Accounting Review by Merrill Lynch for CFA

Global

March 2003

Professor David F. Hawkins(1) 212 449-3263

AccountingBulletin #116

2003 CFA Level I and II Accounting andFinancial Analysis Review

Merrill Lynch Global Securities Research & Economics GroupGlobal Fundamental Equity Research Department

RC#60207802#18405

Investors should assume that Merrill Lynch isseeking or will seek investment banking or otherbusiness relationships with the companies inthis 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

� Section Page

2003 CFA I and II Accountingand 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 Costof Goods Sold 15. 26

Intangible Assets andAmortization 16. 29

Bonds and Interest 17. 31

Contingencies 18. 34

Leases 19. 35


Refer to important disclosures at the end of this report. 3

� Section Page

Pension Benefits 20. 39

Post Retirement BenefitsOther Than Pensions 21. 42

Deferred Taxes 22. 43

Owners’ Equity 23. 46

Earnings Per Share 24. 49

Business Combinations 25. 51

Tangible Assets andDepreciation 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 BetweenU.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 FinancialStatement Analysis ReviewThis Accounting Bulletin is a summary of the financial analysis ratios andaccounting institutions, concepts, definitions, and standards that candidates for theCFA® Level I and II examinations should be familiar with. 1 This AccountingBulletin is not intended to be or act as a substitute for the Association forInvestment Management and Research® (AIMR®) study guides and assignedstudy materials. Rather, the Accounting Bulletin’s intended use is as a quickreview vehicle for the candidate who has completed the official study materials,and wants to refresh his or her recollection of topics studied. Candidates should beaware that the wording, but not the substance, of the definitions and description ofconcepts included in this Accounting Bulletin may differ from those included inthe official materials. This may be a plus for candidates who are having troublecomprehending the official materials. A different wording may help them to graspthe substance of a troublesome topic. While we believe the information containedin this Accounting Bulletin is accurate, if there are any discrepancies between thisAccounting Bulletin and the AIMR® study guides and assigned materials, theAIMR® materials should be followed.

The Bulletin covers both CFA® I and II level materials. CFA® I candidates shouldonly 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. accountingdevelopments should ask their Merrill Lynch sales representative to add theirname 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, orwarrant the accuracy of this Accounting Bulletin. Association for Investment Management andResearch® and CFA® are trademarks owned by the Association for Investment Management andResearch®.



2. Influential OrganizationsAlthough the Securities and Exchange Commission (“SEC”) has the responsibilityto set accounting standards for registered U.S. companies, the SEC has delegatedthis task to the Financial Accounting Standards Board (“FASB”), a private bodysupported by private funds that sets accounting standards for both registered andprivate companies. The accounting standards set by the FASB are referred to asGenerally Accepted Accounting Principles (“GAAP”). The FASB also setsaccounting standards for non-profit organizations. The FASB has a full timestandard setting board supported by a research staff.

The Emerging Issues Task Force (“EITF”), a sub-group of the FASB, deals withemerging accounting issues that need to be resolved in a timely manner. GAAP isalso established, with the approval of the FASB, by the American Institute ofCertified Public Accountants (“AICPA”), a professional organization of certifiedpublic accountants. The AICPA issues Statements of Position (“SOP’s”) dealingwith specific accounting issues, Statements on Auditing Standards setting forthgenerally accepted auditing standards, and Audits and Accounting Guides, whichtypically focus on specific industry accounting and auditing issues.

Accounting standards for government bodies are set by the GovernmentAccounting Standards Board (“GASB”).

The International Accounting Standards Board (“IASB”), located in London,England, is the successor body to the International Accounting StandardsCommittee (“IASC”) established in the early 1970’s to encourage theharmonization of global accounting standards. Prior to its demise, the IASC hadissued a number of International Accounting Standards (“IAS”). 2 The IASB is aprivate body supported by professional accounting associations and privatecontributors worldwide. Many non-U.S. companies, stock exchanges, and nationalaccounting setters have adopted or permit the use of IAS.

Outside of the U.S., accounting standards are typically incorporated throughlegislation or regulatory decisions into the laws governing companies. These maybe supplemented by standards and interpretations issued by independent boards orlocal associations of professional auditors.

Within the European Union (“EU”), the European Commission is responsible forensuring the member states’ accounting standards are consistent with the variousEU’s accounting directives. The European Commission supports and cooperateswith the IASB. While the accounting practices of the EU members differ,increasingly listed companies are using either IAS or U.S. GAAP. All EU listedcompanies must adopt IAS in 2005 or 2007 if they are using U.S. GAAP.

The International Organization of Securities Commissions is a voluntaryorganization without regulatory powers of national security regulators from over60 countries including the USA. It has approved IAS for cross-border listing ofsecurities. 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 ProcessThe FASB develops GAAP through a process that begins by adding an accountingtopic to its agenda and forming an ad hoc task force of experts on the topic towork with it to develop a Discussion Memorandum (“DM”) outlining the relatedissues and possible solutions that the FASB might consider. Next, after publiccomment on the DM, the FASB issues an Exposure Draft (“ED”) of its proposedstandard. The FASB solicits comments on the ED. After reviewing thosecomments, a final Statement of Financial Accounting Standard is issued if it isapproved by a majority of the Board. A final standard includes the standard, anexplanation of the Board’s decisions, and illustrative examples.



4. Enforcement and PenaltiesThe SEC monitors the financial reporting practices of registered companies usingprimarily the annual financial statements included as part of a company’s annualForm 10-K filings, interim period financial statements included as part of acompany’s quarterly Form 10-Q filings, and, in the case of foreign companyregistrants, the local GAAP financial statements and reconciliation of local GAAPand U.S. GAAP results included in Form 20-F filings.

The SEC may require a company whose accounting it believes fails to meet therequirements of GAAP to reissue its financial statements in accordance withGAAP. In some cases, civil or criminal charges might be brought against officersand directors for misstatements, fraud, or criminal acts involving financialstatement representations.



5. AuditingManagement is responsible for their company’s financial statements. Theindependent certified public accountant is responsible for his or her opinion onthose financial statements.

An audit is an examination intended to serve as a basis for an independent certifiedpublic accountant to express an opinion regarding the completeness, fairness,consistency, and conformity with GAAP of financial statements prepared by acorporation or other entity for submission to the public or other interested parties.

Audits should be conducted in accordance with generally accepted auditingstandards. These standards require the auditor to plan and perform an audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatements. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in financial statements. An audit alsoincludes assessing the accounting principles used and significant estimates madeby management, as well as evaluating the overall financial presentation.

An auditor’s report may be an unqualified or “clean” opinion (the usual case), adisclaimer of opinion (usually because of scope limitations, such as inability toaudit inventories), a qualified opinion (everything is okay except for someaccounting practice that is not in accordance with GAAP), and an adverse opinion(the financial statements are not in accordance with GAAP). If there is uncertaintyas to a company’s ability to continue as a going concern, the audit opinion shouldnote this uncertainty.

IAS: Financial statements that comply with IAS should disclose that fact.Financial statements should not be described as complying with IAS unless theycomply with all the requirements of each applicable standard. In the extremelyrare circumstances when management concludes that compliance with arequirement in a standard would be misleading, and therefore that departure froma requirement is necessary to achieve a fair presentation, an enterprise can departfrom IAS with appropriate disclosures of the departure, the reasons for it, and itsfinancial statement impact.



6. Basic Accounting ConceptsAccounting practices and standards rest on a number of basic accounting conceptsthat serve as guides to the appropriate accounting for business transactions and theformulation of accounting standards. The basic concepts are:

Dual Aspect: Assets = Liabilities + Owners’ Equity. After the recording of atransaction in the accounting records, this equation must be in balance.

Monetary: Accounting records only transactions that can be expressed inmonetary terms.

Historical Cost: Non-monetary assets are measured at their cost rather than someother value, such as market value.

Realization: Revenues are realized when goods or services are exchanged for avaluable consideration, and the revenue amount can be verified with a reasonabledegree of objectivity.

Matching: Expenses of a period’s activities are matched with the associatedrevenues.

Materiality: Accounting concepts and standards only apply to material amounts.

Going Concern: Unless evidence suggests otherwise, it is assumed that thecompany 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 associatedwith these entities.

Relevance and Reliability: To be useful, accounting information must berelevant and reliable. Relevance is the capacity of the information to influence ausers’ decision or expectations. Relevance also incorporates the notion thatinformation must be timely. The reliability of information refers to itsrepresentational faithfulness to the underlying economic reality.

Accrual vs. Cash: Financial statements based on cash accounting recordrevenues when cash is received and expenses when cash is paid out. The financialreports of public companies use accrual accounting. Accrual accountingrecognizes revenues in the period in which they are earned, and expenses in theperiod in which they are incurred. The recognition of revenues and expenses is notdependent on when cash is received or paid out. Accrual accounting is preferred toa cash based approach because it provides a better measure of performance bybetter matching of effort and accomplishment.

IAS: Generally, the IASB observes the same basic accounting concepts as theFASB, except the IASB permits as an alternative to the historical cost concept therevaluation upwards of fixed assets such as buildings.



7. Corporate Financial ReportsThe function of corporate financial reports is to provide through a set ofstatements and accompanying notes a continual history, expressed in moneyterms, of the economic resources and obligations of a business enterprise and ofthe economic activities that affect those resources and activities. These items andany changes in them are identified and measured in conformity with financialaccounting principles that are generally accepted at the time the statements areprepared. 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 timelyinformation that is:

• Useful to present and potential investors and creditors in making rationalinvestment and credit decisions.

• Comprehensible to those who have a reasonable understanding of businessand economic activities and are willing to study the information withreasonable 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 tothose resources.

• About an enterprise’s operating and financial performance during a period.

• About an enterprise’s cash flows during a period.

Accompanying Information: Financial statements include explanatory noteswhich are an integral part of the financial report describing the accounting policiesused and providing additional details. Publicly traded companies also provide intheir financial reports a Management Discussion and Analysis section in whichmanagement reviews significant off-balance sheet arrangements, accountingpolicy decisions, trends, events, capital expenditures, liquidity, expectations anduncertainties and their relationship to the company’s financial condition andresults of operations.



8. Balance SheetA balance sheet presents information related to a company’s financial condition asof a specific date based on the basic accounting concepts and generally acceptedprinciples 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) towhich a business holds the rights which have been acquired through a current orpast transaction.

Liabilities are probable, measurable, future economic sacrifices arising from acompany’s obligations to convey assets or perform services to a person, firm, orother organization outside of the company at some time in the future.

Owners’ equity is the residual balance remaining after total liabilities are deductedfrom 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 tobe liquidated (turned into cash) or consumed during the next twelve months or thecompany’s operating cycle, whichever is longer. Current liabilities are thoseliabilities that are expected to become due within the next twelve months. Assetsand liabilities that are not classified as current are classified as non-current. Withinthe current asset section, the assets are listed in descending order of liquidity,(cash, accounts receivable, etc.). Typically, accounts payable are listed at the headof the current liability presentation with the other current liabilities presented in noparticular order.

On the asset side of the balance sheet, current assets are listed above non-currentassets. The same is true for the liability display. Current liabilities are displayedbefore non-current liabilities. Owners’ equity follows total liabilities in the balancesheet presentation. The components of owners’ equity are listed in order of theirpreference 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 investmentpurposes.

Accounts Receivable. Represent claims against customers generated by creditsales for amounts still due the company. The account balance includes onlybillings for services performed or products sold on or before the balance sheetdate. The amount presented is net of the company’s estimated losses fromuncollectible accounts.

Notes Receivable. Amounts owed to the reporting company that are evidenced bya formal note. The account balance is net of estimated uncollectible amounts.

Accounts and notes receivable not expected to be collected during the next twelvemonths 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 ofitems to be sold in the normal course of operations. The inventory account mayinclude three types of inventory: a finished goods inventory, consisting ofproducts ready for sale; a work-in-process inventory, consisting of products invarious 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 asgreat as their cost, in which case the lower-of-cost-or-market rule requires thecarrying value of inventories to be written down below cost.

Prepaid Expenses. Amounts paid to vendors, such as for a 3 year insurancepolicy with 2 years to expiration, that will benefit accounting periods beyond thecurrent period.

Common Non-Current Assets:

Investments. Investments in common stock or debt securities made for long-terminvestment purposes where the company’s 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 thecompany’s operations. Land is reported at its original cost. Other fixed assets arereported at their original cost less their related accumulated depreciation.

Accumulated Depreciation. Depreciation represents the allocation to accountingperiods of the cost of fixed assets due to use and obsolescence. An annual chargefor depreciation is included in the expenses of current operations. The amount ofthis depreciation expense is related to the anticipated useful life of the asset, whichmay 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 ofdepreciation expense related to the fixed assets still carried on the books of thecompany is presented on the balance sheet in an account called “accumulateddepreciation”. Sometimes the term “allowance for depreciation” is used.

Intangible Assets. Non-physical assets created through a business transactionwith continuing value, such as goodwill, copyrights, trademarks, franchises, andinvestments in software. The cost of most intangible assets is charged(“amortized”) against income over their useful life. Acquired intangibles with anindefinite life and goodwill are not amortized. Their carrying amount is writtendown to their fair value when the asset’s value is impaired. The loss of value is acharge to earnings.

Deferred Tax Asset. The amount of a company’s potential future income taxcredits, such as net operating loss tax credit carryforwards, that managementbelieves 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 thathave been recorded as assets or expenses but not yet paid.

Notes Payable. Unpaid obligations to creditors that are evidenced by a note, suchas a short-term bank loan.

Current Maturities on Long-Term Debt. Amount of long-term debt that must bepaid during the next 12 months.

Taxes Payable. Taxes that must be paid to taxing authorities during the next 12months.

Dividends Payable. Dividends declared but not yet paid.

Deferred Revenue. Unearned revenues, such as unfulfilled subscriptions, that willbe earned during the next 12 months. Deferred revenue may also be classified as anon-current account.



Common Long-Term Liabilities:

Long-Term Debt. Debt obligations of a company that will mature beyond oneyear’s time. They are recorded at the present value of all future cash payments.

Deferred Tax Liability. The amount of a company’s potential income taxobligation that a company has deferred from past periods to future periods byreporting lower profits for taxation purposes than for financial reporting purposes.This liability results from using different accounting practices for financial and taxreturn reporting.

Allowances and Contingencies. Estimates of costs already charged to income forplanned 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 (basicownership interest in the corporation).

Capital Received in Excess of Par Value of Stock Issued. The differencebetween the amount received by a company from the issuance of common stockand the amount from the issuance assigned to the common stock account.

Other Comprehensive Income. Change in owners’ equity of a company during aperiod from transactions and other events and circumstances from non-ownersources, such as the gains and losses arising from translating foreign subsidiaryfinancial 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 lessdividends paid to shareholders.

IAS: Companies adopting IAS may use a variety of different balance sheetformats. A common format is, starting at the top of the list of assets, assets arepresented in increasing order of liquidity (property at the top and cash at thebottom). The order of presentation on the right hand side of the balance sheetbegins with owners’ equity, then non-current liabilities followed by currentliabilities. Different terminology may be used for accounts (inventories may becalled stocks).

Financial Analysis: A number of financial ratios are commonly used to analyzeboth the components of the balance sheet as well as their relationship to certainincome statement items (see “Financial Ratio Analysis” discussion).



9. Income StatementThe results of operations of a business for a period of time are presented in theincome 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 cumulativeaccounting change items as part of the net income measurement. Discontinuedoperations are parts of a business that management has decided to sell or closedown. Extraordinary items are rare. They are events or transactions that areunusual in nature given the type of the reporting company’s activities and thatoccur infrequently. Cumulative accounting change items are the cumulative effectup to the date of the change of changing from one accounting principle to another.The cumulative effect is the amount by which the period’s beginning retainedearnings 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 tocustomers. It is usually presented net of returns, allowances, discounts, andwarranty provisions.

Cost of Sales. The costs the company incurred to purchase and convert materialsinto 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 asinterest and dividend income, gains and losses on asset sales, interest expense, andunusual one-time charges.

Income Before Taxes. Operating income plus other income.

Income Taxes. The tax assessed on a company’s taxable income for theaccounting period plus potential future taxes or tax credits arising from thedifference between a company’s income before taxes and its taxable incomeshown on the period’s tax returns.

IAS: Income statements follow similar formats to the U.S. format, withsometimes different terminology. For example, sales may be called turnover andoperating profits may be referred to as trading profits.

Alternative Concepts: There are a number of alternative concepts of income toaccounting income encountered in theory and practice. These include:

Economic Income. A concept of earnings that equates earnings to a company’speriodic net cash flow plus the change during the period in the market value of itsassets. In a world of certainty, the market value of a company’s assets is thepresent value of their future cash flows discounted at the risk free interest rate. Inthe 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 foreconomic income.

Distributable Earnings. The dividends that can be paid without changing acompany’s value.

Sustainable Income. Future periodic income level that can be sustained by acompany’s investment in inventory and fixed assets.



Permanent Earnings. The periodic income level a company can normally earngiven its asset base.

Permanent earnings equals the market value of a company’s assets times itsrequired rate of return.

Economic earnings and its proxies are not equivalent to accrual based accountingearnings.

Financial Analysis: A number of financial ratios are commonly used to analyzeboth the components of the income statement as well as their relationship tocertain balance sheet items (see “Financial Ratio Analysis” discussion).



10. Statement of Cash FlowsStatement of Cash Flows: A statement showing a company’s sources and uses ofcash for a period of time. The statement has three sections – cash flow from (usedin) operations, cash flow used for (from) investments, and cash flow from (usedin) financings. The statement foots to change in cash, which is defined as cash andcash equivalents, (i.e., short-term, highly liquid investments whose value is notimpacted 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 thepresentation of cash flow from operations. The direct format reports cash flowsused in and generated by operations, (i.e., cash paid to suppliers and cash receivedfrom customers), as reflected in the reporting company’s cash account. Theindirect format begins with net income, adds (such as depreciation) or subtracts(such as equity method income in excess of dividends received) as appropriatenon-cash income statement items, and then adds (such as reduction of accountsreceivable) or subtracts (such as increase in inventory) changes in working capitalaccounts, excluding short-term debt, cash and cash equivalents. Both formats willreport the same cash flow from operations amount.

Classification Rules: Typically, the classification of transactions in the statementof cash flows as either operating, investing, or financing transactions isstraightforward. There are some exceptions.

Investing: Investing activities include cash outflows to acquire debt and equitysecurities of other companies as investments (other than cash equivalents) andproperty, plant and equipment. Investing cash inflows include the receipts fromthe sale of investment securities (other than cash equivalents) and the sale ofproperty, plant and equipment.

Financing: Financing activities include proceeds from issuing equity, bonds,mortgages, notes, and short-term borrowings. Cash outflows for financingactivities include repayments of amounts borrowed, dividends, and purchases oftreasury stock.

Operating: Operating cash flows include all cash transactions that are notclassified as either financing or investing activities. Operating activities generallyinvolve producing and delivering goods and providing services.

Dividends Paid and Received. Dividends paid are a financing item. Dividendsreceived are an operating item.

Interest Received and Paid. Interest received and paid are operating items underU.S. GAAP.

Only Cash Items. Irrespective of which category of the statement of cash flows isbeing considered as the correct classification of a transaction, it is important toremember that only items that change a company’s cash balance are classified ascash flows and, therefore, includable in the statement of cash flows. Activities thatdo not change a company’s cash balance, such as the issuance of bonds for abuilding or the issuance of stock for the conversion of convertible debt, are notreported in the statement of cash flows. They are listed as non-cash transactions ina note attached to the statement of cash flows.

Transaction Decisions. A decision to use one form of a transaction rather thananother can change the transaction’s related cash flow classification. For example,a decision to borrow funds using a zero coupon bond rather than straight debt canchange 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 tostructure a lease transaction as either an operating or a capital lease. The cashrental payment on a lease agreement structured as an operating lease is anoperating 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 isaccounted for as interest on the obligation – an operating item – and the rest istreated as a reduction of the obligation – a financing item.

Accounting Policy Decisions. Accounting decisions can change cash flowclassification. The decision to expense an item rather than capitalize it changes theitem’s classification. If software development cash outflows are expensed asincurred, they are an operating item. If they are capitalized, the outflow isclassified as an investment item. Interest capitalized as part of a long-term asset’scost is included in the investing section as part of the asset’s cost. Interest that isnot capitalized is an operating item.

Balance Sheet Classification Decision. The decision to classify an expenditure ofcash 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 rentalfleet as a current asset inventory – an operating cash outflow – or as a non-currentfixed asset – an investing cash outflow.

IAS: A statement of cash flows classified by operating, investing, and financingactivities is required by IAS as an integral part of the financial statements. Interestpaid and received may be classified as an operating, investing, or financingactivity.

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 (Cashreceived from customers, dividends, and interest minus cash paid to suppliers,employees, creditors, taxing authorities, and other operating cash outflows) can bederived 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 insurancepremium 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 operationscan be derived from balance sheet and income statement data as follows: (Netincome plus or minus non-cash income statement items and changes in workingcapital 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 cashflows use the same format and have the same totals under the direct and indirectmethods.

The investing cash flows can be derived from balance sheet and income statementdata (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 sheetand 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 paidCash provided (used) by financing activities

Financial Analysis: Cash flow analysis can enhance the analyst’s understandingof a company’s liquidity, solvency, and financial flexibility. The classificationrules used to prepare statements of cash flows may not always lead to the mostuseful insights into a company’s cash flows and financing decisions. Some of thecommon financial analyst adjustments to published statements of cash flowsinclude: Restating the cash flow from operations to include operating-like cashflows classified as a result of accounting decisions as non-operating, such ascapitalized interest and capitalized software development cash outflows;reclassifying of interest paid and dividends received as financing items to betterunderstand the cash flows related to a company’s core businesses; and, theinclusion of significant non-cash transactions in the cash flow analysis to betterunderstand a company’s cash flow needs irrespective of its financing methods.Another adjustment made to improve the usefulness of accounting cash flow datais the deduction of cash outlays for replacement of current operating capacity fromcash flow from operations to compute “free cash flow”. Free cash flow is theamount available to finance capacity expansion, reduce debt, pay dividends, oracquire a company’s own stock. Sometimes dividends are deducted to computefree cash flow.



11. Journal EntriesThe debit-credit double entry system for recording accounting entries is anextension of the basic accounting equation:

Assets = Liabilities + Owners’ Equityor

Debit Balances = Credit Balances

Debit Entries: Debit entries to accounts are increases in assets, increases inexpenses, decreases in revenues, decreases in liabilities, and decreases in owners’equity.

Credit Entries: Credit entries to accounts are decreases in assets, decreases inexpenses, increases in revenues, increases in liabilities, and increases in owners’equity.

� Debit-Credit Rules

Assets = Liabilities + Owner’s Equity(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 accountingentries are driven by transactions. For example, once a 3-year prepaid insurancepolicy is bought, there are no further transactions to initiate the recording of therelated 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 acquisitionentry is:

Dr. Prepaid Insurance (+Asset) 3,000Cr. Cash (- Asset) 3,000

At the end of each of the next two years, the following adjusting entry must bemade to recognize that one year of the insurance policy has expired:

Dr. Insurance Expense (+ Expense) 1,000Cr. 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). Forexample, 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 company’sincurred wage expense to date is:

Dr. Wage Expense (+Expense) 1,000Cr. Wages Payable (+ Liability) 1,000

When the wages are paid, the entry is:

Dr. Wages Payable (- Liability) 1,000Cr. Cash (- Asset) 1,000



12. ConsolidationConsolidated Statements: Consolidate all entities where parent owns more than50% of the stock. Only transactions with third parties are included in consolidatedstatements.

Equity Method: Ownership interests between 20% and 50% are recorded usingthe equity method; i.e., investor company records as investment (asset) itspercentage share (based on ownership percentage) of investee company owners’equity. Percentage interest of investor in investee company’s income recorded asincome by investor company.

Cost Method: Record investment at cost. Include dividends received in income.

Minority Interest: Equity of shareholders other than parent company inconsolidated entities. Minority interest in consolidated entities is shown betweenliabilities and owners’ equity on consolidated balance sheet. Minority interest inconsolidated entity’s income is deducted to measure consolidated net income.

Joint Ventures: Reported using the equity method. The proportionateconsolidation approach, (i.e., eliminate the parent’s investment and equity methodincome in the consolidated statements and include the joint venture’s financialstatement account balances excluding owners’ equity and net income in theparent’s consolidated statements on a pro rata basis based on the parent’sownership 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 Method1. Investor acquires 19% of investee company’s stock for $200,000

Dr. Investment (+) Cr. Cash (-)

200,000200,000

2. Investee reports $40,000 earnings No entry3. Investee pays $20,000 in dividends.* Dr. Cash (+)

Cr. Dividend Income (+)3,800

3,8004. 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 aboveillustration. The equity method is required:

Transaction Equity Method1. Investor acquires 40% of investee company’s stock for $421,053

Dr. Investments (+) Cr. Cash (-)

421,053421,053

2. Investee reports $40,000 earnings. * Dr. Investments (+) Cr. Income (+)

16,00016,000

3. Investee pays $20,000 in dividends. ** Dr. Cash (+) Cr. Investments (-)

8,0008,000

4. Investee reports $30,000 loss. *** Dr. Income (-) Cr. Investments (-)

12,00012,000

* $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 lossesand debt, as well as lower the taxes payable. A complete analysis of the companyshould include a consideration of these off-balance sheet arrangements.



13. Revenue RecognitionRevenue: The increase in owners’ equity resulting from operations during aperiod of time, usually from the sale of goods or services.

Revenues and gains generally are not recognized until earned and realized orrealizable. Revenues are considered to have been earned when the entity hassubstantially accomplished what it must do to be entitled to the benefitsrepresented by the revenues. Revenues and gains are realized when products(goods or services), merchandise, or other assets are exchanged for cash or claimsfor cash and the related assets received or held are readily converted to knownamounts of cash or claims to cash.

A more specific set of criteria specified by the SEC that must be met in order torecognize revenue are:

1. Persuasive evidence that a properly executed sales agreement exists.

2. Delivery has occurred or services have been rendered.

3. The seller’s 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 recognitionmethods 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 atthe 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 notreasonably 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 whenreliable estimates of costs, revenues, and profit are available and collectabilityis reasonably assured.

4. Recognition at the completion of a long-term contract, (i.e., completedcontract method). Used when it is not appropriate to use the percentage-of-completion method because no contract exists, revenue estimates areunreliable, or collectability is not assured.

5. Recognition as cash is received with profit recognized only after the buyer’scumulative cash payments exceed the seller’s total costs, (i.e., cost recoverymethod). Used when significant uncertainty exists as to collectability ofreceivable 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 servicesinvolved.

4. Right of return may preclude revenue recognition when level of returns isuncertain.

5. Inappropriate interest rates may require remeasurement at market rates.

6. Provisions for bad debts, warranties, and returns should be made at the timerevenues are recognized.



Sale of Receivables: Accounts receivable are sometimes sold at a discount forcash to accelerate the collection of cash from sales of products or services. Toqualify as a sale, the risks and rewards associated with holding the receivables mustbe transferred to the buyer. Otherwise, the transaction is accounted for as a loan.

Allowance For Doubtful Accounts: An estimate of the bad debts expected toresult from credit sales. The estimate is charged to earnings and added to theallowance, (reported as a deduction from accounts receivable). Actual bad debtsare charged against the allowance.

IAS: Similar to U.S. practices. (“Similar” should be interpreted to mean similar inconcept and thrust to U.S. GAAP, but not necessarily identical in all respects withU.S. GAAP).

Illustration: The ABC Company’s retail division uses the sale method to record a$1,000 sale on credit. The accounting entry is:

Dr. Accounts Receivable (+) 1,000Cr. 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 aservice is performed (earned). The ABC Company’s magazine publishing divisionsells magazine subscriptions for 12 monthly issues for $24. At the time thesubscription is received, the company has not yet earned the subscription revenue,so its recognition is deferred for income statement purposes. The accounting entryto record the receipt of cash and deferral of revenue (a liability) is:

Dr. Cash (+) 24Cr. Deferred Revenue (+) 24

As each issue is delivered, an adjusting entry is made to recognize that a portion ofthe deferred revenue liability is earned. The accounting entry per issue shipped is:

Dr. Deferred Revenue (-) 2Cr. Revenue (+) 2

The ABC Company’s retail division sells products on an installment basis. Anitem costing the Company $800 is sold for $1,000 payable in ten $100 monthlyinstallments. The collection of the sale price is not reasonably assured, so theinstallment method is used to recognize revenue. As each $100 payment isreceived, a profit of $20 is recognized [=100 x (1,000 - 800)/1000].

The ABC Company’s construction division has a contract to build a building for$200,000. The estimated cost to complete the building is $150,000. During thefirst month, the Company spends $20,000 on the building’s construction. Underthe percentage-of-completion method, the first month’s 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 berecognized at the end of the month.

The ABC Company has credit sales of $100,000 during the accounting period. Atthe end of the period, $30,000 remains uncollected. Based on past experience, theCompany expects $1,000 of the outstanding accounts receivable to be uncollectible.

1. Recognition of potential bad debts:

Dr. Bad Debt Expense (+) 1,000Cr. 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 (-) 100Cr. Accounts Receivable (-) 100



Financial Analysis: Aggressive revenue recognition should always be questionedby financial analysts, particularly if it is accompanied by an increase or unusuallyhigh level in the days sales outstanding represented by accounts receivable.Different revenue recognition methods lead to different patterns of revenue andprofit over time and different levels of assets, liabilities, and owners’ equity. Forexample, use of the percentage-of-completion method relative to the completedcontract method can lead to less volatile revenues and profits, higher owners’equity, and lower assets. Cash flow is unaffected by the revenue recognitionmethod choice. For example, while the percentage-of-completion method reportsincome earlier than the completed contract method, the cash flow associated witha particular contract is identical in each case.



14. Expense RecognitionExpense: A decrease in owners’ equity associated with profit directed activitiesof an accounting period.

Like revenues, expenses can only result from profit-directed activities that changeowners’ 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’ equityaccount retained earnings. The purchase of inventory on credit is not an expense.It does not change owners’ equity. The purchase increases the asset inventory andthe 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 (+) XXXCr. Accounts Payable (+) XXX

Or Cash (-) XXX

If an expense has been incurred but the company has not yet been billed, thefollowing adjusting entry to recognize the expense is made:

Dr. Expense (+) XXXCr. Accrued Expense (+) XXX

The entry to record payment is:

Dr. Accrued Expense (-) XXXCr. Cash (-) XXX

Financial Analysis: To defer the recognition of an expense, a company mayimproperly capitalize the related expenditure (i.e., call it an asset) and then use anexcessively 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 SoldInventories include all tangible items held for sale or consumption in the normalcourse of business for which the company holds title, wherever they might belocated.

Basic Concept: Inventory and cost of goods sold accounting is based on a costflow assumption.

Basic Equation: Beginning Inventory + Purchases - Ending Inventory = Cost ofGoods Sold.

FIFO (First In, First Out): Cost of sales based on assumption that oldest goodsin inventory (costs) were the first sold during the period.

LIFO (Last In, First Out): Cost of sales based on assumption that most recentlypurchased goods (costs) are sold first during the period. The notes of LIFOaccounting companies indicate the difference between the LIFO inventory’s valueand 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 infinancial reports. When a company changes from LIFO to FIFO inventoryaccounting, it must restate its prior period income statements and balance sheets toa FIFO basis.

Specific Invoice: Each item in inventory is identified and priced at its actualacquisition cost. Usually only used for “big ticket” items.

Weighted Average: Assigns to ending inventory the average cost of the unitsavailable for sale (beginning inventory + purchases) during the period.

LIFO Liquidation: If LIFO inventory levels are lowered (LIFO layerliquidation), old purchase prices flow through to cost of goods sold increasingprofit above their FIFO equivalent (assumes rising prices).

Lower of Cost or Market: Inventory is valued at its cost or current replacementmarket price, whichever is lower. If the current replacement market price is belowthe inventory’s cost, the inventory cost based value is written down to the lowervalue and the amount of the writedown is charged to current income.

Inflation: During periods of rising prices, relative to FIFO inventory accountingLIFO inventory accounting will lead to a lower inventory value, a higher cost ofgoods sold, and lower profits. The lower LIFO profit will be reported for taxpurposes with the result that tax payments will be lower and cash inflow will behigher 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 toFIFO 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. Duringthe month, it makes the following inventory purchases:

Purchase Units Price Per Unit TotalNo. 1 100 $1 $100No. 2 100 $2 $200No. 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 thefollowing: cost of goods sold $100 (“First-in”); ending inventory $500(Purchase No’s 2 and 3); pretax profit $300 (=400 -100); and, at a 40% taxrate, taxes $120 (= 300 x .4). Net income is $180 (= $300 – 120).

2. If the company used LIFO inventory accounting, it would record thefollowing: cost of goods sold $300 (“Last-in”); ending inventory $300(Purchase No’s 1 and 2); pretax profit $100 (=400 - 300); and, at a 40% taxrate, taxes $40. Net income is $60 (= $100 – 40).

3. If the company used weighted average inventory accounting, the average unitcost 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 a40% tax rate, taxes $80 (= 200 x .4). Net income is $120 (= 200 – 80).

4. Summary:

Method Ending Inventory COGS Taxes Net IncomeFIFO $ 500 $ 100 $ 120 $ 180Av. Cost 400 200 80 120LIFO 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 highernet income, inventories, current assets, working capital, total assets, owners’equity, and lower cash inflows. The same is true for average cost inventoryaccounting relative to LIFO inventory accounting.

5. If the ABC Company used LIFO inventory accounting, in the notes to itsfinancial statements, it would disclose a $200 difference in value between itsLIFO valued ending inventory and its FIFO valued equivalent (300 - 500 = -200). This $200 credit balance figure is the LIFO reserve. The $200 change inthe LIFO reserve (beginning LIFO reserve was $0) is the difference in cost ofgoods 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 theeffect of over or understatement of beginning and ending inventories. Forexample, assume beginning inventory is overstated by $1000. What is the effect?

Correct OverstatedBeginning Inventory $1000 $2000+ Purchases 2000 2000= Available Inventory 3000 4000- Ending Inventory 500 500= Cost of Goods Sold $2500 $3500

Last period’s ending inventory (this period’s beginning inventory) is overstated by$1000 (= 2000 – 1000). This period’s cost of goods sold is overstated by $1000.The next period’s beginning inventory (this period’s ending inventory ) is correct.



Assume ending inventory is overstated by $1000. What is the effect?


This period’s cost of sales is understated by $1000 (=2500 – 1500) and nextperiod’s beginning inventory (this period’s ending inventory) is overstated by$1000 (=1500 – 500).

Assume purchases are overstated by $1000. What is the effect?


Beginning and ending inventories are correct, but this period’s cost of goods soldis overstated by $1000 (=3500 – 2500).

The LIFO reserve and the change in the LIFO reserve during the period can beused to convert a LIFO accounting company’s financial statements to a FIFObasis. To convert a LIFO based financial statement to a FIFO basis (assumeincreasing 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 netincome

The after-tax equivalent of the change in the LIFO reserve is equal to the changein the LIFO reserve times one minus the tax rate. Restating LIFO based financialstatements to a FIFO basis for analytical purposes does not change cash flow sinceactual taxes paid is based on the LIFO taxable earnings.

Financial Analysis: In periods of rising prices, companies may reduce LIFOinventory levels to boost current earnings (i.e., run old lower costs through cost ofgoods sold). Previously written down inventory may be sold at current sellingprices to boost current gross margins.



16. Intangible Assets and AmortizationAn intangible asset is an expenditure for a non-monetary item that meets thedefinition of an asset but does not have physical substance. Intangible assets arerecorded at their cost. Revaluation upwards is not permitted. Not all potentialintangible asset expenditures are recorded as assets because their potential benefitsor costs can not be reliably measured. In these cases, their costs are expensed asincurred. The process of recording the cost of an intangible as an asset is referredto as “capitalization”.

Amortization: Systematic process of charging the cost of an intangible asset toincome over the period expected to benefit from the asset. Two exceptions aregoodwill and acquired intangibles with indefinite lives. (See “BusinessCombination” discussion.) These intangibles are not amortized. If indicators ofpossible impairment are present, they are subjected to an impairment test and, ifimpaired, 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 asincurred) testing and coding costs following completion of a working model ordetailed program design establishing technical feasibility. Amortize cost over salesperiod (or, if the annual charge is larger, on a pro rata basis against actual salesusing anticipated sales to determine the allocation rate) if software sold or usefullife if used internally.

Advertising: Advertising costs are expensed as incurred, except direct mailadvertising costs that can be capitalized if a reliable estimate of the response ratecan 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 intangibleassets. In contrast, the costs of developing most intangible assets internally areexpensed as incurred.

IAS: Similar to U.S. GAAP except development costs should be capitalized ifthey are recoverable through future sales. IAS specifies a 20-year maximumintangible asset amortization period which can be extended if justified. Intangibleassets can be revalued upward to their fair value only if fair value can bedetermined by reference to an active market.

Illustration: The ABC Company spent $3 million to develop software forinternal use. Management determined that $1 million was spent prior to reachingthe point where management committed to the completion of the project based ontheir belief that the project had reached the stage of being technically feasible.Management estimated the useful life of the completed software was 5 years. Thecompany accounted for the project as follows ($ millions):

1. The research phase

Dr. Research expense (+) 1Cr. Cash (-) 1

2. Following date technical feasibility established:

Dr. Software asset (+) 2Cr. Cash (-) 2

3. Each year during the application’s useful life:

Dr. Amortization of software asset (+) .4Cr. Software asset (-) .4



Financial Analysis: To convert an expenditure that a company capitalizes duringthe accounting period to an expense as incurred basis, add the change in thecapitalized asset balance during the period to the capitalized asset’s amortizationcharge during the period. Capitalizing expenditures for intangible assets, ratherthan expensing as incurred, results in:

Capitalize ExpenseProfits following switch to capitalization (growing expenditures) Higher LowerIncome volatility Lower HigherTotal assets and owners’ equity Higher LowerNet 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 InterestBonds (and other forms of debt) issued by corporations to raise funds from creditsources represent a promise (1) to repay the amount borrowed at a specific futuredate; and, (2) to compensate the lender for the use of the funds through specifiedperiodic interest payments (coupon rate).

Bonds: Record at face value if issued at par (face value). If issued at price otherthan par, record at amount received, which is the present value of future cashpayments 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 interestrate 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 couponrate), record bond premium (liability) equal to the difference. Amortize premiumand 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 allocatedbetween the instrument’s bond and warrant to buy equity features. The amountallocated to the detachable warrants is accounted for as owners’ equity. If thewarrants 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 expenseand add to bond liability.

Current Maturity of Long-Term Debt: Long-term debt repayments over thenext 12 months are reported as current liabilities.

Early Extinguishment: Until recently, gains and losses from the earlyextinguishment of debt were classified as an extraordinary item. This conclusiondid not apply to gains and losses from cash purchases of debt made to satisfy oneyear’s sinking fund requirements. These gains or losses were recorded as ordinaryincome items. The extraordinary item designation was to ensure that statementusers were aware of the impact on net income of debt extinguishments. The FASBnow classifies early extinguishment gains and losses as non-extraordinary items.

Capitalization of Interest: Capitalization of the cost of debt as part of an asset’scost is required for assets constructed for a company’s own use and assetsproduced for others as part of a discrete project.

IAS: Similar to current U.S. practices, except preferred accounting is that anenterprise that has incurred borrowing costs and incurred expenditures on assetsthat take a substantial period of time to get them ready for their intended use orsale should adopt a policy of expensing borrowing costs as incurred. Capitalizingborrowing 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 (+) 500,000Cr. Bond liability (+) 500,000



To record the payment of annual interest (500,000 x .10):

Dr. Interest expense (+) 50,000Cr. Cash (-) 50,000

To record the repayment of principal at maturity:

Dr. Bond liability (-) 500,000Cr. Cash (-) 500,000

2. The ABC Company issues a $500,000 10-year zero coupon bond payable atmaturity that is priced to yield 10%. To record the issuance of the bond:


The cash received and the bond liability balance are the present value of $500,000paid 10 years hence discounted at 10% (= 500,000 x .386). 3

To record the first year’s interest expense:

Dr. Interest expense (+) 19,300Cr. Bond payable (+) 19,300

The first annual $19,300 non-cash interest expense is 10% of the bond payablebalance (=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 todetermine annual interest and the new bond payable obligation is repeated eachyear until maturity.

To record payment of principal at maturity – the only time cash is paid tothe bond holder:

Dr. Bond payable (-) 500,000Cr. Cash (-) 500,000

3. A $500,000 10-year bond with a 10% coupon rate paid semi-annually isissued at a discount (effective interest rate higher than coupon rate) to yield aneffective interest rate of 12%.

To record the issuance of the bond:


Since interest is paid semi-annually, the annual rate (12%) is halved (6%) and theannual periods (10) are doubled (20). The cash received is the sum of the presentvalue of the $500,000 face value paid twenty 6-month periods in the future plusthe present value of the twenty $25,000 semi-annual interest payments bothdiscounted at a 6% rate (= 500,000 x .312 + 25,000 x 11.47). The initial bondliability is equal to the cash received. It can also be thought of as being equal tothe face value less the $57,250 issuance discount (= $500,000 – 442,750).

To record the first $25,000 semi-annual interest payment:

Dr. Interest expense (+) 26,565Cr. 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 thecash 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 .386is the present value of $1 received 10 periods hence discounted at a 10% rate. The .312 is the presentvalue of $1 received 20 periods hence discounted at a 6% rate. The 11.47 is the present value of $1received each period for 20 periods discounted at a 6% rate. The .456 is the present value of $1received 20 periods hence discounted at a 4% rate. The 13.59 is the present value of $1 received eachperiod for 20 periods discounted at a 4% rate.



process is repeated until maturity when the bond liability balance equals thebond’s face value (500,000). Since the bond liability balance is increasing eachperiod, the interest expense increases each period.

To record the repayment of the bond’s face value at maturity:


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 ofbeing issued at a premium are: cash received at issuance is greater than theface value; bond liability at issuance is greater than the face value; interestpayments are $25,000 each semi-annual period; interest expense decreasesover time and is less than the interest payments; and, bond liability decreasesover time as the bond premium (excess of cash received at issuance over facevalue) included in the bond liability balance is amortized as a debit to theliability (-) and a credit to interest expense (-).

The accounting entries are:

To record issuance of the bond:

Dr. Cash (+) 567,750Cr. Bond Liability (+) 567,750

The cash received is the sum of the present value of $500,000 face value paid 20periods in the future plus the present value of the twenty $25,000 semi-annualinterest 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 issuancepremium (= $567,750 – 500,000).

To record the first $25,000 semi-annual interest payment:

Dr. Interest expense (+) 22,710Bond liability (-) 2,290Cr. 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 liabilitybalance is decreasing each period, the interest expense decreases each period.

To record the repayment of the bond’s face value at maturity:


Financial Analysis: At any point in time, the book value of debt is not likely tobe equal to its market value due to changes in interest rates and, sometimes, theissuers’ credit rating. Increasing market interest rates lower the market value ofdebt. Decreasing market interest rates increase the market value of debt. As aresult, during the life of a debt issue, its market value may be a more appropriatevalue than book value to use for debt-equity ratio purposes. A shift from a relianceon operating cash flows to debt financing to support a business may indicate thebeginning of liquidity problems. Debt with equity features (convertible debt) andequity with debt features (redeemable preferred stock) should be examined closelyand classified appropriately when performing liquidity and solvency financialanalysis. For example, perpetual debt and recently issued very long-lived debtshould be treated like preferred stock for financial analysis purposes. In contrast,redeemable preferred stock classified as owners’ equity for accounting purposesshould be treated as debt.



18. ContingenciesA contingency for the purposes of accounting is an existing condition, situation, orset of circumstances involving uncertainty as to the probable gain or loss to anenterprise that will ultimately be resolved when one or more future events occur orfail 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 whenit 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 amountexpected to settle the obligation.

Illustration: The ABC Company anticipates that it may have to pay $100,000damages as the result of a claim brought against the company in the courts. In theperiod in which the management becomes aware of this probable contingencyloss, it will charge the anticipated $100,000 loss to income and set up a $100,000litigation reserve as a liability. In a later accounting period, when a court decisionconfirms the loss and the successful litigant is paid, the actual loss is charged tothe balance sheet contingency reserve and cash is reduced by a similar amount. Ifthe amount of the claim is less than the related reserve, the excess reserve iscredited to income. If the claim paid is greater than the reserve, the excess ischarged to income.

The accounting entries to establish the reserve :

Dr. Litigation expense (+) 100,000Cr. Litigation reserve (+) 100,000

The entries to record the payment of the $100,000 litigation loss are:

Dr. Litigation reserve (-) 100,000Cr. 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 therecognition of a deferred tax asset (discussed later).

Financial Analysis: The accrual for accounting purposes of a loss related to acontingency does not create or set aside funds which can be used to lessen thepossible financial impact of the loss. The creation of a contingency reserve by acharge 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. LeasesA lease agreement conveys the right to use property over a definite period inreturn for a series of payments. Lease agreements are executory contracts (take-and-pay contracts are another example). Typically, accounting does not recognizeexecutory contracts as giving rise to an asset or liability, since both parties to thecontract 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 andrewards of ownership to the lessee.

Capital Lease: A lease that meets any one of the four capital lease tests (seebelow). Lessee records a depreciable leased asset and a liability. Liability treatedas a borrowing. Lessee accounts for periodic rentalpayment as part interest andpart 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 property’s estimated life.

4. Present value of minimum leased payments is 90% or more of the fair valueof 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 recordsperiodic rental payment as lease expense. Lessor records lease payments asrevenue and depreciates leased asset (still on lessor’s balance sheet).

Direct Financing Lease: Lessor’s function is to finance property acquisition bythe lessee. Lessor accounts for net investment in the lease as a loan to lessee. Ifuncertainty 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 productprofit and treats lease portion of transaction as a direct financing lease.

Sale and Leaseback: A contract to sell property and then lease it back frombuyer. Seller-lessee must amortize any gain on sale over lease life. Recognize anyloss on sale immediately.

Leveraged Lease: Lessor finances lease agreement using all or mostly debt.Lessor’s return is based on lessor’s net investment in the lease, which initially fallsthen rises over the lease term. Lessee uses operating or capital lease accounting.

IAS: Capital lease (called finance lease) accounting required for leases thattransfer the risks and rewards of ownership to lessees. Operating lease accountingsimilar to U.S. GAAP.

Illustration: The ABC Company (the lessee) leased equipment from the XYZCompany (the lessor) for a 3-year period at $10,000 per year under an operatinglease 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 (+) 10,000Cr. 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 (+) 25,000Cr. Equipment inventory (-) 25,000

The lessor retains the equipment leased under the operating lease as an asset on itsbalance sheet, but reclassifies it to the equipment under lease account to indicatethat it is under lease.

2. The lessor receives the first annual lease payment:

Dr. Cash (+) 10,000Cr. Rental revenue (+) 10,000

This entry is repeated for each of the next two years as the rental payment isreceived.

3. The lessor recognizes first year depreciation on the leased equipment:

Dr. Depreciation expense (+) 5,000Cr. Accumulated depreciation (+) 5,000

A similar $5,000 depreciation expense is charged during each of the next twoyears of the lease contract (=25,000/5).

The ABC Company (the lessee) leases another piece of equipment for 3 years at anannual rental of $10,000 under a capital lease agreement. The implicit interest inthe lease arrangement is 10%. The ABC Company uses straight line depreciation

1. The equipment is delivered:

Dr. Leased equipment (+) 24,870Cr. Lease obligation (+) 24,870

The $24,870 asset – leased equipment – and liability – lease obligation – balancesrecognized on the lessee’s balance sheet are the present value of the 3 annual leasepayments (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 obligationinterest expense and lease obligation reduction:

YearBeg.

ObligationLease

PaymentInterest

Expense*ObligationReduction**

End.Obligation

1 24,870 10,000 2,487 7,513 17,3572 17,357 10,000 1,736 8,264 9,0933 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 sheetpurposes as a current liability:

Dr. Lease obligation (-) 7,513Cr. Current maturity of lease obligation (+) 7,513

This step is repeated over the next two years. The amount of lease obligationreduction over each of the next 12 month periods is classified as a current liability.

4. The lessee’s first annual lease payment is made:

Dr. Interest expense (+) 2,487Current maturity of lease obligation (-) 7,513Cr. Cash (-) 10,000



This process is repeated over the next two years using the interest expense andobligation reduction figures in the above table.

5. The lessee recognizes the leased asset’s first year’s annual depreciationcharge (= 24,870/3)

Dr. Depreciation expense (+) 8,290Cr. Accumulated depreciation (+) 8,290

Depreciation is charged to income over the next two years.

6. ABC Company’s two $10,000 rental payment Statement of Cash Flowsclassifications are:

Operating Lease Capital LeaseYear Operating Cash Flow* Operating Cash Flows** Financing Cash Flows***1 10,000 2,487 7,5132 10,000 1,736 8,2643 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 accountingtreatment.

7. Lessee income statement charges:

Operating Lease-Expenses Capital Lease-ExpensesYear Lease Rental Depreciation Interest Total1 10,000 8,290 2,487 10,7772 10,000 8,290 1,736 10,0263 10,000 8,290 909 9,199

The total income statement charge using capital lease accounting is higher than theoperating lease income statement charge during the early years of the leaseagreement. The reverse is true in the later years.

The XYZ Company’s finance subsidiary (the lessor) acting as a finance companyleases equipment to the ABC Company (the lessee) under a 3-year, $10,000 peryear 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% onits net investment in this direct financing lease. (This can not be a sales-type leasebecause the equipment cost is equal to its fair value.) The Company’s netinvestment in the lease is:

Sum of minimum lease payments $30,000Unguaranteed residual value 0Gross investment $30,000Unearned lease financing income (5,130)Net lease investment $24,870

The net lease investment is not listed as an account on the lessor’s balance sheet. Itis 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 (+) 30,000Cr. 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 LeaseYear Payment Received Financing Income Investment Reduction Investment

0 – – – 24,8701 10,000 2,487 * 7,513 ** 17,3572 10,000 1,736 8,264 9,0933 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 (+) 10,000Cr. Lease payment receivable (-) 10,000

Dr. Unearned lease financing income (-) 2,487Cr. 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 isreduced.

The XYZ Company’s 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 equipment’s selling price was $24,870. Theequipment cost $20,000 to make. The division’s 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 (+) 30,000Cr. Sales (+) 24,870

Unearned lease financing income (+) 5,130Dr. 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 directfinancing lease described above.

Financial Analysis: Companies sometimes attempt to structure leasearrangements that would otherwise be capital leases to obtain operating leasetreatment. The objective is to keep the lease liability off the balance sheet.



20. Pension BenefitsA pension plan is an agreement between an employer and its employees wherebythe employer agrees to provide pension payments to employees for servicerendered prior to retirement.

Two Types of Plans: Defined contribution plans obligate employer to makecontributions to a pension fund. The employee bears the investment risks. Definedbenefit plans obligate employer to provide specified benefits to retirees. Theemployer bears the investment risk.

Two Types of Obligations: For accounting purposes, there are two types ofdefined benefit plan employer obligations – the accumulated benefit and theprojected benefit obligations. The accumulated benefit obligation (“ABO”) is thepresent value of the future benefits due to retirees and current employees assumingcurrent employees retired with their current pension rights. The projected benefitobligation (“PBO”) is the present value of the future benefits due to retirees andcurrent employees’ projected benefit rights at their retirement date and final salarylevel.

In order to calculate the PBO, a projection of the rate of future employee salaryincreases must be made. The discount rate used for both the ABO and PBOdetermination is the AA corporate long bond interest rate. The ABO is used forbalance sheet purposes, such as determining a company’s pension liability. ThePBO is used to measure pension costs.

Defined Contribution Plan Cost: Required periodic contribution is employer’speriodic cost.

Defined Benefit Plan Cost: Employer’s cost includes six components:

1. Service cost: Present value of future pension benefits based on employee’santicipated future salary levels earned by employees for services renderedduring period.

2. Interest cost: The increase in the employer’s projected pension benefitobligation due to the passage of time. The projected pension benefitobligation is the present value of expected benefits to be paid to employees inthe future assuming their salaries grow to some higher level.

3. Return on Plan Assets: An assumed normalized annual return on plan assetsthat 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 achange in either the projected benefit obligation or the plan assets (because ofexperience different from that assumed or a change in actuarial assumptions)is included as a component of net periodic pension cost if, as of the beginningof the year, that unrecognized net gain or loss exceeds 10% of the projectedbenefit obligation or the fair value of plan assets, whichever is greater. Ifamortization is required, the minimum amortization is the excess over the10% test divided by the service period of the active employees expected toreceive benefits under the plan. The amortization of any unrecognized netgain (loss) decreases (increases) the net periodic pension cost.

5. Amortization of unrecognized prior service costs: The cost of providingretroactive benefits (that is, prior service cost) arising at the initiation oramendment of a plan are amortized over time rather than recognized in full atthe time of the plan’s initiation or amendment. The cost of retroactive benefitsis the increase in the projected benefit obligation at the date of theamendment. This cost is amortized by assigning an equal amount to eachfuture period of service of each employee active at the date of the plan’sinitiation or amendment who is expected to receive benefits under the plan.



6. Amortization of transition obligation or gain: At the time the FASB’spension standard (FAS 87) became effective, the FASB had to devise a wayfor companies to move to the Statements’ new pension accounting rules. For adefined benefit plan, an employer had to determine for the beginning of thefiscal year in which FAS 87 was first applied, the amounts of (a) the projectedbenefit obligation; and (b) the fair value of plan assets plus previouslyrecognized unfunded accrued pension cost or less previously recognizedprepaid pension cost. The difference between those two amounts, whether itrepresented an unrecognized net obligation or an unrecognized net asset , isamortized on a straight-line basis over the average remaining service periodof employees expected to receive benefits under the plan, except that, (a) ifthe average remaining service period is less than 15 years, the employer mayelect to use a 15-year period; and (b) if all or almost all of a plan’sparticipants 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 employer’saccumulated benefit obligation. This obligation is the present value of the retireebenefits expected to be paid to employees in the future. Unlike the projectedbenefit obligation calculation, it does not assume salaries will grow.

Curtailments and Settlements: Gains and losses from curtailments andsettlements of defined benefit plans are recognized immediately in income.

Vested Benefits: The amount of benefits an employee has the right to receiveregardless of whether the employee stays with the company or not.

Minimum Pension Liability: The minimum pension liability reported on thebalance sheet must at least equal the unfunded accumulated benefit obligation.The offsetting entry is an intangible asset. The intangible asset can be no largerthan the sum of the unrecognized prior service cost and transition obligation orgain. Any excess of the minimum pension liability over this cap is chargeddirectly to owners’ equity.

Plan Asset Change: The change in pension plan assets can be determined asfollows:

Dollar return on plan assets+ Contributions- Benefits paid= Change in plan assets

Projected Benefit Obligation Change: The periodic change in the projectedbenefit 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 definedcontribution plan for its employees.

Dr. Pension cost (+) 500,000Cr. Cash (-) 500,000



The required contribution is the pension cost.

Alternatively, assume the ABC Company contributes to a defined benefit plan forits employees. The cost (sum of the six elements) for the year is $600,000. Thecompany decides to only fund $400,000 of this cost:

Dr. Pension cost (+) 600,000Cr. Cash (-) 400,000 Pension liability (+) 200,000

The determination of the cost is unrelated to management’s funding decision.

Companies ABC and XYZ both have similar accumulated benefit obligations($2,000) and plan assets ($1,000). Each company’s plan is underfunded. CompanyABC has a $500 accrued pension cost liability, and Company XYZ has a $500prepaid pension asset. What is the minimum pension liability for each company?

Company ABC Company XYZAccumulated benefits obligation 2,000 2,000- Plan assets 1,000 1,000Unfunded accumulated benefit obligation 1,000 1,000- Accrued pension cost (500)+ Prepaid pension asset – 500Minimum pension liability 500 1,500

The minimum pension liability must equal the underfunding of the accumulatedbenefits obligation.

Company ABC already has a pension liability of $500. The sum of this liabilityand the minimum pension liability adjustment (500) equals the unfundedaccumulated benefits obligation.

Company XYZ’s prepaid pension asset (500) is added to the unfundedaccumulated benefits obligation balance (1,000) to get a net unfunded pensionliability balance of $1,000 (= 1,500 liability - 500 asset).

Financial Analysis: Pension costs can be manipulated by the discount rate, returnon plan assets, and salary inflation rates assumed by management. The effects ofthese manipulations are:

Accumulated ProjectedBenefit Benefit Service Interest

Assumption Obligation Obligation Cost CostDiscount RateHigher Lower Lower Lower HigherLower Higher Higher Higher LowerRate of Compensation IncreaseHigher 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 effectLower 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 ThanPensionsAccounting: Similar to pension obligation and cost accounting. Benefitobligation calculation includes a projection of inflation in healthcare costs, ratherthan a salary projection. Only one obligation measured. (Accumulated benefitobligation).


Financial Analysis: Understatement of the health care cost inflation rate will leadto understatement of the related obligation and cost.



22. Deferred TaxesA company’s tax expense (credit) is the sum of the taxes it must pay (refundreceivable) 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 usesdifferent accounting methods and estimates for book and tax purposes. Thedifference between an asset or liability’s tax basis and its book carrying amount isreferred to as a “temporary difference”, because the differences will reverse insome future period. There are some exceptions referred to as “permanentdifferences” because the difference between book and tax accounting does notreverse. These do not enter into the deferred tax calculation.

Liability or Balance Sheet Method: The FASB’s deferred tax standard (FAS109) adopts the liability method to account for deferred taxes. This methodcomputes deferred taxes using the differences between the tax basis and financialreporting carrying amounts of assets and liabilities.

Comprehensive Tax Allocation: U.S. companies must recognize deferred taxeson all temporary differences.

Deferred Tax Liability: Tax equivalent of the difference between book and taxbasis 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 ofassets (liabilities) where assets (liabilities) have been charged off (increased)slower for tax purposes than for book purposes. Also includes current recognitionof future tax credits for operating loss carryforwards. The deferred tax assetreported on the balance sheet is the net of the company’s gross deferred tax assetsand their related valuation allowance (see below).

Deferred Tax Valuation Allowance: Tax credits for which the company ispotentially eligible, but management has not recognized because managementbelieves that the probability is less than .5 that the company will be able to makethe tax credits good for tax purposes. Disclosed in notes.

Deferred Tax Expense (Credit): Net change in recognized deferred tax assetsand liabilities during the period. Net deferred tax asset increase leads to a deferredtax credit entry to income. Net deferred tax liability increase leads to a deferredtax expense.

Tax Rate and Code Change: If a tax rate or code change is enacted, the deferredtax liability and asset balances must be recalculated to reflect the change. Theeffect of the change is included in income. A lowering of the tax rate reduces thedeferred tax liability and increases income. A lower tax rate decreases deferred taxassets and reduces income.

Current Tax Expense: The tax expense consists of two components – the currenttax expense (credit) and the deferred tax expense (credit). The current tax expenseis the current period’s tax due to taxing authorities. It is derived from the currenttax returns.


Illustration: The ABC Company buys an asset for $100, which it expensesimmediately for tax purposes. For financial reporting purposes, it depreciates theasset over a 2-year period using the straight-line method. The company’s profitbefore taxes and charges related to the asset is $200 in both years. The company’stax rate is 40%.

1. Deferred tax accounting is required. The asset’s tax basis and book carryingamount differ. Since the asset is expensed faster for tax purposes than forbook reporting, a deferred tax liability and expense must be recognized.



Asset’s Tax Basis and Net Book ValueYearend Tax Basis Net Book Value Difference1 0 * $50 ** $502 0 0 0

* (100-100)** (100-50)

2. For financial reporting purposes, the company’s pretax income is the same inboth years (150)

Pretax Book Income

Year Pretax Income Before Depreciation Depreciation Pretax Income1 200 50 1502 200 50 150

3. For tax reporting purposes, the company’s taxable income is higher in year 2(200) relative to year 1(100).

Taxable Income and Tax Obligation

Taxable Income Depreciation Taxable TaxYear Before Depreciation Deduction Income Obligation

1 200 100 100 402 200 0 200 80

4. The year 1 difference (50) between the company’s taxable income and pretaxbook income reverses in year 2 to net out to zero. This $50 temporarydifference drives the deferred tax calculation.

Taxable Income and Book Pretax Income

Year Taxable Income Book Pretax Income Difference1 $100 * $150 ** $502 200*** 150 ** (50)

$300 $300 $ 0

* (200-100)** (200-50)*** (200-0)

5. The company’s tax expense and balance sheet entries for its current taxpayment and deferred tax liability result in net income of $90 in both years.

Income Statement

Profit Tax Expense Tax Expense NetYear Before Taxes - Current - Deferred Income

1 $150 $40 * $20 ** $902 150 80 *** (20) ** 90

$300 $120 $ 0 $180

* (100x.4)** (50x.4)*** (200x.4)



Balance Sheet

Year Taxes Payable Deferred Tax Liability Deferred Tax Liability - Change1 $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 andbook basis (+50 and –50) times the tax rate. Alternatively, the deferred taxexpense and credit are the changes in the deferred tax liability. The deferred taxaccounting entries for the two years are:

Year 1: Dr. Deferred tax expense (+) 20Cr. Deferred tax liability (+) 20

Year 2: Dr. Deferred tax liability (-) 20Cr. Deferred tax expense (-) 20

Financial Analysis: Deferred taxes should always be examined on a case-by-casebasis. Sometimes deferred tax liabilities are treated as quasi equity rather thanliabilities because in growing or stable companies, the total deferred tax liabilitymay not decline. Analysts should always closely examine changes in a company’seffective tax rate and the causes of the change to determine if the change ispermanent or temporary and not the result of management manipulation.



23. Owners’ EquityOwners’ equity is a residual. It is what is left after total liabilities are deductedfrom 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 thepar value of stock issued. Sometimes called additional paid-in-capital. Somecompanies combine the common stock and capital in excess of par value accountsinto 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 paidand 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 capitalaccounts (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 sharesoutstanding. No entry if par value per share is adjusted to reflect split. If par valueis not adjusted, an amount is transferred from retained earnings to the commonstock 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 afixed dollar amount in liquidation that entitles its holders to a preferred position incorporate liquidations. Dividends are usually cumulative and commonstockholders may not be entitled to dividends until any preferred dividendarrearages are paid. Some preferred stocks are redeemable by the issuer. These areclassified as liabilities.

Comprehensive Income: A section of the changes in owners’ equity statementshowing total changes in owners’ equity from net income and other transactionsnot 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 ABCCompany are ($ millions):

Common stock * 50Capital in excess of par value 4,000Treasury 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 involvingowners’ equity. These transactions and the accounting for them are listed below:

1. The company declares a dividend of $50 million:

Dr. Retained earnings (-) 50Cr. Dividends payable (+) 50

2. The company pays the dividends:

Dr. Dividends payable (-) 50Cr. 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 dividendaccounting is required. The company’s stock price is $10 per share.

Dr. Retained earnings (-)* 500Cr. Common stock (+)** 5

Capital in excessof 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 anegative owners’ equity balance.

Dr. Treasury stock (+) 100Cr. Cash (-) 100

5. The company sells treasury stock previously acquired at a cost of $50 millionfor $75 million. It recognizes a $25 million gain (= 75-50).

Dr. Cash (+) 75Cr. Treasury stock (-) 50

Capital in excess of par value (+) 25

6. The company issues 10 million common shares at $25 per share.

Dr. Cash (+) 250Cr. Common stock (+) 1*

Capital in excessof par value (+) 249

* 10 million shares times $.10 par value

7. The company declares a 2 for 1 stock split. No accounting entry. The numberof shares outstanding are doubled and the per share par value is halved.

8. The company’s earnings ($175 million) are closed out on the company’sbooks to owners’ equity. The closing entry is:

Dr. Income (-) 175Cr. Retained earnings (+) 175

Financial Analysis: Stock splits and stock dividends do not change the totalamount of owners’ equity. Since the result is the issuance of more shares, earningsper share is reduced proportionately. Redeemable preferred stock is treated as debtand its dividends as interest for financial analysis purposes.

The denominator of the book value of owners’ equity per common sharecalculations is the number of shares outstanding. The numerator of the book valueof the common stock calculation is the owners’ equity less the sum of theliquidation value of the preferred stock and preferred dividends in arrears.

The denominator of the book value per preferred share calculation is the numberof preferred shares outstanding. The numerator of the book value per preferredshare calculation is the liquidation value of the preferred stock plus any preferreddividends 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 bookvalue per preferred and common share?

Preferred stock 200,000 sharesoutstanding, 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 perpreferred share = $105.

1. Calculation of book value of preferred and common stock:

Preferred CommonPar value $ 20,000,000 $ 40,000,000Capital in excess of par value 5,000,000Retained 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 $ 34,600,000Divided by number of shares 200,000 400,000= Book value/share $ 117.00 $ 173.00

Note that the preferred stock’s liquidation value (par value + liquidation premium) rather than its par value is used tocompute its book value per share. Also note that shares outstanding (shares issued – treasury stock) rather than issuedare used to compute book values.



24. Earnings Per ShareFAS 128 requires all companies to report their basic earnings per share. If acompany has a complex capital structure (contains options, warrants, orconvertible debt), it may also have to report its diluted earnings per share.

Basic Earnings Per Share: The shareholders’ equity in net income (= netincome 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 potentialissuances of common stock

from the exercise of options and warrants and the conversion of convertiblesecurities. Only reported if diluted earnings per share is lower than the basicearnings 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 convertiblesecurities are included in the measurement of diluted earnings per share. Thetreasury 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 thedifference between assumed shares issued and acquired shares added to thedenominator). The if converted method is used to measure the dilutive effect ofconvertible securities (add common stock to be issued on conversion todenominator and add back convertible debt’s interest cost adjusted for taxes andpreferred stock dividends to the numerator).

Dilutive: Any option, warrant or convertible security whose assumed exercise orconversion leads to a decrease in operating earnings per share or an increase inoperating 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 assumedexercise or conversion leads to an increase in operating earnings per share or alower operating loss per share. Antilutive securities are excluded from themeasurement of diluted earnings per share.


Illustration: The denominator of the annual basic earnings per share calculation isthe weighted average of the number of shares outstanding from the date of issuanceduring 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. Theweighted average number of actual shares outstanding used to calculate the annualbasic 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 theannual basic per share calculation is $1250

(=1500-250), which is the earnings attributable to the common stockholders afterpayment of preferred dividends.

The company’s basic earnings per share is: $1 = $(1500-250) 1,250 shares

The company also had outstanding a convertible bond and unexercised stockoptions. The potential dilutive effect of these two items potentially requires thecompany to disclose a diluted earnings per share figure. The denominator for thiscalculation is the weighted average of assumed shares outstanding each quarterafter 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 pershare were granted. During the first quarter, the average price of the company’sstock 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 adjustmentsto the basic earnings per share calculation are required. First, the numerator isincreased by adding back the after-tax equivalent of the interest that would not bepaid if the bond had been converted [$30=$(500x.1)(1-.4)]. Second, thedenominator is increased each quarter by the shares that would be issued uponconversion of the bond (500). The convertible bond is a dilutive security. Itsassumed conversion reduces earnings per share. (If the convertible security was aconvertible preferred stock, the preferred dividend would not be deducted from netincome and the denominator would be increased by the number of common stockshares issuable upon conversion.)

The options (warrants would do the same thing) trigger the use of the treasurystock method. One adjustment to the denominator of the basic earnings per sharecalculation 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 ($1000cash is received from 100 shares issued at $10 per share) and the cash received isused to acquire 50 shares in the open market (1000/20=50 shares). The 50 sharenet increase in the number of shares as a result of these two assumed sharetransactions (=100-50) is dilutive. When added to the denominator for the firstquarter, it reduces earnings per share. Note the average price of the stock duringthe period is used in this calculation. Since the market price of the stock wasbelow $10 for the remainder of the year, no further denominator adjustments areneeded 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 100shares being issued and 200 shares being bought (=1000/5). The resulting 100(=200-100) net decrease in shares would reduce the denominator and increase theearnings per share. For this quarter, the options are antidilutive.

As a result of recognizing the potential issuance of shares due to conversion of thebond and the exercise of options, the denominator for the annual diluted earningsper share calculation is 1,762.5 [=7050/4=(1000+500+50)/4 + (1000+500)/4 +(1000+500)/4 + (2000+500)/4].

The company’s diluted earnings per share is:

$.73 = $(1500-250)+301762.5 shares

Other Considerations: Reaquired shares (treasury stock) are excluded from thecomputation of earnings per share from date of acquisition. Prior period earningsper share comparative data must be restated to reflect any subsequent stock splitsor stock dividends. Shares issued in a pooling-of-interests (no longer permitted inU.S. GAAP, but discussed later) are considered outstanding for all periodsincluded in prior period comparative presentations. The determination of whetheran option or warrant is antidilutive is made each quarter. The quarterlydeterminations are independent of each other. Common stock issued upon theexercise of options and warrants is included in the weighted average ofoutstanding shares from the issuance date.

Financial Analysis: Since it reflects potential dilution, diluted earnings per shareamounts are used for security investment decisions involving companies withcomplex capital structures. Predicting diluted earnings per share is complicated bythe fact that changes in a stock’s price can influence the results of applying thetreasury stock method. Dividends per share is calculated using actual outstandingshares at the dividend date. It can not be related meaningfully to diluted earningsper share amounts, which may be based on a different number of shares.



25. Business CombinationsA business combination occurs when two or more businesses are joined togetherto 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 usewas not a “free one”. If the transaction qualified for the pooling-of-interestmethod, that method had to be used. All other business combinations had to usethe purchase method. In June 2001, the FASB issued a new standard prohibitingthe use of the pooling-of-interests method.

Pooling of Interests: Add the combining company’s financial statementstogether as if they had been one entity.

Purchase Accounting: All business combinations must be accounted for by thepurchase method. Record acquired tangible assets, intangible assets, and liabilitiesat fair value. Excess of consideration paid over fair value of net assets acquired isgoodwill. Recognize revenue and income of acquiree from date of combination.

Acquired Intangible Assets: The purchase method requires recognition of allacquired intangible assets other than goodwill in the measurement of goodwillthat: (1) Arise from contractual or other legal rights; or (2) If not arising from acontractual or legal right, are separable. An intangible asset is separable if it iscapable of being separated or divided from the acquired enterprise and sold,transferred, licensed, or exchanged. For the purpose of the standards, an intangibleasset that standing alone is not separable but could be part of a contract or groupof assets and liabilities that are separable is considered to meet the separable test.

Acquired-in-Progress Research and Development: An intangible asset acquiredin some purchase transactions that must be included as an intangible asset in themeasurement of goodwill and then expensed immediately if it has no alternativeuse. The result is that future income is not burdened by this acquisition cost.

Goodwill Accounting: Goodwill should not be amortized under anycircumstances 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 operatingsegment. Operating segments are the basis for the segment disclosures in annualreports. An operating segment of an enterprise: (1) Engages in revenue generatingand expense incurrence business activities; (2) Has its operating results reviewedregularly by the enterprise’s chief executive officer for performance assessmentand resource allocation decisions; and (3) Has discrete financial informationprepared for it. A component is one level below an operating segment. It hasessentially the same characteristics as an operating segment, except that itsoperating results are reviewed by segment management.

Goodwill Impairment Test: A two-step methodology is used to test goodwill forimpairment. The two steps are: (1) First, to identify a potential goodwillimpairment, the fair value of a reporting unit assuming it was bought or sold isdetermined and compared to its carrying amount including goodwill. If thereporting unit’s fair value is greater than its carrying amount, the reporting unit’sgoodwill is considered not to be impaired. The second step need not be performed.(2) If the reporting unit’s fair value is less than its carrying amount, the secondstep must be performed as follows: (a) The fair value of the reporting unit’s netassets, excluding goodwill, is determined; (b) The reporting unit’s impliedgoodwill is measured by subtracting the fair value of its net assets, excludinggoodwill, for the reporting unit’s fair value; and (c) If the fair value of thereporting unit’s 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 chargeto earnings equal to the write-down is recognized.



Acquired Intangible Assets Other Than Goodwill: The cost less residual valueof recognized acquired intangible assets other than goodwill should be amortizedover their useful life, which is the period over which the intangible asset isexpected to contribute directly or indirectly to the enterprise’s cash flows. Theonly exception is intangible assets with indefinite lives. They should not beamortized until their useful life is determined to be no longer indefinite.Recognized intangible assets not subject to amortization should be tested annuallyfor impairment. If the carrying amount is greater than its fair value, the intangibleasset should be written down to its fair value and the excess charged to income asan impairment loss.

IAS: A business combination should be accounted for under the purchasemethod, except in the rare circumstances when it is deemed to be a uniting ofinterest in which case the pooling-of-interests method is appropriate. A businesscombination is considered to be a uniting of interest when there is no clearacquirer. Positive goodwill arising in a purchase transaction should be amortizedto income on a systematic basis over a period not to exceed 20 years or a longerperiod if justified.

Illustration: Company A acquired Company B intending to continue theoperations of both companies as a single unit. Company B’s financial position atthe date of acquisition was as follows:

Book Value Fair Value*Net current assets $100,000 $100,000Fixed assets 400,000 700,000Total $500,000 800,000Capital stock $300,000Retained 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 orliquidation sale.

Company A paid $900,000 cash for Company B. The accounting entry inCompany A’s records is:

Dr. Net current assets (+) 100,000Fixed assets (+) 700,000Excess 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 previousowners of Company B received cash and retained no ownership in the new businessunit. Consequently, assuming its fixed assets are all depreciable assets, subsequentoperations 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 purchaseprice over the fair value of the net assets acquired is typically called goodwill.

Company A would record Company B’s operating results beginning from theacquisition date.

Alternatively, assume Company A had acquired Company B with stock worth$900,000, and the transaction qualified for the pooling of interests method underIAS. The effect of acquiring Company B on Company A’s balance sheet is:

Dr. Net current assets (+) 100,000Fixed assets (+) 400,000Cr. Retained earnings (+) 200,000 Common stock (+) 300,000



Company A records the acquisition of Company B using Company B’s bookvalues. Company B’s retained earnings are recorded on Company A’s books, nogoodwill is recognized, and the increase in Company A’s common stock accountis $300,000 (a “plug” number) and not the $900,000 market value of the stockissued to acquire Company B. Company B’s income statement will be combinedwith Company A’s for the current year and all prior years as if the two companieshad always been one.

Illustration: To illustrate the 2-step goodwill impairment methodology, assume:

The ABC Company has six reporting units. Management believes that thegoodwill of one of these reporting units might be impaired. Management reviewsthe public sale prices of companies comparable to this reporting unit andconcludes that the reporting unit’s fair value is $100 million. The reporting unit’scarrying amount is $150 million, which includes $75 million of goodwill. Next,management determines that the fair value of the reporting unit’s net assetsexcluding goodwill is $35 million. The first step in the goodwill impairmentmethodology suggests that the reporting unit’s goodwill might be impaired. Thefair 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 mustbe performed.

The application of the second step indicates that the reporting unit’s impliedgoodwill is $65 million, which is the difference between the reporting unit’s fairvalue and the fair value of its net assets excluding goodwill ($100 million - $35million). Since the goodwill carrying amount ($75 milion) is higher than the fairvalue of the implied goodwill ($65 million), the reporting unit’s goodwill shouldbe 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 indefinitelives are not amortized, managers have an incentive to assign as much of theconsideration paid as possible to these two items.



26. Tangible Assets and DepreciationPhysical assets with a life of more than one year used in operations but notintended 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 residualvalue over its useful life to the owner. Land is not depreciated.

Depreciation Methods: Depreciation methods fall into three categories – straightline, accelerated, and units of production. The straight-line depreciation methodallocates an asset’s depreciable cost (cost – residual value) in equal annualamounts over its useful life. Accelerated depreciation methods (sum-of-the-years’digits and double-declining balance methods) charge in a systematic manner moredepreciation during the early years of an asset’s use than in the later years of itsuse. The units of production method charges depreciation based on some measureof the use of an asset. U.S. GAAP does not permit annuity (sinking fund)depreciation. This method increases depreciation in each period (lower charges inearly years and higher charges in later years).

Accumulated Depreciation: The sum of an asset’s depreciation charges to date.

Presentation: Depreciable tangible assets are reported on the balance sheet on anet basis (=original cost – accumulated depreciation).

Estimated Useful Life Changes: Changes in the estimated useful life used forcalculating depreciation charges are accounted for prospectively. That is, theasset’s (net book value (= original cost – accumulated depreciation) less residualvalue at the change date is depreciated over the new useful life.

Maintenance and Repairs: Expense as incurred. Only capitalize if enhanceasset’s productivity or extends its useful life beyond original estimate.

Tax: Different depreciation methods can be used for tax and financial reportingpurposes. The tax code specifies the accelerated depreciation schedules that mustbe used for tax returns. (Modified Accelerated Cost Recovery System).

Gain or Loss on Disposal: Difference between the assets’ selling price and itsnet book value. Accumulated depreciation account is reduced by assets’accumulated depreciation when the related asset is sold, abandoned or otherwisedisposed of.

Natural Resources: The cost of natural resources is charged to income throughdepletion accounting, which allocates the cost of the natural resource to incomebased on the consumption of the resource. The depletion charge is the cost of thenatural resource divided by its expected output in units times the units consumedduring the period.

Impairment: An asset or group of assets is impaired when its carrying amount isnot recoverable. If the projected cumulative undiscounted cash flow (excludinginterest) 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 andseller would pay). The writedown amount is a charge to income. U.S. GAAP doesnot permit assets written down to be written up at a later date. Asset impairmentwritedowns improve future income (lower future depreciation charges) anddecrease total assets and owners’ equity. This, in turn, increases asset turnoverratios and return on equity, while increasing debt-to-equity ratios.

IAS: Similar to U.S. GAAP, except IAS permits upward revaluations of tangibleassets. 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 arecharged to income. Revaluation upward of previously impaired assets is permitted.



Illustration: The ABC Company acquires equipment with a cost of $6,000 andan estimated salvage value of $1,000 at the end of its 5-year useful life.

1. Acquisition of the equipment:

Dr. Equipment (Asset +) 6,000Cr. Cash (-) 6,000

2. Annual depreciation expense calculation using straight-line method:

Cost of machinery $6,000Less: Estimated residual 1,000Depreciable cost $5,000

Depreciable cost = Depreciation expenseEstimated life

$ 5,000 = $1,000 per year5 years

3. Annual depreciation expense calculation using double-declining balancemethod for each year is computed by multiplying the asset cost lessaccumulated depreciation by twice the annual straight-line rate expressed as adecimal fraction (A .4 rate = .2 x 2). The residual value is ignored in thismethod until the cumulative total of the depreciation charges equals theasset’s cost minus its residual value. At this point, depreciation stops.

First year: $6,000 x 0.40 $2,400Second year: ($6,000 - $2,400) x 0.40 1,440Third year: ($6,000 - $3,840) x 0.40 864Fourth year: ($5,000 - $4,704) 296Fifth year: 0Total $5,000

4. Annual depreciation expense calculation using the sum-of-the-years’-digitsdepreciation method is computed by multiplying the depreciable cost ($6,000- 1,000) of the asset by a fraction based upon the years’ digits. The yearsdigits are added to obtain the denominator (=1 + 2 + 3 + 4 + 5 = 15), and thenumerator for each successive year is the number of the year in reverse order.

First year: $5,000 x 5/15 $1,667Second year: $5,000 x 4/15 1,333Third year: $5,000 x 3/15 1,000Fourth year: $5,000 x 2/15 667Fifth year: $5,000 x 1/15 333Total $5,000

5. The depreciation expense per unit of output calculation using the units ofproduction method (assume estimated salvage value is $1000 after producing100,000 units of output) is:

$5,000 = $0.05 per unit100,000 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(+) 1,000Cr. Accumulated depreciation(+) 1,000

The accumulated depreciation balance is a contra asset account reported as adeduction from the related asset’s original cost. For example, on the balance sheetthe asset is shown at the end of year two as:

Equipment (original cost) $6,000Less: Accumulated depreciation (2,000)Net book value $4,000



7. Assume the ABC Company sold the asset at the end of its second year inservice for $3,000. The loss on the sale would be:

Sale price $ 3,000Net book value (= 6,000 – 2,000) 4,000Loss on sale $(1,000)

The accounting entries would be:

Dr. Cash (+)3,000Loss on sale (+) 1,000Accumulated depreciation (-) 2,000Cr. Equipment (original cost) (-) 6,000

8. Summary (Investment in depreciable assets increasing):

Depreciation Method

Straight Line AcceleratedNet income Higher LowerDepreciation expense Lower HigherTotal assets Higher LowerOwners’ equity Higher LowerCash flow * Same Same

* Same method for tax return purposes.

Financial analysis: Earnings can be managed through the selection of thedepreciation method, useful life, and residual values. During periods of highinflation, depreciation expense based on an asset’s replacement rather than itshistorical cost is used to estimate future cash flow needs and evaluatemanagement’s current performance.



27. InflationInflation: 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 asset’s specific prices. Constant dollar accountingfor inflation restates the dollar results or the dollar value of transactions occurringin different periods to a constant dollar or equivalent purchasing-power basis.When these two approaches are combined, it is referred to as current cost/constantdollar inflation accounting.

Monetary Gains and Losses: Holders of monetary assets lose purchasing powerduring periods of inflation, (i.e., the monetary asset buys less). Creditors havemonetary gains on their monetary obligations during periods of inflation, (i.e.,they pay off their debts with less purchasing power than the original borrowingrepresented). These gains or losses are included in income when using constantdollar accounting.

IAS: The financial statements of an enterprise that reports in the currency of ahyperinflationary economy, whether they are based on a historical cost or a currentcost approach, should be stated in terms of the general price level index at thebalance sheet date. Gains or losses on the enterprise’s net monetary position shouldbe included in net income. The statement does not establish an absolute rate atwhich hyperinflation is deemed to arise. A cumulative inflation rate over 3 yearsapproaching or exceeding 100% is suggested as an indication of hyperinflation.

Financial Analysis: Inflation distorts historical cost income statements in threemajor ways: Income is overstated because depreciation does not reflect the highercost of replacing assets. FIFO method based cost of goods sold leads to anoverstatement of income because it understates the cost of replacing goods sold.Interest expense on floating rate debt increases as creditors raise interest rateswhich in turn lowers income. This effect is misleading since the historical costincome statement does not recognize the offsetting gain by the debtor arising fromthe gains in purchasing power from paying off debt with deflated purchasingpower currency. These gains must be considered to measure the real cost ofborrowing. The balance sheet is distorted by inflation because non-monetary assetvalues are understated. Adjusting financial statements for the effects of changingprices is imperative in periods of high inflation rates.



28. Segment DisclosureBusiness Segments: Segment disclosures present selected income and balancesheet data for the various operating segments of a business. The presentation ofthis disaggregated information should reflect the structure of the company’sorganization and the internal financial reports used by the company’s chiefdecision-maker for resource allocation and performance evaluation purposes.Financial data must also be disclosed for those geographic areas and countries inwhich the reporting company has material activities. Internal accounting policiesand financial statement based performance measurements are used to prepare thedisaggregated information.

IAS: Disclose business and geographic segment data, providing morecomprehensive disclosures about the primary segment of the two. A businesssegment is a distinguishable component of an enterprise that is subject to risks andreturns that are different from those of other business segments. Uses annualreport accounting policies for reporting purposes.

Financial Analysis: Segment data can indicate shifts in a company’s sources ofprofits, geographical risk, and investment requirements.



29. Foreign Currency TranslationForeign 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 FASB’s foreign currency accounting standard(FAS 52) is to set foreign currency translation standards that (a) provideinformation that is generally compatible with the expected economic effects of anexchange rate change on a company’s cash flow and owners’ equity; and (b)reflect in consolidated statements the financial results and relationships asmeasured in the primary currency in which each entity included in theconsolidated results conducts its business.

Functional Currency: The principal currency in which a non-U.S. subsidiarydoes its business.

Current-Rate Method: The current-rate method for translating the foreigncurrency denominated financial statements of foreign subsidiaries into U.S. dollarsis used when the foreign subsidiary’s functional currency is other than the U.S.dollar (the reporting currency of the parent). The current-rate method translatesinto U.S. dollars all balance sheet items of the non-U.S. entity (except the commonstock accounts) at the balance sheet date exchange rate (the current rate). Thecommon stock accounts are translated at the exchange rate on the date the capitalwas invested (the historical rate). Income statement items are translated at thetransaction date exchange rate. In practice, companies translate recurring revenueand expense items at the average exchange rate for the period. This is a lessexpensive approach than attempting to translate each transaction at the exchangerate on the transaction day. If a significant transaction occurs, however, such as amaterial gain on the sale of an asset, the transaction date exchange rate should beused for translation purposes. Translation gains or losses are included directly inowners’ equity as part of other comprehensive income.

Temporal Method: The temporal method (also called remeasurement method) isused for remeasuring foreign currency denominated financial statements into U.S.dollars when the foreign subsidiary’s functional currency is other than its localcurrency. (In the case of U.S. subsidiaries, this is usually the U.S. dollar.) Thetemporal method translates non-monetary balance sheet items (such as fixedassets) at the historical rate (exchange rate at original transaction date), andmonetary 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 thecurrent rate method, except income statement items that relate to non-monetaryitems (such as depreciation and cost of goods sold) are remeasured at theirhistorical exchange rates. Remeasurement gains or losses are included in income.

Highly Inflationary Economy: The temporal method is used when a subsidiaryoperates in a high inflation rate environment. A high inflation rate environment isone in which the 3-year cumulative inflation rate is approximately 100%. Use ofthe current rate method would lead to very low tangible asset values which, inreality, might be rising. The use of the temporal method overcomes this potentialdistortion.

IAS: Similar to U.S. GAAP, except IAS requires companies in hyperinflationaryeconomies to adjust financial statements to yearend purchasing power beforetranslation.

Illustration: The initial illustration presents the worksheet for translating aforeign subsidiary’s local currency balance sheet and income statement intodollars using the current-rate method. Next, the same foreign currency statementsare 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 averagecost 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 arepaid. On January 1, 2002, the exchange rate was four local units to US$1. Duringthe year, the currency steadily devalued relative to the dollar so that on December31, 2002, the exchange rate was eight local units to US$1. The average rate for theyear was six local units to US$1.

The exchange rate for translating Overseas Incorporated’s capital stock in thecurrent rate illustration is four local currency units to the dollar. Thus, the dollarequivalent of these local currency balances in this account can be obtained bymultiplying 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 expensesthat occurred evenly throughout the year. On the last day of the year, the exchangerate 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 sheetaccounts that must be translated at the balance sheet date exchange rate.

2002 Income Statement Current-Rate Method Example – Overseas Inc.

2002 Income 2002 IncomeStatement Statement

(local currency) Translation Factors (U.S. dollars)*Income StatementSales 401 .167 67 Less: cost of sales 196 .167 33Gross Margin 205 .167 34Depreciation 8 .167 1Other expenses 153 .167 26Net income 44 .167 7

* Rounded to nearest dollar.

December 31, 2002 Balance Sheet Current-Rate Method Example –Overseas Inc

2002 Financial 2002 FinancialStatements Statements

(local currency) Translation Factors (U.S. dollars)*AssetsCash and receivables 40 .125 5Inventory 32 .125 4Plant 80 .125 10 Less: accumulated depreciation (8) .125 (1)Total assets 144 18LiabilitiesCurrent liabilities 56 .125 7Long-term debt 24 .125 3Total liabilities 80 10Owners’ EquityCapital stock 20 .25 5Beginning retained earnings 0 – 0Plus net income 44 7

22

–Minus equity adjustment from

currency translation ** (4)Total liabilities and owners’ equity 144 18

* Rounded to nearest dollar.** Plug figure, 18-22.



When Oversea Incorporated’s foreign currency statements using the current rateare translated into U.S. dollars, the balance sheet translation process leads to atranslation adjustment loss of four U.S. dollars, since the company had an excessof translated liabilities and owners’ equity ($22) over translated assets ($18).Because the current rate method is used, the translation adjustment loss is notincluded in the income statements. It is shown only on the consolidated statementsas an adjustment to owners’ equity. This adjustment brings the basic accountingequation (Assets = Liabilities + Owners’ Equity) into balance.

The remeasurement illustration is similar in many respects to the current rateillustration with the exception that inventory is remeasured using the mid-yearexchange rate factor of 0.167 and plant is remeasured at the acquisition date ratefactor of 0.25. Cost of goods sold and depreciation are remeasured using the samefactor used to restate their related assets.

2002 Income Statement Temporal Method Example – Overseas Inc.


(local currency) Translation Factors (U.S. dollars)*Income StatementSales 401 .167 67 Less: cost of sales 196 .167 33Gross margin 205 34Depreciation 8 .25 2Other expenses 153 .167 26

Income before remeasurement gain 6Remeasurement gain (see balancesheet below) 7

Net income 44 Net income 13

* Rounded to nearest dollar.

December 31, 2002 Balance Sheet Temporal Method Example –Overseas Inc.


(local currency) Translation Factors (U.S. dollars)*AssetsCash and receivables 40 .125 5Inventory 32 .167 5Plant 80 .25 20 Less: accumulated depreciation (8) .25 (2)Total assets 144 28LiabilitiesCurrent liabilities 56 .125 7Long-term debt 24 .125 3Total liabilities 80 10Owners’ EquityCapital 20 .25 5Beginning retained earnings 0 – 0Plus net income 44 Plus income before remeasurement

gain (see income statement above) 621

– Plus remeasurement gain ** 7Total liabilities and owners’ equity 144 28

* Rounded to nearest dollar.** Plug figure, 28-21. Not reported on balance sheet. Shown here only to compute net income.



When Overseas Incorporated foreign currency statements are remeasured usingthe temporal method into U.S. dollars, a remeasurement gain is recorded. Thisremeasurement gain is included in income. The remeasurement gain and incomebefore remeasurement gain shown in the above work sheet would be reported asan increase in retained earnings as part of the net income addition to retainedearnings in the actual balance sheet.

Complications: In practice, the determination of the U.S. dollar value of asubsidiary’s inventory and cost of goods sold can be more complicated than it wasin the above temporal method illustration. The complication arises because of theuse of LIFO and FIFO inventory accounting. The problem is solved by using theaverage exchange rate for the appropriate period to translate each of thecomponents of the basic cost of goods sold equation.

Foreign Currency Exposure: Overseas Inc. had a translation loss using thecurrent rate method and a remeasurement gain using the temporal method. Theexplanation is that in the current rate illustration, Overseas Inc. had an excess ofassets 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 positiondeclined when the local currency devalued relative to the U.S. dollar. This loss invalue gave rise to the translation loss. In the temporal method illustration, thereverse occurred. Overseas had an excess of liabilities translated at the current rateover its assets translated at the current rate (a net liability exposure). As a result ofthe devaluation, the Overseas Inc.’s net liability exposure was lower whenexpressed in U.S. dollars. The accounting exposure gain gave rise to theremeasurement gain.

Cash Flow: The choice of the accounting method to convert a foreignsubsidiary’s financial statements to U.S. dollars does not impact a company’s cashflows. In contrast, changes in exchange rates can impact a firm’s cash flows if ithas foreign currency translation exposure (existing exposed assets and liabilitiesand firm commitments) and foreign currency operating exposure (future uncertaintransactions). 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 foreignsubsidiary’s financial statements to U.S. dollars can influence the reported balancesheet and income statement amounts. The impact of this accounting choice onfinancial analysis results should always be identified and assessed for potentialdistortions.



30. Stock Based CompensationAlternative Methods: Under the FASB stock based compensation standard(FAS 123), companies have a “free choice” of one of two methods to account forstock based employee compensation – the intrinsic value method or the fair valuemethod. If the intrinsic value method is adopted, the company must disclose in thenotes what the net income and earnings per share impact would have been if it hadused the fair value method.

Intrinsic Value Method: Under the intrinsic value method, compensation cost isthe excess of the quoted market price of the stock at the measurement date overthe employee’s exercise price times the number of optioned shares. Themeasurement date is the first date that both the number of options to be grantedand the exercise price are known.

In the case of most fixed stock option plans, (i.e., plans where the number ofoptioned shares and the exercise price is known at the grant date), the grant date isthe measurement date. Typically, at this time, there is no intrinsic value or excessof exercise price over market price. Consequently, no compensation cost isrecognized. In contrast, a compensation cost is sometimes recognized for othertypes 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 isnot determinable until some date beyond the grant date. Repriced options andoption plans adopted within 6 months after the cancellation of a former plan areaccounted for as if they were variable stock option plans.

Any compensation cost recognized under the intrinsic value method is amortizedto income as a charge over the vesting period.

Fair Value Method: Under the fair value based method, stock-basedcompensation cost is measured at the grant date based on the fair value of theaward, and is recognized as a charge to earnings over the employee’s serviceperiod, which is usually the vesting period.

In the case of stock options, the fair value is determined using an option-pricingmodel. Once the fair value is determined at the grant date, it is not subsequentlyadjusted for changes in the price of the underlying stock or its volatility, the life ofthe option, dividends on the stock, or the risk free interest rate. Stock options usedto pay non-employees (except directors) for goods and services are accounted forusing the fair value method.

IAS: Disclosure of employee stock compensation plan data is required. Standarddoes not require recognition of employee stock option compensation costs.

Financial Analysis: The earnings and price-earnings multiple of companies thatuse stock options extensively for compensation purposes should be evaluatedusing both the intrinsic and fair value methods to account for stock options.



31. DerivativesMeasurement: All derivatives must be measured at their fair value and shown onthe balance sheet as either assets or liabilities.

Four Categories: If certain conditions are met, management can designate aderivative 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 foreignoperations; or

• Not a hedging instrument.

Fair Value Hedge: Hedge of the exposure to changes in the fair value of an assetor liability recognized on the balance sheet or of an unrecognized firmcommitment, that are attributable to a particular risk. A firm commitment isdefined as:

An agreement with an unrelated party, usually legallyenforceable, under which performance is probable because of asufficiently large disincentive for nonperformance. Allsignificant terms of the exchange should be specified in theagreement, including the quantity to be exchanged, the fixedprice, and the timing of the transaction.

For a derivative designated as hedging an exposure to changes in the fair value ofa recognized asset or liability or a firm commitment (a fair value hedge), anyunrealized fair value gain or loss is recognized in earnings in the period of changetogether with the offsetting unrealized fair value loss or gain on the hedged itemattributable to the risk being hedged. Unrealized fair value gains and losses thatare other than perfectly correlated will impact earnings. Realized gains and losseson the derivative and the hedged item are recognized in income.

Cash Flow Hedge: Hedge of an exposure to variability in expected future cashflows that is attributable to a particular risk. That exposure may be associated withan existing recognized asset or liability (such as all or certain future interestpayments on variable-rate debt) or a forecasted transaction (such as a forecastedpurchase or sale).

For a derivative designated as hedging the exposure to variable cash flows of anexpected future transaction (a cash flow hedge), the effective portion of thederivative’s unrealized and eventual realized gain or loss is initially reported as acomponent of other comprehensive income (a component of owners’ equity) andsubsequently reclassified into earnings when the forecasted transaction affectsearnings. The ineffective portion of any gain or loss is reported in earningsimmediately.

Foreign Currency Net Investment Exposure Hedge: In the case of a derivativedesignated as hedging the foreign currency exposure of a net investment in aforeign operation, any unrealized and realized gains and losses are reported inother comprehensive income along with the cumulative translation adjustment.

Not A Hedge: The unrealized gain or loss on a derivative not designated as ahedge is recognized in current income.

IAS: All financial assets and financial liabilities, including derivatives, should berecognized on the balance sheet. Investments in the form of financial assets shouldbe measured at fair value except the following which should be measured atamortized cost: loans and receivables originated by the enterprise and not held fortrading, and fixed maturity investments intended to be held to maturity.Subsequent to recognition, most financial liabilities should be measured at originalrecorded amount less principal repayments and amortization, except derivative



liabilities that are measured at fair value. Unrealized gains and losses on itemsmeasured at fair value can be recognized in income or owners’ equity. Hedgeaccounting is permitted.

Financial Analysis: It is difficult to determine through financial analysis acompany’s unhedged exposure to financial, foreign currency, and commodityprice risks. Nevertheless, an attempt should be made to assess the degree ofexposure, since it may have a material impact on the level and volatility ofearnings.



32. Marketable SecuritiesThree Categories: Trading, investment, and available for sale.

Trading: Intention is to trade. Use fair value accounting with unrealized gainsand 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 orinvestment. Use fair value accounting with unrealized gains or losses included inother comprehensive income (owners’ equity).

IAS: All financial assets should be recognized on the balance sheet. Investmentsin the form of financial assets measured at fair value except the following whichshould be measured at amortized cost: loans and receivables originated by theenterprise and not held for trading, and fixed maturity investments intended to beheld to maturity. Unrealized gains and losses on items measured at fair value canbe 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. TheCompany intends to hold the securities to maturity. The Company considers thesecurities as an alternative to holding cash. The accounting entries are as follows:

Initial investment:

Dr. Short-term investments (+) 1,000Cr. Cash (-) 1,000

Receipt of interest:Dr. Cash (+) 10

Cr. Interest income (+) 10At maturity:

Dr. Cash (+) 1,010Cr. Short-term investment (-) 1,000 Interest income (+) 10

The accounting would be the same as the above if the security has been classifiedas an investment security.

Assume the security had been classified as a trading security. Furthermore, assumeits market value was $1,020 at the end of 3 months, at which time $10 interest waspaid, and the security was sold at the end of 4 months for $995. The accountingentries for the initial investment and the receipt of the interest payment are thesame as in the above example. The additional accounting entries are:

Recognition of unrealized 3-month gain and adjustment of the trading securityasset’s book value to market ($1,020):

Dr. Trading securities (+) 20Cr. Trading securities income (+) 20

Sale of securityDr. Cash (+) 995

Trading security’s loss (+) 25Cr. Trading securities (-) 1,020

If the above security was classified as an available-for-sale investment, theaccounting entries to record the initial investment and receipt of interest would bethe same as in the initial example. The additional accounting entries are:

Recognition of unrealized 3-month gain and adjustment of available-for-salesecurity asset’s book value to market ($1,020):

Dr. Available-for-sale securities (+) 20Cr. Unrealized gain adjustmentto owners’ equity (+) 20



Sale of security:

Dr. Cash (+) 995Unrealized gain adjustmentto owners’ equity (-) 20Loss on security sale (+) 5Cr. Available-for-sale securities (-) 1,020

A comparison of the last two illustration examples shows that the 3-month tradingsecurity asset was adjusted to market accompanied by an offsetting credit entry toincome, whereas the available-for-sale security asset was adjusted to marketaccompanied by an offsetting credit entry to other comprehensive income (theowners’ equity entry).

Financial Analysis: Investment results should be segregated from operatingresults when analyzing a company’s performance.



33. Special Income Statement ItemsThe basic income statement may be expanded to report the following:

Discontinued Operations: When a company decides to sell or abandon abusiness segment, the segment’s net income and any expected gains or losses onits disposal are shown on a separate line of the income statement below theincome from continuing operations line.

Extraordinary Items: Extraordinary items are both unusual and infrequent inoccurrence. The determination of what is unusual and infrequent is based on thecompany’s business, location, and political environment. In the past, gains andlosses on the extinguishment of debt were classified as extraordinary items. Theyare now classified as regular financing gains and losses. Extraordinary items arerare. They are reported net of any related tax as a special line item below incomefrom continuing operations.

Cumulative Effect of Changes in Accounting Principles: When a companychanges an accounting principle (i.e., accelerated to straight line depreciation), thecumulative effect (the difference in the period’s beginning retained earnings if thenew principle had been used in the past) is reported net of taxes as a special lineitem in the income statement. Below income from continuing operations. Oneexception is a change from LIFO inventory accounting to another inventorymethod. Prior period financial statements are restated to reflect the new method.

Estimate Changes: Changes in accounting estimates (i.e., a change indepreciable life estimate) effect current and future periods only. Accountingprinciple changes that are applied only to future transactions are treated likeestimate changes for accounting purposes.

Prior Period Adjustments: When an error is found in prior period financialstatements, the correction net of taxes of the error is made directly to beginningretained earnings. It does not appear in the income statement.

IAS: Similar to U.S. GAAP, except a correction of a fundamental error and thecumulative effect of a change in accounting policy can be reported by eitherrestatement of prior period financial statements or in the current period financialstatements.

Financial Analysis: In order to determine a company’s future level of incomeusing historical data, financial analysts frequently exclude non-recurring gains andlosses and other unusual non-recurring items from current and past income.



34. Principal Differences Between IAS and U.S.GAAPThe principal differences between IAS and U.S. GAAP are:

International Accounting U.S. Generally AcceptedStandard Accounting Principles

Property, Plant and Equipment Use historical cost or revalued amount. Revaluationgains credited to owners’ equity. Revaluation lossesthat offset previous revaluation gains recognized foran asset charged to owners’ equity until gainseliminated then charged to income. Revaluation of theentire class of assets required when an asset isrevalued

Historical cost only.

Depreciation The cost or revalued amount of depreciable assetsshould be allocated on a systematic basis to eachaccounting period during the asset’s useful life.

Similar, except depreciation based only on asset’scost.

Business Combinations A business combination should be accounted forunder the purchase method, except in the rarecircumstances when it is deemed to be a uniting ofinterest in which case the pooling of interests methodis appropriate. A business combination is consideredto be a uniting of interest when there is no clearacquirer. Positive goodwill arising in a purchasetransaction should be amortized to income on asystematic basis over a period not to exceed 20 yearsor a longer period if justified.

Similar, except that pooling of interests accounting isnot permitted and goodwill is not amortized. It issubjected to an annual impairment test.

Cash Flow Statements A cash flow statement reporting cash flows classifiedby operating, investing, and financing activities shouldbe included as an integral part of the financialstatements. Interest paid and received may beclassified as operating, investing, or financingactivities. Dividends received may be classified as anoperating or financing activity.

Similar, except interest paid or received is classifiedas an operating activity. Dividends paid is classifiedas a financing activity. Dividends received is anoperating activity.

Impairment of Assets Assets should be written down when their recoverableamount is less than their carrying value. Recoverableamount is the higher of the present value of theprojected estimated cash flows from the asset’s useor the asset’s net selling price. Revaluation ofimpaired assets permitted. Projected cash flows fromits use is Impairment loss is the difference betweenthe impaired asset’s carrying amount and its fairvalue. Revaluation of impaired assets is notpermitted.

An asset intended to be sold is impaired if its carryingamount is less than its net selling price. An assetother than goodwill intended to be used by theenterprise is impaired if the undiscounted sum of theless than its carrying amount.

Intangible Assets An intangible asset should be recognized if, and onlyif, it is probable that the future economic benefits thatare 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 fairvalue can be determined by reference to an activemarket. Amortize over a period not to exceed 20years unless a longer period can be justified.Research costs should be expensed as incurred.Development costs should be capitalized andamortized 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 theiruseful life, and intangible assets with indefinite livesare not amortized. They are subjected to periodicimpairment tests. Similar with respect to researchcosts. Development costs should be expensed asincurred, except for internal-use software, andrecoverable costs incurred in the development ofsoftwarefor sale.



35. Financial Ratio AnalysisFinancial ratios: Financial ratios are a fundamental tool for analyzing financialstatements. Financial ratios relate financial statement data to each other in ameaningful way. Financial ratios are used by analysts to evaluate a company’sprofitability, efficiency, and operating and financial risk for the purpose ofprojecting future income statements, balance sheets, cash flows, and assessingoperating and financial risk. Typically, this process involves comparisons of acompany’s financial ratios relative to its historical financial ratio record (timeseries analysis) and those of its major competitors and relevant industries (cross-sectional analysis). Another important relationship examined is the effect of theeconomic environment on the financial ratios. The major end uses of theseanalyses are stock valuations and credit quality ratings.

Adjustments: Financial analysts often modify financial statements beforecomputing financial ratios to reflect what they consider to be a more realistic viewof the company. Common adjustments include: recognizing off-balance sheetfinancings and commitments on the balance sheet (sales of receivables and take-or-pay arrangements); treating operating leases as capital leases; classifyingdeferred tax liabilities as owners’ equity; recognizing the possible impact ofunrecognized potential contingent liabilities; adjusting LIFO inventories to a FIFObasis; consolidating on a proportionate basis unconsolidated investees accountedfor using the equity method; revaluing tangible and intangible assets to reflecttheir fair or market value; restating reserves and charges for bad debts warranties,and product returns; changing the write-off period of intangible assets; valuingdebt obligations to reflect current market interest rates; adding capitalized interestto 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 eachitem on the income statement as a percentage of net sales. A Common-sizebalance sheet uses total assets as the base. To identify changes in a company’soperating results, investment mix and sources of capital, common-size financialstatements for two or more periods are prepared and the percentage figures foreach line item are compared.

Solvency (Internal Liquidity) Ratios: A corporation’s liquidity is determined byits ability to raise cash from all sources, such as bank credit, sale of redundantassets, and operations. Liquidity ratios have a narrower focus. They help statementusers appraise a company’s ability to meet its current financial obligations usingits existing cash and current assets. These ratios compare current liabilities, whichare the obligations falling due in the next 12 months, and current assets, whichtypically provide the funds to extinguish these obligations. The difference betweencurrent assets and current liabilities is called “working capital”.

Current Ratio = Current AssetsCurrent Liabilities

The meaningfulness of the current ratio as a measure of liquidity varies fromcompany to company. Typically, it is assumed that the higher the ratio, the moreprotection the company has against liquidity problems. However, the ratio may bedistorted by seasonal influences, slow-moving inventories, slow paying creditcustomers, or abnormal payment of accounts payable just prior to the balancesheet 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 appropriatefor such a business.

Quick Ratio = Quick AssetsCurrent 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 assetsinclude those current assets that presumably can be quickly converted to cash atclose to their book value. Such items are cash, marketable securities, and accountsreceivable. Like the current ratio, this ratio implies a liquidation approach anddoes not recognize the revolving nature of current assets and liabilities.

Cash Ratio = Cash + Marketable SecuritiesCurrent Liabilities

The cash ratio measures the ability of a company to extinguish its currentliabilities with its most liquid current assets.

Annual Receivables Turnover = Net Annual SalesAverage Receivables

Receivables turnover rate indicates how often a company’s investment in accountsreceivable turn over. It can be used to compute the average time it takes for acompany to collect its outstanding receivables.

Average Receivables Collection Period = 365Annual Receivables Turnover

Average Receivables Collection Period = Accounts ReceivableSales/365

An increase in the average collection period is regarded as a “red flag” alerting theanalyst to the need to inquire into the cause of the increase. To appraise the qualityof accounts receivable, the average collection period can be related to the typicalcredit terms of the company and its history. A collection period substantiallylonger than either of these standards might indicate credit management problems,resulting in an increasing amount of funds being tied up in this asset. The increasemay also be the result of pulling sales in from future periods to boost the currentperiod’s sales level. On the other hand, a significantly shorter collection periodthan is typically in the industry might mean that profitable sales to slower payingcustomers are being missed. Sometimes called “days sales outstanding” (DSO’s).

Annual Inventory Turnover = Cost of Goods SoldAverage Inventory

The inventory turnover ratio indicates how fast inventory items move through abusiness. It is an indication of how well the funds invested in inventory are beingmanaged. The analyst is interested in two items: the absolute size of the inventoryin relation to the other funds needs of the company, and the relationship of theinventory to the sales volume it supports. A decrease in the turnover rate indicatesthat the absolute size of the inventory relative to sales is increasing. This can be awarning signal, since funds may be tied up in inventory beyond the level requiredby the sales volume, which may be rising or falling.

Average Inventory Processing Period = 365Annual Inventory Turnover Rate

Average Inventory Processing Period = Average InventoryCost of Goods Sold/365

By dividing the turnover rate into 365 days, the analyst can estimate the averagelength of time items spent in inventory. If the company uses the last-in, first-out(LIFO) inventory valuation method, in order to reflect the company’s actualinvestment in inventory, the inventory balance must be converted to its equivalentvalue based on the first-in, first-out (FIFO) inventory valuation method. This isaccomplished by adding the LIFO reserve to the LIFO inventory balance reportedon the balance sheet. The LIFO reserve figure can be found in the inventory noteaccompanying the financial statements.

Payables Turnover Ratio = Cost of Goods SoldAverage Trade Payables



The payables turnover ratio indicates how fast a company turns its accountspayable over. It can be used to compute the average payables payment period.

Average Trade Payables Payment Period = 365Average Trade Payables

The day’s-payables ratio becomes meaningful when compared to the credit termsgiven by suppliers to the object company’s industry. If a company’s average day’spayables period is increasing, it may mean trade credit is being used increasinglyas a source of funds. If the payables period is less than the average for theindustry, it may indicate that management is not using this source of financing asmuch as possible. If it is longer, it may mean the company is overdue on itspayables 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 acompany ties its cash up in inventories and receivable balances after allowing forvendor financing in the form of payables.

Cash Conversion Cycle =

Average Collection + Average Inventory – Average PayablesPeriod Processing Period Payment Period

Operating Efficiency Ratios: Operating efficiency ratios indicate how well acompany 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 itsinvestment in total assets to generate sales. High turnover rates suggest efficientasset management.

Equity Turnover = Net SalesAverage Equity

The equity turnover ratio is an indicator of how efficiently a company is able touse its equity to generate sales. High turnover rates suggest efficient equitymanagement. Since equity is the difference between total assets and totalliabilities, a company can improve its equity turnover rate by substitutingliabilities for equity. This may increase the company’s financial risk.

Operating Profitability Ratios. Analysts look at profits in two ways: first, as apercentage of net sales; second, as a return on the capital invested in the business.

Gross Profit Margin = Gross ProfitNet Sales

Gross profit (sales minus cost of sales) as a percentage of sales is an indication ofa company’s 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 ofthe firm. It measures a company’s ability to cover its selling, general andadministrative expenses that tend to be fixed in total. Volatile operating profitratios over time may indicate a high level of business risk. Interest is excludedfrom 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 OperationsNet Sales

Net profit as a percentage of net sales from continuing operations measures thetotal operating and financial ability of a company, since net profit after taxesincludes all of the operating and financial costs of doing business.

Return on Total Capital = Net Income + Gross Interest ExpenseAverage Total Capital

Return on total capital (debt plus owners’ equity) gauges how well a company hasmanaged 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 a12-month period.

Return on Total Equity = Net IncomeAverage Total Equity

The return on total equity (owners’ equity including preferred stock) percentagemeasures the return on total equity after all taxes and interest payments.Sometimes preferred dividends are deducted from net income and preferred stockfrom total equity to measure the return on common stockholder’s equity (totalequity minus preferred stock).

Return on Owners’ Equity (ROE) = Net Income x Sales x Total AssetsSales Total Common Equity Asstes

ROE can be decomposed into three ratios that analysts use to determine how acompany achieved its return on owners’ equity: The profit margin (netincome/sales), the total asset turnover (sales/total assets), and the financialleverage ratio (total assets/common equity). The common equity figure used is theyearend amount. This equation is referred to as the DuPont System.

Extended DuPont System: An extension of the DuPont System examines theeffect of interest, leverage,

and taxes on the return on equity. This analysis begins with the operating marginreturn (Earnings before interest and taxes):

EBIT x Sales = EBITSales Total Assets Total Assets

Next, the negative effect of financial leverage (interest cost) is examined.

EBIT - Interest Expense = Profit Before TaxesTotal Assets Total Assets Total Assets

Then, the positive effect of financial leverage is identified.

Profit Before Taxes x Total Assets = Profit Before TaxesTotal Assets Owners’ Equity Owners’ Equity

Finally, the impact of taxes on return on equity is highlighted.

Profit Before Taxes x (1 – tax rate) = ROEOwners’ Equity

Risk Analysis: Risk analysis involves an assessment of the level of uncertaintyassociated with income flows of the total company and its individual sources ofcapital. Greater volatility in these factors implies higher risk for investors.

Business Risk: Business risk is the uncertainty associated with a company’sincome caused by the nature of its industry, products, customers, productionprocesses, and cost structure. Business risk is measured by the variability of acompany’s income over time. (Standard deviation of operating earnings/Meanoperating earnings).

Financial Risk: Financial risk is the uncertainty of returns to equity holders dueto a company’s fixed obligations to pay interest and repay principal to creditors.



Debt/Equity Ratio = Total Long-Term DebtTotal 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 relativemix of financing provided by owners and long-term fixed obligation credit sources.Typically, the higher the ratio, the higher is a company’s financial risk level.

Total Long-Term Debt/Capital Ratio = Total Long-Term DebtTotal Long-Term Capital

The long-term debt to total capital ratio reflects a company’s policy on the mix oflong-term funds obtained from ownership and non-ownership sources. Thedenominator includes all of a company’s long-term debt and equity capital.

Total Debt Ratio = Total LiabilitiesTotal 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 OperationsInterest Expense

The interest coverage ratio indicates the extent to which operating profits candecline without impairing a company’s ability to cover its fixed interest charges.

Fixed Charge Coverage = EBIT + Lease PaymentsDebt + Lease + Preferred

Interest Payments Dividends/(1-Tax Rate)

The fixed charge coverage ratio measures how well a company’s earnings coverits fixed charges.

Cash Flow/Interest Expense Ratio =

Net Income + Depreciation Expense + Deferred TaxesInterest 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 + InterestInterest Expense

The cash flow coverage ratio is an alternative way of measuring interest coverage.

Cash Flow/Long-Term Debt Ratio = Cash FlowBook Value of Long-Term Debt

The cash flow to long-term debt ratio has proven to be a good explanatory variable instudies using financial ratios to predict bankruptcy. Analysts sometimes use as analternative to the traditional cash flow in the numerator of cash flow ratios the cashflow from operations amount shown in the statement of cash flows or a free cash flowamount (cash flow from operations minus capital expenditures minus dividends).

Growth Analysis: Historical and pro forma growth rate analyses use amathematical expression known as the sustainable growth rate equation. Thisequation demonstrates that if a company does not issue new equity, its potentialmaximum earnings growth rate will be a function of its rate of return on equityand 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 dividendsE (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 earningsgrowth rate cannot be greater than a company’s return on equity; i.e., g = ROE,when dividends are zero. In addition, should a company wish to maintain a givenearnings growth rate, it can do so by a variety of combinations of payout ratio andreturn on equity levels.

Depreciable Asset Analysis: The average depreciable life and the average age ofdepreciable fixed assets can be estimated as follows (years):

Average Depreciable Life = Gross Plant and Equipment CostCurrent Year’s Depreciation Expense

Average Age of Plant and Equipment = Accumulated DepreciationCurrent Year’s 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 theconsideration of relative importance of its financial ratios drawn from the subjectcompany’s history or other comparable companies. To identify any limitations tothis comparative analysis, analysts should ask:

1. Are the accounting policies comparable? Analysts may have to adjust thefinancial statement for accounting differences.

2. How comparable is the firm? Financial ratio differences may arise betweenthe subject company and the comparables because of a different mix ofbusiness.

3. Are the conclusions drawn from the analysis consistent? A good analysisconsiders the total firm, not just one aspect.

4. Are the ratios reasonable? Do the ratios fall within the range anticipated forthe subject company’s industry?



36. Quality of Earnings AnalysisInvestors use accounting earnings and balance sheet data to price stocks because itis thought that the level of earnings and changes in earnings along with the relatedbalance sheet data signal relevant information about a company’s current andfuture ability to generate economic value that other investors will recognize andprice appropriately. Knowledgeable investors have long recognized that not alldollars of reported profit and balance sheet amounts are equal when it comes torepresenting a corporation’s current economic progress and signaling future levelsof economic achievement. Investors aware of this difference carefully examine thesources of reported and projected earnings to assess the degree to which they canbe taken at their face value as reliable economic value creation indicators. Thisexamination and assessment has been labeled “quality of earnings” analysis.

High quality balance sheets have a conservative amount of debt, assets whosemarket value is greater than their carrying amount, and few, if any, off balancesheet liabilities.

High quality earnings are repeatable earnings measured using conservativeaccounting policies.

Current practices: In recent years, the quality of earnings of many companieshas declined because they have adopted one or a number of the followingaccounting 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 ofacquired tangible assets less the fair value of assumed liabilities must be allocated toacquired identifiable intangible assets with any excess remaining being assigned togoodwill. Often today, an unusually high proportion of the excess purchase price isassigned to an intangible asset “research and development in progress”. At themoment of merger, this intangible is listed on the combined companies’ balancesheet. It also enters into the goodwill calculation, reducing goodwill. Then, asrequired by U.S. GAAP, as soon as the combined companies begin operationstogether, this intangible is written off. The result? The acquirer is able to include theacquiree’s profits in future income without having to match against this incomemuch of the purchase price related charges incurred to obtain it.

Inappropriate restructuring charge accounting: The one-time charge improperlyincludes costs that relate to future operations, not the restructuring; the company isslow after taking a restructuring charge to restructure, thereby benefiting fromthose operations without recording their full current cost; or unused restructuringcharges of prior periods are used to absorb unrelated charges; or, are reversed toboost current income.

Unrecorded stock option compensation costs: Stock options as a form ofcompensation have increased in popularity, but their cost is seldom recognized inincome statements. Under FAS 123, companies in most cases have a “free choice”of one of two methods to account for stock-based employee compensation – theintrinsic value method or the fair value method. Nearly all companies have adoptedthe intrinsic value method. Under this approach, compensation cost is the excess, ifany, of the quoted market price of the stock at the grant date over the employee’sexercise price. Typically, at this time, there is no intrinsic value or excess of exerciseprice over market price. Consequently, no compensation cost is recognized.

Front-end income loading: The company recognizes all or most of the incomefrom arrangements that require it to provide services over an extended period oftime at the time the arrangement is signed, and it is questionable as to whether thecompany has earned this income at signing.

Deferral of costs: The company has deferred over future periods expenditures toacquire a potential revenue stream, and it is questionable as to whether the benefitsof these expenditures will be realized over these future periods.



Previously unrecognized deferred tax assets are recognized: Management, withinsignificant changes in the company’s circumstances and prospects, decides thatthe company is now “more likely than not” (a 0.5 or greater probability) to realizepreviously unrecognized deferred tax credits (valuation allowance items) and usesthe book credits to lower tax expense.

Overly pessimistic asset impairment charges: The company in prior periodsrecorded an asset impairment charge, thereby lowering future depreciation andgoodwill charges based on assumptions about the future that in retrospect wereoverly pessimistic. The current profits reflect better operating results thananticipated without being burdened by the excessive prior period write-offs.

Optimistic measurement assumptions: Accounting rules require management tomake assumptions when measuring revenues and costs, for example, gains onsecuritization and pension costs. Managements under pressure to produce profitsmay make overly optimistic measurement assumptions.

The FASB is considering accounting changes that may enhance the quality ofearnings. These include the consolidation of all “controlled” entities with controldefined as the actual or potential ability to direct the policies and management ofanother entity through such things as board control, a significant minority interestand ability to gain control through the exercise of options; all financial assets andliabilities measured at fair value; and, identification of more situations where stockoption compensation should be recorded.

Common Signals: When doing quality of earnings analyses to determine if thequality of current earnings has declined from prior periods, investors should focuson looking for sources of low quality earnings that at the margin make the differencebetween the company earning or not earning the consensus expectation. The morecommon causes or signals of a decline in earnings quality of companies struggling tomeet 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 fromaccelerated depreciation to straight-line depreciation.

2. One-time transactions to generate gains, such as a tax deal that gives up futurebenefits 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 asaccelerating shipments to customers. This is usually signaled by an unusualaccounts receivable build-up.

4. Inclusion of profits from past periods in the current period, such as a reversalof 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 asbad debts, warranty obligations, returns, and allowances.

8. Selling to less credit worthy customers or channel stuffing. Usually signaledby an increasing gap in time between the recording of income and the receiptof cash from customers indicated by a build-up of accounts receivable.

9. Excessive premium paid to selling company which is embedded in highergoodwill that is not charged to earnings.

10. Increasing reliance of earnings sources not central to the company’s principalbusiness activity and strategy.

11. Classifying expenditures as assets that previously were expensed as incurred.



12. A major acquisition accompanied by inadequate disclosure making thecomparisons with earlier periods required to measure and analyze sources ofgrowth 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 thefinancial risk associated with future earnings will be significantly higher thancurrent and past levels.

16. A slowdown in inventory (particularly finished goods) turnover. This mayindicate that the company has production or marketing problems that are notyet reflected in current earnings.

High Cost. Quality of earnings analysis is potentially a high cost activity. Thiscost can be lowered by concentrating on growth company situations thatexperience has taught us are the most likely to resort to lowering earnings qualityin an attempt to keep the growth going. These characteristics include:

1. The company has achieved a significant market share and is growing fasterthan the industry.

2. Business combinations are frequently entered into.

3. Management has a history of using accounting decisions to achieve earningsexpectations.

4. The auditors are changed.

5. The company has grown rapidly.

6. Management’s growth strategy comes down to meeting earnings per sharegoals 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 PercentBuy 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 securitiesduring 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 pricefluctuation, are: A - Low, B - Medium, and C - High. INVESTMENT RATINGS, indicators of expected total return (price appreciation plus yield) within the 12-month periodfrom 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 ofpotential 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 beenprepared 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 dealerunder 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 inSingapore by Merrill Lynch International Bank Ltd (Merchant Bank) and Merrill Lynch (Singapore) Pte Ltd, which are regulated by the Monetary Authority of Singapore. Theinformation 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 otherderivatives related to such securities ("related investments"). MLPF&S, its affiliates, directors, officers, employees and employee benefit programs may have a long or shortposition 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 solicitinvestment 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 ofinvesting in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not berealized. Investors should note that income from such securities, if any, may fluctuate and that each security’s price or value may rise or fall. Accordingly, investors mayreceive 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 insecurities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.

Accounting Review by Merrill Lynch for CFA

Documents

Transcript of Accounting Review by Merrill Lynch for CFA