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Intro duc tion
I. T HE F INA NC IA L S T A T E ME NT A NA L Y S IS F R A ME W O R K
A . F inanc ial R eporting and F inanc ial S tateme nt A naly s is
A c c ounting, from the viewpoint of the C F A examination, is an input (a tool) us ed in the inves tment proc es s , rather than an end in its elf. T he emphas is is on the us e of financ ial s tate ments by an ana lys t who is making an inves tment dec is ion, rather than on their preparation by an ac c ountant. It is s till nec es s ary, however, for ana lys ts to unders tand the proc edures tha t ac c ountants us e and the latitude tha t the y are pe rmitted when c ons truc ting financ ial s tatements , both domes tic ally a nd g loba lly, to judg e the us efulnes s of the information c onta ined in them to the inves tment dec is ion-making proc es s . T he financ ial analys t mus t go beyond the knowledg e of ac c ounting mec ha nic s and learn how to us e the data provide d in financ ial s tatements , in c onjunc tion with other information to make inves tment dec is ions .
II.MA J O R F INA NC IA L S T A T E ME NT S A ND O T HE R INF OR MA T IO N S O UR C E S
T he financ ial reports prepa red by bus ines s es for external us e us ually c ontain the following key financ ial s tatements :
A . B ala nc e S heet
T he balanc e s heet (als o referred to as the s tatement of financ ial pos ition) reports major c las s es and amounts of as s ets , liabilities , and equity c apital at a s pec ific point in time (i.e., the balanc e s hee t date). A s s ets repres ent probable future ec onomic benefits tha t are either purc has ed by the firm or gene rated through its ope rations . L iabilities repres ent probable future s ac rific es of ec onomic benefits and are the c reditors ' c laims on the as s ets of the entity. E quity c apital (s hareholders ' equity for a c orporation) repres ents the owne rs ' c apital c ontributions and othe r internally generated s ourc es of c apital (e.g ., the c umulative undis tributed earning s of the entity).
It is important to unders tand tha t the as s et and liability values reported on the balanc e s hee t do not nec es s arily reflec t the fair market value of thes e items for various reas ons that will be dis c us s ed throughout the text.
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res ulting equity c apital reported on a balanc e s heet s hould not be taken to be the (market) value of a c ompa ny.
B . Inc o me S tatement
T he inc ome s tate ment, als o known as the s tatement of ope rations or the profit and los s (P &L ) s tatement, reports on the performanc e of the firm (i.e., the res ults of its ope rating ac tivities ) for a s pec ific period of time. T he inc ome s tatement is prepared us ing ac c rua l methods and relies on the matc hing princ iple. A s a res ult, it is interrelated with the balanc e s heet and explains s ome, but not all, of the c hanges in the as s ets , liabilities , and equity c apital of a firm between two c ons ec utive balanc e s hee t dates . T he two ba s ic elements reported on the inc ome s tatement are revenues , whic h repres ent inflows of res ourc es from the entity's "c ore" operations , and expens es , whic h repres ent outflows of res ourc es from the s ame operations .
U.S . G A A P does not s pec ify the exac t format of the inc ome s tatement although s pec ific dis c los ures are required. T he de finitions for s ome of the terms found in the inc ome s tate ment a re:
R evenues (Net s ales ) are the proc eeds from the s ale of goods and s ervic es produc ed regularly by the c ompa ny, les s returns and allowanc es . O pe rating expens es inc lude the c os t of g oods s old, whic h is the amount
the firm pa id for the produc ts s old during the ac c ounting pe riod, and s elling , general and adminis trative (S G &A ) expens es . D eprec iation and amortization expe ns es are ofte n not broken out s eparately, but c an be found on the s tatement of c as h flows or in the notes to the financ ial s tatements .
O the r revenues (and expe ns es ) are nonoperating items s uc h as inc ome from inves tments and inc ome from c redit exte nded to c us tomers (i.e ., interes t inc ome) .
Unus ual and/or infreque nt items are nonoperating items that are dis c us s ed in more de tail in the next s tudy s es s ion.
P reta x earning s from c ontinuing ope rations is s ometimes referred to as ope rating inc ome. W he n inte res t e xpens e is added bac k, this is referred to as ea rnings before inte res t a nd taxes (E B IT ).
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Net inc ome is the "bottom line" of the inc ome s tate ment. It is the amount tha t is trans ferred to retained earnings from whic h dividends c an be paid.
Note
R eported inc ome does not us ually meas ure the s us ta ina ble inc ome from whic h future inc ome c an be projec te d bec aus e:
* R evenue and c os t data are reported with a lag and are ba s ed upon
his toric al c os ts , rathe r than c urrent pric es and unit c os ts .
* S ome c os t data , s uc h as es timated bad debts and deprec iation expens es ,
are rea lly alloc ations that may not bear any relations hip to the ac tua l way in whic h c os ts are inc urred.
* S ome revenues and expe ns es are reported in periods that are different
from thos e in whic h c as h was ac tually rec eived or s pent.
* S ome revenues , expe ns es , and inc ome (los s es) are not expec ted to rec ur.
F or all of thes e reas ons , the financ ial da ta pres ented in an inc ome s tatement are only an approximation of ec onomic reality. T hus , the financ ial data are only partially us eful to an analys t who is attempting to dete rmine the long -term ability of a c ompa ny to gene rate funds that are available to mee t its obligations to c reditors and whic h c an be dis tributed to its owners .
C . S tatement of C as h F low s
T he s tate ment of c as h flows reports a firm's c as h rec eipts and c as h payments for the ac c ounting pe riod c las s ified as operating, inves ting, or financ ing ac tivities . O perating ac tivities reflec t the day-to-day operations of a c ompany, inves ting ac tivities inc lude the c ompa ny's purc has es and s ales of long-term as s ets , and financ ing ac tivities relate to the c ompa ny's debt and equity trans ac tions . T he s tate ment of c as h flows provide s information that c an be us ed to as s es s a c ompa ny's liquidity, s olvenc y and financ ial flexibility.
D . S tatement of (C hang es in) S toc k holders ' E q uity
T his s tatement reports the beginning-of-period and end-of-period balanc e s hee t amounts and c hanges in equity c apital ac c ounts from trans ac tions with the owners and as a res ult of c omprehe ns ive inc ome. T he individua l c omponents of the s tatement inc lude:
4 3. A dditional paid-in c apital
4. R etained earnings (or de ficit)
5. E mployee s toc k owners hip plan (E S O P ) adjus tments
6. A c c umulated other c omprehens ive inc ome ("direc t-to-equity" adjus tments ) 7. T reas ury s hares (reduc tion)
In prac tic e, many firms report the c omponents of the s tatement of s toc kholde rs ' equity on the fac e of the balanc e s heet, inc ome s tatement (c hang e in reta ined earnings only), and in the notes to the financ ial s tatements .
III. F INA NC IA L S T A T E ME NT F O O T NO T E S A ND O T HE R S O UR C E S O F
INF O R MA T IO NF O R MA T IO N
F inanc ial s tate ments inc lude s upplementary information in addition to the financ ial data. T his information is found in footnotes , s upplementary s c hedules , Manag ement's D is c us s ion and A na lys is (MD &A ) dis c los ures , and proxy s tatements .
A . F ootnotes
T he footnotes (note s ) to the financ ial s tate ments are an integral part of the s tatements thems elves and are required for a c omplete pres entation in c onformity with Internationa l F inanc ial R eporting S tandards (IF R S ) and U.S . g enerally ac c epted ac c ounting princ iples (U.S . G A A P ), T he footnotes provide detailed dis c los ures , mos t of whic h are s pec ifically manda ted by IF R S , U.S . G A A P , or other regulatory authorities s uc h as the U.S . S ec urities and E xc ha nge C ommis s ion (S E C ). E xamples of the types of information dis c los ed in the footnotes inc lude:
• A s ummary of the s ignificant ac c ounting polic ies inc luding the ac c ounting methods , as s umptions , a nd e s timates us ed by mana gement to prepare the financ ial s ta tements
• D is c los ures for mos t as s et c ateg ories inc luding marketable s ec urities , rec eivables , inventories , fixed as s ets , intangibles , and long -term inves tments
• D is c los ures for debt ins truments , leas es , and off-balanc e s he et financ ing • Inc ome taxes
• Hedg ing and other ris k mana gement ac tivities • B us ines s s egment da ta
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F ootnote dis c los ures are pa rtic ularly important when the analys t is c ompa ring the financ ial s tate ments of different c ompanies . B oth IF R S and U.S . G A A P allow the us e of alternate ac c ounting methods to reflec t the ec onomic differenc es between c ompa nies . F or example, IF R S and U.S . G A A P allow c ompa nies to c hoos e between s everal inventory c os ting methods whe n ac c ounting for inventory. If two c ompa nies us e different inventory methods , it is diffic ult to c ompare the c ompa nies ' financ ial performanc e without making adjus tments for the differenc es . T he financ ial s tate ment footnotes provide the information nec es s ary to make s uc h adjus tments . A dditionally, footnote dis c los ures make it pos s ible to identify and adjus t for differenc es between IF R S and U.S . G A A P whe n c ompa ring U.S . c ompanies to their inte rnationa l c ounterparts .
B . S upplementary S c hedules
S upplementary s c hedules , s ome of whic h are required by the S E C or other regulatory agenc ies , provide an additiona l s ourc e of us eful information. T hes e s c hedules may inc lude s uc h information as the five-year performanc e rec ord of a c ompa ny, a breakdown of unit s ales by produc t line, quarterly s ales and inc ome, a lis ting of oil and gas res erves , and s o forth. T hes e s c hedules are typic ally unaudited.
C . Manag ement D is c us s io n and A naly s is (MD &A )
P ublic ly traded c ompa nies are ofte n required to provide, as part of their annual reports to s hareholders , a dis c us s ion and analys is of the ir operations and pros pe c ts tha t is "both us eful and unde rs ta ndable." T he s pec ific topic s to be addres s ed in the MD &A inc lude:
• A review of the c ompany's c ons olidated operating performanc e and its financ ial c ondition.
• A n as s es s ment of the s ignific ant effec ts of known trends , events , and unc ertainties on the c ompa ny's liquidity, c apital res ourc es , and operating res ults .
• T he c apital res ources available to the firm and its liquidity.
• E xtraordina ry or unus ual events (inc luding dis c ontinue d operations ) that have a material effec t on the c ompa ny.
6 D . P rox y S tatements
P roxy s ta tements are is s ue d by public ly held c ompanies in c onne c tion with s hareholder meetings and c ontain us eful information about board membe rs and mana gement, exec utive c ompens ation, s toc k options , and major s hareholders .
E . Interim R eports
P ublic c ompanies are generally required to provide inte rim financ ial information, either quarterly or s emiannually. Interim financ ial reports , whic h inc lude the key financ ial s tatements and footnotes , are not audited. T hey provide upda tes to a c ompa ny's audited annual financ ial information s o that inves tors , ana lys ts , and othe r interes ted parties c an as s es s a c ompany's inc remental financ ial performanc e.
F . O ther S ourc e s of Information
W hen performing fina nc ial s tate ment analys is , othe r s ourc es of information inc lude c orporate pres s releas es , information on c orporate webs ites , and exte rnal indus try, pe er, and gene ral ec onomic information.
G . R ole of the A uditor and the A uditor's R eports 1. F inanc ia l S tateme nt A udit
Manag ement is primarily res pons ible for the prepa ration of the financ ial s tatements of an ente rpris e. T his res pons ibility inc ludes c hoos ing whic h of the alternatively ac c eptable ac c ounting princ iples are us ed in c ons truc ting the m. T o as s ure the us ers of fina nc ial s tatements that the information c ontained in the financ ial s tatements is ac c urate and reliable, regulatory agenc ies require tha t publicly he ld firms inc lude audited financ ial s tatements in the ir annual reports to s ha reholders and in c ertain other filings . A udits c an als o be required by law or by contrac tua l agreement. A udits mus t be done in ac c ordanc e with applicable auditing s tandards . In the United S tates , auditing s tandards for public c ompanies are is s ued by the P ublic C ompany A c c ounting O vers ight B oa rd (P C A OB ) . Inte rnationa l auditing s tandards , whic h ha ve bee n adopted in many c ountries , have bee n is s ued by the Internationa l A uditing and A s s uranc e S tandards B oa rd of the International F ederation of A c c ountants . O ther c ountries have the ir own auditing s tandards .
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s ubc ommittee of the board of direc tors . T he auditor examines mana gement's financ ial s tate ments and renders an opinion as to whether the y are in c onformity with applicable ac c ounting s tandards (U.S . G A A P , IF R S , or equivalent) .
B oth U.S . and international auditing s tandards require a three paragraph s tandard ( unqua lified) inde pendent auditor's report, inc luding the following : • Introduc tory P arag raph - S tates the financ ial s tatements audited,
mana gement's res pons ibility for (preparing) the financ ial s tate ments , and the auditor's res pons ibility for expres s ing an opinion thereon.
• S c ope P arag raph - S tates the auditing s tandards us ed in c onduc ting the audit, the nature of the audit proc es s , and that the auditor has a reas onable ba s is for the audit opinion given.
• Opinion P arag raph - S tates the auditor's opinion that the financ ial s tatements give a "true and fair view" (international) or are "fairly pres ented" (U.S . and international) in ac c ordanc e with applicable ac c ounting s tandards .
A n unqualified or "c lean" audit opinion provides reas ona ble, but not abs olute , as s uranc e that the audited financ ial s tatements are free of mate rial mis s ta tement res ulting from errors , fraud, or illeg al ac ts tha t have a direc t and material effec t on the fina nc ial s tatements . O the r audit opinions are a ls o pos s ible:
• Qualified ( E x c ept F or) O pinion - Is s ued when there is a material ins tanc e of nonc omplianc e with applic able ac c ounting s ta ndards or there is a limitation on the auditor's ability to c omplete the audit as required by auditing s tandards . A qualified opinion will inc lude an explanatory paragraph des c ribing the problem that prevents the auditor from is s uing an unqualified opinion.
• A dv ers e O pinion - Is s ued when there are ins tanc es of nonc omplianc e with applicable ac c ounting s tandards that are s o material that the financ ial s tatement are not fairly pres ented.
8 2. R eporting on Internal C ontro ls
In the United S tates , the S arbane s -O xley A c t of 2002 inc reas ed mana gement's res pons ibility for mainta ining effec tive inte rnal c ontrols and expa nde d the auditor's required reporting on inte rnal c ontrols . S a rbanes -O xley requires c ompa nies to:
• A c c ept res pons ibility for the effe c tivenes s of inte rnal c ontrols .
• E valuate the effec tivene s s of internal c ontrols by g athering s uffic ient, c ompetent evidenc e.
• P repa re a report on internal c ontrols tha t:
o S ta tes mana g ement's res pons ibility for es tablis hing and mainta ining internal c ontrols .
o O utline s mana g ement's framework for evaluating the effec tivene s s of inte rnal c ontrols .
o S ta tes mana g ement's as s es s ment of the effec tivene s s of the c ompany's internal c ontrol over fina nc ial reporting as of the end of the mos t rec ent yea r.
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F inanc ial R eporting Mec hanic s
I. A C C O UNT S A ND F INA NC IA L S T A T E ME NT S
F INA NC IA L S T A T E ME NT E L E ME NT S A ND T HE A C C O UNT ING E Q UA T IO N
F inanc ial s tate ments c an be broken down into five bas ic elements : as s ets , liabilities , e quity, revenues , and expens es . T he ac counting equation de s c ribes the relations hip be tween thes e elements . A dditiona lly, thes e elements c an be further broken down into c ompa ny-s pec ific s ubc ategories c alled ac c ounts . A lthough c ompa nies us e different ac c ounts , it is important for the analys t to have a gene ral unders tanding of the ac c ounts that are mos t c ommonly us ed. T he next s tudy s es s ion outlines the mos t c ommon ac c ounts (line items ) s een in the financ ial s tatements .
A . A c c ounting E quation
T he bas ic ba lanc e s he et equation reflec ts the fac t that the as s ets of a firm are financ ed by eithe r the liabilities or equity c apital of the firm. T he bas ic equation is :
A s s e ts = L iab ilities + E quity C apital
B y s ta ting the equa tion as follows , the definition of equity c apital as the owne rs ' res idual c laim on the net as s ets afte r all c reditors ' c laims ha ve bee n s atis fied, is c learly demons trated:
A s s ets – L iabilities = E quity C apital (Net A s s ets )
E quity c apital c an be c las s ified by origin: c apital c ontributions from owners and earnings retained in the bus ines s . E quity c apital can therefore be written as :
E quity C apital (Net A s s e ts ) = C ontributed C ap ital + R etained E a rning s *
* A s dis c us s ed in the next s tudy s es s ion, a firm's internally-g enerated c apital inc ludes retained earning s , whic h reflec ts the ac c umulated undis tributed profits that have flowed throug h the inc ome s tatement, and ac c umulated other c omprehens ive inc ome, whic h inc ludes other "direc t-to-equity" adjus tments .
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• D etermine how the trans ac tion affec ts the ac c ounting equa tion by identifying the financ ial s ta tement elements related to eac h ac c ount. • E nter the trans ac tion into the ac c ounting s ys tem.
• V erify tha t the a c c ounting equation is in ba lanc e.
F inanc ial s tate ments c an then be develope d at any time bas ed on the information ente red into the ac c ounting s ys tem.
1. Illus tration - R ec ording a B us ines s T rans a c tion
T o illus trate thes e s teps , as s ume tha t a s mall pe s t c ontrol bus ines s , B ug B us ters , is es ta blis hed on D ec ember 31, 20X 7 by two individuals who c apitaliz e the c ompa ny by c ontributing $25,000 eac h. T his trans ac tion res ults in an inc reas e in c as h (as s et) of $50,000 and an inc rea s e in c ontributed c apital (equity) of $50,000.
T he c ompa ny will us e the following ac c ounts to rec ord its bus ines s trans ac tions :
• A s s ets - C as h, R ent D epos it, Inventory, A c c ounts R ec eivable, E quipment and A c c umulated D eprec iation (a c ontra-as s et ac c ount) • L iabilities - Unea rned S ervic e R evenue, A c c ounts P ayable, A c c rued
P ayroll, Interes t P ayable, Notes P ayable • E quity - C ontributed C apital, R eta ined E arnings • R ev enue - S ervice R evenue
• E x pens e - C os t of S ervic es P rovided, R ent E xpens e, A dvertis ing E xpe ns e, P ayroll E xpens e, Interes t E xpens e, D eprec iation E xpens e
D uring J anuary 20X 8, B ug B us te rs ha s the following bus ines s trans ac tions . F or eac h trans ac tion, the ac c ounts inc reas ed or dec rea s ed are identified (s tep 1). T he financ ial s tatement element (as s et, liability, equity, revenue, expe ns e) that c orres ponds to eac h ac c ount is als o identified ( s tep 2). a. J anuary 2 - P aid $2,000 for offic e s pa c e. T he $2,000 inc ludes a $500
refundable de pos it a nd $1,500 for J anuary rent. T his trans ac tion res ults in a dec reas e in c as h (as s et) of $2,000, an inc reas e in rent expens e (expens e) of $1, 500 and an inc reas e in rent depos it (as s et) of $500.
b. J anuary 3 - B orrowed $15,000 from a loc al bank. P rinc ipal and interes t at 8% are due on J anuary 1, 20X 9. T his trans ac tion res ults in an inc reas e in c as h (as s et) of $15,000 and an inc rea s e in notes pa yable (liability) of $15,000.
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truc k ha ve es timated lives of 5 years and no s alvage value. T his trans ac tion res ults in a dec reas e in c as h (as s et) of $36,000 and an inc reas e in e quipment (as s et) of $36,000.
d. J anuary 8 - P aid $1,000 to advertis e the bus ine s s in s everal loc al news pape rs during J anuary. T his trans ac tion res ults in a de c reas e in c as h (as s et) of $1, 000 and an inc reas e in advertis ing expens e (expens e) of $1, 000.
e. J anuary 10 - P urc has e pes t c ontrol c hemic als for $12,000 on a c c ount. T he c hemic als will be us ed evenly over 20X 8. T his trans ac tion res ults in an inc reas e in inventory (as s et) of $12,000 and an inc reas e in ac c ounts payable (liability) of $12,000.
f. J anuary 15 - R ec eived $30, 000 c as h from fifty ne w res ide ntial c us tomers as pa yment for 12 months of pes t c ontrol s ervic e. T his trans ac tion res ults in an inc reas e in c as h (as s et) of $30,000 and an inc rea s e in une arned s ervice revenue (liability) of $30,000. T his trans ac tion res ults in unearned revenue rather than ac tua l revenue bec aus e the c ompa ny has not yet earned the revenue by performing pe s t c ontrol s ervic es .
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B . F inanc ial S tatement A c c ruals and A djus tments
B oth IF R S and U.S . G A A P require public c ompa nies to us e ac c rual ac c ounting , whic h requires that revenues be rec orded when earned and that expe ns es be rec orded when inc urred. A c ompa ny mus t review its operations at the end of ea c h reporting pe riod to dete rmine if any ac c ruals or adjus tments nee d to be made to the financ ial s tate ments . T he acc ruals and adjus tments mus t be rec orded s o tha t revenues and expe ns es are reported in the prope r ac c ounting period. A c c rual ac c ounting c an be illus trate d us ing the B ug B us ters example a bove.
1. Illus tration- R ec ording A c c ruals and A djus tments
O n J anua ry 31, 20X 8, B ug B us ter will rec ord the following ac c ruals and adjus tments to prope rly reflec t its J anuary revenues and expens es :
J anuary 31 - O n J anuary 25
th
, B ug B us ters hired a part-time bookkeeper through an agenc y. T he agenc y will pa y the employee and ha ndle all payroll taxes . T he c ompany mus t pa y the agenc y $20 per hour. T he employee works 20 hours in J anuary, but will not be paid until F ebruary. O n J anuary 31s t, the c ompany mus t rec ord the wag es of $400 owed for J anuary by inc reas ing ac c rued payroll (liability) by $400 and inc reas ing payroll expens e (expe ns e) by $400.
J anuary 31 - P rovided pes t c ontrol s ervic es to the fifty res idential c us tomers from J anuary 20 - 31. A t the time the s e s ervices were provide d, B ug B us ters earned pes t c ontrol s ervic e revenue equal to 1/12 of the $30,000 payment made by the res idential c us tomers on J anuary15th. T his will res ult in an inc reas e in s ervice revenue (revenue ) of $2,500 and a dec reas e in unearne d s ervic e revenue (liability) of $2, 500.
J anuary 31 - W hen B ug B us ters provide d pes t c ontrol s ervices to its loc al bus ines s c us tomer and its ten res idential c us tomers , the c ompa ny us ed 1/12 of the pes t c ontrol c hemic als (1/12 x $12, 000 = $1,000) purc ha s ed on J anuary 10th. T he us age of the c hemic als is rec orded by inc reas ing c os t of s ervic es provided (expe ns e) by $1,000 and dec reas ing inventory (as s et) by $1,000.
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a c os t of doing bus ines s in tha t month by inc reas ing interes t expens e (expens e) by $100 and inc reas ing inte res t payable (liability) by $100. J anuary 31 - O ne month (1/60) of the total $36,000 c os t of the equipment
is alloc ate d to J anua ry's c os t of doing bus ines s by inc rea s ing deprec iation expe ns e (expe ns e) by $600 and inc reas ing ac c umulate d deprec iation (contra- as s et) by $600. A c ontra-as s et ac c ount is an ac c ount that offs ets the value of an as s et. A c c umulated deprec iation offs ets the equipment ac c ount to s how the net book value of the equipment afte r de prec iation.
17 C . F inanc ial S tatements
T he s preads heet above c an be us ed to prepare B ug B us ters ' inc ome s tatement, balanc e s he et, s tate ment of c hanges in owners ' equity, and s tatement of c as h flows for J anuary 20X 8. T he inc ome s ta tement c an be prepa red from the revenue and expe ns e c olumns . Net inc ome from the inc ome s tatement bec omes pa rt of B ug B us ters ' ending reta ined earnings , whic h is equal to be ginning retained earnings plus net inc ome minus dividends . T he balanc e s hee t c an be prepared from the as s et, liability, and equity c olumns . T he s tatement of c hanges in owners ' equity is prepa red from the equity c olumns and the data from the c as h c olumn form the bas is for the s tatement of c as h flows .
B ug B us ters
I N CO M E STA T EM E N T
F or the Month E nded J anuary 31, 20X 8
S ervice revenue $5, 000
C os t of s ervic es provided 1,000
O pe rating expens es 3,500
Interes t e xpe ns e 100
T ota l expens es 4,600
18 T ota l liabilities & equity $50,000 $105,400
19
Introduc tion:
T he inc ome s tatement pres ents information on the financ ial res ults of a
c ompany's bus ines s ac tivities over a period of time. T he s tatement
c ommunic ates how muc h revenue the c ompany generated during a period and what c os ts it inc urred in c onnec tion with g enerating that revenue. T he bas ic equation underlying the inc ome s tatement, ig noring gains and los s es , is R evenue minus E xpens e equal Net Inc ome. T he inc ome s tatement is als o s ometimes referred to as the "s tatement of operations ", "s tatement of earning s ", or "profit and los s (P &L ) s tatement". Under International F inanc ial R eporting S tandards ( IF R S ) , the inc ome s tatement may be pres ented as a s eparate s tatement followed by a s tatement of c omprehens ive inc ome that beg ins with the profit or los s from the inc ome s tatement or as a s ec tion of a s ingle s tatement of c omprehens ive inc ome. Under U.S . g enerally ac c epted ac c ounting princ iples (U.S . G A A P ) , the inc ome s tatement may be pres ented as a s eparate s tatement or as a s ec tion of a s ing le s tatement, but als o dis c us s es c omprehens ive inc ome ( profit or los s from the inc ome s tatement plus other c omprehens ive inc ome).
I. C OMP O NE NT S A ND F O R MA T O F T HE INC O ME S T A T E ME NT
20
W i d g e t C o m p a n y a n d S u b s i d i a r i e s
C O N S O L I D A T E D I N C O M E S T A T E M E N T
F o r t h e Y e a r s E n d e d D e c e m b e r 3 1
20X 7 20X 6 20X 5
Net s ales $750.3 $686.1 $704.2
C os t of g oods s old 225.1 207.9 215.9
G ros s profit 525.2 478.2 488.3
S elling , g eneral, and adminis trative (S G &A ) expens es 90.0 83.7 84.1
O ther operating expens es 15.2 30.6 19.4
O perating inc ome 420.0 363.9 384.8
Interes t expens e 184.6 195.1 187.5
O ther ( inc ome) expens e (21.4) 19.7 ( 16.3)
Inc ome from c ontinuing operations b efore tax &
minority interes t 256.8 149.1 213.6
P rovis ion for inc ome taxes 102.7 59.6 85,4
Inc ome from c ontinuing operations before minority
interes ts 154.1 89.5 128.2
Minority interes t in inc ome from c ontinuing operations 14.3 9.6 13.5
Inc ome from c ontinuing operations 139.8 79.9 114.7
Inc ome ( los s ) from dis c ontinued operations ( net of tax) ( 23.2) (7.2) --
Net inc ome $116.6 $ 72.7 $114.7
T he above pres entation c ompares c urrent year res ults (in the firs t c olumn) to the res ults for two prior years , as is typic ally done for U.S . c ompanies . A lternatively, the inc ome s tatement c an pres ent the mos t rec ent year in the las t c olumn. W hile the pres entation above reports res ults for the years ended D ec ember 31, 20X 7, 20X 6 and 20X 5, s ome c ompa nies report on a "fis c al yea r" rathe r than on a c alendar year. F or example, retail firms typic ally us e fis c al years ending nea r the end of J anua ry.
T he "top line" for an inc ome s tatement is net s ales or net revenues , whic h ha ve virtua lly the s ame meaning. T he multi-s te p format then s ubtrac ts the c os t of goods s old from ne t s ales to derive g ros s profit.
21
the analys t may need to referenc e the s tatement of c as h flows a nd/or footnotes to determine the deprec iation and amortiz ation expens e for the period.
O the r nonope rating inc ome and expens e items follow ope rating inc ome on the inc ome s tatement. T his s ec tion inc lude s interes t expens e and interes t inc ome, whic h may be reported in total as ne t inte res t expens e. T he multi-s te p format als o reports revenue and expe ns e items that are inc luded in c ontinuing ope rations before taxes and any s ubs equent ("below the line ") items , inc luding the res ults of dis c ontinued operations , net of taxes . T his pres entation is c overed in more de tail under ana lys is of nonoperating and nonrec urring items be low. T he fina nc ial res ults reported for W idget C ompany als o inc lude a minority inte res t (nonc ontrolling interes t) in inc ome from c ontinuing operations . T his repres ents the portion of inc ome (los s ) tha t belongs to the minority (nonc ontrolling) s hareholders of les s than wholly owne d (i.e., les s tha n 100 percent owned) c ons olidate d s ubs idiaries , rather tha n to the parent c ompany.
II. INC OME ME A S UR E ME NT IS S UE S
A s dis c us s ed in the previous s tudy s es s ion, inc ome s tatements prepa red under both IF R S and U.S . G A A P are ba s ed on the ac c rual c onc ept, whic h rec ogniz es revenues and expe ns es when an ec onomic exc hange takes plac e, rathe r tha n at the time c as h is exc hanged. B ec aus e ac c rua l ba s is ac c ounting matc hes expe ns es with as s oc iated revenues rather than the c as h rec eived from the trans ac tion, ac c ounting profit (earnings or net income) will not equa l c as h flow. In addition, ac c rual- bas is ac c ounting requires management to make many s ubjec tive judg ments regarding revenue and expe ns e alloc ation among ac c ounting pe riods .
A . R ev enue R ec o g nition
1. G enera l P rinc iples of R ev enue R ec o g nition
In the IF R S F ramework, inc ome, whic h inc lude s both revenues from ope rating ac tivities and gains from s ec ondary (nonoperating ) ac tivities , is defined as :
22
Unde r IF R S , revenue is rec og niz ed for a s ale of goods when all of the following revenue rec ognition c riteria are met:
1. T he entity ha s trans ferred to the buyer the s ignific ant ris ks and rewards of owners hip of the goods ,
2. T he entity does not mainta in managerial involvement to the deg ree as s oc iated with owners hip or effec tive c ontrol of the goods s old,
3. R evenue a nd related c os ts c an be reliably meas ured, and
4. It is proba ble that the ec onomic benefits as s oc iated with the trans ac tion will flow to the entity.
Unde r IF R S , revenue from s ervices are rec og niz ed over the term of the s ervic e c ontrac t, rather than at the end of the s ervic e c ontrac t, us ing the perc entage of c ompletion method whe n the following c riteria are met: 1. R evenue a nd related c os ts c an be reliably meas ured,
2. It is proba ble that the ec onomic benefits as s oc iated with the trans ac tion will flow to the entity, and
3. T he s tage of c ompletion of the trans ac tion at the balanc e s hee t date c an be reliably meas ured.
2. Is s ues in R ev enue R ec og nition
a. R ev enue R ec o g nition for L ong -term C ontrac ts
B oth IF R S and U.S . G A A P provide two methods of rec og niz ing profit on long - term c ontrac ts s uc h as c ons truc tion c ontrac ts . However, if a los s is expe c ted, the entire es timated los s is rec og nized in the ac c ounting period in whic h the los s bec omes appa rent under both IF R S and U.S . G A A P . A djus tments to inc ome to reflec t revis ed los s es are made pros pe c tively, and ne ver retroac tively.
1. P erc e ntag es -C ompletion Method
W hen reliable es timates of a projec t's total revenues and c os ts (i.e., ability to c alc ulate gros s profit) and deg ree of c ompletion are available, perc entage-of-c ompletion is the preferred method under both IF R S a nd U.S . G A A P .
23
T he formula to rec ogniz e revenues eac h year under the perc enta ge-of- c ompletion method is : gros s profit" and "prior pe riod(s ) gros s profit."
24
inc urred. A s a res ult, no profit is reported until the c ontrac t is c ompleted.
E x a mple
In 20X 1, a c ompany unde rtakes a 3-year projec t at a c ontrac ted pric e of $750,000 and an es timated c os t of $600,000. If the c os ts inc urred eac h year are $120,000, $300, 000, and $180,000, res pec tively, the tota l revenue ($000) rec ogniz ed in 20X 1 and 20X 2 under the c os t rec overy method is equal to the c os ts inc urred eac h period. T he revenue rec og niz ed in 20X 3 is equa l to the c os ts inc urred in 20X 3 plus the $150, 000 profit on the projec t:
20X 1: $120 20X 2: $300
20X 3: $180 + $150 = $330
T ota l revenue rec og niz ed ($000) = $120 + $300 + $330 = $750 3. C omple ted C ontrac t Method ( U.S . G A A P )
W hen reliable es timates of a projec t's total revenues and c os ts (i.e., ability to c alc ulate gros s profit) or de gree of c ompletion are una vailable, U.S . G A A P requires that c ompanies rec ord no revenues , c os ts , or profit until the entire projec t is c ompleted. A ll c os ts ac c umulate as inventory {c ons truc tion-in-prog res s ) and all amounts billed to c us tomers ac c umulate as a liability (advanc e billing s ) on the balanc e s heet. F or financ ial reporting purpos es , c ons truc tion-in-prog res s and advanc e billing s appe ar as a net c urrent as s et or liability.
E x a mple
In 20X 1, a c ompany unde rtakes a 3-year projec t at a c ontrac ted pric e of $750,000 and an es timated c os t of $600,000. Unde r the c ompleted c ontrac t method, no revenue is rec og niz ed in 20X 1 and 20X 2 a nd the e ntire $750,000 in revenue is rec ogniz ed in 20X 3.
25
expe ns e matc hing during the life of a long- term projec t. In any event, c ompanies are required to dis c los e the methods us ed (us ually in the s ummary of s ignific ant polic ies footnote) and analys ts s hould c ons ider the impac ts when c ompa ring financ ial res ults and ratios of s ubjec t c ompanies .
b. Ins tallme nt S ales
R evenue and the c orres ponding profit are generally rec og niz ed when goods are de livered or s ervices are rendered irres pec tive of the c as h payments rec eived (ac c rua l method) . W hen payments are made in ins tallments , there are a limited numbe r of c ircums tanc es whe n the rec ognition of revenue a nd profit a re de ferred.
O ne primary exc eption involves real es tate trans ac tions where the payments to the s eller are made in ins ta llments over an extended period and the re is unc ertainty regarding future c ollec tion of payments from the buyer. Unde r a s c enario where the s eller dee ms there is not s uffic ient c ommitment of the buyer to honor future payments , IF R S requires that revenue only be rec og niz ed up to the amount of c as h rec eived. U.S . G A A P would als o c ons ider this real es tate trans ac tion s c ena rio outs ide of normal revenue rec og nition, allowing the full revenue to be reported in the yea r of s ale, but deferring s ome portion of the trans ac tion's profit.
Unde r the limited c ircums tanc es primarily involving real es tate trans ac tions , U.S . G A A P allows two othe r revenue rec og nition methods , the ins ta llment method and the c os t rec overy method. W he n the ins ta llment method is us ed, the amount of total profit rec og niz ed from the real es tate s ale eac h period is de termined by multiplying the amount of c as h rec eived by the tota l profit margin c alc ulated for the entire trans ac tion.
T he c os t rec overy method is the mos t c ons ervative approac h, as no profit is rec og niz ed from a real es tate trans ac tion in a given pe riod until all c os ts of the property (inc luding both princ ipal and interes t from s eller financ ing) are firs t rec overed by the s eller.
26
E x a mple
Q ua lity R eal E s tate (Q R E ) s old an apartment c omplex for $25,000,000 to a loc al inves tor. T he apartment c omplex has a c os t (book value) of $17,000,000, res ulting in a total profit of $8,000,000 to be rec og niz ed by Q R E . T erms of the trans ac tion inc lude a $5,000,000 c as h down payment with the remaining s ales pric e to be rec eived over a 12-yea r period. G iven the buyer's limited expos ure to real es tate inves tments and the financ ial information provided, the s eller believes there is s ignific ant doubt about the buyer's ability to make all remaining payments .
C alc ulate the profit that s hould be rec ogniz ed on the down pa yment if: A ) the ins ta llment method is us ed; and B ) the c os t rec overy method is us ed.
A ns wer
a) Us ing the ins tallment method firs t c alc ulate the ratio of profit to s ales value .
$8, 000,000/$25, 000,000 = 32%
T hen rec og niz e profit by multiplying the profit ratio to the c as h down payment.
32% x $5,000,000 = $1,600,000
b) Unde r the c os t rec overy method be c aus e the $5, 000, 000 down payment does not exc ee d the property c os t of $17,000,000, no profit is rec ogniz ed during the initial period.
27 B . E x p ens e R ec og nition
In the IF R S F ramework, the term "expe ns es ", whic h inc ludes both expe ns es and los s es , is defined as :
D ec reas es in ec onomic benefits during the ac c ounting pe riod in the form of outflows or depletions of as s ets or inc urrenc e's of liabilities that res ult in dec reas es in equity, other than thos e related to dis tributions to equity partic ipants .
1. T he Matc hing P rinc iple
A firm gene rally rec og niz es expe ns es in the reporting pe riod 1) it rec eives the ec onomic bene fit of a c os t item, or 2) the c os t item los es s ome of its ec onomic be nefit previous ly rec og niz ed in a prior reporting pe riod.
T he matc hing princ iple s tates tha t prope rly matc hing the res ults of operations with the efforts required to produc e the res ults will be s t reflec t the firm's financ ial performanc e. F or example, the inc ome s tatement s hould matc h revenue from the inventory s old with the inventory expe ns e (c os t of goods s old) that produc ed the revenue. P eriod c os ts , s uc h as thos e as s oc iated with marketing , adminis trative, and res earc h ac tivities , gene rally appear as an expe ns e in the period inc urred bec aus e the y apply les s direc tly to a s pec ific s ales ac tivity.
2. E x pens e R ec og nition A pplic ation
IF R S and U.S . G A A P allow s ome judg ment in c ertain type s of expe ns e rec ognition:
28
Manag ement us es prior experienc e to e s timate the pe rc enta ge of c redit s ales that will ultimately be unc ollec tible. Mana gement exerc is e s ignific ant dis c retion in es timating ba d de bts expens e and c an, by adjus ting the s e es timates , s mooth reported e arnings .
Manag ement us es prior experienc e to es timate what perc entage of s ales will res ult in warranty expens es and onc e again has s ignific ant dis c retion in de termining the es timated warranty res erve. T his provides another opportunity for s moothing reported earning s .
Manag ement's c hoic e of fixed as s et deprec iation method and inta ngible as s et amortiz ation method and es timates of us eful lives and s alvag e value s have a s ignificant impac t on reported net earning s . F or example, mana gement would c hoos e an ac c elerated deprec iation method if they des ire a c ons ervative approac h for alloc ating de prec iation expens e to the inc ome s tatement. A c c elerated approac hes rec og niz e greate r deprec iation in the early years of an as s et's life, res ulting in lower reported earnings tha n the s traight-line method. T he deprec iation method s elec ted als o impac ts balanc e s hee t ac c ounts and financ ial ratios . O nc e the c ompany s elec ts a deprec iation or amortiz ation method, manag ement c an c hange parameters to s mooth reporting earnings . F or example, a firm that des ires to reduc e de prec iation expe ns e and improve its reported net earning s c an inc reas e the es timated us eful lives of its fixed a s s ets .
3. F inanc ia l A naly s is Imp lic ations
A n analys t s hould determine whe ther mana gement us es c ons ervative or aggres s ive expens e rec og nition. F or example, s traight-line de prec iation methods res ult in lower deprec iation expens e and higher reporting earnings in the early years of an as s et's life, and F IF O inventory c os ting improves earning s in a ris ing pric e environment. A nalys ts s hould als o examine the paramete rs us ed to es timate bad debt expe ns e and warranty expe ns e.
29
C . A naly s is of Nonoperating and Nonrec urring Items
A na lys ts find it us eful to s eg regate reported earnings into inc ome tha t the c ompa ny c an produc e into the future (rec urring inc ome) and uns us taina ble or unpredic table inc ome ( nonrec urring ) inc ome.
T he ope rating c ompone nt of the inc ome s tatement reports the revenues and expe ns es as s oc iate d with a c ompa ny's c ore bus ines s ac tivities . T his inc lude s revenue generated from its primary operations , c os t of goods s old (s ales ), s elling, general, and adminis trative expe ns e (S G &A ), and other ope rating expe ns es . T he nonope rating c omponent typic ally inc lude s interes t expens e (s ometimes netted agains t inte res t inc ome), inves tment inc ome earned from marketa ble s ec urities (for non-financ ial s ervic e c ompa nies ), and c ertain nonrec urring inc ome and expe ns e items .
B ec aus e "nonrec urring " events do tend to rec ur from time to time, analys ts ofte n exc lude the effec ts of thes e items whe n pe rforming a s hort-term ana lys is of a c ompa ny (s uc h as es timating ne xt year's earning s ), but inc lude the m as an average for long er-term analys es . In addition, a nonrec urring item might affec t a firm's future ea rnings potential. F or example, a nonrec urring los s c ould lower a firm's c redit rating and rais e future inte res t c os ts , or c ould diminis h its ability to financ e growth internally. T herefore, analys ts s hould examine the pos s ible effec ts of nonrec urring inc ome (or los s es ) on the firm's earnings potential. In the final analys is , the ana lys t dec ide s how to meas ure and us e information about nonrec urring items .
T he diagram be low s hows whe re nonrec urring items and othe r unus ual or infrequent items appear on the inc ome s tatement under U.S . G A A P :
R evenues ( Net S ales ) – O perating e xpens es – Interes t expens e
+/– O ther revenues and expe ns es +/– Unus ual or infreq uent items
= P reta x E arnings from C ontinuing Ope rations +/– Inc ome T ax E xpens e
= Inc ome from C ontinuing O perations * (T he “L ine”)
+/– Inc o me (los s ) from D is c o ntinued O perations ( net of tax ) * +/– E x traordinary Items (net of tax )*
= Net lnc ome*
30 1. Unus ual or Infreq uent Items
E vents or trans ac tions that are either unus ual in na ture or infrequent in oc c urrenc e (but not both) are reported preta x as pa rt of inc ome from c ontinuing operations . Material items s hould appear as a s eparate (pretax) line item and the nature of the item s hould be dis clos ed on the fac e of the inc ome s tatement or in the footnotes . S ome events or trans ac tions inc lude d in this c ate gory are:
• R es truc turing c os ts inc luding c os ts as s oc iated with s evering employee s and c los ing or reorganiz ing bus ines s ope rations .
• A s s et impa irment c harges inc luding the write -down or write-off of as s ets .
• G ains or los s es on the dis pos al of a portion of a bus ines s s egment. • G ains or los s es on the s ale of long -lived as s ets .
2. E x traordinary Items
Unde r U.S . G A A P , an event or trans ac tion that is mate rial in amount, unus ual in na ture and infrequent in oc c urrenc e, is c las s ified as an extraordina ry item and is reported net of tax at the bottom of the inc ome s tatement. T hes e rare events or trans ac tions inc lude los s es as s oc iate d with a foreign government's expropriation of as s ets and c ertain natural dis as ters . F irms mus t report gains or los s es from events tha t are NO T extraordina ry (both unus ual and infrequent) above the line as part of "c ontinuing operations ." F irms reporting under IF R S are prohibited from c las s ifying any inc ome s tate ment items as extraordina ry items .
A na lys ts c an generally eliminate extraordinary items from c ons ideration when projec ting a firm's future e arnings .
3. D is c ontinued O perations
Unde r both IF R S and U.S . G A A P , when firms have dis pos ed of or es ta blis hed a plan to dis pos e of a bus ines s c omponent (s eg ment) with whic h they will have no further involvement, the effec ts of the dis pos al are reported under dis c ontinue d operations . G enerally, a qua lifying bus ines s c omponent is defined as ha ving s epa rate ly ide ntifiable ope rations and as s ets .
31 4. C hang es in A c c o unting S tandards
Unde r both IF R S and U.S . G A A P , c hang es in ac c ounting princ iples from one ac c eptable method of ac c ounting to another ac c epta ble method of ac c ounting are reported retros pec tiv ely , unles s it is dee med imprac tic al. R etros pe c tive trea tment involves res tating all prior years pres ented as though the new princ ipa l ha d bee n adopte d throughout all periods . If no prior periods are pres ented or if the effec ts extend beyond the earlies t period pres ented, the c umulative effec t is s hown as an adjus tment to the beg inning balanc e of reta ined earnings for the earlies t pe riod pres ented. P res enting the c hanges in ac c ounting princ iple retros pec tively fac ilitates the c omparability of the years reported on the financ ial s tatements . A dditionally, the s upporting footnotes are required to explain how the c ompa ny made the trans ition from the old to the new s ta ndard, inc luding the rationale for any dis c retionary c hanges . P rior to 2005, the c umulative effec t of c hanges in ac c ounting princ iples was s hown at the bottom of the inc ome s tatement under both IF R S a nd U.S . G A A P .
C hang es in es timates are treate d pros pec tiv ely (no adjus tments for prior periods ) and do not appe ar as a line item on the inc ome s tatement. E xamples inc lude c hang es in es timates for us eful lives or s alvage values of fixed as s ets , or c hanges in pe rcentage es timates us ed to c alc ulate the allowanc e for doubtful ac c ounts or warranty res erves .
C orrec tions of prior period errors are als o nonrec urring items that do not appe ar as a line item on the inc ome s tatement. E rror c orrec tions require res tatement
of the financ ial s tatements (inc luding the balanc e s hee t, s tatement of s toc kholde rs ' equity, and s tatement of c as h flows ) for the prior period( s ) reported with the c urrent period financ ial s tate ments . A nalys ts s hould review the required footnote dis c los ures for ac c ounting errors , as they may provide information on wea knes s es in ac c ounting s ys tems and c ontrols .
III. A NA L Y S IS OF E A R NING S P E R S HA R E
32 weight c alc ulation, as s hown in the following example.
33
If a s toc k s plit or a s toc k dividend oc c urs , the W A C S O c alc ulation mus t res tate the beginning number of s hares and all events that oc c urred prior to the s plit or dividend. In fac t, thes e res tatements retroac tively res tate all prior yea rs reported.
B . E a rning s per S hare for a S imple C apital S truc ture
A s dis c us s ed above, c ompanies with s imple c apital s truc tures only report bas ic earnings pe r s ha re.
E x a mple
S imple C orporation had net inc ome of $250, 000 during the year ende d D ec ember 31, 20X 1. T he c ompa ny had 200,000 s hares of c ommon s toc k is s ued and outs tanding at the end of the year. T he c ompany s tarted the year with 100,000 s ha res and is s ued an additiona l 100,000 on J uly 1. D uring 20X 1, the c ompany had 20,000 s ha res of $25 par value, 5% c umulative preferred s toc k outs tanding. T he c ompany paid no preferred dividends during 20X 1. C ompute the ba s ic e arnings pe r s ha re for S imple C orporation.
A ns wer
B ec aus e the c apital s truc ture inc ludes no c onvertible s ec urities , warrants , and/or options , this c ompa ny ha s a s imple c apital s truc ture. B a s ic ea rning s per s hare is c alc ulate d as :
B as ic E P S
=
Net Income – P referred D ivide nds W A C S O
=
$250, 000 – (0.05 × $500,000) (6/12 × 100,000) + (6/12 × 200, 000)
=
$225, 000
34
E x a mple
A s s ume the s ame fac ts as the previous example, exc ept that the c ompany ins tituted a 2 for 1 s toc k s plit on S eptembe r 15.
A ns wer
T he 2 for 1 s toc k s plit is trea ted as if it oc c urred on J anuary 1. B a s ic ea rning s per s hare is c alc ulate d as :
Note that dividends due on c umulative preferred s hares are s ubtrac te d from net inc ome, regardles s of whether they are ea rned or dec lared bec aus e they repres ent a c laim on earnings be fore c ommon dividends c an be paid.
If a c ompany reports intermediate c omponents of net inc ome s uc h as dis c ontinued operations or extraordinary items , the n E P S is reported s epa rate ly for eac h c ompone nt.
E x a mple
A s s ume tha t the S imple C orporation's reported net inc ome inc lude d an extraordina ry g ain of $10,000. B as ic E P S will be :
E arning s per s hare :
Inc ome before extraordinary item $ 1.43 E xtraordina ry gain, net of tax 0.07
Net inc ome $ 1.50
C . E arning s per S hare for a C omplex C apital S truc ture
A c ompany with a c omplex c apital s truc ture (c onvertible preferred s ec urities , options , warrants , etc .) mus t report both ba s ic and dilute d earnings pe r s ha re when the c ompa ny has dilutive s ec urities . A s ec urity is dilutive if the c onvers ion or exerc is e of the s ec urity de c reas es earnings pe r s ha re. A
nti-B as ic E P S
=
Net Income – P referred D ivide nds W A C S O
=
$250, 000 – (0.05 × $500,000)
(6/12 × 100,000 x 2) + (6/12 × 200,000 x 2)
=
$225, 000
35
dilutive s ec urities that inc reas e E P S if c onverted or exerc is ed are not inc lude d in the c omputa tion of earnings pe r s ha re.
38
40
• Unrealiz ed Holding G ains or L os s es on C ertain Inv es tment S ec urities — T hes e gains or los s es res ult from reporting inves tments c las s ified as "available-for-s ale" bas ed on c urrent market value. A ny unrealiz ed gain or los s during a reporting pe riod does not affec t net inc ome, but doe s affec t s hareholders ' equity as pa rt of othe r c omprehe ns ive inc ome. T he details of ac c ounting for inves tments in marketable s ec urities are c overed late r in this S tudy S es s ion.
• Unrealiz ed G a ins or L os s e s on D eriv ativ e C ontrac ts Us ed for Hed g ing — A ny c hange in the fair value of derivative c ontrac ts us ed for hedging purpos es doe s not impa c t the inc ome s tatement. Ins te ad, the fair value c hanges on thes e derivative c ontrac ts affec t othe r c omprehe ns ive inc ome for the reporting period.
• F oreig n C urrenc y T rans lation A djus tments — T he effec ts of a parent c ompa ny trans lating the as s ets and liabilities of a foreign s ubs idiary during the c ons olidation proc es s are reported as other c omprehens ive inc ome.
• P ens ion A djus tments — A c c ounting rules allow c ompanies to exc lude c ertain pens ion adjus tments from ea rning s to s mooth the impac t of pe ns ions on earnings .
41 of $535 million and $589 million, res pec tively.
42
C ontrib uted C apital
W hat is a c orp oration?
A c orporation is defined as body of pers ons granted a c ha rter rec ogniz ing them as a s eparate legal entity having its own rights , privileg es , and liabilities dis tinct from thos e of its members . In othe r words , a c orporation is a leg al entity s eparate and dis tinc t from its owners .
C ontributed c apital is a c ritic al c omponent in fina nc ing a corporation.
F orming a c orporation
T o form a c orporation, mos t s tates require individuals , c alled inc orporators , to s ign an applic ation and file it with the proper s tate offic ial. T his applic ation contains the artic les of inc orporation. If approved by the s tate, thes e artic les bec ome, in effec t, a c ontract, c alled the company c harter, between the s tate and the inc orporators . T he c ompany is then authoriz ed to do bus ines s .
S toc k holders B oard of dire c tors Manag ement
Inves t in s hares of c apital s toc k and elec t board of direc tors
D etermine
c orporate polic y, dec lares dividends , and appoints
manag ement
E xec ute s polic y a nd c arries out day-to-da y operations
S tart-up and O rg aniz ation C os ts
S ta rt-up and organiz ation expens es
43
C apital S toc k s
A s ha re of s toc k is a unit of owners hip in a c orporation. A s toc k c ertific ate is is s ued to the owne r. It s hows the number of s hares of the c orporation’s s toc k owned by the s toc kholder. S toc kholde rs c an trans fer their owne rs hip at will.
A uthoriz ed S toc k
It’s the maximum number of s hares of s toc k the c orporations are authoriz ed to is s ue.
Is s ued and O uts tanding S toc k
* T he is s ued s toc k of a c orporation is the s hares s old or othe rwis e trans ferred to s toc kholders .
44
C omponents of S to c k holde rs ’ E q uity
S toc k holders ’ E quity C ontributed c apital
P referred s toc k, $50 par value, 1, 000 s hares
authoriz ed, is s ued, a nd outs tanding $50,000
C ommon s toc k, $5 par value , 30, 000 s hares
authoriz ed, 20,000 s hares is s ued and outs tanding$100, 000
P aid-in c apital in exc es s of par value, c ommon 50,000 150,000
T otal c ontributed c apital $200,000
R etained earnings 60, 000
T otal s toc kholders ’ equity $260,000
D iv ide nds
(1) D ate of dec laration:
F eb 21 R .E 56,000
C as h dividends payable 56,000
D ec laration of c as h dividends to c ommon s toc kholders
(2)
D ate of rec ord
Mar 1
No
entry
is
required.
T his
date
is
us ed
s imply
to
determine the owners of the s toc k who will rec eive the
dividends . A fter this date (s tarting Marc h 2) , the s hares
are ex–dividned.
(3) D ate of p a y ment
Mar 11 C as h dividends payable 56,000
C as h 56,000
45
C ommon S toc k
C ommon s toc k is c ompa ny’s res idual equity. T his mea ns tha t all othe r c reditors ’ and preferred s toc kholders ’ c laims to the c ompa ny’s as s ets rank ahe ad of thos e of the c ommon s toc kholders in c as e of liquidation. C ommon s toc k i c arries voting rights , s o it repres ents the means of c ontrolling the c orporation.
P referred S toc k
It is the s ec ond kind of s toc k a c ompa ny c an is s ue is c alled preferred s toc k. B oth c ommon s toc k and preferred s toc k are s old to rais e money. P referred s toc k ha s preferenc e over c ommon s toc k in one or more areas . Mos t preferred s toc k ha s one or more of the following c harac te ris tic s .
C harac teris tic s of preferred s toc k s
P referred as to div idends : is entitled to rec eive eac h yea r a s pec ified dividend before any dividend is paid in the c ommon s toc k. T he dividend is us ua lly s tated a s a dollar amount per s hare.
(No. of s ha res dollars amount/s hare) = dividends O r as % of par value (No. of s ha res pa r value % )= dividends
P referred
s toc k s
often
have
par
values
hig her
than
c ommon
s toc ks .
C umulativ e preferred s toc k s , if all or any amount of dividend of preferred s toc ks is omitted in a given year it is s aid to be in arrears and mus t be paid in s ubs eque nt yea r be fore any dividend c an be paid to c ommon s toc k.
N.B . D ividends in a rrea rs a re not lis ted among the liabilities of a c orporation.
2– S toc k preferred as to as s ets : mos t preferred s toc ks c arry a preferenc e as to as s ets in the event of liquidation of the c orporation.
46
4– C onvertible preferred s toc k: c orporations s ometimes offer a c onvers ion privilege whic h entitles the preferred s toc kholders to exc hang e their s ha res for c ommon s toc k in s tipulate d ratio.
E x .: R . C orporation is s ued a 9% $100 par, c onvertible preferred s toc k in J an 1
s t
at a pric e of $100 pe r s hare. E ac h s hare was c onvertible into 4 s hares of the c ompa ny’s $10 pa r value c ommon s toc k a t any time.
If the holder of 100 s hares of preferred s toc k pres ented this s hares
for c onvers ion
100 100 c onvertible preferred s toc k 10,000
400 10 c ommon s toc k 4,000
remaining A P IC 6,000
47
A c c ounting for S toc k Is s uanc e
A – P a r v alue s toc k :
E x a mple: as s ume tha t B radley C orporation is authoriz ed to is s ue 20,000 s ha res of $10 par value C . S a nd ac tua lly is s ues 10, 000 s hares at $10 per s ha re on J an 1, 19xx. T he e ntry to rec ord the s toc k is s ue at pa r value would be a s follows :
J an 1 C as h 100,000
C ommon s toc k 100,000
Is s ued 10,000 s ha res of $10 par value c ommon s toc k for $10 per s hare
E x a mple: as s ume tha t the 10,000 s ha res of B radley common s toc k s old for $12 per s hare on J an 1, 19xx. T he entry to rec ord the is s uanc e of the s toc k at the pric e in exc es s of par value would be as follows :
J an 2 C as h 120,000
C ommon S toc k 100,000
P aid–in C apital in E xc es s of par
value, C ommon 20,000
48
B – No–P ar s toc k
E x . A s s ume tha t the B radley C orporation’s c apital s toc k is no–par c ommon and tha t 10, 000 s hares are is s ue d on J an 1, 19xx at $15 per s ha re. T he $150, 000 (10,000 s ha res $15) in proc eeds would be rec orded as s hown in the following e ntry.
J an 1 C as h 150,000
C ommon s toc k 150,000
E x . A s s ume tha t B radley’s boa rd puts a $10 s tated vlaue on its no–pa r s toc k. T he entry to rec ord the is s ue of 10,000 s ha res of no–par c ommon s toc k with a $10 s tated value for $15 per s hare would a ppea r as follows :
J an 1 C as h 150,000
C ommon s toc k 100,000
P aid–in c apital in exc es s s tated value,
c ommon 50,000
C – Is s uanc e of S toc k for Non C as h A s s ets :
P riority for market value of s toc k. S uppos e that when the B radley
C orporation was formed on J an 1, 19xx, its attorney ag reed to ac c ept
100 s hares of its $10 par value c ommon s toc k for s ervic es rendered. A t
the time the s toc k was is s ued, its market value c ould not be determined.
However, for s imilar s ervic es the attorney would have billed the c ompany
$1, 500. T he entry to rec ord the non–c as h trans ac tion is as follows :
C as e 1: Market value of s toc k is not given. T ake M.V . of as s et
J an 1 S tart-up and O rg aniz ation exp. 1,500
C ommon S toc k 1,000
P ain–in C apital in E xc es s of par value,
49
Is s ued 100 s hares of $10 par value c ommon s toc k for attorney’s
s ervic es
C as e 2: Market value of s toc k is given = A s s et, ignore M.V . of as s et if given.
Now
s uppos e
that
two
years
later
that
B radley
C orporation
exc hanged 1, 000 s hares of its $10 par value c ommon s toc k for a piec e
of land. A t the time of the exc hang e, the s toc k was s elling on the market
for $16 per s hare. T he entry of rec ord the exc hang e would be as follows :
J an 1 L and 16,000 ( 1,000
$16)
C ommon S toc k 10,000
P ain–in C apital in exc es s of $10 par
value c ommon 6,000
50 D – T rea s ury S toc k
1– P urc has ing of T reas ury S toc k :
E x a mple: as s ume that on S ep 15 the C aproc k C orporation purc ha s es 1,000 s ha res of its c ommon s toc k on the market at a price of $50 per s hare. T he purcha s e would be rec orde d as follows :
S ep 15 T reas ury S toc k, C ommon 50,000
C as h 50,000
A c quired 1,000 s hares of the c ompany’s c ommon s toc k for $50 per s hare
T he treas ury s hares are rec orded at c os t. T he par value , s tate d value , or original is s ue pric e of s toc k is ignored.
T he s toc kholder’
s equity s ec tion of C aproc k’
s balanc e s heet s hows
the c os t of the treas ury s toc k as deduc tion form the total c ontributed
c apital and retained earning s .
2– S ale of T rea s ury S toc k :
A - T reas ury s hares s old at c os t, as s ume that on Nov 15 the 1, 000
treas ury s hares of the C aproc k C orporation are s old for $50 per
s hare. T his entry rec ords the trans ac tion:
Nov 15 C as h 50,000
T reas ury s toc k, c ommon 50,000
R eis s ued 1,000 s hares of treas ury s toc k for $50 per s hare
B -
T reas ury s hares s old above c os t
, s uppos e that on Nov 25 the 1,000treas ury s hares of the C aproc k C orporation are s old for $60 per s hare. T he entry for the reis s ue would be as follows :
Nov 15 C as h 60,000
