Accounting Review by Merrill Lynch For CFA

Global
March 2003
Professor David F. Hawkins
(1) 212 449-3263
Accounting
Bulletin #116
2003 CFA
Level I and II Accounting and

Financial Analysis Review
Merrill Lynch Global Securities Research & Economics Group
Global Fundamental Equity Research Department
RC#60207802 #18405
Investors should assume that Merrill Lynch is
seeking or will seek investment banking or other
business relationships with the companies in
this report.
Refer to important disclosures at the end of this report.
Accounting Bulletin #116 March 2003
2 Refer to important disclosures at the end of this report.
CONTENTS
n Section Page
2003 CFA
I and II Accounting
and Financial Analysis Review
1. 4
Influential Organizations 2. 5
Process of Development 3. 6
Enforcement and Penalties 4. 7
Auditing 5. 8
Basic Accounting Concepts 6. 9
Corporate Financial Reports 7. 10
Balance Sheet 8. 11
Income Statement 9. 14
Statement of Cash Flows 10. 16
Journal Entries 11. 20
Consolidation 12. 21
Revenue Recognition 13. 22
Expense Recognition 14. 25
Inventories and Cost
of Goods Sold 15. 26
Intangible Assets and
Amortization 16. 29
Bonds and Interest 17. 31
Contingencies 18. 34
Leases 19. 35
Refer to important disclosures at the end of this report. 3
n Section Page
Pension Benefits 20. 39
Post Retirement Benefits
Other Than Pensions 21. 42
Deferred Taxes 22. 43
Owners Equity 23. 46
Earnings Per Share 24. 49
Business Combinations 25. 51
Tangible Assets and
Depreciation 26. 54
Inflation 27. 57
Segment Disclosure 28. 58
Foreign Currency Translation 29. 59
Stock Based Compensation 30. 63
Derivatives 31. 64
Marketable Securities 32. 66
Special Income Statement Items 33. 68
Principal Differences Between
U.S. and Non-U.S. GAAP 34.
69
Financial Ratio Analysis 35. 70
Quality of Earnings Analysis 36. 76
1. 2003 CFA
Level I and II Financial

Statement Analysis Review
This Accounting Bulletin is a summary of the financial analysis ratios and
accounting institutions, concepts, definitions, and standards that candidates for the
CFA Level I and II examinations should be familiar with.
1
This Accounting
Bulletin is not intended to be or act as a substitute for the Association for
Investment Management and Research (AIMR) study guides and assigned
study materials. Rather, the Accounting Bulletins intended use is as a quick
review vehicle for the candidate who has completed the official study materials,
and wants to refresh his or her recollection of topics studied. Candidates should be
aware that the wording, but not the substance, of the definitions and description of
concepts included in this Accounting Bulletin may differ from those included in
the official materials. This may be a plus for candidates who are having trouble
comprehending the official materials. A different wording may help them to grasp
the substance of a troublesome topic. While we believe the information contained
in this Accounting Bulletin is accurate, if there are any discrepancies between this
Accounting Bulletin and the AIMR study guides and assigned materials, the
AIMR materials should be followed.
The Bulletin covers both CFA I and II level materials. CFA I candidates should
only focus on the topics required for CFA I. They should ignore the others.
CFA II candidates are expected to know both the CFA I and II materials.
Candidates who wish to keep current with U.S. and non-U.S. accounting
developments should ask their Merrill Lynch sales representative to add their
name to the Merrill Lynch mail and e-mail lists to receive Professor David F.
Hawkins regularly published Accounting Bulletins and Accounting Updates.

1
The Association for Investment Management and Research does not endorse, promote, review, or
warrant the accuracy of this Accounting Bulletin. Association for Investment Management and
Research and CFA are trademarks owned by the Association for Investment Management and
Research.
2. Influential Organizations
Although the Securities and Exchange Commission (SEC) has the responsibility
to set accounting standards for registered U.S. companies, the SEC has delegated
this task to the Financial Accounting Standards Board (FASB), a private body
supported by private funds that sets accounting standards for both registered and
private companies. The accounting standards set by the FASB are referred to as
Generally Accepted Accounting Principles (GAAP). The FASB also sets
accounting standards for non-profit organizations. The FASB has a full time
standard setting board supported by a research staff.
The Emerging Issues Task Force (EITF), a sub-group of the FASB, deals with
emerging accounting issues that need to be resolved in a timely manner. GAAP is
also established, with the approval of the FASB, by the American Institute of
Certified Public Accountants (AICPA), a professional organization of certified
public accountants. The AICPA issues Statements of Position (SOPs) dealing
with specific accounting issues, Statements on Auditing Standards setting forth
generally accepted auditing standards, and Audits and Accounting Guides, which
typically focus on specific industry accounting and auditing issues.
Accounting standards for government bodies are set by the Government
Accounting Standards Board (GASB).
The International Accounting Standards Board (IASB), located in London,
England, is the successor body to the International Accounting Standards
Committee (IASC) established in the early 1970s to encourage the
harmonization of global accounting standards. Prior to its demise, the IASC had
issued a number of International Accounting Standards (IAS).
2
The IASB is a
private body supported by professional accounting associations and private
contributors worldwide. Many non-U.S. companies, stock exchanges, and national
accounting setters have adopted or permit the use of IAS.
Outside of the U.S., accounting standards are typically incorporated through
legislation or regulatory decisions into the laws governing companies. These may
be supplemented by standards and interpretations issued by independent boards or
local associations of professional auditors.
Within the European Union (EU), the European Commission is responsible for
ensuring the member states accounting standards are consistent with the various
EUs accounting directives. The European Commission supports and cooperates
with the IASB. While the accounting practices of the EU members differ,
increasingly listed companies are using either IAS or U.S. GAAP. All EU listed
companies must adopt IAS in 2005 or 2007 if they are using U.S. GAAP.
The International Organization of Securities Commissions is a voluntary
organization without regulatory powers of national security regulators from over
60 countries including the USA. It has approved IAS for cross-border listing of
securities. It supports and cooperates with the IASB.

2
The standards issued by the IASC will continue to be referred to as International Accounting Standards.
The IASB standards are referred to as International Financial Reporting Standards (IFRS).
3. Development Process
The FASB develops GAAP through a process that begins by adding an accounting
topic to its agenda and forming an ad hoc task force of experts on the topic to
work with it to develop a Discussion Memorandum (DM) outlining the related
issues and possible solutions that the FASB might consider. Next, after public
comment on the DM, the FASB issues an Exposure Draft (ED) of its proposed
standard. The FASB solicits comments on the ED. After reviewing those
comments, a final Statement of Financial Accounting Standard is issued if it is
approved by a majority of the Board. A final standard includes the standard, an
explanation of the Boards decisions, and illustrative examples.
4. Enforcement and Penalties
The SEC monitors the financial reporting practices of registered companies using
primarily the annual financial statements included as part of a companys annual
Form 10-K filings, interim period financial statements included as part of a
companys quarterly Form 10-Q filings, and, in the case of foreign company
registrants, the local GAAP financial statements and reconciliation of local GAAP
and U.S. GAAP results included in Form 20-F filings.
The SEC may require a company whose accounting it believes fails to meet the
requirements of GAAP to reissue its financial statements in accordance with
GAAP. In some cases, civil or criminal charges might be brought against officers
and directors for misstatements, fraud, or criminal acts involving financial
statement representations.
5. Auditing
Management is responsible for their companys financial statements. The
independent certified public accountant is responsible for his or her opinion on
those financial statements.
An audit is an examination intended to serve as a basis for an independent certified
public accountant to express an opinion regarding the completeness, fairness,
consistency, and conformity with GAAP of financial statements prepared by a
corporation or other entity for submission to the public or other interested parties.
Audits should be conducted in accordance with generally accepted auditing
standards. These standards require the auditor to plan and perform an audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatements. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in financial statements. An audit also
includes assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial presentation.
An auditors report may be an unqualified or clean opinion (the usual case), a
disclaimer of opinion (usually because of scope limitations, such as inability to
audit inventories), a qualified opinion (everything is okay except for some
accounting practice that is not in accordance with GAAP), and an adverse opinion
(the financial statements are not in accordance with GAAP). If there is uncertainty
as to a companys ability to continue as a going concern, the audit opinion should
note this uncertainty.
IAS: Financial statements that comply with IAS should disclose that fact.
Financial statements should not be described as complying with IAS unless they
comply with all the requirements of each applicable standard. In the extremely
rare circumstances when management concludes that compliance with a
requirement in a standard would be misleading, and therefore that departure from
a requirement is necessary to achieve a fair presentation, an enterprise can depart
from IAS with appropriate disclosures of the departure, the reasons for it, and its
financial statement impact.
6. Basic Accounting Concepts
Accounting practices and standards rest on a number of basic accounting concepts
that serve as guides to the appropriate accounting for business transactions and the
formulation of accounting standards. The basic concepts are:
Dual Aspect: Assets = Liabilities + Owners Equity. After the recording of a
transaction in the accounting records, this equation must be in balance.
Monetary: Accounting records only transactions that can be expressed in
monetary terms.
Historical Cost: Non-monetary assets are measured at their cost rather than some
other value, such as market value.
Realization: Revenues are realized when goods or services are exchanged for a
valuable consideration, and the revenue amount can be verified with a reasonable
degree of objectivity.
Matching: Expenses of a periods activities are matched with the associated
revenues.
Materiality: Accounting concepts and standards only apply to material amounts.
Going Concern: Unless evidence suggests otherwise, it is assumed that the
company will continue to operate into the foreseeable future.
Conservatism: Revenues are recognized when they are reasonably certain.
Expenses are recognized when they are reasonably possible.
Entity: Financial statements are for entities, in contrast to the persons associated
with these entities.
Relevance and Reliability: To be useful, accounting information must be
relevant and reliable. Relevance is the capacity of the information to influence a
users decision or expectations. Relevance also incorporates the notion that
information must be timely. The reliability of information refers to its
representational faithfulness to the underlying economic reality.
Accrual vs. Cash: Financial statements based on cash accounting record
revenues when cash is received and expenses when cash is paid out. The financial
reports of public companies use accrual accounting. Accrual accounting
recognizes revenues in the period in which they are earned, and expenses in the
period in which they are incurred. The recognition of revenues and expenses is not
dependent on when cash is received or paid out. Accrual accounting is preferred to
a cash based approach because it provides a better measure of performance by
better matching of effort and accomplishment.
IAS: Generally, the IASB observes the same basic accounting concepts as the
FASB, except the IASB permits as an alternative to the historical cost concept the
revaluation upwards of fixed assets such as buildings.
7. Corporate Financial Reports
The function of corporate financial reports is to provide through a set of
statements and accompanying notes a continual history, expressed in money
terms, of the economic resources and obligations of a business enterprise and of
the economic activities that affect those resources and activities. These items and
any changes in them are identified and measured in conformity with financial
accounting principles that are generally accepted at the time the statements are
prepared. The typical outputs of this process are the statement of financial position
(balance sheet), the income statement, and the statement of cash flows.
Financial reports should provide reliable, relevant, consistent, and timely
information that is:
Useful to present and potential investors and creditors in making rational
investment and credit decisions.
Comprehensible to those who have a reasonable understanding of business
and economic activities and are willing to study the information with
reasonable diligence.
About the economic resources of an enterprise, the claims to those resources,
and the effects of transactions and events that change resources and claims to
those resources.
About an enterprises operating and financial performance during a period.
About an enterprises cash flows during a period.
Accompanying Information: Financial statements include explanatory notes
which are an integral part of the financial report describing the accounting policies
used and providing additional details. Publicly traded companies also provide in
their financial reports a Management Discussion and Analysis section in which
management reviews significant off-balance sheet arrangements, accounting
policy decisions, trends, events, capital expenditures, liquidity, expectations and
uncertainties and their relationship to the companys financial condition and
results of operations.
8. Balance Sheet
A balance sheet presents information related to a companys financial condition as
of a specific date based on the basic accounting concepts and generally accepted
principles of accounting. These data are classified in three main categories
assets, liabilities, and owners equity.
The basic accounting equation upon which the balance sheet is based is:
Assets = Liabilities + Owners Equity
Assets are probable, measurable, future economic benefits (things of value) to
which a business holds the rights which have been acquired through a current or
past transaction.
Liabilities are probable, measurable, future economic sacrifices arising from a
companys obligations to convey assets or perform services to a person, firm, or
other organization outside of the company at some time in the future.
Owners equity is the residual balance remaining after total liabilities are deducted
from total assets.
Assets and liabilities are presented in two categories: current and non-current.
Current assets are cash and cash equivalents and those assets that are expected to
be liquidated (turned into cash) or consumed during the next twelve months or the
companys operating cycle, whichever is longer. Current liabilities are those
liabilities that are expected to become due within the next twelve months. Assets
and liabilities that are not classified as current are classified as non-current. Within
the current asset section, the assets are listed in descending order of liquidity,
(cash, accounts receivable, etc.). Typically, accounts payable are listed at the head
of the current liability presentation with the other current liabilities presented in no
particular order.
On the asset side of the balance sheet, current assets are listed above non-current
assets. The same is true for the liability display. Current liabilities are displayed
before non-current liabilities. Owners equity follows total liabilities in the balance
sheet presentation. The components of owners equity are listed in order of their
preference in liquidation, (i.e., preferred stock is listed before common stock).
Common Current Assets:
Cash. Includes cash on hand, undeposited checks at the date of the balance sheet,
cash in banks, and checks in transit to banks.
Marketable Securities. Short-term securities held for trading and investment
purposes.
Accounts Receivable. Represent claims against customers generated by credit
sales for amounts still due the company. The account balance includes only
billings for services performed or products sold on or before the balance sheet
date. The amount presented is net of the companys estimated losses from
uncollectible accounts.
Notes Receivable. Amounts owed to the reporting company that are evidenced by
a formal note. The account balance is net of estimated uncollectible amounts.
Accounts and notes receivable not expected to be collected during the next twelve
months or current operating cycle (whichever is longer) are classified as non-
current assets.
Inventories. Products that will be sold directly or included in the production of
items to be sold in the normal course of operations. The inventory account may
include three types of inventory: a finished goods inventory, consisting of
products ready for sale; a work-in-process inventory, consisting of products in
various stages of production; and a raw materials and supplies inventory,
consisting of items that will enter directly or indirectly into the production of
finished goods. Inventories are carried at cost, unless their utility is no longer as
great as their cost, in which case the lower-of-cost-or-market rule requires the
carrying value of inventories to be written down below cost.
Prepaid Expenses. Amounts paid to vendors, such as for a 3 year insurance
policy with 2 years to expiration, that will benefit accounting periods beyond the
current period.
Common Non-Current Assets:
Investments. Investments in common stock or debt securities made for long-term
investment purposes where the companys objective is one of control, affiliation,
or some continuing business relationship with the issuing company.
Property, Plant and Equipment. Long-lived (fixed) tangible assets used in the
companys operations. Land is reported at its original cost. Other fixed assets are
reported at their original cost less their related accumulated depreciation.
Accumulated Depreciation. Depreciation represents the allocation to accounting
periods of the cost of fixed assets due to use and obsolescence. An annual charge
for depreciation is included in the expenses of current operations. The amount of
this depreciation expense is related to the anticipated useful life of the asset, which
may be computed on the basis of either expected years of service or actual use
(i.e., hours of operation, units produced, etc.). The accumulated amount of
depreciation expense related to the fixed assets still carried on the books of the
company is presented on the balance sheet in an account called accumulated
depreciation. Sometimes the term allowance for depreciation is used.
Intangible Assets. Non-physical assets created through a business transaction
with continuing value, such as goodwill, copyrights, trademarks, franchises, and
investments in software. The cost of most intangible assets is charged
(amortized) against income over their useful life. Acquired intangibles with an
indefinite life and goodwill are not amortized. Their carrying amount is written
down to their fair value when the assets value is impaired. The loss of value is a
charge to earnings.
Deferred Tax Asset. The amount of a companys potential future income tax
credits, such as net operating loss tax credit carryforwards, that management
believes will more likely than not reduce future tax payments.
Common Current Liabilities:
Accounts Payable. Amounts owed to trade creditors.
Accrued Expenses. Amounts owed to employees and others for services that
have been recorded as assets or expenses but not yet paid.
Notes Payable. Unpaid obligations to creditors that are evidenced by a note, such
as a short-term bank loan.
Current Maturities on Long-Term Debt. Amount of long-term debt that must be
paid during the next 12 months.
Taxes Payable. Taxes that must be paid to taxing authorities during the next 12
months.
Dividends Payable. Dividends declared but not yet paid.
Deferred Revenue. Unearned revenues, such as unfulfilled subscriptions, that will
be earned during the next 12 months. Deferred revenue may also be classified as a
non-current account.
Common Long-Term Liabilities:
Long-Term Debt. Debt obligations of a company that will mature beyond one
years time. They are recorded at the present value of all future cash payments.
Deferred Tax Liability. The amount of a companys potential income tax
obligation that a company has deferred from past periods to future periods by
reporting lower profits for taxation purposes than for financial reporting purposes.
This liability results from using different accounting practices for financial and tax
return reporting.
Allowances and Contingencies. Estimates of costs already charged to income for
planned or anticipated future events such as restructurings and litigation losses.
Common Owners Equity Accounts:
Common Stock. The par value or stated value of the common stock (basic
ownership interest in the corporation).
Capital Received in Excess of Par Value of Stock Issued. The difference
between the amount received by a company from the issuance of common stock
and the amount from the issuance assigned to the common stock account.
Other Comprehensive Income. Change in owners equity of a company during a
period from transactions and other events and circumstances from non-owner
sources, such as the gains and losses arising from translating foreign subsidiary
financial statements expressed in local currency into U.S. dollars.
Treasury Stock. The cost of acquisitions by a company of its own common stock.
It is a negative owners equity balance.
Retained Earnings. The cumulative net income of a company since inception less
dividends paid to shareholders.
IAS: Companies adopting IAS may use a variety of different balance sheet
formats. A common format is, starting at the top of the list of assets, assets are
presented in increasing order of liquidity (property at the top and cash at the
bottom). The order of presentation on the right hand side of the balance sheet
begins with owners equity, then non-current liabilities followed by current
liabilities. Different terminology may be used for accounts (inventories may be
called stocks).
Financial Analysis: A number of financial ratios are commonly used to analyze
both the components of the balance sheet as well as their relationship to certain
income statement items (see Financial Ratio Analysis discussion).
9. Income Statement
The results of operations of a business for a period of time are presented in the
income statement. The basic income statement equation is:
Net Income = Revenue - Expenses
The income statement may show income (loss) from continuing operations,
income (loss) from discontinued operations, extraordinary items, and cumulative
accounting change items as part of the net income measurement. Discontinued
operations are parts of a business that management has decided to sell or close
down. Extraordinary items are rare. They are events or transactions that are
unusual in nature given the type of the reporting companys activities and that
occur infrequently. Cumulative accounting change items are the cumulative effect
up to the date of the change of changing from one accounting principle to another.
The cumulative effect is the amount by which the periods beginning retained
earnings would have been different if the new principle had been used in the past.
Unusual items are included in income from continuing operations.
Common components of net income:
Revenues. Includes the revenues earned from the sale of goods and services to
customers. It is usually presented net of returns, allowances, discounts, and
warranty provisions.
Cost of Sales. The costs the company incurred to purchase and convert materials
into the finished products sold to customers.
Gross Margin. The difference between revenues and cost of sales.
Operating Expenses. Expenses of an operating nature, such as general, selling,
and administrative expenses, incurred in the generation of revenue.
Operating Income. Gross margin less operating expenses.
Other Income. Includes non-operating sources of income and expenses, such as
interest and dividend income, gains and losses on asset sales, interest expense, and
unusual one-time charges.
Income Before Taxes. Operating income plus other income.
Income Taxes. The tax assessed on a companys taxable income for the
accounting period plus potential future taxes or tax credits arising from the
difference between a companys income before taxes and its taxable income
shown on the periods tax returns.
IAS: Income statements follow similar formats to the U.S. format, with
sometimes different terminology. For example, sales may be called turnover and
operating profits may be referred to as trading profits.
Alternative Concepts: There are a number of alternative concepts of income to
accounting income encountered in theory and practice. These include:
Economic Income. A concept of earnings that equates earnings to a companys
periodic net cash flow plus the change during the period in the market value of its
assets. In a world of certainty, the market value of a companys assets is the
present value of their future cash flows discounted at the risk free interest rate. In
the real world, future cash flows and interest rates are not known with certainty.
As a result, the following other concepts of income are used as a proxy for
economic income.
Distributable Earnings. The dividends that can be paid without changing a
companys value.
Sustainable Income. Future periodic income level that can be sustained by a
companys investment in inventory and fixed assets.
Permanent Earnings. The periodic income level a company can normally earn
given its asset base.
Permanent earnings equals the market value of a companys assets times its
required rate of return.
Economic earnings and its proxies are not equivalent to accrual based accounting
earnings.
Financial Analysis: A number of financial ratios are commonly used to analyze
both the components of the income statement as well as their relationship to
certain balance sheet items (see Financial Ratio Analysis discussion).
10. Statement of Cash Flows
Statement of Cash Flows: A statement showing a companys sources and uses of
cash for a period of time. The statement has three sections cash flow from (used
in) operations, cash flow used for (from) investments, and cash flow from (used
in) financings. The statement foots to change in cash, which is defined as cash and
cash equivalents, (i.e., short-term, highly liquid investments whose value is not
impacted by changes in interest rates).
Two Formats: Cash flow statements can be presented using one of two formats
the direct and indirect formats. The only difference between the two is the
presentation of cash flow from operations. The direct format reports cash flows
used in and generated by operations, (i.e., cash paid to suppliers and cash received
from customers), as reflected in the reporting companys cash account. The
indirect format begins with net income, adds (such as depreciation) or subtracts
(such as equity method income in excess of dividends received) as appropriate
non-cash income statement items, and then adds (such as reduction of accounts
receivable) or subtracts (such as increase in inventory) changes in working capital
accounts, excluding short-term debt, cash and cash equivalents. Both formats will
report the same cash flow from operations amount.
Classification Rules: Typically, the classification of transactions in the statement
of cash flows as either operating, investing, or financing transactions is
straightforward. There are some exceptions.
Investing: Investing activities include cash outflows to acquire debt and equity
securities of other companies as investments (other than cash equivalents) and
property, plant and equipment. Investing cash inflows include the receipts from
the sale of investment securities (other than cash equivalents) and the sale of
property, plant and equipment.
Financing: Financing activities include proceeds from issuing equity, bonds,
mortgages, notes, and short-term borrowings. Cash outflows for financing
activities include repayments of amounts borrowed, dividends, and purchases of
treasury stock.
Operating: Operating cash flows include all cash transactions that are not
classified as either financing or investing activities. Operating activities generally
involve producing and delivering goods and providing services.
Dividends Paid and Received. Dividends paid are a financing item. Dividends
received are an operating item.
Interest Received and Paid. Interest received and paid are operating items under
U.S. GAAP.
Only Cash Items. Irrespective of which category of the statement of cash flows is
being considered as the correct classification of a transaction, it is important to
remember that only items that change a companys cash balance are classified as
cash flows and, therefore, includable in the statement of cash flows. Activities that
do not change a companys cash balance, such as the issuance of bonds for a
building or the issuance of stock for the conversion of convertible debt, are not
reported in the statement of cash flows. They are listed as non-cash transactions in
a note attached to the statement of cash flows.
Transaction Decisions. A decision to use one form of a transaction rather than
another can change the transactions related cash flow classification. For example,
a decision to borrow funds using a zero coupon bond rather than straight debt can
change the treatment of interest. Interest accrued on a zero coupon bond is a non-
cash item. It is not included in the statement of cash flows, whereas straight debts
cash interest paid to debt holders is included. Another example is a decision to
structure a lease transaction as either an operating or a capital lease. The cash
rental payment on a lease agreement structured as an operating lease is an
operating item, since no obligation is recorded. If the lease is structured as a
capital lease, a rental obligation is recorded, a portion of the cash rental payment is
accounted for as interest on the obligation an operating item and the rest is
treated as a reduction of the obligation a financing item.
Accounting Policy Decisions. Accounting decisions can change cash flow
classification. The decision to expense an item rather than capitalize it changes the
items classification. If software development cash outflows are expensed as
incurred, they are an operating item. If they are capitalized, the outflow is
classified as an investment item. Interest capitalized as part of a long-term assets
cost is included in the investing section as part of the assets cost. Interest that is
not capitalized is an operating item.
Balance Sheet Classification Decision. The decision to classify an expenditure of
cash as a current or non-current asset can influence the cash flow classification.
For example, an auto rental company may classify on its balance sheet its rental
fleet as a current asset inventory an operating cash outflow or as a non-current
fixed asset an investing cash outflow.
IAS: A statement of cash flows classified by operating, investing, and financing
activities is required by IAS as an integral part of the financial statements. Interest
paid and received may be classified as an operating, investing, or financing
activity.
Illustration: The basic format of the statement of cash flows is:
Net cash provided (used) by operating activities
+ Net cash provided (used) by investing activities
+ Net cash provided (used) by financing activities
= Net increase (decrease) in cash
+ Beginning cash
= Ending cash
Direct Method. The direct method presentation of cash flow from operations (Cash
received from customers, dividends, and interest minus cash paid to suppliers,
employees, creditors, taxing authorities, and other operating cash outflows) can be
derived using balance sheet and income statement data as follows:
(a) Revenues
- Increase (+ decrease) in accounts receivable
= Customer cash collections *
* Cash inflow from interest received and dividends can be determined in a similar manner.
(b) Cost of goods sold
+ Increase (- decrease) in inventory
- Increase (+ decrease) in accounts payable
= Cash paid to suppliers
(c) Wages and salaries expense
- Increase (+ decrease) in wages and salaries payable
= Cash paid to employees
(d) Interest expense
- Increase (+ decrease) in interest payable
= Cash paid to creditors *
* Cash outflows for other operating cash flow components of an expense nature, such as professional fees and insurance
premium payments, can be determined in a similar manner.
(e) Tax expense
- Increase (+ decrease) in taxes payable
- Increase (+ decrease) in deferred tax liability
= Cash paid to taxing authorities
(f) Net cash provided (used) by operations =
(a) - [(b) + (c) + (d) + (e)]
Indirect Method. The indirect method presentation of cash flow from operations
can be derived from balance sheet and income statement data as follows: (Net
income plus or minus non-cash income statement items and changes in working
capital accounts other than cash and financing related accounts).
Net income
+ Depreciation
+ Goodwill and other intangible asset amortization changes
+ Deferred tax expense
- Deferred tax credit
+ Losses on asset sales
- Gains on asset sales
- Equity method income (net of related investee dividends)
= Funds from operations
+ Decrease (- increase) in current assets *
+ Increase (- decrease) in current liabilities **
+ Increase (-decrease) in current liabilities **
= Net cash provided by operations
* Except cash, cash equivalents, and investment securities.
** Except financing related items, such as short-term debt and current maturities of long-term debt.
Both Methods. The investing and financing sections of the statement of cash
flows use the same format and have the same totals under the direct and indirect
methods.
The investing cash flows can be derived from balance sheet and income statement
data (investments in capitalized intangibles, cash received from asset sales,
purchase of property, plant and equipment) as follows:
(a) Amortization of capitalized intangible assets charge
+ Increase (- decrease) in capitalized intangible assets
= Cash invested in capitalized intangible assets
(b) Book value of assets sold *
+ Gain (- loss) on sale of assets
= Cash received from asset sales
* In the case of depreciable property, original cost - accumulated depreciation.
(c) Ending cost of property, plant & equipment (PP&E)
+ Cost of PP&E sold
- Beginning cost of PP&E
= Cash invested in property, plant & equipment
(d) Net cash provided (used) by investing activities =
[(a) + (b) + (c)]
The financing cash flows (dividends paid, issuance and extinguishment of debt,
and issuance and acquisition of common stock) can be derived from balance sheet
and income statement data as follows:
(a) Net income
- Change in retained earnings
= Dividends declared
- Increase (+ decrease) in dividends payable
= Cash dividends paid
(b) Net cash provided (used) by financing activities =
Increase in long and short-term debt and common stock
- Decrease in long and short-term debt and common stock
- Dividends paid
Cash provided (used) by financing activities
Financial Analysis: Cash flow analysis can enhance the analysts understanding
of a companys liquidity, solvency, and financial flexibility. The classification
rules used to prepare statements of cash flows may not always lead to the most
useful insights into a companys cash flows and financing decisions. Some of the
common financial analyst adjustments to published statements of cash flows
include: Restating the cash flow from operations to include operating-like cash
flows classified as a result of accounting decisions as non-operating, such as
capitalized interest and capitalized software development cash outflows;
reclassifying of interest paid and dividends received as financing items to better
understand the cash flows related to a companys core businesses; and, the
inclusion of significant non-cash transactions in the cash flow analysis to better
understand a companys cash flow needs irrespective of its financing methods.
Another adjustment made to improve the usefulness of accounting cash flow data
is the deduction of cash outlays for replacement of current operating capacity from
cash flow from operations to compute free cash flow. Free cash flow is the
amount available to finance capacity expansion, reduce debt, pay dividends, or
acquire a companys own stock. Sometimes dividends are deducted to compute
free cash flow.
11. Journal Entries
The debit-credit double entry system for recording accounting entries is an
extension of the basic accounting equation:
or
Debit Balances = Credit Balances
Debit Entries: Debit entries to accounts are increases in assets, increases in
expenses, decreases in revenues, decreases in liabilities, and decreases in owners
equity.
Credit Entries: Credit entries to accounts are decreases in assets, decreases in
expenses, increases in revenues, increases in liabilities, and increases in owners
equity.
n Debit-Credit Rules
(Example: Cash) (Example: Notes Payable) (Example: Retained Earnings)
Debit Increases
(+)
Credit Decreases
(-)
Debit Decreases
(-)
Credit Increases
(+)
Debit Decreases
(-)
Credit Increases
(+)
Revenues - Expenses = Net Income
(Example: Sales) (Example: Wage Expenses) (Example: Profit or Loss)
Debit Decreases
(-)
Credit Increases
(+)
Debit Increases
(+)
Credit Decreases
(-)
Debit Loss
(-)
Credit Profit
(+)
Adjusting Entries: Adjusting entries are required because not all accounting
entries are driven by transactions. For example, once a 3-year prepaid insurance
policy is bought, there are no further transactions to initiate the recording of the
related annual expense as the insurance coverage expires over the 3-year period.
An adjusting entry must be made to record the annual expense.
Illustration: A 3-year insurance policy is bought for $3,000. The acquisition
entry is:
Dr. Prepaid Insurance (+Asset) 3,000
Cr. Cash (- Asset) 3,000
At the end of each of the next two years, the following adjusting entry must be
made to recognize that one year of the insurance policy has expired:
Dr. Insurance Expense (+ Expense) 1,000
Cr. Prepaid Insurance (- Asset) 1,000
Another example of an adjusting entry is the recording of accrued expenses
(expenses incurred during the period for which a bill has not been received). For
example, employers have wages of $1,000 due to them for work done to date.
Their payday is two days hence. The adjusting entry to record the companys
incurred wage expense to date is:
Dr. Wage Expense (+Expense) 1,000
Cr. Wages Payable (+ Liability) 1,000
When the wages are paid, the entry is:
Dr. Wages Payable (- Liability) 1,000
Cr. Cash (- Asset) 1,000
12. Consolidation
Consolidated Statements: Consolidate all entities where parent owns more than
50% of the stock. Only transactions with third parties are included in consolidated
statements.
Equity Method: Ownership interests between 20% and 50% are recorded using
the equity method; i.e., investor company records as investment (asset) its
percentage share (based on ownership percentage) of investee company owners
equity. Percentage interest of investor in investee companys income recorded as
income by investor company.
Cost Method: Record investment at cost. Include dividends received in income.
Minority Interest: Equity of shareholders other than parent company in
consolidated entities. Minority interest in consolidated entities is shown between
liabilities and owners equity on consolidated balance sheet. Minority interest in
consolidated entitys income is deducted to measure consolidated net income.
Joint Ventures: Reported using the equity method. The proportionate
consolidation approach, (i.e., eliminate the parents investment and equity method
income in the consolidated statements and include the joint ventures financial
statement account balances excluding owners equity and net income in the
parents consolidated statements on a pro rata basis based on the parents
ownership proportion), is rarely used in the U.S.
IAS: Consolidate all entities controlled by votes or dominant influence, unless long-
term restrictions on ability to transfer funds to parent or held for near-term sale.
Illustration: Assume an investor buys a 19% interest in an investee company.
The cost method is required.
Transaction Cost Method
1. Investor acquires 19% of investee companys
stock for $200,000
Dr. Investment (+)
Cr. Cash (-)
200,000
200,000
2. Investee reports $40,000 earnings No entry
3. Investee pays $20,000 in dividends.* Dr. Cash (+)
Cr. Dividend Income (+)
3,800
3,800
4. Investee reports $30,000 loss No entry
* $20,000 x .19
Assume an investor buys a 40% interest in the same company used in the above
illustration. The equity method is required:
Transaction Equity Method
1. Investor acquires 40% of investee
companys stock for $421,053
Dr. Investments (+)
Cr. Cash (-)
421,053
421,053
2. Investee reports $40,000 earnings. * Dr. Investments (+)
Cr. Income (+)
16,000
16,000
3. Investee pays $20,000 in dividends. ** Dr. Cash (+)
Cr. Investments (-)
8,000
8,000
4. Investee reports $30,000 loss. *** Dr. Income (-)
Cr. Investments (-)
12,000
12,000
* $40,000 x .4
** $20,000 x .4
*** $30,000 x .4
Financial Analysis: Companies may sponsor off-balance sheet arrangements
(entities that are not consolidated) that may be used to fabricate profits, hide losses
and debt, as well as lower the taxes payable. A complete analysis of the company
should include a consideration of these off-balance sheet arrangements.
13. Revenue Recognition
Revenue: The increase in owners equity resulting from operations during a
period of time, usually from the sale of goods or services.
Revenues and gains generally are not recognized until earned and realized or
realizable. Revenues are considered to have been earned when the entity has
substantially accomplished what it must do to be entitled to the benefits
represented by the revenues. Revenues and gains are realized when products
(goods or services), merchandise, or other assets are exchanged for cash or claims
for cash and the related assets received or held are readily converted to known
amounts of cash or claims to cash.
A more specific set of criteria specified by the SEC that must be met in order to
recognize revenue are:
1. Persuasive evidence that a properly executed sales agreement exists.
2. Delivery has occurred or services have been rendered.
3. The sellers price to the buyer is fixed or determinable.
4. Collectability of the amount of the sale is reasonably assured.
5. The costs of the goods or services provided can be readily determined.
Various Methods: The most frequently encountered revenue recognition
methods are:
1. Recognition at the time services are rendered or goods are delivered, (i.e.,
sales method). Used when all the criteria for revenue recognition are met at
the time services are rendered or title to goods is transferred to customer
(usually when goods are delivered).
2. Recognition proportionally at the time an installment payment is collected,
(i.e., installment sales method). Used when collection of the sales price is not
reasonably assured and the sale contract is an installment sale.
3. Recognition proportionally over the performance of a long-term contract,
(i.e., percentage-of- completion method). Used for long-term contracts when
reliable estimates of costs, revenues, and profit are available and collectability
is reasonably assured.
4. Recognition at the completion of a long-term contract, (i.e., completed
contract method). Used when it is not appropriate to use the percentage-of-
completion method because no contract exists, revenue estimates are
unreliable, or collectability is not assured.
5. Recognition as cash is received with profit recognized only after the buyers
cumulative cash payments exceed the sellers total costs, (i.e., cost recovery
method). Used when significant uncertainty exists as to collectability of
receivable or the cost of the services or goods provided.
Other Considerations: Some additional considerations are:
1. GAAP presumes percentage-of-completion accounting will be used for long-
term contracts.
2. GAAP presumes the sale method will be used for installment sale contracts.
3. Non-monetary transactions are based on fair value of assets or services
involved.
4. Right of return may preclude revenue recognition when level of returns is
uncertain.
5. Inappropriate interest rates may require remeasurement at market rates.
6. Provisions for bad debts, warranties, and returns should be made at the time
revenues are recognized.
Sale of Receivables: Accounts receivable are sometimes sold at a discount for
cash to accelerate the collection of cash from sales of products or services. To
qualify as a sale, the risks and rewards associated with holding the receivables must
be transferred to the buyer. Otherwise, the transaction is accounted for as a loan.
Allowance For Doubtful Accounts: An estimate of the bad debts expected to
result from credit sales. The estimate is charged to earnings and added to the
allowance, (reported as a deduction from accounts receivable). Actual bad debts
are charged against the allowance.
IAS: Similar to U.S. practices. (Similar should be interpreted to mean similar in
concept and thrust to U.S. GAAP, but not necessarily identical in all respects with
U.S. GAAP).
Illustration: The ABC Companys retail division uses the sale method to record a
$1,000 sale on credit. The accounting entry is:
Dr. Accounts Receivable (+) 1,000
Cr. Sales (+) 1,000
When the accounts receivable is paid, it is eliminated and cash increased.
Sometimes a seller receives (realizes) payment before the product is delivered or a
service is performed (earned). The ABC Companys magazine publishing division
sells magazine subscriptions for 12 monthly issues for $24. At the time the
subscription is received, the company has not yet earned the subscription revenue,
so its recognition is deferred for income statement purposes. The accounting entry
to record the receipt of cash and deferral of revenue (a liability) is:
Dr. Cash (+) 24
Cr. Deferred Revenue (+) 24
As each issue is delivered, an adjusting entry is made to recognize that a portion of
the deferred revenue liability is earned. The accounting entry per issue shipped is:
Dr. Deferred Revenue (-) 2
Cr. Revenue (+) 2
The ABC Companys retail division sells products on an installment basis. An
item costing the Company $800 is sold for $1,000 payable in ten $100 monthly
installments. The collection of the sale price is not reasonably assured, so the
installment method is used to recognize revenue. As each $100 payment is
received, a profit of $20 is recognized [=100 x (1,000 - 800)/1000].
The ABC Companys construction division has a contract to build a building for
$200,000. The estimated cost to complete the building is $150,000. During the
first month, the Company spends $20,000 on the buildings construction. Under
the percentage-of-completion method, the first months revenue and profit are:
Revenue $26,667 [=200,000 x (20,000/150,000)]; Profit $6,667 (=26,667 -
20,000). Under the completed contract method, no revenue or profit would be
recognized at the end of the month.
The ABC Company has credit sales of $100,000 during the accounting period. At
the end of the period, $30,000 remains uncollected. Based on past experience, the
Company expects $1,000 of the outstanding accounts receivable to be uncollectible.
1. Recognition of potential bad debts:
Dr. Bad Debt Expense (+) 1,000
Cr. Allowance For Doubtful Accounts (+) 1,000
2. Balance sheet presentation:
Accounts receivable (net of 1,000 allowance for doubtful accounts) 29,000
3. Recognition and write-off of $1,000 accounts receivable as a bad debt:
Dr. Allowance For Doubtful Accounts (-) 100
Cr. Accounts Receivable (-) 100
Financial Analysis: Aggressive revenue recognition should always be questioned
by financial analysts, particularly if it is accompanied by an increase or unusually
high level in the days sales outstanding represented by accounts receivable.
Different revenue recognition methods lead to different patterns of revenue and
profit over time and different levels of assets, liabilities, and owners equity. For
example, use of the percentage-of-completion method relative to the completed
contract method can lead to less volatile revenues and profits, higher owners
equity, and lower assets. Cash flow is unaffected by the revenue recognition
method choice. For example, while the percentage-of-completion method reports
income earlier than the completed contract method, the cash flow associated with
a particular contract is identical in each case.
14. Expense Recognition
Expense: A decrease in owners equity associated with profit directed activities
of an accounting period.
Like revenues, expenses can only result from profit-directed activities that change
owners equity. The reduction of inventory as the result of a sale is an expense,
since the net result of this operating transaction is a change in the owners equity
account retained earnings. The purchase of inventory on credit is not an expense.
It does not change owners equity. The purchase increases the asset inventory and
the payment of the liability trade payables decreases the asset cash.
Although the payment of dividends reduces owners equity, it is not an expense.
This transaction reduces cash and the owners equity retained earnings account,
but it is not a profit-directed activity. It is a distribution of capital.
Illustration: The basic entry to record an expense is:
Dr. Expense (+) XXX
Cr. Accounts Payable (+) XXX
Or
Cash (-) XXX
If an expense has been incurred but the company has not yet been billed, the
following adjusting entry to recognize the expense is made:
Dr. Expense (+) XXX
Cr. Accrued Expense (+) XXX
The entry to record payment is:
Dr. Accrued Expense (-) XXX
Cr. Cash (-) XXX
Financial Analysis: To defer the recognition of an expense, a company may
improperly capitalize the related expenditure (i.e., call it an asset) and then use an
excessively long amortization period to charge the capitalized amount to earnings.
Analysts should be alert to this form of earnings manipulation.
15. Inventories and Cost of Goods Sold
Inventories include all tangible items held for sale or consumption in the normal
course of business for which the company holds title, wherever they might be
located.
Basic Concept: Inventory and cost of goods sold accounting is based on a cost
flow assumption.
Basic Equation: Beginning Inventory + Purchases - Ending Inventory = Cost of
Goods Sold.
FIFO (First In, First Out): Cost of sales based on assumption that oldest goods
in inventory (costs) were the first sold during the period.
LIFO (Last In, First Out): Cost of sales based on assumption that most recently
purchased goods (costs) are sold first during the period. The notes of LIFO
accounting companies indicate the difference between the LIFO inventorys value
and its FIFO equivalent value. The difference is referred to as the LIFO reserve.
Under the U.S. tax code, if a company uses LIFO for tax purposes, it must use it in
financial reports. When a company changes from LIFO to FIFO inventory
accounting, it must restate its prior period income statements and balance sheets to
a FIFO basis.
Specific Invoice: Each item in inventory is identified and priced at its actual
acquisition cost. Usually only used for big ticket items.
Weighted Average: Assigns to ending inventory the average cost of the units
available for sale (beginning inventory + purchases) during the period.
LIFO Liquidation: If LIFO inventory levels are lowered (LIFO layer
liquidation), old purchase prices flow through to cost of goods sold increasing
profit above their FIFO equivalent (assumes rising prices).
Lower of Cost or Market: Inventory is valued at its cost or current replacement
market price, whichever is lower. If the current replacement market price is below
the inventorys cost, the inventory cost based value is written down to the lower
value and the amount of the writedown is charged to current income.
Inflation: During periods of rising prices, relative to FIFO inventory accounting
LIFO inventory accounting will lead to a lower inventory value, a higher cost of
goods sold, and lower profits. The lower LIFO profit will be reported for tax
purposes with the result that tax payments will be lower and cash inflow will be
higher using LIFO than if FIFO had been used. During periods of falling prices,
the opposite relationships between LIFO and FIFO occur. That is, LIFO relative to
FIFO leads to a higher ending inventory, lower cost of goods sold, higher profits,
higher taxes, and lower cash inflows.
IAS: Similar to U.S. practice.
Illustration: The ABC Company starts the month with zero inventory. During
the month, it makes the following inventory purchases:
Purchase Units Price Per Unit Total
No. 1 100 $1 $100
No. 2 100 $2 $200
No. 3 100 $3 $300
During the month, the company sold 100 units at $4 per unit.
1. If the company used FIFO inventory accounting, it would record the
following: cost of goods sold $100 (First-in); ending inventory $500
(Purchase Nos 2 and 3); pretax profit $300 (=400 -100); and, at a 40% tax
rate, taxes $120 (= 300 x .4). Net income is $180 (= $300 120).
2. If the company used LIFO inventory accounting, it would record the
following: cost of goods sold $300 (Last-in); ending inventory $300
(Purchase Nos 1 and 2); pretax profit $100 (=400 - 300); and, at a 40% tax
rate, taxes $40. Net income is $60 (= $100 40).
3. If the company used weighted average inventory accounting, the average unit
cost of the ending inventory and cost of goods sold is $2 [=(0 + 100 + 200 +
300)/300)]. The company would record: cost of goods sold $200 (= 100 x 2);
ending inventory $400 (= 200 x 2); pretax profits $200 (= 400 - 200); and, at a
40% tax rate, taxes $80 (= 200 x .4). Net income is $120 (= 200 80).
4. Summary:
Method Ending Inventory COGS Taxes Net Income
FIFO $ 500 $ 100 $ 120 $ 180
Av. Cost 400 200 80 120
LIFO 300 300 40 60
Relative to LIFO inventory accounting and average cost inventory accounting
(inventories stable or rising and prices rising), FIFO accounting results in higher
net income, inventories, current assets, working capital, total assets, owners
equity, and lower cash inflows. The same is true for average cost inventory
accounting relative to LIFO inventory accounting.
5. If the ABC Company used LIFO inventory accounting, in the notes to its
financial statements, it would disclose a $200 difference in value between its
LIFO valued ending inventory and its FIFO valued equivalent (300 - 500 = -
200). This $200 credit balance figure is the LIFO reserve. The $200 change in
the LIFO reserve (beginning LIFO reserve was $0) is the difference in cost of
goods sold as a result of using LIFO rather than FIFO inventory accounting
(100 vs. 300).
Financial Analysis: The basic inventory equation can be used to determine the
effect of over or understatement of beginning and ending inventories. For
example, assume beginning inventory is overstated by $1000. What is the effect?
Correct Overstated
Beginning Inventory $1000 $2000
+ Purchases 2000 2000
= Available Inventory 3000 4000
- Ending Inventory 500 500
= Cost of Goods Sold $2500 $3500
Last periods ending inventory (this periods beginning inventory) is overstated by
$1000 (= 2000 1000). This periods cost of goods sold is overstated by $1000.
The next periods beginning inventory (this periods ending inventory ) is correct.
Assume ending inventory is overstated by $1000. What is the effect?
Correct Overstated
This periods cost of sales is understated by $1000 (=2500 1500) and next
periods beginning inventory (this periods ending inventory) is overstated by
$1000 (=1500 500).
Assume purchases are overstated by $1000. What is the effect?
Correct Overstated
Beginning and ending inventories are correct, but this periods cost of goods sold
is overstated by $1000 (=3500 2500).
The LIFO reserve and the change in the LIFO reserve during the period can be
used to convert a LIFO accounting companys financial statements to a FIFO
basis. To convert a LIFO based financial statement to a FIFO basis (assume
increasing reserve):
LIFO inventory + LIFO reserve = FIFO inventory
LIFO cost of goods sold - change in LIFO reserve = FIFO cost of goods sold
LIFO gross margin + change in LIFO reserve = FIFO gross margin
LIFO profit before taxes + change in LIFO reserve = FIFO profit before taxes
LIFO net income + after-tax equivalent of change in LIFO reserve = FIFO net
income
The after-tax equivalent of the change in the LIFO reserve is equal to the change
in the LIFO reserve times one minus the tax rate. Restating LIFO based financial
statements to a FIFO basis for analytical purposes does not change cash flow since
actual taxes paid is based on the LIFO taxable earnings.
Financial Analysis: In periods of rising prices, companies may reduce LIFO
inventory levels to boost current earnings (i.e., run old lower costs through cost of
goods sold). Previously written down inventory may be sold at current selling
prices to boost current gross margins.
16. Intangible Assets and Amortization
An intangible asset is an expenditure for a non-monetary item that meets the
definition of an asset but does not have physical substance. Intangible assets are
recorded at their cost. Revaluation upwards is not permitted. Not all potential
intangible asset expenditures are recorded as assets because their potential benefits
or costs can not be reliably measured. In these cases, their costs are expensed as
incurred. The process of recording the cost of an intangible as an asset is referred
to as capitalization.
Amortization: Systematic process of charging the cost of an intangible asset to
income over the period expected to benefit from the asset. Two exceptions are
goodwill and acquired intangibles with indefinite lives. (See Business
Combination discussion.) These intangibles are not amortized. If indicators of
possible impairment are present, they are subjected to an impairment test and, if
impaired, written down to their fair value with a corresponding charge to earnings.
R&D: Expensed as incurred.
Software: Capitalize (i.e., record as an asset rather than as an expense as
incurred) testing and coding costs following completion of a working model or
detailed program design establishing technical feasibility. Amortize cost over sales
period (or, if the annual charge is larger, on a pro rata basis against actual sales
using anticipated sales to determine the allocation rate) if software sold or useful
life if used internally.
Advertising: Advertising costs are expensed as incurred, except direct mail
advertising costs that can be capitalized if a reliable estimate of the response rate
can be made based on past experience.
Purchased Intangible Assets: Generally, the cost of purchased intangible assets
(goodwill, patents, copyrights, brands, and licenses) are recorded as intangible
assets. In contrast, the costs of developing most intangible assets internally are
expensed as incurred.
IAS: Similar to U.S. GAAP except development costs should be capitalized if
they are recoverable through future sales. IAS specifies a 20-year maximum
intangible asset amortization period which can be extended if justified. Intangible
assets can be revalued upward to their fair value only if fair value can be
determined by reference to an active market.
Illustration: The ABC Company spent $3 million to develop software for
internal use. Management determined that $1 million was spent prior to reaching
the point where management committed to the completion of the project based on
their belief that the project had reached the stage of being technically feasible.
Management estimated the useful life of the completed software was 5 years. The
company accounted for the project as follows ($ millions):
1. The research phase
Dr. Research expense (+) 1
Cr. Cash (-) 1
2. Following date technical feasibility established:
Dr. Software asset (+) 2
Cr. Cash (-) 2
3. Each year during the applications useful life:
Dr. Amortization of software asset (+) .4
Cr. Software asset (-) .4
Financial Analysis: To convert an expenditure that a company capitalizes during
the accounting period to an expense as incurred basis, add the change in the
capitalized asset balance during the period to the capitalized assets amortization
charge during the period. Capitalizing expenditures for intangible assets, rather
than expensing as incurred, results in:
Capitalize Expense
Profits following switch to capitalization (growing expenditures) Higher Lower
Income volatility Lower Higher
Total assets and owners equity Higher Lower
Net cash flow Same * Same *
Cash flow from operations Higher ** Lower **
Cash flow used for investing Higher ** Lower **
* Expense for tax purposes in both cases.
** Capitalization results in expenditure being classified as an investment.
17. Bonds and Interest
Bonds (and other forms of debt) issued by corporations to raise funds from credit
sources represent a promise (1) to repay the amount borrowed at a specific future
date; and, (2) to compensate the lender for the use of the funds through specified
periodic interest payments (coupon rate).
Bonds: Record at face value if issued at par (face value). If issued at price other
than par, record at amount received, which is the present value of future cash
payments discounted by the market rate of interest for the type of bond issued.
Discounts and Premiums: If issue price is less than par value (effective interest
rate higher than coupon rate), record bond discount (asset) equal to the difference.
If issue price is greater than par value (effective interest rate lower than coupon
rate), record bond premium (liability) equal to the difference. Amortize premium
and discounts over life of bond to record true periodic interest cost.
Variable Rate Debt: Periodic interest rate varies with current market rate.
Generally trade at face value.
Convertible Debt: Debt convertible into common stock. Until converted,
accounted for as if straight debt.
Bonds With Detachable Warrants: The cash received must be allocated
between the instruments bond and warrant to buy equity features. The amount
allocated to the detachable warrants is accounted for as owners equity. If the
warrants are not detachable, no allocation of the cash received is made to owners
equity.
Perpetual Debt: Debt with no stated maturity date.
Zero Coupon Bond: Record at value of cash received. Accrue interest expense
and add to bond liability.
Current Maturity of Long-Term Debt: Long-term debt repayments over the
next 12 months are reported as current liabilities.
Early Extinguishment: Until recently, gains and losses from the early
extinguishment of debt were classified as an extraordinary item. This conclusion
did not apply to gains and losses from cash purchases of debt made to satisfy one
years sinking fund requirements. These gains or losses were recorded as ordinary
income items. The extraordinary item designation was to ensure that statement
users were aware of the impact on net income of debt extinguishments. The FASB
now classifies early extinguishment gains and losses as non-extraordinary items.
Capitalization of Interest: Capitalization of the cost of debt as part of an assets
cost is required for assets constructed for a companys own use and assets
produced for others as part of a discrete project.
IAS: Similar to current U.S. practices, except preferred accounting is that an
enterprise that has incurred borrowing costs and incurred expenditures on assets
that take a substantial period of time to get them ready for their intended use or
sale should adopt a policy of expensing borrowing costs as incurred. Capitalizing
borrowing costs is an allowed alternative treatment.
Illustration:
1. The ABC Company issues at par a $500,000 10-year bond paying 10%
interest at the end of each year.
To record the issuance of the bonds:
Dr. Cash (+) 500,000
Cr. Bond liability (+) 500,000
To record the payment of annual interest (500,000 x .10):
Dr. Interest expense (+) 50,000
Cr. Cash (-) 50,000
To record the repayment of principal at maturity:
Dr. Bond liability (-) 500,000
Cr. Cash (-) 500,000
2. The ABC Company issues a $500,000 10-year zero coupon bond payable at
maturity that is priced to yield 10%. To record the issuance of the bond:
Dr. Cash (+) 193,000
The cash received and the bond liability balance are the present value of $500,000
paid 10 years hence discounted at 10% (= 500,000 x .386).
3
To record the first years interest expense:
Cr. Bond payable (+) 19,300
The first annual $19,300 non-cash interest expense is 10% of the bond payable
balance (=193,000 x .10). The interest is added to the bond payable liability,
which at the end of the period is $212,300 (= 193,000 + 19,300). This process to
determine annual interest and the new bond payable obligation is repeated each
year until maturity.
To record payment of principal at maturity the only time cash is paid to
the bond holder:
Dr. Bond payable (-) 500,000
Cr. Cash (-) 500,000
3. A $500,000 10-year bond with a 10% coupon rate paid semi-annually is
issued at a discount (effective interest rate higher than coupon rate) to yield an
effective interest rate of 12%.
To record the issuance of the bond:
Dr. Cash (+) 442,750
Since interest is paid semi-annually, the annual rate (12%) is halved (6%) and the
annual periods (10) are doubled (20). The cash received is the sum of the present
value of the $500,000 face value paid twenty 6-month periods in the future plus
the present value of the twenty $25,000 semi-annual interest payments both
discounted at a 6% rate (= 500,000 x .312 + 25,000 x 11.47). The initial bond
liability is equal to the cash received. It can also be thought of as being equal to
the face value less the $57,250 issuance discount (= $500,000 442,750).
To record the first $25,000 semi-annual interest payment:
Cr. Cash (-) 25,000
Bond liability (+) 1,565
The interest expense is 6% of the beginning period bond liability balance
(= 442,750 x .06). The $1,565 difference between the interest expense and the
cash interest paid (= 26,565 - 25,000) is added to the bond liability balance. This

3
The discount factors used in this and subsequent sections are found in present value tables. The .386
is the present value of $1 received 10 periods hence discounted at a 10% rate. The .312 is the present
value of $1 received 20 periods hence discounted at a 6% rate. The 11.47 is the present value of $1
received each period for 20 periods discounted at a 6% rate. The .456 is the present value of $1
received 20 periods hence discounted at a 4% rate. The 13.59 is the present value of $1 received each
period for 20 periods discounted at a 4% rate.
process is repeated until maturity when the bond liability balance equals the
bonds face value (500,000). Since the bond liability balance is increasing each
period, the interest expense increases each period.
To record the repayment of the bonds face value at maturity:
Cr. Cash (-) 500,000
4. If the 10% coupon rate bond in the above example had an effective rate of 8%
(rather than 12%) at issuance , it would have been issued at a premium
(effective rate less than the coupon rate). The accounting consequences of
being issued at a premium are: cash received at issuance is greater than the
face value; bond liability at issuance is greater than the face value; interest
payments are $25,000 each semi-annual period; interest expense decreases
over time and is less than the interest payments; and, bond liability decreases
over time as the bond premium (excess of cash received at issuance over face
value) included in the bond liability balance is amortized as a debit to the
liability (-) and a credit to interest expense (-).
The accounting entries are:
To record issuance of the bond:
Dr. Cash (+) 567,750
Cr. Bond Liability (+) 567,750
The cash received is the sum of the present value of $500,000 face value paid 20
periods in the future plus the present value of the twenty $25,000 semi-annual
interest payments discounted at a 4% rate (=$500,000 x .456 + $25,000 x 13.59).
The bond liability is equal to the $500,000 face value plus the $67,750 issuance
premium (= $567,750 500,000).
To record the first $25,000 semi-annual interest payment:
Bond liability (-) 2,290
Cr. Cash (-) 25,000
The interest expense is 4% of the beginning bond liability balance (= 567,750 x
.04). The $2,290 difference between the interest expense and the cash interest paid
(= 25,000 22,710) is deducted from the bond liability. Since the bond liability
balance is decreasing each period, the interest expense decreases each period.
To record the repayment of the bonds face value at maturity:
Cr. Cash (-) 500,000
Financial Analysis: At any point in time, the book value of debt is not likely to
be equal to its market value due to changes in interest rates and, sometimes, the
issuers credit rating. Increasing market interest rates lower the market value of
debt. Decreasing market interest rates increase the market value of debt. As a
result, during the life of a debt issue, its market value may be a more appropriate
value than book value to use for debt-equity ratio purposes. A shift from a reliance
on operating cash flows to debt financing to support a business may indicate the
beginning of liquidity problems. Debt with equity features (convertible debt) and
equity with debt features (redeemable preferred stock) should be examined closely
and classified appropriately when performing liquidity and solvency financial
analysis. For example, perpetual debt and recently issued very long-lived debt
should be treated like preferred stock for financial analysis purposes. In contrast,
redeemable preferred stock classified as owners equity for accounting purposes
should be treated as debt.
18. Contingencies
A contingency for the purposes of accounting is an existing condition, situation, or
set of circumstances involving uncertainty as to the probable gain or loss to an
enterprise that will ultimately be resolved when one or more future events occur or
fail to occur. Contingencies include such items as bad debts, warranty claims,
litigation claims, and restructurings.
Contingency Loss: Recognize estimated loss through a charge to earnings when
it is probable that a loss has occurred and the loss can be reasonably estimated.
Contingency Gain: Disclose. Recognize when realized.
IAS: Similar to U.S. GAAP, except where the time value of money is material,
the amount of the loss provision should be the present value of the amount
expected to settle the obligation.
Illustration: The ABC Company anticipates that it may have to pay $100,000
damages as the result of a claim brought against the company in the courts. In the
period in which the management becomes aware of this probable contingency
loss, it will charge the anticipated $100,000 loss to income and set up a $100,000
litigation reserve as a liability. In a later accounting period, when a court decision
confirms the loss and the successful litigant is paid, the actual loss is charged to
the balance sheet contingency reserve and cash is reduced by a similar amount. If
the amount of the claim is less than the related reserve, the excess reserve is
credited to income. If the claim paid is greater than the reserve, the excess is
charged to income.
The accounting entries to establish the reserve :
Dr. Litigation expense (+) 100,000
Cr. Litigation reserve (+) 100,000
The entries to record the payment of the $100,000 litigation loss are:
Dr. Litigation reserve (-) 100,000
Cr. Cash (-) 100,000
Since the loss can only be recognized for tax purpose when the payment is made,
the earlier accrual of the loss for financial reporting purposes leads to the
recognition of a deferred tax asset (discussed later).
Financial Analysis: The accrual for accounting purposes of a loss related to a
contingency does not create or set aside funds which can be used to lessen the
possible financial impact of the loss. The creation of a contingency reserve by a
charge to income is simply an accounting provision. The accrual, in and of itself,
provides no financial protection that is not available in the absence of the accrual.
19. Leases
A lease agreement conveys the right to use property over a definite period in
return for a series of payments. Lease agreements are executory contracts (take-
and-pay contracts are another example). Typically, accounting does not recognize
executory contracts as giving rise to an asset or liability, since both parties to the
contract have yet to perform. An exception is made in the case of certain leases
(capital leases), which accountants view in essence as transferring the risks and
rewards of ownership to the lessee.
Capital Lease: A lease that meets any one of the four capital lease tests (see
below). Lessee records a depreciable leased asset and a liability. Liability treated
as a borrowing. Lessee accounts for periodic rentalpayment as part interest and
part reduction of liability. Lessor accounts for lease as a loan to lessee.
Four Tests: The four tests for a capital lease are:
1. Title transferred at end of lease.
2. Agreement contains bargain purchase option.
3. Lease term at least 75% of leased propertys estimated life.
4. Present value of minimum leased payments is 90% or more of the fair value
of leased property.
Operating Lease: A lease that does not meet any of the four capital lease criteria.
Lessee does not record a depreciable leased asset and a liability. Lessee records
periodic rental payment as lease expense. Lessor records lease payments as
revenue and depreciates leased asset (still on lessors balance sheet).
Direct Financing Lease: Lessors function is to finance property acquisition by
the lessee. Lessor accounts for net investment in the lease as a loan to lessee. If
uncertainty exists as to collectability of lease payments or reimbursable costs,
lease is accounted for as an operating lease by the lessor.
Sales-Type Lease: Lease is used to sell products. Lessor records normal product
profit and treats lease portion of transaction as a direct financing lease.
Sale and Leaseback: A contract to sell property and then lease it back from
buyer. Seller-lessee must amortize any gain on sale over lease life. Recognize any
loss on sale immediately.
Leveraged Lease: Lessor finances lease agreement using all or mostly debt.
Lessors return is based on lessors net investment in the lease, which initially falls
then rises over the lease term. Lessee uses operating or capital lease accounting.
IAS: Capital lease (called finance lease) accounting required for leases that
transfer the risks and rewards of ownership to lessees. Operating lease accounting
similar to U.S. GAAP.
Illustration: The ABC Company (the lessee) leased equipment from the XYZ
Company (the lessor) for a 3-year period at $10,000 per year under an operating
lease agreement.
1. The equipment is delivered to the lessee.
No entry by the lessee.
2. The first annual lease payment is made:
Dr. Lease expense (+) 10,000
Cr. Cash (-) 10,000
The same entry is made over the next two years as the annual rental is paid.
The equipment of the XYZ Company (the lessor) leased to the ABC Company
(the lessee) had a useful life of 5 years, a cost of $25,000, and no residual value.
1. The equipment is shipped to the lessee:
Dr. Equipment under lease (+) 25,000
Cr. Equipment inventory (-) 25,000
The lessor retains the equipment leased under the operating lease as an asset on its
balance sheet, but reclassifies it to the equipment under lease account to indicate
that it is under lease.
2. The lessor receives the first annual lease payment:
Dr. Cash (+) 10,000
Cr. Rental revenue (+) 10,000
This entry is repeated for each of the next two years as the rental payment is
received.
3. The lessor recognizes first year depreciation on the leased equipment:
Dr. Depreciation expense (+) 5,000
Cr. Accumulated depreciation (+) 5,000
A similar $5,000 depreciation expense is charged during each of the next two
years of the lease contract (=25,000/5).
The ABC Company (the lessee) leases another piece of equipment for 3 years at an
annual rental of $10,000 under a capital lease agreement. The implicit interest in
the lease arrangement is 10%. The ABC Company uses straight line depreciation
1. The equipment is delivered:
Dr. Leased equipment (+) 24,870
Cr. Lease obligation (+) 24,870
The $24,870 asset leased equipment and liability lease obligation balances
recognized on the lessees balance sheet are the present value of the 3 annual lease
payments (similar to a 3-year, $10,000/year annuity) discounted at the 10%
implicit interest rate (= 10,000 x 2.487).
2. The annual lease payments are allocated by the lessee to lease obligation
interest expense and lease obligation reduction:
Year
Beg.
Obligation
Lease
Payment
Interest
Expense*
Obligation
Reduction
**
End.
Obligation
1 24,870 10,000 2,487 7,513 17,357
2 17,357 10,000 1,736 8,264 9,093
3 9,093 10,000 909 9,093*** 0
* Beginning obligation x .1.
** Lease payment - interest expense.
*** Rounding error.
3. The next twelve month reduction (7,513) of the total lease obligation (24,870)
recognized upon equipment delivery is classified for lessee balance sheet
purposes as a current liability:
Dr. Lease obligation (-) 7,513
Cr. Current maturity of lease obligation (+) 7,513
This step is repeated over the next two years. The amount of lease obligation
reduction over each of the next 12 month periods is classified as a current liability.
4. The lessees first annual lease payment is made:
Current maturity of lease obligation (-) 7,513
Cr. Cash (-) 10,000
This process is repeated over the next two years using the interest expense and
obligation reduction figures in the above table.
5. The lessee recognizes the leased assets first years annual depreciation
charge (= 24,870/3)
Dr. Depreciation expense (+) 8,290
Cr. Accumulated depreciation (+) 8,290
Depreciation is charged to income over the next two years.
6. ABC Companys two $10,000 rental payment Statement of Cash Flows
classifications are:
Operating Lease Capital Lease
Year Operating Cash Flow* Operating Cash Flows** Financing Cash Flows***
1 10,000 2,487 7,513
2 10,000 1,736 8,264
3 10,000 909 9,091
* Lease rental payment.
** Interest portion of lease rental payment.
*** Lease obligation reduction portion of lease rental payment.
Annual cash outflow is the same ($10,000) regardless of the lease accounting
treatment.
7. Lessee income statement charges:
Operating Lease-Expenses Capital Lease-Expenses
Year Lease Rental Depreciation Interest Total
1 10,000 8,290 2,487 10,777
2 10,000 8,290 1,736 10,026
3 10,000 8,290 909 9,199
The total income statement charge using capital lease accounting is higher than the
operating lease income statement charge during the early years of the lease
agreement. The reverse is true in the later years.
The XYZ Companys finance subsidiary (the lessor) acting as a finance company
leases equipment to the ABC Company (the lessee) under a 3-year, $10,000 per
year rental capital lease obligation. The leased equipment cost of 24,870 has a 3-
year useful life and no residual value. The XYZ Company expects to earn 10% on
its net investment in this direct financing lease. (This can not be a sales-type lease
because the equipment cost is equal to its fair value.) The Companys net
investment in the lease is:
Sum of minimum lease payments $30,000
Unguaranteed residual value 0
Gross investment $30,000
Unearned lease financing income (5,130)
Net lease investment $24,870
The net lease investment is not listed as an account on the lessors balance sheet. It
is used in Step 2 to determine the unearned revenue earned in each period.
1. The equipment is shipped to the lessee:
Dr. Lease payments receivable (+) 30,000
Cr. Equipment (-) 24,870
Unearned lease financing income (+) 5,130
2. The 3 annual rental payments are allocated to the annual lease financing
(interest) revenue and the reduction of the net lease investment.
Annual Annual Net Lease Net Lease
Year Payment Received Financing Income Investment Reduction Investment
0 24,870
1 10,000 2,487 * 7,513 ** 17,357
2 10,000 1,736 8,264 9,093
3 10,000 909 9,093*** 0
* Net lease investment x .1.
** Annual rental payment minus annual lease financing income.
*** Rounding.
3. The first annual lease payment is received:
Dr. Cash (+) 10,000
Cr. Lease payment receivable (-) 10,000
Dr. Unearned lease financing income (-) 2,487
Cr. Lease financing income (+) 2,487
As each payment is received over the next two years, the above entries are made.
The lease income recognized declines in each year as the net lease investment is
reduced.
The XYZ Companys manufacturing division made and sold equipment with a 3-
year useful life to the ABC Company under a 3-year $10,000 per year rental sales-
type lease arrangement. The equipments selling price was $24,870. The
equipment cost $20,000 to make. The divisions profit on the sale was $4,870 (=
24,870 - 20,000). The implicit borrowing rate for the purchase price was 10%.
1. The equipment is shipped to lessee:
Dr. Minimum lease payments (+) 30,000
Cr. Sales (+) 24,870
Unearned lease financing income (+) 5,130
Dr. Cost of goods sold (+) 20,000
Cr. Inventory (-) 20,000
2. Annual lease payments are made.
The accounting for the annual lease payments received is identical to the direct
financing lease described above.
Financial Analysis: Companies sometimes attempt to structure lease
arrangements that would otherwise be capital leases to obtain operating lease
treatment. The objective is to keep the lease liability off the balance sheet.
20. Pension Benefits
A pension plan is an agreement between an employer and its employees whereby
the employer agrees to provide pension payments to employees for service
rendered prior to retirement.
Two Types of Plans: Defined contribution plans obligate employer to make
contributions to a pension fund. The employee bears the investment risks. Defined
benefit plans obligate employer to provide specified benefits to retirees. The
employer bears the investment risk.
Two Types of Obligations: For accounting purposes, there are two types of
defined benefit plan employer obligations the accumulated benefit and the
projected benefit obligations. The accumulated benefit obligation (ABO) is the
present value of the future benefits due to retirees and current employees assuming
current employees retired with their current pension rights. The projected benefit
obligation (PBO) is the present value of the future benefits due to retirees and
current employees projected benefit rights at their retirement date and final salary
level.
In order to calculate the PBO, a projection of the rate of future employee salary
increases must be made. The discount rate used for both the ABO and PBO
determination is the AA corporate long bond interest rate. The ABO is used for
balance sheet purposes, such as determining a companys pension liability. The
PBO is used to measure pension costs.
Defined Contribution Plan Cost: Required periodic contribution is employers
periodic cost.
Defined Benefit Plan Cost: Employers cost includes six components:
1. Service cost: Present value of future pension benefits based on employees
anticipated future salary levels earned by employees for services rendered
during period.
2. Interest cost: The increase in the employers projected pension benefit
obligation due to the passage of time. The projected pension benefit
obligation is the present value of expected benefits to be paid to employees in
the future assuming their salaries grow to some higher level.
3. Return on Plan Assets: An assumed normalized annual return on plan assets
that reflects anticipated future rate of return on plan assets. A credit entry,
(i.e., reduces pension cost).
4. Amortization of unrecognized net gain or loss: At a minimum,
amortization of the unrecognized cumulative net gain or loss resulting from a
change in either the projected benefit obligation or the plan assets (because of
experience different from that assumed or a change in actuarial assumptions)
is included as a component of net periodic pension cost if, as of the beginning
of the year, that unrecognized net gain or loss exceeds 10% of the projected
benefit obligation or the fair value of plan assets, whichever is greater. If
amortization is required, the minimum amortization is the excess over the
10% test divided by the service period of the active employees expected to
receive benefits under the plan. The amortization of any unrecognized net
gain (loss) decreases (increases) the net periodic pension cost.
5. Amortization of unrecognized prior service costs: The cost of providing
retroactive benefits (that is, prior service cost) arising at the initiation or
amendment of a plan are amortized over time rather than recognized in full at
the time of the plans initiation or amendment. The cost of retroactive benefits
is the increase in the projected benefit obligation at the date of the
amendment. This cost is amortized by assigning an equal amount to each
future period of service of each employee active at the date of the plans
initiation or amendment who is expected to receive benefits under the plan.
6. Amortization of transition obligation or gain: At the time the FASBs
pension standard (FAS 87) became effective, the FASB had to devise a way
for companies to move to the Statements new pension accounting rules. For a
defined benefit plan, an employer had to determine for the beginning of the
fiscal year in which FAS 87 was first applied, the amounts of (a) the projected
benefit obligation; and (b) the fair value of plan assets plus previously
recognized unfunded accrued pension cost or less previously recognized
prepaid pension cost. The difference between those two amounts, whether it
represented an unrecognized net obligation or an unrecognized net asset , is
amortized on a straight-line basis over the average remaining service period
of employees expected to receive benefits under the plan, except that, (a) if
the average remaining service period is less than 15 years, the employer may
elect to use a 15-year period; and (b) if all or almost all of a plans
participants are inactive, the employer must use the inactive participants
average remaining life.
Plan Assets: Recorded by pension plan at fair value.
Pension Liability: Recognized when value of plan assets is less than employers
accumulated benefit obligation. This obligation is the present value of the retiree
benefits expected to be paid to employees in the future. Unlike the projected
benefit obligation calculation, it does not assume salaries will grow.
Curtailments and Settlements: Gains and losses from curtailments and
settlements of defined benefit plans are recognized immediately in income.
Vested Benefits: The amount of benefits an employee has the right to receive
regardless of whether the employee stays with the company or not.
Minimum Pension Liability: The minimum pension liability reported on the
balance sheet must at least equal the unfunded accumulated benefit obligation.
The offsetting entry is an intangible asset. The intangible asset can be no larger
than the sum of the unrecognized prior service cost and transition obligation or
gain. Any excess of the minimum pension liability over this cap is charged
directly to owners equity.
Plan Asset Change: The change in pension plan assets can be determined as
follows:
Dollar return on plan assets
+ Contributions
- Benefits paid
= Change in plan assets
Projected Benefit Obligation Change: The periodic change in the projected
benefit obligation can be determined as follows:
Service cost
+ Interest on projected benefit obligation
+/- Recognized actuarial assumption gains/losses
+ Recognized prior service costs
= Gross pension costs
- Benefits paid
= Change in projected benefit obligation
IAS: Similar to U.S. GAAP.
Illustration: The ABC Company contributes $500,000 per year to a defined
contribution plan for its employees.
Dr. Pension cost (+) 500,000
Cr. Cash (-) 500,000
The required contribution is the pension cost.
Alternatively, assume the ABC Company contributes to a defined benefit plan for
its employees. The cost (sum of the six elements) for the year is $600,000. The
company decides to only fund $400,000 of this cost:
Dr. Pension cost (+) 600,000
Cr. Cash (-) 400,000
Pension liability (+) 200,000
The determination of the cost is unrelated to managements funding decision.
Companies ABC and XYZ both have similar accumulated benefit obligations
($2,000) and plan assets ($1,000). Each companys plan is underfunded. Company
ABC has a $500 accrued pension cost liability, and Company XYZ has a $500
prepaid pension asset. What is the minimum pension liability for each company?
Company ABC Company XYZ
Accumulated benefits obligation 2,000 2,000
- Plan assets 1,000 1,000
Unfunded accumulated benefit obligation 1,000 1,000
- Accrued pension cost (500)
+ Prepaid pension asset 500
Minimum pension liability 500 1,500
The minimum pension liability must equal the underfunding of the accumulated
benefits obligation.
Company ABC already has a pension liability of $500. The sum of this liability
and the minimum pension liability adjustment (500) equals the unfunded
accumulated benefits obligation.
Company XYZs prepaid pension asset (500) is added to the unfunded
accumulated benefits obligation balance (1,000) to get a net unfunded pension
liability balance of $1,000 (= 1,500 liability - 500 asset).
Financial Analysis: Pension costs can be manipulated by the discount rate, return
on plan assets, and salary inflation rates assumed by management. The effects of
these manipulations are:
Accumulated Projected
Benefit Benefit Service Interest
Assumption Obligation Obligation Cost Cost
Discount Rate
Higher Lower Lower Lower Higher
Lower Higher Higher Higher Lower
Rate of Compensation Increase
Higher No effect Higher Higher Higher +
Lower No effect Lower Lower Lower ++
Assumed Rate of Return On Plan Assets +++
Higher No effect No effect No effect No effect
Lower No effect No effect No effect No effect
+ Higher projected benefit obligation leads to higher interest costs.
++ Lower projected benefit obligation leads to lower interest costs.
+++ Higher lower pension cost. Lower higher pension cost.
21. Post Retirement Benefits Other Than
Pensions
Accounting: Similar to pension obligation and cost accounting. Benefit
obligation calculation includes a projection of inflation in healthcare costs, rather
than a salary projection. Only one obligation measured. (Accumulated benefit
obligation).
Financial Analysis: Understatement of the health care cost inflation rate will lead
to understatement of the related obligation and cost.
22. Deferred Taxes
A companys tax expense (credit) is the sum of the taxes it must pay (refund
receivable) based on its current taxable income (current tax expense (credit))
plus its deferred tax expense (credit).
Situation: The need for deferred tax accounting arises when a company uses
different accounting methods and estimates for book and tax purposes. The
difference between an asset or liabilitys tax basis and its book carrying amount is
referred to as a temporary difference, because the differences will reverse in
some future period. There are some exceptions referred to as permanent
differences because the difference between book and tax accounting does not
reverse. These do not enter into the deferred tax calculation.
Liability or Balance Sheet Method: The FASBs deferred tax standard (FAS
109) adopts the liability method to account for deferred taxes. This method
computes deferred taxes using the differences between the tax basis and financial
reporting carrying amounts of assets and liabilities.
Comprehensive Tax Allocation: U.S. companies must recognize deferred taxes
on all temporary differences.
Deferred Tax Liability: Tax equivalent of the difference between book and tax
basis of assets (liabilities) where assets (liabilities) have been charged off
(increased) for tax purposes faster than for book purposes.
Deferred Tax Asset: Tax equivalent of difference between book and tax basis of
assets (liabilities) where assets (liabilities) have been charged off (increased)
slower for tax purposes than for book purposes. Also includes current recognition
of future tax credits for operating loss carryforwards. The deferred tax asset
reported on the balance sheet is the net of the companys gross deferred tax assets
and their related valuation allowance (see below).
Deferred Tax Valuation Allowance: Tax credits for which the company is
potentially eligible, but management has not recognized because management
believes that the probability is less than .5 that the company will be able to make
the tax credits good for tax purposes. Disclosed in notes.
Deferred Tax Expense (Credit): Net change in recognized deferred tax assets
and liabilities during the period. Net deferred tax asset increase leads to a deferred
tax credit entry to income. Net deferred tax liability increase leads to a deferred
tax expense.
Tax Rate and Code Change: If a tax rate or code change is enacted, the deferred
tax liability and asset balances must be recalculated to reflect the change. The
effect of the change is included in income. A lowering of the tax rate reduces the
deferred tax liability and increases income. A lower tax rate decreases deferred tax
assets and reduces income.
Current Tax Expense: The tax expense consists of two components the current
tax expense (credit) and the deferred tax expense (credit). The current tax expense
is the current periods tax due to taxing authorities. It is derived from the current
tax returns.
Illustration: The ABC Company buys an asset for $100, which it expenses
immediately for tax purposes. For financial reporting purposes, it depreciates the
asset over a 2-year period using the straight-line method. The companys profit
before taxes and charges related to the asset is $200 in both years. The companys
tax rate is 40%.
1. Deferred tax accounting is required. The assets tax basis and book carrying
amount differ. Since the asset is expensed faster for tax purposes than for
book reporting, a deferred tax liability and expense must be recognized.
Assets Tax Basis and Net Book Value
Yearend Tax Basis Net Book Value Difference
1 0 * $50 ** $50
2 0 0 0
* (100-100)
** (100-50)
2. For financial reporting purposes, the companys pretax income is the same in
both years (150)
Pretax Book Income
Year Pretax Income Before Depreciation Depreciation Pretax Income
1 200 50 150
2 200 50 150
3. For tax reporting purposes, the companys taxable income is higher in year 2
(200) relative to year 1(100).
Taxable Income and Tax Obligation
Taxable Income Depreciation Taxable Tax
Year Before Depreciation Deduction Income Obligation
1 200 100 100 40
2 200 0 200 80
4. The year 1 difference (50) between the companys taxable income and pretax
book income reverses in year 2 to net out to zero. This $50 temporary
difference drives the deferred tax calculation.
Taxable Income and Book Pretax Income
Year Taxable Income Book Pretax Income Difference
1 $100 * $150 ** $50
2 200*** 150 ** (50)
$300 $300 $ 0
* (200-100)
** (200-50)
*** (200-0)
5. The companys tax expense and balance sheet entries for its current tax
payment and deferred tax liability result in net income of $90 in both years.
Income Statement
Profit Tax Expense Tax Expense Net
Year Before Taxes - Current - Deferred Income
1 $150 $40 * $20 ** $90
2 150 80 *** (20) ** 90
$300 $120 $ 0 $180
* (100x.4)
** (50x.4)
*** (200x.4)
Balance Sheet
Year Taxes Payable Deferred Tax Liability Deferred Tax Liability - Change
1 $40 +20 + 20 *
2 $80 0 - 20 **
* A credit entry (+ liability).
** A debit entry (- liability).
The deferred tax expense and credit is the difference between the assets tax and
book basis (+50 and 50) times the tax rate. Alternatively, the deferred tax
expense and credit are the changes in the deferred tax liability. The deferred tax
accounting entries for the two years are:
Year 1: Dr. Deferred tax expense (+) 20
Cr. Deferred tax liability (+) 20
Year 2: Dr. Deferred tax liability (-) 20
Cr. Deferred tax expense (-) 20
Financial Analysis: Deferred taxes should always be examined on a case-by-case
basis. Sometimes deferred tax liabilities are treated as quasi equity rather than
liabilities because in growing or stable companies, the total deferred tax liability
may not decline. Analysts should always closely examine changes in a companys
effective tax rate and the causes of the change to determine if the change is
permanent or temporary and not the result of management manipulation.
23. Owners Equity
Owners equity is a residual. It is what is left after total liabilities are deducted
from total assets.
Common Stock: Par value of shares issued times number of issued shares.
Capital in Excess of Par Value: Excess value received for stock issued over the
par value of stock issued. Sometimes called additional paid-in-capital. Some
companies combine the common stock and capital in excess of par value accounts
into one account common stock.
Treasury Stock: Cost of reacquired common shares. Shown as negative owners
equity. Gain or loss on resale is an adjustment to capital in excess of par value.
Retained Earnings: The cumulative earnings of a company less dividends paid
and transfers to capital in excess of par value account related to stock dividends.
Stock Dividend: Issuance of stock as a dividend to shareholders of less than 20-
25% of shares outstanding. Transfer market value of shares issued to capital
accounts (common stock and capital in excess of par value) from retained earnings.
Stock Split: Issuance of stock to shareholders in excess of 20-25% of shares
outstanding. No entry if par value per share is adjusted to reflect split. If par value
is not adjusted, an amount is transferred from retained earnings to the common
stock account to adjust its balance to reflect the par value of the new shares issued.
Preferred Stock: An equity security usually with a fixed dividend payment and a
fixed dollar amount in liquidation that entitles its holders to a preferred position in
corporate liquidations. Dividends are usually cumulative and common
stockholders may not be entitled to dividends until any preferred dividend
arrearages are paid. Some preferred stocks are redeemable by the issuer. These are
classified as liabilities.
Comprehensive Income: A section of the changes in owners equity statement
showing total changes in owners equity from net income and other transactions
not involving owners, such as translation gains and losses (explained later).
Sometimes labeled non-owner changes in equity.
Other Comprehensive Income: Comprehensive income less net income.
Illustration: The beginning balances in the owners equity section of the ABC
Company are ($ millions):
Common stock * 50
Capital in excess of par value 4,000
Treasury stock (500)
Retained earnings 6,000
* 500 million shares outstanding par value per share $.10
During the year, the company enters into a number of transactions involving
owners equity. These transactions and the accounting for them are listed below:
1. The company declares a dividend of $50 million:
Dr. Retained earnings (-) 50
Cr. Dividends payable (+) 50
2. The company pays the dividends:
Dr. Dividends payable (-) 50
Cr. Cash (-) 50
3. The company declares a 10% stock dividend and issues 50 million shares
(=500 million x .1). The number of shares issued fall below the 20-25%
dividing line between a stock split and a stock dividend. Stock dividend
accounting is required. The companys stock price is $10 per share.
Dr. Retained earnings (-)* 500
Cr. Common stock (+)** 5
Capital in excess
of par value (+) 495
* 50 million shares x $10
** 50 million shares times $.10 par value.
4. The company buys back $100 million of its own stock. Treasury stock is a
negative owners equity balance.
Dr. Treasury stock (+) 100
Cr. Cash (-) 100
5. The company sells treasury stock previously acquired at a cost of $50 million
for $75 million. It recognizes a $25 million gain (= 75-50).
Dr. Cash (+) 75
Cr. Treasury stock (-) 50
Capital in excess of par value (+) 25
6. The company issues 10 million common shares at $25 per share.
Dr. Cash (+) 250
Cr. Common stock (+) 1*
Capital in excess
of par value (+) 249
* 10 million shares times $.10 par value
7. The company declares a 2 for 1 stock split. No accounting entry. The number
of shares outstanding are doubled and the per share par value is halved.
8. The companys earnings ($175 million) are closed out on the companys
books to owners equity. The closing entry is:
Dr. Income (-) 175
Cr. Retained earnings (+) 175
Financial Analysis: Stock splits and stock dividends do not change the total
amount of owners equity. Since the result is the issuance of more shares, earnings
per share is reduced proportionately. Redeemable preferred stock is treated as debt
and its dividends as interest for financial analysis purposes.
The denominator of the book value of owners equity per common share
calculations is the number of shares outstanding. The numerator of the book value
of the common stock calculation is the owners equity less the sum of the
liquidation value of the preferred stock and preferred dividends in arrears.
The denominator of the book value per preferred share calculation is the number
of preferred shares outstanding. The numerator of the book value per preferred
share calculation is the liquidation value of the preferred stock plus any preferred
dividends in arrears.
Illustration: The XYZ Company has the following owners equity structure.
What is the book value per preferred and common share?
The XYZ Company has the following owners equity structure. What is the book
value per preferred and common share?
Preferred stock 200,000 shares
outstanding, par value $100, 6%
cumulative dividend $ 20,000,000
Common stock 400,000 shares outstanding,
par value $100 40,000,000
Capital contributed in excess of par value 5,000,000
Retained earnings (deficit) (7,000,000)
$ 58,000,000
No dividends have been paid on the 6% preferred stock for the prior two years.
Preferred stock has preference on net assets in liquidation. Liquidation value per
preferred share = $105.
1. Calculation of book value of preferred and common stock:
Preferred Common
Par value $ 20,000,000 $ 40,000,000
Capital in excess of par value 5,000,000
Retained earnings (7,000,000)
Dividends in arrears (1,200,000 x 2) 2,400,000 (2,400,000)
Preference liquidation premium (200,000 x 5) 1,000,000 (1,000,000)
Book value $ 23,400,000 $ 34,600,000
Divided by number of shares 200,000 400,000
= Book value/share $ 117.00 $ 173.00
Note that the preferred stocks liquidation value (par value + liquidation premium) rather than its par value is used to
compute its book value per share. Also note that shares outstanding (shares issued treasury stock) rather than issued
are used to compute book values.
24. Earnings Per Share
FAS 128 requires all companies to report their basic earnings per share. If a
company has a complex capital structure (contains options, warrants, or
convertible debt), it may also have to report its diluted earnings per share.
Basic Earnings Per Share: The shareholders equity in net income (= net
income minus preferred dividends) expressed on a per outstanding share basis,
(i.e., treasury stock is excluded from calculation).
Diluted Earnings Per Share: Basic earnings per share adjusted for potential
issuances of common stock
from the exercise of options and warrants and the conversion of convertible
securities. Only reported if diluted earnings per share is lower than the basic
earnings per share or a greater loss per share than the basic loss per share, (i.e.,
dilutive).
Measurement: Starting with the basic earnings per share calculations
denominator and numerator, potentially dilutive options, warrants, and convertible
securities are included in the measurement of diluted earnings per share. The
treasury stock method is used to measure the dilutive effect of in the money
(market price of common stock higher than strike price) options and warrants
(assume exercised and cash received is used to purchase common stock with the
difference between assumed shares issued and acquired shares added to the
denominator). The if converted method is used to measure the dilutive effect of
convertible securities (add common stock to be issued on conversion to
denominator and add back convertible debts interest cost adjusted for taxes and
preferred stock dividends to the numerator).
Dilutive: Any option, warrant or convertible security whose assumed exercise or
conversion leads to a decrease in operating earnings per share or an increase in
operating loss per share. Operating earnings before discontinued operations,
extraordinary items and cumulative accounting changes is used for this determination.
Antidilutive: Any option, warrant or convertible security whose assumed
exercise or conversion leads to an increase in operating earnings per share or a
lower operating loss per share. Antilutive securities are excluded from the
measurement of diluted earnings per share.
Illustration: The denominator of the annual basic earnings per share calculation is
the weighted average of the number of shares outstanding from the date of issuance
during the year. A company has 1000 shares outstanding for quarters 1 through 3,
inclusive. At the beginning of quarter 4, it issues an additional 1000 shares. The
weighted average number of actual shares outstanding used to calculate the annual
basic earnings per share is 1250[=(1000 x 9/12) + (2000 x 3/12)].
This same company reported net income of $1500 and paid preferred dividends of
$250. Net income is the same amount as operating earnings. The numerator of the
annual basic per share calculation is $1250
(=1500-250), which is the earnings attributable to the common stockholders after
payment of preferred dividends.
The companys basic earnings per share is: $1 = $(1500-250)
1,250 shares
The company also had outstanding a convertible bond and unexercised stock
options. The potential dilutive effect of these two items potentially requires the
company to disclose a diluted earnings per share figure. The denominator for this
calculation is the weighted average of assumed shares outstanding each quarter
after adjusting for potential dilution.
The 10% $500 bond convertible into 500 shares was issued during the prior year.
At the beginning of the current year, options for 100 shares exercisable at $10 per
share were granted. During the first quarter, the average price of the companys
stock was $20. During the remainder of the year, it never rose above $10.
The company has a 40% tax rate.
The convertible bond triggers the use of the if converted method. Two adjustments
to the basic earnings per share calculation are required. First, the numerator is
increased by adding back the after-tax equivalent of the interest that would not be
paid if the bond had been converted [$30=$(500x.1)(1-.4)]. Second, the
denominator is increased each quarter by the shares that would be issued upon
conversion of the bond (500). The convertible bond is a dilutive security. Its
assumed conversion reduces earnings per share. (If the convertible security was a
convertible preferred stock, the preferred dividend would not be deducted from net
income and the denominator would be increased by the number of common stock
shares issuable upon conversion.)
The options (warrants would do the same thing) trigger the use of the treasury
stock method. One adjustment to the denominator of the basic earnings per share
calculation is required for the first quarter. The treasury stock method assumes the
in the money options are exercised at the beginning of the first quarter ($1000
cash is received from 100 shares issued at $10 per share) and the cash received is
used to acquire 50 shares in the open market (1000/20=50 shares). The 50 share
net increase in the number of shares as a result of these two assumed share
transactions (=100-50) is dilutive. When added to the denominator for the first
quarter, it reduces earnings per share. Note the average price of the stock during
the period is used in this calculation. Since the market price of the stock was
below $10 for the remainder of the year, no further denominator adjustments are
needed for the remaining three quarters. Any adjustment would be antidilutive.
For example, assume that the average stock price for the second quarter was $5.
The assumed exercise of the options and repurchase of shares would result in 100
shares being issued and 200 shares being bought (=1000/5). The resulting 100
(=200-100) net decrease in shares would reduce the denominator and increase the
earnings per share. For this quarter, the options are antidilutive.
As a result of recognizing the potential issuance of shares due to conversion of the
bond and the exercise of options, the denominator for the annual diluted earnings
per share calculation is 1,762.5 [=7050/4=(1000+500+50)/4 + (1000+500)/4 +
(1000+500)/4 + (2000+500)/4].
The companys diluted earnings per share is:
$.73 = $(1500-250)+30
1762.5 shares
Other Considerations: Reaquired shares (treasury stock) are excluded from the
computation of earnings per share from date of acquisition. Prior period earnings
per share comparative data must be restated to reflect any subsequent stock splits
or stock dividends. Shares issued in a pooling-of-interests (no longer permitted in
U.S. GAAP, but discussed later) are considered outstanding for all periods
included in prior period comparative presentations. The determination of whether
an option or warrant is antidilutive is made each quarter. The quarterly
determinations are independent of each other. Common stock issued upon the
exercise of options and warrants is included in the weighted average of
outstanding shares from the issuance date.
Financial Analysis: Since it reflects potential dilution, diluted earnings per share
amounts are used for security investment decisions involving companies with
complex capital structures. Predicting diluted earnings per share is complicated by
the fact that changes in a stocks price can influence the results of applying the
treasury stock method. Dividends per share is calculated using actual outstanding
shares at the dividend date. It can not be related meaningfully to diluted earnings
per share amounts, which may be based on a different number of shares.
25. Business Combinations
A business combination occurs when two or more businesses are joined together
to continue the activities that each had carried on previously. Prior to July 2001,
two methods were used to account for business combinations, the pooling-of-
interests method and the purchase method. The choice of which method to use
was not a free one. If the transaction qualified for the pooling-of-interest
method, that method had to be used. All other business combinations had to use
the purchase method. In June 2001, the FASB issued a new standard prohibiting
the use of the pooling-of-interests method.
Pooling of Interests: Add the combining companys financial statements
together as if they had been one entity.
Purchase Accounting: All business combinations must be accounted for by the
purchase method. Record acquired tangible assets, intangible assets, and liabilities
at fair value. Excess of consideration paid over fair value of net assets acquired is
goodwill. Recognize revenue and income of acquiree from date of combination.
Acquired Intangible Assets: The purchase method requires recognition of all
acquired intangible assets other than goodwill in the measurement of goodwill
that: (1) Arise from contractual or other legal rights; or (2) If not arising from a
contractual or legal right, are separable. An intangible asset is separable if it is
capable of being separated or divided from the acquired enterprise and sold,
transferred, licensed, or exchanged. For the purpose of the standards, an intangible
asset that standing alone is not separable but could be part of a contract or group
of assets and liabilities that are separable is considered to meet the separable test.
Acquired-in-Progress Research and Development: An intangible asset acquired
in some purchase transactions that must be included as an intangible asset in the
measurement of goodwill and then expensed immediately if it has no alternative
use. The result is that future income is not burdened by this acquisition cost.
Goodwill Accounting: Goodwill should not be amortized under any
circumstances but tested for impairment annually at the reporting unit level.
Reporting Units: A reporting unit is the same as an operating segment (See
Segment Disclosure discussion) or, in some cases, a component of an operating
segment. Operating segments are the basis for the segment disclosures in annual
reports. An operating segment of an enterprise: (1) Engages in revenue generating
and expense incurrence business activities; (2) Has its operating results reviewed
regularly by the enterprises chief executive officer for performance assessment
and resource allocation decisions; and (3) Has discrete financial information
prepared for it. A component is one level below an operating segment. It has
essentially the same characteristics as an operating segment, except that its
operating results are reviewed by segment management.
Goodwill Impairment Test: A two-step methodology is used to test goodwill for
impairment. The two steps are: (1) First, to identify a potential goodwill
impairment, the fair value of a reporting unit assuming it was bought or sold is
determined and compared to its carrying amount including goodwill. If the
reporting units fair value is greater than its carrying amount, the reporting units
goodwill is considered not to be impaired. The second step need not be performed.
(2) If the reporting units fair value is less than its carrying amount, the second
step must be performed as follows: (a) The fair value of the reporting units net
assets, excluding goodwill, is determined; (b) The reporting units implied
goodwill is measured by subtracting the fair value of its net assets, excluding
goodwill, for the reporting units fair value; and (c) If the fair value of the
reporting units implied goodwill is less than the carrying amount of its goodwill,
its goodwill must be written down to its implied fair value and an operating charge
to earnings equal to the write-down is recognized.
Acquired Intangible Assets Other Than Goodwill: The cost less residual value
of recognized acquired intangible assets other than goodwill should be amortized
over their useful life, which is the period over which the intangible asset is
expected to contribute directly or indirectly to the enterprises cash flows. The
only exception is intangible assets with indefinite lives. They should not be
amortized until their useful life is determined to be no longer indefinite.
Recognized intangible assets not subject to amortization should be tested annually
for impairment. If the carrying amount is greater than its fair value, the intangible
asset should be written down to its fair value and the excess charged to income as
an impairment loss.
IAS: A business combination should be accounted for under the purchase
method, except in the rare circumstances when it is deemed to be a uniting of
interest in which case the pooling-of-interests method is appropriate. A business
combination is considered to be a uniting of interest when there is no clear
acquirer. Positive goodwill arising in a purchase transaction should be amortized
to income on a systematic basis over a period not to exceed 20 years or a longer
period if justified.
Illustration: Company A acquired Company B intending to continue the
operations of both companies as a single unit. Company Bs financial position at
the date of acquisition was as follows:
Book Value Fair Value*
Net current assets $100,000 $100,000
Fixed assets 400,000 700,000
Total $500,000 800,000
Capital stock $300,000
Retained earnings $200,000
$500,000
* The price that could be reasonably expected in a sale between a willing buyer and seller, other than in a forced or
liquidation sale.
Company A paid $900,000 cash for Company B. The accounting entry in
Company As records is:
Dr. Net current assets (+) 100,000
Fixed assets (+) 700,000
Excess of purchase price
over net assets acquired (+) 100,000
Cr. Cash (-) 900,000
This transaction is clearly a purchase of Company B by Company A. The previous
owners of Company B received cash and retained no ownership in the new business
unit. Consequently, assuming its fixed assets are all depreciable assets, subsequent
operations will be charged with depreciation based on fixed asset costs of
$700,000, which is the fair value of the assets acquired. The excess of the purchase
price over the fair value of the net assets acquired is typically called goodwill.
Company A would record Company Bs operating results beginning from the
acquisition date.
Alternatively, assume Company A had acquired Company B with stock worth
$900,000, and the transaction qualified for the pooling of interests method under
IAS. The effect of acquiring Company B on Company As balance sheet is:
Dr. Net current assets (+) 100,000
Fixed assets (+) 400,000
Cr. Retained earnings (+) 200,000
Common stock (+) 300,000
Company A records the acquisition of Company B using Company Bs book
values. Company Bs retained earnings are recorded on Company As books, no
goodwill is recognized, and the increase in Company As common stock account
is $300,000 (a plug number) and not the $900,000 market value of the stock
issued to acquire Company B. Company Bs income statement will be combined
with Company As for the current year and all prior years as if the two companies
had always been one.
Illustration: To illustrate the 2-step goodwill impairment methodology, assume:
The ABC Company has six reporting units. Management believes that the
goodwill of one of these reporting units might be impaired. Management reviews
the public sale prices of companies comparable to this reporting unit and
concludes that the reporting units fair value is $100 million. The reporting units
carrying amount is $150 million, which includes $75 million of goodwill. Next,
management determines that the fair value of the reporting units net assets
excluding goodwill is $35 million. The first step in the goodwill impairment
methodology suggests that the reporting units goodwill might be impaired. The
fair value of the reporting unit ($100 million) is less than its carrying amount
($150 million). As a result, the second step of the impairment methodology must
be performed.
The application of the second step indicates that the reporting units implied
goodwill is $65 million, which is the difference between the reporting units fair
value and the fair value of its net assets excluding goodwill ($100 million - $35
million). Since the goodwill carrying amount ($75 milion) is higher than the fair
value of the implied goodwill ($65 million), the reporting units goodwill should
be written down by $10 million and a $10 million charge to earnings recognized
($75 million - $65 million).
Financial Analysis: Since goodwill and acquired intangible assets with indefinite
lives are not amortized, managers have an incentive to assign as much of the
consideration paid as possible to these two items.
26. Tangible Assets and Depreciation
Physical assets with a life of more than one year used in operations but not
intended for sale in the ordinary course of business.
Cost: Tangible assets are recorded at their cost.
Depreciation: Allocation of the cost to acquire a tangible asset less its residual
value over its useful life to the owner. Land is not depreciated.
Depreciation Methods: Depreciation methods fall into three categories straight
line, accelerated, and units of production. The straight-line depreciation method
allocates an assets depreciable cost (cost residual value) in equal annual
amounts over its useful life. Accelerated depreciation methods (sum-of-the-years
digits and double-declining balance methods) charge in a systematic manner more
depreciation during the early years of an assets use than in the later years of its
use. The units of production method charges depreciation based on some measure
of the use of an asset. U.S. GAAP does not permit annuity (sinking fund)
depreciation. This method increases depreciation in each period (lower charges in
early years and higher charges in later years).
Accumulated Depreciation: The sum of an assets depreciation charges to date.
Presentation: Depreciable tangible assets are reported on the balance sheet on a
net basis (=original cost accumulated depreciation).
Estimated Useful Life Changes: Changes in the estimated useful life used for
calculating depreciation charges are accounted for prospectively. That is, the
assets (net book value (= original cost accumulated depreciation) less residual
value at the change date is depreciated over the new useful life.
Maintenance and Repairs: Expense as incurred. Only capitalize if enhance
assets productivity or extends its useful life beyond original estimate.
Tax: Different depreciation methods can be used for tax and financial reporting
purposes. The tax code specifies the accelerated depreciation schedules that must
be used for tax returns. (Modified Accelerated Cost Recovery System).
Gain or Loss on Disposal: Difference between the assets selling price and its
net book value. Accumulated depreciation account is reduced by assets
accumulated depreciation when the related asset is sold, abandoned or otherwise
disposed of.
Natural Resources: The cost of natural resources is charged to income through
depletion accounting, which allocates the cost of the natural resource to income
based on the consumption of the resource. The depletion charge is the cost of the
natural resource divided by its expected output in units times the units consumed
during the period.
Impairment: An asset or group of assets is impaired when its carrying amount is
not recoverable. If the projected cumulative undiscounted cash flow (excluding
interest) related to an asset is less than its carrying value, the asset is impaired.
Impaired assets must be written down to their fair value, (what a willing buyer and
seller would pay). The writedown amount is a charge to income. U.S. GAAP does
not permit assets written down to be written up at a later date. Asset impairment
writedowns improve future income (lower future depreciation charges) and
decrease total assets and owners equity. This, in turn, increases asset turnover
ratios and return on equity, while increasing debt-to-equity ratios.
IAS: Similar to U.S. GAAP, except IAS permits upward revaluations of tangible
assets. Revaluation gains are direct credits (increases) to owners equity.
Revaluation losses offset any related revaluation gains previously recognized.
Revaluation losses in excess of previously recognized revaluation gains are
charged to income. Revaluation upward of previously impaired assets is permitted.
Illustration: The ABC Company acquires equipment with a cost of $6,000 and
an estimated salvage value of $1,000 at the end of its 5-year useful life.
1. Acquisition of the equipment:
Dr. Equipment (Asset +) 6,000
Cr. Cash (-) 6,000
2. Annual depreciation expense calculation using straight-line method:
Cost of machinery $6,000
Less: Estimated residual 1,000
Depreciable cost $5,000
Depreciable cost = Depreciation expense
Estimated life
$ 5,000 = $1,000 per year
5 years
3. Annual depreciation expense calculation using double-declining balance
method for each year is computed by multiplying the asset cost less
accumulated depreciation by twice the annual straight-line rate expressed as a
decimal fraction (A .4 rate = .2 x 2). The residual value is ignored in this
method until the cumulative total of the depreciation charges equals the
assets cost minus its residual value. At this point, depreciation stops.
First year: $6,000 x 0.40 $2,400
Second year: ($6,000 - $2,400) x 0.40 1,440
Third year: ($6,000 - $3,840) x 0.40 864
Fourth year: ($5,000 - $4,704) 296
Fifth year: 0
Total $5,000
4. Annual depreciation expense calculation using the sum-of-the-years-digits
depreciation method is computed by multiplying the depreciable cost ($6,000
- 1,000) of the asset by a fraction based upon the years digits. The years
digits are added to obtain the denominator (=1 + 2 + 3 + 4 + 5 = 15), and the
numerator for each successive year is the number of the year in reverse order.
First year: $5,000 x 5/15 $1,667
Second year: $5,000 x 4/15 1,333
Third year: $5,000 x 3/15 1,000
Fourth year: $5,000 x 2/15 667
Fifth year: $5,000 x 1/15 333
Total $5,000
5. The depreciation expense per unit of output calculation using the units of
production method (assume estimated salvage value is $1000 after producing
100,000 units of output) is:
$5,000 = $0.05 per unit
100,000 units
The depreciation charge for a year in which 25,000 units are produced is $1,250
(=25,000 units x $0.05 per unit).
6. The accounting entry to record the depreciation expense (straight-line) is:
Dr. Depreciation expense(+) 1,000
Cr. Accumulated depreciation(+) 1,000
The accumulated depreciation balance is a contra asset account reported as a
deduction from the related assets original cost. For example, on the balance sheet
the asset is shown at the end of year two as:
Equipment (original cost) $6,000
Less: Accumulated depreciation (2,000)
Net book value $4,000
7. Assume the ABC Company sold the asset at the end of its second year in
service for $3,000. The loss on the sale would be:
Sale price $ 3,000
Net book value (= 6,000 2,000) 4,000
Loss on sale $(1,000)
The accounting entries would be:
Dr. Cash (+)3,000
Loss on sale (+) 1,000
Accumulated depreciation (-) 2,000
Cr. Equipment (original cost) (-) 6,000
8. Summary (Investment in depreciable assets increasing):
Depreciation Method
Straight Line Accelerated
Net income Higher Lower
Depreciation expense Lower Higher
Total assets Higher Lower
Owners equity Higher Lower
Cash flow * Same Same
* Same method for tax return purposes.
Financial analysis: Earnings can be managed through the selection of the
depreciation method, useful life, and residual values. During periods of high
inflation, depreciation expense based on an assets replacement rather than its
historical cost is used to estimate future cash flow needs and evaluate
managements current performance.
27. Inflation
Inflation: A condition of overall rising prices.
Two Approaches: Current cost accounting for inflation adjusts the costs of non-
monetary assets ( such as depreciable assets) and their related expenses (i.e.,
depreciation) for changes in the assets specific prices. Constant dollar accounting
for inflation restates the dollar results or the dollar value of transactions occurring
in different periods to a constant dollar or equivalent purchasing-power basis.
When these two approaches are combined, it is referred to as current cost/constant
dollar inflation accounting.
Monetary Gains and Losses: Holders of monetary assets lose purchasing power
during periods of inflation, (i.e., the monetary asset buys less). Creditors have
monetary gains on their monetary obligations during periods of inflation, (i.e.,
they pay off their debts with less purchasing power than the original borrowing
represented). These gains or losses are included in income when using constant
dollar accounting.
IAS: The financial statements of an enterprise that reports in the currency of a
hyperinflationary economy, whether they are based on a historical cost or a current
cost approach, should be stated in terms of the general price level index at the
balance sheet date. Gains or losses on the enterprises net monetary position should
be included in net income. The statement does not establish an absolute rate at
which hyperinflation is deemed to arise. A cumulative inflation rate over 3 years
approaching or exceeding 100% is suggested as an indication of hyperinflation.
Financial Analysis: Inflation distorts historical cost income statements in three
major ways: Income is overstated because depreciation does not reflect the higher
cost of replacing assets. FIFO method based cost of goods sold leads to an
overstatement of income because it understates the cost of replacing goods sold.
Interest expense on floating rate debt increases as creditors raise interest rates
which in turn lowers income. This effect is misleading since the historical cost
income statement does not recognize the offsetting gain by the debtor arising from
the gains in purchasing power from paying off debt with deflated purchasing
power currency. These gains must be considered to measure the real cost of
borrowing. The balance sheet is distorted by inflation because non-monetary asset
values are understated. Adjusting financial statements for the effects of changing
prices is imperative in periods of high inflation rates.
28. Segment Disclosure
Business Segments: Segment disclosures present selected income and balance
sheet data for the various operating segments of a business. The presentation of
this disaggregated information should reflect the structure of the companys
organization and the internal financial reports used by the companys chief
decision-maker for resource allocation and performance evaluation purposes.
Financial data must also be disclosed for those geographic areas and countries in
which the reporting company has material activities. Internal accounting policies
and financial statement based performance measurements are used to prepare the
disaggregated information.
IAS: Disclose business and geographic segment data, providing more
comprehensive disclosures about the primary segment of the two. A business
segment is a distinguishable component of an enterprise that is subject to risks and
returns that are different from those of other business segments. Uses annual
report accounting policies for reporting purposes.
Financial Analysis: Segment data can indicate shifts in a companys sources of
profits, geographical risk, and investment requirements.
29. Foreign Currency Translation
Foreign Currency Denominated Receivables and Payables: Measure in U.S.
dollars as of balance sheet date. Changes in dollar value since last measurement
(reporting) date are recorded in income as gains or losses.
FAS No. 52: The objectives of the FASBs foreign currency accounting standard
(FAS 52) is to set foreign currency translation standards that (a) provide
information that is generally compatible with the expected economic effects of an
exchange rate change on a companys cash flow and owners equity; and (b)
reflect in consolidated statements the financial results and relationships as
measured in the primary currency in which each entity included in the
consolidated results conducts its business.
Functional Currency: The principal currency in which a non-U.S. subsidiary
does its business.
Current-Rate Method: The current-rate method for translating the foreign
currency denominated financial statements of foreign subsidiaries into U.S. dollars
is used when the foreign subsidiarys functional currency is other than the U.S.
dollar (the reporting currency of the parent). The current-rate method translates
into U.S. dollars all balance sheet items of the non-U.S. entity (except the common
stock accounts) at the balance sheet date exchange rate (the current rate). The
common stock accounts are translated at the exchange rate on the date the capital
was invested (the historical rate). Income statement items are translated at the
transaction date exchange rate. In practice, companies translate recurring revenue
and expense items at the average exchange rate for the period. This is a less
expensive approach than attempting to translate each transaction at the exchange
rate on the transaction day. If a significant transaction occurs, however, such as a
material gain on the sale of an asset, the transaction date exchange rate should be
used for translation purposes. Translation gains or losses are included directly in
owners equity as part of other comprehensive income.
Temporal Method: The temporal method (also called remeasurement method) is
used for remeasuring foreign currency denominated financial statements into U.S.
dollars when the foreign subsidiarys functional currency is other than its local
currency. (In the case of U.S. subsidiaries, this is usually the U.S. dollar.) The
temporal method translates non-monetary balance sheet items (such as fixed
assets) at the historical rate (exchange rate at original transaction date), and
monetary items at the current exchange rate (balance sheet date exchange rate).
Remeasurement of revenue and expense items into U.S. dollars is the same as the
current rate method, except income statement items that relate to non-monetary
items (such as depreciation and cost of goods sold) are remeasured at their
historical exchange rates. Remeasurement gains or losses are included in income.
Highly Inflationary Economy: The temporal method is used when a subsidiary
operates in a high inflation rate environment. A high inflation rate environment is
one in which the 3-year cumulative inflation rate is approximately 100%. Use of
the current rate method would lead to very low tangible asset values which, in
reality, might be rising. The use of the temporal method overcomes this potential
distortion.
IAS: Similar to U.S. GAAP, except IAS requires companies in hyperinflationary
economies to adjust financial statements to yearend purchasing power before
translation.
Illustration: The initial illustration presents the worksheet for translating a
foreign subsidiarys local currency balance sheet and income statement into
dollars using the current-rate method. Next, the same foreign currency statements
are used to illustrate the temporal method.
The examples assume Overseas Incorporated started business on January 1, 2002;
plant is bought at the beginning of the year; sales, purchases of raw materials, and
expenses are spread evenly throughout the year; inventory is priced at its average
cost for the year (relevant only for U.S. dollar functional currency illustration);
plant is depreciated on a straight-line basis over 10 years; and no dividends are
paid. On January 1, 2002, the exchange rate was four local units to US$1. During
the year, the currency steadily devalued relative to the dollar so that on December
31, 2002, the exchange rate was eight local units to US$1. The average rate for the
year was six local units to US$1.
The exchange rate for translating Overseas Incorporateds capital stock in the
current rate illustration is four local currency units to the dollar. Thus, the dollar
equivalent of these local currency balances in this account can be obtained by
multiplying the foreign currency balance by 0.25 (=US$1/4 local currency units).
Since the exchange rate changed evenly throughout the year, a factor of 0.167
(=US$1/6 local currency units) can be used to translate the revenues and expenses
that occurred evenly throughout the year. On the last day of the year, the exchange
rate is eight local currency units to the dollar. Consequently, a factor of 0.125
(=US$1/8 local currency units) can be used to convert those yearend balance sheet
accounts that must be translated at the balance sheet date exchange rate.
2002 Income Statement Current-Rate Method Example Overseas Inc.
2002 Income 2002 Income
Statement Statement
(local currency) Translation Factors (U.S. dollars)*
Income Statement
Sales 401 .167 67
Less: cost of sales 196 .167 33
Gross Margin 205 .167 34
Depreciation 8 .167 1
Other expenses 153 .167 26
Net income 44 .167 7
* Rounded to nearest dollar.
December 31, 2002 Balance Sheet Current-Rate Method Example
Overseas Inc
2002 Financial 2002 Financial
Statements Statements
Assets
Cash and receivables 40 .125 5
Inventory 32 .125 4
Plant 80 .125 10
Less: accumulated depreciation (8) .125 (1)
Total assets 144 18
Liabilities
Current liabilities 56 .125 7
Long-term debt 24 .125 3
Total liabilities 80 10
Owners Equity
Capital stock 20 .25 5
Beginning retained earnings 0 0
Plus net income 44 7
22

Minus equity adjustment from
currency translation ** (4)
Total liabilities and owners equity 144 18
** Plug figure, 18-22.
When Oversea Incorporateds foreign currency statements using the current rate
are translated into U.S. dollars, the balance sheet translation process leads to a
translation adjustment loss of four U.S. dollars, since the company had an excess
of translated liabilities and owners equity ($22) over translated assets ($18).
Because the current rate method is used, the translation adjustment loss is not
included in the income statements. It is shown only on the consolidated statements
as an adjustment to owners equity. This adjustment brings the basic accounting
equation (Assets = Liabilities + Owners Equity) into balance.
The remeasurement illustration is similar in many respects to the current rate
illustration with the exception that inventory is remeasured using the mid-year
exchange rate factor of 0.167 and plant is remeasured at the acquisition date rate
factor of 0.25. Cost of goods sold and depreciation are remeasured using the same
factor used to restate their related assets.
2002 Income Statement Temporal Method Example Overseas Inc.
Income Statement
Sales 401 .167 67
Less: cost of sales 196 .167 33
Gross margin 205 34
Depreciation 8 .25 2
Other expenses 153 .167 26
Income before remeasurement gain 6
Remeasurement gain (see balance
sheet below) 7
Net income 44 Net income 13
December 31, 2002 Balance Sheet Temporal Method Example
Overseas Inc.
Assets
Cash and receivables 40 .125 5
Inventory 32 .167 5
Plant 80 .25 20
Less: accumulated depreciation (8) .25 (2)
Total assets 144 28
Liabilities
Current liabilities 56 .125 7
Long-term debt 24 .125 3
Total liabilities 80 10
Owners Equity
Capital 20 .25 5
Beginning retained earnings 0 0
Plus net income 44 Plus income before remeasurement
gain (see income statement above) 6
21
Plus remeasurement gain ** 7
Total liabilities and owners equity 144 28
** Plug figure, 28-21. Not reported on balance sheet. Shown here only to compute net income.
When Overseas Incorporated foreign currency statements are remeasured using
the temporal method into U.S. dollars, a remeasurement gain is recorded. This
remeasurement gain is included in income. The remeasurement gain and income
before remeasurement gain shown in the above work sheet would be reported as
an increase in retained earnings as part of the net income addition to retained
earnings in the actual balance sheet.
Complications: In practice, the determination of the U.S. dollar value of a
subsidiarys inventory and cost of goods sold can be more complicated than it was
in the above temporal method illustration. The complication arises because of the
use of LIFO and FIFO inventory accounting. The problem is solved by using the
average exchange rate for the appropriate period to translate each of the
components of the basic cost of goods sold equation.
Foreign Currency Exposure: Overseas Inc. had a translation loss using the
current rate method and a remeasurement gain using the temporal method. The
explanation is that in the current rate illustration, Overseas Inc. had an excess of
assets translated at the current rate over its liabilities translated at the current rate
(a net asset exposure). The dollar value of this accounting net asset position
declined when the local currency devalued relative to the U.S. dollar. This loss in
value gave rise to the translation loss. In the temporal method illustration, the
reverse occurred. Overseas had an excess of liabilities translated at the current rate
over its assets translated at the current rate (a net liability exposure). As a result of
the devaluation, the Overseas Inc.s net liability exposure was lower when
expressed in U.S. dollars. The accounting exposure gain gave rise to the
remeasurement gain.
Cash Flow: The choice of the accounting method to convert a foreign
subsidiarys financial statements to U.S. dollars does not impact a companys cash
flows. In contrast, changes in exchange rates can impact a firms cash flows if it
has foreign currency translation exposure (existing exposed assets and liabilities
and firm commitments) and foreign currency operating exposure (future uncertain
transactions). Managers can reduce the risk associated with these two exposures
(=economic exposure) by entering into foreign currency hedge transactions.
Financial Analysis: The accounting method used to convert a foreign
subsidiarys financial statements to U.S. dollars can influence the reported balance
sheet and income statement amounts. The impact of this accounting choice on
financial analysis results should always be identified and assessed for potential
distortions.
30. Stock Based Compensation
Alternative Methods: Under the FASB stock based compensation standard
(FAS 123), companies have a free choice of one of two methods to account for
stock based employee compensation the intrinsic value method or the fair value
method. If the intrinsic value method is adopted, the company must disclose in the
notes what the net income and earnings per share impact would have been if it had
used the fair value method.
Intrinsic Value Method: Under the intrinsic value method, compensation cost is
the excess of the quoted market price of the stock at the measurement date over
the employees exercise price times the number of optioned shares. The
measurement date is the first date that both the number of options to be granted
and the exercise price are known.
In the case of most fixed stock option plans, (i.e., plans where the number of
optioned shares and the exercise price is known at the grant date), the grant date is
the measurement date. Typically, at this time, there is no intrinsic value or excess
of exercise price over market price. Consequently, no compensation cost is
recognized. In contrast, a compensation cost is sometimes recognized for other
types of stock compensation plans under the intrinsic value method. Typically,
these are plans (variable stock option plans) with variable, usually performance-
based features, where either the option price or the number of optioned shares is
not determinable until some date beyond the grant date. Repriced options and
option plans adopted within 6 months after the cancellation of a former plan are
accounted for as if they were variable stock option plans.
Any compensation cost recognized under the intrinsic value method is amortized
to income as a charge over the vesting period.
Fair Value Method: Under the fair value based method, stock-based
compensation cost is measured at the grant date based on the fair value of the
award, and is recognized as a charge to earnings over the employees service
period, which is usually the vesting period.
In the case of stock options, the fair value is determined using an option-pricing
model. Once the fair value is determined at the grant date, it is not subsequently
adjusted for changes in the price of the underlying stock or its volatility, the life of
the option, dividends on the stock, or the risk free interest rate. Stock options used
to pay non-employees (except directors) for goods and services are accounted for
using the fair value method.
IAS: Disclosure of employee stock compensation plan data is required. Standard
does not require recognition of employee stock option compensation costs.
Financial Analysis: The earnings and price-earnings multiple of companies that
use stock options extensively for compensation purposes should be evaluated
using both the intrinsic and fair value methods to account for stock options.
31. Derivatives
Measurement: All derivatives must be measured at their fair value and shown on
the balance sheet as either assets or liabilities.
Four Categories: If certain conditions are met, management can designate a
derivative as one of the following:
A fair value hedge;
A cash flow hedge;
A hedge of a foreign currency exposure of a net investment in foreign
operations; or
Not a hedging instrument.
Fair Value Hedge: Hedge of the exposure to changes in the fair value of an asset
or liability recognized on the balance sheet or of an unrecognized firm
commitment, that are attributable to a particular risk. A firm commitment is
defined as:
An agreement with an unrelated party, usually legally
enforceable, under which performance is probable because of a
sufficiently large disincentive for nonperformance. All
significant terms of the exchange should be specified in the
agreement, including the quantity to be exchanged, the fixed
price, and the timing of the transaction.
For a derivative designated as hedging an exposure to changes in the fair value of
a recognized asset or liability or a firm commitment (a fair value hedge), any
unrealized fair value gain or loss is recognized in earnings in the period of change
together with the offsetting unrealized fair value loss or gain on the hedged item
attributable to the risk being hedged. Unrealized fair value gains and losses that
are other than perfectly correlated will impact earnings. Realized gains and losses
on the derivative and the hedged item are recognized in income.
Cash Flow Hedge: Hedge of an exposure to variability in expected future cash
flows that is attributable to a particular risk. That exposure may be associated with
an existing recognized asset or liability (such as all or certain future interest
payments on variable-rate debt) or a forecasted transaction (such as a forecasted
purchase or sale).
For a derivative designated as hedging the exposure to variable cash flows of an
expected future transaction (a cash flow hedge), the effective portion of the
derivatives unrealized and eventual realized gain or loss is initially reported as a
component of other comprehensive income (a component of owners equity) and
subsequently reclassified into earnings when the forecasted transaction affects
earnings. The ineffective portion of any gain or loss is reported in earnings
immediately.
Foreign Currency Net Investment Exposure Hedge: In the case of a derivative
designated as hedging the foreign currency exposure of a net investment in a
foreign operation, any unrealized and realized gains and losses are reported in
other comprehensive income along with the cumulative translation adjustment.
Not A Hedge: The unrealized gain or loss on a derivative not designated as a
hedge is recognized in current income.
IAS: All financial assets and financial liabilities, including derivatives, should be
recognized on the balance sheet. Investments in the form of financial assets should
be measured at fair value except the following which should be measured at
amortized cost: loans and receivables originated by the enterprise and not held for
trading, and fixed maturity investments intended to be held to maturity.
Subsequent to recognition, most financial liabilities should be measured at original
recorded amount less principal repayments and amortization, except derivative
liabilities that are measured at fair value. Unrealized gains and losses on items
measured at fair value can be recognized in income or owners equity. Hedge
accounting is permitted.
Financial Analysis: It is difficult to determine through financial analysis a
companys unhedged exposure to financial, foreign currency, and commodity
price risks. Nevertheless, an attempt should be made to assess the degree of
exposure, since it may have a material impact on the level and volatility of
earnings.
32. Marketable Securities
Three Categories: Trading, investment, and available for sale.
Trading: Intention is to trade. Use fair value accounting with unrealized gains
and losses going to income.
Investment: Intention is to hold to maturity. Account for securities at cost.
Available-For-Sale: All other securities not classified as either trading or
investment. Use fair value accounting with unrealized gains or losses included in
other comprehensive income (owners equity).
IAS: All financial assets should be recognized on the balance sheet. Investments
in the form of financial assets measured at fair value except the following which
should be measured at amortized cost: loans and receivables originated by the
enterprise and not held for trading, and fixed maturity investments intended to be
held to maturity. Unrealized gains and losses on items measured at fair value can
be recognized in income or owners equity. Hedge accounting is permitted.
Illustration: The ABC Company invests $1,000 of excess cash in a short-term,
180-day investment. At the end of each three months, it receives $10 interest. The
Company intends to hold the securities to maturity. The Company considers the
securities as an alternative to holding cash. The accounting entries are as follows:
Initial investment:
Dr. Short-term investments (+) 1,000
Cr. Cash (-) 1,000
Receipt of interest:
Dr. Cash (+) 10
Cr. Interest income (+) 10
At maturity:
Dr. Cash (+) 1,010
Cr. Short-term investment (-) 1,000
Interest income (+) 10
The accounting would be the same as the above if the security has been classified
as an investment security.
Assume the security had been classified as a trading security. Furthermore, assume
its market value was $1,020 at the end of 3 months, at which time $10 interest was
paid, and the security was sold at the end of 4 months for $995. The accounting
entries for the initial investment and the receipt of the interest payment are the
same as in the above example. The additional accounting entries are:
Recognition of unrealized 3-month gain and adjustment of the trading security
assets book value to market ($1,020):
Dr. Trading securities (+) 20
Cr. Trading securities income (+) 20
Sale of security
Dr. Cash (+) 995
Trading securitys loss (+) 25
Cr. Trading securities (-) 1,020
If the above security was classified as an available-for-sale investment, the
accounting entries to record the initial investment and receipt of interest would be
the same as in the initial example. The additional accounting entries are:
Recognition of unrealized 3-month gain and adjustment of available-for-sale
security assets book value to market ($1,020):
Dr. Available-for-sale securities (+) 20
Cr. Unrealized gain adjustment
to owners equity (+) 20
Sale of security:
Dr. Cash (+) 995
Unrealized gain adjustment
to owners equity (-) 20
Loss on security sale (+) 5
Cr. Available-for-sale securities (-) 1,020
A comparison of the last two illustration examples shows that the 3-month trading
security asset was adjusted to market accompanied by an offsetting credit entry to
income, whereas the available-for-sale security asset was adjusted to market
accompanied by an offsetting credit entry to other comprehensive income (the
owners equity entry).
Financial Analysis: Investment results should be segregated from operating
results when analyzing a companys performance.
33. Special Income Statement Items
The basic income statement may be expanded to report the following:
Discontinued Operations: When a company decides to sell or abandon a
business segment, the segments net income and any expected gains or losses on
its disposal are shown on a separate line of the income statement below the
income from continuing operations line.
Extraordinary Items: Extraordinary items are both unusual and infrequent in
occurrence. The determination of what is unusual and infrequent is based on the
companys business, location, and political environment. In the past, gains and
losses on the extinguishment of debt were classified as extraordinary items. They
are now classified as regular financing gains and losses. Extraordinary items are
rare. They are reported net of any related tax as a special line item below income
from continuing operations.
Cumulative Effect of Changes in Accounting Principles: When a company
changes an accounting principle (i.e., accelerated to straight line depreciation), the
cumulative effect (the difference in the periods beginning retained earnings if the
new principle had been used in the past) is reported net of taxes as a special line
item in the income statement. Below income from continuing operations. One
exception is a change from LIFO inventory accounting to another inventory
method. Prior period financial statements are restated to reflect the new method.
Estimate Changes: Changes in accounting estimates (i.e., a change in
depreciable life estimate) effect current and future periods only. Accounting
principle changes that are applied only to future transactions are treated like
estimate changes for accounting purposes.
Prior Period Adjustments: When an error is found in prior period financial
statements, the correction net of taxes of the error is made directly to beginning
retained earnings. It does not appear in the income statement.
IAS: Similar to U.S. GAAP, except a correction of a fundamental error and the
cumulative effect of a change in accounting policy can be reported by either
restatement of prior period financial statements or in the current period financial
statements.
Financial Analysis: In order to determine a companys future level of income
using historical data, financial analysts frequently exclude non-recurring gains and
losses and other unusual non-recurring items from current and past income.
34. Principal Differences Between IAS and U.S.
GAAP
The principal differences between IAS and U.S. GAAP are:
International Accounting U.S. Generally Accepted
Standard Accounting Principles
Property, Plant and Equipment Use historical cost or revalued amount. Revaluation
gains credited to owners equity. Revaluation losses
that offset previous revaluation gains recognized for
an asset charged to owners equity until gains
eliminated then charged to income. Revaluation of the
entire class of assets required when an asset is
revalued
Historical cost only.
Depreciation The cost or revalued amount of depreciable assets
should be allocated on a systematic basis to each
accounting period during the assets useful life.
Similar, except depreciation based only on assets
cost.
Business Combinations A business combination should be accounted for
under the purchase method, except in the rare
circumstances when it is deemed to be a uniting of
interest in which case the pooling of interests method
is appropriate. A business combination is considered
to be a uniting of interest when there is no clear
acquirer. Positive goodwill arising in a purchase
transaction should be amortized to income on a
systematic basis over a period not to exceed 20 years
or a longer period if justified.
Similar, except that pooling of interests accounting is
not permitted and goodwill is not amortized. It is
subjected to an annual impairment test.
Cash Flow Statements A cash flow statement reporting cash flows classified
by operating, investing, and financing activities should
be included as an integral part of the financial
statements. Interest paid and received may be
classified as operating, investing, or financing
activities. Dividends received may be classified as an
operating or financing activity.
Similar, except interest paid or received is classified
as an operating activity. Dividends paid is classified
as a financing activity. Dividends received is an
operating activity.
Impairment of Assets Assets should be written down when their recoverable
amount is less than their carrying value. Recoverable
amount is the higher of the present value of the
projected estimated cash flows from the assets use
or the assets net selling price. Revaluation of
impaired assets permitted. Projected cash flows from
its use is Impairment loss is the difference between
the impaired assets carrying amount and its fair
value. Revaluation of impaired assets is not
permitted.
An asset intended to be sold is impaired if its carrying
amount is less than its net selling price. An asset
other than goodwill intended to be used by the
enterprise is impaired if the undiscounted sum of the
less than its carrying amount.
Intangible Assets An intangible asset should be recognized if, and only
if, it is probable that the future economic benefits that
are attributable to the asset will flow to the enterprise,
and the cost of the asset can be measured reliably.
An intangible asset can be revalued only if its fair
value can be determined by reference to an active
market. Amortize over a period not to exceed 20
years unless a longer period can be justified.
Research costs should be expensed as incurred.
Development costs should be capitalized and
amortized if certain recoverability criteria are met,
otherwise they are expensed as incurred.
Similar, except revaluation is not permitted,
intangibles with limited lives are amortized over their
useful life, and intangible assets with indefinite lives
are not amortized. They are subjected to periodic
impairment tests. Similar with respect to research
costs. Development costs should be expensed as
incurred, except for internal-use software, and
recoverable costs incurred in the development of
softwarefor sale.
35. Financial Ratio Analysis
Financial ratios: Financial ratios are a fundamental tool for analyzing financial
statements. Financial ratios relate financial statement data to each other in a
meaningful way. Financial ratios are used by analysts to evaluate a companys
profitability, efficiency, and operating and financial risk for the purpose of
projecting future income statements, balance sheets, cash flows, and assessing
operating and financial risk. Typically, this process involves comparisons of a
companys financial ratios relative to its historical financial ratio record (time
series analysis) and those of its major competitors and relevant industries (cross-
sectional analysis). Another important relationship examined is the effect of the
economic environment on the financial ratios. The major end uses of these
analyses are stock valuations and credit quality ratings.
Adjustments: Financial analysts often modify financial statements before
computing financial ratios to reflect what they consider to be a more realistic view
of the company. Common adjustments include: recognizing off-balance sheet
financings and commitments on the balance sheet (sales of receivables and take-
or-pay arrangements); treating operating leases as capital leases; classifying
deferred tax liabilities as owners equity; recognizing the possible impact of
unrecognized potential contingent liabilities; adjusting LIFO inventories to a FIFO
basis; consolidating on a proportionate basis unconsolidated investees accounted
for using the equity method; revaluing tangible and intangible assets to reflect
their fair or market value; restating reserves and charges for bad debts warranties,
and product returns; changing the write-off period of intangible assets; valuing
debt obligations to reflect current market interest rates; adding capitalized interest
to the interest expense to properly measure interest coverage ratios; and,
recalculation of the tax expense to eliminate short-term aberrations.
Common sized statements: A common-size income statement expresses each
item on the income statement as a percentage of net sales. A Common-size
balance sheet uses total assets as the base. To identify changes in a companys
operating results, investment mix and sources of capital, common-size financial
statements for two or more periods are prepared and the percentage figures for
each line item are compared.
Solvency (Internal Liquidity) Ratios: A corporations liquidity is determined by
its ability to raise cash from all sources, such as bank credit, sale of redundant
assets, and operations. Liquidity ratios have a narrower focus. They help statement
users appraise a companys ability to meet its current financial obligations using
its existing cash and current assets. These ratios compare current liabilities, which
are the obligations falling due in the next 12 months, and current assets, which
typically provide the funds to extinguish these obligations. The difference between
current assets and current liabilities is called working capital.
Current Ratio = Current Assets
Current Liabilities
The meaningfulness of the current ratio as a measure of liquidity varies from
company to company. Typically, it is assumed that the higher the ratio, the more
protection the company has against liquidity problems. However, the ratio may be
distorted by seasonal influences, slow-moving inventories, slow paying credit
customers, or abnormal payment of accounts payable just prior to the balance
sheet date. Also, the nature of some businesses is such that they have a steady,
predictable cash inflow and outflow, and a low current ratio may be appropriate
for such a business.
Quick Ratio = Quick Assets
Current Liabilities
The acid-test or quick ratio measures the ability of a company to use its near-
cash or quick assets to immediately extinguish its current liabilities. Quick assets
include those current assets that presumably can be quickly converted to cash at
close to their book value. Such items are cash, marketable securities, and accounts
receivable. Like the current ratio, this ratio implies a liquidation approach and
does not recognize the revolving nature of current assets and liabilities.
Cash Ratio = Cash + Marketable Securities
Current Liabilities
The cash ratio measures the ability of a company to extinguish its current
liabilities with its most liquid current assets.
Annual Receivables Turnover = Net Annual Sales
Average Receivables
Receivables turnover rate indicates how often a companys investment in accounts
receivable turn over. It can be used to compute the average time it takes for a
company to collect its outstanding receivables.
Average Receivables Collection Period = 365
Annual Receivables Turnover
Average Receivables Collection Period = Accounts Receivable
Sales/365
An increase in the average collection period is regarded as a red flag alerting the
analyst to the need to inquire into the cause of the increase. To appraise the quality
of accounts receivable, the average collection period can be related to the typical
credit terms of the company and its history. A collection period substantially
longer than either of these standards might indicate credit management problems,
resulting in an increasing amount of funds being tied up in this asset. The increase
may also be the result of pulling sales in from future periods to boost the current
periods sales level. On the other hand, a significantly shorter collection period
than is typically in the industry might mean that profitable sales to slower paying
customers are being missed. Sometimes called days sales outstanding (DSOs).
Annual Inventory Turnover = Cost of Goods Sold
Average Inventory
The inventory turnover ratio indicates how fast inventory items move through a
business. It is an indication of how well the funds invested in inventory are being
managed. The analyst is interested in two items: the absolute size of the inventory
in relation to the other funds needs of the company, and the relationship of the
inventory to the sales volume it supports. A decrease in the turnover rate indicates
that the absolute size of the inventory relative to sales is increasing. This can be a
warning signal, since funds may be tied up in inventory beyond the level required
by the sales volume, which may be rising or falling.
Average Inventory Processing Period = 365
Annual Inventory Turnover Rate
Average Inventory Processing Period = Average Inventory
Cost of Goods Sold/365
By dividing the turnover rate into 365 days, the analyst can estimate the average
length of time items spent in inventory. If the company uses the last-in, first-out
(LIFO) inventory valuation method, in order to reflect the companys actual
investment in inventory, the inventory balance must be converted to its equivalent
value based on the first-in, first-out (FIFO) inventory valuation method. This is
accomplished by adding the LIFO reserve to the LIFO inventory balance reported
on the balance sheet. The LIFO reserve figure can be found in the inventory note
accompanying the financial statements.
Payables Turnover Ratio = Cost of Goods Sold
Average Trade Payables
The payables turnover ratio indicates how fast a company turns its accounts
payable over. It can be used to compute the average payables payment period.
Average Trade Payables Payment Period = 365
Average Trade Payables
The days-payables ratio becomes meaningful when compared to the credit terms
given by suppliers to the object companys industry. If a companys average days
payables period is increasing, it may mean trade credit is being used increasingly
as a source of funds. If the payables period is less than the average for the
industry, it may indicate that management is not using this source of financing as
much as possible. If it is longer, it may mean the company is overdue on its
payables and is using this source of financing beyond the normal trade limits.
Average Payable Period = Accounts Payable
(Cost of Goods Sold + Selling, General & Administration - Depreciation)/365
A more inclusive measure of the payables period.
Cash Conversion Cycle: A measure of internal liquidity. The average period a
company ties its cash up in inventories and receivable balances after allowing for
vendor financing in the form of payables.
Cash Conversion Cycle =
Average Collection + Average Inventory Average Payables
Period Processing Period Payment Period
Operating Efficiency Ratios: Operating efficiency ratios indicate how well a
company is using its assets and capital relative to its sales.
Total Asset Turnover = Net Sales
Average Total Assets
The asset turnover ratio is an indicator of how efficiently management is using its
investment in total assets to generate sales. High turnover rates suggest efficient
asset management.
Equity Turnover = Net Sales
Average Equity
The equity turnover ratio is an indicator of how efficiently a company is able to
use its equity to generate sales. High turnover rates suggest efficient equity
management. Since equity is the difference between total assets and total
liabilities, a company can improve its equity turnover rate by substituting
liabilities for equity. This may increase the companys financial risk.
Operating Profitability Ratios. Analysts look at profits in two ways: first, as a
percentage of net sales; second, as a return on the capital invested in the business.
Gross Profit Margin = Gross Profit
Net Sales
Gross profit (sales minus cost of sales) as a percentage of sales is an indication of
a companys ability to mark up its products over its cost.
Operating Profit Margin = Operating Profit
Net Sales
Operating profit (gross profit minus selling, general, and administrative expenses)
as a percentage of sales is an indicator of the operating leverage or business risk of
the firm. It measures a companys ability to cover its selling, general and
administrative expenses that tend to be fixed in total. Volatile operating profit
ratios over time may indicate a high level of business risk. Interest is excluded
from this ratio, since it relates to financing rather than operations.
Operating Profit Margin = Operating Profit Before Depreciation,
Interest and Taxes (EBDIT)
Net Sales
Net Profit Margin = Net Income From Continuing Operations
Net Sales
Net profit as a percentage of net sales from continuing operations measures the
total operating and financial ability of a company, since net profit after taxes
includes all of the operating and financial costs of doing business.
Return on Total Capital = Net Income + Gross Interest Expense
Average Total Capital
Return on total capital (debt plus owners equity) gauges how well a company has
managed the total resources at its command, before consideration of credit costs.
Average total capital is used in the denominator since net income is earned over a
12-month period.
Return on Total Equity = Net Income
Average Total Equity
The return on total equity (owners equity including preferred stock) percentage
measures the return on total equity after all taxes and interest payments.
Sometimes preferred dividends are deducted from net income and preferred stock
from total equity to measure the return on common stockholders equity (total
equity minus preferred stock).
Return on Owners Equity (ROE) = Net Income x Sales x Total Assets
Sales Total Common Equity
Asstes
ROE can be decomposed into three ratios that analysts use to determine how a
company achieved its return on owners equity: The profit margin (net
income/sales), the total asset turnover (sales/total assets), and the financial
leverage ratio (total assets/common equity). The common equity figure used is the
yearend amount. This equation is referred to as the DuPont System.
Extended DuPont System: An extension of the DuPont System examines the
effect of interest, leverage,
and taxes on the return on equity. This analysis begins with the operating margin
return (Earnings before interest and taxes):
EBIT x Sales = EBIT
Sales Total Assets Total Assets
Next, the negative effect of financial leverage (interest cost) is examined.
EBIT - Interest Expense = Profit Before Taxes
Total Assets Total Assets Total Assets
Then, the positive effect of financial leverage is identified.
Profit Before Taxes x Total Assets = Profit Before Taxes
Total Assets Owners Equity Owners Equity
Finally, the impact of taxes on return on equity is highlighted.
Profit Before Taxes x (1 tax rate) = ROE
Owners Equity
Risk Analysis: Risk analysis involves an assessment of the level of uncertainty
associated with income flows of the total company and its individual sources of
capital. Greater volatility in these factors implies higher risk for investors.
Business Risk: Business risk is the uncertainty associated with a companys
income caused by the nature of its industry, products, customers, production
processes, and cost structure. Business risk is measured by the variability of a
companys income over time. (Standard deviation of operating earnings/Mean
operating earnings).
Financial Risk: Financial risk is the uncertainty of returns to equity holders due
to a companys fixed obligations to pay interest and repay principal to creditors.
Debt/Equity Ratio = Total Long-Term Debt
Total Equity
The numerator of the debt to equity ratio includes all long-term fixed obligations,
including convertible debt securities. The debt to equity ratio measures the relative
mix of financing provided by owners and long-term fixed obligation credit sources.
Typically, the higher the ratio, the higher is a companys financial risk level.
Total Long-Term Debt/Capital Ratio = Total Long-Term Debt
Total Long-Term Capital
The long-term debt to total capital ratio reflects a companys policy on the mix of
long-term funds obtained from ownership and non-ownership sources. The
denominator includes all of a companys long-term debt and equity capital.
Total Debt Ratio = Total Liabilities
Total Long-Term Capital
The total debt ratio is often calculated when a company relies heavily on short-
term borrowings. The numerator includes both current and non-current liabilities.
Interest Coverage = EBIT From Continuing Operations
Interest Expense
The interest coverage ratio indicates the extent to which operating profits can
decline without impairing a companys ability to cover its fixed interest charges.
Fixed Charge Coverage = EBIT + Lease Payments
Debt + Lease + Preferred
Interest Payments Dividends/(1-Tax Rate)
The fixed charge coverage ratio measures how well a companys earnings cover
its fixed charges.
Cash Flow/Interest Expense Ratio =
Net Income + Depreciation Expense + Deferred Taxes
Interest Expense
The cash flow to interest expense ratio is an alternative to the interest (earnings)
coverage ratio. The numerator is the traditional measurement of cash flow.
Cash Flow Coverage Ratio = Cash Flow + Interest
Interest Expense
The cash flow coverage ratio is an alternative way of measuring interest coverage.
Cash Flow/Long-Term Debt Ratio = Cash Flow
Book Value of Long-Term Debt
The cash flow to long-term debt ratio has proven to be a good explanatory variable in
studies using financial ratios to predict bankruptcy. Analysts sometimes use as an
alternative to the traditional cash flow in the numerator of cash flow ratios the cash
flow from operations amount shown in the statement of cash flows or a free cash flow
amount (cash flow from operations minus capital expenditures minus dividends).
Growth Analysis: Historical and pro forma growth rate analyses use a
mathematical expression known as the sustainable growth rate equation. This
equation demonstrates that if a company does not issue new equity, its potential
maximum earnings growth rate will be a function of its rate of return on equity
and dividend payout policy.
g = ROE x (1 D)
E
where: g = Annual net income growth rate or sustainable growth rate
ROE = Rate of return on equity
D = Dividend payout ratio; i.e., annual declared dividends
E (D) divided by operating income after taxes (E)
(1 D) = Earnings retention rate; i.e., 1 minus the dividend payout ratio
E
By observation, it can be seen from the above equation that a future earnings
growth rate cannot be greater than a companys return on equity; i.e., g = ROE,
when dividends are zero. In addition, should a company wish to maintain a given
earnings growth rate, it can do so by a variety of combinations of payout ratio and
return on equity levels.
Depreciable Asset Analysis: The average depreciable life and the average age of
depreciable fixed assets can be estimated as follows (years):
Average Depreciable Life = Gross Plant and Equipment Cost
Current Years Depreciation Expense
Average Age of Plant and Equipment = Accumulated Depreciation
Current Years Depreciation Expense
Land cost a non-depreciable asset is excluded from the above calculations.
Limitations: The value of a financial ratio analysis is enhanced by the
consideration of relative importance of its financial ratios drawn from the subject
companys history or other comparable companies. To identify any limitations to
this comparative analysis, analysts should ask:
1. Are the accounting policies comparable? Analysts may have to adjust the
financial statement for accounting differences.
2. How comparable is the firm? Financial ratio differences may arise between
the subject company and the comparables because of a different mix of
business.
3. Are the conclusions drawn from the analysis consistent? A good analysis
considers the total firm, not just one aspect.
4. Are the ratios reasonable? Do the ratios fall within the range anticipated for
the subject companys industry?
36. Quality of Earnings Analysis
Investors use accounting earnings and balance sheet data to price stocks because it
is thought that the level of earnings and changes in earnings along with the related
balance sheet data signal relevant information about a companys current and
future ability to generate economic value that other investors will recognize and
price appropriately. Knowledgeable investors have long recognized that not all
dollars of reported profit and balance sheet amounts are equal when it comes to
representing a corporations current economic progress and signaling future levels
of economic achievement. Investors aware of this difference carefully examine the
sources of reported and projected earnings to assess the degree to which they can
be taken at their face value as reliable economic value creation indicators. This
examination and assessment has been labeled quality of earnings analysis.
High quality balance sheets have a conservative amount of debt, assets whose
market value is greater than their carrying amount, and few, if any, off balance
sheet liabilities.
High quality earnings are repeatable earnings measured using conservative
accounting policies.
Current practices: In recent years, the quality of earnings of many companies
has declined because they have adopted one or a number of the following
accounting practices.
Research and development in process writeoffs arising from business acquisitions:
In a purchase transaction, the excess of the consideration paid over the fair value of
acquired tangible assets less the fair value of assumed liabilities must be allocated to
acquired identifiable intangible assets with any excess remaining being assigned to
goodwill. Often today, an unusually high proportion of the excess purchase price is
assigned to an intangible asset research and development in progress. At the
moment of merger, this intangible is listed on the combined companies balance
sheet. It also enters into the goodwill calculation, reducing goodwill. Then, as
required by U.S. GAAP, as soon as the combined companies begin operations
together, this intangible is written off. The result? The acquirer is able to include the
acquirees profits in future income without having to match against this income
much of the purchase price related charges incurred to obtain it.
Inappropriate restructuring charge accounting: The one-time charge improperly
includes costs that relate to future operations, not the restructuring; the company is
slow after taking a restructuring charge to restructure, thereby benefiting from
those operations without recording their full current cost; or unused restructuring
charges of prior periods are used to absorb unrelated charges; or, are reversed to
boost current income.
Unrecorded stock option compensation costs: Stock options as a form of
compensation have increased in popularity, but their cost is seldom recognized in
income statements. Under FAS 123, companies in most cases have a free choice
of one of two methods to account for stock-based employee compensation the
intrinsic value method or the fair value method. Nearly all companies have adopted
the intrinsic value method. Under this approach, compensation cost is the excess, if
any, of the quoted market price of the stock at the grant date over the employees
exercise price. Typically, at this time, there is no intrinsic value or excess of exercise
price over market price. Consequently, no compensation cost is recognized.
Front-end income loading: The company recognizes all or most of the income
from arrangements that require it to provide services over an extended period of
time at the time the arrangement is signed, and it is questionable as to whether the
company has earned this income at signing.
Deferral of costs: The company has deferred over future periods expenditures to
acquire a potential revenue stream, and it is questionable as to whether the benefits
of these expenditures will be realized over these future periods.
Previously unrecognized deferred tax assets are recognized: Management, with
insignificant changes in the companys circumstances and prospects, decides that
the company is now more likely than not (a 0.5 or greater probability) to realize
previously unrecognized deferred tax credits (valuation allowance items) and uses
the book credits to lower tax expense.
Overly pessimistic asset impairment charges: The company in prior periods
recorded an asset impairment charge, thereby lowering future depreciation and
goodwill charges based on assumptions about the future that in retrospect were
overly pessimistic. The current profits reflect better operating results than
anticipated without being burdened by the excessive prior period write-offs.
Optimistic measurement assumptions: Accounting rules require management to
make assumptions when measuring revenues and costs, for example, gains on
securitization and pension costs. Managements under pressure to produce profits
may make overly optimistic measurement assumptions.
The FASB is considering accounting changes that may enhance the quality of
earnings. These include the consolidation of all controlled entities with control
defined as the actual or potential ability to direct the policies and management of
another entity through such things as board control, a significant minority interest
and ability to gain control through the exercise of options; all financial assets and
liabilities measured at fair value; and, identification of more situations where stock
option compensation should be recorded.
Common Signals: When doing quality of earnings analyses to determine if the
quality of current earnings has declined from prior periods, investors should focus
on looking for sources of low quality earnings that at the margin make the difference
between the company earning or not earning the consensus expectation. The more
common causes or signals of a decline in earnings quality of companies struggling to
meet earnings expectations that investors should be looking for include:
1. Adoption of less conservative accounting estimates, practices, and principles,
such as a decision to use longer depreciation lives or a change from
accelerated depreciation to straight-line depreciation.
2. One-time transactions to generate gains, such as a tax deal that gives up future
benefits to lower current tax rates or sale at a gain of an office building.
3. Operating actions that pull future earnings into the present, such as
accelerating shipments to customers. This is usually signaled by an unusual
accounts receivable build-up.
4. Inclusion of profits from past periods in the current period, such as a reversal
of a reserve set up in the prior period.
5. Early adoption of new accounting standards to boost current earnings.
6. Reduction of managed costs, such as research and development, maintenance,
and advertising costs.
7. Under-reserving for future expenditures associated with current sales, such as
bad debts, warranty obligations, returns, and allowances.
8. Selling to less credit worthy customers or channel stuffing. Usually signaled
by an increasing gap in time between the recording of income and the receipt
of cash from customers indicated by a build-up of accounts receivable.
9. Excessive premium paid to selling company which is embedded in higher
goodwill that is not charged to earnings.
10. Increasing reliance of earnings sources not central to the companys principal
business activity and strategy.
11. Classifying expenditures as assets that previously were expensed as incurred.
12. A major acquisition accompanied by inadequate disclosure making the
comparisons with earlier periods required to measure and analyze sources of
growth difficult.
13. Adoption of a new strategy, while using historical data to estimate reserves,
income timing, and expense recognition.
14. Write-off of investments soon after they are made.
15. An increasing level of financial leverage that has reached the point where the
financial risk associated with future earnings will be significantly higher than
current and past levels.
16. A slowdown in inventory (particularly finished goods) turnover. This may
indicate that the company has production or marketing problems that are not
yet reflected in current earnings.
High Cost. Quality of earnings analysis is potentially a high cost activity. This
cost can be lowered by concentrating on growth company situations that
experience has taught us are the most likely to resort to lowering earnings quality
in an attempt to keep the growth going. These characteristics include:
1. The company has achieved a significant market share and is growing faster
than the industry.
2. Business combinations are frequently entered into.
3. Management has a history of using accounting decisions to achieve earnings
expectations.
4. The auditors are changed.
5. The company has grown rapidly.
6. Managements growth strategy comes down to meeting earnings per share
goals at the apparent expense of other business considerations.
7. The company is doing too well to believe.
Investment Rating Distribution: Global Group (as of 31 December 2002)
Coverage Universe Count Percent Inv. Banking Relationships* Count Percent
Buy 1110 43.46% Buy 391 35.23%
Neutral 1236 48.39% Neutral 319 25.81%
Sell 208 8.14% Sell 43 20.67%
* Companies in respect of which MLPF&S or an affiliate has received compensation for investment banking services within the past 12 months.
In Germany, this report should be read as though Merrill Lynch has acted as a member of a consortium which has underwritten the most recent offering of securities
during the last five years for companies covered in this report and holds 1% or more of the share capital of such companies.
The analyst(s) responsible for covering the securities in this report receive compensation based upon, among other factors, the overall profitability of Merrill Lynch,
including profits derived from investment banking revenues.
OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potential price
fluctuation, are: A - Low, B - Medium, and C - High. INVESTMENT RATINGS, indicators of expected total return (price appreciation plus yield) within the 12-month period
from the date of the initial rating, are: 1 - Buy (10% or more for Low and Medium Volatility Risk Securities - 20% or more for High Volatility Risk securities); 2 - Neutral (0-10%
for Low and Medium Volatility Risk securities - 0-20% for High Volatility Risk securities); 3 - Sell (negative return); and 6 - No Rating. INCOME RATINGS, indicators of
potential cash dividends, are: 7 - same/higher (dividend considered to be secure); 8 - same/lower (dividend not considered to be secure); and 9 - pays no cash dividend.
Copyright 2003 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). All rights reserved. Any unauthorized use or disclosure is prohibited. This report has been
prepared and issued by MLPF&S and/or one of its affiliates and has been approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited,
which is regulated by the FSA; has been considered and distributed in Australia by Merrill Lynch Equities (Australia) Limited (ACN 006 276 795), a licensed securities dealer
under the Australian Corporations Law; is distributed in Hong Kong by Merrill Lynch (Asia Pacific) Ltd, which is regulated by the Hong Kong SFC; and is distributed in
Singapore by Merrill Lynch International Bank Ltd (Merchant Bank) and Merrill Lynch (Singapore) Pte Ltd, which are regulated by the Monetary Authority of Singapore. The
information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Additional information available.
Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other
derivatives related to such securities ("related investments"). MLPF&S, its affiliates, directors, officers, employees and employee benefit programs may have a long or short
position in any securities of this issuer(s) or in related investments. MLPF&S or its affiliates may from time to time perform investment banking or other services for, or solicit
investment banking or other business from, any entity mentioned in this report.
This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives,
financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of
investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be
realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may
receive back less than originally invested. Past performance is not necessarily a guide to future performance.
Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in
securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.

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