Accounting 202 Notes

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Chapter 13Dealing with Current Liabilities

Current Liabilities1. Liabilities that will be satisfied within the year or the operating cycle, whichever

is longerCash to Cash CycleThe average amount of time it takes a company to buy and sell inventory, collect Accounts Receivable and turn the AR into cashIt normally takes 3-4 months to sell average inventory and another couple of months to collect moneyThe whole cycle is usually around 4-7 monthsOperating cycle is usually shorter than the yearYardstick for current liabilities will, therefore, usually be the year, but not always

2. Liabilities that will be paid off by the use of current assetsAccounts PayableWhen do you use an AP? If you owe interest it’s called interest payable?When we buy inventory on credit that is the most common time to use APSometimes are referred to as trade accounts payable – you have an AP because of the trade or business that you happen to be inNotes Payable(Short term)Written agreement to borrow money with interest. If you hold a note, that is an indication that the note has not yet paidIf you borrow $1,000 at 6% on NP from 3/1 to 9/1 – this is a 6-month note so it’s a CL:CASH 1000

SHORT TERM NP 1000

Pay up:STNP 1000INT EXPENSE 30 (1000*.06*(6/12) = 30)

CASH 1030

9/1-3/1:

12/31 Adj. Entry:INT EXP 20 (1000*.06*(4/12))

INT PAYABLE 203/1:

STNP 1000INT PAY 20INT EXP 10

CASH 1030

02/04/15

Current Maturity of Long-Term DebtIf you borrow money from a bank with principle due in 5 years – long-term liability for now, but when we get to the end of year 4, beginning of year 5, the liability will be due within the year so we will have to convert the long-term liability into a short-term liabilityDebit long-term NP and Credit short-term NPLONG-TERM NP

SHORT-TERM NPThis gets rid of the long-term note and creates a short-term note

If you borrow money from a bank with the principle not due all at once in 5 years, but rather the principle is due a little bit each year (on top of the yearly interest)If you borrow 1,000 on a 5-year note, each year you must pay 1/5 of the principle (plus the interest)$200 will be short-term, but the rest of the $800, is still long-termAt the end of year 1, you must pay the next $200 at the end of year 2, etc.Debit LTNP and Credit STNP

Short-Term Obligations Expected to be refinancedIf you have a CL that needs to be paid sometime this year. It’s Feb and the debt is due in May. If you renegotiate with the bank and say that instead of paying the liability, you get an extension on the principle for 2 years in return for an increased interest rate from 2% to 3%.What criteria must be met in order for GAAP to allow this?Refinancing Criteria

1. Must be intent to refinance on a long-term basis2. Must demonstrate ability to refinance

Intent is easy to demonstrate, but how do you show an ability to refinance?Ability to Refinance

a. Actually refinancing demonstrates the ability to do so (sit down with the bank and go through the details and sign the docs that allow the CL to be refinanced)

b. Entering into financing agreement (if you haven’t worked out all the details, a few that are still being negotiated, but the fact that you’ve entered into the agreement, that demonstrates the ability to refinance)

Debit STNP and Credit LTNP

Cash Dividends PayableCompany’s board declares dividend in Dec and usually takes 4-6 weeks before dividend is actually paid, so it will be paid toward the end of January

You’re going to hit 12/31 so you’ll have a short-term liability that hasn’t yet been paidIf you haven’t yet declared the dividend then there is no liability. The liability is created when the Board declares the dividend

Customer AdvancesIf you go to a carpenter and ask him to construct something and he asks for 50% now and 50% at completionFrom the perspective of the carpenter, the customer advance (the 50% that he accepts) creates the obligation to perform services and therefore a current liability

Unearned RevenueYou receive revenue in advance of earning it – this creates a liabilityIf a landlord lets someone rent an apartment, but you have to pay every 3 months in advanceAlways have 3 months rent in advance and it hasn’t been earned so the landlord has unearned revenue and a CLAs every day/month passes, the revenue is being earnedThis and customer advances are pretty much exactly the same

Sales Tax PayableIf you buy something that sells for $100, but at the register you’re charged $108 including sales taxSelling Price (SP) = $100Tax = 8%From perspective of business:CASH 108

SALES 100S.T. PAY 8

Income Tax PayableThe assumption is that we are talking about a corporationSole proprietorship – one ownerPartnership – two or more owners The previous two don’t pay taxesThis doesn’t mean that the owners don’t pay taxes. This just means that the business itself isn’t taxedOn these income statements there are never any lines for income tax of the businessCorporation – a separate legal entity that must pay taxesThere is really a double taxation because the company is taxed and then any dividends distributed to shareholders will be held as personal income, which everyone must pay taxes on There is almost even a triple tax because when you sell the shares at a profit there will be a capital gain, which people will be taxed on as well

Employee-Related LiabilitiesMost of this we won’t discuss – just one issue that we will talk about

From the employer’s perspective:There are people working for she/he that will create liabilities related to themThere are deductions taken out of the check like: FICA (Federal Insurance Contribution Act):

1. Social Security – money is taken out of employees pay check in order to go to SS so that when the individual is 62/65 he will be entitled to government payments

2. Medicare – a subsidy that the government gives employees when they reach 65 to pay for doctors and medication, etc.

Also there are federal and state tax plus union dues (if one is part of a union) and pension plansThe employer must deduct for various items, resulting in CLAll of these deductions represent liabilities from the employer’s point of view because they have the money on hand, but must send it to the necessary list of FICA-related institutionsNot only is money taken out of employees check, but the employer also must deduct from his own pocket whatever is taken out of the employee’s check (dollar-for-dollar) and pay to the FICA systemThe employer must also pay unemployment insurance out of his own money to the federal and state government so that if the employee becomes unemployed he will be entitled to unemployment insuranceThese are a lot of CL and that is the connection to these chaptersThe only issue we will go into depth about is…Compensated AbsencesBecause my employee has worked for me for a certain period of time, he can be absent from work for certain reasons and I, the employer, will have to pay them regardlessWhat kind of absences?Holidays, vacation days, and sick daysAt the end of the year, should the employer recognize the fact that employees may be absent and will still be paid?GAAP says yes if the following 4 conditions exist:

1. The employee’s right to be compensated must be related to services already rendered – the employee must have already worked for the company and rendered services for a certain period of time – because in order for there to be a liability there must be a past transaction or event

2. The rights either vest or accumulate Rights that vest – the employee has this right even if they decide to quit tomorrowRights that accumulate – rights that accumulate from year to year – if you don’t use your vacation days in one year, they will roll over to the next year and have extra vacation/sick daysSome companies have the “use it or lose it” policy so you aren’t for sure going to be paid

3. Payment is probable4. Payment amount can be reasonably estimated

3 and 4 are conditions that are relevant to every single liability, so of course here

We’re up to contingencies

02/09/15

   Contingencieso   Contingent Gain: gain that is contingent on some future outcome or event.  If hurt by a product and in the midst of suing gain is contingent on the court case.  Gain is recognized when case is settled. o   Contingent Losses: loss that is contingent on some future outcome or event.  My Product hurts a customer; in the middle of being sued loss is contingent on the court case.   Probable: highly likely that law suit is going to be lost and amount should be able to be reasonably estimated; loss is recognized before the suit is over.  If loss is a given range ie: $3-5, take most reasonable number within range, indicate it can go as high as $5 in footnotes.  If no way to estimate within the range recognize the lower of the range and indicate in the footnotes the higher of the rangeLOSS FROM LWSUIT                        LIABILITY PAYBLE  Reasonably Possible: No accrual or journal entry; however must be indicated in footnotes either the possible amount or range  Remote: unlikely that you will lose, do not need to have any disclosure  

Chapter 14Bond issued by a Corporation

      Bond indenture: contract between two parties, issuer and buyer.  Indicates the terms of the bonds, payment date, penalties, bond related funds      Types of bondso   Secured: backed by a pledge of some sort of collateral. o   Unsecured: “Debenture” un-backed bonds, usually issued by a company that has minimal risk and offers a higher interest rate. More risk and higher return.o   Term: bond that reaches maturity at the end of a certain term at which point the principal is dueo   Serial bond: interest and some of the principle is paid of at every periodo   Callable Bond: corporation that issued the bond can call the bond back before maturityo   Convertible: if bond holder wishes to give bond back, they can convert to common stock during window of opportunityo   Commodity-Backed: “Asset-Linked” linked to a commodity such as oil or silver, when bond reaches maturity it is payable in either the commodity or cash; whichever is higher

o   Deep-Discount: sold at a discount so that the total interest payoff is received at maturity.

02/11/15

Par Value for StockMinimum legal issuance price of the stock and the least amount one can recover from a stock

Par Value for bonds (Stated Value, Face Value or Maturity Value)Maturity value of the bond – the amount of principle the company will have to pay when the bond maturesA stock can’t be issued below par value, at what price can a bond be issued?

1. At Par: $1,000 pv @ 100 (this means @100% of its par value)2. Discount – below par: $1,000 pv @ 97 (this means @97% or $970)3. Premium – above par: $1,000 pv @ 102

Why would a bond be issued at either one of these? We’ll discuss later, but for now, we know that issuing at a discount or a premium is not a question of who gets the better deal (good or bad), but it’s a question about equilibrium, which we’ll discuss later

There are 2 different interest rates that are associated with a bond:1. Stated Rate of Interest (Face Rate, Coupon Rate, or Contract Rate) – this is

the interest rate that will dictate how much interest will be paid during the period (this may not be the same as the interest expensed)

It is called this because it is stated on the bond certificate that this will be the rate and is called the face rate because the rate is engraved on the certificate. It’s also called coupon rate because the older bonds had a bunch of coupons around the certificate and the bondholder would detach a coupon and send it to the company in return for interest

2. We may discuss laterBONDS PAYABLE IS ALWAYS RECORDED AT PVBonds can be issued at any time when buyers are willing to purchase the bonds (it can be in between interest payment dates too)

Bond issued at par and on an interest payment date:$100,000 PVStated R 6%Semiannual 6/30 and 12/31 Issued on 1/1/1 (don’t be so concerned that 12/31 is one day off)5-year bond

1/1/1CASH 100,000

BONDS PAYABLE 100,000

6/30/1INT EXP 3,000

CASH 3,000 (F*F) = .06*100,000*(1/2) Make sure to multiply by ½ because it is semiannual

12/31/1INT EXP 3,000

CASH 3,000

If issued at:100,000 parStated R, 6%3/1 and 9/1Issued at 3/1/1

3/1/1CASH 100,000

BP 100,000

9/1/1INT EXP 3,000

CASH 3,000

12/31/1 – Adjusting Entry INT EXP 2,000

INT PAY 2,000(F*F) = .06*100,000*(4/12)

3/1/2INT PAY 2,000INT EXP 1,000

CASH 3,000

Issued at par between interest payment dates:RULE: whoever bought this bond should pay in the accrued interest and then on the following interest payment date, the full six months will be paid back – this will make the accounting much simpler100,000 PVStated r = 6%3/1 and 9/1Issued at 4/1/15-year bond:

3/1/1NO ENTRY

4/1/1

CASH 100,500BP 100,000INT PAY 500

Face rate*face value = (f*f) = .06*100,000*(1/12)

9/1/1INT PAY 500INT EXP 2,500

CASH 3,000

12/31/1 – adjusting entryINT EXP 2,000

INT PAY 2,000

3/1/2INT PAY 2,000INT EXP 1,000

CASH 3,000

Bonds Issued at Discount Handout

2/23/15

When it comes to paying interest, the interest rate you use is the stated rateInterest expense means the true cost of the bondSo, in the case of a premium, the interest expense will be less than the interest paidIn a discount, the relationship is just the opposite

Buying a Bond vs. Buying shares in a corporationIf you buy a bond, you are a creditorIf you buy stock, you are an owner/investor

Rights of ShareholdersAs a shareholder you have many rights, but there are 4 main ones for this course:

1. Right to share in profits – This doesn’t mean that you can walk into corporate headquarters and take a check out of 4% of the earnings of the company – the corporation will put most of the earnings back into the corporation – the distribution of dividends will be what the shareholder will share in the earnings

2. Right to share in management – They own the company so they should make the decisions – since they don’t have the expertise to do so, so they aren’t involved in day-to-day decisions – but they can vote in and out the Board of Directors who hire the upper level management who hire people to work in the company – takes place at the annual shareholder’s meeting – if you don’t want to go there you can vote by proxy – sometimes the board will hold a vote on certain company decisions, but not on a day-to-day basis

3. Preemptive Right – 4. Liquidation – should the company liquidate, you have a right to get back what

you invested into the company, but if this happens, the creditors have priority – the shareholders are at the back of the line – the creditors themselves have higher and lower level priorities

2/25/15

Preferred Stock Vs. Common StockA minority of companies issue preferred stock, but most companies do issue common stock

Preferred Stock1. It is preferred as to dividends – the preferred shareholders must receive their

required dividend before common shareholders can receive any dividends2. Upon liquidation, these shares have preference over the common stock as far as

the rights to receiving compensation from the liquidation of a company

Required DividendIf there is a 5% PS, PV of $100, 1,000 shares issued and outstanding, 5,000 shares authorizedPS will pay $5 dividend per share, 5*1,000 = $5,000 in required dividends before any of the common stock shareholders can receive any dividend

Par Value or Legal ConsequenceThe minimum legal issuance price of the stockState law governs corporations (therefore, the laws vary from state to state)

Downside to PS1. Market price of the PS is relatively stable over time and therefore you won’t have

much capital gains like you would have with CS

Cumulative PSIf at any point, the directors don’t declare the dividends for the year, the dividends will accumulate for the next year, but the dividends must eventually be paidThis is how PS is normally sold If in a HW problem it doesn’t specify what type of PS, we assume that it is cumulativeNon-Cumulative PSThe dividends don’t accumulate from period to period. If BOD doesn’t declare a dividend for the year, there is simply no dividend

IF:Dividend In Arrears (DIA) 0Board declares $45,000 dividendPS gets 5,000, CS gets 40,000

SUPPOSE:2 years DIAPS gets $15,000 (10,000 from previous two years and 5,000 from this year)CS will get $30,000

Callable Preferred StockIf the corporation wishes, they could call back the PSA company may do this if interest rates in the market are going down. The corporation may rather borrow money at lower interest rates

Convertible Preferred StockIf the preferred shareholders want, they can give back their shares and convert it into CS at a rate specified by the company in advanceThere is usually a window of opportunity to do this (and after that time they can no longer do this)A preferred shareholder may do this because the price of PS is relatively stuck at its price and gets the same percentage dividend – if the preferred shareholder believes that the company is in good health, a PS won’t help them so they may want to convert it into CS so that they can benefit from capital gains + larger dividends

Fully Participating Preferred StockThe preferred and common shareholders share in any dividends at the same rate (not necessarily the same amount)

Suppose:5% PS, par $1001,000 shares issued and outstanding CS $2 Par100,000 shares I and O

If:DIA = 0 , $45,000 dividendPS gets 5% or $5,000CS gets 5% of $2 = $10,000Then you look at the PV relationship (there’s $300,000 worth total, CS is 2/3 of it and PS is 1/3 of it)PS will get 1/3 total of 45,000 = 15,000 (so they get another 10,000)CS will get 2/3 total of 45,000 = 30,000 (so they get another 20,000)

If:DIA = 3,000PS gets 5%, which is 5,000 plus 3,000 in arrearsCS gets 5%, which is 10,000Then there is 27,000 left to dividePS gets 9,000 (9% of 100,000) and CS gets 18,000 (9% of 200,000)

Both CS and PS participated in the full dividend

Partially Participating Preferred StockPreferred and CS share up to a point, but after that point PS is out and CS takes overEvery company will specify beforehand what that point is

Suppose:PS can participate up to 8%Same details as fully participating PSDIA = 0Dividends = 45,000

PS gets 5% =5,000CS gets 10,000PS gets another 3% of par = 3,000CS gets 3% of par = 6,000So far we gave out $24,000The rest of the 21,000 is divided among the CS holders

If:$20,000 dividendPS gets 5% = 5,000CS gets 5%= 10,000PS gets 3% of par = 3,000CS gets 3% of par = 6,000*, but the problem is that we can’t give the CS holders 6,000 because there isn’t enough left in the dividendSo CS holders will get the remaining $2,000 instead of their 3%

PS isn’t Mutually ExclusiveYou can have PS that is both cumulative and callableAssume there are also dividends in arrearsThe corporation may want to call back the PS and get out of paying any of the DIA, but this isn’t allowedIt will not work – when the PS are called, the DIA must be paidEven if the company only calls back some of their stock, they have to pay back all of the PS holders’ DIA

HW Questions/Exercises/Problems:Chapter 13In syllabusChapter 14Exercises 1,6,7,

03/4/15

4 Types of Preferred Stocks

Issuance of Stock

CS, par %1,000 shares issued and outstandingat $10

Issued stock at par:CASH 10,000

CS 10,000

Issued stock above par at $12:CASH 12,000

CS 10,000APIC 2,000

No par value CS:Issuance price $8Stated value $5 (legally not the same as par value, but it replaces it as far as journal entries)

CASH 8,000CS 5,000APIC 3,000

True No Par CS – no par CS, no stated value:Issued at $9CASH 9,000

CS 9,000

3/09/15

Property DividendWe will be giving an asset as a dividend, but not cashIf a warehouse has inventory that’s not popular anymore they may send those to their shareholders to appease themA more realistic story would be:If company A owns stock in company Z, which is an asset for the company called “Investment in Company Z” that was purchased for $10,000If there is an investment gain of 8,000, the account will now be valued at $18,000

INVESTMENT IN ZGAIN

The company may distribute these shares as a dividend

REINVESTMENT IN Z

This does meet the definition of a dividend

Liquidating DividendThe company is going out of business (liquidating)The creditors are at the head of the line and the shareholders are at the back of the lineUsually the shareholders will end up with zeroBut what if the company can pay the shareholders back what they invested in the company?The company will have to get rid of the CS and the APIC that was created when they purchased shares

CS XAPIC X

CASH X

This doesn’t meet the definition of a dividend because there is no distribution of earnings (even though we call it a dividend because the shareholders are getting something)

Stock Split

Before SS:SE:CS $10 par 10,0001,000 shares issued and outstandingAPIC-CS 8,000RE 62,000

TSE 80,000Let’s assume a 2:1 stock split (2 new for every one old)In a stock split there is no JE

After SS:SE:CS $5 par2,000 shares issued and outstanding 10,000APIC-CS 8,000RE 62,000

TSE 80,000

Main reason for stock splitWhen the market price of the stock is overpricedBy going through a split and flooding the market with more shares, the market price will fall dramatically

Comprehensive Income1. Equity changes because of everything that shows up on the income statement2. Equity changes because of other comprehensive items that never show up on

income statement, but show up directly in the stockholders’ equity sectionAll the reasons why equity changes

Exam will be likely 2 weeks from today

03/16/15

Exam will be in one week from today – exam will be on Monday

For next exam:One other topicConvertible PS we will doStock Warrants we will skipPage 899 we will do computing EPSAll of the HW that was assigned will be on EPS, but the first two topics will be on that exam too

Test #2

Convertible BondBondholders have the right to convert their bonds into CS of the corporationWhat methods do GAAP allow for the conversion of bonds into CS? What would be the affect on the company’s financial statements?GAAP Allows 2 Approaches:

1. Book Value Method2. Market Value Approach

We will go to brief exercise #2 to explain

If we have 2,000 bonds and each can be converted into 50 shares, we would have 100,000 shares after conversion

BV approach:The amount of equity we’ll exchange for these bonds will be based on BV of bonds

Converting the bond into CS:BP 2,000,000 (2,000*1,000 PAR)

DISCOUNT 30,000CS 1,000,000APIC 970,000

We gave out 1,970,000 because that was the book value of the bonds (taking into account the discount)

MV Approach:

We give out equity based on the market value of the stock

BP 2,000,000LOSS… 130,000 (loss on conversion of BP)

DISCOUNT 30,000CS 1,000,000APIC-CS 1,100,000 ($11 value of stock over par*100,000 shares)

Convertible PSPreferred shareholders can convert their preferred shares into CSWhat does GAAP have to say about the JEs?There is only 1 allowed method under GAAP – the BV Approach

Brief Exercise #3BV of PS is 60,000 so this is how much CS we must give out

PS 50,000APIC-PS 10,000

CS 20,000APIC CS 40,000

Two types of Capital Structures:Simple Capital StructureOne that doesn’t have any potentially dilutive securitiesYou must compute Basic EPSComplex Capital StructureOne that does have potentially dilutive securityYou must compute Basic EPS and Diluted EPS

“Potentially Dilutive Security”A security that is not yet in the form of CS, but through conversion or exercise could become CS, and should it become CS, could potentially dilute EPS

Basic EPS(Net Income – PS Dividends) / # of weighted average CS outstanding

Weighted Average CS OutstandingSuppose at beginning of year, company issues 1,000 shares of CSIn ten months they offer another 1,000 CSAt year end, these shares can’t just be added together because half the shares have been earning for 12 months while the other half has only earned for 3 monthsTherefore, we need to take the weighted average1/1-9/1 1,000 * (9/12) = 75010/1-12/31 2,000 * (3/12) = 500

1,250 WACS

(Handout on calculating WACS outstanding)Potentially Dilutive Securities

Convertible PSCan be converted into CSWhat if it was converted, how would that affect EPS?There is an increase in the numerator and the denominatorIf the denominator effect is stronger, EPS will go downTherefore, convertible PS is potentially dilutiveConvertible BondsIf these were converted to CS, what would be the affect?The denominator goes up because there are more shares and the numerator goes up because there will be no more interest expense on the bonds so NI will increaseIf the denominator effect will be the stronger of the two, EPS would go downTherefore, convertible bonds are potentially dilutiveStock Options or Stock WarrantsIn a stock option, select employees of a company have the option to buy more stock at a favorable priceIn a stock warrant, current shareholders have the right to buy more stockIf exercised, the denominator will go up and EPS will fall, making it a potentially dilutive security

With all of these items, none have yet become CS, but they mightGAAP says to show the potential reduction now – make believe as if the dilutive security became CS and show the reduction to EPS now

3/25/15

The Wed before the break and the Mon after the break he won’t be here so we’ll have to make it up during free hour

Chapter 17

There are 2 investments we need to discuss1. Debt securities/bonds2. Investments in equities securities/stock

We’ve discussed this from the perspective of the corporation that’s issuing the bondNow we’ll be talking about the party that is buying the bond and lending money to the issuer – same story with stock

An investment is an assetIf you buy a bond you’re a creditorIf you buy stock you’re and owner

All dependent on FASB 1153 types of bonds one can purchase:

1. Held-to-Maturity Security2. Trading Security3. Available for Sale Security

On day 1 you must decide which of the 3 you’re buying because the rules under GAAP are different for each typeHeld to MaturityWhen you buy the bond you have the intent and ability to hold on to the bond until it maturesThey may mature in 20 years so you must be able to hold on for that longHeld to Maturity bonds are long-term investmentsWe don’t recognize an unrealized gain or loss on the investmentValued at amortized cost (CV or BV; historical cost less amortization)Trading SecurityWhen you buy the bond, you buy it to trade it within a very short period of time (3 months)When you buy it, it’s recorded at historical costIf you still have it at the end of the period it’s valued at fair (market) valueIf FV is above original cost we have a gain, if FV is below we have a lossIt would be an unrealized gain or loss – not a true gain or loss because we haven’t yet sold the securityThis gain or loss should be recognized on the income statementThis is a short-term investmentAvailable for SalePlan to sell it, but not within 3 monthsMust be able to hold it for whatever that time isSimilar rules to trading securitiesIt starts off at historical costAt the end of the period it’s adjusted to FV (same as trading securities)Also results in unrealized gain or lossThis gain or loss should show up on the balance sheet as part of other comprehensive incomeThis can be either short- or long-termIf it’s within the year, it’s short-termIf it’s longer, it’s a long-term

Chart on page 953Valuation doesn’t mean finding valuation on the day you bought it because it always starts at historical costValuation means at the end of the period

Amortized CostHTM BondBought on 1/1/1

Par 10,000Discount (1,000)

9,000SL amortization for 10 years12/31/1Discount = 90012/31/2Discount = 800Therefore, the CV of the bond (BV) is increasing:10,000-900=9,10010,000-800=9,200This CV can also be called amortized cost

(Handout)

Data:Trading SecuritiesMonthly basis4/10 HC 10,0004/30 FV 12,0005/31 FV 9,000

4/10 DEBT INV 10,000

CASH 10,000

4/30 ADJFV ADJ 2,000

UNR GAIN 2,000This will be recorded on the income statementThe new account “FV ADJ” is an asset account so the two assets (investment and FV Adj. will add up to the FV)Unrealized gain is an income statement account and will be closed out at the end of the period (in this case the month) so the T-account will go back down to zeroFV Adj. doesn’t get closed out because it is a balance sheet account

5/30UNR LOSS 3,000

FV ADJ 3,000Now that the FV ADJ T-account has a credit balance, it becomes a contra-asset account

Available-for-Sale SecuritiesSame data

4/10DEBT INV 10,000

CASH 10,000

4/30 Adjusting EntriesFV ADJ 2,000

UNR GAIN 2,000Over here, the unrealized gain will be brought to the balance sheet, not the income statement, and therefore, it will not be closed out at the end of the period

5/31UNR LOSS 3,000

FV ADJ 3,000The unrealized gain/loss T-account will now have a debit balance of 1,000 because it wasn’t closed out in the prior period and will not be closed out now

Buying Stock in a Company

Charts on page 961

First Chart – APB 18Parent-Subsidiary50%-100% stock in a companyLegally a parent and subsidiary are two separate companies, but from an accounting perspective, the two companies are one economic entityOne company owns 50-100% of a companyConsolidation – Only prepare one set of financial statementsThis story of consolidation is the essence of advanced accounting so we just have to know what GAAP says, but not how to consolidate financial statements

20%-50% stock in a companyUsually do have a lot of influence and you used the equity method to prepare statementsSignificant influence example – able to buy fabrics from a company at a significant discountThe percentage is really not that importantWhat’s important is whether or not you have significant influenceIf you own 30% of a company and another shareholder owns 70%, you don’t have significant influenceIf you own 15% and the other million shareholders have around 1%, you do have significant influence and should use the equity methodThe percentage is just a guideline

Up to 20% of a companyUsed the cost method to prepare financial statements according to APB 18The book says to use fair value method, which is the current correct thing to do according to the more recent FASB 115

Second Chart – FASB 115

Holding less than 20%1. AFS Security – On day one, it’s valued at HC. At the end of the period it’s

valued at fair value resulting in unrealized gains or losses. This will show up on the balance sheet in the stockholders’ equity section as part of other comprehensive income

2. Trading Security – When you buy the stock it’s recorded at HC. At the end of the period it is adjusted to fair value resulting in unrealized gains or losses. This will be recognized on the income statement.

For these we use the FV Method

Transfers Between Categories (974)Always picked up in the new category at FV on the day of the transferIf a bond was AFS and then changed to Held-to-Maturity, the investment will show up in HTM at FV on the date of transferIf it was HTM bonds and transferred to AFS, the investment will show up in AFS at FV on the date of transfer

4/15/15

Chapter 17 deals with investments in the 3 types of bonds and also investment in equity securities (3 range possibilities in how much you own)

What’s the basic difference between the FV approach and the Equity approach?Page 965 illustrates the differences

Equity MethodEvery time something happens to the equity section of the company invested in, there will be an affect to the asset (an adjustment)

End of Chapter 17

4/20/15

BEGINNING OF NOTES FOR FINAL EXAM

Chapter 22

Accounting Changes4 that we need to be familiar with:

1. Change in an Accounting Principle2. Change in an Accounting Estimate3. Change Due to an Error4. Change in a Reporting Entity

Change in a Reporting EntityExample:

If company A owns 51% or more of stock of company BThis will be a parent-subsidiary relationship because they are the majority shareholder and are in controlA is parent, B is subsidiaryFor this, we will use a method called consolidation to combine together the financial statements of the two entities onto one set of financial statements and treat them as if they’re one economic entitySuppose this is how it was reported for the last ten years between this parent and subsidiaryWhat if this year, company A bought 51% or more of company CNow it will be parent A and subsidiary B and C (consolidated)This change from just A and B to A, B and C is an example of a change in a reporting entityWhat does GAAP say you should do about this change? How will we ever compare the financial statements of the new entity with the old financial statements?We must handle this change retrospectivelyWe go back and make believe that this reporting entity wasn’t just A and B for the last ten years, but rather, as if it was a combination of A, B and C – Change all of the financial statements of the last 10 yearsAll of the NI will change because we add another entity – this means that we need an adjustment to REOn top of that, we will need footnote disclosure indicating what is going on here with the companies and the changing of the statements

Change in an Accounting PrincipleSuppose we’ve been in business for 10 years and we’ve been using FIFO to value our inventoryNow, we have a strong justification to switch to LIFO (you normally can’t switch, but sometimes they’ll allow it)We have a switch from GAAP to GAAP – both are acceptable methods, we’re just switching based on a strong justificationHow does GAAP say we should handle this change? For the last few years we’ve been using FIFO so it won’t be comparable to the newer statements that are using LIFO?Retrospectively – change all of the old statements to LIFO so that we’ll be able to compare the statementsThis means that all of the NI from the previous years will change, which means that there will need to be an adjustment to REOn top of this, we’ll need footnote disclosure to indicate to the readers the nature of what occurred

Change in an Accounting EstimateWe know that very often in accounting we have to estimateFor example, when we depreciate, we don’t know exactly how long the object is going to lastSame with bad debt expense, we don’t actually know how many accounts are going to go bad

In these situations we make estimates, but the odds are that somewhere along the line, we’ll realize that the original estimate wasn’t correctWhat should we do in this situation?Suppose:We acquire a truck that’s HC is 20,000SV of the truck is 0Estimated life is 10 yearsWe will use SL

After 6 years:HC is 20,000AD is 12,000BV is 8,000

This is only if my original estimate turns out to be correctBut what if after 6 years we determine that the SV is actually 500 and the Life is 9 yearsWe handle this change prospectively – whatever you did until now you leave alone because you estimated the best that you could – just change things for the current and future yearsHC 20,000AD 12,000BV 8,000SV (500)

7,500 / 3 = 2,500 per year

When we were talking about a change in accounting principle, we talked about FIFO to LIFOWhat if we were talking about changing the method of depreciation from double-declining balance to SL or vice versa – is this change from GAAP to GAAP?This isn’t what GAAP says – depreciation isn’t a change in an accounting principle, this is a change in an accounting estimateThe reason why you’re switching depreciation isn’t because you’re changing a principle, it’s because you erred in your estimate – the estimate is what’s causing you to switch your method of depreciation and therefore it’s a change in an accounting estimateThis is a big deal because it will be handled prospectively and not retrospectively

4/22/15

Change Due to an ErrorSuppose in the middle of April we determine that we made a mistake on a previous income statementThe fact that an error was found is a little odd because the statements are usually checked so many times, but we’ll assume that’s what happened3 Types of Errors

1. Arithmetic Mistake – pushed the wrong keys on the computer when computing the numbers

2. Mistake in Estimate – An estimate is “way off” – there’s no exact definition to this, but when you see it you’ll know

3. Usage of an accounting method that’s unacceptable under GAAP – this isn’t a change in accounting principle because that is GAAP to GAAP while this is non-GAAP to GAAP

Retrospectively – You must go back and correct the error whenever the error took placeThis will cause a change in the NI of the period and we will need an adjustment to RE and a footnote of the adjustment Example:If we made an error in our calculation of depreciation expenseDEPRECIATION EXP 40,000 O

IBT 40,000 UTAX EXP (40%) 16,000 U (these two errors will have negating effects)NI 24,000 UThe beginning RE of the next year will be understated 24,000Prior Period Adjustment (net of tax) – We will have to add back 24,000BEG RE ADJ 24,000The main point is that there will be an adjustment to this period’s RE not in the gross amount of the error, but rather the error net of tax

Read the second half of chapter 22 on the “light-side” because it will not be the main part of the course – the first part will need the most studying

End of Chapter 22

Exam on Monday will start a quarter to 11:00am and go until 12:30pmExam is on 16 and 1730 questions, we won’t have to do all of them(908) 591-5929 – evenings are the best time to call

Chapter 23 – Statement of Cash Flows

This chapter will have a very important role on final exam and it deals with the Statement of Cash FlowsAll this time we’ve focused on income statement and the balance sheetThis statement is not trying to tell us how much cash changed over the period because then we wouldn’t need the statement; we’d just use the beginning and ending balance sheet cash accountsStatement of Cash Flows tries to tell us why cash changed3 Activities that Cause Cash to Change

1. Operating Activities2. Investing Activities3. Financing Activities

Although this is the order in which they should appear, we will deal with operating activities last in this class because it is the most difficult

Investing ActivitiesThe change in cash due to the change in certain assetsAs certain assets change, cash will either go up or downFor instance, if we buy a truck, you’re buying an asset so the truck account goes up, but the cash account goes downWhen you sell the truck, you have less truck, but more cash5 Categories of Assets that Affect Investing Activities:

1. Plant Property and Equipment2. Investments3. Intangibles4. Natural Resources5. Notes Receivable

PP&EYou buy a truck or you sell a truckInvestmentsWhen you buy an investment (like a security), the asset will go up and the cash will go downIf you sell an investment, vice versaIntangiblesTrademarks, patents and copyrightsIf you buy a copyright from another company, your intangible account will go up, but cash will go downVice versaNatural ResourcesOil fields, coalmines and timberlandsAs asset changes, cash changesNotes ReceivableThere are many reasons why this account can changeThe most basic reason is if we lend money – cash goes down, but NR goes upWe have a right to get paid back – when we receive the money, NR will goes down and cash will go upWe will receive both principle and interest – which one is the investing activity?The principle is the part that is an investing activityWe will talk about the interest later

Financing ActivitiesThe change in cash due to the change in certain liabilities and stockholder equity accounts

1. Short- and Long-Term Notes Payable (liability)2. Bonds Payable (liability)3. Issuance of Stock (equity)4. Treasury Stock Reacquisitions (equity)5. Cash Dividends Paid (equity)

If we borrow money, our NP goes up while cash goes down and if we pay it back, the NP will go down

Same with bondsIf we issue stock our cash goes up and SE goes up and vice versa with TS (buying back stocks)Cash DividendsCauses SE to go down and cash to go down

Investing deals with Assets and Financing deals with Liabilities and Equity – together, they make up all the changes that take place on the balance sheetOperating activities represent changes that take place on the income statementRevenues will cause cash to go up and expenses will cause cash to go down

Operating ActivitiesDeals with changes that take place on the income statementIncome statement must be prepared using the accrual basis (recognized when earned)On SCF, operating activities, the income statement must be done on a cash basisOur job is to convert the income statement from an accrual to cash basisGAAP Allows 2 Methods for this Conversion:

1. Direct Method* (preferred method)2. Indirect Method (most companies use this method)

Because most companies use the indirect method, this will be the method that we’ll discuss in class even though the direct method is the preferred method

Look at chart on 1227 illustration 23-7Chart shows that you start with NI, which is the bottom line of accrual basis and go through additions and subtractions to get it to cash basis

DEPRC EXP XAD X

This is was prepared on the accrual basisSince it was a noncash expense that we subtracted from NI, we will have to add it backAMORT EXP X

PATENT XThis was subtracted from NI, but is noncashWe will add this back to NIINT EXP X

DISC XThis is a noncash expense so it will be added back to NIWe would do the opposite if it were the amortization of a bond premiumLOSS ON INV X

EQU INV XLoss of Company A’s stock that we own using the equity method (significant influence)If that company posted a loss, we would represent it as our own as a lossThe loss, however, is noncash for us so we must add it back to NI in order to get to the cash basisConversely, if we had income on investment using the equity method, we will subtract this noncash gain from NI

4/29/15

Notes were deleted because this laptop sucksWe did chapter 23, statement of cash flows

5/04/15

LeasesCompanies often have to choose between buying or leasing an asset:If you buy, in the long-run it will be cheaper, but you have to live with all of the problems of the asset even when it stops working as wellIf you lease the asset, you don’t really own it, we’ll make payments every period in order to be able to use the asset. If there are any problems with the asset, it’s the owners problem to fix it. In the long-run it’s probably more expensiveSince you keep renewing leases the asset is always relatively new

Lessor – the one who legally owns the asset and this asset is initially on the lessor’s books (they depreciate it)Lessee – leases the asset and makes payments to the lessor every period

Different types of Leases:Operating LeaseThe risks and benefits of ownership remain with the lessor The lessor, from an accounting point of view, still owns the assetThe lessee is simply renting the asset under this leaseTherefore, the lessor depreciates the assetCapital LeaseFrom an accounting point of view, the risks and benefits of ownership pass over to the lesseeWe view this as if the lessee bought the asset, from an accounting point of viewTherefore, the lessee will capitalize this onto the lessee’s books as if he bought the assetTherefore, the lessee depreciates the asset on his books

Sales-Type Direct Financing

Page 1274 in the textAccounting for leases from the lessee’s point of view

4 Criteria for Capital Lease1275, important chart – capitalization criteria – in blue box there are 4 criteria that if the lessee meets any one, it is a capital lease from the lessee’s point of view

PV of minimum lease paymentsMinimum Lease Payments (MLP)Includes:

1. Annuity Payment that lessee has to pay – PV of OA = A(F4); PV of AD = A(F(n-1)+1)

2. PV – Bargain Purchase Option (BPO) – PV = FV(F2)3. PV – Guaranteed Residual Value (GRV) – PV = FV (F2)

These are the only 3 we need to know about for our purposes even though book has more

Executory Costs1. Insurance Costs2. Property Taxes3. Repairs and Maintenance

Even if lessee is responsible for these three payments, they are not included in the PV of the payments in order to determine whether or not it’s a capital lease from POV of lessee

Discount RateThe lessee should use the Lessee’s Incremental Borrowing Rate (LIBR)This rate will be used to calculate the PV (it’s the “R” factor that you look up in the table)LIBRThe lessee isn’t really buying the asset, they’re just leasing itBut what if they did buy it and it cost $1M, what interest rate would the bank charge for the lessee to borrow this money?Because the lessee already borrowed for the lease, they will be charged an even higher interest rate on the new borrowing to purchase the assetHowever, there’s one exception to the lessee’s usage of LIBRIf lessee knows that lessor’s implicit rate of return is less than the lessee’s incremental borrowing rate, then lessee should use the lessor’s implicit rate of returnIf LIRR < LIBR and lessee is aware of this, lessee should use LIRRLIRRWhatever asset we’re talking about, the lessor made an investment to purchase that asset and are expecting a certain rate of return known as the LIRRPart of any money that the lessor makes is used to cover the original investment

Depreciation PeriodAssuming capital lease and it’s on the lessee’s books, the lessee must depreciate the asset2 Possible Periods to Depreciate:

1. Lease Term – criteria #3 and #42. Economic Life – criteria #1 and #2

It depends on which of the 4 criteria made this into a capital lease which one you depreciate over

Effective Interest MethodIf every month, the mortgage payment is $1,000In this payment, part is toward the principle and part is interestWhen you first borrow the money, most of the payment will be interest, but as time passes on, the interest portion will go down while the principle portion goes upAs time goes on, interest portion goes down, principle portion of payments goes up

Depreciation ConceptsThe point is that if this is a capital lease from the lessee’s POV, the asset must be capitalize on lessee’s books and lessee must depreciate the asset

We will be receiving a handout for numerical example of lessee’s capital lease

5/06/15

Handout on lease payments and journal entries

Sales-Type Capital LeaseBV doesn’t equal FV at the inception of the lease – there is an automatic gain or loss at the start of the leaseDirect Financing Capital LeaseBook Value and the FV are equal – there is no automatic gain/loss at the start of the lease