increase reflects sales not yet collected in cash, and thus the subtracting effect). In the drawing below,
consider that accounts receivable is a current asset, and it increased. This condition relates to the
upper left quadrant; hence the increase is shown as subtracted.

Using the accounts receivable analysis as a benchmark, it then becomes logical that all increasing
current assets result in subtractions in the reconciliation. This relationship is inversed for current
liabilities, as shown in the upper right quadrant of the drawing. Similarly, these relationships are
further inversed for account decreases as shown in the bottom half of the drawing. With the drawing it
mind, it becomes a simple matter to examine changes in specific current accounts to determine
whether they are generally added or subtracted in the reconciliation of net income to cash flows from
operating activities. Using the Emerson example:

Indirect Approach To Presenting Operating Activities


Although accounting standards encourage the direct approach, most companies actually present an
indirect statement of cash flows. The indirect approach is so named because the reconciliation
replaces the direct presentation of the operating cash flows. Except for the shaded areas, this
statement is identical to the direct approach. The first shaded area reflects the substitution of the
operating cash flow calculations. The second shaded area reflects that the indirect approach must be
supplemented with information about cash paid for interest and taxes.

Using A Worksheet To Prepare A Statement Of Cash Flows


Given enough time and careful thought, one can generally prepare a statement of cash flows by
putting together a rough shell that approximates the statements illustrated throughout this chapter,
and then filling in all of the bits and pieces that can be found. Ultimately, the correct solution is
reached when the change in cash is fully explained. This is like working a puzzle without reference to a

supporting picture. But, complex tasks are simplified by taking a more organized approach. To that
end, consider the value of a worksheet for preparing the statement of cash
flows.
The worksheet examines the change in each balance sheet account and relates it to any cash flow
statement impacts. Once each line in the balance sheet is contemplated, the ingredients of the cash
flow statement will be found! A sample worksheet for Emerson is presented on the following page.
In this worksheet, the upper portion is the balance sheet information, and the lower portion is the
cash flow statement information. The change in each balance sheet row is evaluated and keyed to a
change(s) in the cash flow statement. When one has explained the change in each balance sheet line,
the accumulated offsets (in the lower portion) reflect the information necessary to prepare a
statement of cash flows.
Specific explanations for each keyed item in the worksheet are found in the following table. The cash
flow statement explanations are color coded such that blue is the final balancing step, red is cash
outflow, black is cash inflow, and green is special.