Modules 5, 6, 7, 8, 9, 11

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Performance Obligations Satisfied Over Time: Prepayments by the Customer

when a company receives cash in advance of incurring costs under the contract, it records a liability that represents the obligation to deliver the product for which it has been paid.

When is an investing company in "control" of an investee company? --what does GAAP mandate in such a situation?

when stock investment is more than 50% of the investee company's total voting shares *(is this the only situation where this occurs?)* Reporting of the investee company's assets; except all inter-company sales, expeneses, receivables, payable are eliminated in the consolidation process.

after dec 5th, 2017, what is necessary for a company to recognize revenue from a sale?

when the company's *performance obligation under the contract is satisfied* revenue can be recognized -e.g., for the good to be transferred or the service performed

***Employee Restructuring and Severance Costs

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**[MOD 9] Intercorporate Investments** Analysis Implications (of ??)

Because the assets and liabilities are left off the investor's balance sheet, and because the sales and expenses are omitted from the investor's income statement, the components of ROE are markedly affected as follows. Net operating profit margin (NOPM = NOPAT/Sales). Most analysts include equity income (sales less expenses) in NOPAT because it relates to operating investments. However, investee's sales are not included in the NOPM denominator. The reported NOPM is, thus, overstated. Net operating asset turnover (NOAT = Sales/Average NOA). Investee's sales are excluded from the NOAT numerator, and net operating assets in excess of the investment balance are excluded from the denominator. This means the impact on NOAT is indeterminate. Financial leverage (FLEV = Net nonoperating obligations/Average equity). Financial leverage is understated due to the absence of investee liabilities in the numerator.

*Foreign Currency Transactions* -- Foreign Currency Effects -- Foreign Currency and Cash Flows -- Cash Effects of Foreign Currency Transactions

Before financial statements of foreign US company subsidiaries can be consolidated with the parent company, they must first be translated into $USD. As the $US strengthens vis-à-vis other world currencies each foreign currency buys fewer $US. And when the income statement of the foreign subsidiary is translated into $US, the income statement shrinks: reported revenues, expenses, and profit are all smaller than before the dollar strengthened. So does the balance sheet, resulting in a lower $US value for assets, liabilities, and equity.

**[MOD 9] Intercorporate Investments** Non-marketable equity securities (1) defn (2) are companies required to report them? how?

Non-marketable equity securities refers to the stock of privately held companies with no publicly available stock price. Despite these securities being non-marketable, the new accounting standard requires companies to report them on the balance sheet at fair value. This requires companies to obtain necessary cash flow information and other data to support a Level-3 valuation, a time-consuming and imprecise process. Consequently, the new rules give companies the option to measure their non-marketable equity investments at cost, plus or minus changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer.

**[MOD 7] Current and Long-Term Liabilities** Financial Statement Effects: --Current Maturities of Long-term Debt

reported as current liabilities called current maturities of long-term debt. Includes ONLY principal that will be repaid within the year, interest is NOT included in this account.

Cash Effects of Foreign Currency Transactions —more due to realized foreign currency translation effects or unrealized? —impacts on valuation of company?

the realized foreign currency translation effects are likely small, and the foreign currency translation losses are, therefore, likely to be primarily unrealized noncash losses. Because foreign currency effects are largely noncash items, they should not impact our valuation of the company

How is revenue recognized in the cost-to-cost method?

Revenue is recognized as a proportion of total costs incurred to fulfill the contract. ex:) if a company incurs 15% of the total expected cost to create the product in the current period, it recognizes revenues equal to 15% of the contract amount.

**[MOD 8] Stock Transactions, Dividends, and EPS** stock retirement

t-stock account is reduced by the cost of the treasury shares retired (thus increasing S/E), AND the c/s account is likewise reduced (this reducing S/E by an = amount)

**[MOD 7] Current & Long-term Liabilities** (1) What are Credit Ratings? (2) What Determines Credit Ratings?

(1) A company's credit rating, is related to default risk. Default refers to the nonpayment of interest and principal and/or the failure to adhere to the various terms and conditions (covenants) of the bond indenture. Companies that want to obtain bond financing from the capital markets, normally first seek a rating on their proposed debt issuance from one of several rating agencies such as Standard & Poor's, Moody's Investors Service, or Fitch Ratings. The aim of rating agencies is to rate debt so that its default risk is more accurately conveyed to, and priced by, the market. (2) There are a number of considerations that affect the rating of a bond. Standard & Poor's lists the following factors, categorized by business risk and financial risk, among its credit rating criteria. As well as: *(a)* collateral - to the extent debt is secured, the debt holder is in a preferred position vis-a-vis other creditors *(b)* covenants - debt agreements that might restict the self-interest-seeking behavior or the issuing company so as to protect debt holders *(c)* options - options to convert to convert the debt into stock, or options for the company to repurchase.

relative magnitude of A/R is usually measured with respect to ? using any or all of the following ratios:

(1) A/R turnover ratio (2) A/R as a percentage of sales (3) Days sales outstanding

**[MOD 9] Intercorporate Investments** -(1)-For what strategic reasons might a company make intercorporate investments that yield significant influence over the investee company? -(2)- What is "significant influence"? -(3)-how does GAAP require that such investments be accounted for?

(1) Many companies make equity investments that yield them significant influence over the investee companies. These intercorporate investments are usually made for strategic reasons such as the following. Prelude to acquisition. Significant ownership can allow the investor company to gain a seat on the board of directors, from which it can learn much about the investee company, its products, and its industry. Strategic alliance. Strategic alliances permit the investor to gain trade secrets, technical knowhow, or access to restricted markets. Pursuit of research and development. Many research activities in the pharmaceutical, software, and oil and gas industries are conducted jointly. The investment can take a number of forms, including marketable securities, as well as other ownership arrangements, such as partnerships, joint ventures, and limited liability companies. (2) GAAP requires that such investments be accounted for using the equity method. The equity method reports the investment on the balance sheet at an amount equal to the percentage of the investee's equity owned by the investor (hence, the name equity method). (3) Significant influence is the ability of the investor to affect the financing, investing, and operating policies of the investee. Ownership levels of 20% to 50% of the outstanding common stock of the investee typically convey significant influence. Significant influence can also exist when ownership is less than 20%. Evidence of such influence can be that The investor company is able to gain a seat on the board of directors of the investee, or The investor controls technical know-how or patents that are used by the investee, or The investor is able to exert significant influence by virtue of legal contracts with the investee.

(1) A/R Turnover ratio: [formula] (2) A *high A/R Turnover Ratio* signals what? (3) What about a *low A/R Turnover Ratio*?

(1) [formula] = Net Sales / (average A/R) (2) A high A/R turnover ratio can indicate that a company's collection of accounts receivable is efficient and that the company has a high proportion of quality customers that pay their debts quickly. (3) A low A/R turnover ratio might be due to a company having a poor collection process, bad credit policies, or customers that are not financially viable or creditworthy.

Days Inventory Outstanding and Inventory Turnover: --[Avg days inv outstanding] --Analysis of Avg.DIO is important for at least two reasons—what are they?

(2) Overall, analysis of days inventory outstanding is important for at least two reasons. *(i) Inventory quality.* Fewer days implies that products are salable, preferably without undue discounting. Our conclusions about higher or lower days inventory outstanding must consider alternative explanations including the following. --Product mix can include more (or less) higher margin inventories that sell more slowly. --A company can change its promotion policies. --A company can realize improvements in manufacturing efficiency and lower investments in direct materials and work-in-process inventories. *(ii) Asset utilization.* Companies strive to optimize their inventory investment. Carrying too much inventory is expensive, and too little inventory risks stock-outs and lost sales. Companies can make the following operational changes to optimize inventory. --Improved manufacturing processes can eliminate bottlenecks and the consequent buildup of work-in-process inventories. --Just-in-time (JIT) deliveries from suppliers, which provide raw materials to the production line when needed, can reduce the level of raw materials and associated holding costs. --Demand-pull production, in which raw materials are released into the production process when final goods are demanded by customers instead of producing for estimated demand.

**[MOD 7] Current and Long-Term Liabilities** (1) Coupon Rate, Market Rate, and Bond Pricing (2) Effective cost of a bond sold at a discount, premium as compared to a bond sold at par

*(1)* --Coupon Rate > market rate //=bond sells at a premium (above face amount) --Coupon rate = market rate //=bond sells at par (at face amount) --Coupon rate < market rate //=bond sells at a discount (below face amount) *(2)* --When a bond sells at a discount, the issuer must repay more than the cash received from the buyer at issuance. --Effective cost of a discount bond is greater than if the bond had sold at par The effective cost of a premium bond is less than if a bond had been sold at par

**[MOD 7] Current & Long-term Liabilities** Accrued Liabilities *-(1)-*What are they? What's the point of them? When are they added to the financial statements? *-(2)-* On what financial statements are they recognized, and when are they recognized? *-(3)-* What are the types of accrued liabilities?

*(1)* Accrued liabilities (or accruals) are adjustments that accountants make to the B/S after all transactions have been entered into the accounting records and prior to the issuance of the financial statements, so that those statements fairly present the financial condition of the company. --*These adjustments recognize liabilities on the balance sheet (and the related expense on the income statement) that are not the result of external transactions (such as the purchase of goods or services on account that are recognized as accounts payable).* *(2)*Recognized as a liability (neg R.E.) on B/S, and as an expense on the I/S, during the current period. Accrued liabilities are incurred in the current period and, therefore, must be recognized in the current period. When they are paid, debit cash and credit liabilities (as wages payable) *(3)* *Accrued liabilities fall into two broad categories.* *(i.) Accruals for routine contractual liabilities.* These accruals include items such as: Wages that the company is contractually obligated to pay to employees for work performed, but not yet paid for in the current period. Interest due in the current period on borrowed money, but has not yet been paid. Income taxes owed, but not yet paid, as a result of profit earned during the period. Other operating liabilities that have been incurred but not yet paid for in the current period (like rent, utilities, etc.). *(ii.) Accruals for contingent liabilities.* Contingent liabilities depend on the occurrence of a future uncertain event in order to determine whether a liability exists and, if so, in what amount. An example is litigation that has been brought against the company whose outcome and amount depends upon adjudication. Another is warranty liabilities for products sold which depend upon the occurrence of product defects to require the company to repair or replace the product purchased.

**[MOD 7] Current & Long-term Liabilities** Two types of interest rates on a bond: *(1)* Coupon rate *(2)* Market (yield or effective) rate

*(1)* Coupon (contract or stated) rate The coupon rate of interest is stated in the bond contract; It is used to compute the dollar amount of interest payments that are paid (in cash) to bondholders during the life of the bond issue. *(2)* Market (yield or effective) rate This is the interest rate that investors expect to earn on the investment in this debt security; This rate is used to price the bond.

Gross Profit Margin [formula] --what is it descriptively, --what would a decline in GPM possibly indicate? --possible reasons for a GPM decline?

*(1)* Gross Profit Margin is: (gross profit) / (sales) *(2)* A decline in GPM is usually cause for concern since it indicates—that the company has less ability to pass on increased product cost to customers or that the company is not effectively managing product costs—. *(3)* Some possible reasons for a GPM decline follow. *(a)* Product line is stale. Perhaps products are out of fashion and the company must resort to markdowns to reduce overstocked inventories. Or, perhaps the product lines have lost their technological edge, yielding reduced demand. *(b)* New competitors enter the market. Perhaps substitute products are now available from competitors, yielding increased pressure to reduce selling prices. *(c)* General decline in economic activity. Perhaps an economic downturn reduces product demand and places downward pressure on selling prices. Inventory is overstocked. Perhaps the company overproduced goods and finds itself in an overstock position. This can require reduced selling prices to move inventory. *(d)* Manufacturing costs have increased. This could be due to poor planning, production glitches, or unfavorable supply chain reconfiguration. *(e)* Changes in product mix. Perhaps the company is selling a higher proportion of low margin goods.

Discontinued Operations— *(1)* where is discontd. operations reported? *(2)* what are the components of discontinued operations?

*(1)* bottom of the I/S *(2)* *a.* Net income (or loss) from the segment's business activities prior to the divesture or sale. *b.* Any gain (or loss) on the sale of the business.

*Financial Statement Effects:* a sale on credit & the estimate of uncollectible A/R *(1)* gross amount owed = [equation]? *(2)* accounts receivable, net = [equation]? *(3)* Example [image]

*(1)* gross amt owed = A/R - uncollectible A/R *(2)* net A/R = gross amount owed - allowance for uncollectible accounts *(3)* image below

*(1)* What must a disposal of a biz unit represent in order to be counted as a discontinued operation? *(2)* Why segregate discontinued operations on the I/S?

*(1)* must represent a strategic shift for the company that has or will have a major effect on a company's financial results *(2)* Discontinued operations are segregated in the income statement because they represent a transitory item. Transitory are largely irrelevant to predicting future performance. Investors tend to focus on income from continuing operations because that is the level of profitability that is likely to persist (continue) into the future.

**[MOD 7] Current & Long-term Liabilities** What is an annuity? How is the PV calculated?

*(1)*Financial instrument (usually debt instrument, in this case) for which the payment or the receipt (the cash flow) is equally spaced over time and each cash flow is the same dollar amount, we have an annuity. *(2)* get PVs of individual periods and sum them

R&D Expenses *(1)* How are they expensed/recorded? *(2)*Common R&D costs

*(1)*These costs are expensed as incurred except for general purpose PPE assets which are capitalized and depreciated as usual. *(2)*R&D costs broadly consist of the following. Salaries and benefits for researchers and developers. Supplies needed to conduct the research. Licensing fees for intellectual property or software used in the R&D process. Third-party payments to collaborators at other firms and universities. Laboratory and other equipment. Property and buildings to be used as research facilities.

**[MOD 7] Current & Long-term Liabilities** *(1)* 2 different types of Cash Flows to Bondholders *(2)* what is the formula for a bond's price, descriptively?

*(i.)* Periodic interest payments (usually semiannual) during the bond's life; These payments are called an annuity because they are equal in amount and made at regular intervals. *(ii.)* Single payment of the face (principal) amount of the bond at maturity; This is called a lump-sum because it occurs only once. *(2)* The bond price equals the present value of the periodic interest payments plus the present value of the single payment price. --the effective rate of a bond always equals the yield (market) rate demanded by investors, regardless of the coupon rate of the bond. --This means that companies cannot influence the effective cost of debt by raising or lowering the coupon rate. --Doing so will only result in a bond premium or discount.

**[MOD 8] Stock Transactions, Dividends, and EPS** Types of Stock-Based Compensation Plans

***Most stock-based compensation plans contain forfeiture provisions—if the employee is terminated for cause or, leaves the company before the rights to receive shares are vested, the award is forfeited. *Restricted stock.* Shares are issued to the employee but the employee is not free to sell the shares during a restriction period. *Restricted stock units (RSUs).* Employee is awarded the right to receive a specified number of shares (or cash equivalent) after a vesting period. --Unlike restricted stock, shares are not issued to the employee until after the restriction period, at which time the employee has all of the rights of a shareholder (but not during the vesting period). *Stock option plans.* Employees are given the right to purchase shares at a fixed (strike) price for a specified period of time. *Stock appreciation rights (SARs).* Employees are paid in cash or stock for the increase in share price, but do not purchase shares of stock. *Employee share purchase plans.* Employees are permitted to purchase shares directly from the company at a discounted price, typically a set percentage (such as 85%) of the prevailing market price.

**[MOD 8] Stock Transactions, Dividends, and EPS** Components of AOCI

*--Foreign currency translation adjustments.* Foreign subsidiaries often maintain their financial statements in foreign currencies and these statements are translated into $US before the subsidiaries' financial statements are included in the company's 10-K. The strengthening and weakening of the $US vis-à-vis foreign currencies results in decreases and increases in the $US-value of subsidiaries' assets and liabilities. These unrealized gains or losses in the $US value of foreign subsidiaries' assets and liabilities are included in AOCI. *--Employee benefit plans.* Unrealized gains and losses on some pension investments and pension liabilities. *--Gains and losses on derivatives and hedges.* *--Unrealized gains and losses on certain financial securities (derivatives)* that companies purchase to hedge exposures to interest rate, foreign exchange rate, and commodity price risks. **Under the new rules, changes in the fair value of marketable securities are reflected in current income and not in AOCI).

Tax and Cash Effects of Depreciation — what methods of depreciation are used by companies in financial statements? In tax returns?

*Companies typically use:* for financial reporting, SL*;* for tax returns, an accelerated depreciation method. *--The reason is that in early years the SL depreciation yields higher income on financial statements, whereas accelerated depreciation yields lower taxable income.* Even though this relation reverses in later years, companies prefer to have the tax savings sooner rather than later so that the cash savings can be invested to produce earnings. Further, the reversal may never occur—if depreciable assets are growing at a fast enough rate, the additional first year's depreciation on newly acquired assets more than offsets the lower depreciation expense on older assets, yielding a "permanent" reduction in taxable income and taxes paid.

Typical Expense Categories

*Cost of sales.* This is the cost Pfizer incurred to make or buy the products it sold during the year. *Selling, informational and administrative expense.* Usually, this expense category is labelled Selling, general and administrative (SG&A) expense, and it includes a number of general overhead expense categories, such as Salaries, Marketing, and the like. *Research and development expense.* This is the cost Pfizer incurs to conduct research for new products. *Amortization of intangible assets.* Amortization expense is a noncash expense, similar to depreciation expense. *Restructuring charges.* This represents the cost Pfizer has incurred and expects to incur to restructure its operations. *Provision for taxes on income.* Taxes that will be paid to federal and state taxing authorities as well as income taxes levied by foreign governments and municipalities. *Discontinued operations.* This represents the operating profit (or loss) plus the gain (or loss) on the sale of businesses Pfizer has decided to divest. *Income attributable to noncontrolling interest.* The income attributable to the noncontrolling interest is the portion of the subsidiary's income that is attributable to noncontrolling shareholders. The remainder of the subsidiary's net income is credited to Pfizer's shareholders and is added to retained earnings on Pfizer's balance sheet.

**[MOD 8] Stock Transactions, Dividends, and EPS** Two analysis issues relating to stock-based compensation plans

*Expense Recognition.* When shares or options are awarded to employees, companies estimate the fair value of the award and recognize the fair value as compensation expense in the income statement over the period in which the employee provides service. *Potential Dilution.* Dilution relates to the number of common shares outstanding that have a claim against the company's earnings or net assets.

revenue recognition: Licenses

*If a right to use*—recognize when the customer can first use the IP. *If a promise of access*—recognize over a period of time.

Interpretation of (Allowance)/(Gross A/R) trending smaller

*There are two possible interpretations of this trend.* *(1)* Credit quality has improved. If Levi Strauss feels that the collectability of its remaining receivables has improved, it can feel confident in allowing the allowance for uncollectible accounts to decline. *(2)* Levi Strauss is underestimating the allowance account. This is the more troubling of the two possibilities. Levi Strauss might be attempting to increase its profitability by not adding to the allowance account, and, thus, avoiding more bad debt expense.

**[MOD 7] Current & Long-term Liabilities** Accounting for Short-Term Debt

*When the company borrows these short-term funds, it reports the cash received on the balance sheet together with an increase in liabilities (notes payable).* The note is reported as a current liability because the company expects to repay it within a year. Although this borrowing has no effect on income or equity, the borrower incurs (and the lender earns) interest on the note as time passes. GAAP requires the borrower to accrue the interest liability and the related interest expense each time financial statements are issued.

*Sales Allowances* Accounting for Sales Allowances

*sales allowances reduce the amount of cash companies receive from sales.* -- GAAP requires companies to report sales revenue at the net amount expected to be received in cash—this means companies must deduct from gross sales the expected sales returns and other allowances. *Allowance for Sales Returns* = [expected allowance for sales returns] * [sales price of good] *COGS adjustment* = [cost of mats / sales price] * (expected allowance for sales returns) (Sales, net [sales price - allowance for sales returns]) - (COGS [cost of mats - COGSadj]) = *Gross Profit*

(1) When is inventory capitalized? (2) What does capitalization mean? (3) How is that represented on the financial statements? (4) why is inventory capitalization important in a company's financial statements?

-(1)-When inventory is purchased or produced, it is capitalized. -(2)-Capitalization means that a cost is recorded on the balance sheet and is not immediately expensed in the income statement. -(3)-When the inventory is sold, its cost is transferred from the balance sheet to the income statement as an expense (cost of goods sold). -(4)- *--*If higher cost units are transferred from the balance sheet, then COGS is higher and gross profit (sales less cost of goods sold) is lower. *--*If lower cost units are transferred to COGS on the I/S, gross profit is higher.

Days Payable Outstanding [formula] --what could delaying payment mean for a company pro/con?

--Delaying payment to suppliers allows the purchasing company to increase its available cash. --However, excessive delays (called "leaning on the trade") can damage supplier relationships.

Evidence that the performance obligation has been satisfied occurs when the customer has __(4)__

--Legal title to the good or has received the service. --Physical possession of the good. --Assumed the risks and rewards of owning the good or receiving the service. --Accepted the good or service and has an obligation to pay the company.

**[MOD 9] Intercorporate Investments** Accounting for Investments with Varying levels of Control

--Passive investments are recorded at fair value --Under the equity method, the investor's Investment balance represents the proportion of the investee's equity owned by the investor, and the Investor company's income statement includes its proportionate share of the investee's income. --Once control over the investee company is achieved, GAAP requires consolidation for financial statements issued to the public (but not for the internal financial records of the separate companies).

**[MOD 8] Stock Transactions, Dividends, and EPS** What accounts are in the earned capital portion of S/E?

--R.E. --Dividends --Stock splits --AOCI

**[MOD 7] Current & Long-term Liabilities** Interest Expense v. Interest Payments

--The effective cost of debt is reflected in the amount of interest expense reported in the issuer's income statement. --Because of bond discounts and premiums, interest expense is usually different from the cash interest paid.

**[MOD 8] Stock Transactions, Dividends, and EPS** Is Stock-Based Compensation a Cash Expense?

--The stock-based compensation add-back might lead some to conclude that this form of compensation is cash free. --However, a real cash cost occurs when the company buys new treasury shares in the open market to offset the dilution created by the share award to the employees. --To accurately evaluate and forecast operating cash flow, analysts must either include stock-based compensation expense or recognize the related treasury-stock purchase as an operating cash outflow.

**[MOD 8] Stock Transactions, Dividends, and EPS** Basic and Diluted EPS

A common metric reported in the financial press is earnings per share (EPS). Two EPS statistics Basic EPS. Basic EPS is computed as: [(NI - Dividends on Preferred Stock) / (weighted avg number of common shares outstanding during the year)] Subtracting preferred stock dividends, in the numerator, yields the income available for dividend payments to common shareholders. The denominator is the average number of common shares outstanding during the year. Diluted EPS Diluted EPS reflects the impact of additional shares that would be issued if all stock options and convertible securities are converted into common shares at the beginning of the year. Diluted EPS never exceeds basic EPS.

What is the meaning of a sale on credit? How is a sale on credit (meaning customer has agree to pay the company in the future) recorded?

A sale on credit means that the customer has agreed to pay the company in the future, after the good or service has already been transferred to the customer. Many sales are on credit, meaning the customer has agreed to pay the company in the future. --The company still recognizes revenue when the good or service is transferred to the customer, and it records an account receivable that it collects at a later date. --The recognition of revenue is unaffected by the delayed receipt of cash if the company has fulfilled its performance obligation.

**[MOD 8] Stock Transactions, Dividends, and EPS** FinEffects: Stock Repurchase

A stock repurchase reduces the size of the company (cash declines, and, thus, total assets decline) --A repurchase has the opposite FinStmt Effect from a stock issuance: 1. cash decreases by the price*#_of_shares_sold 2. S/E decreases by the same amount. 3. The decrease in equity is recorded in a contra equity account called Treasury stock 4. T-stock has a negative balance, which reduces S/E --When t-stock increases, total S/E decreases

**[MOD 8] Stock Transactions, Dividends, and EPS** Stock Split *(1)* defn *(2)* FinEffects

A stock split happens when a company issues additional common shares to its existing stockholders. Stock splits are usually prompted by the company's desire to reduce its stock price in order to improve marketability of the shares. A stock split is not a monetary transaction and, as such, there are no financial statement effects. However, companies must disclose the number of shares outstanding for all periods presented in the financial statements. Additionally, companies must reduce the par value of the stock proportionally and historical financial statements presented in the current 10-K must be adjusted likewise.

Analysis of A/R: Reporting of A/R

Accounts receivable are reported on the balance sheet net of the allowance for doubtful (uncollectable) accounts

**[MOD 9] Intercorporate Investments** Reporting Subsidiary Stock Issuances

After subsidiaries are acquired, they can, and sometimes do, issue stock. If issued to outside investors, the result is an infusion of cash into the subsidiary and a reduction in the parent's percentage ownership. For example, on October 26, 2015, Ferrari N.V., a subsidiary of Fiat Chrysler Automobiles N.V., completed its initial public offering (IPO). Prior to the sale, Fiat Chrysler owned 90% of Ferrari's stock with the remaining 10% owned by the Ferrari family. During the IPO, Ferrari sold 10% of its common shares to the public and received net proceeds of approximately €900 million and Fiat Chrysler reduced its stake to 80 percent of Ferrari's common shares. The €900 million cash received from the sale was accounted for as an increase in Fiat Chrysler's paid-in capital. The sale by a subsidiary (Ferrari) of its stock in an IPO had no effect on the parent's (Fiat Chrysler's) income statement.

Asset Write-Downs

Asset write-downs accelerate (or catch up) the depreciation process to reflect asset impairment that, likely, occurs over several years. Thus, prior periods' profits were arguably not as high as reported, and the current period's profit is not as low. This measurement error is difficult to estimate and, thus, many analysts do not adjust balance sheets and income statements for write-downs. At a minimum, however, we must recognize the qualitative implications of restructuring costs for the profitability of recent prior periods and the current period.

**[MOD 9] Intercorporate Investments** Accounting for Derivatives

All derivatives are reported at fair value on the balance sheet. Fair value hedges—the asset or liability being hedged (the foreign receivable in the example above) is reported on the balance sheet at fair value. If the market value of the hedged asset or liability changes, the value of the derivative changes in the opposite direction if the hedge is effective and, thus, net assets and liabilities are unaffected. Likewise, the related gains and losses are largely offsetting, leaving income unaffected. Cash flow hedges—there is no hedged asset or liability on the books. In our example above, the anticipated commodity purchases are being hedged. Thus, the company has no inventory yet, and changes in the fair value of the derivative are not met with opposite changes in an asset or liability. For these cash flow hedges, gains or losses from the fair value of the derivative are not reported on the income statement. Instead they are held in AOCI, as part of shareholders' equity. Later, when the hedged item impacts income (say, when the commodity cost is reflected in cost of goods sold), the derivative gain or loss is reclassified from AOCI to income. If the hedge was effective, the gain or loss on the hedged transaction is offset with the loss or gain on the derivative and income is unaffected.

**[MOD 9] Intercorporate Investments** --How/where are passive investments in equity securities reported? --How are ∆es in the fair value of the investment during the accounting period reported?

All passive investments in equity securities where there is a readily determinable fair value are reported on the balance sheet at fair value. Changes in the fair value of the investment during the accounting period are reported in earnings. This is a relatively new accounting treatment that is effective in 2018. Our discussion takes the new standard as a given and we describe the previous standard below.

Analysis of A/R: How is $ amount of uncollectible accounts receivable typically estimated?

An aging analysis. Example in picture

**[MOD 9] Intercorporate Investments** Cash Flow risk / Cash flow hedge

As an example of cash flow risk, consider a company that routinely purchases a food commodity used in its manufacturing process. Any price increases during the coming year will flow to cost of goods sold, and profit will decrease (unless the company can completely pass the price increase along to its customers, which is rarely the case). To avoid this situation, the company can hedge the forecasted inventory purchases with a commodity derivative contract that locks in a price today. When the price of the commodity increases, the derivative contract will shelter the company and, as a result, the company's cost of goods sold remains unaffected. For accounting purposes, this is called a cash flow hedge.

PPE Turnover Rate

Asset write-downs accelerate (or catch up) the depreciation process to reflect asset impairment that, likely, occurs over several years. Thus, prior periods' profits were arguably not as high as reported, and the current period's profit is not as low. This measurement error is difficult to estimate and, thus, many analysts do not adjust balance sheets and income statements for write-downs. At a minimum, however, we must recognize the qualitative implications of restructuring costs for the profitability of recent prior periods and the current period. Higher PPE turnover is preferable to lower. A higher PPE turnover implies a lower capital investment for a given level of sales. Higher turnover, therefore, increases profitability because the company avoids asset carrying costs and because the freed-up assets can generate operating cash flow. PPE turnover is lower for capital-intensive manufacturing companies than it is for companies in service or knowledge-based industries.

**[MOD 9] Intercorporate Investments** Estimating fair value, based on observability of inputs used to measure fair value (3)

Assets and liabilities recorded at fair value are measured in one of three ways based on the observability of the inputs used to measure fair value: *Level 1.* Quoted market prices if the security is traded in active markets. *Level 2.* Quoted market prices in active markets for similar securities and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. *Level 3.* Unobservable inputs that are supported by little or no market activities.

**[MOD 8] Stock Transactions, Dividends, and EPS** FinEffects of people using the conversion feature of a convertible security [example]

Assume that the Xilinx bonds are reported at their face amount of $600 million and that all of the bonds are subsequently converted into 20,243,460 shares ([$600 million/$1,000] x 33.7391 shares) of common stock with a par value of $0.01 per share. The financial statement effects of the conversion are as follows (in $000s).

**[MOD 7] Current & Long-term Liabilities** Balance sheet reporting of discount bonds

Bonds are reported on the balance sheet net of any discount. When the bond matures, the company is obligated to repay the face amount. Accordingly, at maturity, the bonds payable account needs to read the amount that is owed. This means that between the bond issuance and its maturity, the discount must decline to zero. This reduction of the discount over the life of the bond is called amortization. The discount amortization results in additional interest expense in the income statement. This amortization causes the effective interest expense to be greater than the periodic cash interest payments.

**[MOD 8] Stock Transactions, Dividends, and EPS** Financial Effects of Cash Dividends

Cash dividends reduce both cash and retained earnings by the amount of the cash dividends paid. --note: Dividend payments do not affect net income. They directly reduce retained earnings and bypass the income statement. --preferred dividends have priority over those on common, including unpaid prior years' dividends (called dividends in arrears) when preferred stock is cumulative. ex: J&J——assume that JNJ declares and pays cash dividends in the amount of $10 million. The financial statement effects of this cash dividend payment are as follows.

**[MOD 8] Stock Transactions, Dividends, and EPS** Stock Dividend --defn --FinEffects

Companies can also declare a stock dividend where shares of stock are distributed to shareholders instead of cash. *To account for a stock dividend, the company reduces retained earnings (just as for cash dividends) and increases contributed capital accounts.* Cash and the stock's par value per share are both unaffected by a stock dividend. Many companies declare a stock dividend, rather than a stock split, to avoid the reduction of the par value that is required in a stock split. This event is typically described as a stock split effected in the form of a stock dividend.

**[MOD 8] Stock Transactions, Dividends, and EPS** Fin Effects: Common stock issuances: (a) Par; (b) no-par; (c) no-par with a stated value/ Additional paid-in capital

Companies issue stock to obtain cash and other assets for use in their business. PAR Stock issuances increase assets (cash) by the issue proceeds: ( # shares sold)*(price of stock on issue date) Equity increases by the same amount, which is reflected in contributed capital accounts. If the stock has a par value, the common stock account increases by the number of shares sold multiplied by its par value. The additional paid-in capital account increases by the remainder. --for no-par stock, the c/s account is increased by the entire proceeds of the sale and no amount is assigned to additional paid-in capital; for no-par stock w/ a stated value, the stated value is treated just like par value and has the same effect on the c/s and addtl. paid in capital accounts

**[MOD 7] Current & Long-term Liabilities** What does it require for an accrued liability to be recorded on the balance sheet?

Companies must record an accrual (ex: a contingent liability) on the balance sheet, *when two conditions are met.* *(1)* It is probable that one or more future events will confirm that a liability existed at the financial statement date. *(2)* The amount required to settle the liability in the future can be reasonably determined at the financial statement date.

**[MOD 9] Intercorporate Investments** (1) When companies make intercorporate equity investments, what do they usually pay? (2) What is the payment, then, comprised of? (3) How is that represented on a financial statement (1 of 3 ways)?

Companies often pay more than book value when they make equity investments. For example, if Google paid $400 for its 30% stake in Mitel, Google would initially report its investment at its $400 purchase price. The $400 investment consists of two parts: The $300 equity investment described above and The $100 additional investment. Google's management must decide how to allocate the excess of the amount paid over the book value of the investee company's equity and account for the excess accordingly. If management decides the $100 relates to unrecognized depreciable assets, the $100 is depreciated over the assets' estimated useful lives. If it relates to identifiable intangible assets that have a determinable useful life (such as patents), it is amortized over the useful lives of the intangible assets. If it relates to goodwill, however, it is not amortized and remains on the balance sheet at $100 unless and until it is deemed to be impaired.

**[MOD 9] Intercorporate Investments** Debt securities-- examples include? How do companies classify debt securities?

Companies often purchase debt securities, including Corporate bonds, U.S. government agency bonds, and Municipal securities. Companies can choose to classify investments in debt securities as either: Trading securities. Changes in fair value reflected in current income. Available-for-sale securities. Changes in fair value deferred in Accumulated other Comprehensive Income. Held-to-maturity securities. Changes in fair value not reflected in either the balance sheet nor the income statement.

**[MOD 8] Stock Transactions, Dividends, and EPS** Stock-Based Compensation --why use stock-based compensation?

Companies use a range of stock-based compensation plans that share the following features. *--Create incentives for employees to think and act like shareholders.* The amount of the stock award is often tied to corporate performance targets including sales, income, and stock price. Stock-based compensation plans motivate employees to work hard and make decisions that improve company performance. *--Encourage employee retention and longevity.* With most plans, employees earn the right to own or purchase shares over time. The period of time over which ownership rights are earned is called the vesting period. During this vesting period, employees have greater incentive to stay with the company.

**[MOD 9] Intercorporate Investments** Hedging Risk With Derivatives

Companies use derivatives (financial securities) to shelter their income statements, balance sheets, and cash flows from fluctuations in the market prices of currencies, commodities, and financial instruments, as well as for market rates of interest. These exposures can be grouped into two general categories. Exposure to changes in the fair value of an asset (such as accounts receivable, inventory, marketable securities, or a firm contract to sell an asset) or liability (such as accounts payable, a firm commitment to purchase an asset, or a fixed-rate debt obligation). Exposure to variation in cash flows relating to a forecasted transaction (such as planned inventory purchases or anticipated foreign revenues) or cash flow exposure relating to a variable-rate debt obligation. Some of these securities can be purchased in the open market (e.g., options and futures contracts). Other contracts are private agreements between two parties (e.g., forward contracts and swaps). All these types of hedges are called "derivatives" because the value of the hedge (the security or the contract) derives from the value of the hedged position—that is, the currency, the commodity, the interest rate that the company seeks to hedge. Regardless of their form, these hedges serve to transfer risk to parties whose core competencies involve managing and pricing risk. Hedging instruments and contracts act like an insurance policy and the cost of the hedge is treated as an ordinary cost of doing business.

**[MOD 9] Intercorporate Investments** Limitations of Consolidation Reporting

Consolidated income does not imply the parent company has received any or all of the subsidiaries' net income as cash. The parent can only receive cash from subsidiaries via dividend payments. Conversely, the consolidated cash is not automatically available to the individual subsidiaries. It is quite possible, therefore, for an individual subsidiary to experience cash flow problems even though the consolidated group has strong cash flows. Likewise, unguaranteed debts of a subsidiary are not obligations of the consolidated group. Thus, even if the consolidated balance sheet is strong, creditors of a failing subsidiary are often unable to sue the parent or other subsidiaries to recoup losses. Consolidated balance sheets and income statements are a mix of the various subsidiaries, often from different industries. Comparisons across companies, even if in similar industries, are often complicated by the different mix of subsidiary companies. Consolidated disclosures are highly aggregated, which can preclude effective analysis. Consolidated numbers can mask poorly performing subsidiaries whose losses are offset by the positive performance of others.

**[MOD 9] Intercorporate Investments** All Intercorporate Investments with control must be consolidated. What does this mean?

Consolidation accounting includes 100% of the investee's assets and liabilities on the investor's balance sheet and 100% of the investee's sales and expenses on the investor's income statement. All intercompany sales and expenses, and receivables and payables, are eliminated in the consolidation process to avoid double counting. For example, when goods are sold from the investee (called a subsidiary) to the investor (called the parent company) for resale to the parent's ultimate customers.

**[MOD 9] Intercorporate Investments** Motivations for Equity Carve-Outs

Corporate divestitures, or equity carve-outs, are increasingly common as companies seek to augment shareholder value through partial or total divestiture of particular subsidiaries or operating units. Generally, equity carve-outs are motivated by the notion that consolidated financial statements obscure the performance of individual business units, thus complicating their evaluation by outsiders. Corporate managers are concerned that this difficulty in assessing the performance of individual business units, limits their ability to reach full valuation. Shareholder value is, therefore, not maximized. In response, conglomerates have divested subsidiaries so the market can individually price them.

Restructuring Costs

Corporate restructurings are designed to turn a company around and are frequently initiated in response to poor performance, mounting debt, and shareholder pressure. A restructuring can involve eliminating business segments, selling major assets, downsizing the workforce, and reconfiguring debt. Ultimately, the goal of a restructuring is to positively impact a company's long-term financial performance.

Effects of choosing LIFO over FIFO

Effects of choosing LIFO over FIFO: (a) lower reported inventories (b) higher reported COGS (c) lower pretax profits translated into a lower cumulative tax bill (d) higher operating cash flow

**[MOD 9] Intercorporate Investments** How does the equity method treat: (1) investments (2) dividends (3) income (4) ∆es in fair value

Equity method accounting is summarized as follows. Investments are recorded at their purchase cost. Dividends received are treated as a recovery of the investment and, thus, reduce the investment balance (dividends are not reported as income). The investor reports income equal to its percentage share of the investee's reported net income; The investment account is increased by the percentage share of the investee's income or Decreased by the percentage share of any loss. Changes in fair value do not affect the investment's carrying value.

**[MOD 9] Intercorporate Investments** Fair value risk / Fair value hedge

For an example of fair value risk, consider a company with a receivable denominated in a foreign currency. If the $US strengthens, the receivable declines in value and the company incurs a foreign-exchange loss. To avoid this situation, the company can hedge the receivable with a foreign-currency derivative. Ideally, when the $US strengthens, the derivative will increase in value by an amount that exactly offsets the decrease in the value of the receivable. As a result, the company's net asset position (receivable less derivative) remains unaffected and no gain or loss arises when the $US weakens or strengthens. For accounting purposes, this is called a fair value hedge.

What amount is capitalized for types of inventory: (1) Purchased inventories (2) Manufacturer's manufacturing costs

For purchased inventories, the amount capitalized is the purchase price. For manufacturers, manufacturing costs consist of three components: Cost of direct (raw) materials used in the product, Cost of direct labor to manufacture the product, and Manufacturing overhead.

**[MOD 7] Current & Long-term Liabilities** Fair Value Disclosures

GAAP requires companies to provide information about current fair values of their long-term liabilities in footnotes. These fair values are not reported on the balance sheet and changes in these fair values are not reflected in net income. The chief justification for not recognizing fair-value gain and losses is that such amounts can reverse with subsequent fluctuations in market rates of interest and the bonds are repaid at par at maturity.

**[MOD 9] Intercorporate Investments** *Example:* [Consolidation of??] Investments Purchased ABOVE Book Value (in this case, a NON-wholly-owned Subsidiary) Assume Penman acquires *100%* interest in Nissim. Penman paid a premium to Nissim of $1,000 more than the book value of Nissim's stockholders' equity on the acquisition date. The $1,000 premium relates to additional value from corporate synergies, such as increased market presence, ability to consolidate offices, and increased buying power.

General synergies such as this are recognized on the balance sheet as an intangible asset with an indefinite useful life, called goodwill. The $4,000 investment account now reflects two components: The book value acquired of $3,000 (as before) and An additional $1,000 of newly acquired assets (goodwill asset).

** *What is the:* Lower of Cost or Market method? [home depot example]

Home Depot uses FIFO to cost its inventory. At the end of each accounting period, Home Depot compares the ending FIFO inventory balance with the market value of the inventory (its replacement cost). If the market value is less than the FIFO amount, Home Depot "writes down" the inventory to its market value. The result is that the inventory is carried on the balance sheet at whichever amount is lower: the cost of the inventory or its market value. This process is called reporting inventories at the lower of cost or market.

When are R&D costs expensed?

If R&D facilities and equipment are general-use in nature, the costs are capitalized on the balance sheet and depreciated over its useful life like other depreciable assets. R&D facilities and equipment that are purchased specifically fro a single project, and which have no alternative use, are expensed immediately in the I/S

What is asset impairment?

If market values of PPE assets decrease—and the asset value is deemed to be permanently impaired—then, companies must write off the impaired cost and recognize losses on those assets.

Foreign currency and cash flows: Example— -- When the $US company transacts business denominated in foreign currencies.

If the $US strengthens between the date of the sale and the ultimate collection of the Euro-denominated account receivable, the U.S. company suffers a foreign currency transaction loss. Conversely, if the U.S. company purchases goods, the foreign currency denominated account payable would shrink and less $US would be required to settle the obligation, resulting in a foreign currency transaction gain.

Foreign currency and cash flows: Example— When the U.S. parent company borrows money that is denominated in a foreign currency.

If the U.S. parent company borrows in foreign currencies and the $US strengthens, the company will realize a gain as it repays the foreign currency-denominated loan.

Foreign currency and cash flows: Example— When the foreign subsidiary's cash is repatriated to the United States.

If the U.S. parent repatriates cash from foreign subsidiaries (e.g., cash dividend from the subsidiary to the U.S. parent company), a foreign currency transaction loss can arise if the dollar strengthens before the foreign currency is converted into $US to pay the dividend.

**[MOD 7] Current and Long-Term Liabilities** Financial Statement Effects: Warranty Liabilities

If the obligation is probable and the amount estimable w/ reasonable certainty (amount & probability based on past experience), GAAP requires manufacturers to record the expected cost of warranties as a liability and to record the related expected warranty expense in the I/S in the same period that sales revenue is reported. Same effect on financial statements as accruing wages expense. Liability is reported when incurred, warranty payable (from liabs) and inventory are deducted when the warranty is over or the replacement parts have been delivered.

PPE Useful Life --calculation does not include __ or __, because ___ and ___

If we assume straight-line (SL) depreciation (which is consistent with the company's policy) and zero salvage value, we can estimate the average useful life for depreciable assets as follows. --Depreciable assets do not include Land (land does not depreciate) or Construction-in-progress (PPE not in use cannot depreciate).

**[MOD 9] Intercorporate Investments** Spin-Offs

In a spin-off, the parent company distributes to its stockholders, the shares of the subsidiary company as a dividend. On July 17, 2015, eBay Inc. separated its PayPal business via a dividend of PayPal stock to all eBay shareholders, making PayPal an independent company. eBay treats the distribution of PayPal stock as a dividend equal to the book value of the PayPal subsidiary (think of this as the carrying value of the equity investment), which it reports in the following excerpt from its statement of stockholders' equity.

**[MOD 9] Intercorporate Investments** Split-Offs

In a split-off, the parent company buys back its own stock using the shares of the subsidiary company instead of cash. After completing this transaction, the subsidiary is an independent, publicly traded company. *The parent treats the split-off like any other purchase of treasury stock.* As such, the treasury stock account is increased and the equity method investment account is reduced, reflecting the distribution of that asset. The dollar amount recorded for this treasury stock depends on how the distribution is set up. There are two possibilities. Pro rata distribution. Shares are distributed to stockholders on a pro rata basis. The treasury stock account is increased by the book value of the investment in the subsidiary. The accounting is similar to the purchase of treasury stock for cash, except that shares of the subsidiary are paid to shareholders instead of cash. Non pro rata distribution. This case is like a tender offer where individual stockholders can accept or reject the distribution. The treasury stock account is recorded at the market value of the shares of the subsidiary distributed. Because the investment account can only be reduced by its book value, a gain or loss on distribution is recorded in the income statement for the difference. (The SEC allows companies to record the difference as an adjustment to additional paid-in capital; the usual practice, as might be expected, is for companies to report any gain as part of income.)

Balance Sheet Adjustments for a LIFO Reserve

In general, to adjust for LIFO on the balance sheet, we must make three modifications. Increase inventories by the LIFO reserve. Increase tax liabilities by the tax rate applied to the LIFO reserve. Increase retained earnings for the difference. *example* As an example, to adjust CAT's 2015 balance sheet, we would: Increase inventories by $2,498 million. Increase tax liabilities by $874 million (the extra cumulative taxes CAT would have had to pay under FIFO, computed as $2,498 million x 35%). Increase retained earnings by the difference of $1,624 million (computed as $2,498 million - $874 million).

**[MOD 9] Intercorporate Investments** Indicators of Control --tests?

Intercorporate investments with control must be consolidated (1) Variable interest entity (VIE) test: --The investor has the ability to influence the investee's decision making. --The investor can influence the investee's financial results through contractual rights and obligations. --The investor is exposed to variable returns; that is, the investor will absorb any losses as well as benefit from any gains. --The investor has the right to receive residual returns. --The following items are consistent with economic power. (2) Voting Interest Test If the VIE test is not met, there is a second test: the voting interest test. If the investor holds more than 50% of the voting stock of the investee, then economic control is in evidence and the investment must be consolidated.

lengthening of DSO: signals what? is that good or bad?

It's Bad --> signal that A/R has grown more quickly than sales. Generally, such a trend is not favorably for 2 reasons: *(1)* the company is becoming more lenient in granting credit to customers, or *(2)* credit quality is deteriorating [if existing customers aren't paying on time, level of A/R relative to level of sales will increase], or *(3)* sales mix has changed toward markets w/longer payment terms.

**[MOD 8] Stock Transactions, Dividends, and EPS** Non-controlling Interest

Many companies report an additional equity account called noncontrolling interest. This account arises when the company controls a subsidiary but does not own all of the subsidiary's stock. That is, the company owns > 50% of the stock, but less than 100%. The noncontrolling interest is the portion of the subsidiary's stock NOT owned by the company. The noncontrolling interest account increases with any additional investment made by the noncontrolling shareholders and by their share of the subsidiary's net income whose common stock they own. The account decreases by any dividends paid to the noncontrolling shareholders and by share of any net losses of the subsidiary.

**[MOD 9] Intercorporate Investments** Investments in Marketable Securities --what are they? --fin effects acquisition of? --fin effects sale of?

Marketable securities are financial instruments that can be bought and sold on a public exchange. Acquisition and Sale When a company makes a passive investment, it records the shares acquired on the balance sheet at fair value; that is, the purchase price. When investments are sold, any recognized gain or loss on sale is equal to the difference between the proceeds received and the book (carrying) value of the investment on the balance sheet as follows.

*What are the following, and what are they used for?* --FIFO --LIFO --AC

Methods of transferring inventory costs, ultimately for tax purposes. (1) First in, first out method --The FIFO inventory costing method transfers costs from inventory in the order that they were initially recorded. (2) Last in, first out method --The LIFO inventory costing method transfers the most recent inventory costs from the balance sheet to COGS. (3) Average cost method --The average cost method computes the cost of goods sold as an average of the cost to purchase or manufacture all of the inventories that were available for sale during the period.

**[MOD 9] Intercorporate Investments** *Example:* [Consolidation of??] Investments Purchased at Book Value (in this case, a NON-wholly-owned Subsidiary) Assume Penman Company acquires *80%* of the common stock of Nissim Company. The purchase price of $3,000 is equal to the book value of Nissim's stockholders' equity. During the next year, Nissim earned $400, bringing its retained earnings to $1,400.

Now, the equity investment account on Penman's balance sheet will reflect only 80% of Nissim's equity, and The equity income it reports in its income statement will only reflect 80% of Nissim's net income. The remaining 20% of the net assets of the subsidiary and its net income are owned by noncontrolling shareholders. Their share in the net assets of Nissim is reflected on the consolidated balance sheet in a new account titled noncontrolling interest. In addition, we apportion Nissim's net income into The 80%, or $320, attributed to Penman's shareholders ,and The 20%, or $80, attributed to noncontrolling shareholders.

**[MOD 8] Stock Transactions, Dividends, and EPS** Footnote Disclosures for Stock-Based Compensation

Plan Activity Number of shares granted to employees during the year. Number of shares issued during the year to satisfy awards that vested. Any shares forfeited—when employees leave the company or fail to exercise options within the specified time period. Fair Value and Expense Fair value of the stock-based compensation awards. How fair value is determined. Restricted stock awards are valued using the share price on the date of the award. Stock option plans are valued using option pricing models (Black-Scholes model and the bilateral model. The expense on the income statement. Value of the shares issued to employees over and above the price the employee paid for shares (this difference is called the intrinsic value).

**[MOD 8] Stock Transactions, Dividends, and EPS** Preferred Stock --yield. --conversion privileges.

Preferred Stock is a multi-use security with a number of desirable features. In addition to usual dividend and liquidation preferences, preferred stock has two other common features. Yield. Preferred stock can be structured to provide investors with a dividend yield that is similar to an interest rate on a bond. Conversion privileges. Preferred stock can contain an option that allows investors to convert their preferred shares into common shares at a pre-determined number of common shares per preferred share.

**[MOD 8] Stock Transactions, Dividends, and EPS** Stockholder's Equity Accounts --Preferred stock, --Common stock (par value, authorized shares, issued shares), --Accumulated Other Comprehensive Income (AOCI), --R.E. --Treasury Stock

Preferred stock Johnson & Johnson is authorized to issue up to 2,000,000 preferred shares, but to date has not issued any—the balance is $0. Common stock Par value. The par value of its common stock (as stated in its charter) is $1 per share. Authorized shares. It can issue up to 4,320,000,000 shares without further shareholder approval. Issued shares. To date, it has sold (issued) 3,119,843,000 shares at the $1 par value and thus, the common stock account has a balance of $3,120 million. Accumulated Other Comprehensive Income (AOCI) account reflects the cumulative total of changes to S/E other than from transactions with owners and those reflected in net income. This account can be + or - . Retained earnings The cumulative sum of net income recorded since its inception less all of the dividends the company has ever paid out to shareholders. Treasury stock The treasury stock balance is a cumulative amount that reflects open-market repurchases and subsequent resale of its shares. On January 3, 2016, the company held 364,681,000 shares for which it paid $22,684 million.

**[MOD 7] Current & Long-term Liabilities** Current Maturities of Long-term Debt

Principal payments that must be made during the upcoming 12 months on long-term debt are reported as current liabilities called current maturities of long-term debt. Companies must provide a schedule of the maturities of their long-term debt in the footnotes to the financial statements.

Pro Forma Income Reporting *(1)* what are pro forma income statements? Why are they included in a company's disclosures? *(2)* will these pro forma numbers satisfy GAAP? Why not?

Pro forma income statements are non-GAAP numbers that company management believes provide a better measure of their financial performance. The Securities and Exchange Commission (SEC), requires that companies reconcile such non-GAAP information to GAAP numbers (Regulation G). It is important to remember that a company's purpose for making a non-GAAP disclosure is to portray its financial performance the way that management would like us to analyze it. Unscrupulous companies can attempt to lower the bar for analysis by presenting financial results in the best possible light.

**[MOD 9] Intercorporate Investments** ROE and Equity Method Accounting

ROE is unaffected by equity method accounting because the correct amount of investee net income and equity is included in the ROE numerator and denominator, respectively. Still, the evaluation of the quality of ROE is affected. Analysis using reported equity method accounting numbers would use an overstated NOPM and an understated FLEV because the numbers are based on net balance sheet and net income statement numbers. As we discuss in a later module, analysts should adjust reported financial statements for these types of items before conducting analysis.

Recommended steps for a thorough reading of the GAAP financials: (7)

Read the reports from the external auditor, and take special note of any deviation from boilerplate language. Peruse the footnote on accounting policies and compare the company's policies with its industry peers. Examine changes in accounting policies. Compare key ratios over time. Review ratios of competitors, and consider macroeconomic conditions and how they have shifted over time. Identify nonrecurring items, and separately assess their impact on company performance and position. Recast financial statements as necessary to reflect an accounting policy(ies) that is more in line with competitors or one that better reflects economically relevant numbers.

When is revenue recognized for non-refundable up-front fees?

Recognize as revenue when the goods or services are provided.

revenue recognition: Franchises.

Recognize as the goods or services are delivered.

revenue recognition: Variable consideration.

Recognize the expected amount to be received when goods or services are provided.

When is revenue recognized in Bill-and-hold arrangements?

Recognize when control of the good transfers to the customer.

**[MOD 8] Stock Transactions, Dividends, and EPS** Accounting for Stock-Based Compensation

Regardless of the type of stock-based compensation plan, there are common accounting steps. *-1.-*When the award is granted to employees, the company estimates the fair value of the award. *-2.-*The fair value of the award is recorded as an expense in the income statement, ratably over the vesting period. *When the shares are issued, common stock and additional paid-in capital increase in the same manner as for cash-based stock issuances,* as described above.

**[MOD 9] Intercorporate Investments** Analysis of Equity Carve-Outs

Sell-offs, spin-offs, and split-offs all involve the divestiture of an operating segment. Although all three types of carve-outs are one-time occurrences, they can result in substantial gains that can markedly alter the income statement. Following an equity carve-out, the parent company is rid of the cash flows (positive or negative) of the divested business unit. As such, the divestiture should be treated like any other discontinued operation. Any recognized gain or loss from divestiture is treated as a nonoperating activity. Income (and cash flows) of the divested unit up to the date of sale, however, is part of operations, although discontinued operations are typically segregated.

**[MOD 8] Stock Transactions, Dividends, and EPS** Reporting Stock-Based Compensation

Stock-based compensation expense is included on the income statement but rarely reported as a separate line item. Cost of goods sold (for employees in R&D and manufacturing) or Selling general and administrative expense (for employees in selling and administration and executive roles). We can determine the amount of the expense from the statement of cash flows. Because stock-based compensation expense is a non-cash expense, companies add back this expense in the statement of cash flow.

**[MOD 9] Intercorporate Investments** Held-to-Maturity (HTM) Debt Securities

The "cost method" applies to held-to-maturity securities. Changes in fair value of held-to-maturity securities do not affect either the balance sheet or the income statement. The presumption is that these investments will indeed be held to maturity, at which time their market value will be exactly equal to their face value. --Fluctuations in fair value, as a result, are less relevant. The company records the investment at its acquisition cost (like any other asset) and amortizes any discount or premium over the remaining life of the held-to-maturity investment. At any point in time, the acquirer's balance sheet carries the investment at "amortized cost," which is never adjusted for subsequent market value changes.*

**[MOD 7] Current & Long-term Liabilities** How are the details relating to a company's outstanding bonds and notes reported?

The details relating to each of the company's outstanding bonds and notes are provided in a footnote disclosure like the following for Verizon

**[MOD 8] Stock Transactions, Dividends, and EPS** Dividend Payout Dividend Yield

The dividend payout ratio measures the proportion of the company's earnings that is paid out as dividend—[(common stock dividends per share) / (EPS)] Dividend yield is tied to the current market value of the company's stock— [(c/s dividend per share) / (share price)]

**[MOD 9] Intercorporate Investments** *Sell-Offs* *(1) defn* *(2) FinEffects: illustration of a sell off: Emerson Electric* "sale of power solutions biz for 1.4B, recognized pretax gain from the transaction of $939 ($532 after-tax, $0.78 per share). Assets and liabilities sold were as follows: current assets, $182 (accounts receivable, inventories, other current assets); other assets $374 (ppe, goodwill, other noncurrent assets); accrued expenses, $56 (a/p, other current liabilities); other liabilities, $41"

The financial statement effects of this transaction are as follows: Emerson Electric received $1.4 billion in cash. The mechanical power transmission solutions business was reported on Emerson Electric's balance sheet at $459 million ($182 + $374 2 $56 2 $41) in January 2015, the month of sale. Emerson Electric's gain on sale equaled the proceeds ($1.4 billion) less the carrying amount of the business sold ($459 million), or $939 million ($2 million rounding difference). On the statement of cash flows, Emerson Electric subtracts the $939 million non-cash gain on sale from net income in computing net cash flows from operating activities. The cash proceeds of $1.4 billion are reported as a cash inflow in the investing section.

Asset Sales An asset's NBV

The gain or loss on the sale (disposition) of a tangible asset is computed as follows. An asset's net book value is its acquisition cost less accumulated depreciation. When an asset is sold, its acquisition cost and related accumulated depreciation are both removed from the balance sheet and any gain or loss is reported in income from continuing operations.

**[MOD 7] Current & Long-term Liabilities** What is the Market Rate of Interest?

The market rate of interest is usually defined as the yield on U.S. Government borrowings such as treasury bills, notes, and bonds, called the risk-free rate, plus a risk premium (also called a spread).

**[MOD 7] Current & Long-term Liabilities** I/S Reporting of interest expense vis-a-vis a bond (at par, discount, or premium)

The process of recognizing additional interest expense in the case of a bond issued at a discount (or reduced interest expense in the case of a bond issued at a premium) is called amortization. *The amount of interest expense that is reported on the income statement each year represents the effective cost of debt, including both the cash interest paid plus a portion of the additional borrowing costs (or less a portion of the benefit of the premium).*

**[MOD 9] Intercorporate Investments** Accounting for Acquired Intangible Assets

The purchase price is first allocated to the assets acquired and the liabilities assumed. Tangible assets, such as PPE and inventory, are identified and valued. Then, intangible assets are identified and valued. All these assets are recorded on the acquirer's consolidated balance sheet at fair market value just like any other purchased asset. Finally, any excess purchase price is allocated to Goodwill. Common types of intangible assets recognized during acquisitions follow. Marketing-related assets such as trademarks and Internet domain names Customer-related assets such as customer lists and customer contracts Artistic-related assets such as plays, books, and videos Contract-based assets such as licensing, lease contracts, and franchise and royalty agreements Technology-based assets such as patents, in-process research and development, software, databases, and trade secrets

**[MOD 9] Intercorporate Investments** how? common types of intangies?

The purchase price is first allocated to the assets acquired and the liabilities assumed. Tangible assets, such as PPE and inventory, are identified and valued. Then, intangible assets are identified and valued. All these assets are recorded on the acquirer's consolidated balance sheet at fair market value just like any other purchased asset. Finally, any excess purchase price is allocated to Goodwill. Common types of intangible assets recognized during acquisitions follow. Marketing-related assets such as trademarks and Internet domain names Customer-related assets such as customer lists and customer contracts Artistic-related assets such as plays, books, and videos Contract-based assets such as licensing, lease contracts, and franchise and royalty agreements Technology-based assets such as patents, in-process research and development, software, databases, and trade secrets Once recognized, intangible assets with definite useful lives are amortized over their remaining lives. For example, Heinz will amortize the customer relationships over 29 years. Other intangible assets that are considered to be indefinite-lived assets (such as the indefinite-lived trademarks) remain on the balance sheet at their initial value. These assets are tested annually for impairment and written down accordingly, similar to the accounting for all fixed assets and goodwill.

What is the retail inventory costing method? [formula]

The retail inventory costing method allows retailers to readily compute ending inventories at retail selling prices. [formula = Quantities available x Selling price] The company's inventory system tracks both the purchase cost and the retail selling price of inventories. These are inputs in the cost-to-retail percentage calculation. The cost-to-retail percentage is important and managers review the ratio regularly for reliability.

To determine depreciation expense, a company must make what 3 estimates?

To determine depreciation expense, a company makes three estimates. *Useful life*—period of time over which the asset is expected to generate measurable benefits. *Salvage value*—amount expected for the asset when disposed of at the end of its useful life. *Depreciation method*—estimate of how the asset is used up over its useful life.

**[MOD 9] Intercorporate Investments** (1) What are the 3 levels of influence or control? (2) Why does this matter?

There are three levels of influence or control. Little or no influence (passive investments). The investor has a relatively small investment and cannot exert influence over the investee. Generally, the investor is deemed to have little to no influence if it owns less than 20% of the investee's outstanding voting stock. Significant influence. The investor can exert "significant influence" over the investee by virtue of the percentage of the outstanding voting stock it owns or owing to legal agreements between the investor and investee, such as a license to use technology. Absent evidence to the contrary, significant influence is presumed when the investor owns between 20% and 50% of the outstanding voting shares. Control. When a company has control over an investee, it has the ability to elect a majority of the board of directors and, as a result, the ability to affect the investee's strategic direction and the hiring of executive management. Control is generally presumed if the investor company owns more than 50% of the outstanding voting stock of the investee company but can sometimes occur at less than 50% stock ownership by virtue of legal agreements, technology licensing, or other contractual means. The determining factor is the ability to control strategic decisions. The level of influence/control determines the specific accounting method applied and its financial statement implications.

**[MOD 9] Intercorporate Investments** Equity Method Accounting Issues

There can be a substantial difference between the book value of an equity method investment and its fair value. An increase in value is not recognized until the investment is sold. If the fair value of the investment has permanently declined, the investment is deemed impaired and written down to that lower fair value. Recognition of equity income by the investor does not mean it has received that income in cash. Cash is only received if the investee pays a dividend. The investor's statement of cash flows will include a reconciling item (a deduction from net income in computing operating cash flow) for its percentage share of the investee's net income. This is typically reported net of any cash dividends received.

**[MOD 7] Current & Long-term Liabilities** Why might a company want to manipulate how it reports it's warranty liabilities?

There is the possibility that a company might intentionally underestimate its warranty liability to report higher current income, or overestimate it so as to depress current income and create an additional liability on the balance sheet (cookie jar reserve) that can be used to absorb future warranty costs and, thus, to reduce future expenses. The overestimation would shift income from the current period to one or more future periods. Warranty liabilities must, therefore, be examined closely and compared with sales levels. Any deviations from the historical relation of the warranty liability to sales, or from levels reported by competitors, should be scrutinized

**[MOD 9] Intercorporate Investments** Equity Investment and Equity income add up how to comprise equity owned?

They comprise an equal proportion of equity owned

*Analysis of Sales Allowances:* What is analyzed in analysis of the adequacy of the Allowance Account

This analysis compares: the dollar amount of the estimates for future sales returns, with the amount actually realized during the year.

*Analysis of Sales Allowances:* ("Additions charged to net sales" [aka allowances]) / (gross sales [for both sales returns and sales discounts and incentives])

This ratio reveals any effects of the pricing pressure on net sales and we would expect the percentage of sales allowances to gross sales to increase (thus reducing net sales) as pricing pressure increases. ex: increased pricing pressure on Levi's is evident in the increase in allowances as a percentage of gross sales.

Income Statement adjustments for a LIFO reserve

To compare the income statements of companies that use LIFO, we must adjust cost of goods sold from LIFO to FIFO. To do this, we use the change in the LIFO reserve to determine the FIFO cost of goods sold (COGS) as follows.

Depreciation methods: -(1)-Straight-Line Method -(2)-Double-Declining-Balance Method

Under the straight-line (SL) method, depreciation expense is recognized evenly over the estimated useful life of the asset as follows. For the double-declining-balance (DDB) method, the depreciation base is net book value [NBV = cost - accumulated depreciation], which declines over the life of the asset. The depreciation rate is twice the straight-line (SL) rate. JP: Only need to get to last pd of depreciation before salvage value

**[MOD 7] Current & Long-term Liabilities** Warranty liabilities --defn --how recorded?

Warranty liabilities are commitments that manufacturers make to their customers to repair or replace defective products within a specified period of time. If the obligation is probable and the amount estimable with reasonable certainty, GAAP requires manufacturers To record the expected cost of warranties as a liability and To record the related expected warranty expense in the income statement in the same period that the sales revenue is reported.

PPE Percent Used Up

We can also estimate percent used up: the proportion of a company's depreciable assets that have already been transferred to the income statement. This ratio reflects the percent of depreciable assets that are no longer productive and is computed as follows (doesn't count land or works in progress, so you must take those assets out of PPE before you use it as the denominator here). Knowing the degree to which a company's assets are used up is of interest in forecasting future cash flows. If, for example, depreciable assets are 80% used up, we might anticipate a higher level of capital expenditures to replace aging assets in the near future. We also expect that older assets are less efficient and will incur higher maintenance costs.

Capitalization and Depreciation of PPE Assets

When PPE is acquired, it is recorded at cost on the balance sheet. This is called capitalization, which explains why expenditures for PPE are called CAPEX. Once capitalized, the cost of plant and equipment is recognized as expense over the period of time that the assets produce revenues (directly or indirectly) in a process called depreciation. Depreciation recognizes using up of the asset over its useful life.

**[MOD 7] Current & Long-term Liabilities** Balance Sheet Reporting of Premium Bonds

When a bond is sold at a premium, the cash proceeds and net bond liability are recorded at the amount of the proceeds received (not the face amount of the bond). The face amount must be repaid at maturity, and the premium is amortized to zero over the life of the bond. The premium represents a benefit, which reduces interest expense on the income statement.

**[MOD 7] Current & Long-term Liabilities** Gains and Losses on Bond Retirements *(2)* Do these gains/losses carry economic effects?

When a bond repurchase occurs, a gain or loss usually results, and is computed as follows: [Gain or Loss on Bond Repurchase = Net Bonds Payable - Repurchase Payment] The net bonds payable, also referred to as the book value, is the net amount reported on the balance sheet. If the issuer pays more to retire the bonds than the amount carried on its balance sheet, it reports a loss on its income statement, usually called loss on bond retirement. The issuer reports a gain on bond retirement if the repurchase price is less than the net bonds payable. (2) No, they do not carry economic effects—the gain or loss on repurchase is exactly offset by the present value of the future cash flow implications of the repurchase

**[MOD 7] Current and Long-Term Liabilities** Financial Statement Effects: --Short-Term Debt --Interest on Short-Term Debt

When a company borrows short-term funds (as in borrowings from a bank credit line or revolver during the off-season) it reports the cash received on the B/S together with an increase in liabilities (notes payable) --the note is a current liability, paid w/in the year --the borrowing has no effect on SE, but interest accrual does. Interest on short term debt is accrued each time financial statements are issued, as a liability and negative SE account. On I/S, it's recognized as an expense.

Performance Obligations Satisfied Over Time: Costs paid in excess of billings

When a company incurs costs in excess of the amount it bills the customer, it recognizes that excess as a current asset.

**[MOD 7] Current & Long-term Liabilities** Issuance of Bonds

When a large amount of financing is required, the issuance of bonds in capital markets is a cost-efficient way to raise funds. Bonds are structured like any other borrowing. The borrower receives cash and agrees to pay it back with interest. Generally, the entire face amount (principal) of the bond is repaid at maturity (at the end of the bond's life) and Interest payments are made in the interim (usually semiannually).

Assuming inflationary price environment, what would using LIFO mean for a company's financial statements?

When companies reduce inventory levels, older inventory costs flow to the income statement. These older LIFO costs are often markedly different from current replacement costs. Assuming an inflationary environment, sales of older pools often yield a boost to gross profit as older, lower costs are matched against current selling prices on the income statement.

*Cost of Goods Sold* [formula] --How does COGS get on the income statement?

When inventories are sold, their costs are transferred from the balance sheet to the income statement as COGS.

Gross Profit [formula] --descriptively, how is it arrived at?

When inventories are sold, their costs are transferred from the balance sheet to the income statement as cost of goods sold (COGS). COGS is then deducted from sales to yield gross profit.

**[MOD 9] Intercorporate Investments** Reporting the Sale of Subsidiary Companies

When the parent company sells one of its subsidiaries, it accounts for the subsidiary as a discontinued operation if the sale represents a strategic shift for the company that has, or will have, a major effect on a company's financial results. In 2015, United Technologies Corporation sold its Sikorsky Aircraft business to Lockheed Martin Corp. United Technologies reports the income from operations and gain on sale in its 2015 income statement as follows.

Multiple Products and Services Sold for One Price *-hint:-*what kind of components are recognized?

When the sale involves multiple products or services sold at one price, *First.* Companies must first separate the sale into distinct goods or services that can each be valued on a stand-alone basis. *Second.* they recognize revenue on each distinct component. *Components are generally viewed as distinct if the:* *--* the Customer can use the good or service on its own. *--* the Good or service is not highly interrelated with other goods or services sold per the contract.

**[MOD 9] Intercorporate Investments** Are companies required to disclose information about their investment portfolios? If so, where?

Yes, in footnotes to financial statements. --example below

**[MOD 8] Stock Transactions, Dividends, and EPS** Why do company outsiders monitor dividend payments closely?

it is generally perceived that the level of dividend payments is related to the company's expected long-term recurring income. Dividend payment increases are usually viewed as positive signals about future performance and are frequently accompanied by stock price increases.

revenue recognition: Consignment sales.

recognize only commission, not the gross amount of the sale, when goods are sold. This is bc you are acting as an agent for the consigner.

**[MOD 8] Stock Transactions, Dividends, and EPS** Treasury Stock --do t-stocks have voting rights or dividend rights?

stock held in a company's treasury. These shares, while legally owned by the company, have NO voting rights and NO dividends

*Unearned (deferred) Revenue* --defn --reporting of unearned revenue --analysis of unearned revenue

the accounting for unearned revenue involves the recognition of cash and a liability which evidences the company's obligation to deliver a good or perform a service at a future date. --Then, when the good is provided or the service rendered, the unearned revenue liability is reduced and earned revenue is recognized in the income statement. Should deferred revenue liabilities decrease, we infer the company's current reported revenue was collected from customers in a prior accounting period and there have been fewer new prepayments for which revenue will be recognized in future periods. Such a trend could predict future declines in revenue and profit.

**[MOD 8] Stock Transactions, Dividends, and EPS** Book value per share --definition --[formula]

the equity (net book value) of the company that is available to common shareholders


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