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Financial Accounting: Class Notes

9/22/2008 Revision 0.1 Author: Philip Larson

Corporate Acquisitions: Class notes

Table of Contents
1. Lecture 1....................................................................................................................................3

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1. Lecture 1
1.1
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Financial Accounting Aiyesha Dey Class 1 o Three homework assignments Accounting o language of business o Collection, processing and reporting of info about activities and events that affect the organization Three types of accounting users o Financial Accounting and Reporting: recording financial transactions, position and results and communicating it to outside stakeholders o Managerial Accounting and Reporting: communicating the position and results of firm internally. o Tax Accounting and Reporting: recording and reporting financial position to IRS. Accounting Principles o Generally Accepted Accounting Principles (GAAP) SEC has authority to set GAAP SEC delegates this authority to the Financial Accounting Standards Board (FASB) FASB rules are called Statements of Financial Accounting Standards (SFAS) currently over 150 rules Attributes of ideal accounting system Reliability verifiable by an independent party Relevance it has to be timely, and have feedback value and predictive ability to a certain extent (you may want to use the info to make future decisions) Other important accounting concepts Conservatism report bad news but not good news if there is uncertainty Materiality if tracking an account is costly and reporting it doesnt change decisions, it is not worth it. Accounting Qualities o Decision Usefulness Relevance Timely Feedback value tells you about the past (evaluate the managers of the firm); feedback on past performance and management performance Predictive value Reliability Verifiability Representational faithfulness Neutral (compare firm across years and compare across firms) Comparability Materiality o Understandability Assumptions Underlying Financial Accounting o Three Assumptions Entity Concept parent company and any subsidiaries controlled by the parent; independent subsidiaries are not part of the firm Arms length transaction

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Monetary measurement concept Going concern assumption o Discretion accounting information is subject to discretion. Accounting numbers = economic truth + measurement error + incentives o Changes to Accounting Rules and Regulation can change due to lobbying, political pressure, economics and technological change Principal Activities of a Firm o Sources of capital Creditors Owners o Investing Activities Inventory PPE o Operating Activities Creates value o Value creation Earnings, profits, etc. How can a firm return value? Dividends Reinvest earnings into investing activities of the firm Repay your creditors o FINANCIAL STATEMENTS PROVIDE INFORMATION ON EACH STEP Role of Financial Reporting o Who is interested in information about the firm? S/Hs, potential S/Hs Creditors Suppliers IRS Analysts, other intermediaries o What types of information about the firm? Performance Revenue, expenses, Ratios Cash flow Assets & liabilities o Supply Mandatory disclosures Annual audited filings with the SEC (10Ks) Quarterly unaudited SEC filings (10Qs) Annual reports sent to shareholders Key Players in Financial Reporting o Preparers SEC oversight role delegated to FASB FASB rule-making body GAAP set of rules created by FASB Directors audit committee responsible for reporting of the firm Auditors attest to the credibility of the financial reports (Sarbanes-Oxley Act (SOX) July 30, 2002 in response to Enron, WorldCom, etc.) o Users Analysts/Media third party information providers

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Investors large institutions and individuals International Financial Reporting Standards (IFRS) o Set of global accounting standards for the preparation of public company financial statements o Developed by the International Accounting Standards Board (IASB) o IASB is an independent accounting standard-setting body based in London o 12,000 companies in almost 100 nations have adopted IFRS. Many more will transition in 2011 o FASB and IASB are working towards convergence of US GAAP and IFRS o SEC Roadmap 2011: decision whether US Firms are required to use IFRS 2014: implementation year in case of positive decision Financial Statements o Basic Financial Statements Balance Sheet Income Statement Statement of Cash Flows o Supplemental information about the financial condition of a company Statement of Shareholders Equity Notes to Financial Statements footnotes are very important Auditors Report The Balance Sheet o A point in time snapshot of the investing and financial activities of the firm o Balance sheet identity ASSETS = LIABILITIES + SHAREHOLDERS EQUITY E.g. Investments = financial arrangements Resources = claims on resources Owns = owes The Income Statement o A schedule that presents the results of operations of a firm for a specific period of time. o NET INCOME = REVENUES EXPENSES Revenues inflows of assets from selling and providing goods or services Expenses outflows of assets used in generating revenues o Note: there is nothing in these definitions that referto cash o Balance Sheet vs. Income Statement Income statement links the balance sheet at the beginning of the period with the balance sheet at the end of the period Retained Earnings (RE) is increased each period by the net income of the period and decreased by any dividends declared during the period RE (end of period) = RE (beginning of period) + NET INCOME DIVIDENDS Statement of Cash Flows o A schedule that reports the details of where cash came from and where cash went for a period of time. o Cash flows are categorized into: Operating: Providing goods and services Investing: Choice of assets used to run operations Financial: Raising capital to pay for assets Financial Statements: The Link o CASH + NONCASH ASSETS = LIABILITIES + CONTRIBUTED CAPITAL + RETAINED EARNINGS Other Financial Reporting Items

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Statement of Shareholders Equity schedule that reconciles the change in S/Hs equity accounts during a period of time o Notes to financial statements o Auditors opinion o Financial highlights, including trends o Managements Discussion and Analysis o CEO/CFO Certification CHAPTER 2 The Balance Sheet (p59-61 nice summary of balance sheet accounts) Assets o Definition: an asset is an economic resource that is expected to provide future economic value (i.e. generate future cash inflows or reduce future cash outflows) All assets are future benefits; however not all future benefits are accounting assets Executory (uncompleted) contracts do not result in assets (must be an exchange) o An asset is included in the balance sheet (i.e. recognized) when: Ownership the firm has acquired the right to use it in a past transaction or exchange Measurable the value of its future benefits can be measured with a reasonable degree of precision o Examples Cash, Inventory, Accounts Receivable, PPE (property, plant, equipment) Brand name or famous CEO (Warren Buffett) CANNOT be put on the balance sheet Patents are intangible assets (R&D) GAAP requires that you expense the costs of R&D. If you are generating it yourself, you can put a value to it. How can you verify the value? However, if you buy it from an outside party that establishes a reliable value. Assets: Valuation o Three types Acquisition or Historical Cost (adv: verifiable/reliable; disadv: may not reflect economic value) Valued at the amount of resources paid to acquire it Fair Market Value (adv: closer to market value; disadv: hard to measure) Replacement cost entry price (valued at the cost of replacing the asset) Net Realizable Value exit price (valued at the net cash received on selling the asset) Present value of expected future cash flows (adv: closer to economic value; disadv: reliance on assumptions that may not be accurate) o GAAP on Valuation Monetary assets an asset whose realization is fixed in terms of dollars Use PV method Examples: Cash, Accounts Receivable Nonmonetary Asset all other assets Historical Cost Examples: PPE, inventory, etc. Exception: marketable securities (valued at Net Realizable Value) Assets: Classification o Current Assets: assets expected to be realized in cash within one operating cycle (typically one year) Examples: inventory, accounts receivable o Noncurrent assets: assets that are NOT expected to be realized in cash within one operating cycle Examples: PPE o

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Why is this relevant? Liquidity it is a measure of liquidity and how quickly you can get the assets out of the firm. Liabilities: o Definition: a liability is a claim on assets by creditors that represents an obligation to make future payment of cash, gods or services (i.e. consume resources) o All liabilities are obligations; not all obligations are accounting liabilities o A liability is included in the balance sheet (i.e. recognized) when: The obligation is based on benefits or services received currently or in a past transaction The amount and timing of payment is reasonably certain (measurable) Examples: accounts payable, notes payable, advances from customers (prepayment), warranties Is a lawsuit a liability? No. It is not measurable. This is called a contingent liability. You do have to disclose them in notes. Liabilities: Valuation o Monetary liabilities liability whose settlement is fixed in terms of dollars (i.e. by contract) Examples: bonds payable Most liabilities require a specific payment Valuation: PV of expected future cash flows o Nonmonetary liabilities all others! Typically requires delivery of goods or rendering of service rather than payment of cash Examples: advance from customers, warranty liability Valuation: At face value (amount of resources received (e.g. customer advances) At expected cost of providing service (e.g. warranty liabilities) Liabilities: Classification o Current liability: obligation expected to be paid in cash within one operating cycle Example: accounts payable o Non-current liability: obligation with an expected due date beyond one operating cycle Ex: long-term debt o Current ration: Current assets/Current Liabilities o Working capital: CA-CL o Acid Test Ratio (Quick Ratio) = (Cash + Acct Receivable + Short term investment)/Current Liabilities - this basically ignores inventory. If ACID test ratio is less than Current Ratio Inventory is a big deal. How liquid really is the firms inventory? FAS 159: Fair Value Option (FVO) o Firms can optionally elect to use fair values to measure eligible assets and liabilities in their financial statements Fair value is the amount a firm would receive if it sold an asset or would pay if it settled a liability at the measurement date Effective date: fiscal year beginning after November 15, 2007 Management has sufficient discretion in electing specific assets and liabilities, but once FVO is elected it is irrevocable Detailed requirements for applying fair value measurements to the calculation of net income for specific assets and liabilities (e.g. bonds) are still not provided The fair value option is still considered an interim step. o Inputs to Measuring Fair Value (FV) Level 1: Observable quoted prices in active markets for identical assets/liabilities (MOST RELIABLE) Level 2: Observable inputs other than quoted market prices within Level 1 Includes quoted prices for similar asses/liabilities in active market o

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Includes quoted prices for identical asses/liability in markets that are not active Observable factors relevant to using present values of cash flows to measure FV Level 3: Unobservable inputs which reflect the reporting entitys own assumptions (Managements assumptions) about the assumptions market participants would use in pricing an asset/liability. (LEAST RELIABLE) o Disclosures Related to the Fair Value Option (FVO) Balance Sheet Identify the financial assets/liabilities for which it used the FVO and disclose the reasons for choosing to measure those items at FV Income Statement exact rules not yet set Notes to Financial Statements Indicate which Level (1, 2 or 3) you used for measuring FV For assets/liabilities valued using more than one of the leels, classify the asset as coming from the lowest level More disclosure around Level 3 management assumptions Shareholders Equity o Definition: shareholders equity is the residual claim on assets by owners after settling claims of creditors o Valuation: value of assets MINUS value of liabilities. (A=L+SE) o Two basic components of S/Hs equity Contributed capital: initial investment of S/Hs Preferred stock first preference for dividends but no voting rights. Common stock voting rights Additional paid-in capital (APIC) (e.g. if you sell a $1 par value stock in the market for $10 you have $1 common stock and $9 additoinal paid-in capital Retained earnings: additional investment of S/Hs resulting from firms retention of earnings that belong to owners o Is S/Hs equity (i.e. book value of equity) = market value of equity? Market value of equity (market cap) Market to Book Ratio o Ratio of the market value of equity to the book value of S/Hs equity Market value of equity (also known as the market capitalization of the firm) = number of common shares outstanding X market price per share Book value of equity = the accounting value of S/Hs equity o Why would these differ? Market value reflects the economic values o MV/BV examples Dell: 12.5 Microsoft: 6.18 Bank of America: 1.03 NOTE: while BoA holds mainly financial assets that are recorded in the accounting, MSFT and DELL have brand name, R&D, etc. that are not incorporated into the balance sheet Accounting Cycle o Lots of transactions o 1. Analyze Transactions o 2. Create journal entires (two sides must balance) o 3. Post to a ledger which is a collection of T-accounts unadjusted trial balance o 4. Adjusting entries o 5. Closing entries

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o END OF PERIOD three financial statements are created Double Entry Accounting System o Every economic event has two sides a give and a take o Both sides of the transaction are to be recorded o The basic accounting equation remains in balance Assets = Liabilities + Shareholders Equity 1) Inv up $100k, Acct Payable up $100k 2) Cash up $3k, Accounts Receivable down $3k 3) PPE up $40M, Notes payable up $40M 4) Cash up $300M, Common stock up $300M 5) Cash down $20k, Accounts payable down $20k o Assets, Liabilities and S/Hs Equity are stored in accounts T-accounts: easy way to keep track of activity and multiple transactions in an account o Account balances Ending balance = beginning balance + increases decreases o Debit an entry which Is made on the left side of the T-Account Increases an asset account Decreases a liability account Decreases a S/Hs equity account o Credit is an entry which Is made on the right side of the T-Account Decreases an asset account Increases a liability account Incrases a S/Hs equity account o Every transaction must have at least one debit and at least one credit o Sum of debits = sum of credits E.g. Dr. Inv. 100k; Cr. Acct Pay 100k

Class 2 10/6/2008 - Balance Sheet Definitions o Assets: economic resourcecs with the ability to provide future benefits to a firm o Liabilities: creditors claims on the assets of a firm and show some of the sources of the funds the firm uses to acquire the assets. o Shareholders Equity: amount of funds owners have provided and, in parallel, their claims on the assets of a firm. o Retained Earnings: source of funds a firm derives from its earnings that exceed the dividends it has distributed to S/Hs since its formation o Current Liabilities: obligations a firm expects to pay in one year o Current Assets: generally convert into cash within one year. o Historical valuation: reflects the acquisition cost of assets or the amounts of funds originally obtained from creditors or owners o Current Valuation: reflects the current cost of acquiring assets or the current market value of creditors and shareholders claims on a firm. - Income Statement Definitions o Income Statement: attempts to answer question How profitable is the firm? by showing net income or earnings for a period o Net Income: revenues expenses (aka earnings) o Revenues: measure of the inflows of assets (or reductions in liabilities) from selling goods and providing services to customers. o Expenses: measure of outflows of assets (or increases of liabilities) used in generating revenues.

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o Net Loss: when expenses for a period exceed revenues. Equations o Assets = Liabilities + Shareholders Equity o Net Income = revenues expenses PROBLEM 2.29 o 1) Issued for cash 80,000 shares of #10 $800,000 Cash: Debit 800,000 Common Stock: Credit 800,000 o 2) o We are still recording for December, Yr 12 so the 25 yr useful life doesnt begin yet. o 3) o 4) o 5) o 6) o 7) Dr. Equipment 80,000 Cr. Notes Payable 80,000 Dr. Cash 300,000 Cr. Loan Payable 300,000 Dr. Prepaid Insurance 12000 Cr. Cash 12000 Dr. Accounts Payable 250,000 Cr. Cash 245,000 (2% discount - .02*250k=5k) Cr. Inventory 5,000 (adding to an asset is a credit) Dr. Inventory 280,000 Cr. Accounts Payable 280,000 (Notes payable: borrowing money from a lender; Accounts payable: buying inventory; Bonds payable: borrowing from a different kind of lender) Dr. Land 50,000 Dr. Building 450000 Cr. Cash 500000

o A) o Cash: Dr 343000 o Inventory: Dr 275000 o Prepaid Insurance: Dr. 12000 o Land 50000 o Buildings 400000 o Equipment 80000 o Accounts Payable: Cr 30000 o Notes Payable: Cr. 80000 o Loan payable: Cr. 300000 o Common stock: Cr. 800000 Assets o Cash: 343000 Total Current Assets: 630,000 o Land 50000 o Building 450000 o Equipment 80000 Total Assets: 1210000 Liabilities

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o Accounts Payable 30000 o Notes Payable 80000 o Total Current Liabilities 110000 o Loan Payable 300000 Total Liabilities 410000 Shareholders Equity o Common Stock at Par 800000 o Total Shareholders Equity 800000 Total Liabilities and Shareholders Equity 1210000 Analyzing the Balance Sheet o Current Ratio: Current Assets/Current Liabilities = 630000/110000 ~ 6 (way over 1 good sign) o Acid Test Ratio: 343000/1100000 ~ 3 (way over 1 good sign)

THE INCOME STATEMENT - Presents a moving picture of the operating results of a firm for a given period of time (e.g. quarter, fiscal year) o Also known as Statement of Operations, Statement of Earnings - Cash accounting o Cash Accounting method of accounting where revenues are recorded when cash is received and expenses are recorded when cash is expended. o Advantages Provides reliable information about cash flows Intuitive and easy to understand Objective timing of transactions is clear o Disadvantages Delay in recording revenues/expenses until cash changes hands Poor matching of resources expended to benefits received Subject to manipulation for example, firm can delay recording an expense by postponing cash payment o Accrual Accounting Accrual Accounting: method of accounting where revenues and expenses are recorded on an economic basis regardless of the actual flow of cash Revenues recorded when benefits are earned o When is revenue earned? Expenses recorded when resources are expended to produce benefits. Advantages Better measurement of performance and matching of benefits and costs of transactions Curtails manipulation of cash transactions Disadvantages More difficult conceptually (at what point is revenue earned?) Cash is still king Non-cash financial manipulation through discretion and choice in accounting rules o Earnings management: use of accounting discretion to distort reported earnings o Methods of Managing Earnings 1) Cookie Jar Reserves take hits during good periods (restructuring costs) to smooth out earnings numbers.

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2) Concentrate costs in one quarter so future quarters look better. Take a onetime hit, look bad, but then look really good going forward. 3) Financing Arm of company 4) Cutting out R&D costs particularly pharmaceutical and software companies (other discretionary expenses) 5) Earnings guidance to analysts manage analyst expectations so market doesnt expect something higher. 6) Pro forma earnings EBITDA (excluding nonrecurring expenses) be aware that interest, taxes, depreciation, amortization, etc. will continue. Measurement Principles of Accrual Accounting o Measurement involves both timing and amount of the recognition for both revenues and expenses. Timing of revenue recognition Measurement of revenue Timing of expense recognition Measurement of expenses o Over the life of the firm: Cash income = accrual income Revenues o Revenues: benefits (or increases in net assets) earned by a firm for providing goods and services Net Assets = assets liabilities = Shareholders Equity o Revenue recognition criteria Firm has delivered the goods to the customer or performed all or most of the services (i.e. it has earned the revenue) Collection of cash (or other benefits) is reasonably assured though some uncertainty may remain (bad debts, warranties) Cash (or other benefits) to be received is measurable How much revenue is recognized in December? o A) $500k because goods delivered sold on credit o B) 0 this was already recorded in October o C) $10k this is what was earned in December o D) 0 revenue they would have advance from customers o E) This is not an income statement item this would go into paid in capital Expenses o Definition: Decreases in net assets (not necessarily cash) that arise in the process of generating revenue. o The underlying expense recognition concept is the matching principle: recognize costs and/or assets used as expenses in the period in which they generate revenue o Expense recognition criteria expenses are recognized when either: Product costs (costs associated with the production of goods: record in the period when the related revenue is recognized Period costs (cannot easily be matched with revenue: record in the period when the cost is incurred How much expense is recognized in December? o A) 0 revenue not matching to any revenue yet o B) 0 revenue o C) $8,000,000 expense matching to the $15,000,000 in revenue o D) $180,000 expenses in December they did their marketing for that month hard to match to future o E) 25000 in December

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F) this creates an asset, no revenue G) 0 dividends are NOT an expense it is not a part of generating revenues. DIVIDENDS DO NOT GO INTO THE INCOME STATEMENT Basic Accounting Equation with Revenues, Expenses and Dividends o Assets = Liabilities + Shareholders Equity o Shareholders Equity = Contributed Capital + Retained Earnings o Retained Earnings = Retained Earnings Beginning + Net Income for Period Dividend for Period o Net Income = Revenues for Period Expenses for Period Purpose and Use of Individual Revenue and Expense Accounts o Revenue and expenses could be recorded directly to the Retained Earnings account o It is more informative to collect revenues and expenses separately during the accounting period. o At the end of the accounting period, revenues and expenses are cleared (reset to zero) for the new accounting period. Their balances flow into Retained Earnings. This is closing the accounts o Revnues and expense accounts are temporary accounts. In contrast, the balance sheet accounts (asset, liability and S/Hs equity) are permanent accounts whose balances carry over each period Double Entry Accounting System o Revenue: increases credit the account (increase an asset); Decreases debit the account o Expenses: increases are debited; decreases are credited o Closing revenue account If you have a credit in revenue Dr. Revenue by X Cr. Retained Earnings by X Expenses, if you have a balance of Y Cr Expense Account by Y Dr. Retained Earnings by X o Shareholders Equity Increases credited Decreases debited EXAM: DIVIDENDS ARE NOT AN EXPENSE PROBLEM 3.33 Moulton Corporation o Accrual basis of accounting o 1) purchased inventory on account costing $1,100,000 from various suppliers Dr. Inventory 1,100,000 Cr. Accounts Payable 1,100,000 We start with a beginning balance of $343,000 for cash, etc. o 2) Sold merchandise to customers for 2,000,000 on account Dr. Accounts Receivable 2,000,000 (this goes to balance sheet) Cr. Revenue 2,000,000 (this goes to income statement) o 3) Cost of merchandise sold to customers totaled $1,200,000 Dr. Cost of Goods Sold 1,200,000 Cr. Inventory 1,200,000 o 4) Collected $1,400,000 from customers for sales made previously on account Dr. Cash 1,400,000 Cr. Accounts Receivable 1,400,000 o 5) Paid merchandise suppliers $950,000 for purchases made previously on account Cr. Cash 950,000 Dr. Accounts Payable 950,000 o 6) Paid various suppliers of selling and administrative services $625,000. The firm consumed all of the benefits of these services during Year 13. o o

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Cr. Cash 625,000 (balance sheet) Dr. SGA (Selling, General, Administrative) Expense 625,000 (income statement) 7) Firm acquired equipment costing $80k and signed a 6% note payable to the supplier. The note is due on 6/30 Year 13. Equipment has estimated useful life of 5 years. In year 13, firm repaid note payable to supplier with interest. Dr. Interest Expense .06*80k*(1/2 half a year)=$2,400 Cr. Cash 2400 Dr. Notes Payable 80,000 Cr. Cash 80000 8) The firm borrowed $300k from a bank. The loan bears interest at an annual rate of 8% and is due in 5 yrs. The interest is payable on January 1 of each year, beginning January 1, Year 14. On December 31, Year 13 the firm recognized interest on the loan. The 300,000 was from year 12 so it should have already been reflected. Dr. Interest Expense .08*300,000=24000 (on income statement) Cr. Interests Payable 24,000 (liability on balance sheet) 9) Dr. Insurance Expense 12,000 Cr. Prepaid Insurance 12,000 (this reverses out the asset they had) 10) Recognized depreciation expense for Year 13. In Year 12, the firm had purchased a building costing $450,000 with an expected useful life of 25 years beginning on January 1, Year 13. Also, on December 31 it acquired equipment costing $80k which has an estimated useful life of 5 years. Dr. Depreciation Expense 18,000 Dr. Depreciation Expense 16,000 Cr. Accumulated Depreciation 34,000 (contra asset account this goes into balance sheet and is written under the building or equipment you are depreciating. It is still on the asset side of the balance sheet because it makes sense to have them together. It works like a liability because when it increases we credit. 11) 12/31 Year 13, recognized income tax expense and income tax payable for Year 13. The income tax rate is 40%. Assume that income taxes for Year 13 are payable by March 15, Year 14. Sales Revenue: 2,000,000 Expenses Cost of Goods Sold: 1,200,000 SGA Expense: 625,000 Insurance: 12,000 Depreciation: 34,000 Interest: 26,400 Total Expenses: 1,897,400 Net Income Before Income Taxes: 102,600 Income Tax Expense at 40%: (41040) Net Income: 61,560 Dr. Income Tax Expense 41,040 Cr. Tax Payable 41,040 Closing transactions Dr. Revenue 2,000,000 (because that zeros out the credit) Cr. Retained Earnings 2,000,000 Cr. Cost of Goods Sold 1,200,000 Dr. Retained Earnings 2,000,000 Cr. SGA 625,000

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Dr. Retained Earnings 625,000 Cr. Insurance 12,000 Dr. Retained Earnings 12,000 Cr. Depreciation 34,000 Dr. Retained Earnings 34,000 Cr. Income Tax Expense 41040 Dr. Retained Earnings 41,040 Types of Journal Entries o Transaction based entries: sale of product, purchase materials, pay salaries o Adjusting journal entries: Made at the end of an accounting period to reflect non-cash economic events that occurred during the period or prior transactions that were improperly recorded during the period. Usually involve both a balance sheet and an income statement account Example Dr. Unearned Revenue Cr. Revenue Summary of the Double Entry Accounting System o Asset + debit - credit o Liability - Debit + Credit o Stockholders Equity - Debit + Credit o Contributed Capital - Debit + Credit o Retained Earnings - Debit + Credit o Expense + Debit - Credit o Revenue - Debit + Credit Analyses of overstatement/understatement o A) Actual Entry Dr. Cash 1400 Cr. Revenue 1400 Correct Entry Dr. Cash 1400 Cr. Advance from Customer 1400 Correcting Entry Needed Dr. Revenue 1400 Cr. Advance from Customer 1400 Effect on Balance Sheet

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o B) Assets not effected (cash correctly stated) Liabilities (understated because they had an advance but they didnt state the liability) Shareholder Equity (Overstated by 1400 because revenues were overstated by 1400)

Actual Entry Dr. Cost of Goods Sold 5000 Cr. Cash 5000 Correct Entry Dr. Equipment 5,000 Cr. Cash 5000 Dr. Depreciation 500 (5000*1/5 * ) Cr. Accumulated Depreciation (contra account) Correcting Entry Cr. Cost of Goods Sold 5000 Dr. Equipment 5,000 Dr. Depreciation 500 (5000*1/5 * ) Cr. Accumulated Depreciation 500 (contra account) Effect on balance sheet Assets understated by 4500 (5000-500) Liabilities no effect Shareholders Equity understated by 4500 Retained earnings understated by 4500 Expenses overstated by 4500 Income Statement Classification o Operating (related to core operations of firm) Recurring (persist in future) Product sales SGA COGS Non-recurring (temporary charge) Discontinued operations (closed unit) o Peripheral (not related to core activity) Recurring Depreciation Interest Expense/Revenue Income Tax Gains & Losses on Asset Sales Non-recurring Patent litigation Natural disasters o You want to look at these different categories so you can invest properly. Look at what is likely to persist in the future. EPS = (net income dividends)/avg common shares outstanding If effect of dilution on EPS > 3% you must report both basic and diluted EPS.

CLASS 3 - Revenue Recognition Principles o Reasonably Certain that you will collect it from customers o Delivered goods or provided the service at least most of the service or most of the goods

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o Measurable must be measurable or else we cant recognize it in financial statements Staples Example

1) Review the revenue recognition policies of Staples discussed in Note A (Summary of Significant Accounting Policies). What are the types of revenue recorded by Staples? Discuss why the recognition policies for these revenue types are consistent with the revenue recognition criteria discussed in class.
Revenue is recognized at the point of sale for the Companys retail operations and at the time of shipment for its delivery sales. This is consistent with the Revenue Recognition principles of GAAP Sales of extended service plans are either administered by an unrelated third party or by the Company. The unrelated third party is the legal obligor in most of the areas they administer and accordingly bears all performance obligations and risk of loss related to the service plans sold in such areas. In these areas, Staples recognizes a net commission revenue at the time of sale for the service plans. In certain areas where Staples is the legal obligor, the revenues associated with the sale are deferred and recognized over the life of the service contract , which is typically one to five years. This is consistent with GAAP. 2) What is Staples accounting policy for advertising expenditures? What percent of Staples Sales are advertising and marketing expenses in fiscal 2005, 2004 and 2003? What percent of Operating and Selling expenses are advertising and marketing expenses in fiscal 2005, 2004 and 2003? Staples expenses the production costs of advertising the first time the advertising takes place, except for the cost of direct-response advertising, primarily catalog production costs, which are capitalized and amortized over their expected period of future benefits (i.e., the life of the catalog). Direct catalog production costs included in prepaid and other assets totaled $28.4 million at January 28, 2006 and $30.8 million at January 29, 2005. Total advertising and marketing expense was $588.2 million, $526.0 million and $492.7 million for fiscal years 2005, 2004 and 2003, respectively. This is consistent with GAAP. They spend about 4% of sales on advertising in 2003, 2004 & 2005 Advertising over Operating and Selling costs is about 22% across the years. If you are looking for a particular expense, sometimes you need to look at the footnotes. 3. Show the journal entry made by Staples to reflect the amount of dividends declared during fiscal 2005. You may assume that there are no prior period adjustments that affect Retained Earnings. Retained Earnings Credit Debit 2818163 Net Income 834409 Dividends ?? (123402) Ending Balance 3529170 (this increases because of net income) Retained Earnings End Balance = RE Beginning Balance + Net Income Dividends How write as a journal entry? Dr. Retained Earnings 123402 Cr. Dividends Payable (or Cash) 123402 4. What is the number of shares of common stock that have been issued as of January 28, 2006? Show how the accounting value for the Common Stock account in the Balance Sheet on this date was determined. Issued vs. Authorized vs. Outstanding Authorized # shares total number of shares a firm can issue over its life

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Issued # shares dont take away the number they purchased back Repurchased shares (e.g. Treasury stock) Outstanding # shares (e.g. float) shares issued shares repurchased Issued: 829,695,100 Repurchased: 99,253,565 Outstanding = Issued Repurchased = 730441535 REFERS TO GOOGLE 5. What type of opinion did the auditors issue regarding Googles financial statements? What types of opinion did the auditors issue regarding Googles internal controls? 6. Compute the percentage change in revenue from fiscal 2003 to fiscal 2004 and from fiscal 2004 to fiscal 2005. Conduct similar calculations for income from operations. [Note: you should exclude the one-time expense recorded in 2004 and 2005 related to the Yahoo dispute settlement and the Google Foundation contribution, respectively]. Based on these results, did expenses grow at a faster or slower pace than revenues? Which expense categories appear to account for the differences in growth rates between revenues and income from operations? 7. What is the date of the financial statements? What is the date of the auditors report? When did the stock market learn about Googles results? 8. For this question, please read and review: the excerpt of the press release titled Googles Fourth Quarter and Fiscal Year 2005 Results the Google stock market charts in the attached pages and the Wall Street Journal article dated February 1, 2006. a) How would you characterize the Googles results for fiscal 2005? b) Review the stock market charts for the period January 1, 2005 through May 1, 2006 for Google. Compare the fiscal 2005 performance for Google with Googles stock price (from the stock chart) over the same period. Compare Googles 2005 stock price performance with the performance of the broader set of firms trading on the NASDAQ exchange. c) Based on the stock market chart, was the news in the press release perceived as good news or bad news by the market? According to the Wall Street Journal article dated February 1, 2006, what appears to be the rationale behind the markets reaction to the news in the press release? d) The earnings press release includes information about non-GAAP financial measures (also known as pro-forma earnings) for the fourth quarter 2005. Why do you think Google computes and reports these non-GAAP numbers? How might they be used by market participants? The last page of the press release includes a reconciliation from the GAAP income statement measures to the non-GAAP measures discuss the 2 items that are reflected in GAAP Income from Operation that are excluded from the non-GAAP equivalent what does each item capture and why would Google exclude each in computing the non-GAAP measure?

o o o

o o o o

CLASS 3 - Review of Accrual Accounting o Assets = Liabilities + Owners Equity (this is always balanced) - Assets Increase by: o Borrowing (Liabilities increase) o Owner investments (contributed capital increases) o Earnings Income (Retained Earnings increases) - Net Income = Revenues Expenses o Revenues are inflows of assets o Expenses are outflows of assets o Revenues and expenses can be recognized even when cash does not chance hands. Revenue recognition criteria and expense recognition - The Statement of Cash Flows

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Reports changes in cash over a period of time (moving picture) between balance sheet dates due to operating, investing, and financing activities. People want to know the sources and uses of cash (e.g. lenders, suppliers, etc.) Why do we need SCF? o Cash is important enough to warrant reconciliation o Cash flow as an alternative performance measure bankruptcy risk depends more on cash flows than on profits o Past cash flows serve as an aid to Predict future cash flows Evaluate managements effectiveness in generating and using cash Assess liquidity o Net change in Cash = Net Cash from operations + net cash from financing + net cash from investing Types of Activities o Operating Activities Transactsions related to providing goods and services to customers and to paying expenses related to revenue generating activities (income statement transactions) o Investing Activities o Financing Activities How would you classify these? REVIEW THESE DECK 3, SLIDE 4 o Payment of accounts payable - O, o Proceeds from issuing common stock - F, o Collection of accounts receivable - O, o Purchase of land - I, o F, O, O (interest on debt is operating parallels income statement, GAAP),, F, I, O (receipt of dividends on that stock investment parallels income statement, GAAP, even though this seems like an investment deal), NON-CASH TRANSACTION (not in statement of cash flows) Note o Be careful about payments of dividends vs. Interest and dividends collected (operating) Interest and taxes paid (operating) Methods of Presenting the Statement of Cash Flows o Direct Method Lists cash receipts and disbursements by source/use of funds Always used for investing and financing activities Rarely used for operating activities o Indirect method Only used for operating activities Goal is to reconcile net income with cash from operations by removing noncash items from net income Net Income = Cash Revenue + NonCash Revenue Cash Expenses Noncash expenses Net Income (cash) = Cash Revenue Cash Expenses) Almost every company uses this method for operating activities Statement of Cash Flows: Indirect Method o Well focus on indirect format which is used by most firms Involves reconciling net income to cash flow from operations by accounting for noncash items embedded in net income Net Income = Cash Revenue + Noncash Revenues Cash Expense NonCash expense Start with Net Income o

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Cash Flows from Operations = Net Income Non-cash revenues + noncash expenses o Types of Adjustments between net income and cash from operations Non-cash expenses (depreciation Non-operating items in net income Gains and losses on equipment sales Accrual vs. cash flow differences in operating activities (sales vs. cash receipts) Indirect Method: A Summary o ?? Statement of Cash Flows: Examples of Adjustments o Depreciation is a non-cash expense why? When you purchase a long-term asset you spend cash but do not expense the amount right away (matching principle) Example Revenue (Cash) = 100 Expenses, cash = (40) Depreciation (20) Net Income = 40 CFO = NI + Depreciation = 60 Note: Anything that is a noncash expense is added back in. Example 2 Sales = 1400 Cash collections from customers = 1385 Accounts Receivable 100 115 Direct method: use 1385 Net Income = 1400 Change in AR 115-100 = Sales cash received; subtract out this difference from net income and that gives us the cash they collected. Receivables will go up by the difference in cash and noncash revenues Indirect method: 1400 15 = 1385 Example 3 Asset bought for $8 and depreciated $3 Net Book Value = $8-$3 = $5. Sold it for $1 Journal entry o Dr. Cash 1 (investing section of SCF) o Dr. Acc Dep. 3 o Dr. Loss on Sale 4 o Cr. Asset 8 Whenever there is a gain or loss from property you have to adjust the income statement. Problem 4.30 from the text. o A) Dr. Cash 10,000 Dr. Acc. Dep 40,000 Dr. Loss on Sale 0 (goes to income statement) Cr. Equipment 50,000 Cr. Gain on Sale 0 (goes to IS) o B)

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o C) Dr. Cash 8,000 Dr. Acc. Dep 40,000 Dr. Loss on Sale 2,000 (goes to IS) Cr. Equipment 50,000 Cr. Gain on Sale 0 (goes to IS) Note: In C we have a loss on sale of $2,000. What is the effect on the Cash Flow Statement? Sell for $10000 Operations o Income 100 o Depreciation 15 o Gain on sale 0 o Loss on sale 0 o Changes in work cap (40) o Cash flows from operations 75 Investing o Acquisition of Buildings & Equipment o Proceeds from Sale of Equipment o Cash flow from investing Financing o Repayment of long-term Debt (40) Net Change in Cash 15 Cash, Beginning of year 27 Cash, End of year 42 Sell for $12000 Operations o Income 102 o Depreciation 15 o Gain on sale (2) o Loss on sale 0 o Changes in work cap (40) o Cash flows from operations 75 Investing o Acquisition of Buildings & Equipment o Proceeds from Sale of Equipment o Cash flow from investing Financing o Repayment of long-term Debt (40) Net Change in Cash 17 Cash, Beginning of year 27 Cash, End of year 44 Sell for $8000 Operations o Income 98 o Depreciation 15 Dr. Cash Dr. Acc. Dep Dr. Loss on Sale Cr. Equipment Cr. Gain on Sale 12,000 40,000 0 50,000 2,000

(goes to IS) (goes to IS)

o o

(30) 10 (20)

(30) 12 (18)

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o Gain on sale 0 o Loss on sale 2 o Changes in work cap (40) o Cash flows from operations 75 Investing o Acquisition of Buildings & Equipment (30) o Proceeds from Sale of Equipment 8 o Cash flow from investing (22) Financing o Repayment of long-term Debt (40) Net Change in Cash 13 Cash, Beginning of year 27 Cash, End of year 40 Accumulating Information for a SCF o A = L + S/E o REVIEW: Deck 3, Slide 15 o Operating Generally, all changes in current assets and current liabilities Exceptions Marketable Securities investments section Short-term borrowing Financing Otherwise, changes in current assets and current liabilities go to operating o Investing Generally, changes in long-term assets (excluding depreciation which is not a cash transaction) o Financing Generally, change in long-term liabilities and changes in contributed capital accounts Problem 4-35 o If income statement is not provided, you will have the information required. o Example Net Income is given Depreciation expense is given o STEP 1: create T accounts and put in beginning and ending balances from balance sheet o STEP 2: look at additional information given Net Income for year was $568,000 and dividends declared were $60,000 Update Retained Earnings by increasing $568,000 Decrease RE by $60,000 Depreciation was $510,000 Accumulated Depreciation increases $510 (Cr) $120 (plug) represents accumulated depreciation of sold equipment (Dr) o They give you the $120,000 which you could have calculated. How? Machinery goes down (Cr) by $150,000 o They must have purchased new machinery and buildings o Amount purchased is $118 (plug) purchased for year (Dr.) Proceeds from sale was $25000 o What was net book value of machinery sold? $150,000 (original cost) acc. Depreciation of $120,000 = $30000. They sold for $25000. This is a loss of $5000. (remember this when making cash flow statement) Retired bonds at book value

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o Retired $50k Accounts receivable changed by 1052,000 946,000 = 106,000 Inventory: 204,000 Land: 36,000 Accounts Payable: 146,000 Taxes Payable: 16,000 Other payables: 138,000 Common Stock: 32,000 o STEP 3: Cash flow statement Current assets/liabilities go to operations START WITH NET INCOME AND ADD BACK IN DEPRECIATION o Operating Net Income is $568,000 Add back depreciation expense: $510,000 Accounts Receivable: subtract $106 because AR increased Inventory: subtract 204 (inventory increased 204) Loss on Machinery: $5,000 Accounts Payable: add back (accounts payable increased 146) Tax Payable: add 16 (it increased and it is a liability) Other Payable: add 138 o Investing Asset goes up (subtract from cash flow) Land: subtract 36 (land went up 36) Machinery: subtract 1018 (building and machinery increased) Machinery: add 25,000 (put down the proceeds of the sale, not the book value) (what is the corresponding adjustment in operating section? They made a loss. We add that back. Accumulated Depreciation: nothing left Accounts Payable: increased by 146 o Financing Bonds Payable: went down 50 (subtract) Common Stock: went up 32 (add it) Dividends Paid to S/H: subtract 60 (subtract because dividends paid went up. What can firms do to mislead investors regarding cash flows? o Increase or decrease in assets that arent reflected. o Working capital adjustments changes in accounts payable, accounts receivable, etc. Companies can still follow GAAP but they can delay paying suppliers, push customers to pay earlier which isnt always a good business practice. They can effect other business decisions to make their cash flow from operations look better. o Classification Most investors look at cash from operations. This is an important part of the SCF. Are they doing well in their operations. Nortel had accounts receivable changes that were over a year old so they put them in the investing section. The numbers still add up but the operating amount doesnt change. Operating cash flow number may not be fool proof o Depreciation expense method Can affect the operating number because of the add back that can boost operating however, their net income will take a hit. Red flags watch out for if looking at companies o Compare NI & CFO number if earnings and cash flow are going in different directions

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You want the company to recover the cash. If they are growing in different directions, they may be channel stuffing (bogus customers) o Look at Receivables, Inventory Growth & Sales if inventory is growing but sales are not, they may have a lot of inventory that they cant sell. If they are getting receivables but no cash, why? o Free Cash flow number analysts look at this. Free Cash Flow = Cash from operations Capital investments (PP&E, etc.) = CFO (cash flow operations CFI (cash flow from investments) If you have negative free cash flow, look at days to flameout this is liquid resources of firm / cashflow per day. Liquid resources = Cash + AR + Inv + Marketable Securities Cash Flow/day = FCF/365 Days to flameout US Airways o 5) Assume that the property sold by U.S. Airways during 2001 had an original cost of $100 million.
What was the entry to record the sale of the property?

Proceeds from Disposition of Property $53 They got Cash of $53 Accumulated Depreciation What was the depreciation of the sold PP&E? How do we figure it out? We know the gain was $3 (subtracted from operations) We know that it cost $53, so we know accumulated depreciation was $50. Dr. Cash 53 Dr. Acc Depre 50 Cr. Gain 3 Cr. PPE 100 (given)

6) As a result of the September 11 attacks, Congress passed legislation authorizing payments to airlines to compensate them for 9/11 losses. How much did U.S. Airways receive in 2001 from these grants and how much of this amount was in cash? Dr. Cash 264 Dr Acc Rec 56 Cr Airline Grant 320 Cr. 7) Why is the amount for Non-cash Charges an addition to net income in determining cash flow from operations? Because it is non-cash 8) Why are increases in Accounts Payable and Accrued expenses an addition to Net income in determining cash flow from operations?

They are not cash. It is an expense for the period but not a cash expense. Therefore, you add it back because you only want to find the cash part of the period. Add anything that was a non-cash item.

Class 4: Class Notes for Chapter 6 - Accounts Receivable and Revenue Recognition o Revenue is recognized when 1) firm has delivered the goods/services to the customer 2) Collection of cash is reasonably assured 3) Cash to be received is measurable o Accounting for bad debts from customers and other costs associated with accounts receivables focuses on the last two criteria o Objective when reporting Revenue and corresponding A/R:

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Reflect balances at the net amount of cash expected to be received: this reflects the gross amount of Revenue and A/R net of estimated uncollectible amounts. Strict credit policy high quality customers but lower volume Loose credit policy lower quality customers but higher volume Trade-off as users of information, we want to know what the company expects to collect. - Accounting for Uncollectible Accounts: DIRECT WRITE-OFF METHOD o Bad debt expense is recognized in the period in which a specific account is deemed uncollectible. o Recognize Revenue at time of sale CLASS 5 - NOTES are ON CLASS NOTES - MIDTERM REVIEW - Balance Sheet

o Assets = Liabiliities + SH Equity


Assets Debit balance: debit increases, credit decreases o Liabilities Credit balance: credit increases, debit decreases o Shareholders Equity Contributed capital (preferred stock, common stock, addl paid in capital), retained earnings SE accounts have a credit balance: credit increases, debit decreases Income Statement o

o Net Income = Revenue expenses + gains losses


o o o o Accrual accounting: record revenue when earned and match expenses corresponding Revenues/Gains: credit balance - debits decrease, credits increase Expenses/loss: debit balance - debits increase, credits decrease Temporary Accounts Close income statement accounts to RE at end of operating period

REend = REbeg + Net Income Dividends


Dividends are not declared as an expense!! Cash Flow Statement o Net change in cash = net cash from operations + net cash from investing + net cash from financing o Cash flow from operations: Indirect Method Net income + non-cash expenses (depreciation, bad cash expense) - gains from sale of PPE + losses from sale of PPE + increases in operating current liab/decreases in operating current assets 32000 for insurance policy for 4 months. Cost/month $8000. Close books every month. End of 1st month, no entry was recorded. Correct entry o Debit Insurance Expense 8000 o Debit Prepaid Insurance 24000 o Credit Cash 32000 + 8000 NI (NI overstated should have had an expense of 8000) +32000 overstatement in cash - decreases in operating current liab/increases in operating current assets = cash flow from operations

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o Cash flow from investing (Dreict Method) (Purchase/sale of PPE, land, investments)

Sale of PPE: net

book value = acquisition cost accum.

Depreciation Proceeds of sale of PPE = net book value + gain on sale


Cash from investing includes the proceeds from the sale Cash flow from financing (Direct Method) Issue (+)/repurchase stock (-) Dividends paid (-) (dividend revenue from investments is in cash flow from operations) Debt issued/retired (interest payments are in cash flow from operations) o Non-cash transactions are not reported in the cash flow statement Accounts Receivable o At time of sale Dr AR, Cr Revenue Dr bad debt expense, Cr Allowance for uncollectible accounts (contra asset) Bad debt expense: estimated using percentage of sales; aging of AR o When specific customers default Dr. Allowance for Uncollectible Accounts, Cr. AR o When customers pay in cash Dr. Cash, Cr. AR o Cash flow presentation Net Income +- net AR Net AR = Gross AR Net Allowance Net Income + bad debt expense +/- net AR write-offs o Income recognition before and after sale o Ratio Analysis p237 EXAMPLE o Suppose customer owing $5000 in prior period sales defaults. What is effect NI, CA and CFO? Before recording writeoff AR Gross is 100 Net Allowance is (25) Net AR = 75 After recording AR Gross is 95 Net Allowance (20) Net AR is 75 Dr. Allowance Account 5000 Cr. Accounts Receivable 5000 NI is unaffected because the expense was already taken into account CA no impact CFO no impact Inventory o All costs related to acquisition included in inventory value (transportation, direct material, packing/unpacking costs, etc.) o Manufacturing firms Raw materials inventory, work-in-process (WIP) inventory, finished goods inventory Product costs (direct and indirect) included in work in process inventory] Dr WIP, Cr. Cash/salary payable/accum depr./insurance payable RMend = beginning balance + purchased RM used o

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WIPend = Beginning Balance +Raw materials being used + Direct Labor + Overhead completed units value Finaished Goodsend = Beginning balance + Completed Units COGS FIFO Inventory + LIFO Reserve (credit balance) = LIFO Inventory Excess of FIFO over LIFO is the LIFO Reserve

11/10/08 - GAP and AOL Case - Product Development Costs o 1) Capitalize Costs o 2) Amortize Costs o 3) Expense when Technological Feasibility is not reached - Journal Entreis o Capitalize Dr. Product Development Cost 51 Cr. Cash/Payable 51 o Amortize Dr. Amortization Expense 36 Cr. Product Development Cost (Net) Or Cr. Accumulated Amortization 36 o Expensing Dr. Product Development Expense 95 Cr. Cash/Payable 95 - Deferred Subscriber Acquisition Cost o Beginning Balance o Amount Capitalized o Sold Net o Amortization Expense o Write-offs o End Balance - Fiscal Year 1996 - Deferred Subscriber Acquisition Cost o Beginning Balance: 6/30/95 77 o Costs Capitalized (cash flow) 363 o Amortization Expense (SCF) o Writeoffs (SCF) o o End Balance: 6/30/96 314 - Journal Entries o Capitalize Dr. Deferred Subscriber Acquisition Cost 363 Cr. Cash/Payable 363 o Amortization Dr. Amortization Expense 126 Cr. Accumulated Amortization 126 Or Cr. Deferred Subscriber Acquisition, Net 126 o Writeoffs Dr. Writeoff (Inc. Stmt) 0 Cr. Deferred Subscriber Acquisition, Net 0 - Fiscal Year 1997

126 0

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o o o o o 11) No capitalization 1. No amortization Expense 2. No writeoffs 3. Full Expensing of all Capitalized Costs Everything going to the asset on balance sheet should hit income statement as expense. o EQUATION: As if Net Income if no capitalization = Net IncomeAsReported + amortization expense + writeoffs costs capitalized Source: Income Statement 1997 1996 Pretax Income: (499) 62 + Amortization Expense 126 59 + Writeoffs 0 385 - Capitalized Costs (363) (130) ____________________________________________ (175) (185) LONG-TERM LIABILITIES o A liability is a claim on assets by non-owners that represents an obligation to make future payments of cash goods or services o A liability is recognized when Obligation is based on benefits or services received currently or in the past The amount of timing of payment is reasonably certain o Valuation Monetary reflected at the PV of future cash payments Nonmonetary at expected cost of providing service (e.g. warranties) or amount of resources advanced (e.g. customer advance) o Current and Noncurrent classifications Some obligations have both current and noncurrent portions Contingent Liabilities o Contingent liabilities are potential liabilities some event has occurred, but the certainty of an obligation to the firm is not yet determined o GAAP requires recognition of contingent liability if: It is probable (80-85%) that an asset has been impaired or a liability incurred, and The amount of the loss can be reasonably estimated o Most often, contingent liabilities are not recorded but are disclosed in footnotes o New concept constructive liabilities Arise not from an obligation, but from management intent (e.g. costs associated with a planned restructuring activity) E.g. this is a signal to investors contentious because there are cookie jar things where management takes a big hit in one period, and then go forward and reverse that charge. This is very dicey. Potential for earnings management. Dr. Restructuring Charges (IS) Cr. Restructuring Liability Long-term Liabilities o Value at the present value of future cash payments o Beginning Balance: 6/30/96 314 Costs Capitalized (cash flow) 130 Amortization Expense (SCF) Writeoffs (SCF) End Balance: 6/30/97 0 59 385

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o o There are many types of long-term debt with differing types of timing of required future cash flows of interest and principal Common examples Mortgages Coupon bonds Serial bonds Zero coupon bonds Well illustrate using coupon bonds which have periodic payments of interest with the principal amount repaid in one lump sum at the maturity of the bond. Face or par value: the amount due at the maturity of an obligation Interest rate Coupon interest rate stated rate in the bond contract that determines the amount of the periodic payments Historical market interest rate/effective interest rate/yield to maturity the market rate of interest at the date of issue of the bond Determined by general market conditions and overall riskiness (e.g. credit worthiness) of firm Current market interest rate rate in the marketplace for a comparable piece of debt (maturity and risk) Coupon payments: annual/semi-annual interest payments determined by the face value of the bond and the coupon interest rate contract Total promised cash payments = annual/semi-annual interest payments and face value of bond due in full at maturity

o Bonds o o

Bonds o o o o

Dr. Interest Expense Dr. Bond Premium Cr. Cash Ending Balance of Bond Premium eventually becomes zero and Bond value goes down to par value. o Balance Sheet At Issue Date Bonds Payable: 8000000 Bond Premium: 1849208 Net Book Value of Bonds: 9849206 6 months later Bonds Payable: 8000000 Bond Premium 1824682 Net Book Value of Bonds 9824682 1 yr after issue Bonds Payable: 8000000 Bond Premium 1799422 Net Book Value of Bonds 9799422 I NEED TO GET A PHOTOCOPY OF THE BONDS STUFF Bonds o More on Bonds Example Dr. Cash 6627309 Dr. Bond Discount 1372691 (plug) Cr. Bonds Payable 8000000 Market Rate: 10%, period rate 5% USE TABLE 2 and TABLE 4

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o Balance Sheet Bonds Payable LESS (Bond Discount) NBV of Bond Bond Amortization Table 1,2,3,4,5,6 Period, Liability at Beginning Amt Raised, Interest Expense (at 5%), Coupon Payment (at 4%), Difference: decrease in book value, Liability at End of Period Difference: decrease in book value = 3 4 EFFECTIVE INTEREST RATE METHOD Amount by which the bond discounts gets amortized every period. The liability amount is changing every period. How much is the liability changing? This is the same as how much the bond value is changing. Dr. Interest Expense Cr. Bond Discount (amount gets subtracted from unamortized Bond Discount until the balance becomes zero after 40 periods. This amount is the difference between the actual interest expense and the amount actual shelled out in cash. Cr. Cash When you are finding out the book value or to compute interest expense, use the historical a rate. When you are going to retire a bond or want the present value, use the current rate. Gain = Net Book Value Cash Outflow to Retire the Bonds (MV) If the cash you have to pay is less than the book value, you have a gain from retiring the bond. If the cash you have to pay is more than the book value, you are making a loss in retiring the bond.

o o o

o o o

TRIBUNE CASE o 7. What is the amount of long-term debt that is scheduled to be paid by the Tribune Company during fiscal 2002? Note 10: 410,890 o 8. What was the adjusting entry recorded by The Tribune Co. on December 31, 2001 to recognize fiscal 2001interest expense on the LYONs (Liquid Yield Options Notes)? Look at Note 10 The percentage before the amount is a coupon rte. LYONs is a zero coupon bond. YTM was 3.57% but the coupon rate was zero. What is the interest expense every period? It is due in 15 years. Typical journal entry Dr. Interest Expense Cr. Bond Discount Cr. Cash Find out the amount the bond is amortized and that is the same as the interest expense because Cash is zero with a zero coupon bond. Bond Discount Account (Unamortized bond discount) o LYONs are zero coupon bonds interest expense = amount of amortization of discount o Alternative: Change in net book value (NBV) of bond = 291,644 281,602 = 10,042. o Change in Bond Discount Account = Change in Net Book Value (NBV) of bond. this is true even if it is not a zero coupon bond. o 217,498 o 207,456

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Bond got discounted by $10,042. This is the amount the bond discount changed. 9. If The Tribune Co. does not retire any of the LYONs during 2002, what would be their book value on December 31,2002? NBV of Lyons as of 12/31/2002 NBV = Bond Value as of 12/31/2001 + Interest Expense during 2002 = 291644 + (historical rate * beginning liability) = 291644 + (.0357*291644) = 302,056 For a zero coupon, interest expense is the same as the amount the bond discount changes which is how the net book value changes as well. THIS IS VERY IMPORTANT FOR THE FINAL. 10. Show the journal entry that was made by The Tribune Co. to retire the 6.65% notes, including the final annual payment of interest) on their maturity date of October 1, 2001. 6.65% notes matured in October 2001, net of unamortized discount of $551 Company year end is 12/31 so this problem will be tricky. Face Value = amount due at maturity Face Value Bond Discount = Net Book Value (NBV) of Bond NBV + Unamortized Discount = Face Value Face Value = 199,449 + 551 = 200,000 Coupon Payment = Face Value * coupon rate Coupon Payment = 200,000 * .0665 = $13,300 Oct 2000 Dec 2000 = 3 months of interest = 3/12 * 13,300 = $3325 (Interest Payable) From Jan 1, 2001 = Oct 2001 = 9 monghts interest = 9/12 * 13300 = 9975 Only interest expense for 2001 Interest Expense o Dr. Interest Expense 10,526 (plug) o Cr. Bond Discount 551 o Cr. Cash 9975 Maturity Entry o Dr. Bonds Payable 200,000 o Dr. Interest Payable 3325 o Dr Interest Expense 10526 o Cr. Bond Discount 551 o Cr. Cash 213300 11. What is the outstanding face amount of the 7.45% notes due 2009 at December 31, 2001? At December 31, 2000? Face Value = NBV + Unamortized Discount Face Value 12/31/2001 = NBV12/31/2001 + Unamortized Discount(12/31/2001) FV12/31/2001 = 394370 + 5630 = 400,000 FV12/31/2000 = 393649 + 6351 = 400,000 NOTE: face value will not change (unless they retire part of the bond) Coupon Payments = .0745 * 400000 = $29800 Bond Discount Amortization = 6351 5630 = $721 Interest Expense = Interest Payable + Change in Unamortized Discount Journal Entries Dr Interest Expense 30521 Cr. Bond Discount 721 Cr. Cash/Interest Payable (in this case) 29800 o

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12. What adjusting journal entry was made on December 31, 2001 relating to the 7.45% notes due 2009. You may assume that coupon interest payments are due annually on January 1. LEASES o Off balance sheet Financing: use of assets or services by a firm that obligates them to sacrifice cash payments in the future, but the transaction is structured to avoid recording a liability on the balance sheet Example: operating lease of equipment Special Purpose Entities (SPE) can be considered off-balance sheet financing o Goal of GAAP: assess whether the company using the assets (lessee) bears the risks of ownership if so, the lessee will likely have to record the asset and the liability on its balance sheet o Why might firms want to keep debt off the balance sheet? Reduce perceived risk of firm Increase access to new debt Maintain slack in existing debt covenants o Lease A lease is a contract in which an owner (lessor) grants the use of an asset to a second party (lessee) for a fixed period of time in exchange for a series of payments. o Capital lease (financing lease) Lessor transfers substantially all the risks and benefits of ownership to the lessee Lessee purchases the asset o Operating Lease Lessor transfers property rights to the lessee for a period of time Lessee returns property to lessor at the end of thte lease term Lessee rents the asset o Criteria to Determine Lease Accounting Treatment Method of lease accounting is not a choice it is dictated by the structure of the lease. Of course, management has control over how a lease is structured. Key issue which party enjoys the economic benefits and bears the economic risks of the lesae property A firm must account for a lease as a capital lease if the lease meets any one of the following four conditions 1. Lessor transfers ownership to the lessee at the end of the lease term 2. A bargain purchase option exists (lessee has a right to buy the asset at the end of the lease for less than market value. 3. The lease term extends for at least 75% of the assets life 4. The present value of the minimum lease payments is greater than or equal to 90% of the fair value of the asset at the time the lease is signed o Accounting for Lessee: Operating Lease Inception: No entry. At end of each year: Periodic rent expense Dr. Rent Expense Cr. Cash Future operating lease payments must be disclosed in footnotes o Accounting for Lessee: Capital Lease Inception: record an asset and a liability at the present value of the lease payments Dr. Capital Lease Asset Cr. Capital Lease Liability At end of year: record depreciation expense and record cash payments as interest expense and reduction in liability Dr. Depreciation Expense (generally straight line depreciation method) Cr. Accumulated Depreciation o

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Dr. Interest Expense (contract rate * book value of liability) Dr. Capital Lease Liability (PLUG) Cr. Cash (contract payment) o Accounting for Lessor: Operating Lease Inception: record transfer of the product from inventory to equipment (in the hands of the lessee Dr. Equipment Cr. Inventory At the end of each year: record annual revenue and depreciation on the rented equipment Dr. Cash Cr. Rent Revenue Dr. Depreciation Expense Cr. Accumulated Depreciation o Accounting for Lessor: Capital Lease Inception: record the sale of the equipment Dr. Lease Receivable Cr. Sales Revenue (PV of all future lease payments) Dr. COGS Cr. Inventory (book value of the asset leased) At the end of each year: record lease payment, interest on the receivable, and reduction in the lease receivable Dr. Cash Cr. Interest Revenue Cr. Lease Receivable SOUTHWEST CASE - 1. Refer to Note 8 of Southwests 2005 financial report. Record the journal entry to reflect scheduled payments during 2006 for operating and capital leases in place at the end of 2005. Use this information to infer an estimate of the average interest rate used by Southwest to determine the present value of payments on capital leases at the end of 2005. o Journal Entries Operating Lease Dr. Rent Expense 332 Cr. Cash 332 Capital Lease Dr. Interest Expense 5 (plug) Dr. Lease Liability 11 Cr. Cash 16 o Calculate Average Interest Rate used by Southwest Interest Expense = rate * Beginning liability 5 = rate * 74 Average Interest Rate = 6.8% - 2. What would be the total amount of the obligation under capital leases included in the balance sheet at December 31, 2005 if Southwest used an implicit interest rate of 8% to determine the present value of minimum lease payments on all capital leases? Assume that lease payments are made annually on December 31 and that payments after 2010 include 1 payment of $12 million at the end of 2011. o Still on Note 8 Liability of a Capital Lease is the present value of future payments

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Obligation = 16/1.08 + 16/1.08^2 + 16/1.08^3 + 16/1.08^4 + 15/1.08^5 + 12/1.08^6 = 70.76. 3. Compute the debt-to-equity (D/E) ratio, as defined in Chapter 5 in the text, for Southwest at December 31, 2005. o D/E = Total liabilities/(Total Liabilities + Shareholders Equity) = Total Liabilities / Total Assets o = 7,543/14,218 = 53% 4. Southwest has significant commitments under operating leases. If these agreements had been treated as capital leases, what additional amount would be reported as a lease obligation on the balance sheet at December 31, 2005? What would be the impact on Southwests debt-to-equity ratio computed in question 3 above? Why may this type of analysis be useful in evaluating companies? The following assumptions should be used to compute the present value of the minimum lease payments: 1) The annual borrowing rate is 10%; Payments subsequent to 2010 ($1,164 million) are comprised of 5 annual payments of $233 million; and Lease payments are made annually on December 31. Total liabilities for purposes of the debt-to-equity ratio include all operating liabilities (current and longterm), long-term debt and obligations under capital leases and deferred credits. o Capitalize the Operating Lease Payments Convert Existing Operating Lease Commitments into Capital Leases Discount the Operating Lease Payments Year Payment Annuity Payment Discount Factor PV 2006 332 332 .9091 302 2007 309 309 .8264 255 2008 274 274 .7513 206 2009 235 235 .6830 161 2010 219 219 .6209 136 2011-2015 233 each year 3.79079 883 .6209 548 Present Value = 1608 o Debt/Equity Ratio There would be another Liability of 1608 on the balance sheet that is off balance sheet because they are using operating leases. New D/E Ratio = (7543+1608)/(14218+1608) = 58% This is an increase of about 10% just based on how the leases are structured. Therefore, adjusting the lease obligations can keep the debt/equity ratio lower.

DEFERRED TAXES - Introduction o If you use LIFO for accounting, you must use it for taxes. o You can get two separate forms of income depending on the rules. This difference, and how it is reconciled, gives rise to deferred taxes. - Terminology o Book Income Income before income taxes (i.e. pre-tax income) for financial reporting purposes o Taxable Income The amount of income on which taxes currently due is figured for tax reporting purposes o Differences between book and taxable income are of two types Permanent differences: differences between book income and taxable income that arise from the inclusion of revenues and expenses for financial reporting but not for tax reporting some revenues and expenses have special tax treatment E.g. government bonds - interest revenue cannot include in tax statements Fines due to violation of laws cannot include in tax

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Timing Differences: differences between book income and taxable income that relate to the recognition of revenues and expenses in different periods for tax and financial reporting. E.g. depreciation o Book -- straight line for financial; Tax - MACRS Bad debt expense o Book Allowance Method; Tax Direct Write-off Method Deferred Income Taxes o Matching Principle says that tax expense recognized each period should be based on the amount of book income regardless of the amount of taxes actually payable this period based on taxable income. Match income tax expense with the GAAP pre-tax income amount This ignores timing differences while computing the tax expense. o Income tax Expense (also called Provision for Income Taxes) = (Book income before income taxes +/- permanent differences) * Statutory tax rate o Income tax expense is comprised of a current component and a deferred component Current component reflects actual tax due Deferred component reflects tax associated with current period timing differences between book and tax income o Deferred tax assets and liabilities record the difference between tax payable to tax authorities and the tax expense recorded in the income statement Dr. Income Tax Expense Dr. Deferred Tax Asset these account for the differences Cr. Deferred Tax Liability these account for the differences Cr. Tax Payable Deferred Tax Liabilities (DTL) o DTL is something the company has not paid yet but will pay later. o Taxes paid < cumulative income tax expense on I/S If Taxes Paid < Tax Expense on I/S then Deferred Tax Liability o The difference is something the company needs to pay up in the future. Therefore, they get a liability until they pay the liability in the future. o Results from Expenses recognized faster for tax purposes Examples o MACRS for tax purposes but straight line for book purposes Revenues recognized slower for tax purposes Examples o Sales on credit revenues recognized in book income, only cash revenue recognized in tax income Deferred Tax Assets (DTA) o DRA is something the company paid early and does not have to pay later. Almost like Prepaid taxes. o Cumulative taxable income > cumulative book income taxes paid > cumulative income tax expense on I/S o Expenses recognized slower for tax purposes Examples Bad Debt Expense Warranty Expense only recorded in tax when you do the service o Revenues recognized faster for tax purposes Not a very common occurrence. Example: completed contract method Deferred tax Assets and Liabilities

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o o Note: Assume no permanent differences Recording Deferred Tax Liabilities From temporary differences that will result in future taxable income and thus, future tax payments (e.g. book income = $250, IRS income = $225) Journal Entry Dr. Income Tax Expense 100 Cr. Income Taxes Payable 90 Cr. Deferred Tax Liability 10 o DTL of $10 equals ($250-225)*40% tax rate = $10

Kodak Case - 1. According to its tax returns, what was Eastman Kodaks total income tax obligation to all governmental entities in the year 2000? o Tax obligation Tax Payable = 145 + 268 + 35 = 448 - 2. What entry was recorded by Eastman Kodak to record its income tax provision in the year 2000? o Deferred Provision = Income Tax Provision - Income Tax Expense = o Deferred Provision = 225+37+15 = 277 o Income Tax Expense Journal Entry Dr. Income Tax Expense (Provision) 725 Cr. Income Tax Payable 448 Cr. Deferred Taxes (NET) 277 - 3. Assume that the U.S. statutory tax rate of 35% was used to calculate deferred tax liabilities related to depreciation. During the year ended December 31, 2000, which report included a greater amount of depreciation expense: the tax return or the financial accounting income statement? What was the magnitude of the difference? o During the year not cumulative looking for the current period difference in timing due to depreciation o Note 10 DTL regarding depreciation Change in DTL = Current Period Timing Difference * Tax Rate Change in DTL = 555 527 = 28 Current Period Timing Difference = 28/.35 = 80 How do you know if it is higher in tax or book? Depreciation expense is higher in the tax books DTL increased from 527 to 555. Therefore, liability is increasing making the expense higher in the tax books because income is lower in tax books so you paid less taxes and the liability therefore increases. - 4. Assume that the U.S. statutory tax rate of 35% was used to calculate deferred tax liabilities related to depreciation. As of December 31, 2000, which system has recognized more depreciation expense: tax or financial accounting? What is the magnitude of the difference? What would be the percentage change in Net properties on the balance sheet if tax depreciation had been used throughout the assets lives? o Balance in DTL = Cumulative Timing Difference * Tax Rate 555 = Cumulative Timing Difference * .35 Cumulative Timing Difference = 555/.35 = 1586M As of Dec 31, 2000, cumulatively, tax statement has recorded 1586 more of depreciation. Over the life of the total assets, they have recognized more depreciation on the tax statement. o Percentage Change in Net Properties if Tax Depreciation had been used throughout the assets lives?

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Accumulated Depreciation = 7044 + 1586 = 8630 Net PPE = 5919 1586 = 4333 5. What is the purpose of the valuation allowance which reduces the magnitude of deferred tax assets? Which specific items(s) does the allowance relate to? o What is the Valuation Allowance? The portion they dont think they can use in the future.

MARKETABLE SECURITIES AND LONGTERM INVESTMENTS - Investments o Reasons to invest in other companies Improve competitive position To get a return in the form of dividends, interest or capital gains o Types of Investments Minority Passive (less than 20% ownership) firm has no influence Debt Securities hold until maturity o Amortized historical cost Trading Securities mark to market with unrealized gains/losses to income o Market Value Method of Accounting Available-for-sale Securities mark to market with unrealized gain/losses to shareholders equity o Market Value Method of Accounting o Not solely for purpose of speculation hold for longer term Minority Active (Between 20% and 50%) can influence management Equity Method of Accounting adjusted historical cost Majority (More than 50% ownership) effective control Full Consolidation purchase accounting o M&A Course 30117 Lots of Equity Method and Full Consolidation - Minority Passive Investments: Trading Securities o Securities held for short-term profit: intended to be actively or frequently traded for shortterm potential (primarily held by banks, insurance companies, and other financial institutions) o Accounting Treatment Balance Sheet Short-term: current asset called marketable securities Reflected at market value at the balance sheet date (marked to market) o Differences in book value and market value give rise to unrealized gains and losses. these go to the income statement even if you havent sold it. Income Statement Recognize dividend income as earned income All changes in value both unrealized and realized gains and losses are recognized each period in the income statement Statement of Cash flows o All activity is included in the operating section - Minority Passive Investments: Securities Available for Sale o Securities that are neither held to maturity nor trading securities Firms usually acquire these for their perceived longer-term investment potential rather than for short-term speculation purposes o Accounting Treatment Balance Sheet Asset is reflected at market value at balance sheet date (marked-tomarket)

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Unrealized gains and losses stay on the balance sheet as an equity account and do not pass through the income statement Short-term (intending to sell within 1 year): current asset Long-term (intending to hold for longer than a year): noncurrent asset, also referred to as Investment in Securities Income Statement Recognize dividend income as earned Only realized gains and losses (from sale transactions) are recognized each period in the income statement o realized gains on AFS securities = proceeds from sale original cost Statement of Cash Values Dividend income in Operating section Purchases and sales/maturities of securities in Investing section Realized gains and losses adjustment from net income to operating cash flows.

FINAL CLASS (SLIDE 6 MARKETABLE SECURITIES - 11.45 (modified) - Minority Passive Investment o Comprehensive income = net income + other changes in shareholders equity that are not related to owner transactions (e.g. unrealized gains and losses from marketable securities holdings) - Minority Active Investments o Ownership is between 20% and 50% of voting stock o Criterion: is there significant influence? o If there is control, it should be minority active. o Equity Method accounting method used by investing firm Initial purchase (including goodwill) is recorded as an asset at acquisition cost Goodwill excess of purchase price over market value of identifiable net assets Each period, the investing firm recognizes net income equal to its proportionate share of the net income of the investee firm. Dividends received from investee reduce the asset not recorded as revenue but rather a return of capital. Dr. Cash/Dividend Receivable Cr. Investment (why arent we crediting revenue like in minority passive?) Goodwill is tested each period for impairment - Minority Active Investments: Illustration o Suppose A invested in 30% of company B in Year 1. They paid $680k. o Details of B MV of total assets at time of purchase: $2M30% = 600k Net income for Yr 1: $500k 30% = 150k Dividends declared During Yr 1 = 180k 30% = 54000 Company B had an internally developed patent with book value = 0; 30% of the market value of the patent = $80k. The patent has a 10 yr life. o Amortization expense of patent = 80,000/10 - Minority Active Investment - Equity Method Illustration o Dr. Investment in B 680k o Cr Cash 680k o Dr. Investment in B 150k

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o Cr. Equity Share of Income from B 150k (Income Statement of A) o Dr. Cash 54k o Cr. Investment in B (not revenue) 54k o Dr. Amortization Expense 8k o Cr. Investment in B 8k Majority Active Investments o Ownership is greater than 50% of voting stock of another firm called the subsidiary Minority interest: the portion of the subsidiary not owned by the parent o GAAP requires consolidation of both entities into one financial statement Account for investment using equity method during the yr Year end consolidation process is conducted 1) Eliminate the investment in subsidiary account on the parents books and the shareholders equity on the subsidiarys books. 2) Create minority interest account in S/E of parent if the parent owns less than 100% 3) Adjust the assets and liabilities of subsidiary to FMV 4) Create goodwill if the purchase price exceeded the fair market value of the net assets of the subsidiary 5) Eliminate the intercompany transactions between the two firms 6) Add together the various accounts of both companies.

WELLS FARGO 8. What is the amount of net realized gains or losses relating to Securities available for sale sold during 2005? What is the effect of these transactions on net income before taxes for 2005? 40M in net realized gains (cash flow statement and somewhere else) 9. Prepare journal entries for the purchase and sale of Securities available for sale during 2005. You may ignore the impact of taxes. Assume that the carrying value of the securities at the time of sale was $19,029 million. Carrying value exising book value Purchases Dr. AFS Securities Cr. Cash Sales Dr. Cash Dr. Unrealized Gains Cr. Securities AFS Cr. Realized gains $28,634 $28,634 19,059 10 (PLUG) 19,029 40

Acquisition cost of goods sold securities book value unrealized gain Acquisition Cost = Book Value Unrealized Gain = 19029 10 = 19019 Acquisition Cost = Proceeds - Realized gains = 19059 40 = 1919 10. Determine the amount of net unrealized gains or losses for 2005 for securities available for sale securities on hand at December 31, 2005? [Hint: Use the information from question 10 and the information about net unrealized gains/losses in the securities footnote]. What is the effect of these transactions on net income before taxes for 2005?

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Look at Note 5: Securities Available for Sale Unrealized Gain or Loss Account - Beginning Balance = 1438-39 = 1399 - Dr. Unrealized Gains (from previous problem) 10 - Dr. Unrealized Gain/Loss for Securities on Hand 456 (plug) - Ending Balance = 1041 108 = 933 - This has no effect on net income 11. What would be the effect on net income before taxes for fiscal 2005 if securities available for sale were instead classified as trading securities by Wells Fargo? Assume that, as of January 1, 2005, all the securities available for sale had also been reclassified as trading securities. By what amount would total stockholders equity differ at December 31, 2005? Income Statement Effect Trading Security +10 +20 +30

Change in MV at EOY Acquired Y1 +10 Y2 +20 Sold Y3 +30

Available for Sale 0 0 +60

We need to go from 60 to 30. Subtract out the accumulated net unrealized gains/losses of sold securities from prior years. Take out any unrealized gains or losses from prior years. If it was trading, that would have already hit the income statement in prior years. Adjustments 1) Sold Securities - Eliminate net unrealized gains/losses 2) Securities on Hand Include unrealized gains/losses in income 2005 -10 -456

Net Income before taxes would have been lower by $466 if the securities were classified as trading rather than available for sale. What would be the effect on total Shareholders equity? There should not be any effect. It will be the same. Income statement will have a lower value but total shareholders equity will not be affected. Chapter 12: SHAREHOLDERs EQUITY - S/E is a residual interest, representing the SHs claims on the assets of a firm in excess of the claims of creditors o Authorize Shares total shares that can be issued at any time over the life of the company o Issued Shares # of shares issued at any point in time o Outstanding Shares Issued Shares Treasury Shares - Treasury Stock o Shares of the firms stock that have been repurchased by the firm o Why repurchase shares? To have on hand to give to employees exercising stock options May be the best use of excess cash As a takeover defense As a signal of undervaluation of shares Better way to repay S/Hs due to tax reasons (S/H can pay capital gains tax rate rather than dividend rate) Way to boost Earnings per Share o Accounting

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Treasury shares are reflected in S/Hs equity at their cost to the firm until reissued or retired Treasury stock account thus has a debit balance (contra SE account) Treasury Stock Illustration o See slides Other Capital Transactions o Employee Stock options Options give the holder the right to buy a certain number of shares in the future at a stated exercise price Granted by the company to management and other employees o Terminology Grant date date option given to employees Exercise date date the option is exercised by employee Exercise price per share price that stock may be purchased at by the employee (Strike price) In-the-money exercise price below current market price Out-of-the-money exercise price above current market price Vesting period period before the employee can exercise the option o Compensation expense has to be recognized Compensation expense equal to FV of the options is recognized over the vesting period SFAS 123R compensation expense must be recorded Employee Stock options: illustration o 1000 shares with $5 par value at a price of $35. Option to buy at $35. Market value on date of grant o Expense is total FV of options divided by the vesting period

PACIFIC SUNWEAR CASE 1. What amount of cash did Pacific Sunwear use to repurchase shares of its common stock during the year ended February 3, 2007? What was the journal entry made by Pacific Sunwear to initially record the repurchase of these shares during fiscal 2006? What entry was made to reflect the subsequent retirement of the repurchased shares during fiscal 2006? Repurchase o Dr. Treasury Stock o Cr. Cash 99346 99346

Retirement o Dr. Common Stock 49 o Dr. Additional Paid in Capital 99297 o Cr. Treasury Stock Reclassified to Retained Earnings o Dr Retained Earnings 64934 o Cr. APIC

99346

64934

On average, what was the price for the shares repurchased? Average Price for Repurchase = 99346/4916 (in thousands) ~= $20 Average Par Value = 49000/4916000 = .01 2. Using the information in the Statements of Shareholders Equity, show the journal entries made by Pacific Sunwear during fiscal 2006 to reflect (1) stock option grants by Pacific Sunwear and (2) stock option exercises by employees.

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At Grant No Entry Compensation Grants During Vesting Period Stock compensation = stock compensation expense Dr. Compensation Expense Cr. APIC Options 6220 6220

Stock Option Exercises by Employees o Dr. Cash 8570 o Cr. Common Stock 8 o Cr. APIC 8562 3. Using information in the stock options activity chart in Note 10, compute the value of option grants made during the year ended February 3, 2007. Assuming that the options vest, on average, over a 3.5 year period, what proportion of the total stock-based compensation expense recognized in 2006 relates to options granted to employees in 2006? o o o o o # shares granted = 684,325 FV of options granted (weighted average) = 9.36 Total FV of Options Granted = 684,325 * 9.36 = 6,405,282 Compensation expense = Total FV of Options Granted / Vesting Period = 6,405,282/3.5 = 1,830,081 29% of total expense Rest of Expense relates to prior period grant that are not yet vested.

EXAM - Compensation Expense - Treasury Stock Stuff Covered Post Mid-term - Long-lived assets o Capitalize(create an asset) vs. Expense o Three significant choices that affect depreciation Depreciation method, useful life, depreciable basis o Reflecting new information Asset impairment If net book value > undiscounted sum of future cash flows, write down asset to current market value Changes in depreciation estimates Net book value at date of new information used to compute new expense going forward Expense repairs/maintenance; capitalize capital improvements (somewhat of judgment call) Capitalize purchased intangibles; expense self-generated intangibles - Long-term Liabilities o Present Value Concepts PV Lump Sum = Future Lump Sum Amount * Factor from Table 2 PV Annuity = Future Annuity Amount * Factor from Table 4 o Bonds Proceeds/Issue price = PV of future cash outflows @ histoirical market rate Interest expense = beginning liability * historical market rate

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Coupon payments = face value * coupon rate Discount or premium amortized to zero over life of bond Change in bond discount/premium = difference between coupon payments and interest expense At any point in time Book value = PV of remaining cash outflows at historical market rate Market Value = PV of remaining cash flows at current market rate

Leases o Operating vs. Capital Four tests to determine if lease is a capital lease o Operating Lease Record rent expense every period o Capital lesae Record lease liability and asset on signing Record interest expense and amortization expense every period Dr. Interest Expense Dr. Lease Liability Cr. Cash Note: Total interest expense + total lease liability = total cash payments (this is true for EVERY period) o The total amount expensed over the life of the lease under operating and capital lease are identical Amounts expensed under capital lease are larger in the early years o Capitalizing operating leases Effect on balance sheet Deferred Taxes o Arise due to temporary differences between taxable income and book income o For better matching, report tax expense equal to tax impact of book income Income tax expense = (Income before income taxes +/- permanent differences) * statutory tax rate o Deferred tax liabilities (DTL) are created when Cumulative taxable income < cumulative book income, OR Cumulative taxes paid < cumulative income tax expense in I/S o Deferred tax assets (DTA are created when Opposite of above o When tax rates change, record this impact on previously recognized DTAs and DTLs o DTA/DTL on balance sheet = bal TWO EQUATIONS I NEED FROM THE CHALK Investments o Minority Passive: less than 20% ownership Trading and AFS securities are marked to market at the end of the year: Market Vlaue Method Trading: both unrealized gains and losses are recognized each period in the I/S o Realized gain/loss = proceeds from sale book value AFS: unrealized gains and losses stay on the balance sheet as a SE account and do not pass through the I/S o Realized gain/loss = proceeds from sale original acquisition cost o Minority Active: 20-50% Investor firm recognize net income equal to its proportionate share of the net income of the investee firm Dividends received from investee reduce the investment asset not recorded as revenue

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Record depreciation expense of excess of fair value over book value of assets of investee or Shareholders Equity o Treasury Stock Contra SE Account (Dr. when it goes up Cr. When it goes down) Reissue of treasury stock At a price greater than purchase price: Credit balance to APIC At a price lesser than purchase price: debit balance in APIC (or RE if not sufficient balance in APIC) o Employee Stock options Record compensation expense over the vesting period using the FV of the options at the grant date. Summing it all up o Double entry bookkeeping o Financial statements o Knowledge of main asset, liability and SE accounts o Notes to the financial statements Uncovered topics o Pensions o Derivatives o Consolidation (in depth) Take 30116 and 30117 o USING financial statements Financial statement analysis Valuation Take 30130

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