Chapter 1.

Financial Statements and Business Decisions

The Balance Sheet
Elements
A/P: purchase of goods or services frm suppliers on credit w/o a formal written contract
N/P: formal written debt contract w. lending institutions such as banks
The Income Statement
Rev are reported whether or not they have yet been paid for.
Statement of Retained Earnings
Reports the way net income and distribution of dividends affected the financial position of the co
Specified period of time
Beg RE+NI-Dividends = End RE
Elements
Statement of Cash Flows
Operating, investing, and financing activities (CFO, CFI, CFF = change in cash)
Elements
CFO: directly related to earning income
CFI: acquisition or sale of the cos productive assets (purchase equipment ->meet growing demand)
CFO: directly related to the financing of enterprise itself -> payment of money to investors and creditors
(dividends)
Relationships among the statements
-NI -> increase End RE on S of RE
-End RE: one of the two components of stockholders equity
-Beg CF+ CF => End CF on B/S

Chapter 2. Investing and financing decisions and the balance sheet

Balance Sheet
Companies list assets in order of liquidity
Creditor: entities that a company owes money to are called creditors
A/R: payments due from franchisees and others on account
A/P: payments due to suppliers

What Business activities cause changes in financial statement amounts?

Nature of Business Transactions
External events: exchanges of assets, good, or services by one party for assets, services, or promises
to pay
Internal events: measurable internal event such as the use of assets in operations
Selling stock and borrowing from creditors are financing transactions
Current ratio
Current ratio: managing st debt / total asset turnover ratio: utilizing assets / net profit margin:
controlling rev and costs
The higher the ratio, the more cushion a company has to pay its current obligations
Too high of a ratio suggest inefficient use of resources (having CA 1.0-2.0 is good)

*investing and financing activities

-investing activities include buying and selling noncurrent assets and investments
Eg) Lending cash to others / Receiving payments on loans made to others
-financing activities include borrowing and repaying debt, including st bank loans, issuing and
repurchasing stock, and paying dividends
Eg) repaying the principal on borrowings from banks
Repurchasing stock w/ cash
Paying cash dividends
->p) repaid debt: Financing activities / -

Chapter 3. Operating Decisions and the Income statement

Accrual Accounting
Revenue principle
1. delivery has occurred or service shave been rendered
2. there is persuasive evidence of an arrangement for customer payment
3. the price is fixed or determinable
4. collection is reasonably assured.
P116 check (a), (h),

Chapter 4. Operating Decisions and the Income Statement

Chapter 5. Communicating and Interpreting Accounting Information

Institutional investors: managers of pension, mutual, endowment, and other funds that invest on the
behalf of others
Private investors: include individuals who purchase shares in companies
Lenders: include suppliers and financial institutions that lend money to companies
Conservatism: care should be taken not overstate assets and revenues or understate liabilities and
expenses
The disclosure process
Classified B/S
Assets
Current Assets
Noncurrent assets
Total assets
Liabilities
Current Liabilities
Long-term liabilities
Total liabilities
Stockholders equity
Contributed Capital (Common Stock-nominal par value & APIC)
Retained Earnings
Total Stockholders equity
Total liabilities and stockholders equity
Common Stock: par value is a legal amount per share established by the board of directors
( x relationship to the mkt price of stock)
Classified I/S
Net sales

-COGS
Gross profit = net sales less COGS
-Operating expenses
Income from operations (EBIT) = net sales less cogs and other operating expenses
+/- Nonoperating revenues/expenses and gains/losses
Income before income taxes (EBT=pretax earnings) = revenues all expenses except income tax
expense
-Income tax expense
Net Income
*nonoperating items: income, expenses, gains, and losses that do not relate to the cos primary
operations e.g) interest income/expense & gain and losses on the sale of fixed assets and
investments
Nonrecurring items
1. Discontinued operations
2. Extraordinary items
EPS( Earnings Per Share) = Net Income / Average number of shares of common stock outstanding
during the period
Statement of Cash Flows
CFO: ~ earning income
CFI: productive assets, investments in other companies
CFF: financing the business thru borrowing and repaying loans, stock issuances and repurchases and
dividend payment
ROA analysis
Return on Assets = Net Income/ Average Total Assets
Evaluate performance at any level within the organization (independent source financing -debt & equity)
ROA Profit Driver Analysis
Net Inc/Avg TA = NI/Net Sales * Net Sales/ Avg TA
Net profit margin

Total asset turnover

Increase sales volume and sales price

collecting A/R quickly, reduce inv on hand

Decrease COGS and OPS expense

reduce amt of assets necessary to produce

Business strategy: high-value or product-differentiation strategy

Low-cost strategy

*discontinued operations: result frm the disposal of a major component of the business and are
reported net of income tax effect -> separately disclosed in a note
*extraordinary items: are gains and losses that are both unusual in nature and infrequent in
occurrence; they are reported net of tax on the income statement -> report such items very rarely
Note disclosure is needed
*Form 10-K: annual report that publicly traded companies must file with the SEC
*Form 10-Q: quarterly report that publicly traded companies must file with the SEC
*Form 8-K: disclose any material event not previously reported that is important to investors

Chapter 6. Reporting and Interpreting Sales Revenue, Receivables, and Cash

FOB shipping point: title changes hands at shipment and buyer pays for shipping
FOB destination: title changes hands on delivery, and seller pays for shipping
Principal methods: (1) allowing consumers to use credit sales (2) providing business customers direct
credit and discounts for early payment (3) allowing returns from all customers
Credit card discount: fee charged by the credit card company for its service

Sales Discount to Business

2/10: discount percentage / number of days in discount period
n/30: Net / Maximum credit period
*sales discount: cash discount offered to encourage prompt payment of an account receivable
-> prompt receipt of cash from customers reduces the necessity to borrow money to meet operating
needs
-> Since customers tend to pay bills providing discounts first, a sales discount also decreases the
changes that the customer will run out of funds b/4 Deckers bill is paid
Choosing to take or not to take the discount
See interest rate for the 20-day discount period
Amount saved / amount paid = interest rate for 20 days (= 2/98 = 2.04% for 20 days)
Interest rate for 20 days * 365 days/20days = annual interest rate
Bank interest rate < interest rate with failing to take cash discounts -> save by taking cash disC

 20 quick payment & discount

Sales Returns and Allowances

*Sales returns and allowances: reduction of sales revenues for return of or allowances for
unsatisfactory goods
Reporting Net Sales
Sales Revenue
Less:

(Credit card discounts)

(Sales Discount)
(Sales returns and allowances)
Net Sales

Gross Profit Percentage = Gross Profit / Net Sales ->How effective is management in selling goods
and services for more than the costs to purchase or produce them?
Measuring and reporting receivables
Classifying Receivables
A/R vs N/R
A/R: open accounts owed to business by trade customers
N/R: written promises that require another party to pay the business under specified conditions
(amount, time, interest)
Accounting for Bad Debts
Making the end-of-period adjusting entry to record estimated bad debt expense
Writing off specific accounts determined to be uncollectible during the period
*Bad Debt expense: expense associated with estimated uncollectible accounts receivable
Recording BDE estimates

A/R could not be credited in the journal entry b/c there is no way to know which customers A/R are
involved
Writing off specific uncollectible accounts

 This journal entry did not affect any income statement accounts
X change the net book value of accounts receivable
When customer makes payment on account that has been written off, the journal entry to
write off the account is reversed

A/R includes the total A/R, both collectible and uncollectible

Reporting A/R and Bad Debts
Trade A/R, net of allowances of $XX and $XXX in 2008 and 2007, respectively
Estimating Bad Debts
Estimated (1) a percentage of total credit sales for the period or (2) aging of accounts receivable
(1) Percentage of Credit Sales Method
Bases BDE on the historical percentage of credit sales that result in bad debts
Bad debts can be computed by dividing total bad debt losses by total credit sales
Credit * Bad Debt loss rate (1.0%) = Bad debt expense ADA
e.g_ $900,000 / 1% BDE rate -> 9,000 estimate

(2) Aging of A/R

Estimates uncollectible accounts based on the age of each account receivables
Estimated ending balance that should be in ADA

Comparison of two methods

*Percentage of credit sales: directly compute the amt to be recorded as BDE on I/S for adj
*Aging: compute the estimated ending balance of ADA on B/S
In either case -> B/S for 2009 A/R less ADA -> $108,000 (=$120,000-$12,000)
Controls over A/R
Receivables Turnover Ratio
How effective are credit-granting and collection activities?
Receivables Turnover = Net Sales / Avg Net Trade A/R
R/T reflects how many times avg trade receivables are recorded and collected during the period
Higher -> faster collection
Average collection period = 365 / Receivables Turnover = 365/7.6 = 48 days
-A/R on partial Cash Flow Statement

Reporting and Safeguarding cash

Cash and Cash Equivalents Defined

*Cash equivalents: ST investments with original maturities of three months or less that are readily
convertible to cash and whose value is unlikely to change
Internal control of cash
1. Separation of duties

2. Prescribed policies and procedures

Reconciliation of the cash accts and the bank statements

*EFT (electronic funds transfers) -> no additional entry is needed
*NSF Check (non sufficient funds) ->
1) Check for $18 received frm customer and deposited by Company
2) customers account does not have sufficient funds to cover the check
3) the amount of customers check returned to the company -> NSF check remains as receivable (debit
receivable & credit cash)
*SC (Service Charge)
*INT (Interest earned) -> bank pays interest on checking account balances (increases Cos acct)
*Bank reconciliation: the process of verifying the accuracy of both the bank statement and the cash
accounts of a business
The most common causes of differences b/t the end bank balance & the end book balance
1. Outstanding checks: written by the co and recorded cos ledger as credits to the cash but have not
cleared in the bank -> deduction frm the bank balancce
2. Deposits in transit: deposits sent to the bank by co and recorded in the cos ledger as debits to the
cash but bank has not recorded these deposits -> Add on bank balance
3. Bank service charges: expenses for bank service but not recorded on the cos books
4. NSF checks: bad checks or bounced checks ->deposited but must be deducted frm cos cash amt
and recorded as A/R
5. Interest: interest paid to co by bank
6. Errors: may occur when the volume of cash transactions is large

Steps to the bank reconciliation

1. Identify the outstanding checks: comparison of the checks and EFT -> total was entered as

deduction from bank reconciliation

2. Identify the deposits in transit: comparison of the deposit slips on hand with those listed on
bank statement -> addition to the bank statement
3. Record bank charges and credits
a. Interest received from bank / b. NSF check / c. Bank service charges
4. Determine the impact of errors
Objectives of reconciliation: 1) correct cash balance on B/S 2) id previously unrecorded
transactions -> any transactions or changes on cos books side need journal entries

Recording Discounts and Returns

Chapter 7. Reporting and interpreting cost of goods sold and inventory

Nature of inventory and COGS
Items included in inventory
*Merchandise inventory: goods held for resale in the ordinary course of business
*Raw materials inventory: items acquired for the purpose of processing into finished goods
*Work in process inventory: goods in the process of being manufactured
*Finished goods inventory: manufactured goods that are complete and ready for sale
Cost included in inventory purchases
Any additional costs to selling the inventory to the dealers, such as marketing dep salaries & dealer
training sessions, are uncured after inv is ready for use -> included in SG&A expense
Flow of inventory cost
A. Merchandiser: Merchandise purchased -> Merchandise inventory -> COGS
B. Manufacturer: RM/DL/MOH ->RM inv, WIP, FG -> COGS
*Direct Labor: earnings of employees who work directly on the products being manufactured
*Factory overhead: manufacturing costs that are not raw material or direct labor costs
e.g) supervisors salary, cost of heat, light, and power to operate the factory
Nature of COGS
BI+ new purchase = Goods available for sale
EI (ending inventory) = what remains unsold at the end of the period -> B/S
The portion of goods available for sale that is sold -> COGS on I/S

*BI+P-EI = CGS (BI+P=Goods available for sale)

Inventory Costing Methods
Four generally accepted inv costing methods
1. Specific identification / 2. FIFO / 3. LIFO / 4. Average Cost
*Specific Identification Method: Identifies the cost of the specific item that was sold
Cost Flow Assumptions

FIFO: first goods purchased are the first goods sold

LIFO: the most recently purchased units are sold first
Average Cost Method: weighted average unit cost of the goods available for sale for both cost of
goods sold and ending inventory
Average Cost = Cost of Goods available for sale / number of units available for sale
Financial Statement effects of Inventory Methods
Method that gives the highest EI amount gives the lowest CGS and highest gross profit, income tax
expense, and income amounts
When unit costs are rising, LIFO produces lower income & lower inventory valuation than FIFO
When unit costs are declining, LIFO produces higher income and higher inventory valuation
than FIFO

Managers choice of Inventory Methods

1. Net income effects (higher earnings) / 2. Income tax effects (least amt of taxes allowed by law
least-latest rule)
*LIFO conformity rule: if LIFO is used on the income tax return, it must also be used to calculate
inventory and CGS for the financial statements.
-> For inventory with increasing costs, LIFO is used on the tax return b/c it normally results in lower
income taxes
-> For inventory with decreasing costs, FIFO is most often used for both the tax return and financial
statements
A company can use any of the inv costing methods -> HOWEVER, accounting rules require companies
top apply their accounting methods on a consistent basis over time.
(Change is allowed only if the change will improve the measurement of financial results and financial
position)
Valuation at lower of cost or market
*replacement cost ( ): current purchase price for identical goods
*net realizable value (NRV- ): expected sales price selling costs

*Lower of cost or market (LCM): valuation method departing frm the cost principle
-> It serves to recognize a loss when replacement cost or NRV is < Cost
When the goods remaining in ending inventory can be replaced with identical goods at a lower cost,
the lower replacement cost should be used as inv valuation
Damaged, obsolete, and deteriorated items should be assigned a unit cost that represents
their current estimated net realizable value (Sales price Costs to sell) (conservatism)
Holding loss: when the replacement cost of an item drops, rather than in the period the item is sold ->
purchase cost lower replacement cost is added to CGS

Evaluating Inventory Management

Measuring efficiency in inventory management
Inventory Turnover ->How efficient are inventory management activities?
*Inventory Turnover = CGS / Avg Inv
It reflects how many times average inventory was produced and sold ~ the period -> higher ratio
indicates that inv moves more quickly thru the production process
*Average Days to Sell Inventory= 365/ Inventory Turnover
Inventory and Cash Flows

Inventory Methods and financial Statement Analysis

Converting the I/S to FIFO

*LIFO Reserve: contra-asset for the excess of FIFO over LIFO inventory

FIFO CGS is lower, income b/4 income taxes would have been $8,000 higher
If tax rate is 35% -> increase in tax expense is $8000*0.35 = $2,800

Converting Inventory on the B/S to FIFO

Adjust inventory amounts on B/S to FIFO by substituting FIFO values in note for the LIFO values
441,042 / 381,831

Or add LIFO reserve to the LIFO value on B/S

LIFO and Inventory Turnover Ratio

LIFO inventory turnover = 19574.8 / (3042+2337)/2 = 7.3

FIFO inventory turnover = 19754.8 (1324-1233) / (4366+3570)/2
Control of Inventory
Internal Control of Inventory
1. Separation of responsibilities for inv accounting and physical handling of inventory
2. Storage of inventory in a manner that protects it from theft and damage
3. Limiting access to inv to authorized employees
4. Maintaining perpetual inventory records
5. Comparing perpetual records to periodic physical counts of inventory
Perpetual and periodic inventory systems
*Perpetual Inventory System: detailed inventory record is maintained, recording each purchase and
sale during the acct period
*Periodic inventory system: ending inventory and CGS are determined at the end of the acct period
based on a physical count
-> for distinguishable high-value items, specific identification may be used
Errors in measuring ending inventory

b/c CGS was understated, income b/4 taxes would be overstated by $10,000 in the current year

It overstates beg inv and causes the overstatement of CGS in the nxt yr
So, clerical errors are inadvertently offset in the end
Demonstration case

Solutions to calculate End Inv & CGS

When costs are rising, LIFO should be selecter b/c LIFO produces higher CGS, lower pretax income,
and lower income tax payments

Inventory turnover ratio = CGS / Avg Inventory

= 1760 / (2200+2420)/2 = 0.76

Beg Inv + End Inv

Chapter 8. Reporting and Interpreting property, plant, and equipment; natural

resources; and Intangibles
Acquisition and Maintenance of Plant and Equipment
Classifying Long-Lived Assets
*Long-lived assets: tangible and intangible resources owned by a business and used in its operations
over several years
1. Tangible assets- physical substance
e.g) land / buildings, fixtures, and equipment / natural resources
2. intangible assets w/o physical substance
Measuring and Recording Acquisition Cost
Fixed Income Turnover -> How effectively utilizing fixed asset to generate rev?
Fixed Asset Turnover = Net Sales / Avg Net Fixed Asset
->Lower or declining fixed assets turnover rate may indicate company is expanding
->increasing ratio could signal a firm cut back on capital expenditure
-When purchasing land, all incidental costs should be included
-Renovation & repair costs incurred prior to assets use should be included
*Acquisition cost: net cash equivalent amt paid or to be paid for asset.
-acquisition by equity: when giving 1,000,000 shares of its $1.00 par value common stock w/ market
value of $50

-acquisition by construction
*capitalized interest: interest expenditures included in the cost of a self-constructed asset
-> recorded by debiting assets and crediting cash when the interest is paid
e.g) $60,000 labor, $1,300,000 supplies, $100,000 interest exp

Repairs, maintenance, and Additions

1. Ordinary repairs and maintenance: rev exp
-> small amt, x lengthen useful life of the asset
2. additions and improvements: infrequent exp that increases assets economic usefulness in the
future -> added to asset accts
*Capital expenditures: increases the productive life, operating efficiency, or capacity of the asset and
are recorded as increases in asset accounts, not as expenses
Decision to capitalize vs expense
Capitalizaing exp ->increases asset & net income by amt of annual dep
Expensing amt -> decreases taxes immediately
Use, impairment, and disposal of plant and equipment
Depreciation Concepts
*depreciation: process of allocating the cost of bldg. and equipment over their productive lives using a
systematic and rational method
-> its cost allocation -> x process of determining an assets current market value or worth
(remaining balance sheet amt probably does not represent its current market value)
*Net book value (carrying value): acquisition cost of an asset - accumulated depreciation
Three amounts are required for each asset -> 1. Acquisition cost / 2. Estimated useful life to the co /
3. Estimated residual (salvage) value at the end of the assets useful life to the company
*Estimated useful life: expected service live of an asset to the present owner (useful economic life, x
total economic life )
*Residual (Salvage) value: estimated amt to be recovered by the co at the end of the assets
estimated owner
Alternative Depreciation Methods
1. Straight-line
2. Units-of-production
3. Declining-balance
*Straight-line depreciation: allocates the cost of an asset in equal periodic amts over its useful life
(Cost Residual Value) * 1/ Useful Life = Depreciation Expense
Depreciable cost

Straight-line rate

-depreciation expense is a constant amt each yr

-accumulated dep increases by an equal amt each yr

-Net Book value decreases by the same amt each yr until it equals the estimated residual value
*Units-of-production method: allocates the cost of an asset over its useful life based on the relation
of its periodic output to its total estimated output
(Cost-Residual Value) / Estimated Total Production * Actual production
->Depreciation rate per unit of production
*Declining-balance method: allocates the cost of an asset over its useful life based on a multiple of
the straight-line rate (=declining-balance depreciation)
-> match higher depreciation exp w/ higher rev in the early yrs and lower depreciation exp w/ lower rev
in later yrs.
Double-declining-balance rate: double the straight-line rate
(Cost-Accumulated Depreciation) * 2/ Useful Life = Depreciation Expense
*** Not residual value -> A.D is included in formula
***Assets book value cannot be depreciated below residual value
->companies that expect fairly rapid obsolescence of their equipment use the declining-balance
method
How Managers Choose
Financial Reporting
Tax Reporting
Financial Reporting (GAPP) /

Tax Reporting (IRC)

Provide econ info ~ business

raise sufficient rev to pay for the expenditures of govt

Least and the latest rule: pay the lowest amt of tax that is legally permitted and at the latest possible
date
-MACRS (Modified Accelerated Cost Recovery System): similar to declining-balance method and applied
over relatively short asset lives to yield high dep exp in the early years ->reduces taxable income.
However, x acceptable for financial reporting purposes
Measuring Asset Impairment
Step 1) Test for impairment
If net book value > estimated future cash flows, then the asset is impaired
Step 2) Computation of Impairment Loss
Impairment Loss = Net Book Value Fair Value

 The asset is written down to fair value

e.g)
Disposal of Property, Plant, and Equipment
The disposal of a depreciable asset usually requires two journal entries:
1. adjusting entry to update the depreciation expense and accumulated depreciation accounts
2. entry to record the disposal -> cost of the asset & any accumulated dep of disposal must be
removed from the accounts
Difference b/t any resources received on disposal of an asset and its book value -> treated as a gain
or loss (gain I/S, x operating revenue, shown as a separate item on I/S)

Natural Resources and intangible assets

Acquisition and depletion of natural resources

Wasting assets: depleted resources, such as gold or iron ore

*depletion: systematic and rational allocation of the cost of a natural resource over the period of its
exploitation

Acquisition and Amortization of Intangible Assets

Intangible assets are recorded at historical cost only if they have been purchased.
-Definite Life: intangible asset with definite life is allocated on a straight-line basis each period =
*amortization: systematic and rational allocation of the acquisition cost of an intangible asset over its
useful life

-Indefinite Life: not amortized, -> tested at least annually for possible impairment
*Goodwill: the excess of the purchase price of a business over the fair value of the businesss assets
and liabilities
->The only way to report goodwill as an asset is to purchase another business
Goodwill to be reported = Purchase price Fair value of identifiable assets and liabilities
*Trademark: exclusive legal right to use a special name, image, or slogan
Valuable asset, but rarely seen on balance sheets b/c not recorded unless they are purchased
*Copyright: exclusive right to publish, use, and sell a literary, musical, or artistic work
*Technology: includes costs for computer software and web development
*Patent: granted by the federal government for an invention; it is an exclusive right given to the owner
to use, manufacture, and sell the subject of the patent
Patents are recorded at their purchase price or if developed internally -> recorded at registration and
legal costs (GAPP requires immediate expensing of R&D)
*Franchises: contractual right to sell certain products or services, use certain trademarks, or perform
activities in a geographical region
*Licenses and Operating Rights: obtained thru agreements with governmental units or agencies,

permit owners to use public property in performing their services

*R&D expense -> ** NOT intangible asset under U.S.GAPP
Productive Assets and Depreciation
-Depreciation exp must be added back to net income to eliminate its effect
-gain or loss on the sale of long-lived assets (investing activities) is added to determine net income ->
must be subtracted from net income to eliminate its effect

Chapter 9. Reporting and Interpreting Liabilities

Liabilities defined and classified
*liabilities: probable debts or obligations that result frm past transactions, which will be paid with
assets or services
*current liabilities: short-term obligations that will be paid within the current operating cycle or one
year, whichever is longer
*Liquidity: ability to pay current obligations
Quick Ratio:
does a co currently have the resources to pay its short-term debt?
Quick Ratio = Quick Assets / Current Liabilities
High quick ratio suggest good liquidity -> too high a ratio -> inefficient use of resources
Current Liabilities
Accounts Payable
*Accounts Payable turnover
-> how efficient is management in meeting its obligations to suppliers?
Accounts Payable Turnover = Cost of Goods Sold / Average Accounts Payable
Average Age of Payables = 365 Days / Turnover Ratio
High A/P ratio normally suggests that co is paying its suppliers in a timely manner
Accrued Liabilities
*Accrued Liabilities: expenses that have been incurred but have not been paid at the end of the
accounting period
-Accrued Taxes Payable
-Accrued Compensation and Related Costs

Payroll taxes
All payrolls are subject to a variety of taxes, including federal, state, and local income taxes

(employees pay some of these taxes and employers pay others)

-Employee Income Taxes: employers are required to withhold income taxes for each employee = FITW
(Federal Income Tax Withheld)
-Employee and Employer FICA Taxes: imposed in equal amounts and both the employee and the
employer. (Social Security taxes)
-Employer Unemployment Taxes: employers are charged unemployment taxes thru FUTA and SUTA
-Employee compensation expense includes all funds earned by employees & funds paid to others on
behalf of employees

Notes Payable
*time value of money: interest that is associated with the use of money over time
Interest = Principal * Interest Rate * Time

Deferred revenues

*deferred revenues: revenues that have been collected but not earned; they are liabilities until the
goods or services have been provided
Estimated Liabilities Reported on the B/S
-the estimated amt of product that will be returned is reported as a reduction frm sales rev in the year
the sales are recorded
Estimated Liabilities Reported in the Notes
*Contingent Liability: potential liability that has arisen as the result of a past event; it is not an
effective liability until some future event occurs
-> may or may not become a recorded liability depending on future events
e.g) Lawsuits, environmental problems, and product warranties

1. Probable the chance that the future event or events will occur is high
2. Reasonably possible the chance that the future event or events will occur is more than remote but
less than likely
3. Remote the chance that the future event or events will occur is slight
1) a liability that is both probable and capable of being reasonably estimated must be recorded and
reported on the b/s
2) a liability that is reasonably possible must be disclosed in a note in the financial statements
whether it can be estimated or not
3) remote contingencies are not disclosed
Working Capital Management
*working capital: dollar difference b.t total current assets and total current liabilities
Working capital and Cash Flows

Long-Term Liabilities

*Long-term liabilities: all of the entitys obligations not classified as current liabilities (LT notes
payable over one year in the future)
-secured debt: liability supported by the ownership of the asset if liability is not satisfied
Long-Term notes payable and bonds
Private placement: raise long-term debt frm financial institutions -> notes payable having maturity date
-liability is recorded when the debt is incurred and interest expense is recorded with the passage of
time
Lease Liabilities
*Operating Lease: does not meet any of the four criteria established by GAAP and does not cause the
recording of an asset and liability
-ST basis, no liability is recorded when an operating lease is created -> records rent expense as it
uses the asset
e.g) rent five large trucks during Jan 2012 -> No liability is recorded in 2011 & rent exp is recorded
during January 2012 when trucks are actually used
*Capital Lease: meets at least one of the four criteria established by GAPP and results in the
recording of an asset and liability ->purchase and financing of an asset
1. The lease term is 75% or more of the assets expected economic life
2. Ownership of the asset is transferred to the lessee at the end of the lease term
3. The lease contract permits the lessee to purchase the asset at a price that is lower than its fair
market value
4. The present value of the lease payments is 90 percent or more of the fair market value of the asset
when the lease is signed
-most prefer to record lease as an operating lease -> co is able to report less debt on its B/S

Present Value Concepts

*Present value: current value of an amount to be received in the future; a future amt discounted for
compound interest
Present value of a single amt
Present value of an annuity
*Annuity: series of periodic cash receipts or payments that are equal in amt each interest period
Accounting Applications of Present Values

-Computing the amt of a liability with a single payment

e.g) Starbucks bought new delivery trucks, signed a note and agreed to pay $200,000 (lent price +
interest for two years)

Interest expense is recorded in an adjusting entry of each year as follows:

-Computing the amt of a liability with an annuity

e.g) Bought new printing equipment, finance the purchase with a note payable to be paid off in 3 years
in annual installments of $163,686 (each installment includes principal + interest on the unpaid
balance)

-Computing the amt of a lease liability

Chapter 10. Reporting and Interpreting Bonds

Characteristics of Bonds Payable
Reasons to issue bonds instead of stocks
1. Stockholders maintain control
2. Interest expense is tax-deductible
3. The impact on earnings is positive: borrowed at a low interest rate & invested at a higher rate
Major disadvantages ~ w/ issuing bonds
1. Risk of bankruptcy::
2. Negative impact on cash flows

*Indenture: bond contract that specifies the legal provisions of a bond issue
*trustee: independent party appointed to represent the bondholders
-bonds with ratings above Baa/BBB are investment grade
Reporting Bond Transactions
2 types of cash payment in the bond contract
1. Principal: single payment that is made when the bond matures = par value, face value
2. Cash interest payments: coupon rate
-to determine pv of bond, compute the pv of the principal and the pv of the interest payments -> add
two amts
*market interest rate: current rate of interest on a debt when incurred (=yield, effective interest rate) ,
rate that should be used in computing the pv of a bond
Coupon rate < Market rate -> discount
Coupon rate = market rate -> par
Coupon rate > market rate -> premium
when a bond pays interest rate less than the rate creditors demand, they will not buy it unless
its price is discounted

 when a bond pays more than creditors demand, they will be willing to pay a premium to buy it
-corporations and creditors do not care whether a bond is issued at par, at a discount, or at a premium
b/c bonds are always priced to provide the mkt rate of interest
Bods Issued at Par
Bonds selling price is determined by the pv of its future cash flows, not the par value

-Reporting interest expense on bonds issued at par

interested expense is reported as a deduction frm operating income

interest expense that has been incurred but not paid must be accrued with an adjusting entry
Times Interest Earned
-is the co generating sufficient resources frm its profit-making activities to meet its current interest
obligations?
Times interest earned = (Net Income+ Interest Expense + Income Tax Expense) / Interest Exp
-high ratio is viewed more favorably than a low one. -> it shows the amt or resources generated for
each dollar of interest expense
-often misleading for new or rapidly growing companies
Bonds Issued at a Discount

-when bond is sold at a discount, B/P account is credited for the par amt, and discount is recorded as
a debit to Discount on B/P

-whil co received only $96,536 when it sold the bonds, it must repay $100,000 when the bonds

mature. (extra cash is an adjustment of interest expense to ensure that creditors earn the mkt rate of
interest)
-to adjust I/ Exp, borrower amortizes the bond discount to each interest period as increase in I/ Exp.
They use (1) straight line (2) effective interest
-Part A: Reporting Interest Expense on Bond Issued at a Discount Using Straight-Line Amortization
Straight-line amortization: simplified amt of amortizing a bond discount or premium that allocates an
equal dollar amt to each interest period

At the end of the 1st interest period -> book value of bonds increases to $97,402 (96,536+866)
each period, the book value of the bonds increase by $866 (amortizing)
At the maturity date of the bonds, the unamortized discount is zero

Part B: Reporting Interest Expense on Bonds Issued at a Discount Using Effective-Interest Amortization
*Effective-interest amortization: a method of amortizing a bond discount or premium on the basis of
the effective-interest rate; it is the theoretically preferred method
1) Compute interest expense
Current unpaid balance * mkt rate of interest (on the date of sold) * n/12
2) Compute amortization amount
Interest Expense Cash Interest

-the additional $792 was added to the principal of the bond and will be paid to bondholders when the
bond matures
-interest expense for 2H is calculated by multiplying the unpaid balance 96536+792 = 97.328

-interest expense increases each year b/c of the amortization of the bond discount

Bonds issued at a premium

Part A: Reporting Interest Expense on Bonds issued at a premium using straight-line amortization

Part B: Reporting Interest Expense on Bonds Issued at a Premium Using Effective-Interest Amortization

Debt-to-Equity
Relationship b/t amt of capital provided by owners and the amt provided by creditors?
Debt-to-Equity = Total Liabilities / Stockholders Equity
Early Retirement of Debt

Effects on Cash Flows: Bond Payable

Chapter 11. Reporting and Interpreting owners equity

Benefits of stock ownership
A voice in management, dividends, residual claim
*authorized number of shares: maximum number of shares of a corporations capital stock that can
be issued as specified in the charter
*issued shares: the total number of shares of stock that have been sold
*Outstanding shares: total number of shares of stock that are owned by stockholders on any
particular date

*Treasury stock: stock that has been bought back from issued company
Earnings per share (EPS)
-how well is a company performing?
EPS = NI / Avg number of common shares Outstanding
Common stock transactions
*common stock: basic voting stock issued by a corporation
*par value: nominal value per share of capital stock specified in the charter; serves as the basis for
legal capital
*legal capital: permanent amt of capital defined by state law that must remain invested in the
business; serves as a cushion for creditors
*no-par value stock: capital stock that has no par value specified in the corporate charter
Initial sale of stock

Sale of stock in secondary markets

Stock issued for Employee compensation
Repurchase of Stock
*Treasury stock: corporations own stock that has been issued but subsequently reacquired and is

still being held by that corporation -> no voting, dividend, or other stockholder rights
Reason for acquiring-> existence of an employee bonus plan that provides workers with shares of
stocks
-it is less costly to give employees repurchased shares than to issue new ones b/c of regulations

Dividends on common stock

Dividend yield
->what is return on investment based on dividends?
Dividend Yield = Dividends per share / Market price per share
-investors in C.S. earn a return frm both dividends and capital appreciation
*Declaration date: the date on which the board of directors officially approves a dividend
*Date of record: the date on which the corporation prepares the list of current stockholders as shown
on its records; dividends can be paid only to the stockholders who own stock on that date
*Payment date: date on which a cash dividend is paid to the stockholders of record

Declaration and payment of a cash dividend reduce assets and S.E. -> two requires
1) sufficient retained earnings

2) Sufficient cash
Stock Dividends and Stock Splits
Stock Dividends
*stock dividends

-pro rata basis: each stockholder receives additional shares equal to the percentage of shares held
-when a stock dividend occurs, the company must transfer an additional amt frm the RE acct into C.S.
acct to reflect the additional shares issued
-the amt transferred depends on whether the stock dividend is classified as large or small
Large: distribution of additional shares is more than 20-25% currently outstanding shares
Small: distribution of additional shares is less than 20-25% currently outstanding shares

Stock Split
*Stock Split: increase in the total number of authorized shares by a specified ratio; it does not
decrease retained earnings
-stock split is accomplished by reducing the par or stated value per share of all authorized shares
(total par value is unchanged) .eg) 2-for-1
-stock split does not result in the transfer of a dollar amt to the C.S. acct
-> In both a stock dividend & a stock split, stockholder receives more shares of stock w/o having to
invest additional resources
-> dividend: journal entry O / split: no journal entry but disclosed in the notes

Preferred Stock
*Preferred Stock: stock that has specified rights over common stock
Differences
1) Preferred stock does not grant voting rights -> permit to raise funds w/o diluting common
stockholders control

2) Preferred stock is less risky: holders receive priority payment of dividends and distribution of assets
if the corp goes out of business
3) Preferred stock typically has a fixed dividend rate
Dividends on Preferred Stock
*current dividend preference: the feature of preferred stock that grants priority on preferred dividends
over common dividends
-declared dividends must be allocated to preferred stock first, then the remainder of the total dividend
can be allocated

Cumulative Dividend Preference

*cumulative dividend preference: preferred stock feature that requires specified current dividends not
paid in full to accumulate for every year in which they are not paid. These cumulative preferred
dividends must be paid before any common dividends can be paid (dividends in arrears)
*Dividend in arrears: dividends on cumulative P.S. that have not been declared in prior years

Effect on statement of Cash Flows

Chapter 12. Reporting and interpreting investments in other corporations

Types of investments and accounting Methods
Passive Investments in Debt and Equity Securities
-Debt securities are always considered passive investments
1) If co intends to hold the securities until they reach maturity, the investments are
measured and reported at amortized cost
2) If the securities are sold b/4 maturity, they are reported using the fair value
method
-investments in equity securities: investment is presumed passive if the investing
company owns less than 20% of the outstanding voting shares
Investments in Stock for Significant Influence
Significant influence: the ability to have an important impact on the operating,
investing, and financing policies of another co
-presumed if the investing co owns frm 20-50 % of shares
Investments in Stock for Control
*Control: ability to determine the operating, and financing policies of another
company
-presumed when the investing co owns more than 50% of shares

Debt Held to Maturity: Amortized cost method

*held-to-maturity investments: investments in debt securities that management has
the intent and ability to hold until maturity
-cost adjusted for the amortization of any discount or premium
*amortized cost method: investments in debt securities held to maturity at cost

minus any premium or plus any discount

Bond Purchase
-total cost of the bond is debited to the Held-to-Maturity Investments acct

Interest Earned

Principal at maturity

-If the bond investment must be sold b/4 maturity, (no intention b/4) any difference
b/t mkt value and net book value would be reported as a gain or loss on sale
Passive Investments: The Fair Value Method
-only passive investments in marketable securities are required to be reported using
fair value method on B/S
*fair value method: used to report securities at their current market value (amt that
would be received in an orderly sale)
1) why are passive investments reported at fair value on B/S ?
-Relevance / Measurability
2) when the investment account is adjusted to reflect changes in fair value, what
other account is affected when the asset account is increased or decreased?
*Unrealized holding gains or losses: amts associated with price changes of
securities that are currently held
-the value of the investments increases by $100,000 -> adjusting journal entry by
increasing investment account & unrealized holding gain
-the value of the investments decrease by $ 75,000 -> adjusting journal entry by

decreasing investment account & unrealized holding loss

Classifying Passive Investments at Fair Value
*Trading securities: all investments in stocks or bonds held primarily for the purpose
of active trading -> Current Assets
*Securities available for sale: all passive investments other than trading securities
and debt held to maturity -> CA or NCA
Securities Available for sale
Purchase of securities

Year-End Valuation
-assume that fair value of per share is $8 (it was $10), and lost value is $2 per share
for the year -> x being sold , so the loss is unrealized loss
-Reporting the SAS investment at fair value requires asset Investments in SAS up or
down to fair value @ the end of each period -> Net Unrealized Losses/Gains
-reported in the S.E section of B/S under Other comprehensive Income (OCI)
-Only when the security I sold are any realized gains or losses included in net income

Sale of Securities
-Investments in SAS & Net Unrealized Losses/Gains (OCI) are eliminated
-assume that sold all of its SAS investments for $13 per share -> receive $195,000
Gain or loss on sale is computed as follows:
Proceeds frm sale Investment Cost = Gain if positive (Loss if negative)

Comparing Trading and Available-for-Sale Securities

1) Available-for-Sale Portfolio
-balance in net unrealized holding gains and losses is reported as a separate
component of S.E. (x reported on I/S & x affect net income)
-@the time of sale, the difference b/t the proceeds frm the sale and the original cost

is recorded as a gain or loss (investments in SAS & Net Unrealized Losses/Gains

accts are eliminated)
2) Trading Securities Portfolio
-The amt of adj to record unrealized holding gains and losses is included on each
periods I/S
-Net holding gains increase and net holding losses decrease net income
=amt recorded as net unrealized gains & losses on trading securities is closed to RE
-When selling a trading security, cash and only one other B/S are affected:
Investments in TS
-difference b/t cash proceeds frm sale & book value of Investments in TS is recorded
as a gain or loss on sale of TS
-> total income is the same $60,000 for both TS & SAS

Reporting the Fair Value of Investments

Standard recognizes three approaches in order of decreasing reliability
Lev1) Quoted prices in active markets for identical assets
Lev2) Estimates based on other observable inputs
Lev3) Estimates based on unobservable estimates
Economic Return from Investing
How much was earned per dollar invested in securities?
Economic Return frm Investing = Divd & Interest Received + Change in Fair Value /
Fair value of Investments (beg of period)
beg Invst end Invst
Investments for significant influence: Equity Method
*Equity method: when investor can exert significant influence over an affiliate; the
method permits recording the investors share of the affiliates income

*Investments in affiliates or Associated companies: invst in stock held for the

purpose of influencing the operating and financing strategies of the entity for LT
Recording Investments under the Equity Method
-Net income of affiliates: records investment income = its percentage share of the
affiliates net income & increases asset acct Investments in Afliliates
-Dividends paid by affliates: reduces its investment account and increases cash

Reporting Investments under the Equity Method

-do not adjust the investmsent account to reflect changes in the fair value of the
securities that are held
-gain/loss is recorded when being sold
Cash Flows after investments
1) the cash resulting frm the sale or purchase is reflected in Investing Activities
2) Operating activities- adjustments to net income
Gain/loss on the sale is subtracted (added) frm net income

Unrealized holding gain is subtracted (added to) net income

Equity in affiliate earnings/losses is subtracted from (added to) net income -> no
cash is involved
Dividend received frm affiliate are added to net income -> when cash is received, no
rev was recorded
Controlling Interests: Mergers and Acquisitions
Reasons
1) vertical integration: different lev of channels
2) Horizontal growth: same lev
3) Synergy: combined
Recording a Merger
*merger: occurs when one company purchases all of the assets and liabilities of
another and the acquired co goes out of existence
*purchase method: records assets and liabilities acquired in a merger or acquisition
at their fair value on the transaction date
Purchase price allocation
Step1) Estimate the fair value of the acquired cos tangible assets, identifiable
intangible assets, and liabilities
Step2) Compute goodwill, the excess of total purchase price over the fair value of the
assets liabilities listed in Step 1
*Goodwill: excess of the purchase price of a business over the fair value of the
acquired cos assets and liabilities
e.g)
Step 1) equipment 350,000 / patents 600,000 / Note Payable 100,000 =950,000
A
Step 2) Purchase price 1,000,000 / Less: Fair value of A L = -850,000
Goodwill purchased = 150,000

-the book values on the acquired cos B/S are irrelevant unless they represent fair
value
-Goodwill is reported only if it is acquired in a merger or acquisition transaction
Reporting for the Combined Companies
-Consolidated financial statements must be presented
-treat the acquired A & L in the same manner as if they were acquired indiavidually