Morgan Stephens

LEGAL ACCOUNTING OUTLINEFALL 2010

DAVIS

Chapter 1 - Financial Statements, Bookkeeping, and Accrual Accounting

1. Balance Sheet a. Assets (pg. 8)

i. Must control the resourceii. Must reasonably expect to provide a future benefit

iii. Must have obtained the resource in a transaction so that the entity can measure the resource

b. Sources (pg. 9)i. Liabilities

1. Must involve a present duty or responsibility2. Must obligate the entity to provide future benefit3. Must have arisen from a transaction or event that has already occurred so

the entity can reasonably measure the obligationii. Current liabilities

1. Must be paid in less than 1 yeara. Notes payable (money borrowed under promissory notes due within

1 year)b. Accounts payablec. Accrued liabilities or wages: services already performedd. Unearned revenues: what the company will refund if it does not

perform servicesiii. Long term liabilities

1. Lease, mortgage due in more than 1 yeariv. Liabilities get priority when liquidation occurs

1. Secured liability claims stand first in line; they have a claim on a specific asset

2. Unsecured liability are second in line; they don’t have a claim on a specific asset; they have a claim on leftover assets after secured goes.

3. Owners are 3rd in line and get the remaining assets after all the debt has been paid off

v. Equity 1. Amount remaining after a particular accounting entity subtracts its liabilities

from its assets2. Equity increases when the owner invests assets into the business3. Equity decreases when the owner withdraws assets from the business

c. Fundamental Accounting Equation (pg. 13)i. Total Assets = Liabilities + Equity

d. Other Notes on Balance Sheeti. Total assets must equal the sum of the liabilities and equity

ii. Balance sheet speaks of one specific instant in timeiii. Balance sheet records assets at historical costsiv. It only shows assets and liabilities that have meet certain accounting requirements

e. Classified Balance Sheet

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i. Entity classifies assets and liabilities into various categoriesii. Lists current assets first and then according to declining liquidity

1. Assetsa. Current assets (convert in less than 1 year)

i. Marketable securitiesii. Notes receivable

iii. Accounts receivableiv. Inventoriesv. Prepaid expenses

b. Long-term investments (convert in more than 1 year)c. Fixed assets

i. Land ii. Building

iii. Equipmentd. Intangible assets

i. Patentsii. Copyrights

2. Liabilitiesa. Current

i. Notes payableii. Accounts payable

iii. Accrued liabilities or wagesiv. Unearned revenues

b. Long-term liabilitiesi. Bonds payable

2. Double Entry Bookkeeping

Left-Hand Entries DEBITS

Right-Hand Entries CREDITS

Increase in Asset Increase in SourceDecrease in Source Decrease in Asset

a. Transactions are first recorded in journals.i. 5 columns ( date, acct number, explanation, debits, credits)

b. They are then recorded in appropriate accounts. (posting from the journal to the ledger)

3. Income Statement a. Generally

i. Shows the extent to which business activities have caused an accounting entity’s equity, net worth, to increase or decrease over some period of time

ii. It is only a summary of earnings or losses between balance sheet dates.iii. It does not provide prospective information

b. Revenues and Expenses (pg. 34)i. Revenues are increases in assets, decreases in liabilities or both, resulting from

delivering goods, rendering services, or engaging in ongoing operationsii. Expenses represent decreases in assets, increases in liabilities or both, resulting

from using goods or services to produce revenuec. Closing Process (pg. 39)

i. This process occurs when the bookkeeper transfers the balances in revenue, gain, expense, and loss accounts to owner’s equity

ii. Income and Expense accounts differ from other accounts in one important respect:

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1. As subsidiary accounts of proprietorship, they never appear on the balance sheet

2. After the accounts have performed their function of collecting in one place all items of the same kind of income or expense for the period, the net balances in these accounts are brought back together in a single account

iii. THUS, a separate account (P&L) is needed to show just the results of operations and consolidates account for all the income and expense items

iv. Income and expense items are closed to the P&L accountv. THE FINAL STEP IS TO CLOSE THE P&L ACCOUNT INTO THE

PROPRIETORSHIP ACCOUNT1. The net figure in the P&L account is a credit of $525, we need a debit to

P&L of $525 to close the account, and a credit to Proprietorship in the same amount:

P&L _______ $525Proprietorship ___ $525

d. Trial Balance and Six-Column Worksheet (pg. 47)i. First determine the balance in each account by netting one side against the other

ii. BEFORE PROCEEDING ANY FURTHER, prepare a trial balanceiii. Trial balance lists all accounts and their temporary balancesiv. Totals the debits and the creditsv. Use worksheet to aid in the closing process

1. Worksheet separates the revenue, gain, expense, and loss accounts in the trial balance

vi. Trial Balance Procedure :1. List all accounts in the 1st column and enter debit balances in the 2nd

column, and credit balances in the 3rd column2. Extend each trial balance amount to one of the four remaining columns,

entering debit amounts in the debit columns and credit amounts in the credit columns

3. After extending each trial balance amount to one of the four remaining columns, subtotal the last four columns

a. Note: income statement and balance sheet do not balance out right now

4. Next, determine the net income or loss by computing the difference between the two income statement columns

5. Add the net income total to both the debit column of the income statement and the credit column of the balance sheet

a. Note: if the debits of the income statement exceed the total credits of the income statement, then there is a “net loss”

i. So you will enter the “net loss” total in the income statement credit column and then the “net loss” total in the debit column for the balance sheet

6. Compute new column totals for the income statement and the balance sheet columns

Trial Balance Income Statement

Balance Sheet

Account Debit Credit Debit Credit Debit CreditCash 875 875Supplies 100 100Equip 400 400

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Furniture 350 350Library 300 300Acct Pay: Frank 400 400Acct Pay: Elmer 150 150Proprietor 950 950Prof. Inc 1000 1000Rent Exp. 200 200Sec. Exp. 230 230Utl. Exp. 20 20Misc. Exp. 5 5Theft Exp. 20 20

Subtotals 2500 2500 475 1000 2025 1500

Net Inc 525 525

TOTALS

1000 1000 2025 2025

4. Statement of Changes in Owner’s Equity a. Generally

i. This statement fully reconciles the changes in NET WORTH between balance sheets

ii. These are maintained in different accounts 1. Capital- records an owner’s investment in the business2. Drawings- this tracks an owner’s total withdrawals for an accounting period3. Retained earnings- this is net withdrawals against the cumulative net

income.iii. Residual Ownership = Partner’s Equityiv. With multiple partners, separate equity accounts are kept for each partner

b. Sole Proprietorship (pg. 54)c. Partnership (pg. 55)d. Corporation (pg. 57)

i. Contributed Capital1. Shares with Par Value2. No-Par Shares

ii. Earned Capital

5. Accrual Accounting a. Introduction (pg. 70)

i. Assumptions 1. Economic Entity Assumption2. Monetary Unit Assumption

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3. Periodicity Assumption4. Going Concern Assumption

ii. Basic Principles 1. Historical Cost Principle2. Objectivity or Verifiability Principle3. Revenue Recognition Principle4. Matching Principle5. Consistency Principle6. Full Disclosure Principle7. An Emerging Fair Value or Relevance Principle

iii. Modifying Conventions 1. Materiality2. Conservation3. Industry Practices

b. Deferral of Expenses and Income (pg. 78)i. Expenses

ii. Revenuesc. Accrual of Expenses and Income (pg. 87)

i. In General1. Expenses2. Revenues

ii. Income Tax Accounting

d. Summaryi. Prepare original journal entries

ii. Post journal entries to accounts in the ledger – beginning balances from previous balance sheet

iii. Prepare necessary adjusting entries1. Defer paid but unused expenses2. Defer received but unearned revenues3. Record depreciation

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4. Accrue incurred but unrecorded expenses5. Accrue earned but unrecorded revenues6. Complete periodic inventory accounting

a. Transfer beginning balance in Inventory account to Cost of Goods Sold

b. Transfer balances in Purchases and Purchase Returns and Allowances accounts to Cost of Goods Sold

c. Record ending inventory and reduce Cost of Goods Soldi. Physically count inventory at end period

ii. Calculate cost of ending inventory7. Accrue income taxes

iv. Post adjusting entries to the ledgerv. Close revenue and expense accounts

1. Determine the account balances2. Prepare trial balance3. Prepare worksheet4. Make closing journal entries

a. Transfer debit balances to P&L accountb. Transfer credit balances to P&L accountc. Transfer balance in P&L account to Owner’s Equity

5. Post closing journal entries to the ledgervi. Prepare the financial statements

1. Balance Sheet2. Income Statement

6. Accounting for Merchandise Inventory a. Sales (pg. 110)

i. Simply another type of incomeii. Sales account reflects the total amount of sales completed during the period

iii. Sales Returns and Allowances1. Sales Returns

a. When customers bring back defective or unwanted items2. Sales Allowances

a. When customer decides to keep the goods if the seller grants an allowance or deduction from the selling price

iv. Set up as contra-revenue account to the Sales Accountb. Costs of Goods Sold (pg. 111)

i. An expense (increased by debit and decreased by credit)ii. Perpetual Inventory System

1. Business keeps a record of the cost of each pair of shoes as they are purchased for resale and then sold

2. Records continuously show the quantity and cost of the goods the business holds in its inventory at any time

iii. Periodic Inventory System 1. Business keeps a record of the cost of shoes on hand at the beginning of the

period and the cost of the shoes acquired during the period2. Then at the end of the period, the business takes inventory (counts up shoes

left) and determines their total cost3. To compute the cost of goods sold, subtract the cost of what’s left from the

beginning amount plus what’s been acquiredc. Gross Profit and the Multi-Step Income Statement (pg. 112)

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i. Gross Profit 1. Net Sales – Cost of Goods Sold

ii. Multi-Step Income Statement 1. Income Statement that lists gross profits as an intermediate figure in

computing net income or loss2. Multi-Step Statement may also provide more information by separating the

business’s operating and non-operating activitiesd. Periodic Inventory System Example (pg. 114)

i. Check the last balance to determine what the “Opening” Inventoryii. Open a new T-account for Purchases

1. Debit Purchases (8400) by amount of purchases made during the period2. Credit Cash (8400) or an Account Payable depending on how the purchase

was madeiii. If any returns or allowances are made, credit Purchase Returns and Allowances iv. Set up a new T-account called Cost of Goods Sold

1. This is an expense account (debit to increase, credit to decrease)v. Close Inventory, Purchases, and Purchase Returns and Allowances to Cost of

Goods Sold vi. Determine how much inventory remains unsold (usually given to you)

1. Debit Inventory and credit Cost of Goods Sold by this amountvii. Then create a P&L account and close out Cost of Goods Sold, Sales Income, and

other expensesviii. Close P&L to Proprietorship

ix. Journal entries Purchases ____ 8400

Cash _______ 8400 Cost of Goods Sold ____ 2100

Inventory ____________2100 Cost of Goods Sold ____8400

Purchases ____________ 8400 Inventory ______ 3500

Cost of Goods Sold ___ 3500 Profit and Loss ___ 7000

Cost of Goods Sold ____ 70007. Statement of Cash Flows

a. Purpose (pg. 129)i. Provides information about an enterprise’s cash receipts and payments during an

accounting period1. Assess ability to generate positive future net cash flows2. Assess ability to meet obligations, ability to pay dividends, and needs for

external financing3. Assess reasons for differences in net income and associated cash receipts

and payments4. Assess effects on an enterprise’s financial position of both its cash and

noncash investing and financing transactions during the periodb. Cash and Cash Equivalents (pg. 130)

i. Requirements for Cash Equivalents1. An enterprise must be able to convert the equivalents to cash readily, and2. These equivalents’ original maturity dates must not exceed three months, so

that changes in interest rates do not threaten to adversely affect their valueii. Examples

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1. Treasury bills2. Certificates of deposit3. Money market funds

c. Classification (pg. 131)i. Operating Activities

1. Involves acquiring and selling products or services2. Cash inflows from operating activities include interest and dividends from

loans to and ownership investments in other enterprises3. Also serves as a catch all category for anything that doesn’t fit in investing

and financing4. Examples

a. Purchases of raw materials, building inventory, advertising, and shipping the product

b. Receipts from the sale of goods or servicesc. Receipts for the sale of loans, debt or equity instruments in a trading

portfoliod. Interest received on loanse. Dividends received on equity securitiesf. Payments to suppliers for goods and servicesg. Payments to employees or on behalf of employeesh. Interest payments

ii. Investing Activities 1. Includes acquiring and disposing of long-term investments and long-lived

assets2. Shows expenditures to acquire other companies through mergers or stock

acquisitions3. Does not apply to interest and dividends from those long-term investments4. Examples

a. Purchase or Sale of an asset (assets can be land, building, equipment, marketable securities, etc.)

b. Loans made to suppliers or received from customersc. Payments related to mergers and acquisitions

iii. Financing Activities 1. Includes the obtaining of resources from owners and providing them with a

return on and of their investment2. Issuance and retirement of short and long-term debt from creditors3. Examples

a. Dividends paidb. Sale or repurchase of the company's stockc. Net borrowingsd. Payment of dividend tax

d. Operation Section (pg. 132)i. Direct Method Reporting

1. Cash collected from customers, including lessees and licensees2. Interest and dividends received3. Other operating cash receipts4. Cash paid to employees and other suppliers of goods/services5. Interest paid6. Income taxes paid7. Other operating cash payments

ii. Indirect Method Reporting

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1. Enterprise must reconcile net income, determined pursuant to accrual accounting, to net cash from operating

2. Must adjust net income to remove the effect of any current recognition of income or expense attributable to a past deferral of operating cash receipts or payments and all accruals in the current period of future operating cash receipts and payments

3. Adjustments require the enterprise to add back:a. Depreciation, amortization, and other noncash expensesb. So-called sources of cash from decreasing accounts receivable,

inventories, or prepaid expenses and from increasing payablesc. Losses from the sale of long-term investments and property, which

reduced net incomee. Noncash Investing and Financing Activities (pg. 135)

i. Business may engage in an activity that does not involve a cash transfer and doesn’t fall into one of the three categories (exchange stock for the assets of another company)

ii. Although this exchange involves both investing and financing activity, cash flow statements are not required to report the transaction

iii. BUT – must report in a footnotef. Disclosures (pg. 136)

i. Business should disclose its policy for determining which items it treats as cash equivalents

1. If it changes that policy, a change in accounting principle has occurred and the business must restate any financial statements for earlier years for comparison purposes

ii. Must choose to report net cash flow from operations under the direct or indirect method

1. Under indirect method, the business must disclose the amounts of interest and income taxes paid during the period on its statement of cash flows or in the notes of its financial statements

iii. Notes must also disclose any material noncash investing or financing activities

Chapter 2 - Development of Accounting Principles and Auditing Standards

1. Generally Accepted Accounting Principles a. Accounting Principles (pg. 154)

i. Refers to the rules, procedures, and conventions that enterprises use to maintain accounting records and to prepare financial statements

b. GAAP (pg. 156)i. Refers to those conventions, rules, and procedures which define accepted

accounting practice at the particular time

2. Generally Accepted Auditing Standards a. Independent Auditor’s Role

i. Independence (pg. 200)1. To keep from violating SEC rules and professional standards, auditing

firms, their owners, and audit employees cannot own any direct financial interest or material indirect financial interest in an audit client, its parent, any subsidiaries, or other affiliates

ii. Audit Process (pg. 214)

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1. Generallya. Financial statements represent assertions that fall into five broad

categories and it’s the auditor’s job to gather evidence on these five assertions:

i. Reported assets and liabilities exist and that recorded transactions occurred during the particular accounting period

ii. Listed financial statements present all transactions and accounts

iii. Listed assets represent the enterprise's rights and the reported liabilities show the business's obligations

iv. Financial statements record the enterprise's assets, liabilities, revenues, and expenses at appropriate amounts

v. Enterprise has properly classified, described, and disclosed the financial statements' components. An audit gathers evidence about these five assertions

b. Prior Reliance on Internal Controlsi. Before recent financial scandals, auditors often relied on the

business’s internal controls over its accounting process and sampling techniques to test selected transactions to obtain reasonable assurance that the financial statements do not contain any material misstatement

c. Audit Riski. Refers to the probability that an auditor will unknowingly fail

to modify appropriately the audit opinion on materially misleading financial statements

2. Internal Controls (pg. 216)a. Administrative Controls

i. Enterprise’s plan of organization, procedures, and records that lead up to management’s authorization of transactions

b. Accounting Controlsi. Describe the plans, procedures, and records which the

enterprise uses to safeguard assets and produce reliable financial records

3. Planning the Audit and Assessing Internal Control (pg. 228)a. Gather information about conditions in the industry, the business’s

products or services, sales trends, major customers, production and marketing techniques, characteristics of management, personnel, budgeting and accounting systems, affiliations with outside influences, etc.

b. Review prior years’ audit resultsc. Assesses internal controls

i. Identifies critical points in the accounting system where significant fraud and errors could occur (irregularities)

ii. Then determines whether the enterprise has policies and procedures to prevent or detect errors or fraud at those critical points

iii. Performs compliance tests to determine whether the internal controls function properly

iv. Examines transactions and records (vouching)d. Decides whether to rely on some or all of the internal control to

reduce the need to test actual transactions and account balances

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4. Implementing the Audit Program (pg. 229)a. Sets forth the detailed procedures that the auditor will perform to test

transactions and account balances to establish reasonable assurance that the financial statements fairly present the business’s financial condition and operating results

5. Reporting the Audit Results (pg. 230)a. The standard audit report states that:

i. Financial statements remain management’s responsibilityii. Based on the audit, the auditor will express an opinion on the

financial statementsiii. Auditor conducted the audit in accordance with GAAS which

require the auditor to plan and perform the audit to obtain reasonable assurance that the financial statements do not contain material misstatements

iv. Financial statements present fairly, in all material respects, the financial position, the results of operations and cash flows in conformity with GAAP

b. Expectation Gap (pg. 243)i. Generally

1. Audit provides only reasonable assurance against material misstatements, whether intentional or not, in the financial statements

2. Investors set a higher standard for auditors to uncover fraud than to discover errors and that expectations exceed the assurance actually provided

3. Audit does not guarantee that error or fraud has not affected the financial statements nor does an audit offer any assurance about the safety of an investment in a business

ii. Present Fairly 1. Ultimate goal of the auditor is to express an opinion on whether the

financial statements “present fairly” the enterprise’s financial condition, results of operations, and cash flows “in accordance with GAAP”

2. Auditor should assess whether:a. Accounting principles that management has selected and applied

enjoy general acceptanceb. Accounting principles are appropriate in the circumstancesc. Financial statements provide information about those matters that

may affect their use, understanding, and interpretationd. Financial statements classify and summarize information that they

present in a reasonable manner that neither provides too much detail nor too few specifics

e. Financial statements reflect the underlying transactions and events in a manner that presents the financial position, results of operations, and cash flows stated within a range of acceptable limits that the enterprise can reasonably and practicably attain

c. Audit Reports (pg. 252)i. Standard, Unqualified Report

1. General Elements2. Introductory Paragraph3. Scope Paragraph4. Opinion Paragraph5. Report on Internal Control Over Financing Reporting

ii. Explanatory Language Added to an Unqualified Opinion

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iii. Qualified Opinioniv. Adverse Opinionv. Disclaimer of Opinion

d. Accountant’s Legal Liability (pg. 270)i. Generally

1. In a typical case, a creditor or shareholder alleges that management did not prepare the financial statements in conformity with GAAP

2. However, to collect damages from an independent auditor, the plaintiff must also prove that the auditor’s negligence or intentional misconduct prevent the auditor from identifying the failure to comply with GAAP

ii. New York Standard (Something like privity)1. Before accountants may be held liable in negligence to noncontractual

parties who rely to their detriment on inaccurate financial reports, certain prerequisites are required:

a. Accountant must have been aware that the financial reports were to be used for a particular purpose or purposes

b. In the furtherance of which a known party or parties was intended to rely

c. There must have been some conduct on the part of the accountants linking them to that party or parties which evinces the accountants’ understanding of that party or parties’ reliance

iii. New Jersey Standard (Foreseeability)1. Liability is restricted to all those whom the auditor should reasonably

foresee as recipients from the company of the statements for its proper business purposes, provided that the recipients rely on the statements pursuant to those business purposes

iv. California Standard 1. An auditor owes no general duty of care regarding the conduct of an audit to

persons other than the client2. However, an auditor may be held liable for negligent misrepresentations in

an audit report to those persons who act in reliance upon those misrepresentations in a transaction which the auditor intended to influence

3. An auditor may also be held liable to reasonably foreseeable third persons for intentional fraud in the preparation and dissemination of an audit report

Chapter 3 – The Time Value of Money

1. Variables Needed a. Present Valueb. Future Valuec. Interest Rate (includes compounding)d. Term (time)

2. Mortgage Example (compounding interest)a. 100,000 30 year mortgage at 5% = 193,000 total

i. 93,000 worth of interestb. 100,000 30 year mortgage at 5% = $877 per month or $315,000 total

i. 200,000 worth of interestc. 100,000 15 year mortgage at 10% = $1074 per month $193,000

3. Problem 3.1A a. Red, White, and Blue deposit $5,000 in different banks on Jan. 1, 1990

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i. Red – earned 8% simple interest per yearii. White – earned 8% annual interest, compounded annually

iii. Blue - earned 8% interest per year, compounded semiannuallyb. How much would each person have on Jan. 1, 2006 (16 years)

i. Red – $11,4001. Every year he will earn 5,000 x .08 = 400; 400 x 16 + 5000 = 11,4002. Will not earn interest on interest he’s already accumulated

ii. White – $17,129.701. 5000 x .08 = 400; 5400 x .08 = 432; 5832 x .08 = 6298.56, etc…2. Earns a little bit more every year3. We know the present value is $5,000; 8% is the interest rate, and it’s for 16

years4. Table tells us that $1 will be worth 3.42594 (this is our multiplier)5. 3.42594 x $5,000 = 17,129.70

iii. Blue – $17, 540.301. More often your interest compounds, the better your return will be2. Go to 4% interest column and double the period to 36 = 3.508063. 3.50806 x $5,000 = 17,540.30

4. Problem 3.1B a. US purchased Louisiana Territory from France for $15,000,000 in 1803b. What would it be worth in 2005 if France had invested the money in savings with:

i. 6% simple interest per year = $196,800,000ii. 6% annual interest, compounded annually

1. First 100 years = $5,089,531,5002. Second 100 years = $1,726,888,726,0003. Last two years = $1,940,332,173,000

5. Problem 3.2A a. Give $3,000 at the end of the year for college fund over 18 years and earns 8% interest per

year, compounded annuallyi. Go to Future Value table = 37.45024 x 3,000 = $112,350.72

b. What if they gave the money at the beginning of the year instead?i. Look at the table and select 19 periods and subtract 1

ii. 19 periods at 8% would be 41.44626 – 1 = 40.44626 x 3,000 = $121, 338.786. Problem 3.3A

a. Defendant promises to pay plaintiff $180,000 15 years from now; if defendant can earn 9% interest per year, compounded annually, what is the present value of his promise?

i. Look at the Present Value tableii. .27454 x 180,000 = $49,417.20

7. Problem 3.3B a. Promise to give $20,000 in 3 years and earn 10% interest per year, compounded annuallyb. .75131 x. 20,000 = $15,026.20 is present value of their promise

Chapter 4 - Financial Statement Analysis and Financial Ratios

1. Analytical Tools and Techniques a. Generally (pg. 333)

i. A lawyer should: (1) watch out for missing financial statements or disclosures, (2) carefully examine the footnotes, and (3) pay particular attention to the report of the independent accountant or auditor

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ii. A complete set of financial statements will include: (1) a balance sheet, (2) an income statement, (3) a statement of cash flows, (3) information about changes in owners’ equity, and (5) notes to the financial statements

b. Annual Reports (pg. 335)i. How many publicly-traded companies present their financial statements

ii. Summarizes an enterprise’s financial and operational activities for a particular calendar year or other fiscal year

iii. SEC requires its registrants to have the following in their annual reports:1. Audited financial statements2. Quarterly financial statements3. Historical summary of selected financial data for last 5 years4. Description of the business5. Business segment information6. Information about executive officers and directors7. Historical data about the market prices of the business’s equity securities

during past 2 years and dividends during that period8. Management’s discussion and analysis of the enterprise’s financial

condition and the results of its operations9. Management’s report on internal controls over financial reporting and the

corresponding report from the independent auditor on management’s assessment

c. Analytical Procedures (pg. 339)i. Trend Analysis

1. Involves comparing financial statements for an enterprise over several periods

2. Allows the reader to determine where the enterprise generated and spent its resources over a longer period of time

3. May help reader notice various patterns or trendsii. Common-Sized Analysis

1. Consists of reducing a financial statement (income statement or statement of cash flows) to a series of percentages of a given base amount such as net sales or total cash flow for the period

2. Reader can take these percentages and compare them to either similar business’s or prior years

iii. Financial Ratios 1. Liquidity and Leverage Ratios

a. Provide information on an enterprise’s ability to cover its anticipated operating expenses, such as payroll, to meet its debt obligations in the short and long run, and to distribute profits to owners

2. Activity Ratiosa. Measure the relative claims that creditors and owners hold on the

business’s assets3. Profitability Ratios

a. Assess how effectively a business uses its assets

2. Balance Sheet a. Changes in Owner’s Equity (pg. 341)b. Analytical Terms and Ratios (pg. 350)

i. Working Capital1. Current Assets – Current Liabilities

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ii. Liquidity Ratios - Helps an accountant evaluate a business's ability to pay its short term obligations

1. Current Ratio a. Current Assets / Current Liabilitiesb. Common test for evaluating the financial condition of a business,

especially its ability to pay its debts as they mature or become payable

c. Ex: .986, 1.8102. Acid Test

a. (Cash (and Equivalents) + Short Term Investments + Receivables) / Current Liabilities

b. Because a long time may elapse before a business can convert inventory to cash, short term creditors want assurance that the business will repay its debts if a disaster strikes

c. Comes close to applying a worst case scenario because the acid test assumes that the business could not sell any more inventory

d. Ex: .406, 1.063iii. Leverage Ratios - Assesses the business's ability to pay its debts

1. Debt to Equity a. Total Liabilities / Total Owner's Equityb. Measures the relative amount of debt in a business's financial

structure; the relationship of debt to equity provides lenders with some indication about the likelihood that the business will repay a loan, in that the amount of equity serves as a safety net for the creditors in case of financial difficult, because creditors come ahead of stockholders in any liquidation

c. Ex: .681, .3712. Debt to Total Assets

a. Total Liabilities / Total Assetsb. Just another way to compare the business debt to the sum of the debt

and equityc. Ex: .405, .271

iv. Net Book Value1. Net Book Value Attributable to Common Shares / Common Shares

Outstanding2. Refers to the difference between an enterprise's assets and its liabilities as

reflected in the business's accounting record, usually expressed as an amount per outstanding share or other ownership interest

3. Ex: $2.63 per share, $3.22 per share

3. Measurement of Income a. Results of Operations

i. Prior Period Adjustments (pg. 361)1. GAAP limits prior period adjustments to corrections of errors in previously

issued financial statements and requires an enterprise to restate the prior period financial statements; errors can arise form mathematical mistakes, misapplying accounting principles, overlooking or misusing facts, or changing from an accounting principle

2. FASB has other requirements - must disclosea. The nature of the error

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b. The correction’s effect on each financial statement line item and any per-share amounts affected for each prior period presented; and

c. The changes on retained earnings or other appropriate component of equity as of the beginning of the earliest period presented (correct the prior periods)

ii. Discontinued Operations (pg. 362)1. Refers to a distinct component of an entity that an enterprise has sold or

otherwise transferred, eliminated, abandoned, or designated for saleiii. Extraordinary Items (pg. 364)

1. Unusual in nature & infrequent in occurrencea. Mt. St. Helen but not Hurricane Katrina

2. GAAP defines as gains and losses from events or transactions, other than the sale, abandonment, or other disposal of a business segment, that qualify as both unusual in nature and infrequent in occurrence; to qualify as "unusual in nature," an event or transaction must possess a high degree of abnormality and either not relate to, or only incidentally relate to, the enterprise's ordinary activities

3. To satisfy the "infrequent in occurrence" requirement, the enterprise must not reasonably expect the underlying even or transaction to recur in the foreseeable future

iv. Accounting Changes (pg. 366)1. Changes in Accounting Principles

a. Occurs when an enterprise adopts a principle that differs from the one that the enterprise previously used for financial reporting purposes

2. Changes in Accounting Estimatesa. Enterprises must account for changes in estimates in either (a) the

period of change, if the change affects that period only, or (b) the period of change and future periods, if the change affects both

v. Unusual or Nonrecurring Operating Items 1. A material transaction that qualifies as either unusual in nature or infrequent

in occurrence, but not both, must be a separate item in computing income or loss from continuing operations

2. The enterprise should disclose the nature and financial effects of each such transaction, either on the income statement or in the footnotes

b. Pro Forma Metrics (pg. 370)i. Generally

1. A business’s own accounting standards and rulesii. Advantages

1. Knowledgeable investors and analysts can use pro formas to measure an enterprise's current profitability and to try and predict its future operating results

2. Can be useful comparisons between enterprises using different capital structures to finance their operations

iii. Pitfalls 1. Can mislead investors and other users of financial information if they

obscure GAAP results2. The changes of misleading increases when the enterprise reporting the

metric does not disclose where the underlying numbers come from or does not reconcile the metric to a comparable GAAP measure

iv. Regulation G (SOx)

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1. Applies whenever a public company discloses material information that includes a pro forma metric

2. Contains two important componentsa. A general prohibition against materially false or misleading pro

forma metrics; andb. A specific requirement to reconcile the pro forma metric reported

with the most closely comparable GAAP reporting measure3. Questions to ask:

a. Is the pro forma information more prominent than its GAAP counterparts?

b. Are the titles of the pro forma information confusing those GAAP?c. Is it explained and reconciled with the closest GAAP standard?d. Does the company explain why the pro forma information is

significant and useful?e. Does the company designate any items as non-recurring or unusual?f. Has it happened in the last 2 years and is it likely to happen in the

next 2 years?c. Comprehensive Income (pg. 379)

i. Generally1. The change in equity [net assets] of a business enterprise during a period

from transactions and other events and circumstances from nonowner sources

ii. Statement of Financial Accounting Standards divides comprehensive income1. Net Income

a. Includes income from continuing operations, discontinued operations, extraordinary items, and cumulative effects of changes in accounting principles

2. Other Comprehensive Incomea. Includes unrealized gains or losses from certain investments in debt

and equity securities, including related reclassification adjustments, foreign currency translation adjustments, and minimum pension liability

d. Coverage Ratios (pg. 382)i. Times Interest Earned

1. Net Income Before Interest and Taxes / Interest Expense2. Provides some indication about how much the enterprise's earning can

decide without endangering the interest paymentsii. Debt Coverage

1. Net Income Before Interest and Taxes / (Interest Expense + Current Portion of Long-Term Debt)

2. Determines how many times a business can cover both interest and the current portion of long-term debt

iii. Dividend Coverage, Dividend Payout, and Dividend Yield 1. Net Income / Preferred Stock Dividend Preference2. Provides some indication about how much the enterprise's net income can

decline without jeopardizing the regular dividend paymentse. Profitability Ratios (pg. 383) - Accesses how effectively a business operates

i. Earnings Per Share 1. Net Income Attributable to Common Shares / Weighted Average Common

Shares Outstanding

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2. Used for comparing an enterprise's performance in the current accounting period to that in a prior period

ii. Price-Earnings Ratio 1. Market Price / Basic Earnings Per Share2. Compares the market price of the common shares to the earnings per share3. Does not apply to privately-held corporations, who shares are not publically

tradediii. Return on Sales

1. Net Income / Net Revenue2. Provides some index to the enterprise's efficiency3. Shows the percentage of each dollar in revenue that becomes net income

iv. Gross Profit Percentage 1. Gross Profit / Net Retail Sales2. Reflects the business's profitability from selling its products, ignoring

operating expenses, such as general, selling, and administrative expensesv. Return on Assets

1. Net Income / Average Total Assets2. Measures a business's profitability relative to its total assets, usually

expressed in terms of average assets, however defined3. Most simply, analysts define "average assets" as the average beginning and

ending assets for the periodvi. Return on Equity

1. Net Income / Average Shareholders' Equity2. Represents the amounts that owners have invested in the business, whether

directly as a capital contribution or indirectly by leaving accumulated earnings in the business; gives a measure of how successfully the management is utilizing the owners' capital

3. Because P/E ratio cannot be computed for private companies, analysts often use ROE to measure the business's profitability

vii. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)1. Earnings Before Interest, Taxes, Depreciation, and Amortization2. Analysts use this measure to compare the enterprise's current operating

results to a prior period or to its competitors' numbers or to quantify the extent to which an enterprise's "adjusted" income, before interest and taxes, can service the enterprise's debt obligations

f. Activity Ratios (pg. 388) - Compares amounts from the balance sheet and the income statement and measure how effectively the business utilizes its resources

i. Receivables Turnover 1. Credit Sales / Average Accounts Receivable2. Provides some measure of the liquidity of the accounts receivable3. I.e., credit sales = $30,000 and average = $3,000, then 10.0 receivables

turnover4. This means that on average the company collected its accounts receivable in

36.5 days or 1/10th of a yearii. Inventory Turnover

1. Cost of Goods Sold / Average Inventory2. Measures how often a business sells and replaces inventory in a fiscal

period; a low inventory turnover suggests that the business may have overinvested in inventory, may own obsolete or slowing moving goods, or suffer from a poor sales force

iii. Asset Turnover

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1. Net Revues / Average Total Assets2. Indicates how many dollars of sales the business generates for each dollar of

assets that the business owns4. Statement of Cash Flows (pg. 396)

CASH FLOW PATTERNSPattern 1 2 3 4 5 6 7 8Operating + + + + – – – –Investing + – + – + – + –Financing + – – + + + – –

a. First Four Patternsi. Contain situations where an enterprise generated positive net cash flows from its

operations – this denotes a healthy business that can use this cash to expand operations, satisfy long-term obligations, or provide a return on investment to its owners

1. Pattern 1 – very unusual; a business wants to use positive cash from operations to expand

2. Pattern 2 – best pattern/most mature companies; shows that business used cash from operations to invest and pay its debts or distribute earnings

3. Pattern 3 – suggests enterprise has decided to downsize or restructure by selling assets to repay debt or to buy out owners

4. Pattern 4 – typical of a growing business; generated cash from operating and financing activities to buy long-term assets

b. Second Four Patternsi. Describe situations where an enterprise has negative cash flow from operations,

which indicates that the enterprise’s cash flow from operations do not cover its operating expenses – will eventually force business to sell assets, borrow from creditors, or raise additional funds from the owners to continue operating

1. Pattern 5 – to stay open, generated positive cash flow by selling capital assets and seeking additional investments from owners or taking loans

2. Pattern 6 – often a young, fast-growing business; negative cash flow from operations may be from large increases in inventory to prepare for expanded operations and sales

3. Pattern 7 – liquidating or down-sizing; probably sold off capital assets to support its operations and to distribute cash to investors

4. Pattern 8 – unusual; business could not survive if it had cash on hand prior to this period

c. Liquidity and Coverage Ratios (pg. 401)i. Cash Interest Coverage

1. Cash Flows [Net Cash] from Operating Activities before Interest & Taxes / Interest

2. Tells us whether the business is covering its interest expense comfortably or not by comparing prior years

3. If the numbers go up, then the principal (debt) went down and the business is better able to cover the remaining debt or borrow more money

4. Ex: 1,087.2 times, 2,788.3 timesii. Debt Service Coverage

1. CFFO before Interest & Taxes / Interest & Principal Payments [Repayments of long-term debt]

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2. Tell you how many times the business covers its dividends; if the business regularly gives dividend payments then shareholders look at this to see if the business can continue to make those payments

3. Ex: 642.1 times, 955.7 timesiii. Cash Dividend Coverage

1. Cash Flows from Operating Activities / Total Cash Dividends 2. Ex: Not meaningful if no dividends

iv. Cash Flows from Operations to Capital Expenditures 1. (CFFO – Total Dividends Paid) / Cash Paid to Acquire Property, Plant, &

Equipment [Purchases of Fixed Assets]2. If the ratio goes down, then that’s good or indifferent because it shows that

the business has expanded, or if they’re not expanding, they’re at least replacing older fixed assets that are less efficient – shows additional investment

3. Ex: 1.43 times, 2.08 timesd. Profitability Ratios (pg. 401)

i. Cash Return on Investment 1. CFFO before Interest & Taxes / Average Total Assets2. To find “Average Total Assets,” look at the balance sheet from this current

year and the end of last year (Total Assets on Oct. 2005 + Total Assets from Oct. 2004 / 2)

3. Ex: 33.4%, 33.5%ii. Cash Flow per Common Share

1. (CFFO – Preferred Stock Dividend Preferences) / Weighted Average Common Shares Outstanding

2. Find “WACSO” on Income Statement3. Ex: $1.17 per share, $1.08 per share

e. Quality of Income (pg. 402)i. Cash Quality of Income

1. CFFO / Net Income2. Your net cash flow and net income should be trending in the same direction

– if not, it tells you that something is going on3. Ex: 1.87 times, 2.21 times

ii. Cash Quality of Income before Interest, Taxes, and Depreciation 1. CFFO before Interest & Taxes / Net Income before Interest, Tax, &

Depreciation2. Ex: 1.01 times, 1.13 times

Chapter 5 - Legal Issues Involving Shareholders’ Equity and the Balance Sheet

1. Drafting and Negotiating Agreements a. Notes (pg. 507)

i. Make sure GAAP is defined because it can change over time or allow for the parties to later agree to changes in accounting principles

ii. Replace “certified” with “audited”iii. Don’t require “being true, complete, and correct” or “truly, correctly, and

completely”

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iv. Replace “consolidated statements of earnings” with “changes in cash flow”v. Look for vague terms

1. I.e., earnings was not defined in our examplevi. Make sure lender has a right to borrower’s books and records

b. General Principles of Drafting (pg. 481)i. Completely mutual terms are not necessarily even-or best for your client

ii. When relying on past agreements, be careful which document you chooseiii. Long forms are not necessarily superioriv. Make sure the mechanics workv. Clear the documents with your client’s accountants

vi. If your client is in control, use a bottom line concept; if the opposing party is in control, use a top line concept

vii. The longer the term of the agreement, the less important the control of accountingviii. Use proper accounting terminology

ix. GAAP may not be best for your clientx. GAAP is not a static set of principles

Chapter 6 - Revenue Recognition and Issues Involving the Income Statement

1. Essential Requirements for Revenue Recognition (pg. 525)a. Bona Fide Exchange Transaction

i. External Events1. Transferring between business’s divisions2. Shams (form satisfies requirement, but substance does not)

ii. Special Circumstances1. Nonmonetary Transactions2. Related Party Transactions

iii. Exceptions1. Investments in Securities2. Losses3. Personal Financial Statements

b. Earnings Process Substantially Completei. Generally

1. Delivery, Passage of Time, or Performance2. Right of Return and Buy-Back Agreements3. Certain Nonmonetary Transactions

ii. Exceptions1. Accounting for Rent, Interest, and Certain Services2. Long-Term Contracts

a. Percentage-of-Completion Method3. Customer Deposits and Prepayments

c. GAAP Requirementsi. Bona fide exchange transaction with an outsider has occurred

ii. Enterprise has received cash or the right to receive cash or can readily convert any other consideration received into money or money’s worth

iii. Enterprise has substantially completed the earnings processd. SEC Requirements

i. Evidence must persuasively demonstrate that an arrangement existsii. Enterprise must have delivered the product or performed the services

iii. Arrangement must contain a fixed or determinable sales price

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iv. Circumstances must reasonably assure collectability e. In re Kurzweil Applied Intelligence, Inc. (pg. 526)

i. Shipping products from their warehouse to another warehouseii. Began by just waiting for the paper work to go through, but it progressed to the

point where the business was shipping goods to the warehouse that had not even been sold

iii. The business was also booking transactions even though the customers had a right of return on the goods

1. You cannot recognize income if the customer can return the goods after inspection for quality, compatibility, etc.

iv. How did this come to the auditor’s attention?1. Found an invoice from the other warehouse, discovering that the business is

paying for offsite warehouse2. When the auditor confronted the executives, they shipped the goods to a

second warehouse!v. What do we learn from this case?

1. It’s very hard to commit fraud at this level because there are so many individuals involved

f. The Numbers Game by Arthur Levitt (pg. 537)i. Five Ways to Manipulate Income Statements

1. Big Bath Charges a. A company is going to have a bad year and decides to make really

bad by recognizing expenses that belong in other years – artificially accelerated expenses

b. It makes the following years look better and you can just call the bad year an anomaly so shareholders won’t worry

2. Creative Acquisition Accounting a. Business should defer some of those acquisition costs over time

3. “Cookie Jar Reserves” a. A business does not want spikes and falls in income from year to

yearb. In years with a spike in income, throw some extra expenses in there

so it balances out4. Materiality

a. When a company makes mistakes in its accounts receivable, inventory, etc., but claim that it’s not material so there’s no need to fix it

b. However, when you add up all of the mistakes, there’s a big difference in the business’s bottom line

c. SEC says you need to look at materiality on both an item-by-item basis and composite basis

5. Revenue Recognition a. When companies try to accelerate revenue into the current year

g. Recourse Debt vs. Non-recourse Debti. Recourse Debt

1. Recourse you have always have to pay back - seize assets until the full debt is paid

2. Can be unsecured or secureda. Unsecured – like credit card debt; no particular property stands as

security/collateral

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b. Secured – borrower has pledged certain property for loan (i.e., mortgage)

i. If the bank takes the house, but depreciates by some amount - you’re still on the hook for the remaining value of the debt

ii. Bank will continue to seize assets until paidiii. Borrower bears the risk of the debt

ii. Non-recourse Debt 1. Always secured – borrower pledged certain property2. Lending documents read a bit differently in regards to the rights of the

various parties3. What the lender agrees to is that they will not be able to seize anything

more than the property that stands as collateral/security for the debt - no other recourse if the property doesn’t satisfy the debt owed

4. Borrower must pay higher interest and will likely need to make a bigger down payment

h. Bona Fide Exchange Transaction (pg. 546)i. Nature of the Exchange Transaction

1. In Generala. An exchange transaction for revenue recognition purposes occurs

when two or more individuals or enterprises exchange products, services, or the other assets for cash, claims to cash or other consideration

b. To recognize revenue, an exchange must take place that transfers the risks and rewards of ownership

2. In re Reliance Group Holdings, Inc. (pg. 548)a. Company arranges a deal with a broker in which they sell him the

bonds and agree to buy them back at the same price 30 days laterb. There was no risk of ownership because they agreed to buy them

back at the same cost – without regard for how the market’s changedc. The bonds were listed at historical cost, but once the business

repurchases the bonds they can be listed at their current fair market value

d. No economical substance to the transaction; Reliance did not divest itself of ownership and no revenue should have been recognized - just pretended to sale them

3. Lincoln Savings & Loan Ass’n v. Wall (pg. 554)a. Set-up

i. Things are not looking good for Lincoln Savings because they are a troubled bank and at risk of the government taking over

ii. Lincoln wants to show better revenue so it claimed to have sold some land that had appreciated in value

iii. As a result of the land sales, Lincoln recognized a lot more gain in the hopes that the government would back off

iv. However, Lincoln was never paid for the sales and there was never any intent to do so

b. Wescon Transactioni. Lincoln selling property to third party (Wescon) for $14M

ii. $3.5M in cash, $10.5M noteiii. Lincoln paid $3M for the landiv. $11M gain & $250k in accrued interest

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v. Fair Market Value of land is only $9M - inflated sales pricevi. Hidden Valley never intended to part with the land because

Wescon could never pay for the land - non-recourse debtvii. Loan is uncollectable

viii. Liquidity ratios looks better because your balance sheet shows $3.5M in cash and $10.5 in note receivable

c. Phillip Gordon Transactioni. Phillip Gordon buys land from Hidden Valley and sales land

to ACC; ACC buys property from Phillip Gordon at an inflated price

ii. The purpose of the transaction was to provide Gordon with the necessary funds to make the down payment on the Hidden Valley purchase

iii. Gordon would not have bought the Hidden Valley property without ACC’s agreement to buy his property

iv. The two transactions were inextricably linked and the one transaction would not have occurred without the other

v. It was wrong to recognize the profits because it was simply an exchange

ii. Nonmonetary Exchanges (pg. 569)1. Generally

a. An enterprise cannot recognize revenue in a nonmonetary exchange if major uncertainties exist about the fair market value of the assets transferred and received in exchange

b. SFAS directs an enterprise to use the recorded amount when:i. The enterprise cannot determine fair value of either the

received or relinquished assets within reasonable limitsii. The transaction qualifies as an exchange to facilitate a sale to

a customer other than the parties to the exchange ORiii. The transaction lacks commercial substance

c. APB Opinion No. 29 provides:i. An enterprise should regard fair value as “not determinable

within reasonable limits” if major uncertainties exist about a business’s ability to realize value from an asset obtained in a nonmonetary exchange

d. If the circumstances do not reasonably assure that an enterprise will collect the sales price reflected in a receivable and the enterprise also cannot reasonably estimate the degree of collectability, APB Opinion No. 10 permits the business to use either the installment method or cost recovery method to account for the transaction

2. Installment Method (pg. 570)a. Requires the vendor to allocate all ash received from the buyer

between cost recovery and profitb. Ex: Lincoln sold the property for $14M and it cost $3M

i. Lincoln would allocate 3/14ths of each payment to cost recovery and 11/14ths to profit

Cash _______ 3.5MNote Rec. __ 10.5M

Land _____________ 3MDef. Profit on Sale __ 11M

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*** The installment method would treat $2.75M, or 11/14ths of the $3.5M collected as profit. Lincoln should make another entry to record the profit as follows:*** Def. Profit on Sale __ 2.75M

Profit from Sale on Land under Installment Method _____ 2.75M

***Suppose Westcon paid an additional $1M before defaulting. In that event, Lincoln would first record the $1M payment as follows: Cash ____ 1M

Notes Rec. ___ 1M***In addition, Lincoln would recognize 11/14ths of the $1M as profit and could record the following entry:

Def. Profit on Sale __ 785, 714Profit from Sale on Land under Installment Method ______ 785,714

1. Cost Recovery Methoda. Enterprise recognizes equal and offsetting amounts of revenue and

expense as the business collects payments on the receivable until the enterprise has recover all costs

b. Cost Recovery Method postpones any profit recognition until that time

Cash _______ 3.5MNote Rec. __ 10.5M

Land _____________ 3MDef. Profit on Sale __ 11M

*** Because the $3.5M down payment exceeds the $3M cost of the land, Lincoln can recognize $500k in profit and could record the following: ***

Def. Profit on Sale __ 500kProfit from Sale on Land under Cost Recovery Method __________ 500k

***Assuming that Westcon paid an additional $1M before defaulting, Lincoln would record the following:***

Cash ____ 1MNotes Rec. ___ 1M

*** Lincoln would recognize the entire $1M as profit because Lincoln already recovered the $3M cost of the land ***

Def. Profit on Sale __ 500kProfit from Sale on Land under Cost Recovery Method __________ 500k

2. Accrual Method Cash _______ 3.5M

Note Rec. __ 10.5MLand _____________ 3M

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Gain on Sale of Land __ 11M

*** Because Lincoln already recognized $11M in gain under the accrual method, it would not recognize any additional income as it collects payment on the note ***

Cash ____ 1MNotes Rec. ___ 1M

Time Accrual Method Installment Method Cost Recovery MethodSale $11,000,000 $0 $0Down Payment $0 $2,750,000 $500,000First Installment $0 $785,714 $1,000,000Later Installments $0 $7,464,286 $9,500,000Total $11,000,000 $11,000,000 $11,000,000

3. Fine v. American Solar King Corp. (pg. 573)a. Facts: ASK sold solar energy equipment to S.E.P. No. 1 on the last

day of 1982 fiscal year for $1.75M. Paid $20k cash, short term note $905k, and long term, 10 year note at 10% interest. ASK recognized $1,239,000 of revenue and $964k of profits from sale in 1982. By recording the transaction in the fourth quarter of 1982, it made ASK on show a small loss for the year as a whole. Without this sale, they would have reported a very unprofitable year. Plaintiffs allege that ASK engaged in fraud to overstate its financial statements for 1982. Plaintiff’s also alleged that ASK’s accounting firm, Main Hurdman, issued a materially false auditor’s opinion on ASK’s 1982 financial statements

b. Plaintiff’s Arguments: Main Hurdman acted with intent to deceive or severe recklessness when issued its auditors report. Claimed that Main Hurdman knew that ASK improperly recognized revenue from sale. Basically, Main Hurdman didn’t comply with GAAP’s revenue recognition rules

ii. Related Party Transactions (pg. 583)1. Such transactions, while efficient, may also allow a business to manipulate

its earnings by the way it sets prices or allocates expenses2. GAAP requires that a business disclose the following information in their

financial statements for related party transactions:a. The nature of any relationship involvedb. A description of the transactions for which the financial statements

present an income statement, including any information necessary to understand the transactions’ effects on the financial statements

c. The dollar amounts of the transactions and the effects of any change in the method used to establish terms when compared to those followed in the preceding period

d. Amounts due from or to related parties on each balance sheet date and the related terms governing those amounts

3. GAAP requires that an auditor identify related party relationships and transactions and to obtain and evaluate competent evidence regarding the purpose, nature, extent of any relationship or transaction and their effect on the financial statements

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a. Before issuing an unqualified opinion, the auditor must conclude that the financial statements adequately disclose any related party transaction or relationship

iii. Comprehensive Income 1. Net income + other comprehensive income = total comprehensive

incomea. Amazon sheet on 11/10 pg. 2b. Total income = 588,451c. Other comprehensive income = (502) – (10,986) + 5858d. Total comprehensive income = 592,821

2. Shows up statement of shareholders’ equity or deficit iv. Exceptions to the Exchange Transaction

1. Passive Investmentsa. Held-to-Maturity Debt Securities (pg. 589)

i. Where the corporation decides that it would keep the bond until it reaches its payment date when the borrower will pay the principle amount (like a long term investment)

ii. Held primary to earn interest income so we’re not concerned with fluctuations in value as long as it’s temporary

iii. If it’s permanent loss, you have to recognize that loss immediately

b. Trading Securities (pg. 592)i. The intent to sale quickly makes securities, trade securities

ii. Not looking for dividends, but looking for the stock to gainiii. Most companies won’t have many of theseiv. Any fluctuations in value before you sale it and you’re going

to fully recognize it as incomec. Available-for-Sale Securities (pg. 593)

i. Any debt or equity that you don’t hold for long or intend to sale quickly

ii. These show up as unearned income but within out regular income

iii. It goes as a special line in your other comprehensive incomeiv. Example

1. Available for sale security that you bought last year2. Last year’s balance sheet showed up as $110 (fair

value at this point in time)3. This year, you look up its price and now it’s $1254. Additional $15 value will show up as other

comprehensive income2. Active Investments

a. Consolidated Financial Statements (pg. 598)i. If the parent company owns more than 50% of the subsidiary

then they are required to have consolidated statementsb. Equity Method (pg. 600)

i. If the parent owns from 20-50%, required to do the equity method

ii. Share ownership shows up as an investment, but you reflect your share/portion of the retained earnings in the parent’s retained earnings and reflect investment in Assets

b. Earnings Process Substantially Complete

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i. General Rules1. Delivery, Passage of Title, or Performance

ii. Pacific Grape Products Co. v. Commissioner (pg. 609)1. Facts

a. Customer wants Pacific to hold the order at the end of the year but they go ahead and recognize the revenue

b. But Pacific went ahead and billed to the customer2. But the court said this was a “clear reflection of income” for tax purposes3. Under GAAP standards, however, Pacific might have a problem with

substantially completing the transactionsa. Going to argue that the transaction was substantially performed

i. Shipping and labeling is trivial compared to getting the fruit and getting it ready to go

b. Why does substantially performance not look only for title?i. Because you can transfer title before the product has ever

been produced, much less shippediii. Right of Return and Buy-Back Agreements (pg. 614)

1. A seller can recognize revenue when a right of return exists only if the surrounding circumstances satisfy the following conditions:

a. The underlying agreement substantially fixes or determines the price to the buyer on date of the sale

b. The buyer has paid the seller or the underlying agreement obligates the buyer to pay the seller whether or not the buyer resells the product

c. The product’s theft, physical destruction, or damage will not change the buyer’s obligation to the seller

d. The buyer acquiring the product for resale has economic substance apart from any resources that the seller has provided

e. The underlying agreement does not impose significant obligations on the seller for future performance to directly bring about the product’s resale AND

f. The seller can reasonably estimate future returns *** typically, the transaction satisfies the first five requirements and the following factors may impair the seller’s ability to establish a reasonable estimate***

i. The product’s susceptibility to significant external factors, such as technological obsolescence or changes in demand

ii. A relatively long return periodiii. Insufficient or no historical experience with similar sales or

similar productsiv. Changing circumstances, such as modifications in the seller’s

marketing policies or relationships with customersv. Inadequate volume of relatively homogeneous transactions

g. If the seller cannot reasonable estimate future returns, it should wait to recognize revenue when:

i. The return privilege has substantially expired ORii. The underlying circumstances subsequently satisfy the six

conditions, whichever comes firstiv. Nonmonetary Transactions (pg. 615)

1. Enterprise should not recognize revenue in certain nonmonetary exchanges if the transaction does not have commercial substance

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2. GAAP identifies two such transactions:a. An exchange of property held for sale for a product or property that

the enterprise will promptly sell in the same line of business to a third party

b. An exchange that will not result in significant changes in the risk, timing, or amount of future cash flows of the reporting enterprise

v. Exceptions to the Substantial Completion Requirement (pg. 619)1. Rent

a. Rent is an exception because the right to receive the rent accrues over time – so you recognize the revenue over time

b. Almost like each rental period is substantial performance2. Interest

a. Interest income accrues from the forbearance of money over certain periods

b. Do not have to wait until you’re eight months into the loan to recognize your interest income

c. We would recognize interest income and maintain an accrued interest receivable account

3. Long-Term Contracts (pg. 624)a. Example

i. Contract to build a bridge that takes 3 years to completeii. Estimated to cost $1.5M to build the bridge

b. Completion Method i. Requires full, or substantial completion before an enterprise

may treat revenue as earnedii. In example, the business would not recognize revenue in year

1 or year 2iii. Could only recognize when the bridge was fully, or

substantially completedc. Percentage-of-Completion (preferred method)

i. Enterprise may recognize a portion of the estimated profit on a long term contract even though it has no substantially completed the project

ii. BUT the business needs to figure out how much it has finished after year

iii. Cost-to-Cost Method 1. In the example, it costs $1M (2/3 of total costs), then

the business can recognize $2M, or 2/3 of total revenue

2. Journal entries – if we received 500k payment the first year, but incurred $1M (2/3 of total cost) of project, we can recognize $2M which is 2/3 of total revenue

3. Have to be able to make reasonable estimates or the business will need to use the completion method

Year 1 Cash ___ 500k

Accrued Rec. __ 1.5MRevenue ______ 2M

Expenses of Bridge ___ 1MCash ______________ 1M

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***1st year, $2M in revenue and $1M in expenses = Net Income of $1M***

Year 2 Cash ____ 500k

Revenue ____ 500k Expenses of Bridge ____ 250k

Cash _______________ 250k***2nd year, $500k in revenue and $250k in expenses = Net Income of $250k***

Year 3 Cash ____ 2M

Revenue ______ 500kAccrued Rev. __ 1.5M

Expenses of Bridge ___250kCash ____________ 250k

***3rd year, $500k in revenue and $250k in expenses = Net Income of $250k***

vi. Prepayments 1. Boise Cascade Corp. v. United States

a. Boise is an engineering firm that usually recognized their revenue after they performed the engineering services

b. However, sometimes its clients paid upfront before Boise did the work

c. Standard – has Boise substantially completed the earning’s process so that it can recognize this revenue?

Cash ____ 1MUnearned income ____ 1M

***Under liabilities because if the services aren’t performed, the money must go back; at the end of the year, it’s estimated that 25% of the required hours were completed of $1M contract***

Unearned income ____ 250kProfessional Income ___ 250k

Unearned income ____ 750kProfessional Income ___ 750k

d. For tax purposes, was it right for Boise to defer their revenue?i. Government argued that Boise should have recognized all of

the income when it received the prepaymente. From an accounting perspective, this is the perfectly appropriate

rule, and doing it any other way would have been wrong2. Matching Principle for Expenses

a. Basic Rules (pg. 648)i. Sometimes, an enterprises collects cash in advance for services that it will perform

or provide in the future

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ii. Under the accrual method, cannot recognize this income before rendering the services

iii. Basically, you match up expenses with the year you received revenue b. Rules for Expense Allocation (pg. 648)

i. Normal – An enterprise should match expenditures and losses against revenues that result directly and jointly from the same transactions or events

1. To do this, business should accrue or defer expenses to the right time period2. Example 1 : long-term contract that pays $1M for construction of a building

a. Percentage-of-completion depends on how much the architect or engineer says is completed at that point in time

b. Year 1 – engineer says building is 25% completei. Revenue would be 25% of $1M (250k)

ii. Building costs $500k but we’ve already incurred costs of $400k (lots of building material sitting in warehouse waiting to be installed)

iii. How much of our expenses do we allocate to the first year?iv. Recognize 25% of your costs ($125k) and the remaining

$275k that we’ve spent would be a Prepaid Expensev. This is an example of deferring costs to a later year

3. Example 2 : Contract of one year for $1M legal servicesa. We performed all of the legal services and were paid the $1M so we

can recognize the revenues in Year 1, but we don’t pay the associates until Year 2

b. If we pay the associates $300k in Year 2, when should we recognize this expense?

c. Because the expense relates to a particular transaction, we should accrue the expense in Year 1 when the services were performed

d. This is an example of accruing costs to an earlier yearii. Generally Relates – If an expenditure or loss does not directly relate to any

particular revenue-producing transaction, but does generally relate to revenues earned in an accounting period, the enterprise should recognize an expense or loss for that accounting period

1. Accrue or defer it in that accounting periodiii. Several Years – If an expenditure does not relate to a particular transaction, but

generally aids in the production of revenues in more than one accounting period, the enterprise should systematically and rationally allocate the expenditure among the different accounting periods that it expects to benefit from the expenditure

1. Divide the expense between the periods that it benefits2. We’ve seen this in the context of depreciation and prepayments of rent

iv. Neither – If an enterprise cannot relate an expenditure or loss to a particular revenue transaction or to any future accounting period, the enterprise should recognize the item in the accounting period in which the business incurred the cost or discerned the loss

1. Eat the expense in the year in which it occurred2. Example

a. You own a building and you have to make some repairs on the building

b. This doesn’t relate to a specific transaction and doesn’t benefit any future period so you recognize it in the year the expense was incurred

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c. Problem 6.6 (pg. 654)i. Niagara Power Co. is a private corporation

ii. One of its three main plants has a book value of $100M (original cost less depreciation)

iii. A rock slide caused the plant to collapse into the Niagara Riveriv. Company’s earned surplus at the beginning of the year was $600M; gross revenues

were $1800M and “regular” expenses were $1500v. When would Niagara recognize the expense of its plant ($100 book value) going

into the river? From its current income, past income, or future income? 1. You cannot point to any particular transaction to which this cost relates2. You cannot point to any particular revenue that the plant going into the river

relates to3. There’s no benefit to a future period4. Therefore, you’re left in the 4th category (above) where you must recognize

this expense in the current period5. Just like when Tutt’s library burned (Fire Loss)

vi. Assume Niagara was not a private corporation, but a public utility and further assume that the state regulation of public utilities allows for public utilities to spread loses over a 10 year period and your regulated rates can take into account 1/10th of your losses each year for rate increases

1. Now there IS a future benefit for the $100M plant going into the river because it will generate additional revenue in the next 10 year period

2. Now you can allocate this expense to later periods because it’s related to future revenues

3. Category 2 d. Problem 6.7 (pg. 662)

i. At end of fiscal year, Pacific Grape had $300k of completed canned goods inventory which had been ordered by customers but not yet labeled and shipped

ii. The sales price of these goods was $420k, brokers’ commission of 5% of sales price (21k), and the estimated cost of labeling and shipping the goods was $15k

iii. Pacific Grape treated the goods as not being sold in the year that just ended and did not recognize income or related expenses for that year

iv. It’s balance sheet looks like the following:

Pacific Grape Products CompanyBalance Sheet, End of 200X

Assets Liabilities and EquityCash $90,000 LiabilitiesAccounts Rec. Note Payable $500,000 (net of $14,000 allowance for doubtful accounts)

Accounts Payable $334,000 Expenses Payable $75,000

$686,000 Est. Liabilities $12,000Inventory $580,000 Total Liabilities $921,000

Equity Common Stock $1,500,000

Fixed Assets (after depreciation) $1,634,000 Retained Earnings $579,000

Deferred Expenses $10,000 Total Equity $2,079,000Total Assets $3,000,000 Total Liabilities and Equity $3,000,000

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v. How would the balance sheet look if the company treated the goods as sold during the year that just ended? How would this affect the company’s income statement?

1. What would change on the Income Statement?a. Increase in revenue/sales = $420k

i. If we recognize the sales this year, we also have to recognize the costs/expenses that go along with it

b. Increase in Cost of Goods Sold = $300ki. Gross Profit = $120k

c. Commission Exp. = $21kd. Increase Net Income = $84k

2. How does this change the balance sheet?a. We recognized the revenue, but didn’t get paid so our Account

Receivable would go up by $420kb. Inventory would go down by $300kc. Accrued Commission Payable = $21kd. Estimated Labeling and Shipping Cost = $15ke. Retained earnings goes up = $84k

3. Is the company right to recognize the revenue in the period that just ended?a. Have they substantially completed the earnings process?

i. If yes, then we have to get the related costs and expenses into the same period (Category 1 – particularly related to a transaction)

e. Uncollectable Accounts i. Inherent in the nature of dealing with accounts receivable is that not everyone pays

their billsii. Unpaid accounts are an expense of doing business on credit and the question

becomes when should a business acknowledge that expense1. So, you determine total accounts receivable and you know that on average a

certain percentage of them will not be paidiii. Common sense says that the longer an account receivable remains unpaid, the more

likely that it will never be paidiv. Journal Entries

Account Receivable _____ $X (Balance Sheet)Sales/Revenue/Services/Prof. Income ___ $X

Bad Debt Expense _____ $X ***Shows up as expense on Income Statement***

Allowance for Doubtful Accounts ___ $X ***Shows up as contra account on Balance Sheet like depreciation***

f. Problem 6.8 (pg. 668)i. On $5M of sales during the year (not including $420k relating to goods ordered but

not shipped), $12,500 of Bad Debt Expense was producedii. This Allowance Account carries over from year to year

1. Look at beginning of year balance to see that you begin $12k in the Allowance Account

a. $12,000 opening balanceb. $12,500 Bad Debt Expense for yearc. Someone paid $1000 on an account that had previously written off d. Less $11,500 of accounts receivable written off during the year and

charged against the Allowance Account

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e. Currently $14,000 in Allowance Accountiii. Aging the Account

1. Look at your Accounts Receivable and ask how long has been since these have been paid?

a. The older they get, less likely they will be paidb. The business uses the following numbers to determine the likelihood

of payment:

Age Category Amount of Receivables Percentage

Amount Potentially Bad

Less than one month old $440,000 1/4 % $1,100One to three months old $200,000 2% $4,000Three to six months old $40,000 7% $2,800

Six to twelve months old $16,000 25% $4,000

Over twelve months old $4,000 75% $3,000$14,900

iv. Need to make one more adjustment at the end of the year1. Of the Accounts Receivable, the amount likely to be bad is $14,9002. $14,000 is already in Allowance Account 3. So, we need to adjust the Allowance Account to reflect that we have an

additional $900 of bad debt expenses for the year because more debts became bad over the course of the year than we had taken into account

Bad Debt Expense ____ $900Allowance Account ____ $900

4. This is about getting the Allowance Account into the same year as the Accounts Receivable grew

g. Problem 6.5 (pg. 651)i. Two months before the end of 2009, Pacific Grape contracted for 4 months of

advertising for $10,000 per month for a product it will introduce in 2010ii. Pacific Grape paid the entire $40,000 on Dec. 31, 2009 to cover the last two

months of 2009 and the first two months of 2010iii. How should Pacific Grape reflect this payment on its financial statements for

2009? What year should it recognize the expense?1. General principles suggest that because the advertising relates to a product

that will be introduced in 2010, the expenses should be recognized in 2010iv. Why is not appropriate to recognize all $40,000 in 2010?

1. Well, received two months’ worth of ad services in 2009, as well as 20102. Business can’t know if the product will be successful in 2010 – it could be a

complete bust so there might not be any revenue from ita. As a result, there might not be any revenue related to these expenses

in 2010v. Two specific rules that tell us to divide the expenses between the years

1. Statement of Practices 98-5 (Start-up Activities)a. Expense start-up activities when you incur them

2. Statement of Practices 93-7a. You expense advertising when the advertising happens

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b. Consistent with the rule for research and developmenti. Take your expense in the year that you incur the expenses for

R&Dvi. Here, the product’s revenue is speculative so we don’t know that it will be related

to any particular transaction or revenuevii. If the future revenue is speculative, you end up in Category 4 and the expense goes

in the year it was incurredviii. Therefore, $20,000 expense goes in 2009 and $20,000 goes in 2010

1. Journal Entries Advertising Exp. _______ 20,000

Prepaid Advertising _____ 20,000Cash ___________________ 40,000

Advertising Exp. _____ 20,000Prepaid Advertising _______ 20,000

h. Problem 6.9 (pg. 675)i. How would the answer to Problem 6.5 change if Pacific Grape did not pay the

$40,000 on Dec. 31, 2009, even though the amount became payable on that date? How should Pacific Grape reflect the advertising expense on its financial statements in 2009?

ii. Journal Entries Advertising Exp. _____ 20,000

Accrued Advertising Payable _____ 20,000 Accrued Advertising Payable __ 20,000

Advertising Exp. ____________ 20,000Cash _________________________ 40,000

iii. Regardless of when we pay the money, the expense is divided into both yearsiv. Exceptions:

1. Long-Term Leasesa. Business will still accrue that payable because it can be a significant

amount2. Goods or Services Already Delivered

v. What if all of the advertising services were received in 2009?1. All of the expenses would fall into 2009 as well and you’d need to

recognize the payable in that yeari. Problem 6.10A (pg. 675)

i. What’s the point of this problem?1. Determining when the company’s income should show up and when should

its expenses be recognizedii. Set-up

1. Ebasco’s representative earned $60,000 per year and spent 4 months trying to get P Corp. to sign a contract with Ebasco

2. Ebasco retained scientist to work with regular staff in preparation for the proposal with P Corp. for $39,000

3. In July 2009, Ebasco got the contract which called for engineering services for 15-18 months

4. Ebasco was to receive a total of $500,000, payable $100,000 every 3 months starting Sept. 15, regardless of when services were performed (Payments due on Sept. 15 and Dec. 15)

5. Due to P Corp.’s delays, Ebasco performed no services in 2009iii. Analysis

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1. What about the first $100,000 Ebasco received on Sept. 15, can it recognize the revenue yet?

a. No, because the earnings process is not substantially complete – the services have not even started

2. What about the salary of Ebasco’s employee for the 4 months he spend trying to get the contract?

a. His salary could be said to be related to the transaction, but even if the company did not get the contract he would have still received his salary

b. His salary is a general business expense and should be expensed in the year in which they were incurred (2009)

c. ***However, a commission for getting the contract would be specifically related to the transaction (Category 1)***

i. Because all of the revenue would be recognized in 2010, his commission would be recognized then as well (deferred)

3. What about the $39,000 for scientist?a. This is boarder line because the expense is not fixed, but variable

because it’s directly tied to the contractb. But Ebasco could have incurred that $39,000 and still not have

received the contractc. Not a clear resolution so it could go either way if you got the

contractd. If you did not get the contract, it would definitely fall into 2009

because it’s not related to any future revenuee. If you don’t know where the $39,000 should go, but you’re financial

statements are due it would likely go into 20094. Year 1

Sept. 15, 2009 Cash _____ 100,000

Unearned Income ____100,000Dec. 15, 2009

Cash _____ 100,000Unearned Income ____ 100,000

Employee’s Salary Salary Expense ____ 60,000

Cash _______________ 60,000Defer Employee’s Commission

Prepaid Commission ____ 10,000Cash ________________ 10,000

5. Year 2Recognize Contract Revenue

Unearned Income ___ 200,000Cash _____________ 300,000

Revenue _________ 500,000Recognize Commission Expense

Commission Expense _____ 10,000Prepaid Commission _______ 10,000

iv. Suppose Ebasco incurred $45,000 in expenses in 2009 and estimated that it would cost a total of $300,000

1. Assume that P Corp. paid $100,000 in 2009

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a. If Ebasco waited for substantial performance, it would have to recognize the $45,000 of expenses in 2010

i. Prepaid Expense ___ 45,0001. Cash ______________45,000

b. But, could Ebasco recognize SOME of that expense in 2009? Probably yes if it used the Substantial Completion Method and could reasonably estimate the total amount of cost for the contract and could keep track of the cost

i. In 2009, only incurred 15% (45k/300k) of the cost so if it’s reasonably sure that it will cost 300k, it could recognize the same portion,15%, of its expenses in 2009 = $6,750 (Cost-to-Cost Method)

2. Assume that P Corp. did not pay in 2009 because the contract did not require payment until completion

j. Problem 6.10B (pg. 675)i. X Corp. sells and services computers

ii. It provides each buyer the right to have the computer serviced once during the calendar year following the purchase

iii. X Corp. adds $60 to the computer’s selling price because the average cost of service is $50

iv. For the year of sale, how should X Corp. account for the $60 cash received and the $50 cost to be incurred in the following year? Computer with service agreement costs $560

1. One Transaction Year 1

Cash _____ $560Sales/Revenue ____ $560

Service Expense _____ $50Accrued Service Payable ___ $50

Year 2 Accrued Service Payable ____ $50

Cash (for service) ________ $502. Two Transactions

Year 1 Cash _______ $560

Sales/Revenue _____ $500Unearned Income ___ $60

Year 2 Service Expense ______ $50

Cash ______________ $50 Unearned Income _____ $60

Revenue ___________ $60k. Depreciation

i. Units-of-Activity Method 1. (Cost – salvage value) / Estimated useful life in units2. ($12,000 - $2,000) / 20,000 hours = $.50 per hour3. If the company used the asset for 1,500 hours, the depreciation expense for

the period would be 1,500 x .$50 = $750ii. Straight-Line Method

1. (Cost – salvage value) / Estimated useful life in units2. ($12,000 – $2,000) / Four Years = $2,500 per year

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3. Recorded as follows:a. Year 1 Depreciation Exp. = $2,500b. Year 2 Depreciation Exp. = $2,500c. Total = $5,000

l. Problem 6.10C (pg. 675)i. Would not be proper to recognize the revenue in 2001, rather it should be

recognized in 2002 when production and delivery occursii. If you DID recognize the revenue in 2001, you’d need to recognize the related

expenses as wellm. Problem 6.11 (pg. 676)n. Problem 6.12A (pg. 687)o. Problem 6.12B (pg. 687)p. Problem 6.13C (pg. 688)

Chapter 7 – Contingencies

1. Generally a. An event has occurred that may generate a cost based on some future occurrence (future

looking)b. Three choices

i. Accrue the expense (increase this year’s net income)ii. Not accrue but disclose

iii. Do nothingc. Unasserted Claims

2. Financial Accounting Rules a. Contingency is defined as an existing condition, situation, or set of circumstances

involving uncertainty as possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur

i. Probable – the future event are likely to occurii. Reasonably Possible – the chance of the future event occurring is more than

remote but less than likelyiii. Remote – the change of the future event occurring is slight

b. Examples of Loss Contingencies 56:30i. Collectability of receivables

ii. Obligations related to product warranties and defectsiii. Risk of loss or damage by fire, explosion, etc.iv. Pending or threatened litigation

Accounting Treatment for Asserted ClaimsWorks Once You Decide That Assertion of the Claim Is Possible

Ability to Reasonably Estimate the Potential LossReasonable Estimate No Reasonable Estimate

Likelihood of Unfavorable Outcome Probable

Accrue and, if necessary, disclose to avoid misleading financial statements

Disclose contingency and range of possible loss or state that no reasonable estimate possible

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Reasonably PossibleDisclose contingency and estimated amount of possible loss

Disclose contingency and range of possible loss or state that no reasonable estimate possible

RemoteNeither accrue nor disclose, unless guarantee

Neither accrue nor disclose, unless guarantee

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