中南财经政法大学：中级财务会计（英文版）：中级财务会计(英文)课程授课教案

中南财经政法大学会计学院 School of Accouting, Zhongnan University of Economics & Law 中级会计学(英文) 课程 (Intermediate Accounting) 授课教案 (Teaching plan) 《中级财务会计》教学小组编写 Teaching Team of Intermediate Accounting 2006年2月修订 (Feb.2006) Teaching Arrangement 1 Time allocation The total class hour is 51, with 3 scores. Lectures in class are divided into 4 teaching units. The time allocation for each teaching unit is as follows: Teaching Unit Basic Content Time allocated  Part 1 Financial Reporting: Concepts, Finanicial Statements, and Related Disclosures 1 The Environment of Financial Reporting 2 Financial Reporting: Its Conceptual Framework 8   3 The Balance Sheet and the Statement of Changes in Stockholders’ Equity 4   4 The Income Statement and income recognition 6   5 The Statement of Cash Flows 5  Part 2 Financial Reporting: Asset Measurement and Income Determination 6 Cash and Receivables 4   7 Inventories 3   8 Property, Plant, and Equipment 4   9 Intangibles 3  Part 3 Financial Reporting: Valuation of Liabilities and Investments 10 Current Liabilities and Contingencies 4   11 Long-Term Liabilities and Receivables 3   12 Investments 3  Part 3 Financial Reporting: Stockholders’ Equity 13 Contributed Capital 14 Earnings Per Share and Retained Earnings 4  Total  51  2 Teaching methods This course mainly adopts lecture in class, with the help of multimedia. We also allocates some presentations after group discussion out of classroom. It is taught either in English or in the combination of both English and Chinese. Teaching Materials 1. Textbook 《中级会计学》（高等学校会计学类英文版教材），高等教育出版社，2005年1月第1版 (Intermediate Accounting, 9E, by Loren A. Nikolai John D. Bazley) 2. References A. 《中级会计学》（会计类原版教材影印系列），中国财政经济出版社，2002年11月第1版(Intermediate Accounting, 14E, by Earl Kay Stice, James D. Stice, K. Fred Skousen ) B. Statements of Financial Accounting Standards, by FASB C. International Accounting Standards / International Financial Reporting Standards D. Chinese Accounting Standards for Enterprises 3. Related intenet web sites A. FASB www.fasb.org B. IASB www.iasb.org C. the Nikolai and Bazley Intermediate Accounting web site http://Nikolai.swcollege.com ） Teaching Content Lesson 1: THE ENVIRONMENT OF FINANCIAL REPORTING Learning Objectives After careful study , students will be able to: 1. Understand accounting information. 2. Know what is included in financial reporting. 3. Explain generally accepted accounting principles (GAAP) and the sources of GAAP in U.S.A. 4. Identify the types of pronouncements issued by the FASB. 5. Understand how the Financial Accounting Standards Board (FASB) operates. 6. Describe the relationship between the Securities and Exchange Commission (SEC) and the FASB. 7. Understand ethical dilemmas of Accountants. 8. Know the difference of accounting standards development between China and U.S.A. Teaching Hours 3 hours Teaching contents This lesson will begin with some forewords about the course to let students know exactly the course nature, objectives, requirements etc. Then the five sections of this lesson will be discussed logically. 1. Accounting information: users, uses, and GAAP in U.S.A. With the discussion of capital markets, accounting information will be induced. Accounting, the "language of business," has been described as the process of identifying, measuring, recording, and communicating economic information to permit informed judgments and decisions by users of information. Accounting provides a link between the economic activities of a company and decision makers who are interested in the company. These decision makers who use accounting information can be divided into two major groups: external users (such as investors) and internal users (the company's management). Because of their different relationships to the company, the two groups have somewhat dissimilar information needs. Questions will be raised as to examples of external users and internal users and their different information needs. Then differences of financial accounting and managerial accounting will be discussed. Financial accounting is the information accumulation, processing, and communication system designed to satisfy the investment and credit decision-making information needs of external users. Financial accounting information is presented in published financial statements. Managerial accounting is the information accumulation, processing, and communication system designed to meet the decision-making information needs of internal users. The format for internal reports is determined by the company. The system is constrained by the need for information and the cost of providing that information. After students got an overall impression about accounting and accounting information, focus will be conducted to financial accounting and financial reporting. Financial reporting is the process of communicating financial accounting information about a company to external users, primarily through the company's annual report. The annual report includes three major financial statements: the balance sheet, income statement, and statement of cash flows, as well as notes to the financial statements. Many companies include the statement of changes in stockholders' equity as a fourth major financial statement. Most financial statements are audited by an independent certified public accountant, who expresses an opinion as to the fairness, in accordance with generally accepted accounting principles, of the financial statements and accompanying notes. In its audited financial statements, a company must follow generally accepted accounting principles (GAAP), the guidelines, procedures, and practices required for recording and reporting accounting information. GAAP define accepted accounting practices and standards of reporting at a particular time. They have evolved over many years, with the involvement of different policy-making bodies. Emphasis should be put to students that there is no single document including all of the standards for accounting, although the FASB Financial Accounting Research System (FARS) includes most accounting standards in its electronic data base. 2. The development of accounting standards in U.S.A. A brief history introduction about the development of accounting standards in U.S.A. will give students a full impression about accounting standards in U.S.A. From 1938 to 1959 the Committee on Accounting Procedure (CAP) of the AICPA issued 51 Accounting Research Bulletins, which are still part of GAAP unless specifically superseded or amended. Because of criticism of the processes of formulating accounting principles, the AICPA replaced the CAP with the Accounting Principles Board in 1959. From 1959 to 1973 the APB issued 31 Accounting Principles Board Opinions, many based on Accounting Research Studies. Unless amended or rescinded, APB Opinions are also still part of GAAP. Development of accounting principles by the APB was criticized. The structure of the Financial Accounting Standards Board (FASB), which replaced the APB in 1973, was designed to meet these criticisms. The FASB issues several types of pronouncements, including Statements of Financial Accounting Standards, Interpretations, Technical Bulletins, and Statements of Financial Accounting Concepts. Before issuing a statement of concepts or standards, the FASB usually completes a multistage process designed to develop accounting standards efficiently and with due process, in a public forum. Because accounting policy decisions are complex and part of a broader social system, input from interested parties is important. Negotiation and compromise are often necessary during the development of fair, acceptable standards. Here, a question can be raised to discuss that why FASB adopts political and social involvement methods in its standards-setting process. 3. Other organizations currently influencing GAAP in U.S.A. Other organizations currently influencing GAAP in U.S.A. will be discussed then, including SEC, AICPA, EITF, CASB, IRS, AAA, IASB, GASB, G4+1 and Several professional associations. Emphasis will be given to the fact that the Securities and Exchange Commission has the legal authority to prescribe accounting principles and practices for usually all companies issuing publicly traded securities. To date, the SEC has usually allowed accounting principles to be formulated in the private sector, but has occasionally exerted pressure on the CAP, APB, and FASB. In addition, the SEC administers the extensive disclosure requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934. Companies are required to file forms, such as Form 10-K, electronically with the SEC and these forms are located in the SEC's EDGAR. Enron case will be given as an example. The American Institute of Certified Public Accountants is the professional organization for all certified public accountants in the U.S. The FASB Emerging Issues Task Force (EITF) identifies significant emerging accounting issues and develops consensus positions on accounting for these issues. The Cost Accounting Standards Board (CASB), a congressional agency, is charged with setting standards of accounting for negotiated federal contracts and subcontracts. The Internal Revenue Service (IRS) administers the provisions of the Internal Revenue Code. These provisions do not always reflect the goals of financial accounting. However, they do at times influence the choice of accounting methods and procedures. The American Accounting Association (AAA) is an organization comprised primarily of academicians and practicing accountants. The AAA attempts to influence the development of formal accounting pronouncements through education and persuasion. The International Accounting Standards Board (IASB) has as its goals to develop and promote the use of global accounting standards, and to bring national accounting standards into agreement with international standards. The Governmental Accounting Standards Board (GASB) operates under the auspices of the Financial Accounting Foundation. The G4 + 1 is a group of standard-setting boards that strives to influence the development and harmonization of useful high quality accounting standards for international capital markets. The instructor can also insert some new development situations based on update materials in the website of FASB and IASB etc. 4. Ethics in the accounting environment Students will be remind of that accountants are often faced with ethical dilemmas (ethical conflicts) in their professional roles. Because of the important role of accounting in society, accountants must maintain high ethical standards. The AICPA Code of Professional Conduct (CPC) includes six basic principles: members should (a) exercise sensitive professional and moral judgments in carrying out their responsibilities; (b) serve the public interest, honor the public trust, and demonstrate commitment to professionalism; (c) perform professional responsibilities with the highest sense of integrity; (d) maintain objectivity, be free from conflicts of interest, and be independent in fact and appearance; (e)?observe due care in practice; and (f) follow CPC principles in determining the scope and nature of services to be provided. 5. Comparison of the development of accounting standards in China and in U.S.A. Students will be required to find materials about development of accounting standards in China. Then discussion based on the materials and knowledge learned in this lesson about development of accounting standards in U.S. will be induced in class. The case is intended for three purposes: first, with comparison , students will know the differences clearly and grasp new knowledge deeply. Second, student will learn how to find related materials and this ability is very crucial to future independent studies. Third, discussion in class will cultivate students’ creative and critical thinking , which is very important in accounting nowadays. Pedagogical Notes Since this course is the first time that students learn professional knowledge based on original English textbook and bilingual teaching, some students will feel hard to grasp all the knowledge, this lesson as the first lesson of the course should be taught carefully. And instructors should pay attention to the difficulties students might felt. The last section of this lesson, which is a discussion part, instructors should try to cultivate students’ creative and critical thinking. Creative thinking involves the use of imagination and insight to solve problems by finding new relationships (ideas) among items of information. Critical thinking involves the logical analysis of issues, using inductive or deductive reasoning to test new relationships (ideas) to determine their effectiveness. Lesson 2: FINANCIAL REPORTING: ITS CONCEPTUAL FRAMEWORK Learning Objectives After careful study , students will be able to: 1. Explain functions of conceptual framework. 2. Understand the relationship among the objectives of financial reporting. 3. Identify the general objective of financial reporting. 4. Describe the three specific objectives of financial reporting. 5. Discuss the types of useful information for investment and credit decision making. 6. Explain the qualities of useful accounting information. 7. Understand the accounting assumptions and conventions that influence GAAP. 8. Define the elements of financial statements. Teaching Hours 5 hours Teaching contents This lesson will begin with emphasis about functions of theory basis in accounting. 1. FASB conceptual framework A brief background introduction about FASB conceptual framework will be conducted. Students should be remind of FASB’s position in U.S.A., which is different from that of China. The FASB has been charged with developing a conceptual framework of accounting theory and with establishing standards for financial accounting practice. The conceptual framework, which is intended to provide a theoretical foundation for consistent accounting standards, has been essentially completed, with seven Statements of Financial Accounting Concepts issued. In the development process of these seven statements, FASB has divided the conceptual framework activities into several projects. 2. Objectives of financial reporting FASB Statement of Financial Accounting Concepts No. 1 deals with the objectives of financial reporting. These objectives relate to general-purpose financial reporting of companies. That is, they are to meet the needs of a variety of external, rather than internal, users. This is a point should be emphasized. Three broad objectives of financial reporting, which proceed from the more general to the more specific, are identified in the Statement: (a) The general objective is to provide information that is useful to present and potential investors, creditors, and other external users for decision-making; (b) Financial reporting should provide information that is understandable to one who has a reasonable knowledge of accounting and business and who is willing to study and analyze the information presented; (c) While there are many potential users of financial reports, the objectives are directed primarily toward investors and creditors. Additionally, three specific objectives are identified in FASB Statement of Financial Accounting Concepts No. 1: (a) To provide information about a company's economic resources and the claims to those resources, i.e., its economic resources, obligations, and owners' equity; (b)To provide information about a company's comprehensive income and its components; (c)To provide information about a company's cash flows. The FASB has identified five types of information related to the financial reporting objective to help external users assess the amounts, timing, and uncertainty of the future net cash inflows of the company. They are: (a) Investors expect a return on the capital they invest; (b) Risk is the uncertainty or unpredictability of a company's future results; (c) Financial flexibility is the ability of a company to respond to unexpected needs and opportunities by changing the amounts and timing of cash flows; (d) Liquidity relates to how quickly an asset can be converted into cash, or a liability paid; (e) A company's operating capability is its ability to maintain a given physical level of operations. 3. Qualitative characteristics of accounting information FASB Statement of Financial Accounting Concepts No. 2 specifies qualitative characteristics of accounting information that accounting information should possess in order to be most useful. Different from China, FASB has set hierarchy of qualitative characteristics. The hierarchy shows two constraints to accounting information: (a)Cost-benefit: the benefit of information must be greater than its cost. (b)Materiality: the dollar amounts involved must be large enough to make a difference to decision makers. Since no quantitative guidelines were set by the FASB, materiality must be determined by judgment. However, the FASB suggested consideration of nature and relative size to separate material and immaterial items. Understandability is a link between decision makers and the accounting information. Information should be understandable to broad classes of reasonably knowledgeable and diligent users. Decision usefulness is the overall quality which accounting information must possess. The two primary qualities making accounting information useful are relevance and reliability. Accounting information that can make a difference to decision makers is relevant. To be relevant, information must have (a)?predictive value, or usefulness to decision makers in forecasting events more accurately; and/or (b)?feedback value, or usefulness to decision makers in confirming or correcting prior expectations. In addition, relevant information must be timely. Reliable information is reasonably free from error and bias and faithfully reports what it is intended to represent. To be reliable information must (a) be verifiable; (b) have representational faithfulness; and (c) be neutral. Information is verifiable (sometimes called objective) when it can be duplicated using the same measurement method. Verifiability is useful in reducing measurer bias. In auditing, verifiability is a primary concern when the independent accountant reviews the published financial statements of a company, i.e., performs the attest function. Accounting information has representational faithfulness when there is valid correspondence to the economic resources, obligations, transactions, and events it represents. A high degree of representational faithfulness is useful in reducing measurement bias. Neutral information is complete and free from intentional bias. Comparability is a secondary characteristic of accounting information. Information is more useful if it can be compared with similar information from other companies (intercompany comparison) and with similar information from the same company over time (intracompany comparison). Comparability is closely linked to consistency, the use of unchanged accounting policies and procedures from period to period. 4. Accounting assumptions and conventions Certain assumptions and conventions have influenced the development of generally accepted accounting principles. These are similar with those of China. The entity assumption distinguishes each business organization from its owners. Following the continuity (or going-concern) assumption, it is assumed that a company will continue to operate in the near future, unless substantial evidence to the contrary exists. The period-of-time assumption enables a company to report the results of its activities after short time periods (primarily one year), rather than at the end of the company's existence. Historically, the calendar year was used as a reporting period. However, many companies in U.S. now choose fiscal years based on their annual business cycles. This point should be emphasized as a small difference from that of China. Under the monetary-unit assumption accountants have traditionally treated the dollar, or other currency, as a stable unit of measure. However, values, as measured by a monetary unit, change over time for two reasons: (a) the real value of an item can change in relation to the real values of other goods and services, or (b) the purchasing power of the measuring unit (the dollar) can change. To enhance comparability, the FASB encourages companies to make supplemental disclosures relating to the impact of changing prices. As to conventions: (a) an economic activity or resource is initially measured by the exchange price (historical cost) of a transaction; (b) Realization is the conversion of non-cash resources or rights into cash or rights to cash. Recognition is the process of formally recording and reporting an item in the financial statements; (c) The matching principle states that expenses involved in obtaining a period's revenues should be related to (matched against) the revenues recognized during the period; (d) conservatism states that when alternative accounting valuations are equally possible, the alternative selected should be the one which is least likely to overstate assets and income in the current period. 5. Elements of financial statements In the Conceptual Framework, the FASB identified four financial statements: the balance sheet, income statement, statement of cash flows, and statement of changes in equity. The elements of each statement are the broad classes of items comprising it. The balance sheet (statement of financial position) summarizes the financial position of a company on a particular date. The three elements of the balance sheet are (a) assets, or economic resources; (b) liabilities, or economic obligations; and (c) equity, the owners' residual interest in a company's assets, after liabilities have been deducted. The income statement summarizes the results of a company's operations for a period of time. The four elements of an income statement are (a)?revenues, increases in assets and/or decreases in liabilities due to the company's ongoing primary operations; (b) expenses, decreases in assets and/or increases in liabilities due to the company's ongoing primary operations; (c) gains, increases in the equity of the company not related to its primary operations or to investments by owners; (d)?losses, decreases in the equity of the company not related to its primary operations or to distributions to owners. The statement of cash flows summarizes a company's cash inflows and outflows for a period of time, and reconciles the company's beginning and ending cash balances as reported on the balance sheets. The three elements of the statement of cash flows are (a) operating cash flows, cash inflows and outflows from acquiring, selling, and delivering goods, and providing services; (b) investing cash flows, cash inflows and outflows from acquiring and selling investments, property, plant, and equipment, and intangibles, as well as from making and collecting on loans; and (c) financing cash flows, cash inflows and outflows from investments by and distributions to owners, as well as receipts from and distributions to creditors. The statement of changes in equity (for a corporation generally called the statement of changes in stockholders' equity) summarizes the changes in a company's equity for a period of time and reconciles the equity items a company reports on its beginning and ending balance sheets. Two key elements of the statement of changes in equity are (a) investments by owners and (b) distributions to owners. 6. Comparison of accounting concepts in China and in U.S.A. (Case) Students will be required to find materials about accounting concepts in China. Then discussion based on the materials and knowledge learned in this lesson will be induced in class. The case is intended for four purposes: first, the discussion will enhance understanding about the important functions of accounting concepts no matter in U.S.A. or in China. Second, with comparison, students will know the differences clearly and grasp new knowledge deeply. Third, student will learn how to find related materials. Fourth, discussion in class will cultivate students’ creative and critical thinking. Pedagogical Notes This lesson is an important lesson in the whole course as a theory basis. Instructors should try their best to let students grasp these accounting concepts deeply. The last section of this lesson, which is a discussion part, instructors should try to cultivate students’ creative and critical thinking. Lesson 3: THE BALANCE SHEET AND STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY Learning Objectives After careful study , students will be able to: 1. Understand the purposes of the balance sheet. 2. Explain how to measure the elements of a balance sheet. 3. Classify the assets of a balance sheet. 4. Classify the liabilities of a balance sheet. 5. Report the stockholders' equity of a balance sheet. 6. Understand the other disclosure issues for a balance sheet. 7. Describe the SEC integrated disclosures. 8. Explain the reporting techniques used in an annual report. 9. Analyze a company’s performance and financial position through the computation of financial ratios Teaching Hours 4 hours Teaching contents From this lesson, financial statements will be discussed. 1. Interrelationship of financial statements A question about the interrelationship of financial statements will be raised at first. Instructor should know the extent that students already have grasped based on their Chinese accounting knowledge, and then decide whether to discuss this in detail. 2. Elements of the balance sheet First, students should be remind that for an item of information to be recognized as an element (i.e. formally recorded and reported in the body of the financial statements), an item must (a) meet the definition of an element as specified in FASB Statement of Concepts No. 6, (b) be measurable, (c) be relevant, and (d) be reliable. Assets, liabilities, and stockholders' equity are the elements of a corporation's balance sheet. Assets are economic resources (a) acquired as a result of past transactions or events, (b) which will provide probable future economic benefit (service potential), (c) over which the company has control. Liabilities are (a) present economic obligations, (b) arising from past transactions or events, (c) which will be settled by probable future transfer of assets or performance of services. Stockholders' equity is the residual interest of the stockholders in the assets of the corporation after all liabilities have been settled (that is, company assets minus liabilities). Therefore, stockholders' equity is determined by defining assets and liabilities. 3. Measurement of the elements of the balance sheet Assets and liabilities must have a monetary value for balance sheet presentation. The FASB has identified five alternative valuation methods (a)?Historical cost is the exchange price of the asset at the time of the original transaction reduced by any recorded depreciation, amortization, or impairment to date. This valuation method is the most commonly used because of its high degree of reliability. Equipment used in manufacturing operations is recorded at historical cost. (b) Current cost (or current replacement cost) is the amount of cash necessary to obtain the same asset at the balance sheet date. When the market value of inventory is less than cost it is recorded at current cost. (c)?Current market value (or current exit value) is the amount of cash that could be obtained at the balance sheet date from selling the asset in an orderly liquidation. The market value of short-term investments at the balance sheet date is an example of current exit value. (d)?Net realizable value (or expected exit value) is the amount of cash that may be realized as a result of a future sale of an asset or realization of cash. Accounts receivable is an example of an asset recorded at its net realizable value. (e) Present value is the net realizable value discounted to the balance sheet date. A Leased Asset Under Capital Lease is recorded in this manner. 4. Reporting classifications on the balance sheet While classifications of items may vary from company to company, the common goal is to facilitate analysis and to improve the usefulness of the information in predicting the amounts, timing, and uncertainty of future cash flows. A representative classification scheme would include three major sections on the balance sheet, assets, liabilities and stockholders' equity. 4. 1 Asset and liability classifications Current assets are cash and other assets that are expected to be converted into cash, sold, or consumed within one year or the normal operating cycle, whichever is longer. Current assets, usually presented in order of liquidity, include cash (and cash equivalents), temporary investments in marketable securities, receivables, inventories, and prepaid items. Temporary investments in marketable securities are listed at their market (fair) value; receivables are listed at the net realizable value; inventories are listed at the lower of their cost or market value; and prepaid items are shown at historical cost, less any amount used up. Current liabilities are obligations that are expected to be liquidated within 1 year or the operating cycle (if longer) through the use of current assets or the creation of other current liabilities. Accounts and short-term notes payable, wages payable, interest payable, the current portion of long-term debt, and deferred revenues (collections for goods and services not yet provided) are examples of current liabilities. Each is listed on the balance sheet at the amount owed (historical proceeds). The difference between a company's current assets and its current liabilities is called working capital. A company's working capital is a measure of the short-run liquidity of the company. Long-term investments are investments that the company plans to hold for more than 1 year or its operating cycle, if longer. Examples are investments in equity securities (such as capital stock of another firm) and debt securities (such as bonds); land, buildings, and equipment held for future use (such as expansion); special cash funds held for future use; and non-current financial instruments such as stock options. The property, plant, and equipment section of a company's balance sheet includes all tangible assets (fixed assets) used in its operations, such as land, buildings, machinery, furniture, and natural resources. Except for land, these assets are either depreciated, amortized (for leased assets), or depleted (for natural resource assets). For depreciable assets, a contra-asset account (such as accumulated depreciation) is deducted from the original asset cost in order to display both the historical cost and the book value (present undepreciated cost). Intangible assets are noncurrent economic resources, such as patents, copyrights, trademarks, franchises, computer software costs, goodwill, and organization costs that are used in the operations but that have no physical existence. The value of this type of asset lies in the special right of the company to its use. These assets are recorded at historical cost. Intangible assets with finite useful lives (e.g., patents) are amortized over their useful lives and reported on the balance sheet at book value. Intangible assets with indefinite lives (e.g., copyrights) and goodwill are not amortized but are reviewed for impairment annually. They are reported at their historical cost or, if impaired, at their lower fair value. Most business assets will fit into one of the categories already described. Sometimes a balance sheet will have a section labeled "Other Assets" or "Deferred Charges" for assets that cannot be classified otherwise. Because of their vagueness such classifications, as well as "Other Liabilities," should rarely be used. Long-term liabilities (noncurrent liabilities) are obligations that are not expected to require the use of current assets or not expected to create current liabilities within 1 year or the operating cycle, if longer. Examples are long-term notes payable, obligations under capital lease contracts, mortgages payable, accrued pension costs, and bonds payable. A bond obligation is another example of a long-term liability. Bonds (sometimes called debentures) are often sold for more than face value (at a premium) or less than face value (at a discount). On a balance sheet, the bond obligation is reported at its book value. The book value is the face value of the obligation plus any unamortized premium or less any unamortized discount. 4. 2 Conceptual guidelines for reporting assets and liabilities Assets and liabilities may also be further classified according to (a)?their expected function in the central operations of the company (i.e., held for resale or used in production), (b) the method of valuation (i.e., net realizable value vs. historical cost), (c) their financial flexibility (i.e., used in operations vs. held for investment) or (d) the extent to which they result from usual or recurring activities vs. unusual or nonrecurring activities (i.e. core vs. noncore). These subcategories are intended to enhance the external usefulness of the financial statement information. 4. 3 Stockholders' equity classifications The stockholders' equity section of a corporation's balance sheet consists of three main categories: contributed capital, retained earnings, and accumulated other comprehensive income. Contributed capital represents amounts owners have invested in the business. Contributed capital is separated into capital stock which reports the legal capital or par value of the stock, and additional paid-in capital which reports the difference between the par value and the market value when issued. Corporations may issue two types of capital stock, common and preferred, each of which has distinguishing characteristics. Retained earnings represents the cumulative amount of undistributed past net income kept in the business for operating purposes or for purposes of expansion. Accumulated other comprehensive income includes the total amount of items [such as unrealized increases (gains) or decreases (losses) in the market (fair) value of investments in available-for-sale securities] of other comprehensive income. 5. Limitations of the balance sheet Instructor should also inspire students to think about the limitations of the balance sheet, enhancing their understanding of balance sheet. 6. Statement of changes in stockholders' equity FASB Statement of Concepts No. 6 suggests that financial statements include information about (a) investments by owners, or increases in equity from transfers to the company of assets and other valuable items by the owners, and (b)?distribution to owners, or decreases in equity from transfers by the company of assets and other valuable items to the owners. To disclose this information as well as the retained earnings changes, a statement of changes in stockholders' equity which discloses changes in all of the equity accounts is often presented as a financial statement. I Other disclosure issues Since all of the relevant financial information pertaining to a company's activities cannot be disclosed directly in the body of the financial statements, additional disclosures are made in the notes to the company's financial statements. Significant disclosure issues include: Summary of accounting policies. APB opinion No. 22 requires that a company include a description of all significant accounting policies as an integral part of its financial statements. Fair value and risk of financial instruments. FASB Statement No. 107 requires a company to disclose the fair value of all its financial instruments (both assets and liabilities), whether recognized or not on the balance sheet. The Statement also requires a company to disclose all significant concentrations of credit risk due to its financial instruments. FASB Statement No. 133 requires a company to recognize all derivative financial instruments (e.g., stock options) as either assets or liabilities on the balance sheet, and to measure these items at fair value. The Statement also requires a company to disclose other information (e.g., the types of derivative instruments held, objectives in holding the instruments, and strategies for achieving these objectives), as well as the company's risk management policy in regard to each type of instrument. Contingent liabilities and assets. A company discloses contingent liabilities (loss contingencies) in the notes to its financial statements if there is only a reasonable possibility that the loss may have been incurred or if the amount of the loss cannot be reasonably estimated. If it is probable that the loss has been incurred and if the amount can be reasonably estimated, an estimated loss from a loss contingency is accrued and reported directly on the company's balance sheet as a liability or a reduction of an asset. Gain contingencies are not reported in the financial statements and should be judiciously explained if disclosed in the notes. Subsequent events. Another common note to the financial statements describes important events that occur between the balance sheet date and the date of issuance of the annual report, and provide evidence about conditions that did not exist on the balance sheet date. These subsequent events must be disclosed so that users may interpret the financial statements in light of the most recent company information. If a subsequent event provides information about conditions that existed on the balance sheet date and significantly affect the estimates used in the preparation of the financial statements, the statements themselves are adjusted. Related party transactions. FASB Statement No. 57 requires that a company's transactions between related parties be disclosed in the notes to its financial statements. This disclosure includes the nature of the relationship, a description of the transaction including the dollar amounts, and any amounts due to or from the related party at the balance sheet date. Through the SEC's "integrated disclosures" provision, companies regulated by the SEC now satisfy certain Form 10-K disclosure requirements by reference to information included in the annual report. 8. Reporting techniques One of three basic formats is generally used for balance sheet presentation: (a) the report form (the most common format) in which asset accounts are listed first and then liability and stockholders' equity accounts are listed in sequential order directly below assets, (b)?the account form that lists asset accounts on the left-hand side and liability and stockholders' equity accounts on the right-hand side of the statement, and (c) the financial position form that first presents the amount of working capital, by listing current assets minus current liabilities, and then the remaining assets are added to working capital and the remaining liabilities are deducted from working capital to derive the residual stockholders' equity. Supporting schedules (e.g., listing of equipment items) and parenthetical notations (e.g., method of valuation for an account) may be used to disclose required and/or optional supplementary information, in addition to notes (or footnotes). 9. Balance Sheet analysis The balance sheet information helps external users (a) assess the company's liquidity, financial flexibility, operating capability, and overall leverage (b)?evaluate its income-producing performance for the period. Liquidity is the speed with which an asset of the company can be converted into cash or a liability paid. Information about liquidity helps users evaluate the timing of cash flows. Ratios: (a) Current ratio, (b) Quick ratio (acid-test ratio). Financial flexibility is the ability of the company to generate sufficient net cash inflows from operations, from investors and creditors, or from selling of long-term assets. Information about financial flexibility is necessary for evaluating the uncertainty of future cash flows. Operating capability is the company's ability to maintain a given physical level of operations defined by either the volume of inventory produced or the productive capacity of the plant, property, and equipment. This is important in evaluating the amount of future cash flows Overall leverage: comparing liabilities to assets held by a business gives an indication of the extent to which borrowed funds are used to leverage the owners’ investments to increase the size of the firm. Debt ratio: Total liabilities / total assets. Used as an indicator of the overall ability of the company to repay its debts. Generally, debt ratio should be below 50 percent (varies among industries). Lesson 4: THE INCOME STATEMENT AND INCOME RECOGNITION Learning Objectives After careful study , students will be able to: 1. Understand the concepts of income. 2. Explain the conceptual guidelines for reporting income. 3. Describe the major components of an income statement. 4. Compute income from continuing operations. 5. Report results from discontinued operations. 6. Identify extraordinary items. 7. Explain revenue recognition at the time of sale, during production, and at time of cash receipt. 8. Explain the conceptual issues regarding revenue recognition alternatives. 9. Describe the alternative revenue recognition methods. Teaching Hours 6 hours Teaching contents The income statement summarizes the results of a company's operations for the period. Instructor can ask students which statement they think is the most important financial statement if they are investor in capital market. 1. Concepts of income 1. 1 Capital maintenance Under the capital maintenance concept, income for a period is the amount that may be paid to stockholders during that period while leaving the company as well off at the end of the period as it was at the beginning. In other words, income is the difference between the beginning and ending capital (or net asset) balances after adjustment for investments and disinvestments during the period. Accountants and economists could probably agree on the measurement of total income for the entire life of a company. However, for shorter time periods income is subject to dispute, because the values of a company's beginning and ending assets and liabilities may be measured in a variety of ways. 1. 2 Transactional approach The transactional approach is currently used for income measurement. Under this approach, a company records its assets and liabilities at historical cost, and does not record any changes in value unless a transaction, event, or circumstance has provided reliable evidence of the change. The transactional approach uses the accrual basis. That is, the impact of any change is recorded in the period in which it occurs, rather than the period in which related cash is paid or received by the company, and efforts and accomplishments are matched, so that reported income measures a company's earnings performance. Using the accrual-based transactional approach, a company's net income is measured by the equation: Net Income = Revenues - Expenses + Gains - Losses 2. Elements of the income statement In FASB Statement of Concepts No. 6, the FASB defined the elements or "building blocks" of the income statement: revenues, expenses, gains, and losses. Revenues are inflows of (or increases in) assets of a company or settlement of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that are the company's ongoing major or central operations. Expenses are outflows of (or decreases in) assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that are the company's ongoing major or central operations. Gains are increases in a company’s equity (net assets) from peripheral or incidental transactions of the company and from all other events and circumstances affecting the company during a period except those that result from revenues or investments by owners. Losses are decreases in a company’s equity (net assets) from peripheral or incidental transactions of the company and from all other events and circumstances affecting the company during a period except those that result from expenses or distributions to owners. Students should be remind that the distinction between revenues and gains, and expenses and losses depends on the nature and circumstances of the company. 3. Income statement content 3.1 Income from continuing operations Income from continuing operations summarizes the income from usual and recurring operating activities. It includes sales revenues (net of returns, allowances, and discounts), cost of goods sold, operating expenses, other items, and income tax expense related to continuing operations. The computation of cost of goods sold (or cost of goods manufactured for a manufacturing company) is usually shown in a supporting schedule, not on the face of the income statement. Operating expenses are usually classified according to functional categories, such as selling expenses, and general and administrative expenses. Alternatively, expenses may be classified as variable (changing in direct proportion to changes in volume) or fixed (not affected by changes in volume). Other items include recurring revenues and expenses not directly related to the company's primary operations (for example, dividend revenue and interest revenue and expense), as well as material gains and losses from sales of assets that are not classified as results of discontinued operations, and material gains and losses that are not classified as extraordinary. 3.2 Results from discontinued operations The results of discontinued operations section is included on the company’s income statement directly after its income from continuing operations. The results from discontinued operations section includes (1) the operating income (loss) of the discontinued component for the period, and (2) the gain (loss) from its sale. The income (loss) from discontinued operations and the loss (or gain) from the sale of the component are reported net of income tax. That is, the related income taxes are deducted directly from each item, and only the after-tax amount is included in the computation of net income. It may take some time for a company to plan and make a sale of a component of its operations. The company classifies this component as held for sale at the end of the current accounting period when all six criteria discussed in the book are met. When a company classifies a component as held for sale, it records and reports the component at the lower of (1) its book value (book value of assets minus book value of liabilities) or (2) its fair value less any costs to sell. If the fair value (less any costs to sell) is less than the book value, the company records a loss and adjusts the book values of the assets of the component. The company reports the loss (after taxes) in the results of discontinued operations section of its income statement, as discussed earlier. It reports the assets and the liabilities in the respective asset and liability sections of its ending balance sheet, as discussed in lesson 3. 3.3 Extraordinary items In APB Opinion No. 30t, an event is defined as extraordinary if it is both unusual in nature and infrequent in occurrence. The environment in which a company operates is a primary consideration in using judgment to determine whether an item is extraordinary. Examples of events that are treated as extraordinary items, provided that they are both unusual and infrequent for the particular company, include natural disasters, expropriations by a foreign government, and newly enacted prohibitions. Material gains and losses from extraordinary items are reported, net of taxes, in a separate section, following the section reporting results of discontinued operations (if such a section is presented). When practical, individual extraordinary events should be described and disclosed. 3.4 Effects of accounting changes Accounting changes may be classified into four categories: (1)?a change in an accounting principle; (2) a change in an accounting estimate; (3)?a correction of an error; and (4) a change in the reporting entity. A change in accounting principle occurs when a company changes from one generally accepted accounting principle to another for use in its financial reports. A principle, once adopted, should be used consistently, unless a change results in more informative financial statements. The burden of justifying a change is on the company. In most instances, for a change in accounting principle, a company reports the cumulative effect on prior years' earnings in net income for the year in which the change is made. This cumulative effect is shown, net of taxes, after extraordinary items and before net income. The new principle is applied normally in the period of the change. Changes in accounting estimates, which result frequently from new information or events, are accounted for in the period of the change, and in future periods if affected. A note to the financial statements discloses the effects of a material change in estimate on income before extraordinary items, net income, and earnings per share. 3.5 Earnings per share Earnings per share ratios are often used in financial analysis to predict future earnings and dividends and to determine the attractiveness of the company's stock. The authors recommend the use of an earnings per share schedule showing earnings per share amounts net of tax for net income and each of its major components. The number of common shares used in the calculations should also be disclosed. 4. Income statement formats Two basic formats--single-step and multiple-step--are used in a company's income statement to report income from continuing operations. Under the pure single-step format, items are classified as either revenues or expenses. Total expenses are then deducted from total revenues in a single computation to determine income from continuing operations. In the multiple-step format, several subtotals are derived. For example, cost of goods sold is typically deducted from net sales to compute the gross profit or gross margin on sales, from which operating expenses are deducted to determine operating income. 5. Limitations of the income statement Instructor should also inspire students to think about the limitations of the income statement, enhancing their understanding of income statement. 6. Income Statement analysis 6.1 Stockholder profitability ratios indicate how effectively a company has been meeting the profit objectives of its owners, including: (a) Earnings per share; (b) The price/earnings ratio; (c)The dividend yield ratio. 6.2 Company profitability ratios indicate how effectively a company has met its overall profit (return) objectives, particularly in relation to the resources invested, including: (a) Profit margin; (b) Return on total assets; (c)Return on stockholders' equity. 7. Comprehensive income A company's comprehensive income includes its net income and its other comprehensive income. Currently, there are four items of a company's other comprehensive income; an example is any unrealized increase (gain) or decrease (loss) in the market (fair) value of its investments in available-for-sale securities. A company may report its comprehensive income: (a) on the face of its income statement, (b) in a separate statement of comprehensive income, or (c) in its statement of changes in stockholders' equity. If it chooses (c), the statement must be included as a major financial statement in its annual report. 8. Conceptual issues of revenue recognition A company usually recognizes revenue in the period of sale, when (a) realization has taken place, and (b) the revenues have been earned. There are, however, three revenue recognition alternatives: (a) advanced recognition (e.g., during the period of production), (b) recognition at the time of sale, and (c) deferred recognition (e.g., upon receipt of cash). Advanced or deferred recognition is used to increase the usefulness of the financial statements. The revenue recognition alternative used affects not only a company's income recognition on its income statement but its measurement of net assets (assets minus liabilities) on its balance sheet. The following three factors are useful in evaluating revenue recognition issues in specific business situations. The factors may help in determining whether revenue should be recognized at the time of sale, or whether recognition should be advanced or deferred. (a) The economic substance of the event takes precedence over the legal form of the transaction. Usually a company recognizes revenue at the time of the legal transaction. However, revenue recognition may be advanced or delayed if economic "reality" would otherwise be substantially distorted. An example is the recognition of gross profit on a sales-type lease by the lessor before legal title is passed. (b) The risks and benefits of ownership been transferred to the buyer. If the risks and benefits have been substantially transferred, the buyer must recognize revenue. Under a sales-type lease, the lessor must recognize revenue even though no legal sale has occurred because the risks and benefits of ownership have been transferred (c) The collectibility of the receivable from the sale is reasonably assured. If collectibility is not reasonably assured, revenue has not been realized and the earning process is not complete so recognition is deferred. 9. Revenue recognition alternatives 9.1 Normal revenue recognition Revenue Recognition in the Period of the Sale is used because realization has taken place and revenues have been earned at the time of the sale. Accrual accounting is used, expenses are matched against revenues, inventory is recorded at cost, and accounts receivable are recorded at net realizable value. This method is used most often. 9. 2 Revenue recognition prior to the period of sale Revenue Recognition Prior to the Period of the Sale is used to reflect economic substance over legal form. The percentage-of-completion method of accounting for long-term construction contracts and the proportional performance method of accounting for long-term service contracts are examples. Long-term construction contracts arise when a company agrees to construct an asset (e.g., buildings, ships, bridges) for another entity over an extended period. The buyer may provide advance payments to help finance construction, but the legal sale does not take place until the asset is complete. Two alternative revenue recognition methods are possible: (1) the percentage-of-completion method in which a company recognizes profit each period during the life of the contract in proportion to the amount of the contract completed during the period, and values its inventory at the costs incurred plus the profit recognized to date, less any partial billings; and (2) the completed-contract method in which a company recognizes profit only when the contract is complete and records inventory at cost, less any partial billings. The AICPA concluded that long-term construction contracts may be considered "continuous sales" and in its Statement of Position No. 81-1 requires that a company use the percentage-of-completion method for long-term contracts when all of the following conditions are met: a. Reasonably dependable estimates can be made of the extent of progress toward completion, contract revenues, and contract costs. b. The contract clearly specifies the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement. c. The buyer can be expected to satisfy its obligations under the contract. d. The contractor can be expected to perform its contractual obligations. When any of the above conditions are not met, the company uses the completed-contract method. It is also used on short-term contracts and when the risks of the contract are so great that reasonably dependable estimates cannot be made. A company can determine the percentage completed by either "input" or "output" measures. The cost-to-cost method or efforts-expended method are two input measures. With the cost-to-cost method, the company measures the percentage of completion by comparing the cost incurred to date with the expected total costs for the contract. With the efforts-expended method, the company measures the percentage of completion by comparing the work (labor hours, labor dollars, machine hours, material quantities, etc.) performed to date with the total estimated work for the contract. Under either method, once the percentage of completion is determined, this percentage is multiplied by the total revenue on the contract to compute the revenue to be recognized to date. The revenue to date minus the revenue recognized in previous years is the revenue to recognize in the current year. The expense to be recognized is determined in the same way. Alternatively, a company can use output measures such as units produced, units delivered, value added, or other measures of production to measure the percentage of completion. The results achieved to date compared to the total expected results of the contract are used to measure percentage of completion. The revenue and expense are computed in the same way as discussed above for the input measures. Under the percentage-of-completion method, a company uses an account titled Construction in Progress to record all the costs incurred on the project as well as the gross profit recognized to date. A Partial Billings account is used to record receipts paid by the buyer during construction. This account is a contra account to Construction in Progress. When there is a net debit balance in the Construction in Progress account, it is reported on the company's balance sheet as an asset, and when there is a net credit balance, it is reported as a liability. Examples could be showed to students as to how to use the percentage-of-completion method. According to APB Statement No. 4, a company recognizes revenues for services rendered when the services have been performed and are billable. When more than one act is required under a long-term service contract, a company recognizes revenue by the proportional performance method. 9. 3 Revenue recognition after the period of sale In an installment sale, a customer makes a small down payment and contracts to pay the balance over an extended period. Although the customer typically takes possession of the item, the seller retains title until payment is completed. The seller may recognize revenue at the time of the sale if collectibility is reasonably assured or, if not, recognition may be deferred. If recognition is deferred, either the installment method or the cost recovery method may be used. It is important to distinguish between an "installment sale" (a type of legal contract) and the "installment method" of revenue recognition. Under the installment method, some gross profit is recognized with each payment received from the customer. The amount recognized is determined by the gross profit ratio in the year of the sale. Under the more conservative and less common cost recovery method, no gross profit is recognized until all of the cost of the merchandise is recovered. Lesson 5: THE STATEMENT OF CASH FLOWS Learning Objectives After careful study , students will be able to: 1. Explain the uses of the statement of cash flows. 2. Classify cash flows as operating, investing, or financing. 3. Explain the direct method for reporting operating cash flows. 4. Explain the indirect methods for reporting operating cash flows. 5. Prepare a simple statement of cash flows. 6. Using cash flow data to assess a firm’s financial strength Teaching Hours 5 hours Teaching contents Conceptual overview and uses of the Statement of Cash Flows A statement of cash flows is a financial statement of a company that shows the cash inflows, cash outflows, and net change in cash from its operating, investing, and financing activities during an accounting period, in a manner that reconciles the company's beginning and ending cash balances. The statement's primary purpose is to provide relevant information about the company's cash receipts and cash payments during the accounting period, information that is useful in evaluating the company's liquidity, financial flexibility, operating capability, and risk. The statement of cash flows used along with the other financial statements aids external users in assessing a company's (a) ability to generate positive future cash flows, (b) ability to meet its obligations and pay dividends, (c) need for external funding, (d) net income in relation to its associated cash receipts and payments, and (e) cash and noncash investing and financing transactions for the period. Structure of the Statement of Cash Flows 2.1 Three categories of cash flows. A company's operating activities include the transactions and events related to its earning process. The most common operating cash inflows are collections from customers and interest and dividends received. The most common operating cash outflows are payments to suppliers and employees, and payments of interest and taxes. The Cash Flows From Investing Activities section includes all the cash inflows and outflows from the company's investment transactions. The most common cash inflows and outflows from investing activities are receipts from sales of investments in stocks and bonds, as well as receipts from sales of property, plant, and equipment, and payments for investments in stocks and bonds, as well as payments for property, plant, and equipment. The Cash Flows From Financing Activities section includes all the cash inflows and outflows from the company's financing transactions. The most common cash inflows from financing activities are receipts from the issuance of stocks and debt securities. The most common cash outflows from financing activities are payments of dividends, and payments to reacquire stock and to retire debt securities. The net cash amounts provided by (used in) the operating, investing, and financing sections are summed to determine the net increase or decrease in cash of the company for the period. The net change in cash is added to the beginning cash balance to arrive at the ending cash balance, which is the same amount reported on the company's year-end balance sheet Supplemental disclosures Noncash investing and financing activities affect an entity’s financial position but not the entity’s cash flow during a period should be disclosed in supplemental part to cash flow statement. Reporting Cash Flow From Operations Operating cycle A company's operating cycle is the average time taken to spend cash for inventory, process and sell the inventory, collect the accounts receivable, and convert them back into cash. Net income and the net cash flow within the operating cycle are unlikely to be the same because of differences between the timing of the cash flows and the recognition of revenues and expenses. Two methods FASB Statement No. 95 allows two methods for calculating and reporting a company's net cash flow from operating activities. While both methods result in the same amount of net cash provided by operating activities, the FASB prefers the direct method. Under the direct method, the operating cash outflows are deducted from the operating cash inflows to determine the net cash flow from operating activities. The direct method does not "tie" net income to the net cash provided by operating activities, or show how the changes in the company's current assets and current liabilities affected its operating cash flows. The direct method, which separates operating cash receipts from the operating cash payments, may be useful in estimating future cash flows. The reporting of cash flows from investing and financing activities is the same under the direct and indirect methods, although there are slight differences in the preparation of the information. The primary difference is the reporting of (and preparation of information about) cash flows from operating activities. Under the direct method, operating cash inflows are reported separately from operating cash outflows. Cash inflows are reported in three categories: (a) collections from customers: sales revenue, plus decrease in accounts receivable or minus increase in accounts receivable; (b)?interest and dividends collected: interest and dividend revenue, plus decrease in interest/dividends receivable or minus increase in interest/dividends receivable, and plus amortization of premium on investment in bonds or minus amortization of discount on investment in bonds; and (c) other operating receipts: other revenues, plus increase in deferred revenues or minus decrease in deferred revenues, minus gains on disposals of assets and liabilities, and minus investment income recognized under the equity method. Cash outflows from operating activities are reported in five categories: (a) payments to suppliers: cost of goods sold, plus increase in inventory or minus decrease in inventory, plus decrease in accounts payable or minus increase in accounts payable; (b)?payments to employees: salaries expense, plus decrease in salaries payable or minus increase in salaries payable; (c)?payments of interest: interest expense, plus decrease in interest payable or minus increase in interest payable, plus amortization of premium on bonds payable or minus amortization of discount on bonds payable; (d) other operating payments: other expenses, plus increase in prepaid items or minus decrease in prepaid items, minus depreciation, depletion, and amortization expense, minus losses on disposals of assets and liabilities, minus investment loss recognized under the equity method; (e)?payments of income taxes: income tax expense, plus decrease in income taxes payable or minus increase in income taxes payable, plus decrease in deferred tax liability or minus increase in deferred tax liability. Illustration should be given to enhance understanding of indirect method. The indirect method begins with net income and shows adjustments to arrive at the net cash flow from operating activities. That is, the indirect method converts income flows from an accrual basis to a cash flow basis. Many adjustments, involving increases and decreases in current assets and liabilities as well as noncurrent accounts, may be required. According to the FASB, the reconciliation of net income to the net cash provided by (or used in) operating activities may be shown either in the statement of cash flows or in a separate schedule. Most companies are currently using the indirect method. The adjustments to net income are shown on the worksheet in Exhibit 1810 in the text. Note that: Depreciation expense and amortization expense, involving no outflows of cash, are added back to net income (although depreciation and amortization are not cash inflows from operating activities). The decrease in inventories, representing a cash inflow because less inventory was purchased than was recorded as cost of goods sold, is added to net income. The increase in income taxes and interest payable, representing cash outflows less than the expenses recorded, are added to net income. The increase in accounts receivable, representing a cash outflow because cash collections were less than credit sales, is subtracted from net income. The increase in prepaid expenses, indicating that cash paid was greater than the expense recorded, is subtracted from net income. The decrease in accounts payable, representing a cash outflow greater than the expense recorded, is subtracted from net income. The gain on the sale of land, which does not involve an operating inflow, is subtracted from net income. Illustration should be given to enhance understanding of indirect method. Preparing a complete Statement of Cash Flows Process for preparing a statement of cash flows: 1. Prepare the heading for the statement of cash flows and list the three major sections. 2. Calculate the net change in cash that occurred during the accounting period. 3. Determine the net income and list this amount as the first item in the net cash flow from operating activities section. 4. Calculate the increase or decrease that occurred during the accounting period in each balance sheet account (except cash). 5. Determine whether the increase or decrease in each balance sheet account (except cash) caused an inflow or outflow of cash and, if so, whether the cash flow was related to an operating, investing, or financing activity. 6. If no cash flow occurred in Step 5, determine whether the increase or decrease in each balance sheet account (except cash) was the result of a noncash income statement item or a simultaneous investing and/or financing transaction. 7. Complete the various sections of the statement of cash flows and check that the subtotals of the sections sum to the net change in cash and that the sum of the net change in cash and the beginning cash balance is equal to the ending cash balance reported on the balance sheet. Examples can be given to show the steps. Using cash flow data to assess financial strength Instructor should induce students to assess a firm’s financial strength by analyzing the relationships among cash flows from operating, investing, and financing activities and by computing financial ratios based on cash flow data. Lesson 6: CASH AND RECEIVABLES Learning Objectives After careful study , students will be able to: 1. Understand the importance of cash management. 2. Prepare a bank reconciliation. 3. Discuss revenue recognition when the right of return exists. 4. Understand the credit policies related to accounts receivable. 5. Explain the gross and net methods to account for cash discounts. 6. Estimate and record bad debts using a percentage of sales. 7. Estimate and record bad debts using an aging analysis. 8. Explain pledging, assignment, and factoring of accounts receivable. 9. Account for short-term notes receivable. Teaching Hours 4 hours Teaching contents 1. Accounting for cash 1.1 Measurement as a current asset Any money on hand reported under the balance sheet caption "Cash" in the current asset section must be available to pay current obligations and not be subject to any contractual restrictions that prevent these monies from being used to pay current debts. Components: (a) Coins; (b) Currency; (c) Unrestricted funds on deposit with a bank; (d) Negotiable checks; (e) Bank drafts. Not components: (a) Certificates of deposit; (b)Bank overdrafts; (c) Postdated checks; (d) Travel advances; (e) Postage stamps. 1.2 Cash and cash equivalents Some companies use the title Cash and Cash Equivalents on their balance sheet in place of Cash. This category includes cash as well as securities that are defined as "cash equivalents" because of their liquidity and low risk. Examples of cash equivalents are commercial paper, treasury bills, and money market funds. 1.3 Cash management The efficient management of cash is very important to every company. Proper cash management requires the investment of idle funds. However, it is necessary to determine the estimated timing of cash inflows and outflows to ensure the availability of cash to meet the company's needs prior to embarking on a short-term investment program. 1.4 Petty cash system A petty cash system is a cash fund created to allow a company to pay for small amounts that might be impractical or impossible to pay by check. An employee is appointed petty cash custodian, and the fund is established at an amount estimated to be adequate to cover small expenditures over a short period of time. The entry to record the establishment of the fund is: Petty Cash 500 Cash 500 The petty cash account is neither debited nor credited again unless the fund size is to be increased or decreased. As money is paid from the fund, prenumbered vouchers are prepared to document the expenditures but no journal entries are made until the fund is reimbursed. At the time of reimbursement, appropriate expense accounts are debited and the cash account is credited as follows: Office Supplies Expense 120 Postage Expense 150 Cash 370 Any difference between the original petty cash fund balance and the sum of the actual cash plus petty cash vouchers is debited or credited to a Cash Short and Over account when the reimbursement entry above is made. A debit balance is reported as a miscellaneous expense; a credit balance is reported as a miscellaneous revenue. 2. Bank reconciliation A company prepares a monthly bank reconciliation in order to analyze and reconcile the differences between the cash balance on the monthly bank statement and the company's accounting record of the proper cash balance. The reconciliation starts from two different amounts--the cash balance on the books and the bank statement balance--and adjusts each of these balances to one common amount, the adjusted cash balance. Most of the discrepancy is usually due to timing differences such as deposits in transit, outstanding checks, bank service charges, and direct deposits made by the bank. However, the reconciliation may also disclose errors made by the bank or the company. The following procedures should be followed in preparing a bank reconciliation: (1) compare the deposits listed on the company's records with the deposits on the bank statement; (2) compare the checks listed in the company's records with the checks shown on the bank statement; (3)?identify any deposits or charges made directly by the bank that are not included in the company's records; (4) determine the effect of any errors; (5) complete the bank reconciliation. When the reconciliation is completed, adjusting entries must be made to correct errors made by the company, and to record items previously unrecorded on the company's books such as bank service charges, collections made by the bank, and NSF (not sufficient funds) checks. 3. Special topics 3.1 Electronic funds transfer systems Electronic funds transfers (EFT), the use of computer systems to transfer funds between parties without the use of checks, is increasingly being used by banks to process the large number of cash transactions generated by large companies. Because fewer physical source documents (in the form of checks) are available to substantiate such transactions, the importance of internal controls, such as bank reconciliations, is even greater. 3.2 Compensating balances Banks may require a portion of any amount loaned to remain on deposit with the bank for the duration of the loan period. These required deposits are called compensating balances. These deposits reduce the cash available to the company and increase the effective interest rate paid to borrow the funds. The Securities and Exchange Commission (SEC) requires that compensating balances be separately reported on a company's balance sheet if the compensating balances are legally restricted. If they are not legally restricted, they are disclosed in the notes to the financial statements. 4. Receivables 4.1 Classifications Receivables consist of a variety of claims against customers and others arising from the operations of a company. Most of a company's receivables are trade receivables that arise from selling products or rendering services to customers. Trade receivables are recorded at their maturity value, rather than present value, because the short collection period (usually 60 days or less) makes the difference between the two values negligible. Most trade receivables are in the form of accounts receivable, which are nonwritten promises by customers to pay the amount due within a specified time period (typically 30 days). Nontrade receivables are claims that are not related to selling products or rendering services. These receivables are kept separate from trade receivables both in the accounting records and also in the company's financial statements. Examples of nontrade receivables are deposits with utilities, advances to subsidiary companies, deposits made to guarantee performance, declared dividends to be received and accrued interest on investments, and loans made by nonfinancial companies. 4.2 Valuation issues As discussed in lesson 3, one purpose of reporting current assets is to disclose the liquidity of a company; that is, the “nearness to cash” of its economic resources. In this regard, the accounting issues associated with the valuation of current trade receivables are (a) the initial recording based on expected future cash flows, and (b) the estimation of the probability of collection. 5. Accounts receivable 5. 1 Cash (sales) discounts Sellers offer cash (sales) discounts to induce buyers to pay more promptly and to reduce the risk of nonpayment by customers. A buyer should take advantage of any cash discount with a higher effective interest rate than its borrowing rate. Cash discounts are recognized for financial accounting purposes. They may be accounted for by one of two methods by the seller: (a) Gross price method: The receivable is recorded at the gross sales price with no accounting recognition of the available cash discount until it is actually taken. When it is taken, the discount is debited to the Sales Discounts Taken account. This account is deducted from sales on the income statement to determine net sales. (b)Net Price Method: The receivable is recorded at the sales price less the available cash discount (the net price). Subsequently, if the discount is not taken, the difference between the amount paid (the gross price) and the amount originally recorded (the net price) is credited to the Sales Discounts not Taken account. This account is reported as interest revenue in the Other Items section of the income statement. While the gross price method lacks conceptual validity, it is widely used because the cash discount is usually immaterial and the record keeping less complicated. 5.2 Sales returns and allowances A sales allowance is a reduction in price to compensate the customer for defective goods which are retained by the customer. A sales return occurs when the customer returns defective or non-defective goods and receives credit. If sales returns and allowances are estimated at the time of sale, the amount is debited to Sales Returns and Allowances and credited to Allowance for Sales Returns and Allowances. This allowance account is a contra account to Accounts Receivable and decreases the carrying value of Accounts Receivable on the balance sheet. However, since sales returns and allowances are usually immaterial, they are normally recorded at the time they occur and are reported on the company's income statement as a deduction from sales revenue. 6. Valuation of accounts receivable for uncollectible accounts Companies that sell on credit must maintain a balance between maximizing revenue and minimizing bad debt risks. When a reasonable credit policy has been established, the seller will normally experience some degree of nonpayment by customers. Bad debt losses, which decrease the value of Accounts Receivable, may be accounted for by either of two procedures: (a)?in the year of the sale based upon an estimate of the amount of uncollectible accounts, the estimated bad debts method, or (b) as the actual loss is determined, the direct write-off method. Under the estimated bad debts method, bad debts may be estimated through techniques that emphasize either the income statement or the balance sheet: (a) income statement approach: a rate for estimating bad debt expense (percentage of sales) is established by determining the historical relationship between actual bad debts incurred and net credit sales (although total sales may be used). This relationship is expressed as a percentage which is then applied to net credit sales in the current year to determine Bad Debt Expense for the current period. The existing balance in the Allowance for Doubtful Accounts is disregarded in calculating and recording the bad debt expense. The focus is on correctly estimating the expense. This procedure is simple to apply and results in a matching of expenses with sales in the current period. (b) balance sheet approach: bad debt expense may be estimated as a percentage of outstanding accounts receivable or may be estimated based on an aging of accounts receivable. When estimating bad debt expense as a percentage of outstanding accounts receivable, a rate determined from the historical relationship between accounts receivable and bad debts is applied to currently outstanding accounts receivable to determine the estimated uncollectible accounts. When using an aging schedule, accounts receivable are categorized according to the length of time outstanding (e.g., 60 days, 120 days, 240 days) and then historically determined bad debt percentages are applied to each category. These are summed to determine the total estimated uncollectible accounts. Under both balance sheet approaches the amount of estimated uncollectible accounts receivable is compared with the existing balance in the Allowance for Doubtful Accounts. The entry to record bad debt expense is the amount necessary to bring the Allowance account balance up to the required ending balance. The balance sheet approaches provide useful credit information and result in reporting the best estimate of the net realizable value of accounts receivable. When using the direct write-off method, bad debts are recorded as an expense during the period in which a specific receivable account is determined to be uncollectible. The journal entry debits Bad Debt Expense and credits Accounts Receivable. However, this method violates the matching principle and is not allowed under generally accepted accounting principles unless bad debt losses are immaterial. 7. Generating immediate cash from accounts receivable Rather than waiting for customer payments in order to receive cash from accounts receivable, a company may speed up the cash flow by one of three processes: (a) using the receivables as collateral for a loan (pledging). The company retains both risks and benefits of ownership and is responsible for routine collection and administration; (b) contracting with a finance company to receive cash advances on specific customer accounts and to make repayment as the receivables are collected by the borrowing company (assignment). The company retains credit activities and because the accounts are assigned with recourse, the risk of ownership is retained; or (c) selling the receivable (without recourse) to a bank or finance company which assumes credit and collection activities, as well as risk of ownership (factoring). While factoring and assignment agreements are formally entered in the accounting records, pledge agreements are not. However, the existence of factoring, pledging, or assignment agreements related to accounts receivable is disclosed either parenthetically or in the notes to the financial statements. Such information is important in evaluating a company's liquidity and financial flexibility. The disclosure should include important conditions and terms related to the agreements. 8. Notes receivable (short-term) A note receivable is an unconditional written agreement to collect a specified sum of money on a specified date. In addition, it is a negotiable instrument, and usually involves an agreement to receive interest on the principal amount of the note. Short-term notes with a stated interest rate (interest-bearing notes) are recorded at face value and subsequent interest revenue is recorded in the usual fashion. Most short-term notes without a stated interest rate (non-interest-bearing notes) are recorded at their maturity value unless the interest is readily determinable and the company wishes to recognize interest. However, it is conceptually better to record a non-interest-bearing note at its present value and to recognize interest revenue as it is earned. A company may wish to obtain cash from a note prior to its maturity date by discounting the note at a bank. The bank deducts the amount of interest discount it wishes to earn on the transaction from the maturity value of the note and remits the net amount to the company. In order to account for a discounted note each of the following items must be determined: (1) face value of note, (2) interest to maturity (face value x interest rate x interest period), (3) maturity value of note (face value + interest to maturity), (4) discount (maturity value of note x discount percentage x discount period), (5) proceeds (maturity value - discount), (6) accrued interest revenue (face value x interest rate x period of time note is held by company), (7) book value of note (face value?+ accrued interest revenue), (8) gain or loss on sale of note (proceeds - book value). On the date of the discount, journal entries are made to accrue interest revenue and to record the proceeds received, any gain or loss on the transfer of the note, and the contingent liability. Most discounting is done on a with recourse basis which means that the company agrees to pay the bank the maturity value of the note at its maturity date if the maker of the note fails to do so. Lesson 7: INVENTORIES Learning Objectives After careful study , students will be able to: 1. Describe how inventory accounts are classified. 2. Explain the uses of the perpetual and periodic inventory systems. 3. Determine the cost of inventory. 4. Compute ending inventory and cost of goods sold under specific identification, FIFO, average cost, and LIFO. 5. Explain the conceptual issues regarding alternative inventory cost flow assumptions. 6. Understand inventory disclosures. 7. Understand and explain the conceptual issues regarding the lower of cost or market method. 8. Use the gross profit method. 9. Understand the retail inventory method. Teaching Hours 3 hours Teaching contents Classifications of inventory Inventories are the assets of a company which are (1) held for sale in the ordinary course of business, (2) in the process of production for sale, or (3) held for use in the production of goods or services to be made available for sale. A merchandising company needs only one type of inventory account, usually called merchandise inventory. Inventories of a manufacturing concern normally include raw materials, goods in process, and finished goods. II. Alternative inventory systems Students should be remind of the characteristics of different inventory systems based on their knowledge of Chinese accounting. 2. 1 Perpetual A perpetual inventory system provides for a continuous record of physical quantities in the inventory. Such a system is essential to maintain effective planning and control by management over inventory and to avoid stockouts. A perpetual inventory system may keep track of units only or can be maintained for both costs and units. Comprehensive perpetual systems are increasingly common with the availability of sophisticated computer systems. 2. 2 Periodic A company using the periodic inventory system does not maintain a continuous record of the physical quantities (or costs) of inventory on hand. Therefore, the company will not be able to determine its inventory accurately until it takes a physical inventory at the end of the period. At that time, the cost of goods sold, in terms of either units or costs, is represented by the following equation: Beginning Inventory + Purchases (net) - Ending Inventory = Goods Sold In a periodic system a company usually records (debits) the costs of inventory acquisitions to a temporary Purchases account. In both the perpetual and periodic systems, the company usually uses separate accounts to record purchases returns and allowances, purchases discounts, and freight-in. 3. Items to be included in inventory quantities Economic control at the balance sheet date, and not legal ownership or physical possession, determines what items are to be included in the ending inventory. Frequently, some inventory is in transit to the company or its customers at the balance sheet date. If the goods are shipped FOB (free on board) shipping point, the control of (and legal title to) the goods is transferred to the buyer at the shipping point. Therefore, the goods in transit are controlled by (and owned by) the buyer and should be included in the buyer's inventory. If the goods are shipped FOB destination, the control of (and legal title to) the goods is transferred to the buyer on delivery. Therefore, the goods remain under the control and legal ownership of the seller while in transit and should be retained in the seller's inventory. 4. Determination of inventory costs Inventory cost includes costs directly or indirectly incurred in bringing the inventory to its existing condition and location. The cost of purchased inventory includes the purchase price (net of purchases discounts), normal transportation, insurance, storage, applicable taxes, and similar items. Selling costs, which are not associated with bringing the inventory to its existing condition and location, are never included in inventory. Because of cost/benefit considerations, some costs (for example, the costs of a purchasing department) are usually recognized when incurred, rather than attached to inventory. According to FASB Statement No. 34, interest costs are not included in the cost of inventory that is routinely manufactured. Material manufacturing costs which are related directly or indirectly to the production of inventory are costs of inventory. Variable manufacturing overhead is related directly and is always included in inventory. The allocation of fixed manufacturing overhead is difficult and may be somewhat arbitrary: the costs incurred must be traceable to the benefits. Materiality is also a consideration in deciding whether to include costs in inventory. 5. Inventory valuation methods 5. 1 Specific identification The specific identification cost flow assumption requires that each inventory unit be identified as sold or remaining in the ending inventory, and that the actual costs of those units be included in cost of goods sold and ending inventory, respectively. This method is appropriate when each inventory unit is unique, but specific identification may be impractical or prohibitively expensive for high-volume inventories, and may permit management to manipulate profits by arbitrarily selling high-cost or low-cost identical inventory items. 5. 2 First-in, first-out (FIFO) The FIFO cost flow assumption allocates costs in the order in which they are incurred. That is, the first input costs incurred are the first to be transferred to cost of goods sold or to goods in process, then to finished goods and cost of goods sold. The ending inventory is assigned the most recent costs incurred. With FIFO, the ending inventory and cost of goods sold are the same under the perpetual and periodic systems. 5. 3 Average cost The average cost assumption considers that all the costs and units are commingled. Under a periodic inventory system, the average cost method is known as the weighted average method, and the average cost per unit is the cost of goods available for sale divided by the number of units available for sale. Under a perpetual inventory system, the average cost method is known as a moving average method, because a new weighted average cost must be calculated after each purchase. 5. 4 Last-in, first-out (LIFO) The LIFO cost flow assumption assumes that the most recent costs incurred are the first to be transferred out or sold, so the earliest costs incurred are assigned to the ending inventory. With LIFO, the cost of goods sold and the ending inventory differ between the perpetual method and the periodic method. 5. 5 Comparison Instructor should induce students to think about differences between different methods. During periods of rising costs, FIFO produces lower cost of goods sold, higher ending inventory, and higher gross profit (and income) than LIFO because FIFO includes the oldest and lowest costs in cost of goods sold. The opposite results are produced during periods of falling costs. Results from the average cost assumption fall between the FIFO and LIFO extremes. Under the LIFO method, the timing of inventory purchases affects gross profit (and income), and therefore, profits may be deliberately manipulated by delaying or increasing inventory purchases. The FIFO and average cost methods are not so susceptible to income manipulation. The average cost method produces the same cost in a particular period for identical units with the same utility. However, because the average is continually affected by the costs incurred in previous periods, it reflects neither the actual costs paid for the units sold nor the actual costs for inventory held. 6. Inventory valuation at other than cost 6. 1 Lower of cost or market (LCM) The lower of cost or market (LCM) rule requires that a company recognize a decline in the inventory's utility as a loss of the period, and that the company write down its ending inventory to the market value. This rule is consistent with the conservatism convention. Market value is defined as the current replacement cost of inventory (not the current selling price) by purchase or manufacture, with upper and lower constraints imposed. Market value cannot be higher than the ceiling constraint or lower than the floor constraint. Ceiling constraint: The market value cannot be greater than the net realizable value (estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal). Floor constraint: The market value cannot be less than the net realizable value reduced by a normal profit margin (normal markup). The ceiling ensures that a write-down will cover all expected losses currently, and prevents the recognition of further losses in the future. The floor prevents the recognition of excessive losses currently, and excessive profits in the future. To apply the LCM method, a company (1) calculates and ranks the current replacement cost, ceiling, and floor and selects the middle amount as the market value; (2)?compares the selected market value to cost and uses the lower of the two amounts; (3) reports inventory at the lower value on its balance sheet and reports any loss on its income statement. The LCM rule may be applied to individual inventory items, categories of inventory, or total inventory. The method which most clearly reflects periodic income should be used. The acceptability of three alternative methods for the same economic event does not follow the qualitative characteristic of comparability. However, differences resulting from the alternatives are often immaterial. Applying LCM to each individual item is the most common inventory method because it is required for income taxes and results in the most conservative inventory values. Once a company writes down its inventory to the lower of cost or market, the company does not write the inventory back up to cost, even if there is a subsequent recovery in the utility of the inventory. Two alternative accounting methods are acceptable for recording a write-down of inventory to market value: (a) The direct method records the write-down directly in the inventory and cost of goods sold accounts.; (b) The allowance method uses a separate inventory valuation account and a loss account. Although these methods produce the same net results, the allowance method is more desirable because it clearly identifies the effects of the write-down. 6.2 Gross profit method A company uses the gross profit method to estimate the cost of its inventory by applying a gross profit rate based on its income statements of previous periods to the net sales of the current period. The gross profit method may be used, for example, for internal financial statements, for published interim financial statements when the method is disclosed, for estimation by auditors, to estimate casualty losses, or to estimate the cost of inventory from incomplete records. The method involves four steps: (1) Calculate the historical gross profit rate by dividing the gross profit (net sales minus cost of goods sold) of the prior period(s) by the net sales of the prior period(s). (2) Estimate current gross profit by multiplying the historical gross profit rate by net sales for the period. (3) Subtract the estimated gross profit from the actual net sales to determine the estimated cost of goods sold. (4) Subtract the estimated cost of goods sold from the actual cost of goods available for sale to determine the estimated cost of the ending inventory. The gross profit method depends on the accuracy of the gross profit percentage. That accuracy may be enhanced by adjustments for (a) known changes in the relationship between gross profit and net sales; (b)?varying gross profit rates in different types of inventory; or (c)?period-to-period fluctuations in the gross profit rate. 6.3 Retail inventory method A company uses the retail inventory method to determine the cost of its ending inventory based on current-period estimates of the profit percentage. The retail inventory method enables a company to determine its ending inventory without a physical inventory, simplifies record-keeping procedures, and facilitates computation of the ending inventory because reference to actual purchase documents is not required. The method is acceptable for income tax purposes as well as under generally accepted accounting principles. The retail method requires that inventory items be valued at cost and retail in order to determine the cost-to-retail ratio. The cost-to-retail ratio is used to convert the retail value of ending inventory to approximate cost. 7. Effects of inventory errors Errors made by a company in the valuation of inventory and the recording of its purchases can result in errors on the company's balance sheet and income statement for current and succeeding years. Examples of common errors and their effects are given in the text. When a company discovers a material error from a prior period, it makes the correction as a prior period adjustment. Pedagogical Notes Since students have already grasped basic knowledge about inventory valuation methods at cost, emphasis should be put on “Inventory valuation at other than cost”, especially the LCM method is different from that of China. Lesson 8 PROPERTY, PLANT, AND EQUIPMENT Learning Objectives After careful study, students will be able to: 1. Identify the characteristics of property, plant, and equipment. 2. Record the acquisition of property, plant, and equipment. 3. Determine the cost of assets acquired by the exchange of other assets. 4. Compute the cost of a self-constructed asset, including interest capitalization. 5. Record costs subsequent to acquisition. 6. Record the disposal of property, plant, and equipment. 7. Identify the factors involved in depreciation. 8. Explain the alternative methods of cost allocation, including activity- and time-based methods. 9. Record depreciation. 10. Explain the conceptual issues regarding depreciation methods. 11. Understand the disclosure of depreciation. 12. Compute depreciation for partial periods. 13. Explain the impairment of noncurrent assets. Teaching Hours 4 hours Teaching contents 1. Classification as property, plant, and equipment Assets categorized by a company as property, plant, and equipment must (a) be held for use in the business and not for investment, (b) have an expected life of more than one year, and (c) be tangible in nature. Sometimes these assets are referred to as plant assets, fixed assets, or operational assets. A company records asset included in its property, plant, and equipment category initially at their acquisition cost (historical cost). The company then allocates the cost of the assets, other than land, as an expense to the periods in which it consumes the assets and receives the benefits in order to comply with the matching principle. This process is called depreciation. The major types of assets classified as property, plant, and equipment are land, buildings, equipment, machinery, furniture and fixtures, leasehold improvements, and natural resources (also called wasting assets). 2. Acquisition of property, plant, and equipment The cost of a company's property, plant, and equipment is the cash outlay or its equivalent that is necessary to acquire the asset and put it in operating condition. This cost includes the contract price (less any available discounts), freight, assembly, installation, and testing costs. Costs incurred to obtain the benefits of the asset are capitalized when they are recorded as an asset. The recorded value of land includes (a) the contract price, (b) the costs of closing the transaction and obtaining title (such as commissions, options, legal fees, title search, insurance, and past due taxes), (c) the costs of surveys, and (d)?the costs of preparing the land for its particular use (such as the cost of removing an old building) if such improvements have an indefinite life. Because land has an unlimited economic life and its residual value is unlikely to be less than its acquisition cost it generally is not depreciated. Land acquired for future use or as an investment should not be classified as property, plant, and equipment. The recorded cost of buildings includes (a) the contract price, (b) the costs of remodeling and reconditioning, (c) the costs of excavation for the specific building, (d) architectural costs and the costs of building permits, (e) certain capitalized interest costs, and (f) unanticipated costs resulting from the condition of the land. Improvements made by a lessee to leased property normally revert to the lessor at the end of the lease. In this case, the costs of leasehold improvements are capitalized by the lessee and amortized over their economic life or the life of the lease, whichever is shorter. When a company acquires several dissimilar assets categorized as property, plant, and equipment for a lump-sum purchase price, it allocates the price paid to the individual assets purchased. When a company acquires property, plant, and equipment on a deferred payment basis (e.g., issuance of bonds or notes or assumption of a mortgage), it records the asset at its fair value or the fair value of the liability on the transaction date, whichever is more reliable. Assets categorized as property, plant, and equipment may also be acquired by issuing securities such as common stock. In this case the recorded cost is either the fair value of the assets obtained, or the fair value of the securities issued, whichever is more reliable. When a company acquires an asset through a nonreciprocal transfer (donation), the company records the asset at its fair value rather than its cost which would be zero. 3. Assets acquired by exchange of other assets A nonmonetary exchange is a reciprocal transfer between a company and another entity which results in the acquisition of nonmonetary assets or services or the satisfaction of liabilities by surrendering other nonmonetary assets or services or incurring other obligations. Nonmonetary exchanges may be accompanied by the payment and/or receipt of small amounts of boot (monetary consideration). The general principle is that the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered. The company recognizes a gain or loss on the exchange as the difference between the fair value of the asset surrendered and its book value. Productive assets are assets that are held for or used in the production of goods and services. Similar productive assets are of the same general type, perform the same function, and are used in the same line of business. If the assets do not meet the criteria just cited for similar productive assets, they are dissimilar productive assets. To determine the cost of dissimilar productive assets acquired through a nonmonetary exchange the following equation is used: Cost = Fair Value of Asset Surrendered (Unless the fair value of the asset received is more evident) If boot accompanies the exchange, the cost is determined as follows: Cost of Asset Acquired = Fair Value of Asset Surrendered + Boot Paid or - Boot Received Whether or not boot is involved in the exchange, all gains and losses on dissimilar productive assets are recognized in full because the earnings process is considered complete. The Gain (Loss) is determined as follows: Gain (Loss) = Fair Value of Asset Surrendered – Book Value of Asset Surrendered A monetary exchange of similar productive assets occurs when the boot is equal to or greater than 25% of the total value of the exchange. In this case, the exchange is recorded at fair value for both parties. For similar productive assets acquired through a nonmonetary exchange (boot is <25% of total value) between two companies that are using the assets in the same line of business (e.g., an exchange between two dealers or between two non-dealers), all losses are recognized in full by both parties to the exchange whether or not boot is involved. If fair value of the asset surrendered is less than the book value of the asset surrendered, cost and the loss (if there is one) are determined as follows: Cost of Asset Acquired = Fair Value of Asset Surrendered + Boot Paid or - Boot Received Loss = Fair Value of Asset Surrendered - Book Value of Asset Surrendered Because the earning process is not essentially completed by a nonmonetary exchange of similar productive assets, gains are not recognized unless boot is received. When the boot received is less than 25% of the total value, the earnings process is considered complete to the extent that boot is received, and a partial gain is recognized. Students will be required to find materials about nonmonetary exchange standard in China. Then discussion based on the materials and knowledge learned in this lesson about accounting standards of nonmonetary exchange in U.S. will be induced in class. 4. Self-construction The cost of self-constructed assets (items of property, plant, and equipment constructed by a company for use in its own production process) should include all direct costs of materials, labor, engineering, and variable manufacturing overhead. The cost of the self-constructed asset should also include: (a) interest costs incurred during the period of self-construction on the average cumulative invested costs during the period; (b) fixed manufacturing overhead costs: either an allocated portion of total fixed overhead, particularly appropriate when the company is operating at full capacity; the incremental fixed overhead actually incurred, particularly appropriate when the company is operating with excess capacity; or no amount of fixed overhead, if the overhead does not change; and (c) recognition of a loss and a write down of the asset to the fair value if construction cost materially exceeds the fair value of the asset. If a company constructs an asset for either its own use or as a discrete project for sale or lease to others, it must capitalize interest. The amount of interest to be capitalized for a qualifying asset is calculated by multiplying either the interest rate incurred on the specific borrowing or a weighted average interest rate on all other borrowings times the average cumulative expenditures for the qualifying asset during the capitalization period. The total interest cost capitalized each period may not exceed the interest cost incurred during the period. The capitalization period begins when (a) expenditures for the asset have been made, (b)?activities that are necessary to get the asset ready for its intended use are in progress, and (c) interest cost is being incurred. The capitalization period ends when the asset is (a) substantially complete and (b)?ready for its intended use. 5. Costs subsequent to acquisition Additions to already existing assets (e.g., a new wing to a building) represent new assets and a company capitalizes the costs. Improvements (or betterments) and replacements (or renewals) involve the substitution of new or better assets for old ones. Because the economic benefits to be derived from the asset are increased, a company capitalizes the costs by one of the following methods depending on the circumstances: (a) The Substitution Method (when the book value of the old asset is known): the book value of the old asset is removed from the accounts and the new asset is recorded; (b)?Reduce Accumulated Depreciation (when the service life of the asset has been extended): the specific Accumulated Depreciation account is debited with the costs of improvements or replacements on the grounds that service potential that has been written off has been restored; or (c) Increase the Asset Account (when benefits are increased above those originally expected): the specific asset account is debited directly with the new costs on the grounds that an addition has been made to the service potential of the asset. A company expenses in the period incurred any routine repair and maintenance costs which are incurred to maintain the operating condition of an asset. However, in order to prevent distortion of interim financial statements, a company's annual repair and maintenance expense may be estimated and then an equal amount may be recorded as an expense each quarter. The difference between the actual expense and the prorated portion is then recorded in an Allowance for Repairs account (an addition to or offset from property, plant, and equipment) which would have a zero balance at the end of the year. 6. Disposal and disclosure of property, plant, and equipment A company may dispose of property, plant, and equipment by sale, involuntary conversion, abandonment, or exchange. When recording the disposal, depreciation expense up to the date of the disposal must be recorded first. Then the asset account is credited and the accumulated depreciation account is debited to remove these accounts from the records. Any gain or loss on the disposal is recognized and is usually included as an element of ordinary income in the income statement. A company must disclose the balance of its major classes of depreciable assets by nature or by function. 7. Depreciation and depletion Depreciation is the process of allocating, in a systematic and rational manner, the total cost of an asset held for more than one year as an expense to each period benefited by the asset. The total expense or depreciation base (depreciable cost) involved is the difference between the purchase price and the estimated residual value. Depreciation is not an attempt to reflect the market value of an asset. Land, which generally has an unlimited life and a future selling price higher than its cost, is not depreciated. The term depreciation describes the allocation of the cost of tangible assets, such as property, plant, and equipment. A company considers four factors in computing a periodic depreciation charge: (a)?asset cost, (b) service life, (c) residual value, and (d)?method of cost allocation. The cost of an asset includes all the acquisition costs required to obtain the benefits expected from the asset. These acquisition costs include the contract price, freight, assembly, installation, and testing costs. Service life is a measure of the number of units of service expected from an asset before its disposal. This measurement may be made in units of time or units of activity or output. The residual value (salvage value) of an asset is the net amount that can be expected to be obtained from the disposition of the asset at the end of its service life. Sometimes a company expects an obligation related to the retirement of an asset at the end of its life. In this case, at the time of acquisition the company computes the present value of the obligation and records this amount both as an increase in the cost of the asset and as an obligation. Methods used in practice are either activity (or use) methods or time-based methods. Activity methods are appropriate when an asset's service life is affected primarily by the amount of usage, rather than by the passage of time. Activity methods are seldom used for depreciation, however, because of the difficulties of estimation and the cost of measuring the activity level of each asset each period. Time-based methods may be divided into two general categories: the straight-line method and the accelerated methods. Accelerated methods include the sum-of-the-years'-digits method and declining-balance methods. The sum-of-the-years'-digits method multiplies the asset's depreciation base (cost less residual value) by a declining fraction to compute the depreciation charge. Declining-balance methods apply a constant depreciation rate to the book value of the asset at the beginning of the period, ignoring residual value. The choice of a depreciation method can have a significant impact on a company's reported income and assets, although its total income over the life of the asset will be unaffected. Depreciation is not a measurement of the value of an asset, and is not recorded to fund the replacement of an asset. A company should make the following disclosures related to its depreciation: (a) depreciation expense for the period, (b) balances of major classes of depreciable assets, by nature or function, at the balance sheet date, (c) accumulated depreciation, either by major classes of depreciable assets or in total, at the balance sheet date, and (d)?a general description of the method or methods used in computing depreciation with respect to the major classes of depreciable assets. Depreciation may be computed to the nearest whole month, considering assets purchased on or before the 15th of the month as owned for the whole month, and assets purchased after the 15th as not owned during the month. Depreciation may be computed to the nearest whole year, considering assets purchased during the first six months as owned for the whole year, and assets purchased during the last six months as not owned during the year. One-half year's depreciation may be charged on all assets purchased or sold during the year. The term depletion describes the allocation of the cost of natural resource assets, such as oil, gas, minerals, and timber. Depletion, the allocation of the depletable cost of the consumption of a natural resource (wasting asset), to the periods when benefits are received, is normally recorded on the basis of an activity method. The total number of units expected to be extracted is the activity measure. 8. Impairment of noncurrent assets A company should review its property, plant, and equipment for impairment when events or changes in circumstances indicate that their book value may not be recoverable. To test for impairment, a company compares the total expected cash flows (undiscounted) of an asset with the asset's book value. If future net cash flows are lower than book value, an impairment loss may be recognized. For this comparison assets are grouped at the lowest level at which identifiable cash flows are largely independent of the cash flows of other groups of assets. The impairment loss is the difference between the asset's book value and its lower fair value, which may be measured by the present value method. The discount rate used is the rate of return that the company requires for similar investments with similar risks. When a company recognizes an impairment loss when it occurs, and the company reports its productive assets at their fair values, its financial reporting will be enhanced. However, dissenters criticize the use of fair value as a departure from transaction-based historical cost and point out that a current write-down will ensure future profits. Lesson 9 INTANGIBLES Learning Objectives After careful study, students will be able to: 1. Explain the accounting alternatives for intangible assets. 2. Record the amortization or impairment of intangibles. 3. Identify research and development costs. 4. Explain the conceptual issues for research and development costs. 5. Account for identifiable intangible assets. 6. Account for unidentifiable intangibles, including internally developed and purchased goodwill. 7. Understand goodwill amortization. 8. Understand the disclosure of intangibles. 9. Explain the conceptual issues regarding intangibles. Teaching Hours 3 hours Teaching contents 1. Accounting for intangibles Intangible assets, which generally result from legal or contractual rights, do not have a physical substance. Companies may classify intangible assets as either purchased or internally developed, and as either identifiable or unidentifiable. (a) Companies capitalize the costs of purchased identifiable intangibles (for example, purchased patents). (b) Companies capitalize the costs of purchased unidentifiable intangibles. (Goodwill, the major unidentifiable intangible) (c) Companies capitalize certain costs associated with internally developed identifiable intangibles (for example, the legal and related costs of establishing the rights associated with a patent). However, research and development costs are an exception to the general rule of capitalization and must be expensed. (d) Companies expense the costs of internally developed unidentifiable intangibles (such as employee training and product design) as incurred. Intangible assets with a finite life are amortized. A company selects the amortization method based on the expected pattern of benefits. If the company cannot determine the expected pattern, then it uses the straight-line method. Intangible assets with an indefinite life are not amortized (unless they are determined to have a useful life that is finite), but are reviewed at least annually for impairment. To review an intangible asset for impairment, a company estimates the fair value of the asset. The asset is impaired if its fair value is less than its carrying value. In this case, the company debits a Loss account and credits the intangible asset account. 2. Research and development (R&D) Research is the planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process. Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process, whether intended for sale or use. A company includes the following costs of R&D activities in R&D costs and expenses them as incurred: (a)?materials, equipment, and facilities, (b) personnel, (c)?intangibles purchased from others, (d) contract services--the cost of services performed by others in connection with the company's R&D activities, and (e) a reasonable allocation of indirect costs, not including general and administrative costs unless they are clearly related to R&D. a company expense all research and development (R&D) costs as incurred, although R&D costs often benefit future periods. The requirement to expense R&D costs was based primarily on the belief that uniform treatment of R&D costs enhances comparability and eliminates the possibility of income manipulation. In addition, the problems of reliably determining the amount to capitalize and the amortization period are avoided. 3. Identifiable intangible assets Identifiable intangible assets are those intangibles which can be purchased or sold separately from the other assets of the company. Because R&D and operating costs are expensed, a company capitalizes only certain costs of internally developed identifiable intangibles. A company normally capitalizes the legal costs of successfully defending a patent against infringement. A company amortizes the cost of a copyright over its useful life, on either a straight-line or an activity basis. The franchisee capitalizes the initial franchise cost paid and amortizes it over the useful life of the franchise, unless the franchise is granted in perpetuity (in which case it would be tested for impairment at least annually.) Organization costs incurred in forming a corporation include legal fees, stock certificate costs, underwriting fees, accounting fees, and promotional fees. The costs of start-up activities, including organization costs, should be expensed as incurred. 4. Unidentifiable intangibles Many intangibles essential to the performance of the company (such as superiority of employees and advantageous geographical location) do not appear on the balance sheet. Such internally developed intangibles are categorized as goodwill. Companies expense internally developed goodwill as incurred. Companies capitalize purchased goodwill. Purchased goodwill is defined as the difference between the purchase price (market value) of the acquired company as a whole and the fair value of its identifiable net assets (assets – liabilities). Goodwill is never amortized. A company must review its goodwill for impairment at least annually at the reporting unit (i.e., operating segment) level. Negative goodwill arises when the price paid for a company is less than the fair value of the net assets acquired. Negative goodwill is not separately recorded. 5. Disclosure of intangibles In the period a company acquires intangible assets: (1) the cost (separated into assets subject to amortization, not subject to amortization, and goodwill); (2) for assets subject to amortization, the residual value and amortization period; and (3) the cost of any R&D acquired and written off (and where reported on its income statement). In each period for which it presents a balance sheet: (1) for amortized intangibles, the cost, accumulated amortization, amortization expense, and estimated amortization expense for the next 5 years; (2) for non-amortized intangibles, the total cost and cost of each major intangible asset class; (3) for goodwill, the amount acquired, amount of any recognized impairment loss, and amount included in the disposal of a reporting unit; and (4) for any intangible asset impairment, the reason, the amount of the impairment loss, and the method of determining the fair value. 6. Conceptual evaluation of accounting for intangibles Several aspects of accounting for intangibles appear to be inconsistent. First, the requirement that a company expense any purchased R&D costs in an acquisition of another company is inconsistent with the general rule that items purchased are assets. Second, purchased goodwill is recorded as an asset, while internally developed goodwill is expensed. Third, some intangible assets are amortized while other intangible assets are not. Lesson 10 CURRENT LIABILITIES AND CONTINGENCIES Learning Objectives After careful study, students will be able to: 1. Explain the characteristics of a liability. 2. Define current liabilities. 3. Understand and record payroll taxes and deductions. 4. Account for warranty costs. 5. Explain the terms "probable," "reasonably possible," and "remote" related to contingencies. 6. Record and disclose a loss contingency. 7. Disclose a gain contingency. Teaching Hours 4 hours Teaching contents 1. Conceptual overview of liabilities Liabilities are probable future sacrifices of economic benefits arising from present obligations of a company to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liabilities include both legal and nonlegal (but not illegal) obligations. A liability involves a present obligation that will be settled by a probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand. The obligated company is left little or no discretion to avoid the future sacrifice. The transaction or other event obligating the company has already happened. Nature and definition of current liabilities Current liabilities are obligations whose liquidation is reasonably expected to require the use of existing current assets or the creation of other current liabilities within one year or an operating cycle, whichever is longer. Information about liquidity (how quickly a liability can be paid, or its nearness to cash) is important to users because in part the prediction of future cash flows is based on the nearness to cash of liabilities and assets. Financial flexibility refers to a company's ability to use its financial resources to adapt to change. Financial flexibility primarily involves the management of cash and other resources. In addition, it includes the potential to create new current and long-term liabilities, to restructure existing debt, and to manage debt in other ways. The primary types of current liabilities are classified into three groups: (a) current liabilities having a definite amount; (b) current liabilities whose amounts depend on operations; and (c) current liabilities requiring amounts to be estimated. 3. Valuation of current liabilities Conceptually, all liabilities should be recorded at the present value of the future outlays they will require, and should be disclosed in a way that provides useful information about their liquidity. However, most current liabilities are measured, recorded, and reported at their maturity or face value. Usually the difference between maturity value and present value is not material. 4. Current liabilities having a contractual amount Because of the terms of contracts or the existence of laws, the amount and maturity of some current liabilities are known with reasonable certainty. Examples include trade accounts payable, notes payable, currently maturing portions of long-term debt, dividends payable, advances and refundable deposits, accrued liabilities, and unearned revenues. Trade accounts payable arise from the purchase of inventory, supplies, or services on an open charge-account basis. The amount to be recorded is based on the invoice received from the creditor. Theoretically, a company should record the liability net of any cash discount. However, in practice, the liability is recorded in two ways: using the gross price method (at the invoice price) or using the net price method (at the invoice price less the cash discount). Care must be taken that end-of-year purchases and liabilities are recorded in the proper accounting period, when economic control of (and legal title to) the goods passes. A note payable, which may be either long-term or short-term, is an unconditional written agreement to pay a sum of money to the bearer on a specific date. Notes arise out of either trade situations (the purchase of goods or services on credit) or bank borrowings. The interest inherent in a note payable may be either stated or implied in different ways. When a note is interest bearing, the principal amount (face value) recorded is the present value of the liability. Interest expense is recorded over the life of the note. When a note is non-interest-bearing, it is made out for the maturity value and discounted, and the borrower receives less than the face amount. The difference between the face amount and the amount received (the interest element or discount) is systematically recognized as interest expense over the life of the note. The discount currently remaining is shown on the balance sheet as a contra account to Notes Payable in order to report the net amount of the current liquidation value. Unearned items (sometimes called deferred revenues) are amounts which a company has collected in advance but has not earned or recorded as revenues. Unearned items should be properly classified as current or long-term liabilities. Examples include advance collections of interest, rent, subscriptions, or tickets. Such items are current unless more than one year (or one operating cycle, if longer) is required in the earning process, or if noncurrent assets primarily are used to earn the revenue. Current liabilities whose amounts depend on operations A sales tax is levied on the transfer of tangible personal property and on certain services. A seller must collect sales tax from the customer and must remit the amount to the proper governmental authority, usually monthly. Typically, the amount collected is recorded as a current liability until paid. Some small businesses, however, include sales taxes in the price of merchandise and credit the Sales account for the sum of the sales amount and sales taxes payable. In this case an adjusting entry is necessary when the remittance is due, to reduce the Sales account and create a current liability for sales taxes payable. Payroll taxes are paid by both the company (employer) and employee. Taxes withheld from employees' pay include federal and state (and sometimes local) income taxes payable by the employee, and the employee's social security (Federal Insurance Contribution Act or F.I.C.A.) taxes. Such withholdings are current liabilities of the employer until remitted. In addition, the employer must also pay taxes based on payroll, including employer's social security and unemployment insurance taxes. Employer payroll taxes are an expense and a liability. Bonuses may be given to certain employees, particularly officers and managers, as incentives. As additional salaries, bonuses are an operating expense of the corporation and are deductible in computing taxable income. A bonus obligation is recorded as an expense and a current liability when it has been earned by the employee and is pending payment. Current liabilities requiring amounts to be estimated Product warranties require the seller, for a specified period of time after the sale, to correct deficiencies in the quality, quantity, or performance of merchandise, or replace items, or refund the selling price. Theoretically, according to the matching principle a company estimates and records warranty expense and warranty obligation in the period of the sale. The expense warranty accrual method is the theoretically correct method. It requires recognition in the period of sale of the estimated warranty expense and warranty liability, with the warranty liability divided into current and long-term portions. The sales warranty accrual method separates accounting for these two components even when no separate service contract is involved. Under the modified cash basis, warranty costs are recorded as an expense during the period when warranty expenditures are made. This method is required for income tax reporting. It is also often used for financial reporting, although it is theoretically unsound because it violates the matching concept. Contingencies According to FASB Statement No. 5, a contingency is an existing condition, situation, or set of circumstances involving uncertainty that will ultimately be resolved when one or more events occur or fail to occur. This definition has three primary characteristics: (a) an existing condition, (b)?uncertainty as to the ultimate effect of this condition, and (c)?the resolution of the uncertainty based on one or more future events. The FASB used three terms describing the likelihood that a loss contingency will be confirmed: (a) probable - the future event (or events) is likely to occur, (b) reasonably possible - the chance of the future event occurring is more than remote but less than likely, (c) remote - the chance of the future event occurring is slight. A company accrues an estimated loss from a loss contingency in its accounts and reports the amount in its financial statements as a reduction of income and as a liability (or reduction of an asset) if (a)?it is probable that a loss has occurred, and that a future event or events will confirm the loss, and (b)?the amount of the loss can be reasonably estimated. If the two conditions have not been met, but it is reasonably possible that a loss may have been incurred, that loss contingency is disclosed in a note to the financial statements. Disclosure should indicate the nature of the contingency and give an estimate of the possible loss or range of loss, or state that such an estimate cannot be made. Certain contingencies where the possibility of loss is only remote are also disclosed in the notes to the financial statements. Following the convention of conservatism, and the revenue recognition criteria, gain contingencies usually are not accrued. Instead, they are disclosed in the notes to the financial statements. Other liability classification issues The classification of debt as short-term affects liquidity ratios such as current and acid-test ratios. In FASB Statement No. 6, the FASB issued guidelines on reporting short-term debt expected to be refinanced. Short-term obligations are excluded from current liabilities if (a)?there is an intent to refinance on a long-term basis, and (b) there is the ability to refinance. The ability to refinance must be demonstrated by either (a) the issue of long-term obligations or equity securities after the balance-sheet date but before issuance of the statements, or (b) a bona fide long-term financing agreement entered into before the balance sheet date. FASB Statement No. 78 requires that the entire amount of a long-term obligation be classified as a current liability if a violation of a provision of the debt agreement makes (or will make if the violation is not corrected) the liability callable within one year from the balance sheet date or within one operating cycle. Presentation of current liabilities in the financial statements The FASB has provided broad, rather than specific, guidelines for the presentation of assets and liabilities on the balance sheet. Most companies present current liabilities as the first classification under "Liabilities." Current liabilities are usually listed in order of the average length of maturities, or according to amount (largest to smallest), or in order of liquidation preference (the order of legal claims against assets). A description of all significant accounting policies is included as an integral part of the financial statements. Any major issue of significance affecting the measurement or disclosure of current liabilities is included in the notes to the financial statements. Other notes and other supplemental information regarding current liabilities are included when necessary for full disclosure. Lesson 11 LONG-TERM LIABILITIES AND RECEIVABLES Learning Objectives After careful study, students will be able to: 1. Explain the reasons for issuing long-term liabilities. 2. Understand the characteristics of bonds payable. 3. Record the issuance of bonds. 4. Amortize discounts and premiums using the straight-line method. 5. Compute the selling price of bonds. 6. Amortize discounts and premiums using the effective interest method. 7. Explain extinguishment of liabilities. 8. Understand bonds with equity characteristics. 9. Account for long-term notes payable. 10. Understand the disclosure of long-term liabilities. Teaching Hours 3 hours Teaching contents 1. Reasons for issuance of long-term liabilities Companies prefer to issue debt rather than other types of securities for four basic reasons: (a) Debt financing may be the only available source of funds if the company is too risky to attract equity investments; (b) Debt financing may have a lower cost because of the lesser risk associated with debt investments; (c) Debt financing offers an income tax advantage because the interest payments to debt holders are a tax deductible expense; (d) the voting privilege of stockholders is not shared with debt holders; and (e) debt financing offers the opportunity for leverage. 2. Bonds payable A bond is a type of note in which a company (the issuer) agrees to pay the holder (the lender) the face value at the maturity date and usually to pay periodic interest at a specified rate (the contract rate). Companies may issue several types of bonds with different characteristics, such as: (a) debenture bonds which are not secured by specific property; (b) mortgage bonds which are secured by a lien against specific property of the company; (c) registered bonds which require registration of ownership with the company and notification to the company in the event of transfer of ownership for interest to be paid; (d) coupon bonds which are unregistered and which pay interest to the holder presenting a coupon to the company; (e) zero-coupon bonds (deep discount bonds) which pay interest only at maturity; (f) callable bonds which the bondholder can be required by the company to return before the maturity date for a predetermined price and interest to date; (g) convertible bonds which can be exchanged by bondholders for a predetermined number of shares; and (h) serial bonds which are issued at one time but which mature in installments at future dates. when the bonds are sold, the actual rate of interest that must be paid in order to sell the bonds may be different from the contract (stated) rate because of changing market conditions. This actual rate is also called the effective rate, or yield. Rather than change the stated rate which is printed on the bond certificate, the selling price of the bonds is adjusted to achieve the demanded yield. If the yield and the contract rate are the same, the bonds are sold at par (their face value). If the yield demanded is greater than the contract rate, the selling price is less than the face value, and the bonds are sold at a discount. If the yield demanded is less than the contract rate, the selling price will be more than the face value, and the bonds are sold at a premium. When a company sells bonds, it credits the face value of the bonds to a Bonds Payable account. If the bonds are sold at a premium, the company credits the premium to an account entitled Premium on Bonds Payable, an adjunct account which is shown as an addition to Bonds Payable on the company's balance sheet. If the bonds are sold at a discount, the company debits the discount to an account entitled Discount on Bonds Payable, a contra account which is shown as a deduction from Bonds Payable on the company's balance sheet. The book value (carrying value) of a bond issue is the face value plus any unamortized premium or minus any unamortized discount. When a company sells bonds between interest dates, the company usually collects from the investor the interest which has accrued from the last payment date to the date of sale, in addition to the selling price. The amount of accrued interest to be paid is calculated by multiplying the face value by the stated interest rate times the fraction of the year since the last payment date. This amount is usually credited to Interest Expense on the issuance date. On the next interest payment date, the company pays the bondholders a full six months interest and debits the full amount to Interest Expense. The difference between these two entries is the interest expense that the company will report to date. By accounting for the interest expense and payment in this manner, the company reduces errors, and where a computerized system is used, a single routine may be developed for recording and distributing all interest payments. A company must amortize any premium or discount over the life of the bonds. When using the straight-line method, the company amortizes the discount or premium to interest expense in equal amounts each period by dividing the total discount or premium by the number of semiannual periods until maturity. If the bonds are sold at a discount, the recorded amount of interest expense (cash payment + discount amortization) will be higher than the cash paid, indicating that the effective interest rate is higher than the stated rate. If the bonds are sold at a premium, the recorded amount of interest expense (cash payment - premium amortization) will be lower than the cash paid, indicating that the effective interest rate is lower than the stated rate. When the effective interest method of amortization is used, the amount of discount or premium to be amortized is determined by finding the difference between the amount of interest expense and the actual cash payment. The amount of annual interest expense is calculated by multiplying the effective interest rate (yield) times the book value of the bonds (if semiannual interest payments are made, one-half the yield is multiplied times the book value). The effective interest rate is equal to the discount rate which equates the present value of the face value of the bonds plus the present value of the future interest payments with the cash proceeds. Because the book value is the face value plus any unamortized premium or minus any unamortized discount, the book value changes with each successive premium or discount amortization and thus reflects the present value of the remaining cash interest payments plus the present value of the future principal. This is consistent with the method of determining the issuance price of the bonds by discounting the future interest payments and the future principal using the effective interest rate. 3. Extinguishment of liabilities On the bond maturity date, a company repays the face value of the bonds to the bondholders. By this time, the book value equals the face value because any discount or premium has been completely amortized. When bonds are to be retired at maturity, the company reclassifies the bonds as a current liability on the balance sheet immediately before retirement. The entry to record the retirement includes a debit to Bonds Payable and a credit to Cash. Bonds may be retired prior to the scheduled maturity date either as a result of a call provision, which allows the company to recall the debt issue at a prestated percentage of the face value, or by purchasing the bonds on the open market. If the debt is not replaced with another issue, the extinguishment is called a debt retirement; if the debt is replaced with another debt issue, this type of extinguishment is called a refunding. The retirement or refunding of bonds prior to maturity usually results in either a gain or loss as measured by the difference between the current book value of the bonds (plus any unamortized bond issue costs) and the call price (or market price). A company recognizes the gain or loss in the period of recall (the current period) and includes the gain or loss in its income from continuing operations for that period. 4. Bonds with equity characteristics In order to increase the marketability of bonds, a company may issue bonds with detachable stock warrants (stock rights). The warrants (rights) represent the right of the investor to acquire a specified number of shares of common stock at a given price within a certain period of time. When the stock warrants are detached, the investor still retains the right to receive interest on the bonds. Because the warrants sell separately on the open market soon after issuance, a portion of the bond proceeds must be allocated to the stock warrants and accounted for as additional paid-in capital. Convertible bonds are another form of debt which a company may issue and which allows creditors to ultimately become stockholders. The conversion feature, which usually allows the bonds to be sold at a lower interest rate and/or a higher price, enables the bondholder to exchange the bonds for a specified number of shares of common stock. It would appear that the issuance of convertible bonds would in the same manner as bonds with detachable warrants by allocating a portion of the proceeds to the conversion feature. The conversion of the bonds into common stock may be accounted for by either of two methods. The book value method accounts for conversion to stockholders' equity (Common Stock and Additional Paid-in Capital) with no recognition of a gain or loss. The market value method records stockholders' equity at the market value of the shares issued on the date of conversion, and any loss that arises from a difference between the market value of the shares issued and the book value of the bonds on the conversion date is included in the company’s income from continuing operations for the period. 5. Long-term notes payable A company records a note at its present value, and uses the effective interest method to record subsequent interest, regardless of the note's legal structure. The effective interest rate is the discount rate which equates the face value with the present value of the note. If a company issues a noninterest-bearing note for cash, the note is assumed to have a present value equal to the cash proceeds, and the appropriate interest rate is determined by comparing the cash proceeds with the face value. The company debits any difference between the proceeds and the face value to Discounts on Notes Payable which is then amortized to Interest Expense over the life of the note by the effective interest method (as discussed earlier). Discount on Notes Payable is a contra account which is offset against the Notes Payable account on the company's balance sheet to determine the carrying (book) value of the note. In accounting for a note exchanged for cash and rights or privileges, such as the right to purchase goods from the borrower at less than prevailing prices, a company records the note at its present value at the time of issuance by discounting the maturity value using the borrower's incremental interest rate (the going market rate). The difference between the present value of the note and the cash proceeds is initially debited to Discount on Notes Payable and credited to Unearned Revenue. The discount is amortized to interest expense over the life of the note using the effective interest method. Revenue is recognized over the life of the contract using appropriate revenue recognition criteria. When a company exchanges a note solely for property, goods, or services in an external transaction, the stipulated rate of interest is presumed fair unless (a) no interest is stated; (b) the stated rate of interest is clearly unreasonable; or (c) the face value of the note is materially different from either the cash price of the property, goods, or services, or the fair value of the note at the date of the transaction. In any of these cases, the company records the note at the fair value of the note or fair value of the property, goods, or services, whichever is more reliable. If neither of the fair values is known, the present value of the note is determined by using the borrower's incremental interest rate to discount the future cash flows. Any difference between the value assigned to the property, goods, or services and the face value of the note is recorded as a discount and amortized to Interest Expense over the life of the note using the effective interest method. Lesson 12 INVESTMENTS Learning Objectives After careful study, students will be able to: 1. Explain the classification and valuation of investments. 2. Account for investments in debt and equity trading securities. 3. Account for investments in available-for-sale debt and equity securities. 4. Account for investments in held-to-maturity debt securities, including amortization of bond premiums and discounts. 5. Understand transfers and impairments. 6. Understand disclosures of investments. 7. Explain the conceptual issues regarding investments in marketable securities. 8. Account for investments using the equity method. Teaching Hours 3 hours Teaching contents 1. Investments: classification and valuation A corporation acquires securities of other corporations or of the government for several different reasons: to obtain additional income in the case of the investment of excess cash from the time of peak inflows until the next period of cash outflows, to create long-term relationships with suppliers, or to obtain significant influence over related companies. Investments in debt and equity "marketable" securities are classified at acquisition, and on subsequent reporting dates, into one of the following three categories: (a) Trading Securities, debt and equity securities purchased and held principally for the purpose of selling them in the near future. (b) Available-for-Sale Securities, debt securities not classified as held-to-maturity, and debt and equity securities not classified as trading securities. (c) Held-to-Maturity Debt Securities, those debt securities for which the company has the "positive intent and ability to hold the securities to maturity." 2. Investments in debt and equity trading securities According to GAAP, investments in debt and equity securities classified as trading securities are initially recorded at cost and subsequently reported at fair value. In addition, unrealized holding gains and losses (differences between the initial cost and the fair value at the balance sheet date) are included in net income of the current period, and interest and dividend revenue, as well as realized gains and losses on sales, are included in net income of the current period. 3. Investments in available-for-sale debt and equity securities The accounting principles for investments in available-for-sale debt and equity securities are: (a) the investment is initially recorded at cost, (b) it is subsequently reported at fair value, (c) unrealized holding gains and losses are reported as a component of other comprehensive income, and (d) interest and dividend revenue, as well as realized gains and losses on sales, are included in net income for the current period. The initial cost of investments in available-for-sale debt and equity securities includes the market price plus any brokerage fees and taxes. When a company purchases bonds between interest dates, any accrued interest paid for must be separated from the purchase price. The company records interest revenue as it is earned during the period whereas it records dividend revenue as it is received (or declared). The company records the initial cost of the investment in an account called Investment in Available-for-Sale Securities. At the balance sheet date, any unrealized holding gain (loss) is debited (credited) to an Allowance for Change in Value of Investment account, an adjunct/contra account to the Investment in Available-for-Sale Securities account, and credited (debited) to Unrealized Increase/Decrease in Value of Available-for-Sale Securities. The change in the Unrealized Increase/Decrease account is reported as a positive (negative) component of comprehensive income, while the balance of the account is reported as a positive (negative) element in the accumulated other comprehensive income section of stockholders' equity. A realized gain or loss on the sale of securities is recorded in an account called Gain (Loss) on Sale of Available-for-Sale Securities and reported in the company's income statement. It is measured as the difference between the selling price and the cost (of an equity security) or the amortized cost (of a debt security). The cumulative balance in both the Allowance account and the Unrealized Increase/Decrease account reported at the previous balance sheet date are also "reversed" out of the accounts (and the amount is reported as a "reclassification adjustment" in other comprehensive income). 4. Investments in held-to-maturity debt securities The generally accepted accounting principles for investments in held-to-maturity debt securities are: (a) the investment is initially recorded at cost, (b) it is subsequently reported at amortized cost, (c)?unrealized holding gains and losses are not recorded, and (d)?interest revenue and gains and losses on disposal (if any) are all included in income. A company records the acquisition price in the Investment in Held-to-Maturity Debt Securities account which is directly adjusted for any premium and discount amortization. If a company makes an investment in bonds that will be held-to-maturity between interest dates, the company must pay the previous owner for the interest earned since the last interest receipt. To record this payment, Interest Revenue is usually debited and Cash is credited. Then, upon receipt of the next interest payment the amount of interest received is debited to Cash and credited to Interest Revenue. The difference between the original debit to Interest Revenue and the subsequent credit to Interest Revenue reflects the correct amount of interest earned. The effective interest rate associated with the bonds purchased at a premium or discount is different from the stated interest rate. Therefore, a company must amortize any premium or discount associated with these investments in bonds to interest revenue over the remaining life of the bonds in order to assign the proper amount of interest revenue to each period. To account for premiums and discounts, the effective interest method (as described in Chapter 13) must be used unless the straight-line method does not result in a material difference in the amount of interest revenue recognized in any year. A company makes the adjustments for premium or discount amortization directly to the Investment account, which is always reported at its net carrying value on the company's balance sheet. The sale prior to maturity of an investment in bonds classified as being held-to-maturity should be rare. However, such a sale of appropriately classified securities may occur with certain changes of circumstances. When a company acquires held-to-maturity bonds at a premium or a discount between interest dates, the amortization of the premium or discount must take place over the remaining life of the bonds. On the first interest date after acquisition, the company credits Interest Revenue for the sum of the amount of accrued interest paid when the bonds were purchased plus the interest earned to date. The interest earned to date using the effective interest method is equal to the yield rate times the acquisition cost times the fraction of a year from the purchase date to the first interest date. The difference between the cash received and the credit to interest revenue is the premium (discount) amortization and is credited (debited) directly to Investment in Held-to-Maturity Debt Securities. When a company sells an investment in bonds being held-to-maturity prior to maturity, it will collect the sale price plus any interest earned since the last interest payment date. Before the company can determine the amount of the gain or loss on the sale, it must amortize any premium or discount on the bonds from the last interest date to the sales date. Then it compares the carrying value of the bonds with the sales price (excluding accrued interest) to determine the gain or loss. The gain or loss is normally reported as ordinary income (loss). 5. Transfers and impairments The transfer of a security between categories is accounted for at the fair value at the time of the transfer. In the journal entry to record the transfer, the fair value is used as the "new" investment carrying value, and the "old" investment carrying value is eliminated. Any related unrealized gain or loss varies depending on the type of transfer. In a transfer from the trading category, no additional accounting for the unrealized holding gain or loss is necessary because it has already been recognized in net income. For a transfer into the trading category, the previous unrealized holding gain or loss is eliminated and a gain or loss is included in net income. The gain (loss) is recorded in a Gain (Loss) on Transfer of Securities account. For a transfer into the available-for-sale category from the held-to-maturity category, an unrealized holding gain or loss is established and included in other comprehensive income. For a transfer of an available-for-sale debt security into the held-to-maturity category, the unrealized holding gain or loss on the available-for-sale security is eliminated, and an unrealized holding gain or loss on the held-to-maturity security is created for the same amount and included in other comprehensive income. This amount is amortized over the remaining life of the security as an adjustment of interest revenue by computing a new yield to maturity for that security. Impairment occurs when a decline in value below the amortized cost of the debt security classified as available-for-sale or held-to-maturity is deemed to be other than temporary, and it is, therefore, probable that an investor company will be unable to collect all amounts due. In such cases, the company writes down the amortized cost of the security to the fair value, and includes the amount of the write-down in net income as a realized loss. The fair value becomes the new "cost" and subsequent changes in fair value are accounted for as originally described. 6. Disclosures FASB Statement No. 115 requires the following disclosures related to investments in securities: (a) Trading Securities: the change in the net unrealized holding gain or loss included in each income statement must be disclosed; (b) Available-for-Sale Securities: disclosure includes for each balance sheet date, the aggregate fair value, gross unrealized holding gains and gross unrealized holding losses, amortized cost by major security type, and the contractual maturities of debt securities; and for each income statement period, the proceeds from sales and the gross realized gains and losses on those sales, the basis on which cost was determined, the gross gains and losses included in net income from transfers of securities from this category into the trading category, and the change in the net unrealized holding gain or loss included as a separate component of other comprehensive income; (c)?Held-to-Maturity Debt Securities: disclosure includes, for each balance sheet date, the aggregate fair value, gross unrealized holding gains or losses, amortized cost by major security type, and contractual maturities; as well as for any sales or transfers from this category, the amortized cost, the related realized or unrealized gain or loss, and the circumstances leading to the decision to sell or transfer the security. 7. Financial statement classification Investments in trading securities are classified as current assets. Investments in available-for-sale securities are classified as current assets if they will be sold within one year or the operating cycle, whichever is longer. Otherwise, they are noncurrent. Investments in held-to-maturity debt securities are classified as noncurrent assets unless they mature within the next year. 8. Equity method The equity method of accounting (a) acknowledges the existence of a material economic relationship between the investor and the investee, (b)?is based upon the requirements of accrual accounting, and (c)?reflects the change in stockholders' equity of the investee company. APB Opinion No. 18 stipulates that an investor must use the equity method to account for an investment in equity securities if the ownership allows the investor to exercise significant influence over the operating and financial policies of an investee. Generally speaking, this presumption is made if the investment is 20% or more of the outstanding common stock. In every case, however, the degree of influence in the investee company and not the percentage ownership is the determining factor. Therefore, certain circumstances preclude the use of the method even though 20% or more of the investee's common stock is held, and other circumstances mandate the use of the method even though less than 20% of the common stock is held. Under the equity method, the investor uses following accounting procedures: (a) The investment in common stock is originally recorded at cost; (b) Dividends received are recorded as reductions in the carrying value of the investment account; (c) A proportionate share (based on percentage ownership) of the investee's reported net income (loss) is recognized as income. If the investee has both ordinary and extraordinary income, the investor must also account for the income using two accounts. In addition, certain adjustments are made on the investment income of the investor as follows: (1) The effects of any intercompany transactions on investor net income are eliminated; (2) A proportionate share of the difference between the fair values and book values of the investee depreciable assets implied by the acquisition price of the investee assets is depreciated over the remaining useful life; [Any purchased goodwill is not amortized but is reviewed for impairment and, if necessary, an impairment loss is recognized and the investment account is reduced]; and (3) Proportionate shares of investee extraordinary items, results of discontinued operations, and cumulative effects of changes in accounting principles are treated likewise by the investor. The investor discloses the carrying value of the Investment in Stock account (determined by adding the investor's share of investee net income and subtracting dividends, depreciation, and any goodwill impairment) in the long-term investment section of its balance sheet. The investor discloses the total amount of its share of the investee's net income (as adjusted) on its income statement. The notes to the financial statements include a schedule reconciling the investor's share of the investee's ordinary income with the net investment income reported as Other Revenue. Lesson 13 CONTRIBUTED CAPITAL Learning Objectives After careful study, students will be able to: 1. Explain the corporate form of organization. 2. Know the rights and terms that apply to capital stock. 3. Account for the issuance of capital stock. 4. Describe the characteristics of preferred stock. 5. Know the components of contributed capital. Teaching Hours 1.5 hours Teaching contents 1. Introduction A corporation is a legal entity, separate and distinct from its individual owners, created under the laws of a particular state. As a result, the corporation has an unlimited life, owners have limited legal liability, and ownership interests (stocks) are easily transferable. Corporations may be classified as private or public, open or closed, domestic or foreign. Equity in a company is the ownership interest in the company and may be calculated as the difference between assets and liabilities. Equity in a company is first created by owners' investments in the company. Subsequently, the value of the equity is changed by net income (loss), additional investments by owners, and distributions to owners. 2. Corporate capital structure The individual owners are called stockholders whose ownership in the corporation is evidenced by a stock certificate. Each stockholder has various stockholder's rights which include (a) the right to share in profits when a dividend is declared, (b) the right to elect directors and to establish corporate policies, (c)?the preemptive right to maintain a proportionate interest in the ownership of the corporation by purchasing a proportionate share of additional capital stock, if such stock is issued, and (d) the right to share in the distribution of the assets of the corporation if it is liquidated. Common stock has all these rights; preferred stock does not, but has certain other privileges. Authorized capital stock is the number of shares of capital stock which may be issued as stated in the corporate charter. Issued capital stock is the number of shares actually issued as of a specific date. Outstanding capital stock is the number of shares issued to stockholders which are still being held by them. Treasury stock is the number of shares of capital stock which were issued to stockholders and were later reacquired by the corporation but not retired. Issued shares less outstanding shares equals treasury stock. Subscribed capital stock is the number of shares of capital stock that will be issued upon completion of an installment purchase contract with an investor. To protect the creditors of the corporation, states limit the amount of stockholders' equity which can be distributed to the stockholders. Although the amounts vary from state to state, the amount which cannot be distributed is the legal capital. Generally the par value or stated value of the issued capital stock is some or all of the legal capital. Additional paid-in capital arises in a capital stock transaction when the exchange price (market value) of the stock is higher than the par or stated value of the stock. Sound accounting practice, as well as certain state laws, requires a corporation to identify, measure, and record this excess. The stockholders' equity portion of the balance sheet discloses the corporation's capital structure in three sections: (a) Contributed Capital, the total amount invested by stockholders as a result of all corporate stock transactions, (b) Retained Earnings, corporate net income reinvested in the corporation, and (c) Accumulated Other Comprehensive Income. 3. Issuance of capital stock When the stock is issued for cash, Cash is debited, the capital stock account (e.g., Common Stock) is credited with the par or stated value, and the Additional Paid-in Capital account is credited with the difference. Any stock issuance costs related directly to the initial issuance of stock are recorded as an expense. Costs associated with subsequent issuances of stock reduce the proceeds, and Additional Paid-in Capital is reduced (debited) when the costs are paid. Investors may enter into a legally binding contract to purchase a certain number of shares of capital stock at an agreed-upon price with payment spread over a specified time period. The total amount of the stock subscription is recorded by a debit to Subscriptions Receivable: Capital Stock. This account is generally listed as a current asset, although for SEC reporting it is listed as a contra-stockholders' equity account. At the same time, Capital Stock Subscribed is credited with the par or stated value of the stock (or the entire subscription price for no-par, no stated value stock) and is included in the Contributed Capital section of stockholders' equity because the corporation has a legal contract to issue additional stock. Additional Paid-in Capital may also be credited for the difference between the subscription price and the par value of the subscribed stock. When the subscribed stock is fully paid for, the shares are issued to the stockholder, the receivable is credited, and the Capital Stock Subscribed is transferred to the Capital Stock account. When a corporation issues two or more classes of securities in a single "package" transaction, the selling price of the package may be less than what would have been received if each class of securities had been sold separately. Therefore, the corporation allocates the selling price to each class based upon the individual relative fair value of each class. If only one market value is known, that value is assigned to that security and the remainder of the proceeds are assigned to the other security. If no fair values are known, an arbitrary amount may be assigned to each class. Adjustments may be required subsequently when fair values become known. When recording the issuance, the market value is separated into the par value and additional paid-in capital. A nonmonetary exchange occurs when a corporation issues stock in exchange for assets other than cash. Generally, the corporation records the transaction at the fair value of the stock issued or the asset received, whichever is more reliable. Where fair values are unknown, assigned values may be used. The assignment is made by the corporate board of directors and must be carefully made to avoid watered stock (overstatement of assets and a corresponding overstatement of stockholders' equity) or secret reserves (understatement of assets and stockholders' equity). A stock split or stock split-up may be necessary to reduce the market price of a corporation's common stock so that it falls within the "trading range" of most investors. If the stock split is proportionate, it results in a decrease in the par value per share of stock accompanied by a proportional increase in the number of shares authorized and issued and no change in total stockholders' equity. It is recorded by a memorandum entry that indicates the new par value, the total number of shares issued, and the impact on the number of authorized shares. A disproportionate stock split results in a reduction in par value that is not proportionate to the increase in the number of shares. While total stockholders' equity is not affected, the balances of the individual contributed capital accounts are changed. Stock rights may be, issued to current stockholders to allow them to exercise their preemptive right (the opportunity to maintain their proportionate share in the corporation by purchasing additional shares before they are issued to the public) or to encourage rapid sale of a new issue. Stock rights usually allow the stock to be purchased at a price lower than the market value of the stock, thus each right acquires a value. The exercise of the rights is recorded by the usual journal entries to record a stock issuance, while the expiration of any rights is recorded by another memorandum entry. 4. Preferred stock characteristics A preference to dividends is one right preferred stockholders have. That is, preferred stockholders must receive dividends before common stockholders, but only if dividends are declared. These dividends are usually expressed as a percentage of par value or as a specified dollar amount per share. Unless stipulated otherwise, the preferred stockholder has full voting rights. If a dividend on preferred stock is not declared in a particular year, but the undeclared dividends must be accumulated and paid in a later year when dividends are declared, the undeclared dividends are referred to as dividends in arrears and the stock is cumulative preferred stock. Otherwise the preferred stock is noncumulative. Preferred stockholders of cumulative preferred stock must be paid all dividends in arrears before any dividends may be paid to common stockholders. Preferred stock may also provide for preferred stockholders to share with common stockholders in any "extra" dividends that remain after dividends in arrears, preferred dividends, and common dividends at a rate per share equal to that paid on preferred stock are paid. If the extra dividends are shared proportionately (relative to the respective par values) the stock is fully participating preferred stock. If the share in extra dividends is limited to a fixed rate or amount per share, the stock is partially participating preferred stock. Preferred stockholders usually have preference in liquidation over the common stockholders (but after creditors) with respect to the corporate assets. The preference may be expressed as a percentage of (or equal to) the par value and may require the payment of dividends in arrears. 5. Contributed capital section The results of stock transactions are listed in a contributed capital section of stockholders' equity on the balance sheet and are usually disclosed in the following manner: Contributed capital Capital stock Par value of preferred stock Par value of common stock Common (or preferred) stock subscribed Additional paid-in capital On preferred stock On common stock From other sources (stock splits, preferred stock conversions) Additional disclosures include the par value of each share; number of shares authorized, issued, and outstanding; preferred dividend rate; preferred stock characteristics; dividends in arrears; and any other relevant information. These disclosures may be presented either parenthetically or in a note to the financial statements. Lesson 14 EARNINGS PER SHARE AND RETAINED EARNINGS Learning Objectives After careful study, students will be able to: 1. Know the equation for computing basic EPS. 2. Understand how to compute the weighted average common shares for EPS. 3. Identify the potential common shares included in diluted EPS. 4. Apply the treasury stock method for including stock options and warrants in diluted EPS. 5. Calculate the impact of a convertible security on diluted EPS. 6. Compute diluted EPS. 7. Record the declaration and payment of cash dividends. 8. Account for a property dividend. 9. Understand how to report accumulated other comprehensive income. Teaching Hours 2.5 hours Teaching contents 1. Conceptual overview and uses of earnings per share information External decision makers often consider earnings per share to be the best single measure for summarizing a corporation's performance. Earnings per share information is helpful to users in evaluating a corporation's return on investment and risk. Earnings per share can be used to predict future cash flows per share, to compare intercompany performance using the price/earnings ratio, and to indicate the potential impact of the issuance of common stock options, convertible debt, or convertible preferred stock on future earnings per share. 2. Basic earnings per share For a simple capital structure, basic earnings per share is required for reporting purposes and is computed using the following equation: The numerator on the right side of this equation equals only the earnings available to common stockholders. Included in the preferred dividends of the numerator are dividends on noncumulative preferred stock that have been declared, as well as the current dividends on cumulative preferred stock whether or not they have been declared. The weighted average number of common shares outstanding in the denominator of the above equation is the number of common shares outstanding at the end of the accounting period if no shares have been issued or reacquired during the year. If a corporation has issued or reacquired shares of common stock, a weighted average of these shares must be calculated by (a) determining the number of shares outstanding for each portion of the year(b) multiplying each number times the fraction of the year the shares were outstanding to get (c) the equivalent whole units of shares outstanding, and (d) summing the equivalent whole units for each fraction of the year. The result is the total weighted average common shares. The weighted average number of common shares must also be adjusted for stock dividends and stock splits which are given retroactive recognition and assumed to have occurred at the beginning of the earliest comparative period. A corporation reports separate earnings per share for income from continuing operations and net income. If there are any results from discontinued operations, extraordinary items, or cumulative effects of changes in accounting principles, separate earnings per share are shown for each of these items. Each component of earnings per share is based on the same weighted average number of shares. Earnings per share for each of the aforementioned items may be reported on the income statement in a schedule directly below the net income or in the notes to the financial statements. When reported on the income statement, the components are summed to show the contribution of each income statement item to the total earnings per share. 3. Diluted earnings per share A complex capital structure includes potential common shares which can be used by the holder to acquire common stock. Potential common shares include stock options and warrants, convertible preferred stocks and bonds, participating securities and two-class stocks, and contingent shares. Diluted earnings per share shows the earnings per share after including all potential common shares that would reduce earnings per share. A potential common share is included in the earnings per share calculation only when it has a dilutive effect for that particular period. In order to evaluate the dilutive effect of each security, the potential common shares must be included in the diluted earnings-per-share (DEPS) calculation in a particular order. The following sequence should be used: (a) compute the basic earnings per share; (b) include dilutive stock options and warrants, and compute a tentative DEPS; (c) develop a ranking of each convertible preferred stock and convertible bond on DEPS; (d)?include each dilutive convertible security in DEPS in a sequential order based on the ranking and compute a new tentative DEPS; and (e) select as the diluted earnings per share the lowest computed tentative DEPS. Stock options and warrants are always considered first in the diluted earnings per share calculations and are included in diluted earnings per share only if they are dilutive. The treasury stock method is used to determine the impact of the options and warrants upon the number of common shares. The impact is computed on the assumption that the options were exercised at the beginning of the period (or at the time of the issuance, if later), and that the assumed proceeds obtained from the exercise were used to reacquire common stock at the average market price during the period. If the assumed shares issued exceed the assumed shares reacquired, the effect is a dilution of earnings per share. This occurs whenever the average market price is greater than the option price. The incremental shares resulting from the assumed exercise of the options or warrants are then added to the denominator of the basic earnings per share and used to compute diluted earnings per share. The original numerator is used. The resulting diluted earnings per share is final if no convertible securities are outstanding. Convertible securities are considered for inclusion in diluted earnings per share after stock options and warrants and are included only if dilutive. Convertible securities are evaluated in a specified sequence to avoid including a security which is antidilutive in combination with other securities. In order to develop a ranking of the impact of each convertible security on DEPS, the if-converted method is used. Each convertible security is assumed to have been converted into common shares, and then by dividing the resulting increase in the numerator of the earnings-per-share equation by the resulting increase in the denominator, a numerical value is calculated to use in ranking the impact on diluted earnings per share. The security with the lowest numerical impact causes the greatest decrease in diluted earnings per share and is the most dilutive. Beginning with the convertible security having the lowest numerical impact on DEPS, each security is included in a tentative diluted earnings per share calculation until the tentative diluted earnings per share is less than the numerical impact of the next convertible security in the ranking. The final diluted earnings per share is the last tentative figure. 4. Content of retained earnings Retained earnings is the section of stockholders' equity that summarizes the lifetime income of the corporation that has been retained for use in the corporation and not distributed to stockholders in the form of dividends. It links the income statement with the balance sheet. The main items affecting retained earnings are: net income, dividends, prior period adjustments, and appropriations. 5. Dividends Unless stated otherwise, the term "dividend" refers to a cash dividend, the most common type of dividend. Four significant dates are associated with cash dividends as well as all other types of dividends. On the date of declaration of a dividend, the board of directors creates a legal liability when it formally declares that a dividend will be paid to stockholders of record on a specific future date. Prior to payment, Dividends Payable is normally classified as a current liability on the balance sheet. Stock sold after the date of declaration sells "with dividends attached" (at a higher market price that includes the amount of the future dividend payment) until the ex-dividend date when the stock begins selling without the declared dividend. The date of record falls several days after the ex-dividend date to allow the stockholders' ledger to be updated. All stockholders listed in the stockholders’ ledger as of the date of record are eligible to receive the dividend. A property dividend is payable in assets other than cash and typically takes the form of marketable securities held in other companies. This type of dividend is a nonreciprocal nonmonetary transfer to owners (a one-way nonmonetary exchange). On the date of declaration, the asset to be distributed is revalued to its fair value, a gain or loss is recognized, and the liability is recorded. A scrip dividend is a promissory note to pay a dividend at some future date and may include interest. The dividend liability is recorded on the date of declaration, and interest expense is accrued until the date of payment. On the payment date the interest paid must be recorded as an expense separately from the dividend. The classification of Scrip Dividends Payable on the balance sheet is dependent upon the expected maturity date. A corporation may declare a stock dividend issuing shares of its own stock to the stockholders on a pro rata (proportional) basis according to the number of shares each stockholder already owns. In an ordinary stock dividend, shares of the same class of stock (e.g., common stock dividend on common stock outstanding) are issued, while in a special stock dividend a different class of stock (e.g., common on preferred or preferred on common) is issued. No assets are distributed in a stock dividend. Each stockholder maintains the same percentage ownership, and the only change in stockholders' equity is a rearrangement of certain stockholders' equity accounts depending on whether the stock dividend is "large" or "small." From an accounting point of view, a stock dividend is treated as a simultaneous sale of stock and payment of dividend. Liquidating dividends represent a return of contributed capital and may occur when a corporation is ceasing operations, reducing its size, or when a natural resources corporation pays a dividend based on earnings before depletion. The normal portion of a dividend which is, in part, a liquidating dividend is recorded as a reduction in retained earnings, and the liquidation portion is recorded as a reduction of contributed capital. Full disclosure in a note to the financial statements is essential so that stockholders realize that a portion of contributed capital is being returned. 6. Prior period adjustments Correction of all such material errors, as well as certain changes in accounting principles, and a change in accounting entity, are treated as prior period adjustments (restatements) of retained earnings. A prior period adjustment is recorded (net of income taxes) as an adjustment of the beginning balance of retained earnings. 7. Appropriations of retained earnings An appropriation (or restriction) of retained earnings means that a corporation's board of directors restricts retained earnings or makes a portion of retained earnings unavailable for dividends. The appropriation may be made to meet legal requirements, to meet contractual requirements, or because of discretionary actions. 8. Statement of retained earnings Changes in retained earnings may be reported in a separate statement of retained earnings, in the statement of changes in stockholders' equity, or as a supporting schedule directly beneath the income statement. A retained earnings statement usually includes only adjustments to retained earnings for net income and dividends. 9. Accumulated other comprehensive income Other comprehensive income (loss) might include four items: (1)?unrealized increases (gains) or decreases (losses) in the market (fair) value of investments in available-for-sale securities; (2)?translation adjustments from converting the financial statements of a company's foreign operations into U.S. dollars; (3) certain gains and losses on "derivative" financial instruments, and (4) certain pension liability adjustments. A corporation includes its other comprehensive income (or loss) accumulated to date in its accumulated other comprehensive income (or loss) amount which it reports in its stockholders' equity.