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Part 1: Section A: External Financial Reporting Decisions
Financial Statements (Public limited companies-must) Historical
Users-Decisions-Communicate-Results
Users: External/Internal
Shareholders
Tax Authorities
Regulatory Agencies
Banks
Creditors
Management
Employees
Board of Directors
Balance sheet=Picture of OWES (Liab&Equity) & OWNS (Assets)
Income statement-Movie
Assts-Liab=Equity (Proprietary Theory)
Balance sheet=Permanent Accounts (Liquidity,Solvency,Flexibility)
Income statement=Temporary Accounts
Elements of Balance sheet
Assets
Liabilities
Equity
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Asset = Unexpired Cost.
1. You Own
2. Provide Future Benefit
3. Arouse from a past transaction
When we talk about intangible assets we come back to this.
Liability =
1. You Owe
2. Cause Future Cash Outflow
3. Arouse from a past transaction
Current vs. Non-Current (Fixed)
Current Asset is converted to Cash within 12 months or 1 operating
cycle whichever is longer.
For most businesses the Operating cycle is generally less than 12
months but there are some exceptions like construction companies
etc...
Limitations of Balance sheet:
Historical Cost,Judgments and Estimates, e.g.: % of Bad debt, Useful life, Warranty
Internally generated assets are NOT recorded e.g. Goodwill, Brand.
Income Statement – MOVIE (starting point and ending period)
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Single step and Multi step income statements.
Single step:
Revenues
-All Expenses
---------------------------
Net Income
Multi step:
Sales Revenue
-COGS
----------------------
Gross Profit
-Selling, general and admin expenses
----------------------
Operating Income
+ Interest and dividend income-Interest expense
+/- Non operating gains/Losses
----------------------
Income from continuing operationsbefore Income Tax
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-Provision for Income Taxes on above Income
----------------------
Income from continuing operations
+/- Gains/losses on operations of discontinued operation (Net of Tax)
+/- Gains/losses on Disposal of discontinued operation (Net of Tax)
----------------------
Income before Extraordinary item
+/- Extraordinary Gains/losses (unusual and infrequent)
-Applicable Tax
----------------------
Net Income
----------------------
Elements of Income Statement
Revenues Primary Business Operations
Expenses
Gains Non Primary Operations
Losses
Unusual or infrequent is a separate item in Continued operations
Uses:
Asses Risk
Past PerformanceBasis for predicting future performance
Limitations:
Net income Full of assumptions
Eg: accounting method, depreciation method, FIFO or LIFO,
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Items not able to be measured like Brand
Cash Flow
Operating,
Investing,
Financing
Uses:
Liquidity and Cash Analysis
Limitations:Indirect method has limitations
Comprehensive Income: All transactionsexcept transactions with
Owners.
Net income
+/- Gains/losses foreign currency
Translation
+/- Gains/losses prior service costs/
Credits related to pension plan Other Comprehensive Income
+/- Gains/losses Unrealized
Held for sale securities
+/- Gains/losses effective portion
Cash flow hedge-----------------------------
Comprehensive income
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Limitations of financial statements
Only Monetary (Quantitative), No quality items
Lot of Estimation/Judgment/Choices
Past transactions and Historical Cost
Assume Going Concern
Statement of Cash flow (Connected to Income statement)
Income statement is the starting point for Cash Flow Statement.
Income statement and adjustments. i.e. non-cash transactions.Eg: Credit transactions, Depreciation
Also some cash transactions not in income statement.(unearned
revenue)
Cashflow is connected to Income statement.
No. of CashFlowStatement = No. of Income Statements
Three Categories of Activities
Operating Activities:(which are NOT Financing or Investment
Activities i.e Revenues and expences eg.Interest paid and rec’d,
Trading securities, Taxes, DividendsRECEIVED)
Investment Activities: Invest for future benefits eg.Purchase or sale
of PPE, Make(give) and collect back loan, Buying and selling shares
of other companies, Aquiring and disposing debt in other companies
Buying and selling available for sale/held for maturity investments.Financing Activities: to raise capital
Eg.issuing stock,treasury stock transactions,DividendPAID,issue
debt and repay debt(lease, mortgage etc..),obtain and repay loan,
some taxes issues related to share based compensation .
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Notes:
Present each side of transaction and do not net off
Non cash investment and financing transactions present separately at
the bottom of cashflow statement.
e.g. issue of stock to purchase PPE
Cash equivalents(3 months or less) NOT shown
Foreign currency Cash Flows :Use rate in effect or Avg.rate.
Cash Flow Statement –Methods
We know the answer before we begin; Answer to SCF is simple i.e
change in cash during period which comes from balance sheet.
For exam INDIRECT method is important.
The Difference between 2 valid methods under GAAP is in
presentation of operating activities section.
OP
INV
FIN
===
Change in cash
====
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INDIRECT METHOD
Steps forOPERATING Activities
1)Eliminate Non-Cash Items e.g. Depreciation
2)Eliminate Invest & Finance Activities e.g. Asset sale
3)Adjust for operating accounts(Cash items not there in IS)
4)Trading Securities
5)Disclosures
Change in the opening and closing balances need to be considered.
1. Add back depreciation, amortization expense etc..
2. Gain are subtracted and Losses added back from Net income
because these are not operating
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3. If AR or Inventory, increases subtract or vice-versa.
AP increases add back or vice versa.
Rule: Liabilities move same way
In the Exam, Trade securities are generally operating but companies
may choose to be as investing activities.
Under Indirect method:
Cash paid for interest as disclosure
Cash paid for taxes as disclosure
Investment and Finance Activities
How much cash rec’d and how much paid.
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Accounts receivable and Bad Debts
Two methods of Allowance
% of sales method (Income statement method)
% of A/R method (Balance sheet method)
The difference is in calculation, other than that the journal entries and
accounts are same.
Direct write off of Receivables is not allowed in US GAAP unless youhave very few.
Under % of sales method we calculate % of sales that will NOT be
collected.
Under % of A/R method we calculate % of ending AR that will NOT be
collected.
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Factoring
Interest calculation excludes reserve and fee.
Without recourse generally have higher interest rate
because of risk.
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Seller may get all or some of reserve back if customers
pay
.
With recourse is a liability (secondary).
Factor is a party which buys receivables at discount.
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Inventory
lassi!cation
Raw Material
Work in Process
Finished Goods
FOB shipping point Ownership of Goods in Transit.
FOB destination
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How often do we calculate average cost
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Till now we have seen periodic.
!g" Oldest person in the fa#il$ continues to %e oldest.
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&'FO is (ot accepta%le under 'FR).
F'FO*&'FO*W+M are all assu#ptions.
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Treat as one $ear and it will %e corrected, however one $ear isover stated and one $ear it is under stated.
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Totals are correct, %ut individual allocations are not correct.
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-!'&'(G (R/selling price0cost to co#plete or dispose
F&OOR(R/0(or#al Pro1t #argin
Want-urrent Market price
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We need to write down the inventor$ %$ 233.
Investments
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Bu$ing %onds of other co#panies.
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)#all e4uit$ invest#ents treat sa#e as de%t.
"ong term Investments.
5e%t will #ature %ut e4uit$ does not have #aturit$.
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!ven if there are less than 236 7 8 share, %ut there is a control
over the other co#pan$. -onsolidation #ethod is used.
+fter eli#inating 1nall$ we will have onl$ transactions with
outside parties.
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#roperty #lant $%uipment
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Which method is best&
The one which %est #atches revenues and e9penses.
!.g. +sset provide sa#e value of %ene1t ever$ $ear use )&M.
+sset provides #ore %ene1t in initial $ears use 55B.
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Salvage value is 'ot used in till the end.
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"I*"I+I$S
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$xpense warranty is at the time of sale by manufacturer
Sales warranty could be by anybody separately from
product.
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Income taxes
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#ermanent timing di,erences does not create deferred tax
items.
+hey are not same in all countries.
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eferred tax asset is nothing but prepaid tax is di,erence
between
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-ow much we want to pay ebit
-ow much we have to pay /redit
eferred tax asset is nothing but prepaid taxes
eferred tax liabilities is nothing but taxes payable.
It revolves around +emporary timing di,erences.
ommon Stock
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'o 0ournal entry is recorded.
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'ot a liability till it is declared. It has to be disclosed in
'otes.
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'eed more info.
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(o -ash received or paid.
1evenue 1ecognition
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"ong term ontract (more than one year)
When pro!t is recogni2ed&
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iscontinued 3perations and $xtraordinary items
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"eases
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IF1S same method for same inventory.
IF1S 4 *sset retirement obligation cost Inventory cost5S 6**#4 *sset retirement obligation cost *sset ost
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(P %efore Ta9 and e9traordinar$ is before dividend and after
interest.
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