Professional Documents
Culture Documents
Principles derive from tradition, such as the concept of matching. In any report of
financial statements (audit, compilation, review, etc.), the preparer/auditor must indicate
to the reader whether or not the information contained within the statements complies
with GAAP.
• Principle of consistency: This principle states that when a business has once
fixed a method for the accounting treatment of an item, it will enter all similar
items that follow in exactly the same way.
• Principle of non-compensation: One should show the full details of the financial
information and not seek to compensate a debt with an asset, a revenue with an
expense, etc. (see convention of conservatism)
• Principle of prudence: This principle aims at showing the reality "as is" : one
should not try to make things look prettier than they are. Typically, a revenue
should be recorded only when it is certain and a provision should be entered for
an expense which is probable.
• Accounting personnel, who need to know whether the organization will be able to
cover payroll and other immediate expenses
• Potential lenders or creditors, who want a clear picture of a company's ability to
repay
• Potential investors, who need to judge whether the company is financially sound
• Potential employees or contractors, who need to know whether the company will
be able to afford compensation
Purpose
Statement of Cash Flow - Simple Example
for the period 01/01/2006 to 12/31/2006
Cash flow from operations $4,000
Cash flow from investing $(1,000)
Cash flow from financing $(2,000)
$1,000
The cash flow statement was previously known as the flow of funds statement.[2] The
cash flow statement reflects a firm's liquidity.
The balance sheet is a snapshot of a firm's financial resources and obligations at a single
point in time, and the income statement summarizes a firm's financial transactions over
an interval of time. These two financial statements reflect the accrual basis accounting
used by firms to match revenues with the expenses associated with generating those
revenues. The cash flow statement includes only inflows and outflows of cash and cash
equivalents; it excludes transactions that do not directly affect cash receipts and
payments. These noncash transactions include depreciation or write-offs on bad debts or
credit losses to name a few.[3] The cash flow statement is a cash basis report on three
types of financial activities: operating activities, investing activities, and financing
activities. Noncash activities are usually reported in footnotes.
The cash flow statement is intended to[4]
1. provide information on a firm's liquidity and solvency and its ability to change
cash flows in future circumstances
2. provide additional information for evaluating changes in assets, liabilities and
equity
3. improve the comparability of different firms' operating performance by
eliminating the effects of different accounting methods
4. indicate the amount, timing and probability of future cash flows
The cash flow statement has been adopted as a standard financial statement because it
eliminates allocations, which might be derived from different accounting methods, such
as various timeframes for depreciating fixed assets.[5]
In the United States in 1971, the Financial Accounting Standards Board (FASB) defined
rules that made it mandatory under Generally Accepted Accounting Principles (US
GAAP) to report sources and uses of funds, but the definition of "funds" was not
clear."Net working capital" might be cash or might be the difference between current
assets and current liabilities. From the late 1970 to the mid-1980s, the FASB discussed
the usefulness of predicting future cash flows.[6] In 1987, FASB Statement No. 95 (FAS
95) mandated that firms provide cash flow statements.[7] In 1992, the International
Accounting Standards Board issued International Accounting Standard 7 (IAS 7), Cash
Flow Statements, which became effective in 1994, mandating that firms provide cash
flow statements.[8]
US GAAP and IAS 7 rules for cash flow statements are similar. Differences include:
• IAS 7 requires that the cash flow statement include changes in both cash and cash
equivalents. US GAAP permits using cash alone or cash and cash equivalents.[9]
• IAS 7 permits bank borrowings (overdraft) in certain countries to be included in
cash equivalents rather than being considered a part of financing activities.[10]
• IAS 7 allows interest paid to be included in operating activities or financing
activities. US GAAP requires that interest paid be included in operating activities.
[11]
• US GAAP (FAS 95) requires that when the direct method is used to present the
operating activities of the cash flow statement, a supplemental schedule must also
present a cash flow statement using the indirect method. The IASC strongly
recommends the direct method but allows either method. The IASC considers the
indirect method less clear to users of financial statements. Cash flow statements
are most commonly prepared using the indirect method, which is not especially
useful in projecting future cash flows.[12]
[edit] Cash flow activities
The cash flow statement is partitioned into three segments, namely: cash flow resulting
from operating activities, cash flow resulting from investing activities, and cash flow
resulting from financing activities.
The money coming into the business is called cash inflow, and money going out from the
business is called cash outflow.
Operating activities include the production, sales and delivery of the company's product
as well as collecting payment from its customers. This could include purchasing raw
materials, building inventory, advertising, and shipping the product.
Items which are added back to [or subtracted from, as appropriate] the net income figure
(which is found on the Income Statement) to arrive at cash flows from operations
generally include:
Financing activities include the inflow of cash from investors such as banks and
shareholders, as well as the outflow of cash to shareholders as dividends as the company
generates income. Other activities which impact the long-term liabilities and equity of the
company are also listed in the financing activities section of the cash flow statement.
Under IAS 7,
• Dividends paid
• Sale or repurchase of the company's stock
• Net borrowings
• Payment of dividend tax
Contents of Annual Report
An Annual report is a comprehensive report on a company's activities throughout the
preceding year. Annual reports are intended to give shareholders and other interested
persons information about the company's activities and financial performance. Most
jurisdictions require companies to prepare and disclose annual reports, and many require
the annual report to be filed at the company's registry. Companies listed on a stock
exchange are also required to report at more frequent intervals (depending upon the rules
of the stock exchange involved).
• Chairman's report
• CEO's report
• Auditor's report on corporate governance
• Mission statement
• Corporate governance statement of compliance
• Statement of directors' responsibilities
• Invitation to the company's AGM
There are various methods or techniques that are used in analyzing financial
statements, such as comparative statements, schedule of changes in working capital,
common size percentages, funds analysis, trend analysis, and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also for
decision making purposes. They play a dominant role in setting the framework of
managerial decisions. But the information provided in the financial statements is not
an end in itself as no meaningful conclusions can be drawn from these statements
alone. However, the information provided in the financial statements is of immense
use in making decisions through analysis and interpretation of financial statements.
Trend Percentage:
Vertical Analysis:
2. Ratios Analysis:
Profitability Ratios:
Profitability ratios measure the results of business operations or overall performance
and effectiveness of the firm. Some of the most popular profitability ratios are as
under:
Liquidity Ratios:
Liquidity ratios These are the ratios which measure the short term solvency of
financial position of a firm. These ratios are calculated to comment upon the short
term paying capacity of a concern or the firm's ability to meet its current obligations.
Following are the most important liquidity ratios.
• Current ratio
• Liquid / Acid test / Quick ratio
Activity Ratios:
Activity ratios are calculated to measure the efficiency with which the resources of a
firm have been employed. These ratios are also called turnover ratios because they
indicate the speed with which assets are being turned over into sales. Following are
the most important activity ratios:
• Debt-to-equity ratio
• Proprietary or Equity ratio
• Ratio of fixed assets to shareholders funds
• Ratio of current assets to shareholders funds
• Interest coverage ratio
• Capital gearing ratio
• Over and under capitalization
A collection of financial ratios formulas which can help you calculate financial ratios in
a given problem. Click here
Although financial statement analysis is highly useful tool, it has two limitations.
These two limitations involve the comparability of financial data between companies
and the need to look beyond ratios. Click here to read full article.
Dear visitor! Do you like this article? If you like, then please bookmark this page and
also share with your friends. Thank you for your support.
(1) Industry comparison. The ratios of a firm are compared with those of similar firms or
with industry averages or norms to determine how the company is faring relative to its
competitors. Industry average ratios are available from a number of sources, including:
(a) Dun & Bradstreet. Dun & Bradstreet computes 14 ratios for each of 125 lines of
business. They are published in Dun's Review and Key Business Ratios. (b) Robert Morris
Associates. This association of bank loan officers publishes Annual Statement Studies.
Sixteen ratios are computed for more than 300 lines of business, as well as a percentage
distribution of items on the balance sheet and income statement (common size financial
statements).
(2) Trend analysis. A firm's present ratio is compared with its past and expected future
ratios to determine whether the company's financial condition is improving or
deteriorating over time.
After completing the financial statement analysis, the firm's financial analyst will consult
with management to discuss plans and prospects, any problem areas identified in the
analysis, and possible solutions. Given below is a list of widely used financial ratios.
English▼
English▼ Deutsch Español Français Italiano Tagalog
•
•
Analysts can obtain useful information by comparing a company's most recent financial
statements with its results in previous years and with the results of other companies in the
same industry. Three primary types of financial statement analysis are commonly known
as horizontal analysis, vertical analysis, and ratio analysis.
Horizontal Analysis
When an analyst compares financial information for two or more years for a single
company, the process is referred to as horizontal analysis, since the analyst is reading
across the page to compare any single line item, such as sales revenues. In addition to
comparing dollar amounts, the analyst computes percentage changes from year to year
for all financial statement balances, such as cash and inventory. Alternatively, in
comparing financial statements for a number of years, the analyst may prefer to use a
variation of horizontal analysis called trend analysis. Trend analysis involves calculating
each year's financial statement balances as percentages of the first year, also known as the
base year. When expressed as percentages, the base year figures are always 100 percent,
and percentage changes from the base year can be determined.
Vertical Analysis
When using vertical analysis, the analyst calculates each item on a single financial
statement as a percentage of a total. The term vertical analysis applies because each
year's figures are listed vertically on a financial statement. The total used by the analyst
on the income statement is net sales revenue, while on the balance sheet it is total assets.
This approach to financial statement analysis, also known as component percentages,
produces common-size financial statements. Common-size balance sheets and income
statements can be more easily compared, whether across the years for a single company
or across different companies.
Ratio Analysis
Ratio analysis enables the analyst to compare items on a single financial statement or to
examine the relationships between items on two financial statements. After calculating
ratios for each year's financial data, the analyst can then examine trends for the company
across years. Since ratios adjust for size, using this analytical tool facilitates
intercompany as well as intracompany comparisons. Ratios are often classified using the
following terms: profitability ratios (also known as operating ratios), liquidity ratios, and
solvency ratios. Profitability ratios are gauges of the company's operating success for a
given period of time. Liquidity ratios are measures of the short-term ability of the
company to pay its debts when they come due and to meet unexpected needs for cash.
Solvency ratios indicate the ability of the company to meet its long-term obligations on a
continuing basis and thus to survive over a long period of time. In judging how well on a
company is doing, analysts typically compare a company's ratios to industry statistics as
well as to its own past performance.
Caveats
Financial statement analysis, when used carefully, can produce meaningful insights about
a company's financial information and its prospects for the future. However, the analyst
must be aware of certain important considerations about financial statements and the use
of these analytical tools. For example, the dollar amounts for many types of assets and
other financial statement items are usually based on historical costs and thus do not
reflect replacement costs or inflationary adjustments. Furthermore, financial statements
contain estimates of numerous items, such as warranty expenses and uncollectible
customer balances. The meaningfulness of ratios and percentages depends on how well
the financial statement amounts depict the company's situation. Comparisons to industry
statistics or competitors' results can be complicated because companies may select
different, although equally acceptable, methods of accounting for inventories and other
items. Making meaningful comparisons is also hampered when a company or its
competitors have widely diversified operations.
The tools of financial statement analysis, ratio and percentage calculations, are relatively
easy to apply. Understanding the content of the financial statements, on the other hand, is
not a simple task. Evaluating a company's financial status, performance, and prospects
using analytical tools requires skillful application of the analyst's judgment.
ANNUAL REPORT
The SEC requires companies to provide annual reports so that consumers can decide
whether or not investing in the company is a sound decision. Individuals with assets tied
up in the company can also use the annual report to determine the security of the
investment. Closely examining an annual report can provide clues into where the
company is going, how well it is doing on the market, and how the company intends to
grow its market position. It can take time to learn how to read an annual report properly,
and many consumers prefer to leave analysis of annual reports to their stockbrokers or
asset managers.
In many cases, an annual report resembles a marketing brochure more than an official
document. It is commonly printed on glossy paper, with numerous pictures and cutting
edge typography to draw the eye. Some professional graphic design firms specialize in
producing annual reports, and sometimes the slick nature of the annual report can be used
to conceal important information. When looking at an annual report, seek out the
numbers, rather than the company's spin on them. Because an annual report is an audited
document, you should be able to trust the numbers to provide the information you need.
Accounting Equation
Is a useful rule which helps when assembling the balance sheet figures. The rule
which is always true is that:
Assets - Liabilities =Capital
Fixed Assets + Current Assets
-Current Liabilities - Long term Liabilities = Capital + profit - drawings
This means that when preparing a balance sheet there will always be two figures
which are the same and we refer to this state as the the balance sheet balancing
Accounting ratios
Used to help make sense of the figures and include the following categories:
Accrual
An amount unaccounted for, yet still owed at the year end. The amount needs to
be estimated and then added to the expenses deducted from the profit in the
Profit and Loss account. The same amount also needs to be added to Trade
Creditors in the Current Liabilities section of the Balance sheet Learn more
about this
Asset
An item of value owned by the business
Balance Sheet
A financial statement that shows what the business is worth. This is a very simple
definition as the valuation of a business is a very complex topic. It shows the
business assets and liabilities at one point in time and is sometimes referred to as
the "snap shot".
Cash
Money. Can be in the petty cash tin in the office or at the bank.
Current Asset
Assets which are expected to be used up and replaced within one year. Sometimes
referred to as short term assets.They can be :
This amount is usually shown net of Doubtful debts(which means having the
amount of doubtful debts deducted from the total figure for debtors) The
deduction for Doubtful debts is usually an estimate and is known as a Provision
(meaning estimate) for doubtful debts. It represents amounts under dispute with
customers or amounts which customers are having difficulty in paying because of
cash flow problems. Income arising from these amounts is therefore considered
doubtful.
• amounts paid in advance (at the end of the accounting year) of goods and services
received and referred to as Prepayments
Current Liability
Amounts owed (within one year) for goods and services purchased on credit
terms. This means payment for goods and services is due at a date later than the
date of sale. Current liabilities can be:
Depreciation
Is the measure of wearing out of a fixed asset. All fixed assets are expected to
wear out, become less efficient and to get "tired". Depreciation is calculated as the
estimate of this measure of wearing out and is a charge in the Profit and loss
Account. Accumulated Depreciation is the total depreciation charges to date
deducted from the cost of the fixed assets to show Net Book Value in the Balance
Sheet learn more about depreciation
Watch a car becoming more worn out over time When you have finished you
need to press escape and return.
Drawings
Assets withdrawn from the business by the owners. These assets are usually cash
but can be any asset withdrawn. In company accounts the withdrawal of assets by
the owners is either called :
Fixed Assets
Assets used within the business and not acquired for the purposes of resale.
Examples include:
Land and buildings
Plant and machinery, such as knitting machines and cup making machinery
Fixtures and fittings, such as light fittings and shelving
Motor vehicles, such as vans and cars. Fixed assets must be shown at original
cost(purchase price) or valuation. Valuation is preferred in the case of assets which have
changed significantly in value since original purchase. For example the current value of
land and buildings can be quite different from the original cost.
Accumulated Depreciation must also be shown, which is deducted from cost (or
valuation) to give net book value
Goodwill
comes in two flavours:
• Inherent goodwill, which is supposed to reflect the reputation and other positive
characteristics of the business which are all difficult to put a value on. This type
of goodwill should not appear on the Balance Sheet
• Purchased goodwill, which is the excess of purchase price over fair value of the
net assets of the business acquired by the purchaser. learn more about goodwill
Legal framework
The law controls what kinds of books, records and systems of internal controls
that must be maintained by companies which are subject to an annual examination
by external auditors. You will learn much more about these in your studies.
Long term Liability
Amounts owed to someone else which are payable after one year. Examples
include:
Reserves
amounts retained in the business and not distributed to owners. Reserves can be:
• Profits made and not passed on to owners. These are some times known as
retained earnings.
• Capital reserves which can not be passed on to owners and represent the
perceived increase in valuation of some fixed assets.
Shares
Amounts invested in a company by its owners. Owners of companies are called
shareholders
Expenses
Referred to as expenditure and including examples such as:
advertising
rent and rates
wages and salaries
travelling expenses
light and heat
Office Expenses
Miscellaneous Expenses
bank interest
loan interest
depreciation
Provision for doubtful debts . This represents an estimate of amounts customers have
difficulty paying due to their cash flow problems. This figure will be deducted from the
profit in the Profit and loss Account and will also be deducted from the Debtors figure in
the Balance Sheet.
bad debts written off
Amounts owed by customers that cannot afford to pay because they have gone into
liquidation. These amounts need to be deducted from the profit in the Profit and Loss
Account and also from the Debtors figure which is found in the Current Assets section
of the Balance Sheet.
accruals and prepayments.
Accruals are amounts unaccounted for yet still owing at the year end . Estimates need to
be made and then added to the expenses deducted in the Profit and Loss account. This
amount also needs to be added to Trade Creditors in the Current liabilities section of the
Balance Sheet . Prepayments are amounts paid for by the business in advance of goods
and services received. These amounts need to be deducted from expenses in the Profit
and Loss account and will also appear in the Current Asset section of the Balance Sheet
along with Debtors.
Gross Profit
Is calculated by deducting Cost of Sales(sometimes referred to as Cost of goods
sold) from sales. Cost Of Sales is calculated by taking:
• Opening stock, which is the value of stock which exists at the beginning of the
accounting period
• Plus Purchases of goods for resale, made during the accounting period.
o Less Closing stock, which is the value of stock which exists at the end of
the accounting period In other words, it is the value of goods purchased
during the year and in stock at the beginning of the year, less those items
sold during the year. This is the figure which also appears in the balance
sheet as stocks and can be found in the current assets section. learn more
about cost of sales
Historic cost
The method used for preparing accounts which estimates the actual purchase price
of all items purchased. This is as opposed to the alternatives which could be to use
instead the:
• cost of replacing items when they are sold or disposed of .Known as the
Replacement cost or net realizable value
• income expected if items were sold. Known as the Realization cost
Net Profit
Sales less cost of sales less expenses = net profit.
Sales less cost of sales = gross profit.
Therefore Net Profit = gross profit less expenses.
In other words Net Profit represents the surplus of sales made over expenditure
during the accounting period. If a deficit is made(i.e if expenditure is greater than
sales) then this results in a net loss and not a net profit.
Reporting of assets
Key concepts
Accountant · Bookkeeping · Trial balance · General ledger ·
Debits and credits · Cost of goods sold · Double-entry
system · Standard practices · Cash and accrual basis · GAAP /
IFRS
Financial statements
Balance sheet · Income statement · Cash flow statement ·
Equity · Retained earnings
Auditing
Financial audit · GAAS · Internal audit · Sarbanes-Oxley Act ·
Big Four auditors
Fields of accounting
Cost · Financial · Forensic · Fund · Management · Tax
This box: view • talk • edit
Many of the standards forming part of IFRS are known by the older name of
International Accounting Standards (IAS). IAS were issued between 1973 and 2001
by the Board of the International Accounting Standards Committee (IASC). On 1 April
2001, the new IASB took over from the IASC the responsibility for setting International
Accounting Standards. During its first meeting the new Board adopted existing IAS and
SICs. The IASB has continued to develop standards calling the new standards IFRS.
Contents
[hide]
• 1 Structure of IFRS
• 2 Framework
• 3 Role of Framework
o 3.1 Objective of financial statements
o 3.2 Underlying assumptions
o 3.3 Qualitative characteristics of financial statements
o 3.4 Elements of financial statements
o 3.5 Recognition of elements of financial statements
o 3.6 Measurement of the Elements of Financial Statements
o 3.7 Concepts of Capital and Capital Maintenance
o 3.8 Concepts of Capital
3.8.1 Concepts of Capital Maintenance and the Determination of
Profit
• 4 Requirements of IFRS
• 5 IASB current projects
• 6 Adoption of IFRS
o 6.1 Australia
o 6.2 Canada
o 6.3 European Union
o 6.4 Russia
o 6.5 Turkey
o 6.6 Hong Kong
o 6.7 Singapore
o 6.8 United States and convergence with US GAAP
o 6.9 India
o 6.10 Japan
• 7 List of IFRS statements with full text links
• 8 List of Interpretations with full text links
• 9 Further reading
• 10 See also
• 11 References
• 12 External links
There is also a Framework for the Preparation and Presentation of Financial Statements
which describes the principles underlying IFRS...
IAS 8 Par. 11
"In making the judgement described in paragraph 10, management shall refer to, and
consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar
and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses in the Framework."
[edit] Framework
The Framework for the Preparation and Presentation of Financial Statements states basic
principles for IFRS.
Accrual basis - the effect of transactions and other events are recognized when they occur, not as cash is gained or paid.
•
Going concern -an entity will continue for the foreseeable future.
•
Understandability
•
Reliability
•
Comparability
•
The financial position of an enterprise is primarily provided in the Statement of Financial Position. The elements include:
1. Asset: An asset is a resource controlled by the enterprise as a result of past events, and from which future economic benefits are expected to flow to the
enterprise.
2. Liability: A liability is a present obligation of the enterprise arising from the past events, the settlement of which is expected to result in an outflow
from the enterprise' resources, i.e., assets.
3. Equity: Equity is the residual interest in the assets of the enterprise after deducting all the liabilities. Equity is also known as owner's equity.
The financial performance of an enterprise is primarily provided in an income statement or profit and loss account. The elements of an income statement
or the elements that measure the financial performance are as follows:
4. Revenues: increases in economic benefit during an accounting period in the form of inflows or enhancements of assets, or decrease of liabilities that
result in increases in equity. However, it does not include the contributions made by the equity participants, i.e., proprietor, partners and shareholders.
5. Expenses: decreases in economic benefits during an accounting period in the form of outflows, or depletions of assets or incurrences of liabilities that
result in decreases in equity.
Par. 99. Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognised and
carried in the balance sheet and income statement. This involves the selection of the particular basis of measurement.
Par. 100. A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. They include
the following:
(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the
time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example,
income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.
(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired
currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.
(c) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an
orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to
satisfy the liabilities in the normal course of business.
(d) Present value. Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course
of business. Liabilities are carried at the present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in
the normal course of business.
Par. 101. The measurement basis most commonly adopted by entities in preparing their financial statements is historical cost. This is usually combined
with other measurement bases. For example, inventories are usually carried at the lower of cost and net realisable value, marketable securities may be
carried at market value and pension liabilities are carried at their present value. Furthermore, some entities use the current cost basis as a response to the
inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets.[5]Muhammad Mohsin Bhatti
Par. 102. A financial concept of capital is adopted by most entities in preparing their
financial statements. Under a financial concept of capital, such as invested money or
invested purchasing power, capital is synonymous with the net assets or equity of the
entity. Under a physical concept of capital, such as operating capability, capital is
regarded as the productive capacity of the entity based on, for example, units of output
per day.
Par. 103. The selection of the appropriate concept of capital by an entity should be based
on the needs of the users of its financial statements. Thus, a financial concept of capital
should be adopted if the users of financial statements are primarily concerned with the
maintenance of nominal invested capital or the purchasing power of invested capital. If,
however, the main concern of users is with the operating capability of the entity, a
physical concept of capital should be used. The concept chosen indicates the goal to be
attained in determining profit, even though there may be some measurement difficulties
in making the concept operational.[7]
Par. 104. The concepts of capital in paragraph 102 give rise to the following concepts of
capital maintenance:
(a) Financial capital maintenance. Under this concept a profit is earned only if the
financial (or money) amount of the net assets at the end of the period exceeds the
financial (or money) amount of net assets at the beginning of the period, after excluding
any distributions to, and contributions from, owners during the period. Financial capital
maintenance can be measured in either Nominal monetary units or units of constant
purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the
physical productive capacity (or operating capability) of the entity (or the resources or
funds needed to achieve that capacity) at the end of the period exceeds the physical
productive capacity at the beginning of the period, after excluding any distributions to,
and contributions from, owners during the period.
Par. 105. The concept of capital maintenance is concerned with how an entity defines the
capital that it seeks to maintain. It provides the linkage between the concepts of capital
and the concepts of profit because it provides the point of reference by which profit is
measured; it is a prerequisite for distinguishing between an entity’s return on capital and
its return of capital; only inflows of assets in excess of amounts needed to maintain
capital may be regarded as profit and therefore as a return on capital. Hence, profit is the
residual amount that remains after expenses (including capital maintenance adjustments,
where appropriate) have been deducted from income. If expenses exceed income the
residual amount is a loss.
Par. 106. The physical capital maintenance concept requires the adoption of the current
cost basis of measurement. The financial capital maintenance concept, however, does not
require the use of a particular basis of measurement. Selection of the basis under this
concept is dependent on the type of financial capital that the entity is seeking to maintain.
Par. 107. The principal difference between the two concepts of capital maintenance is the
treatment of the effects of changes in the prices of assets and liabilities of the entity. In
general terms, an entity has maintained its capital if it has as much capital at the end of
the period as it had at the beginning of the period. Any amount over and above that
required to maintain the capital at the beginning of the period is profit.
Par. 108. Under the concept of financial capital maintenance where capital is defined in
terms of nominal monetary units, profit represents the increase in nominal money capital
over the period. Thus, increases in the prices of assets held over the period,
conventionally referred to as holding gains, are, conceptually, profits. They may not be
recognised as such, however, until the assets are disposed of in an exchange transaction.
When the concept of financial capital maintenance is defined in terms of constant
purchasing power units, profit represents the increase in invested purchasing power over
the period. Thus, only that part of the increase in the prices of assets that exceeds the
increase in the general level of prices is regarded as profit. The rest of the increase is
treated as a capital maintenance adjustment and, hence, as part of equity.
Par. 109. Under the concept of physical capital maintenance when capital is defined in
terms of the physical productive capacity, profit represents the increase in that capital
over the period. All price changes affecting the assets and liabilities of the entity are
viewed as changes in the measurement of the physical productive capacity of the entity;
hence, they are treated as capital maintenance adjustments that are part of equity and not
as profit.
Par. 110. The selection of the measurement bases and concept of capital maintenance will
determine the accounting model used in the preparation of the financial statements.
Different accounting models exhibit different degrees of relevance and reliability and, as
in other areas, management must seek a balance between relevance and reliability. This
Framework is applicable to a range of accounting models and provides guidance on
preparing and presenting the financial statements constructed under the chosen model. At
the present time, it is not the intention of the Board of IASC to prescribe a particular
model other than in exceptional circumstances, such as for those entities reporting in the
currency of a hyperinflationary economy. This intention will, however, be reviewed in
the light of world developments.[8]
Comparative information is provided for the previous reporting period (IAS 1.36). An
entity preparing IFRS accounts for the first time must apply IFRS in full for the current
and comparative period although there are transitional exemptions (IFRS1.7).
• present all non-owner changes in equity (that is, 'comprehensive income' ) either
in one statement of comprehensive income or in two statements (a separate
income statement and a statement of comprehensive income). Components of
comprehensive income may not be presented in the statement of changes in
equity.
• present a statement of financial position (balance sheet) as at the beginning of the
earliest comparative period in a complete set of financial statements when the
entity applies an accounting
• 'balance sheet' will become 'statement of financial position'
• 'income statement' will become 'statement of comprehensive income'
• 'cash flow statement' will become 'statement of cash flows'.
The revised IAS 1 is effective for annual periods beginning on or after 1 January 2009.
Early adoption is permitted.
For a current overview see IAS PLUS's list of all countries that have adopted IFRS.
[edit] Australia
The Australian Accounting Standards Board (AASB) has issued 'Australian equivalents
to IFRS' (A-IFRS), numbering IFRS standards as AASB 1-8 and IAS standards as AASB
101 - 141. Australian equivalents to SIC and IFRIC Interpretations have also been issued,
along with a number of 'domestic' standards and interpretations. These pronouncements
replaced previous Australian generally accepted accounting principles with effect from
annual reporting periods beginning on or after 1 January 2005 (i.e. 30 June 2006 was the
first report prepared under IFRS-equivalent standards for June year ends). To this end,
Australia, along with Europe and a few other countries, was one of the initial adopters of
IFRS for domestic purposes.
The AASB has made certain amendments to the IASB pronouncements in making A-
IFRS, however these generally have the effect of eliminating an option under IFRS,
introducing additional disclosures or implementing requirements for not-for-profit
entities, rather than departing from IFRS for Australian entities. Accordingly, for-profit
entities that prepare financial statements in accordance with A-IFRS are able to make an
unreserved statement of compliance with IFRS.
The AASB continues to mirror changes made by the IASB as local pronouncements. In
addition, over recent years, the AASB has issued so-called 'Amending Standards' to
reverse some of the initial changes made to the IFRS text for local terminology
differences, to reinstate options and eliminate some Australian-specific disclosure. There
are some calls for Australia to simply adopt IFRS without 'Australianising' them and this
has resulted in the AASB itself looking at alternative ways of adopting IFRS in Australia.
[edit] Canada
The use of IFRS will be required for Canadian publicly accountable profit-oriented
enterprises for financial periods beginning on or after 1 January 2011. This includes
public companies and other “profit-oriented enterprises that are responsible to large or
diverse groups of shareholders.”[11]
All listed EU companies have been required to use IFRS since 2005.
In order to be approved for use in the EU, standards must be endorsed by the Accounting
Regulatory Committee (ARC), which includes representatives of member state
governments and is advised by a group of accounting experts known as the European
Financial Reporting Advisory Group. As a result IFRS as applied in the EU may differ
from that used elsewhere.
Parts of the standard IAS 39: Financial Instruments: Recognition and Measurement were
not originally approved by the ARC. IAS 39 was subsequently amended, removing the
option to record financial liabilities at fair value, and the ARC approved the amended
version. The IASB is working with the EU to find an acceptable way to remove a
remaining anomaly in respect of hedge accounting.
[edit] Russia
The government of Russia has been implementing a program to harmonize its national
accounting standards with IFRS since 1998. Since then twenty new accounting standards
were issued by the Ministry of Finance of the Russian Federation aiming to align
accounting practices with IFRS. Despite these efforts essential differences between
national accounting standards and IFRS remain. Since 2004 all commercial banks have
been obliged to prepare financial statements in accordance with both national accounting
standards and IFRS. Full transition to IFRS is delayed and is expected to take place from
2011.
[edit] Turkey
Turkish Accounting Standards Board translated IFRS into Turkish in 2006. Since 2006
Turkish companies listed in Istanbul Stock Exchange are required to prepare IFRS
reports.
Starting in 2005, Hong Kong Financial Reporting Standards (HKFRS) are identical to
International Financial Reporting Standards. While Hong Kong had adopted many of the
earlier IAS as Hong Kong standards, some had not been adopted, including IAS 32 and
IAS 39. And all of the December 2003 improvements and new and revised IFRS issued
in 2004 and 2005 will take effect in Hong Kong beginning in 2005.
Implementing Hong Kong Financial Reporting Standards: The challenge for 2005
(August 2005) sets out a summary of each standard and interpretation, the key changes it
makes to accounting in Hong Kong, the most significant implications of its adoption, and
related anticipated future developments. There is one Hong Kong standard and several
Hong Kong interpretations that do not have counterparts in IFRS. Also there are several
minor wording differences between HKFRS and IFRS. [12]
[edit] Singapore
US companies registered with the United States Securities and Exchange Commission
must file financial statements prepared in accordance with US GAAP. Until 2007, foreign
private issuers were required to file financial statements prepared either (a) under US
GAAP or (b) in accordance with local accounting principles or IFRS with a footnote
reconciling from local principles or IFRS to US GAAP. This reconciliation imposed extra
expense on companies which are listed on exchanges both in the US and another country.
From 2008, foreign private issuers are additionally permitted to file financial statements
in accordance with IFRS as issued by the IASB without reconciliation to US GAAP.[14]
There is broad expectation among U.S. companies that the SEC will move to allow or
require them to use IFRS in the near future and a growing acceptance of that scenario,
according to Controllers' Leadership Roundtable survey data.[15]
In August 2008, the SEC announced a timetable that would allow some companies to
report under IFRS as soon as 2010 and require it of all companies by 2014.[16]
The SEC received over 220 comment letters from a diverse group of constituents on its
timetable. Some of the key points included: - The ultimate goal must be the worldwide
use of a single set of high quality financial reporting standards - Most respondents
support continuation of the convergence process - Users prefer a principles-based
accounting framework that includes application of sound professional judgment coupled
with clear and transparent disclosures about the economic substance of the transaction,
the reasons for reaching that conclusion, and the related accounting for the transaction. -
Acknowledgment that the expected costs of IFRS adoption will be significant but the
anticipated costs of not adopting will be much more significant to the U.S. Capital
Markets - A clear commitment and adoption date is needed, regardless whether it is 2014,
2015 or 2016 (i.e., a “date certain”) Recommendation to require only one prior year
comparative [17]
Mary Schapiro, SEC Chair, provided an update on the SEC’s proposed roadmap during a
meeting of the International Accounting Standards Committee Foundation (IASCF) on 6
July 2009. The SEC is continuing its detailed analysis of all comment letters and will
readdress this issue in Fall 2009. [18]
[edit] India
The Institute of Chartered Accountants of India (ICAI) has announced that IFRS will be
mandatory in India for financial statements for the periods beginning on or after 1 April,
2011. This will be done by revising existing accounting standards to make them
compatible with IFRS.
Reserve Bank of India has stated that financial statements of banks need to be IFRS-
compliant for periods beginning on or after 1 April, 2011.
[edit] Japan
The Accounting Standards Board of Japan has agreed to resolve all inconsistencies
between the current JP-GAAP and IFRS wholly by 2011. [19]
Bank reconciliation
From Wikipedia, the free encyclopedia
Jump to: navigation, search
Bank reconciliation is the process of comparing and matching figures from the
accounting records against those shown on a bank statement. The result is that any
transactions in the accounting records not found on the bank statement are said to be
outstanding. Taking the balance on the bank statement adding the total of outstanding
receipts less the total of the outstanding payments this new value should (match)
reconcile to the balance of the accounting records.
[edit] Accounting
A company needs to report depreciation accurately in its financial statements in order to
achieve two main objectives:
1. matching its expenses with the income generated by means of those expenses, and
2. ensuring that the asset values in the balance sheet are not overstated. (An asset
acquired in Year 1 is unlikely to be worth the same amount in Year 5.)
Depreciation is an attempt to write-off the cost of Non Current Asset over its useful life.
The word write-off means to turn it into an expense. For example, an entity may
depreciate its equipment by 15% per year. This rate should be reasonable in aggregate
(such as when a manufacturing company is looking at all of its machinery), and
consistently employed. However, there is no expectation that each individual item
declines in value by the same amount, primarily because the recognition of depreciation
is based upon the allocation of historical costs and not current market prices.
Accounting standards bodies have detailed rules on which methods of depreciation are
acceptable, and auditors should express a view if they believe the assumptions underlying
the estimates do not give a true and fair view.
Straight-Line Method:
For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000,
and will have a salvage value of US$2000, will depreciate at US$3,000 per year:
($17,000 - $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other
words, it is the depreciable cost of the asset divided by the number of years of its useful
life.
This table illustrates the straight-line method of depreciation. Book value at the beginning
of the first year of depreciation is the original cost of the asset. At any time book value
equals original cost minus accumulated depreciation.
Book Value = Original Cost - Accumulated Depreciation Book value at the end of
year becomes book value at the beginning of next year. The asset is depreciated until the
book value equals scrap value.
If the vehicle were to be sold and the sales price exceeded the depreciated value (net book
value) then the excess would be considered a gain and subject to depreciation recapture.
In addition, this gain above the depreciated value would be recognized as ordinary
income by the tax office. If the sales price is ever less than the book value, the resulting
capital loss is tax deductible. If the sale price were ever more than the original book
value, then the gain above the original book value is recognized as a capital gain.
If a company chooses to depreciate an asset at a different rate from that used by the tax
office then this generates a timing difference in the income statement due to the
difference (at a point in time) between the taxation department's and company's view of
the profit.
Depreciation methods that provide for a higher depreciation charge in the first year of an
asset's life and gradually decreasing charges in subsequent years are called accelerated
depreciation methods. This may be a more realistic reflection of an asset's actual
expected benefit from the use of the asset: many assets are most useful when they are
new. One popular accelerated method is the declining-balance method. Under this
method the Book Value is multiplied by a fixed rate.
The most common rate used is double the straight-line rate. For this reason, this
technique is referred to as the double-declining-balance method. To illustrate, suppose
a business has an asset with $1,000 Original Cost, $100 Salvage Value, and 5 years
useful life. First, calculate straight-line depreciation rate. Since the asset has 5 years
useful life, the straight-line depreciation rate equals (100% / 5) 20% per year. With
double-declining-balance method, as the name suggests, double that rate, or 40%
depreciation rate is used.
Book Value at the end of year becomes Book Value at the beginning of next year. The
asset is depreciated until the Book Value equals Salvage Value, or Scrap Value.
The Salvage Value is not considered in determining the annual depreciation, but the Book
Value of the asset being depreciated is never brought below its Salvage Value, regardless
of the method used. The process continues until the Salvage Value or the end of the
asset's useful life, is reached. In the last year of depreciation a subtraction might be
needed in order to prevent Book Value from falling below estimated Scrap Value.
Since declining-balance depreciation does not always depreciate an asset fully by its end
of life, some methods also compute a straight-line depreciation each year, and apply the
greater of the two. This has the effect of converting from declining-balance depreciation
to straight-line depreciation at a midpoint in the asset's life.
Activity depreciation methods are not based on time, but on a level of activity. This could
be miles driven for a vehicle, or a cycle count for a machine. When the asset is acquired,
its life is estimated in terms of this level of activity. Assume the vehicle above is
estimated to go 50,000 miles in its lifetime. The per-mile depreciation rate is calculated
as: ($17,000 cost - $2,000 salvage) / 50,000 miles = $0.30 per mile. Each year, the
depreciation expense is then calculated by multiplying the rate by the actual activity
level.
Example: If an asset has Original Cost $1000, a useful life of 5 years and a Salvage
Value of $100, compute its depreciation schedule.
First, determine Years' digits. Since the asset has useful life of 5 years, the Years' digits
are: 5, 4, 3, 2, and 1.
Under the Units-of-Production method, useful life of the asset is expressed in terms of the
total number of units expected to be produced. Annual depreciation is computed in three
steps.
Second, Depreciation per Unit is computed. Depreciation charge per unit is computed
by dividing Depreciable Cost by Total Units, expected to be produced during the useful
life of the asset.
Depreciation Expense = Depreciation per Unit * Units produced during the Year.
Suppose, an asset has Original Cost $70,000, Salvage Value $10,000, and is expected to
produce 6,000 units.
Depreciable Cost = ($70,000-$10,000) $60,000
The table below illustrates the Units-of-Production depreciation schedule of the asset.
Depreciation stops when Book Value is equal to the Scrap Value of the asset. In the end
the sum of Accumulated Depreciation and Scrap Value equals to the Original Cost.
Units of Time Depreciation is similar to units of production, and is used for depreciation
equipment used in mine or natural resource exploration, or cases where the amount the
asset is used is not linear year to year.
A simple example can be given for construction companies, where some equipment is
used only for some specific purpose. Depending on the number of projects, the
equipment will be used and depreciation charged accordingly.
The composite method is applied to a collection of assets that are not similar, and have
different service lives. For example, computers and printers are not similar, but both are
part of the office equipment. Depreciation on all assets is determined by using the
straight-line-depreciation method.
Composite life equals the total Depreciable Cost divided by the total Depreciation Per
Year. $5,900 / $1,300 = 4.5 years.
Composite Depreciation Rate equals Depreciation Per Year divided by total Historical
Cost. $1,300 / $6,500 = 0.20 = 20%
Depreciation Expense equals the composite Depreciation rate times the balance in the
asset account. (0.20 * $6,500) $1,300. Debit Depreciation Expense and credit
Accumulated Depreciation.
When an asset is sold, debit Cash for the amount received and credit the asset account for
its original cost. Debit the difference between the two to Accumulated Depreciation.
Under the Composite method no gain or loss is recognized on the sale of an asset.
Common sense requires Depreciation Expense to be equal to total Depreciation Per Year,
without first dividing and then multiplying total Depreciation Per Year by the same
number. Creators of accounting rules sometimes are very creative, as was noted on the
discussion forum of Accounting Coach at [1]
[edit] Taxes
Main article: Modified Accelerated Cost Recovery System
When a company spends money for a service or anything else that is short-lived, this
expenditure is usually immediately tax deductible in some countries, and the company
enjoys an immediate tax benefit.[3]
1. it has a useful life beyond the taxable year (essentially why it was capitalized in
the first place), and
2. it wears out, decays, declines in value due to natural causes, or is subject to
exhaustion or obsolescence.
Therefore, when a company buys an asset that will last longer than one year, like a
computer, car, or building, the company cannot immediately deduct the cost and enjoy an
immediate large tax benefit. Instead, the company must depreciate the cost over the
useful life of the asset, taking a tax deduction for a part of the cost each year. Eventually
the company does get to deduct the full cost of the asset, but this happens over several
years. In the US, the IRS's depreciation schedule for any given class of asset is fixed, and
is related to typical durability. A computer may depreciate completely over five years; a
nonresidential building, usually 39 years. The maximum allowable useful life under US
income tax regulations is 40 years. Though the IRS does allow a small choice of
permutations for depreciation life and acceleration, it does not allow a taxpayer to invent
any arbitrary asset life. Other countries have other systems, many simply eliminate all
choice altogether. In these jurisdictions accounting depreciation and tax depreciation are
almost always significantly different numbers, as in many instances a form of
"accelerated depreciation" can be used for tax purposes to lower (taxable) net income in a
given period (or, in some instances, a fixed asset may be allowed to be expensed for tax
purposes; Section 179 of the Internal Revenue Code allows for this treatment in some
circumstances). Technically, these are not considered "tax reductions" but tax deferrals:
lowering taxable income now by increasing expenses should increase future taxable
income (and taxes) at a later date.
In the US, there are generally five variables that a taxpayer must take into account when
computing the correct depreciation deduction:
[edit] Economics
In economics, the value of a capital asset is equal to the present value of the flow of
services the asset will generate in future, appropriately adjusted for uncertainty.
Economic depreciation over a given period is the reduction in the remaining value of
future services.
Under certain circumstances, such as an unanticipated increase in the price of the services
generated by an asset, its value may increase rather than decline. Depreciation is then
negative.
In national accounts, depreciation represents the decline in the aggregate capital stock
arising from the use of capital in production, also referred to as consumption of fixed
capital. Hence, depreciation is equal to the difference between aggregate (gross)
investment and net investment or between Gross National Product and Net National
Product. Unlike depreciation in business accounting, depreciation in national accounts is,
in principle, not a method of allocating the costs of past expenditures on fixed assets over
subsequent accounting periods. Rather, fixed assets at a given moment in time are valued
according to the remaining benefits to be derived from their use.
Preference shares
Preferred stock usually carries no voting rights,[2] but may carry priority over common
stock in the payment of dividends and upon liquidation. Preferred stock may carry a
dividend that is paid out prior to any dividends being paid to common stock holders.
Preferred stock may have a convertibility feature into common stock. Terms of the
preferred stock are stated in a "Certificate of Designation".
Similar to bonds, preferred stocks are rated by the major credit rating companies. The
rating for preferreds is generally lower since preferred dividends do not carry the same
guarantees as interest payments from bonds and they are junior to all creditors.[3]
Contents
[hide]
• 1 Rights
• 2 Types of preferred stock
• 3 Typical usage
• 4 Users
• 5 International perspectives
o 5.1 Canada
o 5.2 Germany
o 5.3 United Kingdom
o 5.4 United States
o 5.5 Other countries
• 6 Notes
• 7 External links
[edit] Rights
Unlike common stock, preferred stock usually has several rights attached to it:
• The core right is that of preference in the payment of dividends and upon
liquidation of the company. Before a dividend can be declared on the common
shares, any dividend obligation to the preferred shares must be satisfied.
• The dividend rights are often cumulative, such that if the dividend is not paid it
accumulates from year to year. However, the directors must declare a dividend
before the preferred shareholder has any right to it. In case of non-cumulative, the
dividend right for the year is extinguished if it is not declared for that year.
• Preferred stock may or may not have a fixed liquidation value, or par value,
associated with it. This represents the amount of capital that was contributed to
the corporation when the shares were first issued.[4]
• Preferred stock has a claim on liquidation proceeds of a stock corporation,
equivalent to its par or liquidation value unless otherwise negotiated. This claim is
senior to that of common stock, which has only a residual claim.
• Almost all preferred shares have a negotiated fixed dividend amount. The
dividend is usually specified as a percentage of the par value or as a fixed amount.
For example Pacific Gas & Electric 6% Series A preferred. Sometimes, dividends
on preferred shares may be negotiated as floating i.e. may change according to a
benchmark interest rate index such as LIBOR.
• Some preferred shares have special voting rights to approve certain extraordinary
events (such as the issuance of new shares or the approval of the acquisition of the
company) or to elect directors, but most preferred shares provide no voting rights
associated with them. Some preferred shares only gain voting rights when the
preferred dividends are in arrears for a substantial time.
The above list, although including several customary rights, is far from comprehensive.
Preferred shares, like other legal arrangements, may specify nearly any right conceivable.
Preferred shares in the U.S. normally carry a call provision,[5] enabling the issuing
corporation to repurchase the share at its (usually limited) discretion.
• Prior Preferred Stock – Many companies have different issues of preferred stock
outstanding at the same time and one of them is usually designated to be the one
with the highest priority. If the company has only enough money to meet the
dividend schedule on one of the preferred issues, it makes the dividend payments
on the prior preferred. Therefore, prior preferred have less credit risk than the
other preferred stocks but it usually offers a lower yield than the others.
• Preference Preferred Stock – Ranked behind the company's prior preferred stock
(on a seniority basis), are the company's preference preferred issues. These issues
receive preference over all other classes of the company's preferred except for the
prior preferred. If the company issues more than one issue of preference preferred,
then the various issues are ranked by their relative seniority. One issue is
designated first preference, the next senior issue is the second and so on.
• Convertible Preferred Stock – These are preferred issues that the holders can
exchange for a predetermined number of the company's common stock. This
exchange can occur at any time the investor chooses regardless of the current
market price of the common stock. It is a one way deal so one cannot convert the
common stock back to preferred stock.
• Cumulative preferred stock – If the dividend is not paid, it will accumulate for
future payment.
• Exchangeable preferred stock – This type of preferred stock carries the option to
be exchanged for some other security upon certain conditions.
• Participating Preferred Stock – These preferred issues offer the holders the
opportunity to receive extra dividends if the company achieves some
predetermined financial goals. The investors who purchased these stocks receive
their regular dividend regardless of how well or how poorly the company
performs, assuming the company does well enough to make the annual dividend
payments. If the company achieves predetermined sales, earnings or profitability
goals, the investors receive an additional dividend.
• Perpetual preferred stock – This type of preferred stock has no fixed date on
which invested capital will be returned to the shareholder, although there will
always be redemption privileges held by the corporation. Most preferred stock is
issued without a set redemption date.
• Putable preferred stock – These issues have a "put" privilege whereby the holder
may, upon certain conditions, force the issuer to redeem shares.
• Non-cumulative preferred stock – Dividend for this type of preferred stock will
not accumulate if it is unpaid. Very common in TRuPS and bank preferred stock,
since under BIS rules, preferred stock must be non-cumulative if it is to be
included in Tier 1 capital.[6]
[edit] Users
Preferred shares are more common in private or pre-public companies, where it is more
useful to distinguish between the control of and the economic interest in the company.
Government regulations and the rules of stock exchanges may discourage or encourage
the issuance of publicly traded preferred shares. In many countries banks are encouraged
to issue preferred stock as a source of Tier 1 capital. On the other hand, the Tel Aviv
Stock Exchange prohibits listed companies from having more than one class of capital
stock.[citation needed]
A single company may issue several classes of preferred stock. For example, a company
may undergo several rounds of financing, with each round receiving separate rights and
having a separate class of preferred stock; such a company might have "Series A
Preferred," "Series B Preferred," "Series C Preferred" and common stock.
In the United States there are two types of preferred stocks: straight preferreds and
convertible preferreds. Straight preferreds are issued in perpetuity (although some are
subject to call by the issuer under certain conditions) and pay the stipulated rate of
interest to the holder. Convertible preferreds—in addition to the foregoing features of a
straight preferred—contain a provision by which the holder may convert the preferred
into the common stock of the company (or, sometimes, into the common stock of an
affiliated company) under certain conditions, among which may be the specification of a
future date when conversion may begin, a certain number of common shares per
preferred share, or a certain price per share for the common.
There are income tax advantages generally available to corporations that invest in
preferred stocks in the United States that are not available to individuals.
Some argue that a straight preferred stock, being a hybrid between a bond and a stock,
bears the disadvantages of each of those types of securities without enjoying the
advantages of either. Like a bond, a straight preferred does not participate in any future
earnings and dividend growth of the company and any resulting growth of the price of the
common. But the bond has greater security than the preferred and has a maturity date at
which the principal is to be repaid. Like the common, the preferred has less security
protection than the bond. But the potential of increases of market price of the common
and its dividends paid from future growth of the company is lacking for the preferred.
One big advantage that the preferred provides its issuer is that the preferred gets better
equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as
pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows
financial institutions to satisfy regulatory requirements without diluting common
shareholders. Said another way, through preferred stock, financial institutions are able to
put on leverage while getting Tier 1 equity credit.
Suppose that an investor paid par ($100) today for a typical straight preferred. Such an
investment would give a current yield of just over 6%. Now suppose that in a few years
10-year Treasuries were to yield 13+% to maturity, as they did in 1981; these preferreds
would yield at least 13%, which would knock their market price down to $46, for a 54%
loss. (In all probability, they would yield some 2% more than the Treasuries—or
something like 15%, which would take the market price down to $40, for a 60% loss.)
[clarification needed]
The important difference between straight preferreds and Treasuries (or any investment-
grade Federal agency or corporate bond) is that the bonds would move up to par as their
maturity date is approached, whereas the straight preferred, having no maturity date,
might remain at these $40 levels (or lower) for a very long time.
Advantages of straight preferreds posited by some advisers include higher yields and tax
advantages (currently yield some 2% more than 10-year Treasuries, rank ahead of
common stock in the case of bankruptcy, dividends are taxable at a maximum 15% rather
than at ordinary income rates, as in the case of bond interest).