Ebook Financial accounting - An introduction to concepts, methods, and uses (13/E): Part 2

(BQ) Part 2 book “Financial accounting - An introduction to concepts, methods, and uses” has contents: Marketable securities and derivatives, intercorporate investments in common stock, synthesis of financial reporting, statement of cash flows - another look,… and other contents.

C H A P T E R Notes, Bonds, and Leases Understand the application of the fair value option to financial liabilities Develop an ability to distinguish between capital or finance leases and operating leases based on their economic characteristics, accounting criteria, and financial statement effects Develop the skills to account for capital or finance leases and operating leases Develop the skills to compute the issue price, carrying value, and current fair value of notes and bonds payable in an amount equal to the present value of the future contractual cash flows by applying the appropriate discount rate Understand the effective interest method, and apply it to debt amortization  L E A R N I N G OBJECTIVES C hapter indicated that firms typically finance current operating assets, such as accounts receivable and inventories, with short-term borrowing or trade credit (delayed payments to suppliers) Firms use the cash received from customers within the next several months to repay short-term lenders and suppliers Firms typically finance long-term assets, particularly property, plant, and equipment, with long-term borrowing or funds provided directly or indirectly by shareholders This chapter discusses the accounting for long-term borrowing arrangements (that is, those requiring repayment later than one year from the date of the balance sheet) The more long-term debt in a firm’s capital structure, the greater the risk that the firm will experience difficulty making the required payments when due and, therefore, the greater is the risk of default or bankruptcy Financial analysts use several financial statement ratios to assess risk related to long-term borrowing One financial ratio is the long-term debt ratio This ratio relates the amount of long-term debt to the amount of total financing Long-Term Debt Ratio ϭ Long-Term Debt Liabilities Shareholders’ Equity The debt-equity ratio relates long-term debt to shareholders’ equity,1 indicating the relative mix of long-term financing obtained from lenders versus owners Debt-Equity Ratio ϭ Long-Term Debt Shareholders’ Equity 1In classic usage, the word equity refers to any item on the right-hand side of the balance sheet—any source of funding for a firm Modern business usage has come to restrict the word equity to mean only shareholders’ equity, both contributed capital and retained earnings Still, current usage is sufficiently diverse that you should understand the meaning others have in mind when they use it 461 462 Chapter 10 Notes, Bonds, and Leases EXHIBIT 10.1 Debt Ratios for Four Firms Firm Tokyo Electric Boise Cascade WPP Group Intel Long-Term Debt Ratio Debt-Equity Ratio Property, Plant, and Equipment/Total Assets 43.4% 44.9% 8.3% 3.8% 193.5% 59.1% 24.1% 5.0% 81.5% 54.1% 2.8% 36.4% Exhibit 10.1 presents these two debt ratios, as well as the ratio of property, plant, and equipment to total assets, for four firms in different industries We use these ratios to assess the relations among a firm’s industry economic characteristics; its use of property, plant, and equipment; and its use of long-term debt financing Tokyo Electric Tokyo Electric is a regulated monopoly providing electric services in Japan Property, plant, and equipment dominate the asset side of the balance sheet It relies more on long-term debt than shareholders’ equity to finance these facilities (as a debt-equity ratio exceeding 100% indicates) The regulated monopoly status practically eliminates the risk of default or bankruptcy, so Tokyo Electric faces a relatively low borrowing cost Its production and transmission facilities also serve as collateral for the debt, meaning that lenders can sell the facilities and use the cash proceeds to repay the debt in the event Tokyo Electric does not so Boise Cascade Boise Cascade, a United States-based company, processes wood pulp into paper products in fixed-asset intensive facilities It has the second largest ratio of property, plant, and equipment to total assets and the second largest debt-equity ratio of the four firms Boise Cascade carries higher levels of risk than Tokyo Electric First, Boise Cascade does not have the regulated, monopoly status of Tokyo Electric Thus, market forces and not regulation set the prices for its products Second, the sales of Boise Cascade are more sensitive to changes in the level of business activity than those of Tokyo Electric Third, Boise Cascade has fewer assets to serve as collateral for borrowing The higher risk of Boise Cascade raises its borrowing costs and decreases its reliance on debt financing WPP Group WPP Group is a United Kingdom-based communication services firm whose employees provide advertising, market research, public relations, and other services worldwide Other than relatively small amounts of equipment, it owns virtually no property, plant, and equipment (it leases most of its office space) Of the four firms considered in this example, it exhibits the lowest fixed asset intensity and the second lowest debt-equity ratio WPP Group creates value from employees’ services, not from operating assets, so there is neither the need nor the ability to borrow long-term using property, plant, and equipment as collateral Intel Intel is a United States-based designer and manufacturer of semiconductors It manufactures semiconductors in fixed-asset intensive plants The moderate fraction of its total assets that are property, plant, and equipment results from depreciating its technologyintensive manufacturing facilities over periods as short as four years Intel has the smallest long-term debt and debt-equity ratios of the four firms in this example There are at least two reasons for this relatively low reliance on debt financing First, Intel is exceptionally profitable and therefore generates funds from operations Second, Intel incurs substantial technology risk from product obsolescence, with product life cycles of less than two years Heavy reliance on debt financing would add financing risk and thereby increase borrowing costs even more These examples illustrate the importance of understanding a firm’s industry economic characteristics when analyzing long-term debt and assessing risk This chapter discusses the recognition and measurement of long-term debt Which obligations of a firm U.S GAAP and IFRS recognize as long-term debt? How U.S GAAP and IFRS measure the amount that firms report as debt on the balance sheet? With a few exceptions, the accounting for debt Overview of Long-Term Debt Markets under U.S GAAP and IFRS is similar We consider notes, bonds, and leases in this chapter The next section discusses notes and bonds A later section discusses leases OVERVIEW OF LONG-TERM DEBT MARKETS This section provides a brief description of debt markets to enhance understanding of the accounting for long-term debt discussed in later sections Debt markets have a unique vocabulary, so be prepared to encounter new terms SOURCES OF LONG-TERM DEBT FINANCING Firms that need cash for long-term purposes, such as acquiring buildings and equipment or financing a business acquisition, and that wish to use debt as a means of obtaining cash, will one of two things: Borrow from commercial banks, insurance companies, or other financial institutions Issue bonds in the capital markets Loans from commercial banks and other financial institutions often require firms to pledge assets as collateral For example, a firm borrowing to finance the acquisition of equipment would likely pledge the equipment as collateral If the firm fails to maintain specified levels of financial health while the loan is outstanding or does not pay principal and interest on the loan when due, the lender has the right to seize the collateral and sell it to satisfy the amounts due Common terminology refers to the financial contract underlying bank loans as a note, so that these loans usually appear on the balance sheet under the title Notes Payable Notes of business firms generally have maturity dates less than approximately ten years and arise from borrowing from a single lender Borrowing from a single lender avoids some of the reporting requirements of more public issues of debt However, no public market for the debt exists in this case, so the borrower will have difficulty disengaging from the borrowing arrangement prior to maturity Most firms issue bonds on the market to satisfy their long-term needs for cash A bond is a financial contract, similar in concept to borrowing agreements with banks or insurance companies, in which the borrower and the lender agree to certain conditions about repayment of the bonds, operating policies, other borrowing activities while the bonds are outstanding, and other provisions Bond indenture refers to the financial contract underlying bonds Bonds appear on the balance sheet under the title Bonds Payable In contrast to notes, bonds typically carry maturity dates longer than approximately ten years and involve many lenders instead of a single lender Firms classify the portion of bonds due within the next year as a current liability and the remaining portion as a noncurrent liability Firms must also disclose a list of their long-term debt obligations in notes to the financial statements VARIETY OF BOND PROVISIONS Bond issues vary with respect to their specific provisions For example, particular collateral might back up bonds (a secured borrowing), or firms might issue bonds based only on their credit worthiness as an entity Such unsecured borrowing means that lenders must rely on assets not pledged as collateral for other loans in the event the firm cannot repay the bonds Unsecured borrowing might carry senior rights or subordinated rights in the event of bankruptcy Senior debt holders have a higher priority for payment in the event of bankruptcy than subordinated (junior) unsecured lenders Bonds also vary in terms of their payment provisions The typical debenture bond pays interest periodically, usually every six months, during the life of the bond and repays the principal amount borrowed at maturity A serial bond requires periodic payments of interest plus a portion of the principal throughout the life of the bond A zero coupon bond provides for no periodic payments of interest while the bond is outstanding; the bond requires payment of all principal and interest at maturity A later section defines principal and interest more precisely Convertible bonds permit the holder to exchange the bonds for shares of the firm’s common stock under certain conditions This conversion option has value because the holder 463 464 Chapter 10 Notes, Bonds, and Leases can benefit from some of the later increases in the market value of the firm’s common stock after issuance of the bonds If holders not convert the bonds into common stock prior to maturity, the issuing firm repays the debt at maturity, the same as for nonconvertible bonds We discuss convertible bonds more fully in Chapter 14 Some bonds are callable, which means the issuing firm has the right to repurchase the bonds prior to maturity at a specified price An issuing firm might exercise this call provision if interest rates decline after the initial issuance of the bonds The firm can borrow at the lower interest rate and use the proceeds to finance the repurchase of the bonds initially issued Investors in bonds sometimes hold a put option, meaning they can force the issuing company to repay the bonds prior to maturity under specified contractual conditions Investors might exercise this put option if interest rates increase, and investors can reinvest the cash proceeds in debt securities with a higher yield Bonds can carry either fixed interest rates or variable interest rates Bonds with fixed interest rates pay interest at that fixed rate throughout the life of the bond Bonds with variable interest rates pay interest at rates that change during the life of the bond The bond indenture specifies the formula for the periodic calculation of the variable interest rate Industry economic characteristics, the financial health of a firm, and the particular provisions of a bond issue combine to determine the risk of investing in the bond, which in turn affects the interest rate investors demand and therefore the bond’s price The next section discusses the measurement of financial instruments in general Subsequent sections discuss the measurement of notes, bonds, and leases To understand the calculations illustrated in the remainder of this chapter, you will need to understand compound interest and its use in computing the present value of future cash flows The Appendix at the back of the book discusses compound interest MEASUREMENT OF FINANCIAL INSTRUMENTS: GENERAL PRINCIPLES We use the term financial instrument to refer to a financial arrangement in which a firm contracts to receive or make specified payments in the future in return for cash or other resources paid or received currently Notes, bonds, and leases are financial instruments Derivatives, discussed in Chapter 12, are also financial instruments A characteristic of these examples of financial instruments is that they specify the means of calculating the amounts that firms will receive or pay at specified times in the future The accounting measurement of notes and bonds payable follows two general principles: The amount borrowed initially and the market value of a note or bond at any date subsequent to the initial borrowing equals the present value of the future, or remaining, cash flows discounted at an appropriate interest rate (discussed next) The internal rate of return, often called yield to maturity, is the discount rate that equates the future cash flows to the market value at any date Common terminology also refers to this rate as the market interest rate When a financial instrument does not specify the internal rate of return, the investor can solve for this rate, called the implicit interest rate, following procedures described in the Appendix On the date of initial issuance, the market value will equal the initial issue proceeds—the amount borrowed To understand the accounting for notes and bonds, we need two additional definitions: ◾ Historical Market Interest Rate: The discount rate prevailing at the date of the initial borrowing Discounting the contractual cash flows at this rate equates the present value of future cash flows to the amount initially borrowed—the market value on the initial issue date ◾ Current Market Interest Rate: The discount rate at any date subsequent to the date of the initial borrowing Discounting the contractual cash flows at this rate equates the present value of remaining cash flows to the market value at the subsequent measurement date Later sections of this chapter indicate that U.S GAAP and IFRS permit firms to account for notes and bonds under one of two approaches: Amortized Cost Use the historical market interest rate to compute the carrying value of notes and bonds while these obligations are outstanding and disclose in the notes to the financial statements the fair value of these financial instruments based on the current Accounting for Notes market interest rate This approach dominates current financial reporting, so this chapter focuses on it Fair Value Measure notes and bonds at fair value each period, in effect using the current market interest rate instead of the historical market interest rate to discount the remaining cash flows The FASB and the IASB refer to this approach as the fair value option.2 A later section of this chapter describes and illustrates the fair value option ACCOUNTING FOR NOTES Firms typically borrow from banks, insurance companies, and other financial institutions by signing a note, which specifies the terms of the borrowing arrangement Example Newsom Company borrows $800,000 from its bank to purchase a tract of land on January 1, 2008 The firm pledges the land as collateral for the loan Interest accrues on the unpaid balance of the loan at a rate of 6% compounded semiannually (that is, 3% each six months) The borrower must make payments of $93,784.41 on June 30 and December 31 of each year for five years.3 Initial Valuation The initial valuation of this loan is the $800,000 amount borrowed This amount equals the present value of the future cash payments discounted at the yield required by the lender, which we assume is also 6% compounded semiannually (final calculations taken to more decimal points than shown):4 Present Value of an Annuity of $93,784.41 per Period for 10 Periods at 3% per Period: $93,784.41 8.53020 $800,000.00 These calculations illustrate an important concept: When the stated interest rate for a loan (6% compounded semiannually in this example) equals the yield required by the lender (also 6% compounded semiannually), then the amount borrowed equals the principal amount of the loan (also called the face value in the case of bonds) The significance of this concept will become more apparent when we consider how to measure the carrying value of bonds The entries to record the loan and the purchase of land on the books of Newsom Company are as follows: January 1, 2008 Cash Note Payable Assets 1800,000 = Liabilities + Shareholders’ Equity 800,000 800,000 (Class.) 1800,000 To record $800,000 loan received from bank for five years at 6% compounded semiannually requiring payments of $93,784.41 at the end of each six months 2Financial Accounting Standards Board, Statement of Financial Accounting Standards No 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” 2007 (Codification Topic 825); International Accounting Standards Board, International Accounting Standard 39, “Financial Instruments: Recognition and Measurement,” 1999, revised 2003 3Example in the Appendix shows the derivation of the $93,784.41 payment 4The illustrations in this chapter use present value factors using 15 significant digits in the computer, but rounded to five digits after the decimal for presentation here The Appendix illustrates the use of Excel® to perform these calculations The inputs into Excel for the present value of an annuity are ϭPV(interest rate, number of periods, periodic payment, future value, type) The inputs for this note are ϭPV(.03,10,93784.41,0,0), although Excel does not require the last two zeros 465 466 Chapter 10 Notes, Bonds, and Leases January 1, 2008 Land Cash Assets = Liabilities + Shareholders’ Equity 800,000 800,000 (Class.) 1800,000 2800,000 To record the purchase of land for $800,000 cash Measurement Subsequent to the Date of the Initial Loan During the first six months, interest of $24,000 (ϭ 03 ϫ $800,000) accrues on the loan The firm then makes the required cash payment of $93,784.41 The entry to record interest expense, the loan payment, and the reduction in the amount of the Note Payable is as follows: June 30, 2008 Interest Expense Note Payable Cash Assets 293,784.41 = Liabilities 269,784.41 + Shareholders’ Equity (Class.) 224,000 IncSt S RE 24,000.00 69,784.41 93,784.41 To record interest expense, cash payment, and reduction in Note Payable for first six months Thus, the carrying value of the loan changes during this first six months as follows: Balance in Note Payable on January 1, 2008 Plus Interest for First Six Months: 03 $800,000 Less Cash Payment on June 30, 2008 Balance in Note Payable on June 30, 2008 $800,000.00 24,000.00 (93,784.41) $730,215.59 The carrying value of the loan on June 30, 2008, equals the present value of the remaining cash flows discounted at 6% compounded semiannually (except for minor rounding differences), as the following computations show: Present Value of an Annuity of $93,784.41 per Period for Periods at 3% per Period: $93,784.41 7.78611 $730,215.62 These calculations illustrate a second important concept: The amount reported on the balance sheet throughout the life of a loan (that is, its carrying value) equals the present value of the remaining cash flows discounted at the historical market interest rate (6% compounded semiannually in this example) The current market interest rate usually differs from the historical market interest rate during the life of the loan A firm that does not account for long-term notes and bonds using the fair value option (discussed later), uses the historical market interest rate to account for the loan while it is outstanding Amortization Schedule Exhibit 10.2 presents an amortization schedule for this loan It shows the amount of interest expense and cash payments each six months and the resulting reduction in the carrying value of the loan during the ten periods The interest expense equals the required yield (3% each six months) times the unpaid balance of the loan at the beginning of each six-month period Common terminology refers to the calculations illustrated in Exhibit 10.2 for amortizing a financial instrument to its maturity value over time as the effective interest method The effective interest method has the following features: The note, bond, or other financial instrument will appear on the balance sheet both initially and at each subsequent date at the present value of the remaining cash flows discounted at the historical market interest rate (that is, its initial yield to maturity) Accounting for Notes EXHIBIT 10.2 Amortization Schedule for $800,000 Loan, Repaid in 10 Semiannual Installments of $93,784.41 Interest Rate Is 6% Compounded Semiannually (3% compounded each six months) Period (1) Balance at Beginning of Period (2) Interest Expense for Period (3) Cash Payment (4) Portion of Payment Reducing Principal (5) Balance at End of Period (6) 10 $800,000.00 $730,215.59 $658,337.65 $584,303.37 $508,048.06 $429,505.09 $348,605.83 $265,279.60 $179,453.58 $ 91,052.77 $24,000.00 $21,906.47 $19,750.13 $17,529.10 $15,241.44 $12,885.15 $10,458.17 $ 7,958.39 $ 5,383.61 $ 2,731.64 $93,784.41 $93,784.41 $93,784.41 $93,784.41 $93,784.41 $93,784.41 $93,784.41 $93,784.41 $93,784.41 $93,784.41 ($69,784.41) ($71,877.94) ($74,034.28) ($76,255.31) ($78,542.97) ($80,899.26) ($83,326.24) ($85,826.02) ($88,400.80) ($91,052.77) $730,215.59 $658,337.65 $584,303.37 $508,048.06 $429,505.09 $348,605.83 $265,279.60 $179,453.58 $ 91,052.77 Column (2) ϭ Column (6) from previous period Column (3) ϭ 03 ϫ Column (2), except for period 10, where it is the amount such that Column (3) ϭ Column (4) Ϫ Column (5) Column (4) is given Column (5) ϭ Column (4) Ϫ Column (3) Column (6) ϭ Column (2) Ϫ Column (5) The amount of interest expense each period equals the historical market interest rate times the carrying value of the financial instrument at the beginning of each period We can illustrate again the general principal that the carrying value of this loan at the end of any period equals the present value of the remaining cash flows Take, for example, the loan balance of $265,279.60 at the end of Period At the end of Period 7, three semiannual payments of $93,784.41 remain (for Periods 8, 9, and 10) Following is the present value of these cash flows: Present Value of an Annuity of $93,784.41 per Period for Periods at 3% per Period: $93,784.41 2.82861 $265,279.64 As before, minor differences in measurement arise because of rounding The carrying value of the note changes each period, increasing to reflect the nearer in time of all remaining cash flows and decreasing for the payment of interest and principal This pattern appears in Exhibit 10.3 PROBLEM 10.1 for Self-Study Implicit interest rate and amortization schedule for interest-bearing note Vera Company receives cash of $97,375.69 in return for a three-year $100,000 note, promising to pay $6,000 at the end of one year, $6,000 at the end of two years, and $106,000 at the end of three years a Demonstrate that the required yield, or implicit interest rate, on this loan is 7% compounded annually b Prepare an amortization schedule for this loan similar to that in Exhibit 10.2 467 468 Chapter 10 Notes, Bonds, and Leases Change in Carrying Value of $800,000 Note Accruing Interest at 6% Compounded Semiannually and Requiring Semiannual Payments of $93,781.41 for Five Years EXHIBIT 10.3 Carrying Value $1,000,000 $800,000 $600,000 $400,000 $200,000 Periods $0 10 ACCOUNTING FOR BONDS Firms typically issue bonds on the market to large numbers of debt investors to obtain cash for long-term purposes As previously explained, the provisions of bond issues vary widely, depending on the firm’s cash needs over time and the preferences of investors in the bonds Investment bankers often advise corporate borrowers on the sorts of financial instruments the lending market appears to prefer at the time the firm wants to borrow CASH FLOW PATTERNS FOR BONDS Bonds vary with respect to the pattern of cash payments made by the borrower to debt investors Three common types of bonds are coupon bonds, serial bonds, and zero coupon bonds Example Ford Motor Company issues $250 million of 8%, semiannual, 20-year coupon bonds The bond indenture requires Ford to make coupon payments of $10 million (ϭ 08 ϫ $250 million ϫ 6/12) every six months for 20 years and to repay the $250 million principal at the end of 20 years Common terminology refers to the $250 million as the principal or face value of the bond and the 8% rate as the coupon interest rate In this case the $250 million is also the maturity value of the bonds The term face value refers to the principal amount printed on the face of the bond certificate The principal or face value is the base for computing the amount of each semiannual coupon payment.5 At one time the bond certificate would have coupons attached, with each coupon equal to 4% of the principal amount and each dated, with dates six months apart Investors would clip the predated coupons from the bond certificate each six months and deposit them in their bank accounts, just as they would deposit a check they had received Although checks or electronic funds transfers have replaced coupons, the term coupon remains in use Thus, the 8% coupon rate multiplied times the $250 million principal equals the annual cash payment of $20 million, which Ford pays in two semiannual installments of $10 million each 5Almost everyone in business refers to the periodic payment as “interest payments.” The term causes confusion because, as you will soon see, the amount of interest expense for a period almost never equals the amount of these same payments for that same period The periodic payment will always include some amount to pay interest to the lender, but not necessarily all interest accrued since the last payment If the payment exceeds all interest, then the payment will discharge some of the principal amount Both payment of interest and payment of principal serve to reduce the debt, so one all-purpose term used for the payments is debt service payments Accounting for Bonds Example Chrysler Corporation issues $180 million of 15-year serial bonds The bond indenture requires Chrysler to pay $10,409,418 every six months for 15 years Each periodic payment includes interest plus repayment of a portion of the principal The principal or face value of this bond is $180 million This bond does not specify a stated interest rate, but each payment includes implicit interest We discuss serial bonds more fully later in this chapter Example General Motors Corporation issues $300 million of 10-year zero coupon bonds These bonds not require periodic payments of interest Instead the $300 million maturity value includes both principal and interest Although these bonds not state an interest rate, there is an implicit interest rate embedded in the maturity value We consider zero coupon bonds in greater depth later in this chapter REVIEW OF BOND TERMINOLOGY Let’s take a moment to review to this point: The bond contract specifies the basis for computing all future cash flows for that bond issue Identifying those cash flows is the starting point to account for the bond both initially and at each subsequent measurement date Terminology with respect to bonds includes the following: a Face Value: The amount printed on the face of the bond certificate that serves as the basis for computing periodic coupon payments on coupon bonds.6 The face value equals the maturity value on coupon bonds and on zero coupon bonds but not on serial bonds b Principal: The same as face value on coupon bonds and serial bonds but not on zero coupon bonds c Maturity Value: The amount paid by the issuer at the maturity date of bonds The maturity value equals the face value on coupon bonds and on zero coupon bonds d Market Value: The amount at which bonds sell in the market either at date of issue or at any subsequent date while the bonds are outstanding Firms that account for bonds using the fair value option, discussed in a later section, can use market value to measure fair value e Coupon Interest Rate: The interest rate stated in the bond contract that when multiplied times the face value or principal amount of coupon bonds equals the required annual cash payment The stated coupon rate is always an annual rate The issuer might pay this required annual amount in more than one installment during the year, typically semiannually For example, if the coupon rate is 6% payable semiannually, the issuer pays interest of 3% every six months The frequency of payment affects the yield on the bond and the amortization calculations The coupon rate need not equal the historical market interest rate, a possibility we discuss more fully later in the chapter f Historical Market Interest Rate or Initial Yield to Maturity: The interest rate that discounts all future cash flows such that their present value equals the initial issue price of the bond g Current Market Interest Rate: The interest rate that discounts all future cash flows such that their present value equals the current market price of the bond INITIAL MEASUREMENT OF BONDS The initial issue price of a bond depends on two factors: The promised cash payments indicated in the bond contract as discussed in the preceding section The yield to maturity required by investors to induce them to purchase the bonds, which the next section discusses and illustrates 6Common terminology also refers to the face value of bonds as par value To reduce ambiguity, we use face value in reference to bonds and par value in reference to common and preferred shares in this book 469 470 Chapter 10 Notes, Bonds, and Leases Example (continued) The bonds of Ford in Example require Ford to pay $10 million at the end of every six months and to repay the $250 million principal at the end of 20 years The time line (see Appendix for description of time lines) for this semiannual coupon bond covers 40 six-month periods as depicted in the following graph (amounts in millions): End of Period x c $10 $10 $10 $10 $250 $10 40 Assume that the market requires a yield to maturity for the bonds of Ford of 8% compounded semiannually Thus, the initial issue price for these bonds is $250 million, computed as follows (calculations based on spreadsheet computational accuracy, then rounded to the nearest dollar): Present Value of an Annuity of $10 million for 40 Periods at 4% per Period: $10 million 19.79277 Present Value of $250 million for 40 Periods at 4% per Period: $250 million 20829 Initial Issue Price $197,927,7397 52,072,2618 $250,000,0009 Note the concept described earlier in Example 1: when the coupon rate equals the historical market interest rate or initial yield to maturity, then the initial issue price equals the face value of the bonds Example (continued) Now consider the valuation of the serial bonds of Chrysler Chrysler must pay $10,409,418 at the end of every six months for 15 years The time line is as follows (amounts in millions): End of Period x c $10.4 $10.4 $10.4 $10.4 $10.4 30 Assume that the market requires a yield to maturity of 8% compounded semiannually to induce investors to purchase these bonds The computation of the initial issue price is as follows: Present Value of an Annuity of $10,409,418 million for 30 Periods at 4% per Period: $10,409,418 million 17.29203 $180,000.00 An initial issue price equal to the face value of the bonds means that the implicit interest rate equals the yield to maturity Example (continued) The bonds of General Motors require a payment of $300 million at the end of 10 years The time line is as follows (amounts in millions): End of Period x c $300 10 inputs in an Excel spreadsheet are ϭPV(.04,40,10000000,0,0) inputs in an Excel spreadsheet are ϭPV(.04,40,0,250000000,0) 9The inputs in an Excel spreadsheet to solve simultaneously for the present value of the interest and principal payments are ϭPV(.04,40,10000000,250000000,0) 7The 8The Index Financial statements principal, 7–21, 766 proposed format, 780–5 users, 25 See also Balance sheet, Income statement, Statement of cash flows Financing activities cash flow from, 188 defined, effect on statement of cash flows, 733 relation to investing and operating activities, 737–8 See also Off-balance sheet financing Finished goods inventory as asset account, 45 defined, 369 Finite life, defined, 425 First-In, First-Out See FIFO Fiscal year, defined, Fixed asset productivity, defined, 252 Fixed asset turnover analyzing disclosures of, 444–5 ratio, 252, 273 Fixed assets See Property, plant, and equipment Fixed interest rates, 464 Flow of costs See Cost-flow Ford Motor Company bond issue, 468, 478–80 securitizations, 521–2 Foreign currency translation, 697 Foreign private issuers, defined, 22 Forward commodity contract, 580 foreign exchange contract, defined, 566, 579 purchase contract, defined, 566 Free cash flow, defined, 189 Fundamental qualitative characteristics, 765 Funding agent, defined, 524n Funds statement See Statement of cash flows Furniture and fixtures, as asset account, 46 G GAAP See Generally accepted accounting principles Gains, recognition of, 769 Gap, The, common-size income statement, 161–5 General Electric pension plans, 534–5 subsidiaries, 624 General ledger, defined, 55n General Motors acquisition of land and buildings, 419, 422–3 bond issues, 469 Generally accepted accounting principles (U.S GAAP) defined, 3n, 23 establishing, 22–4 on accounts receivable, 770 on asset impairment, 435–40 on asset revaluation, 434 on balance sheet format, 107 on cash flow from operations, 188, 190–2 on comprehensive income, 160 on consolidation of joint ventures, 779 on contingent obligations, 779 on convertible bonds, 669–71, 779 on corporate acquisitions, 632, 695 on deferred taxes, 537 on derivatives, 579n, 775–6 on discontinued operations, 150, 686–7 on equity method for minority, active instruments, 619–24 on fair value, 111, 118, 595–8, 779 on financial statement presentation, on goodwill amortization, 426 on goodwill impairment, 437–8, 772, 779 on hedges, 581–2, 775–6 on impairments, 771 on income statement display, 146–7 on income transactions, 683, 774–5 on in-process technologies, 421 on intangible assets, 418 on inventory valuation, 374–7 on investment in securities, 775 on lease accounting, 485–6, 773, 779 927 on LIFO layers, 392 on long-lived assets, 418 on marketable securities, 775 on multiple deliverables, 314n on notes payable, 772 on off-balance sheet financing, 519–20 on organization costs, 46 on patents, 46, 426 on pensions, 525, 528, 773 on reliability, 109 on repurchases, 678 on research and development, 420 on restructuring liabilities, 389–90 on revenue recognition, 311–2, 315, 349–50, 770 on sales returns, 328–9 on securitization, 521 on segment data, 44n, 253 on self-constructed assets, 423–4 on statement of cash flows presentation, 189–90 on stock dividends, 675 on uncollectible accounts, 321– 2, 770 on unrealized gains or losses, 689 on variable interest entities, 636, 779 on warranties, 387 summary of differences from IFRS, 777–8 Gift cards, 153 Goals and strategies, establishing, 4–5 Going concern, defined, 113–4 Goods available for sale (use), 367 Goodwill amortization, 426–7 as asset account, 46 defined, 417–8, 625 impairment of, 434–5, 437–40, 771 IFRS on, 772, 779 indefinite life of, 426 U.S GAAP on, 771, 779 Governing board, 22 Grant date of option, 665 Gross margin percentage, 332 Gross vs net reporting of income, 148–50 928 Index H Health-care benefits See Pension benefits Hedge accounting, 581–3 See also Cash flow hedges; Fair value hedges Held-to-maturity investments, defined, 775 Historical amount, defined, 16–7 cost, defined, 110 See also Acquisition cost market interest rate, defined, 464, 469 Hybrid securities, 768 I IASB See International Accounting Standards Board IASC See International Accounting Standards Committee IFRS See International Financial Reporting Standards Impairments defined, 113, 434–5 IFRS on, 435–40 loss on land, 724–5 of inventory, 375 of long-lived assets, 434–40, 572n on goodwill, 772 Implicit interest rate, defined, 464 Improvements to long-lived assets, 433–4 In the money, defined, 665 Income from continuing or discontinued operations, 150, 685–8 Income recognition after the sale, 330–6 at the time of sale, 315–30 before delivery, 336–41 principles, 312–5 See also Revenue recognition Income statement classification of earnings on, 685–9 common-size, illustrated, 161–5, 250 comparative, illustrated, 245 consolidated, illustrated, 14, 719 defined, 17, 146 display, 146–50 illustrated, 59, 147, 196, 202, 209 interpreting and analyzing, 160–65 preparation, 68–70 presentation of long-lived assets, 444 pro forma, illustrated, 280 recognition of pension expense, 528–9 relation to balance sheet, 18, 59–61 and statement of cash flows, 19 terminology, 58–59 See also Common-size income statement; Comparative income statement Income tax deferred, on statement of cash flows, 726 disclosure of, in financial statements, 542–3 effects of stock options, 724 expense defined, 536n, 537 measurement, 536–7 on income statement, 59, 149 on pro forma income statement, 280 recording, 539–40 IFRS on, 774–5 payable as a liability account, 47, 387 defined, 537 U.S GAAP on, 774–5 See also Deferred income tax Indefinite life, 426 Indirect manufacturing costs, 156 Indirect method of computing cash flows, 71, 190–2 Initial yield to maturity, defined, 469 In-process research and development (IPR&D), 421 Installment method of revenue recognition, 332–6 Intangible assets defined, 418 financial statement disclosure of, 445–7 IFRS on, 771–2, 778 U.S GAAP on, 771–2, 778 See also Amortization; Longlived assets Intel, debt ratios, 462 Intercompany eliminations, 629–31 Intercorporate investments See Investment in corporate securities Interest cost (pensions), defined, 526–7 costs during construction, 423 coverage ratio, 271, 273 expense, on income statement, 58 expense under the effective interest method, 466–7 expenses on pro forma income statement, 280 income, on income statement, 59 payable, as liability account, 46, 384–5 payment versus debt service payment, 468n rate swap contract defined, 566, 580, 583 in cash flow hedging, 588–93 in fair value hedging, 583–8 receivable, as asset account, 45 See also Notes payable Interim reports, defined, 7n, 26 Internal audit, defined, 25n Internal rate of return, defined, 464 Internal Revenue Code and cash basis of accounting, 26 on bad debts, 324n Internal Revenue Service (IRS) See Deferred income tax; Income tax International Accounting Standards Board (IASB) as accounting authority, 24 Discussion Paper (fair value measurements), 111n, 477n, 595n Framework for the Preparation and Presentation of Financial Statements, 108n, 115n, 518n, 764n, 765n, 766n Index International Financial Reporting Standard (share-based payment), 665n Standing Interpretation Committee Interpretation 12 (special purpose entities), 637n Web site, 24 International Accounting Standards Committee (IASC), 24 International Accounting Standard No (financial statements), 9n, 145n, 660n, 673n, 685n, 689n, 693n No (inventories), 368n, 375n No (business combinations), 420n, 421n, 625, 632n, 663n No (financial instruments: disclosures), 476n, 576n No (statement of cash flows), 186n No (accounting policies), 691n No (operating segments), 253n No 11 (construction contracts), 337n No 12 (income taxes), 536n, 537n No 16 (property, plant and equipment), 114n, 427n, 431n, 434n, 442n No 17 (leases), 482n No 19 (employee benefits), 523n, 528n No 23 (borrowing costs), 423n No 27 (consolidated financial statements), 623n No 28 (investments in associates), 617n, 635n No 32 (financial instruments), 661n, 669n, 670n, 678n No 33 (earnings per share), 264n, 692n No 36 (impairments), 435n No 37 (provisions, contingent liabilities and contingent assets), 117n, 389n No 38 (intangible assets), 46n, 420n, 426n No 39 (recognition and measurement), 117n, 465n, 477n, 490n, 521n, 530n, 576, 579, 595n, 621n, 637n No 41 (agriculture), 375n SIC Interpretation 12 (consolidation), 522n International financial standards (IFRS) defined, on asset revaluation, 434 on balance sheet format, 107–8 on cash flow from operations, 190–2 on comprehensive income, 160 on consolidation of joint ventures, 779 on contingent obligations, 779 on contract revenue, 340 on convertible bonds, 779 on corporate acquisitions, 695 on derivatives, 579, 775–6 on discontinued operations, 150n, 686n on fair value, 118, 595–8, 779 on financial statement detail, on goodwill impairment, 439, 772 on hedges, 581–2, 775–6 on impairments, 435–40, 771 on income statement display, 146–7 on income tax accounting, 774–5 on intangible assets, 418, 771–2 on inventory valuation, 368, 374–8 on investment in securities, 617, 632 on lease accounting, 486, 773, 779 on LIFO, 379–80, 395, 771 on long-lived assets, 418 on notes payable, 772–6 on off-balance-sheet financing, 519–20 on organization costs, 46 on patents, 46 on pension plans, 528 on preferred stock, 779 on reliability, 108–9 on repurchases, 678 on research expenses, 125n 929 on restructuring liabilities, 389–90 on retirement benefits, 773 on revenue recognition, 311–2, 342, 770 on sales return, 328–9 on securitizations, 521 on segment liabilities, 44n, 254 on service lives, 428 on statement of cash flows presentation, 189–90 on uncollectible accounts, 321–2, 770 on unrealized gains and losses, 689 on variable interest entities (VIE), 779 on warranties, 387 summary of differences between U.S GAAP, 777–8 Inventory as current asset account, 45, 367–8 as investment, cost flow assumptions, 378–81 costs included, 368–74 disclosures, analyzing, 382–3 effect on statement of cash flows, 730 equation, 367 IFRS on, 770–1, 778 manufacturing firms, 156 merchandise, 156 on pro forma balance sheet, 278 remeasurement, 374–8 turnover, defined, 381 turnover ratio, 252, 273, 382 relation to cost of goods sold, 382–3 U.S GAAP on, 770–1, 778 See also Finished goods inventory; Lower-ofcost-or-market; Work-inprocess inventory Investing activities cash flow from, 187–8 defined, 6, 19 relation to operating and financing activities, 737–8 Investment in corporate securities as noncurrent asset, 568–9 consolidation method See Consolidated statements 930 Index Investment in corporate securities (continued) effects on statement of cash flows, 725–6 equity method, 619–24, 739, 776 IFRS on, 776 majority, active, 617, 623 See also Consolidated statements minority, active, 617–23 minority, passive, 616–7 purpose of, 616–7 U.S GAAP on, 776 write-up of, 733–4 Investment in securities, as asset account, 46 IPR&D See In-process research and development J JC Penney, change in accounting principle, 691–2 Joint cost, defined, 426 Joint ventures, 635–8, 779 Journal entries for balance sheet, 54–57 for income statement, 62–4 L Land as asset account, 46 as investment, impairment, loss on, 724–5 Last-In, First-Out See LIFO Leases accounting for, 482–91 on financial statements, 484–5, 734 disclosures, 490 IFRS on, 486, 773, 779 U.S GAAP on, 485–6, 773, 779 See also Capital lease method; Operating lease method Liabilities account titles, 46–7 contingent, 118, 767 constructive, 490–1 deferred performance, 116, 330–6 defined, 11–2, 115, 767–8 limited, 659 long-term, 731–2 measurement, 118–20 recognition, 115–8, 767–8 restructuring, 389–90 to assets ratio, 269, 273 See also Current liabilities; Offbalance-sheet financing LIFO (last-in, first-out) balance sheet, 392 conformity rule, 380n conversion to FIFO, 392–5 defined, 380 effect on financial statements, 391–5 layers, 392 liquidation, defined, 392 prohibited by IFRS, 379n, 380, 771 reserve, defined, 392 See also Cost-flow assumptions; FIFO; Weighted average cost flow assumption Limited liability, 659 Liquidity defined, 7, 365 impact of operations on, 210 risk, long-term, 269–71 risk, short-term, 265–9 Long-lived assets defined, 418 financial statement presentation, 443–4 IFRS on, 418 See also Amortization; Depreciation; Intangible assets; Tangible assets Long-term assets See Long-lived assets creditors, defined, debt disclosure of, 106–7 markets, 463–5 obligations, summary of accounting for, 492 ratio, 269, 273, 461 on pro forma balance sheet, 279 investment in corporate securities See Investment in corporate securities liabilities, and statement of cash flows, 731–2 liquidity ratios, 273 liquidity risk, measures of, 269–71 Loss contingencies, 117 defined, 59 on sale of marketable securities, 725 Losses, recognition of, 769 Louisiana-Pacific Corp., executory contracts, 518–20 Lower-of-cost-or-market basis of inventory valuation, 375–7 U.S GAAP on, 771 M Maintenance of long-lived assets, 433–4 Majority, active investments accounting for, 623–5 defined, 617 See also Consolidated statements Management Discussion and Analysis (MD&A), defined, Managers, defined, 22 Mandatorily redeemable preferred stock, 660 Manufacturing firms, accounting for inventories, 368–374 Manufacturing costs See Product costs Manufacturing overhead costs, 156, 368 Margin, defined, 5n, 738n Market capitalization, 123 interest rate, defined, 464 multiples, 284 participant, defined, 111 price (stock options), 665 to book value ratios, 285 Marketable securities as asset account, 45 classification of, 569 defined, 568 disclosures regarding, 576–8 IFRS on, 775 loss on sale of, 725 measurement issues, 566–76 trading, 573 U.S GAAP on, 775 write-down of, 733 See also Investment in corporate securities Marketing, defined, Index Matching convention defined, 28, 156 for hedges, 582 Materiality concept, 25–6, 765–6 Maturity value of bonds, defined, 468–9 McDonald’s Corp balance sheet, illustrated, 151 income statement, 146–50, 160 MD&A (management discussion and analysis), defined, Merchandise inventory accounting for, 156, 368 as asset account, 45 See also Inventory Merck, treatment of patents, 420, 423, 426 Microsoft, revenue recognition, 313–4, 331 Minority interest in consolidated subsidiary, 631–2 Minority, active investments accounting for, 617–23 defined, 617 Minority, passive investments, accounting for, 616–7 Mitchell & Butlers, Inc., revenue recognition, 313–4 Monetary amount, defined, 8–9 Mortgage payable, as liability account, 47 Multiple deliverable contracts, 314 Mutually unexecuted contracts, 116 N Natural business year, as accounting period, 26 Negative cash cycle, 384 Nestlé Group, inventory accounting, 376–7 Net 30 days, defined, 251 assets, defined, 13 book value, defined, 46 income defined, 17, 59, 145, 769 relation to cash flows from operations, 737 See also Earnings loss, defined, 17, 59, 145 realizable value, defined, 111 sales, defined, 148 settlement, defined, 580 versus gross reporting of income items, 148–50 Nike, redeemable preferred stock, 662 Nokia Corp., financial statement excerpt, illustrated, 446 Nominal value See Par value Noncash transactions on statement of cash flows, 190, 733 Noncontrolling interest in subsidiary, 631–2 Noncurrent assets and liabilities changes in, 737 defined, 16, 106 on pro forma balance sheet, 279 Nonmonetary assets on statement of cash flows, 190 Nonsystematic risk, defined, 244n Nordstrom Corp balance sheet, 107–9, 112, 116, 123–5, 365–6 illustrated, 8, 123 income statement, 148–55, 158, 160–1, 164 inventory impairment, 375–8 profitability ratios, 257 sales returns, 329 statement of cash flows, 185, 189–92 illustrated, 10, 783 statement of comprehensive income, illustrated, 784 statement of earnings, illustrated, statement of financial position, illustrated, 782 statement of shareholders equity, illustrated, 11 uncollectible accounts procedure, 319–20, 325–6 U.S GAAP use, 3–4 Web site, 7n Notes See Supporting schedules Notes payable accounting for, 465–8 as liability account, 46, 384–5 defined, 463 IFRS on, 772 on pro forma balance sheet, 279 U.S GAAP on, 772 Notes receivable, as asset account, 45 931 Notional amounts, defined, 580 O Obligating event, defined, 115, 767 OCI See Other comprehensive income Off-balance-sheet financing defined, 517 rationale for, 518 structuring, 518–9 One-line consolidation, 631 Operating activities, defined, relation to investing and financing activities, 737–8 assets, 366 cash flows, timing, 212 cycle, 106, 384 income, defined, 68, 149 lease method, 482, 486–7 compared to capital lease method, 484–5, 489 See also Leases leverage, defined, 250n liabilities, 366 profit, defined, 68, 149 working capital accounts, 737 Operations, cash flow from, 187 Opinion See APB Opinions; FASB statements Opportunity cost, defined, 111 Options See Stock options Organization costs, as asset account, 46 Other comprehensive income (OCI), 159, 769 Out of the money, defined, 665 Owners’ equity See Retained earnings; Shareholders’ equity P Paid-in capital, defined, 120 Paid-in surplus See Capital contributed in excess of par (stated) value Palmrose, Z-V, et al., 150n Panera Bread Company, stock options disclosures, 667 Par value method for reissued shares, 680 932 Index Par value, (continued) method for repurchased shares, 679 of a bond, defined, 469n of a stock, defined, 120, 663n Parent company, defined, 623 Partnerships defined, 5n don’t pay income taxes, 387n Patents amortization of, 724 as asset account, 46 as investment, protection jurisdiction-specific, 420n PBO See Projected benefit obligation (PBO) PCAOB See Public Company Accounting Oversight Board Pension benefits accounting for, 523–35 IFRS on, 773–4 liability, reporting, 697 terminology, 524–5 U.S GAAP on, 773–4 PepsiCo balance sheet excerpt, illustrated, 443, 446 disclosures related to derivatives, 594–7 fair value disclosures, illustrated, 481 Percentage-of-completion method of revenue recognition, 315, 337–40, 770 Percentage-of-sales procedure for estimating uncollectible accounts, 319–21 Period expenses defined, 156, 368 marketing costs as, 157 Periodic depreciation See Depreciation Periodic inventory system, defined, 378n Peripheral vs central activities, 683–4 Permanent accounts, defined, 45 Permanent differences, defined, 536 Perpetual inventory system, defined, 378n Pervasive constraints, defined, 766 Pfizer, income tax disclosure in financial statements, 542–5 Physical and functional factors in service life, 427 Plan administrator, defined, 524n Plant assets, defined, 771 See also Assets; Long-lived assets; Property, plant and equipment Pol Roget Vineyards, income recognition, 312–3 Polo Ralph Lauren balance sheet, illustrated, 119 profit margin, 160 Posting, defined, 64 Postretirement benefit plans, 530 Preferred stock as owners’ equity account, 47 convertible, 669–72 defined, 658, 660 disclosure of changes in, 693 IFRS on, 779 issued, on statement of cash flows, 732 redeemable, 776 U.S GAAP on, 779 Premium on capital stock account See Additional paid-in capital Prepaid assets, defined, 366 insurance, as asset account, 46 rent, as asset account, 46, 47n Prepayments as current asset account, 366–7 effect on statement of cash flows, 728–9 on pro forma balance sheet, 278 Present obligation, defined, 115 Present value of future cash flows, 283–4, 464 of future net cash flows, 112 of operating lease commitments, illustrated, 491 Pretax book income, defined, 536 Pretax income, defined, 387 Price appreciation, defined, 243 Price-earnings ratio as valuation tool, 284–5 defined, 264 Priceline.com, preferred stock warrants, 664 Primary beneficiary of a VIE, defined, 636 Principal, defined, 468–9 Principles of accounting See Generally accepted accounting principles (GAAP) Prior service cost (pensions), 527, 532–3 Probable, defined, 108n, 115n, 117 Product costs as expenses, 156 treatment of, 368 Product warranties, as liability account, 387–8 Production, defined, Production method of revenue recognition See Percentage-of-completion method of revenue recognition Profit, defined, 17, 59, 145 Profit margin for ROA ratio, 248–9, 273 for ROCE ratio, 262–3, 273 percentages, 160 See also Earnings; Net income Profitability analysis of, 245–64 ratios, 257, 265, 273 Pro forma financial statements analysis of, 282–5 defined, 274–5 illustrated, 275, 280–2 preparation of, 275–82 Progress payments, 336 Projected benefit obligation (PBO), 525 Property dividends, 674 Property, plant, and equipment defined, 771 financial statement disclosure, 444 IFRS on, 771, 778 on pro forma balance sheet, 279 U.S GAAP on, 771, 778 See also Equipment Proportionate consolidation, defined, 635 Proposed reporting format, 778–85 Proprietorship See Retained earnings; Shareholders’ equity Index Provision for bad debts See Uncollectible accounts for income taxes, 536n for uncollectible accounts See Uncollectible accounts Provisions defined, 117 IFRS on, 779 Public Company Accounting Oversight Board (PCAOB), 24 Publicly traded, defined, Purchase method of accounting for corporate acquisitions, 625 Purchasing, defined, Put option, defined, 464, 661 Q Qualifying special purpose equity (QSPE), 637 Quick ratio, 266–7, 274 R R & D See Research and development Rate of return on assets (ROA), 241, 245–9, 256–9, 262, 273 disaggregating, 248–9 on common shareholders’ equity (ROCE), 241, 257–9, 273 disaggregating, 262–3 Ratio analysis limitations of, 272 of accounts receivable, 326–7 usefulness of, 244–5 Raw materials inventory as asset account, 45, 369 defined, 368 Reclassification of securities, 576 Recognition vs realization, 23, 25, 113n Recoverable amount, defined, 436 Recurring vs nonrecurring activities, 683–4 Redeemable preferred shares, 660–2 Redemption right or obligation, 660–2 Reissue of treasury shares See Treasury shares Relevance and reliability, 23, 114, 765–6 Reliability, defined, 108–9, 114 Rent received in advance, as liability account, 47 Repairs to long-lived assets, 433–4 Repatriation of foreign-source income, 543 Report of Independent Certified Public Accountants See Auditors Reporting entity, defined, 769–70 period, 7–8, 26 unit, defined, 437 Repurchases See Stock repurchases Requisite service period, defined, 666 Research and development (R&D) as operating activity, expense, on income statement, 58, 149 IFRS on, 125n, 778 U.S GAAP on, 778 Residual value, defined, 427 Restrictions on dividends See Dividends, legal limitations Restructuring liability, 389 provision, 389 Retained earnings as owners’ equity account, 47 defined, 13–4, 121 on pro forma balance sheet, 280–1 reporting, 696 Retirement benefits See Pension benefits Retirement of debt, 474–5, 732 Retrospective restatement, 690 Return, defined, 243 Return on assets See Rate of return on assets Revaluation See Changes Revenue, defined, 768 Revenue measurement, 155 Revenue recognition at time of sale, 315–30 completed contract method, 340 cost-recovery-first method, 334–6 933 criteria for, 152–5 defined, 150 IFRS on, 311–2, 342, 778 installment method, 332–6 percentage-of-completion method, 315, 337–40 under FASB conceptual framework, 768, 770 U.S GAAP on, 341–2, 778 See also Income recognition Revenues classification of, 18 defined, 18, 58, 145 reporting, 148 See also Revenue recognition Reverse stock split, 676 Rights See Stock rights Risk analysis of, 265–71 defined, 243 Rite Aid, redeemable preferred stock, 661 ROA See Rate of return on assets ROCE See Rate of return on common shareholders’ equity S Saks Incorporated, common-size income statements, 161–5 Sales allowances, discounts, and returns allowance method for, 328–30 revenue recognition of, 155, 314 Sales revenue, defined, 18 Salvage value changes in, 431–2 defined, 426 Sarbanes-Oxley Act of 2002, 24 Scania balance sheet, 107–10, 116–7, 317, 365–6 illustrated, 12–3 consolidated total recognized income, illustrated, 16 consolidation policy disclosure, illustrated, 634 equity method for disclosures, 621–2 income statement, 148–50, 160 illustrated, 14 inventory accounting, 368–9 934 Index Scania (continued) joint venture with Cummins, 635 note to financial statements, 20 restructured liabilities, 389–90 statement of cash flows, 186–7, 189–90 illustrated, 15 use of IFRS, 3–4 warranty expense, 387–8 Web site, 7n Schedules See Supporting schedules Scholes, Myron, 666n Seagram Company, contingent obligations, 519–20 Sears, Roebuck, contingent obligations, 519–20 SEC See Securities and Exchange Commission Securities available for sale accounting for, 574–6 defined, 775 disclosures regarding, 576–8 reclassification of, 576 trading, 573–4 See also Investment in corporate securities; Marketable securities Securities and Exchange Commission (SEC) Accounting Series Release No 268 (redeemable preferred stock), 661n as accounting authority, 22 Form 20-F, 24n on inventory disclosure, 368 registrants, 22 Staff Accounting Bulletin No 104, 341n “Study on Mark-to-Market Accounting,” 478, 690, 891, 892 (OCI format), back endpaper Web site, 7n Securitization, defined, 328, 521 Segment data, analysis of, 44n, 148, 253–5 Self-constructed assets, 423–4 Selling and administrative expenses, 18 Selling expense, on pro forma income statement, 278 Selling, General and Administrative (SG&A) costs, 58, 149 Senior rights, defined, 463 Separability criterion, 421 Service life changes in, 431–2 estimating, 427–8 SFAC See FASB, Statements of Financial Accounting Concepts SFAS See FASB, Statements of Financial Accounting Standards SG&A See Selling, General and Administrative Share premium account, defined, 120 Shareholders, defined, Shareholders’ equity account titles, 47 defined, 12–3, 120, 657 disclosure of changes in, 693–7 measurement and disclosure, 120–2 See also Owners’ Equity; Preferred shareholders’ equity Shares See Stock Short-term funds, defined, 5–6 Short-term liquidity risk, measures of, 265–9, 273 Short-term notes and interest payable, as liability, 384–5 Significant influence, defined, 617 Skype Technologies, acquisition by eBay, 417–8, 420–1, 426 Sole proprietorships don’t pay income taxes, 387n Special purpose entity (SPE), defined, 520, 776, 779 Specific identification system for cost of goods sold, 378–80 Speculation, defined, 573 Standards See Changes in accounting principles; Generally accepted accounting principles (GAAP) Starbucks Corporation, disclosures related to marketable securities, 576–8 Stated value, defined, 663n Statement of cash flows comparative, illustrated, 185, 247 consolidated, illustrated, 10, 721–2 defined, 18 direct method for computing, 70–1, 190–1, 201–4, 735–6 effects of bond coupon payments, 726–7 deferred income taxes, 726 dividends, 732 equipment disposal, 727 fair value option, 738 inventory valuation, 730 investment in securities, 725–6 lease capitalization, 734 long-term bonds issued, 731–2 prepayments, 728–9 short-term bank borrowing, 731 transactions involving accounts receivable, 729–30 transactions involving derivatives, 738–9 transactions involving longterm bonds, 731–2 undistributed earning of affiliates, 728 illustrated, 186, 201, 211, 783 IFRS on, 189–92 indirect method for computing, 71, 190–2 interpreting, 737–8 interpretive issues involving, 212–3 need for, 183–4 overview of, 184–92 preparation of, 70–1, 193–209, 718–735 pro forma, illustrated, 282 proposed format, 781–2 relationship to balance sheet and income statement, 19 underlying concepts, 717–8 using information on, 210–2 Index See also Comparative statements of cash flow; Consolidated statements of cash flows Statement of changes in shareholders’ equity, 19–20 Statement of comprehensive income, proposed, 784 Statement of earnings, illustrated, See also Income statement Statement of financial position, proposed title for balance sheet, 781 Statement of funds See Statement of cash flows Statement of operations, defined, 146 See also Income statement Statement of profit and loss, defined, 146 Statement of shareholders’ equity, illustrated, 11 Statement of recognized income and expense, 160n Statement of sources and uses of funds See Statement of cash flows Statements of Financial Accounting Standards See FASB Statements of Financial Accounting Standards Statutory, limit on dividends, 672–3 Stock dividends, 674–5 options accounting for, 664–8 effect on statement of cash flows, 732–3 expense, 724 IFRS on, 776–7 U.S GAAP on, 776–7 purchase contract payments, 695–6 purchase rights, 677–8 repurchases, 677–8 rights, accounting for, 668 splits, accounting for, 675–7 treasury, 677–81 warrants, accounting for, 664–5, 668–9, 777 See also Common stock; Preferred stock Stockholders, defined, Stockholders’ equity See Shareholders’ equity Stocks, as account title, 45 Stores See Raw materials inventory Straight-line (time) method of depreciation, 428 Straight-line (use) method of depreciation, 428 Strategies See Goals and strategies Strike price, defined, 664 Subordinated rights, defined, 463 Subsidiaries See Consolidated statements Subsidiary, defined, 623 Sum-of-the-years’-digits method of depreciation, 429 Sun Microsystems, reverse stock split, 676 Supporting schedules in annual reports, 20 Swap contracts See Interest rate swap contracts Systematic risk, defined, 244n T T-accounts defined, 51 illustrated, 53, 66–67, 373 work sheets, 193–209 Tangible assets, defined, 418 See also Long-lived assets Target Corporation disclosure of long-term debt, 476 lease disclosures, 490–1 Tax basis, defined, 536 Tax purposes, defined, 113, 536 Tax reporting of depreciation, 429 Taxable income, defined, 387, 536 Taxes payable, 387 See also Deferred income tax; Income taxes Temporary accounts, defined, 45 Temporary differences defined, 537 illustrated, 537–8 Time-series analysis, 146, 161, 245 935 Time value element (stock options), 665 Timeliness, defined, 765 Tokyo Electric, debt ratios, 462 Total assets turnover ratio, 248, 251, 273 Trade payables, defined, 383 Trade receivables, defined, 315–6 Trading in an asset, 442 Trading securities, defined, 573–4, 775 Transferor, defined, 520 Treasury shares, accounting for, 677–81, 777 Treasury stock, reporting, 696–7 Turnover, defined, 18 U Uncollectible accounts allowance method for, 316–9 defined, 316 IFRS on, 770 U.S GAAP on, 321–2, 770 See also Aging-of-accounts procedure; Allowance method; Direct write-off method; Percentage-ofsales procedure Underlyings, defined, 580 Understandability concept, 765 Unearned revenues See Deferred performance obligations Uniform depreciation pattern See Straight-line depreciation Unrealized gains and losses from changes in fair values, 689–90 from trading securities, 573, 697 Unrecognized assets and liabilities, 125–6 Unsecured borrowing, 463 Use method of depreciation See Straight-line (use) method U.S GAAP See Generally accepted accounting principles (U.S GAAP) V Variable interest entities (VIE), 520, 636–8, 776, 779 primary beneficiaries of, 636–8 936 Index Variable interest rates, 464 Vesting date (stock options), 665 W Wages, salaries and payroll items, as current liability, 385–6 Wal-Mart Stores accounts payable turnover ratio, 268 accounts receivable turnover ratio, 251 and competitors’ financial data, 250 asset turnover ratios, 253 cash flow from operations to current liabilities ratio, illustrated, 267, 270 common-size income statement, illustrated, 162–5, 250 comparative balance sheet, illustrated, 246 comparative income statement, illustrated, 245 comparative statements of cash flows, illustrated, 247 competitive advantage, 242 current ratio, 266 debt ratios, illustrated, 270 disaggregation of ROA, 249 earnings per share, 264 fixed asset turnover ratio, 252 interest coverage ratio, 271 inventory turnover ratio, 252 long-lived assets disclosure, 445 pro forma financial statements, illustrated, 280–2 quick ratio, 266–7 rates of return, illustrated, 258 ROA, calculation of, 248–9, 254–6 ROCE, 258, 263 Segment information, 254–5 self-constructed asset costs, 419–20, 423–5 working capital turnover ratio, illustrated, 267 Walt Disney, investment in ESPN, 615 Warranties as liabilities, 387–8 effect on statement of cash flows, 731 Warrants See Stock warrants Warranty liability, defined, 387 provision, defined, 387 Weighted-average cost flow assumption, 379–81 Weyerhaeuser Company, executory contracts, 518–9 Window dressing, defined, 266 Work-in-process inventory as asset account, 45 defined, 369–71 Work-in-progress inventory, 369 Work sheet See T-accounts work sheet Working capital defined, 365–6 ratio, 365 turnover ratios, 267–8 WPP Group, debt ratios, 462 Write-down of marketable securities, 733 Write-up of investment in securities, 733–4 Writing off accounts, 318 Y Yield to maturity, defined, 464 Differences Between U.S GA AP and IFRS (Exhibit 16.1, p 778–779) Chapter Reporting Topic Revenue recognition 8 9 Inventories and cost of goods sold: lower of cost or market Inventories: cost flow Property, plant, and equipment: revaluations above acquisition cost Research and development cost Property, plant, and equipment: impairment loss Intangible assets with finite lives: impairment loss Intangible assets, other than goodwill, with indefinite lives: impairment loss Goodwill: impairment loss 11 Contingent obligations (U.S GAAP) and Provisions (IFRS) Fair value 10, 12 11 Leases 13 Consolidation of joint ventures Variable interest entities (VIE) or special purpose entities (SPE): consolidation policy Preferred stock redeemable at the option of the preferred shareholders Convertible bonds 13 14 14 U.S GAAP Must have delivered a product or service in return for net assets capable of sufficiently reliable measurement Over 200 documents provide industry-specific and transactionspecific guidance Measurement of market value uses a combination of replacement cost and net realizable values Specific identification, FIFO, weighted-average, and LIFO cost-flow assumptions permitted Not permitted IFRS One general standard and a few documents with industry-specific guidance For long-term contracts, use percentage-of-completion method if amounts are estimable Otherwise, use cost-recovery method Completed contract method not permitted Measurement of market value uses net realizable value Specific identification, FIFO, and weighted-average cost-flow assumptions permitted LIFO not permitted Permitted under certain conditions Recognize as an expense in the period incurred Recognize research costs as an expense in the period incurred Capitalize development costs and amortize them over the expected period of benefit If carrying value exceeds undiscounted cash flows value, Recognize an impairment loss for the excess of carrying recognize an impairment loss equal to the excess of value over recoverable amount Recoverable amount is carrying value over fair value larger of the fair value less cost to sell and the value in use Can subsequently reverse the impairment loss but not above acquisition cost If undiscounted cash flows exceed carrying value, Recognize an impairment loss for the excess of carrying recognize an impairment loss equal to the excess of value over recoverable amount Recoverable amount is carrying value over fair value larger of the fair value less cost to sell and the value in use Can subsequently reverse the impairment loss but not above acquisition cost Recognize an impairment loss for the excess of carrying Recognize an impairment loss for the excess of carrying value over fair value value over recoverable amount Recoverable amount is the larger of the fair value less cost to sell and the value in use Test these assets annually for impairment losses and recoveries of impairment losses Step 1: Compare the carrying value to the fair value of a Step 1: Compare the carrying value to the recoverable reporting unit If the carrying value exceeds the fair value, amount for a cash-generating unit proceed to Step Step 2: Recognize an impairment loss for any excess Step 2: Allocate the fair value of the reporting unit to assets of carrying value over recoverable amount of the cashand liabilities based on their fair values and any excess to generating unit First write down goodwill and then goodwill Recognize an impairment loss on the goodwill if allocate any remaining loss to other assets based on the carrying value exceeds the allocated fair value their relative recoverable amounts Step 3: Test goodwill annually for impairment loss or Step 3: Test goodwill annually for impairment losses whenever a goodwill impairment loss is probable Recognize as liabilities if payment is probable (probability Recognize as liabilities if payment is more likely than usually exceeds 80%) Measure at low end of range if no one not (probability exceeds 50%) Measure at the best estimate is better than any other estimate of the amount to settle the obligation Provides a hierarchy of measurement inputs from market No specific measurement guidance prices of identical items to other observable inputs to unobservable (entity-developed) inputs A lease is a capital lease if it satisfies one of four Judgment required based on several indicators to conditions; otherwise, it is an operating lease identify the entity that enjoys the rewards and bears the risk of leasing Not permitted Firms must use the equity method Firms have option to use proportionate consolidation or the equity method Primary beneficiary consolidates a VIE Firm controlling a SPE consolidates it Classified between liabilities and shareholders’ equity Classified as a liability Allocate issue price entirely to bonds and none to conversion option Allocate issue price between the bonds and the conversion option Summary of Financial Statement Ratios (Exhibit 6.14, p 273) Ratio Numerator Denominator Profit Margin for ROA Ratio (before interest effects) Various Expense Ratios Total Assets Ratio Turnover Net Income ϩ Interest Expense (net of tax effects)a Net Income ϩ Interest Expense (net of tax effects)a Various Expenses Sales Average Total Assets during the Period Sales Accounts Receivable Turnover Ratio Sales Inventory Turnover Ratio Cost of Goods Sold Fixed Asset Turnover Ratio Sales Rate of Return on Common Shareholders’ Equity (ROCE) Profit Margin for ROCE Ratio (after interest expense and preferred dividends) Capital Structure Leverage Ratio Net Income Ϫ Preferred Stock Dividends Net Income Ϫ Preferred Stock Dividends Average Total Assets during the Period Net Income Ϫ Preferred Stock Dividends Profitability Ratios Rate of Return on Assets (ROA) Earnings per Share of Common Stockb Short-Term Liquidity Risk Ratios Current Ratio Quick or Acid Test Ratio Cash Flow from Operations to Current Liabilities Ratio Accounts Payable Turnover Ratio Current Assets Highly Liquid Assets (cash, marketable securities, and accounts receivable)c Cash Flow from Operations Purchasesd Days Accounts Receivable Outstanding 365 days Days Inventories Held Days Accounts Payable Outstanding 365 days 365 days Long-Term Liquidity Ratios Liabilities to Assets Ratio Long-Term Debt Ratio Debt-Equity Ratio Cash Flow from Operations to Total Liabilities Ratio Interest Coverage Ratio Liabilities Long-Term Debt Long-Term Debt Cash Flow from Operations aIf Income before Interest and Income Taxes Sales Average Total Assets during the Period Average Accounts Receivable during the Period Average Inventory during the Period Average Fixed Assets during the Period Average Common Shareholders’ Equity during the Period Sales Average Common Shareholders’ Equity during the Period Weighted Average Number of Common Shares Outstanding Current Liabilities Current Liabilities Average Current Liabilities during the Period Average Accounts Payable during the Period Accounts Receivable Turnover Ratio Inventory Turnover Ratio Accounts Payable Turnover Ratio Assets Assets Shareholders’ Equity Average Total Liabilities during the Period Interest Expense a parent company does not own all of a consolidated subsidiary, the calculation also adds back to net income the noncontrolling interest share of net income See Chapter 13 for discussion of noncontrolling interest bThis calculation is more complicated when there are convertible securities, options, or warrants outstanding cThe calculation could conceivably exclude receivables for some firms and include inventories for others dPurchases ϭ Cost of Goods Sold ϩ Ending Inventories Ϫ Beginning Inventories Simplified Statement of Cash Flows (Exhibit 5.16, p 214) Operations Cash Receipts from Customers Less: Cash Payments to Suppliers, Employees, and Others Cash Flow from Operations [5 (1) (2)] Reconciliation of Net Income to Cash Flow from Operations Net Income Additions to Net Income to Compute Cash Flow from Operations Subtractions from Net Income to Compute Cash Flow from Operations Cash Flow from Operations [5 (3) (4) (5)] (1) 2(2) S1 (3) 1(4) 2(5) S1 Investing Proceeds from Dispositions of “Investing” Assets Cash Used to Acquire “Investing” Assets Cash Flow from Investing [5 (6) (7)] 1(6) 2(7) S2 Financing Cash Provided by Increases in Debt or Capital Stock Cash Used to Reduce Debt or Capital Stock Cash Used for Dividends Cash Flow from Financing [5 (8) (9) (10)] Net Change in Cash [5 S1 S2 S3] Cash, Beginning of the Period Cash, End of the Period [5 (11) S4] 1(8) 2(9) 2(10) S3 (11) S4 S5 Comprehensive Income Disclosure GE does not show the material appearing here shaded blue Adapted from General Electric Company [See Notes] (Dollar amounts in billions) The material shaded blue at the bottom of the column to the left shows the same material as GE gives (below in this column), but here the format is easier to comprehend ONE-STATEMENT APPROACH (Developed from GE’s data) Statement of Comprehensive Income Sales of goods and services Gain on sale of securities Total revenues 2007 $169.7 3.0 172.7 Cost of goods and services sold Other costs and expenses 105.8 40.3 Total costs and expenses EARNINGS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES Income Tax Expense 146.1 26.6 (4.1) EARNINGS FROM CONTINUING OPERATIONS Earnings (loss) from discontinued operations, net of taxes 22.5 (0.3) NET EARNINGS 22.2 GE’s ACTUAL DISCLOSURE (Disguising Both Other and Comprehensive Income) Statement of Changes in Shareowners’ Equity CHANGES IN SHAREOWNERS’ EQUITY Balance at January Investment securities—net Currency translation adjustments—net (23.1) Changes other than transactions with shareowners Investment securities—net Currency translation adjustments—net Cash flow hedges—net Benefit plans—net (1.5) 4.5 (0.5) 2.6 Total changes other than earnings Increases attributable to net earnings 5.1 22.2 Total changes other than transactions with shareowners 27.3 Balance at December 31 Cash flow hedges—net Benefit plans—net OTHER COMPREHENSIVE INCOME COMPREHENSIVE INCOME (1.5) 4.5 (0.5) 2.6 5.1 $111.5 Dividends and other transactions with shareowners Cumulative effect of changes in accounting principles Other Comprehensive Income, Net of Tax: 2007 (0.1) $115.6 Notes: General Electric calls the top part of this statement the Statement of Earnings General Electric shows five lines of revenues, condensed here into two, and eight lines of costs/expenses, here condensed into two General Electric does not show the shaded portions $27.3 Notes: GE calls the top part of this statement the “Statement of Earnings” and shows five lines of revenues, condensed here into two, and eight lines of costs/ expenses here condensed into two GE does not show the blue-shaded material at the bottom of the column above, but uses the format in the right-hand column Notes: See Glossary at Other Comprehensive Income for discussion Normal Title GE’s Title Other Comprehensive Income Total Changes [in Shareholders’ Equity] Other than Earnings Comprehensive Income Total Changes [in Shareholders’ Equity] Other than Transactions with Owners How to use this exhibit for learning: Study the presentation on the left, which shows in a single statement, all components of comprehensive income: earnings and other comprehensive income In December 2008, the SEC expressed a preference for the format on the left, including the portion shaded blue Note that companies may report components of other comprehensive income in a Statement of Changes of Shareholders’ Equity and need not use the title Other Comprehensive Income nor Comprehensive Income in doing so Common Accounting Terms (Glossary, p 835–920) account adjunct account advances from customers advances to suppliers asset capital closing entry contra account conservatism control(ling) account depreciation, amortization equity executory contract expenditure expense goodwill income statement liability make (making) money net assets partially executory contract periodic inventory product cost receipt revenue A device for keeping track of the amount on one line (or part of one line) of a balance sheet An account for accumulating additions to another account Liability title used on receipt of cash for future goods or service Asset title used on paying cash for future goods or service Future benefit that (1) the firm controls and (2) arises from someting other than an executory contract Avoid using this word because it has so many different meanings, such as cash, assets, funding sources, and owners’ equity Journal entry made after preparing income statement to move balances in revenue and expense accounts to Retained Earnings An account for accumulating subtractions from another account Defer income to later periods, showing low cumulative income; show low asset totals An account showing the sum of balances in other, similar accounts An allocation of costs to periods of benefit (and, in manufacturing, subsequently to products) Not a decline in market value A source of assets A claim to assets A mere exchange of promises Outflow of cash Gone (net) asset Effect on Balance Sheet: The decrease in owners’ equity accompanying the decrease in (net) assets caused by the sale of goods, the rendering of services, or the passage of time The excess of purchase price (fair value of consideration given) over the fair market value of identifiable net assets in a purchased acquisition Not the Purpose: To report income Purpose: To tell why income was what it was to allow comparisons across time or across companies (divisions), or both An obligation (1) for a reasonably definite amount, (2) due at a reasonably definite time, (3) arising from something other than an executory contract One of at least seven possible meanings Don’t say this unless you can be precise about your meaning Assets minus liabilities Executory contract in which one or both parties have done something other than merely promise Compute cost of goods sold once per period, at the end as: beginning inventory (from books) plus purchases minus ending inventory (go out into the warehouse; then count and cost it) Contrast with perpetual inventory, where firm tracks cost of goods sold with each withdrawal from inventory A manufacturing cost; debited to work in process, not to expense Inflow of cash Service rendered Effect on balance sheet: The increase in owners’ equity accompanying the increase in (net) assets caused by the selling of goods or the rendering of service Measured by the expected net present value of the cash receipts make money making money Do not use these phrases as they can mean any of the following: Earn income: “Microsoft made a lot of money last year.” Earn other comprehensive income: “I still hold the Microsoft shares I bought in 1990, and I’ve made a lot of money on them.” This is an unrealized holding gain, an increase in wealth, but not an increase in cash Save opportunity costs or opportunity losses: “If I’d only sold those shares in 1999, I’d have made more money I didn’t sell the shares, so I lost money.” This use refers to the lost benefits from not doing something Accounting does not recognize opportunity costs Earn revenues: “He made a lot of money touting cooking devices on TV.” He earned income and received payments, but this use subtracts no costs Earn gross margin Sell for cash Generate cash flow from operations Many companies can have positive income but negative cash flow from operations Some analysts will say such a company made no money in such a year Counterfeit Debit-Credit Rules (Glossary, p 859) Typical Asset Account Opening Balance Increase Decrease Dr Cr Ending Balance Typical Liability Account Opening Balance Decrease Increase Decrease Dr Cr Ending Balance Dr Cr Expenses Revenues Shareholders’ Equity Typical Shareholders’ Equity Account Increase Opening Balance Dr Cr Dr Cr Decrease Increase 2 * Dr Cr Ending Balance *Normal balance before closing * Thank You Want More Books? We hope you learned what you expected to learn from this eBook Find more such useful books on www.PlentyofeBooks.net Learn more and make your parents proud :) Regards www.PlentyofeBooks.net ... Maturities February 2, 20 08 (dollars in millions) Due fiscal 20 0 7 -2 011 Due fiscal 20 1 2- 2 016 Due fiscal 20 1 7 -2 021 Due fiscal 20 2 2- 2 026 Due fiscal 20 2 7 -2 031 Due fiscal 20 3 2- 2 037 Total notes and debentures... Assets 21 0,000,000 = Liabilities 122 4,5 82 + Shareholders’ Equity (Class.) 21 0 ,22 4,5 82 IncSt S RE 10 ,22 4,5 82 10,000,000 22 4,5 82 To record interest expense of $10 ,22 4,5 82 (5 045 $22 7 ,21 2,930),... Accounting Standard 39, Financial Instruments: Recognition and Measurement,” 1999, revised 20 03 1 2Financial Accounting Standards Board, Statement of Financial Accounting Standards No 133, “Accounting