Thursday, November 20, 2008

Studying for the Final - Part 3

Journal Entries to Know:

Ch 8
Separately Stated Interest
Dividends at declaration, record and payment dates
Recording and payment of wages
Payroll Taxes and Benefits
Estimated Income Taxes
Product Warranties
Contingent Liabilities

Ch 9
Initial purchase of a long-term asset
Depreciation of a Long-Term Asset
Ordinary repair and maintenance of long-term assets
Extraordinary repair that extends useful life of assets
Additions and betterments of long-term assets
Sale/disposal of an asset at a loss
Sale of an asset at a gain

Ch 10
Bond issued at face value
Payment of bond interest
Bond issued at a discount
Bond issues at a premium
Amortization of bond discount
Retirement of bond issued at a premium with loss/gain on retirement
Retirement of bond issued at a discount with loss/gain on retirement
Conversion of bond issued at a premium
Conversion of bond issued at a discount
On signing a long-term lease
Lease payments
Estimated Pension Liabilities
Funding of Pension Liabilities
Estimated Post-Retirement Benefits
Funding of Post-Retirement Benefits

Studying for the Final - Part 2

Multi-Step Income Statement

Know what to subtract from each item to get from..

Net Sales
Gross Margin
Operating Income
Net Income Before Taxes
Net Income

Studying for the Final - Part 1

There's a lot of material for this exam. Here are the figures and ratios that I'm reviewing:

Working Capital
Current Ratio

Receivables Turnover
Days in Receivables

Inventory Turnover
Days in Inventory

Profit Margin
Asset Turnover
Return on Assets
Return on Equity

Debt to Equity
Interest Coverage

Free Cash Flow

Price/Earnings Ratio
Dividend Yield

Thursday, November 13, 2008

Lecture 10 - Income and Equity Statements

Income and Equity Statements

Quality of Earnings

Everyone looks at the bottom line.

If everyone has the same bottom line (net income), are they equivalent - comparable quality of earnings?

All-inclusive concept requires extraordinary items to be included. However, this can pump up earnings artificially. To the extent that income is attributable to continued operating income, it shows a higher quality of earnings.
Another example: Income from discontinued operations.
See page 613 for examples.

Income Taxes

Depreciation may be different between financial accounting and tax accounting. (Straight line for FA and accelerated for TA)

To resolve this problem, use interperiod income tax allocation. See example in class slides.

To adjust in the first year...
Dr. Provision for taxes 200
--- Cr. Tax Liability 120
--- Cr. Deferred Taxes 80

In the following year...
Dr. Provision for Income Tax 200
Dr. Deferred Taxes 80 (eliminate the previous years' credit)
--- Cr. Tax Liability 280

Discontinued Operations

Notify analysts that some of income is from operations that are no longer going on.
Report the Income from these ops and the gain/loss on disposition of assets.

Ordinary income is the income from continuing operations.

Separate the reporting of the income tax expense from ordinary and taxes from discontinued ops. This is intraperiod income tax allocation.

See example in class slides (pg. 9-15)

Extraordinary Items

Separately disclosed so the reader knows it's not likely to continue. Exact definition is not clear. Standard definition is that it's "extraordinary" if it's "the result of an unusual event and infrequent."

Presented just like discontinued operations and net of tax.

All such income is presented before net income.

Earnings Per Share

Was formerly a very difficult topic on the CPA exam.

It's for common shares only. Subtract out those earnings that are attributable to preferred shares - dividends.

Compute for each component:
Operating income per share
Extraordinary items per share
Net income

Must use a weighted average of shares outstanding throughout the year, not the simplified average that we use with some of the ratios.

Options or other securities that could be converted to common stock are “dilutive” and result in a lower earnings per share. Do an additional calculation based on an assumption that those securities get converted to get a diluted eps. Converting bonds will increase the denominator (# of shares outstanding) but may also increase the numerator also because there will be less interest to pay on those bonds.

Statement of Stockholders’ Equity

The details of this statement are not material for the exam. But there is usually a statement of stockholders’ equity, not just retained earning.

This statement will have information on common stock, preferred stock and other capital accounts in addition to retained earnings.

Unrealized gain/loss on available for sale securities and foreign currency conversion adjustments were once reported in the statement of shareholders’ equity. FASB then required them to appear on the balance sheet and to report “comprehensive income” Some companies start with net income and add items to get to comprehensive income. Apple embeds it in the calculation of net income.

Stock Dividend

Issuance of addition stock as a dividend. These have the advantage that they are not taxable to the shareholders and if they need the cash, they can always sell it.

Note: We’re not covering entries on declaration, record and distribution dates.

Stock Split

Cancels old shares and issues 2x new shares. Why? Makes the shares more affordable for investors.

There are also occasionally reverse splits. Why? Because shares could be delisted if the share price is too low.

No entries are required for stock splits.

Book Value (or Book Value per Share)

Equity attributable to common shares of stock
Equity attributable to

Assets 2,000,000
Liabilities 1,000,000
Owner’s Equity 1,000,000

1,000,000 shares of common stock outstanding

Book value is 1,000,000
Book value per share is $1.00

Ex 2:
Say there was 200,000 common share and 800,000 preferred
Book value per share is $0.80

Ex 3: If preferred stock was callable at 102, reduce the
1,000,000 – 1.02(200,000) / 1,000,000

How valuable is this number? It doesn’t mean that much, it’s hard to interpret. Nonetheless, people give it attention “we paid 5x book value”.

Cash Flow Statement

Required in order to give audited statement. Hard to derive information from other statements. Possible, but difficult.

Focus is on the change in cash balances. If you just look at the bottom line, it’ll be hard to interpret what impacted the cash flow. The source is more important than the amount.

Explains the net increase/decrease in cash by explaining the cash flow from:
Operating activities
Investing activities – of the firm itself. Firm sold some assets to generate cash
Financing activities – raising cash from debt or equity

Some things that are done directly are prepared on separate schedule (ex: issuing shares to purchase a building, if done in one transaction.)

Two methods: direct and indirect. Book only covers indirect (formerly covered both), and we will only cover it also.

Indirect method: Starts with net income and adjusts it to convert to cash flows from operations.

How do we get there?

We assume that net income is a first approximation of cash flow. But some things are not and we need to adjust for those.

On the revenue side, Ex: accounts receivable. It increases the AR asset account but doesn’t affect the Cash account.

So we subtract out any increases in current assets.

We must also subtract out any decreases in current liabilities

On the expense side,
We must add in the increases in current liabilities and…
Add back in the decreases in current assets

How do we handle depreciation and other non-cash expenses? They are expenses that do not involve real cash flows. So add it back in to the net income.

How do we handle gains and losses?
Typically, the entry for the sale of an asset is…
Dr. Cash
Dr. Accum Depr
Cr. Asset
Cr. Gain

Gain shows up in the income statement. But we don’t want that gain in the cash flow. We’re interested in the Cash amount. So deduct any gains and add in any losses.

Some ppl talk about the “cash flow generated from depreciation”. Although it’s a positive number that is added to net income, it’s really not accurate to call it a cash flow. It’s an adjustment.

Cash flow from Investing Activities and Sale of Plant Assets

See examples in class slides.

Friday, November 7, 2008

Lecture 9 - Contributed Capital

Contributed Capital

This only applies to corporations. Sole proprietorship and partnerships are easier.

Limited liability is a benefit – owner is not personally liable, encourages risk-taking, easier to raise capital by selling stock

Lack of mutual agency – in a partnership, one of the partners can obligate the partnership. In a corporation, only officers of the corporation can.

Death of a corporate owner (shareholder) does not affect the corporation.

Disadvantages include govt regulation, taxation, limited liability (may not be able to raise capital from banks due to limited liability) and separation of ownership and control (mgmt may not do what shareholders want).

Ratio Analysis

Dividend Yield = dividends per share / market price per share

Use this to compare to bank interest rate or bonds. Even if it’s less, may be ok due to appreciation of share price.

P/E Ratio = price per share / earnings per share

ROE shows how effectively company is using its assets.
ROE = net income / avg stockholders equity
ROE can be manipulated

Common stock par value
Common stock excess over par

Ex: issuing 100 shares at $18/share with $10 par value per share
Par value 1000
Excess over par 800

Some states have statues against paying dividends from par value.

Some financial statements don’t have a par value (if not required by the state).
Preferred stock

Always has a par value and it’s relevant. It’s an expected dividend. In some sense similar to a bond.

Its dividends are preferred before common stock holders get theirs.

Preferred stock can be non-cumulative and the amounts skipped in prior years are just gone. They can also be cumulative

Convertible preferred shares

Can be convertible from preferred to common shares

Callable preferred stock

Allows the company to buy back the preferred stock.

Treasury stock

Company buys back its stock and puts it in its “treasury”
Issued-treasury = outstanding
Why buy back?
Prevents hostile takeover
To boost earnings per share

Dr. Treasury stock
--- Cr. Cash

Shows up as a reduction of owners equity

On resale of treasury stock, no gain or loss is recognized on the purchase or sale of treasury stock.

Compensatory Stock Options

Usually issued at current market price.

Revised Fasb 123 deals with this. Either record it or put it in the footnotes. They chose to put it in footnotes, of course.

This hiding of compensation expenses and the motivating of officers to manipulate income contributed to the collapse of Enron.

Lecture 9 - Long-Term Leases and Pension Obligations

Long-Term Leases

Leases are similar to borrowing money. Sometimes you have to record it in the same way.

Usually, there’s nothing on the books when you sign the lease. Then record the lease expenses as incurred.

If it’s a big capital lease, like an airplane, and the lease covers the length of the useful life (ex. 20 years), you may be required to record it as if you purchased it:
Dr. Leased Equipment
--- Cr. Lease Obligation

When you make a lease payment,
Dr. Lease Obligation
Dr. Interest expense
--- Cr. Cash

We won’t go through how you make the calculations for the amounts of the lease obligation and the interest.

At the end of the year, depreciate it:
Dr. Depreciation expense leased equipment
--- Cr. Accumulated depreciation on leased equipment

Guidelines and criteria for using capital leasing approach
- how much of the useful life of the asset does the lease cover
- do you have the option to purchase the underlying property at a low rate

Pension Obligations

Defined contribution vs. Defined benefit plan (per ERISA)

Defined benefit plan – employer says to employee: after you retire, assuming you’ve been with the firm for 20 year, we’ll pay you a retirement benefit of 80% of the highest salary you received with the firm. Employer bears the risk of adverse investments. PBGC (pension benefit guarantee corp) guarantees/insures the pension fund.

Defined contribution plan – you and the employer or both (optionally) make contributions to a fund (some tax benefits). When you retire, you can take those funds as a lump sum or an annuity. Employee bears the risk of adverse investment yield. No long term liability for the firm. No need for special accounting.

With Defined benefit plans we need special accounting for the firm’s liability. You must estimate the retirement cost of current employees incurred this year (via actuarial methods).
Dr. Pension Expense
--- Cr. Liability for pensions
Dr. Pension Liability
--- Cr. Cash

If this balances out, you’ll have zero net liability. That would be a “fully funded” pension plan. If not, it’s unfunded pension liability.

Many companies are going from defined benefit plans to defined contribution plans.

Another type of expense on the books that should be recorded today rather than when it’s paid out later – medical expenses to be covered after retirement. Year’s ago, it wasn’t on the books until it was incurred. Now, it’s accounted for like pension plans.
Dr. Post Ret. Med Expense
--- Cr. Liability for Post Ret. Exp
Dr. Liability for Post Ret. Exp
--- Cr. Cash

These expenses can be hugely significant. Many companies canceled/discontinued these plans.

Thursday, November 6, 2008

Lecture 9 - Bonds (cont.)

Amortizing the Discount

Over some period of time, you need to get the discount down to zero. You go thru the process at each payment date. Credit to Cash the amount that you have to pay out (interest rate x face value). Credit the Discount also to reduce it.

Interest Expense as a percentage of the carry value of the bond will be greater than the interest rate on the bond since it has to be the sum of the amount creditted to Cash (the interest amount) plus the amount of the discount being amortized.

Bond face value is 1,000,000
interest rate 5% per year
term = 20 years
interest is paid semi annually

cash payment is 5% of 1,000,000 = 50,000 per year. for half a year, it's 25,000. therefore, credit Cash 25,000. discount is 100,000. amortize over 40 payment periods - 2,500 per period. therefore, credit Discount 2,500. and the Debit Interest Expense 25,000+2,500 = 27,500.

Journal Entries:
Dr. Interest Expense 27,500
--- Cr. Discount 2,500
--- Cr. Cash 25,000

Bonds Bought/Sold between Interest Payment Dates

You're not entitled to the entire next interest payment. Issuing company just pays the full amount to the bond holder at the end of the period. The buyer pays the cost of the bond plus the accrued interest until the time of the sale. (Not covering calculations in detail.)

Retirement of Bonds

The issuing company may call back bonds. This usually happens when the market rate for the bond is going down because interest rates are going down. These are called "Callable Bonds". Even if a bond is not callable, the company may buy them back on the open market.

Getting the bond back

Retirement of Bonds

If interest rates go down and you decide to purchase on the open market one set of bonds and issue a new set at a lower rate, are you likely to recognize a loss on early retirement of the bond.

Even though this incurs a loss, in the long run it may well be in the best interest of the company to redeem the bonds and reissue at a lower rate.

Conversion of Bonds

This refers to converting bonds into stock.

Ex: bond issue is $1,000,000. 1000 bonds worth $1000 each. Each bond is convertible into 40 shares of common stock. Common Stock is selling at $15/share. Converting at this point is not a good idea since it would only bring in $600.

But in the long run, the ability to convert is valuable in case common stock goes up. This is known as an “equity kicker”. As a buyer, you may be willing to pay more for a convertible bond, i.e. be willing to accept a lower interest rate.

If later the stock price is $30. Then, it would be in your interest to convert. This could be good for the company as well.

Journal entries to move bond entries to equity accounts
Dr. Bonds Payable
Dr. Premium (either/or)
Cr. Discount (either/or)
Cr. Common Stock
Cr. Additional PIC (paid-in capital)