far 1-1 role and standard-setting process

FAR_ParticipantGuides_M1 1 27 May 2016 6:45 PM

FASB andStandard Setting

Lesson OverviewIn this lesson we will cover the primary purpose of financial accounting.

The professional organizations that are an integral part of the financial accounting environment

Primary PurposeFinancial accounting and reporting provides information to aid the decision making of the users of the financial statements—primarily the external users need this information to:

• Make investment and credit decisions.• Assess amount and timing of cash flows.• Assess economic resources and

obligations.

Generally Accepted Accounting Principles (GAAP)

GAAP addresses three aspects of financial reporting:

1. Recognition—when recorded on financial statements

2. Measurement—how recorded on financial statements

3. Disclosure—anything that is not on the financial statements

Organizations

The Financial Accounting Standards Board (FASB)

The Securities and Exchange Commission (SEC)

The American Institute of Certified Public Accountants (AICPA)

The Private Company Council (PCC)

FASBThe private sector body that establishes GAAP

Seven full time members—Effective

Mission to improve the usefulness of financial reporting

• Address deficiencies• Promote international convergence

Module 1FAR 1-1 Role and Standard-Setting

Process

1

COPYRIG

HTED M

ATERIAL

2 Wiley CPAexcel® Exam Participant Guide: Financial Accounting and Reporting


FASBFinancial Accounting Foundation (FAF) appoints Board members and advisory councils, ensures funding, and exercises oversight

Financial Accounting Standards Advisory Council (FASAC) advises the FASB on current and possible new agenda items, policy issues, or formation of task forces

Emerging Issues Task Force (EITF) provides implementation guidance within GAAP

FASB Structure

FASBFASB

FASACProvides guidance on policy, priorities,

etc

FASACProvides guidance on policy, priorities,

etc

FAFProvides funding

FAFProvides funding

Standard-Setting Process

Adds Project to Agenda

Adds Project to Agenda

Conducts Research and ssues

DM

Conducts Research and ssues

DM

Public HearingPublic

Hearing

Issues EDIssues EDModifies ED

Modifies ED

Finalizes and Issues

ASU

Finalizes and Issues

ASU

SEC Formed by Congress in the 1933 Act

Authority to establish GAAP—but SEC relinquished that task to the private sector (FASB)

Enforcement authority

AICPA

Professional Organization for practicing CPAs

Substantial input into the standard-setting process

All past standard-setting bodies were created by the AICPA

GAAPAuthoritative GAAP

• FASB Accounting Standards Codification (ASC)

ASC is a compilation of pronouncements issued by FASB, APB, and CAP

Non-authoritative

FASB Concepts, AICPA Issues Papers, IFRS

SEC Guidance—considered part of authoritative GAAP for public companies


FAR 1-1 Role and Standard-Setting Process 3

Summary

Make sure you are comfortable with the main organizations that make up the financial accounting environment.

Accrual Accounting

MUST know for the CPA exam!

Tested frequently andconsistently!

Types of Exam QuestionsConvert cash basis income to accrual basis income.

Convert accrual basis income to cash basis.

Given accrued expense or revenue and solve for cash paid or received (and vice versa).

Given deferred expense or revenue and solve for cash paid or received (and vice versa).

Accrual Basis AccountingAccrual basis accounting recognizes and reports the economic activities of an entity in the period the economic activity was incurred, regardless of when the cash activity takes place.

The Heart of Financial

Accounting and Reporting

Accrual Accounts

• Good or service received from vendor

Event• Accounts

Payable(liability)

Accrual Account

• Cash ReceivedCash

• Good or service provided to a customer

Event• Accounts

Receivable(asset)

Accrual Account

• Cash PaidCash



Deferral Accounts

• Cash ReceivedCash

• Unearned Revenue (liability)

Deferral Account

• Good or service used

Event• Cash PaidCash• Prepaid

Expense (asset)

Deferral Account

• Good or service delivered

Event

Theme of Accruals and DeferralsThe common theme for accruals and deferrals:

When the economic event occurs firstyou create an accrual account (you are accruing the cash to be received or to be paid as an asset or liability).

When the cash activity occurs first you create a deferral account (you are deferring the recognition of an expense or revenue as an asset or liability).

Tools The Accounting Equation: A = L + E

• Use to reconcile accrual basis net income to cash basis net income

• Use to reconcile cash basis net income to accrual basis net income

T-accounts

• Use to solve for accrual basis revenue or expense

• Use to solve for cash received or paid

Use accounting equation to determine change in working capital accounts

1) A = L + E

2) ΔA = ΔL + ΔE

3) ΔCash + ΔOA = ΔL + ΔE

4) ΔCash = ΔL + ΔE – ΔOA

Accrual Net Income to Cash Net Income

Accrual to CashJ&L Pecans maintain accounting records on an accrual basis. J&L decided to convert to cash basis accounting. During the year J&L reported $95,178 of net income. On January 1, 20X5 and December 31, 20X5 J&L had the following amounts:

January December

Accounts receivable 9,250 15,927

Unearned revenue 2,840 4,111

Accrued expenses 3,435 2,108

Prepaid expenses 1,917 3,232

Conversion of Accrual Basis to Cash BasisΔCash = ΔL + ΔE – ΔOA

Net Income on accrual basis $95,178

increase in accounts receivable ($9,250 – $15, 927) (6,677)

increase in unearned service revenue ($2,840 –$4,111)

1,271

decrease in accrued expense ($3,435 – $2,108) (1,327)

increase in prepaid expenses ($1,917 – $3,232) (1,315)

Net income on a cash basis 87,130



Use accounting equation to determine change in working capital accounts (signs are opposite!)

1) A = L + E

2) ΔA = ΔL + ΔE

3) ΔA – ΔL = ΔE

4) ΔE = ΔA – ΔL

Accrual basis net income is essentially the change in equity (retained earnings)

Cash Net Income to Accrual Net Income

Cash to AccrualJ&L Pecans maintain accounting records on a cash basis. Assume J&L decided to convert to accrual basis accounting. During the year J&L reported $87,130 of cash basis income. On January 1 and December 31 J&L determined they had the following amounts:

January December

Cash Received or Revenue Recognized

Use T-accounts

Accounts receivable

Beginning balance

Revenue (sales) Cash collections

Ending balance

Unearned Revenue

Beginning balance

Revenue (sales) Cash collections

Ending balance

Solving for Cash CollectedA company has the following activity with respect to unearned consulting fees during the year.

Unearned consulting fees, Dec 31 2,000

Unearned consulting fees, Jan 1 3,500

Consulting fee revenue 25,000

How much cash was collected for consulting fees?

Solving for Cash CollectedInformation given on unearned revenue:

Unearned Revenue

Beginning balance 3,500

Revenue 25,000 Cash collections 23,500

Ending balance 2,000



Solving for Cash CollectedWhat if the information was accounts receivable?

Accounts Receivable


Revenue 25,000

Cash collections 26,500


Cash Paid or Expense RecognizedUse T-accounts

Solving for Cash PaidA company has the following activity with respect to prepaid insurance expense during the year.

Prepaid expense, Dec 31 2,000

Prepaid expense, Jan 1 3,500

Insurance expense 25,000

How much cash was paid during the year?

Solving for Cash Paid Information given on prepaid expense:

Prepaid Expense


Cash paid 23,500

Expense 25,000


Solving for Cash Paid What if the information was on accounts payable?

Accounts Payable


Cash paid 26,500

Expense 25,000


SummaryConvert cash basis income to accrual basis income or accrual basis income to cash basis.

Given accrued expense or revenue and solve for cash paid or received (vice versa).

Tools:

• The Accounting Equation: A = L + E

• T-accounts



Financial Statements

Income Statement

Reports accrual-based performance over a period of time. It is dated as fiscal year ended (FYE). For example, December 31

Captures all revenues, expenses, gains and losses that were incurred during the period

Certain items are excluded from the income statement but included in comprehensive income.

Statement of Comprehensive IncomeReports non-owner changes to equity over a period of time. It is dated as FYE. For example, December 31 includes:

• Unrealized gains/losses on investments in AFS securities

• Certain pension adjustments• Foreign currency translation adjustments• Certain hedge accounting adjustments

Balance SheetReports economic resources and obligations as of a specific date. It is dated as of December 31:

Assets presented in order of liquidity

Liabilities presented in order of maturity

Current/long-term designation

Various measurement attributes

Exam Question HintThe CPA exam tends to emphasize sections of the balance sheet, such as PPE or Equity.

As we cover the balance sheet items, make sure to understand not only the accounting, but also the reporting of these items.

Statement of Stockholders’ EquityReports the changes related to owners’ equity over a period of time. It is dated as FYE, for example, December 31.Owners’ Equity is presented in order of permanence:

1. Contributed capital is shown first, because it will not be returned to shareholders.

2. RE is shown last because it is less permanent because dividends are paid from RE.



Statement of Cash FlowsReports changes in cash over a period of time. It is dated as FYE, for example, December 31.

Operating—cash flows related to income statement transactions

Investing—cash flows related to long-term assets and investments

Financing—cash flows related to liabilities and owners’ equity

Footnotes and OpinionFootnote disclosures and supplementary schedules:

• Footnotes are an integral part of the financial statements.

• Footnotes present information not captured on the statements.

Auditor’s opinion:

• Opinion on the statements in conformance with GAAP

Financial AccountingStandards Codification

What is the Codification?The Codification is a compilation and reorganization of all GAAP sources

• Accounting Standards Codification (ASC) is the official name of the Codification.

• Accounting Standards Updates (ASU) are how updates to GAAP are communicated. ASU’s are not GAAP. Organized based on a major area and topicA one-stop shop for all accounting guidance on that area or topic

Goals of CodificationThe FASB Codification Research System is on-line, real-time searchable data base in order to:

1. Simplify structure and accessibility of GAAP.

2. Place all authoritative literature in one place.

3. Reduce time and effort to research an issue.

4. Reduce risk of noncompliance with GAAP.

5. Facilitate updating GAAP.

6. Assist with IFRS convergence.

Codification Structure

AreasAreas

TopicsTopics

SubtopicsSubtopics

SectionsSections

Paragraphs

Subsections



Areas and Topics

• 100 Principles Example: Objectives• 200 Presentations Example: Balance SheetGeneral

• 300 Assets Example: Cash• 400 Liabilities Example: Debt• 500 Equity Example: Treasury Stock

Balance Sheet

• 600 Revenue Example: Products • 700 Expenses Example: Start-up Costs

Income Statement

• 800 Broad Transactions Example: Business Combinations

• 900 Industry Example: AgricultureOtherOther

Topic

Receivables (310)

Subsection -Paragraph

Origination Fees (2) and

(3)

Syndication Fees (4)

Subtopic

Nonrefundable (20)

Loans (30)

Section

Scope (15)

Initial Measurement

(30)

310-20-30-4

Topic

Leases (840)

Subsection -Paragraph

Lessees (2)

Lessors (3)

Subtopic

Operating (20)

Capital (30)

Section

Disclosure (50)

Scope (15)

840-20-15-2

Searching the CodificationLocate the citation in the relevant accounting standard to provide guidance for the following issue.

A firm has several securities outstanding that can become common stock in the future. Each has a potential positive effect on the numerator and denominator of Earnings Per Share (EPS). How does the firm decide the order of entering these potential common stock securities in the calculation of diluted EPS?



AICPA.08211248FAR-I.A.II

U Co. had cash purchases and payments on account during the current year totaling $455,000. U’s beginning and ending accounts payable balances for the year were $64,000 and $50,000, respectively. What amount represents U’s accrual-basis purchases for the year?A. $441,000B. $469,000C. $505,000D. $519,000


11

FAR 1-2 Conceptual Framework of Financial Reporting by Business Enterprises

Objectives, Qualitative Characteristics

OverviewThe Conceptual Framework guides the standard-setting process so that the resulting GAAP is cohesive and internally consistent.

Purpose of ConceptsThe Conceptual Framework is based on the overriding objective of financial reporting—decision usefulness.

The Conceptual Framework describes two primary qualitative characteristics of the information that will be decision useful.

There are four enhancing qualitative characteristics.

Decision Usefulness

Primary Characteristics

Faithful Representation

Completeness Neutrality Free from error

Relevance

Predictive Value

Confirmatory Value Materiality

Primary Characteristics

Faithful Representation

+Relevance

=

FaRR

Faithful RepresentationCan I Depend on it?

Complete

• Are all facts embedded in the information?

Neutral

• The information is free from bias; no one interest group is favored; focus is on objectivity and balance.

Free from error

• Would a sufficiently knowledgeable third party derive the same result?



RelevanceDoes it Relate to my decision?

Helps me Predict• Helps form a prediction about future events; prediction

is best formed from elements in the financial statements expected to persist into the future

Helps me Confirm• Provides information about earlier expectations or

predictions; either as a confirmation or disconfirmation; helps understand how past actions have affected current financial position

RelevanceDoes it Relate to my decision?

The information is Material

• This is information that could influence my decision.

FaRR

Decision—useful information

Relevance• Relates to my decision,

helps me predict and confirm predictions. Is material to my decision

Faithful Representation• I can depend on the

information; it is complete, neutral, and free from error.

Enhancing Characteristics

• Between companies• Non uniformityComparability

• Independent observers would reach similar conclusionVerifiability

• Recent enough to make a differenceTimeliness

• Comprehensible by a user with reasonable understanding of business

Understandability

Example QuestionWhat are the Accounting Concepts intended to establish?A. Generally accepted accounting principles in

financial reporting by business enterprises

B. The meaning of "Presented fairly in accordance with generally accepted accounting principles”

C. The objectives and concepts for use in developing standards of financial accounting and reporting

D. The hierarchy of sources of generally accepted accounting principles

AnswerAnswer: C

Here is where careful reading will pay off!

The concepts assist the development of the standards, but they are not GAAP!

Don't fall for the GAAP answers in A, B, or D.


FAR 1-2 Conceptual Framework of Financial Reporting by Business Enterprises 13

Example QuestionAccording to the FASB's Conceptual Framework, predictive value is an ingredient of:

FaithfulRepresentation Relevance

A. Yes Yes

B. Yes No

C. No No

D. No Yes

AnswerAnswer: D

Faithful representation answers the question “Can I depend on it?” Faithful representation is completeness, neutral, and free from material error.

Relevance answers the question “Does it relate to my decision?” Predictive value relates to the relevance of information. Relevant information contains predictive value and feedback value.

ConclusionNow you are ready to complete some questions on your own in study mode. Once you feel comfortable, continue on to the next lesson on the Conceptual Framework.

Study hint: If you had trouble with the terminology in this section, try the flash cards to help you learn the definitions. We strongly recommend that you understand the definitions—it will serve you well and take you farther than just memorization.

You can do it—once you put your mind to it!

Assumptions, AccountingPrinciples

Acronym for AssumptionsAssumptions come “Entirely from your GUT”

The four assumptions are:

1. Entity2. Going Concern3. Unit of measurement4. Time period

Entity Assumption

The entity is separate and distinct from its owners.

Example: The owners of the corporation are separate from the corporation itself. The assets of the corporation do not belong to the owners, but to the corporation.



Going Concern AssumptionA business has an indefinite life that extends beyond the life of the owners.

Absent evidence to the contrary (such as imminent bankruptcy), a business will continue on.

Assets would not be recorded unless we assumed that the business will be there in the next period to use these assets.

Unit of Measurement AssumptionEverything is measured in terms of a stable monetary unit of measure.

Values are not adjusted for inflation

1. Example: Land purchased in 1960 is added to land purchased in 2015 even though the value of the dollar in 1960 is different than the value in 2015.

2. We do not adjust the 1960 dollars to the 2015 equivalent.

Time Period Assumption

Indefinite life is broken into timeframes, such as a year, a quarter, a month, etc.

PrinciplesThere are four Accounting Principles:

1. Revenue Recognition

2. Expense Recognition (matching)

3. Measurement

4. Full Disclosure

Revenue Recognition PrincipleRevenue is recognized when realized and earned.

• Recognized = Recorded on the financial statements

• Realized = Cash or near cash (AR) received

• Earned = Goods or service has been delivered

Much more on revenue recognition in separate lesson

Expense Recognition PrincipleOften referred to as the matching principle

Addresses when to recognize expenses

Recognizes expenses when they produce revenues



MeasurementAssets and liabilities are recorded at the value at the time of origin.

Historical cost: Land

Amortized cost: Plant and Equipment

Net realizable value: Accounts Receivable

Replacement cost: Inventory

Net present value: Bonds

Fair value: Investments

Full Disclosure PrincipleNot all information can be recognized on the financial statements.

• Example: Operating lease obligations

Disclosures are needed to help the financial statement user assess financial obligations of the business.

• Example: The future minimum lease payments are disclosed in the footnotes.

Constraint and Present Value

79

ConstraintCost-benefit

Cost of providing the information should not outweigh the benefit.

Using Cash Flow and PVThis concept refers to measurement when the present value of cash flows are used to estimate fair value.

Governs measurement not recognition

When using cash flows to determine present value, there are two ways to incorporate the risk associated with the cash flows:

1. Discounted cash flows: single cash flow value is discounted using the risk adjusted rate

2. Expected cash flows: probability weighted cash flows is discounted using the risk-free rate

ExampleA cash flow of $200,000 may be received in one year, two years, or three years, with probabilities of 20%, 50%, and 30%, respectively. The rate of interest on default risk-free investments is 5%. The PV factors are:

PV of 1, at 5%, for 1 year is 0.95238PV of 1, at 5%, for 2 years is 0.90703PV of 1, at 5%, for 3 years is 0.86384



Solution$200,000 0.2 = $ 40,000 0.95238 = $38,095

$200,000 0.5 = $100,000 0.90703 = $90,703

$200,000 0.3 = $ 60,000 0.86384 = $51,830

Total $180,628

Example QuestionWhich of the following is not addressed in the concept statement on cash flows and fair value accounting measurements?

A. Measurement methods at initial recognition

B. Interest method of amortization

C. Expected cash flow approach

D. Determining when fresh-start measurements are appropriate

AnswerAnswer: D

The concept statement governs how to measure not when to measure items at present value.

Answers A, B, and C were all how to measure.

ConclusionThis concludes the third lesson on the FASB’s Conceptual Framework.

Make sure to be comfortable with the terminology and concepts presented in the Conceptual Framework lessons.

This material is integral to all other FAR topics.

Best of luck as you continue with your studies!



AICPA.901101FAR-TH-FA

According to the Conceptual Framework, the process of reporting an item in the financial statements of an entity is:A. Recognition.B. Realization.C. Allocation.D. Matching.


18

Elements of Fair Value DefinitionFair value is a market-based measurement.

Fair value is determined for a particular asset, liability or equity item, which may be:

• A single item (e.g., a bond)• A group of related items (e.g., a

business)

Elements of Fair Value DefinitionFair value determination should consider attributes of the specific item being measured:

• Condition, location, restrictions on use• Fair value not based on buyers unique

perspective

Fair Value Framework—Introduction and Definitions

Fair Value Framework CoverageTopics covered in Fair Value Framework include:

• Definition of “fair value” and related elements

• Issues related to determination of fair value at initial recognition of an item

• Approaches to determining fair value• Inputs used in determining fair value and

input hierarchy• Disclosure requirements any time fair

value is used

US GAAP versus IFRS

As a result of the joint efforts of the IASB and the FASB, there are no significant differences between US GAAP and IFRS related to the meaning of fair value, its measurement, or required disclosures.

Fair Value Defined

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

FAR 1-3 Fair Value Framework


FAR 1-3 Fair Value Framework 19

Elements of Fair Value Definition“Orderly transaction” is a hypothetical transaction:

• Assumed to occur at the measurement date

• Assumed to occur under current market conditions

• Not assumed to occur in a forced liquidation or distressed sale

Elements of Fair Value DefinitionHypothetical transaction is assumed to occur in principal market or most advantageous market for the item to which the entity has access:

• Principal market is the market available to the entity with greatest volume and level of activity for the item.

• Most advantageous market is the market available to the entity that maximizes selling price or minimizes transfer price.

Elements of Fair Value DefinitionFair value is determined in the principal or most advantageous market:

• Should not be adjusted for transaction cost—incremental direct cost to execute sale or transfer—which do not measure a characteristic of the asset, liability or equity item

• Should be adjusted for cost of transporting item to market (the location characteristic)

Elements of Fair Value Definition“Market participants” are buyers/sellers that are:

• Independent of the reporting entity• Acting in their economic best interest• Knowledgeable of the item being

measured and the transaction type• Able and willing to enter a transaction,

but not compelled to do so

Fair Value Definition Applied to Nonfinancial Assets

Assumes the highest and best use by market participants, even if it will be used in some other way by the reporting entity

Fair Value Definition Applied to Nonfinancial Assets

Highest and best use considers what is:

• Physically possible

• Legally permissible

• Financially feasible

Highest and best use may be:

• In-use—usually nonfinancial assets

• In-exchange—usually financial assets



Fair Value Definition Applied to Liabilities

Assumes the liability is transferred to a third party, not settled:

• Liability continues, but as an obligation of another party (not based on the price to settle the liability).

• Nonperformance risk is assumed unchanged after transfer.

• Adjustment should not be made for transfer restrictions.

Fair Value Definition Applied to Shareholders’ Equity

Fair value requirements apply to shareholder equity items.

• For example: Equity interest issued as consideration in a business combination

Measurement is from the perspective of market participant that holds the equity item as an asset.

Recognition andMeasurement

Entry Price and Exit PriceEntry price and exit price are conceptually different:

Entry price = Amount paid to acquire an asset or received to assume a liability

Exit price = Amount received to sell an asset or paid to transfer a liability

At initial recognition of an item the entry price and exit price may or may not be the same value.

Reasons Entry Price ≠ Exit Price

Entry price may not be the same as exit price when:

• Transaction is between related parties• Seller is under duress• Unit of account/measure is different than

basis for fair value determination• Market is different than market for fair

value determination

Entry Price ≠ Exit PriceAccounting Treatment

If the transaction price (entry price) is different than the fair value (exit price) a gain or loss is recognized in Income



Possible Techniques or Approaches for Fair Value Determination

Market Approach: Uses prices generated by real market transactions for identical or similar items

Income Approach: Discounts future amounts to a current present value

Cost Approach: Uses current amount required to replace the service value of an existing asset

Use of Alternative Approaches for Fair Value Determination

Some cases: A single approach to determining fair value may be appropriate and adequate.

• Quoted market prices in active markets

Some cases: Multiple approaches to determining fair value may be appropriate

• Valuing an entire business• Professional judgment required if

assessing multiple outcomes

Fair Value OptionEntities can elect to measure the following at fair value:

• Recognized financial assets and financial liabilities (with few exceptions)

• Firm commitments not otherwise recognized and that involve only financial instruments

• Written loan commitments• Rights/obligations under warranties and

insurance contracts that can be settled by paying a third party

Items Not Available for Fair Value Option

Entities may not elect to measure the following at fair value:• Investments in entities to be consolidated• Obligations or assets related to pension

or other employee-oriented plans• Lease-related financial assets or

liabilities• Demand deposits of financial institutions• Instruments that are components of

shareholders’ equity

Fair Value Option Election Dates

Fair value option can be elected only:

• When the item is first recognized• When an eligible firm commitment occurs• When the accounting treatment of an

investment in another entity changes

Fair Value Option Application Requirements

Fair value option may be applied on an instrument-by-instrument basis (with certain exceptions)

• Does not have to be applied to all instruments issued or acquired in a single transaction

• Must be applied to an entire instrument, not just to specific elements of an instrument



Fair Value Option Application Requirements

Fair value option is irrevocable, except when a new election date for a specific item occurs.

If applied to held-to-maturity investment securities, treatment is like investment securities held-for-trading.

Accounting at Eligible Election DateDetermine carrying value (CV).

Determine fair value (FV).

Determine difference between CV and FV.

Recognize difference as:

Write item up or down.

Recognize increase (gain) or decrease (loss) in current income.

Illustration—Accounting at Election Date

Eligible date = January 2, 20X1

CV = $100,000

FV = $110,000

FV > CV (Difference) = $ 10,000

Entry:

DR: Investment in Equity Investee $ 10,000

CR: Unrealized Gain—FV Option $ 10,000

Accounting After ElectionAt each subsequent reporting date:

• Adjust item to new fair value.• Recognize difference as:

1. Write item up or down

2. Recognize increase or decrease in current earnings.

Entry (assume an increase in FV of an asset):DR: Asset

CR: Unrealized Gain—FV Option

Inputs and Hierarchy

Fair Value Inputs Inputs are assumptions and data used in valuation techniques:

• Observable Inputs: Derived from market data from sources independent of the reporting entity

• Unobservable Inputs: Entity’s assumptions based on best information available in circumstances

Use of observable inputs should be maximized; use of unobservable inputs should be minimized.



Fair Value Measurement Inputs Hierarchy

Level 1: Unadjusted quoted prices at measurement date in active markets for identical items.• Highest level with most desirable inputs • Most reliable evidence of fair value• Should be used when available• Liquidity discount—permitted• Control premium—not permitted• Blockage discount—not permitted


Level 2: Inputs observable, either directly or indirectly, that do not meet all conditions for Level 1

• Quoted prices in active markets for similar items

• Quoted prices in markets that are not active

• Observable inputs other than quoted market prices that are relevant to an item being valued


• Inputs derived from or corroborated by observable market data using correlation or other means

• May need to be adjusted for characteristics of the specific item being valued (e.g., condition)

• Use of significant unobservable inputs to adjust observable inputs may result in a Level 3 measurement


Level 3: Unobservable inputs for the item being valued:

• Lowest level with least desirable inputs• May use reporting firm’s internal data• Based on assumptions or inferences that

market participants would make• Example: Determining fair value of

closely held stock

Disclosure Requirements

Distinctions for Disclosure Requirements

Disclosure requirements depend on whether fair value is used:

• On a recurring basis—Fair value is determined and

applied to an item period after period.

• On a nonrecurring basis—Fair value is determined and

applied only when certain conditions or situations occur.

For both of the bullets above, you must disclose the fair value at

reporting date, valuation techniques, and inputs used in those

techniques.



Disclosure Requirements when Fair Value is Used on Recurring Basis

In interim and annual statements for each major category of asset or liability measured at fair value:

• Level of the fair value hierarchy within which measurements falls

• Transfers into and out of each level of the hierarchy shown and discussed separately


In interim and annual statements for each major category of asset or liability measured at fair value:• For measurements in Level 3 a reconciliation of

beginning and ending balances, showing:Recognized gains and losses and whether reported in net income or other comprehensive income

Purchases, sales, issuances, and settlements

Transfers in/out of Level 3


Fair value measurements that fall in Level 3:• Description of the valuation process used• Quantitative information about the

unobservable inputs used• Narrative description of sensitivity to

changes in unobservable inputs• Amount of gains/losses for period due to

change in unrealized gains/losses for items still held at measurement date and where reported

Disclosure Requirements when Fair Value is Used on Nonrecurring BasisIn interim and annual statements for each major category of asset or liability measured at fair value:• Reasons for the fair value measurement

• Level of the fair value hierarchy within which measurements fall

• For measurements in Levels 2 and 3 a description of any changes in techniques

Disclosure Requirements when Fair Value is Used on Nonrecurring BasisFor measurements that fall in Level 3, unobservable inputs:

• The effect of the measurement on earnings or OCI

• Quantitative information about the unobservable inputs used

If highest and best use of nonfinancial assets differs from current use, disclose that fact and why.

Disclosure for Fair Value OptionIdentify items to which the fair value option is applied and reasons for electing the fair value option

Information to enable users to understand how fair value is applied for each item (methods and assumptions)

The amount of gains and losses associated with the fair value changes



Coca-Cola, Inc.—Example Footnote Disclosure

Coca-Cola, Inc.—Footnote Excerpt

Coca-Cola, Inc.—Footnote Excerpt (continued)



AICPA.080117FAR-FVF

Which of the following statements concerning the determination of fair value is/are correct?I. The determination of fair value is based on a hypothetical

transaction. II. The determination of fair value is based on an exit price. III. The determination of fair value of a nonfinancial asset should be based

on the intended use of the asset by the reporting entity.

A. I only. B. II only. C. I and II only. D. II and III only.



AICPA.090421FAR-SIM

In determining the fair value of a nonfinancial asset, assessing the highest and best use of the asset must take into account all but which one of the following?A. What is physically possible.B. What is financially feasible.C. How the reporting entity would use the asset.D. What is legally permissible.


28

SEC—Role andStandard-Setting Process

Creation of the SEC

The SEC was created by Congress after the 1929 stock market crash.

The SEC has the legal authority to set accounting standards, but has delegated that responsibility to the private sector—currently the FASB.

Purpose of the SECThe SEC enforces compliance with US GAAP for all publicly traded companies.

• Compliance with IFRS for foreign registrants

To promote efficient allocation of capital through open, orderly and fair securities markets

Access to information that is decision-useful (relevant) to the market participant is critical

Foreign Issuers Reporting to the SECIn 2008, as part of the “roadmap” to international convergence, the SEC eliminated the reconciliation to US GAAP for foreign private issuers.

This is a significant step to acknowledging the IASB approved IFRSs.

Elimination of the reconciliation should encourage more foreign businesses to list on US exchanges.

Foreign Private Issuer

A foreign private issuer is any non-governmental foreign issuer that:

• Has the majority of its securities owned outside of the US

• Officers and directors are not US citizens or residents

• The majority of assets are outside the US• The business is administered principally

outside of the US

Securities Issued and TradedThe SEC regulates the initial issuance and subsequent trading of securities.

The SEC’s database is IDEA (Interactive Data Electronic Applications) where financial statement information is stored in XBRL (eXtensible Business Reporting Language)

• XBRL tags accounting data into a taxonomy to ease the access to the data

FAR 1-4 US Securities and Exchange Commission (SEC)


FAR 1-4 US Securities and Exchange Commission (SEC) 29

Organizational Structure

Five commissioners appointed by the President of the US

Four divisions

Office of the Chief Accountant

Divisions

• Oversees compliance • Filings submitted to this division

Corporate Finance

Corporate Finance

• Investigates violations• Makes recommendations for punishment

EnforcementEnforcement

• Oversees the secondary markets and exchanges, brokers, and dealers

Trading and Markets

Trading and Markets

• Oversees investment advisors and investment companies

Investment ManagementInvestment

Management

Laws Administered by the SECThe Securities Acts of 1933 and 1934

The Public Utility Holding Company Act of 1935

Trust Indenture Act of 1939

Investment Company Act of 1940

Investment Advisors Act of 1940

Securities Investor Protection Act of 1970

Sarbanes-Oxley Act of 2002

Participation in Standard SettingEven though the SEC delegates standard setting to the FASB, the SEC participates in the setting of accounting standards.

SEC pronouncements along with the FASB Accounting Standards Codification comprise authoritative US GAAP for public companies.

Private companies do not have to comply with SEC pronouncements.

Pronouncements Issued

Financial Reporting Releases• Formal pronouncements—highest ranking authoritative source for public companies

FRR

Staff Accounting Bulletins• SEC’s current position on technical issuesSAB

Accounting and Auditing Enforcement Releases• Reports enforcement actions

AAER

SEC Reporting Requirements



What is a Security?Section 2.1 of the 1933 Act defines a security as: Any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral trust certificate, reorganization certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt of, guarantee of, or warrant or right to subscribe to or to purchase any of the foregoing.

The Securities Act of 1933This act applies to the registration of the initial public offering (IPO) of securities.

Form S-1 is the basic registration form for new securities.

• Part 1 is the prospectus and provides information about the company, business operations, risks, financial statements and use of proceeds.

• Part 2 provides information about the cost of the issuance, information about the directors and officers, and additional financial schedules.

Financial Statements for IPO

The following audited financial statements must be presented:

• 2 years of balance sheets• 3 years of income statements, statements

of cash flow and statements of shareholders’ equity

IPO Process

IssuerIssuer Under-writerUnder-writer DealerDealer PublicPublic

The Securities Act of 1934This act applies to reporting information about securities that are already issued.

Regulation S-X provides detailed guidance on the reporting requirements

Form 10-K is the annual filing

Form 10-Q is the quarterly filing

Form 8-K reports significant events

Annual Filing—Form 10-KThe financial statements in Form 10-K must be audited by an independent registered auditor.

• 2 years of balance sheets• 3 years of income statements,

statements of cash flows, and statements of shareholders equity


FAR 1-4 US Securities and Exchange Commission (SEC) 31

Annual Filing—Form 10-K

In addition to the audited financial statements, there are significant disclosures:

• Management Discussion and Analysis (MD&A)

• Reports on controls• Management certifications• Much, much more (see study guide)

Quarterly Filing—Form 10-Q

The financial statements in Form 10-Q are not audited, but are reviewed by the auditor.

Disclosures in the 10-Q are not as extensive as the 10-K.

Update on significant matters since the last quarter such as legal proceedings, changes in securities outstanding.

Coca Cola, Inc.—10-Q Income Statement Coca Cola, Inc.—10-Q Balance Sheet

Coca Cola, Inc.—10-Q Cash Flows



AICPA.101196FAR-SIM

The SEC defines a foreign private issuer as any issuer other than a foreign government, except an issuer that where more than 50% of the outstanding voting securities are directly or indirectly owned by residents of the US and what other condition?A. The business of the issuer is administered principally in the foreign

country.B. More than 50% of the assets of the issuer are located in the foreign

country.C. The majority of its executive officers or directors are US citizens or

residents.D. All of the above.


33

Balance Sheet/Statement of Financial Position

Balance Sheet

Statement of Financial Position

Measured at one point in time

Assets = Liabilities + Equity = Contra and adjunct accounts

Measurement Attributes

Historical cost—Land, prepaid insurance

Amortized historical cost—Fixed assets

Fair Market value —Marketable securities, derivatives

Net realizable value—Accounts receivable

Present value—Bonds

Contra and Adjunct Accounts

Contra accounts are subtracted from the balance sheet accounts.

Adjunct accounts are added to the balance sheet account.

Current Assets

Assets expected to be realized in cash or consumed within one operating cycle or year

Examples: accounts receivable, prepaid expenses, and investments (short-term)

Current LiabilitiesLiabilities expected to be extinguished with current assets or another liability within one operating cycle or year

Examples: accounts payable, accrued expenses

FAR 1-5 General-Purpose Financial Statements 1



Noncurrent

By default accounts that are not current are classified as noncurrent.

Noncurrent asset examples: PPE, long term investments, and intangibles

Noncurrent liability examples: notes payable, bonds payable, and pension liabilities

Equity AccountsContributed Capital:

• The amount contributed by owners• Example: Common stock, preferred

stock, additional paid-in capital

Retained Earnings:

• The amount of earnings retained by the entity

• Cumulative net income less dividends paid

Coca-Cola, Inc.—Assets Coca-Cola, Inc.—Liabilities and Shareholders’ Equity

Income Statement

DefinitionsRevenues—increases in net assets or settlement of liabilities from PRIMARY activities—providing goods or services

DR: Cash or ARCR: Revenue or Sales

orDR: Unearned RevenueCR: Revenue or Sales


FAR 1-5 General-Purpose Financial Statements 1 35

DefinitionsExpenses—decreases in net assets or incurrence of liabilities from PRIMARY activities—providing goods or services

DR: ExpenseCR: Cash or AP

orDR: ExpenseCR: AP or Accrued Liabilities

DefinitionsGains—increases in net assets from incidental activities

Losses—decreases in net assets from incidental activities

Examples: sale of assets, interest income, and interest expense

Multi-step Income StatementABC Company

FYE December 31SalesCost of Goods SoldGross profitOperating expenses+/– Other income/expensesIncome from continuing operations before taxIncome taxesIncome from continuing operations+/– Discontinued operationsNet Income

Coca-Cola, Inc.—Income Statement



AICPA.950534FAR-FA

Which of the following should be included in general and administrative expenses?

Interest AdvertisingA. Yes YesB. Yes NoC. No YesD. No No


37

Statement of Comprehensive Income

Definition

Comprehensive Income

Other Comprehensive

Income

NetIncome

Other Comprehensive Income Items

• Unrealized gains and losses on AFS securities

• Unrecognized gains and losses from pension costs

• Foreign currency translation adjustments

• Unrealized gains and losses from certain derivative transactions

PresentationComprehensive income can be presented in one of two ways:

• One-statement approach: In combination with the income statement

• Two-statement approach:A separate statement of income and a separate statement of comprehensive income

One-Statement Approach

Statement of Income and Comprehensive IncomeFYE December 31

Revenues $1,000

Expenses (900)

Net Income 100

Other comprehensive income items (net of tax)

Unrealized G/L foreign currency translation (2)

Unrealized G/L AFS Securities 14

Other comprehensive income 12

Comprehensive income $112

Two-Statement ApproachStatement of IncomeFYE December 31

Revenues $1,000

Expenses (900)

Net income $ 100




Two Statement ApproachStatement of Comprehensive Income

FYE December 31

Net Income $100

Other comprehensive income items (net of tax)

Unrealized G/L foreign currency translation (2)

Unrealized G/L AFS Securities 14

Other comprehensive income 12

Comprehensive income $112

Coca-Cola, Inc.—Statement of Comprehensive Income

Coca-Cola, Inc.—Comprehensive Income Disclosure

Example QuestionChoose the correct equation from the following:

A. Net income + Comprehensive income = Other comprehensive income

B. Comprehensive income = Net income + Prior period adjustments + Accounting principle changes

C. Comprehensive Income = Net income + Other comprehensive income

D. Comprehensive income = Total change in owners’ equity – Dividends declared

Statement of Changesin Equity

Changes in Owners’ EquityThis statement provides beginning balances, changes during the year and ending balances for the following items:

• Stock (common and preferred)

• APIC

• Retained Earnings

• Treasury Stock

• AOCI



PresentationChanges in owners’ equity can be presented in the footnotes, supplemental schedules or as a separate statement.

Most large companies present changes in owners’ equity in a separate statement.

Coca-Cola, Inc.—Statement of Shareowners’ Equity

Coca-Cola, Inc.—Statement of Shareowners’ Equity (continued)

Sources and Uses of Cash

Statement of Cash Flows (SCF)Since the SCF’s purpose is to explain the changes in cash and cash equivalents, we must define what is a cash equivalent.

What is cash?

Cash and cash equivalents:

• Are short-term, highly liquid investments• Are readily convertible to known amount

of cash• Bear no interest rate risk

Examples: T-bills, and money market funds

SCFs (continued)

The SCF is a basic statement like the income statement and balance sheet.

SCF is required for all business enterprises that report both a balance sheet and income statement.

The SCF presents information about the sources and uses of cash during the year.



Purpose of SCFThe purpose of the SCF is to provide information so that users can:

• Assess past ability to generate and control cash inflows and outflows.

• Assess probable future ability of the company to generate cash inflows sufficient to meet future obligations.

• Assess the likelihood of future borrowing.

Information Reported

Cash flows related to operating activities

Cash flows related to investing activities

Cash flows related to financing activities

Acronym to Remember

Operating Ohhhhhhh

Investing

Financing

I could pass the CPA Exam!

IF. . .

Other Information ReportedEffects of foreign currency translation on cash flows

Reconciliation of cash at the beginning of the year to cash at the end of the year

If direct method is used must report a reconciliation of accrual net income to cash flow from operations

Significant non-cash transactions

Non-cash TransactionsA supplement schedule must be provided to present significant non-cash transactions.

Examples:

• Purchase of equipment with a note payable

• Settle a liability by paying with common stock and not cash

FormatABC Company

Statement of Cash FlowFYE December 31

Operating activities $1,000Investing activities 500Financing activities (300)

Foreign currency impact 50Change in cash 1,250Beginning cash 750Ending cash $2,000



ConclusionIn this lesson you learned:

• The basic purpose of an SCF is to present the reader with information about the sources and uses of cash

• What is cash or cash equivalents• The sources and uses of cash are

categorized into operating, investing and financing activities

• The impact of foreign currency translation and noncash activities are also required to be presented

Operating, Investing, andFinancing Activities

Operating Activities—Direct MethodCash inflows: • From customers • Interest income or dividend income• Sale of trading investments

Cash outflows: • To suppliers • To employees• To government • For interest or other operational

expenses

Coca-Cola, Inc. Statement of Cash Flows: Operating Activities

EMC Corp.—Statement of Cash Flows: Operating Activities

EMC Corp.—Statement of Cash Flows



Investing ActivitiesCash inflows:

• Sale of property, plant or equipment • Sale of debt or equity securities of other

entities • Collection of loan principal

Cash outflows:

• Purchase of property, plant or equipment• Purchase of debt or equity securities of

other entities

Coca-Cola, Inc. Statement of Cash Flows: Investing Activities

Year Ended December 31, 2013 2012 2011

Financing ActivitiesCash inflows:

• From sale of equity securities • From issuance of debt (bonds and notes)

Cash outflows:

• To stockholders as dividends • To redeem long-term debt • To re-acquire capital stock

Coca-Cola, Inc. Statement of Cash Flows: Financing Activities

Year Ended December 31, 2013 2012 2011

Example QuestionWhich of the following items is included in the financing activities section of the SCF?

A. Cash effects of transactions involving making and collecting loans.

B. Cash effects of acquiring and disposing of investments and PPE.

C. Cash effects of transactions obtaining resources from owners and providing them with a return on their investment.

D. Cash effects of transactions that enter into the determination of net income.

Answer

Answer: C

Answer A is incorrect because when the entity lends and collects money with other parties it is acting as an investor. These inflows and outflows are investing activities

Answer B is incorrect because these are typical investing activities

Answer D is incorrect because it is an operating activity



Example QuestionIn an SCF, if used equipment is sold at a loss, the amount shown as cash inflow from investing activities equals the carrying amount of the equipment

A. Less the loss and plus the amount of tax attributed to the loss

B. Less both the loss and the amount of tax attributable to the loss

C. Less the lossD. With no additional addition or subtraction

AnswerAnswer: C

A journal entry helps to visualize the answer.

So for example if equipment is sold for $200 at a $50 loss the entry is:

Cash 200Loss (50)Equipment (book value) 250

The tax effects are irrelevant as they are an operating cash flow.

ConclusionIn this lesson you learned the sources and uses of cash are categorized into operating, investing and financing activities.

This lesson also presented the different classifications permitted under IFRS.

Complete the practice questions in this lesson—it will really help reinforce what transactions go into each category.

Also, there is a simulation for the SCF. Once you have completed the three SCF lessons—give it a try.

Operating Cash Flows—Indirect Method

Operating ActivitiesCash flow from operations can be presented in one of two ways:

1. Direct method—This method directly shows the amount of cash inflows and outflows from operations. It shows cash received from sales and cash paid in operations.

2. Indirect method—This method is a reconciliation of the accrual-based net income to derive cash flows from operations.

Operating Activities—Indirect Method

Since most recordkeeping is done on an accrual basis, most large companies do not have systems to track cash inflows and outflows from operations.

Therefore, the indirect method requires that the company start with net income and back outall of the accruals made by accrual accounting.

In addition, accrual net income is adjusted for “noncash” income/expenses such as depreciation.



Operating Activities—Indirect Method (continued)

Often a schedule is used showing beginning and ending balances in operating accruals: AR, prepaids, AP, accrued liabilities, etc

Then the changes in those accrual accounts are added or subtracted from net income to derive cash flows from operations

We are going to use a simple approach to help you remember how to complete this reconciliation

Operating Activities—Indirect Method (continued)

A = L + E

ΔA = ΔL + ΔE

Δ Cash + Δ Other assets = ΔL + ΔE

Δ Cash = ΔL + ΔE – Δ Other assets

Non-cash Expenses Any non-cash expenses on the income statement need to be ADDED back to net income to derive cash flows from operations

• Examples: depreciation, losses, amortization

Any non-cash gains on the income statement need to be subtracted from net income to derive cash flows from operation

• Examples: Gains

Coca-Cola, Inc.—Statement of Cash Flows: Operating Activities

Coca-Cola, Inc.—Footnote Excerpt: Net Change in Operating Assets and

Liabilities

Example Question—Adjusting Net Income

Kresley Co. has provided the following 20X5 current account balances for the preparation of the annual statement of cash flows:

December 31 January 1Accounts receivable $11,500 $14,500 Allowance for uncollectible 400 500Prepaid rent / insurance 6,200 4,100 Accounts payable 9,7000 11,200

Kresley's 20X5 net income is $75,000. What would be reported as net cash provided by operating activities in the statement of cash flows?



Answer

Δ Cash = ΔL + ΔE – Δ Other assets

Net Income 75,000– Δ in AR (3,000)+ Δ in Allowance 100 Could also think of this net+ Δ in Prepaid 2,100 AR of (11,100 – 14,000) or

2,900+ Δ in AP 1,500CF from ops 75,700

Example Question—Adjusting SalesThe following information was taken from the 20X5 financial

statements of Plant Corp:

Accounts receivable, January 1, 20X5 $ 21,600

Accounts receivable, December 31, 20X5 30,400

Sales on account and cash sales 438,000

Uncollectible accounts 1,000

No accounts receivable were written off or recovered during the

year. If the direct method is used in the 20X5 statement of cash

flows, what should Planet report for C collected from customers?

AnswerΔ Cash = ΔL + ΔE – Δ Other assets

Sales — accrual basis 438,000

Δ in AR (8,800) (30,400 – 21,600)

Sales — cash basis 429,200

There were no write-offs or recovery of uncollectible during the year — so the allowance stayed the same and therefore it does not impact the calculation.

Example Question—Adjusting an Expense

Duke Co. reported cost of goods sold (COGS) as $270,000 for 20X5. Additional information is as follows:

December 31 January 1 Inventory $60,000 $45,000

Accounts payable 26,000 39,000

If Duke uses the direct method, what amount should Duke report as Cash paid to suppliers in its 20X5 Statement of Cash Flows?


Since we are adjusting an expense, all signs for reconciliation are reversed because expenses decrease net income

COGS — accrual basis 270,000

+ Δ in Inventory (a increase) 15,000 (60,000 – 45,000 = increase)+ Δ in AP (a decrease) 13,000 (39,000 – 26,000 = decrease)COGS — cash basis 298,000

Example Question—Adjusting an Expense

Rory Co.'s prepaid insurance was $50,000 at December 31, 20X5 and $25,000 at December 31, 20X4. Insurance expense was $20,000 for 20X5 and $15,000 for 20X4.

What amount of cash disbursements for insurance would be reported in Rory's 20X5 net cash flows from operating activities presented on a direct basis?




Since we are adjusting an expense all signs for reconciliation are reversed because expenses DECREASE net income

Insurance expense – accrual Basis 20,000

+ Δ in Prepaid (an increase) 25,000 (50,000 – 25,000 = increase)

Insurance expense – cash basis 45,000




In a Statement of Cash Flows, which of the following items is reported as a cash outflow from financing activities?I. Payments to retire mortgage notes;II. Interest payments on mortgage notes;III. Dividend payments.

A. I, II, and III.B. II and III.C. I only.D. I and III.



AICPA.951148FAR-FA

Which of the following is not disclosed on the Statement of Cash Flows, either on the face of the statement or in a separate schedule, when prepared under the direct method?A. The major classes of gross cash receipts and gross cash payments.B. The amount of income taxes paid.C. A reconciliation of net income to net cash flow from operations.D. A reconciliation of ending retained earnings to net cash flow from

operations.


49

Notes toFinancial Statements

Disclosures

Footnote disclosures are an integral part of the financial statements.

Remember disclosures are part of GAAP

Provide information about assumptions and estimates

Provide information that cannot be captured quantitatively

Basic DisclosuresSummary of Significant Accounting Policies

Related Party Transactions

Liability Disclosures

Capital Structure

Errors and Irregularities

Illegal Acts

Management’s Discussion and Analysis

Required narrative for publicly held firms

Includes a discussion about operations, liquidity and capital resources

Forward-looking information can be provided by management

Effects of Changing PricesDuring times of price instability and high levels of inflation firms were required to disclose the effect of changing prices.

There are currently no required disclosures.

Review the study text—this material has a low probability of being tested. Ratios—Liquidity/Solvency

and Operational




Categories of RatiosLiquidity/Solvency• Measures the ability to meet maturing

obligations

Operational• Measures the efficiency of operations

Profitability• Measures operational results

Equity• Measures sources of equity

This Lesson Covers…Liquidity/Solvency

• Measures the ability to meet maturing obligations

Operational

• Measures the efficiency of operations

Purpose of Ratio AnalysisRatio analysis quantifies the relationship between various elements of the financial statements.

Ratio analysis enables comparisons between entities.

Ratio analysis strips the information of magnitude and unit of measure.

Ratios Permit ComparisonAssume you want to compare the performance of a US-based company and a Japanese-based company.

Calculating the profit margin ratio will permit this comparison:

US: NI Sales = $100 $2,500 = 4%

Japan: NI Sales = ¥4,000 ¥65,000 = 6%

Liquidity/Solvency RatiosWorking Capital

Current Assets (CA) – Current Liabilities (CL)

Measures the extent to which CA exceed CL

If positive, then there are more CA than CL

Example: 100 – 80 = 20

If negative, then there are more CL than CA

80 – 100 = (20)



Liquidity/Solvency RatiosCurrent Ratio (CR)

CA CL

States working capital (WC) in a ratio form

If WC is positive, then the CR > 1

Example: 100/80 = 1.25

If WC is negative, then the CR < 1

Example: 80/100 = .8

Liquidity/Solvency RatiosAcid or Quick Ratio

Cash + AR + Marketable Securities

Current Liabilities

Uses the most “liquid” assets to measure the ability to meet maturing obligations

Will always be less than the current ratio because the numerator excludes CA like inventory

Liquidity/Solvency RatiosTimes Interest Earned

NI + Interest Expense + Income Tax Exp

Interest Expense

Measures the ability of current earnings to cover interest costs for the period

Example: 1,000 + 50 + 300 = 27 times

50Current earnings can cover interest 27 times.

Operational RatiosAccounts Receivable (AR) turnover

Net credit sales Average AR

Example: 1,000 {(80 + 90) 2} = 11.76

Number of days in AR = 365 AR turnover

Example: 365 11.76 = 31 days

Measures the average number of days required to collect receivables

Operational RatiosInventory turnover

Cost of Goods Sold Average Inventory

Example: 800 {(75 + 85) 2} = 10

Number of days in Inventory = 365 Inventory turnover

Example: 365 10 = 36.5 days

Measures the average number of days inventory is sold or used

Example QuestionTod Corp. wrote off $100,000 of obsolete inventory at December 31, 20X5. The effect of this write-off was to decrease:

A. Both the current and acid-test ratios

B. Only the current ratio

C. Only the acid-test ratio

D. Neither the current nor the acid-test ratios



Answer

The acid ratio includes only the most liquid assets, cash, AR and marketable securities.

The current ratio included inventory and prepaid assets.

Therefore writing off inventory will effect only the current ratio.

Answer: B

Ratios—Profitabilityand Equity

Categories of RatiosLiquidity/Solvency• Measures the ability to meet maturing

obligations

Operational• Measures the efficiency of operations

Profitability• Measures operational results

Equity• Measures sources of equity

This Lesson Covers…Profitability• Measures operational results

Equity• Measures return on equity and degree of

equity financing

Purpose of Ratio Analysis

Ratio analysis quantifies the relationship between various elements of the financial statements.

Ratio analysis enables comparisons between entities.

Ratio analysis strips the information of magnitude and unit of measure.



Profit Margin

Net Income (NI)

Sales

Measures net profitability on sales

Example: 100 1,000 = 10%

• There is a 10% net profit on sales or

• For every dollar of sales there is 10¢ of net profit.

Return on Assets

Net Income

Average Total Assets

Measures the rate of return on total assets; how effectively total assets generate NI

Example: 100 {(3,000 + 3,500) 2} = 3.08%

There is a 3.08% return on assets or

For every dollar of assets, 3¢ of NI is produced.

Return on Equity

Net Income

Average Common Stockholders’ Equity

Measures the rate of earnings on common shareholders’ investment

Example: 100 {(600 + 700) 2} = 15.38%

There is a 15.38% return on CSE or

For every dollar of CSE, 15¢ of NI is produced.

Earnings Per Share

Net Income – Preferred Dividends

Weighted Avg. Common Shares Outstanding

Measures the income per share of common stock (see EPS lessons!)

Example: 100 500 = $0.20

For each share of common stock, there was $.20 of net income.

Price–Earnings RatioStock price per share

Earnings per share

Measures the price of stock relative to its earnings per share; indicates how the market values the stock

Example: $2.50/$0.20 = 12.5 times

The market has priced this stock at 12.5 times earnings.

Debt–Equity or Leverage RatiosAll are measures of leverage because

A = L + E

L / E, E / A, or L / A

Example: 100 = 60 + 40

L / E = 60 / 40 = 150%: L is 1.5 times E

E / A = 40 / 100 = 40%: 40% financed by E

L / A = 60 / 100 = 60%: 60% financed by L




on December 30, year 1, Solomon Co. had a current ratio greater than 1:1 and a quick ratio less than 1:1.on December 31, year 1, all cash was used to reduce accounts payable. How did these cash payments affect the ratios?

Current ratio Quick ratioA. Decreased DecreasedB. Decreased IncreasedC. Increased DecreasedD. Increased Increased



AICPA.901157FAR-P1-FA

During year 1, Rand Co. purchased $960,000 of inventory. The cost of goods sold for year 1 was $900,000, and the ending inventory on December 31, year 1 was $180,000. What was the inventory turnover for year 1?A. 6.4B. 6.0C. 5.3D. 5.0

far 1-1 role and standard-setting process

Documents