NINJA BOOK FINANCIAL ACCOUNTING AND REPORTING I CONCEPTUAL FRAMEWORK & FINANCIAL STATEMENT PRESENTATION

Transcription

1 NINJA BOOK FINANCIAL ACCOUNTING AND REPORTING I 2018 CONCEPTUAL FRAMEWORK & FINANCIAL STATEMENT PRESENTATION

2 COPYRIGHT This book contains material copyrighted 1953 through 2018 by the American Institute of Certified Public Accountants, Inc., and is used or adapted with permission. Paragraphs from the FASB Accounting Standards Codification and portions of various FASB and GASB documents are copyrighted by the Financial Accounting Foundation, 401 Merritt 7, P.O. Box 5116, Norwalk, CT , and are reprinted with permission. Complete copies of these documents are available from the Financial Accounting Foundation. Material from the Uniform CPA Examination Questions and Unofficial Answers, copyright 1976 through 2018, American Institute of Certified Public Accountants, Inc., is used or adapted with permission. This book is written to provide accurate and authoritative information concerning the covered topics. It is not meant to take the place of professional advice in any way NINJA CPA Review, LLC. All Rights Reserved. i

3 I ACCOUNTING STANDARDS 2

4 A. U.S. Securities and Exchange Commission (SEC) 01 The SEC is a governmental entity created to protect the interest of investors by ensuring full and adequate disclosure by publicly traded companies. Although the SEC has the authority to establish standards, it has generally deferred to the Financial Accounting Standards Board (FASB) or its predecessors to generate U.S. accounting standards. Application: What types of rules are generally issued by the SEC? The SEC issues Financial Reporting Releases that usually agree with U.S. GAAP. The SEC issues U.S. GAAP. The SEC does not issue rules. None of the answer choices are correct. A - The Securities and Exchange Commission (SEC) is a governmental entity created to protect the interest of investors by ensuring full and adequate disclosure by publicly traded companies. Although the SEC has the authority to establish standards, it has generally deferred to the Financial Accounting Standards Board (FASB) or its predecessors to generate U.S. accounting standards. The SEC does issue its own rules in the form of Financial Reporting Releases, which generally agree with U.S. GAAP. 02 The SEC rule-making process can involve several steps: concept release, rule proposal, and rule adoption. Concept Release: The rule-making process usually begins with a rule proposal, but sometimes an issue is so unique and/or complicated that the Commission seeks out public input on which, if any, regulatory approach is appropriate. Rule Proposal: The Commission publishes a detailed formal rule proposal for public comment. Rule Adoption: Finally, the Commissioners consider what they have learned from the public exposure of the proposed rule, and seek to agree on the specifics of a final rule. The SEC issues its own rules in the form of Financial Reporting Releases, which generally agree with U.S. GAAP Application: The Securities and Exchange Commission was created under which of the following acts? The 1933 Securities Act The 1934 Securities Exchange Act The Tax Equity and Fiscal Responsibility Act Both the 1933 Securities Act and 1934 Securities Exchange Act B - The 1934 Securities Exchange Act created the Securities and Exchange Commission (SEC). 3

5 B. Financial Accounting Standards Board (FASB) 01 Basic accounting principles or standards, commonly referred to as generally accepted accounting principles (GAAP), represent the most authoritative position at any point in time as to which economic resources and obligations should be recognized in financial statements as assets and liabilities, which changes in those assets and liabilities should be recognized, when those changes should be recognized, how those recognized changes should be measured, what information should be disclosed and how that information should be disclosed, and which financial statements should be prepared. Application: Generally accepted accounting principles are: pronouncements of the Financial Accounting Standards Board. the basic concepts underlying financial accounting and reporting. guidelines that accountants may choose to follow. established principles that rarely change. B - Generally accepted accounting principles (GAAP) are the basic concepts underlying financial accounting and reporting that have substantial authoritative support. GAAP includes pronouncements of other authoritative bodies, such as the Accounting Principles Board, Governmental Accounting Standards Board, Securities and Exchange Commission, and the American Institute of Certified Public Accountants boards and committees, in addition to pronouncements of the Financial Accounting Standards Board and the FASB's Accounting Standards Codification. GAAP also includes specific practices that have widespread use and are included in accounting textbooks and other writings. GAAP is more than just guidelines. Accountants are required by Rule 203 of the code of professional conduct to follow GAAP except in those limited situations in which unusual circumstances would cause financial statements prepared in accordance with GAAP to be misleading; following GAAP is not a choice left to the discretion of the practitioner. GAAP incorporates a consensus that spurs an evolutionary process, so that these principles continuously change over time in response to changes in economic, legal, political, and social conditions; new knowledge and technology; and demands of users for more useful information. 4

6 02 Review of Underlying Accounting Principles Principle Explanation Application Historical Cost Revenue Recognition Matching Consistency Disclosure Objectivity/ Verifiability Separate Entity Continuity/ Going Concern Unit of Measure Periodicity As a measurement basis, historical cost is the most objectively determinable and is the proper basis for the recording of many asset acquisitions, expenses, costs, creditor equities, and owner equities. Revenue is recognized when it is earned, measurable, and collectible. At this point, the earnings process is virtually complete. Although recognition through sale is the most consistently used test, circumstances may allow recognition at other points in the earning cycle. Net Income or loss for an accounting period is determined by the process of associating realized revenues with those expenses and expired costs necessary to generate them. This often requires estimates and allocations. To enhance financial statement comparability, an entity employs the same accounting procedures from period to period. Changes within GAAP should be justified by more appropriate presentation of financial position and results of operations. Financial statements should include all information germane to the formation of valid business decisions. The user must neither be burdened with an information overload nor misled by the exclusion of material facts. The economic activity which underlies financial statements must not only be substantive in fact but also presented without bias so as to be subject to similar determination by other technically competent individuals. A business enterprise is a discrete unit of accountability whose economic activities are kept separate from those of its owners and other business enterprises. However, in connection with preparing financial statements, management must evaluate whether there are conditions and events that raise substantial doubt about an entity s ability to continue as a going concern. The common denominator upon which all financial data are based is the monetary unit. Further, it is assumed that the monetary unit remains stable in value (or changes are immaterial in amount) so that the impact of real changes in its purchasing power remain unadjusted-for in the primary financial statements. The life of an enterprise is divided into artificial time periods to facilitate reporting and decision making. Plant assets are recorded at their historical cost and not current replacement value or some other basis in the primary financial statements. Accrual accounting recognizes revenue at the point of sale and is generally accepted as opposed to the cash basis of accounting which records revenues in the period during which cash is received. The accrual basis of accounting correctly matches the revenue from the sale of goods with the historical cost of the inventory sold, the salesperson s salary, and other applicable costs and expenses. The LIFO inventory method, once adopted, is applied in following years. Notes to the financial statements are a common form of supplementary disclosure. Plant assets are carried at cost, which is generally definite and determinable, and not at net present value based on subjective judgments. Personal business transactions of a major stockholder are not reported in the financial statements of a corporation. Liquidation values of assets and liabilities are ordinarily not used in preparing a company s Balance Sheet. The economic activity of a U.S. business enterprise is quantified in terms of the dollar. Inflationary trends are not reflected in the primary financial statements by adjustments to non-monetary items. Although the success or failure of an enterprise is subject to the most accurate determination when the enterprise discontinues operations, financial statements are prepared annually. 5

7 Application: Reporting inventory at the lower of cost or market is a departure from the accounting principle of: historical cost. consistency. conservatism. full disclosure. A - Financial accounting is primarily based on the historical cost principle which specifies that assets be recorded and carried at their historical acquisition cost. When reporting inventory at the lower of cost or market, cost is compared with market (usually some variant of replacement cost) and the lower value is used to reflect the loss of utility (i.e., market value) of the goods. Selection and use of a value other than acquisition cost is clearly a departure from the historical cost principle. 03 Modifying Conventions - These represent conceptual explanations for a departure from what might otherwise be thought of as generally accepted. Modifying Convention Explanation Application Conservatism Industry practices. Substance over Form Application of Judgement Materiality When confronted with alternative accounting procedures, the accountant follows that which has the least favorable impact on current income. Departure from strict compliance with GAAP may exist in some cases due to the peculiar nature of the industry in which an enterprise operates. The economic substance of a transaction determines the accounting treatment, even though the legal form of the transaction may indicate a different treatment. In some cases, strict adherence to GAAP produces results that are unreasonable. A departure from GAAP may be made to render results that appear reasonable in the circumstances. The accounting treatment of many items is dependent upon their resultant impact on users decisions. Strict compliance with GAAP is necessary only when an item, due to its dollar size and/or nature, has a significant effect on financial statements and the accompanying investor decisions. Losses may be anticipated while gains are normally not recognized in the accounts until they are realized. Due primarily to allocation problems, the companies in the meat packing industry carry inventory at selling prices less costs of disposal, a departure from the principle of historical cost. Under certain circumstances, leased property may be capitalized as a sale (by the lessor) and as an acquisition (by the lessee). Disclosure of events which is not required by authoritative pronouncements may be considered necessary in specific circumstances by individual accountant(s) responsible for the content of financial statements. The purchase price of inexpensive long-lived assets might be expensed (rather than being capitalized and depreciated over their useful lives) if the dollar amounts involved are so small as to be insignificant. 6

8 04 Accounting Standards Codification - Effective for financial statements issued for interim and annual periods ending after September 15, 2009, the Accounting Standards Codification is the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority. 05 Non-authoritative accounting guidance and literature that include: a. practices that are widely recognized and prevalent either generally or in the industry b. FASB Concepts Statements c. American Institute of Certified Public Accountants (AICPA) Issues Papers d. International Financial Reporting Standards of the International Accounting Standards Board (IASB) e. pronouncements of professional associations or regulatory agencies f. Technical Information Service Inquiries and replies included in AICPA Technical Practice Aids g. accounting textbooks, handbooks, and articles Application: Arpco, Inc., a for-profit provider of healthcare services, recently purchased two smaller companies and is researching accounting issues arising from the two business combinations. Which of the following accounting pronouncements are the most authoritative? AICPA Statements of Position FASB Accounting Standards Codification FASB Statements of Financial Accounting Concepts FASB Statements of Financial Accounting Standards B - Under FASB ASC , effective for financial statements issued for interim and annual periods ending after September 15, 2009, the Accounting Standards Codification (ASC) is the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under federal securities laws are also sources of authoritative GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority. 7

9 06 The FASB is currently the body responsible for developing accounting standards in the United States. The FASB s primary functions are to study current issues and generate new accounting standards. 07 Accounting Standards Updates issued after September 2009 will not be considered authoritative in their own right. Instead, the Accounting Standards Updates will serve only to update the Accounting Standards Codification, provide background information about the guidance, and provide the Basis for conclusions on the change(s) in the Codification. Application: Which of the following statements best describes an operating procedure for issuing a new Financial Accounting Standards Board (FASB) Accounting Standards Update? The emerging issues task force must approve a discussion memorandum before it is disseminated to the public. The exposure draft is modified per public opinion before issuing the discussion memorandum. An update is issued only after a majority vote by the members of the FASB. A new FASB update can be rescinded by a majority vote of the AICPA membership. C - The Board issues an Accounting Standards Update by simple majority vote. Accounting Standards Updates issued after September 2009 will not be considered authoritative in their own right. Instead, the Accounting Standards Updates will serve only to update the Accounting Standards Codification, provide background information about the guidance, and provide the Basis for conclusions on the change(s) in the Codification. 8

10 II CONCEPTUAL FRAMEWORK 9

11 A. Financial Reporting by Business Entities 01 Objective of Financial Reporting - General financial reporting should provide information that is useful to present and potential investors, lenders, and other creditors in making rational decisions about providing resources to the entity. These decisions involve buying, selling, or holding equity and debt instruments and providing or settling loans and other forms of credit. Other parties are not the primary users but may also use general purpose financial reports. a. Primary users of general purpose financial statements are existing and potential investors, lenders, and other creditors. These users make decisions about buying, selling, or holding equity and debt instruments or providing credit by evaluating the expected returns from their investment. These parties need information about the prospects of future net cash inflows to the entity. They also need information about the entity s resources, claims against those resources, and how efficiently the entity s management and governing board have used the entity s resources. b. Financial statements are, to a large extent, based on estimates, judgments, and models. c. Current cash flow information helps users to assess an entity s ability to generate cash flows in the future. It does this by providing information about how the entity generates cash flows. Application: During a period when an enterprise is under the direction of a particular management, its financial statements will directly provide information about: both enterprise performance and management performance. management performance but not directly provide information about enterprise performance. enterprise performance but not directly provide information about management performance. neither enterprise performance nor management performance. C - Financial statements provide direct information about enterprise performance because the primary focus of the statements is to provide information about the financial performance of that enterprise by providing information about earnings. The same cannot be said, however, in regard to management performance. The financial statements depict only indirect information concerning management performance. (Direct information related to management performance would be provided in internal managerial performance reports but not in the external financial statements.) 02 Primary Qualitative Characteristics: Relevance and Faithful Representation a. Relevance: To be relevant to investors, creditors, and other users, accounting information must be capable of making a difference in a decision. Financial information is capable of making a difference if it has predictive value, confirmatory value, or both. It must also be material. 1. Predictive Value: Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. 2. Confirmatory Value: Financial information has confirmatory value if it provides feedback about (confirms or changes) previous evaluations. 3. Materiality: Financial information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. 10

12 Application: Which of the following characteristics of accounting information primarily allows users of financial statements to generate predictions about an organization? Reliability Timeliness Neutrality Relevance D - The qualitative characteristics of useful accounting information are found in SFAC 8, chapter 3. The primary qualitative characteristics are relevance and faithful representation. Relevance to the users of financial information means that the information is capable of making a difference when the user is making a financial decision. The characteristics that have the potential to make a difference are: predictive value, confirmatory value, and materiality. b. Faithful Representation: To be reliable, investors, creditors, and other users must be able to depend on accounting information to represent the economic conditions or events that it purports to represent. To be a faithful representation, accounting information must be complete, neutral, and free from error. (SFAC 8, Chapter 3, QC12) 1. Complete: A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. 2. Neutral: A neutral depiction is without bias in the selection or presentation of financial information not slanted, weighted, emphasized, deemphasized, or otherwise manipulated to increase the probability that financial information will be received favorably or unfavorably by users. 3. Free from Error: Financial information cannot be accurate in all respects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. Application: Conceptually, interim financial statements can be described as emphasizing: timeliness over faithful representation. faithful representation over relevance. relevance over comparability. comparability over neutrality. A - Interim financial statements emphasize timeliness over faithful representation. (FASB ASC ) Interim financial information is essential to provide investors and others with timely information as to the progress of the enterprise. Timeliness is mentioned, but faithful representation is not. 11

13 03 Enhancing Qualitative Characteristics: Comparability, verifiability, timeliness, and understandability are qualitative characteristics that enhance the usefulness of information that is relevant and faithfully represented. a. Comparability: Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Unlike the other qualitative characteristics, comparability does not relate to a single item. A comparison requires at least two items. Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal. Comparability is not uniformity. For information to be comparable, like things must look alike and different things must look different. Comparability of financial information is not enhanced by making unlike things look alike any more than it is enhanced by making like things look different. b. Verifiability: Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities also can be verified. Verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation, for example, by counting cash. Indirect verification means checking the inputs to a model, formula, or other technique and recalculating the outputs using the same methodology. c. Timeliness: Timeliness means having information available to decision makers in time to be capable of influencing their decisions. Generally, the older the information is, the less useful it is. However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends. d. Understandability: Classifying, characterizing, and presenting information clearly and concisely makes it understandable. Some phenomena are inherently complex and cannot be made easy to understand. Excluding information about those phenomena from financial reports might make the information in those financial reports easier to understand. However, those reports would be incomplete and therefore potentially misleading. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyze the information diligently. At times, even well-informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena. Application: According to the FASB conceptual framework, which of the following is an essential characteristic of an asset? The claims to an asset's benefits are legally enforceable. An asset is tangible. An asset is obtained at a cost. An asset provides future benefits. D - SFAC 6, Elements of Financial Statements, identifies three characteristics of assets: An asset has three essential characteristics: (a) it embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly to future net cash inflows, (b) a particular entity can obtain the benefit and control others' access to it, and (c) the transaction or other event giving rise to the entity's right to or control of the benefit has already occurred. Assets commonly have other features that help identify them. For example, assets may be acquired at a cost and they may be tangible, exchangeable, or legally enforceable. However, these features are not essential characteristics of assets. (Emphasis added) 12

14 04 Cost is a Pervasive Constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. There are several types of costs and benefits to consider. In applying the cost constraint, the FASB assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. Application: According to the FASB's conceptual framework, the usefulness of providing information in financial statements is subject to the constraint of: comparability. cost-benefit. faithful representation. relevance. B - SFAC 8, chapter 3, paragraph QC5, identifies two fundamental qualitative characteristics relevance and faithful representation. SFAC 8, chapter 3, paragraph QC19, identifies four enhancing characteristics comparability, verifiability, timeliness, and understandability. In SFAC 8, chapter 3, paragraph QC35, the requirement that benefits exceed costs was identified as a pervasive constraint. Costs are imposed when reporting financial information, and those costs must be justified. The FASB was clearly concerned about the cost-benefit constraint. 05 Elements of the Financial Statements are the building blocks with which financial statements are constructed. a. Assets are probable future economic benefits obtained or controlled by a particular enterprise as a result of past transactions or events b. Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular enterprise to transfer assets or provide services to other enterprises as a result of past transactions or events. c. Equity (or net assets) is the residual interest in the assets of an enterprise that remains after deducting its liabilities. In a business enterprise, the equity is the ownership interest. d. Investments by owners are increases in net assets of a particular enterprise resulting from transfers to it from other enterprises of something of value to obtain or increase ownership interests (or equity) in it. Assets are most commonly received as investments by owners, but what is received may also include services, satisfaction, or conversion of liabilities of the enterprise. e. Distributions to owners are decreases in net assets of a particular enterprise resulting from transferring assets or rendering services to the owner, or incurring liabilities by the enterprise on behalf of owners. Distributions to owners decrease ownership interests (or equity) in the enterprise. f. Comprehensive Income is the change in equity (net assets) of an enterprise, during a period, from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period, except those resulting from investments by owners and distributions to owners. g. Revenues are inflows or other enhancements of the assets of an enterprise or settlements of its liabilities (or a combination of both), during a period, from delivering or producing goods, rendering services, or other activities that constitute the enterprise s ongoing major or central operations. 13

15 h. Expenses are outflows or other uses of assets or incurrences of liabilities (or a combination of both), during a period, from delivering or producing goods, rendering services, or carrying out other activities that constitute the enterprise s ongoing major or central operations. i. Gains are increases in equity (net assets) from peripheral or incidental transactions of an enterprise and from all other transactions and other events and circumstances affecting the enterprise during a period, except those that result from revenues or investments by owner. j. Losses are decreases in equity (net assets) from peripheral or incidental transactions of an enterprise and from all other transactions and other events and circumstances affecting the enterprise during a period, except those that result from expenses or distributions to owners. Application: Rock Co.'s financial statements had the following balances at December 31: Gain on Sale of Truck $ 50,000 Foreign currency translation gain l00,000 Net income 400,000 Unrealized gain on Equity securities 20,000 What amount should Rock report as Comprehensive Income for the year ended December 31? $400,000 $420,000 $500,000 $570,000 C - Comprehensive Income includes all changes in equity during a period except those resulting from owner's investments and distributions to owners. All four of the choices are included in the computation; however, the gain on sale of the truck is already included in the Net Income amount. Comprehensive Income is Net Income plus Other Comprehensive Income items. Other comprehensive items include foreign currency translation gains $100,000 + $400,000 = $500, Articulation is a term used to describe the interrelationship of the elements of the financial statements. Some elements are a snapshot - they reflect aspects of the enterprise at a point in time assets, liabilities, and equity. The remaining elements of the financial statements describe effects of transactions and other events and circumstances that occur over intervals of time. These two types of elements are related in such a way that (a) assets, liabilities, and equity are changed by elements of the other type and at any time are their cumulative result, and (b) an increase or decrease in an asset cannot occur without a corresponding increase or decrease in another asset, liability, or equity. The resulting financial statements are, fundamentally interrelated, even though they include different elements that reflect different characteristics of the enterprise and its activities. 14

16 Application: Articulation means that financial statements are: fundamentally interrelated. separate and self-balancing. unaffected by each other. totally dependent on each other. A - Articulation means that the elements of financial statements are fundamentally interrelated in two ways: (1) beginning balance + changes = ending balance, and (2) assets = liabilities + equity. The concept of double-entry accounting (i.e., debits = credits) incorporates these relationships. In this way, financial statements show different aspects of the same transaction or event affecting the entity. Financial statements are not separate and self-balancing the Balance Sheet is dependent upon the current period income or loss from the Income Statement to be balanced. Similarly, financial statements are affected by the other financial statements changes in Balance Sheet elements (assets and liabilities) are reflected in the Statement of Cash Flows. 07 GAAP financial statements for a period shows the following: a. Financial position at the end of the period b. Earnings for the period c. Comprehensive Income for the period d. Cash flows during the period e. Investments by and distributions to owners during the period Application: According to the FASB conceptual framework, the process of reporting an item in the financial statements of an entity is: allocation. matching. realization. recognition. D - SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises, defines recognition as follows: Recognition is the process of formally recording or incorporating an item into the financial statements of an entity as an asset, liability, revenue, expense, or the like. Remember: Recognition and realization are not synonymous. 15

17 08 Financial Statement items represent in words and numbers certain enterprise resources, claims to those resources, and the effects of transactions and other events and circumstances that result in changes in those resources and claims. An item and information about it should meet four fundamental recognition criteria to be recognized and should be recognized when the criteria are met, subject to cost-benefit and materiality thresholds. a. Definition: The item meets the definition of an element of financial statements. b. Measurability: The item has a relevant attribute measurable with sufficient reliability. c. Relevance: The information is capable of making a difference in user decisions. d. Reliability: The information is representationally faithful, verifiable, and neutral. Application: According to the FASB conceptual framework, which of the following situations violates the concept of reliability? Data on segments having the same expected risks and growth rates are reported to analysts estimating future profits. Financial statements are issued nine months late. Management reports to stockholders regularly refer to new projects undertaken, but the financial statements never report project results. Financial statements include property with a carrying amount increased to management's estimate of market value. D - Reliability was addressed in SFAC Specifically, the FASB noted that: To be reliable, information about an item must be representationally faithful, verifiable, and neutral. To be reliable, information must be sufficiently faithful in its representation of the underlying resource, obligation, or effect of events and sufficiently free of error and bias to be useful to investors, creditors, and others in making decisions. Clearly, values assigned to property based on management's estimate of fair value are not representationally neutral and would not be considered reliable as defined by the SFAC 5. Late financial statements violate timeliness (relevance), not reliability. The term reliability is still used in SFAC 5, even though it has changed to faithful representation in SFAC Recognizing Revenues and Gains is based on their being realized or realizable as well as earned. a. Realized or realizable: Revenues and gains are generally not recognized as components of earnings until realized or realizable. b. Earned: Revenues are not recognized until earned. Revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues. For gains, being earned is generally less significant than being realized or realizable. 16

18 Application: Under a royalty agreement with another enterprise, a company will receive royalties from the assignment of a patent for three years. The royalties received should be reported as revenue: at the date of the royalty agreement. in the period earned. in the period received. evenly over the life of the royalty agreement. B - SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises, identified two factors affecting revenue recognition: being realized or realizable and being earned. In regard to being earned, the statement noted that revenues are not recognized until earned. The royalties should be recognized as revenue in the period earned. 10 Recognizing Expenses and Losses a. Consumption of Benefit: Expenses are generally recognized when an enterprise s economic benefits are consumed in revenue-earning activities or otherwise. b. Loss or Lack of Benefit: Expenses or losses are recognized if it becomes evident that previously recognized future economic benefits of assets have been reduced or eliminated, or that liabilities have been incurred or increased, without associated economic benefits. Application: On October 31, Year 1, a company with a calendar year-end paid $90,000 for services that will be performed evenly over a 6-month period from November 1, Year 1, through April 30, Year 2. The company expensed the $90,000 cash payment in October, Year 1, to its services expense general ledger account. The company did not record any additional journal entries in Year 1 related to the payment. What is the adjusting journal entry that the company should record to properly report the prepayment in its Year 1 financial statements? Debit prepaid services and credit services expense for $30,000 Debit prepaid services and credit services expense for $60,000 Debit services expense and credit prepaid services for $30,000 Debit services expense and credit prepaid services for $60,000 B - The $90,000 payment covers six months' work, of which only two months are in this year. Thus, this year's expenses should be only 2/6 of $90,000, or $30,000. The other 4/6 of the payment is a prepaid expense of $60,000 for next year, so the prepaid expenses need to be increased with a debit of $60,000, and they must come out of the services expenses of this year with a credit of $60,000, lowering this year's expense down to where it should be. 17

19 B. Using Cash Flow Information and Present Value in Accounting Measurements 01 Objective of using Present Value: To capture the economic difference between sets of future cash flows and estimate fair value. For example, without present value, a $1,000 cash flow due tomorrow and a $1,000 cash flow due in 10 years appear the same. With present value, they do not appear the same. Application: On January 1 of the current year, Lean Co. made an investment of $10,000, with interest of 10% compounded annually. The following is the present value of $1.00 discounted at a 10% interest rate: Present Value of $1.00 Periods Discounted at 10% ========= ======================== What amount of cash will Lean accumulate in two years? $12,000 $12,101 $16,250 $27,002 B - The amount accumulated at the end of two years is the future value of a single payment times the $10,000 deposit. Because future values of single payments and present values of single payments are reciprocals, the amount that will be accumulated at the end of two years is $10, , or $12, Estimating Future Cash Flows and Interest Rates - To the extent possible, estimated cash flows and interest rates should reflect assumptions about the future events and uncertainties that would be considered in deciding whether to acquire an asset or group of assets in an arm s-length transaction for cash. a. Interest rates used to discount cash flows should reflect assumptions that are consistent with those inherent in the estimated cash flows. b. Estimated cash flows and interest rates should be free from both bias and factors unrelated to the asset, liability, or group of assets or liabilities in question. c. Estimated cash flows and interest rates should reflect the range of possible outcomes rather than a single most likely, minimum, or maximum possible amount. 18

20 Application: On December 31, 20X1, Key Co. received two $10,000 non-interest-bearing notes from customers in exchange for services rendered. The note from Alpha Co., which is due in nine months, was made under customary trade terms, but the note from Omega Co., which is due in two years, was not. The market interest rate for both notes at the date of issuance is 8%. The present value of $1 due in nine months at 8% is The present value of $1 due in two years at 8% is At what amounts should these two notes receivable be reported in Key's December 31, 20X1, Balance Sheet? Alpha $9,440, Omega $8,570 Alpha $10,000, Omega $8,570 Alpha $9,440, Omega $10,000 Alpha $10,000, Omega $10,000 B - Current receivables acquired as a result of customary trade terms are normally reported at their face value. Long-term receivables are reported at their present value: $10, = 8,

21 III FINANCIAL REPORTING 20

22 A. Balance Sheet / Statement of Financial Position 01 Under current GAAP, a complete set of financial statements for an annual period includes the following: a. Statement of Financial Position (Balance Sheet) b. Statement of Profit or Loss (Income Statement) c. Statement of Cash Flows d. Statement of Changes in Stockholders Equity e. Supplemental and Note Disclosures 02 GAAP does not require a Statement of Changes in Stockholders Equity. However, GAAP requires that all material changes in equity be disclosed, either in a financial statement or in the notes to the financial statements. Many enterprises choose to report their material changes in a financial statement, which is usually identified as a Statement of Changes in Stockholders Equity. 03 GAAP also requires that changes in equity that are identified as Other Comprehensive Income be reported in a financial statement rather than in the notes. Application: Which of the following statements is correct regarding reporting Comprehensive Income? Accumulated Other Comprehensive Income is reported in the stockholders' equity section of the Balance Sheet. A separate statement of Comprehensive Income is required. Comprehensive Income must include all changes in stockholders' equity for the period. Comprehensive Income is reported in the year-end statements but not in the interim statements. A - FASB ASC requires that accumulated Other Comprehensive Income be reported in the stockholders' equity section of the Balance Sheet: The total of Other Comprehensive Income for a period shall be transferred to a component of equity that is presented separately from retained earnings and additional paid-in capital in a statement of financial position at the end of an accounting period. A descriptive title such as accumulated Other Comprehensive Income shall be used for that component of equity. 04 The Balance Sheet represents the position of the enterprise at a point in time (e.g., end of the year). Application: In analyzing a company's financial statements, which financial statement would a potential investor primarily use to assess the company's liquidity and financial flexibility? Balance Sheet Income Statement Statement of retained earnings Statement of Cash Flows A - Evaluation of a company's liquidity would necessitate computation of liquidity ratios such as the current ratio and acid-test ratio. Financial flexibility would be evaluated using debt and equity ratios. The data used in computation of each of the above-mentioned ratios would be obtained from the Balance Sheet. 21

23 05 The Account Form Balance Sheet has assets on the left, equities on the right: NINJA Co. - Comparative Balance Sheets (Account Form) At 12/31/X2 and 12/31/X1 X2 X1 X2 X1 Assets (000s) Liabilities and Stockholders Equity (000s) Current assets Current liabilities Cash $290 $144 Accounts payable $250 $375 Investment in Equity securities Accrued taxes, interest, and Available-for-sale debt securities other expenses Notes and accounts receivable, Dividends payable net of allowance for doubtful Current portion of obligations accounts of $100,000 in 20X2 under capital leases and $150,000 in 20X Total current liabilities $331 $473 Inventories carried at FIFO cost Prepayments and other current Non-Current liabilities Assets Obligations under capital leases $401 $437 Total current assets $2,105 $1,849 9% bonds due in 20X5, net of unamortized discount of Investments $137,000 in 20X2 and Land held for resale $10 $30 $150,000 in 20X Sinking fund for 9% bonds due Total non-current liabilities $1,264 $1,287 in 20X Total liabilities $1,595 $1,760 Total investments $660 $630 Stockholders equity Property, plant, and equipment 7% convertible preferred stock Land $1,150 $1,150 (noncumulative) authorized Plant facilities and fixtures 720 1,055 5,000 shares of $100 par Leased plant equipment under value, issued and outstanding capital leases ,000 shares in 20X1 and $2,370 $2,705 2,500 shares in 20X2 $250 $300 Less accumulated Common stock authorized Depreciation ,000 shares of $25 par Net property, plant, and value, issued 85,000 shares Equipment $2,103 $2,305 in 20X1, 87,000 shares in 20X2 2,175 2,125 Paid-in capital in excess of par Intangible assets value on common stock Patents $190 $194 Paid-in capital in excess of cost of common treasury stock 5 0 Other assets Retained earnings Unamortized organization costs Treasury common stock at cost, 1,000 shares Total assets $5,070 $4,994 Accumulated other Comprehensive Income Total stockholders equity $3,475 $3,234 Total liabilities and stockholders equity $5,070 $4,994 22

24 The following major categories typically appear on corporate Balance Sheets. Item Definition (SFAC 6) Subcategories Assets Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Current assets Investments Property, plant, and equipment Intangible assets Other Liabilities Equity Probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities as a result of past transactions. The residual interest in the assets of an entity that remains after deducting its liabilities. For a corporation, equity is the ownership interest (identified as stockholders equity ). Current Non-Current Contributed capital Par/stated value Amounts in excess of par/stated value Donated capital Capital arising from asset revaluation Retained earnings Treasury stock Accumulated Other Comprehensive Income Application: Mirr, Inc., was incorporated on January 1, 20X0, with proceeds from the issuance of $750,000 in stock and borrowed funds of $110,000. During the first year of operations, revenues from sales and consulting amounted to $82,000, and operating costs and expenses totaled $64,000. On December 15, 20X0, Mirr declared a $3,000 cash dividend, payable to stockholders on January 15, 20X1. No additional activities affected owners' equity in 20X0. Mirr's liabilities increased to $120,000 by December 31, 20X0. On Mirr's December 31, 20X0, Balance Sheet, total assets should be reported at: $885,000 $882,000 $878,000 $875,000 A - Since (1) assets equals liabilities plus equity and (2) the $120,000 amount of liabilities is a given, the key is to compute the December 31, 20X0, balance of equity. The transactions described affected equity as follows: Issuance of stock on 1/1/X0 $750,000 Revenues 82,000 Expenses (64,000) Declaration of cash dividend (3,000) Equity 12/31/X0 $765,000 Therefore, total assets must be $885,000, as shown below: Assets = Liabilities + Equity Assets = $120,000 + $765,000 Assets = $885,000 23

25 06 The Report Form of the Balance Sheet, includes assets at the top of the statement and equities at the bottom. NINJA Co. Comparative Balance Sheets (Report Form) At 12/31/X2 and 12/31/X1 20X2 20X1 Assets Current assets $2,105 $1,849 Investments Property, plant, and equipment, net 2,103 2,305 Intangible assets Other Total assets $5,070 $4,994 Liabilities Current liabilities $331 $473 Non-Current liabilities 1,264 1,287 Total liabilities $1,595 $1,760 Stockholders equity Contributed capital $2,660 $2,655 Retained earnings Treasury stock 0-30 Accumulated Other Comprehensive Income Total stockholders equity $3,475 $3,234 Total liabilities and stockholders equity $5,070 $4, The Financial Position Form of the Balance Sheet, shows the net working capital (by deducting current liabilities from current assets), adds non-current assets, deducts non-current liabilities, and finally nets to the stockholders equity, which is presented in detail in a balancing section. NINJA Co. Comparative Balance Sheet (Financial Position Form) At 12/31/X2 and 12/31/X1 20X2 20X1 Current assets $2,105 $1,849 Less: Current liabilities Net working capital $1,774 $1,376 Non-Current assets 2,965 3,145 Total net working capital and non-current assets $4,739 $4,521 Less: Non-Current liabilities -1,264-1,287 Total net assets $3,475 $3,234 Stockholders equity Contributed capital $2,660 $2,655 Retained earnings Accumulated Other Comprehensive Income Treasury stock 0-30 Total stockholders equity $3,475 $3,234 24

26 08 A general principle of accounting is that the offsetting of assets and liabilities in the Balance Sheet is improper except where a right of setoff exists. This means, for example, that a debtor with a payable to an entity may not offset a receivable from that same entity and display only the difference as a net payable or receivable unless specified conditions are met. FASB ASC specifies the following conditions that must be met for the right of setoff to exist: a. Each of the two parties owes the other determinable amounts. b. The reporting party has the right to set off the amount owed with the amount owed by the other party. c. The reporting entity intends to set off. d. The right of setoff is enforceable at law. Application: Acme Co.'s accounts payable balance at December 31 was $850,000 before necessary year-end adjustments, if any, related to the following information: At December 31, Acme has a $50,000 debit balance in its accounts payable resulting from a payment to a supplier for goods to be manufactured to Acme's specifications. Goods shipped FOB destination on December 20 were received and recorded by Acme on January 2; the invoice cost was $45,000. In its December 31 Balance Sheet, what amount should Acme report as accounts payable? $850,000 $895,000 $900,000 $945,000 C - The $50,000 debit balance in accounts payable for goods to be manufactured should be shown in accounts receivable unless right to set off exists. The goods shipped FOB destination should not be included as a liability until received and were not included in the $850,000 balance. $850, ,000 = $900,000 25

27 B. Income Statement / Statement of Profit or Loss 01 Comparative Income Statement for NINJA Co. for the years 20X2 and 20X1 is presented as follows. NINJA Co. Comparative Income Statements (in thousands) For the Years 20X2 and 20X1 Revenue from sales $2,550 $2,000 Cost of goods sold Gross profit $1,900 $1,440 Selling and administrative expenses 1,210 1,040 Operating income $690 $400 Other income: Gain on sale of land $10 $0 Dividend income 5 4 Other expenses: Interest on long-term debt Loss on investment in equity securities Income before taxes $579 $329 Provision for income taxes Income from continuing operations $300 $169 Discontinued operations Loss from operations of discontinued component, net of applicable tax savings of$27,000 in 20X2 and $18,000 in 20X1 (including loss on disposal of $10,000 in 20X2) X2 X Income before cumulative effect of change in accounting principle $260 $149 Cumulative effect of FASB-mandated accounting change, net of applicable taxes of 28, Net Income $ Earnings per common share Income from continuing operations $3.45 $1.99 Discontinued operations Income before cumulative effect of change in accounting principle $2.99 $1.75 Cumulative effect of change in accounting principle Net Income $3.33 $

28 Application: A company's activities for Year 2 included the following: Gross sales $3,600,000 Cost of goods sold 1,200,000 Selling and administrative expense 500,000 Adjustment for a prior-year understatement of amortization expense 59,000 Sales returns 34,000 Gain on sale of available-for-sale debt securities 8,000 Gain on disposal of a discontinued business segment 4,000 Unrealized gain on available-for-sale securities 2,000 The company has a 30% effective income tax rate. What is the company's Net Income for Year 2? $1,267,700 $1,273,300 $1,314,600 $1,316,000 C - Net Income is computed is follows: Gross sales $3,600,000 Less: Sales returns 34,000 Net sales $3,566,000 Cost of goods sold 1,200,000 Gross profit $2,366,000 Selling and administrative expenses 500,000 Operating income $1,866,000 Other income: Gain on sale of AFS debt securities 8,000 Income before taxes $1,874,000 Provision for income taxes ($1,874,000 x.30) (562,200) Income from continuing operations $1,311,800 Discontinued operations: Gain from disposal of discontinued business segment, net of applicable tax savings of $1,200 ($4,000 x.30) 2,800 Net income $1,314,600 Unrealized gain on available-for-sale debt securities is included in Comprehensive Income, not in Net Income. 27

29 02 The Income Statement illustrated in section 01 assumes that NINJA Co. elects to report items of OCI in a financial statement other than the Income Statement. As demonstrated below, NINJA Co. elects to report items of OCI in a separate Comprehensive Income Statement. NINJA Co. For the Years 20X2 and 20X1 (000 s omitted) 20X1 20X2 Net Income $290 $199 Other Comprehensive Income: Unrealized gains (losses) on AFS debt securities Comprehensive Income $310 $ OCI is required to be reported in a formal financial statement. One of the acceptable alternative methods is that shown above for NINJA Co. Another method that NINJA Co. could have chosen is to include an OCI section at the bottom of the Income Statement with the final caption at the bottom of the statement being Comprehensive Income. A third method that NINJA Co. could choose is to report the items of OCI in its Statement of Changes in Stockholders Equity. 04 Several definitions of the basic elements of an Income Statement, as presented in section 01 are important and are described as follows (SFAC 6): a. Revenue: Inflows of assets or settlements of liabilities, during a period, from delivering or producing goods, rendering services, or other activities that constitute the entity s ongoing major or central operations. b. Expenses: Outflows of assets or incurrences of liabilities, during a period, from delivering or producing goods, rendering services, or other activities that constitute the entity s ongoing major or central operations. c. Gains: Increases in net assets other than from revenues or investments by owners. d. Losses: Decreases in net assets other than from expenses or withdrawals by owners. e. Income (Earnings): Revenues - Expenses + Gains Losses 28

30 05 Gains and Losses relate to peripheral or secondary activities rather than to the major or central operations of the enterprise. While revenues and expenses are presented in gross amounts in the Income Statement, gains and losses are presented in the Income Statement in net amounts. Application: On January 1, 20X1, Card Corp. signed a 3-year, non-cancelable purchase contract, which allows Card to purchase up to 500,000 units of a computer part annually from Hart Supply Co. at $.10 per unit and guarantees a minimum annual purchase of 100,000 units. During 20X1, the part unexpectedly became obsolete. Card had 250,000 units of this inventory at December 31, 20X1, and believes these parts can be sold as scrap for $.02 per unit. What amount of probable loss from the purchase commitment should Card report in its 20X1 Income Statement? $24,000 $20,000 $16,000 $8,000 C - Minimum purchase commitment for 20X2 and 20X3 (100,000 units x $.10/u x 2 years) $20,000 Less scrap recovery (100,000 units x $.02 x 2 years) 4,000 Probable loss from purchase commitment $16,000 The question asks for the probable loss from purchase commitment (i.e., the loss for the remaining two years on the contract). The loss on the 250,000 units already in inventory is not considered part of this loss; it would be reported as an operating loss due to the write-down of inventory due to obsolescence. 06 Income Statements may be presented in either of two formats single step or multiple step. a. Single Step Income Statement: A simple and relatively straightforward presentation whereby all revenues and gains are combined at the top of the statement. From this subtotal, a total amount of all expenses and losses is deducted to render a Net Income figure. A popular variation of the single-step Income Statement is the separation of income taxes from the other expenses, resulting in an income figure before taxes (when revenues and gains are reduced by all other expenses and losses). Income tax is then deducted as a separate item, resulting in a Net Income figure. b. Multiple Step Income Statement: Under the multiple-step Income Statement, a distinction is made between operating and non-operating items. The typical format is that illustrated previously in the example of NINJA Co., wherein cost of goods sold is deducted from revenues to yield gross profit; selling and administrative expenses are then deducted to yield operating income; other income and expense items are then added and deducted to yield Net Income (unless the enterprise is involved in some of the specialized gain and loss transactions). 29

31 Application: In Baer Food Co.'s 20X2 single-step Income Statement, the section titled Revenues consisted of: Net sales revenue $187,000 Results from discontinued operations: Loss from operations of component (net of $1,200 tax effect) $(2,400) Gain on disposal of component (net of $7,200 tax effect) 14,400 12,000 Interest revenue 10,200 Gain on sale of equipment 4,700 Cumulative change in 20X0 and 20X1 income due to change in inventory method (net of $750 tax effect) 1,500 Total Revenues $215,400 In the revenues section of the 20X2 Income Statement, Baer Food should have reported total revenues of: $216,300 $215,400 $203,700 $201,900 D - Items to be included in the revenue section of the 20X2 Income Statement: Net sales revenue $187,000 Interest revenue 10,200 Gain on sale of equipment 4,700 Total revenues $201,900 Under a single-step Income Statement all revenues and gains are combined at the top of the statement. C. Statement of Comprehensive Income 01 Comprehensive Income is defined in SFAC 6 as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period, except those resulting from investments by owners and distributions to owners. Thus, Comprehensive Income includes not only Net Income but also other components of Comprehensive Income that are not included in Net Income. This relationship is illustrated as follows: Revenues and gains $ XXX Expenses and losses XXX Income before income taxes XXX Income taxes XXX Net Income XXX Other Comprehensive Income XXX Comprehensive Income $ XXX 30

32 Application: Comprehensive Income includes all of the following, except: dividends to shareholders. revenues from external customers. interest expense to bondholders. loss from tornado. A - Comprehensive Income is defined in the FASB's conceptual framework as the change in equity (assets - liabilities) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Comprehensive Income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners. The FASB concluded in its conceptual framework that Comprehensive Income should be reported in a full set of financial statements. However, prior to FASB ASC , the FASB had not issued a standard that required the presentation of Comprehensive Income or recommended a format for displaying Comprehensive Income. 02 Comprehensive Income includes some of the following: a. Foreign Currency Translation adjustments b. Foreign Currency Transaction gains and losses that are designated as, and are effective as, economic hedges of a net investment in a foreign entity, commencing as of the designation date c. Cash Flow Hedge gains and losses (effective portion) d. AFS Debt Security unrealized gains and losses Application: Which of the following does not represent an element of Other Comprehensive Income under current generally accepted accounting principles? Foreign currency adjustments Accumulated gains and losses on available-for-sale debt investments Cumulative effect of a change in accounting estimate Amortization of unrecognized prior service costs related to a pension plan C - The components of Other Comprehensive Income are to be presented based on their nature. Under current authoritative accounting literature, three categories of elements of Other Comprehensive Income exist: 1. Unrealized gains and losses on available-for-sale debt investments 2. Foreign currency items 3. Changes in unrecognized prior service costs, unrecognized gains and losses, and unrecognized transition assets or obligations related to defined benefit pension plans and defined benefit other post-retirement plans 31

33 03 Statement of Comprehensive Income: One-Statement Approach ABC Company Statement of Income and Comprehensive Income For the Year Ended December 31, 20X1 Revenues $95,000 Expenses -10,000 Other gains and losses 6,000 Gain on sale of securities 2,000 Income from operations before income taxes 93,000 Income tax expense 23,250 Income before cumulative effect of accounting change 69,750 Cumulative effect of accounting change, net of tax 7,000 Net Income 62,750 Other Comprehensive Income, net of tax: Foreign currency translation adjustments a 9,000 Unrealized gains on AFS debt securities: b Unrealized holding gains arising during period $12,000 Less: Reclassification adjustment for gain included in Net Income Changes in unrecognized items related to pension and postretirement plans c -1,500 10,500-3,000 Other Comprehensive Income 16,500 Comprehensive Income $79,250 Alternatively, components of Other Comprehensive Income could be displayed before tax with one amount shown for the aggregate income tax expense or benefit, as shown below: Other Comprehensive Income, before income tax: Foreign currency translation adjustments a $12,000 Unrealized gains on AFS debt securities: b Unrealized holding gains arising during period $16,000 Less: Reclassification adjustment for gains included in Net Income Changes in unrecognized items related to pension and postretirement plans c -2,000 14,000-4,000 Other Comprehensive Income, before income tax 22,000 Income tax expense related to items of Other Comprehensive Income -5,500 Other Comprehensive Income, net of income tax $16,500 a It is assumed that there was no sale of an investment in a foreign entity. Therefore, there is no reclassification adjustment for this period. 32

34 04 Statement of Comprehensive Income: Two-Statement Approach ABC Company Statement of Income For the Year Ended December 31, 20X1 Revenues $95,000 Expenses -10,000 Other gains and losses 6,000 Gain on sale of securities 2,000 Income from operations before income taxes 93,000 Income tax expense -23,250 Income before cumulative effect of accounting change 69,750 Cumulative effect of accounting change, net of tax 7,000 Net Income $62,750 ABC Company Statement of Comprehensive Income For the Year Ended December 31, 20X1 Net Income $62,750 Other Comprehensive Income, net of tax: Foreign currency translation adjustments 9,000 Unrealized gains on AFS debt securities: Unrealized holding gains arising during period 12,000 Less: Reclassification adjustment for gain included in Net Income -1,500 10,500 Changes in unrecognized items related to pension and post-retirement plans -3,000 Other Comprehensive Income 16,500 Comprehensive Income $79,250 33

35 05 It is also important to note that whether Comprehensive Income is reported (1) under the one-statement format or the two-statement format for reporting Comprehensive Income or (2) in the Statement of Changes in Stockholders Equity, Comprehensive Income must be reported in a primary financial statement. Mere disclosure in the notes is not acceptable. Application: When a full set of general purpose financial statements are presented, Comprehensive Income and its components should: appear as a part of discontinued operations and cumulative effect of a change in accounting principle. be reported net of related income tax effect, in total and individually. appear in a supplemental schedule in the notes to the financial statements. be displayed in a financial statement that has the same prominence as other financial statements. D - FASB ASC requires that all items that are recognized as components of Comprehensive Income be reported in a financial statement that has the same prominence as other financial statements. However, FASB ASC does not prescribe a specific format for the display of such information. 34

36 06 Classifications Within Other Comprehensive Income: Items included in Other Comprehensive Income should be classified based on their nature. Application: A company has available-for-sale debt investments that cost $50,000 and were valued at $45,000 at the beginning of the current period during which the investments were sold for $48,000. Which of the following best reflects the impact of these events on the elements of Comprehensive Income of the current year? Impact on Net Income: $3,000 gain; OCI (reclassification): $5,000 loss; Comprehensive Income: $2,000 loss Impact on Net Income: $2,000 loss; OCI (reclassification): $5,000 gain; Comprehensive Income: $3,000 gain Impact on Net Income: $4,000 gain; OCI (reclassification): $6,000 loss; Comprehensive Income: $2,000 loss Impact on Net Income: $5,000 loss; OCI (reclassification): $5,000 gain; Comprehensive Income: $3,000 gain B - Ignoring any tax effects, these transactions and events affect Comprehensive Income as follows: Net income: Realized loss ($48,000 - $50,000) $(2,000) Other comprehensive income: Reclassification adjustment gain 5,000 Comprehensive income $ 3,000 A realized loss of $2,000 is recognized because investments costing $50,000 were sold for $48,000. That realized loss is included in Net Income. The $5,000 reclassification gain is required to offset the previously recognized unrealized loss ($50,000 - $45,000). To prevent including certain items in the determination of Comprehensive Income twice, reclassification adjustments are required for a transaction or event that has been included as a component of Other Comprehensive Income and later becomes a component of Net Income. Impact Impact Years Before Sale Year of Sale Net income -0- $(2,000) Other comprehensive income: Unrealized gain/(loss) $(5,000) Reclassification -0-5,000 Comprehensive income $(5,000) $ 3,000 35

37 07 Reporting Accumulated Other Comprehensive Income: An entity must present, on the face of the financial statements or as a separate disclosure in the notes, the changes in the accumulated balances for each component of OCI included in that separate component of equity. The presentation of changes in accumulated balances shall correspond to the components of OCI in the statement in which OCI for the period is presented. ABC Company Balance Sheet December 31, 20X1 Assets: Cash $180,000 Accounts receivable 200,000 Available-for-sale debt securities 145,000 Plant and equipment 940,250 Total assets $1,465,250 Liabilities: Accounts payable $150,000 Notes payable 386,000 Pension liability 140,000 Total Liabilities 676,000 Stockholders equity: Common stock $250,000 Additional paid-in capital 350,000 Retained earnings 152,750 Accumulated Other Comprehensive Income 36,500 Total stockholders equity 789,250 Total liabilities and stockholders equity $1,465,250 Application: At the end of the accounting period, the components of Other Comprehensive Income are transferred to which of the following stockholders' equity accounts? Additional paid-in capital (common stock) Retained earnings Accumulated Other Comprehensive Income Treasury stock C - The total of Other Comprehensive Income for a period is transferred to a component of equity that is presented in the statement of financial position separately from retained earnings and additional paid-in capital. This element of stockholders' equity should carry an appropriate title, such as accumulated Other Comprehensive Income. The accumulated balances of each separate classification of that component of stockholders' equity is required, either in the statement of financial position or in notes to the financial statements. The classifications of Other Comprehensive Income must be consistent throughout the financial statements (FASB ASC ). 36

38 D. Statement of Changes in Equity 01 An example of a comparative Statement of Changes in Stockholders Equity for NINJA Co. for 20X1 and 20X2: 7% Conv. P. Stock NINJA Co. Statement of Changes in Stockholders Equity For the Years 20X2 and 20X1 (000 s omitted) C. Stock Capital in Excess of Par Value Capital from Treasury Stock Transactions Treasury Stock at Cost Ret Earnings Bal. Dec 31, 20X0 $300 $1,375 $180 $0 $0 $500 Net Income for the year 20X1 Cash Dividends Declared: 7% Conv. Preferred Stock Common Stock -84 Proceeds from sale of Common Stock, 30,000 shares Common share purchased and held in the treasury, 1,000 shares Bal. Dec 31, 20X1 $300 $2,125 $230 $0 -$30 $594 Net Income for the year 20X2 Cash dividends declared: 7% Convertible Preferred Stock Common stock -86 Conversion of 500 shares of 7% convertible preferred stock to 2,000 shares of common stock Treasury common shares sold, 1,000 shares Bal. Dec 31, 20X2 $250 $2,175 $230 $5 $0 $780 37

39 Application: Selected information from the accounts of Row Co. on December 31, 20X1, follows: Total income since incorporation $420,000 Total cash dividends paid 130,000 Total value of property dividends distributed 30,000 Excess of proceeds over cost of treasury stock sold, accounted for using cost method 110,000 In its December 31, 20X1, financial statements, what amount should Row report as retained earnings? $260,000 $290,000 $370,000 $400,000 A - Retained earnings on December 31, 20X1, would be computed: Total income since incorporation $420,000 Less cash dividends $130,000 Property dividends 30, ,000 Retained earnings on December 31, 20X1 $260,000 The excess of proceeds over cost of treasury stock sold would be credited to additional paid-in capital under the cost method. Application: Which of the following is included on a statement of changes in equity? Column headings identify individual stockholders' equity accounts. Events changing stockholders' equity accounts are listed chronologically to the left. The impact of the transactions on the number of shares of stock, if any, is presented in the descriptions to the left. All of the items listed are included on a statement of changes in equity. D - Statement of Changes in Stockholders Equity includes the following: Column headings that identify individual stockholders' equity accounts Events changing stockholders' equity accounts The body of the statement presented in terms of the dollar impact of various transactions and events The impact of the transactions on the number of shares of stock, if any Ending balances that tie to the items presented in the stockholders' equity section of the Balance Sheet on the same dates 38

40 E. Statement of Cash Flows 01 In this section, the Statement of Cash Flows is presented as part of the set of financial statements of NINJA Co. This statement omits some of the disclosures required by generally accepted accounting principles. NINJA Co. Statement of Cash Flows For the Years 20X1 and 20X2 (000 s omitted) 20X2 20X1 Cash Flows from Operating Activities: Net Income $290 $199 Adjustments to reconcile Net Income to cash provided by Operating Activities: Depreciation expense Amortization expense 8 8 Accounts receivable decr (incr) Inventory decr (incr) Prepaid expenses decr (incr) Valuation of investment in equity securities loss (gain) 50 0 Accounts payable incr (decr) Accrued expenses incr (decr) Bond discount amortization Change in depreciation method Sale of land loss (gain) Sale of business segment loss (gain) 19 0 Forced sale of assets loss (gain) 0-95 Cash Flows From Operating Activities $77 $69 Cash Flows from Investing Activities: Purchase of available-for-sale debt securities 0 -$10 Proceeds from forced sale of assets Proceeds from sale of business segment $191 0 Proceeds from sale of land 30 0 Sinking fund decr (incr) Cash Flows from Investing Activities $171 $85 Cash Flows from Financing Activities: Retire bonds 0 -$750 Dividends paid -$ Capital leases payable incr (decr) Common stock incr (decr) Treasury stock sale (purch) Cash Flows from Financing Activities: -$102 -$110 Net Increase in Cash, Cash Equivalents, and Restricted Cash $146 $44 Cash, Cash Equivalents, and Restricted Cash Beginning of Year Cash, Cash Equivalents, and Restricted Cash End of Year $290 $144 39

41 Application: On February 1, 20X1, Tory began a service proprietorship with an initial cash investment of $2,000. The proprietorship provided $5,000 of services in February and received full payment in March. The proprietorship incurred expenses of $3,000 in February, which were paid in April. During March, Tory drew $1,000 against the capital account. In the proprietorship's financial statements for the two months ending March 31, 20X1, prepared under the cash basis method of accounting, what amount should be reported as capital? $1,000 $3,000 $6,000 $7,000 C: Initial capital investment $2,000 Add: Service revenue collected 5,000 Subtotal $7,000 Deduct: Cash withdrawn (1,000) Capital balance on March 31, 20X1 $6,000 Under the cash method, expenses would be recorded in April when paid. 02 The Statement of Cash Flows is presented in three sections: cash flows from Operating Activities, from Investing Activities, and from Financing Activities. Each section presents both positive and negative cash flows from a specific aspect of the company s activities. The change in cash resulting from the total of these three sections reconciles the change in cash for the period. Application: Pharm, a nongovernmental not-for-profit entity, is preparing its year-end financial statements. Which of the following statements is required? Statement of changes in financial position Statement of Cash Flows Statement of changes in fund balance Statement of revenue, expenses, and changes in fund balance B - The key to this question is that this is a not-for-profit entity, not a government. The basic financial statements for a not-for-profit entity are statement of financial position (like a Balance Sheet), statement of activities, Statement of Cash Flows, and for voluntary health and welfare entities, a statement of functional expenses. 40

42 03 The Operating Activities section of the Statement of Cash Flows presents the positive and negative cash flows from the company s primary Operating Activities. The most common method for presenting cash flows from Operating Activities is the Indirect Method, in which Net Income is adjusted for non-cash items that have been included in its determination. Application: An unrestricted cash contribution should be reported in a nongovernmental not-for-profit entity's Statement of Cash Flows as an inflow from: Operating Activities. Investing Activities. Financing Activities. capital and related Financing Activities. As illustrated in FASB ASC , unrestricted contributions are reported as Operating Activities. Cash received from contributions restricted by donors for non-current purposes such as fixed asset construction, acquisition or improvement, term endowments, or permanent endowments are classified as Financing Activities in the Statement of Cash Flows. Cash received from investment income restricted by donor stipulation to the same purposes also are reported as Financing Activities, not as Operating Activities. 04 The Investing Activities section of the Statement of Cash Flows presents positive and negative cash flows for transactions involving assets that are not held for resale (i.e., inventories). The most significant Investing Activities involve investments in debt and equity securities, plant assets, and intangible assets. 05 The Financing Activities section of the Statement of Cash Flows presents positive and negative cash flows for transactions resulting from sources of financing for the company, primarily debt and equity financing. Application: A not-for-profit voluntary health and welfare entity should report a contribution for the construction of a new building as cash flows from which of the following in the Statement of Cash Flows? Operating Activities Financing Activities Capital Financing Activities Investing Activities B - According to FASB ASC , a contribution to a not-for-profit restricted to long-term purposes like construction shall be reported as a cash flow from Financing Activities. Cash flows received from investment income restricted by donor stipulation to the same purposes also are reported as Financing Activities, not as Operating Activities. 06 The primary purpose of a Statement of Cash Flows is to provide information about the cash receipts and cash payments of an enterprise during a period of time. 41

43 Application: The primary purpose of a Statement of Cash Flows is to provide relevant information about: differences between Net Income and associated cash receipts and disbursements. an enterprise's ability to generate future positive net cash flows. the cash receipts and cash disbursements of an enterprise during a period. an enterprise's ability to meet cash operating needs. C - FASB ASC contains standards for the financial accounting and reporting of an enterprise's cash flows. This pronouncement notes: The primary purpose of a Statement of Cash Flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period. The information provided in the Statement of Cash Flows must be used in conjunction with the related disclosures and other financial statements to assess differences between Net Income and associated cash receipts and disbursements, an enterprise's ability to generate future positive net cash flows, and an enterprise's ability to meet cash operating needs. 07 Cash flow information is considered useful to investors, creditors, and other financial statement users to assess the following: a. An enterprise s ability to generate positive future cash flows b. An enterprise s ability to meet obligations and pay dividends and its need for external financing c. The reasons for differences between Net Income and associated cash receipts and payments d. The effect on an enterprise s financial position of both its cash and non-cash investing and financing transactions that took place during the period 08 The Statement of Cash Flows explains the change during the period in cash and cash equivalents. Cash equivalents are short-term, highly liquid investments that: a. are readily convertible to known amounts of cash and b. are so near maturity that they represent insignificant risk of changes in value due to changes in interest rates. (Generally, only investments with original maturities of three months or less qualify as cash equivalents, such as treasury bills, commercial paper, money market funds, and federal funds sold.) c. Amounts classified as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. 42

44 Application: Mend Co. purchased a 3-month U.S. Treasury bill. Mend's policy is to treat as cash equivalents all highly liquid investments with an original maturity of three months or less when purchased. How should this purchase be reported in Mend's Statement of Cash Flows? As an outflow from Operating Activities As an outflow from Investing Activities As an outflow from Financing Activities Not reported D - FASB ASC states: A Statement of Cash Flows shall report the cash effect during a period of an entity's operations, its investing transactions, and its financing transactions. It is further noted that these are the same amounts as similarly titled line-items or subtotals shown in the statements of financial position as of those dates. Since Mend's policy is to treat these investments as cash equivalents, the purchase would not be reported in the Statement of Cash Flows. 09 Statement of Cash Flows are presented in three primary sections: cash flows from Operating Activities, cash flows from Investing Activities, and cash flows from Financing Activities (in that order). a. Cash flows from Operating Activities: Cash flows from Operating Activities include those cash flows resulting from transactions included in the determination of Net Income, unless specifically classified by FASB ASC as financing or Investing Activities. (1) Cash inflows from Operating Activities generally include the following: (a) (b) (c) Cash receipts from sales of goods or services Cash receipts from interest and dividends on investments in another enterprise All other cash receipts that are not classified as either investing or Financing Activities (2) Cash outflows classified as Operating Activities include the following: (a) (b) (c) (d) (e) Cash payments to acquire materials for manufacture or goods for resale Cash payments to other suppliers and employees for goods and services Cash payments to governments for taxes, duties, other fees, or penalties Cash payments to lenders and other creditors for interest All other cash payments that are not classified as investing or Financing Activities b. Cash flows from Investing Activities: Cash flows from Investing Activities involve asset transactions other than cash (and cash equivalents) and those assets related directly to the determination of operating results (e.g., inventories, receivables). (1) Specifically, the following are types of cash inflows from Investing Activities: (a) Cash receipts from collections or sales of loans made by the enterprise and of other debt instruments that are purchased by the enterprise (b) Cash receipts from sales of equity securities of other enterprises (c) Cash receipts from the sales of property, plant, and equipment and other productive assets (2) The following are categories of cash outflows from Investing Activities: (a) Cash payments for loans made by the enterprise and payments to acquire debt instruments of other entities 43

45 (b) Cash payments to acquire equity instruments of other enterprises (c) Cash payments to purchase property, plant, as well as equipment and other productive assets c. Cash flows from Financing Activities: Cash flows from Financing Activities involve debt and equity financing. (1) Cash inflows from Financing Activities include the following: (a) (b) Cash proceeds from issuing equity instruments Cash proceeds from issuing bonds, mortgages, notes, and other short- and long-term debt instruments (2) Cash outflows classified as Financing Activities are as follows: (a) Cash payments of dividends or other distributions to owners, including outlays to reacquire the enterprise s instruments (b) Cash repayments of amounts borrowed (c) Other principal cash payments to creditors who have extended long-term credit Application: Karr, Inc., reported Net Income of $300,000 for 20X1. Changes occurred in several Balance Sheet accounts as follows: Equipment Accumulated depreciation Note payable $25,000 increase 40,000 increase 30,000 increase Additional Information During 20X1, Karr sold equipment costing $25,000, with accumulated depreciation of $12,000, for a gain of $5,000. In December 20X1, Karr purchased equipment costing $50,000 with $20,000 cash and a 12% note payable of $30,000. Depreciation expense for the year was $52,000. In Karr's 20X1 Statement of Cash Flows, net cash provided by Operating Activities should be: $340,000 $347,000 $352,000 $357,000 B - Using the Indirect Method, Karr computes cash flow from Operating Activities as follows: Reported 20X1 net income $300,000 Add depreciation expense 52,000 Deduct gain on sale of equipment (5,000) Net Cash flow from operating activities $347,000 All items that are included in Net Income that do not affect net cash provided from, or used for, Operating Activities such as depreciation of property, plant, and equipment and amortization of finite-life intangible assets. This includes all items whose cash effects are related to investing or financing cash flows, such as gains or losses on sales of property, plant, and equipment and discontinued operations (which relate to Investing Activities), and gains or losses on extinguishment of debt (which relate to Financing Activities). (FASB ASC ) 44

46 10 The Direct Method is preferred for reporting cash flows from Operating Activities, with disclosures covering: (1) Cash collected from customers (2) Interest and dividends received (3) Other operating cash receipts (4) Cash paid to employees and other suppliers of goods and services (5) Interest paid (6) Income taxes paid (7) Other operating cash payments 11 Alternatively, the Indirect Method is allowed, in which the calculation begins with Net Income and eliminates noncash amounts included in the determination of that figure as well as any transactions that are classified as investing or Financing Activities (e.g., gains or losses on sales of assets). Application: Duke Co. reported cost of goods sold of $270,000 for 20X1. Additional information is as follows: December 31 January 1 Inventory $60,000 $45,000 Accounts payable 26,000 39,000 If Duke uses the direct method, what amount should Duke report as cash paid to suppliers in its 20X1 Statement of Cash Flows? $242,000 $268,000 $272,000 $298,000 D: Reported cost of goods sold for 20X1 $270,000 Add increase in inventory ($60,000 - $45,000) 15,000 Decrease in accounts payable ($39,000 - $26,000) 13,000 Cash paid to suppliers in 20X1 $298,000 45

47 12 Example Statement of Cash Flows - In the following sections, we consider a comprehensive example of the preparation of Statement of Cash Flows, applying the Direct Method of determining cash flows from Operating Activities. NINJA, Inc. Comparative Balance Sheet (in thousands) At December 31, 20X2 and 20X1 20X2 20X1 Assets: Cash $22 $70 Accounts receivable Inventories Property, plant, and equipment Accumulated depreciation Intangible assets Total assets $835 $800 Liabilities and equities: Accounts payable $60 $75 Accrued expenses Taxes payable Bonds payable Common stock Additional paid-in capital Retained earnings Total liabilities and equity $835 $800 NINJA, Inc. Income Statement (in thousands) For Year Ended December 31, 20X2 Sales $377 Expenses: Cost of sales $120 Selling and administrative 70 Depreciation 40 Amortization (of intangible assets) 2 Interest 25 Loss on sale of equipment Income before income tax $115 Income tax expense -46 Net Income 69 46

48 a. Property, plant, and equipment of $150,000 was purchased during the year; PPE costing $50,000, on which $10,000 of depreciation had been taken, was sold at a $5,000 loss. b. Intangible assets costing $10,000 were purchased during 20X2. c. Capital stock with a par value of $75,000 was sold for $100,000 during 20X2. d. Dividends of $35,000 were declared and paid during 20X2. e. Bonds of $100,000 were retired at a $10,000 gain, which was subject to income taxes at 40%. f. Bonds of $50,000 were converted to common stock with par value of $40,000 during 20X2. g. Accounts payable relate to inventory purchases; accrued expenses relate to selling and administrative expenses. 13 The Statement of Cash Flows for NINJA, Inc. for 20X2, applying the Direct Method and disclosure of the reconciliation of Net Income to cash provided by Operating Activities, is presented here. An explanation of key amounts in the SCF follows the statement and the related disclosures. NINJA, Inc. Statement of Cash Flows (in thousands) For Year Ended December 31, 20X2 Cash flows from Operating Activities: Cash received from customers $362 Cash paid to purchase inventory -125 Cash paid for selling and administrative expenses -65 Interest paid -25 Income taxes paid -45 Net cash provided by Operating Activities $102 Cash flows from Investing Activities: Proceeds from sale of property, plant, and equipment $35 Payment for purchase of property, plant, and equipment -150 Payment for purchase of intangible assets -10 Net cash used by Financing Activities -125 Cash flows from Financing Activities: Payment for bond retirement -$90 Payment for dividends on common stock -35 Proceeds from sale of common stock 100 Net cash used by Financing Activities -25 Net decrease in cash, cash equivalents, and restricted cash -$48 Cash, cash equivalents, and restricted cash, beginning of 20X2 70 Cash, cash equivalents, and restricted cash, end of 20X2 $22 Supplemental schedule of non-cash financing activity: During 20X2, bonds of $50,000 were converted into common stock as follows: Common stock (at par value) $40 Additional paid-in capital 10 $50 47

49 14 Calculations of key amounts included in the SCF are as follows: Cash received from customers: Sales $377 Increase in accounts receivable ($115 $100) -15 $362 Cash paid to purchase inventory: Cost of sales $120 Decrease in inventory ($180 $170) -10 Decrease in accounts payable ($75 $60) 15 $125 Cash paid for selling and administrative expenses: Selling and administrative expenses $70 Increase in accrued expenses ($55 $50) -5 $65 Income taxes paid: Income tax expense 46 Increase in taxes payable ($30 $25) Application: The following information pertains to Spee Co.'s 20X1 sales: Cash Sales Gross $40,000 Returns and allowances 2,000 Credit Sales Gross 60,000 Discounts 3,000 On January 1, 20X1, customers owed Spee $20,000. On December 31, 20X1, customers owed Spee $15,000. Spee uses the direct write-off method for bad debts. No bad debts were recorded in 20X1. Under the cash basis of accounting, what amount of revenue should Spee report for 20X1? $100,000 $95,000 $85,000 $38,000 A: Cash collected from cash sales ($40,000-2,000) = $38,000 Cash collected from credit sales: Net credit sales for 20X1 ($60,000-3,000) $57,000 January 1, 20X1, accounts receivable 20,000 Subtotal $77,000 Less December 31, 20X1, accounts receivable 15,000 62,000 Cash basis revenue for 20X1 $100,000 48

50 15 Several important summary observations can be made about the 20X2 SCF of NINJA, Inc. a. Net cash flows from Operating Activities ($102) are the same, whether computed by the direct method or the Indirect Method. If the direct method is used in the body of the SCF, the reconciliation of Net Income to net cash flows from Operating Activities must be included in related disclosures, as was done in the SCF of NINJA, Inc. Alternatively, the Indirect Method can be used in the primary statement by moving the reconciliation disclosure from the previous example into the statement. b. Interest and taxes paid are separately disclosed whether the direct method or the Indirect Method is used for determining cash flows from Operating Activities. In the case of NINJA, Inc., these were included in the SCF itself. Had the Indirect Method of determining operating cash flows been employed, these items would have been presented in related disclosures. c. Gains and losses included in the determination of Net Income on transactions that are classified as investing and/ or Financing Activities are omitted from the Operating Activities section of the SCF. An example from the NINJA, Inc. illustration is the loss on the sale of property, plant, and equipment. These gains and losses are presented as adjustments to the amount of cash paid or received from the individual financing and Investing Activities. d. All income taxes are included in the Operating Activities section of the SCF, even if transactions with tax effects are reclassified as investing and/or Financing Activities. e. Gross positive and negative cash flows are included in all categories in the SCF operating, investing, and Financing Activities. These gross cash flows are then combined to determine a net figure for each major category in the SCF. f. The change in cash resulting from the combining of net cash flows from operating, investing, and Financing Activities is used to reconcile the change in the cash balance from the beginning to the end of the accounting period. g. Non-Cash transactions are separately disclosed outside the body of the SCF. An example in the NINJA, Inc. SCF is the conversion of outstanding bonds into common stock. 16 Preparing a Statement of Cash Flows - Four Steps: a. Determine the change in cash for the period, noting the amount and direction of the change. b. Analyze all Trial Balance/Balance Sheet accounts to determine cash flows in Operating/Investing/Financing. c. Determine that the amounts of Operating, Investing, and Financing cash flows reconcile the change in cash for the period. If they do not, reconsider changes in Balance Sheet accounts to identify incorrect or omitted items. Continue until the reconciliation can be made. d. Prepare the Statement of Cash Flows. 49

51 Application: Baker Co. began its operations during the current year. The following is Baker's Balance Sheet at December 31: Assets BALANCE SHEET Cash $192,000 Accounts receivable 82,000 Total assets $274,000 Liabilities and Stockholders' Equity Accounts payable $24,000 Common stock 200,000 Retained earnings 50,000 Total liabilities and stockholders' equity $274,000 Baker's Net Income for the current year was $78,000 and dividends of $28,000 were declared and paid. Common stock was issued for $200,000. What amount should Baker report as cash provided by Operating Activities in its Statement of Cash Flows for the current year? $20,000 $50,000 $192,000 $250,000 A: Baker should report $20,000 as net cash provided by Operating Activities: Net income $78,000 Adjustments Increase in accounts receivable ($82,000) Increase in accounts payable 24,000 (58,000) Net cash provided by operating activities $20,000 50

52 17 Reconciling Net Income to Net Cash provided by or used in operations involves adjusting for the effects of changes in Current Assets and Current Liabilities that relate directly to Income Statement items and for non-cash items, such as depreciation and amortization. This reconciliation is required, either as a supplemental disclosure (if the operating section of the statement is prepared by the direct method) or as the primary presentation (if the statement is prepared by the Indirect Method). Current Asset: Reconciling Item Adjustment to Net Income Addition (+) Deduction (-) Increase - Decrease + Current Liability: Increase + Decrease - Long-term Debt: Amortization of discount + Amortization of premium - Depreciation and amortization of long-lived assets + Application: Sanni Co. had $150,000 in cash-basis pretax income for the year. At the current year-end, accounts receivable decreased by $20,000 and accounts payable increased by $16,000 from their previous year-end balances. Compared to the accrual-basis method of accounting, Sanni's cash-basis pretax income is: higher by $4,000. lower by $4,000. higher by $36,000. lower by $36,000. C - Relative to accrual basis, a decrease in accounts receivable is an increase in cash because cash must be received to decrease accounts receivable. Relative to accrual basis, an increase in accounts payable is an increase in cash because accounts payable was increased instead of making cash purchases. Decrease in accounts receivable $20,000 Increase in accounts payable 16,000 Total increase in cash-basis income $36,000 51

53 F. Notes to Financial Statements 01 The CPA s responsibility for disclosure extends to the inclusion of all information believed to be relevant to financial statement users who have a reasonable knowledge of accounting and business matters. Application: What is the purpose of information presented in notes to the financial statements? To provide disclosures required by generally accepted accounting principles To correct improper presentation in the financial statements To provide recognition of amounts not included in the totals of the financial statements To present management's responses to auditor comments A - SFAC 5, Recognition and Measurement in Financial Statements of Business Enterprises, addresses the subject of notes to financial statements as follows: Although financial statements have essentially the same objectives as financial reporting, some useful information is better provided by financial statements, and some is better provided, or can only be provided, by notes to financial statements or by supplementary information or other means of financial reporting: Information disclosed in notes is essential and an integral part of the financial statements prepared in accordance with generally accepted accounting principles. This clearly indicates that notes to financial statements provide disclosures required by generally accepted accounting principles. 02 Notes and Supplemental Disclosures are difficult to categorize because appropriate disclosure in any particular set of circumstances is dependent on the particular characteristics of each financial reporting situation. The following chart shows the types of footnotes and supplemental disclosures that are frequently encountered. Supplemental and Note Disclosure Types a. Detail of information presented in the aggregate in the body of the financial statements b. Accounting policies selected in the preparation of financial statements c. Qualitative information related to transactions included in the financial statements d. Qualitative information related to events not quantified and included in the financial statements e. Other disclosures necessary in a particular situation to meet the objective of adequate disclosure Examples Disclosure of each of the next five years lease payments for capitalized leases Disclosure of inventory pricing methods, depreciation methods, etc. Disclosure of various aspects of the company s pension plan Disclosure of contingencies for which accruals have not been made Disclosure of significant events occurring subsequent to the end of the reporting period 52

54 Application: Town, Inc., is preparing its financial statements for the year ended December 31, 20X1. On January 5, 20X2, prior to the issuance of the financial statements, Town redeemed its outstanding bonds and issued new bonds with a lower rate of interest. The reacquisition price was in excess of the carrying amount of the bonds. What is the appropriate reporting requirement? Disclosure only Accrual only Both accrual and disclosure Neither accrual nor disclosure A - Information which becomes known after the Balance Sheet date, but before the financial statements are issued, should be disclosed to keep the financial statements from being misleading. The gains or losses associated with the redemption and issuance of the bonds would be reported and disclosed in the 20X2 financial statements. 03 Accounting Policy Disclosures: Information about accounting policies adopted by a reporting enterprise is an integral part of the financial statements and is necessary in interpreting other financial statement data. Accordingly, when financial statements are issued purporting to present fairly the financial position, cash flows, and results of operations in accordance with generally accepted accounting principles, a description of all significant accounting policies of the reporting enterprise is required. This reporting requirement extends to not-for-profit enterprises. It does not apply to unaudited financial statements issued between annual reporting dates if the reporting enterprise has not changed policies since the end of the latest fiscal year. Application: Which of the following must be included in a company's summary of significant accounting policies in the notes to the financial statements? Description of current-year equity transactions Summary of long-term debt outstanding Schedule of fixed assets Revenue recognition policies D - The purpose of the summary of significant accounting policies is to describe the accounting policies used by an entity. The revenue recognition policies therefore would be included in this note. 04 Examples of accounting principles and methods for which disclosure of policy is frequently made include, but are not limited to, the following: a. Depreciation methods b. Consolidation basis c. Inter-period tax allocation d. Inventory pricing e. Revenue recognition methods 53

55 Application: Which of the following information should be included in Melay, Inc.'s, 20X1 summary of significant accounting policies? Property, plant, and equipment are recorded at cost with depreciation computed principally by the straight-line method. During 20X1, the Delay segment was sold. Operating segment 20X1 sales are Alay $1M, Belay $2M, and Celay $3M. Future common share dividends are expected to approximate 60% of earnings. A - FASB ASC requires a description of all significant accounting policies when financial statements are issued. A listing of required policy disclosures by this pronouncement includes basis of consolidation, depreciation methods, amortization of intangibles, inventory pricing and several other items. Melay should include information concerning the cost and depreciation method(s) relating to property, plant, and equipment in its summary of significant accounting policies. While the other three information items should be disclosed in the financial statements, they should not be included in the summary of significant accounting policies: During 20X1, the Delay segment was sold. Operating segment 20X1 sales are Alay $1M, Belay $2M, and Celay $3M. Future common share dividends are expected to approximate 60% of earnings. G. Consolidated and Combined Financial Statements 01 Many different ratios are computed and used to analyze the operating characteristics of enterprises, primarily by investors and creditors, both present and potential. Several of the frequently encountered ratios are presented in the next illustration of the NINJA Company, whose Income Statement (year 20X2) and comparative Balance Sheet (years 20X1 and 20X2) are presented as follows. The ratios are computed as of December 31, 20X2. NINJA Company Income Statement For Year Ended December 31, 20X2 Net sales (all credit) $1,000,000 Cost of goods sold ($25,000 depreciation) 600,000 Gross profit on sales $400,000 Selling and administrative expenses 225,000 Income from operations $175,000 Interest on long-term debt 50,000 Income before taxes $125,000 Taxes, 40% 50,000 Net Income $75,000 Dividends declared on common stock 10,000 Dividends declared on preferred stock 15,000 Net Income to retained earnings $50,000 Net earnings per common share a $3 a ($75,000-15,000)/20,000 shares = $3 54

56 NINJA Company Comparative Balance Sheets At December 31, 20X1 and 20X2 12/31/X2 12/31/X1 Assets: Cash and marketable securities $250,000 $200,000 Net accounts receivable 200, ,000 Inventories 100, ,000 Total current assets 550, ,000 Net plant and equipment 400, ,000 Goodwill 100, ,000 Total assets $1,050,000 $1,000,000 Liabilities and equities: Accounts payable $200,000 $150,000 Long-term debt 450, ,000 Preferred stock, $100 par 100, ,000 Common stock, $10 par (market price $17.00) 200, ,000 Retained earnings 100,000 50,000 Total liabilities and equity $1,050,000 $1,000,000 NINJA Company Statement of Cash Flows For Year Ended December 31, 20X2 Cash flows from Operating Activities: Cash received from customers $1,100,000 Cash paid to purchase inventory -675,000 Cash paid for selling and administrative expenses -225,000 Cash paid for interest -50,000 Cash paid for taxes -50,000 Net cash provided by Operating Activities $100,000 Cash from Investing Activities: Cash paid for plant and equipment -75,000 Cash from Financing Activities: Proceeds from long-term debt $50,000 Cash paid for dividends on common stock -10,000 Cash paid for dividends on preferred stock -15,000 Net cash provided by Financing Activities 25,000 Net increase in cash $50,000 Cash, beginning of 20X2 $200,000 Cash, end of 20X2 $250,000 55

57 Ratios Used in Financial Statement Analysis Liquidity Ratios Definition Computation Current Ratio Quick Ratio Inventory Turnover Receivables Turnover Current Assets Current Liabilities Current Assets <Net of Inventories & Prepaids> Current Liabilities COGS Average Inventory Net Credit Sales Average Receivables $550,000 $200,000 $550,000 - $100,000 $200,000 $600,000 ($150,000 + $100,000) / 2 $1,000,000 ($200,000 + $100,000) / ROI Ratios Definition Computation Total Asset Turnover Net Sales Average Total Assets Return on Assets Net Income + Interest Expense (Net-of-Tax Effect) Average Total Assets Return on CS Equity P/E Ratio Dividend Yield Profit Margin on Sales Net Income <Less Preferred Dividends> Average CS Equity Market Price per Common Share Earnings Per Share Dividend per Common Share Market Price per Common Share Net Income Sales $1,000,000 ($1,050,000 + $1,000,000) / 2 $75,000 + ($50,000 - $20,000) ($1,050,000 + $1,000,000) / 2 $75,000 - $15,000 ($300,000 + $250,000) / 2 $17.00 $3.00 $10,000 / 20,000 shares $17.00/share $75,000 $1,000, % 7.5% ROI Ratios Definition Computation Debt/Equity Ratio Equity Ratio Times-Interest Earned Total Liabilities Shareholder s Equity Total Stockholders Equity Total Assets Income (before Interest Expenses and Taxes) Interest Expense $200,000 + $450,000 $100,000 + $200,000 + $100,000 $100,000 + $200,000 + $100,000 $1,050,000 $175,000 $50,

58 Application: Barr Co. has total debt of $420,000 and stockholders' equity of $700,000. Barr is seeking capital to fund an expansion. Barr is planning to issue an additional $300,000 in common stock, and is negotiating with a bank to borrow additional funds. The bank is requiring a debt-to-equity ratio of.75. What is the maximum additional amount Barr will be able to borrow? $225,000 $330,000 $525,000 $750,000 B: Debt-to-equity ratio = Total debt / Total stockholders' equity.75 = Total debt / ($700,000 + $300,000).75($1,000,000) = Total debt $750,000 = Total debt Additional debt = Total debt - Present debt = $750,000 - $420,000 = $330,000 H. SEC Reporting Requirements (e.g., Form 10-Q, 10-K) 01 Under federal securities laws, publicly traded companies are required to file forms with the SEC periodically. Revised Deadlines for Filing Periodic Reports Category of Filer Form 10-K Deadline Form 10-Q Deadline Large Accelerated Filer ($700MM or more) 60 days 40 days Accelerated Filer ($75MM or more and less than $700MM) 75 days 40 days Non-accelerated Filer (less than $75MM) 90 days 45 days Application: A company that is a large accelerated filer must file its Form 10-Q with the U.S. Securities and Exchange Commission within how many days after the end of the period? 30 days 40 days 45 days 60 days B - Form 10-Q is the quarterly report required by the SEC for publicly traded companies. The due date is 40 days after the end of the quarter to which it applies. 57

59 IV OTHER FINANCIAL STATEMENTS 58