Summary with the 11th edition of Financial Accounting by Needles and Powers

How to use financial statements for business accounting? - Chapter 1

What are the main definitions?

Accounting can be defined as an information system that measures, processes, and communicates financial information about an identifiable economic entity. An economic entity is a unit that exists independently. Accounting can be seen as a link between business activities and decision makers.

A business is an economic entity that has the aim to sell goods and services to customers at prices that will provide an adequate return to its owners. All businesses have two major goals; liquidity and profitability. The need to earn enough income to attract and hold investment capital is the goal of profitability. In addition, business must meet the goal of liquidity. This means having enough cash available to pay debts when they are due.

All businesses pursue their goals by engaging in the following activities:

• Operating activities such as selling goods and services to customers, and buying and producing of goods.

• Investing activities like spending the capital of a company to achieve its goals. This includes buying resources necessary to operate such as land, buildings and equipment.

• Financing activities involve obtaining funds to be able to begin a business and to continue operating it. It includes for example obtaining capital from owners and from creditors such as banks.

Using financial statements to determine whether a business is well managed and achieving its goals is called financial analysis. The effectiveness of such a financial analysis depends on the use of relevant performance measures. Management accounting is the internal managing of finance and is about financing, investing and operating activities to achieve profitability and liquidity. Financial accounting generates reports and communicates them to the external decision makers. These reports are called financial statements. Bookkeeping is the process of recording financial transactions and keeping financial records and is only a small part of accounting. Ethics is the code of conduct that is applicable to everyday life. Ethical financial reporting is important since fraudulent financial reports can have serious consequences.

Accounting data is used by management, users with direct financial interest and users with indirect financial interest. The management are the people who are responsible for ensuring that a company meets its profitability and liquidity goals. Users with direct financial interest are for example investors, like stockholders, or creditors. Users who have indirect financial interest are tax authorities, regulatory agencies and other groups such as labor unions and consumer groups.

The accountant must answer the following four basic questions in order to make an accounting measurement:

1. What is measured?

2. When should the measurement be made?

3. What value should be placed on what is measured?

4. How should what is measured be classified?

Business transactions are economic events that affect the financial position of businesses. Transactions are recorded in terms of money; this concept is called money measure. The money measure depends on the country in which the business is located. In international transactions exchange rates are used to translate one currency to another. For accounting purposes, a business is seen as a separate entity; it is distinct not only from its creditors and customers but also from its owners. It should have a completely separate set of records, and its financial records and reports should refer only to its own financial affairs.

Which business forms are there?

There are three basic forms of business, which are discussed below:

• A sole proprietorship is a business owned by one person. The person is liable for all obligations of the business.

• A partnership has two or more owners. The partners share the profits and losses of the business according to a prearranged formula. A partnership must be dissolved as the ownership changes; i.e. as a partner dies or leaves.

• A corporation is a business unit chartered by the state and legally separated from its owners (the stockholders). The stockholders do not have direct control over the operations of the corporation. Because of the limited involvement in the corporation, their risk of loss is limited to the amount they paid for their shares. Therefore, stockholders often are willing to engage in risky activities.

To form a corporation, an application must be signed with the proper state official. This contains the articles of incorporation which form a contract between the state and the incorporators. The authority to manage the corporation is delegated by the stockholders to the board of directors and then to the management. A unit of ownership in a corporation is called a share of stock. In the articles of incorporation is stated how many shares a corporation is authorized to issue. The most universal form of stock is common stock. A board of directors is elected by the stockholders. They appoint managers to carry out the day-to-day work. Only the board has the authority to declare dividends, which are distributions of resources, usually in the form of cash, to the stockholders.

Corporate governance is the oversight of a corporation’s management and ethics by its board of directors. To strengthen corporate governance, an audit committee made up of independent directors who have financial expertise, is appointed by the board of directors. The audit committee is also responsible for reviewing the work of independent auditors of the company.

The income statement, also called the statement of operations, is the most important financial report since it shows whether a company achieved its goals of profitability and liquidity. The basic elements of the income statement are revenues, expenses and net income. When revenues exceed expense the difference is called net income. When expenses exceed revenues the difference is called net loss. The retained earnings of a business are its income-producing activities minus amounts that have been paid to stockholders.

What is meant by financial position?

Financial position refers to the economic resources that belong to a company and the claims against those resources at a particular time. Another term for claims is equities. As every corporation has two types of equities: creditors’ equities and stockholders’ equity, the following equation holds:

Economic Resources = Creditors’ Equities + Stockholders’ Equities.

In accounting terminology the economic resources are called assets and creditors’ equities are called liabilities. This gives the following accounting equation:

Assets = Liabilities + Stockholders’ Equity

Examples of assets are: monetary items as cash and non monetary items such as inventory and land. Liabilities are present obligations of a business to pay cash, transfer assets, or provide services to other entities in the future. Among them are debts, amounts owed to suppliers to borrowed money. The owner’s equity is called the stockholder’s equity. It has two parts:

1. the amount that stockholders invest in the business: contributed capital

2. the equity of the stockholders generated from the income-producing activities of the business and kept in use in the business: retained earnings.

Revenues and expenses are the increases and decreases in stockholder’s equity that result from operating a business. Retained earnings can therefore increase as a result of revenues and decrease as a result of expenses and the payment of dividends.

Four major financial statements are:

• The income statement focuses on the company’s profitability. It summarizes the revenue earned and expenses incurred by a business over a period of time. This will give the net income.

• The statement of retained earnings shows the changes in retained earnings over a period of time. It is the difference between the old and the new net income, less the dividends paid to stockholders.

• The balance sheet is used to show the financial position of a business on a certain date. Usually a balance sheet is made at the end of a month or year. The balance sheet presents a view of the business as the holder of the resources, or assets, that are equal to the claims against those assets. On the left side of the balance sheet are the assets, on the right side the liabilities and the stockholder’s equity. Both sides of the balance sheet must be equal.

• The statement of cash flows is directed toward the company’s liquidity goal. The outcome of the cash flows statement should be equal to the amount of cash on the balance sheet.

To ensure that financial statements are understandable for their users, generally accepted accounting principles (GAAP) have been developed. These principles provide guidelines for financial accounting.

How to analyze business transactions? - Chapter 2

How can business transactions be measured?

To be able to measure a business transaction, the accountant must decide:

1. when the transaction occurred (the recognition issue)

2. what value to place on the transaction (the valuation issue)

3. how the components of the transaction should be categorized (the classification issue)

The recognition issue refers to the difficulty of deciding when a business transaction should be recorded. The predetermined time at which a transaction should be recorded is called the recognition point. This is when a company receives a product, buys a service or pays an employee. When a company orders a product and hasn’t received the bill or the product yet, there is no transaction. A monetary value is assigned to each business transaction. The valuation issue is about assigning a monetary value to a business transaction and the resulting assets and liabilities. The value of the transaction should be equal to the original cost, which is the exchange price. The classification issue has to do with assigning transactions to appropriate accounts. Recognition, valuation, and classification of a business transaction are important factors in ethical financial reporting.

The system that is used to record transactions is called the double-entry system. This system is based on the principle of duality, which means that every economic event has two aspects, effort and reward, that offset each other on the balance. So each transaction must be recorded with at least one debit and one credit, which must be equal to each other in order to keep the whole system in balance. The transaction, a T account, has three parts: a title, a left side which is called the debit side, and a right side which is called the credit side.

An example of a T account of cash is represented below:

Cash

Consider the accounting equation discussed before:

Assets = Liabilities + Stockholder’s equity

This means that when a debit is made on the assets side, a credit should be made on the liabilities or stockholder’s equity side.

The trial balance adds all the outcomes of balances to see if both sides are equal. It is prepared by listing each account balance in the appropriate Debit or Credit column. The two columns are then added, and the totals compared.

Not all transactions generate immediate cash. Then, there is a holding period in either Accounts Receivable or Accounts Payable before the cash is received or paid.

What are ledgers?

To be able to identify accounts in the ledger and to make it easy to find them, accountants assign a number to each transaction. The chart of accounts is a list of all the account numbers and titles; it servers as a table of contents for the ledger. The general journal is used to record all transactions chronologically. A separate journal entry is used to record each transaction. It should include:

1. The date

2. The names of accounts debited and the dollar amounts on the same lines in the debit column

3. The names of accounts credited and the dollar amounts on the same lines in the credit column.

4. An explanation of the transaction

5. The account identification numbers, if appropriate.

The general ledger is used to update each account and has four columns for money amounts unlike the journal, which has only two columns. In addition to the two columns, the ledger states the balance of the separate accounts that have been debited or credited.

The accounting cycle involves six steps with the purpose to produce financial statements for financial decision makers. The steps are:

1. Analyze business transactions

2. Record transactions by entering them in the general journal.

3. Post the journal entries to the ledger and make a trial balance

4. Adjust the accounts and adjust the trial balance.

5. Prepare financial statements.

6. Close the accounts and prepare a post-closing trial balance.

How to measure business income? - Chapter 3

For a business to survive or succeed it must earn net income. Net income is the net increase in stockholders’ equity resulting from the operations of a company. Net income = Revenues – Expenses.

When there are more expenses than revenues, a net loss occurs. Revenues are increases in stockholders’ equity resulting from the operations of a company such as selling goods. Expenses are decreases in stockholders’ equity resulting from the operations of a company such as the cost of selling goods.

What are the basic assumptions?

When measuring the income of a business, the following assumptions are made:

• The continuity assumption: This assumption is about the expected life of a business entity. The continuity assumption is that an accountant has to assume that the business will continue to operate indefinitely, unless there is evidence on the contrary. In other words; the business is a going concern.

• The periodicity assumption: Some products have effects that extend over many years. Accountants estimate the time the product will be in use and the cost that should be assigned to each year. Accountants make the following assumption about periodicity: although the lifetime of a business is uncertain, it is useful to estimate the business’s net income in terms of accounting periods. An accounting period of 12 months is called a fiscal year, usually from January 1 to December 31. Accounting periods of less than a year are called interim periods.

• The matching assumption: Deals with the fact that revenues and expenses must be accounted for when cash is received and cash is paid. This is called the cash basis of accounting. The matching rule must be applied, which is the following: Revenues must be assigned to the accounting period in which the goods are sold or the services performed, and expenses must be assigned to the accounting period in which they are used to produce revenue.

As applying the matching rule involves making assumptions, it can lead to earnings management: the manipulation of revenues and expenses to achieve a specific outcome. When the estimates involved are moving outside a reasonable range, the financial statements become misleading and fraudulent.

What is accrual accounting?

Accrual accounting encompasses all the techniques accountants use to apply the matching rule. In accrual accounting, revenues and expenses are recorded in the periods in which they occur rather than in the periods in which they are received of paid. Accrual accounting is accomplished in the following ways:

1. Recognizing revenues when they are earned. Before a revenue is recognized the following conditions must be satisfied:

• Persuasive evidence of an arrangement exists.

• Delivery of the product or service has occurred.

• The seller’s price to the buyer is fixed or determinable.

• Collectability is reasonably assured.

2. Recognizing expenses when they are incurred.
Expenses can be recorded when an agreement is made to purchase goods, the goods have been delivered, a price is established, and the goods or services have been sued to produce revenue. One thing to note is that the recognition of the expense does not depend on the payment of cash.

3. Adjusting the accounts.
This is needed because an accounting period ends on a certain day. All assets and liabilities as of the end of that day must be listed on the balance sheet. There must be a cutoff point for the periodic reports. Some transactions span this cutoff point, and therefore some accounts need adjustments.

What are adjusting entries?

When the transactions span more than one accounting period, accountants use adjusting entries to apply accrual accounting to these transactions. An accrual is the recognition of a revenue or expense that has happened but hasn’t been recorded yet. This could for example be wages earned by employees in the current accounting period but after the last pay period. Another example are fees earned but not yet billed to customers. A deferral is the postponement of the recognition of an expense already paid or a revenue received in advance. Examples are prepaid rent or payments collected for services yet to be rendered. There are four types of adjusting entries, which will be discussed below.

Adjusting entry Type 1: Allocating recorded costs between two or more accounting periods. These are called deferred expenses. The expenditures are usually debited to an assent account, and at the end of the period, the amount that has been used will be transferred from the asset account to an expense account.

Example: Adjustment for prepaid rent.
On July 31: Expiration of one month’s rent, $1600. At the beginning of July, two months’ of rent has been paid in advance. At the end of the month, half of the prepaid rent has expired and should be treated as an expense. The corresponding accounts are:

The same can be done for prepaid insurance.

Adjustment for Supplies
On July 31: Consumption of supplies, 1540 dollar
A company can purchase supplies that will be consumed when performing tasks. An example of this is office supplies. At the end of the month the balance still shows the old amount of office supplies, while inventory shows that a certain amount of supplies has been used. This should be accounted for in the following way:

Depreciation is also a deferred expense. When office equipment depreciates, a contra account called ‘accumulated depreciation office equipment’, will be created. The balance of this contra account is shown on the financial statement as a deduction from the related account, in this case the ‘office equipment’ account.

An example of this is displayed below:

Adjusting entry Type 2: Recognizing unrecorded expenses. This is called an accrued expense. Examples of such an expense are accrued wages and estimated income taxes.

Example: By the end of business on July 31, an employee will have worked three days (29, 30 and 31 of July) beyond the last pay period. The employee has earned wages for those days - 240 dollar per day - but will not be paid until the first payday in August. These last days should be accounted for in the following way:

The accrual of unrecorded wages is 3 days x 240 dollar = 720 dollar.

The wages expense account is an equity account. The wages payable is a liability account.

The same can be done for income taxes. A company can estimate the amount that will go to income taxes for that month and record this amount as income taxes payable and income taxes expense.

Adjusting entry Type 3: Allocating of recorded unearned revenues between two or more accounting periods. These revenues are called deferred revenues. When a company receives a payment in advance, this payment will be recorded as a liability account. At the end of the month, the company should record the part of the job that has been finished under fees earned, a revenue account. Suppose this company received 1400 dollar as advance payment. By the end of the month it had completed $800 of work. This should be recorded in the following way:

Adjusting entry Type 4: Recognizing unrecorded earned revenues. These revenues are called accrued revenues. Suppose that a company agreed to design a website, and wants to have the website operational at July 31. By the end of the month, the company had earned 400 dollar for completing the first section, but had not billed this yet.

This should be recorded in the following way:

What is meant by closing accounts?

The final step in the accounting cycle is closing the accounts and preparing a post-closing trial balance. Balance sheet accounts such as cash and accounts payable are permanent accounts, they carry their end-of-period balance into the next period. Revenue and expense accounts are temporary accounts because they begin each period with a balance of zero. Closing entries are journal entries made at the end of an accounting period. The closing entries serve two purposes, namely to clear the accounts of the balance to set the stage for the next accounting period and they summarize a period’s revenue and expenses. To be able to do this, the balances of the revenue and expense accounts are transferred to the Income Summary account, which is another temporary account. It is only used for closing entries and does not appear in financial statements. There are four steps in closing accounts:

1. Closing the credit balances from income statement accounts to the Income Summary account.

2. Closing the debit balances from income statement accounts to the Income Summary account.

3. Closing the Income Summary account balance to the Retained Earnings account.

4. Closing the Dividends account balance to the Retained Earnings account.

Because errors can be made in posting closing entries to the ledger accounts, it is necessary to prepare a post-closing trial balance to determine that all temporary accounts have zero balances and to double check that total debits equal total credits.

The general rule for determining the cash flow received from any revenue or paid for any expense (except depreciation) is to determine the potential cash payments or cash receipts and deduct the amount not paid or received.

How do Financial Reporting and Analysis work? - Chapter 4

What is Financial Reporting?

Financial reporting is important for three major reasons:

• To furnish information that is useful in making investment and credit decisions

• To provide information useful in assessing cash flow prospects

• To provide information about business resources, claims to those resources, and changes in them.

The goal of generating accounting information is to provide data that can be used by different people to make a decision. To help interpret accounting information, the Financial Accounting Standard Board (FASB) has described qualitative characteristics. The most important ones are relevance and faithful representation. Relevance means that the information must have a direct bearing on the decision. For information to be relevant it must have predictive value, confirmative value or both. With faithful representation is meant that the financial information is complete, neutral and free from material error. Free from material error means that the information should have a minimum level of accuracy so that it does not distort what is being reported. Some other qualitative characteristics are comparability, verifiability, timeliness and understandability.

Accounts must prepare financial statements in accordance with accepted practices. It is helpful to understand the accounting conventions which are used in preparing financial statements to better understand financial information. To deal with the difficulties of understanding financial information accountants depend on five conventions in preparing financial statements:

• Comparability and consistency: The information in a financial statement must be provided in such a way that anyone who reads it can recognize similarities, differences, and trends over time. When a company adopts a certain accounting procedure, it must continue working with this procedure from one period to the next, or inform users when a change occurs. In this way the statements are consistent.

• Materiality: Refers to the relative importance of an item or event. An item is material if there is a reasonable expectation that knowing about it would influence the decisions of users of the statements. When a small asset is not material, a company could decide to record the asset as an expense, instead of a long-term asset that has to be depreciated.

• Conservatism: When accounts are uncertain about a judgment or estimate that they must make they look to the conservatism convention. This means that when an accountant has to choose between two equally acceptable procedures, they should choose the one that is least likely to overstate assets and income.

• Full disclosure (Transparency): It is required that financial statements present all information that is relevant to the users of the statements. The statements need to be transparent such that they include any explanation to keep it from being misleading.

• Cost-benefit: The benefits to be gained from providing accounting information should be greater than the costs of providing it.

Since the passage of the Sarbanes-Oxley Act in 2002, CEO’s and CFO’s have been required to certify the accuracy and completeness of there companies’ financial statements.

What does the balance sheet consist of?

When there are many different accounts in a company, it may be easy to place them into subcategories. Financial statements that are divided into subcategories are called classified financial statements. Assets are often dividend into:

• Current assets: Cash and other assets that are expected to be converted into cash, sold, or consumed within one year, or within the operating cycle, whichever is longer. The normal operating cycle of a company is the average time it needs to go from spending cash to receiving cash.

• Investments: Includes assets, usually long-term, that are not used in the normal operation of the business and that are not planned to be converted into cash within one year.

• Property, plant, and equipment: Include tangible long-term assets that are used in the continuing operation of the business. They represent a place to operate and the equipment used to sell and deliver goods and services. Through depreciation, the costs of the assets are spread over the periods they benefit.

• Intangible assets: Long-term assets with no physical substance and whose value stems from the rights or privileges of their owners.

Sometimes, for simplicity companies place investments, intangible assets, and miscellaneous assets into a single category called other assets.

Liabilities are divided into two categories. In which group a liability falls depends on when the liability is due.

• Current liabilities: All obligations to be paid within one year, or within the normal operating cycle, whichever is longer. These liabilities are paid out of current assets.

• Long-term liabilities: Debts that fall due more than one year in the future or beyond the normal operating cycle. These liabilities are paid out of non-current assets.

The stockholders’ equity section has two parts:

• Contributed capital: The amount that stockholders invest in the company

• Retained earnings

When a company is a sole proprietorship, the equity section simply shows the capital in the owners’ name at an amount equal to the net assets of the company. There is no need to separate retained earnings and contributed capital. When the company is a partnership, the equity section is divided between the partners.

What is the income statement?

Thus far, the income statement was presented by deducting all expenses from revenue in one step to get to the net income. There is also a multistep income statement that goes through a series of steps to arrive at net income. It is used for service companies, merchandise companies, who buy and sell products, and manufacturing companies, who make and sell products. The income statement for merchandise and manufacturing companies differs from the income statement of a service company.

Multistep income statement for a service company:

Multistep income statement for a merchandising or manufacturing company:

• Net sales: Consists of all gross sales of merchandise, less sales returns and allowances and any discounts. Gross sales consists of total cash sales and total credit sales during an accounting period

• Cost of goods sold: The amount paid for the merchandise sold or the cost of making the products sold during the accounting period.

• Gross margin: The difference between net sales and cost of goods sold.

• Operating expenses: The expenses other than cost of goods sold that are incurred in running a business. Often operating expenses are grouped into categories such as selling expenses and general and administrative expenses. Selling expenses include the costs of storing goods and preparing them for sale. General and administrative expenses include expenses for accounting, personnel, collections and other expenses related to overall operations.

• Income from operations: The difference between gross margin and operating expenses. This is the income from a company’s normal business. It is also called the operating income.

• Other revenues and expenses: Revenues and expenses that are not part of a company’s operating activities. It includes revenues from investments, interest earned on credit or notes, interest expense and other kinds of revenues and expenses.

• Income before taxes: The amount a company has earned from all activities before taxes are paid.

• Income taxes: The expense for federal, state, and local taxes on corporate income.

• Net income: What remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and taxes are deducted. It is the amount that is transferred to retained earnings from all the income-generating activities during the year.

• Earnings per share: The net income earned on each share of common stock. The simplest method is dividing the net income by the average number of outstanding stock.

The single-step income statement simply first groups all major revenues and then all major expenses. Then expenses are deducted from revenues to get to the income before income taxes. Income taxes are shown as a separate item and are deducted to get to the net income.

How can classified financial statements be used?

Management has two important goals: maintaining adequate liquidity and achieving satisfactory profitability. Several ratios can be used to reflect a company’s performance with respect to these important goals. These ratios make use of the components in classified financial statements

Liquidity means having enough money on hand to pay bills when they are due and to take care of unexpected needs for cash.

There are two ways to measure it:

• Working capital: the amount by which total current assets exceed total current liabilities. By definition, current liabilities are paid out of current assets. It is calculated by deducting current liabilities from current assets.

• Current ratio: An indicator of a company’s ability to pay its bills and to repay outstanding loans:

Profitability is the ability to earn a satisfactory income. Liquid assets are not the best profit-producing resources. For example, a company can have enough cash and have purchasing power, but profit can be made only when the purchasing power is used to buy profit-producing (and less liquid) assets, such as inventory and long-term assets. There are five common ways to measure to ability of a company to earn income:

• Profit margin: The percentage of each sales dollar that results in net income. The corresponding formula makes use of net income and net sales (also called revenue).

Profit margin = Net income / Net sales

• Asset turnover: Measures how efficiently assets are used to produce sales. It shows how many dollars of sales were generated by each dollar of assets:

Asset turnover = Net sales / Average total sales

The profit margin does not look at the assets that are necessary to produce income, and the asset turnover does not look at the amount of income produced. To overcome these limitations, the return on assets ratio can be used:

• Return on assets: Relates the net income to average total assets. It shows how much net income is generated for each dollar invested.

Return on assets = Net income / Average total assets

Or one can use the formula:

Profit Margin x Asset turnover = Return on assets

• Debt to equity ratio: Shows the proportion of the company that is financed by creditors compared to the proportion that is financed by stockholders. When the value of total liabilities is not stated on the balance sheet, it can be determined by deducting the total stockholders’ equity from total assets.

Debt to equity = Total liabilities / Total stockholders' equity

Assume that the debt to equity percentage of a certain company is 60%. This means that less than half the financing is from creditors and more than half from investors.

• Return on equity: Measures how much stockholders have earned with their investments.

Return on equity = Net income / Average stockholders' equity

What are the Operating Cycle and Merchandising Operations? - Chapter 5

What is merchandise inventory?

A merchandising business earns income by buying and selling goods, which are called merchandise inventory. These merchandise companies use the same basic accounting methods as service companies, but because they buy and sell good the process is more complex. One important issue for merchandising companies is having enough liquidity. A common measure of liquidity is working capital, which is the amount by which current assets exceed current liabilities.

Merchandising businesses engage in a series of transactions called the operating cycle. Most merchandise companies buy and sell merchandise on credit. This makes them engage in the following four transactions:

1. Purchase of merchandise inventory for cash or on credit

2. Payment for purchases made on credit

3. Sales of merchandise inventory for cash or on credit

4. Collection of cash from credit sales

Purchases of merchandise are usually made on credit, so the merchandiser has a period of time before payment is due. However, this period is generally less than the time it takes to sell the merchandise and payment is collected. To finance the inventory until it is sold and the resulting revenue is collected, management must make sure that there are funds available internally or it must borrow from a bank.

The financing period is the amount of time from the purchase of inventory until it is sold and payment is collected, less the amount of time creditors give the company to pay for the inventory. When a company sells most of its inventory for cash, they have very low receivables, and this decreases the financing period. An example is displayed below:

• Day 0: inventory is purchased

• Day 40: Cash paid

• Day 60: Inventory sold

• Day 120: Cash received

Management must choose the inventory system or combination of systems that is best for achieving the company’s goals. There are two basic systems of accounting for the items in the merchandise inventory:

• The Perpetual inventory system: continuous records are kept of the quantity and, usually, the cost of individual items as they are bought and sold. The cost of each item is recorded in the Merchandise Inventory account when it is purchased. When the merchandise is sold, its costs are transferred from the Merchandise Inventory account to the Cost of Goods Sold account.

• The periodic inventory system: the inventory not yet sold is counted periodically, usually at the end of the accounting period. No detailed records of the inventory on hand are maintained during the accounting period.

It is very difficult and expensive to do accounting for the purchase and sale of each item. Therefore, companies that sell items of low value in high volume have traditionally used the periodic inventory system. In contrast, companies that sell items of high unit value have tended to use the perpetual inventory system.

If a company is engaged in international transactions, it must deal with changing exchange rates. A company incurs an exchange gain or loss if the exchange rate between two currencies changes between the date of sale and the date of payment. Exchange gains and losses are reported on the income statement. These gains and losses are especially interesting for managers and investors because of their bearing on a company's financial performance.

It is the responsibility of the management to establish an environment, accounting systems, and control procedures that will protect the company’s assets against theft and embezzlement. These systems are called internal controls. Maintaining control over merchandise inventory is facilitated by taking a physical inventory. This process involves an actual count of all merchandise on hand. It can be difficult to count all merchandise on hand because it is easy to accidentally make a mistake in counting the items. Merchandise inventory includes all goods intended for sale that are owned by a business, regardless of where they are located. It also includes goods in transit from suppliers if title to the goods has passed to the merchant. The actual count is usually taken after the close of business on the last day of the fiscal year.

When losses of goods occur (because of spoilage or shoplifting), the cost of goods sold is inflated by the amount of the merchandise that has been lost. The perpetual inventory system makes it easier to identify such losses. Because the Merchandise Inventory account is continuously updated for sales, purchases, and returns, the loss will show up as the difference between the inventory records and the physical inventory taken at the end of the accounting period. Once the amount of the loss has been identified, the ending inventory is updated by crediting the Merchandise Inventory account. The offsetting debit is usually an increase in the Cost of Goods Sold account because the loss is considered a cost that reduces the company’s gross margin.

What are the terms of sale?

Many merchants quote the price at which they expect the goods to sell. Manufacturers and wholesalers quote prices as a percentage off their list or catalogue prices. Such a reduction is called a trade discount. The list or catalogue price and related trade discount are only used to arrive at the agreed-upon price; they do not appear in the accounting records. On the invoice, the terms of sale are printed and these terms thus are part of the sales agreement. The invoice can be marked “n/10” (“net 10”), which means that the amount of the invoice is due 10 days after the invoice date.

A sales discount is a discount for early payment. It can be labeled “2/10, n/30” which means that the buyer either can pay the invoice within 10 days of the invoice date and take a 2 percent discount or can wait 30 days and pay the full amount.

Purchase discounts are discounts that a buyer takes for the early payment of merchandise. A purchase discount reduces the Costs of Goods Sold or Purchase account, depending on the inventory method used.

In some industries the seller of merchandise has to pay transportation costs and charges a price to include these costs. In other industries, the purchaser has to pay transportation costs. Special terms designate whether the seller or the purchaser pays the freight charges.

• FOB shipping point means that the seller places the merchandise “free on board” at the point of origin and the buyer bears the shipping costs. The title to the merchandise passes to the buyer at that point of origin.

• FOB destination means that the seller bears the transportation cost to the place where the merchandise is delivered. The seller retains title until the merchandise reaches its destination.

How can the perpetual inventory system be applied?

Freight in, also called transportation in, is the transportation cost of receiving merchandise. The costs are accumulated in a Freight in account. Theoretically, freight in should be allocated between ending inventory and cost of goods sold, but most companies choose to include the cost of freight in with the cost of goods sold on the income statement because it is a relatively small amount.

When a seller pays the transportation charge it is called freight out expense, or delivery expense. To facilitate the sale of the product the seller has to incur this cost and therefore this cost is included in Selling Expenses on the income statement.

When an item is returned from the merchandiser to the company it bought the merchandise from, the returned merchandise is removed from the Merchandise inventory account.

Under the perpetual inventory system, at the time of a sale, the cost of the merchandise is transferred from the Merchandise Inventory account to the Cost of Goods Sold account. In the case of a return of sold merchandise, this works the other way.

Returns and allowances to customers for unsatisfactory merchandise are often an indicator of customer dissatisfaction. Such amounts are accumulated in a Sales Returns and Allowances (stockholders equity).

Below are some examples:

Record the following transactions:

1. Purchases of merchandise:

• Oct 3 Merchandise received on credit, invoice dated Oct 1, terms n/10, Dollar 9780

• Oct 6 Returned part of merchandise received on Oct 3 for credit, Dollar 960

• Oct 10 Paid amount in full due for purchase of Oct 3, part of which was returned on Oct 6, Dollar 8820

These transactions must be recorded in the following way:

2. Sales of merchandise:

• Oct 7 Merchandise sold on credit, n/30, FOB destination Dollar 2400; cost of merchandise Dollar 1440

• Oct 9 Accepted return of part of merchandise sold on Oct 7 for full credit and returned it to merchandise inventory, Dollar 600; the cost of the merchandise was Dollar 360.

• Nov 5 Collected in full for sale of merchandise on Oct 7, less the return on Oct 9, Dollar 1800.

These transactions must be recorded in the following way:

How can the periodic inventory system be applied?

In this system, the cost of goods sold must be computed because it is not updated during the accounting period. To calculate this, the goods that are available for sale must be determined.

Goods available for sale = beginning inventory + net cost of purchases during the year.

Cost of goods sold = goods available for sale – end inventory.

An important part of cost of goods sold is the net cost of purchases. This consists of net purchases plus freight charges on the purchases. Net purchases equal total purchases less any deductions, such as purchases returns and allowances and discounts for early payment.

In the periodic inventory system the Merchandise inventory account is not adjusted after each inventory transaction. Therefore, a Purchases or Sales account is used to accumulate the purchases or sales of merchandise during the accounting period. A Purchases or Sales Returns and Allowances account is used to accumulate returns on purchases or sales.

Below are some examples:

Record the following transactions:

1. Purchases of Merchandise:

• Oct 3 Received merchandise purchased on credit, invoice date Oct 1, terms n/10, 9780 Dollar

• Oct 6 Returned part of merchandise received on Oct 3 for credit, 960 Dollar

• Oct 10 Paid amount in full due for the purchase of Oct 3, part of which was returned on Oct6, 8820 Dollar

These transactions must be recorded in the following way:

2. Sales of merchandise:

• Oct 7 Sold merchandise on credit, terms n/30, FOB destination, 2400 Dollar cost of merchandise was 1440 Dollar

• Oct 9 Accepted return of part of merchandise sold on Oct 7 for full credit and returned it to merchandise inventory, 600, the cost of the merchandise was 360.

• Nov 5 Collected in full for sale on Oct 7, less the return on Oct 9, 1800 Dollar

These transactions must be recorded in the following way:

As discussed before, the management of a company must set up a good system of internal control to avoid high losses resulting from embezzlement and theft. An effective system of internal control has five interrelated components:

• Control environment – This environment is created by the overall attitude, awareness and actions of the management. This involves the company’s ethics, operating style, structure, personnel policy, etc.

• Risk assessment – this involves identifying areas in which risks of loss of assets are high. In these risk areas adequate controls can me implemented.

• Information and communication - This pertains to the accounting system established by the management. The employees of the company must exactly understand what their functions are.

• Control activities – the policies and procedures management puts in place to see that its directives are carried out.

• Monitoring – this includes the management’s regular assessment of the quality of internal control. This includes periodic review of compliance with all policies and procedures.

Control activities involve:

• having managers authorize certain transactions,

• recording all transactions to establish accountability for assets,

• using well-designed documents to ensure proper recording of transactions,

• instituting physical controls (controls that limit access to assets).

• Periodic independent verification: means that someone other than the one responsible for the accounting records must periodically check the records and assets,

• separation of duties: means that authorizing transactions, handling assets or keeping records of assets must not be done by one person.

• using sound personnel practices. An example is the process of bonding, which is carefully checking an employee's background and insuring the company against theft by that person.

The effectiveness of internal control is limited by the people involved. Human error, collusion, and failure to recognize changed conditions can contribute to a systems failure.

How can the internal control over merchandising transactions be effective?

For an effective internal control, most firms use the following procedures:

• Separate the functions of authorization, record keeping and custodianship of cash.

• Limit the number of people who have access to cash, and designate who those people are

• Bond all employees who have access to cash.

• Keep the amount of cash on hand to a minimum by using banking facilities as much as possible.

• Physically protect cash on hand by using cash registers, cashiers’ cages, and safes.

• Record and deposit all cash receipts promptly, and make payments by check rather than by currency.

• Have a person who does not handle or record cash make unannounced audits of the cash on hand.

• Have a person who does not authorize, handle, or record cash transactions reconcile the Cash account every month.

What do inventories consist of? - Chapter 6

What does the merchandise inventory consist of?

Merchandise inventory consist of all goods owned and held for sale. There are three kinds of inventory:

• Raw materials

• Partially completed products

• Finished goods

The costs of the goods include raw materials, the cost of labor and the overhead costs. Overhead costs include indirect materials, indirect labor, factory rent, depreciation of plant assets and insurance.

The primary objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues. In accounting for inventories, management must choose among different processing systems, costing methods, and valuation methods. These different systems usually result in different values of reported net income.

Inventory turnover is a measure similar to receivable turnover. It measures the average number of times a company’s average inventory is sold during an accounting period.

Inventory turnover = Cost of goods sold / Average inventory

The days’ inventory on hand calculates the average number of days required to sell the inventory on hand.

Days’ inventory on hand = Number of days in a year (usually 365) / Inventory turnover

There are several options to reduce the level of inventory. With supply-chain management a company manages its inventory and purchasing through business-to-business transactions that it conducts over the internet. In a just-in-time (JIT) operating environment, the company makes sure that shipments arrive just at the time they are needed.

The gross margin is the difference between net sales and cost of goods sold. The higher the cost of the ending inventory, the lower the cost of goods sold and the higher the resulting gross margin. Because the amount of gross margin has a direct effect on the amount of net income, the amount assigned to ending inventory directly affects the net income. Therefore, it is important to correctly determine the ending inventory.

Misstatements of inventory have an effect on the income before income taxes. The effects of misstatements in inventory on income before income taxes are as follows:

The inventory cost includes:

• the invoice price less purchases discounts

• fright-in, including insurance and transit

• applicable taxes and tariffs

Goods flow refers to the actual physical flow of merchandise, whereas cost flow refers to the assumed flow of costs in the operations of a company. Merchandise in transit can be included in the seller’s merchandise inventory when the goods are shipped FOB destination. When the goods are sold FOB shipping point, they are included in the buyer’s inventory. A consignment is merchandise that its owner (the consignor) places on the premises of another company (the consignee) with the understanding that payment is only expected when the merchandise is sold. Unsold items may be returned to the consignor. The lower-of-cost-or-market (LCM) rule states that if the replacement cost is lower than the original cost, the lower figure should be used.

What are the inventory cost under the Periodic Inventory System?

There are four different ways to price inventory.

1. Specific identification method

2. Average-cost method

3. First-in, first-out (FIFO) method

4. Last-in, First-out (LIFO) method

These four methods can be explained using the following data:

1. Specific identification method:

This method prices the inventory by identifying the cost of each item in ending inventory. If the inventory of June 30 consists of 50 units from the June 1 inventory, 100 units from the June 6 purchase, and 70 units from the June 25 purchase, then the cost of goods sold with the specific identification method are as follows:

The method has two disadvantages: it is difficult to keep track of items and when items are identical and it is hard to say at which price they were bought.

2. Average-cost method

Under this method, the inventory is priced at the average cost of the goods available for sale during the period. For this method use the following formula:

Cost of goods available for sale / Units available for sale = Average unit cost

€6350 / 500 units = $12.70

3. First-in, First-out method (FIFO)

This method assumes that the costs of the first items acquired should be assigned to the first items sold. The costs of the goods on hand at he end of a period are assumed to be from the most recent purchase.

An example:

This method gives the highest net income, because cost of goods sold will show the earliest cost incurred, which are usually lower.

4. Last-in, First-out method (LIFO)

This method assumes that the costs of the last items acquired should be assigned to the first items sold. The cost of ending inventory reflects the cost of the oldest purchases. The effect of the LIFO method is to value inventory at the earliest price and to include the cost of the most recently purchased goods in the cost of goods sold.

This method does not reflect the actual physical movement of goods in businesses. The argument that supports LIFO is that when goods are sold in a business, they are replaced with new goods. These new goods have usually higher purchase prices. The LIFO method shows the cost of goods sold at the price level when goods were sold.

What is the impact on Inventory Decisions?

During a period of increasing prices, the LIFO method produces a lower gross margin than the FIFO method. The opposite occurs when there is a period of declining prices; in that case the FIFO method produces a lower gross margin.

Each of the four methods is acceptable for use in published financial statements. However, the company has to choose which method it will use. A basic problem in determining the best inventory measure for a particular company is that inventory affects both the balance sheet and the income statement. LIFO is best suited for the income statement because it matches revenues and cost of goods sold. FIFO is best suited to the balance sheet because the ending inventory is closest to current values.

When there is a period of rising prices, a company that uses LIFO may find that its inventory is valued at a cost far below what it currently pays for the same items. When inventory at the end of the year is less than at the beginning of the year, the company has to pay higher income taxes. This is called LIFO liquidation; the units sold exceed units purchased for the period.

What are the inventory cost under the Perpetual Inventory System?

Under the perpetual system, cost of goods sold is accumulated as sales are made and cost are transferred from the Inventory account to the Cost of Goods Sold account. Assume that the data in the table below represents the movement of inventory in a company:

Under the perpetual system, the average is computed after each purchase:

* new average computed

• Under the FIFO method, instead of calculating an average after each purchase, the price of the first purchase price is used when a sale occurs.

• Under the LIFO method, the last purchase price is used when a sale occurs.

How can the inventory be valued by estimation?

Sometimes it is necessary that the value of ending inventory is estimated. Two methods are commonly used for this purpose:

• Retail method: This method is used in retail merchandising. It uses the ratio of cost to retail price. It is common practice to take the physical inventory at retail. At retail means the amount of the inventory at the marked selling prices of the inventory items. The value of goods available for sale at cost is divided by the value of goods available for sale at retail (this gives the ratio of cost to retail price). The ending inventory at retail is determined by subtracting the net sales during the period from the goods available for sale at retail. This amount is multiplied by the ratio. This gives the estimated cost of ending inventory.

• Gross profit method: This method assumes that the ratio of gross margin remains stable from year to year. The cost of goods available for sale should be established in the usual way. The cost of goods sold should be calculated by deducting the estimated gross margin of 30 percent from sales. Finally, one must deduct the estimated cost of goods sold from the goods available for sale to get the estimated cost of ending inventory.

What do cash and receivables include? - Chapter 7

What are the management issues related to cash and receivables?

The management of cash and receivables is critical to maintaining adequate liquidity. In dealing with cash and receivables, management must address five key issues:

1. Managing cash needs

Management must consider the need for short-term investing and borrowing during seasonal cycles. On the balance sheet cash usually consists of currency and coins on hands, checks and money orders from customers and deposits in checking and savings accounts. It is possible that the cash includes a compensating balance. This is a minimum amount that a bank requires a company to keep in its bank account.

2. Setting credit policies that balance the need for sales with the ability to collect

The accounts receivable and notes receivable accounts are short-term financial assets. These two assets are the result of extending credit to individual customers or other companies. Accounts receivable arise from credit sales and this kind of credit is often called trade credit.

3. Evaluating the level of accounts receivable

There are two common measures that are often used to measure the effect of a companies credit policies. These two are receivable turnover and average days’ sales uncollected. Receivable turnover is the relative size of accounts receivable and the success of its credit and collection policies. It should be calculated in the following way:

Receivable turnover = Net sales / Average net accounts receivable

The average days' sales uncollected is how long it takes to collect accounts receivable. It should be calculated in the following way:

Average days’ sales uncollected = Days in a year (365) / Receivable turnover

4. Financing receivables

Companies can raise funds by selling or transferring accounts receivable to another entity, called a factor. This sale or transfer is called factoring. The sale of accounts receivable can be done with recourse which means that the seller of the receivables is liable to the purchaser if a receivable is not collected. Without recourse means the seller is not liable. A potential liability that can develop into a real liability is called a contingent liability. In this case the event would be the non-payment of the receivable by the customer.

A company can also groups its receivables in batches and sells them at a discount to other companies and investors. This process is called securitization.

A third method is called discounting. This is the selling of promissory notes held as notes receivable. The back deducts the interest from the maturity value of the note to determine the profit. The seller has a contingent liability in the amount of the discounted notes plus interest.

5. Understanding the importance of ethics in estimating credit losses.

Companies extend credit to customers because they expect that this will increase their sales and earnings. However, there is always a chance that the customer cannot or will not pay. The accounts of such customers are called uncollectible accounts. It is important to match these expenses or losses to their corresponding revenues and recognize them at the time credit sales are made.

What are cash equivalents and cash control?

Cash can include cash equivalents. These are investments with a term of 90 days or less. Coins on hand can be controlled through an imprest system. A common form of an imprest system is a petty cash fund. It is set at a fixed amount and all receipts of cash payments must be collected. The fund is periodically reimbursed by the exact amount necessary to restore its original cash balance. Many companies conduct transactions through electronic transportation called electronic funds transfer (EFT). Such a transfer does not involve the actual transfer of cash.

A bank reconciliation is the process of accounting for the difference between the balance on the company’s bank statement and the balance on its Cash account. It involves adjusting for outstanding checks, deposits in transit, service charges (SC), NSF (non sufficient funds) checks, miscellaneous debts and credits and interest income.

What are uncollectible accounts?

Accounts receivable arise from sales on credit. As discussed before, accounts owed by customers who cannot or will not pay their debts are called uncollectible accounts. The federal regulations require companies to use the direct charge-off method to recognize a loss corresponding to uncollectible accounts. Such a method is often used by small companies. This method reduces Accounts Receivable directly and increase Uncollectible Accounts Expense.

Companies that follow GAAP prefer the allowance method. With this method bad debt losses are matched against the sales they help to produce. Because at the time sales are made, it can not be identified which customers will not pay their debits, losses must be estimated. A new account called ‘Allowance for Uncollectible Accounts’ will appear on the balance sheet as a contra account from accounts receivable. Below one can find an example:

From the 100,000 dollar in accounts receivable, 6,000 dollar is estimated to be uncollectible at the end of the year. This must be recorded in the following way:

There are two common methods for estimating the uncollectible accounts expense:

1. The Percentage of Net Sales Method: The management establishes a percentage of the year's net sales that they think will not be collected. This can for example be an average of the past few years. The established percentage determines the amount of uncollectible accounts expense for the year. This amount will be recorded as follows:

The allowance for uncollectible accounts will be added to the amount from previous years.

2. The Accounts receivable aging method: This method asks how much of the ending balance accounts receivable will not be collected.

The year-end balance of Allowance for Uncollectible Accounts is determined directly by an analysis of accounts receivable. The difference between the amount determined to be uncollectible and the actual balance of Allowance for Uncollectible Accounts is the expense for the year. The aging of accounts receivable is the process of listing each customer’s receivable account according to the due date of the account.

Each due date has its own percentage that will not be collected.

• When the Allowance for Uncollectible Accounts has a credit balance, the difference between the amount calculated and the credit balance should be added to the account.

• When the Allowance for Uncollectible Accounts has a debit balance, the calculated amount and the debit amount should be added together before adding the total to the account.

When it becomes clear that a specific account receivable will not be collected, the amount should be written off to Allowance for Uncollectible Accounts. Consider the following situation: a company goes bankrupt, and its still owes you 300 dollar. This will be recorded in the following way:

Suppose that all of a sudden the company does find a way to pay you, the following journal entries must be made:

What is the notes receivable account?

A promissory note is an unconditional promise to pay a definite sum of money on demand or at a future date. The entity who signs the note and promises to pay is called the maker of the note. The entity to whom the payment is to be made is called the payee. The payee includes all promissory notes it holds and which are due in less than once year in the Notes receivable account. A maker includes them in the Notes payable account.

They maturity date is the date on which a promissory note must be paid. The duration of note is the length of time in days between the issue date and maturity date of a promissory note. Interest is the cost of borrowing money or the return for lending money, depending on whether one is the borrower or lender. The maturity value is the total proceeds of a promissory note – face value plus interest - at the maturity date. When the maker of a note does not pay the note at maturity, it is said to be an dishonored note.

What are the time value of money and current liabilities? - Chapter 8

What are current liabilities?

Current liabilities are debts and obligations that the company expects to satisfy within one year or within its normal operating cycle, whichever is longer. If a company fails to manage its cash flows related to current liabilities this can have serious consequences for a business. Shipments from suppliers may be withhold and it can even lead to bankruptcy. Managing liquidity is also important for a company. Common ways to measure liquidity are the payables turnover and the days’ payable. The first one measures the number of times, on average, accounts payable are paid in an accounting period. It also shows the relative size of a company’s accounts payable. It is computed in the following way:

Payables turnover = (Cost of goods sold ± Change in Merchandise inventory) / Average accounts payable

The days’ payable shows how long, on average, a company takes to pay its accounts receivable. It is computed in the following way:

Days’ Payable = 365 days / Payables Turnover

When one has to decide whether to buy stock from a company one must evaluate the current liabilities and future obligations of a company. When doing so, one has to rely on the integrity of the financial statements of the company. Ethical reporting of liabilities requires the following

• Recognition

Timing is very important when it comes to the recognition of liabilities. Failure to record a liability in an accounting period often goes along with failure to record an expense. The liability should be recorded when an obligation occurs. One of the main reasons for making adjusting entries at the end of an accounting period is to recognize unrecorded (accrued) liabilities, such as salaries payable and interest payable. Liabilities that can only be estimated must also be recognized. An example is taxes payable.

• Valuation

On the balance sheet the liability is generally valued at the amount needed to pay the debt or at the fair market value of goods or services to be delivered.

• Classification

Current liabilities are normally paid out of current assets or with cash generated from operations. Long-term liabilities are due beyond one year or beyond the normal operating cycle. They are used to finance the long-term assets. It is important to distinguish between current and long-term liabilities because it affects the evaluation of a company's liquidity.

• Disclosure

To explain some accounts, a company may need to include some supplemental disclosure to the financial statements. The disclosure can include balances, maturities and interest rates. This helps in assessing whether a company has additional borrowing power.

What are common types of current liabilities?

Current liabilities fall into two major groups:

1. Definitely determinable liabilities. These are liabilities that are set by contract or by statute and can be measured exactly. The related accounting problems are to determine the existence and amount of each such liability and to make sure that it is recorded in the right way.

2. Estimated liabilities. These are definite debts or obligations whose exact dollar amount cannot be known until a later date. The primary accounting problem is to estimate and record the amount of the liability.

The two major groups of liabilities will now be further discussed as well as which liabilities fall into which group.

1. Definitely determinable liabilities. The most common definitely determinable liabilities are described below.

• Accounts payable: short-term obligations to suppliers for goods and services. The accounts payable account is usually supported by an accounts payable subsidiary ledger.

• Bank loans and Commercial Paper. Management often establishes a line of credit with a bank, which means that the company can borrow funds when they are needed to finance current operations. A promissory note for the full amount of the line of credit is signed, but the company has great flexibility in using the available funds. A company with excellent credit ratings can borrow short-term funds by issuing commercial paper, which refers to unsecured loans that are sold to the public, usually through professionally managed investment firms. The amount of line of credit and commercial paper are usually combined with notes payable on the balance sheet.

• Notes payable are obligations represented by promissory notes. The interest is usually stated on the face of the note. They should be recorded in the following way:

When the note is paid it should be recorded as follows: (Interest stated separately)

• Accrued liabilities: Liabilities that are not in the accounting records should be recognized and therefore an adjusting entry is made at the end of an accounting period. An example is interest payable. We assume that the accounting period ends 30 days after the issuance of the 60-day note, then the adjusting entries would be as follows:

• Dividends Payable. A liability does not exist until the board declares the dividends. The time between the declaration and the payment of the dividends is usually short. During this interval the dividends declared are considered current liabilities of the company.

• Sales and excise taxes payable. Many states and cities levy a sales tax on retail transactions. The amount of sales tax collected by the company represents a current liability until it is remitted to the government.

• Current portion of long-term debt: If a portion of a long-term debt is due within the next tear and is to be paid from current assets, that current portion is properly classified as a current liability. Companies often have portions of long-term debt due in the next year. When this is the case no entry is necessary and the debt is simply reclassified into two categories; short-term and long-term debt.

• Payroll liabilities. An employer is liable to employees for wages and salaries. Wages refer to the payment for the services of employees at an hourly rate. Salaries refer to the compensation of employees who are paid at a monthly or yearly rate. An employee is a person who is paid a wage or salary and falls under the payroll accounting. An independent contractor is a person who is not an employee and thus not accounted for under the payroll system. All the taxes that are withhold should be accounted for as liabilities. Some common withholdings and taxes are federal income taxes, state and local income taxes, medicare tax, medical insurance, pension contributions, federal unemployment insurance tax, social security tax and state unemployment insurance tax.

• Unearned revenues represent obligations for goods or services that the company must provide in a future accounting period in return for an advance payment from a customer. The revenue is recognized over the period in which the company provides the product or service.

2. Estimated liabilities are liabilities whose exact dollar amount is not known until a later date. The primary problem with these liabilities is to estimate and record the amount of the liability. Some examples of estimated liabilities are shown below:

• Income taxes payable depend on the results of an operation. Because income taxes are an expense in the year in which income is earned, an adjusting entry is necessary:

• Property tax payable. Property taxes are levied on real property, like land and buildings, and on personal property, like inventory and equipment. Because the fiscal years of local governments rarely correspond to a firm’s fiscal year, it is necessary to estimate the amount of property taxes that applies to each month.

• Promotional Costs. Because of marketing programs companies have promotional costs. Companies usually record these costs as a reduction in sales rather than as an expense with a corresponding liability.

• Product warranty liability. The cost of a warranty is properly debited to an expense account in the period of sale because it is a feature of the product sold and thus is included in the price the customer pays for the product. A company can calculate the average cost it has per product. When they multiply this with the number of units sold and the rate of replacement under warranty, they have the amount that has to be set aside as Estimated Product Warranty Liability.

• Vacation Pay Liability: Employees accrue paid vacation as they work during they year. The computation of the vacation pay expense should be:
  The payroll x The vacation pay percentage x The percentage of employees that will collect vacation pay.

What are contingent liabilities and commitments?

A contingent liability is not an existing obligation. It is a potential obligation because it depends on a future event arising out of past transactions whether it will become a liability. Contingent liabilities often involve lawsuits, guarantees of debt, income tax disputes, discounted notes payable and failure to follow government regulations. The FASB has two conditions for determining when a contingency should be entered in the accounting records:

1. The liability must be probable

2. The liability can be reasonably estimated

The most common types of contingencies are litigation and environmental concerns.

A commitment is a legal obligation that does not meet the technical requirements for recognition as a liability and is therefore not recorded. Examples of commitments are purchase agreements and leases.

What is meant by the time value of money?

The fair value is the price for which an asset or liability could be sold or leave the company, as opposed to the price for which the company could buy the asset or liability. There are three approaches identified by the FASB for measuring the fair value:

1. Market approach: External market transactions that involve identical or comparable assets or liabilities are ideal, if available, for determining the fair value.

2. Income (or cash flow) approach: This approach converts future cash flows to a single present value. This approach is used when the market approach cannot be used.

3. Cost approach: This approach is based on the amount that would be required to replace an asset with the same or comparable asset.

The time value of money is defined as the costs or benefits of holding money or not holding money over time. Interest is the cost of using money for a specific period.

• Simple interest is the interest cost for one or more periods if we assume that the amount on which the interest is computed, the principal sum, stays the same from period to period.

• Compound interest is the interest cost for two or more periods if we assume that after each period, the interest of that period is added to the amount on which interest is computed in future periods.

The Future value is the amount an investment will be worth at a future date. It is the amount of principle plus interest after one or more periods. This value can be computed using either simple or compound interest. You can calculate the future value of a single investment but you can also calculate the future value of an ordinary annuity, which is a series of equal payments made at the end of equal intervals of time, with compound interest on these payments. An example: The first year you put $100 in a savings account for 4% interest. After 1 year, you get $4. Then, you add another $100, making the total $204. At the end of that year, you get $8.16 interest, and you add another $100.

The present value is the amount that must be invested now at a given rate of interest to produce a given future value. Again, this can be calculated for a single sum and for an ordinary annuity.

What are the long term assets? - Chapter 9

What are long term assets?

Long term assets are assets that:

• Have a useful life of more than one year

• Are acquired for use in the operation of a business (assets not used in the normal course of business, such as land held for speculative reasons, should not be included)

• Are not intended for resale to customers (An asset that a company intends to resell to a customer should be classified as inventory)

Long-term assets include:

• Tangible assets. These have physical substance and include buildings, equipment and land. Most tangible assets are accounted for through depreciation.

• Natural resources. These assets are extracted from land and purchased for their economic value. Some examples are oil and coal. Natural resources are accounted for through depletion, which is the proportional allocation of the cost of a natural resource to the units extracted.

• Intangible assets. Assets that have no physical substance such as trademarks. Most intangible assets are accounted for through amortization, which is the periodic allocation of the cost of the asset to the periods it benefits.

Long-term assets are generally reported at carrying value, which is the unexpired part of the cost of an asset, also called book value. It is not the market value of an item. Asset impairment occurs when the carrying value of a long-term asset exceeds the fair value; the sum of the expected cash flows from the asset. A reduction in carrying value as a result of impairment is recorded as a loss. In the table below is displayed how you can determine the carrying value of long-term assets on the balance sheet:

The decision to acquire a long-term asset includes a complex process. First the purchasing costs of the asset have to be determined. Then, the savings which the asset generates in its life time have to be written in present value. Third, the disposal price (if any) has to be written in present value. When adding all of these steps together you get the net present value as outcome. If the the outcome, the net present value, is positive then the asset will be profitable.
Example: A Dollar 50,000 software package, making the company save Dollar 20,000 for four years, with a disposal price of Dollar 10,000 and a 10% interest rate. The net present value can be calculated as follows:

There are a few issues when accounting for long-term assets. The first one is how much of the total cost has to be allocated to expense in the current accounting period. The second is how much to retain on the balance sheet as an asset to benefit future periods.

To resolve these issues the management has four questions that have to be answered before the acquisition, use and disposal of each long-term asset. These four questions are:

• How is the cost of the long-term asset determined?

• How should the expired portion of the cost of the long-term asset be allocated against revenues over time?

• How should subsequent expenditures, such as repairs, be treated?

• How should disposal of the asset be recorded?

The answers to these questions can be found in the annual report of the company. The accounting problem is to spread the cost of the services of the asset over its useful life.

What is the acquisition cost of property, plant and equipment?

Expenditure refers to a payment or an obligation to make a future payment for an asset or a service. Expenditures can be classified as capital expenditures or revenue expenditures.

• A capital expenditure is an expenditure for the purchase or expansion of a long-term asset. They are recorded in the asset accounts.

• Revenue expenditure is related to the repair and maintenance of a long-term asset. They are recorded in an expense account because their benefits are realized in the current period.

Capital expenditures include outlays for plant assets, natural resources, and tangible assets. They also include expenditures for additions, betterments and extraordinary repairs. These expenditures are explained below:

• An addition is an enlargement to the physical layout of a plant asset.

• A betterment is an improvement that does not add to the physical layout of a plant asset. Betterments lead to benefits over a period of years and therefore their costs should be debited to an asset account.

• Ordinary repairs are necessary to maintain an asset in good operating condition. These repairs are a current expense. Extraordinary repairs are repairs that affect the estimated useful life or residual value. They are recorded by reducing the Accumulated Depreciation account, assuming that some of the depreciation previously recorded has now been eliminated.

Cost of the asset = Cash paid for the asset + Additional expenditures (such as freight, installation)
If a debt is incurred in the purchase of the asset, the interest charges are not a cost of the asset, but a cost of borrowing money to buy the asset. This makes it an operating expense. There are some problems determining the cost of long-term assets. Many companies establish policies explaining when an expenditure is an expense or an asset.

• Land: The purchase price of land should be debited to the Land account. Other expenditures that should be debited to the Land account are commissions to real estate agents, accrued taxes paid by the purchaser and assessments for local improvements. Land is not subject to depreciation.

• Land Improvements: Some improvements to real estate that are subject to depreciation should be recorded in an account called Land Improvement. Examples are improvements to driveways, fences and parking lots.

• Buildings: When a company buys a building, the new contract price plus other expenditures necessary to put the building in usable condition are included in the cost. Buildings have a limited useful life and are therefore subjected to depreciation.

• Leasehold improvements: improvements to leased property that become the property of the lessor, the owner of the property, at the end of the lease. These improvements are usually classified as tangible assets in the property, plant and equipment section of the balance sheet.

• Equipment: The cost of equipment includes all expenditures that have to do with purchasing the equipment and preparing it for use.

• Group purchases: When land and other assets are purchased for a lump sum, they must have a separate ledger account because land is a depreciable asset. The lump-sum purchase price must be apportioned between land and other assets.

What is depreciation?

All tangible assets except land have a limited useful life and are therefore subjected to depreciation. The two major factors in limiting the useful life of an asset are physical deterioration and obsolescence. The physical deterioration of tangible assets results from use and from exposure to the elements. Obsolescence is the process of becoming out of date. Depreciation does not refer to an asset’s physical deterioration or decrease in market value over time. It is not a process of valuation.

Four factors affect the computation of depreciation:

• Cost. This is the net purchase price of an asset plus all necessary expenditures to get in in place for use

• Residual value: This is the portion of an asset's acquisition cost that a company expects to recover when it disposes of the asset. It is also referred to as the trade-in value as of the estimated date of disposal

• Depreciation cost: The cost of an asset less its residual value

• Estimated useful life: The total number of service units expected from the long-term asset.

There are several methods for computing depreciation. The most common methods are explained below:

• Straight-line method. In this method depreciation cost is spread evenly over the estimated useful life of the asset. The depreciation expense is calculated using the following formula:

Depreciation expense = (Cost – Residual value) / Estimated useful life

The depreciation is the same each year, the accumulated depreciation increases uniformly and the carrying value decreases uniformly until it reaches the estimated residual value.

• Production method: This method is also called the units of production method and assumes that depreciation is the result of use and that time plays no role in the depreciation process. The depreciation expense is calculated using the following formula:

Depreciation expense = (Cost – Residual value ) / Estimated units of useful life

This method should only be used when the output of an asset over its useful life can be estimated with reasonable accuracy and when the unit used to measure the estimated useful life of an asset is appropriate for the asset.

• Declining-balance method: An accelerated method of depreciation results in relatively large amounts of depreciation in the early years of an asset’s life and smaller amounts in later years. It assumes that assets are most efficient when new. It also recognizes that because of fast-changing technology, equipment can become obsolescent. With the declining-balance method depreciation is computed by applying a fixed rate to the carrying value of an asset. The most common rate is a percentage that is equal to twice the straight-line depreciation percentage. This is called the double-declining-balance method.

Group depreciation is a method that companies can use when some pieces (for example a machine) last longer than others pieces of the same kind. Companies can then groups similar items and take the average to calculate depreciation.

Revision of depreciation rates: Assume an asset is worth Dollar 7000 with a residual value of Dollar 1000 and an estimated useful life of six years. After two years of straight line depreciation, the accumulated depreciation is Dollar 2000 and the remaining depreciable cost is Dollar 4000. Assume that after these two years, the company finds out that the truck only has a useful life left of two years, instead of the assumed remaining four. The next two years, the depreciation should be Dollar 4000 over 2 years = Dollar 2000 each year.

What is the disposal of depreciable assets?

Plant assets rarely last exactly as long as their estimated useful life. Discarded plant assets: When machinery is discarded, the proper amount of depreciation should be computed until the month in which the item is discarded. This amount should be accounted for under ‘Accumulated Depreciation, Machinery’. The carrying value is equal to the machinery cost less accumulated depreciation. This should be recorded as ‘Loss on Disposal of Machinery’. Assume machinery has accumulated depreciation of Dollar 4650, and the amount in the Machinery account is Dollar 6500. This must be recorder in the following way:

The entry to record a plant assets sold for cash is similar as the one above. Assume the cash received is Dollar 1850:

Assume now that the cash received is Dollar 1000. The entry changes into:

One can see that in this case a loss occurs. The opposite occurs when more than the carrying value is received in cash.

Exchanges of plant assets: For both financial accounting and income tax purposes both gains and losses are recognized when a company exchanges dissimilar assets. When items are similar, only losses are recognized for financial accounting purposes.

What does accounting for natural resources include?

Natural resources are recorded at acquisition cost. These cost may include some costs of development. When the resource is converted into inventory, the asset account must be reduced when inventory increases. This way, the original cost is gradually reduced and depletion is recognized in the amount of the decrease. The depletion cost per unit is determined by:

Depletion cost per unit = (Cost – Residual value) / Estimated number of units

When machinery with a useful life of twelve years is build on a coal mine that is expected to be depleted in ten years, the machinery should be depreciated over the ten-year period, using the production method.

Under successful efforts accounting only the cost of a successful exploration are recorded as cost of the resources. Failures such as dry wells are written off as being a loss. With the full-costing method all costs, including failures, are recorded as assets and depleted over the estimated life of the resources.

What does accounting for intangible items include?

The purchase of an intangible asset should be treated as a special kind of capital expenditure and must be recorded at acquisition cost. It should be amortized over the useful life of the asset. The useful life of an asset may be definite or indefinite.

• Definite useful life means the useful life is subject to a legal limit or can be reasonably estimated.

• Indefinite useful life means the useful life is not limited by legal, regulations or other factors.

Some special expenditures are:

• All costs that have to do with Research and Development should be treated as revenue expenditures and charged to expense in the period in which they are incurred.

• Costs that have to do with developing computer software for sale are research and development costs until the product has proved technologically feasible.

• Goodwill is the amount that people are willing to pay for a company more than the value of the net assets if purchased individually. It should be reported separately on the balance sheet.

What are long term liabilities? - Chapter 10

What are the issues related to issuing long-term-debt?

There are two sources of long-term funds, which are the issuance of capital stock and the issuance of long-term debt in the form of bonds, notes, etc. There are a few issues related to issuing long-term-debt:

Whether to take on a long-term debt?

The disadvantages of long-term debts are that it represent financial commitments that have to be paid periodically. This leads to the fact that a high level of debt is a financial risk to a company. Common stock has advantages over long-term debt because common stock does not have to be paid back, and dividends are only declared when the company earns sufficient income. However, there are also some advantages related to issuing long-term debt. The advantages of long-term debt are that common stockholders do not have any control of the company, the interest on debt is tax-deductible and when a company earns more on its assets than it pays in interest on debt, the excess will increase its earnings for stockholders. This concept is called financial leverage.

How much long-term debt to carry?

It is important that companies assess how much financial risk is involved in the long-term debt. The level of debt, the financial risk, can be evaluated using the debt to equity ratio and the interest coverage ratio. The debt to equity ratio shows the amount of debt a company carries in relation to its stockholders' equity. The interest coverage ratio measures the degree of protection a company has from default on interest payments. The debt to equity ratio and the interest coverage ratio can be measured using the following formulas:

Debt to equity = Total liabilities / Total stockholders' equity

Interest coverage ratio = (Income before taxes + Interest expense) / Interest expense

If the interest coverage ratio has an outcome of 9.9 this shows that the interest expense of a company was covered 9.9 times in its financial year.

What types of long-term debt to take on?

Common types of long-term debt are bonds payable, notes payable , mortgages payable, long-term leases, pension liabilities, other post retirement benefits, and deferred income taxes. These common types will now be further explained.

Mortgage: A mortgage is a long-term debt secured by real property. A mortgage is usually paid in equally monthly payments. Each monthly payment includes the interest on the debt and a reduction in the debt.

Long-term leases: A company can obtain equipment or a plant in three ways:

• By borrowing money and buying the asset

• By renting the asset on a short-term lease. Such an agreement is called an operating lease. An operating lease is a lease that is short term in relation to the useful life of the asset, and the risk of ownership remains with the lessor.

• By obtaining the asset on a long-term lease. A long-term lease can be treated as a capital lease when it meets the following conditions: The duration of the long-term lease is about the same as its useful life, the lease cannot be canceled and the lessee has the option to buy the asset at a nominal price at the end of the lease. The risks of ownership are transferred to the lessee. Each lease payment consists of interest expense and repayment of debt.

Another common long-term debt is a pension liability. Most employees that work at medium-sized or large companies are covered by a pension plan. A pension plan is a contract between a company and its employees in which the company agrees to pay benefits to the employees after they retire. The employer pays costs but in most companies employees also contribute part of their salaries to the pension plan. The contributions from employer and employees are usually paid into a pension fund.

There are also many companies that do not only provide their retired employees with pensions but also with health care and other benefits. These are called other postretirement benefits.

What is meant by the nature of bonds?

A bond is a security, usually long term, representing money that a corporation or other entity borrows from the investing public. The interest on bonds is usually paid semi-annually. Stocks are shares of ownership, which makes stockholders owners.

Bondholders are creditors. The bond indenture defines the rights, privileges, and limitations of the bondholders. The bond indenture generally describes the maturity date, interest rate and interest payment dates of a bond. A bond issue is the total value of bonds issued at one time. There are two interest rates relevant for bonds.

• The face interest rate is the fixed rate of interest paid to bondholders based on the face value. The rate is fixed over the life of the bond.

• The market interest rate is the rate of interest paid in the market on bonds of a similar risk. Market interest rates fluctuate daily. If the market rate fluctuates from the face interest rate before the bond issue rate, the bonds will sell at either a discount (market > face) or a premium (market < face).

A secured bond gives the owner a pledge of certain assets as a guarantee of repayment. When a bond is issued only on the general credit of a company, it is an unsecured bond. These unsecured bonds are also called debenture bonds.

When all bonds of an issue mature at the same time, they are called term bonds. When the maturity dates are different, they are called serial bonds. If a company retires a bond issue before its maturity date we speak of early extinguishment of debt. Callable bonds give the issuer the right to buy back and retire the bonds before maturity at a specified call price, which is usually above face value. Convertible bonds allow the bondholder to exchange a bond for a specified number of shares of common stock. With registered bonds , the names and addresses of the owners of the bond must be recorded with the company. Coupon bonds are not registered with the organization. These bonds gave coupons stating the amount of interest due and the payment date.

What does accounting for the issuance of bonds include?

Bonds payable are usually shown on the balance sheet as long-term assets. Only when the maturity date is less than one year and the bonds will be retired using current assets, they should be listed as a current liability. When bonds are issued and interest is paid, the following entry should be made:

As mentioned before, when the market interest rate is higher than the face interest rate, the bonds will be issued at a discount. Buyers will have to pay less than the face value. When the opposite occurs, the market interest rate is lower, the bonds are issued at a premium.

Assume that a company issues USD 100.000 of 9%, five-year bonds at USD 96.149 when the market interest rate is 10 percent. This will be recorded as follows:

The unamortized bond discount is a contra-liability account and is deducted from the face amount of the bond. The discount will be written off over the life of the bond. Bond issue cost, which are fees received by underwriters who sell the bonds, increase the discount or decrease the premiums of bond issues.

How can the present value to bond be used?

The value of a bond is determined by the series of fixed interest payments and the payment of the bond issue, and the single payment of the face value at maturity. One has to calculate the present value of these two separately and then add them to find the present value of the bond.

What is meant by bond discounts and premiums?

A bond discount or premium represents the amount by which the total interest cost is higher or lower than the total interest payment. The discount or premium has to be amortized over the life of the bonds in order to make sure that the carrying value is equal to the face value at maturity. The full expense of issuing bonds at a discount is calculated as follows:

The market interest is the real interest cost of the bond over its life. In this case it is USD 48.851. The face interest is USD €45.000. In order to make each year’s interest expense equal to the market interest rate, the discount must be allocated over the remaining life of the bonds as an increase in the interest expense period.

Zero coupon bonds are bonds that do not require periodic interest payments. These bonds are simply a promise to pay a fixed amount at the maturity date.

The straight-line method sets the amortization of the bond discount equal for each interest period. The interest expense for each semiannual period is calculated in four steps:

1. Total interest payments = Interest payments per year x Life of bonds

The previous example gives the following outcome: 2 times a year x 5 years = 10

2. Amortization of Bond discount per interest period = Bond discount / Total interest payments = USD 3.851 / 10 = USD 385

3. Cash interest payment = Face value x Face interest Rate x Time

= USD 100.000 x 0.9 x 6/12= USD 4.500

4. Interest expense per interest period = Interest payment + Amortization of bond discount
   = USD 4.500 + USD 385 = USD 4.885

This would give the following entry on the interest date:

Instead of the straight-line method one can also use the effective interest method. With the effective interest method a constant interest rate is applied to the carrying value of the bonds at the beginning of the interest period. This rate equals the market rate at the time the bonds were issued. The amount that has to be amortized each period is the difference between the interest computed by using the market rate and the actual interest paid to bondholders.

The amortization of a bond premium is the same as the bond discount. The only difference in the straight line method is that step four should be as follows:

4. Interest expense per interest period = Interest payment - Amortization of bond discount

What is meant by the retirement and conversion of bonds?

A company can reduce its bond debt by retiring bonds or converting bonds into common stock. Callable bonds give the issuer the right to buy back and retire the bonds at a specified call price, usually above the face value. When retiring a bond, the cash price that has to be paid is the face value multiplied by the call price. The difference between the face price plus the unamortized bond premium (as calculated with the effective interest method) is the loss or gain on retirement of bonds.

Convertible bonds are bonds that can be exchanged for common stock or other securities of the corporation. They enable an investor to make more money when the market price of the common stock rises. When the stock price does not change, the investor still holds the bond and receives both the periodic interest payments and the principal on the maturity date.

When bonds are sold between interest dates it is common to collect from investors the interest that would have accrued for the partial period preceding the issue date. When the first interest period is completed, the new corporation pays bond-holders the interest for the entire period.

An adjustment has to be made at the end of the accounting period to accrue the interest expense on the bonds from the last payment date to the end of the fiscal year.

What is contributed capital? - Chapter 11

What are management issues related to contributed capital?

A corporation is a business entity chartered by the state and legally separate and distinct from its owners, the stockholders. Some advantages of a corporation are:

• It is a separate legal entity.

• There is limited liability for the owners of the corporation.

• There is ease of capital generation. It is easy to raise capital because the shares of ownership in the business are available to a great number of investors.

• There is ease of transfer of ownership. A share of stock is easy transferable.

• There is lack of mutual agency. If a stockholder wants to enter into a contract for a corporation, the corporation is not bound by the contract.

• Continuous existence, which means that the life of the corporation is set by its charter and regulated by state laws.

• Centralized authority and responsibility: the board of directors represents the stockholders and they delegate the responsibility and authority for every-day operations to a single person, usually the president.

• Professional management. In most large corporations ownership and management are separate.

Some disadvantages of a corporation are:

• Government regulation. The corporation must meet the requirements of state laws. Corporations are subject to greater regulation and state control than other forms of business.

• Taxation. The earnings of the corporation are subject to double taxation, namely the federal and state income taxes.

• Limited liability. It restricts the ability of small companies to borrow money from creditors.

• Separation of ownership and control. Management sometimes makes a decision that is not good for the corporation as a whole. If the management makes a decision and the stockholders disagree with this decision, it is hard for them to exercise control.

A share of stock is a unit of ownership in a corporation. When someone buys a share of stock a stock certificate is issued to the owner. The authorized stock is the maximum number of shares the corporation is allowed to issue and the par value is an arbitrary amount assigned to each share of stock. This value must be recorded in the capital stock accounts. Legal capital is the number of shares issued times the par value.

An underwriter is an intermediary between the corporation and the investing public. He or she can help the company with the initial issue of capital stock. This is called initial public offering (IPO).

When a corporation is formed, incorporation fees and attorneys’ fees have to be paid. These costs are called start-up and organization cost. These costs can be distributed over the entire life of a corporation. However, the corporation's life is normally not known so the costs are recorded as they are incurred.

A dividend is a distribution among stockholders of the assets that a corporation’s earnings have generated. The stockholders receive the assets in proportion to the number of shares they own. Only the board of directors can declare a dividend. A liquidating dividend is a dividend that exceeds retained earnings. The corporation is returning to the stockholders part of their contributed capital. There are three dates that are associated with dividends:

• Date of declaration: The date on which the board of directors formally declares the corporation is going to pay a dividend.

• Date of record: The date on which ownership of the stock is determined. Between that date and the date of payment, the stock is said to be ex-dividend. If the owner on the record date sells before the payment date, the right to the cash dividend remains with that person.

• Date of payment: Date on which the dividend is paid to the stockholders of record.

The liability for payment of dividends arises on the date the board of directors declares a dividend. The declaration is recorded with a debit to Dividends and a credit to Dividends Payable. The record date – the date on which ownership of stock is determined – requires no entry. On the date of payment, the Dividends Payable Account is eliminated and the Cash Account is reduced.

There are several ratios that can be used to evaluate the performance of a company. The most common ones are explained below.

The ratio dividends yield evaluates the amount of dividends received. It is computed as follows:

Dividends yield = Dividends per share / Market price per share

Return on equity is the most important ratio associated with stockholders´ equity. It measures the performance of the management. The stockholders’ equity depends on management decisions about the amount of stock the company sells to the public. It is computed as follows:

Return on equity = Net income / Average total stockholders' equity

The confidence of investors in a company’s future can be calculated with the price/earnings (P/E) ratio. It is computed as follows:

Price/Earnings ratio = Market price per share / Earnings per share

When a company wants to encourage employees to buy stock, it can use a stock option plan. This plan is an agreement to issue stock to employees according to specified terms such as the right to buy stock in the future at a fixed price. On the date the stock options are granted, the fair value of the options must be estimated and the amount in excess must be either recorded as compensation expense or reported in the notes of the financial statements.

What are the components of stockholders’ equity?

All claims of the owners of the company are called stockholders’ equity. The stockholders’ equity consists of:

• Contributed capital: the stockholders’ investments in the corporation.

• Retained earnings: the earnings of the corporation since its inception, less any losses, dividends, or transfers to contributed capital.

Treasury stock consist of the shares of the corporation's own stock that it has bought back on the open market. A corporation can issue two basic types of stock:

• Common stock: the basic form of stock that a corporation issues. This is the company’s residual equity. This means that in case of liquidation, all claims to the company from preferred stockholders and creditors rank ahead of common stockholders. It is usually the only stock that carries voting rights.

• Preferred stock: gives its owners preferences over common stockholders. Preferences related to things such as receiving dividends and claims to assets if the corporation is liquidated.

The issued stock includes the shares sold or transferred to stockholders. Outstanding stock includes stock that has been issued and is still in circulation. Treasury stock is not outstanding because it is out of circulation.

What is meant by preferred stock?

Most preferred stock has one or more of the following characteristics:

• Preference as to dividends
  The holders of preferred shares must receive a certain amount of dividends before the holders of common shares receive anything. The amount is usually stated in dollars per share or as a percentage of the par value.
  With a noncumulative preferred stock, the company is not obligated to make up for a dividend in future years, when if fails to declare one in a year.
  With a cumulative preferred stock, the fixed dividend amount per share accumulates from year to year, and the whole amount must be paid before any dividends on common stock can be paid. Dividends that are not paid in the year they are due are called dividends in arrears. These dividends in arrears are not recognized as liabilities but the amount should be reported in the body of the financial statements.

• Preference as to assets if a corporation is liquidated
  When the corporation’s existence is terminated, the preferred stockholders have a right to receive the par value or a larger stated liquidation value per share before the common stockholders receive any share of the assets.

• Convertible preferred stock
  Owners of convertible preferred stock can exchange their shares for shares of the company’s common stock at a ratio stated in the contract. They are more likely to receive dividends than owners of convertible common stock.

• Callable preferred stock
  This type of stock can be redeemed or retired by the issuing corporation at a price stated in the preferred stock contract. When the preferred stock is convertible, the stockholder can also convert the stock into common stock. Most preferred stock is callable preferred stock.

What does accounting for stock issuance include?

No-par stock is capital stock that does not have a par value. A corporation that is issuing no-par stock may be required by state law to place a stated value on each share of stock. When a company issues no-par stock without a stated value, all proceeds are recorded in the Capital Stock account.

When no-par stock with a stated value is issued, the shares are recorded in the Capital Stock account at stated value. When the stock is issued at a price greater than par value, the excess of par is credited to the Additional paid-in capital account.

An example of par Value stock: Assume a company issues 10.000 shares at USD 10 per share, and sells them for USD 12 per share. This would give the following entry:

What is No-Par stock?

Assume that this company issues no-par stock, 10.000 shares at USD 15 per share, without stated value:

Assume the company puts a USD 10 stated value on its no-par stock. This would give the following entry:

Stock can be issued for assets or services other than cash. It is generally preferred to record the transaction at the fair market value of what the corporation is giving up, in this case the stock. When the fair market value of the stock can not be determined, the fair market value of the asset of service is used. When the fair market value of the asset is higher than the par-value of the stock, the excess is recorded as Additional Paid-in Capital.

What does accounting for treasury stock include?

Treasury stock is capital stock that the issuing company has reacquired. The purchase of treasury stock is recorded as a cost.

Assume that a company purchases 1.000 shares at a price of USD 50 per share. Then USD 50.000 is deducted from the Total contributed capital and retained earnings. This decreases the total stockholders’ equity.

The number of outstanding shares decreases when a company purchases its stock back, but the number of shares issued (and with this the legal capital) does not.

The total stockholders’ equity is calculated in the following way.

Treasury stock can be sold at cost, above cost or below cost. The sale of treasury stock at cost and above cost must be recorded as follows:

When treasury shares are sold below their cost, the difference is deducted from Paid-in Capital, Treasury Stock. When the balance of this account is not enough to cover the cost, Retained Earnings absorbs the excess.

What is the statement of stockholder equity?

The statement of stockholder equity summarizes the changes in the components of the stockholders’ equity section in the balance sheet. The retained earnings equal the profit, less any losses, dividends to stockholders, or transfers to contributed capital. A company is said to have a deficit when retained earnings has a debit balance. This can occur when dividends and losses are greater than profit from operations. A restriction on retained earnings means that dividends can be declared only to the extent of the unrestricted retained earnings. It does not change the total retained earnings but divides it into two parts: restricted and unrestricted retained earnings.

What are stock dividends and stock splits?

A stock dividend is a proportional distribution of shares among a corporation’s stockholders. It involves no distribution of assets and has no effect on the assets and liabilities of a corporation. The stock dividend transfers an amount from retained earnings to contributed capital. The amount is the fair market value of the additional shares to be issued. The stockholders' equity can be calculated as follows:

Suppose the board of directors declares a 10% stock dividend on February 24, distributedable on March 31 to stockholders of record on March 15, market price of the stock is USD 20 per share. The corresponding journal entry is as follows:

The retained Earnings are reduced by the amount of the stock dividend when the Stock Dividends Declared account is closed to Retained Earnings at the end of the accounting period. Assume a stockholder owns 1.000 shares before the stock dividend. After the 10 percent stock dividend is distributed, this stockholder would own 1.100 shares. This can be seen in the following table:

A stock split occurs when a corporation increases the number of issued shares of stock and reduces the par or stated value proportionally. The split does not increase the number of shares authorized. It does change the number of shares issued. This makes an entry unnecessary. It is appropriate to make a memorandum entry in the general journal.

What is meant by book value?

The statement of stockholders' equity summarizes the changes in the stockholders' equity section of the balance sheet. It reveals information about the stockholders' equity transactions during the accounting period and is used by many companies.

The book value of stock represents the total assets of the company less its liabilities. The book value per share represents the equity of the owner of one share of stock in the net assets of the corporation. When only common stock is outstanding, it is calculated with the formula:

Book value per share = Stockholders' equity / Common shares outstanding

When there is both preferred stock and common stock it is common that the call value (or par value) of the preferred stock plus any dividends in arrears is subtracted from the total stockholders’ equity to determine the equity pertaining to common stock.

Below is an example:

What is the statement of cash flows? - Chapter 12

The statement of cash flows shows how a company’s operating, investing, and financing activities have affected cash during an accounting period. The statement explains the net increase or decrease in cash during the period. On the statement of cash flows, cash includes both cash and cash equivalents, which are short-term, highly liquid investments that can be quickly converted into cash. Cash equivalents include money market accounts, commercial paper and U.S. treasury bills. A company invests in cash equivalents to earn interest on cash that would otherwise be unused temporarily.

Management uses the statement of cash flows to assess liquidity, determine dividend policy, and plan investing and financing activities. Investors and creditors use the statement to assess the company’s ability to manage cash flows, generate cash, pay liabilities and dividends, and anticipate the need for additional funding.

The statement of Cash Flows has three major classifications:

• Operating activities: These activities involve the cash inflows and outflows from activities that determine the net income. The inflows include cash receipts from the sale of trading securities. Trading securities are a type of market security that a company buys and sells to make a profit in the near term instead of holding them indefinitely. Examples of operating activities are sale or purchases of goods and inventory, expenses, interest and dividends received on loans and investments, taxes and wages.

• Investing activities: These activities involve the acquisition and sale of property, plant and equipment and other long-term assets and short-term marketable securities, other than trading securities or cash equivalents, and the making and collecting of loans.

• Financing activities: These activities involve obtaining resources from stockholders, issuance and repayment of debt, payment of dividends, and reacquiring of stock.

Sometimes companies also engage in noncash investing and financing transactions. Noncash investing and financing transactions involving only long-term assets, long-term liabilities, or stockholders’ equity. These transactions do not involve cash flows. Because they will affect future cash flows, they should be stated in a separate schedule on the cash flow statement.

How can Cash Flows be analyzed?

When studying a company, two areas that are examined are:

1. Cash flow ratios
   Cash generating efficiency is the ability of a company to generate cash from its current or continuing operations. The cash flow yield is the ratio of net cash flows from operating activities to net income. A cash flow yield of 1.9 means that the company is generating 90% more cash flow than net income. The cash flow yield can be calculated using the following formula:

Cash flow yield = Net cash flows from operating activities / Net income

Cash flows to sales is the ratio of net cash flows from operating activities to sales. A cash flows to sales of 0.09 means that the company generates 9% of net cash from sales. The cash flows to sales can be calculated using the following formula:

Cash flows to sales = Net cash flows from operating activities / Net sales

Cash flows to assets is the ratio of net cash flow from operating activities to average total assets. It can be calculated using the following formula:

Cash flow to assets = Net cash flows from operating activities / Average total assets

2. Free cash flow: This is the amount of cash hat remains after deducting the funds a company must commit to continue operating at its planned level. These commitments cover current or continuing operations, income taxes, interest, dividends, and net capital expenditures. The free cash flow can be calculated as follows:

Free cash flow = Net cash flows from operating activities – Dividends – Purchases of plant assets
+ Sales of plant assets

Free cash flows can be positive or negative. When a company’s free cash flow is positive, it has cash available to reduce debt or to expand because it has paid all its cash commitments. If it is negative, the company will have to sell investments, borrow money or issue stock in the short term to continue at its planned level.

What are operating activities?

The first step is to determine the cash flows from operating activities. The income statement shows the income earned from the company's operating activities. Because the income statement is on an accrual basis, the figures must be converted to a cash basis. There are two ways to do this. The first method is the direct method converts each item from the accrual basis to the cash basis.

The second method is the indirect method. This method lists only those adjustments necessary to convert net income to cash flows from operations. The items that require adjustment are those that affect net income but not net cash flows from operating activities. These items include depreciation, amortization and depletion, gains and losses, and changes in the balances of current assets and current liabilities accounts.

• Depreciation, amortization and depletion : To derive cash flows from operations an adjustment for depreciation is needed to increase net income by the amount of depreciation recorded. This amount can be found on the income statement at Depreciation Expense. The same holds for amortization and depletion. These two appear as amortization expense and depletion expense on the income statement.

• Gains and losses: Gains and losses do not affect cash flows from operating activities and thus have to be removed from this section of the statement of cash flows. The gains of the company have to be subtracted because the gain is already included in the net income. Losses have to be added because losses are already included in the sale of the item.

• Changes in current assets: A decreases in current assets has a positive effects on cash flows and an increase in assets has a negative effect on cash flows. When the Accounts Receivable account decreased in the accounting year by an amount X, this amount has to be added to net income. The increase of the Inventory account has to be subtracted and the decrease in Prepaid Expenses has to be added.

• Changes in current liabilities: These changes have the opposite effect from changes in current assets. Increases in current liability accounts are added to net income, and decreases are subtracted.

What are investing activities?

The second step is to determine the cash flows from investing activities. When cash flows from investing activities are determined, each account that involves cash payments and receipts from investing activities has to be examined separately.

To explain this step we use an example: Assume that the income statement of a corporation shows a Gain on sale of investments of USD 6,000. The objective is to explain this gain. Also consider the following information on the income statement:

1. Purchased investments in the amount of USD 39,000
2. Sold investments that cost USD 45,000 for USD 51,000

3. Purchased plant assets in the amount of USD 60,000

4. Sold plant assets that cost USD 5,000 with accumulated depreciation of USD 1,000 for USD 2,500.

5. Issued USD 50,000 of bonds at face value in a noncash exchange for plant assets.

• Investments: Assume the investments account had a beginning balance of USD 63,500. The account was debited for USD 39,000 (nr.1) and credited for USD 45,000 (nr.2) The gain on nr. 2 (USD 6,000) has already been accounted for as an increase in cash flows, and does not have to be counted again. The ending balance of the Investments account is USD 57,500. This is a difference of USD 6,000. (This is unrelated to the gain of USD 6,000 on nr.2)

The cash flow effects from these transactions that are shown in the investing activities section are as follows:

Purchase of investments -USD 39,000
Sale of investments + USD 51,000

• Plant assets: Both the Plant Assets account and the Accumulated Depreciation account have to be explained. Nr. 3 shows a cash decrease of USD 60,000 and nr.4 shows a cash increase of USD 2,500. Nr.5 is a non cash exchange but does show a significant transaction involving an investing and a financing activity. This must be listed at the bottom of the cash flow statement. So the cash flow effects from these transactions are:
  Purchase of plant assets: -USD 60,000
  Sale of plant assets + USD 2,500

The total balance on cash flows from investing activities is:
-39,000 + 51,000 – 60,000 + 2,500 = -USD 45,500

What are financing activities?

The third step is to determine the cash flows from financing activities. To determine cash flows from financing activities almost the same procedure is followed as with determining cash flows from investments. The accounts that are analyzed are short-term borrowings, long-term liabilities and stockholders’ equity accounts. Consider the following transactions:

1. Issued USD 50,000 of bonds at face value in a noncash exchange for plant assets.

2. Repaid USD 25,000 of bonds at face value at maturity.

3. Issued 7,600 shares of USD 5 par value common stock for USD 87,500.

4. Paid cash dividends in the amount of USD 4.000.

5. Purchased treasury stock for USD 12,500.

From this information we can say the following:

• Bonds payable: Nr. 1 is credited to the Bonds Payable account. Nr. 2 is debited to this account. The balance is a credit of USD 25,000

• Common stock: Issuing 7,600 shares of USD 5 par value credits 7,600 x USD 5 = USD 38,000 to the Common stock account. The excess is 87,500-38,000 =, USD 49,500 and is credited to the Paid-in Capital in excess of Par Value, Common account. This is a cash increase of USD 87,500.

• Retained earnings: Nr. 4 shows a decrease of USD 4,000 because the payment of dividends reduces retained earnings. This is a cash decrease.

• Treasury stock: Nr. 5 shows a decrease of cash of USD 12,500 because of the purchase of treasury stock.

What are financial performant measurements? - Chapter 13

What are foundations?

Financial performance measurement uses all techniques that are available to show how important items on the financial statement of a company relate to the objectives of the company. It is also called financial statement analysis. There are two groups that are interested in measuring the financial performance of a company:

1. The top managers of the company, middle-level managers and lower-level employees who own stock in the company. The management is responsible for carrying out the plan to achieve the financial objectives of the company. This requires constant monitoring of financial performance measures.

2. Creditors, investors and customers who have cooperative agreements with the company. Creditors and investors use the financial performance evaluation to judge the past and present performance of a company. They also use it to assess potential future risk. Investors focus on a company's potential earnings ability and creditors focus on a company's potential debt-paying ability.

The board of directors of a public corporation must establish a compensation committee. This committee must consist of independent directors to determine the compensation for the company's top executives. A typical compensation for executive officers includes an annual base salary, incentive bonuses and stock option awards.

When decision makers analyze financial statements they must judge whether the relationships in the statements are favorable or unfavorable. The three most common used comparison standards are:

• Rule-of-thumb measures. Many analysts use general standards to key financial ratios.

• Past performance. Comparing financial ratios of the same company over time is often used and is better than using rule-of-thumb measures.

• Industry norms. This shows how a company is performing compared to other companies in the industry. Using industry norms as a standard of comparison has three limitations: companies may not be comparable, the companies may use different accounting methods, diversified companies may not be comparable to other companies. Diversified companies are large companies with multiple segments and which operate in more than one industry.

Information about public corporations can have several sources. The three major sources are:

1. Reports published by a corporation. The annual report of a public corporation is an important information source. Most corporations also publish interim financial statements each quarter or each month.

2. Reports filled with the Securities and Exchange Commission (SEC). Public corporations in the US must file annual reports, quarterly reports and current reports with the SEC.

3. Business periodicals and credit and investment advisory services.

How can the quality of earnings be evaluated?

Net income is important and therefore there is great interest in the quality of earnings. This refers to the substance of earnings and their sustainability into future accounting periods. It is affected by accounting methods, accounting estimates and one-time items.

• Accounting methods

The operating income is affected by the accounting method. Generally accepted methods are uncollectible receivable methods, inventory methods such as LIFO and FIFO and depreciation methods such as the production and straight-line method. Different accounting methods also have a different impact on cash flows and financial statements. In general, we can say that methods or estimates that lead to lower current earnings produce a better quality of operating income.

• Accounting estimates

Estimates also have an effect on the income. Revenues and expenses must be assigned to the periods in which they occur. If one cannot establish a relationship between revenues and expenses one must make estimates. This estimate should be based on realistic assumptions.

• One-time items

An increase in earnings due to one-time items will not be sustained in the future. Examples of one-time items are nonoperating items, gains and losses and write-downs and restructurings. A write-down is a reduction in the value of an asset below its carrying value on the balance sheet. A restructuring is the estimated cost of a change in the operations of a company such as laying off personnel. The nonoperating items on the income statement include discontinued operations, segments that are no longer part of the operations of the company, and gains or losses on the sale or disposal of these segments.

What are the tools and techniques of financial analysis?

To determine financial performance one must look at the relationship between numbers and their change from one period to another. There are several tools of financial analysis to show these relationships and changes. These are horizontal analysis, trend analysis, vertical analysis and ratio analysis.

• Horizontal analysis

With horizontal analysis changes from previous year to the current year are computed in both money amounts and percentages. The percentage change relates the size of the change to the size of the money amounts involved. It is computed as follows:

Percentage change = 100 x ( Amount of change / Base year amount)

The base year is the first year considered in the set of data.

• Trend analysis

Trend analysis is a variant of horizontal analysis. With this analysis one calculates the percentage changes for several successive years instead of just for two years. Changes in the business can be highlighted because of this long-term view. Trend analysis uses an index number to show changes in related items over time. The index number for the base year is set at 100. The index for other years is measured with the following formula:

Index = 100 x (Index year amount / Base year amount)

• Vertical analysis

Vertical analysis shows how different components of a financial statement relate to a total figure in the statement. The total figure contains 100 percent and the each component's percentage of the total is computed. This results in a financial statement that is expressed entirely in terms of percentages. This is called a common-size statement.

• Financial ratio analysis

Financial ratio analysis identifies key relationships between the components of the financial statements. Financial rations are very useful for evaluating the financial position of a company.

What is the financial ratio analysis?

We will now look at several financial ratios that are used to evaluate a company's financial performance. There are ratios used for evaluating profitability, liquidity, financial risk, operating asset management and market strength.

1. The financial ratios that are used to evaluate profitability and total asset management are:

• Profit margin = Net income / Net sales

• Asset turnover: Measures how efficiently assets are used to produce sales. The corresponding formula is:

Asset turnover = Net sales / Average Total assets

• Return on assets = Net income / Average total assets

• Profitability ratio relationships: Shows the relationships of the three financial ratios for profitability.

Profit margin x Asset turnover = Return on assets

2. The financial ratios that are used to evaluate liquidity are:

• Cash flow yield: Measures the ability to generate operating cash flows to net income and is the most important one in this group. The corresponding formula is:

Cash flow yield = Net cash flow from operating activities / Net income

• Cash flows to sales: Measures the ability of sales to generate operating cash flows. The corresponding formula is:

Cash flow to sales = Net cash flow from operating activities / Net sales

• Free cash flow: Measures the amount of cash that remains after providing for commitments. The corresponding formula is:

Net cash flow from operating activities – Dividends – Net capital expenditures

3. The financial ratios that are used to evaluate financial risk are:

• Debt to equity: ratio = Total liabilities / Stockholders' equity

• Return on equity = Net income / Average stockholders' equity

• Interest coverage: Measures the degree of protection creditors have from default on interest payments. The corresponding formula is:

Interest coverage ratio = (Income before income taxes + Interest expense) / Interest expense

4. The financial ratios that are used to evaluate operating asset management are:

• Inventory turnover = COGS / Average inventory

• Days' inventory in hand = Days in a year (365) / Inventory turnover

• Receivable turnover = Net sales / Average accounts receivable

• Days' sales uncollected = Days in a year (365) / Receivable turnover

• Payables turnover = (COGS +/- Change in inventory) / Average accounts payable

• Day's payable = Days in a year (365) / Payables turnover

• Current ratio: Measures the short-term debt-paying ability by comparing current assets with current liabilities. The corresponding formula is:

Current ratio = Current assets / Current liabilities

• Quick ratio: Is another measure of short-term debt-paying ability. The corresponding formula is:

Quick ratio = (Cash + Marketable securities + Receivables ) / Current liabilities

5. The financial ratios that are used to evaluate market strength are:

• Price / Earnings ratio = Market price per share / Earnings per share

• Dividends yield = Dividends per share / Market price per share

What do investments consist of? - Chapter 14

What are the management issues?

When making investments the management of a company must understand issues related to recognition, valuation, classification, disclosure and ethics of investments.

• Recognition

The general rule for recording transactions is that purchases of investments must be recorder on the date on which they are made and sales of investments must be reported on the date of the sale.

• Valuation

Investments are valued according to the cost principle; they are valued in terms of cost at the time they are purchased. After the purchase, the value of investments on the balance sheet must be adjusted. Companies sometimes have to measure their investments at fair value. This is the exchange price associated with an actual or potential business transaction between market participants.

• Classification

Investments in debt are either short-term or long-term. Short-term investments, which are also called marketable securities, have a maturity of more than 90 days but are intended to be held only until cash is needed for current operations. Long-term investments are intended to be held for more than one year. These short-term and long-term investments must be further classified as:

1. Trading securities: debt or equity securities that are bought and held principally with the purpose to sell them in the near term.

2. Held-to-maturity securities: debt securities that the management intends to hold until their maturity date.

3. Available-for-sale securities: debt or equity securities that do not meet the criteria for either trading or held-to-maturity securities.

If a firm owns more than 50 percent of another company's stock, it can exercise control over the operating and financial policies of that company.

• Disclosure

In the notes of the financial statements companies provide detailed information about the investments made and how they account for these investments.

• Ethics

It can be that employees use their knowledge about the investment transactions of the company for personal gain. Making use of inside information for personal gain is called insider trading. In the United States this is unethical and illegal.

What are the short-term investments in equity securities?

As noted before, trading securities are short-term investments. These securities are classified as current assets and are valued at fair value. An increase or decrease in the fair value of the company's portfolio of trading securities is included in net income.

Suppose a company makes a purchase of trading securities at an amount of USD 30,000. This must be recorded as follows:

At the end of the year the balance must be adjusted when an unrealized loss or gain has occurred. The gain or loss must be recorder using the Allowance to adjust short-term investments to market account.

The sale of trading securities can go with a gain or loss. Suppose a company has 5,000 shares for USD 15,000 and that it now sells the 5,000 shares for USD 5 per share. This must be recorded as follows:

Available-for-sale securities are recorded in the same way as trading securities with two exceptions:

1. An unrealized loss or gain is reported as other comprehensive income and is disclosed on the statement of stockholders' equity. It is listed as a separate item in the equity section of the balance sheet. It does not appear on the income statement.

2. If a decline in the value of a security is permanent, it is charged as a loss on the income statement.

What are the long-term investments in equity securities?

How to account for long-term investments in equity securities depends on the extent to which the investing company can exercise control over the other company. For the accounting of long-term available-for-sale securities the cost-adjusted-to-market method is required. With this method the securities are initially recorder at cost and are thereafter adjusted periodically for changes om market value by using an allowance account. An available-for-sale securities is classified as long-term if management intends to hold them for more than one year. At the end of the accounting period one must determine the total cost and market value of the investments. If total market value is less than total cost, the difference must be credited to a contra-asset account called Allowance to adjust long-term investments to market.

Purchase of a long-term investment
Suppose a company paid cash for the following long-term investment: 5,000 shares common stock at USD 10 per share. This must be recorded as follows:

At the end of the year, the market price of the common stock is USD 9. The current fair value is 5,000 x USD 9 = USD 45,000 which is USD 5,000 less than the original cost. Therefore, an unrealized loss has occurred. This has to be recorder as follows:

Sale of a long-term investment:
Suppose that the company sells 1,000 shares of common stock at USD 8 per share. This must be recorded as follows:

Similar as with a purchase of a long-term investment an unrealized loss has to be recorded at the end of the year. However, in this case the Unrealized loss is credited instead of debited.

If one owns 20 percent or more of a company's voting stock one can influence the operations of the company. In this case we should use the equity method to account for the stock investment. This method presumes that an investment of 20 percent or more is nor a passive investment and that the investor should therefore share proportionally in the success or failure of the company. The main features of this method are:

• The original purchase of the stock is recorded at cost.

• The investor's share of the company's period net income is recorded as an increase in the investment account with a corresponding credit to an income account. The contrary holds for a periodic loss.

• When a cash dividend is paid to the investor, the asset account Cash is increased and the investment account is decreased.

There are firms that own own less than 50 percent of another company's voting stock that exercise such powerful influence that they control the policies of the other company. When a firm has interest to control another company there exists a parent-subsidiary relationship. The investing company is the parent company and the other company is the subsidiary. Those two are separate legal entities and therefore prepare separate financial statements. However, they are seen as a single economic entity and therefore they have to combine their statements into a single one called the consolidated financial statements.

What are the consolidated financial statements?

One can use the purchase method for preparing the consolidated financial statements. This method combines the similar accounts from the separate statements of the parent company and the subsidiaries. Some accounts are transactions between the two entities. These transactions should not be included in the consolidated financial statements. Therefore, it is important that certain transactions are eliminated. These eliminations avoid the duplication of accounts and reflect the financial position and operations from the standpoint of a single entity.

When a parent company purchases between 50 and 100 percent of the subsidiary's voting stock it must prepare consolidated financial statements. The stockholders who own less than 50 percent are the minority stockholders and the parent company must also account their interests.

A consolidated income statement is made by combining the revenues and expenses of the parent company and its subsidiaries. The same procedure is used as with the consolidated balance sheet. Companies can expand by buying or establishing foreign subsidiaries. Such companies are called multinational or transnational corporations. The reporting currency is the currency in which the consolidated financial statements are presented.