AIF Chapter Outlines 2015 Spring

You should..
1) maximize the spreadsheet

2) look for the tabs at the bottom of the spreadsheet (tabs, by chapter)
3) click on a tab (at the bottom of the spreadsheet)
4) print
AIF - Chapter 11 - Time Value of Money - Making Decisions

1) Business decisions - Management Cycle
A) Planning Phase 1) Conducting Long-Term Planning
2) What are the company's long-term goals?
B) Performing Phase 1) Developing the infrastructure for the company
2) Buying the equipment and resources necessary
for the company
C) Control & Evaluation Phase
1) The business leaders are evaluating the past
business decisions
2) Major parts of investing
A) Return - Measures the performance of an investment
1) Return of Investment vs. Return on Investment
a) Example
Start
End
1,000
1,100
1000
Return of
Investment
Dollar Return =
Rate of Return =
100
Return on
Investment
1,100
(1,000) =
Dollar Return
Original Investment
100
100 =
1,000
10%
B)
Risk
1) A chance of Loss
a) Receive a lower return than expected
b) Receive a return that eats into your initial investment
2) All individuals have different attitudes towards risk
a) Risk seekers
b) Risk avoiders
3) Different Types of Risk
a) Risk-free rate - rate of return on a virtually riskless investment
1) (Short-Term US Government bond)
b) Inflation Risk - a decline in purchasing power due to rising prices
1) as prices increase - more money is needed to purchase the same item
c) Business Risk - Risk associated with a specific business
1) Example - Walmart vs. Kmart- more business risk associated with Kmart
d) Liquidity Risk - Risk an investment cannot easily be converted into cash
1) Example - Selling a house vs. selling 100 shares of IBM
a) selling a house can take months, selling IBM share (seconds)
4) Risk and Return are related
a) As the risk of an investment increases, the require return by the market place increase
1) contrast GAP stock with a short-term US treasury bond
3) Time value of Money

A) Basic concepts - Value of Money
1) Example
Today
1 Year
Today
1 Year
1
Which would you rather have????
Dollar today
Dollar 1 year from now
B) Simple vs. compound Interest

1) Simple Interest -
Periods X Rate X principal
a) Simple Interest Example

Periods =
Rate =
principal
2 years
10%
1,000
2 X .10 X 1,000 =
200 <=== Simple Interest
b) Simple Interest has NO Compounding

2) Compound Interest
a) Define - Compounding has interest earned on interest
b) Compound Interest Example
Periods =
Rate =
principal
Year 1:
Year 2:
2 years
10%
1,000
1,000 X .10 X 1 year =
1,100 X .10 X 1 year =
Total
100
110
210 <== Interest Earned
1,000 + 100
3) Application / Decision Making:

a) Which would you rather have:
1) CD earning simple interest?
2) CD earning compound interest?
< = Answer
b) Which would you rather have:

1) loan with simple interest?
2) loan with compound interest?
< = Answer
C) Major Time Value of Money Concepts

1) Future Value
a) Define - What will a deposit today be worth in the future?
b) Example - Real-Life Example - Place money in a bank - value after a few years??
c) Example - Use Packet
1) Spend time on the rate per period and the rate per year.
2) Example
Start
15,000.00
????
2) Present Value
a) Define - What is the value of a future deposit worth today?
b) Example - Use Packet
2) Example
Start
????
35,000
3) Future Value of an Ordinary Annuity

a) Annuity - A series of equal payments or deposits
b) Future value of an ordinary annuity
Start
100
100
100
Deposits
????
c) Real-Life Example - 401K deposits, creating a "nest egg" for the future
d) Example - Use Packet
4) Present Value of an Ordinary Annuity

a) Present value of an ordinary annuity
Start
100
100
100
Payment
????
b) Real-Life Examples - CAR LOAN, HOUSE LOAN
c) Example - Use Packet
5) Solving for Unknown Values - PACKET EXAMPLE
Parts of this document are the exclusive property of Rodney Vogt.

Those parts are protected by copyright laws ( Rodney Vogt, 2012).
AIF - Chapters 12 & 13

AIF - Chapter 12 - Business Investment
1) General Chapter Direction
A) We are going to look at different ways to evaluate
different investment alternatives.
B) Example
Yes
Invest in a new building
No
2) Capital Budgeting
A) Define - Process of acquiring long-term investments
1) Example - Long-term investment - Shop Building
B) Decision Point / Life Application
1) A good business will require the investment to
generate a minimum return
C) Uses of Capital Budgeting
1) Expand operations
2) Replace - unproductive and worn-out assets
3) Comply with government regulations
a) example => oil refineries => need to meet government regulations
3) Capital Budgeting Steps
A) Identify long-term investment alternatives
B) Select an Investment
C) Finance the investment
D) Evaluate the investment results
7
4) Select an Investment (Step 3 B - Capital Budgeting Steps)

A) Business investments should generate an acceptable rate of return (minimum return)
B) Businesses use - Cost of Capital as a minimum return rate
1)
Define - Cost of Capital - Weighted-average cost of debt and equity

for a business
2)
Simple Example - Cost of Capital

a)
b)
c)
d)
Company has 25,000 debt and 75,000 equity

Debt rate = 12%
Equity required rate = 15%
Compute the Cost of Capital
25,000
75,000
100,000
0.25
0.75
( .25 X .12) + ( .75 X .15 ) =
0.1425 <= Cost of Capital
Cost of Capital => A Rate / %

Weighting => Based on => Total Assets
5) Estimate an investment's profitability => NPV
A) Investment tool = Net Present Value = NPV
B) Big Picture = NPV

1)
Start
100
100
100
PV
- Net Investment Cost
NPV
What is the present value of the above cash inflows?
Compare the cash inflows to the cost of the asset.
C) NPV steps
1) Identify both the timing and amount of both cash
inflows and cash outflows.
2)
Compute the present value of future cash flows
3)
Compute the Net Present Value

Present Value of Future Cash Flows
4)
Net Investment Cost

NPV
Accept or reject based on step # 3

a) NPV > = 0 : Accept Investment
b) NPV < 0
: Reject Investment
6) Assumptions used with discounted cash flows

A) All cash flows are known with certainty
B) Cash flows are assumed to occur at the end of the time period
C) Cash flows can be invested in other investments that can generate the
same rate of return (as the current investment)
7) Net Present Value & Taxes
A) Additional cash comes into the business => Government will tax the profit
B) Tax formula
(Cash Inflow) X ( 1 - Tax Rate) = After-tax cash flows
C) Taxes & Depreciation Expense

1) Journal entry for Depreciation Expense
Depreciation Expense
Accumulated Depreciation
2)
100,000
The above journal entry will reduce taxes:

a)
3)
100,000
Depreciation is a tax deduction
The above journal entry does not represent a cash outflow

a)
NO CASH OUTFLOW
4)
Depreciation creates a cash savings = Also called a Tax Shield
5)
Depreciation Expense Example

Corp. A
200,000
(100,000)
100,000
30%
30,000
Income before Depr. Expense

Taxable Income
Taxes ( 30 % tax rate)
Tax Expense
Corp. B
200,000
(200,000)
30%
-
Depr. Expense shields the company from paying taxes

6)
Summary => Depreciation expense reduces taxable income, shielding a business

entity from paying taxes.
D) Taxes ==> Gains & Losses

1)
Gains: ==> Selling a piece of equipment

Cost
Accum. Depr.
Book Value
Cash Received
Gain
Tax Rate ( 30 %)
Tax Expense
300
200
100
110
10
30%
3
After-Tax Cash Flows =>
Book Value = Bal. Sheet Value

110
Gain: On the Inc. Statement, Adds to Net Income
-3
107
10
11
2)
Losses: ==> Selling a piece of equipment

Cost
Accum. Depr.
Book Value
Cash Received
Loss
Tax Rate ( 30 %)
Tax Savings
300
200
100
90
-10
30%
-3
Book Value = Bal. Sheet Value

90
Loss: On the Inc. Statement, decreases Net Income
After-Tax Cash Flows =>

a)
3
93
The deduction will reduce taxes (create a tax savings), but no cash
outflow will be generated
E) Use Tax Packet Example
AIF - Chapter 13 - Planning for Equity Financing

1) Equity Financing & Debt Financing
A) Rewards of Equity Financing
1)
Generate a return on your equity investment
2)
Psychological (ego) Reward - I own a business
B) Risks of Equity Financing

1)
Not receiving a good return

a) Expect a 15% return, only receive 5%
2)
Receive a negative return

a)
Receive a return that eats into your investment

Receive less than your initial investment (end of investment)
C) Rewards of Debt Financing

1)
Financial Leverage - Reward of Debt Financing

a)
Define - Financial leverage occurs when the return from borrowed funds is greater than the
12
cost of borrowed funds.

D) Risk of Debt Financing
1)
Financial Risk - the chance a company might default on its debt obligations
2) Equity Financing => Sole Proprietorship & Partnerships

A) Disadvantage - Unlimited liability - liability extends beyond the business,
personal wealth can be taken (beyond the business wealth)
B) Disadvantage - hard to raise large amounts of capital
C) Advantage - Easy to form
D) Advantage - Income is only taxed once - No double taxation
(pass-through entity, no tax at the business entity level)
The net income will be taxed (passed to) on the individual's
tax return.
E) Sole Proprietorships & Partnerships - use an account called - Capital
1)
Capital account represents the owner's equity placed into the business
a)
b)
c)
d)
Owner's Capital is increased by contributions <==assets placed into the business

Owner's Capital is increased by any net income
Owner's Capital is decreased by any net loss
Owner's Capital is decreased by any withdrawals
1) withdrawals are like dividend payments of a corporation
13
3) More on Partnerships
A) Division of Partnership Income (ways to divide net income & net loss)
1)
2)
3)
4)
Fixed Ratio
Ratio of Capital Balances
Salary & Interest Allowance
Divide the Remainder
B) Division of Partnership Net Income or Net Loss

1) Net Income Example
a) Capital balances - Beginning Balances
Partner A
Partner B
40,000
60,000
100,000
0.40
0.60
======> Partnership Agreement
b)
Partner A => Receives a 10,000 salary
c)
Each partner receives a 5% interest allowance based on

the beginning capital balance of each partner.
d)
Any remainder should be split based on a 2:1 ratio (Partner A = 2)
e)
Solve based on a Net Income = $25,000

Partner A
Beg. Balance
Salary Allowance
5% Interest Allowance
Remainder
10,000
2,000
6,667
18,667
BB
40,000
0.05
2,000
BB
60,000
0.05
3,000
Partner B
3,000
3,333
6,333
Partner A
Partner B
Bal.
25,000
15,000
10,000
< ===Amount added to each partner's capital account
Remainder
2
1
3
66.67%
33.33%
10,000
3,333
14
f)
Solve based on a Net Loss = $ (12,000)

Partner A
Beg. Balance
Salary Allowance
5% Interest Allowance
Remainder
10,000
2,000
(18,000)
(6,000)
BB
40,000
0.05
2,000
BB
60,000
0.05
3,000
Partner B
Bal.
(12,000)
(22,000)
3,000
(27,000)
(9,000)
(6,000) < ===Amount subtracted from each partner's capital account
Partner A
Partner B
Remainder
2
1
3
66.67%
33.33%
(27,000)
(9,000)
4) Equity Financing => C Corporations

A) Characteristics of Corporation Equity
1)
Advantage (limited liability) - An investor can only loose his or her investment (not personal property)
=> True for => minority shareholders
=> Major stockholders can be liable for their decisions
2)
Advantage - Corporations can raise large amounts of capital (easier than sole proprietorships & partnerships)
3)
Advantage - Unlimited Life - Use IBM Example

a) exchange of share ownership does not end the life of a corporation
4)
Disadvantage - Double taxation

a) Dividend Example
1) Corporation has earnings => taxed on the earnings => Corporation pays a dividend =>
Individual shareholder pays a tax on the dividend
2) The above example shows the disadvantage of double taxation
15
5) Equity Financing => C Corporations => Types of Stock

A) Characteristics of Common Stock
1)
2)
3)
Right to vote (major events & board of directors)

Right to sell shares of stock
Preemptive Right - Existing shareholders have first right to purchase the newly issued shares
4)
5)
Who Cares??? = If existing shareholders do not purchase the newly issued shares, the existing
shareholders will have reduced voting power.
Right to share in any dividends
Right to share in any liquidation
a)
Common shareholders are usually last in line to receive assets of the corporation in the event of
a bankruptcy.
B) Characteristics of Preferred Stock

1)
Preferred stock has special characteristics

a)
b)
c)
2)
P/S is paid first on any dividends declared (vs. common stock)

P/S is paid first on any liquidation (paid before common shareholders (bankruptcy issue))
P/S usually has no voting say in the company (no say in the management of the business)
Cumulative P/S
a)
Cumulative P/S
1) Unpaid P/S dividendsUnpaid
are called
P/S==>
dividends are called ==> Dividends in Arrears
2) Use ==> Dividend in Use ==> Dividend in Arrears Example ==> Packet
16
6) Corporation Stock Terms

A) Shares Authorized => total number of shares a state has approved a corp. to sell
B) Shares Issued => actual shares sold to the public
C) Shares Outstanding
1) Know => Shares issued - Treasury Stock shares = Shares Outstanding
Note: Treasury Stock ==> Shares of a corporation's own stock that have been repurchased
D) Par Value => arbitrary value assigned by the corp. & the state
Note: Legal Capital => Par Value * Number of Shares Issued
===> The legal capital is used to protect creditors in the case of bankruptcy.
8) Corporation Dividends
A) Dividends are distributions from the corporation to the investor
B) Dividends can be cash, stock, or property
C) Important Dates - Dividends
1)
Date of Declaration - board of directors announces the payment of a dividend (legal liability created)
2)
Date of Record - listed shareholders on the date of record will receive a dividend
3)
Date of Payment - pay the dividend

Note: I do not test on the ex-dividend date.
D) Dividends are not an expense of the corporation (dividends represent a return of capital)
17
9) Stock Splits
A) General logic (Stock Splits)
1) Reduce the price of the stock (more people can purchase
the stock at a lower price (increase the liquidity of the stock))
===> Increasing the Liquidity (of the stock) => increase the ease of buying or of selling the stock
===> Berkshire Hathaway Example
B) Stock splits require no journal entries
1)
A memorandum entry should be made to record the stock split
C) Stock splits and par value

1)
Stock splits reduce the par value proportionately
D) Stock splits increase the # of shares outstanding

E) Stock Split Example
1)
Before the stock split

a) 2 for 1 stock split
b) 100,000 shares outstanding
c) Par value = $ 10.00 per share
d) Market Value = $100.00 per share
2)
After the stock split

a) 200,000 shares outstanding
b) Par value = $ 5.00 per share ($10.00 /2)
c) Market Value = $50.00 per share ($100.00/2)
18
10) S Corporation & Limited Liability Company (LLC)

A) Characteristics - S Corporation
1) Limited Liability - provides protection against personal weath attacts
2) Only 100 shareholders allowed
3) All shareholders must be United States citizens.
4) Class of Stock ==> only one class
5) Minutes must be taken each year (more paper work vs. LLC)
==> formal meetings required
6) More liability protection across different states (doing business in many states)
==> An S Corp. provides more liability protection across states vs. an LLC
7) S Corporation ==> is a pass-through entity
==> Income taxed at individual taxpayer level (not business entity level)
B) Characteristics - Limited Liability Company (LLC)
1) Limited Liability (best limitations on liability within one state)
==> Limited Liability - provides protection against personal weath attacts
2) Less paperwork vs. S Corporation / C Corporation
3) An LLC ==> is a pass-through entity
==> Income taxed at individual taxpayer level (not business entity level)
19
AIF - Chapter 14 & Chapter 15 - Debt Financing (Liabilities)

1)
Debt Financing - Notes Payable & Bonds Payable

A)
Debt financing is one of the three ways to finance a business.

1)
B)
Other ways to finance a business => ( earnings & equity)
Borrower Risk = > default on the loan = > Not make scheduled payments
1)
Once a borrower defaults, the borrower has less access to capital.
C)
Investor Risk = > default = > Company does not payoff its debts
D)
Borrower = > Reward from debt financing => Financial Leverage

1)
Define => Financial leverage is created when a company

can generate a return that is greater than the cost
of borrow funds.
Return on
Investment
2)
>
Cost of Borrowed
Funds
Evaluating Debt Financing

A)
Debt to Equity Ratio =
Total Debt
Total Equity
1)
Ratio of 1 => Debt financing equals equity financing
2)
Ratio of 1.5 => More debt financing than equity financing
3)
Who Cares????
a)
4)
General rule, as the debt to equity ratio increases = > the

risk associated with the business increases (default risk, bankruptcy risk)
Remember the Accounting Equation

a)
Assets = Liabilities + Owners' Equity

If you know 2 of the 3 values, you can solve for the missing
value.
B)
Times Interest Earned Ratio

1)
Equation =
2)
Example
Earnings before Interest & Taxes

Interest Expense
30,000 =
10,000
3.00
The above example shows a business generating 3 times

the cash inflows to pay for any interest payments.
20
General Rule: As the times interest ratio goes up, the firm
is in a better position to payoff creditors.
3)
Debt Financing Terms

A)
Note - Written promise to payoff a liability

1)
B)
Note Maker - the person or business entity borrowing resources

( the Maker is borrowing resources)
Covenants - Restrictions placed on the borrower

1) Why important???
a) Example - A typical covenant might restrict the payment of dividends
of a borrower. Why??? A borrower might payout all the assets,
then tell the debt investors there are no assets
to payoff the debt investors (lenders).
C)
Cash Proceeds - The amount of money received by the borrower.
D)
Market Rate of Interest (also called yield, market, & effective rate)
1)
E)
4)
The current market rate demanded by the market place (set by the market place)
Face Rate - Interest rate printed on the face of the note or bond.
Sources of debt financing

A)
Nonpublic Sources - A business borrows from individuals or from institutions (like insurance companies)
B)
Public Sources - A business borrows by issuing debt to the public (Example =>Chicago Board of Trade)
1) Corp. bonds then can be traded
5)
Types of Notes & Bonds:

A)
Installment Note (only one interest rate used (market)):

1)
Series of equal repayments
2)
Each payment includes interest & principal
3)
Examples - Real Life - Car Payments & House Payments
4)
Installment Note # 1 in Packet

a)
Interest Expense - Jan - June 20X4

10,000.00
0.05 <==== .10 / 2
500.00 Interest Expense
21
b)
Principal reduction after first payment
Cash Pmt
c)
Reduction in
- Interest Exp. = Note Payable
2,820.08
(500.00)
2,320.08
Calculate the interest expense July - Dec. 20X4

7,679.92 < === 10,000.00 - 2,320.08
0.05 <==== .10 / 2
384.00 Interest Expense
5)
Recording an Installment Note

a)
Issuing the installment note

Record the Cash Proceeds from an Installment Note
Cash
Notes Payable
b)
10,000.00
10,000.00
Interest Payments - First Year ( 2 periods)

Interest Expense - Jan - June 20X4
Interest Expense
Notes Payable
Cash
500.00
2,320.08
2,820.08
Interest Expense July - Dec. 20X4

Interest Expense
Notes Payable
Cash
384.00
2,436.08
2,820.08
Dec. 20X4 Bal. =>
Interest Expense
500.00
384.00
884.00
Dec. 20X4 Bal. =>
Notes Payable
10,000.00
2,320.08
2,436.08
5,243.84
<== Carrying Value

for the B/S
22
B)
Lump-Sum Note (only one interest rate used (market)):

1)
One repayment at the end of the life of the note
2)
Repayment includes a return of principal and interest
3)
Lump-Sum Note # 2 in the Packet

a) Borrower records the lump-sum note
Cash
Discount on Notes Payable
Notes Payable
Carrying Value of the Note:

Note Payable
Discount on N/P
Carrying Value =>
b)
9,245.56
754.44
10,000.00
10,000.00
754.44
9,245.56 < = Cash Proceeds
Journal entry on 6-30-20X4

Interest Expense
Discount on Notes Payable
Carrying Value
1/2 year (.08/2)
C)
369.82
9,245.56
0.04
369.82
Bonds Payable - use chapter 14's bond packet examples

1)
Bonds sold at face value / par value

a)
2)
3)
market rate = face rate
Bonds sold below face value / par value

a)
market rate > face rate
Bonds sold above face value / par value

a)
D)
369.82
market rate < face rate
Periodic Payment with a Lump-Sum Note => FIGURE JUST LIKE A BOND
1)
Use => Bond Logic
23
6)
Leases
A)
Define - An agreement to transfer use of property from one party to

another party.
B)
Lease Terms
C)
1)
Lessee - Buyer - Property transferred to ==> Lessee
2)
Lessor - Seller - Property transferred from ==> Lessor
Types of Leases
1)
Operating Lease - Lessor / seller retains a substantial interest in the property

a)
Example - Rent a piece of equipment from True Value
b)
Recording an operating lease

1)
Lease Expense (rent)

Cash
XX
XX
Only pay for use, no ownership interest by lessee (like rent expense)
2)
Capital Lease - Lessee / Buyer acquires a substantial interest in the leased property
24
7)
More on discounts & premiums

A)
Market Rate > Face Rate ==> Bond or note sold at a discount
0.15
0.10
1)
B)
Market Rate < Face Rate ==> Bond or note sold at a premium
0.08
0.15
1)
C)
Par value / Face value of Bond or Note = $1,000, then the company
will receive more than $1,000
Market Rate = Face Rate ==> Bond or note sold at a face value (par value)
0.05
0.05
1)
D)
will receive less than $1,000
will receive $1,000.
Student Examples - Bonds

1)
Borrower sets the face rate = 10%
Sell to B
Try to sell bonds to public
Investor A wants
a 15% Return
Investor B
wants a 13%
Return
CFO will sell to investor B => at a discount

2)
Borrower sets the face rate = 17%

Sell to A
Try to sell bonds to public
Investor C wants
a 13% Return
Investor D
wants a 15%
Return
CFO will sell to investor A => at a premium

3)
The above examples show that the borrower will always

pay the market rate. The borrower should always
pay the market rate (independent of the face rate).
8)
Collateral => Assets used to secure a loan
9)
Liabilities & Cash Flow Timing

A)
A business needing a short-term loan to finance

an inventory purchase might use a short-term
installment note to finance the inventory.
B)
A business needing to purchase a long-term

asset (a building) might issue long-term bonds
to finance the long-term asset purchase.
C)
A business leader should evaluate the timing

of benefits (cash received) against the cash payments
required by the liability.
25

26
AIF - Chapter 15 - Recording & Communicating Equity Financing Activities

1)
Sole Proprietorship & Partnerships

A)
Review
1)
An owner has a capital account
2)
The Capital account represents the owner's equity placed into the business
a)
b)
c)
d)
B)
2)
Owner's capital is increased contributions (into the business)

Owner's capital is increased by any net income
Owner's capital is decreased by any net loss
Owner's capital is decreased by any withdrawals
1) withdrawals are like dividend payments of a corporation
Partnership Equity Transactions - Packet & See Web site
Corporate Equity Transactions

A)
B)
Par Value - Legal capital of the corporation

1)
The par value is the minimum price a stock should be sold for
at its initial public offering (IPO).
2)
If a share of stock is sold below the par value during the IPO, then the shareholder
becomes liable for the difference between the par value and the market value.
3)
Both Common & Preferred Stock can have par values
Additional paid-in capital, excess of par value

1)
C)
Add. PIC is used to record value received beyond the par value of the stock
No par stock, without a stated value (will not use the account Add. PIC )
27
D)
Par Value Stock Example

1)
2)
3)
Common Stock, Par value per share =

50,000 shares issued
Market Price per share =
$
$
1.00
50,000
10.00
Journal entry = issuer / seller of stock

Cash
500,000
Common Stock
Add. PIC - C/S
50,000
450,000
Asset +
OE +
OE +
50,000 shares X $10.00

50,000 shares X $1.00
500,000
(50,000)
450,000 Add. PIC - C/S
Total Increase in OE =>
3)
500,000
Corporate Earnings
A)
Retained Earnings - A corporation's earnings flow into an account called

retained earnings.
Retained Earnings
Normal Bal. Beg. Bal.
Net Loss
Net Income
Dividends
Declared
normal credit bal.
B) Quick Review
C)
1)
Revenues & Gains - Expenses & Losses > 0 ===> Net Income
2)
Revenues & Gains - Expenses & Losses < 0 ===> Net Loss
Chapter 15 packet information on closing entries

1)
Go over the closing entries featured in the AIF packet
28
4)
Treasury Stock
A) Define => treasury stock => Company / corporation buys back its own stock
B)
Example ==> Apple Corp. buys back Apple Corp. stock
C) More on treasury stock
D)
1)
Treasury stock is NOT an asset of the corp.
2)
Treasury stock is found in the stockholders' equity section of the balance sheet.
3)
Treasury stock reduces stockholders' equity
4)
Treasury stock reduces the number of shares outstanding
Example - treasury stock

1)
2)
IBM buys its own stock back at $100

# of shares purchased = 5,000
Make the journal entry to record the treasury stock transaction

Treasury Stock
Cash
500,000
500,000
5,000 share X $100

3)
Treasury Stock
500,000
What is the normal balance in most stockholders' equity

accounts?
===> Credit Balance, notice treasury stock has a debit balance
4)
=========>
Treasury Stock
Beg. Bal.
+ Purchases Sales (at
(at cost)
cost)
5)
6)
Use the PACKET EXAMPLE for treasury stock

Contra-equity account
29
5)
Stock Splits
A) General logic (Stock Splits)
1) Reduce the price of the stock, more people can purchase
the stock at a lower price
===> Berkshire Hathaway Example
B)
Stock splits require no journal entries

1)
C)
Stock splits and par value

1)
6)
A memorandum entry should be made to record the stock split
Stock splits reduce the par value proportionately
D)
Stock splits increase the # of shares outstanding
E)
Stock Split Example

1)
Before the stock split

a)
2 for 1 stock split
b)
100,000 shares outstanding
c)
Par value = $ 10.00 per share
d)
Market Value = $100.00 per share
2)
After the stock split

a)
200,000 shares outstanding
b)
Par value = $ 5.00 per share ($10.00 /2)
c)
Market Value = $50.00 per share ($100.00/2)
Recording Corp. Dividends - Corporation

A)
Date of Declaration
Dividends Declared or Retained Earnings
Dividends Payable
B)
1,000
1,000
Date of Record
NO ENTRY REQUIRED
C)
Date of Payment
Dividends Payable
Cash
D)
1,000
1,000
Dividends should be based on the number of shares outstanding.

=> Shares Outstanding = Shares issued - Treasury Stock Shares
30
7)
Stock Dividend (Small => Under 20%)

A)
Stock Dividend => Purpose => Conserve Resources (assets)
B)
Small Stock Dividend => Under 20% of the => shares outstanding
C)
Small Stock Dividend => Example

Information
A)
Shares Outstanding (Common Stock) => 100,000
B)
2% Stock Dividend Declared (June 15, 20X7)
C)
Market Rate => Date of Declaration => $50 Per Share
D)
Date Issued (the shares) => July 1, 20X7
E)
Par Value Per Share => $ 10
F)
Solve
June 15, 20X7 => Declaration

Retained Earnings
Stock Dividends Distributable - C/S
Add. PIC - C/S
Debit
100,000
Credit
Debit
20,000
Credit
< =(100,000*.02)*50
20,000 < =(100,000*.02)*10
80,000 <= Plug
July 1, 20X7 => Date Issued (Common Stock)

Stock Dividends Distributable - C/S
Common Stock
Date Issued ===>
20,000
Stock Div. Dist. - C/S

20,000
20,000 <= Declaration
The below account is a permanent account (balance sheet account) that

will hold the par value of the common stock shares until the common stock
shares are issued.
Account => Stock Dividends Distributable - C/S
31
AIF - Chapter 16 - Operational Assets

1)
Accounting Equation
Assets =
PP & E
Liabilities +
Owners' Equity
Equipment / Buildings
XXX
Accumulated Depr.
XXX
XXX
Land
XXX
NO DEPRECIATION EXP
Patents
XXX
Intangible Assets
Natural Resources
Amortization Expense
XXX
Mines
XXX
Depletion
creates
Inventory
Inventory
XXX
Cost of Goods Sold

XXX
Customer picks up the ore,

then the inventory becomes an
expense (cost of goods sold).
2)
Property, Plant, & Equipment

A)
Balance Sheet Presentation

Equipment
Less: Accumulated Depr.
10,000
7,000
3,000
Value found on the balance sheet

Also called==>Book Value, Carrying Value, &
Remaining Undepreciated Cost
32
B)
Assets found in PP & E

1)
Land - Not depreciated
2)
Buildings
3)
Equipment
C)
PP & E assets are viewed as long-term assets (benefit more than one accounting period)
D)
Acquiring PP & E
1)
PP & E assets are capitalized - placed on the balance sheet, not expensed
all at once (used in the business, NOT FOR RESALE (not inventory))
2)
Other items added to PP & E
3)
a)
Sales tax
b)
Setup costs
c)
Freight
d)
Key - The capitalized asset should include all costs necessary to get
the asset ready for its intended use.
Capitalized Cost example - PP & E ( Buildings & Equipment )

a)
Company buys a drill press for the shop = invoice price = $10,000
b)
Sales tax for drill press = $800
c)
Freight to get the drill press to the shop = $ 500
d)
Necessary setup charges = $ 200
e)
Solve for Capitalized Cost

Invoice Price
Sales Tax
Freight
Setup Charges
10,000
800
500
200
Capitalized Cost
11,500
Starting point for depreciation

Cost placed on the balance sheet, before any depreciation expense (taken)
4)
Items that should NOT be capitalized (generally)

=> items that are recurring in nature are generally not capitalized
---> property taxes paid each year, insurance paid each year, & other recurring items
---> items not part of the asset acquisition should not be capitalized
33
5)
Capitalized Cost example - PP & E ( Land)

a)
6)
b)
Land is part of the PP & E balance sheet category (must be used in the operations
of the business)
Land is NOT depreciated
c)
Items included in the cost of land

1)
Invoice / purchase price of the land
2)
Costs to clear the land for its intended use
3)
Real estate fees & closing cost fees
4)
Key - The capitalized asset should include all costs necessary to get
the asset ready for its intended use.
Capital Expenditure Vs. Revenue Expenditure

a)
b)
Capital Expenditure - the expenditure's benefits extend beyond the current period
1)
Examples - PP& E, Intangible Assets, and other Long-Term Assets
2)
Capitalized Cost - Generally found on the balance sheet
Revenue Expenditure - the expenditure's benefits do not extend beyond the current period
1)
Example ==> Salary of an office worker
2)
An expense is created
Office Salaries Expense

Cash
850
850
34
3)
PP & E , Matching Principle & Depreciation Expense

A)
Matching Principle - Accrual accounting tries to match the benefits (revenues generated)
with the expenses that created the benefits.
1)
B)
Assets used ==> benefits received

Match => benefits with => expenses (use)
Recognize Depreciation Expense

500
500
1)
Depreciation Expense => Reduces Net Income
2)
Depreciation Expense => Is Not a cash outflow
3)
A credit to Accumulated Depreciation reduces total assets

Accumulated Depr.
XXX
Contra Asset
Not closed - balance sheet account
C)
4)
The recording of depreciation is not an attempt to measure fair

market value. Depreciation is just the systematic allocation of
the cost of an asset over the life of the asset (book value not equal to FMV).
Depreciation Calculations
A)
Factors impacting the depreciation calculation

1)
Capitalized cost of the asset (not an estimate)
2)
Estimated useful life

a)
Useful life is impacted by:

1)
Physical wear & tear
2)
Obsolescence - (Example) - the obsolescence of computers (quickly worth nothing)
3)
Estimated Salvage Value / Residual Value
4)
Depreciable Cost
a)
Depreciable cost = Capitalized Cost of the asset - Salvage Value of the asset
35
5)
Depreciation Methods
A)
Straight-line Depreciation
1)
Straight-line Formula =
Capitalized Cost Salvage Value

Estimated useful life of the asset
2)
Matching Principle ==> Straight-line depr. assumes the benefits received

each period are the same, so the depr. expense
each period should be the same.
3)
Straight-line depr. method will report the same depr. expense

each period.
4)
Straight-line example
a)
Purchase price of the equipment =

freight charges
Capitalized Cost
b)
Life of the asset =
c)
Est. Salvage Value =
d)
Solve
Straight-line Formula =
6 years
1,000
Cost
Salvage Value
Estimated useful life of the asset
7,000
1)
5,000
2,000
7,000
1,000
Record the depr. expense

Depr. Expense
1,000
Accumulated Depr.
2)
Depr. Exp.
Each Year
1,000
1,000
Book value after recording depr. expense
Equipment
Book Value
1,000
1,000
2,000
Year 1
7,000
1,000
6,000
Year 2
7,000
2,000
5,000
Yr. 1
Yr. 2
Ending Bal. Yr. 2
36
B)
Units-of-Production
1)
Units-of-Production formula =
Capitalized Cost - Salvage Value

Estimated output
can be hours, units produced, miles, and any other output measure
2)
3)
2 steps for figuring ==> units-of-production

a)
Step 1:
Figure ==> Depr. expense per unit of output (see above formula)
b)
Step 2:
Figure ==> Depreciation Expense = Depr. expense per unit X Actual Output
Units-of-Production example
a)
Purchase price for equipment

Sale Tax for equipment
Capitalized Cost
b)
Salvage Value =
1,000
c)
Actual hours worked the first year =
8,000
d)
Actual hours worked the second year =
e)
Estimated hours of output from the machine
Units-of-Production =
Per unit of output
Step 1:
Step 2:
8,000
2,000
10,000
Cost
10,000
100,000
Salvage Value
Estimated Output
10,000
1,000
100,000
Figure ==> Depreciation Expense = Depr. expense per unit X Actual Output
Depr. Expense = .09 X 8,000 hours the first year =
1)
720
Record the depr. expense

Depr. Expense
720
Accumulated Depr.
2)
720
Book value after recording depr. expense

Equipment
Book Value
Year 1
10,000
720
9,280
Accumulated Depr.
720 Year 1
900 year 2
1,620
3)
Exp. Per Hour

0.090
Year 2
10,000
1,620
8,380
10,000 X .09
Matching Principle ==> Units-of-production method assumes depr. expense is a function

of use (benefits received from use). As a company uses the asset, the
asset's value should decrease do to the use / wear and tear.
(match benefits with expenses)
37
C)
Double-Declining Balance (DDB)

1)
2)
Double-Declining Balance is an accelerated depreciation method

a)
More depreciation is taken in the earlier years of the asset's life
b)
Matching Principle ==> DDB assumes more benefits will be received in the earlier years of an
asset's life. Since more benefits are produced in the earlier
years of an asset's life, more depreciation expense
should be matched with the earlier years.
c)
Real-life examples
1)
Car ==> A car's value will decrease faster in the first few years of a car's life.
2)
Computer => A computer's value will decrease faster in the first few years of a computer's life.
DDB Calculation
a)
Step 1: Figure the depreciation rate

Depreciation rate = ( 1 / estimated useful life of the asset ) X 2
b)
Step 2: Figure the depreciation expense

Depreciation expense = Depreciation Rate X Book Value of the Asset
Note: Look at the starting point for the first year. The book value
equals the capitalized cost of the asset (starting point).
c)
Do not depreciate more than the depreciable cost. Once the book value
equals the salvage value, stop the DDB depreciation expense process.
d)
DDB Example
Asset Purchased, January 1, 20X5
Asset's capitalized cost =
Salvage Value
Est. Life of the Asset
10,000
5,250
8 Year
Step 1: Figure the depreciation rate

Depreciation rate = ( 1 / estimated useful life of the asset ) X 2
Depreciation Rate =
( 1 / 8) * 2 =====>
0.25

Depreciation expense = .25 X 10,000 ===>
2,500
Note: First year: Book Value equals cost

2,500
2,500
38
39
Year 2:
Year 1
10,000
2,500
7,500
Equipment
Book Value

1,875
1,875
Year 1
10,000
2,500
7,500
Year 2
10,000
4,375
5,625
Equipment
Book Value
1,875
Year 3
Years 4 - 8
10,000
###
4,750
4,750
5,250
5,250
Year 3:
1,406.25
Do not use
Note: Year 3, cannot depreciate past the book value

Book Value: Year 2 =
Salvage Value
Plug: Year 3
5,625
5,250
375
375
< === Use
375
Years 4 - 8:
No depreciation will be taken in years 4 - 8.
40
3)
Double-Declining Balance - Other

There is a quick way to figure the DDB method.
=> formula (life = 8 years, capitalized cost = $10,000)
(1/8)*2 = .25 (the depreciation rate)
BB PPE item * ( 1 - Depr. Rate) = EB PPE item
The change in the net value of the PPE item will be
the depreciation expense recorded for the period.
=> example (using the DDB example numbers)
Period # 1: $ 10,000 * ( 1 - .25) = $ 7,500
Period # 2: $ 7,500 * ( 1 - .25) = $ 5,625
Period # 1: BB PPE Item: $ 10,000

Period # 1: EB PPE Item: $ 7,500
Period # 2: BB PPE Item: $ 7,500

Period # 2: EB PPE Item: $ 5,625
Depr. Exp.
$
2,500
Depr. Exp.
$
1,875
41
6)
Disposal of PP & E
A)
Step 1: Make sure depr. expense has been updated to the point of sale
B)
Step 2: Record the Sale
C)
Disposal of PP & E - Example

1)
2)
3)
4)
5)
Equipment is sold on June 30th, 20X1

Straight-line depreciation each year = $ 2,000
Capitalized Cost of the Equipment = $ 20,000
Asset was sold for ==> $ 9,000
Accumulated Depreciation = $ 12,000
Equipment
20,000
Accumulated Depr.
12,000 Past depr. recorded
1,000 January 1, 20X1 - June 30, 20X1
13,000
Cost
Accumulated Depr.
Book Value
Cash Received
Gain on Sale of Equip.
20,000
13,000
7,000
9,000
2,000
Step 1: Update Depr.

1,000
1,000
2,000 X 1/2 a year

Step 2: Record the sale of the asset
Cash
Equipment
Gain on Sale of Equip.
9,000
13,000
20,000
2,000
42
7)
Natural Resources
A) Examples of Natural Resources
1)
Coal
2)
Gold Mine
3)
Oil
B)
Formula for Depletion =
Cost
Salvage Value
Estimated units of Natural Resources
C)
Depletion ==> Creates ==> Inventory
43
8)
Intangible Assets & Amortization Expense

A)
Intangible Assets ==> have no physical substance
B)
Intangible Asset Examples

1)
Goodwill
=> General Example
=> Total Stock Value => $25,000
=> FMV Assets - FMV Liabilities => $ 17,000 - $ 7,000 => $ 10,000
=> Net Assets = FMV Assets - FMV Liabilities
=> Total Stock Value - (FMV of the Net Assets ( FMV Assets - FMV Liab.)) = Goodwill
=> $ 25,000 - $ 10,000 = Goodwill of => $ 15,000
=> Internally generated goodwill will NOT be found on the balance sheet
C)
2)
Patents
3)
Copyrights
Purchase a Patent (example)

Patent
57,000
Cash
D)
57,000
Journal entry to amortize an intangible asset

Amortization Expense
Patent
1,200
1,200
The above entry will increase an expense and reduce an asset's value.
The above journal entry will reduce net income (income statement issue).
The above journal entry will not reduce the company's cash (st. of cash flows issue).
E)
An intangible asset should be amortized over the shorter of an intangible asset's

economic life or an intangible asset's legal life.
F)
Remember ====> Matching Principle

The patent creates benefits. The benefits are matched with the cost of the
intangible asset (over the useful life of the asset).
44
9)
Revision of Estimates
A)
Periodically the initial estimates about an asset will be incorrect.

(example => A corporation buys a piece of factory equipment. The initial
life is assumed to be 10 years. The corporation uses the equipment one year
and realizes the equipment will only last 4 years. The corporation will need to
revise the asset's life (change from 10 to 4 years).
B)
A revision of an estimate is not an error.
C)
Formula
Carrying Value - Revised Salvage Value
Remaining Useful Life
D)
10)
====>
Depr. Expense
An estimate change will impact the current period and future periods. Previous
financials statement will not be revised.
Ordinary Repairs & Ordinary Maintenance

A)
An ordinary repair should be expensed in the period the expense is incurred.
B)
Example Journal Entry

Maintenance Expense
Cash
200
200
45
11)
Exchange of Similar & Dissimilar Assets (New GAAP rules)

A)
Exchange of Similar Assets => Car exchanged for a car

=> Loss always recognized
=> Gain => Generally recognized (always for this class)
Record the exchange at the fair market value of the asset
received.
=> Example
* FMV => New Car
Cost of Old Car
A/D Old Car
12,000
10,000
7,000
Journal Entry
FMV =>
B)
Equipment (new car)

A/D - Old Car
Equipment (old car)
Gain on Exchange
12,000
7,000
10,000
9,000
Exchange of Dissimilar Assets => Car exchanged for a boat

=> Loss always recognized
=> Gain will be recognized
Record the exchange at the fair market value of the asset
received.
=> Example
* FMV => New Boat
Cost of Old Car
A/D Old Car
15,000
20,000
2,000
Journal Entry
FMV =>
12)
15,000
2,000
3,000
20,000
Extraordinary Repairs & Betterments

=>
13)
Equipment (new boat)

A/D - Old Car
Loss on Exchange
Equipment (old car)
Repairs and betterments that extend the life of the asset or

make the asset better should be capitalized.
Additions => should be capitalized

=>
A company adds a new building to a shop. This addition

should be capitalized.
46
14)
Tax Laws
=> Depreciation is based on MACRS.
=> MACRS => Modified Accelerated Cost Recovery System
=> The MACRS rules classify property based on the tax laws.
=> Half-year convention => A company can generally only depreciate
an asset for half of the first year (based on the IRS rules).
=> The MACRS rules do not allow for any salvage value of the asset
at the end of the life of the asset (under the IRS rules).
15) Land held for speculation / held as an investment (not part of the operating assets)
=> This type of land should be classified as an investment asset (not part of PP&E).
16)
Research & Development (R&D)

=>General Rule => Expense
=> Reason => High degree of uncertainty with the success of R&D
projects (conservative approach)
=> Exceptions to the general rule
=> Long-Term R&D assets that will benefit more than one
R&D project should be capitalized. The long-term R&D asset will then
be depreciated (example => R&D research building).
=> legal and filing fees should be capitalized (for
an internally created patent)
17)
Impairment Issues
=>
General Idea => An impairment adjustment will need to be made to

account for the decrease in the value of a long-term asset.
A) Limited-Life Intangibles (example=> a patent)

Recoverability test => then fair value test
B) PP & E => Recoverability test => then fair value test
Impairment Loss
Accumulated Impairment Loss (contra-asset account)
C) Indefinite-Life Intangibles (example => goodwill) => fair value tests
47
18)
Reporting Investing Activities (assets of the business)

A) Trading Securities (purchasing stocks & debt securities as investments)
=> Valued on the balance sheet at FMV (current asset)
=> Assumed to be sold within the near future (intent of management)
=> Unrealized gains & losses will impact net income (shown on the income statement)
=> Example (Trading Security)
November 1 => Purchased 1,000 shares of Adams Inc. @ $20.00 per share
Trading Security - Adams Inc.
Cash
20,000
$
20,000
Dec. 31, Year-End Value => 1,000 shares of Adams Inc., FMV @ $22.00 per share
Trading Security - Adams Inc.
Unrealized Gain - Trading Sec.
2,000
$
2,000
*****Unrealized Gain - Other Income Item - (on the income statement)

B) Available-for-Sale Securities (purchasing stocks & debt securities as investments)
=> Valued on the balance sheet at FMV (generally classified as investment assets, not current assets)
=> Securities assumed to not be sold in the near future (intent of management)
=> Unrealized gains & losses will NOT impact net income
=> Unrealized gains & losses will be found in
stockholders' equity (balance sheet, other comprehensive income)
C) Held-to-Maturity Securities (example => investing in another corporation's bonds)
=> Intent of management => hold to maturity
=> Valued on the balance sheet at amortized cost
---> (generally classified as an investment asset, not a current asset)
---> can move to a current assets based on maturity date
48
19)
Ethical Case:
You start a small oil corporation. This corporation has a few
assets. The assets' prices have increased in value.
The reputation of your business has also grown over the
past few years. Your customers know and value your
technology.
Your accountant creates the below information.
Cash
A/R
PP&E
Patents
Total
Per GAAP
100,000
120,000
650,000
20,000
890,000
You believe the accountant's numbers do not

reflect the true economic values.
Cash
A/R
PP&E
Patents
Goodwill
Total
Est.
Economic
Value
100,000
120,000
900,000
1,200,000
500,000
2,820,000
Issues:
The financial statements should be created in conformity
with GAAP rules. GAAP usually will not let long-term assets
be increased in value. The internally generated goodwill
will NOT be found on the balance sheet.
20)
IFRS - Long-Term Assets

International Financial Reporting Standards (IFRS) - Key Items
=> IFRS will allow impairments to be reversed (based on the IFRS
conditions). GAAP rules will not allow impairments
to be reversed.
=> IFRS will allow long-term assets to be
valued at FMV ( based on IFRS rules).
49
Chapter 17
1) Comprehensive Income
A)
Define - Measures all changes in owners' equity except

1)
Except - Investments by owners & distributions to owners
2)
Except - Errors made on past financial statements
2) Major Financial Statement=> Income Statement

A)
Purpose => The income statement reflects the earnings generated by the
company during the accounting period.
B)
Types of Income Statement Formats

1)
Single-step Format
a)
2)
Total Revenues - Total Expenses
Multi-Step Format
a)
Under the multi-step format, income & expenses are divided by the
activities that created the income or expense
50
3) More on the Multi-Step Format

A)
Net Sales = Sales - Sales Returns & Allowances - Sales Discounts
B)
Gross Profit = Net Sales - Cost of Goods Sold
Expense!!!!
1) Gross Profit = Gross Margin (same number)

C)
Income from Operations = Gross Profit - Selling & Administrative Expenses (Operating Exp.)
D)
Other Revenues & Other Expenses

1)
2)
3)
4)
5)
6)
Interest Revenue / Interest Income

Gains
Dividend Revenue / Dividend Income
Interest Expense
Losses
Unrealized Gains & Losses on Trading Securities
E)
Income From Continuing Operations (before taxes)
F)
Income Taxes
G)
Income From Continuing Operations

1)
H)
Income From Continuing Operations => AFTER-TAX NUMBER
DE items
1) D = Discontinued Operations (net of taxes)
2) E = Extraordinary Items (net of taxes)
I)
Net Income
4) More on the DE Items (all net of taxes)

A)
D = Discontinued Operations (net of taxes)

1)
Discontinued operations are operations management of a company believes

will not contribute to the operations of the business in the future.
2)
Reason for separation - Show financial statement readers the discontinued operations
will not contribute towards future earnings.
a)
If the discontinued operations were mingled with the other central operations of the
business, a reader could not see the sections of the business that will not
contribute to the future earnings of the business.
51
3)
Discontinued Operations (Gain) - Shown Net of Taxes

a)
Discontinued Operations - Gain
b)
Tax Rate - 30%
c)
Discontinued Operations ==>

1)
4)
700 <= Shown on the

Income Statement
(net of taxes)
Discontinued Operations (Loss) - Shown Net of Taxes

a)
Discontinued Operations - Loss
b)
Tax Rate - 30%
c)
Discontinued Operations ==>

1)
B)
( 1,000 X ( 1 - .3))
1,000 (Before Taxes)
( -10,000 X ( 1 - .3))
(10,000) (Before Taxes)
(7,000) <= Shown on the

Income Statement
(net of taxes)
E = Extraordinary Item (net of taxes)

1)
2)
Extraordinary Items => 2 requirements => Both must be met

a)
Unusual => Unusual for the business (not a typical transaction)
b)
Infrequent => Event does not happen very often (almost never again)
Extraordinary Example
a)
3)
4)
Gas fire in Hutchinson --> Say a business was damaged by the gas fire,
this type of event is very unusual and should never happen again.
Why Important to Separate Out

a)
Show the financial statement readers the event is not part

of the normal operations of the business. The event should not
be used to evaluate the future earning potential of the business (event
should never happen again).
b)
Without separating extraordinary events out, readers would believe the

events were part of the normal operations of the business.
Extraordinary Items => Shown => Net of Taxes
52
5) Earnings Per Share ===> EPS

A)
Earnings Per Share Formula =
1)
B)
Net Income - Preferred Stock Dividends

Weighted-Average # of Common Shares Outstanding
Remember => Shares Outstanding = (Shares Issued - Treasury Stock)
EPS Example:
1)
2)
Net Income = $ 600,000

Preferred Stock (Shares Issued = 60,000, P/S Share in Treasury = 5,000
P/S rate = 6%, P/S par value = $100) , (60,000 -5,000) * 100 * .06 =
3)
4)
5)
Common Stock Shares Outstanding ( Jan. 1 - March 31) =

Common Stock Purchased (Treasury Stock), (April 1)
Additional Shares Issued (September 1)
6)
Solve - EPS
a)
330,000
30,000 Shares
5,000 Shares
20,000 Shares
Weighted-Average # of Shares Outstanding
(30,000-5,000)
(25,000+20,000)
30,000 X
25,000 X
45,000 X
3 / 12
5 / 12
4 / 12
7,500
10,417
15,000
32,917
or (30,000-5,000+20,000)
b)
C)
EPS =
$ 600,000 - $ 330,000
32,917 Shares
=====>
8.20
Diluted Earnings Per Share

* Items => Stock Options & Convertible Debt
53
6) Financial Accounting Standards Board (FASB) - Statement 154

=> Accounting Changes & Error Corrections
A)
Past History
=> The income statement would account for the
total change from one accounting principle to another
accounting principle. This catch-up number was called
a cumulative effect of a change in accounting principle.
The catch-up number would adjust net income in total
for the past differences between the two accounting principles.
Example
=> DDB deprecation => would be higher than straight-line depreciation
B)
Current FASB rules - Statement 154

=> Changes in accounting principles from one period to the next period
should be handled retrospectively.
=> Retrospectively => Retrospective treatment means that past
financial statement should be restated to adjust for the application
of the new accounting principle.
=> Exception to the General Rule
=> Past accounting rules required a change in a depreciation
method to be treated as a cumulative effect of a change in accounting principle.
=> Statement 154 treats a change in a depreciation method
as a change in an estimate. This change will only impact
current and future periods. Use the same logic for changes
amortization and for changes in depletion.
C)
The Book (old book issue)=> Cumulative Effect of a Change in Accounting Principle
The new rules have replaced the cumulative accounting logic
found in the book.
54
7) Earnings Quality
A) Definition of Earnings Quality
Definition => High quality earnings should help a financial statement reader
predict future earnings.
*Transitory Earnings => Transitory earnings are earnings that are not
part of the normal earning process.
* (not what the company does), (not part of the normal
earning process)
* Example => Gains & Losses on PP&E Item (selling PP&E assets)
* Example => Impairment Item
* Permanent Earnings => The earnings generated from the central operations of the business.
* Permanent earnings are usually income statement accounts found
before the "other items."
* Net Sales
* Cost of Goods Sold
(Gross Margin)
* Selling & Administrative Expenses (Operating Exp.)
8) A new revenue recognition process will be used by the business world (rules for 2017).
This revenue recognition process will replace the old GAAP rules.
A)
Old GAAP Rules

Two Conditions
1) Earned
2) Revenue must be realized or realizable
a. realized (cash now)
b. realizable (receive something that can be converted into value (A/R))
B)
New Rules (starting in 2017)

Logic of the Five-Step Process
The new rules will take an asset/liability approach. The new approach will look
at the changes in an entity's assets and the changes in an entity's liabilities.
These changes in the assets and the liabilities will be used to develop the
revenue that should be recognized.
The asset => the consideration to be received from the customer (value to be received)
The liability => the obligation to the customer
Steps in the Five-Step Process
1) The business entity should identify the contract(s) with the customer.
2) The business should identify the separate performance obligation(s)
with the customer (liability or liabilities).
3) The business entity should determine the transaction price (consideration/value/asset(s)).
4) The business should then allocate the transaction price
to the separate performance obligation(s).
5) The business should recognize revenue after each performance
obligation is satisfied.
55

56
AIF - Chapters 20 - Financial Statement Analysis

1)
Financial statement analysis:

A)
Leadership Position - Hopefully each student will be in a leadership

position. Leaders generally must look at financial statements.
B)
Personal Financial Responsibility - Our generation cannot rely on pension plans.

1)
C)
Individual Stock Purchases - Life Application

1)
2)
Our generation must take responsibility for our own personal investment.
I believe everyone in this room will have some individual stock ownership.
Any financial statement analysis knowledge should help you make
better investment decisions.
Major users of financial analysis

A)
B)
Creditors - Banks & Bond Investors

1)
Creditors want to make sure they get their investments back and receive a return.
2)
Credit Rating Agencies ---> Watched closely by creditors ( Moody's & Standards & Poor)
Equity Investors - Individuals with a stock ownership in the company.

1)
2)
Equity investors want the stock to generate an acceptable return.

A)
Returns from ---> Stock price increasing
B)
Returns from ---> dividends (if an issue)
What happens when an investor does not feel he or she will receive an acceptable rate
of return?
**
Investor will ---> Sell the stock
3)
Horizontal vs. Vertical Analysis

A)
Horizontal analysis generally compares one period against another period

1)
B)
Vertical analysis compare a given period by a total for the period

1)
2)
4)
Horizontal analysis compares:
Vertical analysis compares:

a)
Balance sheet -----------> account / total assets
b)
Income statement -----> account / total net sales
Common-Size Analysis - Every account in relation to some item
Ratio Analysis
A)
Activity Ratios
1)
Why care about "activity ratios?"

a)
2)
Answer ---> Activity ratios help a financial statement reader assess

whether the company is experiencing any changes in the
normal flow of business.
Major Activity Ratios

a)
Accounts Receivable Turnover Ratio =

Net Credit Sales
Avg. Net Accounts Receivable
Importance: The ratio explains how fast the company is
converting accounts receivable into cash.
1)
General Rule: A company wants to increase the accounts

receivable turnover ratio.
a)
Why ----> Higher ratio means cash is coming into the

business faster.
b)
Inventory Turnover Ratio =

Cost of Goods Sold
Avg. Inventory for the Period
Importance: The ratio explains how fast the company is
converting inventory into sales.
1)
General Rule: A company wants to increase the inventory

turnover ratio.
a)
B)
Why ----> Higher ratio means inventory is not building.

Companies want to keep inventory as low as
possible and satisfy customer needs.
Also, inventory does not produce a return (compared
to a short-term investment).
Liquidity
1)
Current Ratio =
Current Asset
Current Liabilities
Importance: The ratio shows the amount of current assets to
cover current liabilities.
General Rule: A banker would be more likely to give a short-term loan to a

company with a high current ratio vs. a low current ratio.
*
2)
Why ----> A high current ratio means a banker has a higher

likelihood of receiving the bank's money back.
Working Capital = Current Assets - Current Liabilities

Importance: This calculation tries to measure the short-term liquidity
of a business. Could the current assets cover the current
liabilities?
C)
Major Profitability Ratios

1)
Gross Margin Ratio =

Gross Margin
Net Sales
Importance: The ratio shows the % of profit generated by
each sale ( Gross Margin = Net Sales - Cost of Goods Sold)
2)
General Rule: A company wants to increase the gross margin on

each sale. The additional gross margin can be used
to cover expenses below the gross margin.
Earning Per Share (EPS)

Net Income - Preferred Dividends
Weighted - Avg. # of Common Stock Outstanding
Importance: The EPS ratio is the most talked about financial ratio.
*
3)
General Rule: A company wants to increase its earnings per share.
Price-earnings Ratio
Current Stock Market Price
Earnings Per Share (EPS)
Importance: As the P/E ratio increases, the stock becomes
a more expensive stock.
*
General Rule: An investor wants to buy a stock before the P/E ratio increases.
D)
Evaluating Debt Financing

1)
Debt to Equity Ratio =
Total Debt
Total Equity
Ratio of 1 => Debt financing equals equity financing
Ratio of 1.5 => More debt financing than equity financing
Who Cares????
a)
General rule, as the debt to equity ratio increases = > the

risk associated with the business increases (default risk)
Remember the Accounting Equation

*

If you know 2 of the 3 values, you can solve for the missing
value.
2)
Times Interest Earned Ratio

*
Equation =
Example
Earnings before Interest & Taxes

Interest Expense
30,000 =
10,000
3.00
The above example shows a business generating 3 times

the cash inflows to pay for any interest payments.
General Rule: As the times interest ratio goes up, the firm
is in a better position to payoff creditors.

AIF - Chapter 18 - Balance Sheet

1)
Balance Sheet / Statement of Financial Position

A)
General Formula
1)
B)
C)
D)
Reports => Assets ==> Resources having future economic benefits

1)
Types of Assets
2)
Amount of Assets
Reports => Liabilities ==> Liabilities represent future economic sacrifice of resources
1)
Types of Liabilities
2)
Amount of Liabilities
Reports => Owners' Equity ==> Residual interest in the corporation

1)
Assets - Liabilities = Owners' Equity

Residual Interest
2)
Classified Balance Sheet

A)
Why Classify ==> The balance sheet is classified to help readers

understand the different types of assets, liabilities, and owners' equity.
B)
Major Classifications
Note: Assets are placed on the balance sheet according to
their liquidity (Liquidity = > How easily can the asset
be converted into cash).
1)
Current Assets - These assets will be converted into cash or used up within one year.
a)
Common Current Assets

1)
Cash
2)
Marketable Securities
==> Trading Securities (value at FMV)
3)
A/R
====>
A/R
Less: Allow. for D/A
10,000
(600)
9,400
*** Net Realizable Value (expected cash to be received)
2)
4)
Inventory
5)
Prepaids
Investments ==> Long-term investments made by a company

a)
b)
c)
Best Example - A company purchases another company (makes an investment)

Land held for speculation (non-operational asset)
Available-for-Sale Securities (at FMV) & Held-to-Maturity Securities (amortized cost)
(not meeting the definition of a current asset)
3)
Property, Plant, & Equipment ( PP & E)

a)
b)
Characteristics of PP & E
1)
Tangible assets - can touch and feel ( have physical substance)
2)
Used in the business
3)
Long-Term Assets
PP & E assets are shown ( net of accumulated depreciation) => Balance Sheet
1)
c)
4)
Exception ===> Land is not depreciated
Examples of PP & E
1)
Land
2)
Buildings
3)
Equipment
4)
Capital Leases
Intangible Assets
a)
Intangible assets lack physical substance
b)
Patents =>Shown on the balance sheet => Net of Amortization
c)
Examples of Intangible Assets

1)
Patents (net of amortization)
2)
Goodwill - (reviewed annual for a decreased in the value )
5)
6)
Current Liabilities: (Liability order based on the timing of payment)

a)
Remember
Liabilities
XXXXX
b)
Define ==> Current Liabilities ==> economic sacrifice of resources

within one year
c)
Examples (Current Liabilities)

1)
Accounts Payable
2)
Salaries Payable
3)
Taxes Payable
4)
Notes Payable (short-term)
5)
Unearned Revenue
6)
Accrued Liabilities
7)
Customer Deposits (likely returned to the customer)
8)
Bank overdrafts (general rule)
Long-Term Liabilities
a)
Define ==> Long-Term Liabilities ==> future economic sacrifice of resources

beyond the next year
b)
Examples
1)
Notes Payable ( Long-Term)

Notes Payable
Less: Discounts on Notes Payable
Carrying Value
2)
10,000
500
9,500
Bonds Payable
Bonds Payable
Premium on Bonds Payable
Carrying Value
c)
Long-Term Liabilities can become ==> Current liabilities
d)
Banker Classification Example
30,000
1,000
31,000
7)
8)
Stockholders' Equity: Contributed Capital

a)
Define - Value provided by the owners
b)
Examples
1)
Common Stock
2)
Preferred Stock
3)
Additional Paid-in Capital
Stockholders' Equity : Earnings Retained

a)
Retained Earnings summarizes the earnings retained by the corporation

Retained Earnings
Normal Bal.
Net Loss
Net Income
Dividends
Declared
9)
Stockholders' Equity: Other

a)
3)
Treasury Stock ==> Contra-Equity Account
Go over a balance sheet example
4)
Different Types of Audit Reports

A)
Unqualified Opinion - Financial statements conform to GAAP

1)
Clean, no material errors or misstatements
B)
Qualified Opinion - Financial statements are clean - except for

an item (an auditor might not agree with one
application of a GAAP principle)
C)
Adverse Opinion - Financial statements are not found to be

in accordance with GAAP.
1)
D)
Material errors - mislead a financial statement reader
Disclaimer of Opinion - No opinion is given on the financial statements

1)
Might be a scope restriction

a) Example of a scope restriction
1)
Bob owns a CPA firm that audits a Manhattan client.

Inventory represents a large asset for this client.
The inventory is warehoused in Colorado.
The Manhattan client will not let Bob & his staff investigate the
inventory in Colorado.
Bob cannot give an opinion on the financial statements without
investigating the inventory in Colorado.
5)
Statement of Retained Earnings

A)
This statement is a link between the income statement

and the balance sheet.
B)
General Flow => Statement of Retained Earnings

Beginning Balance, Retained Earnings
+ or - Prior Period Adjustments
Adjusted, Retained Earnings Balance
+ or - Net Income
XX
XX
XX
XX
Ending Balance, Retained Earnings
XX
C) Prior Period Adjustments

=> Adjustments to => Beg. Balance Retained Earnings (net of taxes)
=> Previously undiscovered error
AIF - Chapter 19 - Statement of Cash Flows

1)
Statement of Cash Flows

A)
Provides a link between the income statement & the balance sheet
B)
Assesses the entity's ability to generate positive future cash flows
C) Assesses the entity's ability to meet obligations (pay debts) &

pay dividends
D) Assesses the differences between net income
and cash flows
E)
Assess both cash & noncash investing and financing activities

1)
Example - Cash Investing

Equipment
Cash
50,000
50,000
Cash Payment for equipment

2)
Example - Noncash Investing & Financing

Equipment
Bonds Payable
50,000
50,000
Investment in equipment without any cash outflow

Cash will flow from the business as the bonds are paid off
68
2)
Sections of the Statement of Cash Flows

A)
Operating Section
1)
Reports cash flows from ==> Normal operations of the business

a)
The main business activities of the business

1)
B)
Examples => selling grain & selling lumber
b)
Cash paid for interest
c)
Cash received from interest
d)
Cash received from dividends
e)
Cash paid for taxes
Investing Section
1)
Acquiring & Disposing of PP & E and other long-term investments
2)
Example => Buy Equipment (PP & E) or Sell Equipment
3)
Short-Term Marketable Securities

=> investments with a life greater than 90 days
4)
Principal transactions (Lending money to other entities)

=> Notes Receivable (principal only)
69
C) Financing Section
1)
Groups transactions relating to the financing of the business
2)
Examples
3)
a)
Issue Stock => Cash Inflow
b)
Issue Bonds => Cash Inflow
c)
Buy treasury stock => cash outflow
d)
PAYMENT of dividends (cash outflow), not the declaration of dividends
e)
Pay off Bonds Payable => Cash outflow
Short-Term Debt (general obligation debt)

a)
Example => Short-term Note Payable
D) Minor Section - Statement of Cash Flows (Footnotes)

1)
Footnotes - report noncash investing & financing activities

a)
2)
Examples - Equipment purchased

Equipment
Bonds Payable
50,000
Equipment
Common Stock
75,000
50,000
75,000
Footnotes => Disclose

a)
Cash paid for interest
b)
Cash paid for income taxes
70
3)
More examples of transactions found in each section - statement of cash flows

A)
Operating Section
1)
2)
B)
Cash Inflows
a)
Cash received from customers
b)
Cash received from interest revenue and dividend revenue
Cash Outflows
a)
Cash paid to suppliers
b)
Cash paid for operating activities
c)
Cash paid for interest expense
d)
Cash paid for taxes
Investing Section
1)
2)
Cash Inflows
a)
Selling equipment
b)
Selling a building
c)
Principal returned (from a Note Receivable (asset))
d)
Short-Term Marketable Securities (cash received)

Cash Outflows
a)
Buying equipment
b)
Buying a building
c)
Principal invested (from a Note Receivable (asset))
d)
Short-Term Marketable Securities (cash paid)
71

C) Financing Activities
1)
2)
Cash Inflows
a)
Borrowing / Issuing Debt

=> Short-Term Note Payable (general obligation debt)
=> Long-Term Debt (example => Bonds)
b)
Issuing / Selling Equity => Stocks
c)
Selling / Reissuing Treasury Stock
Cash Outflows
a)
Pay off long-term debt => Bonds Payable

=> Short-Term Note Payable (general obligation debt)
=> Long-Term Debt (example => Bonds)
b)
Purchasing treasury stock
c)
PAYING dividends
1)
Does NOT include just declaring a dividend
72
4)
Major Differences Between the Income Statement & the Statement of Cash Flows
A)
Sales on Account
A/R
80,000
Sales
80,000
Increase Net Income

No cash Inflow
B)
A/R customer - cash received

Cash
80,000
A/R
80,000
No impact on Net Income

Cash comes into the business ==> operating section
C) Accrue Salaries - Wages have been earned by the workers, but no cash has been paid
Salaries Expense
Salaries Payable
3,000
3,000
Reduce Net Income

No cash outflow
D) Depreciation Expense
9,000
9,000
Decrease Net Income

No Cash Outflow
5)
Cash Equivalents
=> Short-term investments (maturity => within 90 days)
=> Highly liquid (easy to covert into cash)
73
6)
Two major types of Statement of Cash Flows

A)
Direct Method - The direct method tries to figure where cash inflows and
cash outflows occurred.
==> Firms must still reconcile NI to operating cash flows
B)
Indirect Method - The indirect method converts net income into cash flows
from operations.
==> Indirect Method / Reconciliation Method
C) Indirect Method => See Packet

D) Direct Method => See Packet
7)
Summary Items - Statement of Cash Flows

A)
Steps - Indirect Method Operating

1) Find Net Income
2) Add Depreciation Expense
3) Add Amortization Expense
4) Make Current Assets Adjustments & Current Liabilities Adjustments
a) Increase In => A Current Asset => Subtract from NI
b) Decrease In => A Current Asset => Add to NI
c) Increase In => A Current Liab. => Add to NI
d) Decrease In => A Current Liab. => Subtract from NI
5) Subtract Gains
6) Added Losses
7) Ignore => Cash, S-T Notes Payable (Fin. Act.), & Dividends Payable (Fin. Act.)
B)
Indirect Method - Other Items

1)
2)
3)
4)
5)
6)
7)
Dividends Payable => Financing Activity

S-T Notes Payable & L-T Notes Payable => Fin. Activities
Depreciation Expense => Add to NI => Operating Act. Item
Amortization Expense => Add to NI=> Operating Act. Item
Gains => Subtract from NI=> Operating Act. Item
Losses => Add to NI=> Operating Act. Item
Three expense/loss items could be found in
the operating section (Depr. Exp., Amort. Exp., & Impairment Loss)
8) Dividend Revenue / Dividend Income (Cash RECEIVED)=> Operating Act.
9) Interest Revenue / Interest Income (Cash RECEIVED) => Operating Act.
10) Interest Expense (Cash Paid)=> Operating Act.
74
11) DIVIDENDS PAID => Financing Act.
75
8)
Another Item (indirect statement of cash flows)

You should assume a corporation has only the below journal entry
for a given year.
Operating Expense
Salaries Expense
Cash
50,000
20,000
70,000
Quick St. of Cash Flows

Net Loss
Adj. to the NL
(70,000)
None / Zero adj.
Cash Flows From Operating Act.
(70,000)
Summary:
Cash Outflows = Expenses
No adjustments
You should assume a corporation has only the below journal entry
for a given year.
Operating Expense
Salaries Expense
Utilities Payable
Salaries Payable
Cash
50,000
20,000
3,000 < = C. Liab.
2,000 < = C. Liab.
65,000
Quick St. of Cash Flows

Net Loss
Adj. to the NL
(70,000)
Utilities Payable
Salaries Payable
Cash Flows From Operating Act.
3,000
2,000
(65,000)
Summary:
Cash Outflows Expenses
Adj. must be made
76
77
9)
IFRS - Statement of Cash Flows

International Financial Reporting Standards (IFRS)
A)
IFRS will allow for more flexibility in the

classification of interest received, interest paid,
and dividends paid. These items must be shown
as separate items on the statement of cash flows.
IFRS requires consistent classification of
interest received, interest paid, and dividends paid
(between two reporting periods).
B)
GAAP - Review
1) Interest Received / Interest Income => Operating Item
2) Interest Paid / Interest Expense => Operating Item
3) Dividends Paid => Financing Item

78

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You should..

1) maximize the spreadsheet

AIF - Chapter 11 - Time Value of Money - Making Decisions

3) Time value of Money

B) Simple vs. compound Interest

Periods X Rate X principal

a) Simple Interest Example

200 <=== Simple Interest

b) Simple Interest has NO Compounding

3) Application / Decision Making:

b) Which would you rather have:

C) Major Time Value of Money Concepts

3) Future Value of an Ordinary Annuity

4) Present Value of an Ordinary Annuity

5) Solving for Unknown Values - PACKET EXAMPLE

Parts of this document are the exclusive property of Rodney Vogt.

AIF - Chapters 12 & 13

4) Select an Investment (Step 3 B - Capital Budgeting Steps)

Define - Cost of Capital - Weighted-average cost of debt and equity

Simple Example - Cost of Capital

Company has 25,000 debt and 75,000 equity

( .25 X .12) + ( .75 X .15 ) =

0.1425 <= Cost of Capital

Cost of Capital => A Rate / %

B) Big Picture = NPV

Compute the present value of future cash flows

Compute the Net Present Value

Net Investment Cost

Accept or reject based on step # 3

6) Assumptions used with discounted cash flows

C) Taxes & Depreciation Expense

The above journal entry will reduce taxes:

Depreciation is a tax deduction

The above journal entry does not represent a cash outflow

Depreciation creates a cash savings = Also called a Tax Shield

Depreciation Expense Example

Income before Depr. Expense

Depr. Expense shields the company from paying taxes

Summary => Depreciation expense reduces taxable income, shielding a business

D) Taxes ==> Gains & Losses

Gains: ==> Selling a piece of equipment

Book Value = Bal. Sheet Value

Losses: ==> Selling a piece of equipment

Book Value = Bal. Sheet Value

After-Tax Cash Flows =>

E) Use Tax Packet Example

AIF - Chapter 13 - Planning for Equity Financing

Generate a return on your equity investment

Psychological (ego) Reward - I own a business

B) Risks of Equity Financing

Not receiving a good return

Receive a negative return

Receive a return that eats into your investment

C) Rewards of Debt Financing

Financial Leverage - Reward of Debt Financing

cost of borrowed funds.

2) Equity Financing => Sole Proprietorship & Partnerships

Owner's Capital is increased by contributions <==assets placed into the business

B) Division of Partnership Net Income or Net Loss

Partner A => Receives a 10,000 salary

Each partner receives a 5% interest allowance based on

Any remainder should be split based on a 2:1 ratio (Partner A = 2)

Solve based on a Net Income = $25,000