FAR - Notes Chapter 7

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Financial Instruments
Fair value disclosure required for financial instruments either in the body of the F/S or in the notes

Credit risk – possibility of loss from the failure of another party to perform according to the contract terms
Concentration of credit risk – overweight in some sector, region or companies with similar characteristics
- must disclose all significant concentrations of credit risk in notes to the F/S
Market risk (beta) – risk due to changes in economic circumstances
Derivative instrument (SFAS 133) – financial instrument that derives its value from another instrument or asset
- has one or more underlying assets and has notional amounts (unit of measure)
- requires no initial net investment
- there is a settlement

Forwards are contracted between parties

Futures are made through clearinghouses

Reporting gains and losses

Derivatives that are speculative (don’t hedge anything) are recognized currently in earnings

Fair value hedge – derivative designed to hedge against changes in the fair value of an asset or liability
- g/l’s on the derivative and the g/l on the hedged item are recognized currently in earnings

Cash flow hedge – hedge exposure to expected future cash flows

- effective portion of cash flow hedge – reported in other comprehensive income (PUFE)
- ineffective portion of cash flow hedge – reported in current earnings

Foreign operation currency hedge – report in other comprehensive income as part of cumulative translation adj.

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Stockholders Equity
Five components:
1. Capital Stock (Legal Capital)
2. Additional paid in capital
3. retained earnings or deficit
4. accumulated other comprehensive income
5. treasure stock
6.
Capital Stock (Legal capital) – amount of capital that must be retained by the corporation for protection of
creditors
- also known as par or “stated” value of both preferred and common stock
- possible for a common stock not to have a par value/ management in good faith
Authorized stock – amount of stock hat board has authorized to issue
Issued stock – authorized stock that is issued
Outstanding stock – issued stock held by shareholders

Book value per common share = Common shareholders’ equity/ common shares outstanding

Common Shareholders’ Equity = Total Shareholders’ equity-preferred stock outstanding (at greater of call price
or par value) – cumulative preferred dividends in arrears

Cumulative preferred stock – dividends not paid accumulate. Get paid dividend in arrears before common stock
holder. Dividend pay with par value and %.

Parcitipating preferred stock – share equally then Pro-Rata. Ex. P.17

- allow to share excess dividend with C/S
- Fully Participating = preferred shareholders participate in excess dividends without limit.
- (get their dividend first, then share with C/S)
- Partially participating = have a limit to share with.

Non-Participating Preferred Stock: only get their fixed %

Convertible preferred stock – may be exchanged for common stock at the option of stockholder

Callable (Redeemable) Preferred Stock: to repurchase stock at the option of entity

Mandatory Redeemable Preferred Stock (Liability): must be brought back by the company on the maturity date.

Retained Earnings
- exclude treasury stock and OCI

Net income/loss
-Dividends (cash, property (FMV) and stock) declared
+/- Prior period adjustments (correction of errors)
+/- accounting changes reported retrospectively
+ Adjustment from quasi-reorganizations
Retained Earnings

Dividends declared reduce retained earnings R/E

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Appropriated R/E – some portion of R/E that is legally restricted and not available to pay dividends
Dr. Retained earnings (unappropriated)
Cr. Retained earnings appropriated for [purpose]

Quasi-organization(p.19) – an accounting adjustment to eliminate negative R/E and have a fresh start
1. restate overvalued assets to their FV (dep exp. Decrease) and eliminate a retained earnings
deficit (earnings increase)
2. bring R/E to zero: reduce the Par value of the stock, and APIC,
3. Dr. Common Stock ($ Par value to be reduced
Cr. Retained Earning (eliminate deficit)
Cr. APIC (PLUG)

Accumulated Other Comprehensive Income: not included in determine net income

1. not enter into retained earnings
2. recognized in the period occurred and combined with net income to become comprehensive
income
1.

Transactions with owners (issue/repurchase of stock, paying dividends) are never recorded on the I/S, record in
balance sheet

Treasury stock – is not entitled to any of the rights of common shareholders (no voting, no dividends) and is a
contra equity account
- R/E can only be affected by a treasury stock transaction if its reissued and there is insufficient funds in
the paid in capital account to absorb that calculation

2 methods of accounting for treasury stock:

1. Cost method (p.20) (required by IFRS and used by GAAP entities 95% of the time)
1. Treasury shares are recorded and carried at their reacquisition cost
2. Gain and loss will record after reissued or retired
3. APIC from treasury stock will be created after reissued
3. Losses: decrease APIC from treasury stock first, not enough, then R/E

Buy back above issue price

Treasury stock xx (shares * acquisition price)(at cost, contra equity)
Cash xx

Reissue above cost

Cash xx (amount received)
TS xx (at cost from buy back)
APIC-TS xx (plug)

Reissue below cost

Cash xx
APIC-TS xx (if any)
R/E xx (excess amount)
TS xx (cost; from buy back)

Instead of Reissue, retired

Dr. C/S (orig. Par)
Dr. APIC (Orig)
Dr. R/E (excess loss over APIC)
Cr. Treasury Stock
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Present on B/S after R/E before stockholders equity total

Legal or Par value method (p.22) (prohibited by IFRS)

1. Recorded by reducing the amounts of Par value and APIC received at the time of original
sale.
2. G/L calculated upon buy back/ no g/l on the reissue
3. ex. Orig:
Dr. cash
Cr. Common Stock
Cr. APIC
Buy back Above issue price (loss when buy back)
Dr. Treasury stock (Orig par)
Dr. APIC (orig. excess of par value)
Dr. R/E (add. Loss excess of APIC)
Cr. Cash
Buy back below issue price (Gain)
Dr. T/S (orig.par)
Dr. APIC (orig. issue excess of Par)
Cr. Cash
Cr. APIC-T/S (plug)
4. Never increase R/E, only decrease if necessary
5. Present on B/S after common stock

Instead of reissue, retired

Dr. Common Stock (orig par value)
Cr. Treasury stock
• The primary difference between the two is the timing of the recognition of gain/loss on treasury stock
transactions.
• Both record the gain/loss as a direct adjustment to stockholders equity

Donated stock – no change in stockholders equity, record donated stock at FMV

- number of shares outstanding decreases, so high BV per common stock
Donated TS xx
APIC xx

Stock issued above par value – credit APIC

Stock issued at par value – no APIC entry
Stock issued below par – debit APIC (decrease)

Stock subscriptions – contractual agreement to sell a specified number of shares at an agreed upon price on
credit.
Dr. Subscriptions receivable xx (contra equity)
Cr. Common stock subscribed xx
Cr. APIC xx
So no change in equity account
Later when $ received
Dr. Cash
Cr. Subscriptions receivable

Actual issuance of stock previously subscribed

Dr. Common stock subscribed
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Cr. Common stock (issued)

Stock right: provides the shareholder with an opportunity to buy more share, usually below the market price.
- memorandum entry only
- J/E later when the rights are actually exercised.

Stock issued for outside services should be recorded as the FMV of stock
Expense for services xx (FMV of stock)
C/S xx (par)
APIC xx (excess/plug)

DISTRIBUTIONS TO SHAREHOLDERS
- Dividend: a pro rata distribution by a corporation based on the shares of a particular class of stock and
usually represents a distribution of earnings
- cash dividends are paid from R/E

Property dividends: on the date of declaration, property should be adj. to FV and recognize any G/L on I/S
R/E xx (FMV of building)
Accum Dep xx
Build cost xx
Gain xx (plug)

Scrip dividends – special form of notes payable, corp pays a dividend at a later date
- shifts from current liability to long term liability

Liquidating dividends – when dividends to shareholders exceed R/E

Stock dividend – no dividend income reported by the investor

- Small stock dividend (less than 20-25%) – transfer from R/E to capital stock and APIC at FMV.
Dr. Retained Earnings (FMV)
Cr. Common Stock (par value at the stock outstanding par)
Cr. APIC (plug)

- Large stock dividend (more than 20-25%) – reduce R/E by par value
At declaration:
Dr. Retained Earning (par value)
Cr. Common stock distributable
Distribution of stock dividend
Dr. Common Stock distributable
Cr. Capital Stock, $10 par common

Stock dividends and stock splits are usually not made unless: company trying to maintain a ratio for a
contractual agreement Or state law requires that treasury stock to be protected from dilution.

Stock splits – no change in total book value

- multiply outstanding shares by 2 and divide par value by 2

ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES

- IFRS, NO noncompensatory stock options. All Are Compensatory

Non-compensatory stock options (not meant as compensation)

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• No JE until options are exercised
• Upon exercise
Cash xx (# of shares * option price)
C/S xx (# of shares * par value)
APIC xx (plug)

Compensatory stock options (p.31) –valued at the fair value of the options issued, not FV of stock
• The compensation expense, calculated on the option grant date is allocated over the service period (vesting
period, time between grant date and vesting date) (matching principal).

Expiration of stock options – no change to stockholders equity, compensation expense not affected
APIC-stock options xx
APIC- expired stock options xx

Stock Appreciation Rights (SARs) (P.33): allows an employee to receive an amount (cash) equal to the excess
of the market price of stock at the exercise date over the market price on the
grant date. .
1. (market $ on the stock – market $ on the grant date) times # of rights
outstanding = compensation expense
2. must be adjusted annually
3. treat as changes in estimate, so prospective
4. employee does not require to make any cash payment

IFRS: changes in shareholders’ equity must be in primary F/S

GAAP: may be in primary financial statements or note.

Earnings Per Share

• FASB 128 requires all public entities (IFRS and GAAP) to present EPS on the face of the income statement
• Simple capital: - nothing convertible,
 only has common stock outstanding
 presents basic per share in the income from continuing operation
• complex capital structures:
 (has convertible securities)
 must present basic and dilutive EPS in the continuing operation in I/S
- if entity has discontinued operation or an extraordinary item: break the EPS and dilutive down to those
categories and show the per share amount either on the face of I/S or the note.

Basic EPS = (NI – preferred dividends)

weighted average number of common shares outstanding (WACSO)

Weighted avg # of C/S outstanding (WACSO) =

shares outstanding beg
+ shares sold (on a time weighted basis)
– shares reacquired (on a time weighted basis)
+ stock div and stock splits (retroactively adjusted) (pretend it happened in the beg. Year)
– reverse stock splits (retroactively adjusted)
Weighted average number of C/S outstanding for the entire period (WACSO)

- months till next issuance or year end are the numerator in the initial formula

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Stock dividends and stock splits must be treated as though they occurred at the beginning of the period.
If prior periods are presented, retroactively adjusted for those periods. (prior year EPS data needs to be
adjusted for stock splits occurred in the subsequent years.

If the purchase method is used, weighted average is measured from the date of the combination.

Diluted EPS = NI+ Interest on dilutive securities (treat as the option exercised or converted)
Weighted average # of common share, assuming all dilutive securities are converted to
common stock

Dilution from options, warrants and their equivalents(use of treasury stock method)
Treasury stock method – proceeds from the exercise of dilutive securities will be used to repurchase treasury
stock at the prevailing market price.
- when the options and warrants are exercised, the company going to take whatever cash
they received based on the strike price and buy back as many share as they can at the
market price.

Options and other similar instruments are only dilutive when they are in the money (market price > strike $)
For options and other similar instruments
Additional shares outstanding = number of shares – ((number of shares * exercise price) ÷ avg market price)
1. made it more dilutive.
2. add the add. Shares to WASCO

Dilution from bonds or preferred stock

The “if-converted” method – assumes that the securities were converted to common stock at the beginning of
the period
For convertible bonds
• Add interest expense, net of tax, to the numerator (it increases the income available to stockholders)
• Add dilutive effect to denominator

Only show diluted EPS if it is actually dilutive. Therefore, if its anti-dilutive do/show nothing

For convertible preferred stock

• Add associated preferred dividends to the numerator (it increases the income available to stockholders)
• Add dilutive effect to denominator

Cash flow per share should not be reported

Statement of Cash Flows

The purpose of the statement of cash flows is to provide info about the sources of cash and uses of cash
- Operating
- Investing
- Financing
Regardless of the method, present the investing and financing section the same

Direct method required disclosures

- Reports operating cash flows by major classes.
- A reconciliation of net income to net cash flow from operations.
- The amount of income taxes paid.

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Indirect method – adjust NI to reconcile it to net cash flows from operating activities

Cash received from customers = cash sales + T account (F7-38)

Cash paid to suppliers = 2 steps
Step 1: Beg inventory + purchases, cash paid – COGS = Ending inventory
Step 2: Beg A/P + credit purchases – cash paid = end A/P

Direct method – focuses predominately on working capital (CA and CL)

Categories to report separately:
Inflows (increase cash)
• Cash received, interest received, div received [div paid is financing], cash on sales of trading securities [all
other securities are investing]
Outflows (decrease cash)
• Cash paid to suppliers and employees, interest paid [paying principal is a financing], income taxes paid
[current of deferred], cash paid to buy trading securities, other operating cash payments [rent, utilities,
insurance]

Indirect method – reconciliation DAALGUDI

Net income per I/S
+ depreciation and amortization
- amortization of premiums
+ amortization of discounts/goodwill
+ losses on sale of non-current assets (PPE/LT investments)
- gains on sale of non-current assets
- undistributed earnings from affiliate (equity method)

+ decrease in current assets (or – increase in CA)

+ increase in CL (or – decrease in CL)
= cash flow from operations

Cash proceeds from sales of non current assets is investing inflow

[Selling price – NBV {cost – accum dep) = g/l]

Investing section
• Sale or Purchase of Non-current assets, net accum dep; if we buy then it’s a cash outflow; sell it’s a cash
inflow
• Making loans to other entities; outflow
• Purchasing avail for sale or held to mat securities; outflow

Financing section
• Paying principal on notes, bonds, mortgages; outflow
• Your own stock
• Paying dividends

Material non-cash investing and financing activities require supplemental disclosure

Begin bal bond payable + issuance of bonds - redemption of bonds payable = Ending bal bond payable