CFA Level 1 - Financial Statements

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6.1 - Introduction
INTRODUCTION
Financial statements are a snapshot of a company's well being at a specific point in time. The length of time (the
accounting period) that these financial statements represent varies; they can be annual (fiscal) or quarterly
(every three months), among others. Fiscal year-end is normally defined as 12 months of operations. A
company's year-end is defined by management and may not concur with the calendar year-end (Dec 31). When
comparing the performance of different companies, one must be aware of these timing differences, if any.
The timing and the methodology used to record revenues
and expenses may also impact the analysis and
comparability of financial statements across companies.
Accounting statements are prepared in most cases on the
basis of these three basic premises:

1. The company will continue to operate (going-

concern assumptions).

2. Revenues are reported as they are earned within the

specified accounting period (revenues-recognition
principle).

3. Expenses should match generated revenues within

the specified accounting period (matching principle).

Basic Accounting Methods:

1. Cash-basis accounting – This method consists of recognizing revenue (income) and expenses when
payments are made (checks issued) or cash is received (deposited in the bank).

2. Accrual accounting – This method consists of recognizing revenue in the accounting period in which it is
earned (revenue is recognized when the company provides a product or service to a customer, regardless of
when the company gets paid). Expenses are recorded when they are incurred instead of when they are paid.

6.2 - Cash Vs. Accrual Accounting

A. ACCRUAL ACCOUNTING
Within this section, we will review cash vs. accrual accounting methodologies. Note that the material set forth
in this section is intended as a review and CFA Institute will
most likely not ask a question directly based on this material.
However, we recommend a read of this section is you are
unfamiliar with accounting as you will need this knowledge in
order to succeed in future sections.
I. Cash vs. Accrual Accounting
Within this section we will explain how income measurement issues are resolved, accrual accounting, and why
the accrual basis of accounting produces more useful income statements and balance sheets than the cash basis.

Benefits of Cash Accounting

Benefits

• It is easy to use and implement because the company records income only when it gets paid and records
expenses only when it pays them.
• If accepted by the IRS (limited cases only), the company is taxed when it has money in the bank.
• On average, fewer transactions will be recorded (bookkeeping).

Biggest Drawback

• Cash accounting can distort a company's actual income and expenses, especially if it extends credit to its
customers, purchases raw materials on credit from its suppliers or keeps inventory.

Benefits of Accrual Accounting

• Generally, it provides a clearer picture of the financial performance (income statement) and financial
health (balance sheet).
• It allows management to keep track of accounts receivables and payables more efficiently.
• It is more representative of the economic reality of the business. A service provider may not require
upfront payment for an annual service; this revenue will be recorded as it is performed, not when it is
paid. Similarly, expenses that are paid in advance - such as property taxes, which are paid semiannually
- will be recognized on a monthly basis.
• It enhances comparability of performance (income statement) and financial stability (balance sheet)
from one period to the next.
• There is a smoother earning stream.
• There is enhanced predictability of future cash flow.

Let's consider a practical example to fully understand the impact of Cash versus Accrual Accounting on XYZ
Corporation's Income Statement and Balance Sheet.

Cash Basis Accounting

Taken as is, the financial statements in Figure 6.1 below indicate that XYZ Corporation is not doing well, with a
net loss of $43,200, and may not be a good investment opportunity.
Figure 6.1: XYZ Corporation's Financial Statements using Cash Basis Accounting
Note: For simplicity the tax effect not considered.

Accrual Basis Accounting

Armed with some additional information, let's see what the income statement would look like if the accrual-
basis accounting method was used.

Additional Information:

A1. June 12, 2005 – The company received a rush order for $80,000 of wood panels. The order was delivered to
the customer five days later. The customer was given 30 days to pay. (With the cash-basis method, sales are not
recorded in the income statement and not recorded in accounts receivables: no cash, no record).

A2. June 13, 2003 – The company received $60,000 worth of wood panels to replenish their inventory, and
$40,000 was related to the rush order. The company paid the invoice in full to take advantage of a 2% early-
payment discount. (With the cash-basis method, this is recorded in full on the income statement, and there is no
record of inventory on hand).

A3. June 1, 2005 – The company launched an advertising campaign that will run until the end of August. The
total cost of the advertising campaign was $15,000 and was paid on June 1, 2005.

Figure 6.2: XYZ Corporation's Restated Financial Statements using Accrual Basis Accounting
Note: tax effect not considered

Adjustments:
To obtain the figures in the restated financial statements in figure 6.2 above, the following adjusting entries
were made:

A1. Product sales and Accounts receivable – Even though the client has not paid this invoice, the company still
made a sale and delivered the products. As a result, sales for the accounting period should increase by $80,000.
Account s receivables (reported sales made but awaiting payment) should also increase by $80,000.

Adjusting entries:

A2. June 13, 2003 – Since the entire $60,000 order was paid during the accounting period, the full amount was
included in production costs under the cash-basis method. Only $40,000 of the order was related to product
sales during that accounting period, and the rest was stored as inventory for future product sales.

Adjusting entries:

A3. June 1, 2005 – Marketing expenses included in the income statement totaled $15,000 for a three-month
advertising campaign because it was paid in full at initiation (cash-basis accounting). The reality is that this
campaign will last for three months and will generate a benefit for the company every month. As a result, under
accrual-basis accounting, the company should record in this accounting period only one-third of the cost. The
remainder should be allocated to the next period and recoded as prepaid expenses on the assets side of the
balance sheet.

Adjusting entries:

Results:
Under cash-basis accounting, this company was not profitable and its balance sheet would have been weak at
best. Under accrual accounting, the financials tell us a very different story.

Look Out!
Debit:An accounting term that refers to an entry that increases an
expense or asset account, or decreases an income, liability or net-worth
account.

Credit: An accounting term that refers to an entry that decreases an

expense or asset account, or increases an income, liability or net-worth
account.

Look Out!
Going forward, all statements will use accrual-basis accounting. Please
note that on the exam, candidates should assume that all financial
statements use accrual-basis accounting, unless it is specified that the
cash-basis accounting method is used in the question.

6.3 - Income Statement Basics

I. Basics
Within this basics section, we will define each component
of a multi-step income statement, and prepare a multi-step
income statement.

Multi-Step Income Statement

A multi-step income statement is a condensed statement
of income as opposed to a single-step format, which is the
more detailed format. Both single and multi-step formats
conform to GAAP standards. Both yield the same net
income figure.

The main difference is how they are formatted, not how

figures are calculated.

Figure 6.3: Multi-Step Income Statement

 1. Sales – These are defined as total sales (revenues) during the accounting period. Remember these sales
are net of returns, allowances and discounts
2. Cost of goods sold (COGS) – These are all the direct costs related to the product or rendered service
sold and recorded during the accounting period. (Reminder: matching principle.)

3. Operating expenses – These include all other expenses that are not included in COGS but are related to
the operation of the business during the specified accounting period. This account is most commonly
referred to as "SG&A" (sales general and administrative) and includes expenses such as selling,
marketing, administrative salaries, sales salaries, maintenance, administrative office expenses (rent,
computers, accounting fees, legal fees), research and development (R&D), depreciation and
amortization, etc.

4. Other revenues & expenses – These are all non-operating expenses such as interest earned on cash or
interest paid on loans.

5. Income taxes – This account is a provision for income taxes for reporting purposes.

6.4 - Income Statement Components

Income Statement Format
The following figure demonstrates which components are
used to calculate a company's net income, which is the
income available to shareholders.

Figure 6.4: How Net Income is Derived on the Income

Statement
The Components of Net Income:

• Operating income from continuing operations – This comprises all revenues net of returns,
allowances and discounts, less the cost and expenses related to the generation of these revenues. The
costs deducted from revenues are typically the COGS and SG&A expenses.

• Recurring income before interest and taxes from continuing operations – This component includes,
in addition to operating income from continuing operations, all other income, such as investment income
from unconsolidated subsidiaries and/or other investments and gains (or losses) from the sale of assets.
To be included in this category, these items must be recurring in nature. This component is generally
considered to be the best predictor of future earning. That said, it does assume that noncash expenses
such as depreciation and amortization are a good indicator of future capital expenditures. Since this
component does not take into account the capital structure of the company (use of debt), it is also used to
value similar companies.

• Recurring (pre-tax) income from continuing operations – This component takes the company's
financial structure into consideration as it deducts interest expenses.

• Pre-tax earning from continuing operations – This component considers all unusual or infrequent
items. Included in this category are items that are either unusual or infrequent in nature but cannot be
both. Examples are an employee-separation cost, plant shutdown, impairments, write-offs, write-downs,
integration expenses, etc.

• Net income from continuing operations – This component takes into account the impact of taxes from
continuing operations.

Non-Recurring Items
Discontinued operations, extraordinary items and accounting changes are all reported as separate items in the
income statement. They are all reported net of taxes and below the tax line, and are not included in income from
continuing operations. In some cases, earlier income statements and balance sheets have to be adjusted to reflect
changes.
 • Income (or expense) from discontinued operations – This component is related to income (or
expense) generated due to the shutdown of one or more divisions or operations (plants). These events
need to be isolated so they do not inflate or deflate the company's future earning potential. This type of
nonrecurring occurrence also has a nonrecurring tax implication and, as a result of the tax implication,
should not be included in the income tax expense used to calculate net income from continuing
operations. That is why this income (or expense) is always reported net of taxes. The same is true for
extraordinary items and cumulative effect of accounting changes (see below).

• Extraordinary items - This component relates to items that are both unusual and infrequent in nature.
That means it is a one-time gain or loss that is not expected to occur in the future. An example is
environmental remediation.

• Cumulative effect of accounting changes - This item is generally related to changes in accounting
policies or estimations. In most cases, these are non cash-related expenses but could have an effect on
taxes.

6.5 - Income Statement: Non-recurring Items

INCOME STATEMENT: NONRECURRING ITEMS

Within this section we will further our discussion on the non-recurring components of net income, such as
unusual or infrequent items, discontinued operations,
extraordinary items, and prior period adjustments.

Unusual or Infrequent Items

Included in this category are items that are either unusual or infrequent in nature but cannot be both.

• Examples of unusual or infrequent items:

o Gains (or losses) as a result of the disposition of a company's business segment including:
 Plant shutdown costs
 Lease-breaking fees
 Employee-separation costs
o Gains (or losses) as a result of the disposition of a company's assets or investments (including
investments in subsidiary segments) including:
 Plant shut-down costs
 Lease-breaking fees
o Gains (or losses) as a result of a lawsuit
o Losses of operations due to an earthquake
o Impairments, write-offs, write-downs and restructuring costs
o Integration expenses related to the acquisition of a business

Look Out!
Accounting treatment is usually displayed as pre-tax. That means that
they are displayed on the income statement after income from continuing
operations gross of tax implication.

Extraordinary Items
Events that are both unusual and infrequent in nature are qualified as extraordinary expenses.

• Example of extraordinary items:

o Losses from expropriation of assets
o Gain (or losses) from early retirement of debt

Look Out!
Accounting treatment is usually displayed net of tax. That means that they
are displayed on the income statement after income from continuing
operations net of its tax implication.

Discontinued Operations
Sometimes management decides to dispose of certain business operations but either has not yet done so or did it
in the current year after it had generated income or losses. To be accounted for as a discontinued operation, the
business must be physically and operationally distinct from the rest of the firm. Basic definitions:

• Measurement date - The date when the company develops a formal plan for disposing.
• Phaseout period - Time between the measurement date and the actual disposal date

The income or loss from discontinued operations is reported separately, and past income statements must be
restated, separating the income or loss from discontinued operations.
On the measurement date, the company will accrue any estimated loss during the phaseout period and estimated
loss on the sale of the disposal. Any expected gain on the disposal cannot be reported until after the sale is
completed (same rule applies to the sale of a portion of a business segment).

Look Out!
Important: Accounting treatment of income and losses from discontinued
operations are reported net of tax after net income from continuing
operations.

Accounting Changes
Accounting changes occur for two reasons:

• As a result of a change in an accounting principle

• As a result of a change in an accounting estimate.

The most common form of a change in accounting principle is the switch from the LIFO inventory accounting
method to another method such FIFO or average cost basis.

The most common form of a change in accounting estimates is a change in depreciation method for new assets
or change in depreciable lives/salvage values, which is considered a change in accounting estimates and not a
change in accounting principle. Note that past income does not need to be restated from the LIFO inventory
accounting method to another method such FIFO or average cost basis.

In general, prior years' financial statements do not need to be restated unless it is a change in:

• Inventory accounting methods (LIFO to FIFO)

• Change to or from full-cost method (This is used in oil & gas exploration. The successful-efforts method
capitalizes only the costs associated with successful activities while the full-cost method capitalizes all
the costs associated with all activities.)
• Change from or to percentage-of-completion method (look at revenue- recognition methods)
• All changes just prior to a company's IPO

Prior Period Adjustments

These adjustments are related to accounting errors. These errors are typically NOT reported in the income
statement but are reported in retained earnings. (These can be found in changes in retained earnings.) These
errors are disclosed as footnotes explaining the nature of the error and its effect on net income.

6.6 - Balance Sheet Basics

I. Basics
Within this section we'll define each asset and liability category on the balance sheet, and prepare aclassified
balance sheet

Balance Sheet Categories

The balance sheet provides information on what the company
owns (its assets), what it owes (its liabilities) and the value of
the business to its stockholders (the shareholders' equity) as of a specific date.

Total Assets = Total Liabilities + Shareholders' Equity

• Assets are economic resources that are expected to produce economic benefits for their owner.
• Liabilities are obligations the company has to outside parties. Liabilities represent others' rights to the
company's money or services. Examples include bank loans, debts to suppliers and debts to employees.
• Shareholders' equity is the value of a business to its owners after all of its obligations have been met.
This net worth belongs to the owners. Shareholders' equity generally reflects the amount of capital the
owners have invested, plus any profits generated that were subsequently reinvested in the company.

Look Out!
Components of Total Assets on the balance sheet are listed in order of
liquidity and maturity.

6.7 - Balance Sheet Components - Assets

Total Assets
Total assets on the balance sheet are composed of:

1. Current Assets – These are assets that may be converted into

cash, sold or consumed within a year or less. These usually
include:

• Cash – This is what the company has in cash in the bank. Cash is reported at its market value at the
reporting date in the respective currency in which the financials are prepared. (Different cash
denominations are converted at the market conversion rate.

• Marketable securities (short-term investments) – These can be both equity and/or debt securities for
which a ready market exist. Furthermore, management expects to sell these investments within one
year's time. These short-term investments are reported at their market value.

• Accounts receivable – This represents the money that is owed to the company for the goods and
services it has provided to customers on credit. Every business has customers that will not pay for the
products or services the company has provided. Management must estimate which customers are
unlikely to pay and create an account called allowance for doubtful accounts.Variations in this account
will impact the reported sales on the income statement. Accounts receivable reported on the balance
sheet are net of their realizable value (reduced byallowance for doubtful accounts).

• Notes receivable – This account is similar in nature to accounts receivable but it is supported by more
formal agreements such as a "promissory notes" (usually a short term-loan that carries interest).
Furthermore, the maturity of notes receivable is generally longer than accounts receivable but less than a
year. Notes receivable is reported at its net realizable value (what will be collected).

• Inventory – This represents raw materials and items that are available for sale or are in the process of
being made ready for sale. These items can be valued individually by several different means - at cost or
current market value - and collectively by FIFO (first in, first out), LIFO (last in, first out) or average-
cost method. Inventory is valued at the lower of the cost or market price to preclude overstating earnings
and assets.

• Prepaid expenses – These are payments that have been made for services that the company expects to
receive in the near future. Typical prepaid expenses include rent, insurance premiums and taxes. These
expenses are valued at their original cost (historical cost).

2. Long-term assets – These are assets that may not be converted into cash, sold or consumed within a year or
less. The heading "Long-Term Assets" is usually not displayed on a company's consolidated balance sheet.
However, all items that are not included in current assets are long-term Assets. These are:

• Investments – These are investments that management does not expect to sell within the year. These
investments can include bonds, common stock, long-term notes, investments in tangible fixed assets not
currently used in operations (such as land held for speculation) and investments set aside in special
funds, such as sinking funds, pension funds and plan-expansion funds. These long-term investments are
reported at their historical cost or market value on the balance sheet.
 • Fixed assets – These are durable physical properties used in operations that have a useful life longer
than one year. This includes:

o Machinery and equipment – This category represents the total machinery, equipment and
furniture used in the company's operations. These assets are reported at their historical cost less
accumulated depreciation.
o Buildings (plants) – These are buildings that the company uses for its operations. These assets
are depreciated and are reported at historical cost less accumulated depreciation.
o Land – The land owned by the company on which the company's buildings or plants are sitting
on. Land is valued at historical cost and is not depreciable under U.S. GAAP

• Other assets – This is a special classification for unusual items that cannot be included in one of the
other asset categories. Examples include deferred charges (long-term prepaid expenses), non-current
receivables and advances to subsidiaries.

• Intangible assets – These are assets that lack physical substance but provide economic rights and
advantages: patents, franchises, copyrights, goodwill, trademarks and organization costs. These assets
have a high degree of uncertainty in regard to whether future benefits will be realized. They are reported
at historical cost net of accumulated depreciation.

Look Out!
These assets are listed in order of their liquidity and tangibility. Intangible
assets are listed last since they have high uncertainty and liquidity.

Look Out!
In July 2001, the Financial Accounting Standards Board (FASB) adopted
Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill
and Other Intangible Assets", which sets new rules for goodwill
accounting. SFAS 142 eliminates goodwill amortization and instead
requires companies to identify reporting units and perform goodwill
impairment tests.

6.8 - Balance Sheet Components - Liabilities

Total Liabilities
Liabilities have the same classifications as assets: current
and long-term.

3. Current liabilities – These are debts that are due to be

paid within one year or the operating cycle, whichever is
longer; further, such obligations will typically involve the
use of current assets, the creation of another current
liability or the providing of some service.

Usually included in this section are:

 1. Bank indebtedness – This amount is owed to the bank in the short term, such as a bank line of credit.

2. Accounts payable – This amount is owed to suppliers for products and services that are delivered but
not paid for.

3. Wages payable (salaries), rent, tax and utilities – This amount is payable to employees, landlords,
government and others.

4. Accrued liabilities (accrued expenses) - These liabilities arise because an expense occurs in a period
prior to the related cash payment. This accounting term is usually used as an all-encompassing term that
includes customer prepayments, dividends payables and wages payables, among others.

5. Notes payable (short-term loans) – This is an amount that the company owes to a creditor, and it
usually carries an interest expense.

6. Unearned revenues (customer prepayments) – These are payments received by customers for
products and services the company has not delivered or started to incur any cost for its delivery.

7. Dividends payable – This occurs as a company declares a dividend but has not of yet paid it out to its
owners.

8. Current portion of long-term debt - The currently maturing portion of the long-term debt is classified
as a current liability. Theoretically, any related premium or discount should also be reclassified as a
current liability.

9. Current portion of capital-lease obligation – This is the portion of a long-term capital lease that is due
within the next year.

Look Out!
Current liabilities above are listed in order of their due date.

4. Long-term Liabilities – These are obligations that are reasonably expected to be liquidated at some date beyond one year or
one operating cycle. Long-term obligations are reported as the present value of all future cash payments. Usually included are:

• Notes payables – This is an amount the company owes to a creditor, which usually caries an interest
expense.

• Long-term debt (bonds payable) – This is long-term debt net of current portion.

• Deferred income tax liability – GAAP allows management to use different accounting principles
and/or methods for reporting purposes than it uses for corporate tax fillings (IRS). Deferred tax
liabilities are taxes due in the future (future cash outflow for taxes payable) on income that has already
been recognized for the books. In effect, although the company has already recognized the income on its
books, the IRS lets it pay the taxes later (due to the timing difference). If a company's tax expense is
greater than its tax payable, then the company has created a future tax liability (the inverse would be
 accounted for as a deferred tax asset).

• Pension fund liability – This is a company's obligation to pay its past and current employees' post-
retirement benefits; they are expected to materialize when the employees take their retirement (defined-
benefit plan). Valued by actuaries and represents the estimated present value of future pension expense,
compared to the current value of the pension fund. The pension fund liability represents the additional
amount the company will have to contribute to the current pension fund to meet future obligations.

• Long-term capital-lease obligation – This is a written agreement under which a property owner allows
a tenant to use and rent the property for a specified period of. Long-term capital-lease obligations are net
of current portion.

Look Out!
The liabilities above are listed in order of their due date.

6.9 - Shareholders' (Stockholders') Equity Basics

I. Basics

Components of Shareholder’s Equity

Also known as “equity” and “net worth”, the shareholders’
equity refers to the shareholders’ ownership interest in a
company.

Usually included are:

• Preferred stock – This is the investment by preferred stockholders, which have priority over common
shareholders and receive a dividend that has priority over any distribution made to common
shareholders. This is usually recorded at par value.

• Additional paid-up capital (contributed capital) – This is capital received from investors for stock; it
is equal to capital stock plus paid-in capital. It is also called “contributed capital”.

• Common stock – This is the investment by stockholders, and it is valued at par or stated value.

• Retained earnings – This is the total net income (or loss) less the amount distributed to the shareholders
in the form of a dividend since the company’s initiation.

• Other items – This is anall-inclusive account that may include valuation allowance and cumulative
translation allowance (CTA), among others. Valuation allowance pertains to noncurrent investments
resulting from selective recognition of market value changes. Cumulative translation allowance is used
to report the effects of translating foreign currency transactions, and accounts for foreign affiliates.

Look Out!

These components are listed in the order of their liquidation

priority.
Figure 6.5: Sample Balance Sheet

Stockholders’ Equity Statement

Instead of presenting a detailed stockholders’ equity section in the balance sheet and a retained earnings
statement, many companies prepare a stockholders’ equity statement.

This statement shows the changes in each type of stockholders’ equity account and the total stockholders’
equity during the accounting period. This statement usually includes:

1. Preferred stock
2. Common stock
3. Issue of par value stock
4. Additional paid-in capital
5. Treasury stock repurchase
6. Cumulative Translation Allowance (CTA)
7. Retained earning

6.10 - Components of Stockholders' Equity

Within this section we’ll identify the components that
comprise the contributed capital part of stockholders’
equity.

Contributed Capital
Contributed capital is the total legal capital of the
corporation (par value of preferred and common stock)
plus the paid-in capital.
 • Par value – This is a value of preferred and common stock that is arbitral (artificial); it is set by
management on a per share basis. This artificial value has no relation or impact on the market value of
the shares.

• Legal capital of the corporation – This is par value per share multiplied by the total number of shares
issued.

• Additional paid-in capital (paid-in capital) – This is the difference between the actual value the
company sold the shares for and their par value.

Example:
Company XYZ issued 15,000 preferred shares to investors for $300,000.
Company XYZ issued 30,000 common shares to investors for $600,000.
Par value of preferred shares is $7 per share.
Par value of common shares is $15 per share.

Legal capital:
Preferred shares: $300,000(15,000 x $20)
Common shares: $450,000(30,000 x $15)
Legal capital $750,000

Paid-in capital:
Preferred shares: $ 0 ($300,000-$300,000)
Common shares: $150,000($600,000-$450,000)
Paid-in capital $150,000

Legal capital + Paid-in capital = Contributed Capital

Look Out!
If issued common shares have no par value, the amount the stock is sold
for constitutes common stock. Preferred stock is always sold with a stated
par value.

6.11 - Accounting for Dividends

Dividends
Dividends are payments to stockholders that can be made
regularly (monthly, quarterly or annually) or occasionally.

• Companies are not required to issue a dividend to their common stockholders.

• Companies may have an obligation to issue a dividend to preferred shareholders (see definition and
properties of preferred shareholders).
• A company’s board of directors must approve of a dividend before it can be declared and issued.
There are two basic dividend forms:

• Cash dividends – These are cash payments made to stockholders of record. Retained earnings are
reduced when dividends are declared.

• Stock dividends – These are dividends paid in the form of additional stock of the issuing company to
shareholders of record in proportion to their current holdings. A stock dividend does not increase the
wealth of the recipient nor does it reduce the net assets of the firm. It is a permanent capitalization of
retained earnings to contributed capital.

Dividend Terminology

• Date of Declaration: This is the date the board approved and declared a dividend.

• Date of record: This is thedate set by the issuer that determines who is eligible to receive a declared
dividend or capital-gains distribution.

• Ex-dividend date: This is the first day of trading when the selling shareholder is entitled to the recently
announced dividend payment. Shares purchased as of the ex-dividend date will not receive the
previously declared dividend.

• Date of payment: This is the date on which the company will pay the declared dividend to its
stockholders of record as of the date of record.

Accounting for a Cash Dividend

Let’s examine the payment process of a cash dividend. We’ll use XYZ company again for this example.

XYZ declares a dividend on Jan 1, 2005, for its common shareholders of $400,000 payable to shareholders of
record on Feb 1, 2005, and payable on Feb 31, 2005.

Accounting Impact on the Date of Declaration, Jan 1, 2005:

Accounting Impact on the Date of Payment, Feb 31, 2005:

Stock Dividends
Stock dividends involve the issuance of additional shares of stock to existing shareholders on a proportional
basis. Stock dividends are issued to stockholders of record as of the record date. The dividends are not paid in
cash but are paid as additional shares.

Since a company does not pay out any cash when it declares a stock dividend, the company’s cash account
(current assets) is not affected. The only account that is affected is the company’s contributed capital (paid-up
capital). When a company issues a stock dividend, the company’s retained earnings are reduced by the value of
the stock dividend, and the company will increase its common stock and paid-up capital accounts.
Note that the size of the dividend declared is important. If the company declares a 25% or less stock dividend
(as a percentage of the company’s previous total outstanding shares) then the value of the stock dividend
declared is equal to the market value of the shares issued. (Common shares are increased to reflect value of
dividend.) If the stock dividend is larger than 25%, the company will transfer 100% of the par or stated value of
the common shares to the common-stock account.

Examples:
Stock dividends are best learned by considering an example of a situation where the stock dividend is 25% or
less of previously outstanding shares, and where the stock dividend is 25% or more of the previously
outstanding shares.

Situation 1: Twenty-five percent or less of previous outstanding shares

XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005, one share for
every five shares will be paid to shareholders of records of Feb 1, 2005. XYZ shares have a market value of $10
and a par value of $40. The company has 2 million shares outstanding. What does this mean? A shareholder that
has 100 shares of XYZ will receive 20 additional shares for a total of 120. Furthermore, the company will issue
400,000 additional stocks to stockholders. After the dividend is issued, the company will have 20% more shares
outstanding.

Accounting impact on date of declaration:

Accounting impact on date of issuance:

Situation 2: More than 25% of previous outstanding shares.

XYZ declares a stock dividend on Jan 1, 2005, for its common shareholders. On Feb 31, 2005, three shares for
every five shares will be paid to shareholders of records of Feb 1, 2005. XYZ shares have a market value of $10
and a par value of $40. The company has 2 million shares outstanding. What does this mean? A shareholder that
has 100 shares of XYZ will receive 60 additional shares for a total of 160. Furthermore, the company will issue
1.2 million additional stocks to stockholders. After the dividend is issued, the company will have 60% more
shares outstanding.

Accounting impact on date of declaration:

Accounting impact on date of issuance:

 Look Out!
The most common mistake students make in this section is that they forget
to calculate if the stock dividend is less than or higher than 25% of the
shares outstanding and the reporting effect it will have.

Stock Split
Stock splits are events that increase the number of shares outstanding and reduce the par or stated value per share of the
company’s stock. For example, a two-for-one stock split means that the company stockholders will receive two shares for every
share they currently own. This will double the number of shares outstanding and reduce by half the par value per
share. Existing shareholders will see their shareholdings double in quantity, but there will be no change in the proportional
ownership represented by the shares (i.e. a shareholder owning 2,000 shares out of 100,000 would then own 4,000 shares out of
200,000).

Most importantly, the total par value of shares outstanding is

not affected by a stock split (i.e. the number of shares times
par value per share does not change). Therefore, no journal
entry is needed to account for a stock split. A memorandum
notation in the accounting records indicates the decreased par
value and increased number of shares.

Stocks that are trading on the exchange will normally be re-

priced in accordance to the stock split. For example, if XYZ
stock was trading at $90 and the company did a 3-for-1 stock
split, the stock would open at $30 a share.

Stock splits are usually done to increase the liquidity of the

stock (more shares outstanding) and to make it more
affordable for investors to buy regular lots (regular lot = 100
shares).

6.12 - Accounting for Equities

Preferred Stock Characteristics
Preferred stock (preferred shares) is a hybrid between
common stock and bonds. It provides a specific
dividend that is paid before any dividend is paid to
common stockholders.

• Dividends
o Preferred stocks pay to stockholders a
predefined dividend that is based on a
specific amount, or is a percentage of
the preferred stock’s par value.
o Like common stock, preferred stocks represent partial ownership in a company.
o Preferred stockholders do not usually enjoy any of the voting rights of common stockholders or
any additional net income distributions beyond the stated dividend payout, unless they are
 participating preferred stockholders.

• Superiority in the Event of Liquidation

o Preferred stockholders have precedence over common stockholders in the event of liquidation.
o Bondholders always have precedence over preferred stockholders from a dividend and
liquidation point of view.
o Unlike bondholders, preferred stockholders cannot force a company into bankruptcy.

• Classification
o From an accounting point of view, preferred stock is classified as equity, and the dividend
payments are classified in a similar fashion as common stock dividends.
o Unlike interest paid on bonds, the fixed dividend paid out to preferred stockholders is not
deductible from earnings before taxes (EBT) and is not tax deductible.

• Attributes
In general, preferred stock can have several attributes; they can be:

o Cumulative - This is preferred stock on which dividends accrue in the event that the issuer does
not make timely dividend payments. Unpaid preferred dividends are called “dividends in
arrears”. Most preferred stocks are cumulative.

o Non-cumulative - This is preferred stock on which dividends do not accrue in the event that the
issuer does not make timely dividend payments.

o Participating - This is preferred stock that, in addition to a regular dividend, pays a dividend
when common stock dividends exceed a specified amount.

o Convertible - This is preferred stock that can be converted into a specified amount of common
stock at the holder's option.

o Retractable - This is preferred stock that grants the stockholder the right to redeem the stock at
specified future date(s) and price(s).

o Perpetual - These are preferred shares that have no maturity date.

o Callable (Non-perpetual) – These are preferred shares that have a predetermined maturity date.
At the maturity date, the company will buy back the preferred shares at their par value.
• Voting Rights
Most preferred stock is non-voting. However, most of these securities also include a clause that would
give holders a predetermined voting right if dividends are not paid for a certain period of time (in most
cases, three years).

Stock Issuance
The issuing company will normally receive cash in exchange for shares (stock). The shares may or many not
have a stipulated par value. If they do have a par value, the excess paid to the par value will be recorded in
additional paid-in capital (paid-in capital) account. If the stock sold has no par value, the full amount will be
recorded in the stock account.

Example:
XYZ Company has issued 800,000 common shares at a price of $5 per share.
With par value of $3 per share:

Without par value:

Stock Repurchase
A program by which a company buys back its own shares from the marketplace, reducing the number of
outstanding shares. This is usually an indication that the company's management thinks the shares are
undervalued.

Look Out!
Because a share repurchase reduces the number of shares outstanding (i.e.
supply), it increases earnings per share and tends to elevate the market
value of the remaining shares.

When a company does repurchase shares, it will usually say something

along the lines of, "We find no better investment than our own company."

With par value of $3 per share:

Without par value:

6.13 - Revenue Recognition

I. What is Revenue Recognition?

The Matching Principle

The matching principle of GAAP dictates that revenues must be matched with expenses. Thus, income and
expenses are reported when they are earned and incurred, even if
no cash transaction has been recorded.

For example, say a company made a sale for $30,000 within an

accounting period but has not received payment. Even though the company was not paid, the sale is recorded as
revenue. This revenue has to be matched with the expenses that the company incurred in the accounting period
to generate that revenue (revenues and expanses must match).
If revenues were not matched with their related expenses, companies would produce financial statements that
provide little information to the readers and themselves. (This is a fundamental principle of accrual-basis
accounting)

Revenue-Recognition Principles
SFAS 5 specifies that two conditions must be met for revenue recognition to take place:

1. Completion of the Earnings Process

This means the company has provided all or virtually all of the goods and services for which it is to be
paid. Furthermore, it means the company can measure the total expected cost of providing the goods and
services, and the company must have no significant remaining obligations to its customers. Both must be
true for this condition to be met.

2. Assurance of Payment
There must be a quantification of the cash or assets that will be received for realized goods and services.
Furthermore, the company must be able to accurately estimate the reliability of payment. Both must be
true for this requirement to be met.

The amount of revenues to be recognized at any given point in time is measured as:

Formula 6.3

(Services Provided to Date/Total Expected Services) x Total

Expected Inflow

6.14 - Revenue Recognition Methods and Implications

1. Sales-basis Method
1. Under the sales-basis method, revenue is
recognized at the time of sale, which is
defined as the moment when the title of
the goods or services is transferred to the
buyer.
2. The sale can be made for cash or credit.
This means that, under this method,
revenue is not recognized even if cash is received before the transaction is complete.
3. For example, a monthly magazine publisher that receives $240 a year for an annual subscription
will recognize only $20 of revenue every month (assuming that it delivered the magazine).

4. Implication: This is themost accurate form of revenue recognition.

2. Percentage-of-completion method
1. This method is popular with construction and engineering companies, who may take years to
deliver a product to a customer.
 2. With this method, the company responsible for delivering the product wants to be able to show
its shareholders that it is generating revenue and profits even though the project itself is not yet
complete.
3. A company will use the percentage-of-completion method for revenue recognition if two
conditions are met:
1. There is a long-term legally enforceable contract
2. It is possible to estimate the percentage of the project that is complete, its revenues and
its costs.

4. Under this method, there are two ways revenue recognition can occur:
1. Using milestones - A milestone can be, for example, a number of stories completed, or a
number of miles built for a railway.
2. Cost incurred to estimated total cost- Using this method, a construction company would
approach revenue recognition by comparing the cost incurred to date by the estimated
total cost.)

5. Implication:Thiscan overstate revenues and gross profits if expenditures are recognized before
they contribute to completed work.

3. Completed-contract method
1. Under this method, revenues and expenses are recorded only at the end of the contract.
2. This method must be used if the two basic conditions needed to use the percentage-of-
completion method are not met (there is no long-term legally enforceable contract and/or it is not
possible to estimate the percentage of the project that is complete, its revenues and its costs.)

3. Implication: Thiscan understate revenues and gross profit within an accounting period because
the contract is not accounted for until it is completed.

4. Cost-recoverability method
1. Under the cost-recoverability method, no profit is recognized until all of the expenses incurred to
complete the project have been recouped.
2. For example, a company develops an application for $200,000. In the first year, the company
licenses the application to several companies and generates $150,000.
3. Under this method, the company recognizes sales of $150,000 and expenses related to the
development of $150,000 (assuming no other costs were incurred). As a result, nothing would
appear in net income until the total cost is offset by sales.

4. Implication: Thiscan understate gross profits initially and overstate profits in future years.

5. Installment method
1. If customer collections are unreliable, a company should use the installment method of revenue
recognition.
2. This is primarily used in some real estate transactions where the sale may be agreed upon but the
cash collection is subject to the risk of the buyer's financing falling through. As a result, gross
profit is calculated only in proportion to cash received.
3. For example, a company sells a development project for $100,000 that cost $50,000. The buyer
will pay in equal installments over six months. Once the first payment is received, the company
will record sales of $50,000, expenses of $25,000 and a net profit of $25,000.

4. Implication: This can overstate gross profits if the last payment is not received.
 Summary of Revenue Recognition Methods

First Condition: Second Condition:

Completion of Earning Assurance of Payment
Progress

Goods/ServicesMeasurable
QuantificationReliability
Method Provided Cost
Sales Basis
Yes Yes Yes Yes

Percentage of
Incomplete Yes Yes Yes
Completion

Completed
Incomplete Yes or No Yes/No Yes/No
Contract

Cost
Yes with
Recoverabilit Yes Yes/No Yes/No
Contingency
y

Installment
Yes Yes Yes No
Method

6.15 - Revenue Recognition and Accounting Entries

Accounting Entries
The best way to identify the appropriate accounting entries is to consider an example:

Construction Company ABC, has just obtained a $50 million contract to build a five-building resort in the
Bahamas for Meridian Vacations. Company ABC estimates that each building will take a full year to build.
Meridian Vacations has agreed to pay Company ABC according to the following schedule: $5m in year 1, $10m
in year 2, $10m in year 3, $10m in year 4 and $15m in year 5.
Company ABC has estimated that the total cost of this contact
will be $35m, and will occur over the five years in this way;
$5m in year 1, $4m in year 2, $10m in year 3, $10m in year 4
and $6m in year 5. Equal monthly payments will be made to ABC, and Meridian will have a 30-day grace
period except for the last payment in year 5.

Figure 6.6: Illustration of Construction Company ABC’s expected figures

Total
Revenue: $50M
Total
Cost: $35M
 Year 1 Year 2 Year 3 Year 4 Year 5 Total

5,000,00 10,000,00 10,000,00

Cost 4,000,000 6,000,000 35,000,000
0 0 0

Payment 5,000,00 10,000,00 15,000,00 12,000,00

8,000,000 50,000,000
Terms 0 0 0 0

Cash 4,583,33 14,583,33 12,666,66

9,583,333 8,583,333 50,000,000
Received 3 3 7

Accounts
416,667 833,333 1,250,000 666,667 -
Receivable

Percentage-of-Completed-Contract Method
We first need to estimate the revenues Company ABC will declare each year. Remember we are using the
percentage-of-completion method based on estimated cost.

Figure 6.7: Construction Company ABC’s Estimated Revenues

Year 1 Year 2 Year 3 Year 4 Year 5 Total

5,000,00 4,000,00 10,000,00 10,000,00 6,000,00 35,000,00

Cost
0 0 0 0 0 0

% of
Completio 14.29% 11.43% 28.57% 28.57% 17.14% 100%
n

Cumulativ
14.29% 25.71% 54.29% 82.86% 100%
e

7,142,85 5,714,28 14,285,71 14,285,71 8,571,42 50,000,00

Revenue
7 6 4 4 9 0

Step 1:
Revenues to be declared
We first need to extrapolate how much each annual cost represents as a percentage of the total cost. Armed with
this information we multiply the percentage of completion with the total expected revenue for the project for
each period.

Recall that one of the basic accounting principles is assurance of payment, and here is the formula used to
determine amount of revenues to be recognized at any given point in time:
Formula 6.4

(Services Provided to Date/Total Expected Services) x Total

Expected Inflow

This is basically the same formula used in the percentage-of-completion method.

Step 2:
Cost to be declared
Since this is the basic assumption of this accounting methodology, the expenses remain the same as the ones
that were estimated.

Results:
1. Annual Income Statement Entries
In each year, the revenues, expenses would be entered as seen on the following table.

Note: For simplicity, taxes were not considered.

Figure 6.8: Construction Company ABC’s Income Statement (% of

Completion Method)

2. Balance Sheet Statement Entries

Figure 6.9: Construction Company ABC’s Balance Sheet (% of Completion Method)

Explanation of Balance Sheet Entries:

• Cash:It is the total cash Company ABC has on hand at the end of the year, and is defined as the total
cash inflow minus the total cash outflow. If the result of this equation were negative, the company
would have to borrow from its line of credit additional funds to cover its total expenses.
• Accounts Receivable:The total amount billed less the cash received by Meridian.
 • Net construction in progress (asset) and net advance billing (liability):
These accounts offset each other and are composed of construction in progress less total billings.
1. If the result of this equation were negative, the company would have billed its client for more
than what has delivered. This would have constituted a liability for the construction company,
and would have been reported as net advance billings.
2. If this equation were positive, then the company would have built more than the client has paid
for it, and the result of the equation would have constituted an asset and would be recorded as net
construction in progress.
3. In most cases, companies only report net construction in progress or net advance billing on their
balance sheet.

• Retained earnings –The cumulative shares of the total profit to date. This item is not shown on the
balance sheet above. It normally appears after shareholders equity.

Formula 6.5

Construction in progress = the cumulative cost incurred since

inception + (cumulative percentage of completion x total estimated
net profit of the project)

Less

Total billings = cumulative amount billed to the client since

inception

Look Out!

Remember, if the result of the above equation is:

Positive (asset) = net construction in progress
Negative (liability) = net advance billings

Figure 6.10: Other Items on Company ABC’s Balance Sheet (% of

Completion Method)

Completed-Contract Method
Under this accounting methodology, revenues and expenses are not recognized until the contract is completed
and the title is transferred to the client.

Annual Income Statements

In this case, nothing would be reported on the annual income statements until Year 5.

Figure 6.11: Company ABC’s Income Statement (Completed

Contract Method)

Balance Sheet Statements

Under this method, the balance sheet entries are the same as the percentage-of –completion method, except for
the Net Advance Billing account.

Figure 6.12: Company ABC’s Balance Sheet (Completed Contract Method)

Balance Sheet Entries

• Cash and accounts receivables stay the same under both the percentage of completion and completed
contract methods.
1. This is normal because, no matter which method you use, you always know how mush cash you
have in the bank, and you how much credit you have extended to your client.
• Net construction in progress (asset) / net advance billing – The basic concepts are the same, except that
under this methodology, construction in progress does not include the cumulative effect of gross profits
in the formula (i.e. excludes cumulative percentage of completion x total estimated net profit of the
project).

6.16 - Revenue Recognition Effects on Cash Flows and Financial Ratios

Both methods - the percentage-of-completion and completed-contract methods - produce the same net cash flow
effect.
Cash Flow Effects

• Percentage-of-completed contract method

1. Net income (NI) will be higher in the
first years and lower in the last year.
2. Net Income will be less volatile.
3. Total assets will be greater.
4. Liabilities will be lower.

1. Completed contract method

1. Net income will be nonexistent in the
first years and higher in the last year.
2. Net income will be very volatile.
3. Total assets will be smaller.
4. Liabilities will be higher (no
recognition of retained earnings).
5. Stockholders equity will be lower.
6. Stockholders equity will be more
volatile.

Impact on Financial Ratio

% of Reason Completed
Ratio Formula Completion Method
Method

Construction in
Current
progress
Current Assets
Higher includes portion Lower
Ratio Current
of estimated
Liabilities
profits

Lower - Not
Revenues
Revenue Revenues are measurable
Average Higher
Turnover reported prior to
Receivables
completion

Lower - Not
Retained
Assets to Total Assets measurable
Higher earnings are
Equity Equity prior to
reported
completion

Total Lower Liabilities are Highe

Debt Total smaller and the
Ratio Liabilities denominator
 Total
Liabilities + includes equity
Total Equity which is higher

6.17 - The Cash Flow Statement

I. Introduction

Components and Relationships Between the Financial Statements

It is important to understand that the income statement, balance sheet and cash flow statement are all
interrelated.

The income statement is a description of how the assets and

liabilities were utilized in the stated accounting period. The cash
flow statement explains cash inflows and outflows, and will
ultimately reveal the amount of cash the company has on hand;
this is reported in the balance sheet as well.

We will not explain the components of the balance sheet and the income statement here since they were
previously reviewed.

Figure 6.13: The Relationship between the Financial Statements

6.18 - Cash Flow Statement Basics

Statement of Cash Flow
The statement of cash flow reports the impact of a
firm's operating, investing and financial activities on
cash flows over an accounting period. The cash flow
statement is designed to convert the accrual basis of
accounting used in the income statement and balance
sheet back to a cash basis.

The cash flow statement will reveal the following to

analysts:

• How the company obtains and spends cash

• Why there may be differences between net income and cash flows
• If the company generates enough cash from operation to sustain the business
• If the company generates enough cash to pay off existing debts as they mature
• If the company has enough cash to take advantage of new investment opportunities

Segregation of Cash Flows

The statement of cash flows is segregated into three sections:

1. Operating activities
2. Investing activities
3. Financing activities

1. Cash Flow from Operating Activities (CFO)

CFO is cash flow that arises from normal operations such as revenues and cash operating expenses net of taxes.

This includes:

1. Cash inflow (+)

o Revenue from sale of goods and services
o Interest (from debt instruments of other entities)
o Dividends (from equities of other entities)
2. Cash outflow (-)
o Payments to suppliers
o Payments to employees
o Payments to government
o Payments to lenders
o Payments for other expenses

2. Cash Flow from Investing Activities (CFI)

CFI is cash flow that arises from investment activities such as the acquisition or disposition of current and fixed
assets.

This includes:

• Cash inflow (+)

o Sale of property, plant and equipment
o Sale of debt or equity securities (other entities)
o Collection of principal on loans to other entities
• Cash outflow (-)
 o Purchase of property, plant and equipment
o Purchase of debt or equity securities (other entities)
o Lending to other entities

3. Cash flow from financing activities (CFF)

CFF is cash flow that arises from raising (or decreasing) cash through the issuance (or retraction) of additional
shares, short-term or long-term debt for the company's operations. This includes:

• Cash inflow (+)

o Sale of equity securities
o Issuance of debt securities

• Cash outflow (-)

o Dividends to shareholders
o Redemption of long-term debt
o Redemption of capital stock

Reporting Noncash Investing and Financing Transactions

Information for the preparation of the statement of cash flows is derived from three sources:

• Comparative balance sheets

• Current income statements
• Selected transaction data (footnotes)

Some investing and financing activities do not flow through the statement of cash flow because they do not
require the use of cash.

Examples Include:

• Conversion of debt to equity

• Conversion of preferred equity to common equity
• Acquisition of assets through capital leases
• Acquisition of long-term assets by issuing notes payable
• Acquisition of non-cash assets (patents, licenses) in exchange for shares or debt securities

Though these items are typically not included in the statement of cash flow, they can be found as footnotes to
the financial statements.

6.19 - Cash Flow Computations - Indirect Method

Under U.S. and ISA GAAP, the statement of cash flow can be
presented by means of two ways:

• The indirect method

• The direct method
The Indirect Method
The indirect method is preferred by most firms because is shows a reconciliation from reported net income to
cash provided by operations.

Calculating Cash flow from Operations

Here are the steps for calculating the cash flow from operations using the indirect method:

• Start with net income.

• Add back non-cash expenses.
o (Such as depreciation and amortization)
• Adjust for gains and losses on sales on assets.
o Add back losses
o Subtract out gains
• Account for changes in all non-cash current assets.
• Account for changes in all current assets and liabilities except notes payable and dividends payable.

In general, candidates should utilize the following rules:

• Increase in assets = use of cash (-)

• Decrease in assets = source of cash (+)
• Increase in liability or capital = source of cash (+)
• Decrease in liability or capital = use of cash (-)

The following example illustrates a typical net cash flow from operating activities:
Cash Flow from Investment Activities
Cash Flow from investing activities includes purchasing and selling long-term assets and marketable securities
(other than cash equivalents), as well as making and collecting on loans.

Here's the calculation of the cash flows from investing using the indirect method:

Cash Flow from Financing Activities

Cash Flow from financing activities includes issuing and buying back capital stock, as well as borrowing and
repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also included in this
category, but the repayment of accounts payable or accrued liabilities is not.

Here's the calculation of the cash flows from financing using the indirect method:
6.20 - Cash Flow Computations - Direct Method
The Direct Method
The direct method is the preferred method under FASB
95 and presents cash flows from activities through a
summary of cash outflows and inflows. However, this is
not the method preferred by most firms as it requires
more information to prepare.

Cash Flow from Operations

Under the direct method, (net) cash flows from operating
activities are determined by taking cash receipts from
sales, adding interest and dividends, and deducting cash
payments for purchases, operating expenses, interest and
income taxes. We'll examine each of these components
below:

• Cash collections are the principle components of CFO. These are the actual cash received during the
accounting period from customers.
They are defined as:
Formula 6.7
Cash Collections Receipts from Sales
= Sales + Decrease (or - increase) in Accounts Receivable
•

• Cash payment for purchases make up the most important cash outflow component in CFO. It is the
actual cash dispersed for purchases from suppliers during the accounting period.

It is defined as:
Formula 6.8
Cash payments for purchases = cost of goods sold +
increase (or - decrease) in inventory + decrease (or - increase)
in accounts payable
•

• Cash payment for operating expenses is the cash outflow related to selling general and administrative
(SG&A), research and development (R&A) and other liabilities such as wage payable and accounts
payable.

It is defined as:
 Formula 6.9
Cash payments for operating expenses = operating
expenses + increase (or - decrease) in prepaid expenses +
decrease (or - decrease) in accrued liabilities

• Cash interest is the interest paid to debt holders in cash.

It is defined as:

Formula 6.10
Cash interest = interest expense – increase (or + decrease)
interest payable + amortization of bond premium (or -
discount)

• Cash payment for incometaxes is the actual cash paid in the form of taxes. It is defined as:

Formula 6.11
Cash payments for income taxes
= income taxes + decrease (or - increase) in income taxes
payable

Look Out!
Note: Cash flow from investing and financing are computed the same way
it was calculated under the indirect method.

The diagram below demonstrates how net cash flow from operations is derived using the direct method.
 Look Out!

Candidates must know the following:

 Though the methods used differ, the results are always the
same.
 CFO and CFF are the same under both methods.
 There is an inverse relationship between changes in assets
and changes in cash flow.

Free Cash Flow (FCF)

Free cash flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses,
including net capital expenditures. Net capital expenditures are what a company needs to spend annually to
acquire or upgrade physical assets such as buildings and machinery to keep operating.

Formula 6.12
Free cash flow = cash flow from operating activities – net
capital expenditures (total capital expenditure - after-tax
proceeds from sale of assets)

The FCF measure gives investors an idea of a company's ability to pay down debt, increase savings and increase
shareholder value, and FCF is used for valuation
purposes.

6.21 - Management Discussion and Analysis & Financial

Statement Footnotes
I. Management Discussion and Analysis

The Securities Exchange Commission (SEC) requires this

section to be included with the financial statements of a
public company and is prepared by management

This narrative section usually includes the following;

• A description of the company's primary business

segments and future trends
• A review of the company's revenues and expenses
• Discussions pertaining to the sales and expense trends
• Review of cash flow statements and future cash flow needs including current and future capital
expenditures
• A review of current significant balance sheet items and future trends, such as differed tax liabilities,
among others
• A discussion and review of major transactions (acquisitions, divestitures) that may affect the business
from an operational and cash flow point of view
• A discussion and review of discontinued operations, extraordinary items and other unusual or infrequent
events

Financial Statement Footnotes

These footnotes are additional information provided to the reader in an effort to further explain what is
displayed on the consolidated financial statements.

Generally accepted accounting principles (GAAP) and the SEC require these footnotes. The information
contained in these footnotes help the reader understand the amounts, timing and uncertainty of the estimates
reported in the consolidated financial statements.

Included in the footnotes are the following:

• A summary of significant accounting policies such as:

• The revenues-recognition method used
• Depreciation methods and rates
• Balance sheet and income statement breakdown of items such as:
• Marketable securities
• Significant customers (percentage of customers that represent a significant portion of revenues)
• Sales per regions
• Inventory
 • Fixed assets and Liabilities (including depreciation, inventory, accounts receivable, income
taxes, credit facility and long-term debt, pension liabilities or assets, contingent losses (lawsuits),
hedging policy, stock option plans and
capital structure.

6.22 - The Auditor and Audit Opinion

The Auditor
An audit is a process for testing the accuracy and
completeness of information presented in an
organization's financial statements. This testing process
enables an independent Certified Public Accountant
(CPA) to issue what is referred to as "an opinion" on how
fairly a company's financial statements represent its
financial position and whether it has complied with
generally accepted accounting principles.

Look Out!
Note: Only independent auditors (CPAs) can produce audited financial
statements. That is, the company's board members, staff and their
relatives cannot perform audits because their relationship with the
company compromises their independence.

The audit report is addressed to the board of directors as the trustees of the organization. The report usually
includes the following:

a cover letter, signed by the auditor, stating the opinion.

the financial statements, including the balance sheet, income statement and statement of cash flows

notes to the financial statements

In addition to the materials included in the audit report, the auditor often prepares what is called a "management
letter" or "management report" to the board of directors. This report cites areas in the organization's internal
accounting control system that the auditor evaluates as weak.

What Does the Auditor Do?

The auditor will request information from individuals and institutions to confirm:

bank balances

contribution amounts

conditions and restrictions

contractual obligations
 monies owed to and by the organization.

To ensure that all activities with significant financial implications is adequately disclosed in the financial
statements the auditor will review:

physical assets

journals and ledgers

board minutes

In addition, the auditor will also:

select a sample of financial transactions to determine whether there is proper documentation and whether the
transaction was posted correctly into the books

interview key personnel and read the procedures manual, if one exists, to determine whether the
organization's internal accounting control system is adequate

The auditor usually spends several days at the organization's office looking over records and checking for
completeness.

Auditor Responsibility
Auditors are not expected to guarantee that 100% of the transactions are recorded correctly. They are required
only to express an opinion as to whether the financial statements, taken as a whole, give a fair representation of
the organization's financial picture. In addition, audits are not intended to discover embezzlements or other
illegal acts. Therefore, a "clean" or unqualified opinion should not be interpreted as assurance that such
problems do not exist.

The Qualified Opinion

A qualified opinion is issued when the accountant believes the financial statements are, in a limited way, not in
accordance with generally accepted accounting principles. A qualified option may be issued if the auditor has
concerns about the going-concern assumption of the
company, the valuation of certain items on the balance
sheet or some unreported pending contingent liabilities.

6.23 - Financial Reporting Objectives and Enforcement

I. Financial Reporting Objectives

Objectives of Financial Reporting

Objectives of financial reporting identified in SFAC 1 are
to do the following:

They are to provide information that is useful to present

and potential investors and creditors and other users in
making rational investment, credit, and similar decisions. (Note the FASB's emphasis on investors and creditors
as primary users. However, this does not exclude other interested parties.)

They are to provide information to help present and potential investors and creditors and other users in
assessing the amounts, timing and uncertainty of prospective cash receipts from dividends or interest
and the proceeds from the sale, redemption or maturity of securities or loans. (Emphasize the difference
between the cash basis and the accrual basis of accounting.)

They are to provide information about the economic resources of an enterprise, the claims on those
resources and the effects of transactions, events and circumstances that change its resources and claims
to those resources.

II. Enforcing and Developing U.S. GAAP

FASB Role in Enforcing and Developing U.S. GAAP

The Financial Accounting Standards Board (FASB) is a nongovernmental body. This board sets the accounting
standards for all companies that issue audited U.S. GAAP-compliant financial statements.

Both the Securities Exchange Commission (SEC) and American Institute of Certified Public Accountants
(AICPA) recognize that the Statement of Financial Accounting Standards (SFAS) statements as authoritative.

GAAP comprises a set of principles that are patterned over a number of sources including the FASB, the
Accounting Principles Board (APB) and the AICPA research bulletins.

Prior to the creation of the FASB, the Accounting Principles Board (APB) set the accounting standards. As a
result some of these standards are still in use.

SEC Role in Enforcing and Developing U.S. GAAP

The form and content of the financial statements of public companies are governed by the SEC. Even though
the SEC delegates most of the authority to the FASB, it frequently adds its own requirements, such as the
requirement for a company to provide a management discussion and analysis with its financial statements,
quarterly financial statements (10-Q) and current reports (8-K). These discussions indicate things like changes
in control, acquisition and divestitures, etc.)

Accounting Pronouncements Considered Authoritative

Accounting pronouncements are segmented into four categories. Category A is the most authoritative, and
Category D is the least authoritative:

Category (A)
- FASB Standards and Interpretations
- APB Opinions and Interpretations
- CAP Accounting Research Bulletins

Category (B)
- AICPA Accounting and Audit Guides
- AICPA Statements of Position
- FASB Technical Bulletins

Category (C)
- FASB Emerging Issues Task Force
- AICPA AcSEC Practice Bulletins

Category (D)
- AICPA Issues Papers
- FASB Concepts Statements
- Other authoritative pronouncements

6.24 - Accounting Qualities

1) Primary qualities of useful accounting information:

- Relevance - Accounting information is relevant if it is capable of making a difference in a decision.

Relevant information has:

(a) Predictive value
(b) Feedback value
(c) Timeliness

- Reliability - Accounting information is reliable to the extent that users can depend on it to represent the
economic conditions or events that it purports to represent.

Reliable information has:

(a) Verifiability
(b) Representational faithfulness
(c) Neutrality

2) Secondary qualities of useful accounting information:

Comparability - Accounting information that has been measured and reported in a similar manner for different
enterprises is considered comparable.

Consistency - Accounting information is consistent when an entity applies the same accounting treatment to
similar accountable events from period to period.

Accounting Qualities and Useful Information for Analysts

Here is how these qualities provide analysts with useful information:

Relevance– Relevant information is crucial in making the correct investment decision.

Reliability – If the information is not reliable, then no investor can rely on it to make an investment decision.

Comparability – Comparability is a pervasive problem in financial analysis even though there have been great
strides made over the years to bridge the gap.

Consistency – Accounting changes hinder the comparison of operation results between periods as the
accounting used to measure those results differ.
 Look Out!
Students should note that relevance and reliability tend to be opposite
qualities. For example, an auditor may improve the quality of the audit
but at the cost of timeliness. Relevance and reliability can also clash
strongly in these ways: the market value of an investment can be highly
relevant but may be accurate only to a certain extent. On the other hand,
the historical cost, while reliable, may have little relevance.

6.25 - Setting and Enforcing Global Accounting Standards

What is the International Organization of Securities Commissions (IOSCO)

IOSCO is an international association of securities regulators that was created in 1983. The objective of this
organization is to create a co-operative environment between different countries by aiming to do the following:

- Promoting high standards of regulation in order to maintain just, efficient and sound markets
- Exchanging information on respective experiences in order to promote the development of domestic markets
- Uniting efforts to establish standards and effective surveillance of international securities transactions
- Providing mutual assistance to promote the integrity of the markets by a rigorous application of the standards
and by effective enforcement against offences.

The International Accounting Standard Board (IASB)

The IASB structure's main features are:

- the IASC Foundation - which is an independent

organization whose two main bodies are the Trustees and
the IASB
- a Standards Advisory Council
- the International Financial Reporting Interpretations
Committee

The IASC Foundation Trustees appoint the IASB

members, exercise oversight and raise the funds needed,
but the IASB has sole responsibility for setting
accounting standards. This organization was created to
set international accounting standards in an effort to
bridge the gap between the accounting standards of
different nations.

U.S. GAAP versus IAS GAAP

Under U.S. GAAP, SFAS 95:

- Dividends paid by a company to its shareholders are classified on the cash flow statement under cash flow
from financing.
- The dividends received by a company from its investments are classified as cash flow from operations.
- All interests received and paid by or to a company are classified as cash flow from operations.

Under IAS GAAP:

- Dividends paid by a company to its shareholders, dividends received by a company from its investments and
all interests received and paid by or to a company can be classified as eithercash flow from financing or cash
flow from operations.
These rules are summarized in the following chart:

U.S. GAAP IAS GAAP

Cash Flow from
Dividends paid by a Cash Flow from
Financing or
company to shareholders Financing
Operations
Dividends received by a Cash Flow from
Cash Flow from
company from Financing or
Operations
investments Operations
Cash Flow from
All interest received and Cash Flow from
Financing or
paid by or to a company Operations
Operations

Look Out!
It is highly likely you will need to calculate a figure on a cash flow
statement according to one of the two rules.

6.26 - Future FASB Changes

FUTURE FASB CHANGES

FASB
FASB's agenda is determined through recent
developments in financial reporting, requests for action
on various practices, and through correspondence with
many organizations such as the CFA Institute and the
IASB.

For a list of completed past projects (up to date as of

January 2006), we recommend a read of the following
page on FASB's website:

FASB Website: Completed/Past Agenda Projects

http://www.fasb.org/project/completed_past_projects.shtml

The Norwalk Agreement was formulated between FASB and the IASB in October of 2002. This agreement,
also known as a "Memorandum of Understanding" marked both organizations commitment to converging US
GAAP and IASP GAAP.

For more on the Norwalk Agreement, the following link will direct you to the actual document formulated in
2002:

The Norwalk Agreement

http://www.fasb.org/news/memorandum.pdf

Projects on the FASB Agenda Related to International Convergence

1. Business Combinations

- FASB and IASB's aim is to eliminate inconsistencies related to guidance for assets acquired and liabilities
assumed.
- Determination of which transactions, assets and liabilities should be included in the acquisition method.

For more on the history, background, and decisions made since FASB and IASB's last meeting, check out the
following document online:

Applying the Acquisition Method

http://www.fasb.org/project/bc_acquisition_method.shtml

2. Revenue Recognition

Essentially, FASB's aim is to eliminate inconsistencies, improve guidance, and establish a single rule.

Full details regarding this agenda can be found at the following weblink:

Revenue Recognition
http://www.fasb.org/project/revenue_recognition.shtml

Projects on FASB's Short Term Agenda Related to International Convergence

The following projects are on FASB's agenda to be solved in the short term:

Inventory costs

Asset Exchanges

Accounting Changes

Earnings per Share

Balance Sheet Classification

As of May 22, 2006, FASB has issued Statements on inventory costs, asset exchanges, and accounting changes
have issued an exposure draft regarding Earnings Per Share.

Read more on these tentative decisions in the following weblink:

Short-Term International Convergence

http://www.fasb.org/project/short-term_intl_convergence.shtml

Guidance Rules for Revenue Recognition: FASB vs. IASB

In general, the IASB has one major standard on Revenue Recognition: IAS 18. Consequently, there is limited
guidance on the various types of transactions that generate revenue. On the other hand, FASB does not have any
one standard, but has over 100 pronouncements on specific topics related to revenue recognition.

1) Sale and Leaseback – An arrangement where the seller of an asset leases back the same asset from the
purchaser. We will discuss this arrangement further in the Liabilities section.

Under IASB rule IAS 17, gains on sale and leaseback of assets is recognized immediately if the lease is
classified as operating.

Under FASB rule SFAS 13, gains on sale and leaseback of assets is amortized over the life of the lease,
regardless if the lease is operating or capitalized.

2)Revenue Recognition When Right of Return Exists - According to SFAS No. 48, when a customer has a
right to return the product, revenue is only recognized if the following conditions are met:

- Persuasive evidence of an arrangement exists

- Delivery or service has been completed
- Fee for product or service is determinable
- Collectibility of monies owed from buyer is reasonably assured

In addition, revenue must be reduced to take into account estimated returns. According to IAS 18.14, revenue
can be if the buyer has assumed a substantial portion of the risks and rewards of ownership. In addition to the
above requirements, revenue is also recognized when the cost or future costs of the transactions is determinable.
This is one example where FASB has a specific guidance for these situations, whereas IASB has broad
guidance on revenue recognition as a whole.

Conclusion
You have now completed the first section on Financial Statement Analysis. Within this section we have
discussed accrual accounting benefits; income statement, balance sheet and shareholders' equity basics and
components; revenue recognition, the cash flow statement, other items and GAAP.

The material outlined in this section is important to know as it lays the foundation for effectively learning and
understanding the material presented in the following two sections.