Financial Statements - Cash Flow Computations - Direct Method

The Direct Method

The direct method is the preferred method under FASB 95 and presents cash flows from
activities through a summary of cash outflows and inflows. However, this is not the method
preferred by most firms as it requires more information to prepare.

Cash Flow from Operations

Under the direct method, (net) cash flows from operating activities are determined by
taking cash receipts from sales, adding interest and dividends, and deducting cash
payments for purchases, operating expenses, interest and income taxes. We'll examine
each of these components below:

Cash collections are the principle components of CFO. These are the actual cash
received during the accounting period from customers. They are defined as:

Formula 6.7
Cash Collections Receipts from Sales
= Sales + Decrease (or - increase) in Accounts
Receivable

Cash payment for purchases make up the most important cash outflow
component in CFO. It is the actual cash dispersed for purchases from suppliers
during the accounting period. It is defined as:

Formula 6.8

Cash payments for purchases = cost of goods sold +

increase (or - decrease) in inventory + decrease (or -
increase) in accounts payable

Cash payment for operating expenses is the cash outflow related to selling
general and administrative (SG&A), research and development (R&A) and other
liabilities such as wage payable and accounts payable. It is defined as:

Formula 6.9
Cash payments for operating expenses = operating
expenses + increase (or - decrease) in prepaid
expenses + decrease (or - increase) in accrued
liabilities
 Cash interest is the interest paid to debt holders in cash. It is defined as:

Formula 6.10
Cash interest = interest expense - increase (or +
decrease) interest payable + amortization of bond
premium (or - discount)

Cash payment for income taxes is the actual cash paid in the form of taxes. It is
defined as:

Formula 6.11
Cash payments for income taxes
= income taxes + decrease (or - increase) in income taxes
payable

Look Out!

Note: Cash flow from investing and financing are

computed the same way it was calculated under the
indirect method.

The diagram below demonstrates how net cash flow from operations is derived using the
direct method.
 Look Out!

Candidates must know the following:

Though the methods used differ, the results are

always the same.
CFO and CFF are the same under both methods.
There is an inverse relationship between changes
in assets and changes in cash flow.

ree Cash Flow (FCF)

Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all
of its expenses, including net capital expenditures. Net capital expenditures are what a
company needs to spend annually to acquire or upgrade physical assets such as buildings
and machinery to keep operating.

Formula 6.12
Free cash flow = cash flow from operating activities -
 net capital expenditures (total capital expenditure -
after-tax proceeds from sale of assets)

The FCF measure gives investors an idea of a company's ability to pay down debt, increase
savings and increase shareholder value, and FCF is used for valuation purposes.

Free Cash Flow to the Firm (FCFF)

Free cash flow to the firm is the cash available to all investors, both equity and debt
holders. It can be calculated using Net Income or Cash Flow from Operations (CFO).

The calculation of FCFF using CFO is similar to the calculation of FCF. Because FCFF is the
cash flow allocated to all investors including debt holders, the interest expense which is cash
available to debt holders must be added back. The amount of interest expense that is
available is the after-tax portion, which is shown as the interest expense multiplied by 1-tax
rate [Int x (1-tax rate)]. .

This makes the calculation of FCFF using CFO equal to:

FCFF = CFO + [Int x (1-tax rate)] FCInv

Where:
CFO = Cash Flow from Operations
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)

This formula is different for firm's that follow IFRS. Firm's that follow IFRS would not add
back interest since it is recorded as part of financing activities. However, since IFRS allows
dividends paid to be part of CFO, the dividends paid would have to be added back.

The calculation using Net Income is similar to the one using CFO except that it includes the
items that differentiate Net Income from CFO. To arrive at the right FCFF, working capital
investments must be subtracted and non-cash charges must be added back to produce the
following formula:

FCFF = NI + NCC + [Int x (1-tax rate)] FCInv WCInv

Where:
NI = Net Income
NCC = Non-cash Charges (depreciation and amortization)
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)
WCInv = Working Capital Investments

Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived from
FCFF. FCFE equals FCFF minus the after-tax interest plus any cash from taking on debt (Net
Borrowing). The formula equals:

FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing

Financial Statements - Financial Statement Analysis

A. Financial Statement Analysis

The income statement is a statement of earnings that shows managers and investors
whether the company made money over the period of time being reported. This statement
details the revenues of the firm as well as the expenses incurred to achieve them, and
transforms this into net income. The conclusion of the statement is to show the firm's gains
or losses for the period.
The balance sheet reports the company's financial position at a specific point in time. The
balance sheet is made up of three parts: assets, liabilities and owners' equity. Assets detail
the firm's economic resources that have been built up through the firm's operations or
acquisitions. Liabilities are the current or estimated obligations of the firm. The difference
between assets and liabilities is known as net assets or net worth of the firm. The net assets
of the firm are also known as owners' equity, which is amount of assets that would remain
once all creditors are paid. According to the accounting equation, owners' equity equals
assets minus liabilities

Assets Liabilities = Owners' Equity

The statement of cash flows reconciles the firm's net income to its reports on the company's
cash inflows and outflows. It shows how changes in balance sheet accounts and income
affect cash and cash equivalents. These cash receipts and payments are categorized as by
operating cash flows, investing cash flows and financing cash flows
The statement of changes in owners' equity reports the sources and amounts of changes in
owners' equity over the period of time being reported
Let's consider a practical example to fully understand the impact of Cash versus Accrual
Accounting on XYZ Corporation's Income Statement and Balance Sheet.

Cash Basis Accounting

Taken as is, the financial statements in Figure 6.1 below indicate that XYZ Corporation is
not doing well, with a net loss of $43,200, and may not be a good investment opportunity.

Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting
Note: For simplicity the tax effect not considered.

Accrual Basis Accounting

Armed with some additional information, let's see what the income statement would look
like if the accrual-basis accounting method was used.

Additional Information:

A1. June 12, 2005 - The company received a rush order for $80,000 of wood panels. The
order was delivered to the customer five days later. The customer was given 30 days to
pay. (With the cash-basis method, sales are not recorded in the income statement and not
recorded in accounts receivables: no cash, no record).

A2. June 13, 2003 - The company received $60,000 worth of wood panels to replenish their
inventory, and $40,000 was related to the rush order. The company paid the invoice in full
to take advantage of a 2% early-payment discount. (With the cash-basis method, this is
recorded in full on the income statement, and there is no record of inventory on hand).

A3. June 1, 2005 - The company launched an advertising campaign that will run until the
end of August. The total cost of the advertising campaign was $15,000 and was paid
on June 1, 2005.

Figure 6.2: XYZ Corporation's Restated Financial Statements using Accrual Basis
Accounting
Note: tax effect not considered

Adjustments:
To obtain the figures in the restated financial statements in figure 6.2 above, the following
adjusting entries were made:

A1. Product sales and Accounts receivable - Even though the client has not paid this
invoice, the company still made a sale and delivered the products. As a result, sales for the
accounting period should increase by $80,000. Account s receivables (reported sales made
but awaiting payment) should also increase by $80,000.

Adjusting entries:

A2. June 13, 2003 - Since the entire $60,000 order was paid during the accounting period,
the full amount was included in production costs under the cash-basis method. Only
$40,000 of the order was related to product sales during that accounting period, and the
rest was stored as inventory for future product sales.

Adjusting entries:
A3. June 1, 2005 - Marketing expenses included in the income statement totaled $15,000
for a three-month advertising campaign because it was paid in full at initiation (cash-basis
accounting). The reality is that this campaign will last for three months and will generate a
benefit for the company every month. As a result, under accrual-basis accounting, the
company should record in this accounting period only one-third of the cost. The remainder
should be allocated to the next period and recoded as prepaid expenses on the assets side
of the balance sheet.

Adjusting entries:

Results:

Under cash-basis accounting, this company was not profitable and its balance sheet would
have been weak at best. Under accrual accounting, the financials tell us a very different
story.

Accrual accounting requires that revenue is recorded when the firm earns it, and that
expenses are taken when the firm incurs them regardless of when the cash is actually
received or paid. If cash is received first then an unearned revenue or prepaid expense
account is set up and decreased as the revenue and expense is recorded over time. If cash
is received after goods are delivered then the revenue and expense is recorded and a
receivables or payables account is set up and decreased as the cash is paid. Most accruals
fall into one of four categories:

1. Accrued Revenues: A firm will usually earn revenue before it is actually paid for its
goods or services. Typically the asset account for accounts receivable is increased until the
customer actually pays for goods that have been invoiced. The company records the
revenue when the goods are delivered and invoiced. The accounts receivable account is
decreased when the customer pays the invoice in cash.

2. Unearned Revenue: Some firms collect income before goods are provided.
Subscriptions are examples of goods that are prepaid, but the revenue is not recognized
until the goods are delivered. In this situation the firm increases the asset account cash and
a liability account for unearned income. Unearned income is decreased as revenue is earned
over time.
3. Accrued Expenses: Most firms buy inventories and supplies on account and pay for
them after they have been invoiced. When the goods are delivered and equal amount is
recorded in the expense account and in accounts payable. When the invoice is paid, cash
and the accounts payable account are decreased.

4. Prepaid Expenses: Some companies pay some expenses in advance. A prepaid expanse
account is increased and the actual expense is not recorded until the actual goods or
services are delivered.

Look Out!

Debit:An accounting term that refers to an entry

thatincreases an expense or asset account, or decreasesan
income, liability or net-worth account.

Credit: An accounting term that refers to an entry

thatdecreases an expense or asset account, or increasesan
income, liability or net-worth account.

Look Out!

Going forward, all statements will use accrual-basis accounting.

Please note that on the exam, candidates should assume that
all financial statements use accrual-basis accounting, unless it is
specified that the cash-basis accounting method is used in the
question.

Financial Statements - Income Statement Basics

I. Basics
Within this basics section, we will define each component of a multi-step income statement,
and prepare a multi-step income statement.

Multi-Step Income Statement

A multi-step income statement is a condensed statement of income as opposed to a single-
step format, which is the more detailed format. Both single and multi-step formats conform
to GAAP standards. Both yield the same net income figure.

The main difference is how they are formatted, not how figures are calculated.

Figure 6.3: Multi-Step Income Statement

Sales - These are defined as total sales (revenues) during the accounting period.
Remember these sales are net of returns, allowances and discounts

Cost of goods sold (COGS) - These are all the direct costs related to the product
or rendered service sold and recorded during the accounting period. (Reminder:
matching principle.)

Operating expenses - These include all other expenses that are not included in
COGS but are related to the operation of the business during the specified
accounting period. This account is most commonly referred to as "SG&A" (sales
general and administrative) and includes expenses such as selling, marketing,
administrative salaries, sales salaries, maintenance, administrative office expenses
(rent, computers, accounting fees, legal fees), research and development (R&D),
depreciation and amortization, etc.

Other revenues & expenses - These are all non-operating expenses such as
interest earned on cash or interest paid on loans.
 Income taxes - This account is a provision for income taxes for reporting purposes.

Financial Statements - Income Statement Components

Income Statement Format

The following figure demonstrates which components are used to calculate a company's net
income, which is the income available to shareholders.

Figure 6.4: How Net Income is Derived on the Income Statement

The Components of Net Income:

Operating income from continuing operations - This comprises all revenues net
of returns, allowances and discounts, less the cost and expenses related to the
generation of these revenues. The costs deducted from revenues are typically the
COGS and SG&A expenses.

Recurring income before interest and taxes from continuing operations -

This component includes, in addition to operating income from continuing operations,
all other income, such as investment income from unconsolidated subsidiaries and/or
other investments and gains (or losses) from the sale of assets. To be included in
this category, these items must be recurring in nature. This component is generally
considered to be the best predictor of future earning. That said, it does assume that
noncash expenses such as depreciation and amortization are a good indicator of
future capital expenditures. Since this component does not take into account the
 capital structure of the company (use of debt), it is also used to value similar
companies.

Recurring (pre-tax) income from continuing operations - This component

takes the company's financial structure into consideration as it deducts interest
expenses.

Pre-tax earning from continuing operations - This component considers all

unusual or infrequent items. Included in this category are items that are either
unusual or infrequent in nature but cannot be both. Examples are an employee-
separation cost, plant shutdown, impairments, write-offs, write-downs, integration
expenses, etc.

Net income from continuing operations - This component takes into account the
impact of taxes from continuing operations.

Non-Recurring Items
Discontinued operations, extraordinary items and accounting changes are all reported as
separate items in the income statement. They are all reported net of taxes and below the
tax line, and are not included in income from continuing operations. In some cases, earlier
income statements and balance sheets have to be adjusted to reflect changes.

Income (or expense) from discontinued operations - This component is related

to income (or expense) generated due to the shutdown of one or more divisions or
operations (plants). These events need to be isolated so they do not inflate or deflate
the company's future earning potential. This type of nonrecurring occurrence also
has a nonrecurring tax implication and, as a result of the tax implication, should not
be included in the income tax expense used to calculatenet income from
continuing operations. That is why this income (or expense) is always reported
net of taxes. The same is true for extraordinary items and cumulative effect of
accounting changes (see below).

Extraordinary items - This component relates to items that are both unusual and
infrequent in nature. That means it is a one-time gain or loss that is not expected to
occur in the future. An example is environmental remediation.
 Cumulative effect of accounting changes - This item is generally related to
changes in accounting policies or estimations. In most cases, these are non cash-
related expenses but could have an effect on taxes.

Within this section we will further our discussion on the non-recurring components of net
income, such as unusual or infrequent items, discontinued operations, extraordinary items,
and prior period adjustments.

Unusual or Infrequent Items

Included in this category are items that are either unusual or infrequent in nature but
cannot be both.

Examples of unusual or infrequent items:

o Gains (or losses) as a result of the disposition of a company's business
segment including:
Plant shutdown costs
Lease-breaking fees
Employee-separation costs
o Gains (or losses) as a result of the disposition of a company's assets or
investments (including investments in subsidiary segments) including:
Plant shut-down costs
Lease-breaking fees
o Gains (or losses) as a result of a lawsuit
o Losses of operations due to an earthquake
o Impairments, write-offs, write-downs and restructuring costs
o Integration expenses related to the acquisition of a business

Look Out!

Accounting treatment is usually displayed as pre-

tax. That means that they are displayed on the
income statement after income from continuing
operations gross of tax implication.

Extraordinary Items
Events that are both unusual and infrequent in nature are qualified as extraordinary
expenses.

Example of extraordinary items:

o Losses from expropriation of assets
o Gain (or losses) from early retirement of debt
 Look Out!

Accounting treatment is usually displayed net of

tax. That means that they are displayed on the
income statement after income from continuing
operations net of its tax implication.

Discontinued Operations
Sometimes management decides to dispose of certain business operations but either has
not yet done so or did it in the current year after it had generated income or losses. To be
accounted for as a discontinued operation, the business must be physically and
operationally distinct from the rest of the firm. Basic definitions:

Measurement date - The date when the company develops a formal plan for
disposing.
Phaseout period - Time between the measurement date and the actual disposal
date

The income or loss from discontinued operations is reported separately, and past income
statements must be restated, separating the income or loss from discontinued operations.
On the measurement date, the company will accrue any estimated loss during the phaseout
period and estimated loss on the sale of the disposal. Any expected gain on the
disposal cannot be reported until after the sale is completed (same rule applies to the sale
of a portion of a business segment).

Look Out!

Important: Accounting treatment of income and

losses from discontinued operations are reported
net of tax after net income from continuing
operations.

Accounting Changes
Accounting changes occur for two reasons:

1. As a result of a change in an accounting principle

2. As a result of a change in an accounting estimate.

The most common form of a change in accounting principle is the switch from the LIFO
inventory accounting method to another method such FIFO or average cost basis.
The most common form of a change in accounting estimates is a change in depreciation
method for new assets or change in depreciable lives/salvage values, which is considered a
change in accounting estimates and not a change in accounting principle. Note that past
income does not need to be restated from the LIFO inventory accounting method to another
method such FIFO or average cost basis.

In general, prior years' financial statements do not need to be restated unless it is a change
in:

Inventory accounting methods (LIFO to FIFO)

Change to or from full-cost method (This is used in oil & gas exploration. The
successful-efforts method capitalizes only the costs associated with successful
activities while the full-cost method capitalizes all the costs associated with all
activities.)
Change from or to percentage-of-completion method (look at revenue- recognition
methods)
All changes just prior to a company's IPO

Prior Period Adjustments

These adjustments are related to accounting errors. These errors are typically NOT reported
in the income statement but are reported in retained earnings. (These can be found in
changes in retained earnings.) These errors are disclosed as footnotes explaining the nature
of the error and its effect on net income.

Financial Statements - Balance Sheet Basics

I. Basics
Within this section we'll define each asset and liability category on the balance sheet, and
prepare a classified balance sheet

Balance Sheet Categories

The balance sheet provides information on what the company owns (its assets), what it
owes (its liabilities) and the value of the business to its stockholders (the shareholders'
equity) as of a specific date.

Total Assets = Total Liabilities + Shareholders' Equity

Assets are economic resources that are expected to produce economic benefits for
their owner.
Liabilities are obligations the company has to outside parties. Liabilities represent
others' rights to the company's money or services. Examples include bank loans,
debts to suppliers and debts to employees.
 Shareholders' equity is the value of a business to its owners after all of its
obligations have been met. This net worth belongs to the owners. Shareholders'
equity generally reflects the amount of capital the owners have invested, plus any
profits generated that were subsequently reinvested in the company.

Look Out!

Components of Total Assets on the balance sheet are

listed in order of liquidity and maturity.

Balance Sheet Presentation Formats

Although there are no required reporting balance sheet designs there are two customary
formats that are used, the account format and the report format. The two formats follow the
accounting equation by subtotaling assets and showing that they equal the combination of
liabilities and shareholder's equity. However, the report format presents the categories in
one vertical column, while the report format places assets in one column on the left hand
side and places liabilities and shareholder's equity on the right. Both formats can be
collapsed further into a classified balance sheet that subtotals and shows only similar
categories such as current assets, noncurrent assets, current liabilities, noncurrent
liabilities, etc.
Financial Statements - Balance Sheet Components - Assets

Total Assets
Total assets on the balance sheet are composed of:

1. Current Assets - These are assets that may be converted into cash, sold or consumed
within a year or less. These usually include:

Cash - This is what the company has in cash in the bank. Cash is reported at its
market value at the reporting date in the respective currency in which the financials
are prepared. (Different cash denominations are converted at the market conversion
rate.

Marketable securities (short-term investments) - These can be both equity

and/or debt securities for which a ready market exist. Furthermore, management
expects to sell these investments within one year's time. These short-term
investments are reported at their market value.
 Accounts receivable - This represents the money that is owed to the company for
the goods and services it has provided to customers on credit. Every business has
customers that will not pay for the products or services the company has provided.
Management must estimate which customers are unlikely to pay and create an
account called allowance for doubtful accounts.Variations in this account will impact
the reported sales on the income statement. Accounts receivable reported on the
balance sheet are net of their realizable value (reduced byallowance for doubtful
accounts).

Notes receivable - This account is similar in nature to accounts receivable but it is

supported by more formal agreements such as a "promissory notes" (usually a short
term-loan that carries interest). Furthermore, the maturity of notes receivable is
generally longer than accounts receivable but less than a year. Notes receivable is
reported at its net realizable value (what will be collected).

Inventory - This represents raw materials and items that are available for sale or
are in the process of being made ready for sale. These items can be valued
individually by several different means - at cost or current market value - and
collectively by FIFO (first in, first out), LIFO (last in, first out) or average-cost
method. Inventory is valued at the lower of the cost or market price to preclude
overstating earnings and assets.

Prepaid expenses - These are payments that have been made for services that the
company expects to receive in the near future. Typical prepaid expenses include
rent, insurance premiums and taxes. These expenses are valued at their original cost
(historical cost).

2. Long-term assets - These are assets that may not be converted into cash, sold or
consumed within a year or less. The heading "Long-Term Assets" is usually not displayed on
a company's consolidated balance sheet. However, all items that are not included in current
assets are long-term Assets. These are:

Investments - These are investments that management does not expect to sell
within the year. These investments can include bonds, common stock, long-term
notes, investments in tangible fixed assets not currently used in operations (such as
land held for speculation) and investments set aside in special funds, such as sinking
funds, pension funds and plan-expansion funds. These long-term investments are
reported at their historical cost or market value on the balance sheet.
 Fixed assets - These are durable physical properties used in operations that have a
useful life longer than one year. This includes:
o Machinery and equipment - This category represents the total machinery,
equipment and furniture used in the company's operations. These assets are
reported at their historical cost less accumulated depreciation.
o Buildings (plants) - These are buildings that the company uses for its
operations. These assets are depreciated and are reported at historical cost
less accumulated depreciation.
o Land - The land owned by the company on which the company's buildings or
plants are sitting on. Land is valued at historical cost and is not depreciable
under U.S. GAAP
Other assets - This is a special classification for unusual items that cannot be
included in one of the other asset categories. Examples include deferred charges
(long-term prepaid expenses), non-current receivables and advances to subsidiaries.

Intangible assets - These are assets that lack physical substance but provide
economic rights and advantages: patents, franchises, copyrights, goodwill,
trademarks and organization costs. These assets have a high degree of uncertainty
in regard to whether future benefits will be realized. They are reported at historical
cost net of accumulated depreciation.

The value of an identifiable intangible asset is based on the rights or privileges conveyed
to its owner over a finite period, and its value is amortized over its useful life. Identifiable
intangible assets include patents, trademarks and copyrights. Intangible assets that are
purchased are reported on the balance sheet at historical cost less accumulated
amortization.

An unidentifiable intangible asset cannot be purchased separately and may have an

infinite life. Intangible assets with infinite lives are not amortized, and are tested for
impairment annually, at least. Goodwill is an example of an unidentifiable intangible asset.
Goodwill is recorded when one company acquires another at an amount that exceeds the
fair market value of its net identifiable assets. It represents the premium paid for the target
company's reputation, brand names, customers, suppliers, human capital, etc. When
computing financial ratios, goodwill and the offsetting impairment charges are usually
removed from the balance sheet.

Certain intangible assets that are created internally such as research and development costs
are expensed as incurred under U.S. GAAP. Under IFRS, a firm must identify if the R&D cost
is in the research and development stage. Costs are expensed in the research stage and
capitalized during the development stage.
Financial Statements - Balance Sheet Components - Liabilities

Total Liabilities
Liabilities have the same classifications as assets: current and long-term.

3. Current liabilities - These are debts that are due to be paid within one year or the
operating cycle, whichever is longer; further, such obligations will typically involve the use
of current assets, the creation of another current liability or the providing of some service.

Usually included in this section are:

Bank indebtedness - This amount is owed to the bank in the short term, such as a
bank line of credit.

Accounts payable - This amount is owed to suppliers for products and services that
are delivered but not paid for.

Wages payable (salaries), rent, tax and utilities - This amount is payable to
employees, landlords, government and others.

Accrued liabilities (accrued expenses) - These liabilities arise because an expense

occurs in a period prior to the related cash payment. This accounting term is usually
used as an all-encompassing term that includes customer prepayments, dividends
payables and wages payables, among others.

Notes payable (short-term loans) - This is an amount that the company owes to
a creditor, and it usually carries an interest expense.

Unearned revenues (customer prepayments) - These are payments received by

customers for products and services the company has not delivered or started to
incur any cost for its delivery.
 Dividends payable - This occurs as a company declares a dividend but has not of
yet paid it out to its owners.

Current portion of long-term debt - The currently maturing portion of the long-
term debt is classified as a current liability. Theoretically, any related premium or
discount should also be reclassified as a current liability.

Current portion of capital-lease obligation - This is the portion of a long-term

capital lease that is due within the next year.

Look Out!

Current liabilities above are listed in order of their due

date.

4. Long-term Liabilities - These are obligations that are reasonably expected to be

liquidated at some date beyond one year or one operating cycle. Long-term obligations are
reported as the present value of all future cash payments. Usually included are:

Notes payables - This is an amount the company owes to a creditor, which usually
caries an interest expense.

Long-term debt (bonds payable) - This is long-term debt net of current portion.

Deferred income tax liability - GAAP allows management to use different

accounting principles and/or methods for reporting purposes than it uses for
corporate tax filings (IRS). Deferred tax liabilities are taxes due in the future (future
cash outflow for taxes payable) on income that has already been recognized for the
books. In effect, although the company has already recognized the income on its
books, the IRS lets it pay the taxes later (due to the timing difference). If a
company's tax expense is greater than its tax payable, then the company has
created a future tax liability (the inverse would be accounted for as a deferred tax
asset).
 Pension fund liability - This is a company's obligation to pay its past and current
employees' post-retirement benefits; they are expected to materialize when the
employees take their retirement (defined-benefit plan). Valued by actuaries and
represents the estimated present value of future pension expense, compared to the
current value of the pension fund. The pension fund liability represents the additional
amount the company will have to contribute to the current pension fund to meet
future obligations.

Long-term capital-lease obligation - This is a written agreement under which a

property owner allows a tenant to use and rent the property for a specified period of.
Long-term capital-lease obligations are net of current portion.

Look Out!

The liabilities above are listed in order of their due date.

Financial Statements - Balance Sheet Components - Marketable &

Nonmarketable Instruments

Marketable & Nonmarketable Instruments

Financial instruments are found on both sides of the balance sheet. Some are contracts that
represent the asset of one company and the liability of another. Financial assets include
investment securities like stocks and bonds, derivatives, loans and receivables. Financial
liabilities include derivatives, notes payable and bonds payable. Some financial instruments
are reported on the balance sheet at fair value (marking to market), while others are
reported at present value or at cost. The FASB recently issued SFAS No. 159, "The Fair
Value Option for Financial Assets and Financial Liabilities," which allows any firm the ability
to report almost any financial asset or liability at fair value. Marketable investment
securities are classified as one of the following:

Held to Maturity Securities: Debt securities that are acquired with the intention of
holding them until maturity. They are reported at cost and adjusted for the payment
of interest. Unrealized gains or losses are not reported.
Trading Securities: Debt and equity securities that are acquired with the intention
to trade them in the near term for a profit. Trading securities are reported on the
balance sheet at fair value. Unrealized gains and losses before the securities are sold
are reported in the income statement.
 Available for Sale Securities: are debt and equity securities that are not expected
to be held until maturity or sold in the near term. Although like trading securities,
available for sale securities are reported on the balance sheet at fair value,
unrealized gains and losses are reported as other income as part of stockholder's
equity.

With all three types of financial securities, income in the form of interest and dividends, as
well as realized gains and losses when they are sold, are reported in the income statement.

The following are measured at fair value:

Assets Liabilities
Financial assets held for trading Financial assets held for trading
Financial assets available for sale Derivatives
Derivatives Non-derivative instruments hedged by
derivatives
Non-derivative instruments hedged by
derivatives

The following are measured at cost or amortized cost:

Assets Liabilities
Unlisted instruments All other liabilities (accounts payable,
notes payable)
Held-to-maturity investments
Loans and receivables
Financial Statements - Shareholders' (Stockholders') Equity
Basics

I. Basics

Components of Shareholder's Equity

Also known as "equity" and "net worth", the shareholders' equity refers to the shareholders'
ownership interest in a company.

Usually included are:

Preferred stock - This is the investment by preferred stockholders, which have

priority over common shareholders and receive a dividend that has priority over any
distribution made to common shareholders. This is usually recorded at par value.
 Additional paid-up capital (contributed capital) - This is capital received from
investors for stock; it is equal to capital stock plus paid-in capital. It is also called
"contributed capital".

Common stock - This is the investment by stockholders, and it is valued at par or

stated value.

Retained earnings - This is the total net income (or loss) less the amount
distributed to the shareholders in the form of a dividend since the company's
initiation.

Other items - This is an all-inclusive account that may include valuation allowance
and cumulative translation allowance (CTA), among others. Valuation allowance
pertains to noncurrent investments resulting from selective recognition of market
value changes. Cumulative translation allowance is used to report the effects of
translating foreign currency transactions, and accounts for foreign affiliates.

Look Out!

These components are listed in the order of their

liquidation priority.

Figure 6.5: Sample Balance Sheet

Stockholders' Equity Statement
Instead of presenting a detailed stockholders' equity section in the balance sheet and a
retained earnings statement, many companies prepare a stockholders' equity statement.

This statement shows the changes in each type of stockholders' equity account and the total
stockholders' equity during the accounting period. This statement usually includes:

Preferred stock
Common stock
Issue of par value stock
Additional paid-in capital
Treasury stock repurchase
Cumulative Translation Allowance (CTA)
Retained earning

Financial Statements - Components of Stockholders' Equity

Within this section we'll identify the components that comprise the contributed capital part
of stockholders' equity.

Contributed Capital
Contributed capital is the total legal capital of the corporation (par value of preferred and
common stock) plus the paid-in capital.

Par value - This is a value of preferred and common stock that is arbitral (artificial);
it is set by management on a per share basis. This artificial value has no relation or
impact on the market value of the shares.

Legal capital of the corporation - This is par value per share multiplied by the
total number of shares issued.

Additional paid-in capital (paid-in capital) - This is the difference between the
actual value the company sold the shares for and their par value.

Example:
Company XYZ issued 15,000 preferred shares to investors for $300,000.
Company XYZ issued 30,000 common shares to investors for $600,000.
Par value of preferred shares is $7 per share.
Par value of common shares is $15 per share.

Legal capital:
Preferred shares: $105,000(15,000 x $7)
Common shares: $450,000(30,000 x $15)
Legal capital $555,000

Paid-in capital:
Preferred shares: $195,000 ($300,000-$105,000)
Common shares: $150,000 ($600,000-$450,000)
Paid-in capital $345,000

Legal capital + Paid-in capital = Contributed Capital

Look Out!

If issued common shares have no par value, the amount

the stock is sold for constitutes common stock. Preferred
stock is always sold with a stated par value.

Financial Statements - The Cash Flow Statement

I. Introduction

Components and Relationships Between the Financial Statements

It is important to understand that the income statement, balance sheet and cash flow
statement are all interrelated.

The income statement is a description of how the assets and liabilities were utilized in the
stated accounting period. The cash flow statement explains cash inflows and outflows, and
will ultimately reveal the amount of cash the company has on hand; this is reported in the
balance sheet as well.

We will not explain the components of the balance sheet and the income statement here
since they were previously reviewed.

Figure 6.13: The Relationship between the Financial Statements

Financial Statements - Cash Flow Statement Basics

Statement of Cash Flow

The statement of cash flow reports the impact of a firm's operating, investing and financial
activities on cash flows over an accounting period. The cash flow statement is designed to
convert the accrual basis of accounting used in the income statement and balance sheet
back to a cash basis.

The cash flow statement will reveal the following to analysts:

 1. How the company obtains and spends cash
2. Why there may be differences between net income and cash flows
3. If the company generates enough cash from operation to sustain the business
4. If the company generates enough cash to pay off existing debts as they mature
5. If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows

The statement of cash flows is segregated into three sections:

1. Operating activities
2. Investing activities
3. Financing activities

1. Cash Flow from Operating Activities (CFO)

CFO is cash flow that arises from normal operations such as revenues and cash operating
expenses net of taxes.

This includes:

Cash inflow (+)

1. Revenue from sale of goods and services
2. Interest (from debt instruments of other entities)
3. Dividends (from equities of other entities)
Cash outflow (-)
1. Payments to suppliers
2. Payments to employees
3. Payments to government
4. Payments to lenders
5. Payments for other expenses

2. Cash Flow from Investing Activities (CFI)

CFI is cash flow that arises from investment activities such as the acquisition or disposition
of current and fixed assets.

This includes:

Cash inflow (+)

1. Sale of property, plant and equipment
2. Sale of debt or equity securities (other entities)
3. Collection of principal on loans to other entities
Cash outflow (-)
1. Purchase of property, plant and equipment
2. Purchase of debt or equity securities (other entities)
3. Lending to other entities
3. Cash flow from financing activities (CFF)
CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or
retraction) of additional shares, short-term or long-term debt for the company's operations.
This includes:

Cash inflow (+)

1. Sale of equity securities
2. Issuance of debt securities
Cash outflow (-)
1. Dividends to shareholders
2. Redemption of long-term debt
3. Redemption of capital stock

Reporting Noncash Investing and Financing Transactions

Information for the preparation of the statement of cash flows is derived from three
sources:

1. Comparative balance sheets

2. Current income statements
3. Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow
because they do not require the use of cash.

Examples Include:

Conversion of debt to equity

Conversion of preferred equity to common equity
Acquisition of assets through capital leases
Acquisition of long-term assets by issuing notes payable
Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt
securities

Though these items are typically not included in the statement of cash flow, they can be
found as footnotes to the financial statements.
inancial Statements - Cash Flow Computations - Indirect Method

Under U.S. and ISA GAAP, the statement of cash flow can be presented by means of two
ways:

1. The indirect method

2. The direct method
The Indirect Method
The indirect method is preferred by most firms because is shows a reconciliation from
reported net income to cash provided by operations.

Calculating Cash flow from Operations

Here are the steps for calculating the cash flow from operations using the indirect method:

1. Start with net income.

2. Add back non-cash expenses.
o (Such as depreciation and amortization)
3. Adjust for gains and losses on sales on assets.
o Add back losses
o Subtract out gains
4. Account for changes in all non-cash current assets.
5. Account for changes in all current assets and liabilities except notes payable and
dividends payable.

In general, candidates should utilize the following rules:

Increase in assets = use of cash (-)

Decrease in assets = source of cash (+)
Increase in liability or capital = source of cash (+)
Decrease in liability or capital = use of cash (-)

The following example illustrates a typical net cash flow from operating activities:
Cash Flow from Investment Activities
Cash Flow from investing activities includes purchasing and selling long-term assets and
marketable securities (other than cash equivalents), as well as making and collecting on
loans.

Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing Activities

Cash Flow from financing activities includes issuing and buying back capital stock, as well as
borrowing and repaying loans on a short- or long-term basis (issuing bonds and notes).
Dividends paid are also included in this category, but the repayment of accounts payable or
accrued liabilities is not.

Here's the calculation of the cash flows from financing using the indirect method:
Financial Statements - Cash Flow Computations - Direct Method

The Direct Method

The direct method is the preferred method under FASB 95 and presents cash flows from
activities through a summary of cash outflows and inflows. However, this is not the method
preferred by most firms as it requires more information to prepare.

Cash Flow from Operations

Under the direct method, (net) cash flows from operating activities are determined by
taking cash receipts from sales, adding interest and dividends, and deducting cash
payments for purchases, operating expenses, interest and income taxes. We'll examine
each of these components below:

Cash collections are the principle components of CFO. These are the actual cash
received during the accounting period from customers. They are defined as:

Formula 6.7
Cash Collections Receipts from Sales
= Sales + Decrease (or - increase) in Accounts
Receivable

Cash payment for purchases make up the most important cash outflow
component in CFO. It is the actual cash dispersed for purchases from suppliers
during the accounting period. It is defined as:

Formula 6.8

Cash payments for purchases = cost of goods sold +

increase (or - decrease) in inventory + decrease (or -
increase) in accounts payable
 Cash payment for operating expenses is the cash outflow related to selling
general and administrative (SG&A), research and development (R&A) and other
liabilities such as wage payable and accounts payable. It is defined as:

Formula 6.9
Cash payments for operating expenses = operating
expenses + increase (or - decrease) in prepaid
expenses + decrease (or - increase) in accrued
liabilities

Cash interest is the interest paid to debt holders in cash. It is defined as:

Formula 6.10
Cash interest = interest expense - increase (or +
decrease) interest payable + amortization of bond
premium (or - discount)

Cash payment for income taxes is the actual cash paid in the form of taxes. It is
defined as:

Formula 6.11
Cash payments for income taxes
= income taxes + decrease (or - increase) in income taxes
payable

Look Out!

Note: Cash flow from investing and financing are

computed the same way it was calculated under the
indirect method.

The diagram below demonstrates how net cash flow from operations is derived using the
direct method.
 Look Out!

Candidates must know the following:

Though the methods used differ, the results are

always the same.
CFO and CFF are the same under both methods.
There is an inverse relationship between changes
in assets and changes in cash flow.