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INSTRUCTOR NOTESIntermediate Financial Accounting II

ACG 3111 - D001Summer 1997

Marilyn T. ZarzeskiUniversity of Central Florida

BA 466 -- Orlando Campus823-2150

[email protected]

classes\finactg2\acg3111z.doc

LIABILITIES--Chapters 13 & 14

AP

Cash A. Defn of LIABILITY: probable future sacrifice of economic benefits arising from

present obligations to transfer assets

OR

Un. Rev. Revenue

to provide services as a result of past transactions or events

Debt Ratio = Average Liab. (varies per industry)Total Assets

Defn of CURRENT LIABILITY: obligations that are expected to require use of CA or the creation of CL or rendering of a service, within one year or the operating cycle, whichever is more.

Current Ratio = _Current Assets (CA) _ Current Liabilities (CL)

Working Capital = CA - CL

Since difference between FACE VALUE OF CL and PRESENT VALUE OF CL is usually immaterial, record FACE VALUE on Balance Sheet.

Economic Issues: IF CL are understated, the ratios look better! Therefore, auditors search for UNRECORDED LIABILITIES.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

acg3111z.DOC 2

CURRENT LIABILITIESEffect of Transactions

Exercise 13-16

TIP: Analyze Change in NI first; then analyze Balance Sheet Changes.

1. Inventory 75,000 (A)AP 75,000 (L)

2. AP 75,000Disc. on NP 5,000

NP 80,000

3. Interest expense (E)Interest payable (L)

4. Cash 100,000 (A)Discount on NP 10,000 (L)

Note Payable 110,000

5. Int. expense (E)Discount on NP (Contra L)

6. Cash 74,500 ( A )Sales 70,283 ( R )Sales Tax Payable 4,217 ( L )

7. Wage Expense 35,000 ( E )Cash 25,000 ( A )Payables 10,000 ( L )

8.,9,&10. Exp. Pay

12. Est. LossEst. Liab.

13. Est. Exp.Est. Pay

14. Est. PayCash

(15, 16, & 17 go together)15. Cash ( A )

Sales ( R )Un. Rev. (warranties) ( L )

16. W. Exp. ( E )Cash ( A )

17. Un. Rev. (Warr.) ( L )Rev ( R )

18. Est. Exp. ( E )Est. Liab. ( L )

acg3111z.DOC 3

Compensated AbsencesSolution to Ex. 13-5

1994 (in days) 1994 (in dollars)

Vacation Sick Vacation Sick

Earned +10 +6 Earned $4,320 $2,592 Exp. Payable

Used/Taken - 0 -4 Used/Taken 1,728 PayableEnd of Year 10 days 2 days Cash

Rate = $6.00/hr. Example: 10 days x ($6.00 x 8 hrs.) x 9 workers = $4,320$48/day

FIFO1995 (in days) 1995 (in dollars)

Vacation Sick Vacation Sick

Beg. Bal. 10 x $6 2 x $6 Earned $5,040 $3,024 Exp.Payable

Earned +10 x $7 +6 x $7 Taken 3,8881 2,3762 PayableCash

Taken - 9 -5 7923 Exp.Cash

Ending Ba. 11 3 Rate = $7.00 1 9 days x ($6.00x 8 hrs.) x 9 workers = $3,888

2 2 days x $6.00 x 8 hrs x 9 workers = 864 3 days x $7.00 x 8 hrs. x 9 workers = 1,512

2 2,376

3 9 days x $1.00 x 8 hrs. x 9 workers = 648 2 days x $1.00 x 8 hrs. x 9 workers = 144

(due to increased wages) 3 792

acg3111z.DOC 4

SHORT-TERM OBLIGATIONS EXPECTED TO BE REFINANCED

1994 1995

Balance Sheet Actual IssuanceDate Refinancing of Financial

StatementsSituation A

12/31/94 2/4/95 3/18/95$40,000 STNP 40,000 $40,000 is now LTNPSTNP LTNP 40,000 on 12/31/94 financials

Balance Sheet Refinancing Agreement IssuanceDate signed...for LTNP of $100,000 of Fin. Stmts.

Situation B 12/31/94 INTENT: to use $40,000 to pay off the STNP $40,000 is now LTNP$40,000 No G/L Entry on 12/31/94 financialsSTNP

Balance Sheet Issued C.Stk for $30,000 Issuance ofDate Financial Stmts

Situation C 12/31/94 Cash $30,000 $10,000 is STNP

$40,000 C. Stk. 10,000 $30,000 is LTNPSTNP Paid in Capital 20,000

INTENT: to use the $30,000 to pay part of the STNP

STNP = Short-term Note Payable

acg3111z.DOC 5

SUMMARY OF ACCOUNTING FOR CONTINGENCIES

LOSS CONTINGENCY

Can Reasonably Estimate Cannot Reasonably Estimate

Probable 1. Record both a loss and a liability, and report them in the body of the statements

2. Do not accrue; report as a note in the financial statements

Reasonablypossible



Remote 5. No accrual or note required; however, a note is permitted

6. No accrual or note required; however, a note is permitted

GAIN CONTINGENCY

Can Reasonably Estimate Cannot Reasonably Estimate

Probable 7. No accrual except in unusual circumstances. Note disclosure required

8. If disclosure is made, exercise care to avoid misleading inferences

Reasonablypossible

9. If disclosure is made, exercise care to avoid misleading inferences

10. If disclosure is made, exercise care to avoid misleading inferences

Remote 11. Disclosure not recommended

acg3111z.DOC 6

Contingent Liab. cannot usually be measured precisely and payment is dependent upon on future event.

Determinable CL’s are precisely measured and reasonably certain as to date of payment.

Accounts Payable open accounts with suppliers; normally not subject to specific, formal contracts.

Loans (S.T.)· Short-Term Debts Commercial Paper (co.-to-co. note)

Line of Credit (in footnotes) Current Portion of Debt

Dividends Payable- On Declaration Date, an obligation arises- On Payment Date, obligation is paid

Unearned

Deferred Revenues receipts of cash in advance of us giving the service

Returnable Deposits provision to pay possible future obligations in event of damage or to repay customer at end of contract e.g., Lease commitments.

Third-Party Collections co. holds cash to be sent to governmente.g., Sales Tax and Federal Payroll Taxes

Accumulated Determinable e.g., interest

Accrued Liabilities Conditional e.g., bonus, income taxes

classes\finactg2\acg3111z.doc

LONG-TERM NOTES AND BONDS

A. Sources of Financing (Funds): bank1. Notes Payable obligations evidenced by formal promissory notes another co.2. Bonds Payable obligation to a large no. of creditors, via SEC guidelines3. Leasehold obligation to a lessor; must pay future rent to occupy or to use

someone else’s propertyTerms of Above Financing: Principal Security Provisions, e.g., collateral Interest Ratio Limits Time to Maturity Sinking Funds

B. Economic Consequences of LTL: Effect on fin. ratios and credit rating Obligation to meet debt covenants (restrictions, etc.) and thereby cause limits

on management’s operating activities, including dividend payments

Mgmt has incentives to manage their debt wisely so they can obtain more when needed. Potential manipulation by mgtmt

a) “take a bath” in bad years and thereby look better in future years ORb) “smooth income over” this good year and next ones so that no one year is really bad

C. Difference between STATED RATE AND EFFECTIVE RATENote: the calculation of Present Value is less subjective with the LTLs because princ terms of the agreement are used in the calculation OBJECTIVITY

int. term

All LTLs must be valued on Bal. Sheet at Present Value.

These may STATED RATE typed on the agreementor may (S.R.) Prin. x S.R. x Time = CASH Interestnot be equal EFFECTIVE RATE actual interest rate paid by the borrower

(E.R.)

If there is a difference between S.R. and E.R., then a discount or premium arises.

these are like “holding accounts” for interest

ALWAYS go into the PV tables at the E.R.!D. Effective-Interest Method

calculates the PV of the debt via the effective rate calculates the INTEREST EXPENSE via the effective rate

(Effective rate is what the borrower is really paying over the term of the debt.)

Interest Expense = C.V. x E.R. x Time

C.V. = Carrying Value Principal + Premium Principal - Discount

acg3111z.DOC 8

Three Types of Notes

(1) Interest-Bearing Note (Stated Rate = Effective Rate)

Principal

SR SR SR SR SR SR SR = Interest

To find the table factori = SR = ER = per noten = periods per terms of note

=====================================================================

(2) Non-Interest-Bearing Note (Zero interest-bearing)

Maturity = Principal + Interest

To find the table factori = ER = per the transacted dealn = periods per terms of note

=====================================================================

(3) Combination of the two notes above.

Principal

SR SR SR SR SR SR SR = Stated Rate of Interest < Effective Rate of Interest

To find the table factori = ER = per implicit or imputed rate, per the transacted dealn = number of interest payments per terms of note

acg3111z.DOC 9

Long-term LiabilitiesACG 3111Chapter 14

Effect on NI

Rev. Exp.A L SE Gain - Loss SCF

(cash effect)Issue BondCash NE NE FinancingDisc. on BP BP

AJEInt. Exp. NE NE Disc. on BP Int. Pay

Payment of InterestInt. Pay NE NE (Operating) Cash

Maturity Int. Exp. Disc. on BP Cash1=(Operating) Cash1

BP Cash2 Cash2=(Financing)

Early ExtinguishmentInt. Exp. Disc. on BP or Cash1=(Operating) Cash1

depends onnumbers

in expenseBP & gain Cash2 Cash2=(Financing) E/O Gain

acg3111z.DOC 10

E. LONG-TERM NOTES PAYABLE issued by our co. to banks and other lenders; we owe the money at some future time

CASE 1: SR = ER(Interest-Bearing Note) 11%

Issuance Cash 5,000 i = 11% NP 5,000 n = 2 (periods of interest)

CV x ER x T = Exp

Interest Interest Exp. 550 Note: CV = Carrying Value Payments Cash 550at end of yr. 1 P x SR x T = Cash or Int. Payable

Interest Exp. 550At Maturity Cash 550 or one compound entry

NP 5,000 Cash 5,000

interest payments

CASE 2: Non-Interest-Bearing Note 6733 0 0(9% implied)

8,000

Cash 6733Issuance Discount on Notes 1267

contra liabilityNP 8000

6733 x 9% = C.V. x E.R. x TimeAJE at end Int. Exp. 606of yr. 1 Disc. on Notes 606 _ NP _ _ __Discount__

8000 1267 606

661

C.V. x E.R. = 7339 x 9% Int. Exp. 661

Disc. on Notes 661 C.V. = 8000 - 661 = 7339At Maturity NP 8000

Cash 8000

acg3111z.DOC 11

CASE 3: SR< Effective Rate (somewhat a combo of Case 1 and 2)SR = 5%Pay $400 interest annually

ER = 8%Date: 1/1/90Issuance Cash 7572*

Disc. on N 428NP 8000 FV

8000 6859

PV = FV x table factor PV of $1

6859 = 8000 x .85734 713 400 400 PV of OA

_713_ = 400 x 1.78326 PV FV FV

= Total PV = Cash i= 8%

n = 2Principal = 8000

Date: 12/31/90Interest Payment 7572 x 8% x 1and AJE CV x ER x T At end of Interest Exp. 606 year one Disc. on Notes 206

Cash 400 8000 x 5% x 1 P x SR x T

Always do T-Accts. to keeptrack of Carrying Value

Date: 12/31/91 CV x ER x T _ NP_ _ Discount At end of Interest Exp. 622 8000 428year two Disc. on Notes 222 206(Maturity) Cash 400 P x SR x T 222 12/31/90

222 NP 8000 1/1/91

222Cash 8000 222

0

Straight Line Amortization of InterestGAAP says the company can use this in lieu of the Effective Interest Method if it results in amounts that are NOT

materially different. \

Interest B.V. (C.V.) of the Note Payable Expense bonds usually have this

TO amortize via STRAIGHT-LINE method, Divide the TOTAL Discount (or premium)by the no. of years of months in the term of the note.Note: The balancing figure will now be the INTEREST EXPENSE.acg3111z.DOC 12

In the Effective Interest Method, the balancing figure is the DISCOUNT ON NP.

acg3111z.DOC 13

Impairment of Loan

Creditor still hopes for payment, but thinks it is probable that some of the PRINCIPAL (or interest) will not be paid. Therefore, the Creditor sets up an allowance account. The debtor does not do an impairment entry!

Bad Debt Exp. Allowance for Bad Debt

12/31/97310,460 500,000

Step 1: Total Principal

12/31/95 1 2 3 4 5

Impairment Date CV375,657

225,3 96 300,000Step 2: Expected Principal

12/31/97Payment

CV n = 3 =PV i= 10%

Step 3: Find the difference (Step 1 - Step 2) Loss due to impairment $150,261

Restructuring of Loan

Reduce Principal owed Entries sometimes are needed

Reduce Interest owed at restructure date

Increase Time to maturity

That is, the debtor gets a “good deal.”

acg3111z.DOC 14

Basic Bond Entries and Their Effect on Financial Statements

Effect on NI_Rev. Exp.

A L SE Gain - Loss SCF (cash effect)

Issue BondCash NE NE FinancingDisc. on BP BP

AJEInt. Exp. NE NE Disc. on BP Int. Pay

Payment of InterestInt. Pay NE NE (Operating) Cash

Maturity Int. Exp. Disc. on BP Cash1=(Operating) Cash1

BP Cash2 Cash2=(Financing)

Early ExtinguishmentInt. Exp. Disc. on BP or Cash1=(Operating) Cash1

depends onnumbers

in expenseBP & gain Cash2 Cash2=(Financing) E/O Gain

acg3111z.DOC 15

Issuance of Bonds

A. Given bond data and competitor’s yield, calculate bond issue price CASH

Given: Our Company Our Competitor par $100,000 = principal = facestate rate 14% 4 Yr.=nominal rate 6/30, 12/31

COMPETITOR’SBOND

yield = 16%= effective rate= market rate

Two CASH Features to most bonds:

PV1 $100,000 use PV of $1 table1. Principal

PV2 7000 7000 7000 7000 7000 7000 7000 7000 use PV of ordinary annuity table2. Interest

= P x SR x T n = periods of interest = 4 x 2 = 8 (6 mos.)= 100,000 x 14% x ½ i = effective rate for interest payments = _16% = 8% = $7,000/6 mos. 2 (6 mos.)

Must discount FUTURE CASH values on each time line to the PRESENT (PV1 and PV2)

FORMULA: PV = FV x table factor Issued on 1/1/91:Cash 94,253Disc. on BP 5,747

BP 100,000

For PV1 : Pv1 = $100,000 x .54024 = $54,024For PV2 : PV2 = $ 7,000 x 5.7470 = 40,229

CASH = Total PV = 94,253

B. Given the bond price as quoted in the bond market.Given: Issued 100 bonds of $1,000 at 94¼

1/1/91:100 x $1,000 = $100,000 Face Cash 94,250

__x 94 ¼ % Disc. on BP 5,750$ 94,250 CASH BP 100,000

acg3111z.DOC 16

Issuance of our organization’s BONDS

$100,00014% 4-Yr.6/30, 12/31

C.V. = BP - Discount on BP C.V. = BP + Premium on BP

_PAR_ DISCOUNT PREMIUMStated Rate = 14% SR = 14% SR = 14%Effective Rate = 14% ER = 16 % ER = 10%

Issue Cash 100,000 Cash 94,253 Cash 112,926Date BP 100,000 *Disc. on BP 5,747 BP 100,0001/1/91 BP 100,000 * Prem on BP 12,926_____________________________________________________________________________

EFFECTIVE INTEREST METHOD

Interest Payment 6/30/91 Int. Exp. 7000 Int. Exp. 7540 Int. Exp. 5646

Cash 7000 Cash 7000 *Prem on BP 1354* Disc. on BP 540 Cash 7000

Interest Payment 12/31/91 Int. Exp. 7000 Int. Exp. 7584 Int. Exp. 5579

Cash 7000 Cash 7000 *Prem. on BP 1421 * Disc. on BP 584 Cash 7000

Interest Exp. Is a CONSTANT RATE

Assume Fiscal Year Ends 4/30: The issue date is 1/1/91 and entries are above.

AJE 94,253x16%x4/12 112,926x10%x4/124/30/91Int. Exp. 4667 Int. Exp. 5027 Int. Exp. 3764

Int. Pay 4667 *Disc. on BP 360 *Prem on BP 903 Int. Pay 4667 Int. Pay 4667

Interest Payment 94,253x16%x2/12 112,926x10%x2/12 6/30/91 Int. Exp. 2333 Int. Exp. 2513 Int. Exp. 1882Int. Pay 4667 Int. Pay 4667 Int. Pay 4667

Cash 7000 Cash 7000 *Prem on BP 451*Disc. on BP 180 Cash 7000

* = Balancing Figure (so that debits equal credits)

acg3111z.DOC 17

STRAIGHT-LINE METHODUsing Same Bond Data as on Prior Page

_PAR_ DISCOUNT PREMIUM

Issue Date Cash 100,000 Cash 94,253 Cash 112,9261/1/91 BP 100,000 *Disc. on BP 5,747 BP 100,000

BP 100,000 *Prem on BP 12,926

6/30/91 Int. Exp. 7000 *Int. Exp. 7718 *Int. Exp. 5384Cash 7000 Cash 7000 Prem on BP 1616

Disc. on BP 718 Cash 7000

12/31/91 Int. Exp. 7000 *Int. Exp. 7718 *Int. Exp. 5384Cash 7000 Cash 7000 Prem on BP 1616

Disc. on BP 718 Cash 7000

INTEREST EXPENSE (CONSTANT DOLLAR AMOUNT)

Assume Fiscal Year Ends 4/30: The issue date is 1/1/91 and entries are above.

AJE4/30/91 Int. Exp. 4667 Int. Exp. 5147 *Int. Exp. 3591

Int. Pay 4667 Int. Pay 4667 Prem. on BP 1076Disc. on BP 480 Int. Pay 4667

(120x4) (269x4)Interest Payment

6/30/91 Int. Exp 2333 *Int. Exp. 2573 *Int. Exp. 1795Int. Pay 4667 Int. Pay 4667 Int. Pay 4667

cash 7000 Cash 7000 Prem. on BP 538 Disc. on BP 240 Cash 7000

(120x2)

Case A Case B Case CIssued Bond at: 100 94¼ 113

Issue Date 1/1/91 Cash 100,000 Cash 94,250 Cash 113,000

BP 100,000 Disc. on BP 5,750 BP 100,000BP 100,000 Prem on BP 13,000

* Balancing Figure (so that debits equal credits)

acg3111z.DOC 18

Issuance of Bonds on March 1, 1991Between Interest Payment Dates

PAR DISCOUNT PREMIUM

+2,333 +2,3333/1 Cash 102,333 3/1 Cash 94,253 3/1 Cash 112,926Issuance BP 100,000 Disc. on BP 5,747 BP 100,000

Int. Pay 2,333 BP 100,000 Prem on BP 12,926 Int. Pay 2,333 Int. Pay 2,333

4 mos. PxSRxT

6/30 Int. Exp. 4667 6/30 Int. Exp. 5027 Int. Exp. 3764Cash Int. Pay 2333 Int. Pay 2333 always Int. Pay 2333Payment Cash 7000 Cash 7000 6-mo. checks*Prem on BP 903Date *Disc. on BP 360 Cash 7000

Effective-Interest Method used above

Redeeming Bonds Payable

Situation: Redeem original bonds on 1/1/92 for 99 Assume straight-line amortization of interest

PAR DISCOUNT PREMIUM

1/1/92 1/1/92 1/1/92BP 100,000 BP 100,000 BP 100,000 Cash 99,000 Disc. on BP 4,311 Prem on BP 9,694 E/O Gain 1,000 Cash 99,000 Cash 99,000

E/O Loss 3,311 E/O Gain 10,694

Disc. on BP _ ___ Premium on BP5747 12,926

718 1616718 1616

Bal. 4311 9,694 Bal.

Steps 1. Accrue int. exp. to date of redemption 2. Calculate C.V.

3. Difference between CV and cash is the GAIN or LOSS (extraordinary)

acg3111z.DOC 19

Chapter 14Page 675 + in K & W Textbook

BONDS ISSUED AT PAR10-year, 10% $800,000 with effective rate of 10%, semi-annual interest

Pays interest 1/1 and 7/1(Assume calendar year is the fiscal year)

Issue Date Cash 800,0001/1/95 BP 800,000

7/1/95 Interest Exp. 40,000 CV x ER x T = 800,000 x 10% x ½Interest Cash 40,000 P x SR x T = 800,000 x 10% x ½Payment

12/31/95 Int. Exp. 40,000 CV x ER x T = 800,000 x 10% x ½AJE Int. Pay 40,000 P x SR x T = 800,000 x 10% x ½

(same as cash formula)

1/1/96 Int. Pay 40,000Interest Cash 40,000Payment

................Time Goes By 1/1/96 to 12/31/04

12/31/04 Int. Exp. 40,000Int. Pay 40,000

At Maturity1/1/05 Int. Pay. 40,000 last interest payment

Cash 40,000

BP 800,000 pay off the principal (face value) Cash 800,000

BONDS ISSUED At PAR (Face Value)on interest date (no discount; no premium)

STATED RATE = EFFECTIVE RATE

CV = Carrying Value = Book Value = BP - Discount on BP = BP + Premium on BPAJE = Adjusting Journal Entry

acg3111z.DOC 20

BONDS ISSUED AT A DISCOUNT on interest date10%, $800,000, 10-yr., interest on 1/1, price is 97

Issued 1/1/95 Cash 776,000 (97% x 800,000 par)

* Disc. on BP 24,000 Calendar Year = Fiscal YearBP 800,000 (par)

12/31/95 *Int. Exp. 82,400 (NNTB)AJE Disc. on BP 2,400 STRAIGHT-LINE AMORTIZATION

Int. Pay 80,000 Total P x SR x T (24,000 10 years = 2,400/yr.)

800,000 x 10% x 1 = 80,000 how often you

plan to record an entry

Interest Payment1/1/96 Int. Pay 80,000

Cash 80,000 _ __Discount on BP_ ___ _ _ _BP_ _1/1/95 24,000

800,000 00_____________2,400 12/31/95 1/1/95

12/31/96 *Int. Exp. 82,400 12/31/95 21,600Disc. on BP 2,400Int. Pay 80,000 ______________2,400 12/31/95

12/31/96 19,200

etc.

CV = BP - Disc. on BP12/31/96 CV = 800,000 - 19,200 = 78,800Hint: To find CV on any particular date, look in

the above two general ledger accounts.

At Maturity1/1/05 Int. Pay 80,000

Cash 80,000BP 800,000

Cash 800,000

* = Plug Figure = NNTB = Number Needed to BalanceAJE = Adjusting Journal Entry

acg3111z.DOC 21

+ in K & W Textbook

BONDS ISSUED AT A PREMIUM on interest date10%, $800,000, 10-year, interest on 1/1, price is 103

Issued1/1/95 Cash 824,000 (103% x 800,000 par)

BP 800,000 (par) Calendar Year = Fiscal Year*Prem on BP 24,000

12/31/95 *Int. Exp. 77,600 STRAIGHT-LINE AMORTIZATIONAJE Prem on BP 2,400 (24,000 10 years = 2,400/yr.)

Int. Pay 80,000 (800,000 x 10% x 1 = 80,000)

1/196 Int. Pay 80,000 ______Prem. on BP_____ _____BP_____Interest Cash 80,000 24,000 1/1/95 800,000

Payment 1/1/95

12/31/95 _2,400_________________etc. 21,600 12/31/95

12/31/96 2,400etc.

1/1/05 Int. Pay 80,000At Maturity Cash 80,000

BP 800,000 CV = BP + Premium on BPCash 800,000

* = Plug Figure = NNTB

acg3111z.DOC 22

in K & W Textbook

Bonds Issued At Par BETWEEN INTEREST DATES

10%, 10-year $800,000 issued at 100 on 3/1/95, pays interest 1/1 and 7/1stated rate

But the co. had intended to issue them on 1/1/95.

1/1/95 Planned Issue Date

2 mos.

3/1/95 Cash 813,333 (800,000 + 2 months of cash interest,sinceActual BP 800,000 4 months later, we send a 6-month interestIssue Date Int. Exp. 13,333 payment to whomever is holding (owns) the

bonds on that date).or Int. Pay P x SR x T

4 mos. 800,000 x 10% x 2/12

7/1/95 Int. Exp. 40,000Interest Cash 40,000 P x SR x TPayment 800,000 x 10% x ½(6 months ofinterest in CASH) OR

Int. Pay 13,333 No matter which entry you choose to do,Int. Exp. 26,667 the income statement should have 4 months

Cash 40,000 of interest expense$26,667 as of 7/1/95

12/31/95 Int. Exp. 40,000AJE Int. Pay 40,000

1/1/96 Int. Pay 40,000Interest Cash 40,000Payment

etc.

acg3111z.DOC 23

Textbook K & W

Bonds Issued At A Premium BETWEEN INTEREST DATES

10%, 10-year $800,000 issued at 102 on 3/1/95, pays interest 1/1 (annually)

Planned Issue Date1/1/95

2 mos.

Actual Issue Date3/1/95 Step 1: Ignore the Accrued Interest STRAIGHT-LINE

AMORTIZATIONCash 816,000

BP 800,000 CV Life of Bond Prem. on BP 16,000 9 yrs. 10 mos. = 118

mos.

16,000 118 mos. = $136/ mo. of amortized Interest

10 mos. Step 2: Calculate the Accrued InterestCash 13,333 (PxSRxT = 800,000 x 10% x 2/12

Int. Pay 13,333

AJE Interest 12/31/95 *Int. Exp. 65,307

Prem. on BP 1,360 ($136/mo. x 10 mos.)Int. Pay 66,667 (P x SR x T = 800,000 x 10% x

10/12)

Pay Interest1/1/96 Int. Pay 80,000

Cash 80,000

* NNTB

acg3111z.DOC 24

Caution to Accountants:Bonus System and Profit Sharing Plans Incentive to work

hard and help the co. make money

good for the stockholders

who own the co.

HOWEVER, Incentive to manipulate net income accountants and auditors BEWAREmanagement’s “request” to understand expenses and overstate income!

CONTINGENT LIABILITIES: “Maybe” LIABILITIES

Gain Contingencies never recorded (accrued)rarely disclosed

Loss Contingencies can be:1) Remote Rarely disclose

Disclosure

2) Reasonably Possible put in the footnotes

3) Probable if reasonably estimated, do accrual entry if not reasonably estimated, put in footnotes

Example:

Warranties when a SELLER promises to remove deficiencies in the quantity, quality, or performance of a product sold to a BUYER.

prepare an AJE yearly to match estimated warranty expenses to the revenue earned that year

AJE Warranty ExpenseContingent Warranty Payable/Liability

acg3111z.DOC 25

ACG 3111-- Chapters 14,15,&16Notes, Bonds, and Stock

Market Quotations

STOCKS

52 Weeks Yld Vol NetHi Lo Stock Sym Div % PE 100’s Hi Lo Close Chg

32 7/8 24 3/4 FordMotor F 1.24 3.9 6 16460 32 31 3/4 32 ----

107 1/2 80 3/4 FordMotor pf F 4.20 4.0 --- 296 104 3/8 103 5/8 103 7/8 -1/8

48 33 5/8 Rockwell ROK 1.08 2.3 14 3865 46 3/8 45 5/8 46 1/4 +1/2

BONDS

Cur NetBonds Yld Vol Close Chg

IBM 8 3/8 19 7.4 5 112 7/8 -1/8

BellsoT 8 1/4 32 7.6 25 108 7/8 +1 7/8

acg3111z.DOC 26

Proprietorships and Partnerships

Three Major Types of Business Enterprises:

1. Individual Proprietorship (1 owner) 2. Partnership (2 or more owners) NOT separate legal entities3. Corporation (1 or more owners)

separate legal entity

Partnerships

Usually draw up a Partnership Agreement, although NOT required by law

In a lawsuit, the partners are sued, not the partnership; this stems from UNLIMITED LIABILITY partners are jointly and severally liable a partner’s personal assets are at risk! Liability is not limited to the original investment in the partnership.

No income taxes for the partnership itself; each partner’s share of NI is taxable on his/her personal tax return, even if NO cash is withdrawn.

Partnership interests are not easily transferable like shares of stock.

The return comes in the form of cash withdrawals, which are usually restricted.

The salary to partners is not sal. exp. to the enterprise; it is part of the Income Sharing Agreement.

acg3111z.DOC 27

CORPORATION SINGLE PROPRIETORSHIP PARTNERSHIP

Startup: Cash Cash CashC. Stk FMV =>Land FMV=> LandPIC... etc. FMV =>Equipment

etc.Z, Capital Z, Capital

T, Capital______________ DailyOperations: Same Same Same_______________________

Money to Owners: Dividends/RE Z, Drawing Z, Drawing or Z, CapitalCash Cash T, Drawing or T, Capital

Cash Cash________

Closing books Inc. Sum. Inc. Sum. Inc. Sum.at year end: RE. Z, Capital Z, Cap.

T, Cap.

RE Z, Capital Z, CapitalDiv. Z, Drawing T, Capital

Z, Drawing Entry if drawing T, Drawing _ account is used

Balance Sheet Balance Sheet Balance Sheet_A_ _L_ _A_ _L_ _A_ _L_

Stockholders’ Equity Owner’s Equity Partners’ EquityC. Stock Z, Capital T, CapitalPIC...... Z, CapitalRE

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STOCKHOLDERS’ EQUITY: CONTRIBUTED CAPITALACG 3111--CHAPTER 15

Introduction

Equity means “a claim to something.” Stockholders’ equity represents the claim that the stockholders have to the assets. Creditors’ equity (liabilities) represents the claim that the creditors have to the assets.

A comprehensive study of financial instruments is underway. Part of the study is an attempt to distinguish between liability AND equity instruments.

INCOME includes changes in stockholders’ equity (hereafter equity) during a period, but it excludes changes in equity arising from transactions with owners of the enterprise.

LIABILITY: an obligation to sacrifice future economic benefits (due dates for principal and interest are part of liabilities)EQUITY: NO obligation to sacrifice future economic benefits (equity is the residual claim of the owners to a portion of the assets of the company, after all creditors and other lawful parties receive their money)

THE NATURE OF STOCKHOLDERS’ EQUITY

Stockholders’ equity = assets minus liabilities = net assets = net worth = owners’ equity = partners’ equity = book value of the company = capital

Sources of Equity

Paid-in Capital = Contributed Capital = Common Stock and Paid-in Capital (PIC) in Excess of Par--Common OR Preferred Stock and PIC in Excess of

Par--Preferred, plus miscellaneous PIC accountsEarned Capital = Retained Earnings (The accumulated earnings/losses less the dividends,

since the company’s inception)

Changes in Equity that AFFECT assets and liabilities: Net income/loss and transfers between entity and owners.

Changes in Equity that DO NOT AFFECT assets and liabilities: stock splits, stock dividends, conversion of preferred stock into common stock.

What is Capital?

Beware of the different meanings of the word “capital.”Accountants refer to CAPITAL when they speak about stockholders’ equity.

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THE CORPORATE FORM OF ENTITY

The dominant form of business is the corporation. It is a separate legal entity, apart from its owners. A CORPORATION can enter into contracts, it can get married (merge), it can get divorced (divest), it can have babies (subsidiaries), it can be sued, etc.

Following are special CORPORATION characteristics that affect ACCOUNTING.

1. State Corporate Law. To incorporate, one must obtain approval from the state in which one wants the company to be incorporated. Must submit ARTICLES OF INCORPORATION in order to receive a CORPORATE CHARTER. State laws prescribe the requirements for issuing stock, and other related matters.

2. Capital Stock or Share System. A company can have different classes of stock. Each share of stock in a specific class is equal. Each share of stock has rights and privileges unless restricted legally. Rights include: share in profits and losses, right to vote for directors, receive corporate assets upon liquidation (if there are any left), and share proportionately in new issues of stock (preemptive right). The last right prevents dilution of one’s percentage share of ownership, but this right is usually waived in larger corporations, for ease of processing new stock issues.

3. Variety of Ownership Interests. COMMON STOCK is the basic ownership interest. Upon liquidation, it receives assets last (if there are any remaining). There can be different classes of common stock, with different voting rights. Usually, each common share receives one vote at stockholders’ meetings.

PREFERRED STOCK is a special class of ownership. Its owners have preference to receive assets upon liquidation (before the common shareholders). Its owners also have preference to receive dividends before the common shareholders.

4. Limited Liability of Stockholders. Owners of stock cannot lose more than the money or services that they originally put into the company. If the corporation finds itself in financial trouble, the owners’ personal assets are not placed in jeopardy.

5. Formality of Profit Distribution. Distributions of funds to owners must be IN COMPLIANCE WITH THE STATE LAWS governing corporations. Usually, DIVIDENDS MUST COME FROM RETAINED EARNINGS OR FROM CURRENT EARNINGS. Dividends must be FORMALLY APPROVED BY THE BOARD OF DIRECTORS (BOD).

NOTE: The accountant of the corporation must be familiar with the state law governing corporations. It is advisable that the accountant and corporate attorney and management work together to ensure that the law is obeyed and that the accounting records are maintained properly.

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ACCOUNTING FOR THE ISSUANCE OF STOCK

PAR VALUE STOCK = legal capital = the minimal amount of money for which the stock can be sold, per the corporate charter = the amount of money that goes into the common stock account = number of shares issued multiplied by the par value. EXCESS FUNDS (beyond the par value) RECEIVED UPON ISSUANCE OF STOCK = Pain-in Capital in Excess of Par = Contributed Capital in Excess of Par = Premium on Common Stock. Usually, states do not allow the corporation to delve into the par value to pay bills, dividends, etc. Par value is a type of buffer for the creditors. If par value cannot be touched, then an equal amount of assets cannot be touched.

TERMS TO KNOW:Authorized shares = the maximum amount of shares that a corporation can issue, without going back to the department of regulation for authorization of additional shares.Issued shares = the number of shares that have been issued by the corporation and have not been canceled by the corporation.Outstanding shares = the number of shares that are currently out in people’s hands (or some entity’s “hands”)Treasury shares = the result of the following three events:

1) The shares are originally issued2) The corporation buys back the shares3) The corporation does NOT cancel/retire the shares, but holds them “in its treasury”

with the intent to reissue them in the future.Unissued shares = number of shares authorized but not yet sold.

Outstanding shares (o/s) = issued shares minus treasury shares. THIS NUMBER IS IMPORTANT FOR SEVERAL ACCOUNTING TRANSACTIONS.

NO-PAR STOCK = stock that does not have a legal minimal amount for which it must be issued. No need for the PIC in excess of par account. Just place total dollar amount of cash proceeds into the common stock account. Sometimes, a state requires or permits the corporation to place on the stock a STATED VALUE (similar to par). The excess money received at issuance is recorded in the PIC IN EXCESS OF STATED VALUE account.

STOCK SOLD ON A SUBSCRIPTION BASIS

This occurs when people agree to buy your stock, but they don’t have all of the money up front. They want to make payments. Just wait until you receive all of the payments before you issue the stock. There is a RECEIVABLE on the books for the amount of cash owed to us and there are credits to two stockholders’ equity accounts (COMMON STOCK SUBSCRIBED and PIC IN EXCESS OF PAR). Usually, companies place the RECEIVABLE as a contra-equity account, thereby reducing the stockholders’ equity (SE).

LUMP SUM SALES (not required for this class)

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STOCK ISSUED IN NONCASH TRANSACTIONS

The accounting issue is: WHAT AMOUNT OF MONEY DO WE USE TO VALUE THE TRANSACTION when stock is issued but cash is not received; rather, services or property are received? Generally, use the fair value of the property or services given to us OR the fair value of the stock issued, whichever is more readily determined. It is preferable to use the FAIR VALUE of what OUR company is giving, if both fair values are known. If no value can be determined, the BOD sets a value on the transaction.

ASSESSMENTS ON STOCK

Usually this additional money received from existing stockholders is debited to CASH and credited to PIC ARISING FROM ASSESSMENTS.

COSTS OF ISSUING STOCK

Two different accounting treatments are available for issue costs:1.Debit PIC in EXCESS of PAR

Credit CASH2.Debit ORGANIZATION COSTS (intangible asset)--amortize (expense) over 40 years

or lessCredit CASH

REACQUISITION OF SHARES

A reacquisition of our own company’s shares can result in retirement of the shares or in holding of the shares, called TREASURY SHARES/STOCK. Recall the three events that have to occur for treasury stock to be recorded: stock must have been previously issued, stock is purchased back by the company itself, and the company is holding it with the intent to reissue it in the future.

Reasons for Purchasing Treasury Stock:a) To meet employee stock compensation contracts or meet potential merger needs for many shares of stock.b) To increase EPS by reducing the shares outstanding. EPS = (NI minus Preferred Dividends)/Weighted Average No. Of Common Shares o/s.c) To thwart takeover attempts or to reduce the number of stockholders.d) To make a market in the stock (reduction of shares outstanding can cause the stock price to rise).e) To use for business operations, e.g., for deals with purchase contracts.

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METHODS OF ACCOUNTING FOR TREASURY STOCK

For accounting purposes, either the cost method or the par method may be used. Most companies appear to use the cost method, per a review of balance sheet location of the treasury stock. If the treasury stock is listed below the retained earnings, then the company is using the cost method.

No matter which method is used, most states consider treasury stock to be a restriction of retained earnings. The accountant either should record an Appropriation of RE for Treasury Stock or should ensure that footnote disclosure is made regarding the restriction of RE.

COST Method of accounting for treasury stock (you may ignore PAR method for this class). TIP #1: Always remember that the cost/treasury share get debited to the Treasury Stock account at the date of purchase AND any subsequent credit to Treasury Stock account is valued at the SAME cost/treasury share that was originally debited into the account. TIP #2: Note that NO GAIN or LOSS is ever recorded for transactions with one’s own stock, if initiated by the company itself.

1. Company buys back some common shares.DEBIT Treasury Stock (No. of shares x cost/treasury share)

CREDIT Cash===========================================================2. Company reissues some of the shares at a higher price than the original cost.

DEBIT CashCREDITS Treasury Stock (No. of shares sold x cost/treasury share)

PIC from Treasury Stock (the “gain” on reissue)

3. Company reissues some of the shares at a lower price per share than original cost.DEBITS Cash

PIC from Treasury Stock (use this account first, if it has a balance)

*Retained Earnings (use this account second, if needed; plug figure)CREDIT Treasury Stock (No. of shares sold x cost/treasury share)

*This account holds the “loss” on the reissue.==============================================================4. Retirement of treasury shares which cost a lower price per share than the original issue

price per shareDEBITS Common Stock (par value x number of shares retired)

PIC in excess of par (excess value originally received x number ofshares retired)

CREDITS Treasury Stock (No. of shares sold x cost/treasury share)PIC from retirement (plug figure for the “gain”)

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5. Retirement of treasury shares which cost a higher price per share than the original issueprice per share

DEBITS Common Stock (same as #4)PIC in excess of par (same as #4)Retained earnings (plug figure for the “loss”)

` CREDIT Treasury Stock (No. of shares sold x cost/treasury share)

===============================================================CHARACTERISTICS OF PREFERRED STOCK

Definition: Preferred stock is a special class of stock that has certain preferences or features not possessed by common stock.

Examples of preferences/features:

1. PREFERENCE AS TO DIVIDENDS--If the Board of Directors declares cash dividends, then the preferred shareholders receive their specified dividend first...before the common shareholders...even if that leaves nothing for the common shareholders.

2. PREFERENCE AS TO ASSETS IN EVENT OF LIQUIDATION--Upon liquidation of the corporation, IF there are any assets remaining after all of the creditors are paid, then the preferred shareholders receive their specified “liquidation value” or “call value” first...before the common shareholders receive any assets. The common shareholders are truly the residual owners of the corporation.

3. CONVERTIBLE INTO COMMON STOCK--Preferred shareholders may turn in their preferred shares and receive a specified amount of common shares. This event would perhaps occur when the company’s common shares are growing rapidly in value and there are many stock splits, et cetera, that are advantageous for common shareholders. The preferred shareholders hope to start reaping the “larger” returns of the company when they become common shareholders.

4. CALLABLE AT THE OPTION OF THE CORPORATION--The corporation has the right to “call in” these shares at some future dates and at stipulated prices. This is a nice feature for the corporation, not the preferred shareholder.

5. NONVOTING--Usually the preferred shareholders do not participate in the management of the corporation through voting. They are more like creditors.

6. PARTICIPATING--Preferred shares that are participating shares have the right to share in dividend distributions beyond what their stock certificate specifies as the yearly cash dividend, IF the Board of Directors declares a large enough amount of dividends. Shares may be fully participating or partially participating.

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7. REDEEMABLE--Preferred shares that are redeemable for cash by the holder of the shares, and the corporation has no control over such actions. Nonredeemable stock is redeemable solely by the option of the issuing corporation.

QUESTION? Why would people buy preferred stock? For the larger dividend yield and the relative certainty of dividend receipt.Why would corporations buy preferred stock? To receive the tax advantage of preferred dividends rather than paying the full corporate tax rate, which they have to pay on interest revenue.

Debt Characteristics of Preferred Stock

If preferred stock is nonvoting, has a fixed return, and is redeemable by the shareholder, THEN THE STOCK IS MORE LIKE DEBT THAN EQUITY.

At present, GAAP does not specify the placement of preferred types of stock on the balance sheet. BUT FASB #47 does require note disclosure of any redemption features of a preferred stock issue, plus a list of redemptions over the next 5 years.

The SEC (Securities and Exchange Commission) prohibits commingling of preferred stock with common stock. If preferred stock is redeemable, then a separate category must be used on the balance sheet AND MUST BE OUTSIDE OF THE STOCKHOLDERS’ EQUITY. Companies place redeemable stock either in the TOTAL LIABILITIES or in a separate section BETWEEN LIABILITIES AND STOCKHOLDERS’ EQUITY.

A new type of preferred stock (auction-rate, remarketed, or adjustable-rate) is designed to allow corporations to sell equity to buyers who want short-term debt features. The preferred dividends receive a reduced tax rate for the corporate buyers of such preferred stock. And, the principal price does not fluctuate because the dividend rate is re-set regularly.

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ADDITIONAL PAID IN CAPITAL

Additional capital is the amount above par or stated value that is related to either the common stock or the preferred stock. There are several kinds of situations that cause entries in theAdditional Paid-in Capital accounts.

Events that cause CREDITS in the Additional Paid-in Capital account:--premiums on common stock issued--sale of treasury stock above cost (at a “gain”)--additional capital arising from a quasi-reorganization--additional assessments on stockholders--conversion of convertible bonds or convertible preferred stock--declaration of a “small” (ordinary) stock dividend

Events that cause DEBITS in the Additional Paid-in Capital account:--discounts on capital stock issued (this should be very rare)--sale of treasury stock below cost (at a “loss)--absorption of a deficit in a quasi-reorganization--declaration of a liquidating dividend--retirement of stock that originally was issued above par value

NO operating gains or losses are entered into the Additional PIC accounts.

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ADDITIONAL EQUITY TERMS

Donated Capital AND Revaluation Capital

DONATED Capital occurs when stockholders, creditors, or outsiders donate assets or servicesto the corporation, in circumstances where the donator receives some advantage. Otherwise, the donation should be recorded in a revenue account.

REVALUATION Capital occurs when there is an original writedown of assets fromcost; subsequent write-ups to cost are possible.

Contra Equity Items 1. Treasury Stock is a contra equity account.2. Foreign currency translation adjustments are equity OR contra equity occurrences.3. An excess of additional pension liability over unrecognized prior service cost is a contra equity account.

BASIC RECORDS RELATED TO STOCKA stock certificate book and a stock transfer book are part of the corporate records.Many corporations hire a REGISTRAR and TRANSFER AGENT to handle stocktransactions.

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STOCKHOLDERS’ EQUITYExample Company(In-Class Activity)

1996 JOURNAL ENTRIES

1. Send articles of incorporation to the Department of State in thestate in which we want to incorporate.

2. Receive our corporate charter; common shares have $1 parvalue and 100,000 shares are authorized, preferred shares have $5 par value, 8% cumulative, convertible, and fullyparticipating with 50,000 shares authorized.

3. Sell common shares for cash of $1.50 each. Able to sell 30,000 shares to ourselves.

4. Our attorney accepts 300 shares of our common stock for her fees related to helping us to start our business.

5. Purchase supplies, furniture, and other necessities. Lease someoffice space (operating lease!!). Pay deposits for utilities. Incurmiscellaneous expenses.

6. Obtain our first consulting assignment. Start the job.

7. Need more funds, so go to bank. Unable to obtain too muchfinancing at this early stage.

8. Ask our family and friends to buy some stock at $2 per share.Sell 1,000 shares for cash and get subscription contracts for an additional 5,000 shares. A down payment plus Two installment payments are eventually received. Then we issue the shares.

9. Obtain computer by bargaining with our old UCF friend at hiscomputer store. We receive a computer worth $2,500 and hereceives 2,000 shares of our stock.

10. We forgot to record the $400 of issue costs that were incurred in the issuance of the shares.

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JOURNAL ENTRIES11. We make more money by completing more consulting jobs.We also incur more bills, such as payroll.

12. Cash is still low, so we decide to assess all stockholders with a$1 per share assessment.

13. No dividends are declared since net cash flow inflows are notgreat.

14. Reacquire 20% of the common shares for $3 per share. (Wewant to increase our EPS at the end of the year). We use theCOST METHOD for treasury stock transactions. We anticipatereissuing the shares at a later time.

15. Retire 40% of the treasury shares because we do not plan toreissue them.

16. Compute income before tax and income tax expense in orderto obtain the net income for our first year. Assume that theincome before tax is $35,000 and the corporate tax rate is 40%.Calculate the EPS (earnings per share). Prepare the financial statements (in the real world).

17. IF the Board of Directors (BOD) declared a $10,000 dividend,how much would each share receive?

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(Years pass by)

1999 JOURNAL ENTRIES

1. Issue preferred stock for cash; obtain a price of $12 per shareand sold 15,000 shares. Note that our company has been doing abooming business.

2. Corporation makes much more revenue and incurs much moreexpenses.

3. Finally decide to declare cash dividends of 4 cents per share forthe common, while the preferred receive their designateddividend. Prepare the entries for the DECLARATION DATE and for the PAYMENT DATE.

4. Our corporation owns some General Motors commons shareswhich do not appear to be earning much money for us. The Board of Directors decides to give these shares to the common shareholders in the form of a property dividend. The cost of theshares was $150,000 and they are worth $130,000 on the date ofdeclaration. Prepare the entries for the DECLARATION DATE andfor the DISTRIBUTION DATE.

5. Later in the year, we do not have the cash flows for morecommon stock cash dividends, so we decide to issue scrip dividends, with principal and interest (12%) due in 90 days. The value of the scrip is $50,000. Prepare the entries for the DECLARATION DATE and the DISTRIBUTION DATE.

6. Our Board of Directors declares a small dividend to the commonshareholders later in the year, but this dividend of $10,000 is a return of capital, not a return of profit. Prepare entries for the DECLARATION DATE and for the PAYMENT DATE.

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JOURNAL ENTRIES7. The BOD declares a 10% stock dividend. Prepare entries for the DECLARATION DATE and for the PAYMENT DATE. If theMarket/Selling Price is indeterminable, use the last transaction price$3/share.

8. The Board of Directors declares a four-for-one stock split.

9. Consulting revenue is increasing rapidly toward the end of theyear. The BOD declares a cash dividend of $80,000.

10. The board approves expansion, which will include theconstruction of our own office building. The estimated cost is$3,000,000. Prepare entries for an appropriationof RE and a sinking fund.

11. This year we self-insure for health care costs and incur losses of $60,000. We expect $100,000 of losses next year.

12. At the end of the year, pretend that the retained earningsaccount has a debit balance of $45,000. Do an entry for a deficit reclassification.

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STOCKHOLDERS’ EQUITY: RETAINED EARNINGSACG 3111--CHAPTER 16

Stockholders’ Equity CONTRIBUTED (OR PAID-IN) CAPITAL

Common StockCommon Stock SubscribedStock Dividends DistributablePIC in excess of par--commonPreferred StockPIC in excess of par--preferredPIC from treasury stockPIC from retirement of stockPIC from assessmentPIC from “other events”Donated Capital

EARNED CAPITALRetained Earnings

AppropriatedUnappropriated

(Treasury Stock)(Stock Subscriptions Receivable)Foreign Currency Translation AdjustmentsAdjustments for lower of cost or market===============================================================

Common increases (credits) and decreases (debits) to Retained EarningsDEBITS CREDITS

1. Net loss 1. Net income2. Prior period adjustments 2. Prior period adjustments3. Cash or scrip dividends 3. Adjustments due to quasi-reorganization4. Stock dividends5. Property dividends6. Some treasury stock transactions

NOTES: 1) Liquidating dividends do NOT affect retained earnings normally. The first account to debit is the PIC accounts, then the Common Stock account, and finally the retained earnings account. 2) Stock splits do NOT affect retained earnings; in fact, splits do not affect any account!

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DIVIDEND POLICY

Definition: Dividends, if cash or property, are a return of company assets directly to the existing owners for their own use.

The Board of Directors have the power to declare dividends, but they must ensure that, according to state law, the dividends are permissible. In addition, the dividends should be economically sound for the corporation.

For a CASH dividend, there must be sufficient cash and there must be an equal amount of retained earnings. Note that some states DO allow dividends to be taken out of the PIC in excess of par account.

ASIDE: A debit balance in the Retained Earnings account is called a deficit.

Types of Dividends

CASH DIVIDENDS (three important dates)1. Date of Declaration

RETAINED EARNINGS (RE) or Dividends DeclaredCASH DIVIDENDS PAYABLE

2. Date of RecordNo journal entry (just a memo entry with words)

3. Date of PaymentCASH DIVIDENDS PAYABLE

CASH

Note 1: If you use Dividends Declared, it is a temporary account. Therefore, you must remember to close it into the retained earnings account at the end of the year.

Note 2: Treasury shares do NOT receive cash dividends.

PROPERTY DIVIDENDS (dividends that are some asset other than cash)

1. Date of Declaration(update asset to its fair value and record gain or loss)either: ASSET or LOSS

GAIN ASSET

then: RETAINED EARNINGSPROPERTY DIVIDENDS PAYABLE (fair value of asset)

2. Date of Record (no entry)

3. Date of Distribution

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PROPERTY DIVIDENDS PAYABLEASSET (the name of the account)

SCRIP DIVIDENDS (When the BOD issued a scrip dividends, it is promising to pay cash in the future; therefore, it is similar to a note payable. INTEREST EXPENSE may be involved if the “note” pays interest. Be sure to record the interest into interest expense, not retained earnings.

1. Date of DeclarationRE

SCRIP DIVIDEND PAYABLE (NOTE PAYABLE TO OWNERS)


3. Date of PaymentSCRIP DIVIDEND PAYABLEINTEREST EXPENSE (if interest-bearing)

CASH

LIQUIDATING DIVIDENDS (Any dividend NOT based on earnings must be a reduction of corporate paid-in capital and is called a liquidating dividend).

1. Date of Declaration RE (return of profit)PIC IN EXCESS OF PAR (return of capital)

LIQUIDATING DIVIDENDS PAYABLE


3. Date of PaymentLIQUIDATING DIVIDENDS PAYABLE

CASH

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STOCK DIVIDENDS (Issuance of additional shares of stock to the existing stockholders)

For accounting purposes, a small stock dividend is considered to be additional shares of stock that are less than 20-25% of the outstanding shares. Since the fair value of the stock does NOT change significantly, the accountant values the transaction at fair value. A large stock dividend is MORE than 20-25% of the o/s shares. Since it is difficult to determine what will happen to the fair value (market price) of the stock because there are so many new shares issued, the accountant values the transaction at par value.

Accounting for Stock Dividends:SMALL LARGE

1. Date of Declaration RE (market price x no.) RE (par value x no.)

CS DIV DISTRIBUTABLE CS DIV DISTRIBUTABLEPIC IN EXCESS OF PAR


3. Date of DistributionCS DIV DISTRIBUTABLE CS DIV DISTRIBUTABLE

COMMON STOCK (CS) COMMON STOCK

Note: The Common Stock Dividends Distributable account is a stockholders’ equity account, not a liability. The corporation is giving equity, NOT an asset, liability, nor a service.

STOCK SPLIT (Additional shares of stock are given to the existing shareholders, but the retained earnings account if not touched. In fact, there is NO journal entry. The corporation must obtain approval from the State in order to change the par value and the number of shares authorized.) The Corporation decides to employ a stock split because it wants its market price per share to be less so that more people may be likely to buy shares.

Example: If there are 100,000 shares outstanding, with $10 par value, then there should be $1,000,000 in the Common Stock account.

AFTER a two-for-one stock split, there are 200,000 shares outstanding, with $5 par value AND there should be $1,000,000 in the Common Stock account.

NOTE: The accounting profession recommends that a large stock dividend (which has a huge impact on stock price, as does a stock split) be called a “split-up effected in the form of a dividend.”

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Effects of Dividend Preferences (See examples in textbook)

a) Cumulative Preferred Stock (If dividends are not declared by the BOD, then the preferred stock eventually gets its “dividends in arrears” at some future date when cash is available for dividends, per the BOD’s decision). All dividends in arrears are paid PRIOR to the common stock receiving any dividends. Note: The dividends in arrears is reported in the footnotes only. It is NOT a liability until the BOD declares the dividend.

b) Participating Preferred Stock (If the preferred stock is fully participating, then it receives its yearly dividend rate of the par value, then the common stock receives the same dividend rate of its own par value. If there is still money in the “bag of dividends declared, then both the preferred stock and the common stock receive proportionate amounts of the cash, based on their TOTAL PAR DOLLARS.

APPROPRIATIONS OF RETAINED EARNINGS

Definition: An appropriation of retained earnings is a restriction of a specified amount of the retained earnings such that the Board of Directors CANNOT use it for declaration of dividends.

Account Names: RETAINED EARNINGS (this is the Unappropriated amount) RETAINED EARNINGS APPROPRIATED

BOTH of the above accounts are retained earnings accounts and must be totaled in order to find the TOTAL RETAINED EARNINGS.

GAAP requires that the balance sheet specify that there is an appropriation. The details of the appropriation should be explained in the footnotes to the financial statements.

REASONS FOR AN APPROPRIATION OF RE:1. Legal restrictions, e.g., the amount of treasury stock2. Contractual restrictions, e.g., bond indentures3. Existence of possible or expected losses--this is an arbitrary appropriation4. Protection of working capital position--this is an arbitrary appropriation5. Plant expansion and funds are needed soon--this is arbitrary also.

BEWARE: An appropriation of RE is merely an accounting entry that moves money out of the Unappropriated RE into a special account called Appropriated RE. There is NO cash fund being set up with the foregoing entry. If your company wants a sinking fund, then you have to debit SINKING FUND FOR..... and credit CASH.

JOURNAL ENTRY to APPROPRIATE:RE

RE APPROPRIATED

JOURNAL ENTRY to remove the appropriation:

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RE APPROPRIATEDRE

Note to accountants: You do NOT need to do a journal entry. BUT you must remember to disclose the appropriation in the footnotes.

Disclosures for Self-Insurance

When companies decide to insure themselves for losses that are normally covered by an insurance policy, they are self-insuring.

GAAP allows the following:1. Record the losses as they occur.2. Appropriate RE and record losses as they occur.

GAAP does NOT allow the following:1. Accrue an expense or loss as time goes by. (This would enable the company to manipulate net income by manipulating accruals).

STATEMENT OF STOCKHOLDERS’ EQUITY

See the layout in the textbook and be able to read and gather data from such a statement.

TRENDS IN TERMINOLOGY

Do NOT use the following terms in relation to stockholders’ equity:--surplus--capital surplus--paid-in surplus--reserve (unless it refers to a RE appropriation, but try not to use it at all)

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QUASI-REORGANIZATIONS

Definition: When an corporation suffers enough losses to give itself a deficit (negative retained earnings balance), then a quasi-reorganization (a fresh start) may be effected so that the corporation can have some money in retained earnings and can begin giving dividends, when economically feasible.

Accounting Entries (TWO OPTIONS):1) DEFICIT RECLASSIFICATION (Eliminate deficit without restating assets and

liabilities)PAID-IN CAPITAL (various PIC)

RE

2) ACCOUNTING REORGANIZATION (Restate the assets to their fair value and the liabilities to their present value, with the difference being recorded in the RE account. Then, the PIC accounts are used to reduce the deficit RE to a zero balance.)

ASSETS (various) LIABILITIES (various) RE (plug figure may be a debit or a credit)

ASSETS (various) LIABILITIES (various)

COMMON STOCKPIC ACCOUNTSPIC ACCOUNTS

RENote: For ten years thereafter, the corporation must note in their financial statements that a reorganization occurred.

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Another View of Accounting for Company StockChapters 15 & 16

Stockholders’ Equity

A. Three forms of financing (obtaining funds):

1. NI RE2. Borrow (debt securities)3. Issue stock (equity securities)

Assets = Liabilities + Contributed Capital + Earned Capital Preferred Stock RE Common Stock Additional Paid-in Capital

Difference between debt and equity

Debt (Creditors)

Formal Legal Contract to pay back prin. + interest; specific provisions; creditor can sue if payments not made on time.

Creditors have no direct voice in the management of the company.

INTEREST goes on the Income Statement

Equity (Owners)

No maturity date or legal promise to pay dividends.

If company goes bankrupt, creditors are paid first owners have a residual interest.

Owners can exert influence over management through voting for the BOD

DIVIDENDS do not go on the Income Statement.

The Capital Provider’s Perspective

- owning equity is riskier usually; stock prices are more volatile; stock can produce higher returns

Management’s Perspective

- complex decision regarding the components of capital structure- debt limits a company

future cash payments assets may be collateralized credit rating may fall reduce ability to borrow in future may restrict dividends (usually does) must maintain certain ratio levels

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BUT debt has its good points interest is tax deductible does not dilute ownership interests lessens likelihood of a takeover

To avoid takeover, can also- buy back your own company stock (Treasury stock)- go private (no more public shares)

Accountant’s and Auditor’s Perspective

Debt on Balance Sheet with Liabilities Equity on Balance Sheet in St. Eq.

Debt transactions affect Inc. Stmt. *Equity transactions NEVER affect Inc. Stmt.~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

E15-11Cost Method Only

Purchase 5,000 shares1. T. Stk. 200,000 (5,000 sh x $40/sh)

Cash 200,000

Reissue 2,000 shares2. Cash 88,000 (2,000 x $44/sh)

T. Stk. 80,000 (2,000 x $40/sh)PIC from T.S. 8,000

Reissue 500 shares3. Cash 17,500 (500 x $35/sh)

T. Stk. 20,000 (500 x $40/sh)PIC from T.S. 2,500

Retire 2,500 shares4. C. Stk. 12,500 (2,500 x $5/sh)

PIC in excess 62,500 (2,500 x $25/sh)T.Stk 100,000 (2,500 x $4/sh)

NNTB 25,000 debit.PIC from T. Stk1 5,500 1. Use any remaining 2

RE 19,500 balance in PIC from T.S.2. Debit remaining amount to

R.E.

1 Or, use PIC from Retirement2 NNTB

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Economic Consequences affect credit rating

Financial Ratios company’s stock price\ debt covenants (future borrowing) dividend, etc.

Debt/Equity Ratio is managed carefully

The higher the equity value, the higher the credit rating, usually.

Companies may try to practice OFF-BALANCE SHEET FINANCING(try to obtain long-term financing without putting a liability on the Balance Sheet)

Hybrid Securities are part debt and party equity difficult to (classify) place on the Balance Sheet

Debt Covenant Restrictions (protect creditors)

Corporate Form of BusinessLegal entity, chartered by the state in which the company is incorporated

Main Advantage: LIMITED LIABILITY = A stockholder can only lose the amount paid for the stock.

Corporate Income Taxes: Max. Rate is approximately 34%.

/ Corp. Income Tax on profitsDOUBLE TAXATION +

\ Personal Income Tax on dividend revenue (which is given

from corporate after-tax profits)

Stock returns = Stock appreciation + Cash dividend

Types of Stock (authorized, issued, outstanding)

A. Common

B. Preferred (preferred as to assets and to dividends)1) Other Features: Cumulative Participating Convertible Callable

acg3111z.doc46

par value (no relation to market value)

. Stock Issuance stated value (limits dividend payout) no par

A. Issued for Cash

B. Subscriptions (temporary receivable will turn into CASH) or default occurs

C. Issued for Property or Services• Valued at fair value of: 1) property or service given or 2) stock issued, whichever is more evident.

D. Miscellaneous• Organization Costs (intangible asset• Other Paid In Capital Accounts (contributed capital)

1) PIC from Stock Dividends 2) PIC from Treasury Stock (additional PIC T/S) 3) PIC from Donations (donated capital) 4) PIC from Retirement of Stock 5) PIC from Conversion of Stock etc.

/ Dividend Strategy Dividends ─ (Distribution of earnings from R.E., usually)

/ Declaration DateA. Cash Div. ─ Record Date

\ Payment Date

B. Stock Div.stock split small use market valuein form large use par valueof dividend

C. Property Dividend (“dividends in kind”) use FMV of asset given on date of declaration recognize gain or loss

D. Liquidating Div. (when co. starts to close down) reduces PIC in Excess or C. Stk

E. Miscellaneous Stock Splits (NO Gen. Journal ENTRY)

just a memorandum entry about the new shares and the new par value

IV. Appropriations(Restricted Retained Earnings)

away from the BOD who declares dividends V. Treasury Stock

originally issuedRequired company buys it back

company holds it (does not retire it)

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VI. Statement of Stockholders’ Equity St. Eq. - Preferred Capital

BV of Common SharesVII. Book Value Per Common Share = # Sh. of C. Stk o/s

VIII. Prior Period Adjustments Discontinued Opns

IX. Bottom of Income Statement Extraordinary Items\ Cum. Effect of in Acctg. Prin.

NI - Preferred Div. X. EARNINGS PER SHARE (EPS) = # sh. of com. stk o/s

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

1 Or, use PIC from Retirement2 NNTB

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CHAPTER 17 -- DILUTIVE SECURITIES AND EARNINGS PER SHARE"DILUTIVE" SECURITY

Convertible Bonds

Convertible Preferred Stock

Warrants (a)

(b)

(c)

Options Incentive(Warrants)

Nonqualified

Issued Separately(to existing stockholders)

Nondetachable Warrants on Bonds

Detachable Warrants on Bonds

ISSUE DATE

Cash BP Premium

Cash Preferred Stock PIC in excess...Preferred

No Entry

Cash BP Premium

Cash BP Premium PIC--Stk Warrants

No Entry

Def. Compensation Exp. Stk. Options o/sCompens. Exp. Def. Compens. Exp.

EXERCISE DATE OR CONVERSION DATE

Book Value Method Market Value MethodBP BPPremium Prem C. Stk Loss PIC in excess C. Stk

PIC in excess or(Gain) Pref StkPIC....preferred C. Stk PIC....common(if a debit is needed, use RE) Cash C. Stk PIC in excess

BP Premium C. Stk PIC in excess

Exercise Warrants OnlyCashPIC—Stk Warrants Common Stock PIC in excess

Cash C. Stk PIC in excess

Stk Options o/sCash C. Stk PIC in excess

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RegularRights

SAR's*

*= Not a dilutive security

ISSUE DATE

No Entry

Compensation Exp. Liability under SAR Plan

EXERCISE DATE

Cash C. Stk PIC in excess

Liab. under SAR Plan Cash

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Potentially Dilutive Securities Affect Earnings Per ShareConvertible Bonds

Convertible Preferred Stock

Stock Options

Stock Warrants

Stock Rights

BASIC EPS = NI - Pref Dividends____

# of wt. average COMMON shares o/s

* Primary EPS: Includes effect of the dilutive securities that are PROBABLY going to become COMMON STOCK sooner or later

Fully-Diluted EPS: includes effect of all dilutive securities

= Soon will be BASIC EPS in the United States, in order to be consistent with other countries’ EPS.

WHY? Conservatism

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INVESTMENTS -- Chapter 18

Definition: Investments are sources of interest revenue or dividend revenue; investments are purchased with cash and near cash assets not being used in the current operations. The company (the investor) receives a return on the investment, commensurate with the risk of the investment.

Problems of ACCOUNTING FOR INVESTMENTS: 1) classification into current or noncurrent, 2) measurement at cost, amortized cost, or fair value and 3) disclosure of cost versus fair value reconciliation.

TEMPORARY AND LONG-TERM INVESTMENTS

TEMPORARY investments include:1) short-term paper (CD’s, treasury bills, and commercial paper)2) debt securities (government and corporate bonds)3) equity securities (preferred and common stock)

Criteria for investments to be Temporary (Current Assets):a) Readily marketableb) Intent of management to convert the investment into cash within one year or the operating cycle,

whichever is longer.

LONG-TERM investments are held for more than one year or the operating cycle, whichever is longer. They usually include debt securities, equity securities, and hybrid securities.

INVESTMENTS IN TEMPORARY DEBT SECURITIES

1) At acquisition, add accrued interest to the purchase price, along with commission:

INVESTMENT IN BONDS (commission is part of the cost)INTEREST REVENUE or INTEREST RECEIVABLE (e.g., 4 mos. accumulated)

CASH

2) Receipt of interest revenue (NO amortization of premium or discount is necessary with short-term investments):

CASH (6 mos.)INTEREST REVENUE (6 mos.)

3) At sale of debt securities, recognize gain or loss (REALIZED):CASH

INTEREST REVENUE (mos. since last accrual)INVESTMENT IN BONDS (original cost)GAIN ON SALE (plug figure)

NOTE: For financial reporting purposes, with a group of the same entity’s securities purchased at different prices, GAAP allows any of these COST FLOW ASSUMPTIONS for the sale entry:

a) FIFO b) Specificationc) Weighted average

3111x.doc 51

INVESTMENTS IN DEBT SECURITIES

Valuation and Reporting of DEBT Securities

Definition: Debt securities are bonds or preferred stock (mandatory redeemable OR redeemable by the holder of the bond).

AT REPORTING DATE, the INVESTMENTS IN DEBT SECURITIES are grouped into three separate portfolios for valuation and reporting:

1. held-to-maturity -- intent and ability to hold to maturity; valuation at amortized cost

2. trading -- intent to sell in the near term; valuation at fair value with changesreported in net income

3. available-for-sale -- all other debt securities; valuation at fair value with changesreported through equity (stockholders’ equity)

Held-to-Maturity Securities

1) Can only be DEBT securities because stock (equity securities) has no maturity.

Purchase Entry: HELD-TO-MATURITY SECURITIESCASH

2) The regular amortization of the securities does NOT increase the volatility of EARNINGS or CAPITAL (Stockholders’ Equity). Amortization of premium or discount is similar to premium or discount on bonds payable.

Receipt of Payment and Amortization of Discount: CASH

HELD-TO-MATURITY SECURITIESINTEREST REVENUE

Year-end adjusting entry: INTEREST RECEIVABLEHELD-TO-MATURITY SECURITIES

INTEREST REVENUE

Sale of Bonds: CASHINTEREST REVENUEHELD-TO-MATURITYGAIN ON SALE

3111x.doc 52

Available-for-Sale Securities

1) PURCHASED AT COST

Entry at Purchase: AVAILABLE-FOR-SALE SECURITIESCASH

2) ACCOUNTED for at amortized cost

Receipt of Interest and Amortization of Interest: CASH

AVAILABLE-FOR-SALE SECURITIESINTEREST REVENUE

3) REPORTED at FAIR VALUE, with the UNREALIZED HOLDING GAIN OR LOSS--EQUITY shown in the stockholders’ equity section of the balance sheet. Therefore, the changes in fair value do not affect the volatility of the net income until the securities are actually sold! This approach reduces the volatility of net income, but still reports the gain or loss that the company would have experienced if the security were sold at the balance sheet date.

Entry at reporting date to recognize devaluation of asset:UNREALIZED HOLDING GAIN OR LOSS--EQUITY (St. Equity)

SECURITIES FAIR VALUE ADJUSTMENT (Available-for-Sale)(the SFVA account is an Asset Valuation account)

OR, vice versa for a gain

Note: The unrealized holding gain or loss appears in the Balance Sheet. 4) AT SALE OF BOND INVESTMENTS (before maturity)

a) update the interest revenue through amortizationb) the difference between the cash proceeds and the new carrying value is a REALIZED GAIN or LOSS

that is reported on the Income Statement

Sale entry: CASHLOSS ON SALE OF SECURITIES

AVAILABLE-FOR-SALE SECURITIES

NOTE: When you prepare the above entry, do NOT worry about the previous adjustment for the bonds in relation to the Securities Fair Value Adjustment and the Unrealized Holding Gain or Loss--Equity.

However, at the end of the reporting period, you will analyze the available-for-sale securities and adjust the foregoing two accounts accordingly.

3111x.doc 53

Trading Securities

1) Frequent buying and selling in this portfolio2) Reported at FAIR VALUE and the UNREALIZED HOLDING GAINS AND LOSSES--INCOME are reported on the Income Statement. Therefore, the accountant adjusts the trading securities up or down to their fair values, each reporting period. Do NOT amortize discounts or premiums.

Gain Entry: SECURITIES FAIR VALUE ADJUSTMENT (TRADING) UNREALIZED HOLDING GAIN OR LOSS--INCOME

Loss Entry: UNREALIZED HOLDING GAIN OR LOSS--INCOMESECURITIES FAIR VALUE ADJUSTMENT (TRADING)

Note: UNREALIZED HOLDING GAIN OR LOSS--INCOME appears in “Other Revenues and Gains” on the income statement.

INVESTMENT IN STOCKS

Acquisition:Basically, include all costs in the asset called Available-for-Sale Securities or Trading Securities. NOTE: Stocks typically do not mature; therefore, there is no

Held-to-Maturity account needed for stock investments.

Effect of Ownership Interest:

1) Holdings of MORE than 50% of the voting common stock of another company = controlling interest. The “owned” company is called a subsidiary of the parent company (the owner). ACCOUNTING TREATMENT: Use the equity method and consolidate the financial statements of subsidiary with parent, such that both companies look like ONE company. (AA)1

2) Holdings BETWEEN 20% and 50% of the voting common stock of another company = significant influence over the other company. There is NO legal control. ACCOUNTING TREATMENT: Use the equity method and do NOT consolidate the financials. (AA)

3) Holdings LESS than 20% of the voting common stock of another company = no control. ACCOUNTING TREATMENT: Use the cost method. (Intermediate Accounting)

1 AA = Advanced Accounting topic3111x.doc 54

Cost Method

Acquisition of stock of another company:AVAILABLE-FOR-SALE SECURITIES or TRADING SECURITIES

CASH

Receipt of cash dividends:CASH

DIVIDEND REVENUE or INVESTMENT REVENUE

Sale of stock:CASH (sale proceeds)LOSS (plug figure if cash is less than original cost)

AVAILABLE-FOR-SALE SEC. or TRADING SEC. (original cost)GAIN (plug figure if cash is greater than original cost)

VALUATION AND REPORTING OF EQUITY SECURITIES

For stock investments accounted for under the COST METHOD, the accountant adjusts the asset to FAIR VALUE at the end of each reporting period.

NOTE: There are only two categories of portfolios for EQUITY securities since there is no maturity date on equity securities:

Trading Securities and Available-for-Sale

Refer to the same two categories under “Investment in Debt Securities”

The only difference is that the asset on the balance sheet is usually called “Investment in Stock”

End-of-period Valuation:For Available-for-Sale Securities (if a devaluation occurs)UNREALIZED HOLDING GAIN OR LOSS--EQUITY

SECURITIES FAIR VALUE ADJUSTMENT (AVAILABLE-FOR-SALE SEC.)

For Trading SecuritiesSECURITIES FAIR VALUE ADJUSTMENT (TRADING SEC.)

UNREALIZED HOLDING GAIN OR LOSS--INCOME

Note: The Unrealized account varies between the two types of securities.

3111x.doc 55

FINANCIAL STATEMENT PRESENTATION OF INVESTMENTSDEBT AND EQUITY

BALANCE SHEET ITEMS:

Current Assets:Held-to-maturity securities, at amortized cost (Note 2)Available-for-sale securities, at fair value (Note 2)Trading securities, at fair value (Note 2)

Long-term Assets:Held-to-maturity securities, at amortized cost (Note 2)Available-for-sale securities, at fair value (Note 2)

Liabilities:NO EFFECT

Stockholders’ Equity:Common StockPIC ....Retained earnings

Less: Unrealized holding loss on securities--Equity (Note 2)

TOTAL STOCKHOLDERS’ EQUITY

===========================================================

INCOME STATEMENT ITEMS:

Income from operations $$$$$$$

Realized Gains and Losses ON SALE OF SECURITIES rrrrrrrrrr

Unrealized Holding Gains and Losses -- Income uuuuuuu

Income from extraordinary items iiiiiiiiiiiii

NOTE 2 (schedule to reconcile cost to fair value appears in this footnote)

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Chapter 18 – Accounting for InvestmentsRelated Accounts

Trading Securities (TS) Type of Account

Trading Securities (i.e., Investments) AssetSecurities Fair Value Adjustment (TS) Asset Valuation

Unrealized Holding Gains or Losses – Income Gain orLoss

Gain on Sale or Loss on Sale Gain orLoss

Available-for-Sale Securities (AFS)

Available for Sale Securities (i.e., Investments) AssetSecurities Fair Value Adjustment (AFS) Asset Valuation

Unrealized Holding Gains or Losses – Equity St. Equity

Gain on Sale or Loss on Sale Gain orLoss

Held -To- Maturity Securities (HTM)

Held-To-Maturity Securities (i.e., Investments) Asset

*Securities Fair Value Adjustment (HTM) Asset Valuation

*Unrealized Holding Gains or Losses – Equity St. Equity

Gain on Sale or Loss on Sale Gain or Loss

Loss on Impairment Loss(pertains to all 3 security types)

* This arises only if there has been a TRANSFER to Held-To-Maturity Securities.

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3111x.doc 58

3111x.doc 59

Investments in BondsCommon Journal Entries

In-Class Activity

Transaction TradingSecurities

Available-for-Sale Securities

Held-to-Maturity Securities

1/1/97 Purchase$10,000 par10% stated rate 6/30,1/1 interestMature 12/31/01 (BONDS at Premium) (BONDS at Premium)) (BONDS at Discount))

Cost 110 Cost 110 Cost 956/30 Receive interest and amortize prem. Or disc.

12/31 a) AJE to Accrue Revenue

b) Fair Value Adjustment

Fair Value 102 Fair Value 102 Fair Value 97½(Next Year)3/31 Sale of 40% of the Securities 2

a) Accrue rev.& amort. Prem. Or Disc.

b) Record realized gain or loss

Sell at 100 Sell at 100 Sell at 110(OR)3/31 Sale of ALL Securities (100%)a) Similar to

above part ab) Record

realized gain or loss

2 On partial sales of securities, do not use the Sec. FVA or the Unreal. Holding G or L accounts.3111x.doc 60

TRANSFERS BETWEEN CATEGORIES

Basic rule: When a security is transferred from one category (portfolio) to another, the new investment is recorded at FAIR VALUE at the date of transfer. Therefore, a new “basis” may arise for the new category of securities.

General Guidelines on the Date of Transfer:

Step 1: Update the existing securities accounts to fair value. NOTE: The textbook examples within the chapter assume that this has already been done.Step 2: Make all existing securities accounts zero3 by transferring the moneys to the general ledger accounts of the new securities category. The following transfers assume that step one has been completed.

Transfer Accounting Treatment

FROM TRADING TO AVAIL. FOR SALE a) If Cost (70) is less than Fair Value (85)

AVAILABLE FOR SALE SECURITIES 85TRADING SECURITIES 70SEC. FV ADJUST--TRADING 15

b) If Cost (70) is more than Fair Value (67)AVAILABLE FOR SALE SECURITIES 67

TRADING SECURITIES 70SEC. FV ADJUST.--TRADING 3

FROM AVAIL. FOR SALETO TRADING a) If Cost (70) is less than Fair Value (85)

TRADING SECURITIES 85AVAILABLE FOR SALE SEC. 70SEC. FV. ADJUST.-- AVAIL. 15

UNREAL. HOLDING G or L -- EQUITY 15UNREAL. HOLDING G or L -- INCOME 15

(The $15 gain hits the income statement now.)

b) If Cost (70) is more than Fair Value (67)TRADING SECURITIES 67

AVAILABLE FOR SALE SEC. 70SEC. FV ADJUST--AVAILABLE 3

UNREAL. HOLD. G or L -- INCOME 3UNREAL. HOLD. G or L--EQUITY 3

(Note: The $3 loss hits the income statement now.)

3 There is an exception to this rule: For transfers FROM the Available for Sale category TO the Held to Maturity category, do not touch the Unrealized Holding Gain or Loss--Equity account.3111x.doc 61

FROM “HELD..MATURITY”TO “AVAILABLE..SALE” a) If Cost (70) is less than Fair Value (85)

AVAILABLE FOR SALE SEC. 70SEC. FV ADJUST--AVAILABLE 15

HELD TO MATURITY SEC. 70UNREAL.HOLD. G OR L--EQUITY 15

b) If Cost (70) is more than Fair Value (67)AVAILABLE FOR SALE SEC. 70

SEC. FV. ADJUST--AVAILABLE 3HELD TO MATURITY SEC. 70

UNREAL. HOLD. G OR L--EQUITY 3

FROM “AVAILABLE...” a) If Cost (70) is less than Fair Value (85)TO “HELD TO MATURITY” HELD TO MATURITY SEC. 70

AVAIL. FOR SALE SEC. 70SEC. FV ADJUST.--AVAIL. 15

SEC. FV ADJUST--HELD TO MATURITY 15(Note: The Unreal. Hold. Gain or Loss--Equity remains same and is amortized).

b) If Cost (70) is more than Fair Value (67)HELD TO MATURITY SEC. 70

AVAIL. FOR SALE SEC. 70SEC. FV ADJUST.--AVAIL. 3

SEC. FV ADJUST.--HELD TO MAT. 3

(Note: The Unreal. Hold. Gain or Loss--Equity remains same and is amortized).Note: The above entries assume that separate general ledger accounts are used for each type of security. However, IF all securities are debited to “Investment in...” then the GENERAL ledger account called “Investment in....” is not touched during the transfer. But, the SUBSIDIARY ledger account for each separate debt and equity security must be revised according to the transfer effected.

NOTE: The following four pages show the foregoing entries posted into general ledger accounts.

3111x.doc 62

Investments

From: TradingTo: Available for Sale O = Entry to Transfer

1. Existing Accounts

a) Trading Sec. Sec. FV Adjust-Trading 70 15

70 15

b) Trading Sec. Sec. FV Adjust-Trading 70 3

70 3

From: Available for SaleTo: Trading


a) Avail for Sale Sec. Sec. FV Adj-Avail. Unreal Hold. G or L-Equity70 15 15

70 15 15

b) Avail. for Sale Sec. Sec. FV Adj-Avail. Unreal. Hold G or L-Equity70 3 3

70 3 3

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1. New Accounts

FV gets debited, becausea) Avail. for Sale Sec.

Trading Securities are involved. 85

AND....we assume that the Trading Securitiesaccount has been brought to its fair value already!

b) Avail. for Sale Sec.

67

2. New Accounts To: Income Statement

a) Trading Sec. Unreal H.G. or L-Income

85 15

b) Trading Sec. Unreal H.G. or L-Income

67 3

3111x.doc 64

From: Held to Maturity To: Available for Sale


a) Held to Mat. Sec.70

70

b) Held to Mat. Sec.70

70

From: Available for Sale To: Held to Maturity


a) Avail for Sale Sec. FV Adjust-Avail. Unreal H.G. or L-Equity70 15 15

70 15

b) Avail for Sale Sec. FV Adjust-Avail. Unreal H.G. or L-Equity70 3 3

70 3

3111x.doc 65

3. New Accounts Must put some of “FV” here because we need the equity account

a) Avail. for Sale Sec. Sec. FV Adjust-Avail Unreal. H G or L-Equity

70 15 15

b) Avail. for Sale Sec. Sec. FV Adjust-Avail Unreal. H G or L-Equity

70 3 3

4. New Accounts

Held to Mat. Sec. Sec. FV Adjust.-HTM

a) 70 15

Held to Mat. Sec. Sec. FV Adjust.-HTM

b) 70 3

3111x.doc 66

FAIR VALUE ACCOUNTING CONTROVERSY

There are several issues unresolved.Unfortunately, the FASB still allows some unrealized gains and losses to be placed on the balance sheet, rather than the income statement. Therefore, there is still the practice of gains trading.

SPECIAL ISSUES RELATED TO INVESTMENTS

Impairment of Value

When an investment has declined in value and it is deemed NOT TEMPORARY, then the accountant must record a realized loss. The new cost basis can never be adjusted, even if the security recovers some or all of its value.

Revenue from Investments in Stocks

Under the cost method, dividends received are recorded as Investment Revenue.

Dividends received in Stock (Stock Dividends)

NO formal journal entry is made. Just adjust your stock investment records to show that your company now has more shares of that particular company.

Stock Rights (not discussed in this course)

3111x.doc 67

FUNDS

Definition: A fund is a separate group of assets set aside for a specific purpose.

Current Funds: Petty cash, payroll cash account, dividend cash account, interest fund.

Noncurrent Funds: Sinking fund, plant expansion fund, stock redemption fund, contingency fund.

Entries:Transfer of cash to a fund

PLANT EXPANSION FUND CASHCASH

Purchase securities with the fund moneyPLANT EXPANSION FUND INVESTMENTS

PLANT EXPANSION FUND CASH

Accrue interest and dividends at year-endINTEREST/DIV. RECEIVABLE--PLANT EXPANSION FUND

PLANT EXPANSION FUND REVENUE

Funds and Reserves (Appropriations) Distinguished

A FUND involves an asset account being set up.

A RESERVE or APPROPRIATION only restricts retained earnings away from the hands of the Board of Directors for dividend declaration.

3111x.doc 68

SUMMARYBasic Transactions with Investments in Debt and Equity

Purchase DEBT EQUITYAt cost 4 At cost 5

(record int.rec. inseparate account)

Earnings Interest Revenue Dividend Revenue(include amortiz.of premium or discount)

Sale 1) update amortiz. 1) reduce asset (at cost)and record int. rev. and recognize gain/loss2) reduce amortizedasset and recognizegain/loss

Note regarding sale: Ignore any related unrealized gains/losses and sec. FV adjust.

Temporary Change in Fair Value 6 (By PORTFOLIO CATEGORIES)

HTM (at amortized cost) HTM (not applicable)AFS and TS (at fair value) AFS and TS (at fair value)

Impairment of Value (a change “other than temporary”)

1)Update amortiz. and 1) Remove the orig. cost andrecord interest rev. related accounts for the2)Remove the asset change in value andand related accounts record lossfor the change in valueand record loss

Note for impairment: The remaining value in the asset account is the NEWcost basis.

4 Include brokers’ commission5 Include brokers’ commission6 Record this change in fair value at least at the reporting dates (quarterly and annually).3111x.doc 69

ACCOUNTING FOR INCOME TAXES -- Chapter 20

Historical Background: a) Cash Basis: INCOME TAX EXPENSE

CASH

b) Accrual Basis: (Income Statement Approach) -- APB Opinion #11 (1967)INCOME TAX EXPENSE (pretax GAAP income x tax rate)

INCOME TAX PAYABLE (IRS taxable income x tax rate)DEFERRED TAX LIABILITY (plug figure) *

* the plug figure could be deferred tax asset

c) Accrual Basis: (Balance Sheet Approach) -- FASB Statement #109 (199_)INCOME TAX EXPENSE (plug figure)DEFERRED TAX ASSET (future deductible amounts x tax rate)

INCOME TAX PAYABLE (IRS taxable income x tax rate)DEFERRED TAX LIABILITY (future taxable amounts x tax rate)

===============================================================

TAXABLE INCOME AND FINANCIAL INCOME

Definitions: Taxable income (TI) is computed on the IRS corporate income tax return and is based upon U.S. prescribed tax regulations and rules (IRC/Internal Revenue Code).

TI = TAXABLE REVENUES AND GAINS - DEDUCTIBLE EXPENSES AND LOSSES.

Pretax accounting income (PTAI) is computed on the GAAP income statement and is based upon the U.S. accounting standards (GAAP). PTAI = REVENUES + GAINS - EXPENSES - LOSSES.

NOTE: For the calculations of revenues and expenses, there are several differences between the IRC and GAAP. Therefore, there is usually a deferred tax asset and/or deferred tax liability in the yearly AJE for income tax expense.*

* Another term for “income tax expense” is “provision for income taxes.”

DEFERRED INCOME TAXES AND TAXABLE AMOUNTS

Step #1: Compute the income tax payable (the current year’s liability to the government)

Step #2: Determine whether there are any PERMANENT or TEMPORARY DIFFERENCES between the IRC and GAAP for this year’s revenue and expenses.

3111x.doc 70

Definitions: Permanent Differences are items that either(1) enter into PTAI but never into TI or(2) enter into TI but never into PTAI. Temporary Differences are differences between the tax basis and the carrying value (book value) of an asset or liability, and such differences will result in DEDUCTIBLE AMOUNTS or TAXABLE AMOUNTS in future years. These, in turn, are multiplied by the future tax rate and are called DEFERRED TAX ASSETS or DEFERRED TAX LIABILITIES, respectively.

TEMPORARY DIFFERENCES

CAUTION: Always be very careful about the accounting item that you are analyzing. Be sure to keep in mind whether you are analyzing a REVENUE item or an EXPENSE item.

Less REVENUE in PTAI than TI in current year ==> More TAXABLE REVENUE currently ==> Less REVENUE in TI than in PTAI in future year(s) ==> Less TI in future ==> Less taxes to pay in future ==> Deferred Tax Asset arises currently (a tax benefit to be realized in future years)

VICE VERSA for “More REVENUE in PTAI than TI in current year” but a Deferred Tax Liability arises currently.

Less EXPENSE in PTAI than TI in current year ==> More DEDUCTIBLE EXPENSES currently ==> Less EXPENSES in TI than in PTAI in future year(s) ==> More TI in future ==> More taxes to pay in future ==> Deferred Tax Liability arises currently (a tax sacrifice to be realized in future years)

VICE VERSA for “More EXPENSE in PTAI than TI in current year” but a Deferred Tax Asset arises currently.

=========================KEY QUESTION: Ask yourself: “What effect will this temporary difference have on my FUTURE tax returns? On my future taxable income?

AJE regarding Provision for Income Taxes:INCOME TAX EXPENSE (plug figure = NNTB)**DEFERRED TAX ASSET (deductible amount x tax rate)

INCOME TAX PAYABLE (from current tax return)DEFERRED TAX LIABILITY (taxable amount x tax rate)

3111x.doc 71

SUMMARY OF OBJECTIVES

1. In accounting for income taxes on the financial statements, we should recognize the amount of taxes payable or refundable for the current year.

2. Also, we should recognize deferred tax liabilities and assets that have future tax consequences but are reported currently on either the financial statements or the tax return.

DEFERRED INCOME TAXES AND DEDUCTIBLE AMOUNTS

Definition: A deductible amount arises when a temporary difference causes the current PTAI to be less than the current TI; therefore, IN THE FUTURE the PTAI will be more than the TI, causing less taxes to be paid in the future. Thus, IN THE CURRENT YEAR an asset arises because of the future deductible amount from which we receive a benefit.

DEFERRED TAX ASSET = Deductible Amount x Tax Rate in the future period

In the future, TI will be less than PTAI ==> Less tax to pay in the future ==> A future benefit to us now ==> Deferred Tax Asset now.

VALUATION ACCOUNT FOR DEFERRED TAX ASSET

IF, based upon all available evidence, it is more likely than not that some portion of the DEFERRED TAX ASSET will not be realized (not used), then we must set up an allowance account for the value of the DTA (deferred tax asset) that we are not likely to recover in future years.

Entry: INCOME TAX EXPENSEALLOWANCE . . . DEFERRED TAX ASSET

The ALLOWANCE account is a valuation account for the DEFERRED ASSET ACCOUNT.

INCOME STATEMENT PRESENTATION

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In-Class Activity -- Accounting for Income TaxesACG 3111

Situation: The following information is provided to you by Victory Corporation. The income statements of the Victory Corporation for two years (summarized) are as follows:

1992 1993Revenues/Gains $180,000 $200,000Expenses/Losses 142,000 181,000

Pretax Accounting Income $ 38,000 $ 19,000

1992 Income tax rate, 40%1993 Income tax rate, 30% (enacted)1994 Income tax rate, 25% (under discussion by legislature)

a. Expenses (given above) on the 1992 income statement include $8,000 of estimated warranty costs. The company expects to pay for repair costs under the warranties as follows: half in 1993 and half in 1994.b. There is $5,000 of interest income in the 1992 income statement above. It was accrued at year-end 1992 but the cash was received in 1993. The interest relates to Victory’s investment in the bonds of Seminole County.c. In January 1992, Victory Corporation paid $9,000 for a three-year insurance policy.d. Revenues (given above) on the 1993 income statement include $10,000 rent revenue, which was taxable in 1992 but was unearned at the end of 1992.e. Interest revenue is $500 on the held-to-maturity investment portfolio in 1993, but the cash will not be received until 1994.f. (OPTIONAL for ACG 3111) Expenses in the 1993 income statement include goodwill amortization of $10,000; goodwill arose when Victory Corporation purchased another company for cash at the beginning of 1993. Victory uses 40 years for GAAP amortization and the required 15 years for Internal Revenue Code amortization.

Assume that Victory Corporation applied SFAS No. 109 for the first time in 1992.

REQUIRED:1. Prepare the following for each year:

a) schedule to reconcile accounting and taxable incomesb) computation of income tax payablec) schedule to compute deferred income taxd) journal entry at each year-end to record income taxese) general ledger (t-accounts) for the deferred tax accounts.

2. Show how the income taxes would be reported on the income statement and balance sheet for 1992 and 1993.

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Disclosure of the significant components of income tax expense attributable to continuing operations must be disclosed either1) in the income statement or2) in the notes.

The significant portions are the current tax and the deferred tax.

BALANCE SHEET PRESENTATION (see latter portion of chapter)~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Additional notes:

Deferred Income Taxes these taxes are delayed as far as due date because the company uses one method for income taxes and another method for fin. acctg. purposes

E.g., (for example)

IRC For Tax Return: Use accelerated depn. $4,000 Dep. Exp. (more deductions less at the beginning of asset use)

GAAP For Fin Stmts: Use straight-line depn. $3,000 Dep. Exp.

Deferred Inc. Taxes arise in the entry

Entry Inc. Tax Exp. per the fin stmts Def. Inc. Taxes to be paid in later year(s) Inc. Tax Payable to the gov’t

Recall: Economic Consequences of Liabilities

Liab. affect 7 key ratios AP/Sales

CL/InventoryQuick Ratio Current CL/Net Worth*

Ratio TL/NW Sales/Net WC

Debt Contracts involve ratios that have liab. in them. Creditors get paid before stockholders, in case of liquidation Management may have incentives to understate or to overstate liabilities.

*Net Worth = Stockholders’ Equity

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ACCOUNTING FOR PENSIONSAND POSTRETIREMENT BENEFITS--Chapter 21

Pension Standard: FASB Statement No. 87 “Employers’ Accounting for Pension Plans” (1985)

TYPES OF PENSION PLANS

Definition: A pension plan is an arrangement whereby an employer provides benefits (payments) to employees after they retire, for services the employees provide while employed.

Two most common types of pension plans :

1. Defined Contribution Plan = the employer agrees to contribute to a pension trust fund a certain sum each period, based on a formula. No promise is made about the ultimate benefits paid to the employee during retirement years. The accounting for this type of plan is very simple. When the cash is placed into the fund,DEBIT Pension Expense

CREDIT Cash

A liability arises only if the employer has not paid its yearly contribution in total.

2. Defined Benefit Plan = the employer agrees to contribute enough cash each year into the pension trust fund so that the employee will receive defined benefits when he/she retires. The defined benefits are predicated upon uncertain future variables, such as length of employee service, turnover, mortality, compensation levels, and interest earnings on the investments in the trust fund. Note: If the trust fund does not earn adequate amounts of interest to pay the retirement checks, then the employer is responsible for the payment of the defined benefits! The accounting for these pension plans is complex because the measurement and recognition of the pension liability involves unknown future variables.

a) In form, the trust fund is a separate entity.

b) In substance, the trust assets and liabilities belong to the employer. Theemployer is at risk; therefore, a liability usually is needed.

The accounting for defined BENEFIT plans is the subject of the remainder of this chapter.

==========================================================================

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EMPLOYER versus PLAN ACCOUNTING

Pension accounting involves two entities:1. the corporation for which the employees work2. the pension fund

1. The corporation (employer) is the main entity addressed in FASB No. 87. YOU are the accountant for the corporation that is giving cash each year to the trust fund.

2. The pension fund is the entity that 1) receives the cash from the corporation, 2) invests the money wisely, and 3) distributes the cash to the retired employees. See FASB No. 35 if you become the accountant for a pension fund.

Note: Our textbook addresses the accounting by the corporation (#1 above).

THE ROLE OF ACTUARIES IN PENSION ACCOUNTING

Definition: Actuaries are individuals who are trained through a long and rigorous certification program to assign probabilities to future events and their financial effects.

Relationship of actuaries to pension accounting: It is actuaries who make predictions (actuarial assumptions) of mortality rates, employee turnover, interest and earnings rates, early retirement frequency, future salaries and other factors needed to operate a pension plan.

BEWARE: The assumptions provided by the actuary can significantly affect the PENSION EXPENSE and the PENSION LIABILITY that is recorded.

THE PENSION OBLIGATION (LIABILITY)

Alternative Measures of the Liability

1. Based upon vested benefits only: a liability is owed to the employee after a minimum number of years of employment (usually five years) but the payments are not payable to the employee until retirement occurs.

2. Based upon vested and nonvested benefits, at CURRENT salary levels: a liability is owed to the employees for ALL years of employment but the payments are not payable to the employee until retirement occurs. This measurement of pension obligation is called accumulated benefit obligation and is computed by using current salaries.

3. Based upon vested and nonvested benefits, at FUTURE salary levels: a liability is owed to the employees for ALL years of employment but the payments are not payable to the employee until retirement occurs. This measurement of pension obligation is called projected benefit obligation and is computed by using estimated future salaries.

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The CHOICE from the above measures is critical because it affects the pension expense and the pension obligation (liability) for the corporation’s financial statements. The FASB chose the third measure above for employer accounting of most pensions.

This choice is logical because most defined benefit pension plans compute the retirement checks (benefits) based upon the average of the LAST three to five years of employment...the FUTURE. Of course, there is no way to easily estimate the employee’s title/position when he will retire many years from today...in the FUTURE. Therefore, the salary just before retirement is difficult to estimate. As mentioned above, there are many uncertainties surrounding the accounting for pensions by the corporation.

CAPITALIZATION VS. NONCAPITALIZATION

Definition: Capitalization means measuring and reporting in the financial statements a fair representation of the employers’ pension assets and liabilities.

FASB Statement No. 87 represents a compromise between capitalization and noncapitalization features. Therefore, the calculations for pension accounting are NOT totally logical, complete, or conceptually sound. However, FASB 87 is an improvement over previous pension pronouncements.

Under the CAPITALIZATION approach, the economic substance of the pension plan is emphasized. Under this view, the employer has a liability for pension benefits that it has promised to pay for employee services already performed. As the employees work, pension expense is incurred (matching principle)...and a liability usually arises because cash funding (into the pension trust fund) is lower than needed.

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COMPONENTS OF PENSION EXPENSE

The measurement of PENSION COST is extremely complicated because it is a function of the following components:

Service Cost: The present value of the new future retirement benefits earned by employees during the current year. Recall that FUTURE compensation levels are used to measure this part of pension expense.

Calculation = obtained from the actuary usually.

Interest on the Liability: The interest that must be accrued on the PBO (projected benefit obligation). Remember that pensions are deferred compensation plans and the expense and liability are originally booked at present value. Therefore, annual interest must be added to the PBO by using the settlement rate.

Calculation = settlement rate x BEGINNING PBO.

Actual Return on Plan Assets: The earnings (interest and dividends) that accumulate within the pension trust fund itself. Because these earnings help to reduce the pension liability, they are deducted in the calculation of the annual pension expense.

Calculation = (Plan assets at END of year - Plan assets at BEGINNING of year) - (Contributions from the employer - Benefits paid to employees).

IMPORTANT: The difference between the actual return and the expected return becomes part of the gain or loss that is temporarily unrecorded (see “Gain or Loss” below).

Amortization of Unrecognized Prior Service Cost: The allocation of the cost (prior service cost) of providing retroactive benefits is allocated to pension expense over the current and future years. Retroactive benefits can arise in two different ways: 1) at the inception (beginning) of a new pension plan, the employees are sometimes given credit for their PAST service to the company and 2) at times when the company amends its pension plan to increase benefits, etc., an additional sum of money is owed to the pension trust fund. These usually large sums of “owed moneys” are typically amortized over current and future periods.

Calculation = either 1) straight-line amortization of the unrecognized prior service cost over the future years of service or 2) “years-of-service” amortization of the unrecognized prior service cost.

NOTE: The unrecognized prior service cost is really pension goodwill -- an intangible asset that WOULD HAVE been recorded IF the FASB had adopted full capitalization. Remember, though, that this “asset” DOES enter into the pension expense each year as it is amortized.

Gain or Loss: Two items comprise this gain or loss that affects pension expense: 1) the difference between the actual return and the expected return on the plan assets in the pension trust fund and 2) the unrecognized net gain or loss from previous periods. The two causes of the foregoing are respectively: 1) sudden and large changes in the market value of the plan assets and 2) changes in the PBO from changes in the actuarial assumptions OR when actual experience differs from expected experience, e.g., the length of life of employees changes from that expected because a cure for cancer is found.

Calculation = complex measurements (not to be covered in this class) -- see textbook for explanation if you need to learn this in the future.

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Note: Refer to the worksheet layouts in your textbook to learn how all of the above items help to determine the PENSION EXPENSE.

Typical journal entry for pensions:

PENSION EXPENSECASHPREPAID/ACCRUED PENSION COST

If the Prepaid/Accrued Pension Cost account has a debit balance at the end of the year, then it is an asset -- Prepaid. If it has a credit balance at the end of the year, then it is a liability -- Accrued liability.

The PBO does not enter into the body of any corporation financial statement.The Plan Assets do not enter into the body of any corporation financial statement.Both of the above are in the footnote disclosures.

Minimum Liability is an amount that WILL appear on the balance sheet when the ACCUMULATED benefit obligation (ABO) exceeds the fair value of the plan assets.

1. Calculation of amount needed for the journal entry if there is an ACCRUED pension cost: minimum liability minus the accrued pension cost = additional pension liability.

2. Calculation of amount needed for the journal entry if there is a PREPAID pension cost: minimum liability plus the prepaid pension cost = additional pension liability.

Entry to record the Minimum Liability:

INTANGIBLE ASSET--DEFERRED PENSION COST (never amortized)ADDITIONAL PENSION LIABILITY

The rationale for using ABO is that, IF the obligation had to be settled as of the balance sheet date, then the obligation to the employees would be at the CURRENT salary rates.

Beware: the FASB does NOT allow for a minimum asset if the fair value exceeds the ABO!

Note that the entire PBO usually does not appear on the balance sheet of the corporation. IF the FASB had adopted the full capitalization approach, the PBO would be in the balance sheet, not only in the footnote reconciliation.

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Accounting for Pensions (Defined-Benefit Plan)

50,000 50,000 50,000 etc. 50,000 50,000

∙ working years R retirement years1996 n=10 n=20

i=8% i=6%281,576 Pension

AssetsR = retirement begins Zar’s

Retirement 607,906* Fund vested & nonvested

-at FUTURE salary- PBO____________________________vested and nonvested ABO-at current salary- ____________________________

vested -at current salary

Min. Liability on Balance Sheet

Situation I: Dr. Zareski plans to work for American Express for 10 more

years, at which time she will retire. Her life expectancyat the big R is 20 years. Her pension plan states thatit will pay her 60% of the average salary for her finalthree years of work. Estimated salaries for 2003, 2004,and 2005 are $73,333; $83,333; and $93,333, respectively.

Calculate the following:(a) the amount of funds that must be saved by the end of 2005(b) the amount of funds that must be set aside in the fund annually, from 1996 through 2005.

(a) PVAD = 50,000 x [ tfOA x 1.06 ] AV Salary = 73,333+83,333+93,333(2003, 2004, 2005)= 3

= 83,333

=50,000 x [11.46992 x 1.06] 83,333 x 60% = $50,000

= $607,906* Zar’s Retirement Funds

n=20I=6%

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Pension Situation I (refers to timeline)

281,576 end of 1995

281,576 x 1.08 = 304,102 end of 1996

PBO, if no funding done annually Date

304,102 Dec. 96

328,430 Dec. 97

354,705 Dec. 98

383,081 Dec. 99

413, 728 Dec. 00

446,826 Dec. 01

482,572 Dec. 02

521,178 Dec. 03

562,872 Dec. 04

607,901 Dec. 05

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Accounting for Pensions$607,906

?A ?A ?A ?A A etc. (b) 1996 Retirement 281,576 FVOA= A x tfOA n=10

i=8%

$607,906 = A x 14.48656 PV$1 = 607,906 x tf$1

= 607,906 x .46319 607,906 = A = 281,57614.48656

A = $41,963 = Annual Service Cost(pension amount that is earned each year)

Pension Exp. 41,963 IF fully funded, then NO liability exists. Cash 41,963

Situation II:

The same as above, but the company just begins their defined benefit pension plan in 1996. They agree, in the plan, to give retroactive benefits for the past employment period. Dr. Z has worked for Amex since 1976.

Calculate the Prior Service Cost (assumed to be $100,000)

$100,000 = Prior Service Cost

1976 Prior Service 1996

adoption of defined benefit plan

PBO = 100,000 + 281,576= 381,576

discount = 10%(settlement rate)

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IF Situation I: ( Zarzeski’s funds only)

DATA 1996

Plan Assets, 1/1/96 $250,000 (Assume this amount was set aside in prior(fair market value) years, but the fund was a defined-

contribution plan at that time)PBO, 1/1/96

Annual Service Cost 1996

Settlement Rate %(Discount Rate)

Actual Return on Plan Assets 1996 12% (info provided by pension trustee)

Contributions to pension fund 1996 $80,000 (ask mgtmt for this amount)

Benefits paid 1996 0 (Zarzeski has not yet retired)___________________________________________________________________________

Pension FundCalculation of Pension Expense 1996 FV of

P/A Pension Cost PBO Plan Assets1/1/96 31,576 cr 281,576 250,000

Service Cost 41,963 +41,963 Interest on PBO 22,526 +22,526(8% x PBO)Actual Return on Pension Funds (30,000) +30,000

______ contributions +80,000

Total Expense 34,489 AJE _______ ______ _______

1996 Entry 12/31/96 13,935dr 346,065 360,000Pension Exp. 34,489

Cash 80,000 Assume that the ABO 12/31/96 is 320,000. Do we need P/A Pens. Cost 45,511 another entry for a MINIMUM liability?

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IF Situation II: (Z funds only)

DATA 1996

Plan Assets, 1/1/96 $250,000

PBO, 1/1/96 $381,576(includes PSC of $100,000) Prior Service CostAnnual SC $ 41,963Settlement Rate 12%Actual Return on Plan Assets 8%Contributions to fund $ 80,000Benefits Paid 0___________________________________________________________________________

Calculation of Pension Expense 1996

Service Cost $41,963Interest on PBO 38,158Actual Return (30,000)Amortization of PSC 25,000 (years of service method) provided by actuary

_______

Total Pension Expense 75,121

Entry 1996 NOTE:Pension Expense 75,121 The P/A Pension cost always

Cash 80,000 equals the net of:P/A Pension Cost 4,879 1) PBO

2) FV of Plan Assets3) Unrecognized PSC4) Unrecognized Gain or Loss

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Pension Accounting (Ex 21-7)

Step 1: ABO $650,980 (Am’t the fund should have)FV of Plan 593,480 (Am’t the fund has as investments)Difference $ 57,500 TOTAL minimum Pension Liability that must

appear on Balance Sheet

Step 2: Look at Prepaid/Accrued Pension Cost Account:It has a $27,812 credit balance.Therefore, $57,500 - $27,812 = $29,688 needed on the Balance Sheet

Intangible Pension Asset* Additional Pension Liability P/A Pension Cost Beg 0 0 Beg.

entry 29,688 29,688 entry

end. 29688 29,688 27,812 End

$57,500 Balance Sheet Pension Liability

Balance SheetPension Asset

* K & W called this account “Intangible Asset - Deferred Pension Cost”

Step 3: Vested Benefit ObligationFootnote Accumulated Benefit Obligation Disclosure Projected Benefit Obligation

Plan Assets at Fair Value

Components of Pension Expense

Accrued Pension CostMinimum Pension Liability

I

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Additional Notes Regarding Pensions

Why did the FASB create a standard regarding pensions?

Basically, to improve the annual matching of the pension expense to the revenue that the employees help the company to earn.

When do accountants record an entry?

Recording pension expense occurs when the company (not the employees) contributes to the plan, i.e., non-contributory plan.

Two Examples of Non-contributory Plans(i.e. the employer is funding the plan)

Defined-Contribution Plan Defined-Benefit Plan

Record entry when cash is Pension Expense Calculation sent to the Pension Trustee 1) Ask for investment

2)Entry: Pension Expense

Cash 3) Dr. Zarzeski

4)

Note: No special calculations 5) about thisAre necessary here.

6)

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Miscellaneous Pension Items (not on exams)

1) Pay-as-you-go accounting

Pension Expense MANY years ago, we recorded cash basis for pensions.Cash

Health Care ExpenseCash When the FASB changed health care for retirees to ACCRUAL basis,

many companies eliminated or reduced their health care benefits provided to employees!

2) One of the components of PENSION EXPENSE that we will not need to memorize for the exam is “amortization of unexpected market and actuarial gains or losses”—page 1071. The company is permitted to amortize only LARGE fluctuations from the expected (estimated) gains or losses. This is known as the corridor approach.

The other component of PENSION EXPENSE that we will not need to memorize for the exam is “amortization of transition amount” that arises when our company first applied SFAS 87 in 1985. Eventually, there will be no transition amounts remaining to be amortized.

3) Review the Illustration 21-12 on page 1070, if you want more practice with a pension worksheet.

4) After the accountant records the regular pension expense entry, he must make check to see whether another entry needs to be recordedfor ADDITIONAL PENSION LIABILITY, due to the need for a minimum liability on the balance sheet.

The check rule is: Is the FAIR VALUE of the Pension Plan Assets at least equal to the Accumulated Benefit Obligation?a) If YES, there is no need for a second entry.b) If NO, there is a need for a second entry. Entry: Intangible Pension Asset

Addition Pension Liability Note: There is an exception to the general rule.

Refer to your textbook (p. 1077) if you wish to review this exception.

5) If a company terminates a defined benefit pension plan, the net gain or loss must be recognized in earnings in the year of termination. See SFAS 88.

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Accounting for Leases --Chapter 22

LEASE: a contract granting use or occupation of property during a specified time in exchange for rent payments.

LESSOR: the company that has legal title to the asset but that allows another entity to use the assetFor a periodic cash payment.

LESSEE: the company that uses another entity’s asset for a fixed periodic rate, but does not own theThe asset.

Two categories:

1. OPERATING LEASE- the lessee assumes none of the risks of ownership; property reverts to owner at end

2. CAPITAL LEASE- the lessor transfers risks and benefits to the lessee; property MAY revert to lessee at end of lease like an installment purchase, LEGALLY a lease but ECONOMICALLY a

OPERATING LEASE FOR THE LESSEE

Entry each month: Lease Exp.Cash Note: the asset remains on the Bal. Sheet of

the lessor

CAPITAL LEASE

Entries for the LESSEE (user of asset): Note: the asset is no longer on the lessor’s Bal. Sheet!

Sign the lease Leased Asset record at PV Lease Liab.of Future Cash Payments

AJEs Dep. Exp.Accum. Dep. Usually straight-line

CV x ER x T = Exp.Int. Exp. Lease Liab. (plug) CV = Value in Lease Liab. Account

Cash per contract

Note: The difference in the two methods definitely causes differences in the financial ratios.

Companies try to avoid capitalization of leases because a LIABILITY must be booked if the lease qualifies as a CAPITAL LEASE.

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BONDS vs LEASES

Interest I I I I Interest & Principal Term Bond

Principal only P&I P&I P&I P&I

Lease

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

How To “Obtain” A Long-Lived Asset

FMV$100,000 Owner Entry

Purchase for CASH Asset Cash

I I I I I I & P P&I P&I P&I P&I P&I P&I Purchase on CREDIT

Interest-Bearing Note Non-Interest-Bearing Note

Owner EntryAsset NP or BP (net)

P P&I P&I P&I P&I Lessee entry

Lease (Financing Arrangement) Leased Asset Capital Lease Lease Liability

$ $ $ $ $ Lessee entry

Lease Expense Operating Lease Cash

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Basic Lessor Entries and Their Effect on Financial Statements

Effect on NIRev. Exp.

A L SE Gain - Loss SCF (cash effect)

Operating – LessorBldg. NE NE NE (Investing) Cash NE

Cash NE Operating Lease Rev.

Depr. Exp. NE NE Accum. Depr.

Sale of Bldg.Cash NE InvestingAcc. Dep. Bldg. Gain

Capital—Lessor1/1/97 Lease Rec. Bldg. NE NE NE Un. Int. Rev.

1/1/97 Cash NE NE NE Investing Lease Rec. NE

12/31/97 Un. Int. Rev. NE NE Int. Rev.

1/1/98 Cash Investing Lease Rec. NE & Operating 12/31/98 Un. Int. Rev. NE NE Int. Rev.

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For exam #1, memorize the current ratio, the return on assets ratio, the profit margin, and the debt ratio.

Example of Entry Analysis

Situation: The accountant forgot to record the adjusting entry for depreciation of the capital lease.

1. What is the entry that was NOT recorded?

2. What effect is there on each of the following parts of the financial statements?Use O for overstated, U for understated, NE for no effect.

NI_____________________________(net income)

A______________________________(assets)

L______________________________(liabilities)

SE_____________________________(stockholders’ equity)

3. What effect is there on the debt ratio? Use O, U or NE and show your reasoning.

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K & W TextbookPage 1130

Capital Leases

23,981.62 23,981.62 23,981.62 23,981.62 23,981.62 Ignores $2,000/yr

executory costsFMV $100,000 n = 5

i = 10%

LESSEE

Only Principal __ Leased Asset__ __ Lease Liab.____________1/1/96 Leased Asset 100,000 1/1/96 100,000 100,000 Lease Liability 100,000 1/1/96

1/1/96 23,982_______________1/1/96 Lease Liability 23,982 76,018 Cash 23,982

1/1/97 16,380_______________ 59,638

1/1/98 18,018_______________ 41,620

CV x ER x T

12/31/96 Int. Exp. 7,602 (76,018 x 10% x 1)Int. Pay 7,602

12/31/96 Dep. Exp. 20,000 (100,000 5 years) Accum. Dep. 20,000

1/1/97 Int. Pay 7,602 *Lease Liab. 16,380

Cash 23,982

12/31/97 Int. Exp. 5,964 (59,638 x 10% x 1)Int. Pay 5,964

12/31/97 Dep. Exp. 20,000 1/1/98 Int. Pay 5,964Accum. Dep. 20,000 *Lease Liab. 18,018

Cash 23,982

(*NNTB)

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K & W TextbookPage 1137

LESSOR

FMV of Asset $100,000Less: PV of RV 0____Amount to be recovered 100,000

PVAD = A x tfAD

$100,000 = A x 4.16986 $23,982 = A

n = 5i = 10%

per textbook rounded

1/1/96 Lease Rec. 119,908 ($23,982 x 5 cash receipts = debit to Lease Rec.)Equip. 100,000 (remove equip. FMV = Cost)Un. Int. Rev. 19,908

1/1/96 Cash 23,982 Lease Rec. 23,982 (Principal only because time has NOT gone by.)

Principal and Interest

__ _Lease Rec.____ ____Un. Int. Rev.__1/1/96 119,908 19,908

1/1/96 _________ 23,982_1/1/96

1/1/96 95,926 12/31/96 7,602__________ 12/31/96 Un. Int. Rev. 7,602 12,306 1/1/97

Int. Rev. 7,602 ___________23,982_1/1/97 (CV on 1/1/96 = 95,926 - 19,908) 1/1/97 71,944( = 76,018 )INT. REV. = CV x ER x T = 76,018 x 10% 1

Step 2: 59,638 CV1/1/97 Cash 23,982 x10% Lease Rec. 23,982 __x 1 year

= 5,964 Int. Rev.

Step 1: CV of Lease = Lease Rec. - Un. Int. Rev. 59,638 = 71,944 - 12,306

12/31/97 Un. Int. Rev. 5,964Int. Rev. 5,964

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Other Information about LEASES

Residual Value (RV) Lessor Lessee

Subtract PV or RV If Unguaranteed, ignore RVfrom FMV of Asset to obtainAmount to be Recovered If guaranteed, (Guaranteed or a) Add PV of RV to the Unguaranteed RV) PV of payments

b) If guaranteed,do not depreciatethe RV.

c) Depreciate overLife of Lease

Bargain Purchase Option (BPO)Lessee

Add PV of BPO to thePV of payments.

Renewal Option with BPO For Depreciation, Add the renewal period to the life of

the lease; or use the “economic life,”

assuming your co. will exercise the BPO

Transfer of Ownership or BPO Depreciate over ECONOMIC LIFE of asset

Footnote Disclosure CASH payments for 5 years and aggregate thereafter

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Exercise 22-1LESSEE

WITHOUT Reversing Entries at year end

7/1/96PV of MLP = 102,356 x 2.73554 = $280,000FMV of Asset is 300,000, but we record lease at 280,000If FMV of Asset is less than 280,000, then we record at FMV.

7/1/96 Leased Asset 280,000 _____Leased Asset__ _ ___Lease Liab.__Cash Lease Liab. 280,000 7/1/96 280,000 280,000Payment Lease Liab. 102,356 1/1/96 102,356___________ Cash 102,356 177,644

84,592___________

93,052 93,052____________

-0-CV x ER x T

12/31/96 Int. Exp. 8,882 (177,644 x 10% x1/2) Int. Pay. 8,882

6 Mo. AJE Dep. Exp. 46,667 (280,000 x 1/3 x1/2) __ __Accum. Dep. ___ Accum. Dep. 46,667 46,667

93,333 93,333

7/1/97 Int. Pay. 8,882 ______________46,667Cash Int. Exp. 8,882 280,000Payment *Lease Liab. 84,592 Cash 102,356

CV x ER x T12/31/97 Int. Exp. 4,652 (93,052 x 10% x1/2)

Int. Pay. 4,652

12 Mo. AJE Dep. Exp. 93,333 Accum. Dep. 93,333

7/1/98 Int. Pay 4,652 Int. Exp. 4,652

*Lease Liab. 93,052 Cash 102,356

12 Mo. AJE Dep. Exp. 93,33312/31/98 Accum. 93,333

6/30/99 Dep. Exp. 46,6676 Mo. AJE Acc. Dep. 46,667

Accum. Dep. 280,000 not yet posted Leased Asset 280,000

3111x.doc 95

Exercise 22-1

LESSOR

Principal AND Interest OR Principal Only

7/1/96 Lease Rec. 307,068 GROSS NETLease Rec. 280,000 Machinery 280,000 Machinery

280,000 6 Un. Int. Rev. 27,068mos.

Cash 102,356 Cash 102,356Lease Rec. 102,356 Lease Rec. 102,356

12/31/96 Un. Int. Rev. 8,882 Lease Rec. 8,882 Int. Rev. 8,882 Int. Rev. 8,882

NO DEPRECIATION for LESSOR if it transferred the benefits and risks(i.e., CAPITAL LEASE)

6mos. 1/1/97 Reversing entry if desired (NOT on ACG 3111 Exam)

7/1/97 Cash 102,356 Cash 102,356 Lease Rec. 102,356 Lease Rec. 102,356

6 Un. Int. Rev. 8,882 Lease Rec. 8,882mos. Int. Rev. 8,882 Int. Rev. 8,882

12/31/97 Un. Int. Rev. 4,652 Lease Rec. 4,652 Int. Rev. 4,652 Int. Rev. 4,652

6 mos.

7/1/98 Cash 102,356 Cash 102,356 Lease Rec. 102,356 Lease Rec. 102,356

Un. Int. Rev. 4,652 Lease Rec. 4,652

95class\stksbds.doc 88

6 Int. Rev. 4,652 Int. Rev. 4,652 mos.

12/31/98 NO INTEREST REMAINING because LIAB. owed to us is 0. 6 mos.

6/30/99 No entry, unless Machinery will be used in the future by LESSOR.


Direct Financing LeaseTextbook Exercise 22-1

(But with revised dates)

Cash Cash Cash

1/1/96 1/1/97 1/1/98 12/31/96 12/31/97 12/31/98

1996 1997 1998 Int.Exp. Int.Exp.

Dep.Exp. Dep.Exp. Dep.Exp.

Reminders:

a) No expense can be recognized until TIME HAS GONE BY.

b) When working with lease situations, it is advisable to use cash flow lines that show the periodic entry dates and the complete fiscal year.

c) After the last cash payment is made, the company has no outstanding balance. Therefore, the company has no more interest expense to record.

d) The company is still using the leased asset until the end of the lease term. Therefore, the company must show usage (depreciation expense) until the end of the lease term.

<<<<<<<<<<<<<<<<<<<<<<<<<<<<>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>


Journal Entries:

1/1/96 Leased Asset 280,000Lease Liability 280,000

Lease Liability 102,356Cash 102,356

12/31/96 Depreciation Expense 93,333Accum.Depn. 93,333

Interest Expense 17,764Interest Payable 17,764

1/1/97 Interest Payable 17,764Cash 102,356

Lease Liability 84,592

12/31/97 Depreciation Expense 93,333Accum. Depn. 93,333

Interest Expense 9,305Interest Payable 9,305

1/1/98 Interest Payable 9,305Cash 102,356

Lease Liability 93,051

12/31/98 Depreciation Expense 93,334Accum. Depn. 93,334

NO INTEREST EXPENSE TO RECOGNIZE . . . Why?


<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

ERROR CORRECTIONS--Chapter 23

Situation: We purchase machinery for $10,000 on March 1, 1995. We anticipate using the machinery for three years and then hope to sell it for $1,000.

I. If Error is discovered prior to closing the books:(This is NOT a Prior-Period Adjustment)

Error DoneAsk yourself: "What is Wrong?"

3/17/95 Machinery Expense 10,000 IncorrectCash 10,000 OK

Should Be Ask yourself: "What should have

been the entry?"Machinery 10,000

Cash 10,000

CORRECTION OF ERROR Correct only the mistake

9/28/95 Machinery 10,000 to debit correct accountMachinery expense 10,000 to reverse error to zero

(Assumed that depreciation entry is done at year-end.)


II. If Error is discovered after the 1995 books are closed: Two different situations may occur - Situation A or B on next page.

Error Done

3/1 Machinery expense 10,000 IncorrectCash 10,000 OK

Should Have Been

Machinery 10,000 The difference from aboveCash 10,000

Note: Ask yourself: 1) "Have any adjusting entries been done?" 2) "Did the error affect the income statement?"

For the above example:

1) No adjusting entries were done, but they would have been if MACHINERY had been debited.

2) Yes, there is too much money in the expenses; therefore, NI is understated until we correct the error.

II. (continued)

3) If done correctly, the following would have occurred:

3/1 Machinery 10,000 Assume: 3-yr. life 10,000Cash 10,000 1,000 salvage -1,000

9,000 9,000 x 1/3 = 3,000/yr.

199512/31 Dep. Exp. 2,500

Accum. Dep. 2,500 3,000 x 10/12 = 2,500 (10 months' usage)

Machinery Exp Cash_________ Error 10,000 10,000 OK


SITUATION A:

Correcting Entries (after the 1995 closing process occurred, BUT before the financial statements are released.)

Correcting (for 1995):Machinery 10,000 These entries should be back-dated

Retained Earnings 10,000 to 12/31/95.Early 1996

Dep. Exp. 2,500 This situation is NOT a Prior-Accum. Dep. 2,500 Period

Adjustment

Closing (for 1995):RE 2,500 _

Dep. Exp. 2,500

SITUATION B:

Correcting entries (after the 1995 financial statements are released; in other words, during the next year). THIS IS A PRIOR-PERIOD ADJUSTMENT (PPA) that is placed on the statement of Retained Earnings in 1996.

inmid Machinery 10,000 NOTE: Do not debit an expense this (1996) year if1996 Retained Earnings-PPA 10,000 the dep. expense relates to last year!

Date the entries with July, 1996 date.

Retained Earnings-PPA 2,500 The NI was understated due to overstatedAccum. Dep. (1995) 2,500 EXPENSES.

RE is understated because Mach. Exp. was closed into

RE.

1996 Dep. Exp. 1,500 (Assuming you discover the error at the beginning of July

1996.)Accum. Dep. 1,500 (First half year of usage)


Using Financial Statement Information-- Chapter 25

A. Using Financial Statement Information for PREDICTION and CONTROL

(1) Fin. Acctg numbers help the users to predict a company’s future cash flows by providing indications about its

Earning Power and Solvency Position

mainly investors & creditors

(2) Fin. Acctg numbers help the users to control, direct, and monitor the business decisions made by management

As PREDICTION AIDS:

Earning Power ability to increase wealth through operations and generate cash in the future

Not Independent Concepts

Solvency how well a company turns its cash inflows to its cash obligations (outflows)

Equity Investments (ownership of a co.)- owners are more concerned with earning power, dividends, and stock

appreciation; owners are especially interested in accrual - based fin. stmts.

Debt Investments (creditors of a co.)- returns to creditors come in the form of CASH interest and principal

creditors are more interested in SOLVENCY and CASH flows


As Control Aids:

Equity Investors and Mgtmt Control- to encourage mgtmt to achieve high earning power, bonuses based on

reported profits are given as incentives to mgtmt; Bonuses can be cash Both groups or shares of stocktry to controlbusiness decisions

Creditors and Management Control- to ensure cash flows adequate to pay the principal and interest, creditors may

restrict certain business decisions of managers as condition of the loan

Max. Am’t Collateralized Min or Max

B. Assessing Earnings Power and Solvency

1. Review the auditor’s report find “fairly present”2. Assess the nature and importance of significant transactions.

a) major acquisitions or disposalsb) pending litigation (law suits)c) major writedowns of receivables or inventoriesd) ‘s of acctg. method(s)e) offer to purchase o/s shares of own co. stockf) extraordinary gains & losses

3. Credit Rating Evaluation extensive analyses by private agencies

4. Analyze the Financial Statements themselves see detail on next page


C. Major Limitations of Fin. Acctg. Information:

Much relevant information is ignored (user must consult other sources to learn about the economy, other companies, AND subjective-type data about the co.)

No human resources are reported on the balance sheet.People are often the most important asset.Too subjective to value employees and put them on the Balance Sheet!

No Goodwill (internally-generated)Acctg. rules do not allow the co. to capitalize their reputation for service and

quality onto the fin. stmts.

Few MARKET VALUES (MVs)Mvs are relevant for decision-making, but often are too subjective to be

included in the fin. stmts.

No Inflation Adjustments different levels of purchasing power on fin. stmts.

Mgtmt biases and incentives:There is an incentive to have good fin. results potential to choose acctg

methods, etc. to look good.

Fin. Stmt Info CANNOT be used to identify UNDERVALUED securities (publicly-traded). Why? Because the stock market is EFFICIENT. This means that the PRICES of securities adjust almost instantaneously reflect the public release of new information.

NOTE: The fin. stmts are “old” news because earnings and other information gets released in the fin. press much earlier.

However, fin. stmt analysis is still useful.


D. Analyze the Fin. Stmts themselves

Comparisons make fin. stmts more meaningful (relevant)

1) Comparisons across time (2 or more years of sequential data)

2) Comparisons within industries (use industry averages compared to our company’s ratios)

3) Comparisons within the fin. stmts.a. Ratio Analysisb. Common-Size Statements

On Inc. Stmt On the Bal. Sheetevery item is every item is a %a % of Sales of Total Assets

4) Look for deviations from the norm when analyzing the financial statement numbers.


FLORIDA CPA EXAMINATION REQUIREMENTS(In effect as of April 1989)

Baccalaureate Degree PLUS 30 semester hours

Total Education must include:

36 hours in accounting above elementary (All of these hours must be at the upper division level)

Must Include At Least:12 hours in Financial Accounting (May include cost accounting) 6 hours in Auditing 6 hours in Tax(May Include 3 hours of Internship)

(Internship hours cannot be counted as financial accounting, auditing, or tax)

39 Hours in General Business including at least 6 hours Business Law (At least 21 of these hours must be at the upper division level)

May Include:

Additional Accounting hours above the 36 required

Additional Internship hours

Economics courses

Specialized Industry courses if certified by the department chairman

Oral and written communication courses if they have a business or accounting prefix (or are required of business majors)

A maximum of 9 hours of computer courses

A maximum of 6 hours of upper division statistics courses

May not include:Any elementary accounting coursesVocational or Clerical courses


No experience or additional education needed for certification


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